In the bad old days of rugged, unrestrained capitalism, Wall Street was virtually synonymous with lawful thievery. Stock trading was the province of cold-blooded insiders. Wall Street was a place where shrewd operators fleeced the unwary piker by spreading false information, issuing paper in non-existent companies or borrowing against assets they did not own. After the stock-market crash of 1929, Congress established the Securities and Exchange Commission (SEC) to impose some order. Financial reforms of the 1930s required companies to file audited financial reports, outlawed ‘insider trading’ and forced banks to spin off their stock-brokerage operations.
This made Wall Street a somewhat safer place to do business. But periodic price-rigging and insider-trading scandals led small investors to shun stocks. By the 1970s, only about one American family in ten owned any stock at all.
Then came the 401(k) retirement accounts. Introduced in the mid-1980s, 401(k)s allow US workers to turn a portion of their earnings, tax free, over to their employers, who invests the money in company stock, mutual funds and other financial vehicles. With traditional employer-sponsored retirement plans on the decline, 401(k)s have proved a nifty device for shifting the financial risks of retirement from corporations to individual workers. They have also tossed the life savings of half the US population into the lion’s den of Wall Street.
As retirement savings flooded into the market, media commentators heralded a new era of ‘populist’ finance where worker-shareholders, armed with internet research and common sense, were supposed to be able to outwit market pros and make a bundle. Investment clubs sprang up in small towns throughout the nation and high schools added investment games to their civics curriculum.
When the stock bubble deflated in 2000, though, it turned out that Wall Street had once again taken the investing public for a ride. As Americans poured money into stocks, insiders shoveled it out, scrambling to sell their own shares before the unprecedented scale of the swindle became evident and crashed the market.
Here’s how the swindle worked. During the 1990s, corporate boards began paying executives with stock options rather than with cash. Options enabled the holder to buy shares tomorrow at today’s price. They were only valuable when share prices rose. Executive options grants were frequently so large – involving hundreds of thousands or millions of shares – that a small up-tick in price could make an executive exceedingly wealthy. A big price hike would hurtle them into the Forbes 400. Since share prices rise on good news about company earnings, executive option-holders tried to supply the market with a steady stream of excellent news.
Some firms, like Enron, adopted byzantine financing schemes that shifted costs and debts into purportedly independent ‘partnerships’, while moving revenues and assets from the partnerships to Enron. Some, like WorldCom, engaged in plain vanilla accounting fraud, booking routine costs as capital expenditures (which need not be deducted from revenues in full) to inflate earnings. Others, like Tyco, puffed up earnings by buying up hundreds of smaller firms. In fact, the schemes and scams were myriad. Firms established to sell electricity or broadband capacity conspired in fictitious trading with one another. Both parties booked revenue from the trades. Others entered into contracts expected to generate modest earnings over a number of years, yet booked the entire projected revenue stream for the current year.
CEOs made ambitious earnings forecasts, manipulated accounts to exceed the forecasts then triumphantly announced bested expectations. Share prices shot up and executives exercised their options.
An investigation by the Wall Street Journal and Thompson Financial analysts estimated that top telecommunications executives captured a staggering $14.2 billion in gains from stock sales between 1997 and 2002. ‘All told, it is one of the greatest transfers of wealth from investors – big and small – in American history,’ Journal reporter Dennis Berman wrote. ‘Telecom executives… made hundreds of millions of dollars, while many investors took huge, unprecedented losses.’ The industry is now reeling, 60 firms are bankrupt and 500,000 jobs lost.
Fortune Magazine analyzed 1,035 companies whose stock dropped at least 75 per cent between 2000 and 2002. They discovered that ‘executives and directors of the 1,035 companies took out… roughly $66 billion.’ Telecommunications giant Global Crossing imploded amid accusations of accounting irregularities. Global Crossing’s stock, which had traded at nearly $100 per share, became virtually worthless, but not before CEO Gary Winnick, exercised stock options and walked away with $734 million. Qwest Communications director Phil Anschutz sold stock worth $1.6 billion in the two years before the firm stumbled under a crushing debt load. The stock subsequently lost 96 per cent of its value.
Executives in the energy and telecom sectors were not the only ones to rake in impressive gains. Dennis Kozlowski, CEO of the manufacturer Tyco International, received an annual salary and other compensation valued at $30 million, reaped $258 million selling Tyco stock and captured another $150 million in forgiven loans. Kozlowski defended this windfall with the claim that his leadership had ‘created $37 billion in shareholder wealth.’ By the time Kozlowski quit Tyco under indictment for sales-tax fraud in 2002, some $80 billion of Tyco’s value had evaporated.
