Great expectations
Cistercian's financial gurus discuss the causes and the cures for the business scandals of 2002.

[Published in the December 2002 edition of The Continuum, the alumni magazine of the Cistercian Prep School.]

By David Stewart
"It's a simple, sad story of greed and pettiness," said Jim Smith '72, who has worked in the investment management business for almost 20 years and is a principal in Bedrock Management.
He believes the recent crop of corporate failures like Enron, WorldCom, Tyco, ArthurAnderson, etc., were seeded in the early nineties.
"If you step back a little bit, this is the epitome of the Clintonian narcissism," he said.
"People embraced a very unfortunate sort of MO where they were saying I am looking to serve only my own purposes. I am interested only in that which does something for me, that which enhances my status. You cannot imagine it's that simple, but I think it is."
"I believe we wildly underestimated the cultural ripple effect of watching Clinton's behavior embraced. By virtue of not being called on it, he became a role model."
"Financial statements," Smith insisted, "are just a shell game." They focus investors on one thing, like earnings per share, while weaknesses are hid elsewhere.
"Wall Street slaughters any company that misses its quarterly numbers," said Jere Thompson '74, who found out the hard way as CEO of CapRock Telecommunications, a darling of the Nasdaq in 1999 (a year in which the company generated $193 million in revenues). McLeodUSA purchased the company in 2000 after a brief halt in CapRock's earnings growth and a quick slide in its stock price.
"If there's a hiccup in your momentum, you can be crucified," Thompson explained. "Money managers invest on the basis of the story and the momentum. Any shift in that momentum and they are out. They sell first, ask questions later."
In the face of such consequences - in which employees, customers, vendors, all suffer - even the most honest executives feel pressure to take steps to keep their stock price from falling precipitously and jeopardizing the entire company. That's when some executives "took what appear to be reckless actions," said Thompson.
Like women starving themselves to measure up to runway models, executives take risks with their balance sheets and income statements to meet or exceed Wall Street's expectations.
"Unfortunately," Thompson said, "executives aren't rewarded by Wall Street for running a company conservatively."
"Based on my contacts with others in the industry, it is clear that companies have become more aggressive in 'managing earnings,'" said Joseph Shea '78, finance director of the Operations & Technical group of Dr Pepper/Seven Up, Inc. "This consists of using the balance sheet to smooth profit. If results are especially good, some profit is 'held back' for a rainy day. This is driven in part due to the expectations of Wall Street analysts."
Guys like Robert Schoenvogel '96, a financial analyst at Priderock Management in New York City, try to spot such tricks so that they can protect their investors.
"Financial statements can be like a black box - there is a lot of room to manipulate certain items," Schoenvogel said. "For example, we look to see if companies are setting unrealistically high assumptions for returns on their pension funds. Some companies turn these returns into paper profits to boost their reported income. We also look closely at any unusual charges coming out of acquisitions or divestitures. Those are red flags."
"The number of options granted to management teams and executive compensation levels are also topics that come up frequently in investor conferences," he said.
The average investor, of course, must rely on his own research and the word of the accounting firms, a word that was considered credible just a year ago.
"I think that a lot of the problems observed with Enron and WorldCom show some of the inherent conflicts of interest for the large audit firms, who are supposed to serve as the investing public's watchdog," said Bruce Stevenson '89, a chartered financial analyst and senior associate with CBIZ Valuation Group, Inc. in Dallas.
"First of all, audit work is relatively unprofitable compared to high fee consultancy work previously performed by the (then) big five firms," he said. "The incentive system was set up such that an audit partner's job depended upon his maintaining a particular client. Another issue that has been highlighted is that the interests of management and the board of directors are too closely in line."
Thompson agrees that "when a company is growing and the stock price is rising, no one wants it to end, not management, not the board, the investment bankers, the employees, analysts, nor investors."
"Wall Street is still full of conflicts of interest," Schoenvogel said. "At times it become difficult, if not impossible, to balance these competing responsibilities."
