Now for a few words about Enron and Global Crossing, two formerly immense companies that collapsed in a welter of fraud and self-dealing within the last two months, costing stockholders and lenders tens of billions of dollars.
First, it’s serious. It is not just a matter of interest to the wolves of Wall Street. Millions and maybe tens of millions of Americans lost money because of losses to their mutual funds. Enron and Global Crossing were widely traded stocks beloved of investment managers and when they fell, hundreds of mutual funds were affected. This is not to mention the losses of far more serious proportion to investors who had a larger fraction of their assets in Enron or Global Crossing.
But it’s more serious than the loss of money, although money is a big part of life and losing it is a big cause of loss of peace of mind.
Long ago, Bob Bartley, who was my boss on the edit page of the “Wall Street Journal,” said that a certain event (a U.S. double cross of Israel at the time ) was important mostly because of what it said about us as a people. Enron and Global Crossing are in this category. They say disturbing things about us as a people.
I take it for granted that human beings will be greedy. And I take it for granted that, as my longtime pal here in Hollywood, Michael Shamberg, says, people will be dishonest. These are parts of the human heart and we expect them to appear in action and frequently. People like to steal. People like to embezzle. If they can take money by the stroke of a key on a keyboard instead of by risking their lives in a shootout with police, they are much better off.
The problem of greed and theft in public companies is particularly dicey. By definition, the modern public company, as pointed out by Schumpeter and Director and many others, will have diverse, faraway stockholders. Usually they will not be anywhere near as well informed about the operations of the company as their trustees who run the company. These trustees will see the big pots of money the shareholders have left lying around and they will be tempted to steal. The effort to bring the trustees to heel is almost impossibly difficult for any one or a few investors because of the cost and complexity of litigation.
Unfortunately, as we have just seen in Enron and Global Crossing and many others, it’s not just the temptation that has been overwhelming. The fact is that officers of public companies do defraud their stockholders and bondholders on a continuing basis. This is a big part of the story of the Twenties, of the Drexel-Milken world, of the S&L scandals, and of the tech bubble.
To fight this (it can never be totally prevented), the United States had until 1995 a comprehensive scheme of balances and regulation to stop fraud. There were the 1933 and 1934 Securities Acts that set up the SEC and regulated markets. These acts forbade stock manipulation, required full disclosure of any material events and facts, and forbade any artifice to mislead or defraud investors or markets.
The staff of the SEC stood ready to fight the miscreants who violated securities laws by suing them for civil damages and restraining orders and in very rare cases, asking for criminal sanctions for extremely fraudulent and dishonest behavior.
But there never have been more than a few hundred lawyers and accountants at the SEC. There are tens of thousands of public companies filing data with the SEC. Millions of pages of filings go to the SEC every year. The vast majority of them are never read but just filed away in warehouses and basements, ignored and unread. When the SEC does read and bring cases, which is rare indeed, it is met with well-financed and experienced counsel for the filing companies who can and do resist the SEC mightily.
In other words, the SEC is outgunned. In addition, the SEC staff, while capable, is not well motivated to fight hard against fraud. The lawyers are often (not always) young and inexperienced. They are poorly paid compared with their colleagues in the private bar. And they have little to gain personally from a successful enforcement action. As with most civil servants, pay is a function of seniority, more than anything else. The only way civil servants can raise their hourly pay is to work fewer hours — and this is also a temptation. It does not work well for stockholders.
Luckily, there exists a whole additional scheme to keep officials of public companies from defrauding markets.
First, there are boards of directors who supervise management. They are supposed to exercise independence and keep the officers in line.
Then there are outside auditors, who are also supposed to carefully peer at corporate reports and make sure that they correspond with reality. They are supposed to actually function as the counters who count the stockholders and bondholders’ money. For this they are extremely well paid, by and large.
Then there are Wall Street securities analysts. These men and women are supposed to carefully scrutinize the company, analyze with full independence just what is happening at the company, decide whether the company is giving a fair account of itself to investors, and point out whether the company is really worth what it claims to be worth. They are supposed to tell investors what a fair price for the company’s stocks (and sometimes bonds) should be based solely on the interests of their clients, the investors.
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