IntroductionCapitalism rewards the companies who get closest to the edge, without going over, in order to produce earnings.
–Observation of a financial executive from a Fortune 50 company
What must we do to destroy the integrity of our capital markets?
Nothing! The destruction is well under way. The underside of the stock market became more visible over the past five years during the frenzy of the technology and Internet bubbles. The markets, due to the lies of corporate leaders and those who surround them, are the casinos and dog tracks of this new century. The odds in Las Vegas and the odds of making money by investing in companies have two major differences. In Las Vegas, one can compute the odds of winning or losing. These days, the way publicly traded companies are behaving, you cannot. The dealers in Las Vegas usually do not insert or remove a couple of aces during the game, but on Wall Street and among many of the publicly traded companies, they do. At least in Las Vegas you get a good meal and free drink.
Fifty percent of American households support corporations by buying stock. But the level of trust people have placed in the corporate world by making these investments has not been reciprocated by reliable information about the financial performance and the actual financial condition of the corporation. Both individual and professional investors are becoming more cautious, with many reducing or withdrawing their investments.
We are beginning to understand the importance of verification, validation, and authentication of corporate claims about business performance. Everyone with an interest in our economic health and progress will demand sounder ways to find truth in time to make a difference. Smart, responsible corporations will help this process develop and become leaders in business authenticity.
Investors now see the conflicts of interest and the outright lies about corporate financial performance: the defensive posturing of corporations, auditors, politicians, and Wall Street. Their first line of defense is to placate investors by creating the illusion of reform–a lot of political talk followed by unenforceable rules. After all, much of the political business and financial establishment does not want reform. Disturbing the cozy relationship between Congress and the companies who contribute to political campaigns would upset a long tradition. Too much change would expose them and take them out of the game.
Managed mendacity, systematically applied to the investing public, has become the new science of publicly traded corporations. The one thing corporate leaders know for sure is how to handle the investors. They know just how much information to provide and what kinds of information to hide, and they can rev up the engines of hype and misinformation at the drop of a hat. Lies and deception at their basest level help the inner circle achieve personal goals of greed and cover up their incompetence as executives. Gamesmanship has replaced business management competence as executives and their boards have focused on managing the stock first, the business second, and strategic value last.
This pattern of conduct is not what investors came to the markets for and is the reason why many are now thinking twice about staying unless new methods of verifiable data on corporate performance are developed. The performance reports of Cendant, Waste Management, Sunbeam, Global Crossing, Tyco International, and Enron were certified as accurate by their auditors. But Cendant allegedly booked $500 million in fake revenue over three years. Waste Management defended itself in seventy class-action security fraud complaints and accounting scandals and became the most frequently sued company of 1998. Sunbeam was charged with accounting fraud for shifting $21.5 million from reserves to income to cover up massive discounts and inflated sales forecasts. Global Crossing was charged with Enronlike accounting fraud and inflated revenue reporting. Tyco International was investigated for hiding debt to make revenues look better. Enron and the others are just the tip of a deeply submerged iceberg. The root of some of these cases goes back for more than a decade. None of them received much attention until the Enron story began to develop and the markets declined for the second straight year. The sensitivities of investors have become sharply tuned, and Enron pushed the sensors to full tilt.
Enron and these other companies wanted to make revenue look stronger than it actually was during each reporting period. They shifted expense, debt, and sales forecast numbers from book to book to create the illusion of financial stability. They concocted their stories carefully, never stretching too much at a time. Their reports seemed reasonable, directionally right. Falsehood was concealed among accurate facts. The business leaders who were best at this deception were moneymakers on a “five-year” mission. Their goal was to manage an initial public offering, or take over a solid publicly traded company, push the stock to the sky, and cash out. In the process of making things look better than reality, insiders sold off at market high points to line their own pockets. If investors cannot validate the factual basis of revenue reporting, return on capital, and reports of cash flows, logically, they should not invest. But with all this deception and deliberate concealment, there is no way to validate all the reporting. This is the investors’ “catch-22.”
