CHAPTER 4

War and Post–World War II Business and Corruption

World War II business was about the war effort and avoiding war profiteering. Senator Harry Truman led a special senate committee on the national defense program (Truman Committee), propelling him to the vice presidency and the White House. As with all wars, war profiteering was, in fact, rampant. It was estimated that Truman Committee findings saved the country $10–15 billion, when a billion dollars was real money. After the war, with Europe and Asia in ruins, the United States was the economic colossus with half the world’s production.

The “American model” of manufacturing perfected at General Motors had the management and accounting techniques to emulate. In many ways economic conditions were near-perfect, with high economic growth supported by strong exports, low unemployment, low inflation, educational opportunities, and a rising middle class. Lows included frequent recessions, issues with racism, women’s rights, pollution, and unsustainable political promises. For a variety of reasons, imports would start outstripping exports. Deficiencies in the American model appeared, including inflation as an increasing problem. Investment banking was relatively small with limited power after World War II, but began to flex its growing muscles in the post-war period. So-called financial innovations over the next quarter century included hostile takeovers, leveraged buyouts, junk bonds, and increasing use of derivatives and structured finance.

Fraud did not disappear, but was held in check, usually big fraud at small companies or small fraud at big companies. Over the post–World War II period, the magnitude of fraud and other illicit acts continued to grow, because of increasing opportunities, rising power by banks, and the “innovations” that would be taken to extremes for mergers, market manipulation, and global bribery. The Securities Acts became less effective as banking and industrial power increased and the Securities and Exchange Commission (SEC) budget fell. The argument: regulation stifles innovation; however, innovation can mean great economic advances or greater opportunities to manipulate and cheat the system.

Business in War and Peace

The attack on Pearl Harbor in late 1941 brought war to an unprepared country. Military setbacks continued well into 1942. It took some time for industry to move from a consumer focus to war footing. Factories produced prodigious amounts of war materials, requiring massive spending, high taxes, and gigantic borrowing. One of the lasting policy innovations was income tax withholding in 1943. Workers paid taxes through withholding from each paycheck, producing higher taxes and fewer complaints over the previous annual lump-sum payment. Big government and high taxes continued after the war.

Connections between the military and business have been around at least since the Revolution, with inflated prices, bribery, extortion, and influence peddling common place. Union contracts were extremely valuable during the Civil War, where spending reached billions of dollars. Abraham Lincoln called the profiteers “worse than traitors.” During World War I the government created the War Industrial Board to acquire munitions efficiently and reduce fraud and waste. Du Pont, originally a gun powder manufacturer, was a major beneficiary of government contracts. Du Pont became a major, diversified predominately chemical company funded by the massive profits from World War I contracts—Du Pont charged much higher rates to European allies than to the American military, apparently an acceptable form of war profiteering.

Franklin Roosevelt railed about the profiteering of “war millionaires” during World War II. The Senate Special Committee to Investigate the National Defense Program, chaired by Harry S. Truman, held hearings and investigated war plants across the country. The focus was on inefficiency, waste, and war profiteering. Truman started at Fort Leonard Wood in his home state of Missouri, where construction was reputed to be wasteful and overpriced; military contractors seemed unaccountable, producing poor quality products at inflated prices. In addition to hearings and personal inspections by committee staff, the committee relied on whistleblowers. The Truman Committee saved the country billions and monitored defective output. An excess-profits tax was raised to 90% in an attempt to eliminate abuses.

President Dwight D. Eisenhower in his 1961 farewell address stated: “In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military- industrial complex.” Retired military often work for defense contractors, a reciprocal relationship not necessarily in the best interests of public policy. The basic concept can be extended to all forms of reciprocal relationships between business and government involving spending, special interest influence, and other forms of legal corruption. Public policy issues are complex, dynamic, and subject to abuse. Part of the analysis of business corruption is the abuse of the political process.

With much of Europe and Asia destroyed, the end of World War II brought economic dominance to the United States, with pundits describing it as the American Century. General Motors was the model for efficient big industrial business, commanding half of the domestic automobile market; American producers controlled 99% of the domestic American auto market and exported cars overseas. The chief executive officer (CEO) of GM, Charles (“Engine Charlie”) Wilson, stated: “What was good for the country was good for General Motors, and vice versa.” America continued to dominate, but foreign countries became increasingly competitive. Rising imports and trade deficits, recessions, labor problems, government budget deficits, and inflation became increasingly problematic. By the 1970s and 1980s, General Motors was no longer the model for industrial efficiency or high-quality products.

Conglomerates became the bustling new business model in the second half of the 20th century, thanks in part to accounting gimmicks. The era had its share of corporate fraud and bribery, especially of foreign officials.

Banking became a dynamic money machine beginning in the 1980s, powered by math wizards (quants) generating “financial innovations” using high-risk bets and lots of borrowed money. A gigantic insider trading, junk bond, and savings and loan conspiracy centered on junk bond king Michael Milken in the 1980s. Additional scandals occurred throughout the 1990s, as the tech boom led to fabulous new products and a euphoric investing public.

Merger Accounting and Manipulation

A merger combines two companies into one corporate entity, a common practice since the Civil War as corporations eliminated “excessive competition” and attempted to create monopoly power. These were horizontal mergers involving direct competitors. Vertical mergers were those in related industries. Andrew Carnegie’s steel company, for example, acquired iron ore, coal, and transportation companies to ensure continued supply of basic materials and to lower costs. This strategy of acquiring business components from raw materials to transportation and distribution became a common business approach for big business—and part of a long process of the development of professional management. The third category was conglomerate mergers, the acquisition of a completely unrelated business. General Electric is an example of a 19th-century corporation becoming a successful global conglomerate, with operations from aircraft engines to finance (and, before discontinuing these operations, light bulbs and National Broadcasting Company).

