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Updated June 2009  

What is the current political climate in wake of the 2001 corporate scandals?

As it turns out, the corporate accounting scandals of 2001 were the tip of the iceberg in terms of the failure of the regulatory structure to adequately protect Americans and investors from economic hardship. The packaging of housing debt based on non-existent equity into securities which ultimately became worthless has caused a world wide economic collapse. In addition, there have been more cases of blatant fraud which escaped timely regulatory detection. The most notable case involved Bernard Madoff, a former non-executive chairman of the NASDAQ stock exchange who was convicted of operating a Ponzi scheme that has been called the largest investor fraud ever committed by a single person. On March 12, 2009, Madoff pled guilty to an 11-count criminal complaint, admitting to defrauding thousands of investors. Federal prosecutors estimated client losses, which included fabricated gains, of almost $65 billion. Some involved in the case as well as other unrelated observers have opined that the actual loss to investors could be far less than reported. Former SEC Chairman Harvey Pitt estimated the actual net fraud to be between $10 and $17 billion, because it does not include the fictional returns credited to the Madoff's customer accounts.

The SEC came under fire for not investigating Madoff sooner. In testimony before Congress after the scandal broke, financial analyst Harry Markopolos claimed it was very easy to prove mathematically that Madoff was running a scam. He said it took him five minutes to make an initial assessment of the fraudulent nature of Madoff's purported high investment returns, and about four hours to work the detailed math calculations. However his concerns were ignored when he attempted to raise them in 1999. Madoff has been sentenced and he will spend the rest of his life in federal prison.

While the principals in the various 2001 scandals have been prosecuted, the momentum for lasting reform has quieted. Instead the Bush Administration and Congress is being pressured to roll back some of the reforms which followed the scandals. The resignation of SEC head William Donaldson who had conducted aggressive regulatory policies after his appointment in the wake of the scandals has been seen as one such casualty. Some business leaders are pressing for a partial rollback of regulations enforcing the 2002 Sarbanes-Oxley Act, saying its corporate financial-reporting requirements are too onerous.

What is the present status of the principals in the 2001 corporate scandals?

Enron - The trial of Jeffrey Skilling and Kenneth Lay concluded in May 2006. Both were found guilty of most charges. Chief Financial Officer Andrew Fastow pled guilty and is cooperating with prosecutors. In July 2006, Kenneth Lay suffered a fatal heart attack. In October 2006, Skilling was sentenced to 24 years and 4 months in federal prison for his 19 counts of conviction.
Tyco - CEO L. Dennis Kozlowski and former CFO Mark Swartz were convicted after a second trial in June 2005. The first trial had been declared a mistrial after the jury could not reach a decision and after one juror reported receiving a threat. In September 2005, they were both sentenced eight years and four months to twenty-five years in prison for his role in the scandal.
WorldCom - Former CEO Bernard Ebbers was convicted of federal fraud and conspiracy charges for his part in a massive accounting fraud now estimated at $11 billion. CFO Scott Sullivan pled guilty and is cooperated with prosecutors.
Adelphia - Founder John Rigas and his son Timothy were convicted in federal court in June 2004 of conspiracy, bank fraud and securities fraud. Another Rigas son, Michael, was acquitted of conspiracy charges before the case ended in a mistrial with jurors deadlocked on 17 counts against him. A fourth executive, Michael Mulcahey, was found not guilty of conspiracy and securities fraud.
Imclone - Samuel Waskal was sentenced in June 2003 to more than seven years in prison and ordered to pay more than $4 million for insider trading and fraud charges, to which he had pleaded guilty the previous October. Martha Stewart was convicted in March 2004 of lying to investigators regarding her communications with Waskal. She spent several months in federal prison and was recently released.
Others - Former Qwest former executives Bryan Treadway and John Walker were cleared after a federal trial are on trial relating to accounting practices regarding $34 million in revenue. In the same matter executive Grant Graham pled guilty to a charge of being an accessory and Thomas Hall is to be retried. HealthSouth CEO Richard Scrushy's trial on federal charges of leading a multibillion-dollar scheme to overstate HealthSouth earnings to make it appear the company was meeting Wall Street forecasts resulted in an acquittal in June 2005. Credit Suisse First Boston's Frank Quattrone was convicted in a second trial on federal charges of obstruction of justice, after a first trial ended in a hung jury.

