Control Fraud, Looting and Corporate Culture

William Black is Associate Professor of Economics and Law at the University of Missouri-Kansas City. He was a high-ranking bank regulator during the Savings & Loan crisis and is now a leading expert in the phenomenon of control fraud, in which the person controlling an organization uses it as a vehicle for fraud.

Mr. Black considers accounting to be the “weapon of choice” for crimes committed by senior corporate executives. (1) Referring to studies that show a rising percentage of executive compensation is tied to short-term reported income, he predicts that the incidence of fraudulent manipulation will only increase.

So why aren’t we seeing more CEOs led away in handcuffs? What happened to the heady days in 2002-2004 when the media were filled with stories of $100,000 belt buckles and $2,000,000 birthday parties paid out of company funds?

On April 1, Mr. Black was quoted as saying, “In 1987 and ’88, I believe there were more than 11,000 criminal referrals from the (regulatory) agencies. In the current crisis, we have numbers from two of the agencies, the Office of the Comptroller of the Currency [OCC] and the Office of Thrift Supervision [OTS]. The number is zero(2).

Even without referrals, some investigations are in progress. On March 16, FBI Director Robert Mueller told Congress that the FBI has 667 ongoing probes into corporate fraud and 1,700 open cases of securities fraud. (3) But the three elements of crime – means, motive, and opportunity – have not been addressed, and until they are, looting will continue whether it makes the headlines or not.

Current studies by GovernanceMetrics International (4) and James F. Reda & Associates (5) confirm that the practice of basing incentive pay on short-term income continues to rise. In fact, the GMI study showed that 97% of S&P 500 companies pay incentive compensation to executives even when the company is underperforming its peers.

As the market has rebounded in 2009 and 2010, the value of stock and options held by S&P 500 company executives has soared to $6.3 billion. (6) Profits reported in the S&P 500 Index rose 47% in 2010 through downsizing and cost-cutting, while revenues increased only 7%, (7) and the line from reported profits to share price to incentive bonuses is paved with gold.

The ingenuity with which CEOs can exploit their contracts is truly inspiring. In 2006, U.C. Berkeley’s Robert Reich (8) outlined a newly popular strategy, in which CEOs urge shareholders to approve a buyout by a private equity firm, work to increase profits (driving up the stock price), and cash out when the company goes public again – benefiting the private equity firm and the CEO, but not the company’s original investors.

Nor is the collateral damage limited to investors, who, one would hope, are motivated to monitor a company’s accounting and governance behavior. In January of 2010, a Wisconsin appeals court overturned a $6.5 million jury verdict against corporate looters, citing a State Supreme Court decision that corporate directors have no obligation to creditors for misconduct that occurs while the company is still in business. (9) The company’s owners made more than $10 million, allegedly through excessive compensation and self-dealing, before defaulting on a large loan and being declared insolvent. According to the Wisconsin Bankers Association, banks will protect themselves with “more personal guarantees on corporate loans, stricter underwriting policies and additional audits,” making loans more costly for legitimate businesses. And of course, the cost of the (alleged) executive enrichment through malfeasance was also borne by employees through lower wages and benefits and, ultimately, layoffs.

One longs for the good old days of multi-million dollar bat mitzvahs at company expense or birthday parties in the Mediterranean disguised as a “shareholders meeting.”

For a stroll down Memory Lane, see if you can match these companies with their CEO’s landmark achievement. If you’d like to write to any of the convicted CEOs, you can check Business Insider (10) for their mailing addresses and release dates.

From Rags to Riches To… Federal Court
1. Countrywide a. The biggest restatement in history, transcending Enron, Global Crossing, and Adelphia.
2. ImClone b. Defined by SEC as a “looting case.”
3. Rite-Aid c. Then-largest accounting scandal in history ($11 billion).
4. Tyco d. Defined as “control fraud.”
5. Worldcom e. Called by the SEC, “one of the most extensive financial frauds ever to take place at a public company”
6. Sam Israel f. Called by Time Magazine, “history’s biggest financial swindler.”
7. Bernard Madoff g. On the U.S. Marshall’s Most Wanted List.
8. Adelphia h. Inspired former SEC Chairman Arthur Levitt to say “Insider trading is a cancer which preys upon the system”[11]

When “guilty” verdicts were read in the trial of Dennis Kozlowski and Mark Swartz of Tyco fame, an associate dean at Yale School of Management pronounced a victory for CEOs, who could now “take positions of moral integrity as the judicial system stands behind them.” (12) That was six years ago, and we’re still waiting for the sea change in corporate morality. Instead, looters continue to be richly rewarded.

