CHAPTER 5

Tech Bubble, Bust, and Bankruptcies

The economy was booming and high-tech companies were changing people’s lives. At the start of the 21st century the biggest worry was Y2K, the chance that computers would go bonkers trying to change over to a new millennium, resulting in a crash of all computers and therefore the world economy. This proved a complete dud, either because the techies fixed the problems or no problem really existed. Whatever the answer, the tech bubble continued. The NASDAQ Stock Market (named for the National Association of Securities Dealers Automated Quotations, founded in 1971), where most of the new tech companies traded, rose over 1,000% from 1995 (roughly the start of the tech bubble) to early 2000. That was market euphoria, creating a massive bubble. Greenspan at the Fed was stoking the euphoria with easy money and the Clinton administration was preaching deregulation. Pundits were proclaiming that the economy and markets would continue to rise, while business cycles were a thing of the past. In other words, this was a typical bubble. The market high was reached in early March 2000 with NASDAQ at 5049 on March 10. Then the collapse followed; by late 2002, NASDAQ dropped 80% and the economy was in recession. Recent tech startups were failing in mass, as were many big companies after massive frauds were detected—creating the first financial crisis of the new millennium.

Making the Number

As Mark Twain said, “history doesn’t repeat itself, but it rhymes.” There were unique features this time. Executive motivations had changed as had finance, a continuing process over several decades. From 1939 to 1951, real executive compensation (adjusted for inflation) fell in part because of high income tax rates.¹ In the early postwar period, tax rates remained high and executives were more interested in perquisites like retirement and health care benefits. Tax reform in the 1980s reduced the top personal income tax rate to 28%, raised in the 1990s to 39.6%, then to 35% in the early 2000s, and back to 39.6% in 2013—this was down from 91% in the 1950s. Capital gains and dividend rates fell to 15%. High-paid executives now had the incentive to increase their compensation—they kept most of the money.

Around 1990, academics were promoting stock options as the best way to motivate chief executive officer (CEO) and other executives—they would now align themselves with stockholders. As an added bonus, the compensation expense associated with stock options did not have to be recorded on the income statement—it seemed to be “free money.” Tech company start-ups did not have a lot of extra cash to pay salaries; consequently, they substituted massive amounts of options not just to executives but to almost all employees. The tech companies proved to be either wildly succeeded or crashed and burned. Even low-level workers at an Oracle, Amazon, or eBay could become millionaires—the founders and CEOs, billionaires. Most big and stogy corporations followed suit, giving out piles of options, but miniscule amounts compared to their high-tech counterparts.

Attempting to get tough in the early 1990s, Congress banned corporate tax deductions for executive salary over $1 million. However, compensation based on performance remained unlimited. Compensation includes base salary, cash bonuses, stock options, and other equity- related compensation, plus other benefits such as special pensions. Chief executive officers could now spend considerable time contemplating their own pay—and how it compared to competitors. A well-constructed pay package (that it, as benefiting the executives, not necessarily the corporation) could now bring in tens of millions of dollars to the CEO and under exceptional circumstances hundreds of millions.

The key point became performance, which focused both directly and indirectly on earnings. Cash bonuses typically were (and still are) tied directly to net income, earnings per share (EPS), or other measures of performance. Indirectly, stock options relate to earnings. Options are more likely issued to executives based on past stock price performance, but stock price is expected to follow earnings.

Financial analysts focus on specific companies and industries and make earnings forecasts for the upcoming quarter (and beyond). Institutional Brokers Estimates System and Zacks started compiling analysts’ forecasts in the 1970s, followed by First Call. Analyst forecasts became readily available on the Internet by the 1990s. The consensus EPS forecast for each quarter became the number to “meet or beat.” Stock prices should continue up as long as earnings are both rising and meeting analyst forecasts. Microsoft, for example, met or beat every quarterly earnings forecast but one for over a decade ending in 1996 and became the most valuable company based on market capitalization—and founder Bill Gates the richest man in the world. Similar results came from General Electric (GE) and other companies about the same time. Failing to meet the analyst forecasts can be a stock price disaster. Both Microsoft and GE fell back to the pack after disappointing earnings during the 21st century.

A high-tech darling with a huge stock price to EPS ratio (PE ratio) can see the stock price plummet on an earnings disappointment, even if the EPS missed by only a penny a share—not good for the company’s stock price, particularly not good for CEO compensation. This changed corporate incentives from a long-term focus on success to an immediate focus on this quarter’s earnings. It also meant doing just about anything legal to meet forecasts. Because accounting earnings are subject to judgment and estimates, a one cent shortage should be no problem for the enterprising chief financial officer (CFO). Consider Enron as the classic case of incentives gone wrong.

Enron and Special Purpose Entities (SPE)

Enron is the premier scandal of the tech bubble and likely the major fraud case in corporate American history. Two key points in its claim to infamy are that (1) it was big; at its peak the seventh largest American company by market value, $70 billion after huge stock gains, and (2) the fraud and manipulative culture centered at the top—this was not petty crime by mid-level employees. It took over a decade to develop the sophisticated techniques of corruption needed to create a massive culture of deception parading as a high-tech blue chip company.

Enron merits considerable attention because of its sophisticated maneuvering and its use of techniques that have proven to be prominent ever since—including derivatives, market manipulations, SPE, and fair value maneuvering. In addition, there have been a large number of books written by insiders and journalists.² Consequently, considerable information is known about the perpetrators, motivations, and specific behavior over the entire history of the company. It took a culture of corruption, an accommodating board of directors, auditor, law firms, banks, the SEC, and other regulators, not to mention political clout maintained by campaign contributions and lobbying. Critics sprung up and were slapped down repeatedly. Basically, Enron embraced all the major components of massive business corruption.

