Something is Rotten in Denmark . . . But What?

This is from the "Way Back Machine: First published in August of 2002.  


What are we to make of Enron, Tyco, Global Crossing, Rite Aid, WorldCom, and Xerox? What are we to conclude about Martha Stewart, Bernie Ebbers, Joseph Nacchio, Dennis Kozlowski, and the seemingly endless parade of executive no-gooders? Something is rotten in Denmark, to paraphrase Shakespeare, but what? When the sordid mess now unfolding across our newspapers, magazines, and news shows is relegated like a bad John Travolta movie to the dust heap of recent history, what will we have learned?

It’s possible we may conclude that what is now being called “Corporate Watergate” is nothing more than the result of the greed and avarice of a few people who managed to run the table at Wall Street and have now crapped out. I read an article in my local paper today that quotes Paul Hazen, the former Wells Fargo chief executive who sits on the boards of seven companies as saying that although corporate governance has failed at a handful of companies, it remains successful at the majority of them. "I would hope that we don't just overreact." I have no way of knowing if Hazen was accurately quoted or not, but I’d say his explanation for what’s going on falls into the “few bad men” category: find and punish the few bad men, and everything will be fine.

I have at least two problems with this line of thinking. The first is embedded in the idea of “few”. Towards that, I think the Watergate imagery is in fact quite apt. A quarter of a century later, few people could tell you anything about what happened, why, and what was done as a result other than the villain, played by Richard Nixon, resigned and flew away to write books and later become a rehabilitated elder statesman.

If history is any guide, Hazen has nothing to worry about. We could overreact by a factor of 100 and it wouldn’t be too much. More to the point, it will all be forgotten in twenty years anyway. Remember the savings and loan scandal? For 100 points, name one person who got slapped around as a result. (Double credit if the name you came up with wasn’t Charles Keating.) See what I mean?

No, if you’re going to subscribe to the “bad man” theory, you might as well go all the way. There were lots of bad men involved with Watergate, particularly if you view Watergate as something larger than a bungled burglary. There were lots of bad men involved in the Savings and Loan scandal. Similarly, the names being bandied about in the press today don’t begin to hint at the number of people that have knowingly participated in some form of financial trickery, insider trading, or thinly disguised plausible deniability. Either that, or there are:

  • An awful lot of amazingly unobservant people running companies these days.
  • A lot of people that have simultaneously and mysteriously had portions of their memory and/or intellect wiped out by alien death rays.

One of the pleasant fictions we Americans polish and treasure is that we live in a meritocracy. As long as you’re good, and good at what you will do, you’ll rise to the top. The better you are, the higher you’ll rise. We also tend to define our sense of merit quite inclusively. If you’re good at numbers, you must also be a good person. If you’re a good athlete, you must also be a good role model for children. If you’re a good business person, you must also be a good parent.

I don’t mean to be the one to break your bubble, but 99.9% of the people who “rise to the top” in business, politics, sports, or any other organized endeavor you can name didn’t get there simply because of merit. And no, even if merit is an adequate explanation (which it isn’t), merit is not some universal solvent that washes clean everything it touches. Bill Gates may be smart, but that’s not why he’s the richest civilian in the world. Warren Buffet may look like the kooky uncle you never had, but don’t kid yourself about what he’s capable of.

No, the Gateses, Ellisons, Bushes, Gores, Clintons, Jordans, Bryants, Nixons, Blairs, Husseins, Eisners, Welchs, Ebbers, and Stewarts of the world got where they got because they were cunning, clever, driven, politically astute, and ruthless. Yes they’re also talented, but make no mistake: they abide by an internal moral code that wouldn’t make most of us comfortable if it were on display around the house on a daily basis.

A few bad men? Try thousands. The Bush crowd is delighted that WorldCom and Xerox came along so that attention will be diverted from the all too obvious connections to Enron, Halliburton, and all the others in the energy patch that are busy trying to cover over their misdeeds.

