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CHAPTER FIVE
THE REAL WINNERS OF THE STOCK MARKET GAME

THE EXECUTIVE BENEFICIARY

THE INVESTORS who put their hard-earned dollars into the market take on the majority of the risk but receive only the crumbs of a market advance. The real winners are the executives, the brokerage industry, and the corporations. The potential rewards are so great that the behavior of these beneficiaries of market advances can range from unethical transgressions to outright fraud.

Executive Stock Options—the Fox Guarding the Hen House

The primary argument in favor of large stock option grants to executives is that they give incentive to focus on earnings growth since management benefits if the stock price increases. If the stock price goes up, current stockholders should be happy to reward management for a job well done. There are some major flaws with this line of reasoning due to the inherent conflicts of interest and shortsightedness created by stock option compensation.

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In most companies the chief executive officer (CEO) gets the greatest amount of option grants, usually followed by other officers in the pecking order of the corporate hierarchy.

During the 1990s CEO compensation skyrocketed. A combination of generous stock option grants and ever-increasing cash salaries and bonus structures caused CEO pay to increase by an average of 571 percent from 1990 to 2000. In contrast, corporate profits were up an average of 114 percent, while worker pay was up 37 percent.¹ In 1980 the average CEO made forty-two times the average blue-collar worker’s pay. Twenty years later the spread was a staggering 531 to 1.²

The trend continued during the year 2000. According to the AFL-CIO, the average CEO of a major corporation received $20 million of compensation in 2000. This included a 22 percent increase in salary/bonus and 50 percent increase in stock option compensation. The increase in option compensation is surprising given that in 2000 the S&P 500 index was down 10 percent and the NASDAQ composite index was down by 39 percent. By way of comparison the typical hourly worker received a 3 percent increase in total compensation, while salaried employees received about 4 percent more during the same period.³ The twenty highest-paid CEOs earned an average of $117.6 million in 2000.

Walt Disney’s Michael Eisner was the trailblazer of excessive executive compensation. Eisner’s first contract at Disney made him so rich that other CEOs were green with envy. In 1995 Eisner was the highest-paid CEO in the nation at $194 million. The top figure for all CEOs in previous years was $75 million. Eisner’s total pay for the three years ended in 2000 was $699.1 million. This was during a period when Disney stock actually returned a negative 10 percent to its regular shareholders, and reported net income fell by more than half, from $1.9 billion to $920 million.

The “independent” directors on many corporate boards are nothing but shams—typically handpicked by the CEO and 87loyal to him or her, even while serving on executive compensation committees that ratify bloated executive pay packages. Eisner answered to a board of directors that included the principal of his kid’s elementary school, actor Sidney Poitier, the architect who designed Eisner’s Aspen home, and a university president whose school got a $1 million donation from Eisner. Fortune magazine investigated the board compensation committees that set CEO pay. They found that the committees are generally controlled by the CEOs themselves.⁴ In a speech soon after publication of this article, Laura Unger, the acting chair of the Securities and Exchange Commission said, “Directors have an obligation to the company and its shareholders, not the CEO. Kow-towing to management and blindly signing off on large compensation packages is not a proper discharge of a director’s duties.”⁵

According to the AFL-CIO, almost two-thirds of CEO pay is in the form of stock options. They give examples of excessive overpayments to executives who showed poor performance. Some of these executives were eventually fired or were forced to resign. These cases were referred to as “Poster Children in Executive Excess.⁶

STOCK PERFORMANCE VS. EXECUTIVE PAY

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In 1999 Charles Wang, CEO of Computer Associates, was deemed the highest-paid CEO for that year at $507 million. For the three years ending 2000 his compensation came to $698.2 million. During the three-year period the company’s regular shareholders saw their Computer Associates stock drop in value by 63 percent. Business Week quotes Computer Associates spokespersons as stating that Wang was worth every penny of his pay.⁷

One of the craziest aspects of executive stock options is how they are handled when a company’s stock goes down. In the event that the options become worthless, the board can simply issue more options at a much lower price, even below the stock’s battered-down market value. The logic is that the CEO and key employees need incentives to stay on board and turn things around.

