CYCLES OF SCANDALS –
HISTORY REPEATS ITSELF
Alan S. Brown
Director
Federation of Defense & Corporate Counsel
Locke Reynolds, LLP
Indianapolis, Indiana, U.S.
JOINT FDCC/BILA SEMINAR
Old Library Lloyd’s
London, England
January 27, 2005
I.
INTRODUCTION
The Sarbanes-Oxley Act of 2002 (SOX) was passed by a Congress under pressure to
rein in corporate scoundrels and preserve the integrity of American financial markets.
Legislators responded quickly to the media attention and public outrage, following the historical
path trod by their predecessors.
The ‘90s, as Federal Reserve Board President Alan Greenspan pithily remarked, was
not a period of more greed, but of more opportunities. Neither Congress nor any other
legislative body has yet found a way to curb greed, so legislative fixes have focused on
eliminating opportunities and increasing penalties. SOX, like its predecessor statutes, seeks to
curtail the opportunity to cheat, through increased corporate oversight and financial reporting
requirements. And SOX, also like its predecessors, prescribes harsher penalties for those with
the temerity to cheat.
If the past truly predicts the future, a period of relative calm will settle over American
financial markets. Financiers and corporate titans will generally follow the new rules and
markets will advance (as they have already started to do). But rest assured, the next Michael
Milken or Jeffrey Skilling or Dennis Kozlowski is now in college or graduate school planning for
the day when his or her career path leads to the intersection of greed and opportunity. When
that moment arrives, America will likely face its next financial scandal, predictably followed by
public outrage and a new legislative response.
This all-too-predictable cycle of scandals is the subject of this presentation. What
follows is a summary of the major financial scandals and legislative responses in the United
States over the last century. The picture is one of increasingly-focused legislation designed to
constrain the activities of the greedy. But because the greedy also tend to be clever, as one
avenue of opportunity closes, new ones are discovered.
II.
THE EARLY 1900s
A.
Robber Barons and Monopolists
The U.S. economy in the late 1800s and early 1900s was rife with cartels, monopolistic
mergers, and predatory practices. The national economy evolved at the end of the 19th
century from competitive small enterprises to monopolistic corporations. By 1890, large,
unscrupulous “trusts” dominated their respective markets.
Railroads, manufacturing,
processing and distribution companies consolidated to form enterprises of unprecedented
scale. From 1898 to 1902, at least 300 firms disappeared annually through mergers. In 1899,
approximately 1,200 firms were subsumed through acquisition or merger. By way of example,
the American Tobacco Company was built through the consolidation of 250 separate
businesses.
B.
Effect on the Market
Monopolies limited consumer choices, controlled output, and set artificially high prices.
A wide segment of Americans were harmed economically and socially and came to regard
large businesses as evil and a threat to democracy. Innovation and entrepreneurship slowed.
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C.
Governmental Response
Legislation: The Sherman Act of 1890 (commonly referred to as the Sherman AntiTrust Act) was passed to prevent, in the language of the period, unfair wealth transfers from
consumers to monopolists, that is, prices set higher than a competitive market would permit.
In enacting this bill, Senator Sherman insisted that “Great aggregations of capital” should be
dissolved “because of the helplessness of the individual before them.” Congress created the
Federal Trade Commission (FTC) to enforce the new legislation against unfair trade practices.
The FTC would later be nominated as the national overseer of securities markets.
Prosecution: In landmark decisions such as Standard Oil v. United States and United
States v. American Tobacco Company, the United States Supreme Court condemned the
monopolistic practices of the trusts and applied a “rule of reason” to judge practices allegedly
leading to the power to fix prices and limit production. The Court held that a presumption of
illegality was created by Standard Oil’s 90% market share, accumulated after 41 years of
acquisitions and unfair competition. Despite the court-ordered breakups of Standard Oil and
American Tobacco Company, the “rule of reason” was considered by some as overly-friendly
to business. Despite increased regulation and prosecutorial vigilance, stock prices increased
through the first part of the 20th century.
III.
THE MARKET CRASH OF 1929
A.
