Enron – January 2001

This chapter was written long before the Enron debacle came to light, in fact it is about the inevitability of Enrons because of wholesale cheating to boost reported earnings. Enron was not the exception, it was the rule. Enron undoubtedly passed the line and broke accounting rules, but the majority of publicly held companies push as close to the line as possible in order to enhance reported earnings. Arthur Anderson, its auditor, is not a rotten apple, all the major accounting firms aid and abet the process of overstating earnings.

Solutions do not lie with cleaning up the accounting profession, it is the source that must be attacked – the tremendous payoffs corporate management derives from stretched accounting.

Will the sensational disclosures lead to a clean up, or will the affair blow over with a few revisions to the rules for 401K plans? I am not optimistic. Enron points out once again the overwhelming power of aggressive corporate management to use company funds to benefit themselves. Sound rules carried out in a vigorous manner can solve the problem. Accountants will give us honest figures if freed from the pressure of management wielding big money for compliant manipulation. Enron paid Arthur Anderson $52 million for accounting services in 2000, $25 million just for auditing, a figure topped by only a few other and much larger public companies. That kind of money buys a lot of cooperation. The answer to the mess is truly independent auditors, both in setting rules and enforcing them.

I am utterly fascinated by Enron. A day never passes without at least two new revelations. Its tentacles are so widespread that new chapters will be unfolding for a long time. This is a much bigger story than realized. The war is a tiny affair in comparison because Enron and America are about business. Enron brings into focus many deeply troubling problems that have been swept under the rug by the long bull market.

Enron says a lot about what is wrong with the stock market, for its revealed evils are not at all uncommon. Too many public companies are managed to elevate the stock price, rather for the long term good of the enterprise and the economy. The result is unwise activities that boost earnings over the short term, bad acquisitions, restructuring to erase past mistakes, manipulative accounting that makes investing a guessing game, and an immense waste of capital resources in frivolous ventures. There is a lot more to running a company than hyping the stock.

Some of the revelations about Enrons accounting are mind boggling. Even more amazing is that many are legal, and therefore in common use. Arthur Anderson, Enron’s accountant, is no different from the other big accounting firms. They are all thoroughly enmeshed with management in exaggerating reported earnings in an effort to elevate stock prices. Every knowledgeable person is aware of this scandal, but no one wants to think or do anything about it for fear of hurting the price of their stocks. Now the mess is out in the open.

Why not start at the top. George W. Bush had no qualifications for the presidency, he was selected by big business because as governor of Texas he demonstrated political skill and unqualified support for business. He was elected on big corporate money, though not bought, for he is wholeheartedly their man. The question for his presidency was going to be, can big business run the country? Enron says the answer is no. Destruction of the surplus with tax cuts crowded into the high brackets says no. Give Bush the benefit of the doubt, though, the jury is still out on big business’s governmental management talents, but the signs coming out of Enron are not encouraging.

Next, there is Congress. Enron was built on stock hype and bad accounting. The accounting profession was well aware of spreading misrepresentation, and its governing bodies tried to slow the trend. In the crucial decisions, notably accounting for stock options and separation of auditing and consulting, reform lost because of the intervention of campaign contribution stuffed senators and congressmen. How could these people intervene where they had no expertise when the rule making bodies were doing the right thing? Because corporate management paid them to. The connection is being made between business excesses and campaign contributions.

At yet another level, Enron demonstrates the dreadful practices that overwhelmed leading investment banks. These people are willing to finance anything they can get away with simply because the fees are large. In Enron’s case they raised the money to support many of the fraudulent partnerships and offshore entities that covered up the company’s true condition. They sold a large institutional placement offering information on the company withheld from stockholders, probably illegally, though judging by the subsequent results, the treasured information should have alerted buyers to stay away. A major commercial bank/investment banker provided a vehicle for hiding losses from recent annual reports. Why did bankers engage in these probably illegal activities? The answer is huge fees, just as with underwriting hundreds of dreadful high technology and internet IPOs. They sold manure through unqualified boosting. Lacking full disclosure, deals that violated the intent of the securities laws became everyday. To an extent investors deceived themselves, but they bought the reputation of the underwriters and the hype they provided more than the companies themselves.

