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LEARNING THE LESSONS OF ENRON
(BEFORE IT'S TOO LATE)

Professor Lawrence E. Mitchell
George Washington University Law School
JURIST Guest Columnist

While the Enron fiasco has temporarily faded out of public view until, that is, the lawsuits or settlements begin it seems like a good time to step back and look at the big picture it revealed. It痴 not a pretty one, but in many ways it痴 not a new one either. For the fall of the house of Enron, extreme a case though it may be, is just another example of business as usual in modern American corporate capitalism.

How can this be, you ask? Isn稚 Enron an example of insider trading, self-dealing, greed and deception that goes way beyond the norm? After all, if it wasn稚, American corporations and the markets that finance them couldn稚 survive. There痴 something to that. But to assume that corporations will simply fix their balance sheets if necessary, look ahead to the future, and resume responsible business is to blind one痴 self to the reality behind Enron. For while it is indeed a tale of greed and corruption, the reason behind Enron痴 collapse is much simpler. It was doing what almost every American public corporation has learned to do in the past decade or so, learned in response to market pressures and the perverse incentives of executive stock options. It was simply trying to keep its stock price growing as high and as fast as it could.

The creed Enron痴 management was following in 杜anaging its earnings by keeping debt off the balance sheet and engaging in transactions that fostered the illusion of exploding cash flow is the new American corporate creed: maximize stock price. This is a norm of behavior that is not legally mandated, is only the product of the last several decades, and, as we have seen and may continue to see, is very bad for business.

It痴 not easy precisely to pinpoint the origins of the norm of stock price maximization, but there are several events which we can see as helping to give rise to it. The first is the election of Ronald Reagan in 1980, who gave voice to the basest human instinct captured by the contemporaneous film Wall Street: 敵reed is good. Now human beings are complex animals. But after a generation that preached (though in the long run didn稚 practice) higher values and a diminished emphasis on worldly things, Reagan痴 creed was the rough equivalent of telling an alcoholic that The New England Journal of Medicine had reported the health benefits of excessive consumption of liquor. It isn稚 a surprise that the early 1980s brought with it a spate of insider trading scandals. At the same time, American stockholders began to expect maximized short-term profits in the form of takeover premia as takeover mania swept the country, encouraged by the nearsighted theorists of neoclassical law and economics. Just as mergermania was starting to cool down, the Internet bubble heated up, with seemingly almost daily stories of people becoming rich overnight on the short-term trades from initial public offerings of tech companies. Of course people started to flood into the market in droves, led by the vultures of the bubble-age, the day traders, grabbing at anything that looked like it could move up quickly and running from any company that showed even the slightest failure to meet Wall Street痴 quarterly earnings expectations. The stock market replaced lotteries and Vegas as the get rich quick scheme of choice.

While the causal relationship between these events and the norm of short-term stock price maximization may not be empirically demonstrable, the numbers from the market certainly help to demonstrate the reality of new stockholder expectations. From 1970 to 1999, trading volume on the exchanges increased by 120 times, while the number of people owning stock increased by only 2.5 times. In the decade ending with the turn of the century, the average holding period for exchange traded stocks dropped from two years to eight months, and to five months for over-the-counter stocks (which isn稚 even enough to take advantage of long-term capital gains taxation.) Even mutual funds, the classic diversified long-term investment, experienced a decrease in holding periods from eleven to four years. These numbers, and others, show rather irrefutably that the idea of patient, long-term capital had gone the way of the dodo bird.

In such a volatile and fickle market, what is a corporate manager to do? How can she make sure that she keeps her job? How can she keep her corporation from becoming a tasty takeover target? The answer was obvious: Keep your stock price increasing. To do that, of course, you had to keep your earnings increasing.

Now how do you increase earnings? Well, one approach is the old-fashioned way; you earn them. But that takes time. New products and cheaper methods of production don稚 happen over night. It takes time to achieve industry leadership, customer loyalty, and train your workers better, especially in the so-called 渡ew economy companies that were just beginning to feel their way to success. That kind of long-term thinking, while it may ultimately produce healthier companies, isn稚 likely to keep the wolves at bay. Long-term management in a short-term market is a very risky proposition indeed.

