Analysis Of : “Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)”

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UV7338 Rev. Jul. 24, 2018

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)

On July 19, 2002, Senator Paul Sarbanes (D-Maryland) and US Representative Michael Oxley (R-Ohio) met to shape legislation aimed at limiting corporate fraud and manipulation of earnings. This meeting was a “conference committee” of senators and representatives who would seek to produce a “reconciliation” draft that could pass both houses and be presented to President George W. Bush for his signature. The two houses of Congress had approved their own versions of such legislation. It now depended on the conferees to shape a final recommendation to both houses. The laws passed by each house differed in some respects. The House version was passed on April 24 by a majority vote of 334 to 90. The Senate version was passed on July 15 by a majority vote of 97 to zero. Could the differences in the two acts be attributable to timing? In any event, how should the conferees settle their differences? What prompted this outcome? What was the purpose of the act? How successful would it be?

The Dot-Com Bubble and Bust

From 1992 to March 2000, the US economy and stock market boomed, particularly in the technology sector. Exhibit 1 shows that the NASDAQ Index displayed a 679% increase from January 1, 1995, to March 10, 2000, compared to a 303% increase for the Standard & Poor’s 500 Index (S&P 500).a During this time, venture financing of early-stage technology companies surged. The price increases reflected buoyant investor expectations about growth of the World Wide Web, growth in transmission speeds owing to high-capacity optical fiber cable, and general growth in telecommunications volume. Growing access to the internet meant that tech-based services could become part of everyday life, rather than luxuries for a few.

The appeal of so-called internet stocks reflected powerful economic phenomena, such as network effects, economies of scale, first-mover advantage, and winner-take-all. The strategy of many tech start-ups was “bet big fast; worry about profitability later.” This led to aggressive, if not rash, spending and investment by tech companies. For instance, Boo.com, an online apparel retailer launched in 1999, spent $188 million of venture capital funding and went into liquidation in May 2000.1 Optical fiber telecom cables were laid in a frenzy but later went dark as transmission volume declined. The internet boom was also a time of remarkable hype: breathless media reports profiled new internet millionaires and urged investors to climb aboard.

On March 10, 2000, the NASDAQ Index peaked at 5,132.52. Then the stock market declined dramatically. This reflected the onset of a recession, rising interest rates, and growing disillusionment with the promise of

a The S&P 500 was a market-capitalization-weighted index of shares of the 500 largest companies traded on both the New York and American Stock Exchanges.

This case was prepared by Robert F. Bruner, University Professor, Distinguished Professor of Business Administration, and Dean Emeritus. With his permission, discussion of some topics is drawn from Robert F. Bruner, Deals from Hell, M&A Lessons That Rise Above the Ashes (Hoboken, NJ: John Wiley & Sons, 2005). This case was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright  2017 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an email to [email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Our goal is to publish materials of the highest quality; please submit errata to [email protected]. Do

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This document is authorized for educator review use only by Jaime Torres, Sistema Universitario Ana G. Mendez (SUAGM) until Aug 2018. Copying or posting is an infringement of copyright. [email protected] or 617.783.7860

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the information technology sector. Shares of Cisco fell 86% in the crash; Amazon.com shares also fell, from $107 to $7. Prominent internet-related IPOs, such as Webvan and Pets.com, simply disappeared. From March 2000 to October 2002, about $5 trillion in equity value disappeared in the crash.2

Other events around that time served to amplify anxieties. The presidential election of November 2000 was so close that it had to be settled by a decision of the Supreme Court on December 12, 2000—an outcome that left bitterness and taunts of illegitimacy. An economic recession began in March 2001 and ended in November of that year—the 8-month downturn followed a remarkable 120-month period of growth. During the dot-com bust and the recession, the US economy experienced a period of modest deleveraging, as indicated by slight declines in revolving credit (Exhibit 2) and tightening credit standards by banks (Exhibit 3). The recession was relatively short and shallow: real GDP declined only −0.3%, the slightest of any recession since 1836. And unemployment peaked in June 2003 at 6.3%, the fourth-smallest of 14 recessions since 1929. However, the terror attacks on September 11, 2001, amplified security concerns among Americans. Two financial measures of investor anxiety, the VIX Indexb and the high-yield bond credit spread,c vaulted upward on September 11 (see Exhibits 4 and 5). The period from 2000 through 2002 marked a dramatic turnaround in attitudes and sense of economic well-being from the long period of economic growth, 1992–2000.

The Advent of Private Standards for Internal Control and Fraud Prevention

Prominent instances of ethically challenged corporate political contributions and bribes in foreign countries in the 1970s outraged the public and Congress. In 1985, five professional accounting organizations chartered the Treadway Commission to research and recommend new practices and policies to fight fraudulent corporate financial reporting. This commission published its Report of the National Commission on Fraudulent Financial Reporting in 1987.3 Subsequently, the five accounting organizations formalized their work by organizing the Committee of Sponsoring Organizations (COSO) to produce a more detailed framework for internal control. The resulting four-volume report was published in 1992, entitled Internal Control—Integrated Framework.4

The reports proved to be very influential; the COSO standards for internal control were widely adopted by corporations. Yet the adoption of those standards remained voluntary. Failure to faithfully implement the standards could result in a qualified audit opinion but not in penalties or criminal liability. And COSO itself acknowledged that even faithful implementation of its standards might result in errors arising from human errors in processing or judgment and that its controls might be weakened by managerial coercion or collusion among employees.

Fraud and Earnings Manipulation among Large Corporations in 2001–02

In 2001 and 2002, a number of large corporate frauds and blunders (see Exhibit 6 for a representative list) seized public attention. Enron was exposed in October 2001, Tyco in February 2002, WorldCom in April 2002, and AOL in August 2002. Sarbanes and Oxley received thousands of constituent calls and letters related to these cases.

b VIX was the ticker symbol for the Chicago Board Options Exchange Volatility Index. This measured near-term volatility of equity prices, as implied in the prices of stock options. Higher VIX values suggested greater investor uncertainty and/or anxiety. The VIX index peaked on September 20.

c The high-yield credit spread measured the difference in yields between a portfolio of least-risky corporate bonds (AAA-rated) and speculative-grade corporate bonds (BB-rated). Higher spreads suggested an increase in actual risk and/or in investor risk-aversion. The credit spread peaked on October 4. Do

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October–December 2001: Enron Corp.

On December 2, 2001, Enron Corp. filed for bankruptcy in what was the largest industrial filing to date— Enron had been the seventh-largest firm in the Fortune 500 with sales of about $101 billion and assets of $66 billion. The collapse resulted from the revelation of accounting manipulation and fraud, which triggered a liquidity crisis and ultimately a solvency crisis. Short-term lenders to Enron canceled their loans. And trading counterparties ceased to do business with Enron. It was a classic “run on the bank,” even though Enron called itself an energy trading company. Its bankruptcy concluded a frenetic month of merger negotiations with Enron’s closest competitor, Dynegy Inc. The failure of merger negotiations sealed the evaporation of $70 billion in market value for Enron’s shareholders, the partial liquidation of the firm, the layoff of 60,000 employees, and an explosion of civil and criminal litigation.

Enron was formed from the 1985 merger of two gas pipeline firms and transformed into the nation’s biggest energy trader. Deregulatory reforms of the United States’ natural gas distribution and electric utility industries opened the field to new ways of doing business. Enron seized the opportunity to shape the wholesale power industry in transition. Enron envisioned and developed a marketplace for energy where prices could be set by open bidding, buyers and suppliers could be brought together, and power contracts could be tailored to meet the exact needs of a customer. Soon Enron was trading not just energy but also paper, steel, bandwidth, and even dynamic random access memory (DRAM) chips—Enron had morphed into an entirely different entity. Whereas in 1990 around 80% of its revenue came from the gas pipeline business, by 2000 its trading business accounted for 95% of revenue.5 Enron’s forays into trading earned it the accolade “Most Innovative Company” from Fortune magazine for six years in a row. Enron’s share price skyrocketed, while share prices of other companies in the energy sector rose only modestly.

Enron’s share prices peaked on August 23, 2000, at $90. A month later, a journalist, Jonathan Weil, published an article that questioned mark-to-market accounting and its possible abuses—it called attention to Enron. A leading short-seller, Jim Chanos, read the article, and by November 2000 he had taken a major short position on Enron. Other short-sellers followed suit; by July 2001, the short-interest in Enron’s stock had grown by 30%6 and then grew from 13.8 million shares to 31.1 million shares between September and November.7 The accelerating decline of the firm from its peak in August 2000 to bankruptcy in December 2001 can be traced in several parallel developments.

Enron’s product markets grew turbulent. In the fall of 2000, the California electric power crisis began to appear, leading observers to query its possible adverse impact on Enron. Enron was a supplier to this market and could claim a positive advantage in dealing with it. An investigation later revealed price manipulation in that market by Enron. Trading in other sectors of Enron’s business (such as broadband capacity and water) was not meeting projections, perhaps reflecting new competition from financial institutions and the recession. Enron sought to create new trading arenas in pulp paper, boxcar capacity, and other commodities. But the start-up of trading operations took additional capital.

