Not a Smart Thing to Do

Entrepreneurs were not the only ones who ended up holding the small end of the stick. The other big losers were small investors who bought shares at valuations that made no sense.

In a previous chapter we discussed how the bubble was funded largely by retirement plans. When the bubble burst, many people were left without savings. For example, two middle-aged women working in clerical positions at a New York financial services firm placed their entire 401(k) retirement savings in annuities with a major mutual fund, believing that because it was a large, well-known firm, their savings were secure. But much of the fund in which they were invested had been placed in Internet stocks. When the bubble burst and the value of their fund began to decline, they did what they'd been told to do—stay invested for the long term. After 12 months their savings were almost gone, and still they held on, saying that they would sell when the technology companies in which they'd been invested regained their share prices of the past. Finally their employer told them that this would never happen, and they began to realize that their nest eggs were gone for good. These working people, and millions like them, had become the road kill of capitalism.

It's important to be clear about the financial losses imposed by the bubble. To some degree, the losses were only paper losses. An entrepreneur had little or no net worth one day, and a huge amount the next, and nothing the third. Had he or she really lost money? It had always been on paper, and in a sense he had not. So when it is mentioned that some trillions of dollars were created by the Internet bubble and then disappeared in the bust, the loss was funny money.

But there were real losses to some people, and real gains to others. Managers and employees at dot-coms worked for low pay and in the hope of gains on stock options, and when the companies crashed, they got nothing on the stock and had contributed much of their effort to the company for nothing. They took a real loss.

Many small investors bought into the bubble near or at its height—they were the last people to be allowed in—and when the bubble burst, they lost real money—money they had saved or salted away in pension accounts, and which was gone. These were real, not imaginary losses.

And some people made real, not paper gains—people who invested early and got out early, and bankers and brokers who handled transactions for fees.

As pointed out earlier in this book, there was a substantial transfer of wealth from employees of Internet companies, and from small investors, to professionals in the Financial Value Chain which was a primary economic result of the bubble. The total wealth in the economy went up by some $4 trillion in the bubble and came down by the same amount in the bust, but during the process, other billions of dollars changed hands, and this is where the significant losses occurred.

Whether by virtue of investments in their own company's stock, or by virtue of investments in mutual funds, or by speculating in the shares of dot-coms and telecoms, many small investors, using their pension money, were virtually wiped out by the bubble's bursting.

During the bubble, many companies induced employees to invest in the companies for whom they worked by using a variety of means: 1) buying shares directly through employee stock purchase plans; 2) investing via 401(k) retirement plans; and 3) through incentives and pay in stock options. And many companies, including Gilette, Coca-Cola, Procter & Gamble Co., and Qwest Communications International, Inc., continue to do so. “Benefits consultants Hewitt Associates found in a recent study that nearly half of 215 firms offering company stock in their 401(k) plans only contribute their own shares to employee accounts [that is, they match employee contributions to the retirement plans but only in shares of the company's stock, not in cash], and that 85% of those companies restrict sales of stock.” In many companies, employees can't sell the stock the company has invested in their 401(k) until they are in their 50s.^[92]

Lucent was one of these companies, and a major player in the telecom bubble. At Lucent, some employees “had their [401(k)] plans entirely invested in Lucent,” reported The New York Times.^[93] As Lucent's share price declined, employees' pension savings went down with it.

The Lucent story is bad enough, but is dwarfed by the disaster that overwhelmed employees in the collapse of Enron. At one time Enron was among the 10 largest American companies, and it was a darling of the dot-com era because of its online trading of electricity and natural gas. Because the company was so large, and its success was believed to be so substantial, Enron share prices weathered the first stages of the collapse of the bubble very well. It wasn't until fall 2001 that apparent misrepresentations in the company's financial reports got wide attention and precipitated a sudden fall in the company's share price.

Many of Enron's 30,000 or so employees had most or all of their retirement savings in Enron's stock. The company made its contributions to their plans only in its own stock, and in fall 2001, the plan administrators in the company had restricted sale of Enron shares by plan holders. In consequence, when the company's share price went to almost zero, so did the value of employees' savings plans.

A sobering contrast can be drawn between the experience of Enron's employees in the company's defined contribution plans—which was a disaster—and the very different experience of the employees of another large company that had a defined benefit plan. At the very time Enron's employees were losing their pensions, Unilever was successfully suing Merrill Lynch (though the matter was settled without trial) because Merrill had not made enough money for Unilever's pension plan—not lost money, but not made as much as the contract for management of pension money by Merrill had provided.^[94] It's hard to imagine a clearer example showing why the clout of a large investor (Unilever) is valuable to people saving for a pension with a member of the Financial Value Chain (Merrill Lynch). The employees of Enron, each managing his or her own pension money under a 401(k) plan, had no clout with either the company or its plan managers, and they got killed financially. Unilever, acting to support its pension obligations to its employees, was able to make a performance contract with a major financial services firm, and largely to hold the firm to its commits as to performance of the investment. Unilever's employees were much better protected than Enron's.

Probably what would best have protected the investing public generally from the Enron disaster would be a requirement that every five years or so, the audit committee of a publicly held company must change its public accounting firm. New accountants put more resources into constructing a view of the entire business process of a company. As the complexity of some businesses grows, this is a necessary thing.

A fresh look doesn't ordinarily occur with existing accountants because of the current dynamic between corporate audit committees and accounting firms. Basically, audit committees (which include the chief financial officer of a firm) beat down over the years the audit fee, and often tell the accounting firm that it will make up the lost audit fee in consulting fees from the company. So the accounting firm devotes less time and resources to the audit. This is exactly the wrong set of incentives and directions from the point of view of investors in public companies. If accountants were changed on a five-year basis, there would be more actual accounting business, and far better accounting of the complexities of modern business. The Enron disaster might not have occurred as it did.