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It is vital to know that in every case, the legal and ethical duty of the directors and of the accountants is to the stockholders (and sometimes bondholders, although here the issue is more complex) of the companies they are directing or auditing. In the case of analysts, their ethical duty, as part of the brokerages or investment banks dealing with their investors, is solely to the investors and not in any way to the companies they are analyzing.
The fact is that in Enron and in Global Crossing, and in dozens of other cases involving tech in recent years, all of these safeguards failed miserably. In the Drexel Milken junk bond frauds of the 1980s and the early 1990s, the safeguards also failed pitifully. And in the S&L collapses of the 1980s and early 1990s, the guardians also failed pitifully.
The reasons are not complex. Basically, they have to do with money. The company has all of the money, and it can make it available in meaningful amounts to the people who are supposed to be watching over the company. It can pay the directors so much that the directors lose their independence and only want to be kept on the board and will wink at wrongdoing. This has, in fact, happened. It can and does subvert the work of the accountants (by no means all of the accountants, most of whom are fine people) by hiring them as wildly well paid consultants in addition to their auditing duties. This makes the auditors eager to keep those assignments and extremely reluctant to lose them by fighting with management over fraudulent reporting. (And of course, as the great investment psychologist Dr. Phil DeMuth has pointed out, accounting firms do not want to lose accounting deals either on the audit or the consulting side by alienating clients.)
The analysts can also be bribed. This is sad but it is true and well known at this point. The investment bank, brokerage, and analysts can all be subverted by offers of well-paid underwriting deals, secondary stock offerings, and even cheap stock in an initial allotment. The pressure on analysts to not do their work aggressively and not alienate management by finding fault with the corporation and its reporting thus becomes huge. The pay of analysts can be stupendous if they help a brokerage or an investment bank to get a major underwriting client. If they help to lose that client, their names are mud.
Thus, each and every factor that is supposed to protect the investor can be and is subverted…and this apparently is what happened in Enron and Global Crossing and probably in dozens of others waiting to be discovered. And they all are subverted by reference to the simplest of human vices, love of money — which is something we all have.
There is one and only one countervailing force that restrains corporate managers from fraud that gathers its strength from that same emotion: love of money. That force is the plaintiffs’ securities fraud class action bar. Class action lawyers who sue on behalf of classes of defrauded stockholders (and sometimes bondholders) make money, lots of it, if they successfully sue managers who do wrong. They take the claims of thousands, maybe hundreds of thousands of stockholders, sue managers or accountants or investment entities and if they win or if they get a good settlement, they make money, and lots of it, for themselves. They work hard, show tenacity, and do not give up easily because they are motivated by the same thing that motivates the managers — money. (And this is supposed to be the main motivation in America.)
To be sure, the recovery for stockholders is rarely anything like the full amount it should be. And to be further sure, if a company pays out to suing stockholders, it is often paying money from one group of stockholders to another. And also to be sure, the lawyers often settle on terms that are very generous to them and nowhere near as generous to the victimized investors. This is human nature.
But as flawed as that system is, it is the best restraint on management there is, and by far the best restraint on accountants. No one who has ever been deposed for a long time wants to do it again. No one wants to have to answer interrogatories. No one wants to be yelled at or called names in court filings. No one at an accounting firm wants to be responsible by his or her errors for having the firm pay out hundreds of millions in a fraud settlement or maybe go out of business.
The trial lawyers’ check and balance is very far from perfect: but it is the best we have right now. It relies on the same system of countervailing social forces, and on the gravity of the human soul acting in its own interest to balance other human souls acting in their own interests in much the same way as the Constitution does.
Unfortunately, this system of private securities litigation is nowhere near as good as it should be or used to be.
In the late 1980s and early 1990s, as a result of a mass of securities frauds in Silicon Valley and in the Drexel Milken world and in the S&L’s, there were hundreds of securities law private class action suits against managers, directors, lawyers, and accountants. The recoveries in these cases were in the tens of billions. The accountants were called to account and hated it. Their insurers on their malpractice policies hated the suits. So did Silicon Valley.
The defendants did a smart cost-benefit analysis. They figured out that they would be better off if they got new laws to hinder lawsuits against them than if they actually went to the immense trouble of doing their work properly. It was far cheaper to pay campaign contributions to Congress than to forgo their freewheeling ways. So money was paid, promises were made, and the law was changed in 1995. The Private Securities Litigation Reform Act, possibly the most anti-capitalism law ever passed in Congress since the New Deal, greatly cut down on the rights of shareholders. Powerful restraints were put in place about discovery, who could sue, who could represent shareholders (and sometimes bondholders), and how one would prove a case against malfeasors of great wealth, as one might say. The ability of shareholders to keep control over their own capital and their own managers was greatly hindered.
We now see a part of the result: massive fraud in the tech sector, and giant super fraud at Enron and Global Crossing. (At least as I see it in my humble opinion.) The human heart did not change. The calculus changed, though. Managers knew it would be very hard to sue them, and they ran wild at companies far bigger than any that had been in securities fraud trouble since the Depression.
Now, maybe it is time to repeal the PSLRA. Possibly we need the lawyers to ride herd on erring managers. Don’t get me wrong. The private class action bar are not saints. But they are capable, well trained, and well motivated. Why not take off their shackles-and those of their clients, the investors of America? Set these legal hounds on the scent of the miscreants. Make the bad guys think twice about whether they want to be deposed by Bill Lerach for a month at a time.
I do not practice law, and I don’t because, in large part, I don’t want to be in a deposition room with lawyers. Neither does anyone else in his right mind. Let’s put that fear and that all too human love of money to work for capitalism.
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