To sustain its high price/earnings multiple, Enron had carefully cultivated the market expectations of rapid growth through the ruse of warehousing certain losses and debts in special purpose entities (SPEs) whose results would not be reflected on Enron’s books. During that year, the SPEs required continuing attention because as the asset values underlying these entities declined, Enron would be required to accommodate the investors in the SPEs with fresh capital infusions.

In March 2001, Fortune magazine asked, “Is Enron overpriced? It’s in a bunch of complex businesses. Its financial statements are nearly impenetrable. So why is Enron trading at such a huge multiple?”8 The article signaled growing discontent with the lack of transparency in Enron’s financial reports. Nevertheless, Wall Street analysts continued to issue strong buy recommendations even as they admitted difficulty in deciphering Enron’s Do

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financial statements. “The ability to develop a somewhat predictable model of this business for the future is mostly an exercise in futility,” a Bear Stearns analyst wrote.9

On December 13, 2000, Kenneth Lay announced that he would step down as CEO and that Jeffrey Skilling would assume that position. Three senior executives and founders of the novel businesses that Enron harbored resigned in the spring. In mid-August 2001, Skilling unexpectedly resigned as president and CEO of Enron. Largely credited with helping to transform Enron into a trading behemoth, Skilling cited family matters as the reason for his departure. He also told investors that there were “no accounting issues, trading issues, or reserve issues…I can honestly say the company is in the strongest shape it’s ever been in.”10

Then, on August 15, 2001, Sherron Watkins, a vice president at Enron, contacted Lay, who had resumed the CEO role after Skilling’s resignation. She said, “I am incredibly nervous we will implode in a wave of accounting scandals.” Her concerns focused on the use of SPEs to warehouse debt and losses that should properly have been reflected on Enron’s books. Lay said he would look into the issue.

On October 17, 2001, Enron alarmed the financial community by reporting a $618 million loss in the third quarter owing to $1.01 billion in write-downs of investments in the retail-power business, broadband telecommunications, and technology and water businesses.11 In addition, Enron had taken a $1.2 billion charged to shareholders’ equity to repurchase 55 million shares previously issued to a limited partnership called LJM2 Co-Investment LP, a partnership that had been run by Enron CFO Andrew Fastow. Enron said that the equity reduction resulted in its debt-to-equity ratio increasing to 50% from 46% previously.12 Enron’s dealings with limited partnerships, particularly those run by Fastow, had been criticized by investors for their opacity and for the possible conflict of interest from having the Enron CFO be the general partner in the limited partnerships at the same time. In response to shareholder criticism, Enron ordered Fastow to end his involvement with the partnerships in July 2001.13 These financial revelations prompted Moody’s to put Enron’s long-term debt on review for a possible downgrade. Fitch followed suit while S&P downgraded its outlook on Enron from stable to negative.

On October 22, Enron disclosed that the US Securities and Exchange Commission (SEC) had launched an inquiry into LJM2 and other Enron partnerships. Investors, worried about the impact of more undisclosed negative news and a ratings downgrade, hammered the stock. A Goldman Sachs analyst told the Wall Street Journal that “he heard people voice concerns about a possible ‘death spiral’ in which increasing credit concerns about Enron would decrease the number of people willing to do business with the company, which would, in turn, weaken its finances and lead to further business reductions.”14 On October 24, Enron CFO Fastow was fired.

By October 25, Enron’s share price had fallen 80% from the first of the year. At that point, Enron approached Dynegy about the possibility of a merger. The potential synergies were large: combining the two firms’ trading and distribution operations would grant huge market power and economies in head-office expenses. As the second-ranked energy trader, Dynegy aspired to conquer Enron and to stabilize an increasingly nervous industry—the steady stream of bad news about Enron was hurting business. It might be cheaper to buy Enron at the enormously discounted price currently than to weather the fallout of a larger collapse. Therefore, Dynegy began to negotiate a merger with Enron.

On November 1, Enron announced a $1 billion financing from Citibank and JPMorgan Chase—both large banks had been picked as advisers to the merging firms, heightening their incentive to complete the deal. That

d As later emerged, the SPEs were not entirely independent from Enron, as would have been necessary for Enron not to consolidate SPE results on Enron’s books. Not only was Fastow the managing partner of some SPEs, but Enron had given guarantees to the SPEs that linked the economic welfare of Enron to the SPEs. Do

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same day, the SEC demanded fuller disclosure by November 5 (later relaxed to November 8) about the extent of Fastow’s participation in SPEs.

Despite obtaining the additional $1 billion credit line, Enron began to experience difficulty in refinancing its commercial paper. Enron seemed in desperate need of more cash to finance its trading operations and to unwind unprofitable positions. Transaction volume had begun to slow down and other parties grew wary of trading with Enron. Therefore, Enron began discussions with buyout groups and other energy concerns to seek an additional $2 billion capital infusion.

On November 2, Enron’s board met to approve the deal. Key to the board’s action were the prospective cash infusions that would restore confidence in Enron’s trading operations—the scenario of recovery was crucial to the thinking of senior management and the board. An internal assessment foresaw that Enron would consume $3 billion in cash before year-end, plainly more than Dynegy’s $2.5 billion infusion. The disparity was justifiable only on the assumption that announcement of the deal triggered a rebound in trading volume and profitability at Enron. The board minutes show that Jeff McMahon, the new CFO of Enron, “expressed concerns on the inadequate level of financial liquidity, noting that the Company had begun to defer certain trade payments currently due, noting that if the Moody’s published debt rating was not maintained at investment-grade, significant obligations would become due immediately and the Company would be illiquid.”15

Also at the board meeting, Enron’s accounting firm, Arthur Andersen, revealed that two of the largest SPEs should have been consolidated on Enron’s books.e As a result, the write-down of $1.2 billion that had previously been announced on October 16 would need to be restated.

On Monday, November 5, Enron’s general counsel called the Dynegy merger team to disclose the change in accounting that would be reported to the SEC in an 8-K filing, and to disclose the firings of two senior executives related to the SPEs. That same day, Fitch cut Enron’s debt rating to BBB−, the borderline just above junk debt status.

The merger announcement and restatement to the SEC coincided on Thursday, November 8. First, Enron disclosed the restatement consolidating the SPEs and erasing $586 million in net income over the previous four years, and disclosed that Fastow had made more than $30 million from the SPEs. But just before the merger announcement, Moody’s declared that it intended to cut Enron’s debt rating to junk-bond status—this would trigger billions in default provisions in the SPEs and would effectively terminate the merger. The Enron merger team frantically renegotiated terms of the deal with Dynegy that would give Moody’s sufficient comfort not to cut the debt rating. Specifically, the exchange ratio was revised downward to reflect Enron’s deteriorating condition, and the “material adverse change” clause of the merger agreement was strengthened to limit Dynegy’s ability to exit from the transaction. In addition, the two banks, Citibank and JPMorgan Chase, committed $500 million in new equity capital. Moody’s relented and cut the bond rating to BBB−. S&P followed suit.

Finally, on November 9, Dynegy and Enron announced the merger agreement. In reaction to the announcement, Enron’s share price rose 16%; Dynegy’s rose 19%.

In an effort parallel to the Dynegy merger negotiations, Lay reached out to US Treasury Secretary Paul O’Neill, Commerce Secretary Don Evans, and Chairman of the Federal Reserve Alan Greenspan. Lay reported on the company’s mounting difficulties. But the government officials later denied any request or discussion of a bailout. President Bush denied having any knowledge of these discussions. But the mood in the White House

e Belatedly, this confirmed that the SPEs were not independent. And it became the trigger for much of the criminal and civil litigation in the months and years to follow. Do

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was opposed to government assistance of private companies. Ari Fleischer, the White House press secretary, said, “Bankruptcies happen in our economy. And it’s not uncommon for people who are in the community, business community, or in the labor community, to talk to a cabinet secretary to tell them about the financial status of their business, and it ends there.”16

Despite the promises of new cash (and its subsequent delivery on November 13) Enron’s condition continued to deteriorate. Within six days, Enron burned through $1 billion in cash as trading partners demanded more collateral or simply defected to other partners. Volume on its energy trading platform dropped by half.

That same day, Enron filed its third-quarter report with the SEC. In it, Enron reported three bad developments. First, the loss for the third quarter was $664 million, worse than previously reported. Second, Enron disclosed that the ratings downgrade had triggered obligations to the SPEs of $690 million. And the report revealed that cash was in short supply—in effect, Enron had burned through $1 billion in six days and $2 billion in the past month as it met the demands of lenders and trading counterparties to liquidate their positions in Enron.17 It was a classic “run on the bank.”

Enron shares dropped 45% in value over the next two days, to $5.01 per share, less than half Dynegy’s implied purchase price. The fall in Enron’s share price ignited fears that the deal with Dynegy would fall apart, even though Dynegy had already injected $1.5 billion into Enron. Trading on Enron’s platform slowed to a trickle as trading partners remained wary of Enron’s future.

