CHAPTER ELEVEN
REFORMING THE SYSTEM

OVERHAUL!

WE HAVE SEEN the tremendous conflicts of interest that plague corporations and their CEOs, the accounting industry, the brokerage industry, and even our federal government. These conflicts contributed to the shocking evaporation of wealth that investors endured in the early 2000s when the market bubble finally burst.

The solution to these problems isn’t easy. It will take a concerted effort by all concerned to re-create a fair and equitable capital system in which the investor gets a reasonable return that is proportionate to the risk assumed when purchasing equities. The markets will eventually provide such a solution, either through decreased share prices or meaningful change at all levels. If reformation doesn’t occur, further harm to stock portfolios is inevitable.

Investors who employ strategies for protecting principal are prepared for any scenario. The major overhaul required to win back investor faith and confidence is a huge and complex undertaking. Conflicts of interest still exist, which make the task a strenuous challenge. 190

A Taxing Situation

The American public is entitled to be fed up with corporations as well as the regulators, analysts, and auditors who are expected to assure that this system that spawns greed and arrogance doesn’t get too far out of control. Situations that would have seemed impossible, surreal, and undemocratic 200 years ago are part of everyday life today. We need to rekindle the revolutionary spirit of yesteryear and break out of this downward spiral of economic servitude.

Our capital system should be based on fairness among all participants in the economy. Shareholders, employees, and ordinary citizens of the United States are being taken advantage of by corporations and, in a sense, their own government, whose policies enable the continuation of the current system that creates wealth for the benefit of the few.

Just reflect on our tax code and the many ways corporations reduce their tax burden. When companies employ strategies to reduce the taxes they would otherwise be paying, it puts the burden back on individuals to pick up the tab.

Consider the research of finance professors Simon Pak, of Pennsylvania State University, and John Zdanowicz, from my alma mater, Florida International University, on corporate tax evasion from international trade transactions. Cheating Uncle Sam is a relatively simple process for the multinational corporation. For example, a Japanese automaker manufactures a car radio for $100, but its U.S. subsidiary buys it for $199, then sells it for $200. The company’s bottom line hasn’t changed, but the taxable profit in the United States is now just $1 instead of $100. A tax bill that would have been $34 is reduced to 34 cents. This is why U.S. companies are paying as much as $113 a piece for imported razor blades from Britain and $4,896 for tweezers from Japan.

The converse is true as well, as U.S. trading partners get the deals of a century: car seats exported to Belgium for $1.66 each, missile launchers to Israel for $52 a shot, and watches encased 191in precious metals to Colombia for $8.68 a pop. There is no profit recognized at these prices in the United States, but the profit is recognized overseas, where the tax rates are lower or nonexistent. Pak and Zdanowicz calculate that this transfer pricing cost the public treasury $53 billion in 2001 alone!²

The Tax Reform Act of 1986 was passed to deal with the abusive tax shelters that resulted from the passage of the Economic Recovery Tax Act of 1981. Investors were able to write off far more than their investment in real estate and real estate partnerships and, as a result, greatly reduce or even eliminate their tax liability. Real estate was being developed and deals being struck not from need but purely because of the tax benefits. The 1986 act pulled the rug out from under this game and caused a temporary collapse in commercial real estate prices that ultimately led to the downfall of virtually the entire savings and loan industry, which eagerly provided the financing for these ventures.

Individuals and small closely held corporations now have to abide by the “passive loss” rule, which strictly limits the amount that an investor can deduct from real estate investment losses primarily caused by depreciation. However, large corporations were exempted from the passive loss rule. Large corporations can use passive losses to offset any amount of income from any source even to the point of bringing taxes down to zero. With the financial lifeline of both major political parties connected so tightly to corporate interests, it shouldn’t be surprising that the tax code closes an abusive loophole to individuals but lets large corporations continue to use this tax dodge freely and legally.

CORPORATIONS AND THEIR EXECUTIVES

I worked for several large profitable corporations early in my career. I always shook my head in wonder at the chaos and 192how some of these organizations could be showing positive earnings. It always seemed as if very few people, including those at the top, had an adequate handle on the big picture. The politics, the meetings, the absolutely stupid decisions—it was maddening!

