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As debacles go, this was extraordinarily thorough: At just the moment when investors need to regain confidence in America's capital markets and in the financial statements of U.S. companies, the chairman of the Securities and Exchange Commission resigns, then the SEC's chief accountant resigns, and then the chairman of the new accounting oversight board resigns, all in one week. At precisely the time when these institutions need the strongest leadership available, they instead have no leadership at all. It doesn't get much worse.
To get a clear idea of just how much is at stake, consider a couple of stories told by former New York City mayor Rudolph Giuliani and former GE chairman Jack Welch at the recent FORTUNE Global Forum in Wahington, D.C. Speaking to a couple of hundred CEOs in a hotel ballroom, and to tens of thousands of TV viewers around the world, Welch described his passion for giving employees frequent, rigorous, honest evaluations - letting them know in blunt language exactly what they do well, what they need to do better, and where they stand in the organization.
I'm a big believer in frequent, honest evaluations, but I've found that whenever I talk about this topic in speeches, someone from the audience will almost always come up afterwards and say, "That sounds great, but I work in government - so I can't fire underperformers."
That doesn't matter, Giuliani said -- and he described how he had used a system highly similar to Welch's to reduce crime dramatically in New York. The approach was to measure, precisely and daily, crime in each police precinct in the city. Then, on a rolling schedule, the police officials in charge of each precinct attended meetings at police headquarters where the crime statistics from their precinct were displayed for all the top brass and other precinct chiefs to see.
When the system was introduced, some precinct chiefs could barely stand the pressure. They'd never been evaluated -- and held accountable for their performance -- like this before. One even showed up for his session drunk. More significantly, over time this system showed everyone who the stars were and who the chronic poor performers were. When people got promoted, it was clear why. And at the other end of the spectrum, the poor performers tended to leave on their own. They could see they weren't cutting it, and everyone else could see it too. Life wasn't fun, and they realized they'd be better off doing something else. So even though laws and union rules made firing them almost impossible, it wasn't usually necessary.
The lesson that came through quite clearly was that making performance data public is powerful. When everyone can see who's doing well and who isn't, a lot of problems tend to take care of themselves.
That's exactly the philosophy behind U.S. securities regulation. The Securities and Exchange Act is mainly a huge rulebook about disclosure. Even in the middle of the Great Depression, with memories of the '29 crash still painful, Congress realized it would be foolish for government to specify how companies should be run. So it passed a law that specifies in excruciating detail exactly what companies must report. The reasoning was just the same as the logic behind Giuliani's approach to managing the NYPD: Let everyone know the truth about performance, and rational people will take it from there.
The problem is that while adding up car thefts and murders is pretty straightforward, reporting the financial results of publicly traded companies has become an exercise in judgment-rendering, hair-splitting, rule-bending, and number-fudging. You could say it was ever thus -- we've all heard the joke about asking an accountant how much two plus two is, and he replies, "How much do you want it to be?" -- but the problem is much worse than before. The rules have become so complicated, and the expertise of accountants and lawyers has become so advanced, that the financial statements of many companies are truly incomprehensible to anyone outside the company -- that is, to the audience for whom they're intended. Ultimately, that's why Congress established the new accounting oversight board.
So now we see what's really at stake in the SEC debacle. Our whole system of capital markets, by far the world's largest, is based on public disclosure of performance. To mean anything, that disclosure must be based on accounting rules and practices that have integrity. Our accounting rules and practices lost that needed integrity, which is why the oversight board became necessary. For the board to function, it needs a chairman, which it now lacks. The chairman must be named and approved by the SEC, which is now, after chairman Harvey Pitt's departure, divided equally between Republicans and Democrats. Result: perfect gridlock.
No, our economic system won't collapse this week because these leadership positions are empty. But we're talking about rebuilding the foundations of our capital markets. This is big stuff. That's why the White House needs to fill these positions with great people, and do it right now.
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