In 2001, the investment markets were shocked by a wave of scandals. What happened?

While the particulars of each case vary, most of the alleged concerns have included accounting practices which have hid the true financial state of the company involved, thus unrealistically inflating stock prices. While investors may have been deceived, it appears that the bankruptcies have also been the result of unanticipated economic trends. WordCom and Global Crossing were affected by the lack of sufficient demand for broadband services. Adelphia and Enron also had substantially invested in broadband. Most of the companies involved used "high risk" growth and acquisition tactics to achieve their success - and their demise.

How has this occurred? Isn't the securities industry tightly regulated?

In the wake of the Great Depression, legislation was enacted to regulate securities. Companies which offered public stock were required to register with the Securities and Exchange Commission (SEC). Companies are required to provide initial and regular financial statements which disclose the fiscal condition of their companies. Stock exchanges, brokers, and dealers must file information about themselves with the SEC. Manipulative practices and false and misleading statements are prohibited. Other practices, such as short sales and market pegging, are regulated. There must be regular reporting of all "insider" stock transactions. There are substantial penalties for failure to comply with SEC regulations. In addition, information developed through SEC investigations can be used by shareholders to collect civil damages from companies which have been found to have engaged in fraudulent activities.

The SEC issues regulations and conducts investigations relating to many types of alleged irregularities. But the budget and staff of the SEC has not kept pace with the increase in workload.    Some of the accounting irregularities might have been uncovered sooner with more thorough and timely SEC review. The budget was increased subsequent to the wave of scandals but has leveled off since. Moreover, not all budgeted positions have been filled.   As a result there has been no substantial increase in investigations   and the number of investigators has not significantly increased.

What companies have been involved?

The most publicized cases are the following:

    Enron

    The Enron scandal has deservedly been the most publicized of the corporate scandals primarily because of its degree of political influence and the still mysterious nature of its business transactions.

  • Company overview
  • Enron was created in 1985 through a merger of two utility companies. The deal integrated several pipeline systems to create the first nationwide natural gas pipeline system. In 1990 around 80% of its revenues came from the regulated gas-pipeline business. But Enron expanded into new areas. At the time of its collapse in December 2001, Enron Corporation was listed as the seventh largest company in the United States, with over $100 billion in gross revenues and more than 20,000 employees worldwide. Among its ventures included numerous overseas utility operations and a developing a "broadband" service along its gas pipelines. But its primary business was energy trading. In 2000, 95% of its revenues and more than 80% of its operating profits came from "wholesale energy operations and services." Enron stock prices remained stable until they started a steep climb in 1999. They precipitously fell in value in November 2001.    Its earnings reports made the company a Wall Street favorite but, as a March 2001 Fortune Magazine report observed, the details of its business undertakings could not be understood even by experienced securities analysts. After its executives sold stock near its peak value , Enron collapsed in the fall of 2001.

  • Alleged activity
  • The full details of the Enron collapse are still emerging. Enron, with the assistance of its accounting firm Arthur Andersen, misrepresented the company's finances by establishing complicated partnership arrangements which absorbed significant amount of the company's debt. As a result, stock purchasers were led to believe that Enron's resources were far greater than they were. The losses claimed so far by public pension funds are approaching $2 billion.   Also victimized were rank and file Enron employees whose retirement funds were rendered worthless. Some of these employees had long careers with utilities which had recently been purchased by Enron.

    Enron had an unusually high degree of political involvement, particularly with the Bush Administration. During the 2000 election year, Enron ranked 14th among all corporate donors.    The majority of this money was directed to Republican candidates, particularly George Bush.  (Click to see chart)    Enron was also the leading corporate sponsor of Governor George Bush in Texas and a major contributor to Congressional campaigns.    Enron and its subsidiaries also spent heavily in lobbying activities.    Enron has been a major supporter of the last three Republican National Conventions. In 1992, when the event was held in Houston (where the company is based), former Enron chief Kenneth Lay served as chairman of the convention's organizing committee, in charge of fund-raising and logistics. According to press reports, Enron contributed at least $250,000 to the event. Four years later, Enron gave at least $500,000 to the San Diego host committee, according to the Republican National Committee. On top of its political contributions, Enron also made its company jet readily available to the Bush-Cheney campaign during the 1999-2000 election cycle at a greatly reduced price. Kenneth Lay, who had considerable ties to former President Bush, became a close friend of the current President while he was Governor of Texas.