Cleverly Rigged Accounting Ploys (CRAP)

Two theories of acquisition accounting developed and were standardized in the 1960s by the Accounting Principles Board. The first was pooling of interests, which presumed the combining of “equal” companies using historical cost. The resulting company would record the assets and liabilities of the two companies based on existing book values without regard to current values. Depreciated property, plant, and equipment could have a relatively low book value and be a fraction of current (replacement) cost. Patents and other intangible assets stayed unrecorded.Inventory could be manipulated down, for example, due to perceived obsolete inventory or expected bad debts. In total, the result could be a low asset base and lower future operating expenses. The second theory, the purchase method, assumed that one company (the parent) acquired another (the subsidiary) and the accounting comes closer to economic reality. Using actual acquisition price (based on a cash or stock purchase) resulted in assets and liability restated to “fair value” (usually upward, sometimes by a lot), including the value of patents and other intangible assets. Of course, fair value is determined by “professional judgment.” The difference between the acquisition price and restated fair value of net assets (the “premium paid”) resulted in goodwill, something of a plug figure, for this difference.

Abe Brillof, Distinguished Professor Emeritus at Baruch College, used the term CRAP to describe “dirty pooling.” His point was acquisition accounting could be used to generate manipulated profits using accounting practices allowable at the time. Acquisition assets could be recorded at historic cost or some measure of fair value based on “judgment.” Assets that would be sold quickly could be recorded at a low value to generate a substantial gain on sale. Depreciable assets could be recorded at a high value to minimize taxes. Using dirty pooling some assets could be valued based on pooling while others were based on the purchase method. Accounting standards on acquisitions changed to eliminate the most blatant abuse, although acquiring firms still have considerable flexibility in valuations—now based exclusively on the purchase method.

Conglomerates

One long-time business strategy is the acquisition of diverse companies and this became a speculative obsession in the 1950s. The managers claimed that the industry was irrelevant when competent management was introduced: a “highly efficient” parent could turn around a floundering subsidiary by cutting unnecessary costs and improving operating efficiency. The other argument was diversity—with subsidiaries in many industries the conglomerate could thrive even during recession. Major conglomerates of the time such as Textron or Ling-Temco-Vaught (LTV) achieved big premiums (high price/earnings ratios), making stock acquisitions of low premium subsidiaries seemingly a bargain. The “great management” argument was oversold, but the key strategy for profitability was acquisition accounting, using dirty pooling and other forms of CRAP. (Note that continued growth, and merger manipulation could work for any acquisitive firms, not just conglomerates.)

This scheme worked for decades. Continued low-priced acquisitions fueled growth—the company was bigger, with more revenues and income, whether well run or not. Accounting gimmicks could make up for any management shortcomings. James Ling started with an electrical contract business and then went on a buying binge in the 1950s: L.M. Electronics in 1956, Temco Aircraft and Chance Vaught Aerospace, forming LTV. LTV became an industrial giant. According to Geisst¹ the Ling’s strategy was “Buy them, incorporate their earnings, and then sell part of them off to a hungry investing public and use the proceeds to buy something else.” Ling relied on credit to finance his empire. When profits dropped in the late 1960s, Ling was fired. LTV survived only by selling off subsidiaries and avoided bankruptcy until 2000.

International Telephone and Telegraph (ITT) also started in the 1950s. Founder Harold Geneen acquired some 350 companies. An antitrust investigation discovered that ITT overstated earnings by 70% using merger manipulations and the Justice Department brought suit. Political payoffs by Geneen were used to stay in business, including $400,000 to the reelection campaign of Richard Nixon and a $1 million payment to the Central Intelligence Agency to protect ITT’s interests in Chile. Conglomerates Litton and Gulf + Western used political payoffs to promote defense contracts.

The success could not last. With operating problems in difficult industries, recessions, inflation, dollar devaluations overseas, and big debt payments, profits cratered. As the price premiums declined and leverage became too high, further acquisitions were no longer possible. Leaders were fired and conglomerates were no longer fashionable. The last major conglomerate scandal was Tyco in the early 21st century. On the other hand, conglomerates can work. General Electric continues to be a successful conglomerate, as do reorganized firms Textron and ITT.

Hostile Takeovers, Leveraged Buyouts (LBOs), Junk Bonds, and the Destruction of an Industry

Merger strategies took additional ugly turns during the last quarter of the 20th century. More acquisitions were hostile takeovers, which meant acquiring the companies without the permission of the board of directors. Insiders and well-financed outsiders took over companies using LBOs, borrowing to finance the takeover. Much of this debt was in the form of junk bonds (risky, noninvestment grade bonds). Michael Milken created a junk bond empire at investment bank Drexel Burnham, using underhanded methods that including insider trading, deceptively investing in accounts of family members and confederates for personal gain, manipulating junk bond prices, and enticing the newly deregulated savings and loans (S&Ls) to invest in his high-risk offerings. If all of these are considered simultaneously, this could be considered the largest business scandal in American history.

Hostile Takeovers

Big business and investment banking divisions specializing in mergers and acquisitions look to find corporate targets based on bargain prices, market share benefits, specialized expertise, or other potentially positive factors. Almost always, the potential buyer sends out feelers to the CEO and board of directors of the target firm. The board of the target can accept the offer or ask for a higher price—part of the “friendly takeover” process. If friendly, the buyer usually can access the records of the target for a thorough due diligence review. The target has other alternatives: reject the offer out of hand or seek another buyer, a “white knight.”

Generally, “until the 1970s, it was considered scandalous for one company to buy another company without the target agreeing to be bought. … Then came the 1970s. The old aversion to lawsuits fell by the wayside. It became easier to borrow money. Federal regulations were relaxed. Investors became more aggressive, and the result was a boom in the number and size of corporate takeovers.”² The first hostile takeover was the American firm Reynolds Metals attempting to acquire British Aluminum in the late 1950s, successful although British Aluminum fought the takeover and sought a white knight. During the 1960s, Northwest Industrial was stopped by potential target B.F. Goodrich, when Goodrich convinced the state of Ohio to block the merger.