The nice people on Wall Street that issued all those glowing “buy” recommendations on companies they knew were “turkeys” are similarly relieved now that the SEC has a new toy to play with.

The politicians who begrudgingly voted for campaign reform are feeling a bit squeamish, but not so much so that it didn’t stop their lackeys on the Federal Election Commission from gutting the intent of the law.

All that said, I guess I’d be happy thinking that the answer is as simple as punishing the guilty. It’s not. The other problem with the “few bad men” theory is the implication that everything else was fine: it’s just the bad people who screwed up. In other words, there was nothing wrong with the larger game or the rules by which it’s run just the bad men (and occasional woman) who were playing it. I don’t buy that.

 

The Evils of Bigness: A Modern Morality Play

You have to at least consider the possibility that the events now unfolding are part of a larger morality play about bigness, the dangers of playing God, or both. That what has gone wrong isn’t ruthless people reaping the whirlwind, but the inevitable consequence of what happens when you think you’re smart enough to optimize, fix, build, or otherwise tinker with something that has millions of moving parts.

Big, highly complex systems are, well, complex. That’s true of companies like WorldCom and Enron, just like it’s true of ecosystems like a forest or prairie, or biological systems like the human body. Nature assembles these later systems over very long periods of time (assuming time even exists) and with lots of messiness and redundancy built in. There are plenty of disasters, crashes, burns, and other seeming cataclysms. In the grand scheme of things, these are nature’s way of working things out and building a system that works.

But that’s not how we humans like things to work. We want it all, we want it perfect, and we want it now. Got to go, go, go! Life is short! There are places to go, people to see, lands to conquer, brands to build, enterprises to expand, industries to invent, and street corners without McDonalds or Starbucks to populate. Big is good. Bigger is better. Gigantic is better still. Nothing is too complex when capital is cheap and the markets are hungry. For whatever reason we think we’re smart enough to swizzle a couple of variables, raise a bunch of money, and be near-deific masters of complexity.

So, for the past ten years, despite the overwhelming historical evidence that big mergers and acquisitions don’t work, executives supported by their accounting and investment banking and legal entourages, bought and merged like there was no tomorrow with little thought as to how all the disparate pieces would fit together.

And they haven’t worked. Every one of the companies we’re reading about now is an example of the God complex in full bloom. Too much, too complex, too fast, and too bad. For every one of these that works, nine more don’t. And no, Carly Fiorina isn’t any smarter or better than the rest, and no HP won’t work either.

The trouble with playing God—and messing with or trying to build wildly complex systems in a cosmological nanosecond is exactly that—is that we’re not very good at it. In the grand scheme of things, we come up just a bit short on the omnipresent, omniscient, and omnipotent dimensions.

For example, it’s only the beginning of July 2002 as I write this, and wildfires have burned some 2.5 million acres of the American west. That’s a lot. More than a “normal” year and we’re not anywhere close to being done. I’m not smart enough to know how all the pieces fit together, but smarter people than me say that decades of misguided forest management and land management policies have upset the natural rhythm of things out where the trees grow. Comparatively small fires that would otherwise have thinned out forests have been vigorously contested, turning vast swaths of the west into monster tinderboxes waiting to happen.

It turns out that removing an unwanted feature of the ecosystem—in this case the natural burn cycle—has significant downstream implications. A bit closer to home, this same phenomena shows up in dog breeding. I’m not sure what they’ve done to deserve this, but man’s attempts to engineer the perfect dog has turned Man’s Best Friend into breed after breed of mutated messes, each now with significant physical and mental problems. Think about that next time someone raises the topic of genetic engineering.

I don’t think it’s at all coincidental that the companies we’re now reading about are arguably the financial equivalent of a forest that hasn’t been allowed its natural burn cycle or a dog that’s been over-bred in the name of better ears. They’re mutated freaks of commerce burdened by too much debt, phantasmagorical expectations, and scrambled accounting DNA. And yes, many have been assembled and run by “bad men.” The only shock in all of this is that anyone is shocked. You could see it coming a mile away but for the irrational exuberance we were all feeling.