It gets worse. If only there were a simple checklist of indicators, like the following, that would give an signal that something is amiss:
*Abrupt turnover at CEO and key senior executive positions without convincing explanations about why people are leaving (Jeffrey Skilling, for example, resigned as CEO of Enron for “personal reasons.”)
*Cash-out moves by senior management (i.e., insider stock trading in large and frequent volumes)
*Restatements of earnings
*SEC warnings for aggressive accounting
*Reductions in shareholder equity
*Special and complex partnerships and financial instruments
*Elaborate compensation and stock options plans
*Complex SEC filings
*Sudden downgrades in credit/bond ratings
*Withdrawal by hedge funds
However, keeping up with the indicators of lies and deception is like trying to paint a moving train. Since the Enron accounting spill, corporations will move to other devices to play their games. They will be extremely careful in the future, and they will change their patterns. Any system as complicated as our system of investing cannot be simplified to a set of bullet points. Investors can’t simply rely on a checklist but need to ask some hard, even rude, questions. Why hesitate being tough-minded when it comes to protecting your financial life?RUDE INVESTORS
Individual investors have been left to trust the professionals–the fund managers, brokers, and advisers–to ensure that their money is with the best possible companies. Individuals, however, must still be responsible for their own investments. We need to let the fund managers and professional investors know that we now expect them to do their homework and recommend companies who are not hiding behind technical compliance but are willing and able to disclose fully what they are doing. Here is a list of questions that can be used to start developing an understanding of companies.
Basic Financial Verification
*How can you explain the last three years of the company’s statements of cash flows and return on capital?
*What are the “off-balance-sheet” debt, revenue, and tax situations of the corporations from the past three years to the present date?
*Does the corporation finance any part of its revenue by providing loans to customers or any other outsiders?
*What does the corporation do to ensure that employees understand their legal and ethical responsibilities?
*Does the company provide an independent “hot line” so that anyone in the company can report fraud or suspicious activity without being fired and with assurance of appropriate response?
*How has the company treated “whistle-blowers” in the past?
*Has any executive of the corporation been sued as a result of business fraud or any other business-related activities?
*What do the most important customers say about the company and its management team?
*During the last three annual meetings, how has the leadership team responded to and treated shareholder questions and comments?
The Board of Directors
*Who is on the board, and what are the backgrounds, accomplishments, mistakes, and qualifications of the directors?
*How have the directors added value to the corporation over the last year, and what do they plan to do in the next year?
*Has the board evaluated itself? How?
*What is the board’s point of view on the following?
*How will the audit committee of the board ensure that audits produce an accurate picture of company performance? In addition, what steps has the board taken to ensure accuracy and exactness in all managerial reporting inside and outside of the corporation?
*How many board sessions are held each year, and what is their length?
*Does the board have outside consultants and advisory groups assisting them with their work?
*Since many directors have given the excuse that they did not always know what was going on in the business or otherwise demonstrated that they were not competent to understand the business, how do we know that the current directors understand the business?
*Do all of the directors own company stock?
This list is just for starters, an example of the kind of questions that shift the burden to corporations to “show us” they are right. If you can’t get answers that satisfy you, then you know one, perhaps two, things are wrong. First, the investment “pro” you are dealing with doesn’t have much in the way of useful information. What are you paying him for? Second, the company that can’t or won’t provide this information is suspect. As Enron unfolded, reporters noted that Warren Buffet commented that if he could not understand an annual report, perhaps the company did not intend for him to understand it.
Shareholders have lost billions in the stock manipulations because they had no early-warning indicators, or they thought they had the right ones but really didn’t. Fraud is a game of stealth and maneuver. As soon as you think you know where companies are, they have moved somewhere else. To the extent that we believe what we hear from corporations, we are at a profound psychological disadvantage. Market psychology runs along a simple spectrum between greed and fear. The people running corporations have the greed; the investor just inherited the fear.
The fraud makers and innocent investors have a curious relationship. Like hamsters in a plastic ball, we all run with directionless motion unable to stop or determine how to change what we are doing. The net result is that investors do not know what to believe or when to believe it. They do believe, by now, that Enron was a culture of corruption. They are not sure about other companies, and they wonder what will happen next, uncertain about whether there is a reliable way to figure out what is happening in the capital markets or about having the facts they need to make investment decisions.