Enron was created as a merger of two gas transmission companies in 1985 and Kenneth Lay soon emerged as CEO and Chairman of the Board, remaining the corporate head throughout. His initial actions suggested executive talent, but ethical lapses and seemingly poor judgment soon emerged. His overall plan was to remake the stogy transmission company into a high-tech conglomerate. This seemed a reasonable plan, except for inept judgment on many issues, misguided incentives of key players, and mass corruption and fraud. The views are still somewhat mixed on whether he tolerated an “overly aggressive behavior” corporate culture versus being fraudster in chief. There is no doubt that his actions were unethical and his conviction for securities fraud and other illegal acts demonstrates criminality. As with many if not most CEOs, his short-term economic incentives encouraged cheating—his cumulative compensation would total hundreds of millions, mainly thanks to massive stock options.

Enron’s first fraud happened in 1987, not in Houston, but in a small trading subsidiary in New York City—sham transactions, kickbacks, phony companies, offshore accounts, and the manager skimming millions of dollars. Lay and other executives were not involved in the manipulation, but covered it up rather than face market and regulatory sanctions. Auditor Arthur Andersen investigated the fraud and reported it to the audit committee. Enron, with Andersen’s blessing, declared the fraud immaterial, did not report it, and Lay claimed no responsibility. The manager went to jail because of a Justice Department investigation, not thanks to Enron. Lay got away with it, apparently the lesson he learned for future decisions.

Gas Trading and Derivatives

Natural gas pipelines, a highly regulated industry until the late 1980s, were on the list of extraordinarily stodgy low-risk businesses. The strategy was based on long-term contracts, with prices, quantities, and destinations established far into the future. Enron had massive debt, but this was not considered a major problem in a low-risk industry. The ratings agencies were not particularly keen on Enron debt and the company struggled to get and maintain a low investment grade bond rating. That environment changed for the industry and particularly Enron. Gas was on the deregulation to-do list of the Reagan administration. Spot market sales (usually 30-day supply contracts) replaced long-term deals and price volatility spiked. Ken Lay’s business strategy changed, shifting focus to a gas trading business. As a market maker, Lay soon looked like a genius. Buyers (mainly utilities) and sellers (mainly drillers) feared this unstable market; they were price takers interested in other aspects of the business. Enron traders became expert middlemen, moving to longer-term contracts as their expertise increased where they could charge a premium over anticipated spot prices. Enron became the major gas trader in North America, the acknowledged expert in the field.

Jeffrey Skilling, a McKinsey consultant, moved to Enron in 1989 to run Enron’s Gas Bank, a technique to improve gas market stability by funding drillers in exchange for future gas deliveries—somewhat similar to banks loans, which many drillers were unable to get. Enron could then write long-term contracts with utilities and other users. Skilling’s next idea was gas trading based on these long-term contracts—what he called an “asset-light” strategy. This, of course, was in addition to Enron’s big pipeline business.

Enron provided derivatives to drillers (suppliers), pipelines, and other users to hedge volatile gas prices, in this case forwards and futures (forwards are buying and selling assets, usually commodities, at a specific price and time in the future, while futures are standardized forwards trading on a formal market). Enron was in the middle, and these lucrative contracts allowed all players (including Enron) to control market risks by hedging. Standardized futures contracts were soon traded on the New York Mercantile Exchange (NYMEX). As the standardized contracts became less lucrative, Enron moved into more complex over-the-counter (OTC) options (the option to buy or sell rather than the commitment) and swaps (such as swapping natural gas for oil).

The easy ability to manipulate derivatives for personal gain (also meaning a higher price or a loss to the counterparty—these are zero-sum-game products) became a predatory strategy and part of the Enron culture. As Enron’s trading expanded, so did the use of options, swaps, and various exotic versions often designed to be complex, opaque, possibly deceptive, and profitable. These characteristic made them additional arrows in the quiver of manipulation. Enron traders increasingly speculated in gas and other markets (becoming something of an internal hedge fund), usually quite profitably. When losses struck, they were camouflaged, often using fair value (mark-to-market) to misstate the asset values. It proved to be easy to mislead auditors and regulators about the true value of complex products.

Skilling and Mark-to-Market

Skilling pushed the use of mark-to-market (fair value) accounting for gas trading and received permission from the board and approval from the SEC. The SEC and the Financial Accounting Standards Board (FASB) had been moving toward fair value accounting for financial assets and liabilities, but this was before fair value became generally accepted accounting principles (GAAP) for most financial items. The logic of fair value makes sense for securities that are widely traded and market value easily determined. As part of the fair value process, gains and losses are recognized. Fair value typically “front-loads” income, the rationale being that the actual trade determines profit rather than at the time of delivery and cash collection.³

There are downsides to mark-to-market accounting, especially when public market values do not exist. The most critical is the potential for manipulation, particularly in the hands of a deceptive culture like Enron. Many of the long-term gas and other contracts did not have a ready market, especially the various OTC contracts that were inherently more lucrative than trading on NYMEX. Value depended on “mark-to-model,” with Enron quantitative experts (“quants”) developing the models and determining values to plug into those models. Skilling and other higher-ups could (and did) demand specific gain or loss results for a particular quarter. An increase of two cents in net income to meet analysts’ consensus forecasts might require an additional gain of, say, $100,000. The revaluation for each accounting period to the new market value increased earnings volatility (and likely increased the need for further manipulation). Again, income statement numbers were not well connected to cash flows when using fair value.

