What's Wrong? --- Venal Sins: Why the Bad Guys Of the Boardroom Emerged en
Masse --- The Stock Bubble Magnified Shifts in Business Mores While
Watchdogs Napped --- Galbraith Explains the `Bezzle'
By David Wessel

06/20/2002
The Wall Street Journal
A1
(Copyright (c) 2002, Dow Jones & Company, Inc.)

[First in a Series]

Every decade has king-size corporate villains. In the 1970s, Robert Vesco
was indicted for looting the Investors Overseas Services mutual funds. In
the 1980s, arbitrageur Ivan Boesky and junk-bond inventor Michael Milken
went to jail.

But the scope and scale of the corporate transgressions of the late 1990s,
now coming to light, exceed anything the U.S. has witnessed since the years
preceding the Great Depression.

Enron Corp.'s top executives reaped hundreds of millions as the company
collapsed. Arthur Andersen LLP, Enron's auditor, was convicted last week of
obstructing justice. Tyco International Ltd.'s lionized chief executive is
charged with tax evasion and accused of secret pay deals with underlings.
Cable giant Adelphia Communications Corp. admitted inflating numbers and
making undisclosed loans to its major shareholders. Xerox Corp. paid a $10
million fine for overstating revenues. Dynegy and CMS Energy Corp.
simultaneously bought and sold electricity in transactions with no point
other than pumping up trading volumes. Merrill Lynch & Co. paid $100 million
to settle New York state charges that analysts misled investors, and other
Wall Street firms are now under scrutiny.

"I've never seen anything of this magnitude with companies this large," says
Henry McKinnell, 59, chief executive of pharmaceutical maker Pfizer Inc.

Why is so much corporate venality surfacing now? Is there more of it, or is
more attention being paid? Did a few executives lose their ethical moorings
in the exuberance of the 1990s? Or did a few notorious offenders break rules
that many others merely bent? Is the entire system of corporate governance
and regulation flawed? Or was the system abused by a few cleverly diabolical
executives who deserve, as Treasury Secretary Paul O'Neill puts it, "to hang
. . . from the very highest branches?"

The answer, put simply: A stock-market bubble magnified changes in business
mores and brought trends that had been building for years to a climax. The
victims: the very shareholders the executives were supposed to be serving.

One culprit was stock options, which gave executives huge incentives to
boost near-term share prices regardless of long-term consequences. No CEO
pay package seemed to strike any board of directors as too big.

These incentives helped turn the widely practiced art of earnings management
-- making sure profits meet or barely exceed Wall Street expectations --
into a gross distortion of reality at some companies.

And the institutions that were created to check such abuses failed. The
remnants of a professional ethos in accounting, law and securities analysis
gave way to getting the maximum revenue per partner. The auditor's signature
on a corporate report didn't testify that the report was an accurate
snapshot, says Mr. O'Neill. He says it too often meant only that a company
had "cooked the books to generally accepted standards."

The current sordid chapter in the history of American business opened on
Aug. 14 last year when Jeffrey Skilling quit as chief executive of Enron
Corp., an unmistakable sign that all was not well inside one of the
country's most-admired corporations.

Enron is "the private sector's Watergate," says John Coffee, a Columbia
University securities-law professor. Although not all politicians were
crooks, Watergate bred a virulent cynicism about government among the
public, the press and even some politicians. That cynicism persists 30 years
after the White House-blessed burglary of the Democratic National
Committee's office.

Enron and all that followed threaten to do the same to American business. "I
have had a lot of e-mail from shareholders who seem to have gone off the
deep end and think all corporate executives are crooks and all accountants
are sheep, just as some think all Catholic priests are pedophiles," says
mutual-fund manager James Gipson of Clipper Fund. "None of those statements
are true."

Measuring the volume of corporate skullduggery precisely is difficult. The
SEC opened 570 investigations last year. That's more than in any of the
previous 10 years -- but just 10 more than in 1994. More than 150 companies
restated their earnings in each of the past three years, an acknowledgment
that they had misinformed investors. That's more than triple the levels of
the early 1990s, but represents only one of every 100 publicly traded
companies.

One view, a staple of speeches by chief executives and government officials,
underscores that only a small fraction of companies and executives stand
accused of wrongdoing. It's the "a few bad apples" analysis. Treasury
Secretary O'Neill, former chief executive of Alcoa Inc., talks of "a very
small number compared to all the enterprises out there."