    Enron's political activities were not limited to Republicans. During the 1990's Enron contributed nearly $2 million to Democratic causes. Kenneth Lay at times was President Clinton's golf partner and slept in the Lincoln Bedroom and other top Enron officials regularly attended Clinton's regular fund-raising "coffee klatches". A seat on Enron's board of directors was offered to Robert E. Rubin, President Clinton's Treasury secretary, in 1999 just before he left the government.

    The degree to which Enron profited from its political activities is still being investigated. The Clinton administration provided more than $1 billion in subsidized loans to Enron projections overseas. It has become increasingly clear that Enron had a major role in engineering the electricity deregulation scheme which substantially affected the California economy. Not only was Enron the leading non-utility energy company to contribute to California politicians, including Gray Davis, it was the only major energy supplier who helped shape the deregulation plan which California adopted. Evidence is mounting that Enron exploited weaknesses in the California Power Exchange to manipulate the wholesale price of electricity within the state from 1999 to 2001 and that this was its true major revenue source.

    According to some accounts, Enron was a company fashioned after the "Dallas" television show which was devoid of institutional morality or oversight. Expense reports, for example, were routinely approved without a thorough review. This corporate atmosphere may have permitted unscrupulous employees to act unilaterally in contributing to Enron's financial collapse. The absence of corporate morality was also reflected in the personal lives of its high level employees. Office affairs were rampant and divorce among senior executives was very common.

  • Key figures
  • Kenneth Lay, age 60 - This onetime Exxon economist and university professor also worked in Washington for the Federal Energy Regulatory Commission before returning to Houston to where he rose up the ranks in the utility industry. He was instrumental in the creation of Enron and expanding its mission to include electricity and energy trading. He was the CEO of Enron except during a brief period in 2001 when he was succeeded by Jeffery Skilling. During the '90s, his principal activity consisted in cultivating political relationships.

    Jeffery Skilling, age 49 - A standout Harvard MBA who came to Enron with a background in banking. He showed business acumen even as a teenager when he quickly became the manager of a start-up television station. He was recruited by Enron after taking an active roll in advising Enron regarding certain natural gas contracts and quickly became Chief Operating Officer. Skilling was a brilliant and unconventional executive known for exotic "adventure" vacations. He had a decisive and uncompassionate leadership style which rewarded economic achievement over conventionality and was thus largely responsible for the unusual corporate culture which existed at Enron. His corporate nickname was "Darth Vader", a name that he apparently relished. While at Enron, Skilling divorced his wife and promoted his fiance, a secretary, to a $600,000 position. Skilling assumed the CEO position in 2001 but abruptly resigned just months later citing "personal reasons".

    Lou Pai, age 55 - Born in Nanking, China, he was an economist with a masters degree from the University of Maryland. He is sort of a mystery figure. Prior to joining Enron in 1986, he worked for Standard Oil. Along with Thomas White, he was involved with Enron Energy sales. While at Enron, he divorced his wife and married a former strip tease dancer. According to published reports, high level Enron employees were frequent customers of a Houston strip club. Pai apparently purchased massive landholdings in Colorado and records indicate that he sold more stock prior to Enron's collapse than did Lay or Skilling.

    Andrew Fastow, age 40 - A graduate of Tufts with a major in Chinese and Economics and a master's degree in business administration from Northwestern, Fastow joined Enron in 1990. He became a protege of Skilling's and was named head of Enron's retail energy group and spearheaded the company's push into the newly deregulated electricity markets. He was promoted to Chief Financial Officer in March 1998. Fastow was unquestionably involved in setting the up the limited partnerships into which Enron assets and debts were converted and kept off the books. He was allowed to establish and operate off-the-books entities designed to transact business with Enron which was highly unusual and disturbing because he was a senior officer at Enron and an equity holder and general manager of the new entities. The degree to which Fastow was operating under instructions from other Enron officials is still being investigated. Fastow has been arrested but has steadfastly maintained his innocence and has refused to plea bargain and thus implicate his associates. His trial is pending.

