BOOK REVIEW

Take On The Street
by
Arthur Levitt

FUTURECASTS online magazine
www.futurecasts.com
Vol. 5, No. 3, 3/1/03.

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The Wall Street jungle:

 

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  Both government and corporate interests lust for the public's pension and investment funds, former SEC Chairman Arthur Levitt, writing with Paula Dwyer, sharply points out right from the beginning. Unless individual officials - like his father, Arthur Levitt, Sr., when N.Y. State Comptroller - make determined stands against powerful political and corporate interests, trust funds - both public and private - are always at risk.
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  From early in his career, the author learned that, "when it comes to protecting investors, no political party has an edge over the conscience of an honest public servant." During his 28 years on Wall Street, he also learned that:

  • Lobbyists for even the most narrow special interests always "cloak business benefits in the garb of some supposed public good."

  • While most brokers he encountered "were good, honest and intelligent business people, - - - their primary motivation came from a compensation system that rewarded them for the number of transactions they executed, not on how well client portfolios performed."

  • To get lucrative municipal bond underwriting business, brokers had to "pay-to-play" by purchasing tables at political fund raisers.

  • To get investment banking business from companies, brokers have to demonstrate an ability to "get the word out" by favorable "buy" recommendations from their analysts - and to place the issuer's securities offerings in the accounts of their brokerage clients. "I can recall no sell recommendations - there must have been some - during my years with the firm."

  • Corporate CEOs routinely gave insider information to cooperating brokerage firms.

  • However, this information was deployed for the benefit of the broker's major clients, not the small retail client. Small investors quickly came to believe that they "will always play second fiddle to large institutions and people in the know."

  "What I witnessed was just the tip of the iceberg. The web of dysfunctional relationships among analysts, brokers, and corporations would grow increasingly worse over the coming decades, and ending it would be one of my primary goals at the Securities and Exchange Commission."

There is no interest in changing brokers' compensation so that it is based on their client's returns rather than on the number of transactions.

  There are two cultures on Wall Street.

  "One rewarded professionalism, honesty, and entrepreneurship. This culture recognized that without individual investors, the markets could not work. The other culture was driven by conflicts of interest, self-dealing, and hype. It put Wall Street's short-term interests over investor interests. This culture, regrettably, often overshadowed the other."

  There is no interest in changing brokers' compensation so that it is based on their client's returns rather than on the number of transactions.
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CEOs were paying more attention to managing their share price than to managing their business.

  When Levitt became SEC Chairman during the 1990s bull market, he became increasingly concerned with the dysfunctional side of Wall Street.

  "For instance, many CEOs were paying more attention to managing their share price than to managing their business. Companies technically were following accounting rules, while in reality revealing as little as possible about their actual performance. The supposedly independent accounting firms were working hand in glove with corporate clients to try to water down accounting standards. When that wasn't enough, they were willing accomplices -- helping companies disguise the true story behind the numbers. With one-third of accounting firm revenues coming from management consulting in 1993 -- that proportion would balloon to 51 percent within six years -- it was hard not to conclude that auditors had become partners with corporate management rather than the independent watchdogs they were meant to be."

  In addition, there was an "unholy alliance" between analysts at brokerage houses and the corporations they were following. This alliance was designed to produce "revenue for the analyst's firm but hardly any benefits for most of their clients." At the NASDAQ and the NYSE, collusive practices siphoned vast sums from investors and protected institutional interests.
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  While mutual funds and pension funds did use their size and financial muscle to get good information and service, "they had their own, more subtle, ways of taking investors money through a confusing array of fees." They spent billions advertising past results, but offered no explanation of such important factors as how much fees, taxes, and portfolio turnover reduced returns.
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Washington power games:

  As soon as Levitt became SEC Chairman, numerous CEOs, analysts, brokers, and Wall Street officials urged him to move against the business conditions that promoted these excesses. "They wanted me to stop it, even though they were beneficiaries."
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Many Wall Street insiders wanted positive reforms - even though they were the beneficiaries of the increasing excesses.

