Corporate Crooks: How Rogue Executives Ripped off Americans and Congress Helped Them Do It!

Overview

How did the most trusted financial system in the world become the breeding ground for the massive corruption uncovered in the Enron and Worldcom scandals? The simple answer is greed. Greed so blinded CEO’s, auditors, and even members of Congress that they allowed a gang of rogue executives to rig the game and cheat investors out of $200 billion, wiping out the life savings of many unsuspecting Americans.
In Corporate Crooks, veteran USA Today investigative journalist Greg ...
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Corporate Crooks: How Rogue Executives Ripped Off Americans... and Congress Helped Them Do It!

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Overview

How did the most trusted financial system in the world become the breeding ground for the massive corruption uncovered in the Enron and Worldcom scandals? The simple answer is greed. Greed so blinded CEO’s, auditors, and even members of Congress that they allowed a gang of rogue executives to rig the game and cheat investors out of $200 billion, wiping out the life savings of many unsuspecting Americans.
In Corporate Crooks, veteran USA Today investigative journalist Greg Farrell explains how this breakdown happened. The book shows how incentive compensation for CEOs, combined with the decline of the American auditing industry, led to a series of spectacular accounting frauds, not just at Enron and WorldCom, but at other companies as well.
Farrell details how a series of seemingly minor Congressional actions—from a law penalizing corporations for paying salaries in excess of $1 million to a Senate vote to scuttle a rule calling for the expensing of stock options—created the conditions that led to the accounting abuses that eventually brought gigantic corporations down.
Written in a straightforward, explanatory style, Corporate Crooks allows the average investor to understand the root causes of the biggest accounting frauds of the past five years. But understanding how these frauds took place isn’t enough. Farrell also arms readers with the knowledge they’ll need to judge whether the next fantastic, fast-growing company of the new economy is a genuine business success or another Enron waiting to implode.
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Product Details

  • ISBN-13: 9781591024552
  • Publisher: Prometheus Books
  • Publication date: 9/28/2006
  • Pages: 1
  • Product dimensions: 6.30 (w) x 9.30 (h) x 0.70 (d)

Meet the Author

Greg Farrell (Pelham, NY) is an award-winning reporter who writes about Wall Street for The Financial Times. Prior to joining the FT, he was an investigative reporter for USA Today, where he specialized in white-collar crime, legal affairs, and the regulation of corporate behavior. He is a past winner of the American Business Press’s Jesse Neal Award for investigative reporting and a recipient of the Knight-Bagehot Fellowship for business journalism.
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Read an Excerpt

CORPORATE CROOKS

How Rogue Executives Ripped Off Americans ... and Congress Helped Them Do It!
By GREG FARRELL

Prometheus Books

Copyright © 2006 Greg Farrell
All right reserved.

ISBN: 978-1-59102-455-2


Chapter One

Executive Compensation

The day after Christmas, 2001, Harlan Waksal called his brother Sam with some bad news about their company, ImClone, and its cancer-fighting drug, Erbitux. After months of review, the U.S. Food & Drug Administration was going to deny their company's request for approval to market the new drug to the public. The brothers had spent the last few years of their lives working doggedly to develop and promote the drug, which promised relief to millions of Americans suffering from cancer. But when Sam Waksal heard about the FDA decision, the last thing on his mind was the suffering of cancer patients. All he could think about was his own bank account and how the negative FDA decision could wipe him out.

Waksal, the mercurial son of Holocaust survivors, had climbed his way to the top of New York society by combining the scientific promise of his medical company's products with his love of the glamorous life. He dropped huge sums of money on lavish parties and befriended stars such as Mick Jagger, but there was substance beneath the style: some medical experts believed ImClone's new drug could be an effective tool in the fight againstcancer.

But the negative FDA decision threatened to shatter Sam Waksal's life. Most of his wealth was tied up in shares of his publicly traded company, ImClone. Once the FDA announcement was made public, which would probably happen within days, the price of ImClone's stock would plummet and with it, Waksal's net worth. Worse, Waksal had used his stock holdings in ImClone as collateral for a series of loans which allowed him to live like a prince among the jet-setters who divided their time between Manhattan, the exclusive Hamptons and a series of exotic vacation spots around the globe. The FDA decision would pull the plug on Waksal's princely lifestyle.

Faced with a financial collapse, Waksal reacted instinctively, breaking the law that serves as the foundation of the nation's capital markets. He tried to sell a big stake of his ImClone stock immediately, before news of the FDA decision was disseminated to the public, and ImClone's shareholders.