The SEC approval was mark-to-market for gas contracts. Skilling and Lay expanded fair value across the Enron balance sheet, more or less any asset could be changed to market if needed for earnings manipulation purposes. This did require audit approval and Andersen generally remained accommodating. The SEC also did not review Enron’s financial statements vigorously, although the company had a growing record of financial aggressiveness.

Skilling became Enron’s Chief Operating Officer in 1996, after Richard Kinder resigned. Kinder believed in earnings management, meeting earnings targets (generally quarterly for meeting EPS forecasts) usually though operating changes to achieve cost savings or any number of accounting gimmicks. The incentives were obvious: executive compensation (especially Lay, Kinder, and Skilling) depended on meeting earnings targets. These executives received piles of options that took years to vest and, as part of the compensation terms, required the executive to continue meeting earnings targets—15% annual earnings growth in addition to meeting or beating earnings forecasts. After Kinder left, Skilling did not hesitate to use increasingly aggressive manipulation tactics.⁴

Fastow’s Arrival and SPE

A SPE is a financial arrangement where a separate legal entity (corporation, trust, or partnership) is created for some specific purpose. Various legal details are required including an independent equity investor. First Boston repackaged General Motors Acceptance Corporation (GMAC) automobile loans in 1985 and used an SPE to hold the securities until they were resold as asset-backed securities—similar to long-term bonds. The repackaging of various standardized consumer bank loans (such as autos, mortgages, or credit card debt) became a common banking practice called “structured finance.” The use of SPEs expanded beyond structured finance to serve virtually any specific function that required a separate legal entity. The major advantage was to eliminate assets—and especially liabilities—from the books of the originating company. Of course, from an external analyst’s perspective, “off-balance-sheet” accounting screams manipulation.

Given Enron’s big debt load, poor bond rating, desire to enter various trading markets and other businesses, plus a penchant for manipulation, SPEs were an obvious choice as a new potential financial weapon. McLean and Elkind⁵ summarized Enron’s motives as: “keep fresh debt off the books, camouflage existing debt, book earnings, or create operating cash flow.” Skilling hired Andrew Fastow, who was working at Continental Illinois Bank as a SPE specialist. Fastow would add his own fraud strategy, well beyond what was asked for or known by the Enron brass.

SPE number one at Enron was a structured finance arrangement called Cactus, created in 1991 to fund the financing of gas and oil drillers using the Gas Bank. Long-term contracts with drillers of $900 million were packaged and sold to GE and others. The purpose was to generate cash and unload the debt to the SPE. Enron formed a partnership with the California Public Employees’ Retirement System (CalPERS) in 1993 called JEDI (Joint Energy Development Investments) to acquire drilling and other companies—as a joint venture, this provided the accounting advantages of equity method reporting.⁶ When Enron bought out CalPERS interest in 1997, a separate SPE called Chewco was created—keeping the debt off-balance-sheet. However, Fastow could find no one to take the required equity interest (3% of fair value at the time). After being rejected as the “independent investor” by the board, the equity investor became Fastow employee Michael Kopper—an obvious independence violation but accepted by the accommodating auditor and board of directors (the rationale: Kopper was not an officer of Enron). The Chewco deal may have been the start of Fastow’s self-serving (and illegal) side deals.

Fastow created LJM (named for Fastow family members Lea, Jeffrey and Michael) in 1999 as a partnership using the SPE structure (LJM2 was created later). The point of LJM was to provide whatever accounting manipulation Enron needed quickly—especially to meet those quarterly earnings targets. Fastow and friends became the independent investors and proceeded to skim off millions in side deals.

Enron bought into several international projects, some energy related and, as Enron had no expertise in such enterprises as water projects, many of these proved idiotic. One strange deal in 1999 was power plants actually floating on barges Enron acquired that ended up on the Nigerian coast. Finding no buyers, Fastow created a sham sale through LJM with Merrill Lynch—it was really a loan. Enron booked a $12 million gain to meet the $1.17 quarterly earnings target. The barges were “bought” back by LJM2 the next year, with the Merrill profit built in.

Enron made a small investment in Rhythms NetConnections, a small Internet company, which went public in 1999 during the bubble period, generating a substantial gain for Enron. To lock in the gain, ill-conceived derivative instruments were used and offset by Enron stock. The complex transactions were fraudulent and bankers from Greenwich NatWest were later indicted for wire fraud—the first of many people caught up by Enron deceptions. Multiple SPEs were created under LJM2, called Raptor I-IV, used to provide various deceptive practices. Fastow added over $200 million to Enron earnings and skimmed millions for himself and co-conspirators. The specifics of Fastow’s LJM manipulations apparently were not made clear to executives, the board, or the auditor, especially the nearly $60 million he paid himself from LJM and LJM2.

The Tech Bubble Crashes, So Does Enron

Tech stocks crashed in spring 2000, creating market havoc and a recession. The Raptors were mainly funded by Enron stock (an illicit practice because Enron, in fact, had “no skin in the game,” that is, real assets serving as “collateral”), whose price also fell. No further manipulation options were possible. The SPEs were terminated and losses of about $700 million taken. Between this write-down and a multitude of disintegrating businesses, Enron reported a big loss for the third quarter of 2001. Andersen discovered new errors and demanded an addition $1.2 billion write-off of equity and a restatement of earnings from 1997 to 2000. Enron’s bond rating was downgraded to junk, which meant no counterparties would trade with Enron except for cash. Rescue attempts were tried; they failed and Enron filed for bankruptcy December 2, 2001. This was the biggest bankruptcy in U.S. history up to that time and unexpected by the investment and Wall Street community. Enron had repeatedly lied about its financial position.

