“Analysis of the Contributions of Five Influential Market Participants to the Dot-Com Technology Bust in 2001-2002”
By: Alan S. Pleat (Full-Time MBA Student, ’20)
The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America
Author: Alex Berenson
In The Number, Alex Berenson paints a clear image of the underlying factors that contributed to the growth of the technology bubble and its eventual bust in 2001-2002. Five market entities that have contributed to the dangerous magnitude of the tech bust include The Securities and Exchange Commission (SEC), big accounting firms with in-house consulting practices, myopic fund managers and individual stock investors, executive board members of large corporations, and Investment Bankers. We will discuss how the decisions of these market players (specifically the SEC and large accounting firms with cross-selling consulting arms) contributed to the environment that facilitated the onset of the tech bust. I will evaluate the ethical nature of these participants’ behaviors to reach quarterly earnings per share figures and what could have been done differently by these organizations to lessen the severity of the tech bust.
One of the primary market participants that contributed to the tech bust is the SEC. The SEC did not have the budget, personnel, and/or governmental backing to properly regulate the financial accounting practices of large publicly traded corporations. The extremely large number of corporations and the scope of their respective accounting gimmicks were simply too widespread for the SEC to regulate effectively. A second market participant that contributed to the onset of the tech bust are large accounting firms with associated consulting arms. These large accounting firms were often inhibited from practicing impartial GAAP standardized accounting because they were afraid to lose the consulting business of the companies they were working for. In essence, accounting firms were often swayed and coerced into cutting corners for their large clients. A third market participant that contributed to the magnitude of the tech bust were semi-professional high margin day traders, analysts, and mutual fund managers. This group was largely fixated on the superficial earnings numbers and neglected to conduct the necessary due diligence. Individual investors and mutual fund managers alike possessed an irrational exuberance towards internet companies that greatly contributed to the tech bubble. The preoccupation of these investors with quarterly earnings numbers is largely responsible for creating a cut-throat environment in which executives at large companies felt the urge to engage in manipulative and fraudulent actions in order to reach their projections. A fourth market participant that contributed to the tech bust are these executive board members of large corporations. The executive board members took advantage of their leadership positions by greedily providing themselves with large salaries and stock option packages. They would also attempt to manipulate their earnings projections by paying employees primarily with stock options, which they cleverly did not include in their company wage expense figures. A fifth market participant that contributed to the onset of the tech bust are investment bankers that sought to underwrite internet companies with great fervor. These investment bankers eagerly sought to capitalize on the public’s insatiable appetite for internet companies during the late 1990s and early 2000s. Investment bankers would attempt to hype up the internet companies they were underwriting during trade shows regardless of whether the companies actually possessed viable businesses.
The Securities and Exchange Commission was largely helpless in its ability to regulate the fraudulent behavior that was occurring during the period leading up to the tech bust because of budget, personnel, political, and government bureaucratic constraints. Despite Arthur Levitt’s (the Chairman of the SEC from 1993-2001) efforts to advocate for individual investors by reining in control of the markets, the SEC largely failed to be more than a “paper tiger” when it came to confronting company fraud. In a September 1998 speech with the bull market about to begin its final manic acceleration, Levitt effectively diagnosed “the cancer that threatened the markets’ integrity” (Berenson, 130). In this speech he asserted that earnings expectations were overriding common sense business practices and creating a game of “nods and winks” in which wishful thinking was winning over faithful representation. However, he failed to take aggressive action to temper this storm. Action to counteract this widespread accounting fraud was far from easy to implement for the SEC. By 2011, the SEC was responsible for over 5,000 investment companies, 7,400 registered investment advisers, and 14,000 companies that have issued securities. Meanwhile, the commission’s staff had not grown since 1980, or for that matter 1939. In 2001, while “260 million shares traded on the New York Stock Exchange, the agency had [just] seventeen hundred employees” (Berenson, 131). Clearly, the SEC was severely understaffed. Further exacerbating the issue, the commission encountered difficulty retaining highly specialized accounting and legal professionals in the 1990s because it could not compete with the average salary offerings of equally or less skilled private sector positions. For example, first-year associates at major law firms in NYC were making over $100,000 more than senior SEC lawyers. Thus, more than 30 percent of the SEC’s employees quit between 1998 and 2000. Of course, these low SEC salary figures is a direct resultant of the commission’s meagerly allocated government budget.