Following the crash of the stock market in 1929, Congress passed the landmark securities laws of 1933 and 1934. The crash had been caused partly by unscrupulous promoters peddling ever larger amounts of overvalued stock to investors, and selling out before the public learned the truth about the companies they owned. The Securities Act of 1933 made it illegal for officers of publicly traded companies to cash in on inside information. The law is the bedrock upon which today's stock market was built and the Securities and Exchange Commission, established by the Securities and Exchange Act of 1934, enforces it aggressively.

But on the evening of Dec. 26, 2001, Waksal wasn't thinking of the SEC and wasn't concerned about his fiduciary duties to ImClone's shareholders. All he could concentrate on was getting his money out of ImClone before the public got wind of what was happening. He placed a series of frantic phone calls to his father and daughter, telling them to sell their stakes in the company the first thing the following morning. Then, on the morning of Dec. 27, he tried to sell a chunk of his shares housed in his account at Merrill Lynch. But a young broker's assistant named Douglas Faneuil said he would need written approval from ImClone's top lawyer before he could allow Waksal's insider trade to go through.

Getting desperate, Waksal tried to get his Merrill Lynch ImClone shares transferred to his daughter so that she could sell them. Again, the request was refused. When Faneuil's boss, a Merrill Lynch broker named Peter Bacanovic, learned that Sam Waksal was trying to sell stock, he called Martha Stewart, his most important client, and left a message, warning her that ImClone stock "was starting to trade downwards." Later that day, Stewart sold her 3,928 shares in the company, for nearly $229,000.

On Dec. 28, after the 4 p.m. close of the stock markets, the FDA made its announcement regarding Erbitux. The stock had slid from $61 to $55 on Dec. 27 and 28th. On the next trading day, Monday, Dec. 31, it began to plummet downwards as investors realized that the company's wonder drug had failed to pass muster with the FDA. The stock price dropped 16% that day to close at $47. Over the next few months, the price dropped below $10 per share.

Whenever a momentous announcement affects the price of a stock, regulators take a close look at who was buying and selling in the days leading up to that announcement. In the case of ImClone and the FDA decision, it didn't take long for SEC officials to learn that Waksal's father and daughter both sold substantial amounts of ImClone shares the day before the FDA news.

In interviews with the SEC, Waksal lied about his conversations with family members and denied he was involved in any insider trading activity. But armed with cell phone records indicating calls between Waksal and his father and daughter on Dec. 26, FBI agents arrested Waksal in June of 2002. Prosecutors indicted him on insider trading charges, as well as obstruction of justice (for lying to investigators) and a separate count of bank fraud.

The SEC filed civil charges against Waksal, including one which demonstrated how little Waksal cared for his own shareholders. The SEC discovered that on the same day he was trying to unload his own ImClone shares, Waksal bought a series of "put" options on his own stock through a Swiss intermediary. In other words, Waksal placed bets against ImClone stock, and the more that ImClone's investors suffered when ImClone's price went into freefall, the bigger Waksal's score would be.

The jet-setting scientist eventually pleaded guilty to many of the charges he faced. In July of 2003 he arrived at the Schuylkill Federal Correctional Institution in Pennsylvania to begin his stretch of 87 months of incarceration. Reasonable people might wonder why Waksal would do something so stupid as to try to unload his stock just days before the FDA announcement. It's like trying to rob a bank without wearing any disguises: the security guards identify you on videotape in no time. But where huge sums of money are involved, even the brightest, most gifted scientist can be reduced to a greedy, impulsive child getting caught with his hand in the cookie jar.

From salaries to stock options

Waksal was not a stock swindler trying to fool the investing public or a con artist running a ponzi scheme. He was the CEO of a legitimate company who got paid primarily in stock and stock options. But it was that stock compensation that drove him to break insider trading laws. If Waksal's salary and bonuses had been paid entirely in cash, he wouldn't have had the same motivation to fleece his own investors on Dec. 27, 2001. If Waksal had been paid entirely in cash, the FDA ruling would have been a professional setback, but not a ruinous financial calamity for him.

The reason that ImClone's board of directors paid Waksal in stock options, on top of a healthy base salary, is because of a revolution in the way top managers have been compensated over the past 25 years. A quarter century ago, most top executives of publicly traded companies were paid a hefty salary. Some also received stock awards, especially if their companies achieved certain growth targets. But by and large, executives received paychecks to manage companies for the true owners, the stockholders.