Fortune magazine published its own list of poster children in executive excess in an article aptly entitled “You Bought, They Sold” in September 2002.⁸ Most everyone had heard about the corporate criminals of the day, including executives at Enron, Global Crossing, Worldcom, Adelphia, Tyco, and so on. But what were executives at other companies doing? The not-so-secret dirty secret is that even as investors were losing 70 percent, 90 percent, or even all of their holdings, top officials of many companies that had sunk the lowest were getting immensely, extraordinarily, and obscenely wealthy. They got rich because they were able to take advantage of the bubble to cash in hundreds of millions of dollars’ worth of stock—stock that was usually handed to them via risk-free options—at vastly inflated prices. When the bubble burst, their shareholders were left holding the bag.

Only the largest companies, with greater than $400 million in market value, that had stock price decreases of 75 percent or more from peak to trough met the criteria of Fortune’s study.89 The time period for the report was January 1999 to May 2002. This amounted to 1,035 corporations where executives and directors hauled in roughly $66 billion. Of that amount, a total haul of $23 billion went to 466 insiders at the twenty-five corporations where the executives cashed out the most—approx-imately $50 million per person!

At the top of the heap was Phil Anschutz, a director at Qwest Communications, who received over $1.5 billion. Other Qwest insiders cashed out to the tune of another $750 million, according to Fortune. Qwest was once a $50 stock. Three years after the CEOs cashed in, it was less than $5. It didn’t help when Qwest announced that it had inflated its revenues over three years.

The two top people at Broadcom brought in over $800 million each from stock sales. Anyway, you get the idea. The tragedy of all of this is that these huge windfalls were being siphoned directly from investors to enrich people who were not deserving of these rewards.

How the Real Money Is Made in the Stock Market

The highest price paid for a single-family home in the United States was more than $40 million for the old Hilton estate in Bel Air, California. The purchaser of this house was Gary Win-nick, the CEO of Global Crossing, which now has the unenviable distinction of being one of largest companies to declare bankruptcy. In early 1999 the company was valued at $47 billion. Today it’s close to zero. Consider that Winnick, a former associate of junk bond king Michael Milken, made over $700 million in profits from selling stock in this company that was driven into the ground on his watch.

According to Business Week, Winnick worked as a bond trader and salesman for thirteen years. Like most successful salesmen, his spending was partly for show. He carried cigars but rarely smoked them. His long-winded profanity-laced conversations tended to include a fair amount of name-dropping.⁹

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Consider how the real money is made in the stock market. Look at Global Crossing. It went public in August 1998 and made instant millionaires of hundreds of insiders. As the company was hyped by Wall Street and increased in value, the insiders sold. People who ended up buying stock in the company as a long-term investment lost and lost big. In January 2002 the company went bankrupt. Just remember who lives in the most expensive single-family home in the United States and where that money came from.

Executive compensation packages have obviously gotten out of control and are a major problem. The packages create shortsightedness and a structural inducement to deemphasize long-term planning. Management is encouraged to focus on the short-term price movements of the company stock. Of course, this is usually not in the best long-term interest of the corporation or the shareholders. In addition, when the executives’ own compensation is at stake, many become tempted to manipulate earnings and use other tactics in a desperate effort to prop up the stock price over the short run.

Executives of large corporations typically receive a cash salary in one year that would take the average employee several lifetimes of work to achieve. In addition, corporate executives pay nothing for the stock options granted by the board, which may or may not be offered to the lower employees. If the price of the stock goes down, the executive will still receive his or her salary, maybe a bonus, and other perks, such as the use of a company jet. But when the stock goes up, the executive stands to reap a windfall of wealth that dwarfs the cash salary. It’s an unbelievably great deal for the executive. There are massive possible rewards without any risk at all.

Options dilute the value of stock held by investors for the benefit of the executive and other corporate employees. The bottom line is that it’s a great deal for the executive and a raw91 deal for the investor. Excess option compensation is destructive to the continuing well-being of investors and can be a key factor in the destruction of the long-term health of the corporation.

