As the corporate scandals of the last year unfolded, I thought back upon a metaphor offered some years ago by a theology professor at the University of Notre Dame. He suggested that “the most serious sin is not shaking your fist at God, but rather walking to the edge of the cliff and waiting for the wind to blow.”
Looking at this metaphor literally, you can see how it applies to Arthur Andersen.
Consider the deception and circularity involved in just one of the Enron special-purpose entity transactions that Andersen endorsed: LJM, created by Enron chief financial officer Andrew Fastow, set up an adjunct, Swap Sub, to hedge Enron’s investment in one of its volatile companies, Rhythms NetConnections, a dot-com phenom.
Rhythms had been acquired by Enron for $1.85 a share, went public at $21, and rose to $69 its first day of trading. Enron realized hundreds of millions of dollars of income as Rhythms rose in value; were it to drop in value, Enron would also realize millions of dollars of losses. Eventually, it was worthless.
Swap Sub was set up to hedge the value of this volatile investment so that a drop in value would be offset by a rise in the value of the hedge, supposedly avoiding a big “hit” on Enron’s earnings. But Swap Sub was funded with Enron stock. The value of Enron was a function of the value of its assets.
Supposedly, the value of Enron’s assets was “protected” by the hedge, but the hedge was supported only by the value of the Enron stock, not the obligation of a solvent third party. This circularity lacked economic substance. Its only purpose was to hide the drop in value of Enron’s assets. Yet Andersen went along with it.
Metaphors often have subtler meanings as well.
As I look back at Enron, WorldCom, Tyco and Martha Stewart, it seems to me the real insight of the metaphor above is that the greatest evil is so clouding your mind that eventually you are not aware what you are doing is wrong.
This is a process, not an instantaneous occurrence.
You can’t just label Fastow as evil, nor can you say that of Richard Causey, the former chief accounting officer of Enron, Mark Belnick, the former general counsel of Tyco, and Martha Stewart, of ImClone and media fame.
How did they get in their current fixes?
Expectations created
Let’s look at some of the social, economic and legal developments that helped make these corporate scandals possible. First, a bubble stock market is very seductive. Investors begin to expect a 20 percent annual return, and executives believe that it is their skill and leadership that is responsible for such wealth creation.
Expectations and entitlements are created. Steady and robust growth become the norm. The stock of Walgreen is “punished” because the firm misses earnings targets by a penny a share.
In reality, myriad factors, some of them artificial, were responsible for the rise in stock prices. Moreover, all businesses are more or less volatile. A model embodying steady, uniform and predictable earnings is an illusion.
In addition to the illusion that all was well and that the Dow would go to 40,000, there were some as-yet-unappreciated legal developments that contributed to managers and professionals being able to cloud their minds to the path they were walking.
In 1994, the U.S. Supreme Court, in the Central Bank of Denver case, eliminated aiding-and-abetting liability for accountants and lawyers, among others. The current court is supposedly conservative, favoring judicial restraint. But the validity of the doctrine of aiding and abetting initially was not even before the court. Rather, the court, on its own motion, instructed the parties to brief the issue of whether aiding-and-abetting liability existed at all–even though all the federal Courts of Appeal had recognized the doctrine for decades.
This decision created a “what, me worry?” mentality among lawyers and accountants. This is not to say that accountants consciously said to themselves, “Now it is OK to cheat.” But it resulted in a relaxation of vigilance and a disposition to be more responsive to the demands on management. And management certainly had a motivation to keep earnings high to justify both their reputation and compensation.
Managing earnings became a game that led to more and more “aggressive” accounting treatment until finally the edge was crossed.
A year later, another legal development helped aggressive-minded managers sleep more easily.
The centerpiece of Newt Gingrich’s “Contract With America” was the Private Securities Litigation Reform Act of 1995. One of the more significant provisions was that fraud needed to be pleaded with particularity. The act also required that a plaintiff do this without an opportunity for discovery. This is almost impossible without a mole or whistleblower. But a California court, in Silicon Graphics, held that even a detailed pleading was insufficient if the identity of the whistleblower was not disclosed.
Fortunately, other jurisdictions have not endorsed this requirement to disclose the identity of a whistleblower. Moreover, the new Sarbanes-Oxley Reform Act includes explicit protections for whistleblowers. Otherwise, management would have an almost perfect insulation from liability since no employee in his or her right mind would make disclosure and run the risk of being blackballed from employment for the rest of the person’s life. Without specific information about who knew what and when, a lawsuit predicated upon misleading financial disclosure cannot get past the pleading stage.
The stock market bubble also intertwined with executive compensation and stock options to lead to insider trading. The conventional wisdom is that stock options align the interests of management and shareholders. Unfortunately, there is one fundamental difference: Those who own stock may realize not only the upside potential but also bear the downside risk; management, holding stock options, may realize the gain through exercise of their options but without having their own funds at risk.
Typically, executives borrowed funds from the company to exercise the options and then sold the shares to pay the money back. Enron, WorldCom and Global Crossing demonstrate the ability of management, who can exercise options and then sell, to bail out with millions of dollars and leave public shareholders holding the bag when the truth comes out.
Manipulating prices
The stock market bubble created a tremendous incentive to manipulate the price of stock upward and then get out before the true earnings are disclosed. When executives think they are entitled to the inflated value of their company’s stock, it is hard to watch that value erode.
And millions of dollars were at stake because boards of directors handed out options to executives as though the options were free. And, in a sense, they were–since they need not be expensed by the company.
The Martha Stewart situation involves an interesting twist on “sin.”
Most of us remember that, when we were younger, our parents always cautioned us to tell the truth; otherwise, we would be caught in our own fabrications. It now looks as though a stockbroker called Stewart to tell her to sell her stock. Depending upon the specifics of what she was told, she might not even have had civil liability. She probably would not have had criminal liability.
But, if she fabricated her story about having a pre-existing order to sell, her greater risk is obstruction of justice rather than insider trading liability.
But Stewart is not the only one who may have engaged in fabrications. The whole world of special-purpose entities–from a disclosure standpoint–is a fabrication. The literature on special-purpose entities extols the virtue of “making the balance sheet look better.”
But isn’t this deception?
A company pays lawyers, accountants and investment bankers hundreds of thousands of dollars in transaction costs to make the balance sheet look better. Banks, financial institutions and analysts on behalf of the public likewise spend thousands of dollars to try to ferret out the true picture of the company. The latter either succeed or they don’t.
If they succeed in uncovering the true picture of the company, untold thousands of dollars in transaction costs have been wasted. But if financial institutions and the public can’t figure out what the company really looks like, isn’t that fraud?
Why don’t we just tell the truth?