American capitalism works because of a blending of the free market and government regulation. Left unfettered, the free market gets caught up in intense greed and self- destructs. Karl Marx was about the inevitable self-destruction, except Marx was wrong because government stepped in and controlled the instinctive unfairness in the free market. We operate under a delicate balance between the free market and government regulation that swings back and forth. The free market self-destructs, the government steps in and over-regulates, then the free market regains its energy and outwits government controls, only to once again self destruct in its excesses. The end of the great bull market and the Bush election probably mark the high water mark for the up phase of the free market. Now that its bad aspects are revealed in all their ugliness, the pendulum will swing back toward government control. The problems are profound and the swing to more control will take time, especially with the Bush administration manning the free market ramparts.

Many of the best minds on the market think stocks will go no where for a good many years until pricing returns to reasonable levels. Those of us who felt the market was reaching a long term peak a couple of years ago did not know what forces would end the long rise. Now we know – bad corporate practices arising out of the market’s own excesses. A flat market will be supported by modest earnings growth, making extreme overpricing stand out. Improved accounting standards will be a force holding down earnings. A slow period for the market will be helpful, as all would be forgotten if we once again entered euphorialand.

One of the most intriguing questions arising from Enron is why otherwise respectable people use manipulative accounting. The answer is the tremendous incentive in stock options. Options allow management to become extremely rich in a short period of time. We are going to find that twenty or so people at Enron became very rich on options. The present secretary of the army, a former Enroner, was a second line executive who became an eight figure multi-millionaire as the second in command of a division that was guilty of gross figure manipulation. Apparently his job was sales and he did not know the ridiculous accounting tricks being played with the long term energy contracts he brought in. Is it comforting to know that one of Bush’s cabinet members was too dumb to understand what was going on in his own division? He stretched out his sales of Enron stock, required by his government position, so clearly he was ignorant of the gimmickry. Bush shares that kind of innocence. If Clinton’s number one backer had come out as has Enron with Bush, everyone would be screaming because of knowing he had probably given something in return. In Bush’s case, his standard bewilderment about anything complicated makes it easy to believe he failed to understand the implications, particularly when catering to big business is what brought him the presidency.

There is little appreciation of the extent to which management of public companies has been stealing ownership out from under stockholders. In the more popular companies, options often represent 30% of outstanding shares. Counting already exercised options, management and employee shares can end up representing over 50% of ownership on a free ride. Management gets away with this theft because options, while obviously a form of compensation, never appear as an expense on the income statement because of a special exemption earned through congressional intervention. In addition, Enron, Cisco, Microsoft to a large extent, and practically all high technology companies because of their particular abuse of options, have never paid income taxes because they are permitted to take options as an expense at the highest valuation.

The option system is crazy. It encourages earnings enhancement because even a temporarily high level for the stock can fix management up for the rest of their lives. The set up involves no risk and no investment, because the stock is usually pay for simultaneously with cashing in the exercised options. Being fully aware of the hype that elevated the stock, management is in position to make timely purchases and sales. While options are supposed to be an incentive for good management, in fact they are just the opposite. The popular slogans, pay for performance and aligning management and shareholder interests, are baloney. One of the subtler entanglements coming to light through Enron is the role of boards of directors. Why have boards allowed management to get away with huge stock option awards, a highly anti-stockholder form of compensation? The answer is that management buys their cooperation through large fees, stock options, and inclusion in company pension plans. The total package is so fat that directors would be acetic spartans not to follow management’s lead and forget their purported job of representing stockholders. Enron brings the highly conflicted position of boards of directors, and their decisions in favor of management and against stockholders, out into the open.

On management’s part, the temptation to become very rich overrides fear of dishonesty, aided by many of the figure enhancing practices being perfectly legal. If you want to hear insistent pleas of innocence, don’t go to death row, listen to top managers pleading their devotion to Generally Accepted Accounting Principles. Management is no longer concerned about the day of reckoning that goes with bad accounting because restructuring allows the cheating to be erased.

