Enron, One Year Later
One year ago, the Enron Corporation filed for Chapter 11 bankruptcy protection. Little did anyone know what was to follow: bankruptcy filings by Kmart (Jan. 22), Global Crossing (Jan. 28), Adelphia (June 25), and finally WorldCom (July 21), the largest bankruptcy in U.S. history.
This is not to mention the deluge of other corporate scandals including Bristol-Myers (under investigation for inflating revenues by $1 billion), Qwest (using swaps to inflate revenue by $950 million), and Xerox (forced June 28 to restate $6 billion in revenue across 5 years).
Worse were stories about outrageous perks going to top executives, even apart from the $33 million Enron CFO Andrew Fastow reaped from Enron's now-infamous partnership deals. Global Crossing CEO Robert Annunziata received a $10 million signing bonus, $4 million in stock options, and a guaranteed yearly bonus of $500,000. After remaining on the job for just a little more than a year, he received another $2 million just for walking away. Global Crossing was a telecom company that never made a profit and today is the 5th-largest bankruptcy in U.S. history.
The recent graft didn't affect just New Economy companies such as E*Trade, which suffered losses of $241.5 million in 2001 while its CEO Chris Cotsakos pocketed $4.9 million in salary plus bonus, a $15 million forgiven loan, $29 million in restricted stock, and over $9 million in retirement benefits. Old Economy firms such as the now-bankrupt Kmart were also affected. For running Kmart into the ground, CEO Charles Conway picked up a hefty $13.2 million and a $4 million bonus just for leaving.
After having run a home-improvement and then a supermarket chain into the ground, Kmart welcomed Mark Schwartz with open arms and made him its President and COO. He cashed out with almost $11 million. Kmart has laid off 22,000 employees and closed almost 300 stores this year.
Many pundits have attempted to diagnose why such a wave of scandals and record bankruptcies occurred when it did. A typical effort was a cover story in the June 24, 2002 issue of Fortune entitled "System Failure." Despite the promising title, the seven suggestions for reform offered by Fortune's writers lead nowhere. The suggested reforms included having auditors grade the quality of a company's earnings, reducing CEO pay, and making fund managers exercise more power in ownership.
These suggestions fail to address underlying causes. Auditing grades would be subject to "grade inflation." CEO pay seems excessive, but not because the market in managerial talent is not sufficiently regulated (more on that below). Although 75 fund managers control about 44% of the market, it's absurd to expect them to re-make Corporate America. First, fund managers have a short-term perspective because their job is to make bets on firms and beat the market. To charge them with the farsighted responsibility for corporate governance is to transform them into something they're not and never will be. Additionally, large corporations are often the clients of the funds holding their shares. Not many fund managers want to cross large clients.
Perhaps the largest of the red herrings is the debate over employee options expensing. Getting exercised over the issue are some impressive names, including Warren Buffett and Nobel-winning finance professor Robert Merton. Merton et al. focus on the pedantic issues of the expense vs. status quo debate. Should options be expensed? Yes, but this question begs another as to why options have become such a large portion of current top-executive compensation.
The real macro focus (apart from the Fed) should be the "agency problem," the problem of management not having the incentive to efficiently use stockholder funds. Agency problems definitely played a major role in recent scandals, especially given that the wave of corruption was almost completely isolated to corporations, not proprietorships and partnerships. Business per se in America hasn't been shown to be corrupt.
The agency story begins in the 1960s, after the U.S. economy entered a long postwar expansion. With Europe and Asia's economies being rebuilt after World War II, American corporations rose to prominence in the world with relatively few international competitors. This ascendancy made agency problems in American companies conspicuous. While some managers ran companies in owners' interests, maximizing production and shareholder returns, others used shareholder funds to buy themselves gold desks, frequent and unnecessary junkets to meetings in warm climes, and secretaries who looked like supermodels but could only type five words per minute.
Takeover investors saw an economic gain to be made in booting the managerial frat boys who were living it up at shareholder expense. The result was the Saturday Night Special, a quick takeover that (according to some sources) got its name from deals where bidding for stock shares could begin late in the week with a new board and management team in place at the target company by Monday morning.
The prospect of getting a swift boot didn't sit well with the old corporate guard, so it lobbied Congress to pass the Williams Act of 1968. Williams required an investor buying more than 5% of a target firm's shares to file a statement 13(d) with the SEC within 10 days, disclose the takeover investor's identity, the source(s) of funds financing the takeover, and what the takeover investor's intentions were with the company (control, liquidation, or passive investing). Also, tender offers had to be held open for at least 20 trading days. Williams ended up dramatically increasing the premium takeover bidders had to pay for shares of a target company and hence reduced the economic gains of takeovers.
With Williams in place, all was peaceful at the corporate heights until the early 1980s when investment banker Michael Milken ignited the market in high-yield bonds (derided by some as "junk bonds"). The bonds provided badly needed funds to new companies untested by the market, becoming controversial when they were used to revive hostile takeovers.
Unlike the 1960s takeovers which precipitated Williams (where mostly large, well-funded firms pursued smaller targets), Milken's bond deals allowed small firms to pursue large targets. With Milken's help, Carl Icahn pursued Phillips Petroleum and Henry Kravis captured RJR Nabisco. From 1985-1990, hostile takeover deals added up to about $140 billion, peaking at 46 deals in 1988 but falling to just 2 in 1991.
Why such a sudden and steep decline? The recession of 1990-91 played some part. A likely bigger factor was new state-level restrictions. Ohio enacted a control-share acquisition law. This law nullified the voting rights of stock obtained in hostile takeovers. To win back voting rights, takeover investors had to survive a special shareholder vote more than a month and a half after obtaining shares.
Delaware settled on a merger-moratorium law. This type of law prevented takeover investors who had purchased more than 15% of a target firm's shares from seizing control of the target for up to 5 years. Delaware in particular required that takeover investors obtain over 85% of a target's shares in order to be exempt from moratorium! By January 1991, most states had adopted laws similar to those of Delaware or Ohio. Profitable, quick hostile takeovers were now relegated to the dustbin of history.
The last piece of the agency puzzle explaining the 2001-2002 wave of corporate scandals was a change made in 1993 to the U.S. tax code requiring non performance-based pay for CEOs greater than $1 million per year to no longer be tax deductible. This change strongly skewed the compensation of senior executives toward stock options. Stock options are expensed when the options are exercised whereas grants of stock are expensed when issued. Thus in 1980 stock options comprised less than 20% of the average CEO's compensation but by 2000 they comprised about 63%.
The skewing of pay so heavily toward options is dangerous in terms of the incentives it creates. To top executives, there is no downside to "free" options but there is a huge financial windfall if they can manipulate financial data, get share price soaring (and thus the value of their options soaring as well), and then cash out. The bull market and economic boom of the 1990s hid corporate malfeasance well just as the bear market and current recession have exposed it. The rest is history…
For skeptics on the issue of agency, here's a question to ponder. In which town will consumers on average get a better deal on a new car: a town with one car dealer or a town with twenty? If the answer is twenty, then how are small investors better off with only one management team to choose from to run their companies? They're not, no more than Cuban or Iraqi voters are better off with only one choice of candidates in their presidential elections. One major lesson of Enron et al. is that significant corporate corruption will end when one-party rule of Corporate America does. Until then, expect more Enrons.