  Levitt was not just a Wall Street insider. As owner of "Roll Call" - the only newspaper dedicated exclusively to coverage of Capitol Hill - and experience with an array of business associations - he was also well connected politically and thought he knew the ropes.

  "Once I began pursuing my agenda, however, I saw a dynamic I hadn't fully witnessed before: the ability of Wall Street and corporate America to combine their considerable forces to stymie reform efforts. Working with a largely sympathetic, Republican-controlled Congress, the two interest groups first sought to co-opt me. When that didn't work, they turned their guns on me."

Political pressure from members of cognizant Congressional committees and from many other Congressmen and Senators stymied other reform efforts.

 

 "None was a more formidable foe than Senator Joe Lieberman of Connecticut."

 

The "long term national interest in honest, transparent accounting" was sacrificed on behalf of some narrow special interests of the moment."

 

 

  He was forced to back down on proposals to expense stock options in the income statement so as to reveal their true cost. His efforts to warn about the froth in the roaring bull market were generally disparaged - or condemned. Political pressure from members of cognizant Congressional committees and from many other Congressmen and Senators stymied other reform efforts.
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  The author relates the power games played by special interests and their lobbyists in Washington. Business, labor, bankers, brokers, accountants and many others have powerful lobbyists and associations - but nobody speaks in Washington for the investor.
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    Levitt mentions GOP Representatives Tom Bliley and Billy Tauzin - successive Chairmen of the Energy and Commerce Committee - as prominent among those lawmakers who intervened to thwart SEC efforts to protect investor interests and assure reporting transparency. However, when the Enron scandal broke, Tauzin conducted hearings at which he could display his extreme indignation with Enron and its auditors.
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  Other lawmakers mentioned by Levitt for obstructing SEC rulemaking efforts are GOP Senator Mike Enzi and Dem. Senators. Chuck Schumer, Evan Bayh, Bob Torricelli - and especially, Joe Lieberman. "None was a more formidable foe than Senator Joe Lieberman of Connecticut."
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  Lieberman in 1994 blocked an accounting stock option reporting rule. As late as 2001, Lieberman, with GOP Senator Spencer Abraham, blocked an accounting rule for amortizing "good will" arising from mergers and acquisitions. The "long term national interest in honest, transparent accounting" was sacrificed on behalf of some narrow special interests of the moment - interests of special tech companies and accounting firms that were major contributors to political campaigns and powerful voices in communities across the country.
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  Lawmakers mentioned as frequently supporting investor interests include Dem. Senators Carl Levin and Paul Sarbanes, GOP Senators Susan Collins and Judd Gregg, Dem. Congressmen John Dingell and Ed Martin.
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Corporations, auditors, investment analysts, and brokerage houses had colluded to assure short term spikes in share prices so corporate insiders could sell their options for huge gains. Boards of directors and audit committees routinely approved financial reporting that couldn't be understood.

  Publicity in the press frequently countered this pressure and permitted the SEC to successfully pursue cases against abusive practices in the NASD, the NYSE, and the municipal bond market. New SEC rules improved auditor independence and banned selective disclosure of insider information. Levitt also initiated extensive efforts to educate the investing public and thus gain countervailing political pressure against the lobbyists.
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  However, the corporate scandals that broke after he had left the SEC indicated that not enough had been done. Corporations, auditors, investment analysts, and brokerage houses had colluded to assure short term spikes in share prices so corporate insiders could sell their options for huge gains. Boards of directors and audit committees routinely approved financial reporting that couldn't be understood. Finally, Congress was forced to act to create an accounting oversight agency.
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  "Despite Congress's belated lurch toward reform, only a few lawmakers truly care more about individual investors than about their corporate patrons." The SEC budget has been routinely short changed.
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Corporate disclosure abuses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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  The reforms that Levitt favors include the strengthening of the boards of directors and the key board committees, and the imposition of various requirements on them.