In the aftermath, Congress held hearings, journalists wrote articles and books attempting to explain how this big Wall Street darling could fail so spectacularly, Enron executives paid themselves additional million and fired most of the staff, and criminal investigations and civil lawsuits followed. Fastow was one of the first to be indicted—in addition to his illicit activities for Enron, he also defrauded the company out of millions. He was charged with almost 80 criminal counts, pled guilty, and agreed to a 10-year prison term. Both Skilling and Lay were convicted of multiple felony counts; Lay died before sentencing, while Skilling was sentenced to almost 25 years in jail. In total, over 30 Enron executives and employees were indicted and many jailed.

Giant Frauds: WorldCom, Tyco, Adelphia, and More

Enron was not alone in bad behavior. Bubbles and booms bring out euphoria, increased speculation, and, in an era of huge compensation and profits, greater incentives for manipulation. The 1990s was a decade of continuing emphasis on deregulation. The seemingly perpetually underfunded SEC did a less than adequate job of policing financial reporting of public firms—including Enron. As with the Great Depression, big manipulators crashed in the aftermath of the bursting bubble.

WorldCom

WorldCom has a similar story to Enron, in this case a small, stogy telecommunications company becoming a giant success as a result of government deregulation, and then crashing spectacularly as massive fraud could no longer hide corporate failure; corrupt executives also would be sentenced to long jail sentences. Bernard Ebbers was a founder of Long Distance Discount Services in 1983, after the federal government broke up American Telephone and Telegraph (AT&T) and effectively deregulated long distance phone service. Ebbers became CEO and gobbled up dozens of competitors—working the usual merger manipulation tricks to show spectacular profits. This dinky telco became WorldCom in 1995. The big event was the acquisition of the much larger MCI (for Microwave Communications, Inc.) Communications in 1998.

By the end of 2001, WorldCom had over a hundred billion dollars in assets; however, 2001 net income was $1.5 billion, down from $4.1 billion in 2000. That was not the really bad news. Even the $1.5 billion was fraudulent, discovered by internal audit. It turned out that over $11 billion of operating expenses were capitalized, a simple fraud to book nonexistent earnings (unlike the complex fraud at Enron), originated at the highest levels of the company. These were mainly “line costs,” fees to other telecom companies to pay for network access rights—obvious operating expenses. Other fraudulent acts included double counting revenues and unrecorded debt.

Arthur Andersen was WorldCom’s auditor; internal auditor Cynthia Cooper, not Andersen, discovered the fraud. Financial statements were restated and Andersen withdrew its 2001 audit opinion. CFO Scott Sullivan was fired and Ebbers resigned. The SEC investigated and WorldCom filed for bankruptcy in mid-2002. WorldCom replaced Enron as the largest bankruptcy in U.S. history. Ebbers was convicted of conspiracy and securities fraud and sentenced to 25 years in prison. Other WorldCom executives also were convicted of various crimes. WorldCom emerged from bankruptcy in 2004 as MCI. The Sarbanes-Oxley Act (SOA) would be passed within a few days of the WorldCom bankruptcy.

Tyco

Tyco Laboratories started as a science research company in 1960 and, after going public, turned itself into a conglomerate. Dennis Kozlowski joined Tyco, rising to CEO in 1992. Mergers became more rapid under Kowlowski, eventually acquiring over 1,000 companies, earnings him the title “Deal-a-Day Dennis.” The company became Tyco International in 1993, since Kozlowski viewed the company as a global leader. Tyco excelled in aggressive merger manipulation, the tradition that made conglomerates stock market powerhouses in much of the post–World War II period. The tactics were aggressive enough to cause a SEC investigation in the late 1990s, although Tyco was not charged with fraud.

Tyco’s acquisition of CIT Group (a giant commercial finance firm, originally Commercial Investment Trust) became a public road map for merger manipulation when CIT maintained separate financial statements because it had a relatively high credit rating. Tyco made CIT charge off various assets and other adjustments before the acquisition date to give the perception of better performance just after the acquisition (a form of “spring loading” accounting numbers)—CIT reported a loss before the acquisition date and substantial profit and higher revenues just after. Despite the shenanigans, CIT was a bad acquisition when the tech stocks crashed. The subsidiary was sold, netting a $6 billion after-tax loss. Both Kowlowski and CFO Mark Swartz were charged with various fraud-related crimes and other felonies. They were convicted and sentenced to 8–25 years. Tyco settled fraud charges with the SEC and paid $3 billion in class action suits. PricewaterhouseCoopers, Tyco’s auditor, paid $225 million in fines. Despite the fraud and lawsuits, Tyco avoided bankruptcy and continues to be listed on the New York Stock Exchange (NYSE). It later split into three companies.

Adelphia

Adelphia was a relatively small company, but deserves special attention for its utter disregard for corporate governance requirements in addition to accounting fraud. John Regas started a local Pennsylvania cable franchise in 1952 and turned it into a communications conglomerate of cable, long-distance phone, and Internet, relying on acquisitions and accumulating massive leverage in the process. Despite massive merger manipulation and various frauds, the company was in trouble by the late 1990s, posting substantial net losses in 1998–2000. The last 10-K was filed for 2000; the company was delisted by NASDAQ. The company restated earnings for 2000 and 2001, in part related to “co-borrowing agreements” with Regas family members using off-balance-sheet affiliates and falsifying statistics. After an SEC investigation of Adelphia and various executives for fraud, the company filed for bankruptcy in June 2002 (about the same time as WorldCom).

