TCS Daily

Beware the Scandal Mongers

By Duane D. Freese - July 12, 2002 12:00 AM

History is something that you can use, or abuse. And in the political scuffling going on over the WorldCom scandal, there's a lot of abuse of it going on.

The key question in the WorldCom mess is how to improve the system - accounting, regulation and ethics -- to raise ethical standards, restore public confidence in the markets, improve economic growth and raise living standards over the long term.

Now, if someone can explain how dwelling upon a 12-year-old story about George W. Bush's sale of stock in Harken Energy will do that, I'd be glad to listen. But thus far, it sounds like the kind of broken record that some Republicans became stuck on regarding Bill Clinton and Whitewater. Only it's worse, in this case, because it involves an action by Bush before he ever ran for public office.

Indeed, once you dig into the actual record rather than the spin, much as Gertrude Stein said of Oakland, Calif., there is no there, there.

The most baldly partisan angle has come in an ad campaign from American Family Voices. The organization appears to be a front group for Democratic Party smear campaigns against Bush.

The New York Times reported on Aug. 11, 2000, that the group was started up with $800,000 from the American Federation of State, County and Municipal Employees. AFSCME, through its state affiliates, overwhelmingly endorsed Al Gore for president. Further, according to the Center for Public Integrity, it provided $2 million to the Democrats in the 2000 last election cycles, making it among the party's largest soft money donors. AFV, not surprisingly, used $640,000 of its money on issue ads attacking George Bush after the Republican convention in 2000, according to the Annenberg Public Policy Center and the Campaign Media Analysis Group. As The New York Times pointed out on July 9, the group is supported by a lot of Clinton administration followers.

The World According to Krugman

But New York Times Op-Ed columnist Paul Krugman in a July 2 column put the slickest spin on the issue. He intimated that Bush acted on insider information to sell his stock in Harken before bad news about the company's earnings, due to an improper sale of a subsidiary, led to its stock plummeting.

To quote Krugman: "only a few weeks before bad news that could not be concealed caused Harken's shares to tumble - Mr. Bush sold off two-thirds of his stake for $848,000. ... Oddly, though, the law requires prompt disclosure of insider sales, he neglected to inform the SEC about this transaction until 34 weeks had passed. An internal SEC memorandum concluded that he had broken the law, but no charges were filed. This, everyone insists, had nothing to do with the fact that his father was president."

There's a logical and ethical disconnect in Krugman's analysis, though. It begins with Bush failing to inform the SEC. Krugman leaves out that Bush did inform the SEC of his intent to sell his shares on the day he sold them. Failing to point that out makes what happened sound more sinister, as if Bush was trying to cover up the sale. What the SEC didn't get was information from Harken Energy that the sale was completed.

Krugman also makes Bush a more knowledgeable insider than the record demonstrates. A March 27, 1992, SEC memo "From: Herb" (Herb Janick III, who was the one whose other memo Krugman glosses over as indicating an illegality), noted starkly: "The Vast Majority of the 2Q Loss (the restatement of which supposedly led to Harken's stock price tumbling) Was Unknown to Management, Let Alone Bush." It goes on to outline in detail what Bush's role was, which was very limited, and the problems with the supposed transaction.

Worst of all, Krugman was wrong about the bad news causing "Harken's shares to tumble." An SEC economic analysis, which Krugman as an economist ought to understand, showed that on the day before and after the restatement of earnings, Harken's shares went from $3, down to $2.37 and back to $3. As the SEC report read: "Over a two day window surrounding Harken Energy's August 20, 1990, earnings announcement, its stock price remained unchanged. While the stock price dropped significantly on August 20, it rebounded on August 21. Because no other news release explains this subsequent stock price reversal, the evidence suggests that the earnings announcement did not provide investors with new material information."

Eventually, Harken Energy's stock price did plummet, but that had something more to do with war with Iraq. A year later, it was at $8, twice the price for which Bush sold his shares.

Finally, Krugman intimates the SEC looked the other way, thus accusing its investigators of covering up a crime. Only, he doesn't say that, because he knows it's not true. Bush appointees recused themselves in the matter. Still, knowing those things and not reporting them makes Krugman truly a spinmeister and prime abuser of the historical record.

Good History Lessons

What history provides some useful guidance in these times? Well, how about three years after the great Bush scandal.

A slow recovery from the recession of 1991 that spiked unemployment rates above 7% nationally put William Jefferson Clinton in the White House and reform-minded Democrats in control of both the House and the Senate.

Much the same way they are attacking business leaders and Bush today, Democrats tried to make a big deal about the 1980s being the decade of decade of greed. Indeed, they were fond of quoting, Gordon Gekko, a character from movie Wall Street, in which the Michael Milken and Ivan Boesky-like character stood up at a stockholders meeting to declare: "Greed is good! Greed works! Greed will save the USA!"

Oddly, though, among their targets were the same corporate executives that Gekko in his speech went after. Corporate downsizings in the recession of 1991 made heavies of these managers, especially as their own wealth seemed to be rising. Business Week reported CEO pay had jumped from 42 times that of the average hourly worker's in 1980 to 85 times by 1990.

So in the reforms that summer, which raised taxes and slashed defense spending, there was a new provision added to the tax code. It limited deductions from corporate income taxes for non-performance based pay of each of the top five executives to $1 million.

And following up to further expose executive compensation to closer shareholder scrutiny, Clinton's Security and Exchange Commission put in place rules to require more details from corporations in reporting executive compensation.

And what did all this "restraint" serve to accomplish? By 2000 and the end of Clinton's two-terms, CEO compensation had jumped to 531 times the average worker's wage.

Not Optional

This history demonstrates the law of unintended consequences. By taking the focus off competitive pay to get good executives, the action encouraged boards to develop pay for performance plans, including massive stock options, made legal by President Harry Truman's Revenue Act of 1950 when he raised corporate income taxes to pay for the Korean War.

Stock options and bonus arrangements remained rare through most of the 1950s and early1960s. They gained currency only when the stock market began to slump in the 1960s and 1970s. But the 1993 act with its emphasis on pay for performance led to them taking off.

Taking flight with them was basing executive compensation on the improvement of a company's earnings per share - the profit of a company divided by its outstanding shares. Coupled with the new information about how other execs were making money provided by the SEC rule, executives went well armed to compensation committees to get increased pay.

In addition, the rules and guidelines provided some with new incentive to produce rosy earnings in the short term. As a study by Stern Stewart & Co., compensation consultants, noted, Enron did so by over-leveraging the balance sheet. Rather than issue new shares to raise money, it relied on debt financing "beyond the brink of financial prudence."

And in other quarters, it's led to cooking the books.

But does this mean that stock options should be tossed out or that pay for performance be discarded? The growth of the 1990s was hardly all smoke and mirrors. Productivity growth made a big turn upward, and high technology and communications firms provided the basis for that. And many of their executives and workers were motivated by the chance of owning pieces of their companies.

The historical lesson here is that before you change anything, you'd better make sure of what you're trying to accomplish.. In the rush for reform after the WorldCom fraud and Enron accounting scandals, a focus on beefing up enforcement and tougher penalties for fraud makes immediate sense. If an executive cheats, he ought to lose his wealth and his liberty for he has violated a public trust.

But working out truly better accounting rules and compensation incentives will take a lot of investigation and hard work. Treatment of assets and expenses for tax and financial treatment differ and need reconciling to produce real transparency and economic efficiency.

Congress needs to be wary of doing something just to look good. The scandal mongering of a decade ago led to "reforms" that underlie today's scandals. Abusing history or forgetting it both lead to hard lessons.



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