  The simple fact of the matter is that you invest in management more than in businesses or assets. As FUTURECASTS has repeatedly pointed out, if you invest in a company with incompetent, reckless or corrupt management, you have made a bad investment, and no amount of institutional oversight will save you. However, increasingly strict oversight requirements will add additional costs onto all companies, including those run in the shareholders' interests by honest and competent management - which even in the 1990s included the vast bulk of corporations in the U.S.
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  FUTURECASTS emphasizes yet once again that much of the frenetic pursuit of capital gains and options is driven by powerful noxious incentives in our incredibly destructive tax laws which penalize dividends and ordinary earnings.
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  FUTURECASTS has also repeatedly pointed out that one of the functions of recessions is to collapse the "houses of cards" that inevitably proliferate during periods of prosperity and bull markets. The duration and vigor of the 1990s bull market permitted an inordinate number of these dysfunctional corporations to arise and grow to vast extents. The unreliability of brokerage house analysts should be a surprise to nobody.
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  However, the extent to which the major auditing firms had become corrupted frankly came as a surprise considering the publisher's extensive experience with members of these firms in prior decades when rigid ethical standards prevailed. The increasing incomprehensibility of balance sheets in response to ever denser rule-based accounting standards should have been a warning sign.

  It is the competitive securities markets that have driven the most positive changes, Levitt knowledgably points out.

  "The most positive changes have come at investors' behest, not as the result of new laws and rules. Under pressure from pension and mutual funds, companies are disclosing more detail in their earnings reports and letting shareholders vote on stock option plans. Some companies have decided not to use their auditors as consultants any longer. And many investors are avoiding the stock of companies with aggressive accounting, especially the kinds of off-balance-sheet devices that destroyed Enron."

  As the author wisely notes, "no regulator can provide total protection against fraud." Only the investor can protect himself by avoiding corporations with dubious management practices. Levitt's book provides them with knowledge that will help in that essential task.
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Broker and adviser abuses:

  Brokerage firm conflicts of interests and abuses of trust are covered in some detail. Retail brokers, online brokers, and their analysts are all subject to various temptations.
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  Many brokerage firm advisers used buy recommendations "as bait to win business for their firm's investment bankers" even though they considered the stock to be "junk" or "crap" or "dogs." Some punished companies by downgrading their shares if they went elsewhere for investment banking services.
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  Rules have since been tightened, but analysts and their compensation have not yet been completely separated from investment banking business. Celebrity analysts Mary Meeker and Henry Blodget are especially harshly criticized by Levitt.
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Even with new regulatory rules, analysts are still being used to facilitate investment banking business.

  Television financial shows and news channels - Wall Street Week, CNBC, CNNfn, Fox News - refused to require guest analysts to reveal their conflicts of interest. This has now changed. But even with new regulatory rules, analysts are still being used to facilitate investment banking business.
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  Levitt advises investors to do their homework - and pay more attention to investment advice that is independent - such as from the "Value Line Investment Survey," S&P's "Outlook," "Dow Theory Forecasts," "Dick Davis Digest," and analysts from Prudential Securities.

  "No matter how strictly the NASD and NYSE end up enforcing their new rules, analysts who are paid according to the deals they bring their investment banker colleagues will find it hard to say negative things about companies that are, or someday could be, clients."

A broker, after all, is a sales person who may want you to succeed, but makes his living buying and selling securities.

  Levitt offers advice on investment strategy - especially for pension account investments. Small investors should just buy index funds - and larger investors should get a professional investment adviser - a "certified financial planner."
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  However, these, too, have varying levels of competence, prudence and ethics. These, too, can have conflicting interests, and the author offers advice on how to spot them.  Some information is available about individual advisers on the web. (However, as with corporate management, it is the individual investor's inevitable responsibility to evaluate competence, prudence and ethics of their advisers.)
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  Levitt thinks highly of the approach of regional brokerage house Edward Jones, which does no investment banking - doesn't offer exotic or speculative securities - doesn't sell in-house mutual funds - doesn't pay up-front bonuses to attract star brokers - trains its own new brokers - and stresses long term investing. He offers common sense advice on managing a relationship with a broker - who even at best, after all, is a sales person who may want you to succeed, but makes his living buying and selling securities.
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  He also gives standard advice about doing your investment homework and devising and following an investment plan - and investing for the long term.
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Accounting abuses:

  Accounting rules have proliferated to the point where they undermine disclosure requirements. (Houdini loved complex knots - the more complex the knots, the more wiggle room he could find.) Few people can any longer understand a balance sheet - and opportunities to mislead even the experts have proliferated.
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  As SEC Chairman, Levitt had to switch his investments to government bonds or mutual funds. He, too, noticed that mutual fund financials were impossible to understand even with his extensive financial background. "Impenetrable legalese" made them meaningless - the unintended but inevitable consequence of the combination of "rigid rules" and high risks of legal liability. At Levitt's urging, some funds now provide a "profile" written in "plain English" that summarizes their performance, investment style, and risks.

  The federal securities law emphasis on disclosure has been a huge success and a major economic asset for the nation. Anything that increases the accuracy, sufficiency, timeliness and reliability of pertinent information strengthens market systems.
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  The effort at improvement must be ongoing - but it must be kept in mind that not every "reform" is an improvement. Efforts to achieve perfection will be counterproductive - since the art of accounting is incapable of anything approaching perfect precision. Legal ramifications for mistakes will induce caution in the vast majority of conscientious management. Caution can cut off the disclosure of forward estimates - the most useful of investment information.
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 And, there will always be powerful interests seeking to find ways to circumvent the basic requirement for transparent reporting and to undermine disclosure requirements. They will wrap their efforts at regulatory alteration in the cloak of "reform."

Mutual fund abuses:

  The sins of mutual funds are manifold. The primary sin is a lack of meaningful disclosure that might help investors evaluate fund prospects. How funds have fared in the previous year or two is of little help in predicting future performance.
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There is generally a lack of meaningful disclosure that might help investors evaluate fund prospects.

  Levitt also criticizes such practices as:

  • "Front running," where fund personnel purchase stock for their own account then use fund monies to bid up the price of the stock so it can be sold at a profit.
  • Allocation of attractive initial public offerings ("IPOs") to particular funds that they want to boost.
  • Accepting low priced IPO shares as personal gifts without disclosure.
  • "Portfolio pumping" by buying large amounts of shares at the end of the quarterly reporting period to temporarily boost the price on shares already held. This is especially potent for promoting new funds that start out with small amounts of assets under investment management.
  • "Herd activity," that leads fund managers to buy the same stocks as other fund managers so they can at least perform as well as their peers.
  • Promoting funds on the basis of previous performance - even though that is an unreliable guide to future performance.

  With mutual fund providers offering an array of various funds, they always have some funds that have done well in the previous year or two that can be touted.

  • Churning - turnover rates for most funds are in excess of 100% per year - increasing transactions costs and tax costs. Studies confirm that performance varies inversely with turnover rates.
  • The payment of fees to brokers and advisers to recommend their funds.
  • Trading with high commission brokers to receive various services in return - "kickbacks" - from the brokers ranging from research to salaries to vacations for fund personnel.
  • Basing compensation on pre tax returns instead of after tax returns.
  • Basing compensation on several different types of funds, including a hedge fund that managers may favor in allocating good investments because of the chance to boost total salaries.
  • Allocating tax liability to all fund shareholders of record even though some of the shareholders invested in the fund just before the taxable transaction. New SEC rules require funds to report their "after tax" returns if they advertise themselves as "tax-efficient" in taking steps to avoid such tax liabilities.
  • Fees that produce expense ratios in excess of 1%, with some ranging as high as 4% of assets each year. The performance of funds with expense ratios of 1.5% or more has been no better than funds with expense rations of 0.5%. "In fact, most researchers have concluded that funds with low expense ratios actually outperform more expensive funds." It's hard to make up for the higher fees charged to the fund. Indeed, Levitt warns, funds with high expense ratios sometimes make more risky investments in an effort to justify their higher fees.

