Hot Deals, Looting, and Cover-ups: Understanding Corporate Fraud [Part 2] [Pt 1 ~ 3]

Even if zealous prosecution of corporate predators is unlikely, we can, at least, try to understand these recent phenomena so that we may better protect ourselves in the future.  One important development, already crucial in the S & L scandal, is the advent of deregulation.  Swooning from the passion of former President Ronald Reagan’s love affair with free enterprise, Congress cut down a multitude of laws that held financial institutions in check.  In the case of the Savings and Loans banks, this meant fewer and fewer limits on banks’ lending decisions, while the Federal Deposit Insurance Corporation stood ready as always to protect the banks’ customers’ bank accounts.  The result was a volatile combination.   Riskier and riskier loans backed up by the U.S. Government and, behind it, the taxpayer.  Needless to say, many bank execs simply could not resist. [xiii]  The current scandal is also a product of galloping deregulation.  Writes Gary Weiss in Business Week,

Congress must share the blame for Enron because it chipped away at investor protections.  The Private Securities Litigation Reform Act of 1995 “set the stage for all that went wrong at Enron.  They removed the ‘aider and abettor’ rules, so the accountants and lawyers could give advice without liability,” says John Lawrence Allen, a New York securities lawyer. [xiv]

The scams perpetrated by executives and companies during 2002 are a diverse collection. Some, like those of which Adelphia Communications stands accused, appear to involve relatively straightforward looting by the founding family, which allegedly used the company as its personal bank to enrich itself. Others, like Enron’s, involve complicated financial transactions to inflate earnings, and thus stock prices, artificially. Martha Stewart is alleged to have benefited from insider information that allowed her to sell shares at a high price before stock prices fell dramatically on bad news. Some of these incidents are run-of-the-mill white-collar crime, with a few reflecting the increasingly casino-like economy of big finance.  As the Washington Post reported, “Former SEC [Securities and Exchange Commission] chairman Richard Breeden warned Congress about financial fraud in early 1993; and in 1998, Arthur Levitt, who chaired the commission until last year, cited a culture of corporate gamesmanship.” [xv]

A summary of the most serious examples of alleged (and sometimes admitted) corporate wrongdoing is provided in Table 1: Scoundrel Capitalism, 2002.  Because of the large amount of such wrongdoing, the table focuses on the most harmful incidents and highlights the multiple dimensions of corporate misbehavior. The status of the cases reflects developments through early October 2002; interested readers can consult the web-based version of this paper for updated information. At the moment, charges have been filed in some, but by no means all, of the troubled companies and, frequently, it is underlings in the organization who are the targets of indictments. As discussed below, massive frauds require widespread cooperation, but the indictments have been highly selective. It remains to be seen whether this narrow and selective prosecution is part of a strategy to get information to build cases against others—especially top executives—or whether the charges are meant only to give the appearance of getting tough while top executives get off unscathed. 

Some of the current scandals involving grossly overstated corporate earnings have their origin in reforms that were meant to correct the earlier anomaly of corporate executives drawing enormous salaries while their corporations were doing poorly. Making stock options a larger part of executive compensation, it was assumed, would give management strong motivation to run the company well, thus increasing stock prices and making their stock options more valuable. Instead, executives engaged in various questionable forms of manipulation to hide corporate losses or debts so that their shares would be artificially high (that is, higher than they would have been had the true state of the corporation’s balance sheet been known to investors)—at least until they cashed in, leaving others holding large amounts of stock whose value crashed when the companies had to restate their earnings.  As with the S & Ls, so the recent scenarios involve “collective endeavors in which top management ran their own institutions into the ground for personal gain”—an extraction of wealth at the expense of numerous others. [xvi]

Enron, for example, allegedly used insiders and a network of friends to create so-called “independent” firms that would enter into multi-year contracts to swap a service and give the appearance of transactions. Enron would then book the total “revenue” of the multi-year contract as income for that year while writing down the expense over many years of the contract; such firms could also be used to mask expenses or bad investments, thus reducing apparent debts and making the financial picture look rosier. Much of Enron’s “revenue” came from loans (on which banks took healthy origination fees), which it then put into various partnerships (on which partners took fees) that then returned some of the money to Enron. Chief Financial Officer Andrew Fastow and former Director of Global Finance Michael Kopper, along with friends and partners, made more than $50 million in one series of “hot deals.” [xvii]  Rather than blowing the whistle on these transactions, some of their colleagues were heard to say, “Next time Fastow is going to run a racket, I want to be part of it.” [xviii]  Enron executives unloaded nearly a billion dollars worth of stock—while employees were locked out of selling the holdings in their pensions during part of the period in which the company’s stock fell from $80 a share to $0.30. Enron investors collectively lost about $60 billion. [xix] [see: The Collapse of Enron: A Bibliography of Online Legal, Government and Legislative Resources]

