Securities fraud and the ensuing scandals are devastating to investors and to the markets as a whole. There were numerous high-profile instances of accounting scandals and securities fraud in the early twenty-first century; in 2002 alone, the SEC filed 163 enforcement actions, up from 103 in 2000. (See Table 4.5.)
Illegal Insider Trading
Insider trading is the buying or selling of stock by someone who has information about the company that other stockholders do not have. Most often, it refers to directors, officers, or employees buying or selling their own company's stock. Insider trading by itself is not illegal, but insiders must report their stock transactions to the SEC. Insider trading becomes illegal when it is unreported to the SEC and breaches a fiduciary duty to the corporation; that is, when it violates a duty to act in the corporation's best
TABLE 4.5
| SEC enforcement efforts and outcomes, 2000–02 | |||
| SEC activity | FY 2000 | FY 2001 | FY 2002 |
| SOURCE: "Table 2.1. SEC Enforcement Efforts and Outcomes 2000–2002," in Economic Report of the President, U.S. Government Printing Office, February 2003, http://www.gpoaccess.gov/usbudget/fy04/pdf/2003_erp.pdf (accessed January 4,2005) | |||
| Financial fraud and issuer reporting actions filed | 103 | 112 | 163 |
| Officer and director bars sought | 38 | 51 | 126 |
| Temporary restraining orders filed | 33 | 31 | 48 |
| Asset freezes | 56 | 43 | 63 |
| Trading suspensions | 11 | 2 | 11 |
| Subpoena enforcement actions | 8 | 15 | 19 |
| Disgorgement ordered (millions) | $463 | $530 | $1,328 |
| Penalties ordered (millions) | $44 | $56 | $116 |
interests. Most often this happens when someone in the company has confidential information and uses it as the basis for a stock transaction. For example, if a company officer knows that the company is going to file for bankruptcy the next day and sells the company's stock because he or she knows the stock price is going to plummet tomorrow, the trading is illegal. The same goes for someone who leaks the information to an outside stockholder.
The best-known case of illegal insider trading in the early twenty-first century involved the company ImClone Systems, Inc., along with Martha Stewart and her stockbroker, Peter Bacanovic. The SEC alleged that Bacanovic passed confidential information to Stewart and that she sold her stock in ImClone because of that information. The SEC also accused Stewart and Bacanovic of trying to cover up the matter afterward by lying to federal investigators. The insider trading charge against Stewart was dropped, but she was convicted of lying to investigators and obstruction of justice. Bacanovic was also convicted of most of the charges against him. Stewart entered prison to serve a five-month sentence in October 2004 and was released to house arrest in March 2005.
Overvaluing and Accounting Scandals
Overvaluing is the overstatement of income by companies with the assistance of their accountants in order to create an inflated impression of financial success among investors, thereby increasing the value of stock. In the early twenty-first century Wall Street experienced numerous scandals concerning such accounting practices at major corporations. According to Penelope Patsuris of Forbes.com ("The Corporate Scandal Sheet," http://www.forbes.com/home/2002/07/25/accountingtracker.html, August 26, 2002), inflated figures were reported for such companies as Halliburton, Kmart, Xerox, Merck, Adelphia Communications, Bristol-Meyers Squibb, and AOL Time Warner. The most egregious and notorious breaches of regulations occurred at three companies: Enron, WorldCom, and Tyco. All three became targets of SEC investigations,
FIGURE 4.3
with company executives brought up on criminal fraud charges and investors losing billions of dollars.
ENRON. Based in Houston, Texas, Enron was an international broker of commodities such as natural gas, water, coal, and steel. In August 2000 Enron's stock rose to an all-time high of $90 a share. But the company was incurring more and more debt because its contracts outstripped its ability to deliver. To hide its liabilities, Enron created a web of partnerships; the idea was to transfer debt so it would not show on the company's books. Enron's accounting firm, Arthur Andersen, helped the company hide its debts and shredded key documents. With debts transferred to other entities, Arthur Andersen and Enron could overstate the value of the company, and its stock continued to perform well.
