Corporate executives in handcuffs. A declining stock market with losses of about $8 trillion in investor wealth over a two-year period. Reform legislation to overhaul accounting procedures. Resignations at the Security and Exchange Commission (SEC) and among the White House's leading economic advisers. And $1 billion in fines for Wall Street brokerage firms. These were some of the top business stories of 2002.

Those stories helped rewrite the history of United States business. A decade of unparalleled prosperity came to an end in the spring of 2000. But confidence in the stock market itself began to unravel in late 2001 and early 2002 when the largest accounting frauds in U.S. history were uncovered. Several major companies filed for bankruptcy after admitting that their financial statements had concealed losses.

The scandals sent stocks into steeper declines, extending a bear market that had begun in 2000. The Enron Corporation, an energy trading firm that had become the country's sixth largest company, was the first to admit that it had issued fraudulent financial statements going back over a five-year period. Then WorldCom, Inc.*, a giant telecommunications company, set the record for accounting fraud. WorldCom first revealed that company financial officers had concealed more than $3 billion in business losses. Later revelations upped that figure to more than $9 billion.

Not long after the Enron scandal broke, stock ratings issued by Wall Street brokerage firms came under scrutiny. Stock analysts were charged with publicly recommending stocks that they privately ridiculed. The New York State attorney general uncovered e-mails showing that analysts for some Wall Street firms avoided giving negative reports on companies that were prospective customers of the firms' investment banking houses. An analyst who privately described one company as "a piece of junk" publicly gave the company's stock a "buy" recommendation. Another e-mail disclosed that some analysts gave "buy" recommendations for some stocks in public statements while privately warning their richest investors to stay away from the stocks. (See Stock Exchange; Stock [business].)

As the scandals sent stocks plummeting, millions of Americans who were heavily invested in the stock market in their 401(k) retirement plans had to postpone retirement and rethink their investment strategies. According to one estimate, American workers lost $175 billion in retirement savings during the free-fall. The losses came at a time when 401(k) plans had become increasingly popular with employers, replacing defined benefit pension plans that guaranteed a set amount of money during an employee's retirement. 

Did deregulation derail ethics?
Why did these business scandals occur and why on such a colossal scale? Was there anything unusual about this period in the history of American business that encouraged accounting fraud or that made it possible for the fraud to go undetected for so long? Economists, business historians, and business journalists advanced a number of explanations during 2002.

One explanation held that the scandals were due to a wave of deregulation during the 1980s and 1990s that changed the playing field for American business and made it possible for Wall Street firms to branch into a variety of financial activities. Both Enron and WorldCom were in industries that had been recently deregulated, and thus freed from government oversight that might have uncovered some of their shady finances.

In addition, a government decision in the 1990s not to regulate financial instruments known as derivatives* also made it possible for Enron to play accounting tricks that concealed its losses. The repeal in 1999 of the Glass-Steagall Act removed the last of the barriers separating the banking industry, investment banking, and the selling of stocks and bonds--barriers that had existed since the end of the Great Depression.

As a result, critics charged, banks made risky loans and their affiliated brokerage houses recommended risky stock and bond offerings, all to cultivate lucrative investment banking deals. Investors in WorldCom ended up suing J. P. Morgan Chase & Co. and Citigroup Inc., charging that they had a conflict of interest in lending money to WorldCom and selling its bonds.

Along with this deregulation came a political climate that reduced budgets for agencies such as the Securities and Exchange Commission, which was charged with monitoring the accuracy of financial statements. (See History of United States Business.)

Options for misdeeds?
Another explanation for the scandals focused on changes in the way U.S. business executives were compensated, particularly the issuing of stock options. Stock options were conceived as a way to align the interests of a company's managers with the company's shareholders. If managers could direct the company so that the company's profitability increased and the value of the stock kept going higher, both the managers and the shareholders would benefit. Options were also attractive to small, startup companies, particularly in high-tech industries, that were short on cash but long on ambition. Options rewarded risk-taking.

Keeping stock prices high proved to be an incentive for fraud, however, in the case of some companies. Enron, for example, had entered into a number of key partnerships on the premise that the corporation's stock price would remain at or above a certain level. Financial statements disclosing losses could send the stock price plummeting, thereby ruining these business deals, and so Enron executives reportedly undertook various "creative accounting" steps that hid the corporation's losses. Meanwhile Enron executives were exercising their options and unloading their stock, reaping millions of dollars, while publicly encouraging their own employees to buy the stock.

As it turned out, many of the executives who were subsequently indicted or implicated in scandal had been exercising their stock options before the stock prices plummeted. And others, who had been part of the dotcom phenomenon that saw stock prices reach their peak in early 2000, were getting rich off their options while their companies were still struggling to make a profit. Investigations by the Financial Times, Fortune magazine, and the Wall Street Journal disclosed that top executives of the corporations that went into the sharpest decline during the bear market sold their stock near the peak price while the vast majority of shareholders held on to suffer the losses.

Fortune found that of the 1,035 corporations whose stock value plummeted by 75 percent from 1999 to 2002, corporate executives and directors of those corporations sold about $66 billion worth of stock, almost one-eighth of the total value lost on the market during that period. The Financial Times investigated the nation's 25 largest bankruptcies from January 2001 to July 2002 and found that the executives and directors of those failed companies pocketed $3.3 billion because they sold when their stock prices were at the top of the market.

The Wall Street Journal concluded that on balance executives were able to time their option sales when their stock prices were peaking, while shareholders who held on to the stocks lost value. To many observers these timely sales smacked of insider trading and contradicted the original reason for awarding options since none of these executives could boast that they had improved their company's business.

The string of scandals and the conflict-of-interest charges leveled against brokerage and accounting firms led to a number of reform measures in 2002. Chief among them was the passage of federal legislation known as the Sarbanes-Oxley Act of 2002. The new law imposed the strictest government oversight of accounting firms since the 1930s. (See Accounting and Bookkeeping.)

As the year drew to a close, Wall Street's biggest brokerage firms agreed to pay nearly $1 billion in fines to end investigations into whether they issued misleading stock recommendations. They agreed to pay an additional $500 million to finance independent research by stock analysts, research that would be shared with small investors.

Nevertheless, a number of questions remained unanswered: Should derivatives be regulated? Should stock options be treated as corporate expense? And perhaps most important to millions of Americans, how safe are their 401(k) plans?

* Articles marked with a (*) are available to those with access to MSN Encarta Premium. Learn more.

• J. P. Morgan Chase & Co.*
• Citigroup*
• Securities and Exchange Commission*
• Insider Trading*

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