Corporate Cancer

A serious disease afflicts the corporation, and it is causing a startling mutation in the very purpose of its existence. Traditionally, the corporation produces its product and sells its services with the intention of making a profit for its owners. The owner-shareholders elect a board of directors, which appoints management to run the affairs of the corporation for the owners’ benefit. The owner-shareholders are willing to risk their capital in return for a reasonable return on their investment.

In the mutated corporation the board of directors and senior management appropriate funds from the owner-shareholders and focus their attention on the short-term movements in the stock price at the expense of long-term planning and sustainability. The transfer of wealth is now from the shareholders to management. The large corporation is being utilized as a mechanism for reassigning wealth from the general populace to a select few individuals.

No Relief for the Little Guy

Stockholders can’t depend on the courts to protect their interests either, even when common sense would argue otherwise.

In October 1995 Michael Ovitz was hired to be president of the Disney Corporation. His employment was rocky from the start, and less than one year later he was seeking employment elsewhere. Ovitz and the board of Disney agreed to a severance payment valued at $140 million.

Shareholders sued the board alleging that Ovitz should have been fired for cause and that his termination was at the very least a voluntary resignation. The Delaware Supreme Court agreed with the lower courts and said that the board acted with 92sound business judgment in that the exchange was not so onesided that no businessperson of ordinary intelligence could conclude that the company did not receive adequate services for the money involved.¹⁰

Because of favorable accounting treatment, tax incentives, and court rulings of this nature, it is likely that the use of stock options will remain an essential element of the executive compensation plan. Disgruntled shareholders seeking to curb the excess through the courts are fighting an uphill battle. The courts encourage shareholders not to depend on the legal system for relief.

THE CORPORATE BENEFICIARY

Using Stock As Currency

It seems that hardly a day goes by without news in the financial press about a new merger or acquisition of one company by another. When one company purchases another it is financed either by cash, stock, debt, or a combination of all three. We’ve already seen how corporations use their stock as a substitute for cash to compensate top management. Another creative use of company stock is for acquisitions of other companies.

In the 1960s there was a flurry of merger and acquisition activity in what could be called the “conglomerate boom.” Antitrust laws kept large companies from purchasing firms in the same industry, so creative entrepreneurs went on to purchase businesses in completely different fields without any hassle from the Justice Department. The motivation behind these purchases was that the acquisition process itself could produce growth in earnings per share. With an easy bit of basic accounting magic, they could put together a group of diverse companies and produce rising earnings per share for a period of time.

The accounting trick that makes this game work occurs when a company that has a high price-to-earnings ratio swaps its high-multiple stock for the stock of another company with 93a lower multiple. For example, assume that Hi-Tech Growth Company earns $1 per share, has 1 million shares outstanding, and a P/E ratio of 50. This means the stock sells at $50 per share. Hi-Tech Growth decides to buy Old Tyme Meat Packing, a company that earns $1 per share, has 1 million shares outstanding, but sells at a P/E ratio of 10. This means Old Tyme stock sells at a price of $10 per share.

Hi-Tech rolls in and offers Old Tyme shareholders $15 per share, or 50 percent more than the current trading price, in the form of Hi-Tech stock. Therefore, Hi-Tech issues 300,000 ($15 million/$50) new shares to Old Tyme shareholders for 100 percent of the company. The next year, Hi-Tech and Old Tyme earn the same amount, $1 million each, for a total of $2 million. Hi-Tech shows an increase in earnings per share of almost 54 percent to $1.54 ($2 million/1.3 million), even though the earnings for both organizations were flat.

Investors see over 50 percent growth rates in earnings per share when in reality the conglomerate literally manufactured growth. The more acquisitions of this kind Hi-Tech can make, the faster earnings per share will grow, making the stock even more attractive to investors. This ploy makes top management look like geniuses when in reality it is just another accounting deception.

As a side note, in the 1980s many of the old conglomerates began to play the game of deconglomeration. In order to boost earnings, the old conglomerates began to shed their unrelated poor-performing acquisitions that were mismanaged and losing money.

