By Alain Saffel
This is an article I wrote for my magazine writing class in my last semester at school. We called our magazine XS Magazine.
"The point is, ladies and gentleman, is that greed - for lack
of
a better
word - is good. Greed is right. Greed works.
Greed clarifies, cuts through, and captures the essence of the evolutionary
spirit. Greed, in all of its forms - greed for life, for money, for love, knowledge
- has marked the upward surge of mankind."
Gordon Gekko "Wall Street" (1987) Played by Michael
Douglas
Greed
is good. Greed is right. Greed works. They may be the words of a character
in a movie, but the view is echoed by many in the business world. There's
usually a cost to greed and it's borne by the little guy.
Enron, a high flyer in the energy market in the late 1990s is now bankrupt.
In early 2001 it was worth $85 per share. By December of that year it had declared
bankruptcy. The share price by that time was sitting at about 30 cents per
share. Approximately $75 billion worth of share value evaporated during the
course of that year. And throughout that year, company insiders dumped Enron
stock before the bubble burst.
The reason for the bankruptcy? Outright accounting fraud. To pump up the stock
price, the company engaged in fraudulent accounting practices. It made insiders
at Enron very wealthy. Pension funds held large amounts of Enron stock. Their
holdings in Enron disappeared. And who are the main beneficiaries of pension
funds? It's the little guy.
To top it all off, Enron's auditing firm, accounting giant Arthur Andersen,
faced charges and was convicted of obstruction of justice in the Enron case
for shredding documents. If you can't trust the auditors, who can you trust?
In 2002 the US Securities and Exchange Commission fined Xerox $10 million for
overstating revenues by $3 billion and pre-tax profits by $1.5 billion from
1997 to 2000. Xerox was forced to restate its financial statements for those
years.
Over the course of six months starting in September 2000, Nortel's Networks'
shares dropped in value by 80 per cent. The value of that drop?
$300 billion. That made for a few unhappy shareholders.
Nortel still hasn't straightened out the overstatement of its revenues, and
has failed to meet several deadlines to do so. Amazingly, it's still in business
and trading around $3 per share. A far cry from the $120 share range it was
in at its peak.
Worldcom's $11 billion accounting fraud put the company into bankruptcy. Bernhard
Ebbers, Worldcom's CEO was found guilty of all the fraud and conspiracy counts
against him, and faces 85 years prison. Worldcom shareholders saw their stock
value evaporate. Bondholders were lucky to get a third of their money back.
Again, Worldcom's revenues were overstated to keep up with stock market expectations
and quarterly earnings projections.
These are just a few examples of the kind of accounting frauds that have taken
place. There are many more, and doubtless there are many more that have yet
to have been discovered.
These kinds of accounting frauds are an inevitable result of quarterly earnings
forecasts. When CEOs are paid with stock options, it's no wonder that they're
so focused on stock price. It's an obvious conflict of interest when an executive
is also a shareholder in a company.
This conflict of interest leads executives to focus on what is going to benefit
themselves in the short-term instead of what is going to benefit the company
and also the other shareholders in the long-term. This short-term executive
thinking manifests itself in "smoothing earnings" to make them match
their quarterly earnings forecasts.
Wall Street likes to see steady progress. They like to see companies meet their
targets. It's even better when companies exceed expectations. But what happens
if a company fails to meet its forecast, even if it's only by pennies on earnings
of a dollar per share? Recently IBM's share price dropped $4.86 to $78.78 after
its quarterly earnings didn't meet the 90 cents per share expected by Wall
Street analysts. They had a quarterly profit of 85 cents. Rarely do the percentages
match so nicely.
During the dot-com bubble, there were many examples of companies failing to
meet earnings expectations and share value would drop by 25 per cent even if
they missed earnings forecasts by a few per cent. It's ludicrous. How does
missing an earnings forecast by two or three per cent translate into a company
worth 25 per cent less? Perhaps it was less sophisticated day traders focused
on the short-term and not understanding the fact that the company still had
a strong underlying value.
Short-term thinking pops up again. It warps the market. It forces executives
that have a large portion of their pay tied to stock prices to focus on that
stock price. It's only natural isn't it? As long as executives have their pay
tied to stock value, expect these kinds of scandals to continue.
And how do these executives manipulate the stock price? By playing accounting
games and not following Generally Accepted Accounting Principles. It is rather
technical to explain but one common game is to play with when revenue is recognized.
By moving revenue back and forth from year to year you can make up for a bad
year by pulling in sales that are actually going to be made in the next year.
Made too much this year? No problem. Let's put it ahead to next year.
