Posted on 08/18/2002 6:35:32 AM PDT by SBeck
Make Pinocchio CEOs Pay
This was a tough week for corporate CEOs. They had to swear under oath that the numbers they are reporting to investors are actually true. I suppose you could call it putting your mouth where other people's money is.
This provision of the newly enacted corporate reform law has gotten loads of ink, as well it should. CEOs could be criminally liable for bearing false witness. We can only hope that the requirement to truth-tell does not represent a trend, else so many other institutions, such as politics and matrimony not to mention the Catholic Church, may never be the same.
Risk-Free Game
However, there is another provision in the new corporate law, largely overlooked, that will do even more to ensure that CEOs start playing straight. For too long, CEOs and their underlings have been playing a risk-free game. They put out false or misleading earnings, got the stock to rise and then bailed out.
When trouble came, even when the company had to admit that its prior earnings reports were bogus, the executives who had capitalized on (and often concocted) the phony reports almost invariably were able to hang onto their loot. This was not an incentive to perform. It was an incentive to steal.
The executives even thought of it as a game (as opposed to, say, a duty to faithfully disclose to fiduciaries). Just this week, a former executive of Metromedia Fiber Networks Inc., a onetime telecom high-flier now under investigation for its accounting, likened his sale of company stock to a poker player's pocketing his "winnings." He used his stock sales, The Wall Street Journal reported, to buy a winery. Of course, the investors who were not insiders had no winnings and no Chardonnay. The company is now in bankruptcy.
A similar tale could be told at dozens of other companies, including Enron. And at virtually every case where executives cook the books -- even when the cooking becomes a matter of public record -- the executives keep the profits (and the yachts, and the vineyards) produced by their misleading or fraudulent disclosures.
This is surely one reason why the number of earnings restatements keeps rising, from 50 a year in the early 1990s to well over 200 a year now. Even when uncovered, the "crime" has paid. True, executives who are convicted may be forced to pay restitution. But indictments are extremely rare, even when the legerdemain is blatant. Ask Al Dunlap, the chain-saw CEO who wrecked Sunbeam. The government has only so many attorneys, and proving that an apparent fraud was deliberate isn't easy.
In most cases, until now, the SEC has simply gotten the company to promise not to misstate earnings again. Private plaintiffs are free to sue -- and they do, of course -- but they go after the company and its insurance policy, not the executives. The new Sarbanes-Oxley law enables shareholder attorneys to go after the CEO's, and the CFO's, personal pocketbook.
To see how it might work in the future, let's take the example of Qwest Communications International, a company whose hubris was as lofty as its name. In its salad days, it put out glowing earnings reports. The releases did their job -- that is, they pumped up the stock. Then, the executives did their job -- that is, they sold boatloads of shares. Between 1999 and 2001 they unloaded $500 million worth. That was when telecom was going to the moon. To hear promoters tell it, folks were going to have phones in their bathtubs, phones in their closets, phones in their phones.
Nowadays, things are different. People seem happy with just the phones they've already got. Qwest's stock has fallen to a buck. Oh, and one other thing -- its earnings didn't really glow. The company admitted it improperly accounted for 220 complicated "swap" deals. The deals had a value of $1.6 billion, and helped to persuade investors that the future remained bright even after telecom growth had faded. A probe into other irregularities is ongoing. Meanwhile, the people who bought on the basis of those non-existent earnings are out of luck. And since the errors occurred before the new law was enacted, the executives at Qwest will presumably keep their stash.
For future Qwests, however, it could be a different story. Section 304 of the Sarbanes-Oxley Act, "Forfeiture of Certain Bonuses and Profits," orders the CEO and the CFO to reimburse the company for "any bonus or other incentive-based or equity-based compensation" and "any profits" from selling stock in the 12 months following an earnings release that the company later restated. In other words, if you tilt the market with incorrect information, you forfeit any profits resulting from the tilt.
The clause has two catches, one reasonable and one regrettable. The restatement must be "material." Small errors are permissible. Secondly, the misstated earnings must be "as a result of misconduct."
At Qwest, for example, Oren G. Shaffer, the new CFO, says a "mistake" was to blame. "This is purely and simply an accounting error," he told the press. "These things happen." Right.
Proving Misconduct
How will attorneys prove that "misconduct" and not just an innocent error was the culprit? In an ideal world, they wouldn't have to. The most effective deterrent would be for execs to forfeit profits derived from any material misstatements. The point is not to assign blame -- it is simply to prevent execs from profiting from misinformation that they disseminate, and to remove the incentive for same.
As the new law stands, attorneys will have to prove misconduct. "We'll have a debate over what that means," says John Coffee, a securities expert at Columbia Law School. But, he points out, the statute suggests that it needn't be misconduct by the CEO or CFO -- just by someone. That ought to be enough for plaintiff's attorneys to build a case -- and, more importantly, for CEOs and CFOs to want to get their disclosures right the first time. Nothing hurts like giving the money back -- maybe not even telling the truth.
Mr. Lowenstein, author of "When Genius Failed: The Rise and Fall of Long-Term Capital Management" (Random House, 2000), is writing a book on the Wall Street bubble.
...or fancy.
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