Making a Killing in Business
When crime pays, there will be plenty of criminals.
The reason there are so many murders in Washington, D.C., is that people can get away with it. In the 1990s D.C. police caught fewer than four people for every 10 murders in the District. At the end of 2000, two in three individuals who killed in 1999 were free. Considering these odds, killing for some becomes simply another dispute resolution tool. There's a similar explanation for America's outrage du jour: the market-tumbling revelation that during much of the 1990s a few corporate chieftains pushed the bounds of honesty in financial reporting.
Is the comparison between executives and murderers too harsh?
Downgrade it to thieves. The reason someone burglarized my apartment in San Francisco several years ago is that he figured he would get away with it. In 2000 a dot-com executive defrauded me of $2,000 in article fees for the same reason. Both thieves were right.
Even when they aren't the same person, chief financial officers, thieves, and masters of the short con are cut from the same cloth: the cloth of humanity. And all human beings respond to incentives. Increase the cost of something, and there will be less of it. Lower the cost, and there will be more.
The inverse holds for rewards. Until recently the rewards for massaging financial data, structuring finance to make debt disappear from books, and engaging in sham trades to increase revenue were huge. The companies that facilitated the deals—Citibank, Merrill Lynch, J.P. Morgan—pocketed millions in fees, with the promise of millions more. Executives received millions in compensation for their companies' superior performance.
Just as important, the punishment for not playing could be devastating. "The equity market put enormous pressure on management to manufacture good earnings," says Robert Barbera, chief economist with Hoenig & Company. "That's not to say that fraud is a reasonable option. It simply describes the system that would push many in the direction of creative accounting." The system, like my open window, was irresistible for some.
As one who believes in both the morality and the efficiency of the free market, I think it's important to recognize that markets aren't pristine institutions handed down by God that make people fair and trustworthy. They are systems framed by rules that foster cooperation among individuals and organizations that are seeking to maximize their happiness, which usually translates into money. Over the long term, markets reward honesty. Over shorter periods, scammers can do very well.
The recent business scandals remind us that two forces police markets. One is cops or regulators, who seek compliance with written rules and punish those who break them. The other, more powerful force is customers, who withdraw their money from companies in which they lose confidence. This phenomenon is obvious in financial markets, where companies like Enron and WorldCom are severely punished by investors. But it also happens in consumer markets. Who do you think the manufacturer of Tylenol feared more when it was discovered in 1982 that someone had laced its product with cyanide: regulators or customers?
If either of these forces slacks off, one can expect more people to bend and even break rules. That's what happened in the late stages of the boom. Investors not only failed to scrutinize business plans or read the footnotes in financial statements, they also demanded perfect performance, at least on paper. Many investors were lusting after growth stocks at any price. Not all investors and analysts were fooled; there were plenty of people who sat out the runup. It doesn't take a genius, after all, to know that when someone goes on TV and says a stock will double they are just talking smack, and it's time to sell off one's position in tulips.
But there were also plenty of people who chased the returns. Many lost big. No one likes to lose money, and when people do they usually want to blame someone else. Since the market peaked in early 2000, its decline has wiped out $7 trillion, $70,000 per household, which is a lot of blame to allocate.
All this brings us back to Washington, where, in late July, Congress passed and the president signed a corporate reform package. Like much of what passes for work in D.C., the spectacle featured plenty of absurdities. To hear a lecture on proper accounting from Congress—whose favorite financial tool is shuffling liabilities off its balance sheet, in the form of either unfunded mandates or unfunded promises such as Social Security—is a joke.
Our first MBA president declares, "The business pages of American newspapers should not read like a scandal sheet." But like Congress on financial management, Catholic priests on sexual morality, or Jimmy Carter on military tactics, George W. Bush has a credibility problem. The only thing remarkable about his business career was his ability to parlay one failure into the next based on his family connections. Serious investors included him in the deal that made him a millionaire—the purchase of the Texas Rangers—as a hood ornament. Even his ceremonial role was possible only because he played financial games worthy of Enron CFO Andrew Fastow.
The corporate reform package, which will on balance probably do harm, is really a sideshow. Old-school liberals such as American Prospect Co-Editor Robert Kuttner blame deregulation for the market's slide and boldly assert that it's time for regulators to save capitalism from itself once again.
But it wasn't lack of regulation that caused the financial bubble, and it won't be increased regulation that will help asset prices rise from their lows. That's a job for investors, who will be a bit more circumspect about the next new things and perhaps won't ignore cover stories in Fortune and elsewhere that expose large companies as Ponzi schemes.
So when Congress sets up a new regulatory body to police accountants and forbids firms from auditing and consulting for the same company, its actions are redundant. These are properly issues between investors and management. Instead of putting D.C. in charge of accounting standards, a better reform would be to repeal the Depression era law that requires public companies to be audited and gives public accountants a lock on the business. If audits add value, investors will reward companies that pay for them with higher stock prices. If an accounting firm becomes known for catering to management, companies that hire it will suffer a lower valuation.
That's not to say there isn't a role for the cops. Markets are imperfect, and investors are limited in the justice they can mete out. Investors brutally punish companies in which they lose confidence. Much is made of WorldCom's collapse after it disclosed its $3.8 billion mistake. But that merely snuffed the company out. Its stock was already down 99 percent, from a high of $61.47 in June 1999 to 83 cents a share at the time the creative accounting became known. That news simply took it from 83 cents to zip.
But as harsh as investors can be with companies that misbehave, they cannot bring misbehaving individuals to justice. That's the role of the cops. Executives who crossed the line that separates creative finance from fraud—a fact that can be established not by the press but only by a court of law—need to pay with not only their wealth but also their freedom.
After all, if committing murder in D.C. or burglarizing apartments in San Francisco meant losing one's freedom, there'd be far fewer killers and burglars. And if defrauding investors meant going to jail rather than moving on to the next lucrative job or easing into a comfortable retirement, there would be a lot less of that as well.