Because of the sharp price break in Enron’s shares, the exchange ratio in the merger would have to be renegotiated. It remained to be seen whether the deal could be salvaged again.

On Monday, November 26, Dynegy called off the planned merger, invoking a “material adverse change” clause in the merger agreement.18 Dynegy’s CEO said, “We worked our butts off to make this thing work…I wasn’t about to put our balance sheet in jeopardy.”19 Though Dynegy’s finances had been managed more conservatively, it too experienced growing risk-aversion among investors. Later that morning, at 10:57 a.m. on November 28, S&P announced that it had lowered Enron’s rating two full grades, to B− from BBB−, placing Enron in junk status. Moody’s and Fitch downgraded Enron to junk status a few hours later. The downgrades triggered immediate repayment of $3.9 billion in liabilities.20 Trading at Enron’s platform ground to a halt soon after the announcements. Enron shares sank to $0.61, while its bonds traded at 20 cents on the dollar.

On December 2, Enron filed for bankruptcy. That same day Enron filed a $10 billion lawsuit against Dynegy for backing out of the merger. Enron claimed that Dynegy had no right to invoke the “material adverse change” clause:

With its eyes open, Dynegy committed itself to acquire Enron and its highly profitable energy-trading business…Dynegy knew that Enron was in a precarious financial condition, was on the verge of dropping to a non-investment grade credit rating, and was in no small measure dependent on the successful completion of the merger for its very survival.21

Dynegy filed a countersuit against Enron the next day, insisting on its right to claim Enron’s Northern Natural Gas pipeline system immediately given the two parties’ initial agreement.

Enron’s last balance sheet reported total liabilities of $13 billion, but bankers estimated that including off- balance sheet obligations brought total debt closer to $40 billion. Do

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Dynegy backed out of the merger with Enron because of the surprises that Enron’s liabilities were larger and accelerating, and its profits were smaller and dwindling, more than previously estimated. The drumbeat of bad news and the apparent ignorance or unwillingness of Enron’s senior management to deal proactively with it prompted a market panic. But Skilling called it a “run on the bank” that denied Enron the liquidity or market activity it needed to stay afloat.

The fallout from Enron’s collapse drew headlines for years. In addition to the lost jobs and distress in Enron’s hometown (Houston), Lay, Skilling, and Fastow were tried and convicted of crimes broadly described as fraud on the market. Skilling and Fastow served jail sentences; Lay died before his sentence began. In early January 2002, Enron’s accounting firm, Arthur Andersen, admitted that it had destroyed documents relevant to criminal investigations and subsequently surrendered its licenses to practice as certified public accountants. Andersen had been the largest accounting firm in the world.

January–March 2002: Tyco International

On January 22, 2002, Dennis Kozlowski, CEO of Tyco International Ltd., announced a radical restructuring plan for the firm that would break Tyco into four segments. The transaction would entail three spin-offs. Kozlowski argued that the firm would be worth 50% more after the restructuring: “Acquisitions have become far less important. The model for the future is far more for organic growth.”22 Securities analysts were mystified by the announcement. Tyco had been the target of SEC accounting investigations—so far, these had turned up nothing.

But a new spate of rumors had dogged the firm since late fall 2001, speculating that Tyco’s profitability was declining and would create problems in trying to service its huge debt load, built up during its acquisition program. The sale of stakes in operating units would generate about $8 billion in cash to service and pay down some of the debt. Just a week earlier, Tyco had announced that its earnings for the current quarter would not meet forecasts. This triggered an 8.5% decline in the firm’s shares.

Kozlowski had articulated a growth strategy in his letters to shareholders that would deliver a sustained rate of growth in excess of 20% annually. Tyco would achieve this through organic growth in the low double digits and the balance from acquisitions. Excerpts from Kozlowski’s letters, and from other aspects of the annual reports, suggested an acquisition strategy that focused on momentum, a steady percentage rate of growth, and an increase in the number and dollar value of acquisitions per year over time. At the core of Tyco’s acquisition-growth story was a buoyant stock market that created a high-priced acquisition currency and a feedback effect that together resulted in perceived momentum in the financial performance of the firm.

Accounts of the development of the restructuring program for Tyco suggested confusion among the senior leadership of the firm, stimulated in no small part by the mounting investigations by the SEC and district attorney’s office into accounting and financial irregularities at the firm.

The spin-off announcement triggered a 58% decline in the firm’s share price. But this was only the beginning of a dramatic unraveling of a strategy of growth by acquisition. In February 2002, Tyco revealed that it had not disclosed 700 acquisitions over the past three years, worth about $8 billion. The company argued that individually these deals were immaterial and unworthy of disclosure.23 That same month, Tyco divested CIT Group, booking a loss of $7 billion on the acquisition.

In July 2002, Kozlowski and Tyco CFO Mark Swartz were fired after news that they would be indicted following a criminal investigation. Edward Breen was hired as the new CEO. Finally, in September 2002, Kozlowski and Swartz were indicted on grounds that they had looted $170 million from Tyco in unauthorized Do

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compensation and $430 million in fraudulent stock sales. The indictment accused them of running a “criminal enterprise.”

And in December 2002, Tyco released a report of the results of an internal investigation that revealed that the company had systematically managed its accounting to inflate earnings. Specifically cited were tapping reserves to cover unrelated expenses and booking current charges as long-term expenses. The aggressive creation of reserves by Tyco’s targets before acquisition was also cited as a means of inflating Tyco’s postacquisition performance. In its 2003 annual report, Tyco enumerated the costs of its fall. The write-offs of impaired goodwill and operating losses reduced shareholders’ equity by $9 billion.

April–July 2002 WorldCom Inc.

WorldCom Inc. was a telecommunications firm formed through a merger in 1997. In 1999, the company announced a merger with Sprint, which would have been the largest merger in corporate history. But on January 2, 2002, the US Department of Justice sued to block the merger on antitrust grounds. WorldCom’s stock price fell, triggering margin calls to WorldCom’s CEO, Bernard Ebbers, who had pledged the stock for loans to finance other business interests. WorldCom’s board loaned or guaranteed debt of over $400 million to Ebbers to help cover his obligations. The stock continued to sag, and in April 2002, Ebbers resigned. The new CEO and a team of internal auditors subsequently discovered that the company had used fraudulent accounting methods from 1999 to 2002 to increase earnings in hopes of maintaining the price of WorldCom’s shares. These efforts had inflated the company’s assets by about $11 billion. On July 21, 2002, WorldCom filed for bankruptcy.

July 2002: AOL and Time Warner

On January 10, 2000, Steve Case and Jerry Levin, CEOs of AOL and Time Warner respectively, issued a press release announcing an agreement to merge their two firms to “create the world’s first Internet-Age Media and Communications Company.”24 The merger of AOL and Time Warner in 2001 offered two superlatives: the biggest deal to date and possibly the most notorious. Nearly $200 billion in market value evaporated in the months following the announcement of the deal. CEOs and other senior executives of both companies were sacked. Accounting chicanery triggered a government investigation. Disaffected shareholders launched class- action lawsuits. And eventually the AOL name was expunged from the corporate moniker. A sampling of some of the printable criticism about the deal includes: “worst deal in history,”25 “disaster of belly flop proportions,”26 “one of the greatest train wrecks in history,”27 “biggest and stupidest moment in the whole era,”28 “miasma,”29 “financial weakness…bamboozled…disaster,”30 “like the Mongolian invasion of China,”31 “catastrophic,”32 and “largest annual loss in U.S. corporate history.”33

Boosters of the deal predicated their outlook on convergence among print, broadcast, cable, and internet media. The merger embodied this convergence. Convergence would lead to ubiquity of reach for advertisers that would dominate any of the individual media alone. Much of the promise of this new medium assumed a move of consumers from narrowband access (over copper wire, such as telephone dial-up service) to broadband (over coaxial cable or high-speed optical fiber such as cable TV). This permitted delivery of richer content, particularly video and telephone services.34

Early critics of the deal doubted the fundamental value of AOL’s shares, likening it to “Weimar Republic money.”35 The inflation in the prices of internet company stocks created a problem of moral hazard, the incentive to acquire companies with overvalued shares, thus transferring to the seller some of the loss that would occur when the price was corrected. Even though AOL had a fraction of Time Warner’s revenue or Do

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operating cash flow, its shareholders would receive over half the shares of NewCo—this disparity, reflected in the huge goodwill and allocation of value to intangible assets, meant that the fairness of the deal price was founded on uncertain growth prospects rather than solid, demonstrated performance. Other critics doubted that print media content could be imported to the internet profitably.36 And finally, some critics argued that investors in each company presumably bought those shares because they wanted pure plays in the internet and old media respectively—the merger would dramatically change the industrial commitment that investors were making.