    Thomas White, age 58 - A West Point graduate and presently Secretary of the Army, an appointment which was almost certainly based as much on his 10 year service with Enron, as on his military career. While in the Army, he served two tours in Vietnam and in posts across the United States and Europe. Eventually he went to the Pentagon to the Joint Chiefs of Staff, ultimately serving as Gen. Colin Powell's executive officer and becoming the first in his West Point class to attain the rank of general. He retired in 1990 and joined Enron and was in management with Enron Energy Services, which specialized in energy privatization, and was, like the rest of the company, committed to remarkably aggressive growth. As the highest-ranking Bush administration official to have worked at Enron, he delayed in meeting his responsibility to divest himself of Enron stock. Nonetheless, he did sell his stock in the summer of 2001, before Enron's collapse. Records indicate that he had numerous contacts with Enron personnel prior to selling.

    Cliff Baxter, age 44, was found dead in his vehicle from a gunshot wound on January 25, 2002. His death has been ruled a suicide although foul play cannot be completely ruled out. Baxter had been vice-chairman of Enron before his resignation in May 2001. He had reportedly been opposed to the creation of the limited partnerships and was a prospective witness in the Congressional investigation of Enron. In the wake of the Enron revelations, he had reportedly expressed concern about his personal safety shortly prior to his death.

    WorldCom

  • Company overview
  • WorldCom, currently ranked #42 in the Fortune 500, is an outgrowth of a small Mississippi company begun in 1983 when long distance telecommunications were deregulated. The company grew rapidly through acquisitions and in 1995 the company was renamed WorldCom. By this time, WorldCom had a large stake in providing telephone services to business customers and providing internet services. In 1998, WorldCom accomplished one of the largest corporate mergers in history with the $37 billion dollar purchase of MCI Communications, a company three times its size. The new company was named MCI WorldCom. WorldCom was able to finance this purchase by high value of WorldCom stock and through cost cutting strategies.

    The newly formed WorldCom gained control 25% of the $80 billion worth US long distance market, compared to 50% for the market leader AT&T, and strengthened its grip on the $100 billion worth local loop market, where it would have connections in over 100 US cities. But WorldCom did not have any stake in the wireless business. Revenues decreased due to the recession and WorldCom's effort to acquire the Sprint wireless network in 2000 was blocked by the Justice Department and was opposed by the European Union as well. With these developments, Wordcom's stock which had increased following the MCI acquisition, began a precipitous decline.    The company filed the largest bankruptcy in history in June 2002.

  • Alleged activity
  • The heart of the controversy concerning the WorldCom bankruptcy is an accounting which misrepresented its expenses. Instead expenses were classified as capital expenditures, leading trained analysts to believe that earnings were substantially larger than they actually were and that such earnings were being reinvested in expanding the company's services. Instead it appears that WorldCom was spending only enough to upgrade existing equipment. The accounting firm of Arthur Andersen was also involved with WorldCom.

  • Key figures
  • Bernie Ebbers, age 60, grew up in Edmonton, Alberta. He immigrated to Mississippi to attend college and play basketball and has lived in Mississippi ever since. After coaching basketball and running a small hotel chain, Ebbers started LLDS which later became WorldCom. Ebbers, unconventional and folksy, was not a prototypical CEO. But his daring run of highly leveraged acquisitions was the ingredient of his success and his downfall. Ebbers has been arrested and his trial is pending

    Scott Sullivan, age 40, had been the Chief Financial Officer of WorldCom since 1994. He provided the technical accounting expertise that helped Ebbers and WorldCom pursue its aggressive acquisition strategies. He had developed a reputation for trust among Wall Street analysts but is now accused of falsifying recent WorldCom reports. Sullivan and David Myers, WordCom's controller, were arrested in connection with this matter in August 2002. Their trials are also pending.

    Global Crossing

  • Company overview
  • Global Crossing was founded in 1997 by with a relatively simple business plan. He planned to build an undersea broadband network that would link continents together and serve global carriers like Deutsche Telekom and AT&T. Wall Street investment firms such as Salomon Smith Barney were simultaneously involved in underwriting the financing for Global Crossing and recommending its stock for purchase. Based these expectations which were also fueled by unrealistic predictions regarding the financial impact of Internet services, the stock took off.    But Global Crossing's anticipated revenues did not materialize as there was insufficient consumer demand for broadband services. Global Crossing, which had survived because of its stock revenues, could not make its interest payments and was forced into bankruptcy in January 2002.

