Legal differences

Most private investors do not appreciate that the laws affecting shareholders’ rights vary enormously around the world, and while London and Wall Street may have a broadly similar approach to public companies, much of the rest of the world does not. This fact has many complex and unexpected effects – for example, while you may be able to make some sense of the accounts produced by a company in the UK, you may be unaware that its subsidiary in, say, Brazil, is allowed to operate in ways not allowed in the UK, which could give you a distorted picture of the whole group.

Commercial law derives either from ‘common law’ (in the UK and much of the US) or from ‘civil law’ (itself derived from Roman law, common in much of Europe). Most of the newer, developed economies have taken their commercial law from one of these two sources, but via an intermediary system. For example, the laws governing the stock markets of Malaysia, Hong Kong and Singapore are based on English law, while those of South Korea and Japan are based on German law, and those of Brazil, Italy and Turkey are based on French law. These differences really matter; by and large, English law provides significantly better protection for small shareholders than do the other systems, while French law is generally thought to offer the least protection. For example, in the French system it is common for minority shareholders to have restricted voting rights.

Corporate governance from the investor’s point of view

Warren Buffett often says he only likes to invest in companies that are honestly run and whose senior management comprises people of high integrity; and he often adds there aren’t many such firms to be found. As investors we are swamped with material suggesting that companies are all honestly managed and it is easy to make direct comparisons between them. Neither of these notions is universally true; in fact, it is extremely difficult to make exact comparisons between companies even when their accounts are honest, and, as we have seen throughout this book, many companies do not produce honest accounts.

Modern listed companies survive in a maelstrom of codes and regulations, collectively known as ‘corporate governance’. These include stock market regulations, voluntary codes of practice and other commercial laws. In theory, good corporate governance should enable companies to borrow money, issue shares, and strive to increase the value of their shareholders’ investments while at the same time acting ethically and responsibly towards all other stakeholders and to the whole of society. That’s quite a tall order. Business is a rough, tough, competitive world, and as investors we probably wouldn’t mind too much if the CEOs of the companies we invest in were a bit rougher and tougher – and better at bending the rules – than their rivals, but that wouldn’t be fair, would it? So is the solution, popular in these days of ongoing financial crisis, to string up every CEO for the tiniest infraction or to bring in the dead hand of government bureaucracy to tie up firms in a rigid system that prevents them from being able to make profits while the going is good?

Clearly, there needs to be a balance between regulation and freedom to act. Many would argue that the balance went too far towards freedom during the ‘noughties’, and this led directly to the banking crisis of 2007/8. In any case, it is clear, during boom times corporate governance tends to become more relaxed, and it is only after the inevitable bust that the really grotesque failures of corporate governance emerge and the public starts baying for blood. When times are good, investors seem not to want to look too deeply into how the companies they invest in are achieving their profits; but when times are bad, investors are extremely eager to know whom to blame for their losses.

The long-term trend towards globalisation, if it continues, makes corporate governance more important than ever. As China, India and other newly developed countries launch their megafirms on to the world’s stock markets, the whole stock market system may be threatened if they do not conform to the norms of corporate governance, and this could be bad for everyone (this is not to ignore the multitude of corporate governance scandals that occur periodically in the long-established stock markets such as in the US and the UK). It is now widely recognised that there is a need for a bigger push towards better universal standards of corporate governance. In 1999, for example, the Organisation for Economic Cooperation and Development (OECD) issued the OECD Principles for Corporate Governance, which was ratified by its 29 members. These principles are worth considering in a little detail.

Transparency

Investors should receive enough information about the company for them to make informed decisions. For a publicly listed company, such information should be announced publicly to ensure that everyone gets the information at the same time.

Accountability

It should be clear who is responsible for corporate governance within a firm. There should be an effort to make the interests of investors and senior managers converge – this is often not the case.

Responsibility

Companies should obey the laws and regulations of the countries in which they do business. This might seem obvious, but think about what can happen when a large firm is the main employer in a poor country in, say, Africa or Latin America.

Fairness

Investors, especially minority shareholders and foreign shareholders, should be treated fairly.

To the outsider, these OECD principles might seem to be stating the obvious, but the fact is that they are open to interpretation, both honestly and dishonestly, and much depends upon the legal system in the country where the company operates, as mentioned above. In any case, they are far too general in themselves to help us, the small private investors.

