Infectious Greed

by Frank Partnoy

  Welch could barely contain himself in public, stammering, “This reprehensible scheme . . . has all of us damn mad.” When a Wall Street Journal reporter asked Welch to respond to comments that he had lost his management touch, he shot back, “Who says that? Be sure and quote them by name.”116

  Welch immediately hired Gary Lynch, the former Securities and Exchange Commission enforcement lawyer who—in another demonstration of how little the circles of Wall Street extended—had investigated Kidder Peabody’s Martin Siegel during the 1980s. When asked whether Kidder should have tighter controls, Welch—referring to Lynch—snapped, “I’m paying a lot of bright people a lot of money to find out.”117

  After firing Jett on April 17, Cerullo left Kidder in July with a $10 million severance package, only $50,000 of which he paid to the SEC to settle the case against him (he didn’t admit liability and was barred from the industry for one year).118 Mullin resigned the next month, and Kidder suspended several other officials. Welch had no more patience for his tarnished bond-trading firm—which no longer was the number one or two business in its area. He quickly sold Kidder to PaineWebber, which kept some of Kidder’s employees and assets, but deleted the firm’s name.119 Twenty-five hundred employees were offered a harsh severance package that included just two weeks’ pay for each year of employment, and that required them to agree not to publish any books related to their experience.120

  Lynch’s report criticized Kidder’s lax oversight, and described a culture in which employees were unwilling to ask questions about a successful rising star. It focused the blame on Jett, and didn’t criticize Jack Welch or General Electric. Several senior partners from Lynch’s law firm had spent months working on the report, billing huge numbers of hours. For GE, it was worth every penny.

  Welch later admitted that he and his managers hadn’t really understood Kidder’s business. In one interview, he described getting into a business they didn’t understand, and stressed the importance of culture: “Culture counts. When I got into one I didn’t understand, we screwed it up. We were lucky it was small enough. We sold it and got out. And got out alive. But it could have eaten us up if it were a bigger thing.” Not surprisingly, Welch didn’t focus on Kidder or Jett in his 2001 autobiography, except to note that when he learned of the losses, he vomited.

  Jett remained a mystery. If he had intended to engage in a fraudulent scheme, he had done so very foolishly. Jett had conducted his trades openly on Kidder’s accounting system, which many other traders used and numerous employees could access. Jett also had recorded the trades in large “red books,” ledgers he kept on his desk. He even had helped Kidder’s auditors with inquiries into his trading (they said Jett “was more helpful than most other managers”).121 Jett also had kept all of his cash bonuses—millions of dollars—in accounts at Kidder, where they were immediately frozen when his bosses discovered the losses. By 1996, Jett was down and out, moving from one friend’s apartment to another, unable even to afford the $500-a-month rent for a tiny studio in Hell’s Kitchen, spending most of his time preparing his legal defense.122

  Jett ultimately was acquitted of securities fraud, showing how difficult it was for prosecutors to send any participant in an alleged fraudulent financial scheme to jail. (He was found guilty of the lesser charge of false record keeping and fined $200,000.) Jett also avoided damages from civil lawsuits, which General Electric settled for $19 million. Ironically, the publicity surrounding Jett’s failed prosecution enabled him to revive his career. He became the chief investment officer of a multimillion-dollar offshore investment fund, which even advertised Jett’s experience at Kidder Peabody managing “roughly 10% of the assets of Kidder’s parent, General Electric.” If you are impressed by this, and want to invest your money with Jett, you can do so at www.josephjett.com.

  The collapse of Kidder Peabody raised troubling new questions. It seemed virtually impossible to design a system of controls that would catch a rogue trader. Although Jett’s remarkable turnaround might have generated suspicion in a different industry, it was very common for traders to find a new product or strategy that produced unusually large returns. How could a manager tell if Jett was different from one of John Meriwether’s traders at Salomon?