AOL was driven to grow by its CEO and its culture of aggressive competitiveness. The internal mantra during the 1990s was “get big fast.” In her account of the AOL-Time Warner story, Wall Street Journal reporter Kara Swisher recounted,

[Steve Case’s] near term goal was to be one of the biggest and most powerful media and communications companies in the world—and very, very soon. My first thought—since he did not appear to be an egomaniac, like so many executives I had interviewed—was that he might actually be insane…Still, I soon learned that Case had been spinning his impossible scenario to many visitors, which was why most reporters who covered AOL considered him a bit of a crank. Besides predicting the inevitability of world domination by his tiny business, he also never seemed to let up on endless pie-in-the-sky speeches, mixing in references to “convergence” and “interactive” and all sorts of other computing hoo-ha and linking it with the future of all mass media.37

The haste and ambition of the firm were stimulated by the perception that there was a brief window of opportunity to establish a strong competitive position in the market—like the Oklahoma land rush, if you got there first, you owned it. This was described by Robert J. Frank and Philip J. Cook as the “winner-take-all economy,” in which the first mover in an internet product or service would garner a commanding market position.38

An executive said, “We all knew we were living on borrowed time and had to buy something of substance by using that huge currency. We definitely needed to trade up, and fast.”39 During the year that it took government regulators to approve the merger, the internet bubble collapsed in the US equity markets, and AOL’s stock price plummeted and dissipated the acquisition premium up to the date of closing, January 11, 2001.

Needing to save the merger, AOL pressed its advertisers hard to maintain their spending so that AOL could report the targeted revenues. In this context, AOL’s business affairs unit, always the most aggressive in the firm, pushed into deals whose impact on reported earnings was merely cosmetic. Alec Klein of the Washington Post published two articles starting on July 18, 2002, that described AOL’s sketchy efforts to bolster its advertising revenues. He wrote,

AOL converted legal disputes into ad deals. It negotiated a shift in revenue from one division to another, bolstering its online business. It sold ads on behalf of online auction giant eBay Inc., booking the sale of eBay’s ads as AOL’s own revenue. AOL bartered ads for computer equipment in a deal with Sun Microsystems Inc., AOL counted stock rights as ad and commerce revenue in a deal with a Las Vegas firm called PurchasePro.com Inc.40

Shortly after the publication of Klein’s exposé, the US Justice Department commenced an investigation into the financial accounting for AOL’s revenues, prompting AOL Time Warner to make its own internal investigation—on August 14, 2002, the company disclosed that $49 million in revenues had been “inappropriately recognized.” Though small compared to the total revenues of the firm, the revelations shattered the confidence of investors in the new firm’s management. Do

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Weaknesses Exposed

The dot-com crash and the wave of frauds and bankruptcies staggered the public’s perception of well- being. Analysts identified a number of weaknesses revealed during this turnaround:

 Failures of corporate governance. The episode revealed self-dealing by CEOs, “sweetheart deals” between boards and their CEOs, rising executive compensation, cronyism, and inattention by board members. These examples eroded the trust of shareholders in their directors to be independent of management, well-informed, and faithful in representing shareholders’ interests.

 Auditing failures. Virtually all leading auditing firms were embroiled in the wave of accounting scandals. The leading firm, Arthur Andersen, actually dissolved following the Enron scandal. At issue were claims that auditors were inattentive and/or captured by their clients. Most auditors provided consulting work that exploited long-standing auditing relationships and that was more profitable than auditing. Were the auditors serving shareholders and the public?

 Failures of securities analysts, rating agencies, and bankers. Investors scorned analysts and bankers for incomplete due diligence behind their investment, lending, and underwriting recommendations. Why had they failed to see the frauds and board failures and to alert the market of them? Critics pointed to cozy relationships with their clients and a herd mentality.

 Inadequate funding of the SEC. The “market watchdog” said that the growth in the number of publicly listed firms and of the number of securities offerings had outstripped its resources to monitor, enforce rules, and make new rules as conditions changed.

Civic Reaction

The wave of prominent corporate fraud seemed linked to the recent dot-com crash: Hadn’t they both been based on blue smoke and mirrors? All segments of American society expressed outrage at the events and looked to the federal government to fix the mess. Recent polling of public sentiment by the Gallup Organization found a sharp rise in respect for “big government” and a sharp decline in respect for “big business” (see Exhibit 7). Even the Economist, a conservative-leaning editorial voice, opined,

The Enron case still embodies many of the doubts that Americans have about [the President]: that he is too close to Big Business (and the energy industry in particular), and that his concerns are not the concerns of ordinary Americans. This is the President whom last summer Democrats were skewering for his desire to open up Alaska’s oil fields supposedly “for his friends in Houston” and for allegedly letting industrialists put arsenic into drinking water. What can he do? The obvious targets of change in the wake of Enron’s collapse are campaign-finance rules and regulations governing the auditing profession.41

On March 6, 2002, President Bush announced a “Ten-Point Plan to Improve Quarterly Reporting and Protect America’s Shareholders.”f He asserted that most of these goals could be met by the SEC. And he

f President Bush’s 10-Point Plan: 1. Each investor should have quarterly access to the information needed to judge a firm’s financial performance, condition, and risks. 2. Each investor should have prompt access to critical information. 3. CEOs should personally vouch for the veracity, timeliness, and fairness of their companies’ public disclosures, including their financial

statements. 4. CEOs or other officers should not be allowed to profit from erroneous financial statements. 5. CEOs or other officers who clearly abuse their power should lose their right to serve in any corporate leadership positions. 6. Corporate leaders should be required to tell the public promptly whenever they buy or sell company stock for personal gain. 7. Investors should have complete confidence in the independence and integrity of companies’ auditors. Do

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pledged to work with Congress in producing any necessary enabling legislation.42 Then, four months later, President Bush announced an executive order to create a Corporate Fraud Task Force, an interdepartmental agency. Exhibit 8 gives an excerpt of his statement upon this announcement.

Meanwhile, Congress gained momentum on the issue of corporate fraud. Exhibit 9 summarizes the steps of hearings and enactments leading up to the conference meeting between members of the Senate and House of Representatives. Although the bills of each house of Congress (see Exhibits 10 and 11) were different in some respects, the speed and similar tone of the bills attracted attention. As shown in Exhibit 12, the Democratic Party held a majority in the Senate, and the Republican Party held a majority in the House of Representatives. In reflecting on the effort to craft the act, Senator Sarbanes said:

By the end of 2001, Enron was bankrupt, and as it turned out, it was the canary in the mineshaft. The abuses in the capital markets did not begin or end with Enron. There were problems in the market— problems that were broad, deep, systemic, and structural. News stories at the time made this clear: “Financial Restatements Up Sharply”—New York Times; “Securities Suits Hit Record Total”—Wall Street Journal; “If You Can’t Believe the Auditors, Who Can You Believe?”—BusinessWeek; “System failure…This isn’t just a few bad apples we’re talking about here…This, my friends, is a systemic breakdown”—Fortune. A number of very major, highly-regarded public companies, along with their auditors, were relying upon convoluted and often fraudulent accounting devices to inflate earnings, hide loses, and drive up stock prices.43

It fell to Paul Sarbanes and Michael Oxley to hash out the final draft of the new bill. What were their differences? Could they come to agreement?

8. An independent regulatory board should ensure that the accounting profession is held to the highest ethical standards. 9. The authors of accounting standards must be responsive to the needs of investors. 10. Firms’ accounting systems should be compared with best practices, not simply against minimum standards. Do

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Exhibit 1

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)

NASDAQ and S&P 500 Indexes

1/3/1995 1/3/1996 1/3/1997 1/3/1998 1/3/1999 1/3/2000 1/3/2001 1/3/2002

NASDAQ and S&P 500 Indexes, Indexed to 1.00 at January 1, 1995

NASDAQ Index S&P500 Index

Data source: http://finance.yahoo.com/.

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Exhibit 2

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)

US Consumer Loans Outstanding, January 2000 to June 2002

Source: Board of Governors of the Federal Reserve System (US), “Total Consumer Loans Owned by Depository Institutions, Outstanding [TOTALDI],” FRED, Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/TOTALDI (accessed June 27, 2018).

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Exhibit 3

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)

Tightening Credit Standards of Banks

Source: Board of Governors of the Federal Reserve System (US), “Net Percentage of Domestic Banks Tightening Standards on Consumer Loans, Credit Cards [DRTSCLCC],” FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DRTSCLCC (accessed June 27, 2018).

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Exhibit 4

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)

VIX Index, June 1–December 31, 2001

6/1/2001 7/1/2001 8/1/2001 9/1/2001 10/1/2001 11/1/2001 12/1/2001

Data source: http://finance.yahoo.com/.

Exhibit 5

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)

High-Yield Credit Spread Percentage

6.00 6.50 7.00 7.50 8.00 8.50 9.00 9.50

10.00 10.50 11.00

Data source: “ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield Master II Option- Adjusted Spread [BAMLH0A0HYM2],” FRED, Federal Reserve Bank of St. Louis, https://research.stlouisfed.org/fred2/series/BAMLH0A0HYM2/downloaddata (accessed Aug. 23, 2017). Do N

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Exhibit 6

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)

Reported US Accounting Scandals 2000 to mid-2002

Company Date of First

Public Exposure of Scandal

Notes

Unify Corporation May 2000 Fraudulent revenue recognition and “round tripping.”