An interesting undertone to the corrective process is that Bush, ever catering to business interests, brought in as head of the SEC a man totally conflicted by being a leading SEC lawyer for big companies and accounting firms. He began to dismantle many of the progressive moves initiated by his predecessor. He reminds me of Joseph Kennedy, who FDR named as first SEC head under the theory it takes a crook to know a crook. Now Pitt, the new head, looks like a fool, so maybe he can turn himself around and stop protecting the thieves. The cards are face up on the table, and what used to be easy to get away with no longer is. Dick Cheney’s claim that he was only consulting the experts in dealing with oil executives while drawing up energy policy might have been accepted a year ago, now it is greeted with the guffaw it deserves. Suddenly we appreciate the extraordinary greed that has overtaken corporate culture.

Inauguration Commentary – January 2001

The new president is greeted with glee by comedians, but his presidency may be a watershed event. Bush Jr, to a greater extent than any predecessor, is the man of business. Reagan was all for the free market, but he was an idealist able to believe wacky ideas like voodoo economics and star wars. He never followed through on reducing the size of government. Father Bush, we forget so soon, was seen as an empty man lacking idealism. He was a competent administrator who saw the need for reducing the deficit and lost Republican support by raising taxes. Unfortunately, he had harped on no tax increases to get elected and going back on his word created the impression that Bush senior did not stand for anything.

Not so Dubya, he stands for something – unqualified support for business. Bush has sought to identify himself with education, a nice comfortable political issue, but education is a sideline. The central theme of Bush’s rule in Texas was support for business and that support is what got him elected. Business leaders picked him out as their man and provided the largest pot of money in the history of elections. He was not bought, he is a true believer that businessmen should run the country. Bush will pay absolutely no attention to McCain’s election reform effort. He is the big business candidate McCain’s program is specifically aimed at.

The cabinet appointments prove the point. Start with treasury, a businessman. Look at defense. Rumsfeld is a known supporter of increased defense spending, a powerful business issue. Bush talks about raising soldier pay, but the real support will be for new weapons. Our defense contractors sold so many advanced weapons overseas that we apparently need new ones to counter all those now in the possession of foreign powers. The appointment of a general as secretary of state (if he weren’t black we would all be shaking our heads at a general in this position) would seem to further the point.

The lesser appointments are more revealing. The original labor nominee, Chavez, is a union basher and critic of the minimum wage. Could corporations wish for anyone better. Energy: the qualification here is that the new secretary has championed closing the department. Interior: the lady’s only known position is opening up government lands to business. The most subtle is Christy Whitman as head of the Environmental Protective Agency. This may seem like a reward to a fellow member of the eastern establishment, but not so. Whitman’s predecessor introduced one of the most comprehensive environmental programs of any state and she simply disbanded it. Who better to run the EPA in the interests of business.

As for Justice, look for a dismantling of the anti-trust effort of recent years. Ashcroft’s own views are less interesting than the fact Bush would pick someone so far to the right (he did owe them a big one for repulsing the McCain bandwagon in South Carolina). The SEC – look for it to be turned over to Wall Street (an established Bush trick is turning a regulatory agency over to those being regulated) and some of the activist Levitt initiatives reversed.

The takeover of government by corporations goes beyond cabinet appointments. Business representatives, CEOs, lobbyists have swarmed the transition office seeing that sub-cabinet and other positions fall into friendly hands.

As to Prime Minister Cheney, we are so relieved to have a solid experienced man to shield us from an in-over-his-head Bush that we forget his far right views and the fact that he picked these people.

Bush endlessly talked of being a healer, but the cabinet appointments reveal the emptiness of his views on bipartisanship. Disguised by ethnic and gender diversity, the Bush appointments are blunt in-your-face moves from a man supposedly placed in a conciliatory position by the questionable nature of his win. His actions demonstrate the extend to which he is unalterably allied with big business, not the most popular interest of the common man.

The important question, will the alliance of business and the administration be good for the country? A few years ago the judgment would unquestionably have been no. Twenty years ago Bush would have been laughed at as a presidential candidate, now as the business president he is a product of changed times. Business has greatly increased its influence in government and prosperity has never been greater. Starting off with a recession, or a severe slump, means that his timing is good. Over the short run, business probably needs a helping hand and Bush is going to provide it. For the stock market over the next year, we could not ask for a better choice.