Company accounts

‘And now, it’s spinach time!’, as Warren Buffett wrote in the introduction to the accounting section of one of his annual reports. We all know we are supposed to look carefully at company accounts, but they are confusing and hard work, and it’s so much easier just to place our bets and hope the share price goes up. In this chapter I’m going to assume that you know enough of the basics about publicly listed company accounts (which in principle are no different from small business accounts, or even household accounts) to be able to follow our tale of woe. If you don’t know enough, before becoming an investor you should definitely read one of the many good books on corporate accounts that are widely available.

So, here goes. First, as mentioned at the beginning of this chapter, it is important to understand that there is no single, universally accepted theory of accounting, and accounting methods vary greatly between individual firms, industries and countries. This may be perfectly reasonable and cause no problems for firms themselves, but it makes it difficult for investors to understand accounts, and even more difficult for them to make comparisons between, say, firms or industries.

Accountants like to apply certain general principles that, though sensible in themselves, can raise really knotty problems and cause confusion among investors. These are the following.

Historic cost

Accountants like to value company assets at the price it cost the company to buy them. This is sensible, because it helps to prevent management from marking up their assets to ludicrous levels. However, what if the firm bought an office block in 1915 for £2,000 and it is now worth £25 million? Valuing it at cost would not present a true picture. For this reason, revaluations are allowed from time to time. The ‘asset strippers’ of the 1960s and 1970s exploited the historic cost principle by buying up old companies with massively undervalued assets and selling these assets off at a profit – hence the revaluation rule. As we will see, however, newer creative accounting methods, such as ‘mark-to-market’, have on occasion been misused in order to produce figures far in excess of those generated by the historic cost method.

Materiality

An independent auditor (accountant) can’t check how every single paper clip has been used, so he or she is usually allowed to decide what is ‘material’, i.e. important, and what is ‘immaterial’, i.e. unimportant. This gives canny managers some scope for abuse, especially if they can bully or deceive the auditor, as in the case of Crazy Eddie (see below).

Conservatism

When in doubt, accountants will choose the most conservative number; for example, by accounting for losses as soon as they are foreseen. This often puts them into conflict with managers, who generally are trying to paint the best picture possible of their company’s profits. Investors, often their own worst enemies, sometimes weigh in to try to influence valuations – for example, in bull markets, investors may campaign for optimistic valuations, and some accountancy firms may be willing to become ... well, less conservative, shall we say. A good accountant is a wise and wonderful creature – and no self-respecting crook wants one of them auditing his firm.

Substance

There are many, many ways to arrange things so that an important transaction doesn’t appear on the books. Why would you want to do this? You might want to avoid tax illegally by keeping profits low, for instance. Alternatively, you might want to hide the enormous debts you have accumulated so that your share price doesn’t drop. Good accountants are supposed to prefer the ‘substance’ of the transaction over its ‘form’ and to prevent these manoeuvres.

Consistency

Accountants believe that companies shouldn’t change their accounting methods and policies frequently. Occasionally a change may be justified, but it is considered a red flag when a company or group of companies does this often. Robert Maxwell, the owner of the Mirror Group of newspapers in the 1980s and 1990s, is known to have changed the reporting date of some of the companies in his group frequently, and by doing so to have deceived his auditors. Consistency helps investors compare like with like; if there has been a change, investors need to make sure that they understand the reasons for the change, and if these reasons are legitimate.

Realisation

Wise accountants think that you should record a profit when you have raised an invoice, or better still, when you have been paid. Sometimes they agree to record the profits on invoices issued, but make a ‘provision’ (i.e. a downward adjustment) in case full payment is not received. There is scope here for managerial deceit.

Going concern

Lastly, accountants assume that the company will keep going; thus, for example, the materials the company purchases will eventually be turned into finished products. If the company goes bust this will not happen – so the ‘going concern’ idea produces higher values than can be obtained if the company goes bust.

Canny managers, who may be upstanding individuals in all other ways, often try to exploit the difficulties that these accounting principles raise, and thus we can never be completely certain that we, the outside investors, are getting a true picture. But occasionally really ruthless crooks appear, whose raison d’être is to deceive outsiders about their accounts. They’re more common than you might think, but the company we are going to look at first managed to do it so thoroughly, both as a private company and then as a publicly listed company, that it really deserves a prize for chicanery. Its name? Crazy Eddie Inc.