  Even more troubling, the structure of Wall Street compensation seemed to encourage traders to take excessive risks, or even to defraud their firms. In cataloguing many of the instances of “rogue trading” during this period, Professor Jerry W. Markham noted that traders were motivated to expose their firms to as much risk as possible to maximize their own compensation: “There is very little downside when taking on more risk, and the upside is much greater. There is also little motivation to protect the firm’s capital from excessive risk. The trader is motivated to be successful, but that motivation lends itself to taking on risk and earning short-term profits, even if this requires illegal or improper conduct.” 123 Consider Jett’s financial incentives. In his short time at Kidder, his compensation grew from $5,000 to $2.1 million to $9.3 million. He was a poster child for traders looking to make a quick buck.

  In July 1994, international regulators from the Basel Committee of international supervisors had warned banks not to tie the bonuses of derivatives traders too closely to their profits, because such links could create excessive risks.124 But, as usual, the banks ignored the regulators. If they took any message from the fiascos of 1994, it was that they needed to link compensation even more closely to performance. Traders who reported huge profits would make millions; traders who did not report huge profits would be fired.

  Finally, Jett’s losses exposed how much companies such as General Electric depended on high finance. Treasurers of industrial companies had begun operating as profit centers, taking on huge risks, and receiving compensation based on their success. Many treasury officials believed that they should not tell their managers about the risks they were taking on, in order to preserve their flexibility.125 Just as the managers of banks had lost control over their traders, the CEOs of major companies were losing control over their treasury operations.

  Shareholders of these companies were just as ignorant of their treasurers’ activities as the residents of Orange County had been of Robert Citron’s. Companies weren’t about to tell their shareholders about these practices, either. More than a third of CEOs surveyed by Fortune magazine said they thought shareholders were being told enough already.126

  SEC chairman Arthur Levitt ended his term unconcerned with the question of which company would be next, largely oblivious to the revolution in markets that had occurred under his watch. In one final interview with Hal Lux, senior editor of Institutional Investor, Levitt arrived in the midst of his Christmas shopping, loaded with packages from expensive Madison Avenue boutiques.127When Lux asked him what his legacy was, as the longest-serving SEC chair in history, Levitt was hard-pressed to come up with an answer: “investor education” was the best he could do, although he did mention several failed initiatives. (Later in the interview, he mentioned Regulation FD—the rule that prohibited senior managers from selectively disclosing non-public information to securities analysts—as one of the “landmark attainments of this Commission,” saying, “I don’t know why I forgot that.”) Levitt admitted that it had been a mistake for him to recommend his chief of market regulation, Richard Lindsey, for a job at Bear Stearns while the SEC was supposedly conducting a serious investigation into that firm’s clearing unit. But, throughout a lengthy and substantive interview, covering many topics—including the challenges facing his successor—he did not mention derivatives.

  For more than seven years, Arthur Levitt was a long-standing sideshow to the Clinton administration. Levitt’s interaction with Clinton was, in his words, mostly “social.” President Clinton—a notoriously prolific letter and memo writer—had written only one note to Levitt in all that time: a one-liner about an article in the New York Times.128

  In contrast to Levitt, Mark Brickell—the ISDA lobbyist from J. P. Morgan—rema
ined engaged in the issues, and continued his run of successes, arguing on July 22, 2000, to the House Banking and Financial Services Committee, that swaps should be permanently exempt from regulation because of their custom-tailored nature. In reality, most swaps were not custom tailored and, instead, were as standardized as government bonds. Nevertheless, the permanent exemption became Congress’s “farewell gift” to the derivatives industry, on its last day of the session in December 2000, during the heat of debate about the Florida ballots in the presidential election.

  As luck would have it, at this hearing Brickell was seated next to Shawn Dorsch, cofounder of Blackbird Holdings. Blackbird had been trading derivatives on a high-tech, Internet-based system since September 1999. It held seventeen patents pending, more than many biotechnology and pharmaceutical firms, and experts regarded Blackbird—and other automated systems like it—as the future of financial trading, and the enemy of Wall Street. Compared to most derivatives dealers, Blackbird had superior technology and significantly lower costs. Brickell and Dorsch found common ground, and Brickell agreed to oppose Wall Street for the first time since the 1970s, by signing on as CEO of Blackbird.