 

Blame the System

It’s also possible that “Corporate Watergate” has nothing to do with bad people or the evils of messing with complexity. It could be that all of this can be explained by basic systems theory. In this version of reality, the interlocking pieces of corporate governance, finance, accounting, capital markets, public ownership, and the political process each ratcheted the others up, up, up in the name of growth until the entire system became unstable. Systems don’t like instability. They like equilibrium and over time the internal dynamics of any and every system seek to reestablish balance. What we’re seeing is just another example of systems at work.

While you can’t reasonably blame the accounting profession for the current spectacle, it’s as good a place as any to see how the system ratcheted out of control.

The truth is that the accounting profession has been hiding a dirty little secret for at least a decade if not longer: accounting firms hate audits. Conventional wisdom back in the early nineties was that audits were boring commodities. Companies bought them because they had to and wouldn’t pay a dime more for them than was absolutely necessary. That probably was true, but this seemingly simple assertion led the accounting profession in multiple directions, all of which are now smashing up against public confidence in American capitalism.

1)    The growth of consulting. The first conclusion was to buy or build other lines of business. This had actually been going on for quite some time but took off with a vengeance starting in the late eighties. Audit partners, the high priests of the profession and keepers of the all important executive relationships, would now become door openers for all manner of non-audit services like systems integration, cost recovery, inter-company transfer studies, appraisals, economics, forensics, intellectual property management, document management for the legal profession, and in countries other than the US, even the practice of law. And that’s just a sample. Similar cleverness went on over on the tax side of the business, where the best and brightest came up with complex schemes to use off-shore entities, insurance vehicles, and tiny loopholes in footnote 12.23.45.45 on page a billion of the tax code to avoid paying taxes, and often to garner refunds for taxes never paid in the past.

2)    The growth of outsourcing. Many of these services could be both sold on a project basis as well as outsourced. This created a nice double fee dynamic because the firms could not only capture an ongoing revenue stream, but get paid to account for the now off-balance sheet entity as well. In many ways the showstopper was the outsourced internal audit. The rules at first seemed pretty clear: firms couldn’t be the internal auditor for the same company they were the external auditor for, but you can tell where that went.

3)    Re-invention of the audit. Many firms also undertook brave sounding initiatives designed to reinvent the prosaic old audit into something fresh, exciting and vital. This actually had its roots ironically enough with Arthur Andersen himself who was the inventor of the “blue back,” the comments and analysis that he and his colleagues began to issue along with the normal attestations provided to investors and lenders. Mostly this didn’t get very far, but it wasn’t for lack of trying.

4)    Audit as loss leader. CFOs shared the accountants’ disdain for the audit, and over the ensuing decade hammered and hammered at the cost until the audit became a loss leader for the accounting firms. Auditors may be a lot of things, but they aren’t stupid. One way you cut loses is to cut back the service you provide. The other way is to cross-sell high margin services in order to cross-subsidize the audit and to make the entire relationship profitable. Accounting firms did both, thus leading to annual tabs like the $50 million Enron reportedly paid to Andersen, of which only a fraction was the audit.

 

Meanwhile, here in 2002, the accounting profession’s dirty little secret became a cancer. At a time when audit fees should have been rising dramatically to cover the cost of dealing with ever more complex businesses, they were flat or declining in real dollars. Accounting firms turned this legal and public trust into little more than a blue light special. Ignore the noble words and look at the actions. The audit is the ugly step child of the accounting profession. Firms compete with each other to lose money providing the smallest amount of diligence they think they can get away with to companies looking for a firm to skate as close to the line as possible.

None of this was happening in a vacuum. The changes in the accounting profession were part of a larger system in which businesses were undergoing radical transformation and growth during an era of seemingly unlimited opportunity and capital. Companies bought, sold, consolidated, converged, transformed, and sought global scale and reach at a pace that simply outstripped the capacity of all the interlocking balancing systems to keep up. In fact, they couldn’t keep up because they were being denuded of talent and energy.