Touts and Speculators
Securities traders in New York, Philadelphia and Boston operated under their own
exchange agreements, such as the Buttonwood Tree Agreement, an early predecessor to the
New York Stock Exchange. In a vacuum of federal regulation, private self-regulating bodies
established ineffective codes of conduct and exercised lax enforcement. State “blue sky” laws
governed the issuance of corporate charters and securities. An eight-year bull market, fueled
by speculation during the wildly-optimistic “Roaring ‘20s,” was accompanied by widespread
fraud, price manipulation, short-selling, bear raids, and pooling. From 1920 to 1929, many
stocks quadrupled in value and investors borrowed heavily to invest in the market. This
overheated market set the stage for financial catastrophe.
B.
Effect on the Market
The market crashed in October 1929 ushering in the Great Depression. NYSE stocks
lost 83% of their value between September 1929 and July 1932. Investors lost confidence and
many were unable to pay the debts incurred to buy stock. Consumer demand waned and
stocks could not be sold to fund new investment. Banks were unable to collect funds loaned to
speculators. Many banks had also invested -- and lost -- depositors’ funds in the stock market.
As word spread that banks’ balance sheets included mountains of bad debt and worthless
stock, frightened depositors began runs on banks, leading to hundreds of bank failures in 1932
and 1933.
C.
Governmental Response
Legislation: After the NYSE failed to heed President Herbert Hoover’s pleas for
stronger self-regulation, Hoover initiated a senate investigation in 1930. After two years, as
securities abuses continued to make headlines, the senate presented findings of widespread
fraud in capital markets. Franklin D. Roosevelt, like his trust-busting relative before him, won
the presidential election in 1932 by promising governmental reform. Roosevelt shepherded
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passage of the Securities Act of 1933 (‘33 Act) which gave oversight responsibility to the FTC
for the issuance of stocks and bonds. The ‘33 Act required issuers of stock to disclose
pertinent financial information underlying stock and bond issues, to aid investors in their buying
decisions. It also attacked fraud in connection with the sale of securities. To address the
trading of existing securities, Congress enacted the Securities Act of 1934 (‘34 Act), which
established the Securities Exchange Commission (SEC) as the federal regulatory body
overseeing the issuance and exchange of securities. The ‘34 Act required registration of
nationally-traded securities and periodic financial reporting; set standards for transactions
among directors, officers and insiders, and for tender offers and proxy solicitation; and added
anti-fraud provisions.
IV.
INSIDER TRADING OF THE 1980s
A.
Greedy Insiders
The 1980s brought an increase in mergers and acquisitions. The surge in transactional
activity was accompanied by an epidemic of insider trading, evidenced by rises in the stock
prices of companies slated for hostile takeover before the deal was publicly announced. The
early 80s saw a few high-profile insider trading prosecutions by the SEC, but with little
deterrent effect given the weak penalties available to the SEC. However, beginning in 1986,
the SEC brought a series of highly-publicized insider trading prosecutions against Dennis
Levine, Ivan Boesky, Michael Milken and the trading firm Drexel Burnham. Boesky was
alleged to have earned tens of millions of dollars buying and selling stock on non-public
information received from Levine, a mid-level investment banker who had assiduously
cultivated Wall Street sources close to deals. (Levine’s sources included Ilan Reich, an upand-coming mergers and acquisitions lawyer at the powerhouse Wall Street firm, Wachtell
Lipton.) In return, Boesky provided Levine a percentage of the trading profits. The SEC
sniffed out Levine’s off-shore account and Levine gave up Boesky. The chain of prosecution
continued when Boesky assisted the government in building a case against Milken, Drexel
Burnham’s high-flying “junk bond king.”
B.
Effect on the Market
Investors showed their lack of confidence in the integrity of the market by dumping deal
stocks and fleeing to safer and less volatile investments. The use of “junk bonds” as a
financing vehicle declined precipitously. Some economists point to the insider trading scandal
and the collapse of the junk bond market as a contributor to the recession of the early ‘90s.
C.
Governmental Response
Legislation: The insider trading scandal triggered a wave of legislation creating stricter
penalties for insider trading and fraud. Before the Levine/Boesky scandal, the SEC’s lack of
authority to seek civil penalties in other insider trading cases prompted the passage of the
Insider Trading Sanctions Act of 1984. The Act allowed the SEC to seek penalties
representing triple the amount gained or loss avoided. Prior to enactment, the SEC could only
seek disgorgement of profits and injunctive relief. The Act made possible massive penalties
against Boesky, Milken and Drexel Burnham. Increased penalties were added by the
Securities Fraud Enforcement Act of 1988 and the Securities Enforcement Remedies and
Penny Stock Reform Act of 1990.