The bidder going into hostile takeover mode uses expensive law firms and investment banks that specialize in hostile strategies. Alternative one is a proxy fight, seeking enough stockholders to replace current board members with bidder-friendly alternatives. The bidder can accumulate at least half the outstanding shares in a tender offer (the winner was determined in the “snake pit,” the counting room where inspectors could be influenced by competing lawyers). In a “creeping tender,” the bidder can buy target shares to accumulate enough shares to change the board. The bidder can use the media to accuse the target of incompetent management and operating blunders, while claiming to “rescue stockholders” with a large price premium—perhaps 25%–50% above the market price.

New York law firm Skadden, Arps became a hostile takeover specialist, initially hired by investment bank Morgan Stanley. Morgan Stanley’s first takeover attempt involved International Nickel’s (Inco) 1974 raid on Philadelphia battery maker Electric Storage Battery (ESB). ESB fought back, assisted by Goldman Sachs, finding a white knight in United Aircraft (now United Technologies). After a nasty bidding war, Inco won but at a cost of $41 a share—the original offer was $27. After Morgan, several other banks pushed hostile takeovers, while Goldman and others specialized in hostile takeover defenses.

The 1970s produced economic conditions favorable to the acquirers, with high inflation and a long-term bear market with stock prices down substantially. It became more inexpensive to acquire a rival or complementary firm than starting from scratch and expanding internally. With mergers left and right, virtually all corporations except the giants felt threatened. Competent companies with less debt, substantial liquidity, and steady earnings were prime targets. The solution seemed to be to become less compelling: increase debt, reduce cash, and insert poison pills (provisions to make the company less attractive such as a huge payment to management in case of a hostile takeover). All in all, this did not make American business attractive or more productive.

The Reagan presidency of the 1980s proved business friendly, antitrust became almost a nonissue, and mergers increased. Junk bonds became more available, the number of acquisitions, hostile and friendly, increased as did the size of the targets. Blue chip companies got into the action. Du Pont acquired Conoco in 1981for the astronomical (at the time) price of $7.8 billion after a bidding war with three other firms and almost double the original market value of Conoco. Michael Milken’s empire reached its peak and helped facilitate both hostile takeovers and leveraged buyouts. Private equity companies, often using hostile takeovers, got bigger and more powerful at this time.³

Leveraged Buyouts

The high-risk LBO became a speculator’s and would-be-billionaire’s dream. The target would be bought on borrowed money, usually using high-cost junk bonds with the target’s assets serving as collateral. A ruthless entrepreneur could get in, sell off pieces of the acquisition, reorganize operations to cut costs (with massive layoffs and reduced salaries and benefits being a significant strategy), and use manipulative merger accounting to show increasing profitability. The acquisition by McLean Industries of Pan-Atlantic Shipping in the mid-1950s is usually given credit as the first LBO, with $42 million borrowed of the $49 million price tag (86%).

Milken created a vast high-priced junk bond market, by then populated with private equity firms created to specialize in takeovers. Various players were called venture capitalists (usually investing in startups) and vulture capitalists (usually taking over firms close to failure) and exhibited a wide range of ethical standards. Success meant billions in profits; failure meant bankruptcy for the target and possibly the private equity fund. Equity firms (and major junk bond users), such as Kohlberg, Kravis, and Roberts (KKR), T. Boone Pickens, Victor Posner, and James Goldsmith, became major LBO players. KKR bought RJR Nabisco in 1989 for $31 billion after a bidding war increased the share price from $75 to $109, the largest LBO of the time. Milken’s empire and the junk bond market would collapse at the end of the 1980s, but both LBO and junk bonds would be resurrected and even more common in the 1990s and 21st century. Twenty-first century LBOs included Toys “R” Us, Metro- Goldwyn-Mayer, Chrysler, Hertz, and Hospital Corporation of America.

Michael Milken’s Junk Bond Empire

Bond ratings have been around since financial analyst John Moody used letter grades to assess credit risk beginning in 1909. Moody’s ratings start at Aaa for the highest quality bonds, down to C for really risky bonds. Those between Baa and Aaa were considered “investment grade,” satisfactory for conservative investing. Below Baa were the speculative bonds, affectionately known as junk bonds. To better appeal to investors, these were called “high income” bonds. Early on, virtually all bonds seeking a bond rating achieved an investment grade rating; without it, the bonds could not be easily issued through investment banks—better to stay unrated that be called speculative. Junk bonds were mainly “fallen angels,” those initially rated investment grade but fallen on hard times and downgraded. Milken would change that.

Milken started as a bond researcher and trader at the firm that became Drexel, Burnham and Lambert, at a time when investment banks traded almost exclusively with investment grade bonds. Milken was familiar with research showing that a diversified portfolio of junk bonds provided a higher total risk-adjusted return than investment grade bonds. He started a junk bond trading group at Drexel in the 1970s set up in Southern California. S&Ls became major investors when the industry was deregulated in the early 1980s. With little competition, Milken dominated this growing market, especially setting prices. This was basically an unregulated market with little public information. Milken controlled junk bond prices to maintain huge spreads and massive profits for Drexel and himself.

A significant new market was the creation of primary junk bond issues, starting with a $30 million Texas Instruments issue in the 1970s. Milken’s customer base bought the TI bonds and other new issues followed. Default rates stayed low, thanks to Milken. When companies had difficulty making interest and principal payments, the bonds were restructured and new issues floated. His empire was a perfect fit for the hostile takeover/LBO markets of the time. Private equity traders became Milken clients, using junk bonds to go after much of American business: Boone Pickens went after Unocal, Victor Posner got Sharon Steel in a hostile takeover, and James Goldsmith went after Crown Zellerbach. KKR’s takeover of Beatrice Foods, Storer Communications, and RJR Nabisco were financed in part through Milken’s junk bonds.