Crazy Eddie

Crazy Eddie Inc. was a chain of TV and electronics stores in New York, run by a close-knit family of Syrian origin. Established in the late 1960s, the company was well known in the New York area for its aggressive advertising – ‘his prices are IN-SA-A-A-A-A-ANE!’ – and by the 1980s it was being parodied on national television. In 1984 the firm went public, and within two years its share price had risen from $4.50 to $37.50, and, significantly, about half of its shares were owned by financial institutions. Wall Street liked Crazy Eddie. The price to earnings ratio was high at 39, but that was OK because Wall Street believed it was going to go on growing. Even from the publicly available information, there were some worrying aspects to Crazy Eddie.

The firm’s boss, Eddie Antar, employed a number of relatives in senior positions. The firm did not own its stores, but leased them, and some of these stores were leased from relatives of Eddie Antar. Crazy Eddie had done a lot of business with companies owned by relatives of Eddie Antar, and the firm had made loans to some of these individuals. Crazy Eddie had also made substantial loans to employees of the company, some of whom were relatives of Eddie Antar. Furthermore, some of the Antars employed by the firm had rather generous stock option plans. So, why should any of this worry an investor? Because all this was prima facie evidence that Eddie might have been working in the interests of his family rather than the interests of the shareholders.

In 1986 the firm announced that it was getting into the TV home-shopping business, and the share price shot up to $40. Wall Street analysts continued to foresee great things. In October 1986 there was a profits warning. In January 1987 Eddie Antar resigned as CEO. The share price dropped to $10, and by the spring it had become clear that the firm wasn’t growing. In May Eddie launched a takeover bid, offering $7 per share, but was outbid by another wheeler-dealer, Elias Zinn. Zinn acquired the firm in November 1987, and promptly audited the firm’s stock, only to find that some $65 million worth of stock was absent (this was later revised up to $80 million). Zinn claimed that Eddie Antar had produced false accounts.

As the firm collapsed, Eddie Antar went into hiding in Israel. In 1993 he was extradited from Israel to the US, and in 1994 he was sentenced to 12½ years in prison for racketeering and fraud. This was overturned, but in a 1997 trial he was sentenced to eight years in prison and ordered to pay $150 million in fines. Various other lawsuits are ongoing.

What’s interesting about this case is the detail. Crazy Eddie was found to have recorded fictitious sales, made its employees lie to the auditors, borrowed stock from suppliers to exaggerate its inventory, concealed debts, and changed auditors’ notes without their knowledge. Pretty good going!

Here’s how they did it. Sam Antar is a relative of Eddie Antar, the firm’s boss. Sam served as Crazy Eddie’s Chief Financial Officer and was convicted for three felonies relating to the firm, but served no jail time as the result of a plea bargain. In recent years he has set up as an adviser to government agencies investigating fraud, and has produced extensive analysis of the various fraudulent practices that occurred at Crazy Eddie. His descriptions of them are instructive. Many of the methods used are well-known ‘hardy perennials’, and can be easily detected; however, the ways in which Sam and other insiders managed to conceal the frauds provide useful insights into how relatively simple wrongdoing can evolve into a complex web of deceit that fooled thousands of stock market investors.

According to Sam Antar, the Crazy Eddie saga had three distinct phases: an initial decade (1969–1979) when the company was privately owned by the family, during which efforts were focused on illegally under-reporting profits and failing to record employee payments in order to avoid taxation; a second phase, from 1980 to 1984, when the family reduced the under-reporting of profits, thereby creating the impression of additional profit growth, in preparation for floating the company on the stock market; and a final phase from 1985 to 1987, during which company insiders sought to inflate reported profits and disguise liabilities, thereby boosting the company’s share price. Sam Antar claims that there was a decision to float the company on the stock market because the potential fraudulent gains were much larger. By inflating the profits of the public company, the earnings per share (EPS) could be increased. The EPS is an important investment measure. As the EPS increases, the company’s share price will also tend to increase, enabling major shareholders to offload shares at a higher price.

As a young accountant, Sam Antar went to work for Crazy Eddie’s external auditors, while secretly also working for Crazy Eddie, with the explicit intention of learning how to ‘take advantage’ of the auditors. In 1979, Crazie Eddie’s owners pocketed some $3 million in unrecorded cash income (known as ‘skimming’), but in preparation for going public the skimming was reduced over the next few years, reaching zero by 1984. This had the effect of making it appear that Crazy Eddie was growing during the period, when in fact its profits and income had been stagnant. Employees who had previously been paid mainly in cash off the books to avoid payroll taxes were now included in the accounts, at their full salaries, including payroll taxes. This sudden leap in the cost of salaries was explained away as being a reward for success.

