The cover of the July 1, 2002 issue of Fortune magazine had the words “System Failure” emblazoned in bold red letters. The cover story went to great lengths to offer a handful of ways that investor confidence could be restored. But the one article that caught my attention was Geoffrey Colvin’s Value Driven piece, titled “Money Woes Strike Ex-CEOs.”
No passage captures what is wrong with the current state of the markets better than his conclusion. Colvin was right when he stated that “these executives, like [Worldcom’s Bernie] Ebbers, [Adelphia’s] Rigases, and other CEO debtors, were hailed as brilliant managers by their companies and cheerleading Wall Street analysts back when they were borrowing all that dough.” True, and Americans should not forget that everyone loved stock option plans and laissez-faire capitalism when the markets were rising.
That being said, as a general rule, I try not to criticize respected editors at any magazine, especially Fortune . But in all fairness, Colvin was wrong by stating that “Now that the chips are down, why deprive them of this opportunity to reclaim their reputations ()? These guys certainly — definitely, emphatically, imperatively — deserve one more chance to show what great managers they really are.” No, they do not deserve that chance. Investor confidence was not rattled by 9/11 nearly as much as it has been by the slew of scandals to rock corporate America.
Symptom versus cause
When faced with a crisis, the United States is remarkable at pinpointing the symptoms and eradicating them. But when it comes to determining the causes at the root of the problem, the US often turns a blind eye. As employees lose jobs, pension plans evaporate and investor confidence gets shattered, America has to decide whether it wants to apply a bandage to this problem or whether it wishes to solve the problem with a long-term vision.
A crime by any other name
The first issue is that lawmakers — this includes Democrats and Republicans who have both been pocketing billions to look the other way — must come to grips with the fact that what happened at Enron, Andersen, Worldcom, Adelphia, and many other firms, represent crimes. Ethics and morality are gray matters in business, but a crime is a crime. If we lock up people for lesser crimes that harm few, why should we overlook corporate crimes when they hurt millions?
These are crimes for the simple reason that as publicly traded firms, the founders and managers have a fiduciary duty to all shareholders, and that includes employees that have been cheated out of their pension plans.
If the Rigas family wished to borrow $2.3 billion from Adelphia (the company they founded), they should have kept the firm private. It is a crime to take a firm public and expect to reap the benefits of capital markets and at the same time manage it like a private one. Borrowing such a huge sum at the detriment of shareholders is robbery.
Ebbers stayed hush-hush…
If Bernie Ebbers, the former CEO of Worldcom, wanted to borrow $400 million from his firm’s coffers — the same ones that he pledged to protect — he should have kept his firm private. By going public, you agree to air your dirty laundry. But Ebbers stayed mum about his loan. It seems that Colvin is a fan of Ebbers and don’t get me wrong, I was too. The maverick Canadian businessman went from high-school basketball coach to telecommunications czar.
Don’t trust analysts
Enron has gotten lots of ink. But to put matters into perspective, that firm managed to evaporate $63 billion of value. The entire telecommunications industry has evaporated about $3 trillion in shareholder wealth over the past few years (Colvin himself asserts this much in a previous piece). Most of that loss was a result of telecom firms over investing and demand not meeting the supply. In all fairness, little of that $3 trillion evaporation was a result of criminal activity. The entire dot-com “blowout sale” cost shareholders $1 trillion even though it got more press.
This brings us to the next culprits: the analysts. Analysts have been treated like whipping boys (and girls). Mary Meeker and Henry Blodget are two examples of analysts that “allegedly” misled investors. But they are not the only bankers to have acted questionably. The entire investment banking community should be having trouble looking at itself in the mirror.
CSFB’s Frank Quattrone comes to mind. The man is a genius, but he was too smart for his own good, costing his firm $100 million in fines. Merrill Lynch, the most powerful firm on Wall Street, also got hit with a $100 million fine. Something tells me that they will all bounce back. The problem in corporate finance remains that the so-called Chinese Wall between research analysts and investment bankers is nonexistent. The hypocrisy needs to stop. We as human beings have insatiable needs yet we expect bankers (of all people) to act ethically and not suffer from a conflict of interest. The industry has to choose from the following three alternatives:
1- Keep firms intact and suffer from a conflict of interest and a loss of investor confidence;
2- Break them up and have more firms, each one specializing in one area or another;
3- Leave the status quo but let investors know that a research analyst’s research is nothing more than an infomercial for the stock that the investment banker underwrote.