  Levitt advises purchase of index funds and exchange traded shares that mimic the S&P 500 or the NASDAQ 100 large corporations. For regular funds, he advises seeking no-load low fee funds - avoiding fad and volatile sector funds - avoiding "hot shot" managers who are likely to "flame out" - and avoiding funds sponsored by organizations that have had trouble with the SEC. Finding experienced management is, of course, very important.
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Insider information regulation:

  SEC efforts to block trading on material insider information has been ongoing for several decades. These efforts are designed to protect the small investors who are inevitably the last to receive bad news, and to prevent insiders from profiting before good news is released to the public. Under Levitt, the SEC promulgated a new rule that requires companies to disclose new material information broadly rather than initially through a select few analysts.
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Analysts must now do their own homework rather than relying on selective disclosure from the companies that they follow.

  The new regulations restrain primarily the analysts and their favored clients. Analysts must now do their own homework rather than relying on selective disclosure from the companies that they follow. The rule also protects smaller companies from being forced to provide selective disclosure to analysts who otherwise threaten them with a drop in coverage. It "provided investors with a sense of fair play, and protected them from analysts' disingenuous buy ratings."

  Small investors can never be protected from insider trading influences. That's why small investors can't trade short term - but must profit from establishing long term positions in well managed corporations. Insider information will always get out before the proverbial "small investor" hears it.
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  Employees and major customers and suppliers are always alert to whether a corporation's business is waxing or waning. They may know even before the company's Chief Financial Officer. The local businesses in the vicinity of corporate headquarters or other major facilities are always abuzz with gossip about the corporation. Even episodic events - like mergers or major contracts - require so many participants that leakage is common. Markets will always move before news gets out broadly - and before the typical small investor can react.
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  Nevertheless, sharp price increases or declines occurring when unexpected news is properly broadcast indicates that the new SEC "Fair Disclosure" regulation is having some impact on limiting the amount of leakage and limiting some of those who are profiting from the news. The sharpness of these reactions demonstrates, however, that the typical "small investor" has not in fact been protected.
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  Insider trading regulation is more an effort to restrain certain insiders from profiting from their positions than to protect the proverbial small investor. The benefits are transferred to the professional traders who can react fastest to the information, and remain with peripheral recipients of insider information.

Auditing the auditors:

 

Whenever the FASB tried to crack down by tightening accounting standards, it ran into a phalanx of corporate, Congressional, and auditor opposition.

  What went wrong with the nation's auditors - and why the problems weren't fixed - are next explained by Levitt.

  "Over the years, - - - , the standard-setting process had failed to keep up with the games companies play to make their numbers appear better than they actually are. And auditing firms had grown reliant on the money they received by selling consulting services to their audit clients. Whenever the FASB [the Financial Accounting Standards Board - a private sector standard setting organization] tried to crack down by tightening accounting standards, it ran into a phalanx of corporate, Congressional, and auditor opposition."

"By saying that stock options were essential to growth, especially for one particular segment of the economy, these legislators essentially were arguing that transparent reporting should be secondary to other political and economic goals."

 

Unlike real shares of stock, "the options craze created an environment that rewarded executives for managing the share price, not for managing the business.'"

  The Clinton administration and Sen. Lieberman blocked a proposed FASB rule for proper expensing of options.

  "[Lieberman] introduced legislation that would bar the SEC from enforcing the FASB stock-option rule. In addition, Lieberman's measure would strip the FASB of authority by requiring the SEC to ratify every FASB decision, in effect relegating the private sector's standards to mere recommendation. Lieberman didn't stop there. He also sponsored a Senate resolution that declared the FASB proposal a cockamamie idea that would have 'grave consequences for America's entrepreneurs.'"

  Lieberman was joined by numerous Republicans and a smaller group of pro business New Democrats - all of whom were the recipients of large campaign contributions from Silicon Valley firms. "By saying that stock options were essential to growth, especially for one particular segment of the economy, these legislators essentially were arguing that transparent reporting should be secondary to other political and economic goals."
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  The Lieberman resolution passed the Senate 88 to 9 - effectively blocking FASB action. Levitt and the FASB retreated in the face of this overwhelming political opposition. The author, in hindsight, believes he was wrong and should have supported the FASB position. "By 2001, some 80 percent of management compensation was in the form of stock options." Unlike real shares of stock, "the options craze created an environment that rewarded executives for managing the share price, not for managing the business.'"