Xerox June 2000 Falsifying financial results.

Computer Associates September 2000 Fraudulent revenue recognition: backdating of contracts.

MicroStrategy December 2000 Overstated revenues for three years.

Sunbeam May 2001 Fraudulent revenue recognition and aggressive use of “cookie jar” reserves.

Enron October 2001 Fraudulent recognition of revenues, liabilities, and assets.

Homestore.com January 2002 Improper booking of sales.

Kmart January 2002 Fraud: aggressive and premature recognition of vendor allowances.

Tyco International January 2002 Fraudulent earnings management. Managerial conflicts of interest.

Qwest Communications February 2002 Fraudulent recognition of $3.8 billion in revenue.

Global Crossing February 2002 Inflated revenues through network capacity swaps with other carriers.

Adelphia April 2002 Securities fraud. Looting by CEO. Aggressive use of off-balance sheet debt.

WorldCom April 2002 Fraudulent inflation of revenues. Booking expenses as capital expenditures.

CMS Energy May 2002 Inflated revenues: deceptive round-trip energy trades.

Duke Energy May 2002 Inflated revenues: sham trading and “wash sales.”

Dynegy May 2002 Improper disclosure of $300 million in financing. Inflated revenues through round-trip trades.

El Paso Corporation May 2002 Improperly inflating estimates of proven oil and gas reserves. Misstatement of earnings.

Halliburton May 2002 Inflated revenues by overbilling for services and inflating accounts receivable. Also minimized accounts payable.

Reliant Energy May 2002 Fraudulent booking of round-trip trades.

Peregrine Systems May 2002 Fraudulent inflation of revenues and stock price.

ImClone Systems June 2002 Insider trading. Obstruction of justice. Bank fraud.

AOL July 2002 Fraudulent revenue recognition.

Bristol-Myers Squibb July 2002 Inflated revenues through “channel stuffing” and aggressive use of “cookie jar” reserves.

Merck & Co. July 2002 Fraud: recognition of $12.4 billion in copayments that were not collected.

Mirant July 2002 Overstated assets and liabilities by $253 million.

Nicor July 2002 Manipulation of earnings and misrepresentation of natural gas inventory.

Source: Created by author from publicly available sources, especially Penelope Patsuris, “The Corporate Scandal Sheet,” Forbes, August 26, 2002, https://www.forbes.com/2002/07/25/accountingtracker.html#78f8da2257e8 (accessed June 27, 2018). Do

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Exhibit 7

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)

Gallup Organization Survey Results

10%

20%

30%

40%

50%

60%

70%

8/ 1/ 19

95 11

/1 /1 99

5 2/ 1/ 19

96 5/ 1/ 19

96 8/ 1/ 19

96 11

/1 /1 99

6 2/ 1/ 19

97 5/ 1/ 19

97 8/ 1/ 19

97 11

/1 /1 99

7 2/ 1/ 19

98 5/ 1/ 19

98 8/ 1/ 19

98 11

/1 /1 99

8 2/ 1/ 19

99 5/ 1/ 19

99 8/ 1/ 19

99 11

/1 /1 99

9 2/ 1/ 20

00 5/ 1/ 20

00 8/ 1/ 20

00 11

/1 /2 00

0 2/ 1/ 20

01 5/ 1/ 20

01 8/ 1/ 20

01 11

/1 /2 00

1 2/ 1/ 20

02 5/ 1/ 20

Survey question: In your opinion, which of the following will be the biggest threat to the country in the future—big business, big labor,

or big government?

Big Business Big Labor Big Government No Opinion

Data source: “Big Business,” Gallup, http://www.gallup.com/poll/5248/big-business.aspx (accessed Aug. 23, 2017).

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Exhibit 8

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)

Excerpt of Statement by President Bush upon Creation of Corporate Fraud Task Force, July 9, 2002

America has tackled financial problems when they appeared. The actions I’m proposing follow in this tradition, and should be welcomed by every honest company in America.

First, we will use the full weight of the law to expose and root out corruption. My administration will do everything in our power to end the days of cooking the books, shading the truth, and breaking our laws. Today, by executive order, I create a new Corporate Fraud Task Force, headed by the Deputy Attorney General, which will target major accounting fraud and other criminal activity in corporate finance. The task force will function as a financial crimes SWAT team, overseeing the investigation of corporate abusers and bringing them to account.

I’m also proposing tough new criminal penalties for corporate fraud. This legislation would double the maximum prison terms for those convicted of financial fraud from five to 10 years. Defrauding investors is a serious offense, and the punishment must be as serious as the crime. I ask Congress to strengthen the ability of SEC investigators to temporarily freeze improper payments to corporate executives, and to strengthen laws that prevent the destruction of corporate documents in order to hide crimes.

Second, we’re moving corporate accounting out of the shadows, so the investing public will have a true and fair and timely picture of assets and liabilities and income of publicly traded companies. Greater transparency will expose bad companies and, just as importantly, protect the reputations of the good ones. To expose corporate corruption, I asked Congress four months ago for funding to place 100 new enforcement personnel in the SEC. And I call on Congress to act quickly on this request. Today I announce my administration is asking Congress for an additional $100 million in the coming year to give the SEC the officers and the technology it needs to enforce the law. If more scandals are hiding in corporate America, we must find and expose them now, so we can begin rebuilding the confidence of our people and the momentum of our markets. I’ve also proposed a 10-point Accountability Plan for American Business, designed to provide better information to shareholders, set clear responsibility for corporate officers, and develop a stronger, more independent auditing system. This plan is ensuring that the SEC takes aggressive and affirmative action.

Corporate officers who benefit from false accounting statements should forfeit all money gained by their fraud. An executive whose compensation is tied to his company’s performance makes more money when his company does well— that’s fine, and that’s fair when the accounting is above-board. Yet when a company uses deception—deception accounting to hide reality, executives should lose all their compensation—all their compensation—gained by the deceit. Corporate leaders who violate the public trust should never be given that trust again. The SEC should be able to punish corporate leaders who are convicted of abusing their powers by banning them from ever serving again as officers or directors of a publicly-held corporation. If an executive is guilty of outright fraud, resignation is not enough. Only a ban on serving at the top of another company will protect other shareholders and employees.

My accountability plan also requires CEOs to personally vouch for their firms’ annual financial statements. Currently, a CEO signs a nominal certificate, and does so merely on behalf of the company. In the future, the signature of the CEO should also be his or her personal certification of the veracity and fairness of the financial disclosures. When you sign a statement, you’re pledging your word, and you should stand behind it. And because the shareholders of America need confidence in financial disclosures right away, the SEC has ordered the leaders of nearly a thousand large public companies to certify that the financial information they submitted in the last year was fair and it was accurate. I’ve also called on the SEC to adopt new rules to ensure that auditors will be independent and not compromised by conflicts of interest.

Source: “President Announces Tough New Enforcement Initiatives for Reform,” Remarks by President George W. Bush on Corporate Responsibility, Regent Wall Street Hotel, New York, July 9, 2002, White House, http://georgewbush-whitehouse.archives.gov/news/releases/2002/07/20020709- 4.html (accessed Jul. 13, 2017). Do

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Exhibit 9

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)

Legislative Chronology for the Sarbanes-Oxley Act

Feb. 14, 2002—Referred to the House Committee on Financial Services.

Mar. 4, 2002—Referred to the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises.

Mar. 13, 2002—Committee hearings held.

Mar. 20, 2002—Committee hearings held.

Apr. 4, 2002—Committee hearings held.

Apr. 11, 2002—Committee consideration and mark-up session held.

Apr. 16, 2002—Committee consideration and mark-up session held; ordered to be reported (amended): 49-12.

Apr. 22, 2002—Reported (amended) by the Committee on Financial Services.

Apr. 24, 2002—Amendments offered; passed by House: 334-90.

Apr. 25, 2002—Received in the Senate; Senate struck all after the Enacting Clause and substituted the language of S.2673 as amended.

July 15, 2002—Passed Senate with an amendment by voice vote; Senate insisted on its amendment, requested a conference; House agreed to a conference.

July 19, 2002—Conference to be held.

Source: William H. Manz, Corporate Fraud Responsibility: A Legislative History of the Sarbanes-Oxley Act of 2002 (Buffalo, NY: William S. Hein & Co., 2003).

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Exhibit 10

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)

Summary of HR 3763 Passed by House of Representatives, April 24, 2002

Corporate and Auditing Accountability, Responsibility, and Transparency Act of 2002 - States that the Securities and Exchange Commission (SEC) shall not accept a financial statement certified by an accountant unless such accountant is subject to oversight by a public regulatory organization (PRO), and is in good standing with it.