In September 1984 Crazy Eddie went public at $8 a share. Company insiders retained significant stock holdings in the company, and stood to gain if the share price rose and they could offload their shares at a higher price. According to Sam Antar, members of the Antar family were able to sell $90 million worth of their personal holdings during the next three years as they successfully managed to boost the share price by fraudulent means.

How was this done? After all, the stock market has very elaborate structures and rules to prevent exactly this kind of fraud from occurring. For example, public companies must have independent auditors, and if they do not use one of the large, well-established accounting firms they are regarded with suspicion.

When it went public, Crazy Eddie switched to the large firm Peat Marwick Main (now KPMG), an entirely normal move when a private company goes public. Like other large firms, Peat Marwick used junior staff to do the donkey work for the annual audit. According to Sam Antar, these individuals – and their immediate supervisors – were all under 30. They could be distracted. Antar claims that he conducted a calculated programme of subversion, encouraging Crazy Eddie employees to become as friendly as possible with the auditors, constantly taking them out for meals at the company’s expense, while Sam himself took out the more senior supervisors to glamorous bars. Antar claims that this method had two effects: first, the auditors were genuinely taken in by the charm offensive and came to believe that Eddie and his staff were honest and likeable; and second, these social activities had the effect of drastically slowing down the auditing process. The audit, lasting eight weeks, took place once a year, and the more the auditors’ work was slowed down, the more information they would have to take on faith, rather than checking it for themselves.

Early in 1986, company insiders wanted to issue more shares to the public, and at the same time to sell some $20 million of their own shares. For this to work, the company’s quarterly figures had to meet or exceed Wall Street analysts’ predictions for the growth in sales. Analysts had predicted a 10% growth in ‘same-store’ sales (i.e. sales in long-established stores, rather than in newly opened stores), but the Antars knew that the quarterly figures they were about to announce would show that same-store sales had only grown by 4%. They had to make it look as if same-store sales had grown by 10% if they were to have a successful share issue. To achieve this, the family brought back some $2 million dollars from secret overseas bank accounts (this money had been accumulated from off-the-books cash sales during the private company phase) and deposited it in Crazy Eddie’s accounts, making it look as if it was the proceeds from current sales. They didn’t try very hard; Sam claims that the company didn’t even take the trouble to create false sales invoices to explain the deposits of the overseas money (which were in the form of bank drafts worth tens of thousands of dollars each). Moreover, the overseas money was deposited all at once, which made it appear that the majority of same-store sales had occurred in the last two days of the financial year, a very unlikely occurrence and one that should have alerted auditors to the problem.

Sam claims that on this occasion his calculated plan to distract the junior auditing staff succeeded in slowing their work to the extent that there was no time for them to make the various checks that would have uncovered this fraudulent injection of cash into the company. The new issue of shares went well, and Eddie Antar and his father (also named Sam) sold some of their own shares; because Crazy Eddie had met analysts’ projections, the share price had increased, and the Antars collected $24.3 million for their shares, rather than the $20 million they had expected. Thus, by secretly returning $2 million of their illegally gained profits, they had not only ensured the success of the share issue and the sale of their own shares, but had also more than covered the $2 million they had had to put in to the company.

‘Ah,’ you may be thinking, ‘this kind of thing may have gone on back in the 1970s and 1980s in the mean streets of New York, but it is not common now. Most firms, both private and public, have genuine accounts.’ If you believe this, you need to revise your views. Firms have considerable leeway in how they present their accounts, and there is ample opportunity for companies, small and large, to commit such egregious frauds.

Let’s look now at a much more substantial company that not only committed accounting fraud involving billions of dollars but also brought about the collapse of its auditors, Arthur Andersen, then one of the ‘big five’ worldwide accounting firms. This was Enron, a global giant that was a major player in an international derivatives market for gas, oil, electricity, broadband communications and other commodities.

