![Smith Barney analyst who had been WorldCom's biggest Wall
Street cheerleader and who only withdrew his "buy"
recommendation on the stock earlier this year. Mr Grubman had
put out a note as recently as Friday sounding a caution about
WorldCom and its precarious finances - something that
prompted speculation about whether he had an inkling of what
was to come.
In an interview with CNBC, the analyst said: "Nobody saw this
coming. I am as shocked about this as everyone else."
Salomon's work in helping Mr Ebbers assemble WorldCom
through a string of acquisitions has already brought it extensive
unwanted attention since the company's decline set in, while a
string of other banks are set to come under scrutiny for their
role in helping the company with a giant bond issue a year ago -
a time when it may have been in the midst of perpetrating a
giant fraud, it has now emerged. Copyright Financial Times
Limited 2002. All Rights Reserved.
Word count: 817
Copyright Financial Times Information Limited Jun 27, 2002
x Prosecutors had no comment on whether they plan to arrest
ousted WorldCom chairman Bernard J. Ebbers or indict
WorldCom as a corporation. They also declined to comment on
widespread speculation that they hope to get [Scott D. Sullivan]
or [David Myers] to provide incriminating information against
Ebbers, who grew WorldCom from a no-name Mississippi long-
distance reseller into a dominant global telecom provider
through a string of 60 deals over 17 years. Many of the biggest
deals were engineered by Sullivan.
An internal WorldCom auditing memo filed with court papers
yesterday gave some details of how Sullivan and Myers shifted
operating expenses known as "line costs" over to capital
accounts where they could be written off over years, improving
WorldCom's reported cash flow.
1. Scott D. Sullivan (center), former chief financial officer of
bankrupt telecommunications giant WorldCom, and former
controller David Myers (not shown) surrendered to federal](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-8-320.jpg)
![Amendment rights against incriminating themselves.
WorldCom filed for Chapter 11 bankruptcy protection 11 days
ago, the largest filing in US history. It listed $41 billion in debt
and assets of $107 billion. Besides long-distance carrier MCI,
WorldCom operates key Internet facilities such as UUNet that
handle an estimated half of all US Net traffic.
WorldCom spokeswoman Julie Moore said the company was
cooperating fully with the government probe.
"Nobody wants to get to the bottom of this quicker than
WorldCom," she said.
An internal WorldCom auditing memo filed with court papers
yesterday gave some details of how Sullivan and Myers shifted
operating expenses known as "line costs" over to capital
accounts where they could be written off over years, improving
WorldCom's reported cash flow.
"David [Myers] acknowledged that the line costs should
probably not have been capitalized and stated that it was
difficult to stop once started. David indicated that he has felt
uncomfortable with these entries since the first time they were
booked," the internal auditors' memo said.
A WorldCom staff accountant who began raising questions
about the moves, Cynthia Cooper, was urged this spring by
Sullivan to delay completing an audit of the line costs until this
summer.
Sullivan's attorney, Irv Nathan, accused federal prosecutors of
turning the "honest and honorable" Sullivan into a scapegoat.
"We deeply regret the rush to judgment and the political
overtones involved," Nathan said.
Noting that the men were the subject of a criminal complaint,
not a formal indictment, Nathan said, "All of this suggests this
is a lot of politics. Unfortunately, politics are intruding into the
criminal justice system."
Reid Weingarten, the attorney representing Ebbers, said the
made- for-TV arrests of Sullivan and Myers may have been
"good theater." But Weingarten said prosecutors have yet to
"prove that Sullivan and Myers ever acted with criminal intent,](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-11-320.jpg)
![an essential element we doubt the government will ever be able
to prove in this case."
Emphasizing the public-relations value of the WorldCom arrests
in the wake of President Bush's signing a new law toughening
penalties for white-collar crime, White House spokesman Ari
Fleischer said the president is "determined that people who
break America's laws and engage in corporate practices that are
corrupt will be investigated. [They] will be held liable, will be
held accountable and will likely end up in the pokey, where
they belong."
Ashcroft said, "When financial transactions are fraudulent and
balance sheets are falsified, the invisible hand that guides our
market is replaced by a greased palm. Information is corrupted,
trust is abused and the . . . ruthless and corrupt profit at the
expense of the truthful and law-abiding."
But Senator Tom Daschle of South Dakota, the Democratic
majority leader, said, "There hasn't been anyone in handcuffs
from Enron, and we don't know the reason why."
Executives of the Houston energy giant, which filed for Chapter
11 bankruptcy protection in January, had been key political
patrons of Bush in Texas. Enron collapsed amid questions about
phony profits and elaborate accounting ruses to hide debt.
Also yesterday, the Justice Department nominated former US
Attorney General Richard Thornburgh to serve as its
independent examiner in the WorldCom bankruptcy
proceedings, charged with investigating mismanagement and
fraud.
If approved by federal bankruptcy judge Arthur J. Gonzalez,
Thornburgh would have 90 days to file a report detailing what
caused WorldCom to fall into bankruptcy.
Peter J. Howe can be reached at [email protected]Abstract
(summary)
TranslateAbstract
WorldCom is under investigation by the Justice Department and
the Securities and Exchange Commission. Scott Sullivan,
WorldCom's former chief financial officer and Ms. [Cynthia](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-12-320.jpg)
![Cooper]'s boss, has been indicted. He has denied any
wrongdoing. Four other officers have pleaded guilty and are
cooperating with prosecutors. Federal investigators are still
probing whether Bernard J. Ebbers, the company's former chief
executive, knew about the accounting improprieties. Since the
initial discoveries, WorldCom's accounting misdeeds have
grown to $7 billion.
Behind the tale of accounting chicanery lies the untold detective
story of three young internal auditors, who temperamentally
didn't fit into WorldCom's well-known cowboy culture. Ms.
Cooper, 38 years old, headed a department of 24 auditors and
support staffers, many of whom viewed her as quiet but
strongwilled. She grew up in a modest neighborhood near
WorldCom's headquarters and had spent nearly a decade
working at the company, rising through its ranks. She declined
to be interviewed for this story. Mr. [Morse], 41, was known for
his ability to use technology to ferret out information. The third
member of the team was Glyn Smith, 34, a senior manager
under Ms. Cooper. In his spare time he taught Sunday school,
took photographs and bicycled. His mom had taught him and
Ms. Cooper accounting at Clinton High School.
The confrontations put Ms. Cooper in a sticky position. Mr.
Sullivan was her immediate supervisor. Plus, her vague
discomfort with the way WorldCom was handling its accounting
led her into areas that were not normally her bailiwick.
Although her department did a small amount of financial
auditing, it primarily performed operational audits, consisting
of measuring the performance of WorldCom's units and making
sure the proper spending controls were in place. The bulk of the
company's financial auditing was left to Arthur Andersen. But
neither of those things dissuaded Ms. Cooper from following
her nose to the root of the ill-defined problem.Full Text
· TranslateFull text
·
CLINTON, Miss. -- Sitting in his cubicle at WorldCom Inc.
headquarters one afternoon in May, Gene Morse stared at an](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-13-320.jpg)
![---
Journal Link: See further coverage of the WorldCom scandal,
including bios of key players, in the Online Journal at
WSJ.com/WorldCom.Abstract (summary)
TranslateAbstract
The report, which also criticized the company's outside auditors
and Salomon Smith Barney's former telecommunications analyst
Jack Grubman, hints that the extent of the improper accounting
at WorldCom, this time relating to revenue, could be more
extensive than the $7.2 billion restatement the company already
has said it will make. Now, the report indicates, WorldCom also
is under fire for accounting methods used in recording revenue,
an entirely new avenue for investigators. Those investigators
also are looking at what the report refers to as "fraudulent
journal entries and adjustments" made by WorldCom executives.
The report also provides new details about Mr. [Bernard
Ebbers]'s $1 billion in borrowings and makes the argument that
the leverage Mr. Ebbers placed on his huge WorldCom holdings
put the interests of WorldCom shareholders at risk since the
company's shares could plummet if he tried to sell the stock.
"Furthermore by using his WorldCom shares to collateralize
massive debt obligations, Mr. Ebbers placed himself under
intense pressure to support WorldCom's share price," the report
says.
The report also points to Mr. Ebbers's role in determining
bonuses and other compensation for WorldCom executives.
Though WorldCom's disclosure documents suggest that bonuses
were paid to top executives based on performance, the report
says that Mr. Ebbers could adjust performance bonuses received
by individual employees. "Some individuals, even at lower
ranks, were paid massive performance bonuses equal to many
times their base salaries, while others received bonuses equal to
only a small percentage of their salaries." Mr. [Richard
Thornburgh] intends "to inquire whether these bonuses were
indeed based on quantitative performance factors or were used
instead for some improper or other purpose."Full Text](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-27-320.jpg)
![Circuit in an opinion by Judge Stephen F. Williams.17 At that
time, the FCC was already in the midst of its Triennial Review
of its unbundling rules. The FCC thus already had a proceeding
underway to answer the following kinds of questions that would
give economic content to the definition of "impairment." If FCC
regulation succeeded in reducing the CLECs' level of
"impairment," what variable would we observe changing:
Prices? Output? Investment? CLEC profit? Sales of
complementary hardware and software? The FCC said that it
wanted to review its UNE policies "in light of [its] experience"
since 1996.18 Experience implies empiricism, and unless the
FCC clearly states its hypothesis concerning the predicted
effects of its particular unbundling policies, such as the
impairment test, it cannot know what changes to expect or the
method by which to measure them.
The standard economic metric is consumer welfare, yet that is
the one conspicuous variable that the FCC excluded from its
laundry list of five factors that were supposed to unpack the
phrase "materially diminishes."19 I submit that no reasonable
understanding of "the public interest" can be reconciled with the
FCC's exclusion of consumer welfare from the list of relevant
considerations. A cynic might speculate that the reason for the
omission is that consideration of consumer welfare would
vitiate many of the FCC's conclusions on the essentiality of
unbundling particular network elements. Consideration of
consumer welfare would undo the competitor-welfare standard
by which the FCC hoped to straighten the Leaning Tower of
Pisa.
In this sense, the unbundling debate illustrates the potential
circularity of regulation. "Impairment" cannot be defined
without reference to the price regulation to which UNEs are
subject. Impairment is thus endogenously determined by UNE
price regulation. Moreover, impairment is endogenously
affected by the allowed duration of the lease. Under existing
TELRIC pricing, would a CLEC be impaired if it were required
to lease a UNE for its useful life (more precisely, for the](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-44-320.jpg)
![duration of its depreciable life for regulatory purposes), instead
of being free to lease the UNE for a period that is terminable at
will by the lessee and capped by regulators?
Furthermore, what is the fundamental economic characteristic of
"impairment?" Increasingly, the bottleneck of the
telecommunications network is regarded as the trench in the
street. The costliness of digging holes is a breathtakingly
unpersuasive justification for mandating the unbundling of
telecommunications networks, especially next-generation
services. It is regrettable that only a fraction of regulatory
energy was devoted to the coordination of the actual trenching
and sizing of conduit as was devoted to estimating the forward-
looking cost of an unbundled loop in a hypothetical network. A
CLEC faces no barrier to entry with respect to the provision of
a service if the ILEC itself is overlaying existing facilities or if
it is building new facilities or totally rehabilitating previous
facilities. The ILEC faces the same sunk cost that a CLEC
would. This analysis would seem to answer the FCC's central
question in its Triennial Review: should the FCC "modify or
limit incumbents' unbundling obligations going forward so as to
encourage incumbents and others to invest in new
construction[?]"20
The FCC would clarify the meaning of "impairment" if it
assessed the magnitude of the real option conferred on the
CLEC by mandatory unbundling of a particular network element
at a TELRIC-based price.21 The value of the real option held by
the CLEC increases with three factors: uncertainty concerning
technology, consumer demand, and regulation; the duration of
the lease; and the degree to which the leased assets are
investments by the ILEC that are sunk rather than salvageable.
The real option view of mandatory unbundling meshes neatly
with two of the five factors that the FCC had been using to
determine the scope of unbundling-that is, before the D.C.
Circuit's May 2002 decision in the U.S. Telecom Association
case.22 The first factor is, in the FCC's words, "whether the
[unbundling] obligation will promote facilities-based](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-45-320.jpg)
![Congress delegate the making of transparently political
decisions concerning telecommunications to a body whose
comparative advantage is not supposed to be politics? Why not
leave political decisions with the elected federal legislature? If
the FCC's review of mandatory unbundling policy ultimately
will turn on politics, why should Congress permit the FCC to
waste more than a year compiling a record by which the agency
might pretend to have reached its decision by a more
disinterested means?
The Triennial Review also incidentally suggests how Chevron
can cheapen the constitutional role of the judiciary with respect
to oversight of the administrative state. Agencies and the
litigants before them engage in highly strategic use of the
administrative process in which the sustainability of regulations
on appeal is a major component. If the purpose of appellate
review is to determine whether a supposedly expert independent
agency has managed to produce one "reasonable" reading of its
statute, then how much is really left for appellate judges to do
in administrative law? It does not require a penchant for judicial
activism to believe that Chevron can diminish the proper role of
the Judiciary as the interpreter of acts of Congress. How much
deference is due an agency decision like the Triennial Review,
which mocks the administrative process?
Turning to the substance of the FCC's decision, the
Commission's press release redefined "impairment" such that
"[a] requesting carrier is impaired when lack of access to an
incumbent LEC network element poses a barrier or barriers to
entry . . . which are likely to make entry into a market
uneconomic."36 This analysis, the FCC said, "specifically
considers market-specific variations, including considerations
of customer class, geography, and service."37 The only UNE
that the FCC removed from the unbundling list was switching
for high-capacity loops (which principally serve business
customers), and even that national finding may be rebutted by
individual states.38 With the exception of high-capacity
switching, the new status quo would seem to be that all UNEs](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-51-320.jpg)
![Internet service providers or backbone carriers. When it sought
to acquire Sprint's sixteen percent share of the Internet
backbone business, WorldCom controlled thirty-seven percent
or more of the Internet backbone market.48 Consequently,
investors, competitors, and the public had good reason to take
WorldCom's representation about Internet traffic growth on its
face, since the company was uniquely positioned at the time to
know this information. WorldCom surely understood how
heavily the marketplace and government agencies relied on its
Internet traffic reports. In his testimony to Congress in January
2003, Commissioner Michael Copps explained how the FCC is
forced to rely on honest reporting by telecommunications
carriers:
[W]e must use our current authority to reduce the chance that,
in a competitive market, corporate misdeeds and
mismanagement will injure American consumers or the
competition that Congress sought to promote in the 1996 Act. In
light of all the accounting depredations we have witnessed in
the financial world regulated by the SEC, we need to reassure
ourselves that our own accounting procedures and requirements
are in good stead. Our accounting data inform our decisions
about the reality of competition and the protection of
consumers.
Commissioner Copps argued that the FCC must reduce its
dependency on regulated carriers for data:
We have come to rely over the years perhaps too much on self-
reported industry data or Wall Street analysts for information to
make critical decisions. We must commit to doing the hard work
of collecting our own data rather than relying on potentially
misleading and harmful financial, accounting, and market
information produced by corporate sources subject to clear
biases and market pressures.50 In retrospect, it appears that
WorldCom used this asymmetry of information to exaggerate
the value of its stock by overstating the growth in Internet
traffic volumes.
WorldCom's misrepresentation of that growth encouraged](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-55-320.jpg)
![particular company on the event day of June 26, 2002, when
WorldCom initially announced a $3.8 billion accounting
restatement.58 The market model is given by the following
equation:
where R^sub it^ represents the return to company i on day t,
R^sub mt^, represents the return to the S&P 500 Index on day t,
and [epsilon]^sub it^ represents an error.59 The estimate of
[alpha] "alpha," is the average rate of return the stock would
expect on a day when the S&P 500 Index realized a zero return.
The estimate of [beta]^sub i^, or "beta," represents the
sensitivity of company i's returns to general market movements,
or its "systematic risk." Betas and alphas were estimated using
the ordinary least squares method for the market model equation
over a 200-trading-day estimation period (which is t = -250 to -
50, where t = 0 is the event date, June 26, 2002). The "expected
return" of a stock is defined as the stock's estimated alpha plus
the product of the actual daily return of the S&P 500 Index and
the stock's estimated beta. I calculated the "abnormal returns"
for each firm by subtracting the expected returns from the
actual returns. That is, the daily abnormal returns are the
residuals for each observation in the regression analysis.
Consider now an unexpected announcement when t = 0, or the
event day. I consider two windows. The first is a window of
three days, from one day before the announcement to a day after
the announcement. The second is a one-day window that
considers the abnormal returns solely on the event day itself.
For each window, I compute the cumulative abnormal returns
for that period. I also compute abnormal returns for value-
weighted portfolios of affected firms. Finally, for each window,
I compute the standard errors of the abnormal returns (for each
company and each portfolio) by using information covering the
200-day estimation period.
