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The Top 10 Financial Scams
of the 2002
Corporate Crime Wave
By Lee Drutman and Charlie Cray
Public confidence in chief executive officers (CEOs) and other
corporate leaders sank to a new low in 2002 after a series of accounting
scandals and financial scams capped a $5 trillion loss in market value and
trashed the pensions and lifetime savings of millions of investors, workers
and pensioners.
The 570 new SEC investigations opened up this year ó more than any
year of the previous decade ó unearthed such a cornucopia of business
improprieties that everyone had a hard time keeping up. First came Enron.
Then WorldCom, followed by a trail of others ó Adelphia, Global Crossing,
Tyco, ImClone, Vivendi, etc.
In July, President Bush reacted to mounting concerns about a systemic
contagion by going to Wall Street, where he announced a 10-point corporate
responsibility plan, including the creation of a new corporate fraud task
force. But the task force had no budget or staff, and was headed by deputy
attorney general Larry Thompson who, it was soon discovered, had been a
board member of Providian Financial Corporation, a credit card company that
paid more than $400 million to settle allegations of consumer and securities
fraud.
But this was not atypical of an administration that had made the
corporate-government revolving door spin so fast it shredded ethical
concerns like a Cuisinart. A few of the 40 or so members of the Bush
Administration that had ties to Enron were beginning to sweat under
Congressional scrutiny, including Army Secretary Thomas White, the former
head of the division of Enron that ripped off California ratepayers. And
Democrats were promising to make an election-year issue out of SEC
investigations into both President Bush (who had been cleared of insider
trading at Harken 11 years ago, while his father was President) and Vice
President Cheney (who had instituted an aggressive stance on booking
disputed revenue while CEO of Halliburton.)
But then Bush changed the topic, using his plans for war in Iraq as a
fundamental distraction from these and other issues. Meanwhile, the
administration was quietly scaling back increases to the SECís budget and
shying away from a strong head for the new accounting oversight board.
By the end of the year, an already-overworked SEC staff was left
reeling by the botched appointment of William Webster and the resignation of
Harvey Pitt.
Below is a list of 10 different kinds of financial and accounting
transgressions that dominated the 2002 corporate crime wave. The forms of
fraud are so varied, the patterns so broad, and the players so many that the
corruption can only be explained as a systemic problem. Thus, it is unlikely
the Sarbanes-Oxley law, which only deals with accounting, can prevent
another corporate crime wave. Yet after the U.S. mid-term elections, it is
obvious that the only thing likely to stimulate another round of significant
legislative reforms is another major scandal or a full-fledged market
collapse.
Accounting conflicts-of-interest
After the collapse of Arthur Andersen, business pundits railed against
accountants as the "short-order cooks of financial legerdemain" who had long
lost their role as the independent conscience of corporations. Instead, they
had become cozy insiders who happily looked the other way when the numbers
did not add up, knowing that any criticism would jeopardize a business
relationship that included lucrative consulting and other services.
Despite the passage of a major federal accounting reform law
(Sarbanes-Oxley) and the industryís attempt to reform itself by spinning off
large consulting units, the Wall Street Journal reported in September that
accounting firms were still reaping half of their revenue from nonauditing
sources (down from three quarters).
Meanwhile, new proposed SEC rules still allow auditing firms to advise
on a variety of other activities, including some tax services and litigation
support.
Until there is an absolute ban on auditors performing non-auditing
services, the audit will not be independent and investors will suffer. As
accounting professor Don Moore of Carnegie Mellon University says, "Even the
most honest auditors will continue to see the world in a biased way, and
failures of auditor independence will continue."
Analyst conflicts-of-interest
In May, New York Attorney General Eliot Spitzer released incriminating
e-mails which revealed that analysts at Merrill Lynch had been publicly
touting stocks that they privately derided as "junk" and "crap."
