2003 Commentary on Fraud
I wrote this column at the beginning of 2003. It was basically a reflection on how frauds come to light after markets reach tops. Of course, the 2007-2008 financial crisis revealed even more, but the lessons are pretty much the same.
2002’s Top Investment Story — Fraud
Jarrod Wilcox, January 1, 2003
The year 2002 will be remembered as one in which the bear market revealed a
disappointing fraction of both Main Street and Wall Street without their ethical
clothing. The tolerance of unethical behavior that stretches in good times gave
way to doubt, suspicion, fines and even jail terms as the angry losers reacted.
Winter– Arthur Andersen, then one of the big five accounting firms,
caught in an emerging Enron scandal, fires directly responsible partner
Duncan, and acknowledges shredding key documents it had reason to believe would
be subject to SEC subpoena. Then two US House of Representative committees
investigate Enron. Sherron Watkins whistleblower letter is released. Many Wall
Street analysts still rate company a buy even after the SEC investigation
becomes public. Enron’s CEO Ken Lay is grilled, along with Andersen’s CEO
Berardino, and the SEC’s Chairman Pitt for not staying on top of accounting
fraud. The SEC files modestly tighter reporting rules. The US Justice
Department indicts Arthur Andersen, who in turn, fires CEO Berardino.
Spring — Adelphia Communications is discovered to have enormous
undisclosed loans benefiting founder Rigas and family. New York Attorney
General Eliot Spitzer, after pursuing Internet and technology stock touters for
months, reveals Henry Blodget’s Merrill Lynch e-mail describing as “junk”
a company he had been recommending. WorldCom sharply cuts its sales
forecast, after denying it had any accounting issues. Bernie Ebbers resigns as
its CEO. WorldCom agrees it broke accounting rules to enhance profit. Merrill
Lynch settles Spitzer’s case for $100 million, setting a precedent for going
after other Wall Street examples of transgressions. The SEC opens an inquiry
into analyst integrity. Trading scandals result in ouster of CEO’s at
ImClone and Dynergy. ImClone insider trading investigation turns
to Martha Stewart. Dennis Kozlowski, Tyco CEO, departs and is indicted
for evading NY sales tax on art purchases.
Summer — Qwest Communicationsis investigated by both the Justice
Department and NY Attorney General Spitzer, the latter regarding the CEO’s
sweetheart IPO deals with Salomon Smith Barney. Congressional hearings
are held on WorldCom scandal. Record-breaking WorldCom bankruptcy declared.
Questionable deals made to enhance apparent profit at AOL are revealed.
Its COO Pittman exits. Adelphia Communications founder Rigas, two sons, and
others are arrested. Top auction house Sotheby’s former CEO Taubman goes
to prison for price fixing. the Tyco scandal widens with reports of Kozlowski’s
personal spending that point to undisclosed compensation and lack of proper
oversight by the Tyco board of directors.
Fall — Andrew Fastow, Enron CFO, is charged with criminal activities.
William Webster is named by SEC’s Harvey Pitt to be head of new accounting
oversight board. Then Pitt and Webster both resign after it is revealed that
Webster was head of the audit committee for a company involved in fraud, and
that Pitt had kept this information from fellow commissioners who had urged
choosing a more aggressive investor protection figure. Under pressure,
Goldman Sachs reveals allocation of hot IPO’s to executives of companies
from whom they are seeking business. Pattern of Wall Street conflicts of
interest in regard to analysts versus investment banking business is documented
through large part of Wall Street establishment by Spitzer’s investigation. The
result is a $1.4 billion settlement from a long list of Wall Street firms as a
quid pro quo for avoiding possible jail sentences. Firms agrees to greater
independence of analysts from investment banking. Gary Winnick, Global
Crossing Chairman, resigns. Global Crossing assets in bankruptcy are
reported by the NY Times to have been sold for about 1% of previously-declared
accounting values of $22 billion.
How should we react to these scandals? They stem from structural
conflicts of interest between company managers vs. shareholders and between
brokers vs. investors. As a society, we try to maximize the goal congruence of
these agents and their principals. However, when we are honest with ourselves,
we recognize that some tendency toward selfish cheating, especially when rules
are not taught early and enforced rigorously, is part of our human nature. So
it is a waste of energy to be outraged. It also tends to misdirect curative
efforts toward mere penalizing of individuals rather than structural reform. As
citizens, we can support efforts toward accounting transparency, auditor
independence, and enforceable regulation that balances business flexibility
against minimizing the impact of conflicts of interest. But what should we do
as investors? Here is my list.
Advice for owners. The scandals reinforce the validity of a passive
approach to investing. Continue to invest passively in index funds or some
other tax-advantaged, risk-managed fashion that pays little attention to what
management or Wall Street analysts say. You then won’t be much hurt by scandals
for a few individual companies. You do not “take advantage” of brokers offering
to get you in on initial public offerings, and you read analyst reports only for
general information, not advice. Sadly, the Spitzer settlement is irrelevant,
since even if analysts were to offer more objective advice, in an extremely
competitive market you wouldn’t expect it to lead to better profits. The most
relevant changes would be any that affect the market as a whole, including less
compliant and more knowledgeable boards of directors whose job it is to
supervise company executives, more uniform accounting treatment and stronger
reinforcement of auditor’s independence. These changes might dampen speculative
excesses and reduce overall market volatility to a modest degree. They also
might result in less wasted investment and better economic growth, with better
returns for all of us together.
Advice for hobbyists and sporting types. The scandals reinforce that
healthy cynicism that you need to properly evaluate financial information and to
distinguish between what CEO’s, CFO’s and analysts say and what they are
actually thinking. If better regulation of the industry helps level the playing
field between small and large investors, that is wonderful. However, it is
sobering to consider that large institutional investors were prominent among the
investment losers as hyped stocks tanked. The really advantageous distinction
is not based on size-related access to analysts but on access to data and on
experience and judgment in interpreting it. With the advent of fair disclosure
rules that have encouraged public conference calls between company executives
and analysts, the availability of SEC filings on Edgar via the Internet, and
superb Internet tools for concentrating news items, I believe you have as much
chance as a professional analyst to discover useful information for investing.
That chance is modest, but, in my opinion, real. It just doesn’t come at low
cost from the “experts.”
Advice for professional investors. Scams and their later revelation
are meat and potatoes for short-selling. As an investor, though not as a
citizen, I would be sorry to see these profitable opportunities go away.
However, they are not likely to disappear entirely — experience shows that no
matter how many times history reveals truth, the market forgets as new investors
enter the arena. However, the current public outcry, and the effort by
politicians to react to it, is leading to new regulations and new laws. These
changes in the market’s structure will create new investment opportunities for
those who react faster than their competitors. For example, the Sarbanes-Oxley
Act of 2002 establishes a public company accounting oversight board and
restricts the ability of accounting firms to engage simultaneously in consulting
and auditing. It behooves us as professional investors to once again master
GAAP accounting and footnotes and put aside pro-forma reports and buzz. For a
time, fundamentals are likely to be king.