Although he had a gigantic compensation package at Drexel, he set up private agreements and partnerships to further enrich himself, family, and friends using insider information—violating both Drexel policy and the law. Arbitrageur Ivan Boesky was a Milken co-conspirator, using information supplied by Milken and various investment bankers. Boesky, for example, would make big bets following Milken’s orders and the two would later split the profits. According to Stewart,⁴ “Milken and Boesky were deeply intertwined in what was a sweeping criminal conspiracy. Taken together, the ventures were practically a catalogue of securities crimes, starting with insider trading, and including false public disclosures, tax fraud, and market manipulation, as well as a slew of more technical crimes. … The crimes were mere way stations toward outcomes, such as hostile takeovers, that were, on their face, perfectly legal.”

At the end of the 1980s, with the S&L industry in shambles and many industries in trouble, Milken’s clients failed in large numbers, about 25% of Drexel-financed firms, and the junk boom collapsed. Milken and Drexel were indicted under the Racketeer Influence and Corrupt Organizations Act. Drexel declared bankruptcy after pleading guilty. Milken pled guilty to securities fraud, insider trading, and other felonies, sentenced to 10 years in prison and fined over $1 billion.

S&L Debacle

S&Ls were designed to take in short-term deposits and make long-term mortgages, which worked as long as interest rates were low and stable. That changed in the 1970s as high inflation forced interest rates to rise. S&Ls had to raise interest rates to maintain their deposit base, but were still stuck with low-interest mortgages. In a misguided attempt to avert the total collapse of the industry, Congress passed the Garn-St. Germain Act in 1982 deregulating the industry. The S&Ls could do all sorts of investing and other activities—areas they knew nothing about. A single individual could now own an S&L (the old rule was a minimum 400 investors), allowing building contractors, organized crime, and assorted others to buy S&Ls with every intent of manipulating the system.

With few regulatory constraints, the industry exploded to $1.5 trillion in assets. A major source of funding was high-priced jumbo certificates of deposit, while high-yielding junk bonds became a major investment category—Milken was the early supplier of the industry. Corrupt executives introduced a multitude of illicit practices, from speculation to selfserving activities in commercial real estate including fraud. Perhaps the most corrupt executive was Charles Keating of Lincoln Savings headquartered in Phoenix, Arizona. Keating was a major investor in junk bonds and relied on accounting fraud to maintain his empire. This included property swaps with other companies to claim profits on sales. A regulatory audit discovered much of the abuse, including unreported losses of $135 million. Lincoln was seized by the government and Keating indicted. He pled guilty to fraud and sentenced to 12 years in jail.

The collapse of the industry required a federal bailout and Congress established the Resolution Trust Corporation (RTC) to dispose of the real estate of over 700 failed S&Ls. The estimated cost was $250 billion, although the final net cost to the federal government was $87 billion. The RTC was disbanded in 1995, after the liquidation was completed.

Small Companies, Big Fraud

From the end of World War II roughly to the 1970s was an era of low inflation and low volatility in securities markets plus the general view that little corruption existed. The securities laws seemed to be working, including improving accounting and auditing standards. Wall Street was relatively “un-manipulative” with little obvious speculation; regulatory agencies were viewed as diligent and tough. The major accounting firms, the “Big Eight” (at the time made up of Arthur Andersen, Coopers & Lybrand, Haskins & Sells, Ernst & Ernst, Peat, Marwick Mitchell, Price Waterhouse, Touche Ross, and Arthur Young) were considered elite, hard-working, and competent. Despite this overall view of relative harmony, corporate fraud cases erupted periodically challenging the overall view of auditors. Among the most infamous were Investors Overseas Services (IOS), Equity Funding, National Student Marketing, EMS Governmental Securities, and ZZZZ Best, mainly big frauds at small companies. These were hits to investor confidence rather than economic chaos. Later fraud cases into the 1990s included bigger companies, such as Waste Management, Sunbeam, and Cendant.

Recurring frauds demonstrate several important points. First, the potential for corruption and fraud is always present, driven by incentives to cheat by ethically challenged individuals and corporate cultures. Consequently, the need for internal controls, diligent reviews, and audits, plus aggressive regulators remains constant. Auditors are not incredibly good at detecting fraud—the auditors claim this is not their job; the public, on the other hand, thinks it is. This created what was called the “expectations gap.” It turns out that whistle-blowers have always been the most common detectors of fraud, not auditors or regulators. A related problem is that auditors are hired and paid by the corporate clients. The auditors’ incentives include being as accommodative as possible to the client—rejecting every controversial practice normally does not result in long-term relationships with corporate clients. Audit staff and managers point out and document accounting and reporting “gray areas,” and it is up to the managing partner to reach consensus with the chief financial officer (CFO) and audit committee on what is acceptable for the audit firm to issue an unqualified (clean) opinion.

The individual cases have unique circumstances that require review, including the incentives and character of the individuals involved, the overall business environment and culture, and the economic and regulatory framework at the time. The small company-big fraud cases of the early postwar period can be considered “outliers,” not typical of most corporations. The 1990s frauds involved larger companies, widespread fraud, and more likely represented a common corporate culture of manipulation and aggressive accounting in a period of lax enforcement.⁵

Investors Overseas Services

IOS was a Swiss mutual fund, run by crooked Americans—one of the rare cases when one fraudster was replaced by another fraudster. New Yorker Bernard Cornfeld founded the company in 1955 to sell mutual funds mainly to the American military stressing tax avoidance and lax regulations. IOS grew to $2.5 billion in assets. The SEC forced IOS to shut down American operations in 1965, accusing the company of securities violations. The company collapsed at the end of the 1960s, and Cornfeld was fired. He was charged with fraud by the Swiss regulators but acquitted after spending almost a year in jail.

