Confidence goes bust

Cooking the books is hardly new in capitalism – so why the overblown reaction to WorldCom’s whiz? James Malone reports from New York.

News of the WorldCom accounting fraud came at an awkward time for President Bush – just as he was attending the Group of Eight summit in Canada. In an ironic reversal, Bush had to listen to President Putin of Russia express his concerns about US business practices.

WorldCom is the latest US company found to have accounting ‘irregularities’ in the wake of the Enron scandal. WorldCom, a major telecommunications firm, overstated its operating cashflow by $3.8billion (six times Enron’s overestimation). It didn’t count a large portion of its everyday costs of doing business when calculating profits, claiming that these were long-term capital expenditures whose cost could be spread over time. As the New York Times put it, ‘Even a child can understand that painting a house is not the same as building a new one’ (1).

The deception was shocking in its simplicity – if auditors and board members could miss something this basic, many thought, surely the rot must run deep. The latest revelations of WorldCom put Bush on the defensive, and further damaged the confidence of American business.

The response to WorldCom showed that the US elite has recognised the need to change. Bush promised to crack down on wrongdoers, and urged business leaders to be ethical. ‘Corporate America has got to understand there’s a higher calling than trying to fudge the numbers, try to kind of slip a billion here or a billion there and hope nobody notices’, said Bush (2).

Senator Tom Daschle, the Democratic Party majority leader, says the reform bill proposed by fellow Democratic Senator Paul Sarbanes now has clear majority support from both parties. Harvey Pitt, head of the Securities and Exchange Commission (SEC), the US government’s regulatory body, has announced that offending executives could do jail time, and that CEOs will have to certify their companies’ financial statements personally.

Yet the response to Enron, WorldCom and the other scandals is an overreaction. Financial manipulation is as old as capitalism itself, if not older. The response today seems to be driven more by doubt and insecurity, than by the accounting shenanigans themselves.

Even before Enron, US business was on the defensive. Investor activists competed with anti-globalisation protesters as to who was more critical about boardroom practices. Enron focused the nation’s attention on corporate malfeasance, leading many to believe that business leaders were not just out to damage the environment and rip off the third world, but were crooks too.

The problems revealed at the Houston energy trader set in motion an amazing slew of investigations and reform proposals. Not since the 1930s, when legislation created the SEC to prevent investment frauds seen in the prior decade, has there been such a substantial move to regulate. But that was after the historic Wall Street Crash. Now, with news of WorldCom and others, it is easy to forget that it only took a single company – Enron – to initiate today’s frenzied demands for change.

Legislation and other reforms from the White House, Congress, the SEC and the stock exchanges will now seek to change how corporations are run. Reforms promise tighter government regulation; more SEC and stock exchange oversight, including stricter enforcement of company financial reports; greater rights of investors to intervene in company affairs; the holding of CEOs personally responsible; and to ensure auditor independence.

Some CEOs, including Henry Paulson of top investment bank Goldman Sachs, have spoken publicly on the US business world’s perceived lack of integrity, and the need for reform. The economic policy group Conference Board has formed a committee of the great and good that seeks to restore trust in business, and is reportedly thinking of demanding that CEOs take an ‘oath’ that they will personally attest to truthful accounts.

Historical comparisons make clear how today’s response to company scandals is exaggerated. Cooking the books is hardly new to capitalist enterprises. In the early 1930s, the case of Middle West Utilities involved allegations of stock fraud, crooked accounting and (like Enron) the setting up of multiple companies to deceive. The Equity Funding Corp of America collapsed in 1973, when it was found to be riddled with fraud, even though the accountants (like Andersen) signed off on the books. In the 1980s there was the infamous insider trading and junk bond scandals.

The editorial writers of the New York Times and the Wall Street Journal now find themselves in rare agreement – both concurring that the scandals at Enron, WorldCom et al, like scandals in the past, are byproducts of a boom gone bust. As the New York Times says, ‘In the 1920s and 1980s, speculative run-ups were [also] followed by a painful relearning of certain basic truths’ (3). But what commentators rarely point out is that most of the accounting scandals in the past did not create the same zeal for reform that we see today.

Again, perhaps the only comparable reform effort to today is the 1930s. A number of observers have made glib analogies between the two periods. But what is more striking is how starkly different the conditions are. During the 1929 Wall Street Crash and the Depression of the 1930s, huge economic events, there was a drastic decline in economic output and mass unemployment, while the political system, facing the rise of fascism and communism, was racked by conflict. Today’s US elite faces no such underlying problems, the recession has been mild, and politics is far from oppositional. Yet, the US establishment’s own insecurities are now sufficient to generate the sense that widespread change is required.