The new-technology bubble of the late 1990s caused a lot of high-tech companies to have sky-high price to earnings multiples. Many of the companies couldn’t be evaluated by this traditional ratio because they didn’t even have positive earnings. Mergers and acquisitions came into vogue again as companies 94used their high-priced stock in exchange for other companies. However, in most cases there was a large contrast between the strategy of the conglomerates in the 1960s and that of high-technology companies in the late 1990s. The focus wasn’t on immediate profit but on establishing a commanding lead in market share in an area that had the expectation of tremendous growth in the future. It became common for companies to issue hundreds of millions or even billions of dollars worth of stock for a company that had only a fraction of the acquisition price in tangible assets.

Many corporations that were graced with these colossal valuations just couldn’t seem to help themselves from going after other companies. Lots of the deals had shareholders scratching their heads, but most bought into the concept that the potential future business was so huge that the premium prices being paid for these companies were justified. Besides, the accounting treatment on these acquisitions was very favorable to the acquirer.

When Goodwill Turns Bad

There used to be two accepted means of accounting for a merger. One was by the pooling of interests method. The other was by the purchase acquisition method.

According to a study completed by PriceWaterhouseCoop-ers, over 60 percent of the mergers valued at $500 million or more between 1994 and 1997 were accounted for using the pooling method. The method was very simple: you simply added the balance sheet items of the two companies together. If a company exchanged stock worth $5 billion for another with assets of only $1 billion, you simply ignored the extra $4 billion that was paid. Shareholders’ stake was diluted, but this excess cost was never charged to earnings. Corporate executives loved it! Management could overpay for ego-gratifying acquisitions, and the cost of this stupidity never showed up anywhere. Pooling of interests was the dominant method used 95in the conglomeration boom described earlier. Pooling was completely idiotic, and the only reason it was accepted for so long was because of intense lobbying by business.

In the purchase acquisition method, any premium paid in excess of the acquired company’s book value gets recorded as goodwill. This is amortized over time, which causes a decrease in earnings because of the amortization expense. Usually, the goodwill is written off over a period of about five years.

The SEC spent a lot of time on the merger accounting issue and wanted to set up standards to strictly limit and phase out the pooling method of accounting for acquisitions. A resounding majority of senior corporate executives wanted to keep the pooling method. It has become a political issue, with subcommittees of Congress hearing arguments from corporations and accounting firms. The bottom-line argument for utilizing the pooling method was that the alternative purchase acquisition method resulted in lower reported earnings per share.¹¹ If earnings per share decreased, the stock would likely decrease in price, and no one is going to be happy about that.

Even when companies were forced to use the purchase acquisition method, they tried to minimize the amortization impact on earnings by pointing out that this was a noncash expense. Some companies decided to take the big bath in one quarter and write off all the goodwill at once as a separate line item on the income statement. Again, they emphasized that this was a nonrecurring, noncash charge.

New accounting pronouncements require that companies use the purchase method instead of the pooling method when accounting for acquisitions, but now goodwill is treated as a nonwasting asset. This means that goodwill can stay on the books permanently unless impaired. And impairment is based upon the judgment of management and their auditors. Close one loophole and open another.

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Too Little, Too Late

The regulators are backlogged with reviewing corporate financials. Aggressive or questionable accounting practices can slip through the cracks or take years to clamp down on. By the time regulators take action the company may be out of business or may have hoodwinked investors long enough to use its overpriced stock to issue additional securities for cash and/or acquisitions to feed its growth.

One such scenario of regulators catching up after the fact is America Online (AOL). For years AOL sent out millions of computer disks to potential customers to entice them to try its services. Personally, I must have received at least a dozen of these by direct mail. Like any other junk mail, I immediately disposed of these disks and wondered to myself how much the company was spending on this marketing program and whether everyone else around the country was getting multiple offers to sign up with AOL. It turns out AOL was spending a truckload of money on distributing these disks and aggressively deferring these expenses on their financial statements. This means that the bulk of this marketing expense was carried as an asset on the company’s balance sheet. This accounting ruse allowed AOL to dramatically overstate its profits. Investors were totally enamored with an Internet company that was actually making a profit and mindlessly continued to buy the stock. It’s almost certain that AOL stock would have been trading at a much lower level if its accounting had been done properly.