Instead of governing, attesting, monitoring, and watching, the auditors, analysts, regulators, and politicians that normally make up the balancing systems were doing everything they could to help these newly mutated corporate life forms get even bigger, grander, and more complex in exchange for ever larger fees and campaign contributions. It was the golden era of the Robber Barons all over again, except the names weren’t Crocker, Stanford, Carnegie, Rockefeller, and Morgan.

Everyone and everything was rigged for unbridled growth. Investors large and small demanded predictable and ever upward financial performance. CFOs obliged by jiggling revenue and expense recognition to back into the analysts’ consensus estimate. Economic juggernauts like Microsoft and General Electric used their muscular balance sheets and multiple lines of business to play the earnings game with marvelous predictability. Many more companies, lacking the huge reserves and healthy business models, did the same except that there was no there there.

It’s a slippery slope that leads from financial engineering (a euphemism for what most companies do to make their numbers), to financial manipulation, to outright fraud. Many more companies than we’re reading about today went way down that slope, goaded on by the dynamics of the system and the players in it.

It’s not that any of this is a surprise. In a larger sense, the system worked. All the dynamics that lead to this point have been plainly on display for years. It’s just that most of us didn’t particularly care while everything was heading towards the stratosphere.

  • If executives were getting paid more than the gross national product of most third world countries, who cared?
  • If companies were making six figure contributions to politicians’ war chests, who cared?
  • If disinterested third party analysts were getting paid seven and eight figure bonuses, who were we to impugn their motives or independence?
  • If accounting firms began to take on the profile of a diversified services firm with growth stock performance, who cared? 
  • If company after company managed to miraculously meet or just beat the consensus earnings estimate, who were we to suggest it was anything other than good financial management?

We’re just all angry that we didn’t get out before the self-balancing forces of the cosmos turned on the house of cards that irrational exuberance built. But make no mistake, the inexorable laws of system dynamics were always at work in the background.

At some point, and it was probably sometime in 2000, the great system that is American capitalism got horribly unstable, and being a system, automatically sought its own balance point. If you’re an Enron or WorldCom employee and 401(k) owner, that explanation offers scant comfort. But we shouldn’t overlook the fact that according to systems theory, everything that is happening is completely predictable, even if the details can’t be foreseen beforehand: the excesses will be wrung out and the system will seek equilibrium, however painfully.

 

Does Any of This Matter?

All of this leaves me with a more disquieting question: does any of this really matter?

From the standpoint of the media, it’s great theater and provides juicy fodder for pages and pages of reportage, analysis, and punditry. No doubt there will be Pulitzer prizes and more for a few of the more enterprising (meaning cunning, clever, driven, politically astute, and ruthless) scribblers. But make no mistake, this will all be yesterday’s fish wrap by August at the latest unless someone can find an Enron connection to Bush or implicate Dick Chaney at Halliburton, and that’s just not going to happen.

The folks who exercise the real power have already decided that the time for blood letting must stop. No more accounting firms will be allowed to fold. No more investment banking firms will be publicly flogged. The wild card is how many more companies so badly cooked their books that they’re going to implode, but there’s an end in sight to even that.

More to the point, something else will come along—and I don’t even want to speculate on what that will be—and the press will move on.

Absent the glare of publicity or a congressional vendetta, the wheels of justice will grind all of this slowly into hundreds of millions of dollars in legal fees and little more. Individual investors and employees are out of luck: they’ll get nothing. Some of the bad men will be further embarrassed and a couple of them might even have to pay a fine, do a few months in a minimum security penal farm, or otherwise be inconvenienced. Guys like Jeffrey Skilling and Bernie Ebbers might even have to live off their cash hordes for several years before they can get something new going.

There will also be new pronouncements by the SEC. There will be thousands of pages of new regulations and standards that lawyers and accountants will be paid handsomely to lobby against and then to interpret after they’re promulgated. The price of audits will go way up as will premiums on errors and omission and directors insurance. Companies will have a hard time finding board members for awhile.

