America's business model in crisis

Three opinions

No wonder President George W. Bush looked frustrated when news of WorldCom's monster con game reached the hilltop in Canada where heads of the world's biggest economies were gathering. Long gone are the days when a triumphal American leader could attend these summit conferences and gloat about the superiority of America's home-grown capitalism. Even President Vladimir Putin of Russia was moved to express grave concern about American accounting practices.

WorldCom, the telecommunications giant, reported late Tuesday that it had overstated its operating cash flow by $3.8 billion in the last five quarters, by improperly booking ordinary expenses as capital expenditures to be depreciated over time. Even a child can understand that painting your house is not the same as building a new one, but that basic concept seems to have eluded the people who were paid to keep an eye on WorldCom's books. It's no wonder that Europeans are now beginning to recoil from America's demand that the rest of the world adopt the accounting principles used in the United States.

Coming on the heels of Enron and a slew of other prominent financial scandals, WorldCom's apparent fraud left Washington regulators reeling, as well it might. In a speech Wednesday night, Harvey Pitt, chairman of the Securities and Exchange Commission, quoted the line from the movie "Network": "I'm mad as hell, and I'm not going to take it anymore." Pitt said chief executives of major corporations would now have to certify their companies' financial statements personally, which is a good thing. Echoing the president's vow "to hold people accountable," Pitt said corporate crooks and charlatans would be doing jail time, and that too is fine. Yet there is a lot more that Pitt, who has been accused of being much too cozy with the accounting industry, could do as a policy maker. One obvious move is to issue a blanket rule that auditors cannot provide companies whose books they police with any other services.

The simple nature yet breathtaking scale of WorldCom's deceit raises anew all the Enron questions about the failure of market guardians to prevent it. Was anyone on the board of directors even remotely suspicious? Why didn't the auditing firm, Arthur Andersen, realize that the company was booking false profits? Did high-profile WorldCom boosters on Wall Street give the company's phony numbers a pass because they were eager to win WorldCom's banking business?

One positive byproduct of this seemingly endless parade of companies behaving badly could be a turnaround in Congress. If elected officials have any sense of embarrassment, Paul Sarbanes' sensible accounting reform bill ought to sail through the Senate and prevail over a weaker House version in conference. Certainly if every lawmaker who benefited from campaign contributions from now-discredited companies and financial institutions votes for it, it will be on President Bush's desk quicker than you can say "market fundamentals."

In the meantime, anxious investors are left to wonder what other financial scandals lie around the corner. America's status as the world's ultimate safe haven for investors is looking shaky. The huge inflow of foreign capital, $400 billion a year, has been a key factor in the country's recent prosperity. Two-fifths of all Treasury bonds are in foreign hands. An erosion of confidence in the United States could accelerate the dollar's recent decline and dry up needed credit. Capital flight is a danger we usually associate with countries like Argentina, but a few more WorldComs and the comparison may seem apt.

We have been down this road before, but there is something about the sight of billions of dollars in potential profits that makes investors forget the lessons of history. In the 1920s and 1980s, speculative run-ups were followed by a painful relearning of certain basic truths. Breathless hype about the dawn of a new gravity-defying era and accounting gimmicks are no substitute for real profits. It may come as little consolation to WorldCom shareholders, who have lost $150 billion since the stock reached its all-time high in 1999, but the flushing out of the dishonest self-dealers is the first step toward a recovery.

Copyright © 2002 The International Herald Tribune

NEW YORK So you're the manager of an ice cream parlor. It's not very profitable, so how can you get rich? Each of the big business scandals uncovered so far suggests a different strategy for executive self-dealing.

First there's the Enron strategy. You sign contracts to provide customers with an ice cream cone a day for the next 30 years. You deliberately underestimate the cost of providing each cone; then you book all the projected profits on those future ice cream sales as part of this year's bottom line. Suddenly you appear to have a highly profitable business, and you can sell shares in your store at inflated prices.

Then there's the Dynegy strategy. Ice cream sales aren't profitable, but you convince investors that they will be profitable in the future. Then you enter into a quiet agreement with another ice cream parlor down the street: each of you will buy hundreds of cones from the other every day. Or rather, pretend to buy - no need to go to the trouble of actually moving all those cones back and forth. The result is that you appear to be a big player in a coming business, and can sell shares at inflated prices.

Or there's the Adelphia strategy. You sign contracts with customers, and get investors to focus on the volume of contracts rather than their profitability. This time you don't engage in imaginary trades, you simply invent lots of imaginary customers. With your subscriber base growing so rapidly, analysts give you high marks, and you can sell shares at inflated prices.

Finally, there's the WorldCom strategy. Here you don't create imaginary sales; you make real costs disappear, by pretending that operating expenses - cream, sugar, chocolate syrup - are part of the purchase price of a new refrigerator. So your unprofitable business seems, on paper, to be a highly profitable business that borrows money only to finance its purchases of new equipment. And you can sell shares at inflated prices.

Oh, I almost forgot: How do you enrich yourself personally? The easiest way is to give yourself lots of stock options, so that you benefit from those inflated prices. But you can also use Enron-style special-purpose entities, Adelphia-style personal loans and so on to add to the windfall. It's good to be chief executive.

There are a couple of ominous things about this menu of mischief.

First is that each of the major business scandals to emerge so far involved a different scam. So there's no comfort in saying that few other companies could have employed the same tricks used by Enron or WorldCom - surely other companies found other tricks.

Second, the scams shouldn't have been all that hard to spot. For example, WorldCom now says that 40 percent of its investment last year was bogus, that it was really operating expenses. How could the people who should have been alert to the possibility of corporate fraud - auditors, banks and government regulators - miss something that big? The answer, of course, is that they either didn't want to see it or were prevented from doing something about it.

I'm not saying that all U.S. corporations are corrupt. But it's clear that executives who want to be corrupt have faced few obstacles. Auditors weren't interested in giving a hard time to companies that gave them lots of consulting income; bank executives weren't interested in giving a hard time to companies that, as we've learned in the Enron case, let them in on some of those lucrative side deals. And elected officials, kept compliant by campaign contributions and other inducements, kept the regulators from doing their job - starving their agencies for funds, creating regulatory "black holes" in which shady practices could flourish.

(Even while loudly denouncing WorldCom, President George W. Bush is trying to appoint the man who drafted the infamous "Enron exemption" - a law custom-designed to protect the company from scrutiny - to a top position with a key regulatory agency.)

Meanwhile the revelations keep coming. Six months ago, in a widely denounced column, I suggested that in the end the Enron scandal would mark a bigger turning point for America's perception of itself than Sept. 11 did. Does that sound so implausible today?

The New York Times

Copyright © 2002 The International Herald Tribune