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Junk Bonds in Drag

stirling s newberry stnewberry@earthlink.net

Bush spoke on his program to "restore investor confidence" and deal with the mushrooming corporate scandals - live, and in the middle of the day, it was carried by the financial networks without interruption.

If Bush's speech had lasted 15 seconds, it would have been a great speech. Filled with moral outrage about corporate wrong doing and demands that business schools teach ethics and "right from wrong". But the Wall Street types who listened to it applauded weakly, the stock market continued to tread water, and even the cable networks had only modest praise, even Fox had trouble putting lipstick on this pig. This speech failed, in other words, even by the standards of a corporate Republican agenda for fixing the problems with the markets and corporate accountability, and instead is another Potomac blizzard. Washington and Buffalo New York are the only two cities where most of the snow flies horizontally - but the difference is that in Washington it can happen during July.

The measure of the failure of the speech is that it did not even adopt the recommendations made by Alan Greenspan, The American Institutional Investors Association - that is pension funds and massive hedge funds - and the Wall Street Journal - hardly a collection of raving anti-corporate closet communists.

The program was for tougher sentences, penalizing CEOs if the balance sheet does not hold up, requiring at least half of the directors on a board to be "truly independent" and creating a separate commission to regulating the accounting industry. He also called for a small increase in the SEC's budget, comparable to the cuts made 20 years ago under Reagan. So what isn't there?

The most glaring omission is the absence of the demand for changes in the accounting practices. After all, it doesn't matter how many people you have enforcing inadequate laws. At the top of the list of omissions is a proposal that has been put forward by Greenspan and Warren Buffett - stock options have to be carried on the books as a liability and a cost.

As importantly, the end of "pro forma" accounting being included in quarterly reports, and a failure to redefine Earnings Before Interest, Taxes, Depreciation and Amortization, or EBITDA, to prevent wash sales, sales to captive entities and assorted other gimmicks to pump up the bottom line.

Finally, he failed to call for the reform that the most dear to the hearts of many large Republican firms on Wall Street - requiring that all exchanges follow the strict listing standards promulgated by the New York Stock Exchange.

In other words Bush's program was a classical case of speaking very loudly, and then sticking it to the American people. We've seen this happen before.

Two months ago a series of troubling revelations about the failures of the American intelligence community before 911 were scandalizing Washington. To date, no one has resigned over those failures - instead, a huge bill to reorganize everything except the CIA and FBI - where the failures had been - was put forward, and the trail of incompetence was buried in the middle ranks of the FBI. An already ongoing purge of FBI special section chiefs was reworked as an overhaul of the bureau, and that was that. It seems likely that the same plan - elephantine bluster backed with flea bite changes, is being attempted again.

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But the failure runs deeper. Currently there are two commissioner seats open on the SEC. Bush did not come forward with strong candidates with clean records. He continues to back SEC chief Harvey Pitt - who even Republican Senators are grumbling is too dirty, too slothful and too lax. His promise of a "kinder, gentler SEC" will come back to haunt them. The effect of this has been the dismissal of one case brought by the SEC already, and a failure to pursue investigations - many of them started in the Clinton Administration - which might well have uncovered corporate wrongdoing earlier.

The failure is rooted in a failure for the American people to admit that we have drifted away from capitalism, and towards a kind of feudal oligarchy.

The most misquoted book in the history of the world is easily the Christian Bible. But if there is a competition for the silver medal, then Adam Smith's Wealth of Nations must surely be the strongest contender. We are told by the Microsoft Encyclopedia that Smith declared government non-involvement with the economy to be the only necessity for prosperity, and hear over and over again how we should just "trust the market" to fix everything. In fact, what Smith opposed was collusive relationships between the king and the very wealthy - relationships that produced artificial monopolies like Microsoft.

Reading Smith's actual book, one finds that his faith was not in the rich and powerful - who he felt would attempt to sabotage the market with collusion and fraud - nor did he advocate that people be allowed to make whatever profit the market would bear. Instead, his faith was in a society where people are forced to do better to make a profit. His guiding ethic was that only "improvements to ones stock of capital" qualified as the basis for profit.

With this pervasive dishonesty and disinformation about what capitalism is, it is no surprise that we no longer live in a capitalist society. And it is even less a surprise that we are paying the price for this.

How can I prove this?

If we were capitalists, then it would stand to reason that the people who would have the power in any situation would be the owners of capital. And yet this is not the case. In corporation after corporation, the stock holders have been wiped out, or nearly wiped out, while executives and bankers have been protected. Clearly, if executives and bankers - and not owners of the capital - are the ones protected, we don't have capitalism, but an oligarchy. The power is held by a small private club, insulated from the rest of the world.