Enron

Enron’s CEO, Kenneth Lay, had built the firm up from a local seller of gas and electricity in Texas in the 1980s into the US’s seventh-largest company by 2001. Its business was very complex – mystifying to many outsiders – but in early 2001 Enron looked like a very solid company indeed, and its bonds were rated AAA (S&P’s top investment grade). In hindsight, its annual report for 2000 makes interesting reading. In the financial highlights section, its total sales are given as a staggering $100.789 billion, with a net income of $1.266 billion. Over ten years, the S&P 500 index had produced a total return of 383%, dwarfed by Enron’s total return of 1,415% over the same period. A reader might have experienced a little twinge of doubt, though, when looking over the sales figures in previous years – just over $100 billion in 2000, up from some $40 billion in 1999, $32 billion in 1998, and $20 billion in 1997. How can any company achieve such an extraordinary growth in sales?

Enron’s explanation was superficially convincing – it was all to do with being in the right place at the right time in newly deregulated markets, such as energy, and in entirely new markets, such as broadband. Enron had ‘networks of strategic assets’, ‘unparalleled liquidity and market-making abilities’, and ‘innovative technology’ that enabled it to beat the competition in the wholesale markets across the world. All these markets were set to grow massively over the next few years, and Enron was going to get a bigger piece of the pie. It had operations all over the world – including Japan, Singapore, Europe and Australia. It had more than 20,000 employees, 38 power stations, a host of pipelines in the Americas, gas extraction plants, paper mills, oil exploration companies ... in short, Enron was big, really big, and it said it was going to go on growing. The firm had reported that it was on track to double its sales figures in 2001, which would have made it the largest, or second-largest, corporation in the whole world in terms of sales.

It’s easy to be wise after the event, but a Forbes magazine article of 2002, the year after Enron had begun to collapse, points out that it was rather extraordinary for a firm with only 20,000 employees to be able to generate sales on a similar scale to those of Citigroup (238,000 employees), General Electric (312,000 employees) and IBM (312,000 employees). Looked at another way, firms with a similar number of employees to Enron were unable to achieve anything like Enron’s sales figures, such as Texaco ($50 billion) and Goldman Sachs ($33 billion).

People who believed in Enron were very excited about a notion known as ‘the ”New Economy”’.People who believed in Enron were very excited about a notion known as ‘the “New Economy”’. The New Economy was all about being ... well, it was never quite clear what the New Economy was really all about, but there was a lot of talk about ‘business models’ (which often seems to be code for ‘We have no idea how we are going to make money’), the power of the internet, the increase in globalisation and free markets, the opportunities in derivatives thanks to the new methods of valuing them, and so on. In short, it was all achingly hip – this was the time of the internet bubble, remember – and, as Jeff Skilling, who had joined Enron in 1990 and took over the top job from Kenneth Lay early in 2001, used to say, you either get it, or you don’t. But Enron wasn’t some fly-by-night internet start-up, it was a genuinely massive firm, so if its boss thought there was such a thing as the New Economy it was not unreasonable, perhaps, to give him the benefit of the doubt. Skilling and other Enron managers were talking about the firm being ‘asset-less’ – a classic New Economy phrase – because it dealt in ‘risk-intermediation’, providing services to customers to hedge the risks of price fluctuations in the underlying commodities it dealt in. In actual fact, however, Enron was not asset-less at all. As we have seen, it owned a large number of assets, in which it had invested rapidly during the preceding five years, and many of these assets were not generating profits. Indeed, some of Enron’s investments, including Wessex Water in the UK, an Indian power plant, and a curious power plant mounted on a barge next to a hotel in the Dominican Republic, were losing very substantial sums of money.

Then, in April 2001, Skilling decided to hold a conference call with stock market analysts and financial reporters. During the call a hedge fund manager, Richard Grubman, pressed Skilling to provide a quarterly balance sheet along with the earnings statement Enron had announced, at which Skilling called Grubman an ‘asshole’. This unCEO-like behaviour was widely reported at the time, and has since become an iconic example of corporate arrogance. Perhaps we should not judge Skilling too harshly for the outburst (he apparently was aware that Grubman was short-selling Enron stock on a large scale), but the question, innocent or not, must have touched a nerve, as Skilling was well aware at the time that Enron was hiding massive debts.