AOL made the most of its high-flying stock by making many aggressive acquisitions. For example, in November 1998 AOL agreed to acquire Netscape in a pooling of interest transaction valued at $4.2 billion. Netscape at the time had a book value of $394 million. Since the acquisition, the Netscape brand name has all but disappeared, and many of the company’s talented people, including founder Marc Andreesen, left AOL. In other words, AOL probably spent about $3.8 billion 97too much. This loss never had to be reflected in the income statement because AOL used the pooling of interest method for the merger.

On January 10, 2000, AOL announced that it was acquiring communications giant Time Warner, a much larger organization in every respect. According to the press release:

On May 15, 2000, after an investigation by the SEC turned up the improper accounting, AOL submitted to a settlement (without admitting or denying any wrongdoing), paid a $3.5 million fine, and restated its prior reported income to losses. Of course, by that time the company was home free. AOL had already used its overinflated stock to buy one of the largest news organizations in the world.

By the way, the $3.5 million fine paid by the company pales in comparison to the $349.7 million made by Steve Case, chairman and CEO of AOL from 1998 to 2000. The merger deal generated stock option bonanzas for Case, his deputy Robert Pittman, and Time Warner’s top five executives, totaling an estimated $3 billion. Another interesting note is that in the three years after the initial merger announcement the market value of the combined organization has gone from $334 billion to approximately $60 billion. 98

THE INVESTMENT INDUSTRY BENEFICIARY

When a company decides to do a direct offering of its stock to the public, there is no law that says it must go through a Wall Street investment bank. However, very few firms are able to do this on their own unless they are only attempting to raise a modest sum of money. The investment banking industry has the infrastructure to raise huge sums of cash for corporations with the support of a distribution system composed of brokers/advisers, research analysts, and valued contacts with institutional money (the really big money). Investment bankers serve as intermediaries between the corporations that need to issue stock or bonds and the investors willing to invest in such instruments.

I’ve already given examples in Chapter 3 of the significant dilution that occurs for the investor in an initial public offering (IPO). The conflict of interest that exists for the company that wants to get as much money as possible and give up as little of the company as feasible is readily apparent. This conflict and the significant dilution are readily disclosed in the IPO offering document. Now if only the investor had the inspiration and time to read as well as comprehend the report.

An institutional investor has access to large sums of money with the primary purpose of investing a large percentage of these funds in the securities markets. Investment bankers savor their relationships with these organizations. It’s the institutions that provide funding for the bulk of IPOs as well as bond offerings.

When an IPO is brought to market by an investment banker, who is the actual client of the investment banker? Is it the corporation for whom the money is being raised? Or is it the retail investor who has a brokerage account with the firm? What about the institutional investor? The answer of course is that all are clients, but all are not treated equally.

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Exorbitant Fees

In 1999 and 2000 companies raised approximately $121 billion from 779 IPOs. Of that amount, over $8 billion was paid to investment banks in the form of underwriting fees. However, that is only a fraction of the true cost to the companies issuing new stock. The investment banks priced the stock far below the full market price—measured as the price reached on the first day of trading. This cost amounted to $62 billion. In other words, for every dollar raised by the underwriters, corporate America paid 57 cents in fees and foregone proceeds.¹³

In lieu of selling the shares to those willing to pay the most, Wall Street handed the underpriced shares to a privileged group of institutions that frequently trade with the investment banks. This was a nice windfall to the institutions. They were able to purchase stock at the offering and benefit from the huge demand for IPOs by the retail investor, who was willing to pay dizzying amounts over and above the offering price. On the first day of public trading, prices jumped an average of 71 percent in 1999 and 57 percent in 2000. These kinds of numbers only occur in a hot market, and the investment banks certainly made hay while the sun shined.

The investment banks would have received higher underwriting fees if they had priced the IPOs correctly. But they received far higher income from trading revenues. In exchange for the low-priced shares that were practically guaranteed to jump once they started trading, institutions gave the investment banks huge commissions that reached an outrageous $1 per share. The SEC wonders whether these unusually high commissions were actually “kickbacks” to the Wall Street firms in exchange for the shares. Private lawsuits describe these commissions as “excessive and undisclosed.”