Over the past two decades, executive compensation has changed dramatically. A series of obscure government rulings and changes in law, as well as the boom in technology, conspired to transform executive compensation from the salaries that most people receive into generous grants of shares in the company's stock. The short-term reasoning behind the shift was logical: if the CEO is paid primarily in stock, rather than a salary and bonus, he or she will work much harder to build the business.

But in the wake of accounting frauds at Enron, WorldCom and other companies, it has become obvious that managers whose compensation depends on their company's stock price at the end of each quarter have enormous incentives to make sure they report positive earnings each quarter, whether or not those earnings are real. The top executives at Enron and WorldCom claim they never explicitly ordered their subordinates to falsify numbers on their earnings statements, but they created a climate where their subordinates were driven to commit fraud in order for those companies to report consistent earnings growth every quarter.

Executive compensation goes Hollywood

Business fads come and go, sometimes in the course of months. But revolutionary ideas that change the way business is conducted evolve over a period of years. Their emergence is so gradual that by the time these ideas take over, they no longer seem revolutionary, but appear to be natural occurrences.

One such idea that flourished in the 1990s was the concept of aligning management's interests with those of shareholders. In the early 1980s, corporate raiders like Ronald Perelman, T. Boone Pickens and Carl Icahn launched hostile bids for venerable U.S. companies. The corporate raiders, saying they represented the interests of shareholders, argued that the managers of a particular company had grown lazy and complacent. As a result, they-the shareholders-suffered, because the company's stock price lagged.

In a successful raid, a well-financed shareholder-backed by mountains of loans-offers to buy a majority stake of the company's shares at a price much higher than where the shares are currently trading. After acquiring majority control, the raider takes over, boots out the under-performing managers and installs a new set of managers who have put up their own money for a stake in the company. If the new managers turn the business around, they become wildly rich.

In the 1980s, hostile takeovers led by corporate raiders were rare, but highly publicized. Newspapers across the country covered each raid like the business version of a sporting contest. Gradually, the idea that managers should have a stake in the companies they run took root in the public mind.

This idea used to be confined to the nation's business schools. In 1987, with the release of the movie Wall Street, it became part of the popular culture. The movie stars Michael Douglas as a fictitious character named Gordon Gekko. In the film's central scene, Douglas' character, who is modeled on the corporate raiders of the era, delivers an impassioned speech to shareholders of an embattled corporation he wants to take over. He declares that "Greed is good," and accuses the company's managers of protecting their cushy jobs instead of working for the interests of shareholders.

In the film, Douglas' character is a corrupt cheater who breaks the law. Ultimately, he pays for his misdeeds. But in corporate America, the concept of rewarding managers by giving them a stake in the companies they run was just beginning to take hold.

Easing of restrictions

SEC rules forbid company "insiders," including top executives and directors, from selling stock in their companies less than six months after they purchased the shares. Therefore, before 1991, if insiders wanted to exercise stock options, they were required to purchase the shares, then wait six months to sell the underlying stock. Because of these complications, most managers and directors didn't exercise their stock options until after they had stepped down from their positions.

In 1991, the SEC changed all that, adopting a new rule which changed the definition of what constituted a purchase of stock by company insiders. Up until then, the SEC maintained that an insider didn't buy the stock until he or she paid to exercise the options. But the new rule allowed insiders to date the "purchase" of their stock from the moment the options were originally granted by the company's board of directors, not the time at which the insiders decided to exercise those options.

The change suddenly made it easier for officers and directors to benefit from a surging share price in their company's stock: they could cash in options immediately, instead of having to wait six months. And, as insiders, they would be in a better position to judge whether the company's performance (and share price) would be improve or decline in the immediate future.

In January of 1992, just after the new SEC rule went into effect, the first President Bush took a fact-finding trip to Asia. With him were several top automotive executives from Detroit. On the trip, reporters questioned the salary levels of U.S. auto executives such as Chrysler CEO Lee Iacocca compared to their Japanese rivals. Iacocca and his peers in Detroit were paid millions of dollars per year. By contrast, top Japanese auto executives-whose companies were performing better than the U.S. automakers-were paid hundreds of thousands of dollars.

Democrats in Congress tried to limit what they perceived as runaway executive salaries. Up until then, corporations could deduct the full amount of their top executives' salaries on their tax returns. So Congress passed a law penalizing corporations that paid their executives more than $1 million per year by prohibiting them from deducting any compensation that exceeded that number. President Bush vetoed the bill.

A year later, President Bill Clinton signed a similar bill into law. The bill included Section 162 (m) of the Internal Revenue code, limiting the tax deductibility of every dollar paid over $1 million to top executives. But, as often happens with laws aimed at stopping one type of behavior, the intended targets of the legislation soon figured out a way around the $1 million salary cap.