The first news of WorldCom's accounting error came on the
evening of June 25, 2002. By the next morning, Nasdaq had
suspended trading in WorldCom's stock. WorldCom's stock had
closed at 83 cents on June 25, 2002. Trading resumed on July 1,](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-58-320.jpg)
![September 2002 that "[r]egulatory accounting data and related
information filed by telecommunications carriers is used by
federal and state telecommunications policymakers to fulfill
various responsibilities, such as determining interstate access
charges, evaluating federal-state jurisdictional separations,
setting rates for unbundled network elements and calculating
universal service support."61 WorldCom must report data on
gross billed revenues on an annual and quarterly basis.62 Those
data are filed on FCC Form 499-A or 499-Q, signed by an
officer of the company, along with revenue information
collected on FCC Form 159 submitted in September of each
year. The Commission uses those data to calculate regulatory
fees as well as contributions to support the Universal Service
Fund, Local Number Portability Administration, North
American Numbering Plan Administration, and
Telecommunications Relay Service.63 To the extent that
WorldCom provided false information, those public programs
and services might not be funded appropriately.
WorldCom's false statements to regulators influence the
investment decisions of its rivals. For example, WorldCom and
MCI have actively participated over the years in FCC
proceedings determining whether AT&T should be released
from price regulation or whether the Bell companies should be
allowed to offer long-distance service. If false or unreliable
information in such proceedings skews the FCC's development
of regulations, the investment decisions and competitive
strategies of telecommunications carriers will also be
misdirected, all to the ultimate detriment of consumers.
D. Can Federal Courts, Regulators, Congress, and Cabinet
Departments Trust WorldCom's Filings?
WorldCom's accounting fraud destroys the company's
credibility in proceedings before the federal courts, regulatory
commissions, Congress, and cabinet departments. Since 1996,
for example, WorldCom has argued to state and federal
regulators that the cost of an unbundled loop is much less than
incumbent local exchange carriers say it is. Yet a central thrust](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-61-320.jpg)
![of Internet Backbone Services Bore No Relation to Cost and
Thus Served To Distort Competition
It is entirely plausible that WorldCom priced its Internet
backbone service below its actual long-run average incremental
cost ("LRAIC"). WorldCom was reporting lower costs than it
actually incurred. In his first report as the court-appointed
Examiner of the WorldCom bankruptcy, former Attorney
General Dick Thornburgh observed that over the course of five
quarters in 2001 and 2002 WorldCom "took the brazen and
radical step of converting substantial portions of its line cost
expenses into capital items," a step that overstated capital
investment and understated expenses.74 WorldCom's rivals
could not detect that WorldCom was engaged in predation.
WorldCom's rivals were forced to cut their prices and possibly
incur actual losses on their books or forfeit market share to a
rival whose lower prices were not the result of superior
efficiency. According to Sprint's former chairman and chief
executive officer, William Esrey, the pressure to compete in the
market, and to match the growth claimed by companies that
later turned out to be falsifying their accounting, pushed
telecommunications companies into unreasonable expansion,
foolish investments, and unsustainably low pricing. Esrey notes
"[w]e kept asking ourselves what we were doing wrong because
we couldn't generate the numbers WorldCom reported . . . . As
we discovered, the margins were a hoax but the devastating
effect on our industry was very, very real."75 That deception
explains how WorldCom could use "low-ball" bids to secure
lucrative government contracts. If competitors were bidding on
the basis of actual costs, while WorldCom was bidding on the
basis of fictitious costs, the most efficient carrier would not
necessarily win the bidding.
For example, in 2001, before WorldCom admitted that it was
falsifying its books, WorldCom earned $1.7 billion, or eight
percent of its revenue, from state and federal government
contracts.76 In November 2002, the federal government
awarded WorldCom a contract to provide telecommunications](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-66-320.jpg)
![its losses from pricing without regard to cost.
By analogy, economists and policymakers have recognized that
public enterprises may not need to recoup predatory losses.83
The Organization for Economic Cooperation and Development
has drawn the distinction that, in the case of a public enterprise,
predatory pricing is a subset of "distortionary" pricing, which
does not necessarily require conventional recoupment of losses:
It is convenient . . . to label pricing below cost as
"distortionary." "Predatory" pricing is a temporary form of
distortionary pricing. Even where distortionary pricing does not
lead to prices subsequently being raised above cost, it may still
be of public policy concern, because of the effect on productive
efficiency. Distortionary pricing might induce a more efficient
firm to leave or to not enter the competitive market.84
One can extend this reasoning to WorldCom's case, where a
serious principal-agent problem decoupled shareholders' interest
in profit maximization from management's interest in personal
wealth maximization.
WorldCom's managers could have personally benefited without
recoupment of losses in three ways. First, insiders may have
sold WorldCom stock (or tipped others to sell) in anticipation of
the stock's collapse. Second, WorldCom may have extended
sweetheart loans to WorldCom's senior executives that were
collateralized by WorldCom stock. At the time of WorldCom's
bankruptcy, Mr. Ebbers owed the company more than $400
million in personal loans having long repayment terms and
interest rates of 2.18 to 2.21 percent.85 The Financial Times
reported that "[t]he loans were made to cover a series of margin
calls on personal loans Mr. Ebbers had guaranteed with his
significant WorldCom shareholding."86 As of December 2002,
Mr. Ebber had not repaid the loan.87 In addition, Mr. Ebbers
himself personally loaned $650,000 to his chief operating
officer, Ron Beaumont, whom WorldCom's board relieved of
operating responsibilities on October 1, 2002.88 Since its
bankruptcy, WorldCom has been forced to sell, among other
assets, a shipyard and the largest cattle ranch in Canada, both of](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-68-320.jpg)
![dissemination, as well as preferred participation in initial public
offerings ("IPOs") of other companies, in exchange for lucrative
investment banking work.93 Attorney General Thornburgh
reported to the bankruptcy court in November 2002 that he had
found evidence that Jack Grubman, the lead telecommunications
equity analyst at Salomon Smith Barney, had "alerted
[WorldCom] ahead of time to the questions he would ask in
conference calls between securities analysts and WorldCom
management."94 Mr. Thornburgh also reported that his
examination would continue to investigate "the wildly
enthusiastic analyst reports issued by [Salomon Smith Barney]
and others with respect to WorldCom at a time when the stock
was plummeting."95 Based on his examination as of November
2002, Mr. Thornburgh reported: "In the transactions we have
reviewed to date, [Salomon Smith Barney] and its predecessors,
Salomon Brothers and Smith Barney, collectively received more
engagements from WorldCom than any other investment
banking firm during the past five years."96
Similarly, WorldCom's auditor, Arthur Andersen, may have
provided WorldCom's management false and misleading audits
in exchange for lucrative consulting work.97 In his November
2002 report, Mr. Thornburgh questioned "the extent to which
Arthur Andersen should have done more to determine whether
the risks of abuses were adequately taken into account by the
Company's internal control systems, most pointedly its internal
audit function."98
In addition, to increase the likelihood of keeping WorldCom's
investment banking work, conglomerate financial institutions
may have supplied WorldCom's chairman, Bernard Ebbers, and
the company's other senior executives with hundreds of millions
of dollars of personal credit lines that were inadequately
collaterized with those managers' individual holdings of
WorldCom stock. Mr. Ebbers obtained over $800 million in
personal loans from conglomerate financial institutions over a
period of seven years, using his personal holdings of WorldCom
stock as collateral.99 Citigroup lent Mr. Ebbers $499 million in](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-70-320.jpg)
![would constitute state aid in violation of Article 87. The state
aid would take the form of the American bankruptcy court's
elimination of WorldCom's debt (in whole or part) as part of the
reorganization plan. As discussed earlier, the economies of
scale in telecommunications imply that WorldCom's ability to
shed debt would dramatically reduce its costs relative to the
costs of competitors that otherwise would be equally or more
efficient. The relevant standard under Article 87 is distortion of
competition, which obviously differs from the more demanding
monopolization standard in American antitrust law.108 One can
make little dispute that WorldCom's artificial cost advantage
resulting from its reorganization under Chapter 11 would
"threaten[] to distort competition" in European
telecommunications markets, even if that state-conferred
advantage did not have the effect of reducing or destroying
competition.
C. The Differing Responsibilities of the Securities and
Exchange Commission, the Bankruptcy Court, and the FCC
An opaque process could result from the FCC's failure to place
WorldCom's fraud squarely on its agenda for 2003. The
Commission can proceed, in its Triennial Review, to rewrite
unbundling and access pricing as if WorldCom will remain a
legitimate competitor in the local telecommunications market.
Yet that rulemaking approach implicitly assumes that the
Commission has already determined that WorldCom is still
qualified to hold its licenses.
To make matters worse, it is more likely than not that regulators
would coddle a reorganized WorldCom, lest they fail by
allowing it to collapse a second time. The ramifications would
be serious for innocent parties. The Commission can sculpt the
arcane contours of general policies affecting the ILECs and the
CLECs-such as price regulation of an already competitive
market for switched access or the restatement of TELRIC
pricing principles for unbundled network elements-so as to give
WorldCom an implicit bailout. For example, on the day that the
FCC announced the outcome of its Triennial Review on](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-74-320.jpg)
![add conscious neglect to the agency's previous inattention-if it
allows the company to emerge from Chapter 11 reorganization
without ever having to answer this fundamental question: How
does it serve the public interest for the FCC to allow WorldCom
to continue holding its licenses and authorizations? The FCC
has a duty to determine promptly whether WorldCom must
surrender its licenses and authorizations. If so, regulators
should not interfere if the capital markets soon cause WorldCom
to cease to exist.
What did seven years of good intentions teach us? At least three
things. First, the journey from regulation to a truly deregulated
market is costly, and the alternative of managed competition is
surely costlier. Second, a consumer-welfare approach to the
mandatory unbundling of telecommunications networks would
have been simpler, more intellectually coherent, and more
beneficial to society than the competitor-welfare standard that
has permeated FCC policy from 1996 through 2002. Third,
policy makers who cling to caricatures of incumbents and
competitors risk missing the big picture.
Let me conclude by invoking the wisdom of Jim Quello, who
served two decades as an FCC commissioner. He is widely
credited with saying, "What this industry needs is a whole new
set of cliches." It is reminder of the failure of good intentions
that audiences in 2002 groaned at that quip instead of laughing.
Let us hope that it does not take another seven years for the
joke to evoke laughter once more.
Footnote
1 Telecommunications Act of 1996, Pub. L. No. 104-104, 110
Stat. 56 (codified as amended in scattered sections of 47
U.S.C.).
Footnote
2 Unbundling is the shorthand used to describe a method of
entry into local telephony that relies on "the leasing of
unbundled network elements, [which are] the building blocks of
the local network," including loops and switches. Jerry A.
Hausman & J. Gregory Sidak, A Consumer-Welfare Approach to](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-81-320.jpg)
![Local Competition Provisions of the Telecommunications Act of
1996 Deployment of Wireline Services Offering Advanced
Telecommunications Capability, Notice of Proposed
Rulemaking, CC Dkt. Nos. 01-338, 96-98, 98-147, [para] 23
n.69 (2001) [hereinafter UNE Triennial Review NPRM].
12 See ROBERT W. CRANDALL, AN ASSESSMENT OF THE
COMPETITIVE LOCAL EXCHANGE CARRIERS FIVE
YEARS AFTER THE PASSAGE OF THE
TELECOMMUNICATIONS ACT (2002), available at
http://www.criterioneconomics.com/documents/Crandall%20CL
EC.pdf.
13 UNE Triennial Review NPRM, supra note 11, [para] 25.
14 47 U.S.C. [sec] 251(d)(2) (2000).
15 AT&T Corp. v. Iowa Utils. Bd., 525 U.S. 366 (1999).
Footnote
16 Implementation of the Local Competition Provisions of the
Telecommunications Act of 1996, Third Report and Order and
Fourth Further Notice of Proposed Rulemaking, 15 F.C.C.R.
3696, 3725 (1999).
17 United States Telecom Ass'n v. FCC, 290 F.3d 415 (D.C.
Cir. 2002).
18 UNE Triennial Review NPRM, supra note 11, [para] 4.
19 Id. [para] 19.
Footnote
20 Id. [para] 24.
21 See Hausman & Sidak, supra note 2; Jerry Hausman, Valuing
the Effect of Regulation on New Services in
Telecommunications, 1997 BROOKINGS PAPERS ON ECON.
ACTIVITY: MICROECONOMICS 1.
22 United States Telecom Ass'n v. FCC, 290 F.3d 415 (D.C.
Cir. 2002) (vacating and remanding FCC's impairment test)
stayed by No. 00-1012, 2002 WL 31039663 (D.C. Cir. Sept. 4,
2002).
23 UNE Triennial Review NPRM, supra note 11, [para] 9.
Footnote
24 This line of analysis is directly responsive to the FCC's](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-83-320.jpg)
![request in its Triennial Review for comments on "whether [the
Commission] can balance the goals of Sections 251 and 706 by
encouraging broadband deployment through the promotion of
local competition and investment in infrastructure." Id. [para]
23.
25 Hausman & Sidak, supra note 2. Admittedly, a product-
specific, geographically specific analysis would require greater
administrative resources than a blanket rule that required a
particular network element to be unbundled everywhere in the
nation. But weighing in the opposite direction are two
considerations. First, it may be possible to use the Hausman-
Sidak analysis to eliminate a particular network element from
the mandatory-unbundling list on a nationwide basis, or very
nearly so. Switching would be a leading candidate for such
treatment. Second, the purpose of the Hausman-Sidak inquiry is
to produce an unbundling result that maximizes consumer
welfare. One might quibble that the proper social welfare
function should be the difference between consumer welfare and
the transactions costs of regulation. But an unbundling rule that
sought only to minimize transactions costs (without regard to
the impact on consumer welfare) would be a very constricted
interpretation of "the public interest," and not one that would
coincidentally protect consumer welfare.
Footnote
26 UNE Triennial Review NPRM, supra note 11, [para][para]
27-28.
Footnote
27 This analysis is relevant to "the rapid introduction of
competition in all markets," which is one of the five factors that
the FCC had been using to judge impairment at the time of the
U.S. Telecom Association decision. Id. [para] 21.
28 FCC, LOCAL TELEPHONE COMPETITION: STATUS AS
OF DECEMBER 31, 2001 tbl.5 (2002); FCC, LOCAL
TELEPHONE COMPETITION AT THE NEW MILLENNIUM
tbls.2-3 (2000).
29 Scott Wooley, Bad Connection, FORBES, Aug. 12, 2002, at](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-84-320.jpg)
![AT&T's top lobbyist, James Cicconi, a veteran of the first Bush
administration, also is said to have encouraged the view that
[Commissioner Kevin] Martin['s] plan [to decide the Triennial
Review on unbundling] is good politics for President Bush,
because it prevents chaos and bankruptcies before the 2004
election. That spawned rumors that it was a coup masterminded
by White House aide Karl Rove.
Id.
36 Press Release, Federal Communications Commission, FCC
Adopts New Rules for Network Unbundling Obligations of
Incumbent Local Phone Carriers 1 (Feb. 20, 2003), available at
http://hraunfoss.fee.gov/edocs_public/attachmatch/DOC-
231344A1.doc.
Footnote
37 Id.
38 Id. at 2.
39 Attachment to Press Release, Federal Communications
Commission 4 (Feb. 20, 2003), available at
http://hraunfoss.fcc.gov/edocs_public/attachmatch/DOC-
231344A2.doc.
Footnote
40 WorldCom's Myers To Plead Guilty, WALL ST. J., Sept. 26,
2002, at A3 (reporting that David Myers, former controller of
WorldCom, is expected to plead guilty). More guilty pleas soon
followed. See Susan Pulliam & Jared Sandberg, Two WorldCom
Ex-Staffers Plead Guilty to Fraud, WALL ST. J., Oct. 11, 2002,
at A3 (Betty Vinson, former director of management reporting,
and Troy Normand, former director of legal entity accounting).
41 Yochi J. Dreazen, Wildly Optimistic Data Drove Telecoms
To Build Fiber Glut, WALL ST. J. ONLINE, Sept. 27, 2002, at
http://online.wsj.com/public/us.
42 See, e.g., EASTERN MANAGEMENT GROUP, IS
WORLDCOM TOO BlG TO FAIL? LIQUIDATION COULD
IMPROVE TELECOM SECTOR 4 (2003).
Footnote
43 Dreazen, supra note 41.](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-86-320.jpg)
![44 The Power of WorldCom's Puff, ECONOMIST, July 20,
2002, at 61.
45 Dreazen, supra note 41.
46 Peter Behr, On or Off the Bandwidth Bandwagon?, WASH.
POST, Sept. 24, 2000, at H1.
47 The Power of WorldCom's Puff, supra note 44.
Footnote
48 Press Release, U.S. Dept. of Justice, Justice Department
Sues To Block WorldCom's Acquisition of Sprint: Unless
Blocked, Deal Would Result in Higher Prices for Millions of
Consumers (June 27, 2000), available at
http://www.usdoj.gov/opa/pr/2000/June/368at.htm ("WorldCom
operates the largest internet backbone network, which carries
approximately 37 percent of all internet traffic."). The European
Commission estimated that WorldCom's share of the Internet
backbone market at that time was between 32 and 36 percent.
