Bear Left!

The Gilded Triangle
Tim Francis-Wright

Last week, in a remarkable speech at the National Press Club, a speaker called for wholesale reform of the American financial system. The speaker derided investors and analysts for being lax and complacent, and called the widespread scrutiny of corporations and their advisers to be deserved. The speaker was not some corporate gadfly, or some populist politician, but Hank Paulson, the chairman of Goldman Sachs. The titans of Wall Street are calling for reform. It is apparent that the Democratic party cannot lead on this issue. But can it at least follow?

A gilded triangle now allows executives to run companies for their own personal enrichment. First, the executives who supposedly manage companies for the benefit of shareholders are too often willing sacrifice the long-term future of their companies, as well as the jobs and pension of their employees, for short-term gain. Second, the accounting firms supposedly employed to certify the accuracy of corporate financial statements too often work to obfuscate those statements. Third, boards of directors, supposedly acting in the best interests of shareholders, too often fail to question or stop the more dubious actions of management.

Executives at various companies have made obscene amounts of money, often without the consent or even the knowledge of shareholders. WorldCom lent its former CEO $366 million to cover his stock trading losses. (Try asking your bosses for $366 and see what they say.) E*Trade paid its CEO, Christos Kotsakos, $49 million in 2001, including a $15 million write-off of a loan it made to him, another $15 million to cover the taxes on that transaction, and $9 million for a supplemental retirement plan. (Try asking your bosses to forgive even a $15 loan out of petty cash.) Over the past four years, Tyco paid Dennis Kozlowski over $300 million, including huge payments on life insurance policies and a supplemental retirement plan. But even that was not enough: Kozlowski had the company pay for a Manhattan home costing over $18 million. (Try asking your boss to help you with just one rent or mortgage payment.) These are just some of the examples of executive greed, most of it completely approved by the companies for which they work.

Stock options, a favorite tool of corporate executives, are supposed to serve a noble purpose. In theory, if executives have substantial holdings in the companies that they manage, then they will act more like owners and less like hired hands. In practice, the value of stock options depends not on the long-term health of a company, but on the current value of the company's shares in the stock market. Executives with huge allocations of stock options have an intrinsic motivation to boost stock prices. If the market goes up, the value of their holdings goes up as well.

The second side of the gilded triangle is the role of accounting firms in engendering a culture in which bottom-line profits are malleable numbers that can have little relation to reality. Sometimes, the manipulation is minor. The Securities and Exchange Commission found that Microsoft engaged in "cookie jar" accounting, manipulating financial results to make profits steadily rise over time without the deviations inherent in real results. In Microsoft's case, only some gullible investors, who thought that Microsoft was somehow immune to the vicissitudes of the software development cycle, were hurt, and only them in the short run. (In the long run, Microsoft's accounting reported the proper amount of profits, just not the proper timing.)

But many other examples of financial misstatements involved hiding losses, hiding debt, or overstating revenues, all actions that seriously misrepresent the size or the worth of corporations. At Enron, Arthur Andersen helped Enron falsely claim that its energy trading business was wildly successful. In reality, Enron hid huge losses and debts in other entities. Many of Enron's competitors in the energy trading business, such as Dynegy and Williams, inflated their revenues by falsely claiming to sell goods or services to one another. At Adelphia Communications, Deloitte and Touche failed to report that the corporation overstated not only its cash flow, but also the number of subscribers of its cable television systems. Deloitte failed to inform Adelphia stockholders that the corporation guaranteed billions of dollars of loans made to the Rigas family, the founders of the company. Deloitte knew about the guarantees, because it prepared the Rigas family's own financial statements.

Any accounting firm faces a conflict of interest the very moment that it accepts an engagement to audit a publicly traded company. The SEC depends on the accounting firm report accurate information about the company's income, expenses, assets, and liabilities. But the company, not the SEC, hires the accounting firm. In addition, the accounting firm usually takes on other tasks for the corporation that present other conflicts. The accountants almost always prepare the corporation's income tax returns, and often do other consulting work.

Andersen's role in the fall of Enron outlines the folly of allowing auditing firms to provide consulting services to their clients. Andersen provided Enron with, among other services, internal auditing: in effect, Andersen prepared Enron's books, then certified that its own work was correct. Andersen has a built-in conflict of interest not to accuse itself of wrongdoing. But there are other, more common conflicts. The main job of the any accounting form in its tax and consulting engagements is to minimize the corporation's tax bill. In many cases, firms negotiate fees based on the savings that they generate for the company. But auditors are supposed to be independent of their clients. If the accounting firm's tax and consulting services make its clients more profitable, then the presumption of independence is laughable.

The huge compensation packages for many corporate executives would not be possible without the acquiescence of their boards of directors. A corporate board is supposed to serve the interests of the owners of a company, the shareholders, but other factors can and do intervene. Directors often receive lucrative compensation packages that are tied to the share price of company stock, so they have a financial incentive to go along with the schemes that executives use to pump up stock prices. For example, at Enron, the board of directors explicitly approved many of the schemes to move Enron's debts off of the corporations's balance sheet.

At many companies, few directors are truly independent of management, and many serve at the request of management. Furthermore, many "independent" directors serve on several boards at once.* Elections to corporate boards generally resemble elections in the former Soviet Union, with exactly the same number of nominees as positions on the board. Only the rarest of hostile takeover bids presents any opportunity for elections to corporate boards to resemble any sort of competitive election.

It is all too easy for leftists to merely wallow in schadenfreude when arrogant executives like Dennis Kozlowski or Ken Lay get at least some of their just desserts. When these executives find their risky schemes falling apart, they affect the lives of thousands of their employees, who lack the huge financial cushions that these titans of ersatz industry have prepared for themselves. Millions of ordinary workers rely on their employers for their medical, dental, and life insurance. Many of them rely on investments in the stock market for the bulk of their savings for retirement.

The Republican party views corporate executives and their chief functionaries as their chief constituency. It relies on corporations, corporate executives, and their legal and accounting firms for its campaign funds. It caters its tax policy towards the needs and demands of the rich. s tax policies are designed to reward functionaries. The Democratic party, by contrast, is divided about corporations. Liberal and populist Democrats naturally appeal to the working class, out of both political affinity and political strategy. But the conservative wing of the party, notably the Democratic Leadership Council thinks otherwise.

The DLC has always preferred to imitate Republican ties to business rather than criticize those ties. When former SEC chairman Arthur Levitt tried to force accounting firms to separate their auditing and consulting arms, he found that the accounting forms were foursquare against the idea. Their allies in Congress were both Republicans and DLC Democrats like Joseph Lieberman.

Now, Lieberman and his ideological compatriots in the Senate must not bend again to the will of the gilded triangle yet again. Senator Paul Sarbanes is the sponsor of a current bill in the Senate that would damage the gilded triangle by imposing strict limits on what accountants could do for their clients. The main opposition to the bill comes from Republican troglodytes like Phil Gramm. There is something rotten in the stock exchanges on Wall Street. Even the head of Goldman Sachs recognizes this. When will the Democratic party realize it as well?

(*The chairman of the board of directors where I work is independent of management, but also serves on the boards of Merrill Lynch, Colgate-Palmolive, and Nike.)