  • Alleged activity
  • It is alleged that Global Crossing inflated its revenues by swapping capacity with other carriers, say analysts, and lured customers and investors by overstating the reach and capabilities of its network. Global Crossing has also been accused of excessive political involvement, unreasonably high CEO pay and Director compensation, and insider profit-taking. During Global Crossings' short life, it went through five CEOs who were collectively compensated through salary and stock sales in the amount of $104.9 million.

    Global Crossing's main political largess has been to Democrats. Global Crossing donated over $1 million in soft money to the Democratic Party and CEO Gary Winnick contributed another $1 million to the Clinton library. In 1997, Winnick hired Terry McAuliffe, Clinton's chief fundraiser and presently head of the Democratic National Committee as consultant. Reported McAuliffe was able to turn a $100,000 Global Crossing investment into $18,000,000. Global Crossing also contributed heavily to Republican New York Governor Pataki, apparently to facilitate its sale of assets belonging to New York-based Frontier Communications which Global Crossing had purchased.

  • Key figure
  • Gary Winnick, age 54, a native of New York, who had no particular expertise with the telephone industry. Instead, he was a veteran of Wall Street junk bond trading having worked for disgraced Michael Milken's Drexel operation in Los Angeles. He used his Wall Street connections to raise the funding for Global Crossing. Although the endeavor proved to be unsuccessful, Winnick did not suffer financially. Through timely stock sales, he earned $750.8 million in less than 5 years, sufficient to construct one of the most expensive homes in the nation's history. Despite his evident mismanagement, federal prosecutors have indicated that he will not be indicted for his role in the company's collapse.

    Tyco

  • Company overview
  • Prior to the arrival of Dennis Kozlowski in 1976, Tyco Laboratories was a small manufacturer of a variety of products including undersea cables to fire sprinklers. Under Kozlowski's leadership, Tyco quickly began acquiring a variety of companies. In order to make the acquisitions profitable, Kozlowski would slash costs and consolidate and close factories. Top executives were usually shown the door in favor of eager, young middle managers willing to work long hours. As a result, Tyco today is a conglomerate engaged in electrical manufacturing and distribution, energy production, undersea cable manufacturing, fire detection and suppression systems, manufacturing and distribution of medical supplies and financial services. It ranks 103 on Fortune Magazine's ranking of global companies. Tyco's stock reached its highest levels in the summer of 2001 before concerns about its debt and ability to fully manage its diversified products began dampen investor enthusiasm. An aborted plan in 2002 to break Tyco into four separate companies caused the stock price to decline further.

  • Alleged activity
  • Dennis Kozlowski was recently indicted in New York for conspiring with executives and employees of art galleries and consultants to avoid paying more than $1 million in tax to New York City and State due on his purchase of costly paintings, including falsifying records to make it appear that the objects were shipped out of state. Kozlowski has resigned from Tyco in the wake of these charges. The criminal charges against Kozlowski for tax evasion has caused investors to worry that faulty accounting practices may have affected Tyco's performance reports.

  • Key figure
  • Dennis Kozlowski, age 55, was the son of a Newark N.J. police detective. He majored in accounting at nearby Seton Hall University, living at home to save money, and worked his way through college. He began his business career by working for a firm engaged in hostile takeovers. In 1987 he was appointed to the Tyco Board of Directors and was named president and chief operating officer in 1989. He has been chief executive officer since July 1, 1992 and became chairman on January 1, 1993. For his Tyco efforts, Kozlowski rewarded himself handsomely, ranking 5th in the nation in CEO compensation according to a recent survey.    He has an $18-million apartment on Fifth Avenue, a Nantucket beach house and an estate in Boca Raton, Florida. His trial is currently in progress.

    Adelphia

  • Company overview
  • Adelphia was a cable business which originated in Coudersport, a small town in northwestern Pennsylvania, in 1952. When John Rigas' sons became involved in the business, the company began to truly expand. In 1985, Adelphia went from 53,538 subscribers to 122,500 after it acquired a cable system in New Jersey. By the mid-90s Adelphia was publicly traded and was one of the nation's ten largest cable companies, managing 1.2 million subscribers. Additional acquisitions helped Adelphia grow into a company with revenues of $3.5 billion and 5.8 million cable subscribers thus qualifying Adelphia for the 2001 Fortune 500 list and helped Adelphia stock to soar from $10 to $70 per share in two years. But concerns about earnings and the amount of debt which ultimately resulted in charges of fraud caused the stock to steadily lose value.    The company declared bankruptcy in April 2002.