Realize that 1/3 of all the money in the US stock market is held by pension funds. Nearly another third is held by mutual funds. Both of these groups regularly do not vote their shares, or always vote in favor of management as a matter of policy. Instead the owners of 1/3 of the capital have, in effect, all of the power. Since a share is ownership, and the idea is that owners will have a say in what they own this means something very simple:

If you can't effectively vote your shares, then you don't own stock - you own junk bonds in drag.

There have been rumblings for "reform" of the system. There were "reforms" a decade ago too. And a decade before that. And yet, the same group of people keep becoming executives, and they have been paid more and more and more money over the last 30 years. Any number of studies have documented the mushrooming level of executive pay. Some have proposed wage limits, others have proposed taxes. But there is a simpler and more effective remedy.

Democratic Capitalism.

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The solution then is not reform or a few rules - it is restoration of the idea that the people who own a stock should run the company. The challenge becomes doing this. Right now pension funds and mutual funds basically treat the equities they own as speculation or as unsecured bonds that return on a price paid. Instead there must be a mechanism by which those who are the ultimate owners of these two blocks of money have a say in how they are run.

The means is first, to have a requirement that funds appoint an individual to determine how to vote their shares for a particular company. The individual would be the same for all of the funds a company manages or owns, and would be required to make recommendations based on what would be best for the company - and not for the fund as a whole. If necessary a requirement that he not be allowed to make recommendations for more than one competing company could be made.

Then, every beneficiary of the pension fund, and every owner in the mutual fund would get, well before the vote is taken, a list of what the issues are, and how his fund intended to vote. He would then have a period of time to "object" to the vote. If more than a threshold of 10% of the participants in a fund object, then the fund would have to inform everyone that the objection level had been reached, and hold a general vote of all of the beneficiaries - on a weighted basis. The vote would be binding. To make this work there would have to be anti-bundling rules, which would prevent there being more than a certain percentage of a fund being voted by any one individual. If a fund is owned by other funds, then the individuals in those funds would vote individually, and not be gathered together as a block first.

For example, Fidelity would have one person making recommendations on GE for all of its funds. But the holders of each fund would then vote separately, GE owners in a conservative fund might like the recommendations, while owners in an aggressive growth fund might not.

In this way, the 2/3 of the shares owned by institutional investors would be voted, and that vote would reflect the will of the owners or beneficiaries.

While crafting the exact regulatory scheme that would prevent rigging of votes or other means of sabotaging the intent would take time, this mechanism is technically within the reach of our current system of electronic communication and customer relationship management. The software and hardware is there, the will to enact it exists, only the lack of imagination on the part of the political class, and the entrenched interest of the executive class - which currently gets the benefits of having control over three times as much money as they actually have, without any disadvantage - stand in the way.

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In the same vein, there is a simpler and more direct means of enforcing corporate honesty for insiders. Many CEOs, after being paid hundreds of millions, have disclaimed knowledge of the goings on in their company. All the better to avoid charges of being insiders when trading. At Enron, Lucent, Adelphia and WorldCom - high level executives have acted as if they were completely ignorant. What exactly was their job description? It must have been "generate plausible deniability".

Currently, if an executive acts on "material non-public information" they have violated the rule on insider trading. If caught they may serve jail time - but no matter what, they must "disgorge illegal profits" - that is, they lose the money.

This same rule should apply to "negligent insider trading". Any executive who, with due diligence, should have known about illegal activity at their firm must disgorge any profits made from sales of stock. To repeat: all profits from "out of the loop" trades would have to be returned. In other words, if Ebbers sold WorldCom at 50, and the stock later goes to .24 cents because accounting fraud is discovered, then he will have to disgorge 46.76 per share he sold - because he ought to have known. You will be amazed at how fast executives will become attentive to making sure that the books are clean, if they are financially responsible for the results of failure. We are told that executives are paid well for the risk. Then let us make sure that the risk is there.

Bush was willing to come out and say that CEOs should be held accountable, but looking at his own career - where "the lawyer ate my homework, the bureaucracy at the dots, and the files ate my service records" - evasion of that responsibility will simple mean finding the appropriate low level flunky to take the hit.

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These two proposals are necessary for a restoration of confidence, and restoration of capitalism to our current system. Failure to take such steps will lead, in due course, to another meltdown from opacity. In 1998 many prominent economists intoned as to the necessity for transparency as part of the Tiger Economies of East Asia - from Solow and Krugman, to Greenspan and Friedman. And it is true, the paper universe must look like the real one for there to be a market were people buy and sell equities. But creating such an equivalence is not accident, nor does it happen as long as there is an incentive to commit fraud, or remain negligently uninformed while others commit fraud on your behalf.