Rounding out the alphabet, Rite Aid overstated its quarterly income by more than $US 3.2 billion between May 1997 and May 1999; certain Tyco International executives were accused of using shareholders’ funds to buy art for their own use and the company’s CEO has been indicted for tax evasion; Sotheby’s former Chairman was sentenced to one year in prison for price-fixing with Christie’s; perhaps most prominently, WorldCom allegedly inflated its earnings by $US 3.8 billion and threatens to surpass Enron’s unenviable record as America’s greatest corporate collapse; and last but not least, Xerox has agreed to settle an investigation into its accounting by paying a record $US 10 m civil penalty. According to Bloomberg (5 July), “Europe has its own list of financial scandals... While none is as large as WorldCom’s $US 3.8 billion in mischaracterised expenses, there’s no guarantee against something similar, accountants and investors say... ‘It could definitely happen here’ said a spokesman for German shareholder activist group SdK. The only reason you don’t see any cases on the same scale as in the US is that there’s a time lag. Our regulators aren’t as stringent.’” Similarly, according to The Australian Financial Review (3 July) “could a restatement of financial results as reported by WorldCom (and Xerox) happen here? Yes. It has happened before, and will happen again. The main – perhaps only – difference is one of scale. WorldCom had capitalised batches of expenses rather than charge them against profits... Australian companies follow much the same processes in capitalising expenses and showing ‘deferred costs’ as assets... [Australian] accounting standards not only permit, they encourage such treatments. Sums spent on ‘goodwill’ are to be recorded as assets. So too are the arcane processes of tax affect accounting.”

So What’s the Problem?

Mark Westfield wrote in The Australian (11 July) that “the harsh reality is that investors big and small got so carried away in the five-year boom which went bust in mid-2000 that they were grabbing at anything. Hype and greed pushed aside care and observance of fundamentals while the market partied … In reality, investors will not change. They’ll be licking their wounds for a while and call for tough measures, but once the next boom begins … the well-meaning talk will fly out the window.”

According to the AFR (3 July), “the heart of the problem is the lack of clear-cut definitions of key accounting concepts (like ‘asset’) to ensure financial statements yield commonsense reflections of financial position. It took the profession almost 100 years to develop any definitions of basic concepts and the definitions eventually produced seemed designed to accommodate existing reporting practices rather than promote reform.” A range of journalists, politicians and tycoons are not nearly so prosaic. According to the AFR (5 July), “recent corporate disasters including WorldCom and Enron have been driven by ‘sheer greed’ rather than personal integrity, Victoria’s former Liberal premier said yesterday. Mr Jeff Kennett, now a drive-time host and part-owner of Melbourne radio station 3AK, told guests at an Australian Institute of Management lunch that management in these cases had ‘veered substantially away from fundamental life values of honesty, integrity and punctuality.’”

Similarly, The Australian (2 July) reported that “financier George Soros believes the recent accounting irregularities in major US corporations reflect an American culture that admires material success more than morality. ‘Rules alone are not enough’ Mr Soros told BBC TV on Sunday. ‘You need principles.’ The fact that so many irregularities have come to light, he said, raises ‘far-reaching issues about the values that guide us. There is a culture is the US that success matters and that’s the only principle that you really have to rely on. So anything goes … If you are successful, particularly financially successful, you have admiration, respect and so on … There is a lack of what I would call moral principles now. You see it in politics as well … This is a very unsound basis for a society.’”

A columnist in the IT section of The Australian (2 July) stated that “a culture of impossible expectations combined with greed and stupidity lies behind the financial crisis on Wall Street. Ample evidence suggests the cesspit of greed, doubletalk and dishonesty has spilled over the levy with unprecedented force. The 1990s stock market culture and that cliché, ‘shareholder value,’ lie at the root of this evil. It has put intolerable strain on some companies to achieve growth rates beyond their capacity … They, and their pitiful directors, are guilty of buckling under Wall Street’s demand to produce a minimum 15 per cent growth year after year – no matter what it takes … The situation is critical. The environment that permits excessive pay, greedy leadership, biased analysts, contemptibly stupid boards and dodgy accounting must be destroyed. I don’t buy the argument that shareholders knew the risks. They knew some, but no one believed the game was rigged. Until now.”

Perhaps most vociferously, Peggy Noonan of The Wall Street Journal wrote on 1 July that “something is wrong with – what shall we call it? Wall Street, Big Business. We’ll call it Big Money. Something has been wrong with it for a long time, at least a decade, maybe more. I don’t fully understand it. I can’t imagine it’s this simple: a new generation of moral and ethical zeroes rose to run Big Money over the past decade, and nobody quite noticed but they were genuinely bad people who were running the system into the ground … Those who invested in and placed faith in Global Crossing, Enron, Tyco or World Com have been cheated and fooled by individuals whose selfishness seems so outsized, so huge, that it seems less human and flawed than weird and puzzling. Did they think they would get away with accounting scams forever? Did they think they’d never get caught?Noonan recommended that “we should study who these men are – they are still all men, and still being turned in by women – and try to learn how they rationalised their actions, how they excused their decisions, how they thought about the people they were cheating. I mention this because I’ve been wondering if we are witnessing the emergence of a new pathology: White Collar Big Money Psychopath.”

What Is To Be Done?