Case COMP/M.1741-MCI WorldCom/Sprint, Commission
Decision of June 28, 2000 Declaring a Concentration
Incompatible with the Common Market and the CHA Agreement
[para] 116, available at
http://europa.eu.int/comm/competition/mergers/cases/
decisions/m1741_en.pdf. Because WorldCom and Sprint
formally withdrew their application for Transfer of Control of
Licenses and Section 214 Authorizations in July 2000, the FCC
was not able to present its market share estimates.
49 Statement of Michael J. Copps, Commissioner, Federal
Communications Commission, Before the Senate Committee on
Commerce, Science, & Transportation (Jan. 14, 2003), available
at http://hraunfoss.fcc.gov/edocs_public/attachmatch/DOC-
230241A4.doc.
50 Id.
Footnote
51 K-.G. COFFMAN & A.M. ODLYZKO, AT&T LABS,
INTERNET GROWTH: IS THERE A "MOORE'S LAW" FOR
DATA TRAFFIC 7 (2001), available at
http://www.dtc.umn.edu/~odlyzko/doc/internet.moore.pdf](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-87-320.jpg)
![(citing L. Bruno, Fiber Optimism: Nortel, Lucent, and Cisco
Are Battling To Win the High-Stakes Fiber-Optics Game, RED
HERRING, June 1, 2000).
52 For an example of analysts' linking Internet growth to excess
telecommunications network capacity, see Joelle Tessler,
Telecom Companies Struggle with Glut of Fiber-Optic
Networks, SAN JOSE MERCURY NEWS, Apr. 13, 2002, at A1
(attributing to Scott Cleland, chief executive of the Precursor
Group, a telecommunications investment research firm, the view
that "[m]uch of the great fiber build-out was based on a big
miscalculation" owing to WorldCom).
53 EASTERN MANAGEMENT GROUP, supra note 42, at 2
(quoting Joelle Tessler, WorldCom Spine UUNET Is Critical
Part of Internet, SAN JOSE MERCURY NEWS, Sept. 1, 2002).
54 Id.
Footnote
55 Statement of Kathleen Q. Abernathy, Commissioner, Federal
Communications Commission, Before the Senate Committee on
Commerce, Science, & Transportation (Jan. 14, 2003), available
at http://hraunfoss.fcc.gov/edocs_public/attachmatch/DOC-
230241A3.doc.
56 Two days after WorldCom's first accounting restatement, one
business reporter wrote, "WorldCom Inc.'s disclosure [that] it
improperly accounted for $3.8 billion in expenses has wreaked
much havoc in the financial markets this week," Ross Snel,
WorldCom's Pain May Eventually Prove AT&T's Gain, DOW
JONES NEWS SERV., June 28, 2002. According to one
investment banker, WorldCom's accounting revisions caused the
bond market to be "skittish and paranoid," WorldCom Crash
Brings Fear and Loathing to Markets, EUROWEEK, June 28,
2002.
Footnote
57 One could hypothesize that telecommunications equipment
manufacturers experienced negative abnormal returns because
they were among WorldCom's creditors. The increased risk of
nonpayment to these creditors would arise from the fact that](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-88-320.jpg)
![indicates statistical significance at the five percent level of
precision or beyond.
Footnote
61 Press Release, Michael K. Powell, Chairman, Federal
Communications Commission, Federal-State Joint Conference
on Regulating Accounting Issues (Sept. 5, 2002), available at
http://hraunfoss.fcc.gov/edocs_public/attachmatch/DOC-
225969A1.doc.
62 47 C.F.R. [sec][sec] 54.706, 54.711, 54.713, 64.604 (2002).
All telecommunications carriers providing interstate
telecommunications service, interstate telecommunications
providers offering interstate telecommunications for a fee on a
non-common-carrier basis, and payphone providers that are
aggregators must contribute to the Universal Service Fund and
file a Telecommunications Reporting Worksheet annually (on
FCC Form 499-A) and quarterly (on FCC Form 499-Q), 47
C.F.R. [sec][sec] 54.706, 54.711, 54.713 (2002).
63 Every common carrier providing interstate
telecommunications services is required to contribute to the
Telecommunications Relay Services ("TRS") Fund on the basis
of its relative share of interstate end-user telecommunications
revenues. 47 C.F.R. [sec] 64.604 (2002). The calculations are
based on the Telecommunications Reporting Worksheet. 47
C.F.R. [sec] 64.604(c)(5)(iii)(B) (2002). Moreover, all
telecommunications carriers in the United States are required to
contribute to the costs of establishing a numbering
administration, and the contributions are based on the
Telecommunications Reporting Worksheets. 47 C.F.R. [sec]
52.17 (2002). All telecommunications carriers must contribute
to the costs of long-term number portability. 47 C.F.R. [sec]
52.32 (2002).
Footnote
64 See Seth Schiesel, WorldCom Report Adds to the Size of Its
Sales Drop, N. Y. TIMES, Jan. 30, 2003, at C1 (reporting that
"sales at five important divisions of WorldCom, the troubled
long-distance communications carrier, withered far faster in the](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-90-320.jpg)
![second half of 2002 than the company has publicly reported,
according to an internal WorldCom document").
Footnote
65 Press Release, WorldCom, WorldCom Announces Intention
To Restate 2001 and First Quarter 2002 Financial Statements
(June 25, 2002), available, at http://www.worldcom.com/
global/about/news/.
66 Plaintiffs Complaint at 2, Sec. and Exchange Comm'n v.
WorldCom, Inc., Case No. 02 CV 4963 (JSR) (S.D.N.Y. June
26, 2002) [hereinafter SEC Complaint].
67 WorldCom, supra note 56.
68 Id.
Footnote
69 Press Release, WorldCom, WorldCom Announces Additional
Changes to Reported Income for Prior Periods (Aug. 8, 2002),
available at http://www.worldcom.com/global/about/news/.
Footnote
70 George A. Akerlof, The Market for "Lemons": Quality
Uncertainty and the Market Mechanism, 84 Q.J. ECON. 488
(1970).
71 See RICHARD A. BREALEY & STEWART C. MYERS,
PRINCIPLES OF CORPORATE FINANCE 457 (4th ed. 1996).
72 This conclusion follows from a priori economic reasoning. It
could be difficult, however, to establish this proposition
empirically because one cannot yet say (for purposes of time-
series analysis) when the fraud at WorldCom began. Therefore,
it is not possible to compare WorldCom's cost of capital during
a fraud-free period with its cost of capital during the fraud.
73 See, e.g., Kurt Eichenwald, Corporate Loans Used
Personally, Report Discloses, N.Y. TIMES, Nov. 5, 2002, at C1
(discussing the results of the initial report by former Attorney
General Dick Thornburgh, WorldCom's bankruptcy examiner).
Footnote
74 WorldCom, Inc., First Interim Report of Dick Thornburgh,
Bankruptcy Court Examiner, Case No. 02-15533 at 8 (Bankr.
S.D.N.Y.) (Nov. 4, 2002) [hereinafter Thomburgh Report].](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-91-320.jpg)
![in Merger Accounting, at
http://www.fool.com/LunchNews/1997/LunchNews971008.htm
(stating that if it recognized the purchase of MCI as a pooling-
of-interests transaction, WorldCom's "reported earnings would
be about 28% higher than under a purchase treatment").
Footnote
91 See 15 U.S.C. [sec] 1 (2000).
92 The fact that parties to an agreement happen to compete in
wholly different markets from one another would not preclude a
finding that there existed a conspiracy in violation of Section 1
of the Sherman Act, 15 U.S.C. [sec] 1 (2000). The Fifth Circuit,
for example, has recognized that, even when conspirators who
are not competitors of the victim have no interest in curtailing
competition in a market in which they do not compete, "when
they have been enticed or coerced to share in an anticompetitive
scheme, there is still a combination within the meaning of
[Section 1] of the Sherman Act." Spectators' Communication
Network, Inc. v. Colonial Country Club, 253 F.3d 215, 221 (5th
Cir. 2001); see also Perington Wholesale, Inc. v. Burger King
Corp., 631 F.2d 1369, 1377 (10th Cir. 1979) ("The fact that [the
defendant's] coconspirators competed in markets different from
[the defendant's] market does not preclude finding a conspiracy
to monopolize [the defendant's] market."). For purposes of
doctrinal antitrust analysis, a possible conspiracy between
WorldCom and Salomon Smith Barney does not differ from the
garden-variety vertical agreement (between a distributor and a
retailer, for example). A conspiracy in violation of Section 1
need not be, to borrow Judge Richard Posner's paraphrasing of
George Bernard Shaw, "the vertical expression of a horizontal
desire." Valley Liquors, Inc. v. Renfield Importers, Ltd., 678
F.2d 742, 744 (7th Cir. 1982). It is sufficient that the common
scheme has an anticompetitive effect. See, e.g., McLain v. Real
Estate Bd., 444 U.S. 232, 243 (1980) ("[I]n a civil action under
the Sherman Act, liability may be established by proof of either
an unlawful purpose or an anticompetitive effect."); United
States v. United States Gypsum Co., 438 U.S. 422, 436 n.13](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-94-320.jpg)
![(1978) (noting same).
93 On September 3, 2002, the Wall Street Journal reported:
Mr. [Jack] Grubman [of Salomon Smith Barney], who earned an
average of $20 million a year during recent years, and received
a severance package of about $30 million, has been criticized
for staying wildly bullish on many telecommunications
company clients of Salomon-including WorldCom, Inc., Global
Crossing Ltd., and Winstar Communications Inc.-even as their
troubles deepened. . . . The close relationship between Mr.
Grubman and WorldCom has drawn special scrutiny in the wake
of confirmation last week that Salomon allocated hard-to-get
IPO sharesto WorldCom executives and directors, such as
former CEO Bernard Ebbers, who made millions of dollars in
profits when the stocks shot up.
Charles Gasparino, Salomon Probe Includes Senior Executives,
WALL ST. J., Sept. 3, 2002, at C1; see also Susanne Craig,
Offerings Were Easy Money for Ebbers, WALL ST. J., Sept. 3,
2002, at C1 (reporting on the House Financial Service
Committee's investigation into whether Salomon Smith Barney
won investment-banking work from WorldCom by issuing
WorldCom executives shares of "hot IPOs" that it was
underwriting). A subsequent Wall Street Journal story
specifically addressed Salomon Smith Barney's "buy"
recommendation on WorldCom:
Mr. Grubman kept his "buy" on WorldCom as it slid to $4 from
$64.50, not downgrading it until a week before the company
ousted founder Bernard Ebbers [in the spring of 2002],
Meanwhile, over four years Salomon collected $107 million in
fees for advising WorldCom on 23 deals, says [New York
Attorney General Elliot] Spitzer's suit [against WorldCom].
Although Mr. Grubman was so close to WorldCom that he
helped plan its strategy, he has said he saw no sign of the $7
billion accounting fraud now engulfing the company.
Charles Gasparino et al., Wildcard: Citigroup Now Has New
Worry: What Grubman Will Say, WALL ST. J., Oct. 10, 2002,
at A1. During the summer of 2002, the National Association of](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-95-320.jpg)
![securities Dealers ("NASD") initiated an enforcement
proceeding against Mr. Grubman. See Charles Gasparino, NASD
Prepares Action Against a Star Analyst, WALL ST. J., July 22,
2002, at A1 ("[NASD's decision to pursue regulatory action
against Mr. Grubman] marks the first major crackdown by
federal securities regulators investigating how big securities
firms obtained investment-banking business with overly rosy
stock picks.").
Footnote
94 Thornburgh Report, supra note 74, at 7.
Footnote
95 Id.
96 Id. at 82.
97 According to the Wall Street Journal, a WorldCom executive
notified Arthur Andersen in 2000 that the company was
improperly accounting for expenses, yet the practice continued
undiscovered by Arthur Andersen for two years. Yochi J.
Drcazen & Deborah Solomon, WorldCom Alerts About
Accounting Went Unheeded, WALL ST. J., July 15, 2002, at
A3.
98 Thornburgh Report, supra note 74, at 51.
99 See Pulliam et al., supra note 89. Mr. Ebbers used his loans
to purchase, among other things, a soybean plantation, a
500,000 acre cattle ranch (the largest private ranch in Canada),
460,000 acres of timberland, a shipyard, and a 132-foot yacht
christened "Aquasition," and WorldCom lent Mr. Ebbers $415
million to pay back some of these loans when declines in
WorldCom's slock price prompted margin-calls from certain
banks. Id. According to an interim report by a federal
bankruptcy examiner, however, $27 million of those loans from
WorldCom were used by Ebbers for personal reasons, including
the construction of a $1.8 million private home and $3 million
in gifts and loans to friends and family. Eichenwald, supra note
73.
100 See Pulliam et at, supra note 89. Mr. Ebbers' total worth is
taken from Forbes' 1999 list of the 400 Richest Americans,](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-96-320.jpg)
![which is available at http://www.forbes.com/lists/2003/02/26/
billionaireland.html.
Footnote
101 Pulliam et al., supra note 89; see also Kirchgaessner, supra
note 85 and accompanying text. Attorney General Thornburgh
reported in November 2002:
When Mr. Ebbers left WorldCom [in 2002], the [company's
Compensation] Committee negotiated, and the Company
approved, a severance package that included a cash payment of
$1.5 million per year for life, lifetime medical and life
insurance, lifetime use of a corporate jet and conversion of
approximately $408 million in demand notes into 5-year non-
callable term notes with a significant annual interest rate
subsidy.
Thornburgh Report, supra note 74, at 65.
102 Competition Issues in the Telecommunications Industry:
Hearing Before the Senate Comm. on Commerce, Science, and
Transportation, 108th Cong. (2003), available at
http://hraunfoss.fcc.gov/edocs_public/attachmatch/DOC-
230241A1 .pdf (statement of Michael K. Powell, Chairman,
Federal Communications Commission).
103 MCI reported that it acquired over 1 million subscribers in
its Neighborhood Plan as of October 2002. See Press Release,
WorldCom, MCI Welcomes Arkansas to the Neighborhood (Oct.
8, 2002), at http://www.worldcom.com/global/about/news. As of
January 2003, AT&T claimed that it had acquired over two
million households. See Press Release, AT&T, AT&T to Offer
Residential Local Service in Washington, D.C. (Jan. 13, 2003),
at http://www.att.com/news.
Footnote
104 Gregory Zuckerman & Deborah Soloman, Telecom Debt
Debacle Could Lead to Losses of Historic Proportions, WALL
ST. J., May 11, 2001, at A1.
Footnote
105 ROBERT W. CRANDALL, WOULD A DEBT-FREE
WORLDCOM WRECK THE TELECOM INDUSTRY? (Working](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-97-320.jpg)
![Paper, 2002). Similarly, Professor Todd Zywicki has argued that
the "traditional bankruptcy approach of looking at a company's
bankruptcy in isolation is not possible in the telecom industry
because these bankrupt firms have a competitive impact on each
other." Ron Orol, Domino Effect, THE DAILY DEAL, Jan. 16,
2003, at 27 (quoting Professor Todd Zywicki of George Mason
University).
106 Consolidated Version of the Treaty Establishing the
European Community, 1997 O.J. (C 340)173, 208.
107 See, e.g., Case C-39/94, SFEI v. La Poste, 1996 E.G.R. 1-
3547, at [para] 58.
Footnote
108 See, e.g., United States v. Microsoft Corp., 253 F.3d 34
(D.C. Cir. 2001).
109 Stephen Labaton, F.C.C. Ruling Is Expected To Favor
Bells, N.Y. TIMES, Feb. 20, 2003, at C1; see also Murray,
supra note 35.
Footnote
110 Because the telecommunications industry is characterized
by large fixed costs and negligible marginal costs, the textbook
rule of marginal-cost pricing does not apply. See William J.
Baumol & David F. Bradford, Optimal Departures from
Marginal Cost Pricing, 60 AM. ECON. REV. 265 (1970).
111 See, e.g., In re Eagle Bus Mfg., 158 B.R. 421 (Dist. Ct.
S.D. Tex. 1993).
112 Century Glove, Inc. v. First Am. Bank of N.Y., 860 F.2d
94, 102 (3rd Cir. 1988).
113 Sec. & EXCHANGE COMM'N, THE INVESTOR'S
ADVOCATE: HOW THE SEC PROTECTS INVESTORS AND
MAINTAINS MARKET INTEGRITY, at
http://www.sec.gov/about/whatwedo.shtml.
114 47U.S.C. [sec] 151 (2000).
Footnote
115 Id. [sec] 214.
116 Id. [sec] 308(b).
117 Policy Regarding Character Qualifications in Broadcast](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-98-320.jpg)
![Licensing, Amendment of Part 1, the Rules of Practice and
Procedure, Relating to Written Responses to Commission
Inquiries and the Making of Misrepresentations to the
Commission by Applicants, Permittees and Licensees, and the
Reporting of Information Regarding Character Qualifications, 7
F.C.C.R. 6564 (1992).