The SEC charged Adelphia with hiding billions of dollars of liabilities, falsified earnings, and camouflaging Regas family self-dealings—including some $2.3 billion in loans to various family members. Fraud was rampant, including sham transactions and fraudulent documents. Five of the nine members of the board of directors were John Regas, three sons, and a son-in-law. These family members used Adelphia cash to buy stock, purchase houses, build a golf course, and so on. John was convicted of securities fraud, bank fraud, and conspiracy and sentenced to 15 years in jail. Convictions also came down for other Regas family members and Adelphia executives.

Arthur Andersen

Andersen was the auditor of many ill-fated corporations, not a fraud- committing corporate giant. The federal government considered their actions so heinous that they merited an indictment—a death sentence for an auditor of public clients. After shredding massive amounts of Enron documents (well documented by Houston news as truck load after truck load of shredded documents were hauled off). Forced to surrender its CPA license, the company was soon out of business; the Big Five were down to the Big Four.

Arthur Andersen cofounded his Chicago firm in 1913, built on audit consistency and integrity. It became one of the “Big Eight” audit firms— a term that became popular by the early 1960s for the accounting firms that audited most of the public corporations in America (and increasingly around the world). Audit firms also specialized in tax work and, in the post-World War II period, consulting activities. The auditors became computer experts and developed lucrative computing services. As consulting became the major profit center of the firm, Andersen Consulting split from the rest of the firm in 1989. (Andersen Consulting became the largest consulting firm in the world and changed its name to Accenture.)

With Andersen Consulting gone, revenues were reduced and hard to maintain; the company found it difficult to compete in an increasingly competitive market. Audits became more “aggressive,” meaning the company was increasingly willing to audit difficult and manipulative clients and more accommodating to their needs. Barbara Toffler, a former Andersen partner in charge of ethics, summed it up: “in the new world, clients had become too valuable to defy. The distortion of the ‘Tradition’ now meant you could best serve the client—and therefore, keep the client—by keeping it happy. ... The worst possible sin you could commit at Arthur Andersen, I learned the hard way, was to upset the client—even if they desperately needed to hear the bad news.”⁷ The result was Andersen became the auditor giving clean opinions to one audit- scandal-corporation after another. Sunbeam and Waste Management were major late-1990s frauds and Andersen paid millions to settle stockholder lawsuits. The really big ones were Enron and WorldCom—both considered by Andersen as among the “most important clients” according to Toffler.

It is little wonder that the Justice Department had little patience with Andersen and saw the document-destroying episode as an outrage. Andersen was convicted of obstruction of justice. Lawsuits followed. Although the conviction was reversed by the Supreme Court in 2005, it was too late to save Andersen. Several pundits predicted that other firms deserved to be indicted, but none were—possibly because they were now “too big to fail.”

And More

The early 21st century, like the 1930s, uncovered widespread manipulation, corruption, and fraud. Accounting write-offs and earnings restatements became commonplace, often in the billions of dollars. SEC investigations and class action lawsuits often followed. Cisco Systems wrote down $2.8 billion in inventory in 2001 on take-or-pay supply contracts. JDSU (originally JDS Uniphase, the merger of JDS Fitel and Uniphase) wrote off $40 billion in goodwill and long-term assets in 2001. Xerox restated $6 billion in earnings in 2002 after inflating revenues over the previous five years. Bristol-Myers-Squibb also overstated earnings (by $2 billion). Quest Communications overstated revenues in 2002 and was subject to SEC and Justice Department investigations associated with “hollow swaps.” AOL-Time Warner (after the merger of America Online and Time-Warner) wrote off $54 billion in goodwill from the disastrous merger (the total loss for the year, 2002, was almost $100 billion). Various banks and other financial institutions had multiple legal problems with predatory practices, securities analysts’ deceptive stock analysis, and assorted misdemeanors. Imclone Systems CEO Samuel Waksal was jailed for insider trading; the case made national headlines when Martha Stewart was investigated for insider trading when informed by Waksal to sell and convicted of lying.

Even this expanded list represents only the tip of the corruption iceberg flow, but represents the bigger icebergs. In a 2002 study the General Accounting Office(GAO) (GAO, later called the Government Accountability Office) analyzed 919 earnings restatements from 845 public companies from 1997 to 2002. Restatements were almost unheard of through the 1980s and suggest the substantial drop in earnings quality and growing use of manipulation during the booming 1990s. The biggest category was revenue recognition problems, almost 40% of the total. Included in the GAO’s list were 80 Standard & Poor’s (S&P) 500 companies, about 16% of the total. Tice and Tse (2013) identified 8,859 restatements over the 10-year period 2000 and 2009.

The Sarbanes-Oxley Act

Congress held hearing after many of the accounting scandals in the 1970s and 1980s, issuing reports and calls for reform. Such was also the case after Enron’s bankruptcy in December of 2002. Perhaps a dozen special committees in both the House and Senate pontificated mightily as Enron executives and other bit players stonewalled as the news cameras rolled. The Senate Banking Committee under Senator Paul Sarbanes (Democrat from Maryland) proved to be the most important, laying out a foundation for legislation based on specific problems, including audit problems, weak corporate governance, and a poorly funded SEC.

Legislation more or less died in committee, in part because Congressman Michael Oxley (Republican from Ohio), Chairman of the House Committee on Financial Services, was less interested in massive reform. (After he retired from Congress in 2007, Oxley became a lobbyist for the Financial Industry Regulatory Authority, affiliated with the securities industry.) Then WorldCom went bankrupt (and several other scandals and bankruptcies occurred around the same time, such as Adelphia) in mid-2002. Legislation quickly followed this renewed outrage and the SOX of 2002 passed and was signed into law by the end of July. Thanks to WorldCom, SOX included a fairly stringent reform package.

