Bull!

by Maggie Mahar

  Confrontation was not Arthur Levitt’s style, however. When he came to the SEC his plan was to cajole, to lead, to use moral suasion—to regulate without making enemies. He thought he understood how the game of power politics was played—“how to find common ground with lawmakers, regardless of political party,” how to “build political capital.”

  But, he confessed in his memoir, it was only after he joined the game that he discovered how little political capital an SEC chairman has. “Once I began pursuing my agenda, I saw a dynamic I hadn’t fully witnessed before: the ability of Wall Street and corporate America to combine their considerable forces to stymie reform efforts…. The two interest groups first sought to co-opt me. When that didn’t work, they turned their guns on me.”

  But in this first round of fighting, it is fair to say that Levitt was co-opted. The political players persuaded him to see the question of options reform from their point of view—not as a question of right and wrong, not, as Warren Buffett saw it, as a fairly straightforward accounting question (If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it?), but as a political question: Which way is the political wind blowing?

  Nine years later, Levitt apologized to FASB. “In retrospect, I was wrong. I know the FASB would have stuck to its guns had I not pushed it to surrender. Out of a misguided belief that I was acting in the FASB’s best interests, I failed to support this courageous and beleaguered organization in its time of need, and may have opened the door to more meddling by powerful corporations and Congress. The last thing I wanted was to politicize FASB,” he added, “which can’t function if it must please every last CEO and deal with the whims of Washington lawmakers.”41

  In the years that followed, Levitt would take a more proactive role in battles over corporate accounting. But as early as 1993, Wall Street needed to be reined in. Major corporations were already concealing expenses in order to inflate earnings. And everyone knew it. This is not to say that most congressmen at the hearing understood how the illusion that options cost nothing would corrupt both corporate management and corporate accounting. But just about everyone at that subcommittee hearing did understand—or should have—that options cost someone something, that the cost was not being reported on earnings statements—and that if it was, investors might not be willing to pay as much for shares.

  That was their greatest fear: if the expense was shown, earnings would fall. And share prices would follow.

  At the end of the decade, some would blame the CEOs who cooked their books for the bull market’s sorry end, saying that they caused the market to crash. To the contrary: CEOs who cooked their books caused the market to rise. The higher reported earnings, the more shareholders would ante up for a company’s stock. Bogus bookkeeping did not bring the market down; it helped build the bubble.

  But in 1994, few fretted that share prices were rising too fast. That year, S&P companies reported earnings up 39.8 percent. Only a skeptic would question whether there might be a difference between “reported earnings” and actual profits.

  Warren Buffett was just such a skeptic. In his 1995 letter to Berkshire Hathaway’s investors, Buffett quoted Gilbert and Sullivan’s HMS Pinafore: “‘Things are seldom what they seem, skim milk masquerades as cream.’…In the production of rosy scenarios,” Buffett added, “Wall Street can hold its own against Washington.”

  Certainly, as Act II of the Great Bull Market of 1982–99 drew to a close, CEOs at some of America’s largest corporations had every incentive to put a little lipstick on their projections. Their personal fortunes turned on double-digit growth. At the end of 1994, Disney’s Michael Eisner, for instance, was sitting on options worth $171 million based on the company’s share price at the end of 1994. Just behind Eisner on the list, PepsiCo’s Wayne Calloway held options worth $64 million, followed by Oracle’s Larry Ellison ($60.5 million), Compaq Computer’s Eckhard Pfeiffer ($54 million), Reebok International’s Paul Fireman ($49.6 million), United Healthcare’s William McGuire ($49 million), and Coca-Cola’s Robert Goizueta ($46 million). A little further down on the list, Scott Paper’s Al Dunlap ($23 million) and GE’s Jack Welch ($22.6 million).42

  One of the year’s biggest winners: an up-and-comer in Houston, Enron’s Kenneth Lay. In 1994, Lay received $10.1 million in salary plus the option to buy 1.4 million shares. Enron’s board gave him 10 years to exercise those options. If Lay could just move the stock’s price up by 10 percent a year over those 10 years, the board’s gift would be worth $76 million.

