Introduce the subject by reading the following to students and discussing the questions.
A. A man with a pistol points it at a liquor store clerk, demands all the cash in the register and flees with $2500. Later the robber is caught, tried and sentenced to 10 years in prison.
B. The chief financial officer of Globalcorp designs a financial strategy that makes it appear as if the company has a profit of more than $1 billion when in fact it has lost money. The officer is caught, tried and sentenced to one year in prison.
C. Do you agree with these sentences? If so, why? If not, why not?
D. Some additional information about the Globalcorp officer's behavior: Before the release of Globalcorp's statement of earnings for the year, its stock price was $31 per share. After the release, fraudulently showing that the company made more than $1 billion, the stock price doubles. The officer, who had bought one million shares at $31, then sells them and makes a profit of $31 million. When the fraud is discovered, the stock price drops to pennies per share. Tens of thousands of employees who have bought Globalcorp's stock at $31 and have most of their pension money for retirement invested in it now find their pensions virtually worthless. Seventeen thousand of the company's employees also lose their jobs when the corporation is forced to apply for bankruptcy.
E. Given this additional information, would you change either or both of the sentences? Why or why not?
F. Have students read Student Reading 1. Then discuss the questions that follow the reading.
STUDENT READING 1:
The WorldCom Scandal
WorldCom, second only to AT&T as a long-distance carrier and probably the most important operator of the internet in the world, said this summer that it had improperly accounted for $7.1 billion in irregularities going back to 1999.
WorldCom began as a telephone company in 1983 under the name LDDS Communications. Through a series of mergers and acquisitions such as MCI, it grew swiftly. It had 85,000 employees; in 2001 it had revenues of $35.2 billion. It also claimed net income of $1.4 billion, though it is now clear that the company actually suffered losses.
When a company reports its earnings, it must subtract everyday operating expenses like salaries immediately; its capital expenses for things like heavy machinery with a useful life of many years can be spread over long periods of time. For a company to book an operating expense as a capital expense can give the appearance that it is more profitable than it is. This is precisely what WorldCom's chief financial officer Scott D. Sullivan and other executives are alleged to have done. They have been charged with securities fraud and filing false statements with the Securities and Exchange Commission, (SEC) a governmental regulatory agency. Their chief gimmick seems to have been booking WorldCom operating expenses—like sums paid to other companies for use of their telecommunications networks—as capital expenses. The result was to make it appear as if WorldCom was making significant profits instead of experiencing significant losses.
WorldCom CEO (Chief Executive Officer) John W. Sidgmore said he was "shocked" by the revelations. Sullivan was fired. The company's stock price, which had been $62 per share in 1999, has spiraled down to pennies. On July 21, WorldCom filed for the largest bankruptcy in U.S. history, a victim of its overly ambitious business strategies, the tremendous glut of telecommunications capacity that has developed in recent years, and its accounting practices. The company owes hundreds of millions of dollars to such other telecommunications companies as Verizon and SBC, from which it buys services.
Sullivan sold almost 1.4 million shares of WorldCom stock from 1997 to 2000, which made him a profit of about $30 million. WorldCom's previous CEO Bernard J. Ebbers, who resigned suddenly in April 2002, owes the company more than $366 million for loans and loan guarantees. The company's internal e-mails seem to demonstrate that executives besides Sullivan knew as early as 2000 that the treatment of expenses was improper. Yet at a March 2002 meeting of the audit committee of the WorldCom board, Ebbers sought a 50 percent cut in internal audit spending, just when such auditing was on the verge of uncovering irregularities.
Representative Billy Tauzin, chairman of the House Energy and Commerce Committee, said, "This is a company simply determined for several years to misstate its earnings to the American public...doing so in the face of advice from their own officials inside the company that it was improper and illegal to do so." He added that Ebbers' behavior just before he resigned indicates that "top leaders of this company likely knew what was going on." (New York Times, 7/16/02)
WorldCom has announced that it is cutting 20% of its employees, which means a job loss to 17,000 people.
1. What questions do students have? How might they be answered?
2. What is the distinction between operating costs and capital costs? Give an example other than those provided in the reading.
3. How and why does it make a difference in a company's apparent profitability if it books operating expenses as capital expenses?
4. Why did WorldCom's stock price drop?
5. What do you think were Sullivan's motives for what he did?
6. Why do you suppose that none of WorldCom's other executives blew the whistle on its accounting practices?
7. Why do you suppose WorldCom is cutting its employees sharply?
8. Note the similarities between the WorldCom story and the hypothetical Globalcorp story.
Divide the class into pairs for a few minutes to discuss whether or not they would now make any further change in the prison sentences assessed earlier. Why or why not?