So how did it all happen? Unlike Crazy Eddie, the shenanigans at Enron were not a case of a tightly knit family setting out to commit a long-term fraud from the outset. It seems that rather than being entirely pre-planned, senior management in Enron became progressively enmeshed in a truly complex web of deceit as many of its elaborate profit-making ventures gradually began to go wrong. The deregulation of utilities industries around the world during the 1980s and 1990s had presented a genuine opportunity for Enron to expand, and Kenneth Lay was truly an industry expert – he had actually been an energy regulator for the US government in the 1970s. The idea of becoming a market maker in a host of energy and commodity industries seems to have been pushed by Skilling during the 1990s, rather than by Lay. By arguing that Enron had created new trading markets in these commodities, Skilling was able to persuade accountants that it was appropriate to use ‘mark-to-market’ accounting. Mark-to-market accounting is very complicated but briefly it is where the total profit that Enron would make on a contract would be recognised when the contract was first signed – hitherto the firm had used a traditional historic cost approach (see page 159), where actual costs and revenues were booked as they occurred. Enron was heavily involved in derivatives, where mark-to-market methods are problematic because there is often no way to validate estimates of true market values. To estimate the values, Enron had to make very complex assumptions – which, with the best will in the world, might be wrong – about such things as future demand, future interest rates, and future variation in prices. It seems that Enron had an understandable tendency to make rather optimistic assumptions in these matters, which tended to improve its earnings figures.

Mark-to-market alone might be forgivable, but Enron was up to other tricks, too. It was using a legal loophole to report the total sales value of its derivative deals as income, which dramatically inflated its sales figures. Enron’s proprietary trading platform, Enron Online, allowed other parties to trade in energy and commodities, with Enron taking a small cut of each transaction. Normally such an operation would be accounted for on the ‘agent’ model, where the value of the fees would be reported, but not the entire value of the transaction – Goldman Sachs and other firms with trading systems use this accounting model. But because Enron could argue that it owned or controlled the items being traded, it was able to use the ‘merchant’ model, reporting the entire value of the cost and sale value of each transaction, which had the effect of vastly increasing the firm’s sales figures. This, of course, did not increase the profit figures, but in the fast-paced world of the New Economy it appeared all that would improve later – the name of the game was to grab as large a chunk of the business as possible. According to some estimates, if Enron had not used mark-to-market and the merchant model, its 2000 sales figures would not have been the $100.789 billion, but a paltry $6.3 billion.

It also emerged later that Enron had been using a large number of offshore companies called Special Purpose Entities (SPEs) to hide massive losses, claim more than $1 billion in fictitious earnings, and to adjust the point when income was recognised as having been received in order to ‘manage earnings’ in line with analysts’ expectations. The SPEs were in effect a means to keep much of Enron’s activities ‘off-balance sheet’, away from the prying eyes of Wall Street analysts.

During mid-2001 Skilling sold $33 million worth of his own shares in Enron, and then resigned from the company in August. Kenneth Lay tried to reassure Wall Street that nothing was wrong, but the share price continued to drop, as it had been during the early part of the year. Analysts had begun to ask too many awkward questions. In February, for instance, a report from John S. Herold Inc. expressed doubts about Enron’s profitability, and wondered if the company could keep its position as market leader in the energy industry. In March an article in Fortune magazine suggested that Enron’s share price might be too high. In October Enron began to sell some assets, and then announced that it had suffered a $1 billion loss in non-recurring expenses. In November the dam finally burst; Enron revealed that it had overstated its earnings by just under $600 million, and it owed $3 billion to its SPEs. Its AAA bonds were drastically downgraded and the SEC began a formal investigation. Enron went bust, leaving thousands of employees with no job and having lost their savings in Enron share purchase plans. Soon, the SEC sued Arthur Andersen, Enron’s auditors. Employees of the massive accountancy firm were eventually convicted of deliberately shredding Enron-related documents in an effort to obstruct justice, which severely damaged the firm’s reputation. Arthur Andersen surrendered its accountancy licences in 2002 and went out of business. After a long trial Jeff Skilling was sentenced to 24 years in prison for securities fraud. Kenneth Lay was also convicted of securities fraud but died of a heart attack before sentencing.

In the grand regulatory tradition of shutting the stable door after the horse has bolted, in 2002 US Congress introduced the Sarbanes–Oxley Act, which, in the words of one researcher, ‘is a mirror image of Enron: the company’s perceived corporate governance failings are matched virtually point-for-point in the principal provisions of the Act.’ Well, the government has to be seen to be doing something when a scandal of this magnitude occurs, but Sarbanes–Oxley, or ‘SOX’, has attracted much criticism in recent years for having a damping effect on business in the US. More importantly, SOX was completely unable to prevent the next big scandal in the US, the sub-prime mortgage scandal – in which the wrongdoing involved lending too much money to the wrong people, rather than, as in the case of Enron, pretending to be making more money than it actually was. The point is that there are a million ways to cheat the public, and producing legislation as a knee-jerk reaction to the last crisis is very unlikely to anticipate the next crisis, which usually appears in a different form; in other words, new regulations tend to learn the wrong lessons from a major scandal.