(Sec. 2) Directs the SEC to prescribe the criteria that would permit recognition of a PRO for purposes of this Act, including: (1) a five- member board composed of one non-accountant, two licensed and recently experienced public accountants, and two who may be licensed public accountants who have not practiced during the two years before appointment to the board; (2) the capacity to review work product and potential conflicts of interest; (3) the authority to impose sanctions for intentional or knowing misconduct, including a determination that an accountant is not qualified to certify a financial statement or certain categories of financial statement; and (4) procedures for notifying the relevant organizations or persons of review procedures and results and any other relevant information.

 Requires such organization to be self-funded and not solely dependent on members of the accounting profession. Requires the SEC to comply with the PRO’s requests to compel testimony or production of records unless it determines that to do so would not be in the public interest.

 Directs the SEC to revise auditor independence regulations so as to exclude financial information system design or implementation or internal audit services from activities permissible for an independent auditor. Requires the periodic review of services by auditors to determine if any affect their independence and should therefore be added to the prohibited nonaudit services list. Directs the SEC to report to the appropriate congressional committees on its conduct of any reviews, including recommended regulatory or legislative steps.

 Prescribes procedural guidelines for: (1) prompt notification of PRO sanctions to the SEC; (2) SEC review of such sanctions, including nondisclosure of any accountant review proceedings except as otherwise authorized; (3) review, approval, revision, or abrogation of a PRO’s rules or proposed rule changes by the SEC; and (4) a PRO’s annual report and budget submission to the SEC and, subsequently, to Congress.

(Sec. 3) Prohibits an officer, director, or affiliated persons of an issuer of a registered security from exerting improper influence upon the conduct of audits.

(Sec. 4) Mandates, upon SEC request, rapid disclosure of an issuer’s financial condition or operations, including electronic disclosure of insider and affiliate transactions.

(Sec. 5) Prohibits a ten percent beneficial owner from engaging in insider trades during pension fund blackout periods. Requires disgorgement of profits realized in violation of this prohibition. Exempts certain such owners from this proscription. Bars a lawsuit for violation of such insider trades two years after the date the insider trade profit was realized. Do

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Exhibit 10 (continued)

Summary of HR 3763 Passed by House of Representatives, April 24, 2002

(Sec. 6) Directs the SEC to modify regulations governing corporate disclosures, requiring adequate and appropriate disclosure of off-balance sheet transactions and relationships with unconsolidated entities or other persons. Requires an analysis of the need for disclosure of additional information to improve transparency, completeness, or usefulness, including identifying key accounting principles, the trading of non-exchange traded contracts, and format.

(Sec. 7) Directs the SEC to propose rule changes to improve the transparency and clarity of the financial reporting information available to investors as it concerns the issuer, its officers, directors, employees and/or affiliates, including insider relationships and transactions, relationships with philanthropic organizations, insider-controlled affiliates, joint ownerships, and the provision of professional services by related persons.

(Sec. 8) Directs the SEC to revise its regulations concerning matters requiring prompt disclosure on Form 8K to require the immediate disclosure, by means of such Form and by the Internet or other electronic means, by any issuer of any change in, or waiver of, the issuer’s code of ethics.

(Sec. 9) Requires the SEC to review issuers’ disclosures on a more regular and systematic basis, based on a confidential SEC-established risk rating system, but in no event less than once every three years.

(Sec. 10) Requires the retention of records for no less than seven years after an audit.

(Sec. 11) Permits the SEC to prohibit any person who committed fraud or deception in the purchase or sale of securities in violation of the Securities Act of 1933 and the Securities Exchange Act of 1934 from serving as an officer or director of a public company if such person’s conduct demonstrates substantial unfitness to serve in such capacity. Requires the SEC to consider a person’s degree of scienter, economic gain, the severity of the conduct, and its likelihood of recurrence when determining substantial unfitness.

(Sec. 12) Requires the SEC to analyze when an officer or director of an issuer must disgorge profits gained or losses avoided in the sale of securities of such issuer during the six-month period preceding the filing of a restated financial statement. Requires the SEC to prescribe a rule requiring disgorgement if necessary to the public interest or for the protection of investors.

(Sec. 13) Provides for the disgorgement and allocation of funds resulting from SEC administrative or judicial proceedings brought against Enron, Arthur Andersen L.L.C., and any of their subsidiaries, officers, directors, or principal shareholders.

(Sec. 14) Directs the SEC to review and report to the appropriate congressional committees on any final rules by any registered self-regulatory organization related to equity research analyst conflicts of interest, including any recommendations for additional rulemaking.

(Sec. 15) Directs the SEC to review, report, and make recommendations on: (1) current corporate governance practices and whether they serve the best interests of the shareholders; (2) SEC enforcement actions, focusing on areas of reporting that are most susceptible to fraud, manipulation, or inappropriate earnings management; and (3) credit rating agencies in the operations of the securities market, including their role in evaluating securities issuers and any impediments, barriers, or conflicts of interests. Do

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Exhibit 10 (continued)

Summary of HR 3763 Passed by House of Representatives, April 24, 2002

(Sec. 18) Directs the Comptroller General to study and report to Congress on: (1) whether investment banks and financial advisors assisted public companies in manipulating their earnings and obfuscating their true financial condition through transactions which may have been designed solely to enable them to manipulate revenue streams, obtain loans, or move liabilities off balance sheets without altering the economic and business risks they faced, with particular attention to the collapse of Enron and the failure of Global Crossing; and (2) Model Rules of Professional Conduct for attorneys of issuers promulgated by the American Bar Association and related SEC rules, and whether current ethical guidelines are sufficient to guide such attorneys and protect corporate shareholders.

(Sec. 20) Extends existing SEC enforcement authority to the provisions of this Act.

(Sec. 21) Excludes specified investment companies registered under the Investment Company Act of 1940 from certain financial disclosure and corporate governance review requirements of this Act.

Source: “Summary: H.R.3763 – 107th Congress (2001–2002),” Congress.gov, https://www.congress.gov/bill/107th-congress/house- bill/3763/summary/36?q=%7B%22search%22%3A%5B%22HR3763+April+2002%22%5D%7D&resultIndex=1 (accessed Jul. 12, 2017).

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Exhibit 11

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)

Summary of S. 2673 Passed by the Senate on July 15, 2002

Public Company Accounting Reform and Investor Protection Act of 2002 - Title I: Public Company Accounting Oversight Board - Establishes the Public Company Accounting Oversight Board to: (1) oversee the audit of public companies that are subject to the securities laws; (2) establish audit report standards and rules; and (2) investigate, inspect, and enforce compliance relating to registered public accounting firms, associated persons, and the obligations and liabilities of accountants.

(Sec. 101) Prohibits Board membership from including more than two certified public accountants.

(Sec. 102) Mandates registration with the Board by any public accounting firm that performs or participates in any audit report with respect to any issuer.

(Sec. 105) Empowers the Board to impose disciplinary or remedial sanctions upon registered public accounting firms and their associated persons who are in violation of this Act, including the securities laws relating to the preparation and issuance of audit reports and the obligations and liabilities of accountants with respect to them.

Restricts liability to intentional conduct, or repeated instances of negligent conduct.

Authorizes Board sanctions upon a registered accounting firm or its supervisory personnel for failure to supervise.

(Sec. 106) Places within the purview of this Act: (1) foreign public accounting firms that prepare or furnish an audit report with respect to any issuer; and (2) audit workpapers.

(Sec. 107) Grants the Securities and Exchange Commission (SEC) general oversight of the Board and the power to review Board actions, including general modification and rescission of Board authority.

(Sec. 108) Amends the Securities Act of 1933 to: (1) authorize the SEC to recognize, as “generally accepted” for purposes of the securities laws, any accounting principles established by a standard setting body; and (2) direct the SEC to study and report to Congress on the adoption by the US financial reporting system of a principles-based accounting system.

Title II: Auditor Independence - Amends the Securities Exchange Act of 1934 to prohibit a registered public accounting firm from performing specified non-audit services contemporaneously with a mandatory audit. Requires preapproval for non-audit services not expressly forbidden by statute.

(Sec. 203) Mandates: (1) audit partner rotation on a five-year basis; and (2) auditor reports to audit committees of the issuer.

(Sec. 206) Prohibits a registered public accounting firm from performing statutorily mandated audit services for an issuer if the issuer’s senior management officials had been employed by such firm and participated in the audit of that issuer during the one-year period preceding the audit initiation date. Do

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Exhibit 11 (continued)

Summary of S. 2673 Passed by the Senate on July 15, 2002

(Sec. 209) States that it is the intention of this Act that, in supervising nonregistered public accounting firms and their associated persons, appropriate State regulatory authorities should make an independent determination of the proper standards applicable, particularly taking into consideration the size and nature of the business of the accounting firms they supervise.

Title III: Corporate Responsibility - Vests the audit committee of an issuer with responsibility for the appointment, compensation, and oversight of any registered public accounting firm employed to perform audit services. Requires committee members to be a member of the board of directors of the issuer, and to be otherwise be independent.