ASSIGNMENT: Student Reading 2 and accompanying written work
STUDENT READING 2:
Business Fraud and Its Victims
The Enron debacle was the first major corporate scandal to rivet public attention. Beginning as a natural gas company operating a pipeline, Enron grew rapidly in the deregulated marketplace it and other energy companies lobbied Congress to create. It bought up electricity-generating plants and branched out from the energy field into broadband cable, newsprint, and other industries. But by late 2001 it was filing for bankruptcy and the company and a number of its top executives were under investigation for multiple potential frauds. One was hiding debts through hundreds of offshore subsidiaries to make it appear as if its profits were much greater than they were and thus to drive up its stock price.
A second was manipulating the California energy market to make huge profits and, again, to drive up its stock price. It is uncertain whether such acts are illegal or just ethically questionable. But one Enron finance officer pleaded guilty in August 2002 to wire fraud conspiracy and money laundering, and indictments of other officers are expected on various charges.
Since the Enron revelations, an avalanche of other major corporate scandals and accusations of white collar crime have been reported almost daily involving companies such as Dynegy, CMS Energy, AOL Time Warner, and Merck.
Three members of the Rigas family, founders of Adelphia Communications, a cable provider, have been indicted for hiding $3 billion in loans to themselves and overstating the number of their customers. Four former top executives of Rite Aid have been indicted on charges of securities and accounting fraud. Dennis Kozlowski, the ex-CEO of the conglomerate Tyco, has been indicted for tax evasion, and the company is under investigation for improper merger and accounting practices.
The list goes on and on. Some other highly questionable and/or illegal practices include:
Investment firms telling investors to buy stocks in corporations that the investment firm itself does work for - while privately bad-mouthing the same stocks as "horrible" and "a piece of junk." Example: Merrill Lynch, an investment banking firm which recently paid a $100 million fine to New York and other states for such practices, has also been questioned about its participation in fraudulent Enron transactions.
Buying or selling stocks based on insider information on which it is illegal to profit. Example: Samuel D. Waksal, former head of ImClone Systems, a bio-pharmaceutical firm, has also been indicted for bank fraud, forgery, and destroying records to obstruct a federal investigation.
Companies employing their own "independent auditor" to do well-paid non-audit consultant work. This create conflicts of interest for the auditor, whose responsibility is to protect shareholder interests. Example: The auditing firm Arthur Andersen was recently convicted of "obstruction of justice" for its role in the Enron disaster. Arthur Andersen was auditing Enron's books even as it was collecting millions in consulting work from the same company.
Booking sales several years before they will be paid. Example: Computer Associates.
Offering incentives for wholesalers to buy more of their products than retailers are selling. Example: Bristol-Myers Squibb.
Most of these practices have been aimed at artificially and often illegally pumping up a company's profits, which in turn results in pumping up a company's stock price. Top executives usually hold options to buy a stock at a fixed price and stand to gain many millions by selling it when the stock price goes up — and before it goes down after its questionable practices become public.
Federal Reserve Chairman Alan Greenspan in his July 2002 testimony before Congress on the mounting corporate scandals said: "Too many corporate executives sought ways to harvest...stock market gains. As a result, the highly desirable spread of shareholding and options among business managers perversely created incentives to artificially inflate reported earnings in order to keep stock prices high and rising." Greenspan supports changing the rules for stock options, for he sees them as a major contributor to the "infectious greed" that "seemed to grip the business community."
Enron executives Kenneth Lay, Jeffrey Skilling, and Andrew Fastow cashed in for millions before Enron's stock tanked, causing investor losses of $60 billion. Joseph Nacchio of Philip Anschutz of Qwest, a telecommunications company, profited to the tune of $226.7 million and $1.453 billion respectively, leading two dozen Qwest executives who also profited handsomely. Qwest's stock price, once valued at $66 per share, closed at $1.49 on July 29, 2002 after revelations of the company's improper accounting.
A terrible result of corporate unethical and criminal behavior is the effect on employees and investors in companies like Qwest, Enron, WorldCom, and many others. Some 600 top Enron executives received $100 million in bonuses as the company was collapsing in the fall of 2001. Twenty-nine leaders of the company collected $1 billion in stock sales, knowing that Enron was in serious trouble though issuing optimistic reports about its future. But thousands of Enron employees who were required to invest in company stock and had more than half of their retirement money in it lost both their pensions and their jobs. And many thousands more investors, some of whom were deliberately ill-advised by their advisors at companies like Merrill Lynch, lost untold millions.
Where were the directors of such companies while executives were cooking the books? Many, like the executives, sold their shares before the company collapsed, raising serious questions of corporate governance and oversight.