Enron was a massive failure of corporate governance. It was the hot firm at a time when the US was both excited about the potential offered by the internet and globalisation, and worried about the rise of China as a manufacturing power. Wall Street could and should have known better: if expert analysts can’t really understand a company’s accounts, it’s usually not a good sign, but Wall Street went along for several years with the idea that Enron was a fabulously innovative firm heading for stardom. Although it was never fully established how Arthur Andersen came to approve Enron’s highly questionable accounting methods, it seems likely that this was a case of trying to observe the letter, rather than the spirit, of the law. The accountancy firm had quite an incentive not to make waves – in 2001 alone, it received $25 million in auditing fees and $27 million in consultancy fees.

Investors and accounts

So what can we learn from all this as investors? Three things are clear.

1. Wall Street analysts often ignore warning signs about a company that is in fashion. As investors, we cannot rely absolutely on the material put out by analysts; we need to use our own capacity for critical thinking. Businesses are real things, run by real people. In the case of Crazy Eddie, it would not have been easy for a private investor to detect fraud in the firm; however, Sam Antar argues that anyone who had carefully read the footnotes of the company’s reports would have seen that Crazy Eddie had poor internal accounting controls. Furthermore, Barron’s magazine had published a sceptical article about the firm before it went public, and in its filings to the SEC (publicly available) it was quite plain that many members of the Antar family had been involved in ‘related party dealings’ with the firm, including, for example, a large loan to a medical school in St Lucia in which family members had shares. In short, there was sufficient information available, if anyone had chosen to look, to suggest that Crazy Eddie was not all that it should have been. As for the Wall Street hype surrounding Enron, you could either believe, as many did, that the ‘New Economy’ was going to sweep all before it without any casualties along the way, or you could choose not to do so. The obvious issue with Enron was its ridiculously rapid growth in sales at the same time as its percentage of profit was declining. Ultimately, whether or not you chose to believe the explanations proffered depended on your personal judgement, and it was not possible for an outsider to penetrate the accounts provided – but that in itself is a warning sign. The moral? If you can’t understand the accounts, don’t invest! Don’t rely on the analysts to do the work for you.
2. Corporate governance really does matter, but it only really works if the principals involved – the people running the company – are sincerely trying to implement corporate governance properly. For example, it was plain long before its collapse that Enron’s accounts were not transparent, and its sexy creative accounting methods, such as mark-to-market and SPEs, which were mentioned in its annual reports, should have raised eyebrows among eagle-eyed investors. Company accounts can be sufficiently transparent without giving away trade secrets – and senior managers do have the power to make accounts transparent if they wish to do so. Senior managers at Enron evidently did not wish to do so. With Crazy Eddie, the mere fact that there were poor internal controls and extensive related-party transactions – both reported publicly – should have been enough to make an investor wonder if the firm’s management were really committed to good corporate governance.
3. Investors cannot rely on auditors’ opinions. They should be able to do so – that’s what auditors are there for – but history has demonstrated that auditors have, on occasion, approved fraudulent accounts in very large firms, for reasons about which, sadly, we can usually only speculate. That Crazy Eddie, a much smaller firm than Enron, was able to fool its auditors is more surprising; thanks to Sam Antar, we now have a detailed account of how this was done (employees even went so far as to climb up ladders during stock checks to save the auditors the trouble, and then shouted down exaggerated numbers of the goods sitting on the high shelves, according to Antar). For the private investor, the frequent failures of auditors are a real problem – the whole market system relies on accurate information to function – but all is not lost. The art of assessing a company depends not only upon trying to understand its accounts, but also upon triangulation: cross-checking the information against managers’ statements, company activities, news reports and even talking to company employees. You don’t have to do this with every company on the stock market – just the ones that seem interesting, and ‘smell right’.

If you don’t have the interest or ability to do this kind of digging, then you will have to rely on the opinions of others about the quality of particular companies and, as we have seen, the opinions of others, even professionals, may be wrong. This doesn’t mean that you should avoid financial investment altogether, but it probably does mean you should avoid investing directly in individual companies – stick to index trackers, investment trusts and other forms of collective investment.