(Sec. 302) Requires the chief executive officer and chief financial officer of an issuer to: (1) certify that periodic financial statements filed with the SEC fairly present, in all material respects, the operations and financial condition of the issuer; and (2) forfeit certain bonuses and compensation received following an issuer’s accounting restatement owing to noncompliance with securities laws.

(Sec. 305) Authorizes a court to prohibit a violator of certain SEC rules from serving as an officer or director of an issuer if the person’s conduct demonstrates unfitness to serve (the current standard is “substantial unfitness”).

(Sec. 306) Prohibits insider trades during pension fund blackout periods. States that profits realized from such trades shall inure to and be recoverable by the issuer irrespective of the intent of the parties to the transaction.

Title IV: Enhanced Financial Disclosures - Instructs the SEC to require by rule: (1) disclosure of all material off-balance sheet transactions and relationships that may have a material effect upon the financial status of an issuer; and (2) the presentation of pro forma financial information in a manner that is not misleading, and which is reconcilable with the financial condition of the issuer under generally accepted accounting principles.

(Sec. 401) Directs the SEC to study and report to Congress on: (1) the extent of off-balance sheet transactions and the use of special purpose entities; and (2) whether generally accepted accounting rules result in financial statements that reflect the economics of such off-balance sheet transactions in a transparent fashion to investors; and (3) the extent to which special purpose entities are used to facilitate off-balance sheet transactions.

(Sec. 402) Prohibits a corporation from making personal loans to its corporate executives. Cites exceptions for home improvement and manufactured home loans made in the ordinary course of the consumer credit business of such issuer and made on terms that are no more favorable than those offered to the general public.

(Sec. 403) Reduces the mandatory period for principal stockholders or senior executives to disclose changes in ownership of securities or security-based swap agreements to two business days after changes were executed (presently ten days after the close of a calendar month). Includes electronic filing within such mandate to disclose. Do

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Exhibit 11 (continued)

Summary of S. 2673 Passed by the Senate on July 15, 2002

(Sec. 404) Directs the SEC to prescribe rules mandating inclusion of an internal control report and assessment within requisite annual reports. Requires a public accounting firm that issues the audit report to attest to, and report on, the assessment made by corporate management.

(Sec. 406) Directs the SEC to issue rules requiring a code of ethics for senior financial officers of an issuer applicable to the principal financial officer, comptroller or principal accounting officer.

(Sec. 407) Sets a deadline for the SEC to promulgate rules mandating issuer disclosure whether its audit committee comprises at least one member who is a financial expert.

Title V: Analyst Conflicts of Interest - Requires the SEC to adopt rules governing securities analysts’ potential conflicts of interest, including: (1) restricting the prepublication clearance or approval of research reports by persons either engaged in investment banking activities, or not directly responsible for investment research; (2) limiting the supervision and compensatory evaluation of securities analysts to officials who are not engaged in investment banking activities; (3) prohibiting a broker or dealer involved with investment banking activities from retaliating against a securities analyst as a result of an unfavorable research report that may adversely affect the investment banking relationship of the broker or dealer with the subject of the research report; and (4) establishing safeguards to assure that securities analysts are separated within the investment firm from the review, pressure, or oversight of those whose involvement in investment banking activities might potentially bias their judgment or supervision.

Directs the SEC to adopt rules requiring securities analysts and broker/dealers to disclose specified conflicts of interest.

Title VI: Commission Resources and Authority - Authorizes appropriations for FY 2003 to the SEC for: (1) additional compensation, salaries and benefits; (2) enhanced oversight of auditors and audit services; and (3) additional professional staff for fraud prevention, risk management, market regulation, and investment management.

(Sec. 602) Grants the SEC censure authority in connection with appearance and practice before the Commission. Sets forth rules of professional responsibility for attorneys representing public companies before the SEC, including: (1) requiring an attorney to report evidence of a material violation of securities law or breach of fiduciary duty to the chief legal counsel or the chief executive officer of the company; and (2) if corporate executives do not respond appropriately, requiring the attorney to report to the audit committee of the board of directors.

(Sec. 603) Amends the Securities Exchange Act of 1934 and the Securities Act of 1933 to grant Federal court authority to prohibit specified brokers, dealers, or issuers from participating in offerings of penny stock.

(Sec. 604) Amends the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940 to authorize SEC censure or restriction of associated persons of brokers and dealers who are subject to any final order of certain State regulatory entities barring them from engaging in the business under their regulatory purviews. Do

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Exhibit 11 (continued)

Summary of S. 2673 Passed by the Senate on July 15, 2002

Title VII: Studies and Reports - Mandates studies and reports to Congress by: (1) the Comptroller General regarding the consolidation of public accounting firms, and the impact upon the capital formation and securities markets; and (2) the SEC regarding the role and function of credit rating agencies in the operation of the securities market.

Title VIII: Corporate and Criminal Fraud Accountability - Corporate and Criminal Fraud Accountability Act of 2002 - Amends Federal criminal law to prohibit: (1) knowingly destroying, altering, concealing, or falsifying records with the intent to obstruct or influence an investigation in a matter in Federal jurisdiction or in bankruptcy; and (2) auditor failure to maintain for a five-year period all audit or review work papers pertaining to an issuer of securities. Directs the SEC to promulgate regulations regarding the retention of audit records containing conclusions, opinions, analyses, or financial data.

(Sec. 803) Amends Federal bankruptcy law to make non-dischargeable in bankruptcy certain debts that result from a violation relating to Federal or State securities law, or of common law fraud pertaining to securities sales or purchases.

(Sec. 804) Amends the Federal judicial code to permit a private right of action for a securities-fraud claim to be brought not later than the earlier of: (1) five years after the date of the alleged violation; or (2) two years after its discovery.

(Sec. 805) Directs the United States Sentencing Commission to review and amend Federal sentencing guidelines to ensure that the offense levels, existing enhancements, and/or offense characteristics are sufficient to deter and punish violations involving: (1) obstruction of justice; (2) record destruction; (3) fraud when the number of victims adversely involved is significantly greater than 50 or when it endangers the solvency or financial security of a substantial number of victims; and (4) organizational criminal misconduct.

(Sec. 806) Prohibits a publicly traded company from discharging or otherwise discriminating against an employee because of any lawful act by the employee to: (1) assist in an investigation of prohibited conduct by Federal regulators, Congress, or supervisors; or (2) file or participate in a proceeding relating to fraud against shareholders.

Delineates remedies for such aggrieved employee, including reinstatement, back pay, and compensatory damages.

(Sec. 807) Subjects to a fine and imprisonment any person who defrauds shareholders of publicly traded companies.

Title IX: White-Collar Crime Penalty Enhancements - White-Collar Crime Penalty Enhancement Act of 2002 - Amends Federal criminal law to increase criminal penalties for: (1) conspiracy to commit offense or to defraud the United States, including its agencies; and (2) mail and wire fraud.

(Sec. 904) Amends the Employee Retirement Income Security Act of 1974 to increase the criminal penalties for violations of such Act. Do

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Exhibit 11 (continued)

Summary of S. 2673 Passed by the Senate on July 15, 2002

(Sec. 905) Directs the United States Sentencing Commission to review Federal Sentencing Guidelines to: (1) ensure that they reflect the serious nature of the offenses and the penalties set forth in this Act, the growing incidence of serious fraud offenses, and the need to deter and punish such offenses; and (2) consider whether a specific offense characteristic should be added in order to provide stronger penalties for fraud committed by a corporate officer or director.

(Sec.906) Amends Federal criminal law to require senior corporate officers to certify in writing that financial statements and the disclosures therein fairly present in all material aspects the operations and financial condition of the issuer.

Subjects to criminal liability any person who recklessly and knowingly violates such requirement, including maximum imprisonment of: (1) ten years for willful violation; and (2) five years for reckless and knowing violation.

(Sec. 908) Subjects to a maximum ten-year prison term anyone who corruptly tampers with a record with intent to impair the object’s integrity or availability for use in an official proceeding, or otherwise impedes an official proceeding.

(Sec. 909) Amends the Securities Exchange Act of 1934 to authorize the SEC to seek a temporary injunction to freeze extraordinary payments earmarked for designated persons or corporate staff under investigation for possible violations of Federal securities laws.

(Sec. 910) Requests the United States Sentencing Commission to: (1) promptly review sentencing guidelines applicable to securities and accounting fraud; and (2) expeditiously consider promulgation of new sentencing guidelines to provide an enhancement concerning senior corporate officers who commit fraud and related offenses. Prescribes guidelines for Commission consideration, including a request that it ensure that the sentencing guidelines and policy statements reflect the serious nature of securities, pension, and accounting fraud and the need for aggressive and appropriate law enforcement action to prevent such offenses. Sets a deadline for promulgation of such guidelines.

(Sec. 911) Amends the Securities Exchange Act of 1934 and the Securities Act of 1933 to authorize the SEC to prohibit a violator of rules governing manipulative and deceptive devices, and fraudulent interstate transactions, respectively, from serving as officer or director of a publicly traded corporation if such person’s conduct demonstrates unfitness to serve.