Other companies engaged in various “hollow swaps” or "wash trading" that involve two companies agreeing to swap essentially the same good or service for the purpose of booking revenue and showing activity rather than filling a substantive business need.  In one of many examples of these practices,

Qwest was buying non-operating network circuits from Enron that it didn't need. Enron had agreed to buy telecommunications services from Qwest over a 25-year period at a time when its own telecom operations were collapsing. Andersen was the accountant for both companies. On the day the quarter closed, the companies finally made their deal, exchanging checks for $112 million as initial payment. [xx]

Such swaps help boost (apparent) earnings, although not all of them involve the degree of sophistication and amount of money characteristic of Enron.  The SEC is investigating such practices at CMS Energy, Duke Energy, Dynergy, El Paso, Reliant Energy, Qwest Communications and telecommunications company Global Crossing. The CEO of Qwest unloaded $1.57 billion in stock over the years when its price was high, some at $47 a share, far more than the September 2002 trading price of about $1 a share. The CEO of Global Crossing sold $734 million in shares before the company was forced to revise downwardly its previously-inflated earning report, causing its price to fall. A host of other companies “restated” earnings that had been inflated through a variety of means, with WorldCom having misstated more than $7 billion in earnings, and Xerox having misstated $1.4 billion.  The SEC charged Adelphia with fraudulently excluding $2.3 billion in debt from its earnings report. AES, AOL-Time Warner, Cedent, Haliburton, K-Mart, Lucent Technologies, MicroStrategy, Rite Aid, and Waste Management are all said to have misstated revenues in different ways at more than $100 million in each case.

We also have been treated to a new wave of “insider trading,” where people with access to significant nonpublic information use it to enrich themselves by making well-timed stock purchases or sales. Martha Stewart, for example, sold 4,000 shares of biotech company ImClone the day before the Food and Drug Administration rejected a cancer drug developed by the company. Stewart is under investigation for insider trading, obstruction of justice and possible false statements, while her friend, ImClone CEO Sam Waksal, has been arrested for tipping off family members about the impending FDA decision. Questions about insider trading also plague President Bush from his days as a director of Harkin Energy. Bush sold a substantial number of shares just days before the company released an especially poor earnings report and he apparently failed to file some required SEC reports afterwards. An investigation by the SEC during the presidency of the elder George Bush found no wrongdoing in the case of the younger Bush.

Large-scale financial trickery requires the cooperation of numerous people, including some who cover up the wrongdoing of others. The notable example here is accounting firm Arthur Andersen, which improperly shredded documents related to its dealings with Enron.  Andersen is the first major accounting firm to be convicted of felony obstruction of justice. Arthur Andersen also raised investigators’ eyebrows by serving as auditors for Enron while taking in millions of dollars from consulting deals with the company. This dual role of auditor and consultant created an obvious conflict of interest.  Andersen auditors would surely be reluctant to bite the hand that was feeding them by letting the market know the real extent of Enron’s losses and indebtedness.  Andersen is, of course, quite experienced at this sort of thing, having audited such other corporate suspects as Global Crossing, Halliburton Oil, Qwest, Waste Management and WorldCom, and before that, Charles Keating's Lincoln Savings and Loan, “which became a symbol of the nation's savings-and-loan crisis when it failed in 1989 at an eventual cost to taxpayers of $2.9 billion.” [xxi]

Further, financial service firms like J.P Morgan Chase and Citigroup appear to have loaned money to corporations and helped them to hide their level of indebtedness from investors who lack an inside track. Fortune approvingly quoted a Wall Street Journal editorial that called the banks “Enron Enablers” and went further: “They appear to have behaved in a guileful way and helped their corporate clients undertake unsavory practices. And they appear to have had an entire division that, among other things, helped corporations avoid taxes and manipulate their balance sheets through something called structured finance, which is a huge profit center for each bank.” [xxii]  In addition, brokerage firms came under fire because their high-profile analysts enthusiastically endorsed stocks publicly that they were disparaging privately (in emails), all because their firms derived underwriting fees or other business from the troubled companies. [xxiii]  Salomon Smith Barney telecoms analyst Jack Grubman admitted that “The bank supported ‘pigs’ [i.e., stocks in poorly performing firms] in supposedly objective research notes to ensure that [those firms] granted Salomon investment banking business.”  And Merrill Lynch internet analyst Henry Blodgett described some stocks as a “piece of shit” while recommending them to small investors. [xxiv] 

In the mad scramble for billions in banking fees, analysts spoke out of both sides of their mouths. Publicly, they ladled praise on wispy companies with no earnings, calling them "strong buys," even "screaming buys." Privately, according to the e-mails, they mocked firms as "pigs" and "dogs" and worse. "On Wall Street, Stock Doublespeak: Public, Private Talk at Odds, Papers Show" Washington Post, April 30, 2003; Page E01 

When called before Congress, Enron executives took the Fifth, so committee members filled in the quiet time with speeches full of moral condemnation. As more and more companies were forced to revise previously inaccurate earning statements, the stock market fell dramatically and President Bush addressed the nation in an unsuccessful effort to slow the decline. Bush, our first President with an MBA, noted that widespread stock ownership creates a moral responsibility for the executives to run an honest company. He indicated that the problem was one of a few bad apples and called for a new ethic of corporate responsibility: “In the long run,” said the President, “there's no capitalism without conscience; there is no wealth without character.” [xxv]  In laying out a reform agenda, Bush declared that executives should forfeit compensation gained by deception.