  • Alleged activity
  • In July 2002, John, Tim and Michael Rigas were indicted for conspiracy to commit securities fraud. Among other allegations, they are charged with overstating company earnings. The problem with Adelphia was that the Rigas family did not sufficiently adjust to the requirements of a publicly traded company. Instead, they continued to operate Adelphia like a family business and did not separate personal and corporate financial matters. Adelphia made frequent loans of company money to the Rigas family for a variety of non-corporate related expenses, including John Rigas' purchase of the Buffalo Sabres hockey team and golf club memberships. In addition, Rigas' financial generosity to the residents of Coudersport was legendary. The board of directors of Adelphia consisted of family members and close associates and there was no true oversight of the company's operations. A major problem was the fact that instead of selling Adelphia stock has it increased in value, the Rigas family purchased additional shares with money borrowed from the corporation. When Adelphia stock decreased in value, they could not repay the loans.

  • Key figure
  • John Rigas, age 76, was the son of a Greek immigrant and restaurant owner. His first business venture was to own and operate the Coudersport movie theatre. In 1952 he overdrew his bank account to buy the town cable franchise for $300 from a local hardware store owner who'd erected an antenna on Dutch Hill. Then he persuaded a local doctor and state senator to help him wire Coudersport for cable. He soon did the same in neighboring towns. Rigas ran a successful business but he always borrowed heavily to finance Adelphia's expansion and for personal expenses. Rigas has been arrested and criminal charges are pending.

    Halliburton

    Halliburton is a oil services and general construction company ranked 153 on Fortune's 500 list. Halliburton and its accounting firm Arthur Andersen has been accused of improperly recording revenue from cost overruns on big construction jobs while Vice President Richard Cheney was serving as CEO. Halliburton vigorously denies this charge. Halliburton's stock decline is primarily related to a decrease in all energy stocks which is in turn based upon the recession and the decrease in oil prices. Halliburton has been under major criticism for using its political influence to obtain sizeable contracts involving Iraqi reconstruction.

    ImClone

    ImClone is a biopharmaceutical company founded in 1984 by Samuel Waksal, age 54, and his brother Harlan with venture capital. Imclone had obtained the rights to Erbitux a medication which designed to combat colorectal cancer and which was thought to have some potential especially when the company reached an agreement with Bristol Myers for the distribution of this product. In December 2001, the Food and Drug Administration took action to withhold approval of this Imclone's application for approval of Erbitux. The stock price, which had been based on the anticipation of approval, took an immediate plunge.    Waksal has been arrested and charged with influencing sales of Imclone stock by his father and daughter and by his close friend Martha Stewart just before the news of the FDA rejection became public knowledge. He pled guilty and is presently serving a seven year prison term.

    Xerox

    Xerox, a name synonymous with copy products and ranked 120 in the Fortune 500, has struggled during the last two decades to maintain its place in a highly competitive and technologically changing business. Its stock, together with all technology stocks, increased dramatically in 1999 but has precipitously declined since that time.    The recently company admitted that it overstating equipment sales by $6.4bn - although other revenues, including services, rentals or outsourcing made up $5.1bn of that. It is unclear to what extent this misreporting was the responsibility Xerox officials or of its former accounting firm, KPMG.

    Other companies

    Other companies which have been accused of accounting irregularities are: Sunbeam, K Mart, Rite-Aid, Computer Associates, American Online, Dynegy, Cendant, CMS Energy, Dollar General, Duke Energy, El Paso, Oracle, Merck, Merrill Lynch, Lucent, MicroStrategy, Network Associates, Peregrine Systems, PharMor, PNC Financial Services, Qwest Communications, Reliant Energy, and Vivendi.

Interestingly all of the major figures involved in the scandals came from either poor or working class backgrounds.

How have accounting firms participated in this process?

All companies are required to submit detailed financial reports to the SEC from an "independent" auditing firm. As a practical matter, there have been five major accounting firms which perform the bulk of this audit work.   The "big five" accounting firms have increasingly turned to "management and consulting services" as a revenue source to the extent that audit fees represent less than half of their revenues.    This trend has been accomplished primarily in the last decade.    Several major corporations have expended over 90% of their fees to accounting firms for such services.    Critics maintain that auditing firms should not be compromised by providing consulting services to the companies that they audit.