The SEC’s inability to reprimand fraudulent behavior and send a message to the entire stock market is exemplified in its response to the Tel-Save case. At its peak, Tel-Save was worth $2 billion but in the 1998 it was losing hundreds of millions of dollars annually. In response to this, Tel-Save was engaging in very aggressive and illegal accounting practices. Tel-Save was clearly using another public company to shift expenses off of Tel-Save’s income statement. The SEC never opened an investigation into the company. While the SEC’s internal functionalities deserve blame for its inaction on this pivotal fraud case among others, the encompassing government and political climate warrant large-scale culpability. When Libertarians and conservative Republicans took over Congress in 1994, they quickly instilled a majority perspective that the SEC was an expensive and insignificant regulatory entity that was hampering American free enterprise. Unable to fundamentally alter the mission of the SEC, the GOP effectively starved the agency. The GOP proposed cuts of 20 percent to the SEC’s already relatively meager $300 million budget. The SEC’s weakness reverberated throughout the justice system, as prosecutors largely avoided initiating fraud cases, which were more difficult to conduct than criminal charges. While the actions of the SEC were not unethical in any way, the commission should have aggressively used its however meager clout to raise attention to pivotal instances of large corporation accounting fraud. Instead of focusing its attention on sophomoric and low impact accounting schemes, the SEC should have conserved its resources to attack accounting fraud head-on. From the onset the SEC should have pooled its resources in order to open a few ambitious civil investigations and/or criminal cases against these law-breaking companies. Levitt was too passive in his response to these illegal accounting practices, as he largely left it up to the financial community to regulate itself. The SEC should have worked with short-sellers to bring to the surface these cases of fraud.
At the start of the 1970s, the “Big Eight” accounting firms began vertically integrating their service offerings through the means of cross-selling managerial consulting arms. Regulators and Congress were concerned that joint accounting and consulting practices would “create a professional and financial interest by the independent auditor in a client’s affairs which is inconsistent with the auditor’s responsibility to remain independent” (Berenson, 116). These government officials were absolutely right on the money with these considerations. The SEC attempted to no avail to prohibit accounting firms from taking on consulting roles that created internal financial control systems that they themselves would later audit. Unfortunately, the SEC’s proposed limitations on joint accounting and consulting activities, like many other of its regulatory initiatives, went nowhere. Accounting firms contended that consulting arms made them more knowledgeable about their clients’ businesses and in turn better auditors. However, these major accounting firms were primarily motivated by greed and were unwilling to compromise for the greater good of their accounting autonomy. By 1994, approximately half of Arthur Andersen’s and Price Waterhouse’s U.S. revenues came from their consulting and tax advisory practices (while their accounting profits steadily declined). Before the 1980s, the Big Eight accounting firms at least appeared to be public servants. In the 1990s, their primary objective was profiteering at all costs. In 1997, Levitt attempted to mitigate the effects of this cross-selling of accounting and consulting services by creating an SEC sub-committee called the Independent Standards Board. This board sought to determine where accountants should face stricter rules on cross-selling practices. However, the board was made up of eight members: four from the SEC and four from accounting firms. As one would expect, a stalemate ensued. The Big Five went to war with Levitt and the SEC. The Big Five had the support of the incoming Bush Administration (they had given $39 million in political contributions to his campaign from 1989 to 2001) as well as the backing of the majority conservative Republican Congress. Levitt was forced to relent, and the accounting firms were able to operate as they pleased.
The unethical nature of the ubiquitous practice of cross-selling became highly conspicuous during the many devastating fraud scandals that erupted in 2002. For example, Arthur Andersen was convicted of being complicit in the fraudulent institutional and systematic accounting of approximately $100 billion in Enron’s company revenue. Arthur Andersen’s role in the infamous Enron scandal forced the company to permanently forfeit its CPA license and go out of business. Clearly, Arthur Andersen and other accounting firms that faced similar fraud cases had not fulfilled their fiduciary responsibility to the global public to provide accurate, clear, unbiased, and ethical accounting services to their institutional clients. In order to prevent this conflict of interest from occurring again, the SEC must have full power to evaluate and regulate the actions of accounting firms. Accounting firms must be constrained in the amount of funding they can provide to political candidates in order to prevent corruption. Compromises must be made between the SEC and accounting firms when necessary. Most importantly, accounting and consulting firms must be separated. Accounting firms should not be able to consult for the same company they are actively auditing to prevent potential conflicts of interest. Accounting firms must be smaller in market share and specialize in providing fair accounting and auditing services compliant with GAAP.
Overall, Alex Berenson provides readers of the Number with keen insights into the many contributing factors that lead to the propagation of major financial crises. His book highlights the importance of accounting firms to serve as impartial watch dogs for global financial markets. He eloquently explains the detrimental effects that irrational investor exuberance can have on the incidence of stock bubbles through his analysis of the dot-com crisis. Just as the internet provided a catalyst for lots of value creation and destruction, new technologies like virtual reality and machine learning provide promise, though not all stakeholders involved will benefit, as the dot-com bubble has taught us. A more symbiotic relationship must form between investors, publicly traded companies, government regulators, and accounting firms in order to ensure that all participants are fully informed about market conditions.
Works Cited
Berenson, Alex. The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America. Random House, 2004.