The total compensation of some of these so-called executives at the top seemed totally out of line with reality. Some were earning the equivalent of what 400 to 500 employees earned. The situation has gotten even worse over time. Today, I equate some of these executive compensation packages to legalized theft from shareholders. Stock option incentive plans can enrich management beyond comprehension and certainly way beyond their contribution to the success of the business.

In addition, the accounting for stock option compensation makes no sense. If it’s compensation and acting as a drag on shareholders, it’s only logical that it should be treated as an expense. But we need to do more than accounting reform. We need to go back to the original argument against the legality of options and consider them for what they really are—corporate waste. The stock option as a compensation tool should be completely eliminated. Stock options help to drive management’s focus on the short-term performance of the stock’s price. This in turn creates a conflict of interest between the long-term owners of the company (the shareholders) and management. Executives come and go, but while they are at the helm, many definitely try to make the most of it for themselves.

It is fair for management to receive higher compensation than other employees because they have more responsibility. But shareholders should demand that top management receive maximum compensation based on a multiple of the firm’s lowest-paid employees. For example, if the multiple is 60 and the lowest-paid employee makes $20,000 per year, top management shouldn’t make more than $1.2 million. This multiple could be adjusted up and down based on the size and nature of the firm. 193

The straightforward task of corporate accounting has become a convoluted mess. Generally Accepted Accounting Principles (GAAP) allow too much leeway and judgment on the part of corporate management. There are some simple ways to solve this problem and force proper accounting.

Reporting Assets

Corporations should only report assets that have a tangible value on their balance sheets, and these values should be based on what the asset is actually worth. Just study a corporation’s balance sheet and the amounts it lists as assets. Some companies have billions of dollars of intangible assets such as goodwill. These “assets” have zero value. The company can’t sell or redeem them for cash and never expects to realize anything from them, yet they are still listed as assets.

If a corporation reports only its tangible net worth to its shareholders, it becomes much harder to cook the books and play with the numbers. It’s also much easier for outside auditors to concentrate on the verification of asset values instead of tiptoeing around this issue. If the tangible net worth of a firm has increased over the period, a profit has been made. If it has decreased, there was a loss. If a company makes a boneheaded acquisition and pays over $40 billion for another company with assets of half a billion dollars, as JDS Uniphase did in its purchase of SDL, Inc. in early 2001, the difference of over $39.5 billion should be reported as an immediate loss after the purchase.

Management should have to answer to shareholders as to why they think it’s good for the company to pay out a dollar and receive less than two cents of assets in return. That $39.5 billion was booked as goodwill and appeared as a “phantom” asset on the company’s books shortly after the acquisition.

The common practice of pro forma accounting and reporting earnings before income taxes, depreciation, and amortization (EBITDA) should be prohibited. It’s fine if a company wants to include this as supplementary information, but these numbers should not be referred to in a press release.

Reporting Liabilities

Corporations need to report all of their liabilities. Innovative accountants have masterminded methods for hiding liabilities by using vehicles such as offshore subsidiaries.

A firm’s pension liabilities and assets should be clearly stated on the net worth statement. Nowadays you have to scour the footnotes to the financial statements to find these important details. In addition, the actual value of the pension liabilities should always be reported instead of some fictitious number based on an unrealistic assumed interest rate as is commonly done today. Companies should all be required to use a uniform interest rate such as the rate on thirty-year treasury bonds.

ACCOUNTANTS AND REGULATORS

Accounting for the large corporation is an exceedingly complex task. A company like Citigroup has subsidiaries in over 100 different countries. Many of these countries have accounting standards that differ from those used in the United States. There are at least twenty-six different methods of accounting used throughout the world that affect U.S. corporations. Consolidating all of this into one statement is a herculean task.³

Generally, accountants do the best they can to present an accurate picture of a company’s financial posture. Unfortunately, there are far too many areas in which judgment plays a part in determining how and when to report certain items. Accountants are conservative by nature, but they come under immense pressure from upper management to portray the 195numbers in a positive light. As a former accountant, I remember the pressure to get creative and make the numbers look better so that my firm’s management would make or come close to its projections.

The Securities and Exchange Commission tries to assure that there is a level playing field by requiring corporations to make full disclosures, but they can’t force investors to read them or prevent investors from making foolish mistakes.