Prosecution: Ivan Boesky pleaded guilty to one count of conspiracy to commit
securities fraud and was sentenced to three years in prison, of which he served 19 months.
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He also agreed to pay $100 million, of which half was a civil fine—one of the largest civil fines
ever imposed by the government on an individual. Drexel Burnham pleaded guilty to six felony
counts of wire and securities fraud and paid a $650 million penalty. Milken, facing 98 counts of
fraud and racketeering, was sentenced to ten years in jail and agreed to pay $600 million in
fines. (He could afford it: published accounts indicate he was paid $296 million in 1986 and
$550 million in 1987.) Drexel Burnham and Milken additionally paid $1.3 billion into a pool to
settle hundreds of private lawsuits. Since his early release from prison after being diagnosed
with prostate cancer, Milken has stayed in the public eye by founding a cancer charity, a
profitable educational services company, and an economics think tank. He has written a bestselling cookbook. He has also remained on the SEC’s radar screen. In 1998, the SEC
charged Milken with violating the terms of his 1991 plea agreement by acting as a “consultant”
in three major deals, including MCI’s investment in News Corp. The SEC forced him to
disgorge a $42 million consulting fee plus $5 million in interest. He remains under a lifetime
prohibition from participating in the securities industry.
V.
ENRON’S COLLAPSE
A.
Thieves in the Executive Suite
In December, 2001, Enron Corporation, a Houston, Texas-based energy company, filed
for federal bankruptcy protection, becoming the largest bankruptcy filing in U.S. history at the
time. The filing occurred less than a month after Enron admitted to accounting “errors” that
inflated earnings by almost $600 million over six years. Enron hid massive debts in off-thebooks partnerships maintained by Enron executives, who themselves made millions from the
partnerships. Months before the collapse, Chairman and CEO Kenneth Lay sold millions of
dollars of stock, but under then-existing SEC rules, did not report the sale until the following
February. Accounting firm Arthur Andersen LLP, which had served as both auditor and
consultant for Enron, was implicated in shredding thousands of Enron documents.
Government prosecutors alleged that Andersen was willing to overlook the huge sums of
money kept off Enron’s books because Enron paid up to $100 million per year in fees to the
giant accounting firm.
Before and after Enron’s collapse, other publicly-traded companies, including Sunbeam,
Waste Management, WorldCom, and HealthSouth, are alleged to have used misleading
accounting practices to overstate profits and inflate stock prices. In nearly every case,
company executives were eligible for huge gains from bonuses and stock options if the
company’s stock price rose.
The turn of the century brought another breed of corporate rascal to the forefront.
These executives, represented by Dennis Kozlowski and his henchmen at Tyco International,
Rigas father and sons at Adelphia Communications, and Richard Scrushy at HealthSouth
Corp., allegedly looted public companies by steamrolling subservient boards for excessive
compensation packages and generous loans (which were later forgiven). With lax accounting
and board oversight, these executives are alleged to have treated publicly-traded businesses
as personal banks, spending millions of dollars of company money for personal expenses.
(Who can forget Kozlowski’s $2 million Sardinian birthday party for his wife or his $6,000
shower curtain?)
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B.
Effect on the Market
Enron employees lost their retirement savings (heavily invested in Enron stock) and
investors lost billions when Enron stock value plummeted. WorldCom (now MCI) and
HealthSouth entered bankruptcy. Investor confidence sagged. Estimates put investor losses
from dubious accounting practices at $200 billion. Loss of confidence in financial reporting and
controls has been cited as a contributing factor to the bear market that continued through mid2004. Most economists instead point to normal bull-bear market cycles and investor overexuberance that triggered the dot com stock collapses at the turn of the century.
C.
Governmental Response
Legislation: Congress rushed to pass the Sarbanes-Oxley Act of 2002. The Act, and
regulations promulgated by the Securities and Exchange Commission in furtherance of its
purposes, require increased board independence and oversight, increased auditor
independence, more stringent auditing standards, mandatory reporting and disclosure
requirements, affirmation by senior managers of financial reports, and speedier reporting of
insider transactions. It also regulates loans to executives and provides for stiffer penalties for
white collar criminals. Notably, Sarbanes-Oxley makes it easier for the SEC to remove
directors and officers for “unfitness” and allows the SEC to force executives to return bonuses
or incentive-based compensation.