Audit the auditors
Enron is a good example of no one doing their job. Everyone has blamed accountants and auditors, but that is only half the picture. True, Andersen had a flagrant conflict of interest. But it is unfair to blame the accountant because an accountant records a company’s performance. That would be like blaming a historian for the Holocaust. Yes, accountants must respect Generally Accepted Accounting Principles (GAAP), but people should question the institutional imperative and ask whether GAAP is relevant in our economy. It is not.
Auditors should be blamed in the Enron mess. They blessed Enron’s books when they were obviously not accurate of the burgeoning debt it was carrying. So the culprit at Enron was that the Chinese Wall between accountants and auditors was broken. Consulting firms have already begun to separate from their accounting brethren. Is it ironic that years after mergers between accounting and audit firms occurred in order to increase efficiency, we now realize that too much inefficiency begets a conflict of interest that makes the markets ineffective?
Before accountants got in the picture though, analysts should have questioned Enron’s ever-changing business model. No one dared to ask why an energy company was using its trading platform to commoditize everything else. It seemed perfect for capital markets. But if it sounds too good to be true, it probably is.
With time, no one was questioning the firm’s management and this is when the debt level crept up to unbearable levels. Had the checks and balances been respected initially, never would the debt level have been able to get out of control.
Some possible solutions…
In hindsight, it is unfair for anyone (yours truly included) to question these problems. So how could we fix the system?
America needs to understand that the problems are both cultural and structural. If you want to root out terrorism, they say you need to go to the schools where the hate is preached. Fair enough. So let’s hit the business schools and see what students are being taught.
What is not on the curriculum is the social conscience that would prevent someone from ripping off a legion of employees. What is also missing is the common sense that just because you are fortunate enough to have a well paying job and great benefits, does not mean that you are allowed to abuse your position.
Schools have a moral duty to the greater community to educate students that everything they do, they should do for employees, clients and then shareholders. After all, this is the order in which former Southwest Airlines CEO Herb Kelleher ranked stakeholders. The problem is that even shareholders are getting ripped off in today’s climate and this should alarm everyone. Without the investor, we would be communists. Remember them, they were our so-called enemies for most of the 20th century, so we should certainly not emulate them, should we?
Challenger, Gray, & Christmas Inc., a North American recruitment firm, reported over 30,000 dot-com jobs lost from December 1999 through November 2000 alone (the cuts came from 383 companies, 20% of which had gone out of business). With the trend accelerating in 2001, that number now sits in the hundreds of thousands of jobs lost. To make matters worse, these employees borrowed off their stock options, and once the market cratered, the options were useless and the debt suffocated them.
This year, we have seen the results of excess leverage on corporations, as many have succumbed to it. But what has made some firms go down was the lack of disclosure of those debts. This leads us to potential victims down the road: banks.
The next victims?
One stakeholder that is trying to remain on the sidelines is the banking industry. Remember that when Adelphia, Worldcom or Enron crashes and burns because it borrows too much, there is an entity on the other side of the transaction. That entity is a financial institution. No one borrowed as much as the telecom industry and no one will suffer as much as banks.
After all, when a company like Worldcom loses over $100 billion in market value and the stock goes down to $0, it is not only shareholders that are left with nothing — creditors lose as well. Worldcom is special because it has a physical infrastructure that can be salvaged. But no amount of fiber will make up for the billions (if not trillions) that banks may lose on their own telco bets.
The danger is that banks should be more open and forthcoming about their own exposure. But because they fear that investors will punish their stock prices, few are openly admitting their full short and long-term exposures. When the music stops, many banks will be left standing with worthless IOUs. If you thought a company letting go of tens of thousands of employees was bad, imagine what it means for a bank to let down millions of clients because it too took on too much risk.
And this is the current dilemma. At a time when everyone is urging these criminals to get tossed into jail, we are asking would-be criminals to come clean. Seems like risky business to me. But isn’t that what capitalism is all about: risk?
Stop the hypocrisy
Critics seem to cry that the rich get richer — perhaps. But when wealth evaporates, it is the rich that get hit most. In 2001, investors lost $2.9 trillion — equivalent to the entire private banking industry in Switzerland — but the world’s richest households lost $2.6 trillion of that amount.
This brings me to my final point. Advocates and pundits are crying foul because people are getting burned. If you seek to increase your return, you will face higher risk. When employees wanted to share in the profits of the firm and reap the same benefits as top brass, they openly embraced stock option plans and the like.
When the party was over though, no one seemed interested in cleaning the mess. You can’t have your cake and eat it too; with capitalism comes excess, conspicuous consumption and the potential for crime.
Ash Karbasfrooshan is also the author of Course To Success, available at www.CourseToSuccess.com.