This was standard practice at most big firms during the stock boom ó
brokers pushed the stocks of companies that bankers saw as lucrative
clients, and companies gave their business to firms whose analysts rated
their stocks favorably. According to independent analyst Martin Weiss, 47 of
the 50 largest brokerage firms covering companies that went bankrupt in the
first four months of 2002 continued to tell investors to buy or hold their
shares even as the companies were filing for Chapter 11.
The most egregious example of the incestuous analystís back-scratching
game was former Citigroup (Salomon Smith Barney) analyst Jack Grubman, who
allegedly changed his rating on AT&T stock at the behest of his boss, Sandy
Weill (who was seeking to persuade AT&Tís CEO, a Citigroup board member, to
support Weill in an internal company fight). In exchange, Grubman wrote in
an e-mail, Weill worked to get Grubmanís kids into a tony Manhattan
pre-school.
Will a deal that state and federal regulators are trying to cut with
the banks be enough to stop these conflicts? Probably not. As Business Week
put it in an article about Citigroup in September, "itís starting to look as
though the very model of the financial conglomerate is fundamental flawed."
And until those flaws are dealt with by structural reforms that
fundamentally separate the analyst function from other banking services, the
conflicts are likely to remain.
Frontloading Income
Enron made the practice of booking uncertain future revenues famous as
"mark to market" accounting. But Enron was hardly alone.
In May, the Securities and Exchange Commission (SEC) opened an
investigation into accounting practices at Halliburton, the oil services
company formerly headed by Vice President Dick Cheney. Under Cheney, the
company switched to a new aggressive method of accounting. When a big
construction project, like a natural gas processing plant, went over budget,
the company booked the over-budget charges as revenue under the assumption
that the customer would pay later, ignoring possible disputes. All told,
Halliburton reported more than $100 million in disputed revenue, misleading
investors who were kept in the dark for a year.
What did the companyís accountants have to say about that? A
promotional video for Arthur Anderson taped in 1996 resurfaced this year. In
it, Cheney said he got "good advice, if you will, from their people based
upon how weíre doing business and how weíre operating, over and above the,
just sort of the normal by-the-books audit arrangement."
Improperly booking expenses
In July, WorldCom dropped a bombshell when it disclosed that it had
improperly booked $3.8 billion in expenses as capital expenditures. A month
later, the figure was more than $7 billion and before the year ended,
bankruptcy investigator Richard Thornburgh had estimated that the company
was able to inflate its earnings by as much as $9 billion.
A large part of the deception was accomplished by booking routine
expenses (line use costs) as capital investments. By disguising its
operating expenses as capital expenses, WorldCom was able to meet projected
earnings, finance a rapid and opportunistic acquisition of numerous
companies during the telecommunications sector bubble, and mislead millions
of investors, who lost an estimated $140 billion when the deception was
finally revealed.
Insider loans
In the race to compensate executives even more excessively, boards of
directors discovered a new tool that did not have to be disclosed to
shareholders: insider loans. According to the Corporate Library, 1,133 of
the top 1,500 companies (roughly 75 percent) have now disclosed insider
loans. The average loan was $5.5 million. Of an estimated $5 billion in
insider loans, SEC records show that about $1 billion have been or will be
forgiven.
WorldComís Bernie Ebbers got about $400 million in company loans.
Adelphiaís Rigas family borrowed $263 million from the company. Tycoís
Dennis Kozlowski borrowed $120 million.
Although the Sarbanes-Oxley Act bans insider loans, corporate
lobbyists are hard at work pressuring lawmakers and the SEC to weaken the
law.
Insider
Trading
Trading on information not available to the general public is illegal.
But that never seems to deter the greed of high-flying executives.
The big insider trading scandal of 2002 came at drug maker ImClone,
where CEO Samuel Waksal and his family and friends sold company shares right
before the company disclosed some bad news: the FDA was not going to examine
its new cancer drug Erbitux.
The company drew further popular attention when it was discovered that
Waksal friend Martha Stewart dumped 4,000 ImClone shares around the same
time. Waksal has admitted he was guilty of insider trading, but Stewart, who
is potentially facing both civil and criminal prosecution, is maintaining
her innocence, although an assistant to her broker has agreed to testify
against her.
