The Fraudulent Corporate Fraud Bill
July 31, 2002

Maria Tomchick

While the stock market bubble was expanding in the '90s, you could open any newspaper or listen to any news program and hear a lot of hype about technology companies, the Internet, and the economy--all geared to fuel the expansion. When the bubble started to deflate in 2000, you could read or hear plenty of happy talk geared specifically to avoid a meltdown. Today, the papers and airwaves are full of soothing pap to calm investors and consumers. One such example is the "corporate oversight" bill passed by Congress last week.

It's a bill to save the stock market. Passed in a hurry while the market was plunging, it contains a lot of interesting things that sound good on paper, but won't provide much new, significant oversight of corporations and CEOs--nor much compensation for shareholders and retirees devastated by the collapse of Enron and Worldcom.

Foremost in the bill is the new accounting industry oversight board to regulate accounting firms that audit the books of major corporations. Sounds good, huh? If there had been someone looking over Arthur Andersen's shoulder, they tell us, then Enron and Worldcom would never have happened.

Not true. The SEC, which is tainted by its inability to detect troubles at Enron, Worldcom, and a host of other companies, will be the agency in charge of setting up and administering the new oversight board. Giving a failed oversight agency, staffed with accounting industry insiders, more responsibilities is a recipe for more failure.

Likewise, the increased funding for the SEC, which would bump up the agency's budget by two-thirds, will only be effective if drastic changes are made within the SEC; however, the impetus is to maintain the status quo. Harvey Pitt, SEC Chairman and George W. Bush's appointee, has made a career out of lobbying for liberalized accounting rules and less oversight over the accounting industry. His nominees--top-level auditors from the Big Four accounting firms--are rapidly filling new slots at the SEC. More of the same will not produce better quality oversight.

Certain provisions of new the bill double the penalties for fraud committed by chief executive officers, chief financial officers, and other upper-level management. It would be nice to punish some of these guys, but don't hold your breath. CEOs and CFOs are particularly hard to indict and convict, for several reasons:

First of all, upper management crooks are smart enough to cover their tracks. All the penalties in the world for shredding evidence don't apply if few or no written records are kept in the first place. CEOs are not bank robbers who grab a gun and knock over a bank in one afternoon; they're at it for months, even years, and they have plenty of time to lose, misplace, destroy, or hide the evidence.

Secondly, most corporate criminals have the money to hire the very best legal counsel available--much, much better than the government lawyers pursuing them. Given the complexity of financial fraud, good attorneys can make all the difference in the courtroom.

Thirdly, the evidence needed to obtain a conviction usually involves an insider in the company testifying against his or her bosses, backed up by written evidence in the company's files. One witness alone is not credible enough; the paper trail has to exist, too. Likewise, the paper trail is not enough; a witness has to testify that the CEO actually read company memos and understood what was going on. It's very, very difficult to get both of these things together in one case.

In addition, CEOs and CFOs may be right in claiming that they didn't do anything wrong. The US accounting system is a "rules-based" one, not one based on ethical intent. Accountants follow the rules published by the Financial Accounting Standards Board, and they follow them to the letter. This means that, if something is not specifically forbidden by the rules--Enron's off-balance-sheet partnerships, for example--then it's considered legal, even if the company's intention was to mislead investors. This is why Kenneth Lay, Jeffrey Skilling, and Andrew Fastow have not been indicted, and may never face charges. The corporate oversight bill doesn't change our rules-based accounting system.

More importantly, the corporate oversight bill ignores one issue that could easily stop future fraud in its tracks: stock options. Many investors and analysts think that stock options awarded to CEOs and CFOs in order to tie their performance to their company's stock prices (originally to bring their interests in line with investors' interests) to be the main reason for the current crisis. Stock options have had the opposite effect: CEOs who stand to receive tens of millions of dollars when they exercise their stock options are tempted to go to any length, including fraud, to boost stock prices, eventually ruining shareholders in the process. One way to prevent this would be to require companies to expense stock options on their books, and so make it easier for investors to see which companies are using stock options to reward their CEOs. Yet stock options were completely untouched by the new bill.

Why? Well, last week Congress was deluged with lobbyists from high-tech companies, CEOs of Fortune 500 companies, venture capitalists, biotech companies, and business industry groups who all had one mission: save stock options. The parade through Congressional offices was unremitting: Cisco Systems, Intel, Dell, AOL/Time Warner, Sun Microsystems, the Business Roundtable, the Stock Option Coalition, the National Venture Capital Association, Financial Executives International, the Information Technology Industry Council, and even the Nasdaq market administrators put pressure Democrats and Republicans alike. Considering that the high-tech industry alone contributed $20.7 million to Democrats and $18.5 million to Republicans in the last election cycle, our elected representatives were happy to comply.

Yet this flies in the face of reality. The Coca Cola company has already voluntarily started to expense stock options on its books, and others will soon follow. Last week, SEC Chairman Harvey Pitt admitted that expensing stock options is inevitable, but it's something he'd like to see happen in the far distant future. Even Fed Chairman Alan Greenspan admitted that expensing options will happen; he prefers leaving it to the Financial Accounting Standards Board to write rules on the subject. However, the FASB has been attempting to write such rules for over a decade without much luck. Past efforts have been stymied by accounting industry and business lobbyists--the same folks who stampeded Capitol Hill last week.

And finally, the bill provides little relief for investors burned by the Enron and Worldcom scandals. It will set up a fund to collect penalties from corporate criminals and repay that money to shareholders, but the amounts levied against companies and upper management historically have been tiny compared to the damage done. Last year, the SEC collected only $24 million and only $45 million so far this year--peanuts compared to the billions investors have lost from the collapse of Worldcom alone.

Investors, particularly mom-and-pop 401(k) savers, would be better served to ignore the soothing talk of the business pages and TV financial shows and remember the advice of Lester C. Thurow, a professor at the Sloan School of Management at MIT: "New laws and regulations adopted in the aftermath of scandal are almost always useless in preventing future wrongdoing, especially in financial matters. The last great wave of regulatory lawmaking, designed to prevent systemic fraud and abuse among savings and loans in the 1980s, proved largely irrelevant to preventing systemic fraud and abuse among accounting firms today. So what can be done about the inevitable scandals of capitalism? The first and best solution is to warn all small investors that the game is rigged. No individual investor, no matter how well informed, can play on the same level as the major institutional investors, Wall Street firms and corporate executives ... no government can ever guarantee that the small investor has an equal chance of winning. It is beyond dishonest to pretend that rules can be written to prevent future financial scandals; it is faudulent."