Enron had to pay the debts either with cash or with stock, and doing so would create a huge loss that the company could not hide. Enron vice president Sherron Watkins discovered the accounting discrepancy in the summer of 2001, becoming the key whistleblower when she sent a memo about the problem to CEO Kenneth Lay. In October 2001 Enron announced part of the loss—$638 million in the third quarter of 2001, with a loss in shareholder equity of $1.2 billion—and its stock price plummeted. The company announced that it was being investigated by the SEC for possible conflicts of interest with its many partnerships. In November 2001 Enron stock dropped to less than a dollar a share, and in December the company filed for bankruptcy. (See Figure 4.3.) Four thousand employees were laid off at that time.
Shortly before announcing the income overstatement, Enron executives took two additional steps. First, some of them sold their stock so they could get their money out before the stock lost all its value. Second, the company imposed a freeze on employee sales of the stock shares in their 401(k) plans. So when the news broke and employees tried to sell their stock to save what they could of their savings funds, they found that they were stuck with worthless stock in a bankrupt company. According to the labor union American Federation of Labor-Congress of Industrial Organizations (AFL-CIO) ("What Went Wrong at Enron?" http://www.aflcio.org/corporateamerica/enron, accessed March 9, 2005), more than 6,100 people lost their jobs, along with their health care, retirement funds, and, in many cases, life savings. While investors both in and outside the company lost tens of billions of dollar, Enron wrote $55 million in bonus checks for company executives the day before it declared bankruptcy.
In February 2005 a U.S. district judge in Houston set January 17, 2006, as the start date of the criminal trial of Enron founder Kenneth Lay, former CEO Jeffrey Skilling, and former accounting officer Richard Causey. Skilling and Causey were charged with thirty counts of fraud, conspiracy, and insider trading; Lay was charged with seven counts of fraud and conspiracy. According to the Houston Chronicle ("Enron: Houston Chronicle Special Report," http://www.chron.com/content/chronicle/special/01/enron/index.html, accessed March 9, 2005), as of March 2005 criminal charges were brought against thirty-three former Enron executives and others affiliated with the company, with six jury convictions, fifteen guilty pleas entered, three British bankers fighting extradition to the United States to stand trial, one acquittal, and five others awaiting trial in addition to Lay, Skilling, and Causey. Enron's accounting firm, Arthur Andersen, was appealing its conviction on obstruction of justice charges; the appeals case was due to be heard in April 2005.
WORLDCOM. News broke in March 2002 that WorldCom—the second-largest long-distance telephone company in the United States and the world's largest Internet provider—had overstated its accounts by $3.8 billion. In November 1997 WorldCom had merged with MCI (the largest company merger up to that point in U.S. history) to form MCI WorldCom. Two years later, in October 1999, the company announced plans to merge with another long-distance carrier, Sprint, which would have made it the largest telecommunications company in the United States. But before the deal could go through, the United States Justice Department raised questions about the three merged companies creating a monopoly in the telecommunications industry, so the deal was dropped. In 2000 MCI WorldCom went back to calling itself WorldCom.
In June 2002 the SEC began investigating WorldCom's accounting practices. A month later the company filed for bankruptcy—the largest such filing in U.S. history to date. The stock held by investors was worthless, and former employees who lost their jobs, pensions, benefits, and severance pay formed the ex-WorldCom Employees Assistance Fund and joined with the AFL-CIO to retrieve some of what they had lost. In June 2002 WorldCom owed four thousand of its former employees $36 million (Nomi Prins, "Whose Jobs? Our Jobs!" Dollars and Sense: The Magazine of Economic Justice, no. 246, March-April 2003, http://www.dollarsandsense.org/archives/2003/0303prins.html). By 2003 WorldCom was believed to have inflated its accounts by more than $11 billion. In May 2003 the company—which changed its name to MCI after filing for bankruptcy—agreed to settle the SEC's fraud suit against it by paying $500 million in fines, which would be paid to shareholders, according to the guidelines of the Sarbanes-Oxley Act (Stephen Labaton, "MCI Agrees to Pay $500 Million in Fraud Case," New York Times, May 20, 2003, http://www.nytimes.com/2003/05/20/business/20PHON).