Longer term, the issue breaks down to the relative view of capitalism. The free market is seen by some as solving all economic problems and producing the greatest benefit to the greatest number. The rich may get an apparently unfair slice of the pie, but the poor end up much better off than under any other system. Certainly capitalism has proven itself in modern times. While the returns are mixed overseas because of centuries old cultural barriers, capitalism works in this country.

So the issue isn’t capitalism, it is the degree to which capitalism compromises democratic principles. Communism did not come out of the old feudal serfdom, it came out of the industrial revolution and the exploitation of labor. Free market capitalism does give rise to unfairness. The rich become greedy, they never have enough. They use money power to accumulate more and lose their sense of justice. Monopoly is an inevitable corporate goal and monopoly slows progress and leads to higher prices, defeating the free market. Enthusiasts point out that the free market ultimately destroys monopolies, but it takes time and in a democracy we are unwilling to wait. The monopoly problem may be moot, for in the fast moving high technology international economy, establishing a monopoly is almost impossible, so the anti-trust laws may have become superfluous. The government beat Microsoft, but with the peaking of the PC, Microsoft is back in a fight for its life. But the problem remains – business means big corporations and big corporations exercise great power in an undemocratic manner.

The point is that the completely free market is not utopia, it almost instinctively goes astray. I think we face a serious problem at the moment because of the crazy, greedy, indiscriminate new issuance market brought to us by Wall Street. We are seeing the downside of overselling the market and driving stocks to ridiculous levels. More significant than the immense waste of capital is the false sense of wealth that may have put the consumer behind the eight ball. Greenspan’s efforts to control stock market speculation were directed at preventing just this situation, but he failed. On the subject of Greenspan, apparently he is close to Cheney, so he may be protected, but look for the Bush people to go after him, specifically with blame for the slowdown. Business does not like Greenspan’s powerful and moderating influence on the economy, it wants a free hand.

In America we developed a government restrained capitalism to control the nastier, undemocratic practices that inevitably develop in a free market. The government is also an important partner in providing services that assist the free market to grow. The idea that government is always a hindrance is ridiculous. On the other hand, coming out of the New Deal, the need to counter the Russian threat, fears about a shortage of energy, the need for a central bank of last resort, and many other examples, government undoubtedly became too active in our lives. The environment needs protection, but the original cleanup laws of twenty-five years ago went too far. The influence of government in our lives has gradually diminished and that probably helped sustain the long prosperity of the 1990s.

Although business recognizes the contribution of government, it can’t resist fighting to reduce that role. Business wants the roads, but it does not want to pay for them. Business has captured the keys to the regulatory safe and this administration will do whatever it can to eliminate regulation. Will they overdo it? Corporations are not noted for restraint when it comes to their self-interest. The cabinet nominations are evidence of a must-have-it-our-way attitude that gets corporations in trouble. A corporation can be run as an autocracy, the country can’t.

The question is, will the business takeover be good or bad? I am a firm believer that government restraint is an important cog in the success of our form of capitalism and that given the chance business will go astray. But what do I know, maybe the unfettered market will provide new stimulus. That decision will not be made in the next four years, this is a long term contest. The pendulum of relative strength between government control and the free market has moved in favor of the free market. The result is big business flexing its muscles as never before, but that swing may be reaching a peak.

You can’t help but admire Bush’s don’t give a damn attitude, but in a democracy a business president probably holds a bad hand. I am disturbed by the constant talk show spinmeisting that this is the greatest cabinet ever, when it clearly lacks in distinction. This may reflect a defensive foreboding among Republicans about the cabinet, or an effort to obscure what this group actually stands for.

The majority of voters believe in government and anyone letting the big corporations run wild may be placing himself in an unelectable position. But maybe not. Business is on top and the majority of Americans are stockholders with a more benign view of big corporations. Business will never have a better chance to prove it can lead. The next four years will be fascinating for students of capitalism.