Robert Vesco was the CEO of conglomerate International Controls Corp and bought IOS in 1970 using a LBO, turning it into a holding company with offices in remote locations to avoid regulators. Vesco proceeded to loot the company, using dummy companies to move some $235 million to other remote locations. The SEC investigated and charged Vesco with embezzlement. He fled to Costa Rica and spent the rest of his life on the run, becoming the “undisputed king of the fugitive financiers.”⁶ Vesco became especially infamous by contributing vast sums to Richard Nixon. Congressional hearings followed in the 1970s, but did not result in new regulations.

ZZZZ Best

Barry Minkow founded ZZZZ Best (pronounced “Zee Best”) when still in high school. It was an insurance restoration company, starting as a carpet cleaning service in the 1980s. Thanks to fraud (such things as check kiting and false credit card charges), stealing, and a crooked CFO in Charles Arrington, Minkow got bank loans based on bogus financial statements. The company was audited, but the auditors relied on fake documents reporting substantial revenues from insurance companies and false examples of restoration projects in progress.

Minkow’s company went public in 1986, listed on NASDAQ (an American stock exchange competing with the NYSE). From the initial public offering of $15 million, the stock price rose to $18 a share in 1987, giving the company a market value of $100 million. Minkow also used Milken’s junk bonds to acquire a larger carpet cleaning company, KeyServe. Like many other frauds, Minkow became too successful to hide his inglorious past. The Los Angeles Times reported Minkow’s fake credit card use, and then accounting firm Ernst and Whinney resigned from the audit after discovering fraud. The internal investigation by ZZZZ Best discovered embezzlement by Minkow of over $20 million, forcing him to resign. Indictments and convictions were not far behind and in 1989 Minkow was sentenced to 25 years in prison for securities fraud, racketeering, and embezzlement. He served seven years and then after his release was convicted of insider trading in another company.

Other Scandals in 1960s to 1980s

Allied Crude Vegetable Oil borrowed money based on its inventory of salad oil. Company CEO Tino De Angelis had ships filled with water and salad oil on top; inspectors confirmed the oil inventory. The fraud was discovered in 1963—De Angelis spent seven years in jail. American Express was the biggest loser, writing off $58 million in the “Great Salad Oil Swindle.”

Continental Vending became a successful criminal case brought against the auditor, Lybrand, Ross Brothers & Montgomery (now part of PricewaterhouseCoopers, a Big Four auditor), for certifying financial statements the auditor knew were false. A subsidiary of Continental Vending Machine Corp. borrowed a large sum from the parent for the benefit of an executive unable to repay a loan. The loan was still recorded as an asset on the books of Continental. Although Lybrand claimed Continental was correctly following generally accepted auditing standards, three Lybrand auditors were found guilty of criminal fraud in 1969.

National Student Marketing was established by Cortes Randell in 1964 to provide jobs to college students and other services. Randell claimed this was a $100 million conglomerate, with tremendous growth in earnings and assets. He cashed out before the authorities discovered the company was bogus. That did not get him off the hook and he was convicted of stock fraud and spent a year and a half in prison.

Founded in 1964, Equity Funding Corporation of America sold life insurance; the innovation was the use of policy cash values to buy mutual funds. When expected profits did not materialize, the financial reports were falsified. To generate cash, the policies were sold to other insurance companies (reinsurance). To actually pay back the reinsurers, bogus policies were created, along with all the necessary documentation to maintain the insurance year after year. Killing off imaginary customers on policies shipped to the reinsurers generated additional cash (there were no relatives to receive the proceeds). Whistle-blowers tipped off the California regulators. Equity Funding was shut down in 1972 as the SEC was investigating. Several Equity Funding executives were convicted of fraud and sent to jail.

In a strange twist of the Equity Funding case, whistle-blower Ray Dirks was charged with insider trading by the SEC and the case went to the Supreme Court before Dirks was acquitted. This was a period when neither insider trading nor whistle-blowing was well defined. Despite additional regulations and court cases, both whistle-blowing and insider trading are still problematic.

The Baptist Foundation of Arizona was founded in the 1940s to support Baptist causes. The Foundation lost its way by the 1990s under a new management, losing over $3 million in 1992 from “dubious transactions.” Instead of coming clean, the organization hid the losses, started even more illicit transactions, and siphoned off cash to Foundation executives and board members. These included borrowing heavily, an investment Ponzi scheme to bring in more cash, land-flipping, and other bogus real estate deals. The Foundation went bankrupt in 1999, with over $500 million in liabilities and only $70 million in assets. Several executives and directors were eventually convicted of fraud and sent to prison. Arthur Andersen was the auditor and settled by agreeing to pay over $200 million to bilked investors.

Waste Management

Waste Management was a 1968 merger of two garbage collection business owned by Dean Buntrock and Wayne Huizenga. Buntrock took control in the 1980s after Huizenga stepped down and later founded Blockbuster. Business boomed, particularly as local governments privatized garbage and Waste Management stepped in—acquiring some 100 garbage and landfill enterprises. Waste Management used a combination strategy of lobbying, political contributions, and, when necessary, outright bribes. The company developed a reputation for violating environmental rules and antitrust laws, resulting in substantial fines.

On top of these lapses, Waste Management increasingly used earnings manipulation and blatant fraud to meet analysts’ expectations as this industry got more competitive and less profitable. By the 1990s, the company was manipulating merger and fixed asset accounting. Expenses could be understated by increasing the salvage value of property and making the useful lives of plant and equipment longer. Operating costs of landfills also were capitalized. The most blatant form of fraud was recording gains on sham transactions.