Back in the 1980s a couple of hucksters scammed a group of investors out of $120 million. Amazingly they carefully laid out their scheme in the prospectus they gave to potential investors. They disclosed the huge fees they took out of the deal and the fact that the business had virtually no chance of being profitable. At the same time, they projected a 17 percent tax-free return, and the investors bought into it without looking at the details. Very few investors bother looking at financial statements or disclosures. And the sad fact is that very few investment professionals bother looking at them either.⁴

It’s our responsibility to read the fine print and understand what we choose to invest in. If there is a guarantee against loss, it’s essential to know when and how we collect on the promise. Plenty of bad investments can easily be avoided if we take the time to understand the risks and properly evaluate the potential for rewards.

Taking Advantage of Investors

I received an unsolicited email from something called the OTC Newsletter, “Discover Tomorrow’s Winners,” in August 2002. It touted a stock by saying a “licensed and registered investment expert” says now is the time to buy it. There were lots of reasons to buy, according to the email. They are reproduced verbatim here:

1. Liquidity will increase including coverage by other analysts
2. 196 Has a network of strategic alliances designed to assist company in obtaining DOMINANT MARKET SHARE
3. Current market in which company operates is expected to grow between $900 million and $25 billion
4. Company growing at fast rate
5. One of the fastest growing companies in its field
6. Company is profitable and on track to beat all earnings estimates
7. Impressive client list including Chevron, GE, and the U.S. Air Force
8. Buy now. Price will hit $2 in 4 months and $5 in 16 months.

Just for fun I looked up the stock and actually found a financial statement filed with the SEC. The company was a sole proprietorship and had divided itself into three impressive sounding divisions. That one employee must be pretty busy!

The company had $1,400 in cash, $4,000 worth of furniture, and a $2,400 deposit on the office that it leases. That about sums it up. The liabilities exceeded assets, resulting in a negative net worth of $8,200. The company had six-month revenues of $138,000 and six months of expenses of $140,000. Most of the expenses were related to the salary of the sole employee.

It looks like the one employee is some sort of manufacturer’s sales rep who gets paid a commission. This employee decided to incorporate but is making sure that he takes out everything that he makes in salary. Of course the one employee is president197 and chairman and has grand plans for this business in the future. According to SEC filings, the “insiders” are selling from $50,000 to $100,000 of this company’s stock each month.

Here is a guy who has been grossing about $200,000 a year in commissions from selling who knows what. The SEC filing says phonograph records. He incorporates. He buys a shell of a company for virtually nothing, and that company purchases his business for stock and starts pumping the stock. At a minimum he pays a stock promoter (most likely with stock) to blast emails to investors around the country. Enough interest is generated each month to allow him to sell miniscule pieces of his worthless company to investors so that he makes an additional $600,000 to over $1 million each year. What a scam!

Believe it or not, there are over 21 million shares outstanding, and the stock trades for 40 cents a share. This means that the market values this fledgling company at over $8 million! This person has discovered the real secret of making money in the market with little risk: taking advantage of investors.

Would it surprise you to know that there are many similar companies doing this? It’s certainly unethical but in most cases perfectly legal. Regulators have no power to crack down on these kinds of operations except to require disclosure. But obviously the disclosures are not read or comprehended by investors.

Many investors don’t understand what they are actually purchasing when they make an investment. If everyone truly understood the real risks of gambling on stocks, there would be far fewer people willing to place their hard-earned dollars on the line.

THE BROKERAGE INDUSTRY

In early 2002, a court order by the New York attorney general described the purpose of a major brokerage firm’s research department as “attracting and keeping investment banking 198clients, thereby producing misleading ratings that were neither objective nor independent, as they purported to be.”⁵

Investment banking firms should be prohibited from publishing research on any company. The average investor thinks there is value in the firm’s recommendations when in reality the suggestions are virtually useless.

Investors would be better off avoiding investment research reports when they are making an investment decision. This applies to ongoing buy, hold, and sell recommendations from the firm’s analysts.

The hundreds of new mutual funds that are churned out each year by the investment industry are not helping investors. The thousands of managers and advisers who promise market-beating returns are ignoring history and the fact that it’s impossible to provide consistent superior returns without taking on added risk. The time spent and fees charged for these services are a waste of resources.

