Prologue For The Prevailing NormSubmitted by LibBerte on Sat, 07/26/2008 - 08:40
Looking Back Always Tells You What's Coming.
This article is more than 6 years old... and could not be more timely.
Repeating The Past
By William K. Black
Forgetting the mistakes of the past is bad, but we've done something far worse. This newest wave of corporate fraud occurred because we learned exactly the wrong lessons from our last wave, the savings & loan debacle. As Mark Twain warned, "It ain't what people don't know that hurts them, it's what they do know that ain't so."
The S&L collapse was the largest financial scandal in U.S. history and cost taxpayers $150 billion, but the conventional economic wisdom about it is, even with the benefit of hindsight, 20:200. The best way to see this is to read a classic textbook, "The Economic Structure of Corporate Law," authored by Frank H. Easterbrook and Daniel R. Fischel. Here students are taught five myths about fraud:
Fraud is not a problem because the markets easily spot it. "A rule against fraud is not . . . an important ingredient of securities markets."
Only honest firms can get a clean opinion from a top auditor. "The accountant who certifies the books of many firms has a reputational interest . . . much greater than the gains to be made from slipshod or false certification of a particular firm."
CEOs who own stock in the firm will not defraud it. "If the firm does poorly, the managers lose with the other investors."
Highly leveraged firms are unlikely to be fraudulent. "Debt . . . forces the managers to pay out the profits, and if there are no profits, forces the firm into bankruptcy."
Regulation not only can't reduce fraud, it encourages fraud.
Massive frauds repeatedly fool the markets.
Every fraudulent S&L got a clean opinion from a top firm.
The worst S&L frauds were committed by owner/CEOs (these are known as "control frauds"). CEOs can loot millions while the firm fails, increasing their income and prestige. Insiders sell their shares before values collapse.
Debt creates pressures that induce fraud, and fraud staves off bankruptcy.
Fraud grows where rules and regulators are weak. For example, more than 1,000 S&L insiders were convicted of felonies, and the catastrophic failures were all control frauds.
What do today's cases share with the S&L control frauds? They seem to understand that the way to loot a firm is with bad accounting, not by embezzling. You shop for an auditor who will bless your bad accounting. This perverts what is supposed to be an external control into your greatest ally. Fraud creates fictional income, which allows you to use normal corporate mechanisms such as bonuses and stock options, which you exercise and sell before the crash. Embezzlers are easy to convict, but it is very difficult to convict someone for receiving a bonus.
Another understanding that the new and old frauds share is that a few politicians in the pocket can speed deregulation, which almost invariably makes accounting fraud easier and fends off the regulators. And all the CEOs involved share a similar personality: They are not brilliant but audacious.
Enron set up scam partnerships that used "hedge accounting"—a notorious area of abuse—to create more than $1 billion of phony income while hiding the real losses. WorldCom's form of accounting fraud was pure audacity; no remotely competent auditor could have missed labeling $4 billion in expenses as "investments." Global Crossing swapped identical bandwidths with rival companies and both booked a gain. Imagine going to a department store and exchanging a medium shirt for a large at the same price. Now imagine that both you and the store claimed that this exchange created profit. That's what Global Crossing did.
If it's any consolation, the S&Ls did something far worse. It was called "I'll trade you my dead horse for your dead cow." Both of our S&Ls paid $40 million to buy office buildings that were worth only $12 million. The regulators were demanding we each recognize a $28-million loss. We would buy each other's building for $50 million. Our real losses were instantly transmuted into fictional $10-million gains.
Arthur Andersen played a prominent role in both scandals. At Enron, Andersen destroyed documents to cover up its culpability. But that was after Enron's collapse was public and it didn't hurt investors. At Lincoln Savings, Andersen created documents to make it look as if the S&L was following the law, giving cover to CEO Charles Keating to loot the company in what became the largest financial failure in U.S. history. Unfortunately, Andersen was not prosecuted though it paid scores of millions of dollars in damages.
Enron bought national and state politicians wholesale and used its political leverage to bring about deregulation and force the chairman of the Federal Energy Regulatory Commission, Curtis Hebert, out of office when he wouldn't do Enron's bidding—Hebert has said this himself—and convince President George W. Bush to appoint Enron's choice as his replacement. Consider how large the list of prominent politicians is right now that is scrambling to return WorldCom's contributions.
The newest control frauds were made possible by the greatest bull market in history during the second half of the 1990s, in which firms with no track record, no product and absurd valuations could raise funds in the equity markets and borrow from banks. This is the worst thing a bubble economy does: Investments are no longer made on the basis of fundamentals. Some CEOs were attracted by the chance to commit fraud as the bubble expanded; these we could call "opportunistic control frauds." More CEOs embraced fraud as a way to cover up their firm's failure when the bubble burst—"reactive control fraud." There are now dozens of investigations trying to sort out who did what to whom when.
A new mentality took hold during the bubble. Cheating became rampant in the mid 1990s, and because it was the norm it was no longer seen as wrong. Indeed, it became seen by competing CEOs as clever. Many firms used this scam: Sell the product just before the end of the quarter and get the product back a week later as a return. This created phony profits for scores of Silicon Valley firms.
The S&L scandal occurred during a time when real estate values in Texas were skyrocketing, even as vacancy rates were rising. This was a bubble: As real estate values shot up, the S&Ls created fictional income so they could pour even more real estate into a market that was already glutted; fundamentals had stopped driving investment decisions.
Deregulation was a principal cause of the S&L debacle by making it easy to commit massive accounting fraud and grow rapidly. Deregulation of energy and telecommunications permitted the sales of energy and bandwidths that powered the Enron, WorldCom and Global Crossing frauds.
Deregulation is made worse by "desupervision." If you don't vigorously enforce the rules, you create a fraud-friendly environment. The SEC does not have one-tenth the staff it needs to do its job, but its lack of leadership and will is even more disabling.
There are two victims of fraud—the public and honest firms. Strong accounting regulation helps honest firms and makes markets more efficient. We need a new SEC chair committed to enforcement. President George W. Bush should stop opposing real accounting reform, remove the complacent regulators he put in place who have failed to protect the public, and prosecute the frauds. The rogue Democrats who blocked accounting reform under Clinton should not be re-elected.
With both parties in thrall to the big auditors, it's hard to imagine real reform occurring. But this time, unlike in the S&L debacle, the crisis so severe that it is hammering the stock markets, causing the dollar to fall and threatening the entire economic recovery. The politicians can either back real reform or risk their re-election.
William K. Black is an assistant professor at the LBJ School of Public Affairs, University of Texas at Austin. He was director of litigation for the Federal Home Loan Bank Board. He is also the visiting scholar at the Markkula Center for Applied Ethics 2002-03.
This article originally appeared in Newsday on July 7, 2002.