NOTES

[xiii] L. William Seidman, former chair of the Resolution Trust Company, which managed S & L banks’ assets during the bailout, commented: “We provided them with such perverse incentives that if I were asked how to defend the S & L gang in court, I’d use the defense of entrapment” (Calavita et al., Big Money Crime, p. 15).

[xiv] Weiss, “Congress Will Huff and Puff and . . . Do Little,” p. 116.

[xv] Lynn Turner, “Just a Few Rotten Apples? Better Audit Those Books,” Washington Post (July 14, 2002), p. B1.  Enron is a good example, according to the Washington Post series, which quoted one executive as saying: "The culture at Enron is all about 'me first, I want to get paid.' I used to tell people if they don't know why people are acting a certain way, go look up their compensation deal and then you'll know. There were always people wanting to do deals that didn't make sense in order to get a bonus." Peter Behr and April Witt, Visionary's Dream Led to Risky Business, Washington Post July 28, 2002; Page A01

[xvi] Calavita, Kitty, Henry Pontell and Robert Tillman, Big Money Crime: Fraud and Politics in the Savings and Loan Crisis (Berkeley: University of California Press, 1997). p. 171; see also Gimein, “You Bought. They Sold,” passim.

[xvii] Carrie Johnson, “Ex-Enron Executive Pleads Guilty,” Washington Post (August 21, 2002), available http://www.washingtonpost.com/wp-dyn/articles/A44232-2002Aug21.html

[xviii] Peter Behr and April Witt, “Visionary’s Dreams Led to Risky Business,” Washington Post (July 28, 2002), p. A1.

[xix] Allan Sloan, “Free Lessons on Corporate Hubris, Courtesy of Enron.” Washington Post (December 4, 2001), p. E3; see also Gimein, “You Bought. They Sold,” passim.

[xx] Peter Behr and April Witt, Concerns Grow Amid Conflicts” Washington Post (July 30, 2002), p. A1.

[xxi] David Hilzenrath, “Two Failures With a Familiar Ring: Arthur Andersen Audited Foundation, S&L That Collapsed” Washington Post (December 6, 2001), p. A21.

[xxii] Julie Creswell, “Banks on the Hot Seat,” Fortune (September 2, 2002), p. 80.

[xxiii] In one recent case, the National Association of Securities Dealers fined the Salomon Smith Barney Unit of Citigroup $5 million for “materially misleading research reports” on Winstar Communications. Analysts kept a $50 target price and a “buy” rating on the company until the price of a share hit $0.14. An article for TheStreet.com notes Salomon made $24 million in fees from Winstar, and Citigroup CEO Sandy Weill made $70 million a year for the last three years, plus has holdings in Citigroup worth about $960 million. “Meanwhile, the NASD trumpets that this settlement is the third largest in NASD’s history. Well, if we were the NASD and we wanted to strike fear in the hearts of brokerage firms, we would keep that little statistic a secret.” George Mannes, “The Five Dumbest Things on Wall Street This Week” (9/27/2002), http://www.thestreet.com/markets/dumbest/10044586.html.

[xxiv]  David Teather, “The Whores or Wall Street,” Guardian (October 2, 2002), available at http://www.guardian.co.uk/usa/story/0,12271,802926,00.html.

[xxv] The text of the speech is available through the White House Corporate Responsibility portal, http://www.whitehouse.gov/infocus/corporateresponsibility/.

[xxvi] Anitha Reddy, “$100 Million More for SEC Not Enough, Ex-Officials Say,” Washington Post (July 10, 2002), p. E1.

[xxvii] Stephen Pearlstein, “Measures Not Likely to End Abuses,” Washington Post (July 10, 2002), p. A1.

[xxviii] The particulars of the legislations and some of its limitations is from Citizen Works, http://citizenworks.org/enron/accountinglaw.php.

[xxix] Jonathan Weisman, “Some See Cracks In Reform Law,” Washington Post (August 7, 2002), p E1.

[xxx] Calavita, Kitty, Henry Pontell and Robert Tillman, Big Money Crime: Fraud and Politics in the Savings and Loan Crisis (Berkeley: University of California Press, 1997). p. 3.

[xxxi] Steven Pearlstein, Washington Post (September 25, 2002), p. A3.