Pfizer's Mr. McKinnell, who serves as vice chairman of the Business
Roundtable's corporate-governance task force, cautions against generalizing
from "eight or 10 companies who allegedly behaved in ways that are
incomprehensible . . . and deserve what they're getting." Securities and
Exchange Commission Chairman Harvey Pitt, who has been practicing securities
law in and out of government for 35 years, chides business reporters by
recalling how the reporting of muckraking journalist Lincoln Steffens
created a "crime wave" in the 1890s at a time when the actual number of
crimes was falling.

For this camp, the smart response is to punish the miscreants severely and
tinker with the parts of the system that are broken, taking care to avoid
hasty changes with unintended consequences. "Things aren't as broken as they
appear to be," says Mr. McKinnell.

But there's another view: The headline-making cases are symptoms of a
broader disease, not exceptions, and a regulatory apparatus that isn't up to
the challenge. "A few bad apples? Looks like we've got the whole peck here,"
says retired federal judge Stanley Sporkin, the SEC's enforcement chief in
the 1970s.

"Everybody did this," says economic historian Peter Temin of the
Massachusetts Institute of Technology. "The people who got in trouble are
those who are most at the edge. Enron didn't get caught. Enron got so far
out on the edge that it fell off."

To this camp, the reasonable response is broader legislation and tougher
regulation on the scale of the 1930s laws that created the SEC and the
modern regulatory regime.

The "irrational exuberance" so famously flagged in 1996 is an essential part
of explaining the 1990s. When the man who coined the term, Federal Reserve
Chairman Alan Greenspan, talks informally with business and other groups, he
says the greediness of human beings didn't increase in the 1990s. What
increased, he says, were the number of opportunities to satisfy that greed.
The run-up in stock prices meant there was more to grab.

Revelation and outrage always follow the bursting of a bubble. The cycle is
immutable. "At any given time there exists an inventory of undiscovered
embezzlement," economist John Kenneth Galbraith wrote in "The Great Crash of
1929." "This inventory -- it should perhaps be called the bezzle -- amounts
at any moment to many millions of dollars. . . . In good times people are
relaxed, trusting and money is plentiful. But even though money is
plentiful, there are always many people who need more."

Mr. Galbraith continues: "Under these circumstances the rate of embezzlement
grows, the rate of discovery falls off, and bezzle increases rapidly. In
depression all this is reversed. Money is watched with a narrow, suspicious
eye. The man who handles it is assumed to be dishonest until he proves
himself otherwise. Audits are penetrating and meticulous. Commercial
morality is enormously improved. The bezzle shrinks."

Mr. Gipson, the mutual-fund manager, says, "There is a tendency during boom
times for even honest people to shift their moral compasses, and there is a
belief that everyone else is doing it. It's when the music stops, if you
will and the scrutiny goes up that the over-the-top cases become apparent."

Stock options were supposed to solve a problem of the past: entrenched
corporate management that wasn't serving shareholders -- the indictment that
corporate raiders made with such ferocity in the 1980s.

"Today, management has no stake in the company," raider Gordon Gekko says in
his speech to shareholders in the 1987 movie "Wall Street." "Where does Mr.
Cromwell [the CEO] put his million-dollar salary? Not in Teldar stock. He
owns less than 1%. You own the company. That's right, you, the stockholders.
You are being royally screwed over by these bureaucrats with their steak
luncheons, hunting and fishing trips, their corporate jets and golden
parachutes."

The solution, widely embraced in American business, was to use stock options
to link executives' and shareholders' interests. It sounded reasonable:
Executives would benefit if they managed companies in a way that lifted
share prices.

It didn't work as intended. A soaring stock market rewarded executives not
for good strategic management, but for riding the roller coaster. And when
the stock price dipped below the exercise price -- essentially making the
options worthless -- some companies simply revised the terms or, in Wall
Street jargon, "reloaded" them.

Even worse, the incentives to do almost anything to increase the stock price
were huge. And the incentives weren't to increase profits and share prices
over a decade or two, but rather to increase profits -- never mind if they
have to be restated later -- just long enough for executives to cash out,
often without ever risking any of their own money to buy shares in the first
place.