The accounting firms have contributed heavily to federal election campaigns. When compared to revenues, campaign contributions of four these firms were among the top 10 givers in the country.    Until the recent wave of corporate scandals, the accounting industry has successfully resisted congressional and regulatory efforts to separate the auditing and consultative functions. In 1995, the industry was able to convince the Senate to override a Presidential veto and pass legislation which limited the liability of accounting firms in shareholder litigation.

The accounting firm most under fire has been Arthur Andersen LLP. Andersen was founded in Chicago in 1913 and provided reputable accounting services for nearly a century. In the wake of its felony conviction in the Enron matter, Andersen stopped providing SEC audit services and the firm has now been dissolved. The conviction resulted because its "Enron project" employees shredded and destroyed crucial documents relating to Enron's operations. The temptation for complicity between Andersen and Enron is quite understandable because its auditors and accountants had permanent offices in Enron's building. Its staff wore Enron golf shirts, attended Enron parties and ski trips and generally were difficult to tell from Enron staff. Many Andersen employees were "promoted" into positions with Enron. Finally, Enron paid more for Andersen's consulting services than it did for its auditing service.

Aside from accounting practices, what other characteristics of many of these companies have come under fire?

  • High rate of campaign contributions
  • The campaign contributions and lobbying activity of many of the companies under suspicion have been significant.   Campaign contributions by companies unquestionably are motivated by a desire to influence public policy in a manner which will benefit the enterprise. Some analysts maintain that when a company contributes substantially more than others in the same industry, it is a sign that the company seeks to financially benefit from its government relationships rather than from engaging in traditional economic competition with its competitors.

  • High concentration of Board of Director "insiders" or high Director pay
  • There are several major corporations where more than 50% of all board members are connected to the corporation.    As was particularly apparent in the case of Adelphia, there can be a woeful absence of board oversight of questionable company activities when the board membership is composed of company insiders and their close associates. Just as compromising is exorbitant Director pay. The Enron board has been one of the national leaders in this category.

  • Excessive CEO Pay
  • The high rate of CEO for corporate America in general has been long been criticized by organized labor and other groups concerned with income inequality. These critics note that CEO compensation has risen astronomically while worker wages have remained flat and that American executives are compensated far more than their counterparts in other countries.   They also note that this pay often is unrelated to company performance. The companies which compensate executives at the highest rate have been also criticized by Wall Street analysts for using shareholder money for unreasonable personal enrichment.

  • Insider stock transactions
  • Institutional investors and company pension holders who have been victims of the bankruptcies have been particularly angered by the fact that insiders sold large amounts of stock at a high price. Although the law requires such stock transactions to be recorded, the information does not become public until as much as 13 months after the date of the transaction.

  • Providing stock options as compensation
  • In 2006, over half of the value of CEO compensation was in the form of stock options and other equity incentives. This compensation structure is considerably different than in Europe.    It has been estimated that over 10% of the common stock issued by major corporations is held by executives. The wisdom of the practice of providing a large percentage of executive compensation in the form of stock options is a practice which has its believers and critics inside and outside of industry. On one hand, it provides an incentive for performance but it also provides executives with a substantial advantage over other company shareholders who have paid full market value for their stock. In addition, it creates the temptation for insider transactions. No matter how rapidly insider trading is reported, company executives are almost always in a far better position to assess the company's relative financial position. Finally, under current rules, the stock incentives provided to executives are not sufficient itemized on accounting records to provide investors a full picture of the company's compensation expenses.

  • Employee pension plans tied to company stock
  • The 401K plans for employees of many large companies are substantially composed of company stock. For large companies, fully 43% is invested in company stock and ten companies require employees to have more than 75% in company assets.    In addition, most plans impose some restrictions on the sale of company stock such as a prohibition of trades until age 50 or requiring employees to hold company stock for a prescribed period.

What reforms have been proposed and/or enacted?

In July 2002, a virtually unanimous Congress passed legislation to improve regulatory oversight of the securities industry and to stiffen penalties for violators. The growing number of alleged accounting irregularities and other practices, together with the decline in stock prices, quickly helped persuade the Administration and Republicans in Congress of the need for stronger measures. Only two months earlier the House had rejected the concept of Public Company Accounting Oversight Board, which was ultimately established by the legislation.

  • Improved corporate financial disclosure
  • Reformers recommend: That the SEC require stricter disclosure of company information including "off balance sheet transactions", conflicts of interests, charitable relationships, taxes, government contracts, and campaign contributions. Under current rules, a non-governmental industry agency, the Financial Accounting Standards Board, sets many of the disclosure rules. Reformers urge that this responsibility be shifted to a public agency.