The suit was one of the largest the SEC had ever filed, but it still did not address the activities of WorldCom's executives, many of whom were themselves accused of fraud. Former WorldCom chief financial officer (CFO) Scott D. Sullivan and chief executive officer (CEO) Bernard J. Ebbers in particular were believed to have been involved in the accounting scam. Both were indicted on charges of conspiracy and securities fraud. Sullivan, who faced twenty-five years in prison, agreed to testify against Ebbers, who was accused of inflating WorldCom's accounts to cover his own $350 million in loans that he owed to Bank of America ("Prosecutor's Attack Former WorldCom Chief's Claims of Ignorance," March 2, 2005, http://www.hoovers.com/free/news/detail.xhtml?ArticleID=NR200503021180.3_e9a100191fcfe639). On March 15, 2005, Ebbers was convicted of all nine charges against him. He could be sentenced to a maximum of eighty-five years in prison but was expected to appeal the conviction.
TYCO. Tyco International, Ltd., originally based in Bermuda but later located in West Windsor, New Jersey, is a holding company whose many branches produce fire and security systems, electronic components, medical supplies, and pharmaceuticals. In 2002 a series of scandals erupted, centered around Tyco's CEO, L. Dennis Kozlowski, and its CFO, Mark Swartz. Kozlowski was forced to resign in June, soon to be followed by Swartz. By the end of the year Tyco was suing its former executives in connection with $600 million in loans, salary, and fringe benefits they allegedly took from the company without board approval. The government indicted the men for grand larceny and securities fraud, among other criminal charges.
Kozlowski and Swartz were originally brought to trial in New York State Supreme Court in September 2003, accused of taking $170 million in "unauthorized compensation" from the company and "covertly" selling $430 million in stock at artificially inflated prices (Dan Ackman, "Dennis the Menace on Trial Today," http://www.forbes.com/2003/09/29/cx_da_0929topnews.html, September 29, 2003). Particularly at issue during the trial was Kozlowski's extravagant lifestyle. Prosecutors told of Kozlowski throwing his wife a $2.1 million birthday party paid for in part by Tyco, living in a $19 million Manhattan duplex bought for him by the company, and purchasing a $6,000 shower curtain, all while Tyco investors lost millions because of his stock manipulations. Kozlowski and Swartz were among the first company heads indicted on criminal charges after the fall of Enron. Their case, however, was declared a mistrial in April 2004, when a juror, suspected of communicating with defense attorneys, was named in the media and subsequently received threatening letters and phone calls. Kozlowski and Swartz went on trial for a second time in January 2005. Each could receive twenty-five years in prison if convicted on the most serious of the charges against them.
Special Favors and Special Timing of Mutual Funds
Mutual funds reduce risk to investors by diversifying investments, and until recently they were considered by
FIGURE 4.4
many to be a good choice for investors who wanted a relatively high return with less risk than a straight stock investment. Indeed, the percentage of American households that owned mutual funds grew from 5.7% in 1980 to 44% in 1998. (See Figure 4.4.) As waves of scandals began to hit the securities industry, it seemed wiser than ever to invest in mutual funds.
In late 2003, however, questions began to arise about the business practices of mutual fund companies. As government agencies began investigating, they discovered illegal transactions in more than a dozen mutual fund companies, including well-known and trusted firms like Bank of America and Charles Schwab. The investigations centered primarily on two types of transactions: market timing and late trading. These two types of transactions are illegal; however, executives at mutual fund companies allowed preferred clients to make these trades. Furthermore, company executives engaged in these transactions themselves.
Market timing is the practice of making rapid "in and out" trades to manipulate prices. Mutual funds are valued only one time each day. Market timing allows the investor to take advantage of "stale" information to buy low and sell high. Late trading also depends on the once-a-day pricing system for mutual funds. The market closes at 4:00 p.m. By trading at 4:01, the trader gets the benefit of the next day's higher price. These practices are problematic because the illegal trader gets a windfall that corresponds exactly to a loss suffered by other investors who did not have the same advantage. By March 2005 some of the indicted companies had agreed to pay settlements to the government. Other cases are still unfolding.
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