Stock options, Mr. Pitt says, were "a device that was supposed to align
shareholder and manager interests -- and actually `disaligned' them." Not
all executives were swayed, of course, but an ill-designed compensation
system pushed them in the wrong direction.

Of course, corporate executives aren't supposed to be monarchs. All sorts of
checks and balances have been established during the past century:
accountants, lawyers, securities analysts, investment bankers, audit
committees, regulators, even the press.

None of the abuses that have been exposed in the past 10 months were
committed by chief executives who worked alone to steal shareholders' money.
"In every one of these cases," says Mr. Sporkin, the former SEC chief, "you
have professional assistance."

This exposes one of the problems that have plagued corporate capitalism
since its inception. "When the laws or regulations fail to protect
investors, corporate insiders -- whether managers or owners -- tend to
expropriate," economists Gene D'Avoilio, Efi Gildor and Andrei Shleifer
asserted in a paper they presented at a Federal Reserve Bank of Kansas City
conference last summer.

Perhaps the rules were inadequate; that's still being debated. But there is
little debate about the failure of the professionals who are supposed to see
that rules are obeyed and executives are honest.

The decay of professionalism -- and codes of ethics that distinguished a
profession from a job -- intensified in the 1990s, but it didn't begin then.
Reflecting on his 23 years in corporate management, Mr. O'Neill recalls a
parade of Wall Street professionals who came to his office with plans for
"new and exotic" financial maneuvers to reduce his company's tax bill or
report debt levels in ways "not clearly prohibited by the tax code or law,"
but not designed to illuminate corporate operations, either.

"They get," he says, "into an ethical vacuum space."

The shortcomings of accounting firms are now well exposed. The duplicity of
some highly paid Wall Street analysts is documented in internal e-mails that
are now public. The acquiescence of the lawyers inside Enron and Tyco, as
well as the readiness of lawyers to clear increasingly aggressive corporate
tax shelters for other companies, is readily apparent.

This disturbing pattern is the biggest reason why the abuses of the 1990s
can't easily be dismissed as the fault of a few flawed human beings. "The
professional gatekeepers were greatly compromised by finding they could make
tremendous profits by deferring to management," says Columbia's Mr. Coffee.

But not one of the instances of egregious abuse of shareholder interest
could have occurred if the CEO had simply said, "No!"

The climate made it commonplace. The incentives were perverse. The watchdogs
were sleeping. But not every company did it. What distinguishes those that
did from those that didn't?

Mr. Gipson, the mutual-fund manager, divides offenders into two classes: the
"confirmed crooks" who deliberately and willfully ripped off shareholders,
and the "morally marginal who went right up to the line of acceptable
behavior" and then "when the line was moved found themselves on the other
side."

Treasury Secretary O'Neill makes a similar point: "A little lie leads to
ever bigger ones in lots of cases without a recognition on the part of the
perpetrator that they ever told a lie, even when it gets grotesque. They
say, `If only I had another 12 months . . . '"

At Harvard Business School, the citadel of corporate management, the faculty
uses case studies of heroes and villains in an effort to inoculate students
against the temptations they will inevitably confront.

"Maybe," says a member of that faculty, Richard Tedlow, "we ought to think
about CEOs and other managers as fully formed human beings, not as people
who focus on one variable and who check their personalities at the coat
rack. Some of what was going on was people doing exactly what the incentives
suggest that they do: Give me a lot of stock options, and I'll make the
stock go up.

"But something is missing," he adds. "Life is lived on a slippery slope. It
takes a person of character to know what lines you don't cross. That part of
the equation of corporate management hasn't had the emphasis it should have
had in the last decade or two."

The excesses of the 1920s and the spectacular crash of the stock market in
1929 led to the creation of modern financial regulation, from bank-deposit
insurance to the ban on insider trades, in 1933 and 1934. Despite the
obvious parallels, this is a different time. The U.S. is not in an economic
depression, nor does George W. Bush see himself as Franklin Delano
Roosevelt's heir. The debate over how to repair the system is just beginning
to take form; this week saw competing legislative and SEC proposals to
tighten oversight of accountants.

The nature and dimensions of the reforms depend on factors that aren't
knowable. How many more Enrons and Tycos remain unreported? How swiftly will
corporations, boards of directors, the New York Stock Exchange, the National
Association of Securities Dealers and other self-regulatory organizations
move to reassure investors? And, most important of all, how much longer will
the stock market languish?