SOX is by far the biggest regulatory reform in financial markets, financial disclosure, and auditing since the original 1930s securities acts. Particularly important are major changes to corporate governance requirements, the creation of the Public Company Accounting Oversight Board (PCAOB) and other audit-related rules, and new responsibilities of CEOs and CFOs. SOX also affected SEC requirements, FASB funding, and stock exchange rules. Various parts of the bill came under attack, mainly by corporations and their various supporters, in large part because of perceived huge additional compliance costs. The standard argument was used: the expected benefits did not justify the costs.

Corporate Governance

Corporate governance became a major area for reform. The potential for corruptions expands exponentially when governance is weak, accommodating, or part of the manipulation. Such was the case at Adelphia, when Regas family board members used their fiefdom as a convenient automatic teller machine. Virtually all of the scandal-plagued companies suffered from weak governance or worse. After the debacles at Enron, Adelphia, and all the rest, governance became a substantial concern of Congress.

The objectives of the board of directors are long-term strategic planning and oversight of the company’s business strategy and operations. Corporate governance is the overall structure in place to promote these objectives. The majority of big corporations are run by a dominant leader who is both chairman of the board and CEO. Consequently, the CEO typically was in position to control the board and ensure that board members were allies. Researchers in economics and business have analyzed governance for decades, providing evidence of preferred practices. Findings suggest a well-functioning board should be made up primarily of diligent outsiders preferably not buddies of the CEO, the audit committee of the board should have substantial power in picking and reviewing the results of the audits, and substantial disclosure should be made related to board and executive compensation, information on the board members to be elected (preferably all should be elected annually), board committee results (audit, compensation, executive, and so on), and thorough information on amendments up for stockholder votes.

New corporate governance rules were part of SOX, which included some guidance but also shifted responsibility to the stock exchanges and SEC oversight. The NYSE and NASDAQ rewrote governance guidelines including the need for the majority of the board members to be independent, and various rules on the major committees—compensation, audit, etc.—which would be composed exclusively of independent directors.

Particularly important to investors and analysts are the expanded SEC disclosure requirements in the proxy statement. The members of the board up for election are listed with a short biography. Most companies require annual election for all members; however, because they generally run unopposed, the important point is to determine the relative competence of the members. The members of board committees and board member compensation also are disclosed, along with committee responsibilities. Reasonable details of the audit committee are described, including fees paid to the external auditor, the auditor selection process, and information on auditor/audit committee meetings and interactions.

An analysis of compensation paid to the major executives is detailed, listing base pay, bonuses, stock-based compensation, retirement funding, and various perquisites and other benefits. Some discussion is usually presented on the relationship of compensation and corporate performance. SOX does not limit executive compensation, but current SEC rules do provide considerable information. Because the executive incentives remain basically the same as before SOX, the potential to manipulate accounting numbers remains virtually unchanged. The concept of “performance-based compensation” does not seem to eliminate big pay packages for mediocre or worse performance. Each company’s compensation committee determines how performance is to be measured. Additional rules were added by the Dodd-Frank Act, described in the next chapter.

Audit Requirements and Additional Reports

The audit committee is responsible for both external and internal audits. Auditors are hired and paid by the corporations (now through the audit committee). Therefore, the auditor incentives remain to be as accommodating as possible. The audit committee must be made up exclusively of independent board members and the committee chair must be a “financial expert,” with expertise on GAAP, audit preparation, and internal controls. That may provide some assurance; however, the various financial and accounting scandals both before and after SOX suggest continued concern.

The auditor’s report (also called the audit opinion) is included in the 10-K, usually at the start of the financial statement section. Almost all opinions are clean (which are called “unqualified opinions” and include: “the statements present fairly the financial position and results of operations ... in accordance with GAAP”). The date of the opinion indicates when the audit was completed and is listed on the audit report. Presumably, an early date suggests a problem-free audit. The SEC requires the 10-K to be issued to the SEC within 60 days of the end of the fiscal year, which means the audit must be completed quickly. Any 10-Ks submitted after this 60-day limit suggests severe accounting/auditing problems.⁸

SOX requires addition reports from executives and the auditor. Both the CEO and CFO of corporations must certify that each 10-K and 10-Q under Section 302: “fairly presents, in all material respects, the financial condition and results of operations of the issuer.” A later section of SOX describes severe penalties for failure to comply (“willfully providing false information” or “providing false information” could results in jail time up to 20 years and million dollar fines). Consequently, increased executive incentives exist not to commit fraud. In theory at least, chief executives at companies like Enron could not claim ignorance. It turned out that conviction proved to be difficult. Soon after SOX the CEO of HealthSouth was indicted but not convicted in what seemed to be a clear cut violation of Section 302.

Internal controls represent the procedures to direct corporate resources, including measurement and monitoring. Internal control has been an integral part of auditing for decades and a federal requirement since the foreign Corrupt Practices Act of 1977. The Treadway Commission (National Commission on Fraudulent Financial Reporting) began in 1985 to study fraud and their findings included an internal control framework.