"For years, my colleagues and I have advocated greater consultant independence," said Matt Morris '92, a senior partner at Value Incorporated where he is often asked to quantify the economic damage to shareholders that results from "corporate accounting misstatements."
"Many times, we're hired to help protect shareholders who have felt the impact that conflicts of interest can have on their investments," Morris said.
Accountants shouldn't shoulder all the blame, said Martin LeRoy '90 who worked as an auditor for Ernst & Young before becoming a financial analyst at Intel.
"The accounting firms are faced with the same pressures every other business has," he pointed out. "Their customers constantly pressure them to lower fees. Therefore they have to cut costs. The way they do it is by cutting the amount of time spent on each project.
"All the accounting firms are required to test for is unintentional, significant misstatement of financials. If shareholders wanted them to provide a higher level of assurance they would have to be willing to pay them a lot more for their services."
But management occasionally succeeds in co-opting their accountants.
"Why were they open to being co-opted?" Smith asked rhetorically. "They were looking at Clinton as a role model. They're working 80 hours a week and they're seeing these big dollars being made."
"No legislation, creation of oversight boards, or any other outside form of regulation will prevent crises like this in the future," suggested Paul Wehrmann '84. An attorney for Haynes and Boone, he works in the public securities field, spending countless hours on the progeny of the accounting scandals, the Sarbanes-Oxley Act.
"You can't legislate character, morals, or ethics," Wehrmann added. "As long as the only benchmark of success in the business world is monetary gain, those who are successful will continue to be those who manipulate the rules to make money without regard to the effect such manipulation has on others or society as a whole. In a system where value equals profit (either personally or for your business), integrity plays no part."
"I agree with the premise that you cannot legislate character, morals or ethics," answered Buck Smith '71, chief counsel for 7-11 Inc. "I strongly disagree, however, with the implied notion that a profitability benchmark is somehow the sole driver of the type of manipulation that led to the corporate meltdowns that we have witnessed in the last couple of years.
"Let's don't let ourselves slip into a populist notion of apologizing for corporate profits. The bottom line is that corporations must make money, not only for the benefit of all corporate stakeholders (shareholders, vendors, employees, etc.), but also for the success of a democratic society."
"The unfortunate result of the avarice of a few morally bankrupt individuals is that a bunch of entrenched and self-interested politicians in Washington D.C. took it upon themselves to 'craft' a blueprint for governance that applies to each and every corporate entity. The Sarbanes-Oxley Act, in my opinion, is fodder for plaintiff's lawyers, academicians, and insurance companies."
Alex Frutos '87, an attorney who handles private equity offerings, mergers and acquisitions for Akin Gump Strauss Hauer and Feld LLP, believes the legislation has some benefits.
"This legislation has greatly increased the responsibilities of boards of directors, executive officers and independent accounting firms and will dramatically affect how companies do business. When the dust settles, I think a healthier environment will emerge where companies have a renewed focus on ethical business practices."
From the corporate boardroom, a different assessment:
"I believe that we will survive this latest round of legislative activism directed at corporate America," Buck Smith said. "My hope is that we don't find ourselves too bogged down in the process of complying with the nits and the nats and forget about the need to make money."
That's one thing that Wall Street will be watching closely.
"Wall Street expects steady earnings growth," Schoenvogel said, "but that's not the way the real world works. The events of the past year have started to create a flight to quality."
That flight to quality may be the most promising sign since greedy investors helped spark the crisis in the first place.
"The culture of greed grabbed everyone's psyche," Jim Smith insisted, not just corporate management and accounting firms. "It was a mass psychosis. During the mania of 1998-2000, you could not talk sense to people. Investors at even the most sophisticated levels took wild gambles. It was crazy."
"In the business world of the nineties, life was a game in which I serve myself and the world exists to serve me. It was everywhere. It's still really bad. Too many people have done too well," said Smith. "It may take a real live crash before we can get down to a base from which we can build again."
"Investors who lost a lot of money recently had lost their mind - and their sense of perspective - years before," Smith concluded. "They were caught up in the money thing. You can't let it run your life or it will ruin your life. Be careful out there."