---

Question of the Day: What's most to blame for the spate of scandals
surrounding U.S. corporations? Visit WSJ.com/Question to vote. And e-mail me
at capital@wsj.com. See questions and answers Sunday at
WSJ.com/CapitalExchange

--- Corporate Accountability

A parade of big companies face serious questions about their business
practices.

Company: Adelphia
Issue: Whether it failed to properly disclose $3.1 billion in loans
and guarantees to its founder's family.
Percent Change In Share Price Since 1/14/00*: -99.75%

Company: CMS Energy
Issue: Disclosed it overstated revenue in 2000 and 2001 by including
artificial `round trip' energy trades.
Percent Change In Share Price Since 1/14/00*: -56.78

Company: Computer Associates
Issue: Whether it artificially inflated revenue and improperly
rewarded top executives.
Percent Change In Share Price Since 1/14/00*: -73.58

Company: Dynegy
Issue: Whether its `Project Alpha' transactions served primarily to
cut taxes and artificially increase cash flow.
Percent Change In Share Price Since 1/14/00*: -64.97

Company: Enron
Issue: Admitted it improperly inflated earnings and hid debt through
business partnerships.
Percent Change In Share Price Since 1/14/00*: -99.80

Company: Global Crossing
Issue: Whether it sold its telecom capacity in a way that
artificially boosted its 2001 cash revenue.
Percent Change In Share Price Since 1/14/00*: -99.87

Company: Halliburton
Issue: Whether it improperly recorded revenue from cost overruns on
big construction jobs.
Percent Change In Share Price Since 1/14/00*: -56.51

Company: ImClone Systems
Issue: Former CEO Samuel Waksal charged with insider trading.
Percent Change In Share Price Since 1/14/00*: -52.34

Company: Kmart
Issue: Says the SEC is investigating its accounting and other
practices. The company investigated whether it improperly accounted
for vendor allowances, and since changed its practice.
Percent Change In Share Price Since 1/14/00*: -91.02

Company: Lucent Technologies
Issue: Adjusted fiscal 2000 revenues by $679 million, spurring SEC
investigation. Agency also investigating whether vendor-financing
played an improper role in its sales.
Percent Change In Share Price Since 1/14/00*: -93.39

Company: MicroStrategy
Issue: Settled without admitting wrongdoing an SEC suit accusing it
of backdating sales contracts to meet quarterly financial estimates,
among other improper revenue-recognition practices.
Percent Change In Share Price Since 1/14/00*: -99.07

Company: Network Associates
Issue: Whether it hid expenses and overstated revenue from 1998 to
2000.
Percent Change In Share Price Since 1/14/00*: -28.25

Company: PNC Financial Services
Issue: Restated its 2001 results by $155 million after regulators
raised concerns about how PNC accounted for a transfer of loans.
Percent Change In Share Price Since 1/14/00*: +15.61

Company: Qwest Communications
Issue: Whether it inflated revenue for 2000 and 2001 through capacity
swaps and equipment sales.
Percent Change In Share Price Since 1/14/00*: -88.35

Company: Reliant Resources
Issue: Admitted it inflated revenue by counting artificial `round
trip' energy trades.
Percent Change In Share Price Since 1/14/00*: N.A.

Company: Tyco International
Issue: Whether it improperly created `cookie jar' reserves that were
supposed to cover merger costs but instead were drawn on to boost
profits; and whether it improperly `spring-loaded' earnings from
acquisitions by accelerating their pre-merger outlays.
Percent Change In Share Price Since 1/14/00*: -55.15

Company: WorldCom
Issue: Whether it used questionable methods to book sales, classify
assets and account for debts it couldn't collect.
Percent Change In Share Price Since 1/14/00*: -96.60

Company: Xerox
Issue: Fined $10 million without admitting or denying wrongdoing for
inflating revenue and profits from 1997 to 2000 by including future
payments on existing contracts.
Percent Change In Share Price Since 1/14/00*: -67.53

Sources: WSJ research; WSJ Market Data Group

*Date the Dow Jones Industrial Average hit its all-time high

Copyright © 2000 Dow Jones & Company, Inc. All Rights Reserved.