    Legislative action: The legislation addresses the "off balance sheet transaction" issue by mandating that the SEC study this issue and report to Congress. It empowers a newly created Public Company Accounting Oversight Board to assume the duty of setting standards for accounting reports. The majority of the board is to be composed of individuals who are not accountants.

  • Require diversification of Corporate Employee Pension Plans
  • Reformers recommend: Apply Employee Retirement Income Security Act (ERISA) safeguards to corporate 401(K) plans which would, among other provisions, mandate that limits on the concentration of stock to no more than 5 percent in any single security.

    Legislative action: The corporate reform legislation does not address this issue. However, it does prohibit executives from negotiating insider trades during employee pension blackout periods. Separate legislative proposals to modify 401(K) requirements in this manner are pending in Congress.

  • Ban company loans to executives
  • Reformers recommend: Loans made on favorable terms to corporate executives and board members should be banned. Such "insider" loan activity has been widespread and was the cause of the Adelphia bankruptcy.

    Legislative action: The legislation bans such loans to executives although it permits an exception for home if made on terms that are no more favorable than those offered to the general public.

  • Require that corporate boards be independent
  • Reformers recommend: The SEC should establish standards for corporate board participation which insure that shareholders are sufficiently insulated from insider influence.

    Legislative action: None

  • Require auditor independence
  • Reformers recommend: All independent auditors should be banned from doing non-audit consulting work for the same client.

    Legislative action: The new legislation prohibits accounting firms from performing specified non-audit services contemporaneously with a mandatory audit. It does not prohibit all types of consulting work. The accounting industry had previously been strongly opposed to this type of reform.

  • Require rotation of auditing firms
  • Reformers recommend: That companies be required to change auditing firms every five years to further insure independent review.

    Legislative action: None

  • Expensing stock options
  • Reformers recommend: Corporations should be made to value stock options at the time of the option grant and count them as expenses on their income statement and should deduct the value of the option at the time of the grant as they would with compensation paid in cash. This would eliminate a huge tax cut deduction that corporations presently exercise from stock option grants.

    Legislative action: The recent legislation did not address this issue. Separate legislative proposals addressing this question are being considered. An effort by Senator McCain to include such a provision in the corporate reform legislation was rejected by the Senate.

  • Better reporting of insider trades
  • Reformers recommend: Investors should know immediately when insiders have sold stock. Currently there can be a 13 month delay.

    Legislative action: The legislation requires the SEC to establish a system which will provide such notification within two working days.

  • Eliminate broker conflicts of interest
  • Reformers recommend: When the same company is involved in underwriting the issuance of securities and issuing recommendations to investors, there is an inherent conflict of interest. Brokerages need to better separate these functions.

    Legislative action: The corporate reform legislation requires the SEC to adopt rules addressing this issue governing securities analysts' potential conflicts of interest, including limiting the supervision and compensatory evaluation of securities analysts to officials who are not engaged in investment banking activities.

  • Increase the funding of the SEC
  • Reformers recommend: The SEC has been significantly under funded and also lacks enough trained accounting staff to provide the necessary oversight.

    Legislative action: The House has overwhelmingly passed legislation to increase SEC funding by 77%. The matter is now pending in the Senate

  • Restore full civil liability to accounting firms
  • Reformers recommend: Under the 1995 legislation, the civil liability of accounting firms to damaged shareholders was severely limited. Restoring full civil liability would help insure the integrity of the system by financially penalizing accounts for misleading reports.

    Legislative action: None.

How are investors protected in other countries?

The United States has the most sophisticated securities regulation system. In Europe, commissions comparable to the SEC exist in most countries, but their power and scope are more limited. This is due to the fact that securities markets have only recently begun to assume importance. European companies have historically relied more on the banking system than a U.S. style "market based" financial system. The UK moved closer to the U.S. in 1986 with the adoption of the Financial Services Act, and closer still in 1998 when it centralized regulatory authority in one agency. Japan's recent economic downturn has led to changes that applies much of the U.S. substantive law to Japanese securities markets although no single commission has been created for enforcement. With a growing global economy, there has been increasing pressure to harmonize international securities regulation most particularly with respect to accounting standards.

 

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