The law of unintended consequences has already taken hold. Having now been
through one SOX reporting cycle, affected businesses estimate the added per-company cost
of SOX--particularly SOX regulation 404, the most burdensome accounting controls
requirement--at around $2 million annually. It has been anecdotally reported that small
businesses have decided to go (or stay) private rather than incur the added costs of SOX
compliance. As reported in the Wall Street Journal on December 17, 2004, “One recent study
found that the number of companies that delisted their common shares from stock exchanges
nearly tripled in 2003, in part to avoid some of the regulations required by Sarbanes-Oxley.” In
the same article, the WSJ reported that in response to complaints from small businesses, SEC
Chairman William Donaldson has acknowledged the impact of SOX and has pledged to create
an advisory committee to study the law’s impact on smaller public companies. Given the prosmall business attitudes of the Bush administration, many expect a relaxation of SOX
regulations for smaller companies.
Prosecution: Arthur Andersen LLP was convicted of obstruction of justice for its role in
Enron document shredding. The Andersen partnership disintegrated under an avalanche of
lawsuits and criminal charges and its partners and employees--nearly all of whom had had
nothing to do with Enron--scrambled to land elsewhere. To date, 32 people have been
indicted for their involvement in Enron, 15 of whom have pleaded guilty. Andrew Fastow,
former CFO, has pleaded guilty to conspiracy to commit fraud and his wife, a former Enron
employee, has pleaded guilty to income tax charges. (The Fastows are negotiating with
prosecutors to serve their sentences separately, so one parent can remain at home to raise
their children.) Several others, including Skilling and Lay, Enron’s former president and former
chairman, have been indicted and are awaiting trial.
Highly publicized trials involving Tyco executives Kozlowski (hung jury), CFO Mark
Swartz (hung jury), and general counsel Mark Belnick (acquitted), and Rigas family members
(convicted on 18 counts), have been completed. Kozlowski and Swartz face retrial.
WorldCom CEO Bernie Ebbers’ trial has yet to be scheduled. Former HealthSouth CEO
Richard Scrushy’s trial began on January 3, 2005. Scrushy has the unfortunate distinction of
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being the first executive to face Sarbanes-Oxley charges, which comprise three of the 58
counts brought against him.
These corporate misdeeds triggered shareholder actions against current and former
officers, directors, accountants, and law firms. In the WorldCom case, a tentative settlement
was recently announced. As reported in the January 7, 2005 Wall Street Journal, a total of
$54 million will be paid, with insurers paying $36 million and a combined payment of $18
million coming from outside directors. While none of these directors was directly involved in
any accounting shenanigans, they were collectively accused of allowing CEO Bernie Ebbers to
run roughshod. The lead plaintiff in the case, the New York State Common Retirement Fund,
is reported to have insisted that the outside directors contribute significant amounts from their
personal assets. The expected contributors include Gordon Macklin, former president of the
National Association of Securities Dealers (NASD).
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Alan S. Brown, a partner at Locke Reynolds LLP, Indianapolis, Indiana, focuses his
practice on business, contract and complex litigation and general business counseling. He is
chair of the firm’s Business Services Group; chair of the Business Litigation Group; and former
member of its management committee (chair 1997-2000). Mr. Brown is a member of the
Indianapolis Bar Association; Federation of Defense and Corporate Counsel (director and
member of executive committee; past chair, Business Torts and Commercial Litigation
Section); Federal Bar Association; and Defense Trial Counsel of Indiana. He has served as a
faculty member for the National Institute of Trial Advocacy, the Indiana Continuing Legal
Education Forum, the FDCC Litigation Management College, and the FDCC Law Firm
Management Conference. In 1998, Mr. Brown was named to the Indianapolis Business
Journal’s “Who’s Who in Law” list and is listed in the 2001-2002, 2003-2004 and 2005-2006
editions of The Best Lawyers in America. In 2004 and 2005, he was recognized as an Indiana
“Super Lawyer” by Indianapolis Monthly. Mr. Brown is admitted to practice in Indiana, to the
Seventh Circuit Court of Appeals and to the United States Supreme Court. He received his
A.B. from Indiana University in 1974 and his J.D., cum laude, from Indiana University School of
Law in 1978.
Mr. Brown expresses his gratitude to his colleague at Locke Reynolds, Angie Ordway,
for her excellent research and contribution to this article.
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