Where was the government while Scott Sullivan at WorldCom was pretending that operating expenses were capital expenses? Not paying much attention. Withdrawing responsibility by deregulating the energy, cable, and other industries. Underfunding regulatory agencies like the SEC, which was created after the 1929 stock market crash specifically to protect investor interests. It was the lack of such protection that contributed to the crash. Fed Chairman Greenspan now says that his view had always been that government regulation of accounting was "unnecessary and indeed most inappropriate. I was wrong."
One of the reasons cited for the government's lack of attention are the substantial contributions that corporations like Enron, WorldCom, and Merrill Lynch make to the campaigns of politicians running for public office. Recent legislation to ban "soft money," or unlimited contributions to political parties, was intended to address this problem.
Another reason for the government's inattention is that regulatory agencies like the SEC are swamped with work and have inadequate resources to do their jobs. By law the SEC has the responsibility of reviewing the financial records of 17,000 public companies, overseeing thousands of mutual funds, vetting all brokerage firms, ensuring the proper operation of exchanges like the New York Stock Exchange, and watching for all kinds of corporate and market manipulations and possible misdeeds. Yet the SEC has only about 100 lawyers to study documents of those 17,000 public companies. And because the SEC's lawyers and examiners are paid up to 40 percent less than comparable employees in other federal agencies, the turnover rate at the SEC is 30 percent, double that of the rest of the government.
What's more, white collar crime is often very difficult to prove. Laws regulating companies and accounting rules can be ambiguous and criminal intent hard to demonstrate. Juries are often unfamiliar with complicated financial concepts and lawyers for corporations are experts at creating reasonable doubt.
(1) Write down and bring to class two or three of the best questions you can think of which, if answered well, would help you to understand the unethical and/or criminal activities that have been going on in the U.S. business world.
(2) Imagine that you are a member of Congress. Write down and bring to class two or three laws do you think would best prevent questionable and illegal business practices?
A. Have the class consider a sampling of student questions. Which questions can other students answer? How well? Which questions call for further inquiry? For a full treatment of how teachers might deal with student questions, see "Teaching Critical Thinking" on this website.
B. Divide the class into groups of four. Each student should present two or three proposed laws to the group. Other group members should ask any clarifying questions about them. Then the group should select for presentation to the class the one or two laws it judges most worthwhile.
C. Have a member of each group present its proposed laws to the class.
D. Distribute Student Reading 3: What Is Being Done by Congress and the President? After students have completed the reading, discuss and compare with suggested student laws. If necessary, continue the discussion into the next class session.
E. ASSIGNMENT. Student Reading 4: The Profitable World of Stock Options. After students have completed the reading, they are to write one paragraph arguing for or against changing the rules for how companies account for stock options. Provide supporting evidence.
STUDENT READING 3:
What Is Being Done by Congress & the President
In response to unethical and criminal behavior in the corporate world, President Bush has promised a $100 million increase in the SEC's budget, a sum that Democratic critics say is way short of the need, proposing instead $750 million. The House and Senate have passed overwhelmingly and the President has signed legislation designed to reform business law. Critics welcome the reform, but say it is insufficient. The new regulations:
1. Establish a regulatory board to oversee the accounting industry and discipline corrupt auditors.
2. Prohibit accountants from providing a number of, but not all, consulting services to companies they audit.
3. Make it a crime to engage in any "scheme or artifice" to defraud shareholders.
4. Require that chief executives and chief financial officers of publicly traded companies certify their financial statements as accurate and be jailed for up to 20 years if they "knowingly or willfully" allow significantly misleading information into reports.
5. Prohibit company loans to executives that are not available to outsiders.
6. Prohibit Wall Street investment firms from retaliating against research analysts who criticize investment banking clients of their firms.
The New York Stock Exchange has announced the following new rules for companies whose shares trade on the exchange:
1. They must have a majority of directors who have no ties to the company.
2. They must, in most instances, have shareholder approval before issuing stock options.
3. They must keep all business communications for at least three years.
The SEC has announced that major corporate chief executive officers and chief financial officers must "personally certify, in writing, under oath...that their most recent reports filed with the Commission are both complete and accurate" or face penalties.
STUDENT READING 4:
The Profitable World of Stock Options
Some critics of recent business law reform say that new regulations do nothing to change how companies account for stock options. They see this as essential to eliminating corporate incentives to inflate their stock prices artificially, even illegally. Others view the current system of stock option accounting as basically sound and abused by a relatively small number of greedy executives.
What is a stock option? A stock option is the right, granted by a company to an employee, to buy that company's stock at a fixed price, usually the price of the stock when the option was first granted. According to the National Center for Employee Ownership, most stock options go to top executives who typically get tens or hundreds of thousands of options. Lower level employees typically get a few hundred.