  "Options gave executives strong incentives to use accounting tricks to boost the share price on which their compensation depended. And as many feared, stock options made corporate earnings look a lot better than they really were."

 

 

Levitt became aware that the major accounting firms were no longer the public's watchdog, but instead had become advocates for corporate clients who employed them for lucrative consulting services as well as for auditing.

 

Prior to restatements and stock price declines, corporate management was able to cash in their stock options at artificially high prices - leaving investors holding the bag. In 1981, only 3 companies had had to restate earnings.

 

The tech industry had become especially dependent on creative accounting to justify the high growth expectations built into their soaring stock prices.

 

The result was that several weaknesses in financial reporting for mergers remain to this day - something investors need to be wary of.

 

 

  Levitt goes on to relate battles over auditor independence - the makeup of accounting oversight bodies - accounting standards for derivative contracts - the premature booking of earnings - and pooling of interests accounting for mergers. He became aware that the major accounting firms were no longer the public's watchdog, but instead had become advocates for corporate clients who employed them for lucrative consulting services as well as for auditing. The use of creative accounting schemes to smooth out or artificially boost reported earnings increased substantially towards the end of the 1990s bull market. As consulting fees expanded, audit fees declined from 70% of accounting firm revenues in 1976 to just 31% in 1998.

    "Auditors, increasingly captives of their clients, would give them the clean audits they wanted, despite lots of chicanery. - - - Consulting contracts were turning accounting firms into extensions of management -- even cheerleaders at times. Some firms even paid their auditors on how many nonaudit services they sold to their clients."

  Of course, eventually, the false earnings figures had to be "restated." (This is not quite impossible with dividend yields. But, dividend yields are statements of fact, whereas earnings are just expressions of opinion. Thus, manipulation of dividend yields is inherently far more difficult and limited.) From 1997 through 2000, about 700 companies had to restate earnings - with stock prices hammered each time. However, prior to these restatements and stock price declines, corporate management was able to cash in their stock options at artificially high prices - leaving investors holding the bag. In 1981, only 3 companies had had to restate earnings.
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  Levitt and the SEC moved aggressively against these abuses, but they were opposed at every step of the way, especially by AICPA [American Institute of Certified Public Accountants] Pres. Barry Melancon and by Harvey Pitt, then a leading attorney representing accounting firm interests and later the Bush administration's short lived appointee as SEC Chairman.
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  The tech industry had become especially dependent on creative accounting to justify the high growth expectations built into their soaring stock prices. They lobbied hard to block SEC efforts to reign in accounting abuses. Cisco Systems CEO John Chambers and venture capitalist John Doerr are particularly mentioned by Levitt. Senator Phil Gramm used the Senate Banking Committee to put pressure on the SEC and FASB. The Clinton administration kept hands off on this issue. But the result was that several weaknesses in financial reporting for mergers remain to this day - something investors need to be wary of.
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  The major accounting firms fought hard against proposed SEC auditor independence rules that separate certain consulting services from auditing. Levitt asks: How can you audit your own work? A wide variety of legislators responded by joining the obstructionist efforts. Senators Evan Bayh, Ron Wyden, Rod Grams and Rick Santorum are mentioned by Levitt. Senator Richard Shelby and Congressman Henry Bonilla threatened to attach riders to an appropriations bill cutting off SEC funding for enforcement of any audit independence rule.
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  The SEC can't fight its Congressional masters.  The final rules do prohibit auditors from performing such services as keeping the books, providing appraisals, acting as a broker, and managing the audit client's human resources.

  "But we gave up considerable ground on the two biggest issues. The final rules allow an unlimited amount of IT consulting to audit clients, though there are some restrictions. Auditors cannot, for example, make management decisions on the types of financial information a client's computer system will capture and cannot actually operate a client's IT system. The final rule also allows auditors to perform up to 40 percent of a company's internal audit work, and it exempts companies altogether if they have less than $200 million in assets."