As Mr. Black points out, cheating on exams and assignments is common in business school; it is illogical to expect attitudes of entitlement would be any different when students find themselves in the executive suite with hundreds of millions of dollars under their control. Mr. Black pointed out that Enron’s CFO, Andrew Fastow, received an “Excellence Award” from CFO Magazine in 1999 while excelling at accounting fraud .(13) And Adelphia founder and former Chairman, CEO and President John Rigas – currently serving his sentence in Butner Federal Correctional Complex, Butner, North Carolina (14) - was inducted into the Cable Hall of Fame(15).

Nor are family businesses exempt from looting. Last year Allan Smidt, founder of Harbor Freight Tools, now based in Calabasas, California, sued his son, Eric. The complaints alleged that after pressuring his parents for a controlling interest, Eric “dramatically” leveraged the company to the tune of more than $500 million in loans which he used to acquire real estate, artworks, and other property for himself while omitting contracted payments to his father. (16) Eric had his father removed from the Board and escorted off the property. (This matter was settled last April following mediation; (17) terms of the settlement were not disclosed.)

So how does the stakeholder identify executives who are practicing “cookie-jar accounting” (transferring reserves to the “Revenue” column) or “mark to myth” (arbitrarily inventing asset values irrespective of the market) or the countless other manipulations that produce a false profitability on the balance sheet? Looking behind the numbers, forensic analysis can detect traces of corporate behavior that point to manipulation and fraud.

And how do we prevent it? Just as firemen remove one of three elements (heat, fuel, and oxygen) to extinguish a fire, the flagrant looting of public companies will only be stopped by removing means, motive, or opportunity. Boards must revise executive compensation packages to eliminate the factor of short-term reported income or profitability.

Investors should determine whether the company’s accounting behavior is inconsistent with the company’s history or its industry peers, and whether risk is inherent in the company’s executive structure and incentive compensation plan.

And our regulators and investigators should take every opportunity to pursue, prosecute, and convict executives who reward themselves for cheating.

1 “Epidemics of ‘Control Fraud’ Lead to Recurrent, Intensifying Bubbles and Crises,” William K. Black
2 “Financial Crisis Leads to Fewer Accounting Control Fraud Prosecutions,” Steven Andersen, www.InsideCounsel.com, April 1, 2011
3 “FBI Chief Defends Mortgage Fraud Efforts,” Reuters, March 16, 2011
4 “Preliminary Executive Pay Scorecard Review,” Michelle Lamb and Greg Ruel, www.GMIratings.com, april 6, 2011
5 “Study of 2009 Incentive Design and Performance Metrics Among Top 200 SS&P 500 Companies,”James F. Reda & Associates, LLC, January 2000
6 “CEO pay tops prerecession level,” Rachel Beck/Associated Press, The Detroit News, May 11, 2011
7 “The corporate looting of America,” www.wsws.org, April 4, 2011
8 “Oh Henry,” Robert B. Reich, The American Prospect, November 22, 2006
9 “Critics blast ruling in ‘corporate looting’ case,” www.LeaderTelegram.com, January 28, 2010
10 “Top 10 White-Collar Criminals in Jail,” www.BusinessInsider.com, July 16, 2009
11 Answers: 1-d, 2-h, 3-a, 4-b, 5-c, 6-g, 7-f, 8-e
12 “Ex-Chief and Aide Guilty of Looting Millions at Tyco,” Andrew Ross Sorkin, www.nytimes.com, June 18, 2005
13 “Why the financial reform bill won’t prevent another crisis,” William K. Black, www.CNNMoney.com, July 26, 2010
14 “Top 10 White-Collar Criminals in Jail,” Business Insider
15 Cable Hall of Fame Archives, www.cablecenter.org
16 “Harbor Freight CEO accused by parents of ‘looting’ company,” Stephanie Hoops, Ventura County Star, July 19, 2010
17 “Harbor Freight founder settles lawsuits,” Stephanie Hoops, Ventura County Star, April 5, 2011
©2011 James A. Kaplan and Phyllis Elliott

James A. Kaplan, a founding Director of MarketWatch, serves on the Board of GovernanceMetrics International which recently merged with Audit Integrity and The Corporate Library. Mr. Kaplan previously created CMS BondEdge. His commentary can be found at www.jamesakaplan.com.

Phyllis Elliott has published financial research and reports on the airline and travel industries. She has written extensively in the U.S. and abroad about arts and sports education, as well as producing children’s stories, poetry, and works for stage and screen.