The average investor would be best served if the industry provided more authentic ways to eliminate or reduce the threat of loss to an individual’s money beyond the tired method of investing in stock and utilizing asset allocation, diversification, and a long-term time horizon to address market risk.

Market-linked and guaranteed products give the investor the potential for above-average returns while controlling the danger that is usually inherent in seeking higher returns. Investment advisers are in a unique position to give advice relating to such risk-management decisions by investors. But the advisers themselves need to rethink the arcane teachings of wealth management that have been drummed into their heads.

If investment advisers did nothing else but observe the behavior of their clients, they would perceive that what clients really want is not to lose money. When the overall market is up 19915 percent and an individual’s investment is up 10 percent, the investor is usually happy, even though the objective of beating the market was a miserable failure. Now if the market is down 15 percent and the investor is down 10 percent, the investor is not at all happy, even though the performance was better than the overall market.

To thrive in the future, the investment industry needs to provide more education, products, and services that are desperately wanted and needed by the average investor. To continue the pattern of pushing the same old stuff down the average investor’s throat will eventually result in an upheaval of dissent and disgust. The author of an article in our local small newspaper, the Medford Mail Tribune, expressed this growing anger as follows:

THE INDIVIDUAL INVESTOR

The unprotected investor is always at the mercy of the whimsical changes that occur in the marketplace. This fact is conveniently forgotten during roaring bull markets and painfully remembered in tumbling bear markets.

The economy, corporate behavior, investment company actions, and the stock market are out of our immediate control. Cross your fingers and pray that the market goes up because our savings, children’s education funds, retirement funds—our very lives—have been tied to the markets. But we can choose not to subject our portfolio and ourselves to such agonizing volatility and to regain control of our financial destiny.

We have the economic freedom and the power not to participate in the skullduggery of unprotected investments in the stock market. Our economic system is in serious need of an overhaul, but the beneficiaries of the current system have too much at stake to make any meaningful changes. There have been some cosmetic reforms, but we need much more. If we pull our money off the gambling table and refuse to place our bets, we could see positive change take place from business itself. Government regulations can help, but stockholders and consumers have ultimate control of the lifeblood of the corporation—money.

These changes would hopefully include a resurgence of small business, in which investor control is clearly defined, and a decrease in the power of big business, whose structure creates many problems, ranging from societal concerns to unethical 201activity that hurts the owner-shareholders. We’ll also see more investment possibilities to choose from that meet Webster’s definition of an investment, not Wall Street’s.

We need to realize that stock investing, when mixed with human emotion, is not a formula for success. We have to distance ourselves from market timing decisions and investments that can implode without warning. We should never put ourselves in a position where we have to agonize over whether to buy or sell a security, because we’ll usually make the wrong decision.

We need to put pressure on our employers to offer protected investment alternatives for 401(K) and other retirement plans instead of just more mutual fund choices. Protected investment alternatives are available today. Self-directed 401(K) plans can be designed to give the risk-averse investor attractive investment choices. It won’t happen unless we tell our employers that we want some intelligent options for our retirement accounts, not just more mutual funds.

We hold the keys to creating positive individual and societal change by removing our support of what some would argue is a corrupt system. The scheme depends upon the willingness of the individual investor to continue to fuel this out-of-con-trol train by shoveling money into individual stock and mutual equity funds. Pull out of these investments and you regain personal control of your money and are no longer a passenger on this wild ride that determines your financial future.

America was born of a revolution against the abusive power exercised by the British monarchy in the 1700s. The crown controlled the colonies through chartered corporations such as the East India Company, the Hudson’s Bay Company, and the Royal Africa Company. These corporations exercised total authority over the colonists—conscripting them into corporate militia, instructing them on what to grow, what work to do, where to buy goods, and where to market their products.

It is our economic freedom that allows us to rebel against the new kind of dominance corporations and their leaders brazenly 202employ to take advantage of American citizens over 200 years after the signing of the Declaration of Independence. The power we can demonstrate simply by changing our investment and spending habits can totally improve not just our own personal finances but also the course of human history.

We can avoid the prophecy of President Abraham Lincoln, who said just before his death:

Let us reclaim our destiny and keep it in our own hands, where it belongs!