Swamped by a wave of deceit

By ANNA ADAMS*

Worldcom, Enron, Andersen, Tyco - the American corporate scandals dancing across the business sections of the world's newspapers sound like a nursery rhyme. But investors across the globe are hoping that they don't have to face too many more verses.

If the scandals were just plain corporate fraud, they might not. But unfortunately Wall St's series of accounting debacles has uncovered problems much bigger than a few high-flying chief executives' malfeasance.

Fundamental flaws in the United States' capital-raising and corporate governance systems have been revealed, and fixing these will require major reform.

So what exactly happened? It started with the takeover wars and the economic neo-liberalism of the 1980s, which dramatically changed the incentives that drive big American corporations and produced a wave of financial market deregulation. These helped to stimulate the exuberant technology-powered boom of the 1990s.

The boom was in many ways a good thing. But it had a number of seriously flawed features and, like financial time-bombs, these eventually undermined the functioning of a transparent, rational and efficient securities market.

One major shortcoming of the boom was the serious conflicts of interest that developed in the critical Wall St auditing and securities research sectors. The Andersen-Enron scandal is just the worst example of this.

But professional auditors and analysts did not find themselves in a bind by accident. The boom produced an obsessive fixation on share price and company earnings that drove executives to many dubious management practices. The decade's explosive growth in stock options and executive pay had unexpectedly supplied them with all the wrong motivations, and in this climate boardroom greediness ran rampant.

And while these time-bombs were ticking, the Government was unfortunately as intoxicated with the economic champagne as the public. Keeping the increasingly sophisticated securities market tethered to fundamental accounting principles seemed like drudgery when the Nasdaq was soaring, free-market fundamentalism reigned and everybody was in the money.

Perhaps the best-known feature of the Enron scandal is the grave conflict of interest that Enron's auditors, Andersen, developed.

Public auditors and accountants such as Andersen are charged with ensuring that the information available to the market on publicly traded companies is complete, accurate and fair. They are the watchdogs that keep the public companies honest.

Not so Andersen. The Enron bankruptcy revealed just how seriously Andersen failed in its duties. Andersen looked the other way and certified Enron's accounts, despite their extraordinary use of off-the-balance-sheet partnerships and a host of other ruses to conceal a mountain of debt and generate near-fictitious earnings.

Andersen has now been criminally convicted for its actions and had its US auditor's licence retracted. Which leads to the question: why did it do it?

The answer lies in the accounting firm's consulting business. In the 1980s and 1990s, Andersen and all of the big accounting firms aggressively marketed themselves as business consultants to their audit clients. The business flowed in and soon consulting was a lot more lucrative than auditing.

A company can fire its auditor if the auditor refuses to certify its accounts. When that same company also sends millions of dollars in consulting business to the auditing firm (as Enron did to Andersen), such a firing can be devastating.

So, progressively, the auditors were tamed. By the late 1990s, auditors in accounting firms were intensely afraid of endangering their consulting partners' lucrative client relationships.

In this environment, how could the auditors subject their clients' accounts to all necessary scrutiny? They couldn't. They had a patent conflict of interest, producing a major defect in market information. Andersen has been the worst example in a succession of accounting fiascos involving many of the big auditing firms.

The same kind of conflict plagued the securities analysts in investment banks. An investigation by the New York Attorney-General revealed numerous emails written by Merrill Lynch analysts that privately ridiculed as "junk" the same stocks that they were praising to the public with strong "buy" recommendations. Presumably the pressure from the bankers down the hall got too much.

What was the Government doing about these developing conflicts? At one point the Securities and Exchange Commission tried to get the accounting firms to separate their auditing and consulting branches. Intense lobbying by the firms put a stop to that. The commission was threatened with a budget cut and eventually surrendered.

Of course, the pressure experienced by the auditors and analysts did not occur in a vacuum. Behind it all were chief executives and chief financial officers consumed by their company's stockmarket performance.

The takeover wars of the mid-1980s had produced new demands on management to deliver "value" to shareholders or risk being fired. This in itself was not a bad thing. The problems arose when the market reflexively latched on to earnings per share as the overriding measure of company value.

By the time the bull market took off in the early 1990s, only two things mattered: a company's share price and its upcoming quarterly announcement, which had to beat its prior earnings forecast or face a thrashing of the stock. The market developed what has since been called "irrational exuberance": the only way a stock could go was up, and the only reports a company could make were good.

The darlings of Wall St, such as Cisco and General Electric, focused relentlessly on creating records of continuous earnings growth and stock price escalation. Other long-term predictors of corporate health, such as returns on invested capital, profit margins and cash flow, were disregarded.

So how were the corporate titans achieving these miraculous earnings feats? Unfortunately, by fancy accounting - most of it legal, some of it not, and almost all of it highly misleading to investors.

Companies made strings of high-risk acquisitions, funded by their own overpriced stock and heavy borrowing, solely to pull the acquired companies' earnings on to their balance sheets. They would play with their reserves, anticipate credit, forget supplier dues and slash their margins dangerously low, all to pump up their earnings.

Most of this was, in fact, permissible under US accounting rules at the time. Or at least it was not illegal. And the Government, itself caught up in the euphoria and intensively lobbied by the corporations, was not inclined to keep track of all the latest accounting tricks. The lone critic seemed to be legendary investor Warren Buffett, and he was deemed a little old-fashioned.

As it turns out, Buffett was right. When the bubble burst last year, many of Wall St's star stocks plummeted. Their spectacular earnings growth turned out to be ephemeral, based more on creative accounting than real corporate strength.

And as the recession advanced, it became apparent that celebrated companies such as Enron and WorldCom had been committing accounting fraud. The costs of this have run into the billions.

The question that naturally springs to mind is: why did chief executives, who are usually responsible, experienced business people, go along with the accounting gimmicks? The answer is fairly simple: executive stock options.

The proliferation of stock options was another consequence of the mid-1980s' focus on shareholder value. The idea was that management was more likely to promote shareholder value if the managers' interests were aligned with those of the shareholders.

Thus, the notion of "pay for executive performance" developed. If the company stock price rose, the executive was granted options to buy the stock, usually at very cheap prices. The executive could then make a substantial profit by selling the stock on the market.

It was a great idea in theory, but it got out of control very quickly. Business Week has calculated the average chief executive of a major US corporation made 42 times the average hourly worker's pay in 1980, 85 times in 1990 and 411 times in 2001.

This escalation produced staggering salaries. Last year's top earner was Larry Ellison, of Oracle Corporation. His pay totalled US$706 million ($1.5 billion). Kenneth Lay, the former chief executive of Enron, made more than US$100 million ($213.4 million) in stock sales in the year before Enron went bankrupt.

With every upward tick of the company stock producing such immediate gains, it is not surprising that corporate managers lost their heads.

The Government was not exactly on guard. Loosened accounting rules meant that by the mid-1990s stock options were effectively a licence to print money, not counting as an expense.

But when the slide started last year, investors and employees lost their shirts. Unlike managers' deals, employee stock options usually restricted when the shares could be sold, so employees went down with the stock.

If there is a lesson in it all, it is that governments, directors, and shareholders can no more let their guard down in a boom than in a bust.

When everyone is making such fantastic sums, the temptation is simply to catch the wave. But the problem with ignoring basic principles of corporate governance and accounting, or the need to properly regulate securities markets, is that eventually the principles come back to haunt the players.

* Anna Adams, a New Zealand solicitor, practises litigation in New York.