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.
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.