Media exposés uncovered dozens of deals that yielded extraordinary gains not only for executives, but for political cronies as well. Terry McAuliffe, chair of the Democratic National Committee, parlayed a $100,000 investment in Global Crossing into $18 million a few years later – a mind-boggling 17,900 per cent rate of return. Vice President Dick Cheney earned $36 million in 2000 from the sale of stock in Halliburton Corporation. During Cheney’s stint as chief executive, Halliburton ‘altered its accounting policies so it could report as revenue more than $100 million in disputed costs on big construction projects’, according to an investigation by the SEC.
Economic historian Robert Brenner estimates that executives and their boards also kept share prices aloft by devoting hundreds of billions in corporate profits and in borrowed funds to repurchasing their own outstanding stock. Between 1995 and 2000, over $1 trillion in corporate wealth was devoted to buying up the shares that were given out as executive stock options.
Executives and their cronies could never had pulled off such swindles without help from the financiers who analyze them and the accountants who audit them. Top five accounting firm Arthur Andersen signed off on Enron’s accounts in return for lucrative consulting contracts. When employees of Andersen’s Houston office were caught shredding Enron-related documents, prosecutors indicted the firm for fraud and it was disbanded. Congressional hearings disclosed that Merrill, Citigroup and other top banks helped set up, participated in and profited from the partnership deals that were used to loot cash from Enron.
As conditions deteriorated in the high-tech sector presumably-independent financial analysts at top investment firms like Morgan Stanley, Salomon Smith Barney and Merrill Lynch issued strong ‘buy’ recommendations to gullible investors. Any rational analysis would suggest that the bull market was over and prices had peaked. Serious allegations of accounting irregularities were already starting to emerge, yet fewer than one percent of analyst reports recommended unloading stock.
Wall Street insiders attributed this bullishness to optimism about new technologies. But investigations by New York Attorney General Eliot Spitzer found internal emails in which Merrill and Salomon employees privately dismissed the stocks they were touting to the public as ‘crap’ or ‘junk.’
Salomon Smith Barney analyst Jack Grubman actively plugged Global Crossing and WorldCom shares until just a month before the telecom behemoths filed for Chapter 11 bankruptcy. Grubman earned $20 million in 2001 for steering telecom corporate finance accounts to Salomon. He resigned in August 2002 with $32 million severance. Merrill technology analyst Henry Blodget earned his keep not by providing sound analysis to the firm’s brokerage clients, but by courting business from the companies he analyzed. For ‘generating $115 million in revenue from 52 deals… Blodget’s compensation quadrupled – from $3 million to $12 million – in 1999 and 2000,’ according to Business Week.
Major investment firms routinely ‘wooed analysts with multimillion-dollar contracts based on their ability to generate investment banking fees’ from the very firms they were supposed to analyze, says the Wall Street Journal. Enron alone paid $323 million in banking fees to Wall Street and was touted as a great buy all over the street.
In the aftermath of the scandal, US politicians promised to prosecute wrong-doing and restore ‘investor confidence’. But few of the recent scams violated any laws. Financial markets are and probably always will be the province of insiders. Concepts like earnings, revenues and even costs are highly elastic. They are easily ‘massaged’ through creative accounting practices. Sound information about corporate finances is the province of senior executives and the lawyers, consultants and auditors in whom they confide, and the investment bankers who advise them and the politicians who court them. Insiders have every incentive and plenty of opportunity to skate along on legal thin ice. They are confident that not they, but the mobs following behind, will go under.
Writing in the New York Times Magazine, financial journalist Michael Lewis held the investing public to blame for its own greed. How else to explain, Lewis asks, people’s credulity as stocks doubled, tripled, quintupled in value? What else accounts for the stratospheric prices reached by dot.com start-ups without earnings or even sales? Sure, Wall Street analysts and television pundits plugged stocks shamelessly, but Americans were primed to buy.
But Lewis misses an important point. This is not just a cautionary tale of ruthless cons and greedy marks. Millions of small-scale savers who bought high were ushered to the table courtesy of their employers and a woefully inadequate public pension system.
Consider Enron. Elevators in Enron’s Houston headquarters sported TV sets tuned to CNBC, constantly tracking the firm’s stock price and acclaiming stocks generally. These daily market updates made employees – 60 per cent of whose retirement accounts were held in company stock – feel quite wealthy. But Enron workers were not free to sell this stock. For a full month before the bankruptcy filing the company executives who managed the plan froze employee accounts. Meanwhile Enron executives and board members dumped their own personal stock and options, netting $1.2 billion cash – almost exactly the amount employees lost.
Could the workers have been smarter, more savvy, have diversified their portfolios more diligently? No doubt. Caveat emptor has always been the soundest financial advice for small-scale investors. But it is not a principle on which a civilized country builds a national retirement system.