  In these instances, the auditors are in fact auditing their own work - a practice that reeks of conflict of interest.
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  The disclosure requirements of the rule - revealing how much auditors earn from non audit work - provide some warning of lack of auditor independence. The flood of accounting scandals flowing from the recession soon thereafter demonstrated the massive extent of the failures. Investors lost $60 billion in the Enron scandal - but Enron executives made $1.2 billion by cashing in their options while the share prices were being kept artificially high by creative accounting.

  Of course, some horror stories will always be with us - especially as periodic recessions perform the necessary task of collapsing the houses of cards that inevitably proliferate during prosperous times. Inevitably, there are many - all too many - true innocents who are badly hurt.
  However, equities are not called "risk capital" for nothing. It is precisely the stockholders who are supposed to bear these risks. That's why they get the lions share of the rewards for corporate success. That's just one reason why equity investors are supposed to diversify.
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  Even so, the damage caused by these scandals is always grossly overstated - as if every individual shareholder bought at the top and was entitled to be able to sell precisely at the top. Nor should one sympathize much with the individual stock purchaser who greedily invested in high p/e ratio stocks - the very definition of high risk speculative investment.
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  Fiduciaries who invest pension and similar trust funds in high p/e ratio stocks should clearly be viewed as violating their duty of care. What excuse can there be for chasing uncertain capital gains by investing tax advantaged pension funds in high p/e ratio stocks when dividend or interest income can be received reliably and without tax consequences?

Reading financial statements:

  Investors should examine certain key aspects of financial statements filed with the SEC - available at www.sec.gov - under the EDGAR link. The author provides advice as to what to look for. He explains the balance sheet, the income statement, and the cash-flow statement.
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  Balance sheet warning signs include:

  • Inventories and receivables growing substantially faster than "sales" or "revenues." This indicates a variety of weaknesses that may eventually force write-downs of these assets when the situation becomes too bad to ignore.
  • Ratio of long term debt to total invested capital - debt and equity together - above 20% is considered high - threatening the ability of the firm to survive the next recession.
  • Total debt - long term and short term - substantially above cash levels is a rough measure of higher risks.

  Income statement elements that require careful evaluation include:

  • Revenues - which may be affected by creative accounting in determining when revenue may be recognized for performance due in the future.
  • Operating expenses - which indicate how well management is controlling its overhead costs.
  • Research and development - which may be either too high or too low. If it is substantially above the level for similar companies as a percentage of revenues, it may indicate a failure to manage R&D wisely. If it is dropping fast, it may indicate panic cost cutting. Revenue from new products coming out of the R&D pipeline is also an important indication of management quality.
  • Extraordinary charges and restructuring costs - are a sign of trouble if they appear too often.
  • "Pro forma" operating earnings - are not as reliable as net income derived pursuant to generally accepted accounting principles -"GAAP." Pro forma earnings may more easily be manipulated by creative accounting methods.
  • Return on assets - should be at least 5%.
  • The basic "earnings per share" number - is similarly not as reliable as fully diluted earnings per share.

  "The fully diluted takes into account stock options issued to managers but not yet exercised. It also figures in bonds, preferred shares, and stock warrants that can be converted to common stock, thus causing basic [earnings per share] to drop significantly."

  The cash-flow statement "shows where the money is coming from and how it is being spent." It may indicate creative accounting abuses:

  • If operating cash is suddenly growing significantly slower than reported net income growth; or
  • if net income is substantially different from total cash from operating activities.

  In 2000, Enron showed total sales of $101 billion but only $4.8 billion in cash from operating activities - which included $1.8 billion from one-time sales of assets and $5.5 billion from customer deposits for future sales - without which it had a negative $2.5 billion cash flow - "a sign something is fundamentally wrong."
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  Footnotes are important. They "tell the story behind the numbers." Enron's Special Purpose Entities were revealed in footnotes. Stock options, operating leases, and pension assets and liabilities are disclosed and explained in footnotes.

