Social and ethical investment after Enron and 9/11


The world's stock markets have taken a battering from both the 9/11 terrorist attacks and the revelations of large-scale accounting fraud in major corporations (Enron, WorldCom etc.) This article aims to look at the impact of these on both ethical investment and the social economy.


Before 9/11 and before Enron, many stock market analysts expressed concern that shares listed on stock markets, particularly in the US, were over-valued. It was therefore no surprise that both these events caused a drop in the market. Even after the recent market falls, these same concerns remain. How did this come about, and what are the implications for ethical investment and the social economy?


On the surface, shares became over-valued because their prices were determined by speculation on future values. That is, instead of buying shares at the price at which they could expect, say, a 5% return on their money from dividends, people started buying shares which paid little or no dividend because they expected the share price to rise. This was particularly the case for stocks, where even loss-making companies became very popular.


Conventional corporations lost employees to higher-paying businesses and in some cases even became takeover targets. Unfortunately, some responded by "financial engineering": accounting tricks designed to improve their apparent profitability and boost their own share prices. Similar tricks were used by some businesses too.


When the bubble burst, the "financial engineering" continued. While some of the "financial engineering" was perfectly legal (though perhaps misleading), in a few cases it amounted to outright fraud. Enron, then WorldCom, and then many other corporations came under suspicion of fraud. Once the suspicions start, share prices quickly fall, ultimately damaging the market as a whole.


In this process, 9/11 actually played a less significant role than fraud. After all, 9/11 meant an increase in sales for the arms industry and the security industry, even though it was clearly bad for the airline industry. Fraud, on the other hand, is bad news for nearly all business sectors.


The biggest contribution of 9/11 was the damage to consumer confidence, to which the central banks responded by lowering interest rates. Cheaper credit makes it more attractive for consumers to borrow and reduces borrowing costs for businesses, while lower interest rates means there is less incentive to leave money in the bank. The central banks' move would have been just what the market ordered, if it were not for accounting fraud..


The accounting fraud scandal threw a spanner in the works. After all, even the low return on savings in the bank is better than outright losses on the stock market. What is more, people won't borrow if their jobs are under threat, and businesses can't borrow if they are under suspicion of accounting fraud. Further interest rate cuts, leading to the lowest interest rates for decades, failed to help.


Meanwhile, analysts continue to warn that markets are over-valued. At first sight, it seems crazy that any new money should be flowing into stock markets under these conditions. Nevertheless, a steady stream of money keeps coming in to the market via pension scheme contributions. The amount of money coming in is not related to market profitability at all - once someone starts a pension plan, they generally keep paying in each month until they retire. This money must find a home somewhere, even if it ends up propping up over-valued shares.


Ironically, the law largely prevents this money from being invested in one profitable area largely unaffected by accounting fraud: unlisted businesses. Businesses not listed on the stock market have little incentive to exaggerate their profits; without outside investors to please, all this would do is increase their tax bill. If they do need extra investment, they generally cannot get this directly from pension schemes or mutual funds because of legal restrictions on what these funds can do with their money.


Venture capital firms may be interested in helping them, but often only if they plan to expand enormously and float the business on the stock market. Venture capital relies on the stock market for its profitability. One venture capitalist said that of six businesses they invest in, three are likely to go bust, two will be "plodders" (businesses that make regular profits but fail to expand) and one will boom, increasing its value more than enough to cover the three bankruptcies. This value would be realized either by floating the booming business on the stock market or selling it to a larger corporation. A stock market collapse puts both of these options into doubt, so venture capital offers no easy route out of the current crisis.


Ethical investment


What does offer a route out of the crisis? One possibility worth considering is ethical investment. After all, faced with the clearly unethical practices of accounting fraud, many people will be interested in ethical alternatives.


Here we must distinguish between the two types of ethical investment criteria: negative (screening) and positive (pro-active) criteria. Negative screening excludes companies involved in "unethical" activities such as producing tobacco or destroying the environment. However, accounting standards were up to now not generally included in most funds' ethical criteria. What is more, some of the industries usually excluded, such as the arms trade, are likely to benefit from post-9/11 arms sales, whereas industries that have suffered, such as airlines, were less likely to be excluded. The net result is that funds based on purely negative screening are likely to share in the market malaise.


Funds using positive screening, on the other hand, might well out-perform the market in the current climate. After all, the ethical stance of companies selected under positive criteria means that they are far less likely to engage in accounting fraud. Some alternatives such as wind energy may even benefit, since terrorists are far more likely to target a nuclear power plant than a wind turbine. Now is therefore a good time to promote positive screening in ethical investment.


Nevertheless, the poor performance of the stock market as a whole is likely to discourage all investors. Indeed, ethical investors may be particularly concerned about current events and therefore discouraged from investing. Even positive screening, therefore, provides no quick solution.


Social investment


The situation is different again with social investment. This is where money is invested primarily to achieve social aims and only secondarily, if at all, for financial returns. Social investment funds, together with social banks such as Triodos Bank, invest mostly in small businesses or non-profit organizations, and very few of these are listed on a stock market. The stock market crisis has little effect on them. Also, the ethical stance of the projects means that, just as with positively screened ethical investment, accounting fraud is much less likely.


Because of the secondary role of financial returns, social investment funds and social banks traditionally offered lower rates of return, or even zero returns. Nevertheless, falling interest rates mean that the rates offered by social investments may not seem so low any more. Indeed, even zero returns are better than the recent losses on the stock market. Ironically, in the current financial climate it is even possible that the small but nevertheless positive returns of social investment could attract conventional investors out for financial gain!


In any case, the current crisis provides an opportunity to extend the circle of social investors. For example, it is a good time to try to persuade institutions already involved in positively-screened ethical investment to branch out into social investment. After all, the crisis could mean more demand than ever for investment in social projects providing a working alternative, particularly if large-scale job losses occur.