When the going gets tough, Australian company directors go to workshops. The AFR (5 July) reported that “worried by successive business debacles here and overseas, directors are enrolling in accounting courses, lining up for corporate governance workshops and paying outside consultants to assess their performance … The courts are continuously reinterpreting directors’ roles and responsibilities and therefore the directors see the need to keep up with these rulings and changing community expectations of directors, particularly in the light of the recent corporate collapses both here and overseas … The Australian Industry Group’s deputy chief executive, Heather Ridout, said poor corporate practice was often overlooked in good times. ‘However, when the tide is going out, you find out who has been swimming naked and there can be some pretty ugly bodies to observe.’” When the going gets tough, others run under the skirts of government. The chief economist at a Chicago investment house, when informed of a senior Treasury official’s view that valuations on American equity markets are still stretched, replied “wow, that’s a major quote. It says he thinks the market’s significantly overvalued. But to hear them talk as if it’s still a bubble, and we just have to wait for it to come back to normal, is kind of frustrating. That tells us they have no policy in mind to help the market” (AFR 15 July).

Perhaps not, but they have clearly received an avalanche of advice. “President Bush must be feeling a bit blindsided by his buddies on Wall Street. They are the ones who repeatedly entreated him to keep the government out of their affairs. But last week, they led the stampede for tougher government action – and left the president behind in a cloud of dust, endorsing much weaker solutions for restoring market confidence. The business and financial worlds, of course, always have been foul-weather friends of government. When times are good, they see Washington as a nuisance; when times are bad, they come begging for help” (The Wall Street Journal 9 July).

Indeed, according to The Sunday Telegraph (14 July), “many individual investors and market analysts believe the market will continue falling until the US Government passes tough laws against corporate fraud.” At least one tycoon agrees. George Soros stated that the US Securities and Exchange Commission has already taken “the most important step” to correct the problem by informing company directors they are henceforth personally responsible for giving a fair representation of financial affairs “irrespective of the rules.” (AFR 1 July). By 14 August, CEOs of 945 of America’s largest companies must attest to the accuracy and propriety of all company financial documents dating back to their 2001 annual reports. Thereafter, and at the risk of personal liability for misstatements, CEOs must personally verify the veracity of their accounts.

And when the going gets tough, politicians pontificate, congregate and prepare to legislate and regulate. “US President George Bush and the Federal Reserve have moved to arrest the dangerous crisis of confidence affecting American markets and the US dollar. Mr Bush promised to act against dishonest companies and said that ‘no violation of the public’s trust will be tolerated.’ As mistrust of the US markets grows, officials said Mr Bush would seek to restore faith by making a speech on Wall Street on 9 July to announce harsher penalties for corporate malfeasance. Fears about the crisis of confidence have prompted President Bush to express outrage several times over the behaviour of executives.”

Like his predecessors in the wake of the Panic of 1907 and the Great Depression of the 1930s, Mr Bush has proposed various legal and regulatory measures. These measures include longer prison sentences for corporate officers found guilty of fraud and a new “financial crimes SWAT team” to oversee investigations and prosecutions of corporate officials. Within days of Mr Bush’s speech, Congress agitated for tougher action. The Senate, for example, has voted 97-0 to establish sweeping new powers to target corporate fraud. Rep. Michael Oxley (R-Ohio), who heads the Financial Services Committee noted that the upper chamber, in its zeal to demonstrate its disapproval of corporate malefactors, is presently engaged in a “feeding frenzy” and that “summary executions would get about 85 votes right now.” According to Barron’s (15 July), previewing a book by former Securities and Exchange Commission head Arthur Levitt (Take On the Street, to be published by Random House and excerpted by Readers Digest in October), these are some of the same Congressmen who in 1999 sabotaged Levitt’s efforts to crack down on lax accountants. “Some 46 Congressmen, all allegedly recipients of campaign contributions from accountants, wrote Levitt threatening or intimidating letters in a successful effort to block his proposed new rules. Levitt won’t give away his goods yet, but says his book will contain several such missives that have never been made public.”

Coping With Torrents of Nonsense

A legion of journalists, academics, clerics, plutocrats and politicians of all stripes have declared in the wake of the Enron, WorldCom and other fiascos that a “crisis of ethics” exists and that what is needed is a new batch of laws, regulations and ethical standards (“A Restoration of Character Should Top the Reform List” The Wall Street Journal 1 July). They are utterly wrong. As financial history (to say nothing of the King James Bible) reminds us, vices have been with us since time immemorial. In the late 1920s, 1960s and 1980s, so too in the late 1990s: the ultimate cause of the current wave of “scandals as they are erroneously called, derives not so much from dishonest individuals’ motives (such individuals have always possessed unsavoury motives), but rather from institutional arrangements and business conditions brought about by reckless and misguided government policy, i.e., by governments’ creation of an unsustainable boom. Bad apples are a constant of history; and at some points in time egregiously bad policies and institutional arrangements give bad apples full rein. “Scandals in other words, are synonymous with the revelation and liquidation of the “malinvestments” created during the boom. Part II shows that governments’ accounting and managerial practices are at least as scandalous – and more parlous – than is commonly realised. It concludes that politicians and governments have no moral basis on which to demand standards of accountability from anyone, let alone private businesses.

Part III goes further: it shows that investors should be sceptical that governments’ laws and regulations (existing and proposed in light of recent events) will make investments safer. If they do so, bravo; but one should not expect these intended consequences. Anglo-American countries already have enforcement agencies and thousands of securities laws. In the U.S., the Securities and Exchange Commission spends a half-billion dollars every year protecting investors from fraud. Why would new laws provide any more protection than the old ones? Alas, despite their critically important functions, governments can no more protect investments than they can win a War on Drugs, a War on Poverty or a War on Terrorism. Despite their best intentions governments cannot keep these promises; and for these reasons investors should not rely upon them for protection. Fortunately, the history of financial busts and the methods of Graham, Buffett and other value investors provide a path through the wilderness.

…continued in Part II

Designed & maintained by
Artist Web Design
©1999-2010 All Rights Reserved