But in the end, nothing of any real consequence will change. It will all be window dressing.

Why? Human nature won’t change. People willing to exercise power will continue to rise to the top because most of us are ambivalent about power. We’re just as happy for someone else to grab the wheel as long as they play by the rules, the first rule being, don’t be too obvious; the second being, don’t get caught being too obvious. Soothing words will be spoken. Politicians and regulators will give us their best steely eyed looks. And we’ll all go back to hoping that the people who exercise power will play nicely this time.

Our individual and collective desire to play God also won’t change. Unlike every other species that inhabits this planet, we refuse to leave things as they are. It’s just not the way we are. We’ve been making tools and otherwise messing with nature at least since Homo Erectus and in the evolutionary scheme of things, the financial gymnastics now on display courtesy of Enron, Tyco, Global Crossing, Rite Aid, WorldCom, and Xerox are no different. Incinerating a trillion dollars of phantom wealth certainly isn’t a good enough reason to stop.

The system clearly isn’t going to change. As individual players seek new sources of advantage, other parts of the system will rise up to balance or outdo that temporary source of imbalance. Up and up the system will ratchet until it reaches a point where it can go no further and then it will lock up, reset, appear to disintegrate, and then it will start all over again.

Depressing? Maybe. But only if one or all of the following is true:

1)    You’re surprised by what’s happened. If that’s the case, you’re operating under the assumption that the current events are truly aberrations, abnormalities that should be purged so we can get back to the way it was. Maybe next time you won’t be surprised.

2)    That just because that’s the way it is, just because nothing is going to change, that there’s nothing you can do. I realize that sounds crazy, but just because people have always cheated at cards doesn’t mean you have to be depressed. You can cheat as well. You can not play. You can modify how you play based on your knowledge that the people around you are cheating (remember Paul Newman and Robert Redford in The Sting?). You can start another game. You can become a vigilante and hunt down card players and expose them for the cheats they are. There are lots of things you can do to protect yourself or improve your lot.

3)    You believe that just because someone like me writes 3900 words that conclude with “nothing will change,” that nothing will change. That means that you believe that the way things are or have been dictates the way they will be. There’s a lot of evidence that supports that point of view, but also evidence that doesn’t. Even relatively modern human history is filled with examples of epic and profound change. The fall of the Soviet Union and the events that followed are one example (I realize that’s an incredibly simplified way of describing what did or didn’t really happen). Our own American revolution is another. There are a hundred other examples in between where huge change was fomented by relatively small groups of people with passion and purpose that started something small that became something big enough to sweep away the old and make a place for something new.

 

This last point is the one that causes me to not descend into complete cynicism. I find the knowledge that the system will always seek equilibrium encourages me. That I got swept along in the irrational exuberance and behaved like the laws of economics and system dynamics had been suspended is my fault. I can learn from that lesson.

Similarly, I can be much more watchful for signs of the “God complex”. I can choose to stay away from enterprises or endeavors that have been assembled by the financial or political equivalent of Dr. Frankenstein. I can not buy stock in companies with no obvious business or business case, and make no mistake, there will be another wave of them any decade now. I can eat organic food. I can grow my own. I can agitate against genetic engineering. I can buy a mutt. There’s lots I can do to weigh in on the side of simplicity, or at least a more rational approach to dealing with complexity.

Finally, I find the thought that people seem to rise to the top through less than desirable traits to be oddly bracing. It makes me especially curious, interested, and wanting to be supportive when I find people who’ve succeeded and still managed to hang on to their morals, ethics, decency, humanity, and sense of fair play. It also takes the veil off of an assumed but ultimately corrosive sense that if it has something to do with American capitalism, it must be good. That’s a bad assumption.

Most importantly, I can also choose to be much more watchful about my own standards. I can choose to set an example for my children and whoever else it is that might be watching. I can choose to think differently about people power and maybe create some small cosmic counterweight to the twisted morality that seems so rampant in the halls of power. And if there is to be any sort of real change, that is where it will start. 

Kevin Hoffberg