The overreaction to Enron and subsequent scandals can be seen in the way the American business class has started questioning everything. What began as a movement to rein in boardroom behavior has become a debate about the merits of US-style capitalism. Enron and others are said to reflect broader problems of US economic policy, such as: deregulation of the energy and financial markets; the encouragement of complex company financing arrangements (such as Enron’s complex partnerships); and pressure from investors to achieve quarterly earnings targets.

Felix Rohatyn, chairman of investment bank Lazard Freres and former US ambassador to France, was one of the first to fear that Enron raised bigger issues about the integrity of US financial markets, claiming that he now finds it difficult to defend the American economic model to Europeans (4). Where five years ago President Clinton boasted to world leaders in Denver that other nations see their future in developing an economic system like America’s, now Bush has to beg the gathering in Canada to give him a break while he sorts out the mess.

Even basic economic motives of capitalism are now being questioned. Performance goals and executive incentives, such as share options (which provide gains to the extent the share price goes up), are said to encourage share manipulation and fraud. As Holman Jenkins of the Wall Street Journal writes, that’s like blaming the gold medal for Olympic cheating (5).

Journalist Jack Beatty says we have forgotten that the eighteenth-century classical economist Adam Smith distrusted corporations, viewing the separation of ownership (the shareholders) from control (the managers) as dangerous (6). So even the author of capitalist bible The Wealth of Nations is recast as the originator of the X-Files worldview ‘trust no one’. Or, as S David Freeman, chairman of the California Power Authority, put it in relation to California’s electricity crisis: ‘the so-called invisible hand of Adam Smith was Enron and their fellow gougers picking the pockets of Californians to the tune of billions of dollars.’ (7)

What’s even more revealing is how the elite has come to see itself as ethically flawed. Arthur Levitt, former head of the SEC, says that Enron highlights ‘a cultural erosion of values’. In Business Week, Bruce Nussbaum contrasts greedy business leaders with ‘the professionalism of modestly paid firefighters and police doing their duty on 11 September’ (8). Andy Grove, chairman of the chip giant Intel, says ‘I’ve been in business 40 years’, but lately ‘I find myself feeling embarrassed and ashamed’ to be a businessman (9).

Robert Solomon, a consultant on business ethics, compares today’s wayward executive to an alcoholic who ‘chooses to drive home to avoid having to admit to his friends that he’s too drunk, but risks arrest – not to mention his life – in doing so’ (10). Here, executive behavior is reinterpreted as a form of addiction – so the next step must be some form of treatment. Maybe that’s why MBA students at the University of Maryland’s business school are now sent to prison for a ‘scared straight’ field trip in white-collar crime (11).

The establishment’s fears are self-generated; they cannot be explained by pressure from the public. Business Week cites a CNN/USA Today/Gallup Poll which found that 20 percent of Americans have a ‘great deal’ or ‘quite a lot’ of confidence in big business. But in 2001, before the recent revelations, the level was not much higher at 28 percent (12). The latest scandals serve to entrench cynicism, which is fuelled more by resignation than anger. And it would hardly be surprising if more people started expressing doubts about business, when political and business leaders hold such a grim view of themselves.

The American elite fears that it is not trusted, and moreover it doesn’t trust itself. This is why a few cases of accounting scandal – regular occurrences in the market system – can lead them to seek safety in reforms, the likes of which we haven’t seen for decades. It didn’t have to be a crisis, but the prophecy has become self-fulfilling.

Read on:

In the wake of WorldCom, by Phil Mullan

Accounting for Enron, by Daniel Ben-Ami

Enron: and on and on, by James Malone

spiked-issue: Economy

(1) New York Times, 28 June 2002

(2) Financial Times, US edition, 29 June 2002

(3) New York Times, 28 June 2002

(4) New York Review of Books, 28 February 2002

(5) Wall Street Journal, 13 March 2002

(6) The Atlantic, 13 March 2002

(7) New York Times, 12 April 2002

(8) Business Week, 28 January 2002

(9) New York Times, 1 July 2002

(10) New York Times, 1 July 2002

(11) PBS News Hour, ‘Money and Ethics’, 26 June 2002

(12) Business Week, 8 July 2002