A familiar name in allowing aggressive accounting, Arthur Andersen was the auditor. Andersen apparently was well aware of many if not most of the tricks, but continued to give Waste Management a clean opinion by claiming the transactions were immaterial. The SEC investigated and charged “defendants’ improper accounting practices were centralized at corporate headquarters. … They monitored the company’s actual operating results and compared them to the quarterly targets set in the budget.”⁷ Waste Management understated expenses by $1.7 billion and the SEC forced the company to restate earnings for fiscal years 1992 through 1997—the largest restatement up to that time. Both Waste Management and Andersen were fined by the SEC and forced to settle stockholder lawsuits. The company was acquired by USA Waste Services, which kept the Waste Management name. That was not the end; new fraud was discovered and an additional $1.2 billion had to be written off. Despite the abuse, Waste Management is still around with a market value of $17 billion.

Cendant

Cendant was the result of the acquisition of CUC (Comp-U-Card) International by Hospitality Franchise Systems (HFS) in 1997 and a name change. HFS owned hotel franchises, including Howard Johnson, Ramada, and Days Inn, with much of the growth from acquisitions. Unfortunately for HFS stockholders, CUC had been committing fraud for years. CUC had a membership-for-a-fee program to sell consumer products with extended payments. CUC CEO Walter Forbes used the common strategy when failing to meet analyst expectations—manipulate, a strategy started in the early 1980s. Merger manipulation led the list, the ability to determine valuations of acquisitions, use merger reserve accounts, and so on. Advertising costs and various operating expenses were capitalized, write-offs were ignored, while revenues were recognized aggressively (including immediate recognition on long-term sales, which should have been deferred). Other revenue accounts were bogus. In other words, a long list of items were manipulated and fraudulently reported quarterly over a long period.

CUC ran out of manipulation tricks by 1996 as real losses were growing and hiding fraud became increasingly difficult. HFS, before the acquisition, discovered no fraud at CUC and completed the $14 billion merger. Fraud was discovered in 1998, only months after the merger was completed. Restatement of earlier years was required, reducing Cendant’s income by $440 million. Indictments against the former CUC executives and investor lawsuits against Cendant and auditor Ernst & Young followed. The settlements with investors totaled $3 billion, a record up to that time. Walter Forbes, the former CUC CEO, was convicted and sentenced to 12 years in prison plus substantial fines. Cendant recovered but later split into several companies—none of which used the Cendant name.

Sunbeam

Sunbeam was a consumer products manufacturing company, created in 1989 from the ashes of bankrupt company Allegheny International. It manufactured products under the Sunbeam name and several others, including Coleman, Mr. Coffee, and Oster. When performance declined in the early 1990s, the board of directors hired outsider Albert Dunlap to restructure the company in 1996. Dunlap had a track record as a turnaround specialist at Scott Paper, where stock prices increased over 200% while he was in charge. Dunlap’s restructuring involved severe cost cutting and employee layoffs (some 11,000 at Scott Paper—earning his epithet “Chainsaw Al”).

Living up to his nickname, Dunlap fired about half of Sunbeam’s employees and wrote off $340 million in special charges. The special charges proved a form of accounting manipulation: the write-offs were blamed on the previous management and simultaneously created reserve accounts for future write-offs (called “cookie jar reserve”) to make the performance under his watch look better. It was just the start of manipulation and fraud. Aggressive revenue recognition included “channel stuffing” and “bill-and-hold sales” (pushing out inventory to customers by promising huge discounts and recording revenues before actual sales, respectively). On the expense side, a multitude of tactics were used. Operating expenses were capitalized or just not recorded, such as warranty costs, sales returns, and advertising. Other costs were charged directly to restructuring; that is, using those cookie jar reserves. The market loved it. Stock price rose from 12.50 when he started, peaking at 52, up over 400%.

When manipulation was not enough to meet analysts’ forecasts, Dunlap turned to outright fraud, recording bogus sales as revenue. Auditor Arthur Andersen understood the manipulation, but gave Sunbeam an unqualified opinion anyway in 1997. Despite the accommodating auditor, Sunbeam still missed analyst forecasts for the year. It was only after the press made negative statements about Sunbeam that the board of directors started an internal investigation. They discovered the manipulation and fraud, firing both Dunlap and the CFO. Earnings were restated in 1998. The SEC later claimed that Sunbeam “created the illusion of a successful restructuring to inflate its stock price and thus improve its value as an acquisition target.”⁸ Investor lawsuits of Sunbeam and Andersen followed. Sunbeam went bankrupt in 2001, only to restructure and emerge as American Household in 2002. American Household was acquired by Jarden Corp. in 2004.

Financial Fraud Gets Complex and Goes Global

As Japan, Europe, and various developing countries were growing their economies in the post–World War II period, American companies, capital, and expertise followed. Global opportunities attracted financial “innovators” and speculators, and various speculative excesses bubbled up. Derivative instruments (financial instruments derived from securities, others assets and related indices, including futures and options) became really significant after economists Fischer Black and Myron Scholes developed the famous Black-Scholes model in 1973 to price options (pricing models for everything derivative-related followed). Unfortunately, the respected derivatives in the hands of financial traders and quants were turned into complex instruments, leading to massive speculation hidden from the public and, ultimately, fiascoes. Part of the problem was that many of the buyers and sellers did not understand the instruments or the underlying costs and risks involved.

When the United States went off the gold standard in 1971, all currencies floated against one another, instead of being relatively fixed against the value placed on gold. Soon, foreign currency futures, swaps, and options became an essential financial activity. Some currencies would eventually collapse, often bringing down entire economies, made worse by potential speculation. Hedge fund manager George Soros helped bring down the British pound in 1992. Mexico’s peso collapsed in 1995, followed by Thailand and a multitude of other Asian currencies. Russia followed. The Russian default would bring down the biggest of the hedge funds, Long-term Capital Management in 1998.

Continental Illinois became the first “too big to fail” bank, bailed out by the Federal Reserve in the mid-1980s. Investment bank Salomon Brothers almost went under due to a Treasury bond scandal in 1991 and was soon acquired by Travelers (now part of Citi Group). Derivatives broker Nicholas Leeson brought down the venerable British investment bank Barings in 1995, losing billions on unauthorized derivative trades using Tokyo’s Nikkei futures.