According to Michael Tennenbaum, former vice chairman of investment banking at Bear Stearns, “Wall Street has always attracted greedy, power hungry people.”¹⁴ In the past, investment bankers had to sell offerings at about 10 percent below 100their estimated price once the stock started trading. The institutions clamored for this cheap stock. But in return, the firms asked that the institutions hold the stock for at least several months. In 1999 and 2000 the prices were up so much that the institutions sold immediately, a practice referred to as flipping, and used the proceeds to get in on another IPO. It worked out great for the institutions and the investment banks, but not so well for the individuals who bought in at the high.

“Spinning” Out of Control

Investment banks used the inexpensive stock as a perk to get business. They would often hand shares of a current IPO to the founders and majority owners of still privately owned corporations, guaranteeing them a nice fast profit—a practice called spinning. Wall Street needed a steady source of new IPOs to keep the money machine cranking. Essentially, this meant that Wall Street was using what should have been another issuer’s money to pay for the firm’s own marketing expenses. The investment bank had control over the distribution of the underpriced stock, and they used it to their advantage wherever and whenever possible.

Corporate America was a loser in that they should have received the benefit of their overpriced stock, not the institutions and their own investment bank. But the biggest loser, as always, was the individual retail investor. Individuals had no access to IPOs unless they were in a position to benefit the investment bank. They bought stock after the opening of trading and paid the huge premiums over the IPO price. By the size of the trades, you could tell that these were small investors, and it was their willingness to purchase that allowed the institutions to sell and make a quick buck.

Just six months after the 779 IPOs of 1999 and 2000, 75 percent of these firms traded at prices below the initial offering price. Two years later many of these companies were trading at a fraction of their offering price or had gone out of business. 101The small investor who bought into these at the opening-trading price and is holding for the long term is now a minuscule investor.

STEERING CLEAR OF THE INSANITY

The common assumption that the best prescription for prosperity is a free market economy in which the government allows substantial freedom for businesses to pursue profits has been corrupted by the degenerative evolution of the corporation. Adam Smith, the late-eighteenth-century Scottish economist, addressed this issue in his magisterial work The Wealth of Nations. This writing has served, perhaps more than any other single work in the economic field, as a guide to the formulation of governmental economic policies.

Adam Smith believed that owners, not managers, exercise the greatest diligence in the efficient use of assets and capital.

This was written in 1776, but its message is certainly timely. Adam Smith, deemed the father of capitalistic thought by many economists, believed that it was best for the individual to invest locally because of the inability to supervise his or her capital when it was far from home. He did not conceive of a corporate structure that disconnects the rights and powers of ownership from the consequences of their use. The fact is that the most shareholders can lose on a stock investment is the amount of their investment. Owners are shielded from any 102liability resulting from the consequences of management activities and are kept largely unaware of actions taken in their name for their exclusive benefit. They are given historical reports that, as we have seen, do not always portray the truth.

The Enron case provides a dramatic example of the outright corruption that is possible in our financial system that goes far beyond the “negligence and profusion” predicted by Adam Smith. Enron was led by arrogant executives with inflated egos, who refused to admit that they made grave errors in business judgment and hid their mistakes through creative accounting maneuvers. Wall Street, anxious to do business with the seventh largest company in the country, continued to recommend Enron. This enabled the stock price to remain artificially high as insiders cashed in their options and made hundreds of millions of dollars, all the while encouraging the rank-and-file employees not only to hold but also to buy more stock. Enron had paid Wall Street firms over $320 million over the years in underwriting and consulting fees. As late as September 26, 2001, Chairman Kenneth Lay urged employees to buy the company stock and assured them in an internal memo that “the third quarter is looking great.” This was three weeks before the company announced a $638 million third-quarter loss as opposed to projected profits.

The only airtight solution for investors is to avoid gambling on the uncertain returns of individual stocks and mutual funds by developing a personal strategy for dealing with threats to the safety of their investment principal.