Insider trading questions also surround President George W. Bush, who
sold 212,140 shares of Harken stock on June 22, 1990, when he was a company
director. A letter from the firmís outside lawyer dated June 15, 1990 warned
directors not to sell company stock if they had negative information about
the companyís prospects. That letter showed up at the Securities and
Exchange Commission on August 22, 1991 ó one day after the SEC cleared Bush
of insider trading charges.
IPO Spinning
One of the ways Wall Street banks attracted business was by offering
rare and valuable initial public offerings (IPOs) to executives of client or
prospective client companies, a process known as "spinning." For example,
Citiís Salomon Smith Barney investment-banking subsidiary gave telecom CEOs
preferential access to shares of hot IPOs that could be flipped in hours or
days at great profit. As a result, these already rich executives got even
richer on IPOs while ordinary investors were shut out of the profitable IPO
offerings. However, this process of awarding IPO shares for banking business
is illegal, even if the prohibition is sparsely enforced.
In October, New York Attorney General Eliot Spitzer sued the officials
at five telecom companies for $28 million in profits they made from shares
of initial public offerings purchased through Salomon Smith Barney.
Massachusetts Secretary of State William Galvin has documented similar
practices at Credit Suisse First Boston.
Overseas Bribery
The pressure from top level corporate management to "deliver the
numbers" extended to multinationalsí overseas operations.
Claims of corruption have arisen in a number of Enron-related projects
in numerous countries, including India, Bolivia, Ghana and the Dominican
Republic. (Foreign bribery is illegal under the Foreign Corrupt Practices
Act.)
In July, Xerox reported "certain improper payments" totaling nearly
$700,000 in 2000 from executives of its Indian subsidiary to government
officials. That same month, Business Week reported that a Tyco subsidiary
may have used illegal means to win a $200 million contract to build an
industrial water-treatment facility in Venezuela.
But federal prosecutors say foreign bribery cases are notoriously
difficult to win because they depend on foreign witnesses and access to
documents held outside the United States.
In addition, a loophole in the law was opened in April, when U.S.
District Court Judge David Hittner ruled in a case involving two executives
of American Rice, Inc. that it is legal for an executive from a U.S. company
to make payments to a foreign official to reduce the companyís tax burden or
customs duties.
Round-tripping and
network capacity swapping
Under pressure to improve or meet projected earnings, energy trading
companies discovered how to inflate revenue by fake trades known as
"round-tripping," whereby one company sells energy to another company, which
sells it back to the first company at the same price, allowing both
companies to report a sale even though nothing was actually purchased.
Dynegy, CMS Energy and Reliant Resources have all admitted to
"round-tripping." Another 150 companies are being investigated. Energy
experts say 40 percent of all energy revenue for 2001 may have been
overstated.
Telecom companies figured this trick out as well, swapping excess
capacity on their fiber-optic networks to artificially boost revenue. Global
Crossing and Qwest remain under investigation for swapping network capacity
to falsely inflate revenue.
AOL Time Warner and Homestore.com traded online Internet advertising
in a third variation on this theme. Both are also under investigation.
Special Purpose Entities
Enron made special-purpose entities (SPEs) famous, but big banks like
Merrill Lynch, J.P. Morgan, Citigroup and others helped make them possible.
According to a lawsuit filed by shareholders, these and other banks
structured or financed Enronís off-the-books partnerships, which were used
to hide debt and falsely inflate profits.
Merrillís alleged involvement with Enronís SPEs includes raising $390
million in private equity for LJM2 and investing $40 million of its own
money in Zephyrus, both off-the-books partnerships; J.P. Morgan allegedly
helped Enron line up $1 billion for a series of SPEs.
Additionally, "secret or disguised transactions by J.P. Morgan,
Citigroup and CS First Boston also concealed billions of dollars of loans to
Enron," the suit alleges.
Lee Drutman is communications director, and Charlie Cray is project
director of the corporate reform campaign, at the Washington, D.C.-based
Citizen Works.
c/
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