The new law did not limit the deductibility of incentive-based compensation, so a board of directors that paid its CEO on the basis of performance could get around the $1 million limit. Stock options became the answer. Companies granted their CEOs huge numbers of stock options and deducted that compensation from their annual tax bills. The stage was thus set for a remarkable transformation in the way CEOs got paid for the rest of the 1990s. Over the next eight years, during a boom economy in which stock prices soared, more and more companies embraced stock options as a way to reward their top executives.

Unaccountable

Only one cloud remained on the horizon, and it was located in Norwalk, Conn., home of the Financial Accounting Standards Board. This board, known as FASB, is an independent panel that draws up the rules that accountants must follow when administering their audits. By 1993, the FASB had noticed that one particular accounting convention was being abused to the point where it distorted corporate earnings statements.

What the board wanted to fix was how companies accounted for stock options awarded to management. The problem, according to FASB, was that the cost of those stock options never appeared on a company's income statement. And so a corporation could pay the equivalent of hundreds of millions of dollars in salaries, and as long as that compensation was awarded in the form of stock options, it would not show up as a cost. In this way, thousands of U.S. businesses inflated their earnings statements without breaking any rules.

To puncture this inflation of earnings, the FASB proposed a new rule: that all stock options awarded to managers and employees be counted as salary expense and deducted from operating profits. Corporate America reacted with outrage, promising to fight FASB at every turn. In particular, the technology community in Silicon Valley objected to the change in accounting. More than any other sector of the business community, small high-tech start-up companies benefited from the accounting rules that did not deduct grants of stock options as salary expenses.

(Continues...)



Excerpted from CORPORATE CROOKS by GREG FARRELL Copyright © 2006 by Greg Farrell. Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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Table of Contents

Contents

Foreword by Joseph T. Wells......................................13
Introduction.....................................................17
Chapter One - Executive Compensation.............................23
From salaries to stock options...................................27
Executive compensation goes Hollywood............................28
Easing of restrictions...........................................30
Unaccountable....................................................32
CEO pay versus the average wage..................................35
Postscript to Waksal's crime.....................................37
Chapter Two - Enron..............................................39
Edifice of mirrors...............................................41
From gas pipelines to the "gas bank".............................42
Enron's business.................................................43
The $80,000 lemonade stand.......................................46
Fastow's secret partnerships.....................................48
Bank prostitution................................................52
Bogus businesses.................................................54
Clipped hedges...................................................57
Sherron Watkins' letter..........................................58
Enron's implosion................................................60
Criminal investigations..........................................61
Aiding and abetting..............................................62
Chapter Three - The Auditors.....................................65
The bad olddays.................................................66
The true believers...............................................68
From profession to business......................................69
Loosening the legal shackles.....................................72
Auditors serving two masters.....................................75
Consultants versus auditors......................................79
The management of Waste Management's earning.....................81
The black hole at Enron..........................................82
The shredding of Arthur Andersen.................................84
The verdict......................................................86
Pyrrhic victory..................................................88
Chapter Four - WorldCom..........................................91
Motels and Ma Bell...............................................95
The masterstroke: MCI............................................97
Master and commander of the board................................98
Ebbers' money troubles...........................................100
Cutting corners..................................................102
Capitalization of line costs.....................................104
The fraud unravels...............................................106
Trial and conviction.............................................109
Chapter Five - Tyco..............................................113
A difficult trial................................................114
The board's duties...............................................117
A criminal birthday party?.......................................118
A brilliant career...............................................123
Beginning of the end.............................................127
The finale.......................................................130
Retrial..........................................................132
Chapter Six - HealthSouth........................................133
An Alabama success story.........................................135
Living in a dream world..........................................138
Cooking the books................................................141
Security and paranoia............................................145
Televangelist....................................................148
Aquittal.........................................................149
Chapter Seven - Stock Analysts...................................153
Conflicts of interest............................................157
The end of an era................................................158
Jack Grubman's revolution........................................162
Judgment day.....................................................164
Chapter Eight - The Securities Cops..............................169
The Keystone Kops................................................173
No respect.......................................................174
The starving of the SEC..........................................179
Stagnation.......................................................182
Cops without bullets.............................................184
Congress acts....................................................187
Competition......................................................189
Epilogue.........................................................191
Lessons learned..................................................195
Notes............................................................201
Special Thanks...................................................215
Index............................................................217
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