Transparency has its Price

STEVE ZWICK DsseldorfPity the poor Haffa brothers, Florian and Thomas. This time last year they were closing in on the purchase of the late Jim Henson's Muppet empire a deal that brought Kermit the Frog, Miss Piggy and the denizens of Sesame Street into the fold of their company, EM.TV & Merchandising. The two Bavarian businessmen were the toast of Germany's Neuer Markt and big players in the business of entertaining little people. Look at 'em now. Florian is out of his job as EM.TV's chief financial officer, and both men are facing criminal investigation and shareholders lawsuits.

Things like this didn't happen in good old Deutschland AG, where everyone was part of a dense, tangled old-boys' network that didn't let comrades fall. Troubled operations were discreetly set right, without all this messy slicing of corporate necks a bloodbath that of late has cost many high-profile executives their jobs and put a few behind bars. For the Haffas, the road to the courts began in December, when they "adjusted" their projected year 2000 earnings down from $250 million to just $24 million shortly after telling investors that all was well. The already sluggish shares then spiraled into a free fall that bottomed out 97% below last February's high amid allegations that insiders had not only kept their investors in the dark but some had even unloaded shares before coming clean. "A lot of old-style owners think that small shareholders are just there to fork out money and go away," says Mark Tngler, an attorney with the dsw shareholders' union. "Well, the rules have changed."

The once cozy world of German boardrooms began crumbling in 1995 when the country adopted laws on corporate transparency and governance first mandated by the E.U. seven years earlier. Among them was a provision allowing German companies to use American or international accounting practices within Germany, something nearly all of the dax 30 companies have since opted to do. The difference between U.S. and German accounting standards first became obvious when Daimler-Benz listed on the New York Stock Exchange in 1993. The result of that historic event was two thoroughly different balance sheets: under American rules, Daimler-Benz lost nearly $579 million in the first half of 1993, while under German rules, which allow a company to keep "hidden reserves," it turned a $102 million profit. Although the transparency of U.S. accounting rules may not paint a flattering picture, it paints a picture investors like to think they can trust. When the Deutsche Brse launched its Neuer Markt, it required either American or international accounting practices.

But transparency goes beyond accounting. Insider trading, once considered a management perk in Germany, is no longer part of the game. Not warning investors of foreseeable bumps in the road is also verboten. "It seems clear that a lot of Neuer Markt guys were only publishing good news, which is a violation of the ad hoc disclosure rules," says Marco Becht, co-author of a forthcoming book The Control of Corporate Europe. "In the U.S., the [Securities and Exchange Commission] has always been pretty ruthless with companies that didn't come clean, and it will be interesting to see what happens here."

Federal Securities Supervisory Office investigations have led to 14 criminal convictions (two of which carried prison terms) for insider trading since the law took effect in 1995. But many of the cases are covered by private, not criminal law. (Among them are revelations that Thomas Haffa sold $18 million worth of shares within six months of EM.TV's November 1999 capital increase. Shareholder advocates say that violates Deutsche Brse's "lock up" rules, but Haffa says he received clearance and violated no government regulations.) Reliance on private law means shareholders and exchanges become de facto regulators. "There's a role for this mechanism, but you wonder if a stronger hand might not help," says Carmen Weber, a fund manager with Metzler Investment in Frankfurt.

Jack Guynn, president and CEO of the U.S. Federal Reserve Bank's Atlanta branch, likes to cite a 30-year-old paper by economist George Akerlof called 'The Market for 'Lemons': Quality Uncertainty and the Market Mechanism'. In the U.S., a "lemon" is a car that doesn't work. Says Guynn: "Professor Akerlof demonstrated that when buyers have no way to distinguish between products when they are forced to assume the worst the market price tends to be the [lower] lemon price, and good sellers eventually leave the market."

Increasingly, small investors who find themselves holding a lemon like EM.TV don't just get mad they sue. "You can't sue just because your share price drops," Becht says. "But if you can prove that management misled you, then that's something else." Becht believes a secondary battle could erupt in Europe between the growing ranks of small shareholders and the old-guard, large-block shareholders who dominate industry in many cases old families that haven't come to terms with their shared ownership status. "When the Quandt family, which is BMW's major block holder, didn't like what the CEO was doing, they fired him," says Becht. "The large-block holders usually know what they need to know, and they act on it. The question is, are they acting on behalf of the public as well, or are they just another group of insiders?"

For its part, the Deutsche Brse is tightening Neuer Markt rules on reporting and insider trading. As of this month, quarterly reports are to be standardized but, critics are quick to point out, not audited. In March, managers will have to file a report when they sell shares in their companies. "I think the Deutsche Brse's own wording about these new rules reveals a lot," Weber says. "They talk about bringing the Neuer Markt up to international standards, which raises the question of why these standards weren't there to begin with."

Deutsche Brse's website, neuermarkt.com, will soon be upgraded to offer access to both the exchange's database and that of U.S. information provider Multex. Retail investors will be able to call up free analysts' reports and compare companies in the same industry worldwide. And both Deutsche Brse and the Berlin Stock Exchange are building Internet-friendly order entry systems that will let retail customers watch how their orders get filled. But all of these snazzy devices are just gimmicks if investors don't trust the underlying information. After all, a candy-coated lemon is still a lemon.