A number of companies, governments, retirement funds, and insurance companies were sold risky, complex, and high-priced derivative-based investments by Wall Street, based on relative interest rates. The biggest victim was Orange County, California, which bought billions of toxic instruments and paid investment bank Merrill Lynch over $100 million in fees. Orange County Treasurer Robert Citron even borrowed additional billions to speculate on margin with these presumably “safe, high- yield investments.” One of the most outrageous was the “inverse rate floaters,” which paid a high interest rate—but minus London interbank interest rate (LIBOR) (LIBOR—see Timeline, 2012 for more on LIBOR manipulation). These and other instruments paid investors handsomely as long as short-term interest rates (in this case LIBOR) stayed low. But they did not. In the early 1990s, the Federal Reserve under Chairman Alan Greenspan increased rates and Orange County investments collapsed in 1994. The $1.8 billion loss resulted in the county’s bankruptcy. Citron pled guilty to filing false statements, receiving probation. Orange County sued Merrill and eventually received $400 million to settle. Other governments suffered losses, but nothing compared to Orange County. Many corporations had derivative losses around the same time, including Procter & Gamble (losing $100 million) and Gibson Greetings ($20 million). Investment banks developed a reputation of looking for easy targets (“dumb money,” basically naïve investors) to sell expensive products to.

The bribery of foreign governments by American multinationals became a major scandal and resulted in a SEC investigation in the mid-1970s of over 400 major companies that admitted to bribing foreign governments (and related officials and political parties) plus additional potentially illegal acts. One of the most egregious examples was Lockheed’s bribing officials of foreign governments to receive military contracts, including the Netherlands, West Germany, Italy, and Saudi Arabia. “Bananagate” focused on Latin American officials specifically for favorable terms on banana exports. A major difficulty was the widespread corruption in many foreign countries and the expectation of appropriate payoffs to receive favorable treatment. These issues led to additional regulations, including the Foreign Corrupt Practices Act, which banned bribery of foreign officials.

One of the most amazing stories was the Bank of Credit and Commerce International (BCCI) scandal, based on the rogue BCCI, founded in 1972 by Mohammed Zaigham Abbas, a Pakistani financier. The Sheikh of Abu Dhabi and Bank of America provided much of the initial funding, but Bank of America later withdrew most of its investments as evidence of fraud became apparent. BCCI grew to $20 billion in assets, with operations in almost 80 countries by the 1980s. BCCI was registered in Luxembourg, with operations run in Grand Cayman, Karachi, and London, a banking structure established to avoid regulatory restrictions. This required shell corporations and layers of opaque entities.

The results of BCCI operations included massive fraud, bribery, tax evasion, and money laundering to arms traffickers, drug dealers, and others. BCCI acquired U.S. banks secretly to avoid regulations designed to keep it out of the country and used well-known Americans for political influence. Investigations discovered the illegal activities and audits discovered millions of dollars that were lost. American indictments started in 1988 and regulators forced the worldwide liquidation of BCCI in the early 1990s. Robert Morgenthau, Manhattan District Attorney, called BCCI “the largest bank fraud in world financial history.”

Regulatory Action

Federal, and to a lesser extent state and local, regulatory agencies were active throughout the period, usually involved in the discovery and prosecution of fraud and other illicit acts, but playing other roles as well. Sometimes the SEC and sundry federal agencies enforced the laws stringently and other times loosely. New laws were recommended and (occasionally) passed. Periods of strict enforcement existed, such as after the Foreign Corrupt Practices Act of 1977 following a number of major bribery cases. Periods of deregulation and/or slack enforcement happened during the Reagan administrations in the 1980s and around the time of the tech bubble in the late 1990s. It proved to be a bumpy ride for enforcement and economic activity in general.

Remove That Punch Bowl

Regulations and regulators generally were stringent early in the postwar period, a continuation of the substantial financial legislation of the Great Depression. Federal Reserve Chairman (from 1951 to 1970) William McChesney Martin famously stated: “The job of the Federal Reserve is to take away the punch bowl just as the party gets going.” The 1950s were boom years, but suffered three minor recessions, largely because of Fed action to increase interest rates. Later Fed policy makers, like Nixon’s Fed Chairman Arthur Burns, were more reluctant to take away that punch bowl—booms became longer, but so did the levels of manipulation and recessions.

As inflation increased in the later 1960s and 1970s, caused in part by federal budget deficits over wars in Vietnam and on poverty, President Nixon abandoned the gold standard (technically the gold reserve standard of the Bretton Woods Agreement, which established the foreign exchange system after World War II) in 1971. This made inflation worse, exacerbated by the massive oil price increases caused by the Organization of the Petroleum Exporting Countries. With stagflation rising (the combination of the unemployment rate and inflation rate, both over 10% around 1980) Fed Chairman Paul Volcker (1979–87) dramatically increased interest rate, which caused disruptions and recession, but tamed inflation by 1983.

President Reagan, first elected in 1980, preached deregulation and delivered. The economy boomed, as did manipulation and fraud. The S&L debacle previously described, showed the dark side of deregulation and lax enforcement (not only the collapse of an industry, but also massive insider trading and junk bond abuses)—and the direct cost to American taxpayers. Reagan appointed economist Alan Greenspan at Fed Chairman in 1987, a deregulation ideologue. Greenspan promoted economic growth and downplayed regulation, claiming that the market participants would regulate themselves. In fact, the extraordinary greed on Wall Street and in much of business America would be well displayed over the 20 years of Greenspan service. In addition, the Fed punch bowl would continue to be filled late into the proverbial party night.

