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Stories of people making fortunes from the securities market have enticed many others into risky investments. Congress created the Securities & Exchange Commission (SEC) to protect investors. Many corporation managers became greedy and made self-serving decisions that created the principle-agent problems. The solutions for these problems lead to more unethical behavior from management. The creative use of financial statements even tricked analysts and brokers. Public trust began to erode with unethical corporation behavior. Analyst's suspicions of some corporations cooking the books were confirmed with an announcement from WorldCom. The public's distrust started to mount while accusing brokers of hyping stocks. People began to invest without brokers' advice. With numerous risks rising for individual investors, Congress passed the Sarbanes-Oxley Act and the SEC responded by passing the Reg AC act.
Ordinary Investors Enter the Market:
Golden opportunities lie ahead for those who invest well in stock market securities. "The stock market, which was once the province of the very rich, is now easily accessible to millions of ordinary investors." (Ethical Issues in Financial Services). Ordinary investors have flooded stock market securities with money in hopes of striking it rich. Many people were told by investment brokers the stock market securities are safer than it used to be. They were informed the Security and Exchange Commission (SEC), and the National Association of Securities Dealers (NASD) are the watchdog for the small investor.
Congress Acts to Protect Investors:
Congress created the SEC shortly after the 1929 stock market crash in order to protect investors. Their goal was to restore investor confidence and faith in the financial sector, which was notorious for fraudulent activities, easy credit, and hazardous investments. (Investopedia). The NASD is the largest self-regulatory organization (SRO) in the securities industry in the United States. An SRO is a membership-based organization that creates and enforces rules for members based on the federal securities laws. SROs, which are overseen by the SEC, are the front line in regulating broker-dealers. (Investopedia). In addition to federal regulations most states have created blue-sky laws to protect investors from fraudulent security offerings. (Finance). Even with these safe guards many companies have participated in fraudulent financial activities such as off-balance-sheet reporting and fooled many brokers and analysts.
Shareholders and Corporation Management Conflicts:
In the mid to late 1990s many shareholders of corporations were discovering management and executives were making self-serving decisions. Dishonest managers were increasing their expanses with corporate owned vacations villas, high salaries and excessive perks for themselves.
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The Incentive Lead to Unexpected Side Effects:
The solution of aligning interests between management and shareholders lead to unexpected side effects. Several managers started to hide corporate costs, overstating revenues, and engaging in deceptive transactions in order to exaggerate profits and boost the stock prices. (Finance). As the stock price soars under these perceived profits the managers would sell off their stock options and make fortunes. These managers used their financial statements to fool brokers and analysts as well as the public.
The Publics Trust is Eroded:
People placed their trust and money with investment brokers and analyst recommendations. Many brokers and analysts claimed that Enron, WorldCom, and others were financially sound and stable. Brokers and analysts promoted these companies as good investments with nominal risks. When analysts became suspicious of the accounting practices of several companies, they began to use cash-flow statements in addition to the other financial statements. The reasoning for this was because they were losing faith in corporations accrual-accounting based income numbers. Even with these suspicions they failed to inform the public of their concerns.
The Suspicions of Analysts Confirmed:
In 2002 WorldCom, Inc. disclosed that it had improperly capitalized expenses: It moved $3.8 billion of cash outflows from the "Cash from operating activities" section of the cash flow statement to the "Investing activities" section, thereby greatly enhancing cash provided by operating activities." This type of accounting fraud boosts profits and hides net losses. Other firms such as Enron, Global Crossing, Tyco, and Xerox were accused of incorrect accounting practices and had to restate past year's financials; some executives were fined while others were sent to jail. (Finance). "After Enron, many companies were forced by increased investor criticism and regulator scrutiny to improve the clarity of their financial disclosures. IBM announced that it would begin providing more detail regarding its "Other gains and losses." It had previously included these items in its selling, general, and administrative expenses, with little disclosure." (Financial Accounting: Tools for Business Decision Making, 3rd Edition).
Public Distrust Mounted:
Some stock analysts and brokers were accused of "hyping" stocks to attract lucrative investment fees. This caused many people to become distrustful of the brokers and analysts because of these unethical issues. These people felt that the brokers, analysts, and the SEC were suppose to be finding illegal financial practices with companies not hype them up. With mounting tensions, people began to feel that brokers were taking advantage them with their high fees and mediocre advice.
People Begin Investing Without Broker Advice:
A growing number of people began taking financial matters into their own hands through the Internet. The Internet provides millions of potential investors with information on company's financial statements, and investment tips. On-line discount brokers such as Sharebuilder, Scottrade, Ameritrade, and many others provide easy investment options with low commission fees. They allow a person to make his or her own decisions on which investments he or she wants with or without advice or recommendations. Even though the risks may be greater for the small investor, they can purchase their desired investment for as little as $4 per trade.
The Risks are Numerous:
"Securities markets are full of pitfalls for individual investors. Examples of fraud and regulatory violations in the markets are common." (The Individual Investor in Securities Markets: An Ethical Analysis). Many investors have lost their entire fortunes due to these pitfalls. The risks are numerous. Even once considered safe investments such as bonds no longer provide security. "Even the bond markets, which in the past at least gave the outside appearance of stability, are increasing turmoil. For instance, the SEC is now investigating the possibility that securities firms dumped billions of dollars of risky municipal bonds on individual investors because they were unable to sell them to institutions." (The Individual Investor in Securities Markets: An Ethical Analysis). In the wake of such unscrupulous activities, it is questioned if the SEC is actually protecting the investor.
Response from Congress and the SEC:
The Sarbanes-Oxley Act was passed in 2002 by Congress in response to corporate accounting and ethical scandals. This act created a Public Company Accounting Oversight Board, eliminated conflicts of interests between accounting firms and corporations, and enhanced corporate and analysts responsibilities. The SEC responded by passing the Reg AC in February 2003 that requires analysts to "certify the truthfulness of the views they express in research reports and public appearances, and disclose whether they have received any compensation related to the specific recommendations or views expressed in those reports and appearances." (Investopedia). The idea behind the new regulations is to increase trust in the financial system and greater accounting transparency to help shareholder wealth. I believe both the Congress and SEC are acting in the best interest of the investors and are creating safeguards that are helping the economy as a whole.