Title X: Corporate Tax Returns - Expresses the sense of the Senate that the Federal income tax return of a corporation should be signed by the chief executive officer of such corporation.

Source: “Summary: S.2673 – 107th Congress (2001–2002),” Congress.gov, https://www.congress.gov/bill/107th-congress/senate-bill/2673 (accessed Jul. 12, 2017).

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Exhibit 12

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)

Party Representation in the US Senate and House of Representatives

44% 45% 46% 47% 48% 49% 50% 51% 52% 53%

104th (1995–1997) 105th (1997–1999) 106th (1999–2001) 107th (2001–2003)

Percentage of Seats Held by Parties in US House of Representatives

Republican % %Demo.

40%

42%

44%

46%

48%

50%

52%

54%

56%

1995–1997 1997–1999 1999–2001 2001–2003

Percentage of Seats Held by Parties in US Senate

% Republican % Democrat

Data sources: “Party Divisions of the House of Representatives, 1789–Present,” History, Art & Archives, United States House of Representatives, http://history.house.gov/Institution/Party-Divisions/Party-Divisions/ (accessed Jul. 12, 2017) and “Party Division,” Art & History, United States Senate, http://www.senate.gov/history/partydiv.htm (accessed Jul. 12, 2017). Do N

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http://history.house.gov/Institution/Party-Divisions/Party-Divisions

Page 29 UV7338

Endnotes

1 For more on the story of Boo.com, see the memoir of one of its founders, Ernst Malmsten, Boo Hoo: A Dot.com Story from Concept to Catastrophe (New York: Random House Business Books, 2001).

2 The loss in equity value was reported in Chris Gaither and Dawn C. Chmielewski, “Fears of Dot-Com Crash, Version 2.0,” Los Angeles Times, July 16, 2006.

3 “Report of the National Commission on Fraudulent Financial Reporting,” COSO website, http://www.coso.org/Publications/NCFFR.pdf (accessed Jul.13, 2017).

4 “Internal Control— Integrated Framework,” COSO website, http://www.coso.org/IC-IntegratedFramework-summary.htm (accessed Jul. 13, 2017).

5 Bethany McLean, “Is Enron Overpriced?,” Fortune, March 5, 2001, 122. 6 Ira Carnahan, “Short Signals,” Forbes, April 15, 2002, https://www.forbes.com/forbes/2002/0415/252.html#5f0973bf6b1e (accessed Jun. 27,

2018). 7 Paul R. La Monica, “Enron: Could Your Stock Be Next?,” CNNMoney, November 30, 2001,

http://money.cnn.com/2001/11/30/investing/q_short/ (accessed Jun. 27, 2018). 8 McLean. 9 McLean. 10 John R. Emshwiller, “Enron’s Skilling Cites Stock-Price Plunge as Main Reason for Leaving CEO Post,” Wall Street Journal, August 16, 2001, A2. 11 John R. Emshwiller, “Enron Jolt: Investments, Assets Generate Big Loss—Part of Charge Tied to 2 Partnerships Interests,” Wall Street Journal,

October 17, 2001, C1. 12 Rebecca Smith and John R. Emshwiller, “Partnership Spurs Enron Equity Cut—Vehicle is Connected to Financial Officer,” Wall Street Journal,

October 18, 2001, C1. 13 Emshwiller, “Enron Jolt,” C1. 14 Rebecca Smith and John R. Emshwiller, “Enron Replaces Fastow as Finance Chief—McMahon Takes Over Post; Move Follows Concerns Over

Partnership Deals,” October 25, 2001, A3. 15 Bethany McLean and Peter Elkind, The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (New York: Portfolio, 2003). 16 This quotation and the further discussion of the White House stance on Enron may be found in “Bush and Enron’s Collapse,” Economist, January

11, 2002, http://www.economist.com/node/938154 (accessed Jul. 13, 2017). 17 John R. Emshwiller, “Enron Stock, Bonds Receive More Hits Following Warning,” Wall Street Journal, November 21, 2001, A4; Rebecca Smith,

“Enron Warns of Eroding Profit,” Wall Street Journal, November 20, 2001, B16; Rebecca Smith and John Emshwiller, “Dynegy Deal to Buy Enron Hits Crossroads,” Wall Street Journal, November 23, 2001, A3.

18 Gregory Zuckerman and Jathon Sapsford, “Why Credit Agencies Didn’t Switch Off Enron—S&P Cries ‘Junk,’ But the Warning Comes Too Late,” Wall Street Journal, November 29, 2001, C1.

19 Zuckerman and Sapsford. 20 Rebecca Smith and John R. Emshwiller, “Running on Empty: Enron Faces Collapse as Dynegy Bolts, and Stock Price, Credit Standing Dive,” Wall

Street Journal, November 29, 2001, A1. 21 Robin Sidel, Thaddeus Herrick, and Richard Schmitt, “Enron Files for Chapter 11 Bankruptcy, Sues Dynegy—At Least $10 Billion Sought;

Wrongful Termination of Merger Is Charged,” Wall Street Journal, December 3, 2001, A3. 22 Andrew Ross Sorkin, “Market Place: Investors React Negatively to Tyco’s New, and Abrupt, Breakup Strategy,” New York Times, January 24, 2002,

http://www.nytimes.com/2002/01/24/business/market-place-investors-react-negatively-tyco-s-new-abrupt-breakup-strategy.html?mcubz=3 (accessed Sept. 18, 2017).

23 R. Moore, “Fool on the Hill: The Breaking Point,” Motley Fool, February 21, 2002, http://222.fool.com/Server.FoolPrint.asp?file=/news/foth/2002/foth020221.htm (accessed Sept. 18, 2017).

24 Press release, January 10, 2000, filed with US Securities and Exchange Commission. 25 Kara Swisher and Lisa Dickey, There Must Be a Pony in Here Somewhere: the AOL Time Warner Debacle and the Quest for a Digital Future (New York: Crown

Business, 2003). 26 Swisher and Dickey, 10. 27 Quotation from Fortune magazine in Swisher and Dickey, 10. 28 Swisher and Dickey, 12. 29 Swisher and Dickey, 16. 30 Alec Klein, Stealing Time: Steve Case, Jerry Levin, and the Collapse of AOL Time Warner (New York: Simon & Schuster 2003), 287–88. 31 Klein, 292. 32 Klein, 293. 33 Klein, 300. 34 Raymond Lee Katz, Katie Manglis, and Michael Kelman, “AOL Time Warner, Inc.,” Bear Stearns Research Report, April 9, 2001, 25. 35 Swisher and Dickey, 146. 36 J. B. Haller, “AOL: Best—or Worst—of Times?,” ZDNet News, January 17, 2000. 37 Swisher and Dickey, 3. 38 Swisher and Dickey, 19. 39 Richard Hanlon, AOL’s chief of investor relations, quoted in Swisher and Dickey, 128. 40 Alec Klein, “Unconventional Transactions Boosted Sales,” Washington Post, July 18, 2002, 1. 41 http://www.economist.com/node/938154. 42 For the full White House press release, see “The President’s 10-Point Plan,” Wall Street Journal, March 6, 2002,

http://www.wsj.com/articles/SB1015460971646141720 (accessed Jul. 13, 2017). 43 Nance Lucas, “An Interview with United States Senator Paul S. Sarbanes,” Journal of Leadership and Organizational Studies 11, no. 1 (2004): 4. Do

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http://www.wsj.com/articles/SB1015460971646141720

http://www.economist.com/node/938154

http://222.fool.com/Server.FoolPrint.asp?file=/news/foth/2002/foth020221.htm

http://www.nytimes.com/2002/01/24/business/market-place-investors-react-negatively-tyco-s-new-abrupt-breakup-strategy.html?mcubz=3

http://www.economist.com/node/938154

http://money.cnn.com/2001/11/30/investing/q_short

https://www.forbes.com/forbes/2002/0415/252.html#5f0973bf6b1e

http://www.coso.org/IC-IntegratedFramework-summary.htm

http://www.coso.org/Publications/NCFFR.pdf

Structure Bookmarks

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)
The Dot-Com Bubble and Bust
The Advent of Private Standards for Internal Control and Fraud Prevention
Fraud and Earnings Manipulation among Large Corporations in 2001–02
October–December 2001: Enron Corp.
January–March 2002: Tyco International
April–July 2002 WorldCom Inc.
July 2002: AOL and Time Warner
Weaknesses Exposed
Civic Reaction
Exhibit 1
Exhibit 2
Exhibit 3
Exhibit 4
Exhibit 6
Exhibit 7
Exhibit 8
Exhibit 9
Exhibit 10
Exhibit 10 (continued)
Exhibit 10 (continued)
Exhibit 11
Exhibit 11 (continued)
Exhibit 11 (continued)
Exhibit 11 (continued)
Exhibit 11 (continued)
Exhibit 12
Endnotes