118 Policy Regarding Character Qualifications in Broadcast
Licensing; Amendment of Rules of Broadcast Practice and
Procedure Relating to Written Responses to Commission
Inquiries and the Making of Misrepresentations to the
Commission by Permittees and Licensees, 1 F.C.C.R. 421, 424
(1986) ("[C]ommon carriers are distinguished from broadcasters
for purposes of character qualifications because no content
regulation is involved and because such issues are adjudicated
on a case -by-case basis without the guidance of a specific
policy statement. As a result, reference is occasionally made in
common carrier cases to broadcast policies and precedents as
aids in resolving character issues."). For an example of a recent
revocation proceeding, see Application of Alee Cellular
Communications, 17 F.C.C.R. 3237 (2002).
119 TeleSTAR, Inc., 3 F.C.C.R. 2860 (1988).
120 Revocation of the Licenses of Pass Word, Inc., 86 F.C.C.2d
437, 449 [para] 29 (1981).
121 See, e.g., RKO Gen'l, Inc. (KHJ-Television), 3 F.C.C.R.
5057 (1988).
Footnote
122 Thornburgh Report, supra note 74, at 6, 58-63.
123 Id. at 6.
124 Jonathan Krim, Fast and Loose at WorldCom, WASH.
POST, Aug. 29, 2002, at A1.
Footnote
125 EASTERN MANAGEMENT GROUP, supra note 42, at 3.
126 Id. at 1.
127 See MERRILL LYNCH, WORLDCOM GROUP 4 (Jan. 4,
2002); cf. MORGAN STANLEY DEAN WITTER, WORLDCOM
GROUP 3 (October 15, 2001).](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-99-320.jpg)
![128 Christopher Stern, WorldCom To Lay Off 5.000 More
Employees, WASH. POST, Feb. 4, 2003, at 125 (quoting Susan
Kalla, telecommunications analyst at Friedman, Hillings,
Ramsey Group Inc.); see also id. (attributing to Ms. Kalla the
view that "[w]hen WorldCom gobbled up competitors in the
1990s, it did not integrate the separate networks into a single
operation").
129 See, e.g., Benjamin Klein & Keith Leffler, The Role of
Market Forces in Assuring Contractual Performance, 89 J. POL.
ECON. 615 (1981).
130 Christopher Stern, WorldCom CEO Rolls Out Turnaround
Plan, WASH. POST, Jan. 15, 2003, at E2 ("[WorldCom's new
CEO, Michael] Capellas also said yesterday that WorldCom will
eventually change its name in an effort to separate itself from
its now-tainted past.").
131 WorldCom, Inc., Press Release, WorldCom Completes
Preliminary Review of Goodwill, Intangibles, and Property
Equipment (Mar. 13, 2003), available at
http://www.worldcom.com/global/news/news2.xml?newsid=721
2&mode=long&lang=en&width=530 &root=/global/.
132 Id.
133 Id.
Footnote
134 See Stephanie Kirchgaessner, WorldCom Set To Restate
Dollars 2bn of Its Accounts, FIN. TIMES, Sept. 20, 2002, at 27
(London ed.) ("While [WorldCom's] bondholders have said the
additional [accounting] restatements do add uncertainty to the
company's future prospects, they are more concerned with
WorldCom's ability to retain contracts and not lose
customers."). Cf. Stephanie Kirchgaessner, WorldCom Cuts UK
Jobs as Cash Reserves Dwindle, FIN. TIMES, Sept. 17, 2002, at
21 (London ed.) ("On a conference call to senior executives in
August [2002], Lucy Woods, senior vice-president of
[WorldCom's] international operations, said the group was
having difficulty attracting new customers.").
135 As of March 31, 2003, the states and dates of Section 271](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-100-320.jpg)
![authorization were: Alabama (Sept. 18, 2002), Arkansas (Nov.
16, 2001), California (Dec. 19, 2002), Colorado (Dec. 23,
2002), Connecticut (July 20, 2001), Delaware (Sept. 25, 2002),
Florida (Dec. 19, 2002), Georgia (May 15, 2002), Idaho (Dec.
23, 2002), Iowa (Dec. 23, 2002), Kansas (Jan. 22, 2001),
Kentucky (Sept. 18, 2002), Louisiana (May 15, 2002), Maine
(June 19, 2002), Massachusetts (Apr. 16, 2001), Mississippi
(Sept. 18, 2002), Missouri (Nov. 16, 2001), Montana (Dec. 23,
2002), Nebraska (Dec. 23, 2002), North Dakota (Dec. 23, 2002),
New Hampshire (Sept. 25, 2002), New Jersey (June 24, 2002),
New York (Dec. 22, 1999), North Carolina (Sept. 18, 2002),
Oklahoma (Jan. 22, 2001), Pennsylvania (Sept. 19, 2001),
Rhode Island (Feb. 24, 2002), South Carolina (Sept. 18, 2002),
Tennessee (Dec. 19, 2002), Texas (June 30, 2000), Utah (Dec.
23, 2002), Vermont (Apr. 17, 2002), Virginia (Oct. 30, 2002),
Washington (Dec. 23, 2002), and Wyoming (Dec. 23, 2002). See
RBOC Applications To Provide In-Region InterLATA Services
Under [sec]271, at
http://www.fcc.gov/Bureaus/Common_Carrier/in-
region_applications.
Footnote
136 Press Release, Verizon, Verizon Now Third Largest Long-
Distance Company (Jan. 7, 2003), at
http://newscenter.verizon.com/proactive/newsroom/release.vtml
?id=78494.
137 Implementation of the Non-Accounting Safeguards of
Sections 271 and 272 of the Communications Act of 1934, 11
F.C.C.R. 18,877, 18,943 [para] 137 (1996).
Footnote
138 Applications of Voicestream Wireless Corp., Powertel, Inc.,
Transferors, and Deutsche Telekom AG, Transferee, for Consent
To Transfer Control of Licenses and Authorizations Pursuant to
Sections 214 and 310(d) of the Communications Act, 16
F.C.C.R. 9779 [para] 90 (Apr. 27, 2001).
139 Purchasers of WorldCom's assets would likely employ some
of WorldCom's former employees. Certainly WorldCom](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-101-320.jpg)
![employees have the most experience operating WorldCom's
networks.
AuthorAffiliation
J. Gregory Sidak[dagger]
AuthorAffiliation
s[dagger] F. K. Weyerhaeuser Fellow in Law and Economics
Emeritus, American Enterprise Institute for Public Policy
Research. This Article is based on my Beesley Lecture in
Regulation, delivered at the Royal Society of Arts in London on
October 1, 2002. I thank Colin Robinson of the Institute of
Economics Affairs and Leonard Waverman of London Business
School for inviting me to speak. In the months following my
lecture, several telecommunications companies retained me to
analyze the WorldCom fraud and bankruptcy in greater depth.
They have permitted me to incorporate that additional analysis
into this Article. I thank Allan T. Ingraharn, Hal J. Singer, and
workshop participants at Yale Law School for valuable
comments and Brian Fried, Daniel Nusbaum, Brian O'Dea, and
Adelene Tan for excellent research assistance. I thank Jerry
Hausman for suggesting the title of this Article. The views
expressed here are solely my own and not those of the American
Enterprise Institute, which does not take institutional positions
on specific legislative, regulatory, adjudicatory, or executive
matters.
Copyright (C) 2003 by Yale Journal on RegulationAbstract
(summary)
TranslateAbstract
Humanity is maturing slowly and is soaked in blood, passing
through his age of childhood and adolescence. He is now going
through the last stages of his adolescence - producing,
distributing, and trying to manage weapons of mass destruction;
grabbing all he can for his selfish interests while millions starve
in other lands and in our own neighborhood; holding also
tightly to his ancestor's dogmas, superstitions, and divisive
ideals of race, nationalism, and religion. Such mindset has
recently manifested itself in huge scandals in the Catholic](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-102-320.jpg)
![Church, and previously in Protestant denominations, and
embezzlements in billions by the likes of Enron, Worldcom, and
Arthur Anderson, and ultimately by the fundamentalist
ideologies manifested in the likes of Osama Bin Laden and the
Al-Quaida organization. The democratic systems, while hanging
on to old ideas, have necessitated what George Orwell foresaw
as the need for "double-speak" and "correct-think" to be able to
keep the illusion of democracy and at the same time control the
passions of the masses. Wars, in the meantime, have continued,
have brought devastation to the world and have claimed the
lives of some 200 million people in the twentieth century alone.
Man is at the brink. The question of business ethics cannot be
addressed in a vacuum if he has lost a bigger truth - his
humanity. One must either learn to grow up quickly or perhaps,
perish. [PUBLICATION ABSTRACT]Full Text
· TranslateFull text
·
Headnote
Keywords Ethics, Democracy, Religion, Politics, Economics,
War
Abstract Humanity is maturing slowly and is soaked in blood,
passing through his age of childhood and adolescence. He is
now going through the last stages of his adolescence -
producing, distributing, and trying to manage weapons of mass
destruction; grabbing all he can for his selfish interests while
millions starve in other lands and in our own neighborhood;
holding also tightly to his ancestor's dogmas, superstitions, and
divisive ideals of race, nationalism, and religion. Such mindset
has recently manifested itself in huge scandals in the Catholic
Church, and previously in Protestant denominations, and
embezzlements in billions by the likes of Enron, Worldcom, and
Arthur Anderson, and ultimately by the fundamentalist
ideologies manifested in the likes of Osama Bin Laden and the
Al-Quaida organization. The democratic systems, while hanging
on to old ideas, have necessitated what George Orwell foresaw
as the need for "double-speak" and "correct-think" to be able to](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-103-320.jpg)
![keep the illusion of democracy and at the same time control the
passions of the masses. Wars, in the meantime, have continued,
have brought devastation to the world and have claimed the
lives of some 200 million people in the twentieth century alone.
Man is at the brink. The question of business ethics cannot be
addressed in a vacuum if he has lost a bigger truth - his
humanity. One must either harn to grow up quickly or perhaps,
perish.
Bird's eye view of the past
East Asia gave to the world, Hinduism, Confucianism,
Buddhism, Shintoism, and Taoism - all promoting virtues and
the fundamentals of virtuous and decent human living. Athens
with Socrates, Plato, and Aristotle gave to humanity an inkling
of democracy and freedom of thought and the merits of reason
and wisdom (Durant, 1961). Pharaohs ruled Egypt and most of
the known world, followed by Persians (sixth century BC),
Greeks (fourth century BC), Romans (second century BC),
Christianity (sixth century AD), Islam (eight century AD),
Ottomans (fourtheenth century AD), and the warring
colonialists of Europe (eighteenth and nineteenth centuries).
Middle East gave to the world, Judaism, Zoroastrianism,
Christianity, Islam, and the Baha'i Faith - all promoting belief
in one God, obedience to His manifestations and His
commandments[1]. Arnold Toynbee (1971) concludes (not
including the recent phenomenon of Baha'ism) that while
Buddhism, that did not claim particular allegiance to an
unreachable God, appears to have been the most tolerant among
the higher level religions and lived in harmony with Taoism and
Shintoism in China and Japan and Eastern Asia, Christianity and
Islam proved to be the most intolerant of each other and their
own internal denominations through history, as evidenced by
the wars between Shiis and Sunnis among Moslems from the
eighth century on and the religious wars of Europe during the
sixteenth century when one-third of the European population
were slaughtered to the current conflicts as manifested in
Afghanistan and Iraq, as well as the infamous Crusades that](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-104-320.jpg)
![lasted some two centuries from the eleventh to thirteenth
centuries, resulting in the slaughter of an untold number of
people:
The greatest paradox of the twentieth century is that in this age
of powerful technology, the biggest problems we face
internationally are problems of the human soul (Ralph Peters).
Europe contributed to the age of Renaissance (fifteenth
century), Reformation (sixteenth century), Enlightenment
(seventeenth century), Industrial Revolution (eighteenth
century), Freedom and Liberty (nineteenth century), and
unprecedented technological advances (twentieth century)[2].
The new freedom released a huge level of energy and
precipitated the birth of Colonialism, Imperialism,
Individualism, Communism, Fascism, Nazism, Socialism, and
Capitalism[3]. By the end of twentieth century, Capitalism with
the ideals of individualism, free enterprise, and relentless
competition was only standing, while with an unprecedented
level of death and destruction, other ideologies were virtually
vanquished. oil and most lethal armaments now have their hold
on the humankind. Church and State are totally divorced from
one another on the national scene, and the question of who dies
and who lives is essentially decided and determined through the
power of human logic in board meetings and through political
maneuverings. Might is right is the final arbiter in human
relations[4].
A little detail
To be ignorant of what occurred before you were born is to
remain always a child. For what is the worth of human life,
unless it is woven into the life of our ancestors by the records
of history (Cicero, 46BC).
Emperor Constantine (fourth century AD) of the Byzantine
Empire became Christian and his domain (most of the Middle
East and North Africa) accepted the Christian faith. Rome was
defeated and disintegrated (sixth century AD). The Christian
church dominated Europe and to a lesser extent the Byzantine
Empire until the sixteenth century. Uniformity was achieved at](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-105-320.jpg)
![the cost of suppression of any deviation from the Church's
standards through harsh inquisitional practices. Outside threats
were met through organized violence and generational wars.
Prophet Muhammad introduced the religion of Islam which
conquered the area from Arabia to the whole Middle East and
beyond from the East and all North Africa to Spain and
Southern Europe, promoting the oneness of God, compassion in
human dealings, and justice through adherence to the tenets of
the Koran. Pope Gregory (Urban II) commenced 200 years of
crusades to conquer Jerusalem and annihilate
"Sarasans"(eleventh century). An untold number of Moslems
and local Jews and Christians were killed in this religiously
motivated warfare[5]. Mongol herds attacked the Middle East
from three directions during the thirteenth century AD, and
brought with them devastation and an unprecedented level of
cruelty and conquered the whole of Asia up through Eastern
Europe (Armstrong, 2001):
In trying to make themselves angels, men transform themselves
into beasts (Michelle de Mountaine).
Inquisition and burning non-believers and those who had
deviated from the chosen path and strict obedience to the
Church was the rule in Europe, while the Middle East advanced
in art, philosophy, and sciences. Italy saw the beginning of the
Renaissance in art, culture, and other scientific endeavors
(fifteenth century). Ottoman Turks defeated the Byzantine
Empire, Arabs, and to a large extent Persians and ruled the
Middle East and North Africa from the fourteenth through
nineteenth centuries. The Middle East was a safer place to live
compared to Europe. Hundreds of thousands of Christians,
Moslems, and Jews escaped and resettled in the Middle East in
this time period. The Middle East was called the land of peace
while Europe was referred to as the land of war (Lewis, 1997).
Printing press and Martin Luther's revolt (sixteenth century
AD), known as · Reformation and the Protestant Movement,
contributed to diffusion of ideas and serious clashes of religious
and nationalistic forces that left about one-third of Europe dead](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-106-320.jpg)
![within the course of one century. An outburst of thoughts led to
scientific revolution and appearance of Copernicus, Galelio,
Newton, Bacon, and philosophers such as Kant, Espinoza,
Voltaire, and Russou (seventeenth-eighteenth centuries). This
was the age of European Enlightenment and the age of reason:
Your soul is often times a battlefield upon which your reason
and your judgment wage war against your passion and your
appetite. Would that I could be a peacemaker in your soul, that I
might turn the discord and the rivalry of your elements into
oneness and melody. But how shall I, unless you yourselves be
also the peacemaker, nay, the lovers of all elements (Khalil
Gibran).
Advances in military science and the passion for movement and
power led to the military might, east and southward expansion
of France and its final defeat and withdrawal a short while later
(1800s). Europeans (Portugal, Spain, France, England, Russia,
Germany, Italy, Belgium, Denmark, etc.) also ventured to
conquer and dominate all the continents of the globe. The age of
Colonialism and Imperialism was on us. Millions of Africans
were enslaved and brought to the fields of America for hard and
free labor. At least nine million died in this cruel transport.
Millions of others died working in the fields. American Indians
were slaughtered and their lands confiscated by the resettling
Europeans[6]:
Killing is forbidden except if it is to the sound of the trumpet
and marching of the band (Voltaire)
1776 - Industrial Revolution was introduced with the Watts
steam engine. Adam Smith authored Wealth of Nations.
American Revolution succeeded and a nation was born. Europe
was devastated by the Napoleonic wars. Revolutions ensued in
other parts of Europe including France, Portugal, Spain, and
Italy:
I have sworn upon the altar of God eternal hostility against
every form of tyranny over the mind of man (Thomas
Jefferson).
1800s - some 700,000 Americans were killed in the Civil War](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-107-320.jpg)
![than convert... it creates bitterness in the survivors and brutality
in the destroyers (Dr Martin Luther King).