  THE SAFE HARBOR PROVISION

  A year later, the corporate lobby that beat FASB won yet another beltway battle that would encourage “creative accounting.” In December of 1995 Congress passed the Safe Harbor Act, a bill designed to shield both corporations and their accountants against shareholder suits if they misled investors about their earnings.

  Opponents called it “The Pirate’s Cove Act.”

  Part of the Private Securities Litigation Reform Act of 1995, the Safe Harbor provision was designed to curtail frivolous lawsuits by offering corporate management “safe harbor” when making predictions about a company’s products, future revenue, and earnings. “The bill is important,” The Wall Street Journal explained to its readers, “because class action lawyers often hold companies’ forecasts against them, asserting they have defrauded investors by lying to them or misleading them with unrealistically optimistic predictions.”43

  Seven years later, the idea of holding companies responsible for their forecasts would not seem so frivolous. When short seller Jim Chanos testified before the House Energy and Commerce Committee’s hearing on the Enron scandal in February of 2002, he pointed to the Safe Harbor Act as a law that “emboldened dishonest managements to lie with impunity by relieving them of concern that those to whom they lie will have legal recourse.” Indeed, Chanos declared, “the statute has probably harmed more investors than any other piece of recent legislation.”44

  But in 1995 the Journal was expressing the consensus on Wall Street that in an increasingly litigious society, companies needed to be protected against shareholders inclined to believe that life’s disappointments are best addressed by calling a lawyer. With that goal in mind, the new law made it much more difficult for shareholders to bring a class-action suit in federal court if a company’s forecasts did not pan out—as long as the company’s executives surrounded their predictions with “meaningful cautionary statements,” identifying “important factors” that might skew results.

  “From that point forward,” Chanos recalled in a 2001 interview, “at the beginning of every corporate conference call, they read a few sentences of legal boilerplate [to the effect that] any projections about earnings, revenues, or products [contain] forward-looking statements, which are subject to known and unknown risks, uncertainties, and other factors…

  “What they were really saying,” Chanos observed, “was, ‘Now we’re going to lie to you. But remember, you can’t sue us!’ After that, the whole system could be gamed.”45

  The bill raised the bar for what investors needed to prove before launching a suit. In the past, plaintiffs only had to prove that there was good reason to suspect wrongdoing might have taken place before proceeding to the “discovery” stage of a case, where the plaintiff’s lawyers would be allowed to interview senior executives. But under the Safe Harbor Act, the plaintiff would have to provide specific facts suggesting that corporate insiders knew they were committing fraud before the plaintiff’s attorneys could interview them. Finally, the law protected not only corporate officers but accounting firms that might be inclined to look the other way when corporate clients fudged their books. “The change could save the firms staggering sums in the event of a major calamity such as the savings-and-loan crisis, which forced the Big Six accounting firms to pay more than $1.6 billion in damages and settlements to investors,” supporters noted.46

  State securities regulators, consumer groups, the American Associ
ation of Retired Persons, the Mayors’ Conference, and class-action lawyers all fought the legislation. “If the bill becomes law, investors will be taken back to a world of caveat emptor,” declared Michael Calabrese, who monitored congressional affairs for Public Citizen, a consumer-advocacy group.47

  Both President Clinton and SEC Chairman Arthur Levitt expressed reservations.

  But by 1995, Congress was making it clear to Levitt that he was on a very short leash. That year the House and Senate froze the SEC’s budget. David Ruder, a Republican who had served as SEC chairman from 1987 to 1989, understood what was happening: “The Republican Congress is dealing with the SEC as though it is the enemy instead of the policeman on the beat.”48

  Still hoping to regulate through compromise, Levitt tried to find common ground with the Safe Harbor Act’s supporters. Senator Alfonse D’Amato, the chairman of the Senate Banking Committee, was one of the bill’s biggest backers, and Levitt instructed SEC staffers to sit down with Banking Committee staff to work out language that would be acceptable to both sides. Ultimately, they crafted a compromise, and, in a letter to Senator D’Amato, Levitt gave the revised bill his blessing.