  William O. Douglas, Supreme Court justice and SEC chairman, had famously advised that, in financial markets, “Government should keep the shotgun, so to speak, behind the door, loaded, well oiled, cleaned, ready for use.” With Levitt and Brickell in charge, the shotgun, now 60 years old, had gone missing, empty of shot, dry, and dirty.

  Douglas had understood that there were certain inevitable risks associated with a market economy, and some firms and individuals would end up bearing those risks. As William Donaldson, chair of the NYSE (and future nominee to chair the SEC), put it in 1992, “No matter how much hedging is done, somebody winds up holding the hot potato when the music stops.”129 The goal of the law was to ensure that the people who could best bear the risks would, in fact, end up bearing them, so that the hot potato landed in the right place. But as the derivatives markets were beginning to show, risks in modern financial markets were moving in the opposite direction, migrating progressively to less sophisticated investors: first, Bankers Trust, First Boston, and Salomon Brothers; now, Procter & Gamble, Piper Jaffray, and General Electric.

  The deregulatory response to the losses of 1994 led to two dramatic changes in financial markets. First, corporate executives in the United States became much more willing to “cook the books,” inflating income and hiding expenses. At first, many of these accounting schemes were relatively simple, short-lived, and easy to understand. Most executives—especially those willing to commit accounting fraud—did not yet comprehend how recent financial innovations could be used to further their schemes. (In other words, the really big trouble was still a few years away.)

  Second, financial innovation moved abroad. In foreign venues, the risks of these instruments spread in fantastic and unanticipated ways, leading to several market crises in Latin America, Europe, and Asia.

  The first set of changes—the wave of bald-faced accounting fraud in the United States—is covered in the next chapter. The second set—the migration of financial innovation abroad—is covered in Chapter 8.

  7

  MESSAGES RECEIVED

  The regulatory changes of 1994-95 sent three messages to corporate CEOs. First, you are not likely to be punished for “massaging” your firm’s accounting numbers. Prosecutors rarely go after financial fraud and, even when they do, the typical punishment is a small fine; almost no one goes to prison. Moreover, even a fraudulent scheme could be recast as mere earnings management—the practice of smoothing a company’s earnings—which most executives did, and regarded as perfectly legal.

  Second, you should use new financial instruments—including options, swaps, and other derivatives—to increase your own pay and to avoid costly regulation. If complex derivatives are too much for you to handle—as they were for many CEOs during the years immediately following the 1994 losses—you should at least pay yourself in stock options, which don’t need to be disclosed as an expense and have a greater upside than cash bonuses or stock.

  Third, you don’t need to worry about whether accountants or securities analysts will tell investors about any hidden losses or excessive options pay. Now that Congress and the Supreme Court have insulated accounting firms and investment banks from liability—with the Central Bank decision and the Private Securities Litigation Reform Act—they will be much more willing to look the other way. If you pay them enough in fees, they might even be willing to help.

  Of course, not every corporate executive heeded these messages. For example, Warren Buffett argued that managers should ensure that their companies’ share prices were accurate, not try to inflate prices artificially, and he criticized the use of stock options as compensation. Having been a major shareholder of Salomon Brothers, Buffett also criticized accounting and securities firms for conflicts of interest.

  But for every Warren Buffett, there were many less scrupulous CEOs. This chapter considers four of them: Walter Forbes of CUC International, Dean Buntrock of Waste Management, Al Dunlap of Sunbeam, and Martin Grass of Rite Aid. They are not all well-known among investors, but their stories capture the changes in CEO behavior during the mid-1990s. Unlike the “rocket scientists” at Bankers Trust, First Boston, and Salomon Brothers, these four had undistinguished backgrounds and little training in mathematics or finance. Instead, they were hardworking, hard-driving men who ran companies that met basic consumer needs: they sold clothes, barbecue grills, and prescription medicine, and cleaned up garbage. They certainly didn’t buy swaps linked to LIBOR-squared.

