Corporate Catharsis Jayati Ghosh

Another day, another Wall Street scandal. The regularity and frequency with which “bad news” is coming out of the corporate world in the US, involving some of the giants of international business, is almost laughable. Each week, at least one major company is being forced to reveal that it has been involved in financial irregularities, often of breathtaking extent.

Some companies “forget” to record their losses, or record them as loans to specially created subsidiaries. Other companies “just happen” to slip in normal expenses as “capital expenses”, thereby removing them from the profit-and-loss account. In some instances, important flows of finance are simply not recorded at all, and just disappear from the balance sheets. Other accounting discrepancies include understatement of interest payments, fictitious investments, and simply taking cash out of employees’ pensions and social security funds.

In most of these cases, the numbers involved are not small, usually amounting to several billion dollars. And the indications are that these malpractices are not just once-off mistakes, but have been going for some years – suggesting that auditors have been negligent or even complicit. Quite often, there is even no mention of these practices in the companies’ books, making it difficult to trace what exactly has been going on.

The biggest and most public scam of recent times was that concerning the energy trading multinational giant Enron, which was earlier seen as the most effective symbol of the swashbuckling new globalised capitalism of the 1990s. But now it turns out that the case of Enron – huge and dramatic as it was – is just the tip of the iceberg in terms of shady and ultimately unsustainable business practices in the international corporate world.

Consider just some of the scams that are now plaguing the already overworked Securities and Exchange Commission (SEC), the US government agency that is supposed to regulate all this. The company Adelphia is facing an SEC probe into $3.1bn in off-balance sheet loans, some of which were used to cover the assets of the founder of the company and his family. Global Crossing is under investigation for its accounting treatment of long-term wholesale capacity contracts, which artificially inflated profits. Lucent Technologies and Peregrine Systems have been found to be “adjusting” fiscal revenues and are being forced to restate incomes and profits for the past few years. The largest retailing company in the US, K-Mart, has had to lower its recorded profits after admitting to incorrect accounting methods.

Enron, as is well known, admitted to improperly inflating earnings and hiding debt through a complex web of off-balance sheet business partnerships. The company’s subsequent bankruptcy created a ripple effect across the corporate and financial world even in developing countries. Other energy trading companies are not pristine either. Duke Energy has admitted to “round-trip” or “wash” trades, in which two or more traders buy and sell energy among themselves for the same price and at the same time, which added at least $1 billion to its revenues over three years. Dynegy, the company that earlier offered to rescue Enron just before its collapse, is being investigated for using partnerships in deals to inflate its cash flow.

And then there is the insider trading, along with instances of top management seeking to save the value of their own assets of reward themselves before the imminent collapse of the company. The founder and other top managers of Computer Associates awarded themselves more than a billion dollars in shares (which they then sold) only days before issuing a profit warning which sent the share price down. The founder and CEO of Imclone Systems was found to be selling large numbers of shares held by his family and friends just before the cancer drug which was its sole product was denied approval by the US FDA. The chairman and other executives of Tyco International spent vast amounts on luxury housing for themselves and other perks, just before declaring losses.

The list goes on and on. The most recent examples are of the telecom giant WorldCom and the multinational Xerox, both of which represent in some ways the essence of current global capitalism.

WorldCom, like Enron, was a potent symbol of aggressive capitalism in the past decade. Like Enron, it is a company of recent origin, founded by the flamboyant entrepreneur Bernie Ebbers, who was perhaps the most aggressive acquirer during the US mergers and acquisitions boom of the 1990s. WorldCom’s stock market success even surpassed that of Enron. Before the US stock market started to sag in 2001, WorldCom’s asset value had soared to $180bn – nearly three times that of Enron at its peak.

WorldCom has now admitted that $3.8 billion of operating costs were treated as capital spending, forcing it to restate results for 2001 and the first quarter of 2002. Since the company is already facing losses, it is likely that it will soon file for bankruptcy and default on its $35 billion debt.