  Word of the letter leaked to the press, and Levitt’s imprimatur was taken as an indication that President Clinton, too, was now on board. Confident of the president’s support, the Senate passed the Private Securities Litigation Reform Act of 1995 on December 5, with the Safe Harbor provision intact, by a vote of 65–30. The next day the House sent the bill to the White House with strong bipartisan support, voting 302 to 102 in favor of passage.

  But then President Clinton threw Congress a curve. At the 11th hour—just before a midnight deadline on December 19, 1995—Clinton vetoed the legislation.

  The bill’s backers were fit to be tied. Congressman Christopher Cox, a Republican from Newport Beach, was the bill’s principal supporter in the House, and he denounced the presidential veto: “President Clinton has turned his back on everyone who owns a mutual fund, participates in a pension plan or has a job at a public company.”49

  It might seem curious to suggest that Clinton had betrayed investors by scotching a law that limited their right to sue when they were misled by corporate management. But in 1995, many truly believed that, because so many executives were themselves shareholders, the interests of corporate management and investors were aligned. What was good for one group was good for the other. At the time, few stopped to consider the crucial difference between insiders and outsiders: insiders were in a much better position to know if earnings projections were over the top, and so better positioned to bail out, before the balloon popped.

  Following the veto, Clinton tried to defend himself: “I just didn’t want innocent people to be shafted.” Although he acknowledged that dubious lawsuits posed a threat to business (“There have been examples of frivolous lawsuits filed which really have been unfair to people in California and elsewhere”), Clinton argued that the Safe Harbor provision of the Reform Act went too far in the other direction. “I would ask the American people to remember there have been a lot of examples in the last 15 years of people who have been ripped off to a fare-thee-well, who didn’t get all their money back but at least got some of their money back because they could go to court.”50

  Congress was not impressed. The next day the House voted 319 to 100 to override the president, the very first time that the House overturned a presidential veto on Clinton’s watch. Two days after that, on December 22, the Senate joined the House, with a vote of 68 to 30.

  A sign of the times, The Wall Street Journal headline four days later: “Congress Sends Business a Christmas Gift.”51

  THE MEDIA, MOMENTUM, AND MUTUAL FUNDS (1995–96)

  —9—

  THE MEDIA: CNBC LAYS DOWN THE RHYTHM

  They saw whither led the torrent of the public will; and it being neither their interest nor their wish to stem it, they allowed themselves to be carried with it.

  —Charles MacKay, Extraordinary Popular Delusions & the Madness of Crowds1

  1995, and the theme—on Wall Street, on Main Street, and in the media—was speed: In just nine months the Dow catapulted from 4000 to 5000. Ralph Acampora predicted that Dow 7000 was within reach. IPOs doubled their first day out. And on CNBC, a breathless Maria Bartiromo reported from the floor of the New York Stock Exchange.

  That year, Richard Russell surveyed the scene: “The Dow has not experienced a 10 percent decline within a single calendar year in four years—unprecedented. Twelve years have now gone by without the Dow breaking below the low of a previous year—unprecedented…This is a market that’s been feeding on itself, and the feeding has evolved into a frenzy. In fact the frenzy is now rubbing off on global stock markets, and with interest rates declining worldwide, markets everywhere have headed higher. The whole situation is turning into the party of the century.”

  What was driving the market? Russell offered his readers an anecdote: “As a young man back in 1958, in New York City, I used to frequent the boardrooms. During the explosive up-year of 1958, I asked one crusty old-timer why, in his opinion, stocks were surging higher day after day. He looked at me with palsied eyes and replied, ‘More buyers than sellers.’”2

  It was that simple: demand was sending stocks to the moon. The third and final phase of the bull market had begun.3

  Now, middle-class Americans began to pile in, pouring their savings into stocks and mutual funds that invested in stocks. Wealthier Americans already owned equities: a 2002 survey of households with over $500,000 in financial assets revealed that more than three-quarters of these households made their first purchase sometime before 1990.4 Over the next five years, less affluent investors began to edge into the market—the same survey showed that one-third of households with financial assets of $25,000 to $100,000 bought their first stock or stock funds sometime between 1990 and 1995.5 But many middle-class investors did not join the party until the second half of the decade. Indeed, 40 percent of those with financial assets of $25,000 to $99,000—and 68 percent of those with less than $25,000—reported making their first purchase after January of 1996.