1914-1918 - some 20 million people, mostly civilians, were
killed in this war. The defeated powers were humiliated and
pushed to pay huge reparations[7]. This provided the basis for
the start of the second World War that resulted in the death of
some 50 million people and destruction of thousands of cities
and villages - mostly Christians killing Christians, but now
under the name of Nazism and Fascism. The Middle East was
partitioned into some 20 plus countries. Some 40, non-
homogeneous, and artificially created entities within Africa
claimed independence. After 200 years of Colonialism, little
hope for stability and progress appeared to be in sight for these
regions. Russian Revolution brought Bolsheviks and
Communists to power (Fromkin, 2001):
The nations put him [Hitler] where he belongs, but don't rejoice
too soon at your escape. The womb he crawled from is still
going strong (Bertold Brecht).
1945 - the USA dropped two atom bombs over Hiroshima and
Nagasaki. Some 200,000 Japanese perished and hundreds of
thousands of others were impaired for the rest of their lives.
Japan surrendered. The second World War ended. President
Truman stated that he did not lose any sleep over the bombing.
Otherwise, more people would have to be killed. Fifty years
later, most history books tell us that Japan was already
destroyed and defeated, and it could have been a matter of days
before the surrender would have taken place. It is now argued
that the bombing was necessary to scare the Soviets under
Stalin. In the meantime, Stalin killed some 50 million Russians
to promote uniformity in thinking and Mao killed 50 million
Chinese for essentially the same reason. Russia and China could
not reconcile the nationalistic sentiments with the global vision
of Communism. Another 30 million people were slaughtered in
all other regional wars of the twentieth century including the
wars in Korea, Vietnam, Afghanistan, Iran, Iraq, former
Yugoslavia, and various regional wars in Africa[8]. Europe with](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-109-320.jpg)
![and no shedding of American blood. Arnold Toynbee and Will
Durant commenced their celebrated and most prolific writings
with an analytical view of history and philosophy (Tyonbee,
1966, 1971, 1978):
Sixty years ago, I knew everything. Now I know nothing.
Education is the progressive discovery of our own ignorance
(Will Durant).
1960s - huge unsettlement in the USA about the draft, the
Vietnam War, the rights of Negroes and the Civil Rights
Movement, and the opposition of segregationists such as
governor Wallace of Alabama created tremendous tensions and
imbalance in the fabric of the American democracy. The decade
ended with the assassination of President Kennedy, his brother
Robert Kennedy, and civil rights leader, Martin Luther King.
Young people, alienated and angry about the Vietnam War,
turned to sex and drugs as their refuge and solace, perhaps with
a nod from the ruling elite:
The general prey of the rich over the poor is the devouring of
people in wars (Thomas Jefferson).
1970s - President Nixon ordered acceleration of bombing in
Vietnam in order to bring about peace. Cambodia fell under the
rule of Pol Pot regime. Some 40 per cent of the country's
population of 7 million were slaughtered. Nixon ordered the
infamous Watergate burglary and was forced to resign to avoid
impeachment. He later stated that he was not sorry for any of
the lying and cheating. He was sorry that he was caught[9]. The
decade ended with the defeat of the Shah and takeover of Iran
by Islamic militants and taking of some 70 Americans hostage
for 444 days until inauguration of President Reagan (Mackey,
1998).
1980s - Soviets invaded Afghanistan. The USA funded and
supported "freedom fighters" who turned into Talibans and
terrorists and battled America some 20 years later. Some
500,000 Afghans were killed and some 6 million became
refugees in Iran and Pakistan (Brzezinski, 1983). Saddam (Iraq)
attacked Iran. The USA supported Iraq openly and Iran covertly](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-111-320.jpg)
![of production in Southeast Asia and elsewhere forces many US
manufacturing facilities to be closed and to be moved
elsewhere:
Democracies die behind closed doors. Selective information is
misinformation (Judge Damon J. Keith).
The West, freed from the shackles of the Catholic Church,
encouraged by the advances in industrialization, and allowed to
think and reason without being subdued and controlled by a
higher authority, left the world of religion and authoritarian rule
for a new era of democracy, freedom, individualism,
selfishness, and cut-throat competition. In many corners, the
ideals of greed and selfishness were actively promoted as the
engine for ultimate human progress. Professor Hayeck of
the University of Chicago together with the Nobel prize winner,
Milton Freedman, promoted the ideals of free market and less
government interference[10]. The ideals were promoted by
politicians from Reagan in the USA to Margaret Thatcher in the
UK. The last revolution in Western politics and economics
brought with it certain additional efficiencies at a huge cost to
those who had gained some rights and equity in the course of
the last 100 years and resulted in a much wider gap between the
haves and the have-nots both within the · country and among
nations. The disparities, disappointments, and hopelessness
appeared to be too much to handle or to overcome:
More compassion automatically opens our inner self. Too much
self-centered attitude closes our inner door. The very concept of
war is out of date. Destruction of your neighbor as an enemy is
essentially a destruction of yourself (Dali Lama).
The age of individualism and greed was at its peak, leading to
several scandals, insider trading, and dissolution of savings and
loan association resulting in billions of dollars of loss.
Professor Paul Kennedy (1988) authored his famous work, The
Rise and Fall of Great Powers, illustrating the mix of economic
superiority with military strength and argues that the
civilization that has the last dollar is the one that stands and the
one who falls short of money ultimately falls. However, those](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-113-320.jpg)
![who overextend themselves in military terms (Soviet Union)
ultimately make the economy bankrupt and fall. Professor Alan
Bloom (1987) writes his famous work, Closing of the American
Mind, lamenting that in this age of reason and liberty we may
have lost something far more precious. Quoting Nietsche, he
elucidates that in the process we may become either truly
liberated or go mad and eventually destroy ourselves:
We must pursue peaceful ends through peaceful means (Martin
Luther King).
Lord Kenneth Clark completed his award winning series titled
Civilization[11] in which he took us through the ages of
Renaissance, Enlightenment, Industrial Revolution,
Colonialism, Humanism, Wars, revolutions, and present
scientific advances and concluded that while freedom of thought
was the vehicle for all the human (primarily Western) advances
of the past five centuries, we seem to have lost, in this "post-
Christian era", that sense of awe, discipline, obedience to God
and authority that became manifest in the works of Raphael,
Leonardo di Vinci, and Michael Angelo. We may be at the edge
of a cliff now, and we could very well destroy ourselves in the
process. He ultimately thinks that order is better than disorder
and that our age of reason must need to be supplemented with
some higher purpose to hold the civilization together:
The only thing for the triumph of evil is for good men to do
nothing (Edmund Burke).
1990s - Iraq invaded Kuwait. A coalition was formed. Iraq was
defeated, but Saddam was not removed. The USA pulled out of
Somalia after some marines were brutally killed and paraded
through the streets. A US ship was targeted and attacked near
the coast of Yemen. There were several other terroristic targets
of US embassies in East Africa and the Middle East. A few
years earlier, 243 marines were killed in Lebanon and the US
forces pulled out immediately then after:
The saddest lesson of history is that we never learn anything
from history (Hegel).
Republicans fought Democrats in the Congress. The federal](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-114-320.jpg)
![TranslateAbstract
WorldCom, Inc. perpetrated the largest accounting fraud in U.S.
history. WorldCom, now called MCI, emerged from bankruptcy
protection on April 20, 2004 after being fined $750 million. In
total, WorldCom reported accounting irregularities of $11
billion. While employees and investors look for individual
culpability, much of WorldCom's organizational structure and
culture potentially contributed not only to the fraud but also to
the length of time over which it occurred. In many ways,
groupthink may help explain some of the issues and fraudulent
activities at WorldCom as well as the pressures that were placed
on employees extending the period over which the fraud
occurred. [PUBLICATION ABSTRACT]Full text
· TranslateFull text
·
Headnote
WorldCom, Inc. perpetrated the largest accounting fraud in U.S.
history. WorldCom, now called MCI, emerged from bankruptcy
protection on April 20, 2004 after being fined $750 million. In
total, WorldCom reported accounting irregularities of $11
billion. While employees and investors look for individual
culpability, much of WorldCom's organizational structure and
culture potentially contributed not only to the fraud but also to
the length of time over which it occurred. In many ways,
groupthink may help explain some of the issues and fraudulent
activities at WorldCom as well as the pressures that were placed
on employees extending the period over which the fraud
occurred.
We were duped, how could we have been so stupid, and the
more humorous my 401K is now a 101K. These and many others
are all sentiments heard around the halls and coffee machines at
WorldCom (now named MCI) after the largest accounting fraud
in history occurred. Currently the nation's second largest long-
distance phone company, MCI is headquartered in Ashburn, VA.
MCI emerged from bankruptcy protection on April 20, 2004
reporting accounting irregularities of $11 billion (Young, 2004).](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-126-320.jpg)
![report (2003), one manager wrote an email to her employees
referring to some of the irregular accounting charges. The email
stated, "[t]hese documents are sensitive and confidential and
should not be distributed outside of the department without
advising [her] or myself first" (p. 69). One of her direct reports
replied: "Opps! [sic] I sent it to AA [Arthur Andersen]. IT'S A
JOKE.
I fully agree with your concerns" (p. 69). The manager then
replied, "smart ass. Just trying to be dramatic and liven things
up a bit" (p. 69). This email string identifies two of the
underlying realities at WorldCom. First, while most of the
65,000 WorldCom employees had no knowledge of the
accounting irregularities, it was not limited to only a handful of
executives. To support this assertion, WorldCom, since these
activities were uncovered, has fired over 400 finance and
accounting employees. Secondly, while it is apparent that these
employees did not want the fraudulent reports and charges
going to Arthur Anderson for review, the email string displays a
certain level of audacity and bravado that usurping the external
auditors was considered appropriate even at the lower levels of
the company.
Rationalizations
In addition to a sense of invulnerability, groupthink
organizations in the past have manufactured outrageous
fabrications and rationalizations to justify their behavior.
According to Sims (1992), under stress, members of an
organization may develop certain defenses including:
"(1) Misjudging relevant warnings, (2) inventing new arguments
to support a chosen policy, (3) failing to explore ominous
implications of ambiguous events, (4) forgetting information
that would enable a challenging event to be interpreted
correctly, and (5) misperceiving signs of the onset of actual
danger." (p. 653.)
The SEC (2003) found that Scott Sullivan had the misguided
reputation among employees for his impeccable integrity. Many
of the finance and accounting employees who were aware of the](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-131-320.jpg)
![irregularities may have rationalized that because of Sullivan's
unquestionable integrity he must have found some new
methodology or loophole in the Generally Accepted Accounting
Principles (GAAP) to support the entries he was directing. The
numerous awards Sullivan received probably reinforced these
feelings as well as the clean audit reports from Arthur
Anderson, the company's external auditor, and the consistent
buy recommendations sent throughout the company from
financial analysts. Even after Sullivan's indictment, many
finance employees' initially felt that he must have been setup or
was being made a scapegoat. While Ebbers put very little on
electronic mail, one memo remains where Ebbers discussed his
rationalization of "those one-time events that had to happen in
order for us to have a chance to make our numbers" (The
Economist, 2004, para. 5).
Beyond the accounting fraud, both Ebbers and Sullivan engaged
in very questionable dealings with their employees. For
example, according to the SEC (2003), over an eighteen month
period ending in 2002, Ebbers gave Ron Beaumont, WorldCom's
ex-Chief Operating Officer (COO), a total of $650,000 whereas
Sullivan wrote personal checks to seven of his managers giving
them $20,000 each by writing one check to the employee for
$10,000 and another to the employee's spouse for the same
amount. Sullivan rationalized these payoffs as a company bonus
even though they were written on his personal checking account
and no additional bonus was authorized by the company's board
of directors. The SEC (2003) stated that these acts were "not
necessarily improper in themselves... [they] created conflicting
loyalties and disincentives to insist on proper conduct" (p. 23).
It is difficult to believe that the seven employees receiving
checks from Sullivan did not see these payments as highly
questionable, especially when Sullivan wrote personal checks to
their spouses as an alleged company bonus. Yet each of these
employees must have rationalized the validity of these payments
because none came forward. In addition to these one-time
payouts, there were also a select number of employees who](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-132-320.jpg)
![where leaders and managers were not to be doubted or
questioned. The SEC Report (2003) came to a similar
conclusion; that "Ebbers created the pressure that led to the
fraud. He demanded the results he had promised, and he
appeared to scorn the procedures (and people) that should have
been a check on misreporting" (p. 18). Moreover, the SEC
Report (2003) concluded that:
"WorldCom's continued success became dependent on Ebbers'
ability to manage the internal operations of what was then an
immense company, and to do so in an industry-wide downturn.
He was spectacularly unsuccessful in this endeavor. He
continued to feed Wall Street's expectations of double-digit
growth, and he demanded that his subordinates meet those
expectations. But he did not provide the leadership or
managerial attention that would enable WorldCom to meet those
expectations legitimately." (p. 5)
Due to WorldCom's culture, employees felt that they risked
losing their jobs by disagreeing with executives or policies that
were implemented. Even Sullivan appeared to feel some of this
pressure. When asked specifically if Ebbers pressured him to
make the incorrect accounting entries, his response was "you
know Bernie [Ebbers], he could put pressure on you indirectly"
(SEC, 2003, p. 127). Further, David Scherler, a lawyer
representing Buford Yates, WorldCom's ex-Director of General
Accounting, stated that Sullivan and Ebbers placed his client in
an untenable position. Although it is difficult to view any
WorldCom executive with years of experience as low level
employee who could not stand up for their rights, Scherler
remarked that "I think that Vinson, Normand and Yates are all
low-level players in this who wound up being the victims of
unscrupulous higher managers" (Pullman, 2003, p. A1).
Stereotypes
Janis (1971) found that "victims of groupthink hold stereotyped
views of the leaders of enemy groups: they are so evil that
genuine attempts at negotiating differences with them are
unwarranted" (p. 46). These negative views are not necessarily](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-135-320.jpg)
![there is a bankruptcy effect that makes it more likely that
bankruptcy cases will succeed. This finding likely reflects a
form of hindsight bias on the part of judges who decide
bankruptcy cases.
This study has implications for understanding the role of
securities class actions. Perhaps the most compelling cases
brought by investors involve companies that fall into
bankruptcy in the wake of a fraud. The study of bankruptcy
cases shows that judges use heuristics not only to dismiss
securities class actions but also to deny motions to dismiss.
This tendency could reflect hindsight bias as well as the belief
that there is a core set of cases where there is greater consensus
as to the utility of securities class actions. Certainly, context
matters in the way that judges and parties assess the merit of
securities class actions.
Footnote
1. See, e.g., Baruch Lev & Meiring de Villiers, Stock Price
Crashes and 10b-5 Damages: A Legal, Economic, and Policy
Analysis, 47 Stan. L. Rev. 7, 35 (1994) ("[S]tock price crashes
are short-term phenomena . . . . [B]uilt-in forces, namely the
informed investors' realization that the stock price is below
fundamentals, will start operating in a crash and return the price
to its fundamental or equilibrium value.").
2. See, e.g., Frank H. Easterbrook & Daniel R. Fischel, Optimal
Damages in Securities Cases, 52 U. Chi. L. Rev. 611, 641
(1985) (observing that diversified investors are protected from
impact of securities fraud).
3. See, e.g., Janet Cooper Alexander, Do the Merits Matter? A
Study of Settlements in Securities Class Actions, 43 Stan. L.
Rev. 497, 572 (1991) (arguing that shareholder compensation
shifts losses "from current . . . to former shareholders" and that
"the net result is simply the destruction of shareholder value in
the amount of the transaction costs of the litigation").
4. See In re Enron Corp. Sec., Derivative & "ERISA" Litig., No.
MDL-1446, 2008 WL 4178151 (S.D. Tex. Sept. 8, 2008)
(approving $7 billion settlement fund including settlements by](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-181-320.jpg)
![sufficient time to turn the ailing firm around").
14. See id. at 715 ("Under our last period hypothesis, Fraud on
the Market usually results from the efforts of a few desperate
managers to hide the fact that the corporation is ailing or has
done sufficiently badly relative to reasonable expectations that
senior managers can expect to be replaced.").
15. Mitu Gulati et al., Fraud by Hindsight, 98 Nw. U. L. Rev.
773, 778 (2004); see also Jeffrey J. Rachlinski, A Positive
Psychological Theory of Judging in Hindsight, 65 U. Chi. L.
Rev. 571, 571 (1998) ("[P]sychologists have demonstrated
repeatedly that people overstate the predictability of past
events-a phenomenon that psychologists have termed the
'hindsight bias.' ").
16. See, e.g., Zoe-Vonna Palmrose, Litigation and Independent
Auditors: The Role of Business Failures and Management
Fraud, Auditing: J. Prac. & Theory, Spring 1987, at 90, 96 ("In
the context of business failures, allegations usually include the
assertion that business difficulties were hidden by the use or
manipulation of financial information, so that either the
existence or degree of financial distress was unexpected when
finally disclosed.").
17. 15 U.S.C. § 78u-4(b)(2) (2006).
18. E.g., Rothman v. Gregor, 220 F.3d 81, 90 (2d Cir. 2000)
(noting that "to plead scienter . . . a complaint may . . . allege
facts that constitute strong circumstantial evidence of conscious
misbehavior or recklessness"); In re Silicon Graphics Inc. Sec.