How do stock options work? Let's say Jim Smith, a junior executive, is given as a condition of employment an option to buy 10,000 shares of the company's stock at any time during the next five years at its current price of $50 per share. Two years later the stock has gone up to $60 per share. Jim Smith decides to exercise his option and buys 10,000 shares at a cost to him of $500,000 (50 x 10,000) and promptly sells them for $600,000 (60 x 10,000). He has made himself $100,000. If, on the other hand, the value of the stock should stay the same or even go down, Smith loses nothing by simply not exercising his options.
Why does a company issue stock options to employees? The primary reason is usually to attract a person to the company and to give him or her an incentive to work hard, help make the company profitable and raise its stock price. Corporations gain other advantages by offering stock options. Companies do not have to include the cost of their stock option grants in their earnings records, but they can deduct their cost from their taxable income. In the case of Jim Smith, the company could make a deduction of $100,000. As a result, such companies as Microsoft, Cisco Systems and Dell Computer are able to erase much, perhaps all, of what they owe in taxes. In 2001 WorldCom's earnings would have been 57 percent lower than they were if the company had had to include their costs for stock option grants in their earning records. Enron's deductions for stock options helped eliminate more than $625 million in taxes from 1996 to 2000.
Argument for leaving stock option rules essentially unchanged. Senator Joseph Lieberman (D-CT) argues: "One popular solution to the current crisis of corporate crime is to fix the accounting rules for stock options....I wish it were that easy. The reality is that giving options to employees is an innovative idea that has been abused by greedy executives. But changing the accounting rules won't change their behavior; it will only deny options to average workers who have done nothing wrong....Options are a valuable tool for attracting talent and spreading wealth because they give employees a greater stake in their companies. And business leaders, particularly from the high-tech community, said they would have to give fewer options if they had to subtract their estimated value from their profits....It would significantly reduce earnings for many companies with large option plans, which in turn would reduce the value of their stock in particular and the market in general. This is the last thing we need now." (New York Times, 7/21/02)
Argument for changing stock option rules. Walter M. Cadette, a senior scholar at the Levy Institute of Bard College and a retired vice president at J.P. Morgan & Company, says: "The stock-options culture is at the root of the current scandals on Wall Street. Options...bring with them a powerful incentive to cheat. They hold out the promise of wealth beyond imagining. All it takes is a set of books good enough to send a stock price soaring, if only for a while. If real earnings are not there, they can be manufactured—for long enough, in any case for executives to cash out. This is in essence what happened at Enron, WorldCom, Xerox—indeed, at quite a long list of companies....Corporate America appears to be overstating earnings by at least 20 percent. About half of the exaggeration reflects the lack of any recorded expense for options; the other half, manipulated operating earnings....Treating options like other forms of pay would make executive compensation transparent, diminish the temptation to cook the books and make managers less inclined toward excessive risk-taking." (New York Times, 7/12/02)
Companies fighting stock options reform. During recent Congressional discussions about stock options reform, business groups lobbied representatives and senators intensively. The leading group was the Stock Option Coalition, which is made up of such high-tech companies as Cisco Systems, Intel, Dell Computer, AOL Time Warner, and Sun Microsystems. These companies are among the biggest users of stock options. Cisco Systems, for example, has 1.7 billion stock option shares outstanding. In the 2000 election, high-tech companies contributed $40 million to both parties. During the campaign against changing the rules for stock options, Rhett Dawson, president of the Information Technology Industry Council, wrote to Tom Daschle (D-NB), the Democratic majority leader of the Senate: "At the end of the 107th Congress, key votes will be compiled and analyzed to assign a 'score' to every Member of Congress." Dawson said the score would be used to determine who gets the high-tech industry's political support. Congress turned down the proposed reform. Senator Daschle voted with the majority.
Companies that have changed their rules. Some companies now say they will charge their balance sheets for the costs of stock options. They include: General Electric, Coca-Cola, the Washington Post, Bank One, and Amazon.com. Boeing has been doing so for some time. GE has also announced that top executives will no longer be allowed to take profits right after cashing in options.
A. Divide the class into groups of four to read and discuss their paragraphs and to select the one they regard as best to be read to other students.
B. Have the student papers read to the class.
C. Consider with students any remaining issues.
Note to the Teacher: For further information about Enron, see "The Enron Debacle" on this website.
The New York Times
Business Week: businessweek.com—"Why Corporate Crooks Are Tough to Nail," 7/1/02
Forbes: forbes.com—"The Corporate Scandal Sheet," 7/25/02
Fortune: fortune.com—"System Failure," 6/24/02 Time: time.com
Wall Street Journal—wsj.com
PBS, "The News Hour" with Jim Lehrer. Interviews with Senators Carl Levin (MI), chairman of the Senate Subcommittee on Investigations, and Susan Collins, (ME), 7/30/02)
This lesson was written for TeachableMoment.Org, a project of Morningside Center for Teaching Social Responsibility. We welcome your comments. Please email them to: email@example.com.