  By then, the stock market was hosting the party not just of the century but of the millennium. Everyone wanted to attend. Seemingly overnight, over 3,000 equity funds had materialized to escort each and every individual investor to the ball. By 1996, investors were pouring $235 billion into stock funds—nearly double the dollars invested a year earlier.6

  Broadcasters and business journalists covered the heady goings-on. Each stock tick was noted, every earnings whisper reported, and personal fortunes were charted on a daily basis. By 1996 the trading was raucous. In that year alone, 22 brand-new business magazines hit the newsstands; CNN launched its own financial news network, CNNfn; AOL opened its own mutual fund center, and TheStreet.com debuted online.7

  The market was going up because people were buying stocks. People were buying stocks because the market was going up. The mutual fund industry’s superb marketing fed the momentum. Individual investors provided the cash. The media covered it all. It was impossible to say who or what drove share prices. Everyone was involved. Few dared question the fundamental values of the market. It was now running on its own momentum.

  In 1995 even a skeptical Richard Russell urged the readers of his Dow Theory Letter to hold on: “True valuations are absurd, bullishness is rampant and every magazine and newspaper lets you in on which mutual fund to buy,” he acknowledged. “But this bull market has developed a tremendous upside momentum, and upside momentum does not die quickly.”8

  CNBC

  The financial world was well on its way to becoming part of pop culture, and nowhere was this more apparent than at GE’s cable network, CNBC. General Electric bought the bankrupt Financial News Network and folded it into its own Consumer News and Business Channel (CNBC) in 1991. But it was not until 1993 that CNBC began to find its true audience.

  Someone had to figure out how to bring production values to the People’s
Market, and Roger Ailes, who came to CNBC that year, turned out to be the perfect fellow for the job. A political strategist who had orchestrated winning campaigns for Presidents Richard Nixon, Ronald Reagan, and George Bush, Ailes turned his talents to drawing out the personalities of CNBC’s on-air talent. On Ailes’s watch, the network’s profit soared from a paltry $8 million to $50 million in just two years.9

  CNBC simultaneously fed and reflected the market’s frenzy. In 1995 the network launched Squawk Box, its pregame show. Each morning, before the market opened, Mark Haines, the show’s host, Joe Kernen, CNBC’s on-air stock editor, and David Faber, the network’s Wall Street correspondent, traded wisecracks while they revved up viewers for the action to follow. When the market opened, the cameras turned to Maria Bartiromo, reporting from the New York Stock Exchange.

  Buffeted by a sea of men, shaking her shiny black hair out of her eyes, Bartiromo was the first television journalist ever to report from the trading floor of the NYSE. Some fans compared Bartiromo to a young Sophia Loren. Without question, she was both charismatic and gutsy. Ignoring the swarm of white shirts that jostled her, Bartiromo held her own on the crowded floor, breathlessly rattling off the tips and touts circulating on the Street that morning, her voice growing hoarse as she shouted into a camera that seemed to hang far above her—making her appear all the more vulnerable, and all the more brave, as she struggled to bring her viewers breaking news of what stocks Wall Street’s brokerages were promoting that day.

  Bartiromo worked hard to get access to the “morning calls” at the major Wall Street houses, bringing her viewers the highlights of the confabulations that Wall Street firms hold, each day, on their “squawk boxes”—the intercom systems that connect them with brokers across the nation, and, in some cases, around the globe. These conference calls give the firms an opportunity to share new information before the market opens, telling their salesmen which stocks their in-house analysts are recommending that day.