There痴 another way. You can cut your costs as rapidly as you can. Now this doesn稚 mean more efficient methods of production; as I noted above, those tend to take time to figure out and implement. Instead, it means lopping off whatever you can, much like sailors jettison cargo on a leaky ship. So you lay off masses of workers that痴 a sure fire way to get your short-term stock price up by boosting earnings (reducing costs), even though in the long run it may well be damaging to the corporation by depriving it of a well-trained and loyal workforce at the same time as it inflicts pain on the laid-off workers for the gain of stockholders. The highly celebrated former General Electric chair, Jack Welch, proved this when he dropped more than 120,000 workers in upstate New York and Western Massachusetts, which may have inflicted enormous wounds on those regions.

You can also cut your research and development budget that takes some expense right off the bottom line. Of course if you do, you may be imperiling your ability to compete in future markets and thus your ability to prosper over the long term, but you will surely improve your earnings picture now. You could pollute. After all, you might not get caught, and the savings now might justify taking the chance. You might, like Microsoft, violate the antitrust laws. And there are undoubtedly other creative ways of boosting your earnings, even if it means damaging the long-term prospects of your own business and causing pain to others.

You have a third option, and this is the one Enron chose. You can cook the books to show better earnings than you actually have. Now this doesn稚 necessarily mean that you池e doing anything illegal. One of the things the American public has learned from Enron is the extraordinary and largely non-economic ways in which generally accepted accounting principles allow corporations to manipulate financial statements, through off-balance sheet financing aimed directly at the purpose of manipulating earnings to marking futures contracts to market and the like. You don稚 necessarily have to break the law to accomplish this; accommodating accountants have been more than happy to help aggressive managers for years. It痴 just that the imperative to obtain this help has increased in the face of market pressures.

It痴 not fair just to blame the markets. One other notable fact is the extraordinary increase in executive compensation paid in stock options and stock, encouraged by an early 1990s amendment to the tax code that prohibited corporations from deducting more than $1,000,000 in cash compensation for each executive. Stock options grew to the point where the average Fortune 1000 CEO was making more annually in stock compensation than in cash. And few of these options were restricted, as evidenced by Ken Lay痴 practice of selling off big chunks of his Enron stock on a regular basis. This had the obvious effect of concentrating the executive mind on the short-term stock price too. After all, if the real money you池e making isn稚 realized till you sell, and you have some ability to control the prices at which you sell, then you try to get those prices up as fast as you can and then bail. Not a formula likely to encourage long-term management.

So if short-termism is the problem, which I think it obvious that it is, what are we to do about it? I have a number of suggestions, but in the space and time allotted to me I壇 like to concentrate on one. I think it痴 time we revisited our capital gains tax laws, not only to redefine the long term but to punish the short term. Simply put, we ought to punitively tax short-term trading and gradually reduce the tax burden on stock profits on a sliding scale until, perhaps, we could eliminate taxation entirely for stock held for the very long term. Of course we壇 have to be careful. After all, what is short-term for some industries is long-term for others, and we壇 need to design the scale to be industry specific. And we壇 have to exempt market professionals, like specialists, who actually perform a service by short-term trading to stabilize the markets in particular stocks. Equally obvious is the fact that sometimes people are faced with unanticipated cash needs forcing them to sell stock before they otherwise might do so. The IRS could provide an explanation box on the tax form that would enable such sellers to obtain exemptions from the punitive tax and pay some average of the various tax rates (and of course this would require some monitoring both for verification and to avoid abuses like repeat 兎mergencies.)

But the beauty of such an approach is it would throw sand into the short -term gerbil wheel of our market, giving people incentives to invest for the long term. And the same would be true for corporate managers who own stock. This would not only have the salubrious effect of greatly diminishing short-term pressure to allow managers to plan for the long-term sustainability and health of our corporations, but would also encourage investors to look more carefully at the corporations in which they invest, knowing that they池e likely to be locked in for the long-term. It might even encourage them to pay attention to the corporation痴 operations and behavior, and, heaven forbid, fill out their proxy cards and vote.

This might be the greatest reward of all, fulfilling the fiction of stockholder democracy at the same time as it restores our markets to their original social function of allocating capital efficiently (and, in the secondary markets, reinforcing those allocations by affecting corporations costs of capital) instead of allowing them to continue as largely unregulated casinos. If we learn the lesson of Enron and design a cure to fit the problem, then we will emerge with a much healthier capitalism, one that behaves responsibly and is capable of carrying American prosperity far into the future. If we don稚, we may well find ourselves like those other historic leaders of world commerce, the Dutch and the British, who now find themselves secondary players on the world scene and far less prosperous than once they were.


Lawrence E. Mitchell is the John Theodore Fey Research Professor of Law at The George Washington University and the author of Corporate Irresponsibility: America痴 Newest Export (Yale 2001)

June 3, 2002

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