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If that's not enough, some
companies just make it up. In 2002, a US company called Global Crossing
went bankrupt. That cost investors at least $12 billion. The chairman
of the company sold his stock in the company worth $700 million,
but he did pledge $25 million to help workers at the company that
lost their life savings in the bankruptcy. Global Crossing is accused
of falsifying at least $1 billion in revenue. Their auditor? Arthur
Andersen. They're accused of permitting the "improper" entries.
It's a nice way of saying fraudulent.
Another practice that companies
engage in is especially damaging to the little guy. To boost stock
prices you need to increase profits. There are a couple of ways of
doing this. Cut expenses or increase revenue. Increasing revenue is
harder to do, but cutting expenses is easy. The easiest way to do that?
Cut employees. If you are in a business that has high wage expenses,
then this is a great one. The short-term oriented market will think
the CEO is a hero by cutting expenses. The last ten years has been
rife with these kinds of examples. You can almost instantly increase
a company's profit by cutting say, 20 per cent of the employees. This
could translate into a substantial increase in profit.
There's a downside to this. In the longer term the company is likely to suffer.
The remaining 80 per cent of the employees have to take on 100 per cent of the
work. Eventually this leads to employees getting burned out, stressed out and
sick. Inevitably that increases health benefit plan costs. It also leads to skilled,
trained, productive employees leaving the company for a less stressful environment.
The end result is that the company loses more of its key asset: people. This
is the long-term effect of a short-term attempt to increase profits. And after
all that? The company's revenues and profits begin to decline.
Short-term thinking is not just endemic to greedy corporate executives. We find
it everywhere in our society from the magic pill that will make us lose weight
with no effort but end up killing us (Fen Phen) to our gas guzzling SUVs that
contribute to global warming, smog and use up our ever diminishing oil supplies.
It's the quick fix. Don't invest for the long-term. You'll be dead by the time
global warming is a problem right? At least if the diet pill kills you, you'll
leave a pretty corpse. Business really is a reflection of the rest of society,
and who doesn't want to get rich quick? In that sense, who can blame these greedy
executives?
What can be done to protect unwary investors that might risk losing their life
savings in the next Enron? (There will be others.) The investors that lose their
life savings either have little in the way of life savings, or have violated
the cardinal rule of investing of not putting all your eggs in one basket. Every
business failure news story seems to have an interview of someone who lost their
life savings. The reporter never asks them why they invested everything in one
company! Why not? The irony here is that these small investors are undone by
their own greed. Greed meets greed. It's almost poetic justice.
Government should bring in a few measures to protect investors. The first is
that executives should not be directly compensated with stock options and the
second is that companies and stock analysts should not be allowed to publicize
company earnings projections, annual or quarterly. Third, public companies should
have much stricter standards placed on them in terms of auditing. Auditing standards
leave much to be desired. The net they cast must be of a much finer mesh to catch
the accounting games that companies play. The government needs to work on tightening
up accounting standards and implement these changes through auditors as well
as their taxation branch
Executive stock compensation is an obvious conflict of interest. Whose interest
will the executive be working in? Bonuses should also be based on the companies
audited financial statements. It wouldn't hurt to have stockholders vote on
the bonuses at the company's annual general meeting as well.
The second recommendation to disallow any earnings projections will also go a
long way to reducing the potential for a conflict of interest. If your company
and stock analysts haven't projected what you'll make per share in the next year
or quarter then there's a lot less pressure to engage in fraudulent accounting
practices just to make sure your stock price doesn't hit the basement.
Lastly, auditing and accounting standards could really be beefed up. There is
a lot of flexibility and games that companies can play. Much of this can be caught
be auditing, and the penalties have to be much more severe when executive fraud
is uncovered. Where's the deterrent if you wear an ankle bracelet for a year
and after that you catch up with your fortune in the British Virgin Islands?
Losing that fortune gained by fraud and ten years in jail might just be a good
deterrent. Stronger auditing standards and closing the holes in GAAP will also
help.
In the US, the Sarbanes-Oxley Act, passed in 2002 as a direct result of scandals
such as Enron, Worldcom and Arthur Andersen. The Act provides much tougher penalties
for executive fraud. It requires CEOs and Chief Financial Officers to certify
that the financial reports are accurate. There are a number of other measures
in this law, including much heavier fines, penalties and jail sentences. The
law passed with a vote of 423-3 in the House and 99-0 in the Senate. Sounds like
they're getting a little more serious south of the border, and it will affect
Canadian companies that are listed on US exchanges as well.
There are some efforts being made to change how business does business, but
how
effective those changes are remains to be seen. And just how "good" is
greed? Well, that just depends if you're a Gekko or a grunt. |