Section 401 of SOX proved to be the biggest problem in regulatory enforcement shortly after SOX (regulatory overreach and onerous audit costs to comply according to the critics, who included most public corporations and the Chamber of Commerce). Section 401 requires that both the auditor and company must submit reports on internal control as part of the 10-K, particularly pointing out any “material weaknesses” discovered. Media coverage on post-SOX audits was intense, which encouraged companies to submit to greater audit scrutiny (and considerably higher costs). The greater audit time involved in these audits caused the Big Four to drop a number of audit clients (generally smaller public companies and likely those with lower accounting quality), which were picked up by non-Big Four auditors.⁹ The high cost of compliance was the early complaint, relative to the perception of few benefits, including “over-auditing” in the field and over-regulation by the SEC. Analysts and other outsiders generally assumed that because internal control requirement had been in place for decades it was unlikely that major corporations could be substandard or need much additional audit time.

In Earnings Magic and the Unbalance Sheet,¹⁰ I evaluated the auditors’ internal control reports for the 30 companies in the Dow Jones Industrial Average shortly after SOX. These are the bluest of the blue chip corporations of America. Even in this group, material weaknesses were found for two companies, American Insurance Group (AIG) and GE, both firms that had AAA bonds ratings and later fell from grace during the 2008 mortgage debacle. Both were required to restate earnings. Derivative accounting was the problem at GE—this conglomerate has a major finance subsidiary, GE Credit, with a large derivative operation. AIG had multiple problems, including “control environment, controls over evaluation of risk transfer, controls over balance sheet reconciliation, controls over accounting for certain derivative transactions, and controls over income tax accounting.” AIG, of course, became one of the big losers in 2008 (as were the taxpayers forced to bail out the company).

Regulatory Funding

A great way to make regulation effectiveness go away is to eliminate, or at least substantially reduce, funding. Without much of a budget, it is difficult to do a competent job. That had sometimes been the fate of the SEC as funding has gone up and down as presidential administrations changed. Those favoring deregulation (common since the Reagan revolution of the 1980s) have seen falling budgets. The SEC’s roles were expanded without expanded budgets. The 1990s saw tremendous economic and corporate growth, especially the new high-tech companies that went public well before profits emerged. The SEC focused on these problematic companies, to the detriment of persistent reviews of 10-Ks and other financial reports. Enron was the most prominent neglected example.

One of the regulatory fixes of SOX was better funding for the SEC, FASB, and brand new PCAOB. SEC funding, a federal appropriation, increased substantially—at least in the short run. Prior to SOX, the FASB was on its own, raising money from contributions (much of it from corporations and corporate-sponsored organizations—leading to conflicts of interest) and selling copies of pronouncements and other stuff. SOX allows the FASB to receive “support fees” from public companies based on corporate market value. Basically, the FASB draws up a budget (with SEC approval) and bills the corporations for their share. PCAOB funding works the same way. The concept is that adequate funding will be maintained and both organizations will remain independent and free of corporate conflicts.

PCAOB

Historically, auditing standards (GAAS) were created by committees of the American Institute of Certified Public Accounting (AICPA), essentially the trade association for CPAs. This was the group that had the expertise, but also self-interest in promoting themselves. SOX replaced this with the PCAOB as a semi-public nonprofit organization. Both public companies and the auditors must register with the PCAOB. The five-member board is chosen by the SEC to serve five-year terms (and can be appointed for a second term, but no more).

The PCAOB issues auditing standards; in addition to that, auditors are inspected for audit quality, with the power to institute disciplinary actions after appropriate investigations for violating the law and professional standards. In 2003 the PCAOB adopted various existing standards as “interim.” As of 2013 the regulator issued a total of 16 auditing standards, all approved by the SEC. In addition the PCAOB issued ethics and independence rules, quality control standards, attestation standards, plus “audit practice alerts and other guidance.” The organization’s website (pcaobus. org) also lists “current standard-setting and related rulemaking activities.”

The PCAOB inspects the audit firms to “assess compliance with the Sarbanes-Oxley Act, the rules of the Board, the rules of the SEC, and professional standards in connection with the firm’s performance of audits, issuance of audit reports, and related matters involving U.S. companies, other issues, brokers, and dealers” (pcaobus.org.inspections/pages/default. aspx). The initial inspections were made on the Big 4 by 2004. The auditors that issue reports on at least 100 firms must be inspected annually; all others, within three years. There were nine auditors inspected annually in 2012, including Big 4 Deloitte & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers, plus BDO Seidman, Crowe Horwath, Grant Thornton, MaloneBailey, and McGladrey & Pullen. The inspection reports are listed on the Board’s website.

The Board has the authority to: “investigate and discipline registered public accounting firms and person associated with those firms for noncompliance.” The process includes investigations, hearings, sanctions, and disciplinary orders. Settled disciplinary orders by auditor are listed, a total of 50 in 2013, including Deloitte & Touche in 2007, PricewaterhouseCoopers in 2011, and Ernst & Young in 2012.

The Board is funded by the audited public corporations. The PCAOB prepares a budget, which must be approved by the SEC and the total cost is charged to the public companies as “accounting support fees” based on the total market capitalization of those over $25 million. The 2013 budget was set at $245.6 million, an 8% increase over the 2012 budget, with an increasing number of international inspections and implementing a new broker-dealer inspection program given as the primary reasons for the increase.

Manipulation Continues

With a better funded SEC after SOX, a chastened audit industry subject to a new regulator, bankrupt companies with leaders facing severe prison time, and companies with considerably more governance, audit and disclosure requirements, scandals should have dropped close to zero. But no. Scandals continued until (and beyond) the big one—subprime loan in 2008. HealthSouth was a major fraud uncovered in 2003. Dozens of stock options scandals were uncovered mid-decade. Several frauds were discovered, including various financial firms well before the subprime meltdown. The biggest one was Bernard Madoff’s Ponzi scheme, uncovered about the time that the world economy was in crisis in late 2008.