Litig., 183 F.3d 970, 974 (9th Cir. 1999) (finding that
plaintiff"must plead, in great detail, facts that constitute strong
circumstantial evidence of deliberately reckless or conscious
misconduct"). Of course, in some circuits, plaintiffs can also
plead scienter by alleging motive and opportunity, Rothman,
220 F.3d at 90, an arguably easier standard to meet.
19. Rothman, 220 F.3d at 90 (quoting Rolf v. Blyth, Eastman
Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978)).
The standard for finding an auditor liable in a Rule 10b-5 case
is an even higher standard of recklessness. See, e.g., PR](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-183-320.jpg)
![Diamonds, Inc. v. Chandler, 364 F.3d 671, 693 (6th Cir. 2004)
("[T]he meaning of recklessness in securities fraud cases is
especially stringent when the claim is brought against an
outside auditor."); DSAM Global Value Fund v. Altris Software,
Inc., 288 F.3d 385, 391 (9th Cir. 2002) (requiring allegation of
"such an extreme departure from reasonable accounting practice
that [the auditor] knew or had to have known that its
conclusions would mislead investors" (internal quotation marks
omitted)); Rothman, 220 F.3d at 98 (noting that to find that an
auditor acted recklessly, the conduct must "approximate an
actual intent to aid in the fraud being perpetrated by the audited
company" (internal quotation marks omitted)).
In 1994, the Supreme Court rejected a more lenient standard of
aiding and abetting for holding auditors liable under Rule 10b-
5. See Cent. Bank of Denver, N.A. v. First Interstate Bank of
Denver, N.A., 511 U.S. 164, 191 (1994).
20. See, e.g., Rachlinksi, supra note 15, at 592 ("Even if
subjective standards invite biased judgments, the hindsight bias
probably has less influence on judgments made under subjective
standards than it does on judgments made under objective
standards.").
21. See, e.g., John C. Anderson et al., The Mitigation of
Hindsight Bias in Judges' Evaluation of Auditor Decisions,
Auditing: J. Prac. & Theory, Fall 1997, at 20, 21 ("[W]e
established the existence of hindsight bias with judges and then
attempted to mitigate it with two individual debiasing
methods."). The hindsight bias may also affect auditors who
evaluate the work of other auditors. See Jane Kennedy,
Debiasing the Curse of Knowledge in Audit Judgment, 70 Acct.
Rev. 249, 257 (1995) ("This experiment finds that subjects-
auditors and MBA students-are susceptible to outcome
knowledge that should be ignored . . . .").
22. See, e.g., Thomas A. Buchman, An Effect of Hindsight on
Predicting Bankruptcy with Accounting Information, 10 Acct.,
Orgs. & Soc'y 267, 274 (1985) ("Reporting bankruptcy
increased the perceived likelihood that it would happen, as](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-184-320.jpg)
![would be expected from prior research."); D. Jordan Lowe &
Philip M.J. Reckers, The Effects of Hindsight Bias on Jurors'
Evaluations of Auditor Decisions, 25 Decision Sci. 401, 417
(1994) ("In spite of receiving instructions to base their
responses on information available before learning of an
outcome, jurors tended to make auditor evaluative judgments in
the direction of the negative (bankruptcy) outcome. Outcome
knowledge of the audit client's bankruptcy resulted in lower
evaluations of the auditor's performance.").
23. See Marianne M. Jennings et al., Causality as an Influence
on Hindsight Bias: An Empirical Examination of Judges'
Evaluation of Professional Audit Judgment, 21 J. Acct. & Pub.
Pol'y 143, 161 (1998) ("[J]udges' assessments of the external
auditor's responsibility to anticipate the outcome was directly
related to the degree of outcome foreseeability.").
24. Tom Baker & Sean J. Griffith, How the Merits Matter:
Directors' and Officers' Insurance and Securities Settlements,
157 U. Pa. L. Rev. 755, 787 (2009).
25. See 15 U.S.C. § 78j (2006) (prohibiting manipulative and
deceptive devices). The Supreme Court has recognized an
implied private right of action for investors harmed by
violations of section 10(b). See Tellabs, Inc.v. Makor Issues &
Rights, Ltd., 551 U.S. 308, 318 (2007).
26. See 17 C.F.R. § 240.10b-5 (2011) (SEC Rule enacted
pursuant to section 10(b) of the Securities Exchange Act).
27. See 15 U.S.C. § 77k(a) (providing cause of action against
issuer and other parties for misstatements in the registration
statement).
28. See 11 U.S.C. § 362 (2006).
29. E.g., Notice of Proposed Settlement of Class Action, Motion
for Attorneys' Fees, and Settlement Fairness Hearing at 1, In re
Eagle Bldg. Techs., Inc. Sec. Litig., No. 02-80294- CIV-
RYSKAMP (S.D. Fla. Jan. 31, 2006) ("Bankruptcy counsel for
Eagle and counsel for the Settlement Class have agreed that the
Settlement Class shall have an unsecured claim of $8,000,000 in
Eagle's liquidation. However, secured and unsecured claims](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-185-320.jpg)
![exceed the available proceeds for liquidation and the Settlement
Class is likely to receive only a small fraction of its claim
against Eagle from the bankruptcy estate.").
30. Section 510(b) of the Bankruptcy Code provides the
following:
[A] claim arising from rescission of a purchase or sale of a
security of the debtor or of an affiliate of the debtor, for
damages arising from the purchase or sale of such a security, or
for reimbursement or contribution allowed under section 502 on
account of such a claim, shall be subordinated to all claims or
interests that are senior to or equal the claim or interest
represented by such security, except that if such security is
common stock, such claim has the same priority as common
stock.
11 U.S.C. § 510(b).
For a critique of this provision, see generally Kenneth B. Davis,
Jr., The Status of Defrauded Securityholders in Corporate
Bankruptcy, 1983 Duke L.J. 1 (1983).
31. See, e.g., Kenneth M. Ayotte & Edward R. Morrison,
Creditor Control and Conflict in Chapter 11, 1 J. Legal Analysis
511, 522 (2009) (finding that equityholders recover in only 9
percent of chapter 11 cases when creditors have not been paid in
full, marking a shiftfrom recovery rates during the 1980s).
32. See, e.g., Lynn M. LoPucki & William C. Whitford,
Bargaining over Equity's Share in the Bankruptcy
Reorganization of Large, Publicly Held Companies, 139 U. Pa.
L. Rev. 125, 143 (1990) (finding equity recoveries of between
$400,000 and $63 million).
33. See, e.g., Notice of Class Action, Proposed Settlement and
Hearing Thereon at 1, In re Mpower Commc'ns Corp. Sec.
Litig., No. 00-CV-6463t(b) (W.D.N.Y. Feb. 20, 2003) ("On
April 8, 2002, defendant Mpower Communications Corp.
('Mpower' or the 'Company') filed a petition for relief under
Chapter 11 of the Bankruptcy Code. As of the effective date of
Mpower's First Amended Joint Plan of Reorganization (the
'Plan'), Mpower was discharged and released from any claim,](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-186-320.jpg)
![Minoco Grp. of Cos., Ltd.), 799 F.2d 517, 519 (9th Cir. 1986)
(finding that particular D&O insurance proceeds are "property
of the estate . . . because the policies insure [the corporation]
against indemnity claims"); Circle K Corp. v. Marks (In re
Circle K Corp.), 121 B.R. 257, 259 (Bankr. D. Ariz. 1990).
38. See, e.g., Richard M. Cieri & Michael J. Riela, Protecting
Directors and Officers of Corporations that Are Insolvent or in
the Zone or Vicinity of Insolvency: Important Considerations,
Practical
Solution
s, 2 DePaul Bus. & Com. L.J. 295, 333-34 (2004); Nan Roberts
Eitel, Now You Have It, Now You Don't: Directors' and
Officers' Insurance After a Corporate Bankruptcy, 46 Loy. L.
Rev. 585 (2000); see also Kelli A. Alces, Enforcing Corporate
Fiduciary Duties in Bankruptcy, 56 U. Kan. L. Rev. 83, 119-125
(2007) (noting that derivative suits are controlled by the
bankruptcy estate).
39. See Arlen & Carney, supra note 13, at 715.
40. See id. at 723.
41. Id. at 726.
42. Id. at 725.
43. See id. at 731 ("[A] sample of six firms is too small a
sample from which to generalize.").
44. See, e.g., Alexander, supra note 3; James Bohn & Stephen
Choi, Fraud in the New- Issues Market: Empirical Evidence on](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-188-320.jpg)
![the primary source of funding settlements in bankruptcy cases.
Id. at 377 n.73.
47. Notice of Pendency of Class Action, Proposed Settlement
Thereof, Settlement Fairness Hearing and Right to Share in
Settlement Fund at 2, In re CHS Elecs., Inc. Sec. Litig., No. 99-
8186-CIV-GOLD/SIMONTON (S.D. Fla. Nov. 29, 2001).
48. Typically, multiple securities class actions are filed against
a company. The court will consolidate these class actions into
one action and choose a lead plaintifffor the class action.
49. See, e.g., Arlen & Carney, supra note 13, at 722 (excluding
cases involving allegations relating to mergers and hostile
takeovers); Choi, supra note 44, at 604-05 (excluding IPO
allocation cases from sample); Michael A. Perino, Did the
Private Securities Litigation Reform Act Work?, 2003 U. Ill. L.
Rev. 913, 932 ("The allegations in the [IPO] allocation cases
are markedly different from the traditional securities fraud class
actions.").
50. A notice of bankruptcy is a pleading filed by a party to
apprise the court of a defendant's bankruptcy. See, e.g., Yang v.
Odom, 392 F.3d 97, 99 n.1 (3d Cir. 2004) (noting that with the
filing of a notice of bankruptcy, a securities class action was
stayed against the issuer but could proceed against individual
defendants).
51. In some cases, the parties and court recognize that the
bankrupt company will not contribute anything to the](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-190-320.jpg)
![settlement, but the company is not formally dismissed from the
case. In a small number of cases, the bankrupt company makes a
contribution to the settlement that is usually minimal.
52. This is consistent with an earlier study finding that auditor
"litigation tends to precede bankruptcy." See Joseph V. Carcello
& Zoe-Vonna Palmrose, Auditor Litigation and Modified
Reporting on Bankrupt Clients, 32 J. Acct. Res. (Supplement) 1,
25 (1994) ("[L]itigation following bankruptcy has the lowest
occurrence rate . . . . ").
53. It appears that a substantial percentage of large public
companies filing for bankruptcy face a securities class action.
According to the LoPucki Bankruptcy Research Database, 448
"large" public companies filed for bankruptcy from 1996 to
2004, the period of the data set. Not all of the bankruptcy cases
in the data set involved "large" companies. However, a
comparison of the data set with the cases listed in the LoPucki
database found that at least 135 of 448 (30 percent) of the large
public companies that filed for bankruptcy from 1996 to 2004
were also the subject of a securities class action. Of course,
these rates may not be transferable to bankruptcies of smaller
public companies as large companies may be more susceptible
generally to securities class actions. The 30 percent rate of suit
for large bankrupt companies is slightly higher than the 24
percent litigation rate for bankrupt companies found in a study
by Joseph V. Carcello and Zoe-Vonna Palmrose. See id. at 2](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-191-320.jpg)
![(studying a sample of 655 public companies that declared
bankruptcy between 1972 and 1992); see also Palmrose, supra
note 16, at 96 (examining a sample of 458 companies declaring
bankruptcy from 1970-1985 and finding that 21 percent were
involved in auditor litigation). It is also lower than the 38
percent litigation rate for companies restating their earnings
found in a study by Zoe-Vonna Palmrose and Scholz. Zoe-
Vonna Palmrose & Susan Scholz, The Circumstances and Legal
Consequences of Non-GAAP Reporting: Evidence from
Restatements, 21 Contemp. Acct. Res. 139, 145 (2004).
54. I do not classify cases that are voluntarily dismissed by the
plaintiffas "dismissed" and limit the term "dismissal" to cases in
which the court decides a motion to dismiss against the
plaintiffand enters a judgment dismissing the plaintiff's claims
that is not later overturned on appeal.
55. H(0) designates the null hypothesis and H(A) designates the
alternate hypothesis.
56. See, e.g., Baker & Griffith, supra note 24, at 787 ("[O]ur
participants frequently mentioned earnings restatements, insider
selling, and SEC investigations as highly significant in
determining settlement outcomes."); Choi et al., supra note 44,
at 43 (noting that a restatement, SEC investigation, or
enforcement action is "hard evidence" of fraud); Perino, supra
note 49, at 948 ("[S]cholars and courts often consider
allegations of accounting misrepresentations or unusual trading](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-192-320.jpg)
![by insiders during the class period as generally stronger, all
other things being equal, than allegations that a company's
forecasts or other predictive statements were fraudulently
made.").
57. For an example of a study that uses dismissal rates as a
measure of merit, see C.S. Agnes Cheng et al., Institutional
Monitoring Through Shareholder Litigation, 95 J. Fin. Econ.
356, 357-58 (2010).
58. See Joseph A. Grundfest, Why Disimply?, 108 Harv. L. Rev.
727, 740-41 (1995) ("[A] key statistic in the merits debate is the
difference between the observed settlement amount and the
amount a defendant would be willing to pay simply to avoid the
costs of mounting a defense.").
59. See, e.g., Choi, supra note 44 at 613-14 (using $2 million
threshold).
60. See, e.g., Cox et al., supra note 46, at 381 (using $3 million
threshold).
61. In addition to the $3 million threshold, I use higher
thresholds in some calculations. See infra Table 6.
62. See Baker & Griffith, supra note 24, at 791-96.
63. The Supreme Court has erected significant barriers to suits
against gatekeepers. The Central Bank case precluded aiding
and abetting liability during the period of this data set. See
Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver,
N.A., 511 U.S. 164, 191 (1994). The impact of the Court's](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-193-320.jpg)
![decision in Stoneridge, which was decided four years after the
last year of the data set, is likely limited with respect to this
study, though some of the later cases in the data set may have
been affected. See Stoneridge Inv. Partners, LLC v. Scientific-
Atlanta, Inc., 552 U.S. 148, 166-67 (2008).
64. See John C. Coffee, Jr., Reforming the Securities Class
Action: An Essay on Deterrence and Its Implementation, 106
Colum. L. Rev. 1534, 1551 (2006) ("The reality is that
corporate insiders are sued in order for the plaintiffs to gain
access to their insurance, but their personal liability appears not
to be seriously pursued.").
65. See, e.g., Stephen J. Choi et al., Do Institutions Matter? The
Impact of the Lead PlaintiffProvision of the Private Securities
Litigation Reform Act, 83 Wash. U. L.Q. 869, 892 (2005)
("[W]e consider one measure of the pre-filing strength of the
cases . . . the presence of an accounting restatement . . . . ");
Johnson et al., supra note 44, at 633-34 ("Some of the strongest
evidence to satisfy [the requirement of a material misstatement
or omission] . . . is a violation of generally accepted accounting
principles (GAAP) that results in an earnings restatement,
which is required only when earnings have been materially
misstated.").
66. Indeed, a restatement might also indicate that management
is conscientious about acknowledging mistakes. Ideally, a
distinction would be drawn between voluntary and involuntary](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-194-320.jpg)
![restatements, but it can be difficult to find data that makes such
a distinction.
67. See, e.g., Johnson et al., supra note 44, at 646-47
("[L]awsuits in the post-PSLRA period are significantly more
likely to result in a settlement if the firm restated class period
earnings."); Perino, supra note 45, at 382-83.
68. See 15 U.S.C. § 78u-4(b)(2) (2006).
69. See Pritchard & Sale, supra note 44, at 146.
70. This study focuses on public pension funds as lead plaintiffs
because private pension funds may not be as publicly minded as
public pension funds. When the study refers to a pension fund,
it is referring only to public pension funds. However, I also
estimated regressions using a broader definition of pension fund
that included private pension funds, and the results of the study
did not differ.
71. See, e.g., Choi et al., supra note 65; James D. Cox &
Randall S. Thomas, Does the PlaintiffMatter? An Empirical
Analysis of Lead Plaintiffs in Securities Class Actions, 106
Colum. L. Rev. 1587 (2006); Perino, supra note 45.
72. See Choi et al., supra note 65, at 892 ("These results . . .
suggest that public pensions tended to target both larger stakes
cases and those with stronger evidence of fraud.").
73. See id. at 896 ("[P]ension funds correlate with a
significantly greater outcome for the class in the post-PSLRA
period . . . . "); Cox & Thomas, supra note 71, at 1636 ("Our](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-195-320.jpg)
![the Enron and World- Com settlements) was approximately $40
million while the median settlement was approximately $6
million. The average size of settlement in settled cases
involving a bankrupt company (excluding the Enron and
WorldCom settlements) was approximately $21 million while
the median settlement was approximately $7 million. The
average size of settlement in settled cases involving a
nonbankrupt company was approximately $44 million while the
median settlement was approximately $6 million.
83. See, e.g., Baker & Griffith, supra note 36, at 1806 (citing
average D&O limits of $28.25 million for small-cap companies,
$64 million for midcap companies, and $157.69 million for
large-cap companies).
