Once again, Washington is tripping over itself to fix a problem whose real solution lies elsewhere. This time, it's the corporate accounting scandal, with congressmen racing breathlessly to the microphones to announce the latest and toughest proposal to punish financial misbehavior. We just saw, for example, a bill extending jail terms sweep unanimously through the Senate so fast that few possibly could have understood its real import. Yes, there are some legislative and regulatory changes that can improve our financial disclosure system, and let's enact them. But it is the capital markets that wield the real sword of justice.

Crushing Shares

Indeed, they already are solving this deplorable accounting mess by imposing the swiftest and most effective discipline of all. Around the world, markets are crushing the shares and bonds of companies whose numbers are suspicious. In turn, senior executives are dropping like flies as their boards revolt over the collapse of these securities. Fifty times more CEOs will be axed this way than through any Securities and Exchange Commission investigation or new legislation.

Just look at Tyco, Bristol-Myers Squibb and Merck. These are companies whose reported historical results have been good. But the equity markets developed suspicions about the reliability of those numbers. Their shares fell sharply, with Tyco and Bristol-Myers down over 50% during the past six months alone. That forced these companies to restate their financials to present a more accurate record of performance. Tyco's CEO is long gone; Bristol-Myers's leader is on thin ice; and Merck just cancelled a $5 billion subsidiary financing.

The markets have ridden to the rescue this way before. Typically, the market pendulum overshoots sharply on both the upside and the downside. Yes, this means that phony managerial and financial behavior often is tolerated by shareholders and creditors longer than logic would suggest. This is an inherent weakness of our system. But investors eventually reject such behavior with a vengeance. Then, justice is served because the securities are pulverized and the managements are ousted.

This occurred, for example, during the conglomerate boom 30 years ago. Then, companies like LTV Corp., Avco and Gulf & Western were all the rage, using indecipherable accounting schemes to temporarily inflate their shares. These companies went on unprecedented acquisition binges. They bought completely unrelated businesses, arguing that strong management could make them all perform. Investors and lenders loved them for a while, but they eventually woke up to the accounting games and the falsity of the reported results. It didn't take long for the companies and their managements to turn to dust.

Today, the real scandal is not that scores of corporate officers have committed outright fraud, like the apparent misdeeds at Enron or WorldCom. Nor is it that armies of accountants have conspired with those officers in fraudulent schemes. Yes, some are guilty of that, and they will be prosecuted and convicted, as they should be.

But the biggest abuse involves legal but misleading financial and accounting practices. A long list of companies have become financial contortionists, twisting themselves into ever more complex knots to report better operating performance and financial conditions than really exist. All to make managements look good and enhance the value of executives' options and shares.

Most have played these games while conforming with generally accepted accounting principles. They haven't broken any laws on the books today, or any likely new laws. This is because complying with GAAP is an art, not a science. The "P" in GAAP refers to "principles," not mathematical equations. As with any other principles, in business as in life, there are countless ways to follow them.

Many legal but misleading financial practices have worked temporarily, not because our laws or regulations were totally deficient, but because investors ignored them during exuberant market periods. At those times, they don't bring a skeptical eye to corporate announcements and don't read the fine print in corporate financial statements. In other words, there are times when managements get rewarded for inflating results.

The need now is to discourage such legal but misleading financial behavior. And that is precisely what the market is doing. In the past two weeks alone, more than $1.41 trillion in value has been expunged from U.S. stocks. Painful as it may be, the capital markets are better at disciplining corporate America than the U.S. legal and regulatory system. Nevertheless, there are certain new laws and regulations that are timely and make sense.

Worthy Proposals

On the criminal side, corporate accounting fraud is a serious crime, and should be punished accordingly. The SEC proposal to require CEOs and CFOs to attest to the accuracy of corporate financial statements under oath is a good one. Further proposals that merit support include requiring a majority of truly outside directors on any public board, requiring that audit committees consist only of outside directors and requiring the expensing of stock options. But none of these changes will truly root out financial misrepresentation. Most of it will not only remain legal but will conform to GAAP. At any rate, boards of directors can only act upon the information that management gives them.

It is only the capital markets that, albeit on a delayed basis, can ultimately change corporate financial misbehavior. Today, managements live and die with their stock prices. When markets periodically turn against misleading accounting, as they always do, those prices crash and those officers are history. And it is a very long time before their companies play financial games again.

Mr. Altman, chairman of Evercore Partners, was deputy Treasury secretary in the Clinton administration.

This article was originally published in the Wall Street Journal on July 23, 2002.