Why the SEC should not be all lawyered up

Here is a quick quiz that will test your qualifications to fill either of the two current openings on the Securities and Exchange Commission:

Which of the following is most important to investors in deciding whether to buy or sell the securities of a public company?

A) Knowing that the chief executive and chief financial officer have promised that the company’s financial statements are complete and accurate.

B) Knowing that the chairman of the in-house audit committee is a “financial expert.”

C) Knowing how much of the company’s net income is the result of changes in the company’s accounting estimates and how much is due to the company’s cash flow?

If you selected A or B, you are obviously not a professional investor, and therefore you are not yet disqualified as the next nominee to be an SEC commissioner. If you are a professional investor, say, a portfolio manager or research analyst, forget it — you don’t have a chance.

All three of the remaining SEC members are securities lawyers, as were the two departed commissioners. Approximately 75% of the Clinton and Bush nominees for the commission have been securities lawyers. Not one institutional investor has been nominated by the last two administrations to be an SEC commissioner.

Now, some of my best friends are securities lawyers, and I’ll bet some of your best friends are securities lawyers. But let’s look at the big picture. Who is better equipped by training and experience to protect the best interests of investors: securities lawyers or institutional investors? Which group makes a living by choosing which stocks or bonds to buy and which not to buy? Which group better understands what information is needed in order to make an intelligent investment decision? Which group better understands the serious flaws and shortcomings in today’s financial statements, which satisfy generally accepted accounting principles, according to the certified public accountants, yet mislead investors?

As professional users of public-company disclosures, institutional investors have both the analytical skills and the experience to help align the SEC’s priorities with those of investors, as opposed to crafting patchwork responses to the scandal(s) of the day.

The composition of the SEC should look like a sound investment portfolio: diversified. Several institutional investors, an economist, a business school professor and a securities lawyer would represent a healthy mix of disciplines and bruises. But four or five securities lawyers — what does that get us?

It gets us an abdication by the SEC of its fundamental responsibility for fair and comprehensible financial disclosures by public companies. The SEC’s attorney commissioners have delegated accounting rulemaking to the CPAs at the Financial Accounting Standards Board in Norwalk, Conn.

The result has been an increasingly incomprehensible maze of accounting estimates and guesstimates (also known as GAAP). With each new FASB ruling, the percentage of investors (and CEOs and directors) who really understand what’s going on beneath the GAAP facade shrinks. GAAP financial statements are so misleading that Wall Street firms have invested in proprietary software in an attempt to strip out the accrual estimates required by GAAP to determine a company’s free cash flow. The SEC and the standards board have together created an unlevel playing field for the vast majority of individual investors, who lack access to de-GAAPing software.

Including several institutional investors in a diversified panel of SEC commissioners will not result in investor nirvana. But a balanced SEC will allocate limited resources less to secondary issues and more to the primary needs of investors: understandable and transparent information disseminated on a level playing field. Absent such information, the SEC can appear busy by rearranging the board chairs on the USS Public Company until the next megascandal explodes, but where does that leave investors?

George C. Christy is the author of “Free Cash Flow: A Two-Hour Primer for Management and the Board” (Booklocker.com, 2006) and is a principal with Oakdale Advisors, a consulting firm in Pasadena, Calif.

Related Topics: Securities and Exchange Commission