84. Some of these variables were not statistically significant in
all of the regressions. However, the pension fund variable was
consistently statistically significant for all regressions.
85. Choi, supra note 44, at 601 (discussing nonobvious indicia
of merit).
86. See, e.g., Stephen M. Bainbridge & G. Mitu Gulati, How Do
Judges Maximize? (The Same Way Everybody Else Does-
Boundedly): Rules of Thumb in Securities Fraud Opinions, 51
Emory L.J. 83, 87 (2002) ("[J]udges are using substantive
heuristics to dispose of securities cases at the motion to dismiss
stage."); Hillary A. Sale, Judging Heuristics, 35 U.C. Davis L.
Rev. 903, 946 (2002) ("[C]ourts are, consciously or](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-198-320.jpg)
![unconsciously, utilizing the heuristics to clear complex cases
that would otherwise remain on the dockets for lengthy periods
of time.").
87. Stephen Choi finds that nonnuisance claims without "hard
evidence" are more likely to be dismissed post-PSLRA. Choi,
supra note 44, at 598. Bankruptcy may be one setting in which
the PSLRA bias toward obvious indicators of fraud is not as
influential.
88. See, e.g., Rachlinski, supra note 15, at 602 ("[R]epeat
players might notice the tendency of biased judgments to raise
standards after the fact, as might judges. This could undermine
the perceived fairness of the system of civil liability.").
89. Shareholders only receive recovery after creditors are paid.
See 11 U.S.C. § 1129(a)(8)(A), (b)(2)(B)(ii) (2006).
90. See, e.g., James J. Park, Shareholder Compensation as
Dividend, 108 Mich. L. Rev. 323 (2009) (describing and
critiquing circularity problem).
91. Coffee, supra note 64. Another version of the circularity
problem states that because shareholders are diversified, they
are as likely to be winners as they are to be losers from
securities fraud. In some cases, investors buy stock inflated by
fraud but in others, they sell stock inflated by fraud. However,
if a company in an investor's portfolio goes bankrupt, it is more
difficult to offset such a loss with gains from securities fraud.
Because the universe of bankrupt companies is smaller than](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-199-320.jpg)
![securities class action. When bondholders recover
compensation, such payment is not a circular transfer. The
transfer is likely to come from a third party such as an
underwriter or auditor, or from D&O insurance that is funded by
the shareholders.
95. Denny v. Barber, 576 F.2d 465, 470 (2d. Cir. 1978)
(Friendly, J.) ("[T]he complaint is an example of alleging fraud
by hindsight."); see also DiLeo v. Ernst & Young, 901 F.2d 624,
627-28 (7th Cir. 1990) (Easterbrook, J.) (applying the fraud-by-
hindsight doctrine and noting that "[b]ecause only a fraction of
financial deteriorations reflects fraud, plaintiffs may not proffer
the different financial statements and rest").
96. See DiLeo, 901 F.2d at 627-28 (dismissing a complaint
under the fraud-byhindsight doctrine because it alleged "nothing
other than the change in the stated condition of the firm"). One
group of commentators describes the fraud-by-hindsight
doctrine as "another way of saying that plaintiffs must have
more in their complaints than just backward induction from the
fact that a problem subsequently surfaced-there have to be facts
showing awareness at the time of the fraud." Gulati et al., supra
note 15, at 820.
97. E.g., Rachlinski, supra note 15, at 617 ("The 'fraud by
hindsight' doctrine guards only against a severe abuse of the
hindsight bias; it does not entirely purge the system of the bias's
influence.").](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-201-320.jpg)
![98. It is interesting that hindsight bias does not appear to affect
the SEC and pension fund lead plaintiffs. The SEC does not
investigate cases involving bankrupt companies at rates greater
than it investigates cases involving nonbankrupt companies.
Pension funds do not appear as lead plaintiffs at higher rates in
bankruptcy cases. On the other hand, perhaps the SEC and
pension funds are more sophisticated in assessing securities
fraud than generalist judges.
99. As noted earlier, in 54 out of the 234 bankruptcy cases (23
percent), the bankruptcy filing occurred before the filing of the
complaint, and in 180 out of the 234 bankruptcy cases (77
percent), the bankruptcy filing occurred after the filing of the
complaint. I estimated regressions where the bankruptcy
variable was defined as including only the cases where the
bankruptcy occurred prior to the complaint. In those
regressions, the bankruptcy variable was not statistically
significant. On the other hand, when I estimated regressions
using only the cases where the bankruptcy filing occurred after
the filing of the complaint, the bankruptcy variable retained its
statistical significance.
100. See 11 U.S.C. § 1141(d)(1)(A) (2006) ("[T]he confirmation
of a plan . . . discharges the debtor from any debt that arose
before the date of such confirmation . . . ."). Equity holders
often receive little to no distribution under a chapter 11 plan.
See, e.g., Ayotte & Morrison, supra note 31, at 522. Civil](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-202-320.jpg)
![actions by equity holders against a chapter 11 debtor for
securities fraud will generally be treated as equity claims. See
11 U.S.C. § 510(b) (subordinating claims "arising from the
purchase or sale of such a security" to the priority of
distribution associated with that security). Thus, the prospect of
recovery for such claimants is low.
101. E.g., M. Todd Henderson, Paying CEOs in Bankruptcy:
Executive Compensation when Agency Costs Are Low, 101 Nw.
U. L. Rev. 1543, 1596 (2007) (finding that 60 percent of CEOs
are replaced in the zone of insolvency); Lynn M. LoPucki &
William C. Whitford, Corporate Governance in the Bankruptcy
Reorganization of Large, Publicly Held Companies, 141 U. Pa.
L. Rev. 669, 729 (1993) (finding that 95 percent of CEOs
leftoffice before or during reorganization).
102. There is some evidence that managers do not suffer a
reputational penalty for being the subjects of a securities class
action. Eric Helland, Reputational Penalties and the Merits of
Class-Action Securities Litigation, 49 J. L. & Econ. 365 (2006).
103. Baker and Griffith find through interviews of participants
in securities litigation "that defendants filed a motion to dismiss
in every case with which [the participants] were familiar."
Baker & Griffith, supra note 24, at 775.
104. Most of the third-party settlements involving bankrupt
companies involve complaints that only allege Rule 10b-5
claims. In thirty-two of the fifty-six (57 percent) third-party](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-203-320.jpg)
![their reputational capital by knowingly acquiescing to their
clients' securities frauds. In concluding that the current state of
securities law does not provide the market with enough
incentive to demand that gatekeepers invest in and maintain
their reputations, this Note argues that Congress must restore
the right of private plaintiffs to bring aiding and abetting claims
under 10b-5.
Introduction
It is perhaps dismaying that participants in a fraudulent scheme
who may even have committed criminal acts are not answerable
in damages to the victims of [their] fraud .... However, ... the
fact that the plaintiff-investors have no claim is the result of a
policy choice by Congress .... This choice may be ripe for
legislative re examination.1
This quotation from Judge Gerald Lynch of the Southern
District of New York neatly sums up the state of securities law
today and its treatment of aiding and abetting liability for the
securities industry's gatekeepers-accountants, lawyers,
securities analysts, and credit-rating agencies.2 Judge Lynch
made these remarks in In re Refco, Inc. Securities Litigation in
which a lawyer, Joseph Collins, a partner at the law firm of
Mayer Brown LLP, was alleged to have knowingly helped his
client, Refco, fraudulently conceal its massive debts from its
shareholders through an elaborate financial scheme.3 While Mr.
Collins was later found to be criminally liable for his actions,4](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-208-320.jpg)
![Securities Laws
In response to the stock market crash of 1929 and the
subsequent Great Depression, Congress enacted The Securities
Act of 1933 ("the '33 Act") and the Securities Exchange Act of
1934 ("the '34 Act).29 The '33 Act established registration
requirements for securities issued on the primary market.30 The
'34 Act provided for the regulation of securities trading,
exchanges, and broker-dealers, and it established the Securities
and Exchange Commission ("SEC").31 The four most important
provisions for the imposition of liability upon gatekeepers for
securities violations are Sections 11, 12(a)(1), and 12(a)(2) of
the '33 Act, and Section 10(b) under the '34 Act.32
A. The Securities Act of 1933
1. Section 11
Section 11 of the '33 Act imposes strict liability on issuers for
any material misstatement or omission in a registration
statement.33 It also provides an express private right of action
against "every accountant, engineer, or appraiser, or any person
whose profession gives authority to a statement made by him,
who has with his consent been named as having prepared or
certified any part of [such] registration statement. . . ,"34
Through this provision, Congress arguably recognized a
deterrence role for the gatekeeping professions in preventing
the filing of materially false or misleading registration
statements.35 However, Section 11 also provides a due](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-212-320.jpg)
![diligence defense for gatekeepers which can relieve them of
liability if the defense is properly established.36 So while
Section 11 is a strict liability regime for issuers, it is only a
fault-based liability regime for gatekeepers.37
Furthermore, the courts will find gatekeepers liable under
Section 11 only in very specific circumstances.38 In McFarland
v. Memorex Corp., the district court held that "there is no
accountant liability unless . . . misleading data [certified by the
accountant in the registration statement] can be expressly
attributed to the accountant."39 Therefore, Section 11 liability
will not apply to an accountant unless she is an auditor or has
otherwise lent her name to a registration statement.40
Similarly, attorneys who help prepare a registration statement
generally cannot be held liable under Section 11 unless they act
as "experts"41 or if they also serve as directors or officers of
the company.42 A non-director, non-officer attorney is an
"expert" within Section 11's statutory meaning only if she
"expertises" a portion of the registration statement, usually by
providing a legal opinion that is included within the
statement.43
2. Section 12(a)(1)
Section 12(a)(1) of the '33 Act provides that "[a]ny person who
... offers or sells a security in violation of [Section 544]... shall
be liable .. . to the person purchasing such security from him . .
. ,"45 This provision makes available an express private right of](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-213-320.jpg)
![action for a purchaser against a seller of securities found to be
in violation of Section 5.46 In effect, Section 12(a)(1) was
designed to enforce the registration requirements of Section
5.47
In Pinter v. Dahl, the Supreme Court held that "'seller' is not
limited to an owner who passes title ... but extends to a broker
or other person who successfully solicits a purchase of
securities, so long as he is motivated at least in part by a desire
to serve his own financial interests or those of the securities
owner."48 So, theoretically, a gatekeeper as agent for the
securities owner could be held liable under Section 12(a)(1) so
long as she solicits the purchase of a security that is in violation
of Section 5.49 However, on its face, Section 12(a)(1) imposes
a privity requirement, and the Pinter Court recognized such in
its opinion.50 Thus, the mere participation by a gatekeeper in
the preparation of a registration statement is not enough to
trigger liability under Section 12(a)(1).5' Indeed, even the
substantial involvement in such preparation will not create
liability unless the gatekeeper is also actively involved in the
negotiations leading to the sale in question.52 Damages under
Section 12(a) are limited to "the consideration paid for [the]
security with interest thereon, less the amount of any income
received thereon."53
3. Section 12(a)(2)
Section 12(a)(2) of the '33 Act imposes the same level of](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-214-320.jpg)
![liability as 12(a)(1) for those who offer or sell securities and, in
doing so, make omissions or untrue statements of material fact
in prospectuses or oral communications.54 Just as in actions
under 12(a)(1), gatekeepers must also be "sellers" under §
12(a)(2) in order to be found liable.55 Section 12(a)(2) is
viewed as a strict liability provision,56 and unlike fraud claims
under Rule 1 Ob-5,57 it is not necessary for the plaintiff to
show either his or her own reliance or scienter on the part of the
defendant.58 However, Section 12(a)(2) also offers defendants
an affirmative defense if they can "sustain the burden of proof
that [they] did not know, and in the exercise of reasonable care
could not have known, of [the] untruth or omission."59
"Reasonable care" connotes negligence liability for gatekeeper
sellers facing an action under § 12(a)(2).60 Such gatekeepers
will be held liable unless they can show that their actions were
reasonable, not just without recklessness or intent.61
B. The Securities Exchange Act of 1934 - Section 10(b) and
Rule 10b-5
As can be seen, the '33 Act provides liability for gatekeepers
only under specific limited circumstances.62 Gatekeepers have
liability under the '33 Act (1) where the gatekeeper has made
false statements in a registration statement that can be
attributed to her, and (2) where the gatekeeper is an active
seller of a security and the security is either unregistered and
nonexempt, or the gatekeeper has made material misstatements](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-215-320.jpg)
![or omissions in oral communications or in the security's
prospectus.63 Gatekeepers who commit securities fraud outside
of these circumstances are most often subject to liability under
Section 10(b) of the '34 Act.64.
Section 10(b) makes it "unlawful for any person, directly or
indirectly, . . . [t]o use or employ, in connection with the
purchase or sale of any security . . . any manipulative or
deceptive device or contrivance in contravention of such rules
and regulations as the Commission may prescribe . . . ."65 In
1942, the SEC promulgated Rule 10b-5 pursuant to its statutory
authority under 10(b).66 Rule 10b-5 makes it unlawful through
the use of an instrumentality or interstate commerce:
(a) [t]o employ any device, scheme, or artifice to defraud, (b)
[t]o make any untrue statement of a material fact or to omit to
state a material fact necessary in order to make the statements
made, in the light of the circumstances under which they were
made, not misleading, or (c) [t]o engage in any act, practice, or
course of business which operates or would operate as a fraud
or deceit upon any person, in connection with the purchase or
sale of any security.67
The language of Rule 10b-5 has been described as open-ended
and adaptable, allowing it to reach a wide variety of fraudulent
schemes.68
1. Primary vs. Secondary Liability
Generally, most securities violations have multiple participants,](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-216-320.jpg)
![the plaintiffs' claims, the Supreme Court granted certiorari "to
address whether JCM can be held liable in a private action
under Rule 10b-5 for false statements included in Janus
Investment Fund's prospectuses."152 The Court stated that
"[u]nder Rule 10b-5, it is unlawful for 'any person, directly or
indirectly,... [t]o make any untrue statement of a material fact'
in connection with the purchase or sale of securities, [citation
omitted.]."153 To be liable, therefore, the Court said that JCM
must have "made" the material misstatements in the
prospectuses."154
The Court held that JCM, even though it administered the fund
and prepared the prospectuses, did not "make" the statements
within them that the plaintiffs alleged were false.155 The Court
ruled that for claims under Rule 10b-5 alleging that a person
made false statements, the "maker" of a statement "is the person
or entity with ultimate authority over the statement, including
its content and whether and how to communicate it."156 The
Court further stated that "[o]ne who prepares or publishes a
statement on behalf of another is not its maker."157 The Court
analogized its rule tothe relationship between a speaker and a
speechwriter: "[e]ven when a speechwriter drafts a speech, the
content is entirely within the control of the person who delivers
it[, a]nd it is the speaker who takes credit-or blame-for what is
ultimately said."158 In a footnote, the Court explained that it
was drawing](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-226-320.jpg)
![a clean line between [those who are primarily liable (and thus
may be pursued in private suits) and those who are secondarily
liable (and thus may not be pursued in private suits)]-the maker
is the person or entity with ultimate authority over a statement
and others are . 159 not.
Thus, to be held primarily liable under Rule 10b-5 for a
materially false or misleading statement, a gatekeeper must
have "ultimate authority" over that statement.160
C. SARBANES-OXLEY AND DODD-FRANK
Two recent major pieces of legislation have attempted to
increase liability for and regulation of gatekeepers. This
subsection examines them.
1. Sarbanes-Oxley
Congress passed the Sarbanes-Oxley Act of 2002 in response to
the waves of massive corporate accounting scandals from that
time period such as Enron and WorldCom.161 The purpose of
the legislation was to redesign the network of institutions and
intermediaries that served investors in the capital markets in
order to reduce deception and fraud.162
Sarbanes-Oxley created the Public Company Accounting
Oversight Board (PCAOB).163 The PCAOB is charged with
establishing quality control, auditing, and independence
standards for accountants that perform auditing services for
public companies.164 It is also charged with inspecting
registered public accounting firms and establishing disciplinary](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-227-320.jpg)
![owes ultimate allegiance to the corporation's creditors and
stockholders, as well as to investing public."); DiLeo v. Ernst &
Young, 901 F.2d 624, 629 (7th Cir. 1990) ("An accountant's
greatest asset is its reputation for honesty, followed closely by
its reputation for careful work.").
Footnote
12. Jonathan Macey, The Value of Reputation in Corporate
Finance and Investment Banking (and the Related Roles of
Regulation and Market Efficiency), 22 J. Applied Corp. Fin. 18,
18 (Fall 2010), available at http://ssm.com/abstract= 1733798.
13. Jonathan Macey, The Demise of the Reputational Model in
Capital Markets: The Problem of the "Last Period Parasites", 60
Syracuse L. Rev. 427, 436 (2010) [hereinafter Demise of the
Reputational Model].
14. Coffee, supra note 2, at 9.
15. See Macey, supra note 12, at 19.
16. See Coffee, supra note 2, at 4 (noting that "reputational
intermediaries face losses that exceed the likely one-time gain
from acquiescence in fraud ... ").