  "Investors should be aware that footnotes sometimes are purposely obfuscatory, and avoid the stock of companies that seem to be burying gory details. If a footnote seems confusing, there's probably a reason."

Creative accounting:

  Some of the pitfalls of creative accounting are then explained by the author.
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"GAAP has plenty of built-in flexibility that allows companies to take liberties."

  Things that investors need to watch out for include:

  • "Pro forma" income reports - outside GAAP requirements - can make results look better than they are by omitting unusual expenses - all too many of which are not really unusual.
  • "Restructuring charges" - may include various everyday operating expenses that the company wishes to de-emphasize - including ordinary expenses expected in the future - to make the rest of the income statement and future income statements look better.
  • The "smoothing" of earnings trends - may be achieved by delaying income recognition during good times and drawing on it or accelerating recognition during harder times. The manipulation of reserve accounts - for loan losses, warranty costs, and/or sales returns - or the acceleration of shipments to retailers and distributors in return for discounts or cheap financing - are frequently used for this purpose.
  • Manipulation of write downs of excess inventory - facilitates subsequent boosts to earnings by sales of excess inventory at their written down cost levels.
  • Risky financing of customer purchases - to temporarily boost sales and reported earnings.
  • Manipulation of "goodwill" evaluations arising from mergers and acquisitions - can be a major factor. AOL Time Warner carried $127 billion in goodwill on its balance sheet as a result of its merger at inflated stock prices. A huge $54 billion was written off in 2002 - and none of the rest has to be amortized under current rules.
  • Bloated write downs of "in process R&D" ostensibly not expected to realize marketable results - can inflate future earnings when marketable results are in fact achieved.
  • Booking revenues prematurely - inflates sales and earnings for that period.

    As FUTURECASTS has repeatedly pointed out - accounting is a nebulous practical art - a profession not a science - that when professionally conducted provides extraordinarily useful information for commercial purposes - but in no way provides valid economic data - and is completely dependent on the professional standards and abilities of practitioners for its reliability. As Levitt notes: "GAAP has plenty of built-in flexibility that allows companies to take liberties."

The stock markets:

  The development and operations - and abuses of the major U.S. stock markets - the NYSE and NASDAQ and ECNs and other market systems - are explained by Levitt. The SEC now requires all markets and brokers to disclose data that enables investors to evaluate the efficiency of their trade executions.
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Boards of directors:

  He then explains the roles of boards of directors in governing public corporations - how they should operate and how they all too often fall short of how they should operate.
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  While the board is not a part of management, it constitutes the oversight element of the management structure. Most of the board should be independent of management, and all members should have a hefty equity stake at risk in the company.

  It bears repeating: No matter how good a corporation looks on paper, if the management has problems of competence or ethics, the investors have made a bad investment. A conscientious board can limit but can never prevent the damage - and incompetent or unethical management will almost always arrange to have a less than conscientious board.

  Levitt relates a series of corporate governance horror stories going back 40 years. A common component of these events was the failure of oversight by boards of directors - and especially by their audit committees. He relates the long history of efforts to strengthen board oversight - (none of which ever seem to be quite enough). These efforts have been reinforced by recent scandals as companies scramble to regain investor confidence.

  A leader in getting major shareholders - large pension funds and investment funds - to insist on more conscientious boards of directors and more transparent accounting is Robert A.G. Monks, who has provided a pamphlet on the subject: "Capitalism Without Owners Will Fail." He points out that "'cheat proofing' the system through external controls won't work because corporations will outmaneuver new policies through lawyers and lobbyists."
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  A more aggressive approach to reform is "stakeholder" representation on boards of directors, supported by J. Scott Armstrong,  in several articles linked from his web page at http://jscottarmstrong.com

  The author provides web sources for corporate proxy and periodic reports and other governance information. He also explains how to evaluate board independence, commitment, structure, compensation, procedures, and anti takeover provisions.
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Government policies:

  Levitt offers information about the major lobbying agencies and advice on how individual investors can get the information they need and make their voices heard on Capitol Hill.

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Copyright 2003 Dan Blatt