  And yet they were at the center of financial schemes that were even bigger than the derivatives scandals of 1994.

  Over time, commentators dismissed these four CEOs, and dozens like them, as just “bad apples.” But the metaphor is false, as abundant evidence and economic theory show. Instead, the stories of these four men symbolize a cultural change among corporate executives during the 1990s that flowed predictably—even inevitably—from the earlier regulatory changes. The apples fell because the tree was rotten.

  This claim may seem counterintuitive at first. Most investors had supported the regulatory changes of 1994-95 to deter specious litigation, and there was evidence that, paradoxically, even more securities lawsuits were being filed under the restrictive 1995 securities law.

  Moreover, economists had long argued that corporate executives would never systematically take advantage of investors, because their reputations would be destroyed if they did. As the argument went, CEOs would secure reputations for honesty and hard work by keeping accurate books, refusing overly generous options pay (or at least disclosing the options they received), and hiring only independent accountants and bankers, regardless of changes in law. If they failed to do these things, investors would flee the company’s stock, and when the stock price dropped, the CEOs would lose their wealth—and their jobs. In other words, CEOs were rational economic actors just like any other member of the species homo economicus; they avoided fraud for the same reason they avoided any other bad business decision: it didn’t pay.

  It became clear during the 1990s that this argument, although perhaps sound in theory, was wrong in practice. CEOs manipulated their companies’ earnings, paid themselves huge amounts of options, and established cozy relationships with their accountants and securities analysts, but they did not acquire bad reputations—at least not until several years later. Instead, CEO reputations—at least in the short run—depended almost entirely on the performance of their firms’ stock prices, which in turn depended on whether CEOs were able to meet the quarterly expectations of analysts, and do so—on television—with a charming smile. Few investors or analysts paid attention to the details of particular business units or financial disclosures. As The Economist magazine put it, “it was easier to follow the jockeys than the form.”1

  Investors trusted the charismatic CEO who assured them earnings would be up next quarter, an
d then announced he had beaten the earlier target by a penny a share. If the CEO told a good story (think Michael Armstrong of AT&T, Kenneth Lay of Enron, or Jack Welch of General Electric), investors flocked to the stock. When the stock price went up, the CEO became even more alluring, and more investors joined in, all regardless of what the company actually was doing, and regardless of whether the company’s reported numbers were accurate.

  Although some economists insisted that such an irrational cycle was impossible—just as they previously had insisted that arbitrage opportunities did not exist, and that no $20 bills were lying on the ground—a new group of academics were creating a new field, called behavioral finance, to describe the mountain of evidence inconsistent with classical theory.2 According to these new theories, stock markets weren’t efficient—not even close—and stock prices could (and did) diverge wildly from reality. Arbitrageurs who sold overpriced stocks wouldn’t close the gap between perception and reality, because anyone betting against a company that could artificially inflate its earnings for several years would likely go broke before the scheme unraveled.

  Previous chapters of this book have tracked the spread of risk from a few Wall Street traders to hundreds of less sophisticated money managers. As companies recovered during the aftershock of the losses of 1994, many of them temporarily abandoned these complex financial innovations (although plain-vanilla derivatives markets, overall, continue to grow, especially outside the United States). With a few notable exceptions, the financial innovations described in the first chapters of this book lay dormant during the mid-to-late 1990s, and did not figure prominently among the major accounting frauds of the period.

  Instead, at this point, the major changes in financial markets took a new turn. The financial virus spreading through the markets, which previously had involved primarily new risks, broke through a significant barrier and began to involve new methods of deceit. This was the beginning of the time Alan Greenspan was referring to when he told the Senate Banking Committee in 2002, “An infectious greed seemed to grip much of our business community.”