HealthSouth

HealthSouth was the country’s largest inpatient rehabilitation health facility at the start of the new millennium, founded by Richard Scrushy in the 1980s. Once again, mergers provided both massive growth and merger manipulation magic. Healthcare, especially Medicare and other government programs, allowed inpatient care providers substantial opportunities to cheat and Scrushy and Co. became manipulation specialists. HealthSouth was eventually charged by Medicate with illegally inflating billings, after which profits dropped and other providers piled on with lawsuits and charges of fraud. The company was forced to restate $2.5 billion in earnings and the SEC charged the company and executives with accounting fraud. Stock trading in the NYSE was suspended and the bond rating down-grading to low junk status. The Justice Department charged securities, wire and mail fraud, as well as money laundering.

Several executive pled guilty and testified against Scrushy, who became the first CEO charged for knowingly filing false reports with the SEC under the SOX Section 302 provisions. Amazingly, he was acquitted. He did have to pay SEC fines and settle stockholder lawsuits. Justice was apparently done when he was later convicted of bribery in a completely different case and sentenced to seven years in prison. HealtchSouth avoided bankruptcy, reorganized, and regained its listing on the NYSE.

Stock Option Maneuvering

Stock options have been a major driver in CEO compensation since the 1990s and probably the prime motivator for corporate manipulation. The amazing gains available proved not enough for many companies, who invented new ways to cheat in the form of “backdating” and “spring loading.” After stock options were approved by the board (which legally sets the option-granting date), many companies falsified the grant date to a date earlier than legally granted, usually the lowest stock price of the period when stock prices were lower, which increased to amount of gain to the holder—it also reduced the amount of cash to be paid to the company. The practice violated SEC disclosure requirements, accounting and tax laws. The SEC investigated over 140 companies and filed civil charges against 24; about 150 companies restated earnings based on internal investigations of backdating.¹¹

Spring loading happens when options are granted immediately before good news (basically a form of enrichment based on insider information). Another form of this move was issuing options after very bad news and stock drops—186 companies handed out options just after 9/11. Finally was the practice of “exercise backdating,” backdating after options have been exercised to a lower stock price. The SEC investigated over 100 companies related to stock option maneuvering. The usual defense claim was ignorance of the rules.

Another interesting form of manipulation was “speed vesting.” Using their new-found independence after SOX provided funding directly from public companies, the FASB required companies to record the value of stock options granted on their income statements as compensation expense beginning in 2006. (Prior to that, the option compensation expense had to be disclosed in a footnote but expensing was not required.) To avoid the added expense in 2006, many companies had them vest in 2005, speed vesting. This was not illegal, but frustrated investors and analysts hoping for greater accounting honesty and fewer greedy executives.

Financial Scandals

Major manipulation at Enron included the abuse of both SPEs and derivatives. Both of these instruments continued to be means of abuse and the financial industry was a master misusing both. Evidence for this showed up well before 2008. Fannie Mae, the quasi-governmental (called a government-sponsored entity or GSE) buyer of mortgages, with a set of special provisions to reduce expenses (including a line of credit from the Treasury Department and special tax breaks), relentlessly used its political clout and weak oversight to enrich the company (e.g., expanding allowable leverage) and especially its senior executives. In 2004 Fannie suffered from weak internal control and was forced to restate earnings by $9 billion because of faulty derivative valuations; excessively compensated CEO Franklin Raines and CFO Timothy Howard were fired. AIG accounted for reinsurance improperly and overstated stockholders’ equity $1.7 billion. The company also paid fines to the SEC and Justice Department for incorrectly accounting for insurance deals. Both companies proved to be big-time losers in the 2008 financial crisis.

The mutual fund industry was investigated by then New York Attorney General Eliot Spitzer in 2003, mainly associated with late trading and market timing. Mutual fund prices are set every day after market trading closes. Buy and sell order received after market closing had to wait to the end of the next business day to be executed. Various mutual fund companies were executing late orders after market closing for “select customers.” Because only these traders had full information on market prices, this was considered unfair. The mutual funds booked the entries to appear as if the trades had been received before market closing. Following Spitzer, the SEC found additional abuses, including another form of “front-running,” in this case by providing select customers and employees insider information about expected price movements based on block trading (buying or selling large blocks of stock) the mutual funds were expected to do. The tipped-off customers would then buy or sell in front of the block trade.¹² The settlement involved large fines rather than jail time for the perpetrators.

Lessons to be Learned

Enron was America’s major (and most infamous) business scandal, but with several close competitors in the 21st century. At the time, Enron paid top-dollar for executive talent. Detailed annual financial reports were submitted. Accounting standards were in place, as were many levels of monitoring and oversight. How could an outrageous, complex fraud continue for years with few people even recognizing a possible problem could exist? Apparently, the potential rewards for cheating were too great to resist, while oversight proved ineffective. Enron, of course, was not unique. High-level manipulation at major companies was pervasive. Unfortunately, Enron, WorldCom and most of the rest had to blow themselves up before the frauds were discovered.

The response seemed right on, detailed public hearings and media scrutiny, followed by the major reform bill, Sarbanes-Oxley—the most significant regulatory reform since the 1930s. It was long and complicated and involved major overhauls of auditing, corporate governance, and increasing responsibilities for the SEC (along with substantial budget increases) and the creation of the PCAOB. However, other areas of concern remained uncorrected, the most important being the uncontrolled executive compensation fueling future incentives to cheat. Areas of particular concern to the financial industries (structured finance, SPEs, derivatives, captured financial regulators) also remained and these would explode into a gigantic world-wide crisis in just a few year.