Companies performing well for their investors do not need to lie. The trouble is, sooner or later, almost every company passes through that valley of the shadow of poor performance and/or internal corruption, and that’s when it resorts to lies and deception. This unfortunate behavior usually begins as a small act of stretching a fact or two about products or revenues. Stretching the facts eventually gets out of hand and turns into a big problem. Corporate lies are like the small streams and lakes of the Adirondacks of New York that grow to become the upper reaches of the Hudson River. The river grows in depth and force as it moves downstate, ultimately flowing down the west side of Manhattan, passing Wall Street, and emptying into the Atlantic Ocean. Corporate lies have small beginnings that turn into mighty torrents and ultimately overwhelm tens of thousands of investors. Corporate cultures condition people to think that it’s all right to lie a little. One little lie, deemed to be innocent, grows–and then one day an Enron happens.
Little lies that grow into big ones are one of the causes of situations like Enron; planned conspiracy is another. Many corporations have come to believe that they can get away with almost anything, and weak enforcement deterrence whets the appetite of conspiracy. They know that the Securities and Exchange Commission (SEC), the FBI, and the Department of Justice (DOJ) don’t have the resources to check on all the possible schemes companies can employ in the pursuit of deception. When the SEC does uncover a problem, it is too late in the day for investors. There is no reliable investor early warning system. All the bad news is after the fact, and the good news is questionable. There is clearly little deterrent effect in the way the enforcement community conducts its oversight of corporations.
The entire process of investing in corporate America is significantly broken, risky, and not relevant to the needs of a global economy. The progress of the global economy has outrun an archaic set of rules based on a politicized structure created nearly three-quarters of a century ago. Like campaign financing, everyone agrees that something must be done, but the entrenched groups cannot move. It is time for reform in the structure and processes of investing, the type of reform that can stay ahead of the maneuvers of corporations that lie to investors.
We are not just presenting some case details and interesting stories about corporate misbehavior, nor are we presenting a comprehensive case study of Enron. Rather, in addition to discussing specific cases, we explore the issues that must be addressed as publicly traded companies find themselves in a new context where protection on several fronts is required. Corporations clearly need to be protected from the damage they do to themselves when they provide false information, give less than full disclosure, and allow conflicts of interest.
Among the more than 14,000 publicly registered companies in the U.S. and the even larger number of privately held companies, there are a class of people who will lie to the public, the regulators, their employees, and anyone else in order to increase personal wealth and power. Investors want to know who the liars are and how to get rid of them. In the very near future, CEOs, boards, and key managers will find their records and backgrounds examined as never before. Both companies and recruiters involved in executive searches are now insisting on rigorously double-checking references, past employment and performance, and academic degrees.
Executives will have to do more than talk about their skills, experiences, and ethical beliefs; they will need to offer evidence. They will do well to think about what kind of leadership legacy they want to leave. If they are caught up in an “Enron,” they can be sure they will not be admitted back on the field of play. Beyond fundamental issues like fake reporting and bad audits, a fundamental shift has occurred in the management foundation of public companies and the governance of capital markets. The forces driving the shift include:
*Complexity. In business, particularly in global business, complexity is becoming deeper and wider and is providing the hiding places for new forms of business deception.
*Technology. Advancements are providing speed for business maneuvers, both the good and the legal and the bad and illegal.
*Inability to Grasp Reality. Corporations are losing touch with the performance reality states of their business operations, finance and accounting, deal-making consequences, and the value of their intellectual capital.
*The Need for Precision. Managerial tasks require more rigor, more precision, and complete accountability in the boardroom and from the leadership teams.
Congress can wave its arms and pass a few more rules. However, unless corporations understand the new requirement for performance reality as a managerial task, congressional rule-making will be like firing a water pistol into a hurricane.