Just a few days later, Xerox admitted that it would have to reclassify more than $2 billion of its revenues. Under pressure from the SEC, it has subsequently announced that the extent of overstatement of revenues for a five-year period was even greater, at more than $6.4 billion. Once again the auditors at Xerox, as usual one of the international “Big Five”, had apparently not noticed the discrepancies for all these years.

Obviously, the story is not going to end here, and many more such cases will probably emerge in the near future. What exactly is going on? What explains this sudden flurry of unsavoury revelations and the apparent collapse of even minimal corporate accounting norms that these cases are bringing to light?

Forget, for a moment, the issues of morality, corporate ethics, and all that. Forget even the interests of the unfortunate shareholders of all these companies, which include not just get-rich-quick financiers but also workers’ pension fund managers and other presumably worthy groups. The real question is what all this tells us about the current phase of international capitalism, and what implications there are for the near future.

The first point to note is that such scams are not new or unexpected; in fact they are part of capitalism’s normal functioning. Only the most naïve of interpretations of the history of capitalism would leave out the crucial role played by fraud, deceit and skullduggery in the accumulation of capital and its subsequent use. And the notion that the “new” capitalism is somehow more open, accountable and democratic, is a false illusion purveyed by the media which also have major stakes in the system.

The second point is that such scams typically emerge at the end of a boom, or when it is beginning to peter out. It is not that the scams cause the financial or economic collapse; rather, they are symptoms of the turning point, when companies find that profit expectations are not being met, and try to prevent or delay the anticipated downturn with whatever means they possess, including fraud. Thus, while many of the financial malpractices have been going on for several years, they have been exposed only recently, as the economic slowdown and the stock market bear trend have fed into each other. This is characteristic of the “revulsion” phase of the financial cycle.

The third point has to do with the specific nature of US capitalism, which is “capital-market-based” rather than “bank-based”. After the financial crises in Japan and South Korea, bank-based systems (especially in Asia) came in for a lot of criticism internationally, for being opaque and prone to “crony” behaviour and clientelism. The current spate of scandals in the US shows that capital-market-based systems can be even more problematic. Not only do they allow (and even encourage) creative accounting, they are prone to the worst forms of “insider” excesses.

More to the point, they may even force managements to misstate actual results, since so much of the stock market value depends on this, and the stock value in turn typically determines not just assets but even management’s own remuneration. Those investigating WorldCom have found that the important sums involved in recent wrongly classified transactions — which reduced reported operating expenses over the last five quarters — were exactly those needed for WorldCom to meet its profit margin goals, and so keep its shareholders satisfied.

This does not mean that it is only the US corporate world which is in trouble. It is likely, as some European analysts have suggested, that because Western European accounting norms are stricter such cases of fraud will be less common and the European bourse may even benefit from the current revulsion away from US stocks. Indeed, the recent downward drift of the dollar – which has required co-ordinated central bank intervention to slow down – is one indication of this. But European corporations are by no means immune, as may become clear quite soon. First, the same macroeconomic forces of slowdown and reduced investor confidence are likely to affect European companies just as they have already hit Japanese and US corporations. Second, across the world the pattern has been to take on more and more elements of the “US model”, even in bank-based systems such as in France and Germany, and so such financial scandals are more likely there now than in the past.

It is clear the SEC-type regulation is inadequate to monitor and regulate markets which are so open to fraud because of the severe information problems they suffer from. It is also clear that during a slowdown, more and more cases of explicit and implicit fraud are likely, and they in turn can add to the more bearish investor sentiment which in turn would worsen the slowdown.

All these instances – and the new ones that are almost inevitably going to emerge from the woodwork quite soon – add up to a really big financial mess, and certainly do portend a major crisis of confidence for corporate US. Unfortunately, however, they still do not signify the end of capitalism as we currently know it. In fact, they do not even mean that the corporate world will necessarily become much cleaner and more “ethical” as a result. But if they do bring about a much more serious public reconsideration of the system as a whole, then they are probably to be welcomed.