A major example of Greenspan’s blind spot to abuse and need for regulation was in derivative instruments, which boomed after the improved pricing models of the mid-1970s. Shortly after Greenspan became Fed chair, the Market Crash of 1987 resulted in the biggest one-day loss on the Dow Jones Industrial Average ever (23%). The major cause was the use of “portfolio insurance,” a derivative play that tanked the market. Greenspan’s Fed flooded the system with cash, limiting the damage. In the 1990s, massive derivative losses were suffered by governments (including Orange County), corporations, the collapse of Mexican, Asian, and Russian currencies, and the downfall of the biggest hedge fund, Longterm Capital Management. The Fed stepped in repeatedly to bail out Wall Street.

Given the massive abuse of derivatives literally worldwide, Brooksley Born, chairman of the Commodity Futures Trading Commission (CFTC), which regulates the formal futures and commodities markets, proposed modest regulation and CFTC oversight of over-the-counter (OTC) derivatives (the opaque derivatives that banks design for specific users and caused the 1990s problems). In Congressional hearings, Born was slapped down by Greenspan and officials at Treasury and the SEC. Instead, Congress passed the Commodities Futures Modernization Act of 2000, which called for the complete deregulation of OTC derivatives. Despite the many collapses involving derivatives and needed Fed bailouts, Greenspan won—the economy would soon pay the price.

Over an extended period, commercial and investment banks were growing and gathering political clout. Investment banks also were going public (traditionally, they were relatively conservative partnerships), taking on increasingly risky deals (they were now playing with other people’s money) and paying massive compensation packages. Commercial and investment banks were also merging operations. Citibank led the way, merging with Travelers Insurance to form Citigroup in 1998 to create the biggest bank of the period. This violated the Depression-era Glass-Steagall Act and Citi lobbied to make the new mega-bank legal. Congress complied with the Gramm-Leach-Bliley Act (Financial Services Modernization Act of 1999). This allowed commercial and investment banks, as well as insurance firms and other financial operations, to consolidate. Too-big-to-fail became a significant issue. Basically, the early 21st century became a period of near-deregulation of Wall Street and banking. Congress and the regulators created a broken system and were slow to correct the mistakes.

Cycles of the Audit Risk Environment

Auditing thrived in the postwar period, with the Big Eight emerging as the premier accounting firms globally. Accounting and audit standards expanded and professionalism became increasingly important. CPA licensing requirements became more stringent, with many states requiring first a college degree and then instituting “five year programs” (terminology differed, but generally accounting students needed the equivalent of masters’ degrees to become CPAs).

A major result of the widespread bribery and corruption of operating in foreign countries was the Foreign Corrupt Practices Act (FCPA) of 1977. The Act banned bribery of foreign officials—easier said than done when dealing with cultures of corruption. Other major countries later passed similar rules on bribery. Corporations have been prosecuted over suspected bribery ever since, such as McDonald’s Mexican bribery scandal in 2012.

Of more importance to auditors was the FCPA requirement for adequate internal controls (procedures to ensure efficient and effective operations, reliable financial reporting, and legal compliance). If internal controls are reliable, the changes of fraud and certain types of manipulation are reduced. The Committee of Sponsoring Organizations (COSO) was created in 1985 to sponsor the National Commission on Fraudulent Financial Reporting (called the Treadway Commission after chairman James Treadway, a former commissioner of the SEC). This followed the multiple prosecutions of fraud and scandals of the period, earlier committees such as the 1974 Cohen Commission that discovered an “expectations gap” in what investors perceived were the auditor’s responsibilities in detecting fraud, plus Congressional investigations and legislation—especially the FCPA. The Treadway Report issued in 1987 focused on fraud and emphasized the lack of proper internal control in major fraud cases. Based on the report, COSO studied internal control attempting to provide an overall framework. The framework described the process of effective operations, financial disclosure reliability, and complying with laws and regulation through risk assessment, monitoring, and other components.

While these regulatory attempts increased government oversight, other factors went in the opposite direction. In 1979 the Justice Department and Federal Trade Commission attempted to increase auditor competition and outlawed the profession’s bans on competitive bidding and advertising. Competition increased, resulting in fierce bidding for new clients and the practice of “low balling,” submitting a low bid to get the new client. As a result, profitability declined and many complained that it reduced “professional integrity.”⁹ The Private Securities Litigation Reform Act of 1995 limited auditor legal liability in class action suits over fraud, which was thought to lead to more “aggressive auditing;” that is, allowing more client accounting manipulation.

Auditing regulations (and accounting oversight in general) have gone through cycles of aggressive and lax enforcement and there is good evidence that the relative oversight influenced corporate and audit behavior. Cassell and Giroux¹⁰ document most of the early postwar period as a high- regulation period and, therefore, associated with less accounting and audit risk. The periods of lax enforcement were 1985–1989 and 1994–2001.

Both were periods of financial and economic euphoria with antiregula- tory regimes (under the Reagan and Clinton presidencies). Empirical results support the lower accounting quality (and implied lower audit quality) for these periods¹¹ Enforcement tightened up somewhat during the H.W. Bush presidency (1989–1993) and, particularly, after the tech crash, major fraud cases including Enron, and the Sarbanes-Oxley Act of 2002. Despite Sarbanes-Oxley much of the 21st century before the subprime meltdown saw continued lax enforcement for the financial sector of the economy.

Lessons to be Learned

After World War II, the level of business corruption gradually increased for a number of mutually reinforcing reasons. Budgets were cut at the SEC and other regulators as business grew and became more complex, but politicians increasingly preferred deregulation—encouraged by an ideological shift and substantial campaign contributions. Business and financial innovations such as derivative pricing, hostile takeovers, structured finance, and junk bonds were introduced and abused. Increased “performance-based” executive compensation drove manipulation incentives. Finally, business culture shifted to increasingly aggressive behavior as more people “got away with it.” Particularly important is the significance of continued diligent monitoring and regulatory oversight. Fewer businesspeople get away with it if they are effectively monitored and prosecuted.