The cornerstone of the next economic period and the absolute minimum standard for corporate managers will be a new form of scientific management based on performance reality and accuracy in reporting on corporate capabilities. This is a management science and discipline that is possible, but largely forgotten in modern corporations. This is the management capability for advancing the best companies and checking the fraudulent. The growth of a corporate underclass is an important development in an economy that grows ever more complex. The capability for increasingly serious economic disasters means that companies that lie are the equivalent of economic terrorists in our midst.
Companies, even those that play games with accounting rules, still want to know the reality of their performance. They struggle to understand the details of counting revenue, cash flow, expenses, and a list of complex indicators that should tell them about real performance. The trouble with getting to performance reality lies in a jumble of different forms of measurement and analysis. What’s lacking is a unified system of measuring and determining the reality of verifiable financial performance that is linked to actual operational performance. When a company can understand the combined effects of what it has sold, the real expenses it has encountered, and the potential consequences of the deal structures under which it has performed, it will be closer to reality.
Companies need to develop performance reality standards to bring financial and operational measurements under a guiding discipline, to provide more accurate, verifiable performance data. Performance reality reporting involves those people in the corporation who are closest to the material resources and assets of the corporation, not just financial experts and auditors. Performance reality defines an approach that traces how “performance factors and metrics” move from the marketplace, through the contractual screens and financial filters, and into the service and product delivery capabilities of the corporation.
The end game of the performance reality approach is the creation of information about corporate performance and the related reporting that is verifiable, authenticated, and accurate well beyond the standards we see today. This is the way to create a reliable picture of corporate performance and potential that investors must have.
The new realities of business are in conflict with a growing number of people seeking greater financial security. There is an aging population with serious amounts of money for investing, part of the record number of investors who came to the market during the Internet boom and the rise of online investing. While investors now want financial security over hot growth (they would actually like both), they are losing faith in the prospects of either. Their faith in future markets now depends on what action they see being taken to cure our vulnerabilities and establish a market that has high levels of truth in investing as well as good levels of growth.
Clearly, the Enron situation is a warning sign, an alarm, which compels us to uncover the bad habits our corporate leaders are comfortable with. For example, CEO Ken Lay’s letter to the shareholders in the 2001 Enron annual report contained a lengthy and heady sermon about the integrity and high standards of the Enron culture. Lay claimed that Enron was sponsoring a wide range of activities to ensure the social responsibility of the firm and otherwise protect shareholders and employees. Few, if any, of the claims were true. Enron not only failed to carry out these commitments, it was, in fact, incapable of this kind of work. Ken Lay talked about the principles of “respect, integrity, communications, and excellence.” While Enron executives implemented none of these principles in their day-to-day work, most Enron employees probably took them seriously and practiced them. This is the ultimate power of deception, to cause good people to do the right things while those in power do the opposite. The executive team at Enron was satisfied with only the appearance of having said all the right words while doing all the wrong things–all to make investors feel good. In retrospect, in light of what we know today, anyone who closely examined this statement would not have been alerted to its incredible exaggeration. There was no factual basis to measure the difference between reality and pure fantasy. Enron substituted distortion for truth. Investors must demand that any form of declaration about corporate performance pass the highest test of public diligence.
As we look back at how fraudulent companies have presented themselves, we now see what went wrong: the arrogance of corporate management teams, and the hyperbole about performance and lack of facts. Smoke and mirrors stand in the way of investors trying to figure out what they should do. Investors are overwhelmed with unbelievable and continuous good news from corporations.
Investors hear loose talk and “trust me” attitudes from business leaders who drain value from companies and put investors at risk. It is wake-up time. Investors are about to learn how to break the mirrors and blow the smoke away.
What investors want to find is companies that tell the truth about performance and value. Concerned investors just can’t sit and wait patiently for the SEC, Congress, and the corporations to do the right thing. This book will help investors to inform themselves about who is telling the truth, to be less easily persuaded about what companies say about financial performance, and to probe for reality.From the Hardcover edition.
Excerpted from How Companies Lie by A. Larry Elliott and Richard J. Schroth. Copyright © 2002 by A. Larry Elliott and Richard J. Schroth. Excerpted by permission of Crown Business, a division of Random House LLC. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.