17. See generally In re Refco, Inc. Sec. Litig., 609 F. Supp. 2d
304 (S.D.N.Y. 2009), aff'd sub nom. Pac. Inv. Mgmt. Co. LLC
v. Mayer Brown LLP, 603 F.3d 144 (2d Cir. 2010) (lawyers
helped to fraudulently conceal massive company debt); In re
Enron Corp. Sec., Derivative & "ERISA" Litig., 439 F. Supp. 2d
692 (S.D. Tex. 2006) (accountants helped to fraudulently](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-245-320.jpg)
![conceal debt and create the appearance that Enron was healthy);
In re WorldCom, Inc. Sec. Litig., 352 F. Supp. 2d 472, 480
(S.D.N.Y. 2005) (auditors aided fraud by certifying company's
fraudulent financial statements).
18. See Mark Klock, Improving the Culture of Ethical Behavior
in the Financial Sector: Time to Expressly Provide for Private
Enforcement Against Aiders and Abettors of Securities Fraud,
116 Penn St. L. Rev. 437, 467 (2011) (lamenting that without a
private right of action, only the SEC can enforce aiding and
abetting liability, but the SEC cannot pursue all such cases).
Footnote
19. Cent. Bank of Denver v. First Interstate Bank of Denver,
511 U.S. 164, 191 (1994).
20. Pub. L. No. 104-67, 109 Stat. 737 (codified as amended in
scattered sections of 15 U.S.C.).
21. See id. § 104 (codified as amended at 15 U.S.C. § 78t(e)
(2012)).
22. See, e.g., United States General Accounting Office, GAO-
03-138, Report to the Chairman, Committee on Banking,
Housing, and Urban Affairs, U.S. Senate, Financial Statement
Restatements: Trends, Market Impacts, Regulatory Responses
and Remaining Challenges, 6 (October 2002), available at
http://www.gao.gov/new.items/d03138.pdf (last accessed Nov.
28, 2014) [hereinafter GAO Study],
23. Coffee, supra note 2, at 317.](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-246-320.jpg)
![24. See generally Coffee, supra note 2; Macey, supra note 12;
Demise of the Reputational Model, supra note 13; Frank
Partnoy, Barbarians at the Gatekeepers?: A Proposal for A
Modified Strict Liability Regime, 79 Wash. U. L.Q. 491 (2001)
(elaborating on the theory of reputational capital and how the
theory helps to explain why gatekeepers would aid and abet
fraud).
25. Coffee, supra note 2, at 3.
26. See infra Part II.
27. See John C. Coffee, Gatekeeper Failure and Reform: The
Challenge of Fashioning Relevant Reforms, 84 B.U. L. Rev.
301, 337 (2004) [hereinafter Gatekeeper Failure].
Footnote
28. See Klock, supra note 18, at 493 (calling for the same action
by Congress).
29. Erin L. Massey, Control Person Liability Under Section
20(a): Striking A Balance of Interests for Plaintiffs and
Defendants, 6 Hous. Bus. & Tax L.J. 109, 11112 (2005).
30. Thomas L. Hazen, The Law of Securities Regulation §
1.2[3][A] (6th ed. 2009).
31. Id. § 1.2[3][B],
32. Carsten Gemer-Beuerle, The Market for Securities and Its
Regulation Through Gatekeepers, 23 Temp. Int'l&Comp. L.J.
317, 333 (2009).
Footnote](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-247-320.jpg)
![33. 15 U.S.C. § 77k(a)(l) (2012).
34. Id. § 77k(a)(4).
35. See Shuenn (Patrick) Ho, A Missed Opportunity for "Wall
Street Reform Secondary Liability for Securities Fraud After
the Dodd-Frankact, 49 HARV. J. ON LEGIS. 175, 184 (2012)
("In the past, Congress has recognized that gatekeepers are
uniquely placed to detect and block fraudulent transactions and
explicitly adopted a strategy of imposing civil liability on
gatekeepers such as accountants and appraisers to deter the
filing of false securities registration statements.") (citing 15
U.S.C. § 77k(a)(l)(4)).
36. 15 U.S.C. §77k(b)(3).
37. Tuch, supra note 10, at 1636.
38. See, e.g., Herman & MacLean v. Huddleston, 459 U.S. 375,
386 n.22 (1983); McFarland v. Memorex Corp., 493 F. Supp.
631, 643 (N.D. Cal. 1980) (holding that "there is no accountant
liability unless . . . misleading data can be expressly attributed
to the accountant"); Escott v. BarChris Const. Corp., 283 F.
Supp. 643, 683 (S.D.N.Y. 1968) (attorneys who help prepare a
registration statement generally cannot be held liable under
Section 11 unless they act as "experts").
39. McFarland, 493 F. Supp. at 643.
Footnote
40. Hazen, supra note 30, § 7.3[10].
41. Huddleston, 459 U.S. at 386 n.22.](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-248-320.jpg)
![42. Hazen, supra note 30, § 7.3[ 10].
43. Ben D. Orlanski, Whose Representations Are These
Anyway? Attorney Prospectus Liability After Central Bank, 42
UCLA L. Rev. 885, 904 (1995); see also BarChris, 283 F. Supp.
at 683 ("To say that the entire registration statement is
expertised because some lawyer prepared it would be an
unreasonable construction of the statute.").
44. Section 5 of the '33 Act provides that all securities not
exempted from doing so by other provisions in the Act must be
registered. 15 U.S.C. § 77e(c) (2012).
45. 15 U.S.C. § 771(a)(1).
46. Id.; see also Hazen, supra note 30, § 7.2[ 1 ].
47. Hazen, supra note 30, § 7.2[1],
48. Pinter v. Dahl, 486 U.S. 622, 623 ( 1988).
Footnote
49. See id.
50. See id. at 642 ("At the very least... the language of §
12[(a)](l) contemplates a buyer-seller relationship not unlike
traditional contractual privity.").
51. Hazen, supra note 30, § 7.2[2].
52. See In re DDi Corp. Sec. Litig., No. CV 03-7063, 2005 WL
3090882, at *18 (C.D. Cal. July 21, 2005); see also Junker v.
Crory, 650 F.2d 1349, 1360 (5th Cir. 1981) (holding an attorney
to be "an active negotiator in the transaction" and liable under
Section 12(a)(1)).](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-249-320.jpg)
![57. See infra Part II.B.
58. Hazen, supra note 30, § 7.6[1]; see also Wright, 953 F.2d at
262 ("... reliance on alleged misrepresentations or omissions is
not an element of a section 12[(a)](2) cause of action.").
59. 15 U.S.C. § 771(a)(2). In 2005, the SEC promulgated a rule
clarifying that the "know, and . . . could not have known"
language of § 12(a)(2) means "knowing at the time of sale." 17
C.F.R. § 230.159(c).
60. 15 U.S.C. § 771(a)(2); see also Partnoy, supra note 24, at
515 (". . . § 12(a)(2) imposes negligence liability on issuers and
gatekeepers selling a security using a prospectus (or oral
statement) that is false or misleading ....").
61. Partnoy, supra note 24, at 515.
62. See supra Part I.A.
63. See infra Part II.A.
64. Cf. John C. Coffee, Jr., Partnoy 's Complaint: A Response,
84 B.U. L. Rev. 377, 378 (2004) (". . . most securities class
actions are brought . . . with respect to the secondary market
(where scienter must be proven before the issuer can be held
liable under Rule 10b-5)."); Assaf Hamdani, Gatekeeper
Liability, 77 S. Cal. L. Rev. 53, 62 (2003) ("The general
prohibition on fraud under Rule 10b-5 covers an unlimited
number of transactions and an undefined range of capital-market
participants."); Evaluating S. 1551: The Liability for Aiding and
Abetting Securities Violations Act of 2009: Hearing Before the](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-251-320.jpg)
![Subcomm. on Crime and Drugs of the S. Comm, on the
Judiciary, 111th Cong. 2-4 (2009) (testimony of Professor John
C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia
University Law School) (commenting that most fraud by
gatekeepers will go undetected if the private right of action for
aiding and abetting liability under § 10(b) is not restored)
[hereinafter Hearing on S. 1551],
Footnote
65. 15 U.S.C. § 78j(2)(b). Section 10(b) is often described as a
"catchall" provision. See, e.g., Chiarella v. United States, 445
U.S. 222, 234-35 (1980) ("Section 10(b) is aptly described as a
catchall provision, but what it catches must be fraud.").
66. James D. Cox et al., Securities Regulation Cases and
Materials 695 (7th ed. 2013).
67. 17 C.F.R. § 240.10b-5 (2015).
68. See Donald C. Langevoort, Rule I Ob-5 As an Adaptive
Organism, 61 Fordham L. Rev. S7, S19-S21 (1993) (describing
the benefits of the ambiguity of Rule 10b-5's language).
Footnote
69. Cox ET al., supra note 66, at 795.
70. Id.
71. Id. (italics in the original).
72. See Janus Capital Grp., Inc. v. First Derivative Traders, 131
S. Ct. 2296, 2301 n.3 (2011).
73. Cent. Bank of Denver v. First Interstate Bank of Denver,](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-252-320.jpg)
![511 U.S. 164, 191 (1994).
74. See Cox et al., supra note 66, at 795 (listing secondary
violators as "lawyers, accountants, and banks, to mention just a
few . . . ."); see also Ho, supra note 35, at 183-84 (discussing
the rationale for extending secondary liability to gatekeepers
such as "auditors, credit rating agencies, investment bankers,
and lawyers ... ").
75. Cox ET AL., supra note 66, at 796.
76. See infra Part II.B.2.C.
77. See, e.g., SEC v. Timetrust, Inc., 28 F. Supp. 34, 43 (N.D.
Cal. 1939) (permitting aiding and abetting due to the precedent
set in criminal cases).
Footnote
78. William H. Kuehnle, Secondary Liability Under the Federal
Securities LawsAiding and Abetting Conspiracy, Controlling
Person, and Agency: Common-Law Principles and the Statutory
Scheme, 14 J. Corp. L. 313, 321-22 (1989) ("Although aiding
and abetting liability generally is not provided expressly for
under the federal securities laws, courts almost universally have
been willing to infer joint tortfeasor liability for aiding and
abetting, utilizing the statement of liability in section 876(b) of
the Restatement.") (internal citations omitted). Restatement
(Second) of Torts § 876 (1979) provides that "[f]or harm
resulting to a third person from the tortious conduct of another,
one is subject to liability if he ... knows that the other's conduct](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-253-320.jpg)
![constitutes a breach of duty and gives substantial assistance or
encouragement to the other so to conduct himself...."
79. Brennan v. Midwestern United Life Ins. Co., 259 F. Supp.
673, 680-81 (N.D. Ind. 1966).
80. Id.
81. The Dodd-Frank Act added the words "or recklessly" after
the word "knowingly" in § 20(e) of the '34 Act. See infra note
181.
82. See 15 U.S.C. § 78t(e) (2012).
83. Kuehnle, supra note 78, at 322 (citing cases articulating
various formulations of the three elements).
84. Ronald J. Colombo, Cooperation with Securities Fraud, 61
Ala. L. Rev. 61, 67 (2009).
Footnote
85. Kardon v. Nat'l Gypsum Co., 69 F. Supp. 512, 513-14 (E.D.
Pa. 1946).
86. Id. at 513.
87. Id. at 514.
88. 404 U.S. 6, 13 n.9 (1971) ("It is now established that a
private right of action is implied under § 10(b).").
89. See Cox ET AL., supra note 66, at 796 ("For three decades
[before Central Bank in 1994], accountants, lawyers,
underwriters, banks, and others were routinely held liable under
Section 10(b) and Rule 10b-5 of the ['34 Act] on the ground
[that] they had aided and abetted their client's violation.").](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-254-320.jpg)
![90. See, e.g., Blue Chip Stamps v. Manor Drug Stores, 421 U.S.
723, 754-55 (1975) (discussed herein); Emst & Emst v.
Hochfelder, 425 U.S. 185, 187-88 (1976) (discussed herein).
91. See Corr. Servs. Corp. v. Malesko, 534 U.S. 61, 67 (2001)
(". . . we have retreated from our previous willingness to imply
a cause of action where Congress has not provided one .... Just
last Term it was noted that we 'abandoned' the view of Borak
decades ago, and have repeatedly declined to 'revert' to 'the
understanding of private causes of action that held sway 40
years ago.'" (quoting Alexander v. Sandoval, 532 U.S. 275, 287
(2001))).
92. Blue Chip Stamps, 421 U.S. at 754-55.
Footnote
93. See id. at 737 ("... it would be disingenuous to suggest that
either Congress in 1934 or the Securities and Exchange
Commission in 1942 foreordained the present state of the law
with respect to Rule 10b-5. It is therefore proper that we
consider . . . what may be described as policy considerations
when we come to flesh out the portions of the law with respect
to which neither the congressional enactment nor the
administrative regulations offer conclusive guidance.").
Rehnquist also stated that "[w]hen we deal with private actions
under Rule 10b-5, we deal with a judicial oak which has grown
from little more than a legislative acorn." Id.
94. Ernst & Ernst, 425 U.S. at 187-88.](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-255-320.jpg)
![95. Id. at 188-90.
96. Id. at 191 n.7. Six years later, the Court had another chance
to reach the question but again declined to do so. See Herman &
MacLean v. Huddleston, 459 U.S. 375,379 n.5 (1983).
97. See Cent. Bank of Denver v. First Interstate Bank of
Denver, 511 U.S. 164, 191 (1994) (discussed herein).
98. Hazen, supra note 30, § 7.13[1][A],
99. Cox ET AL., supra note 66, at 796.
100. Hazen, supra note 30, § 7.13[1][A],
101. Cent. Bank of Denver, 511 U.S. at 191.
Footnote
102. Id. at 191.
103. See supra Part LB.2.
104. Santa Fe Indus, Inc. v. Green, 430 U.S. 462,477 (1977).
105. Cent. Bank of Denver, 511 U.S. at 169.
106. Id. at 173.
107. Id.
108. See id. at 192 (reasoning that the text of section 10(b)
itself does not prohibit aiding and abetting).
109. Matthew P. Wynne, Rule I0b-5(b) Enforcement Actions in
Light of Janus: Making the Case for Agency Deference, 81
FORDHAM L. Rev. 2111, 2120 (2013).
110. Pub. L. No. 104-67, 109 Stat. 737 (codified as amended in
scattered sections of 15 U.S.C.).
111. Id. § 104 (codifiedas amended at 15 U.S.C. § 78t(f)](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-256-320.jpg)
![(2012)).
112. Wynne, supra note 109, at 2120.
113. Klock, supra note 18, at 467.
Footnote
114. 15 U.S.C. § 78u-4(b)(2)(A); see also Elizabeth Cosenza, Is
the Third Time the Charm? Janus and the Proper Balance
Between Primary and Secondary Actor Liability Under Section
10(b), 33 Cardozo L. Rev. 1019, 1029-30 (2012) (PSLRA was
enacted in 1995 and included "a heightened pleading standard
for allegations of scienter in section 10(b) cases."). The
accounting industry lobbied aggressively for the passage of the
PSLRA. See Coffee, supra note 2, at 363.
115. See Coffee, supra note 2, at 337.
116. Cosenza, supra note 114, at 1030.
117. Private Securities Litigation Reform Act of 1995, Pub. L.
No. 104-67 § 201, 109 Stat. at 758-62.
118. Office of the Gen. Counsel, U.S. Sec. & Exch. Comm'n,
Report to the President and the Congress on the first Year of
Practice Under the Private Securities Litigation Reform Act of
1995, at 2, 73 (1997), available at http://www.
sec.gov/news/studies/lreform.txt [hereinafter SEC Study].
119. Id. at 1.
120. "The Big Six firms were Arthur Andersen LLP, Deloitte
&Touche LLP, Ernst & Young LLP, KPMG LLP, Price
Waterhouse, and Coopers Lybrand." Coffee, supra note 2, at 73](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-257-320.jpg)
![MJW, 2012 WL 4955244 (D. Colo. Oct. 17, 2012) ("Under
Janus, an attorney who prepares a false statement to be
disseminated to investors can be liable for the contents of that
statement if the attorney has the ultimate authority over the
contents and dissemination of the statement, but not where the
attorney is simply preparing the statement at the direction of a
client who is controlling the contents of that statement.").
161. Coffee, supra note 2, at 16.
162. Id.
163. Sarbanes-Oxley Act of 2002, Pub. Law 107-204 § 101, 116
Stat. 745, 750 (2002) (codified at 15 U.S.C. § 7211(a) (2012)).
164. Id. § 103, 116 Stat. at 755 (codified as 15 U.S.C. § 7213).
165. Id. §§ 104-105, 116 Stat. at 757-759 (codified as 15 U.S.C.
§§ 7214-7215).
Footnote
166. Id. § 102(a), 116 Stat. at 753 (codified at 15 U.S.C. §
7212(a)).
167. Celia R. Taylor, Breaking the Bank: Reconsidering Central
Bank of Denver After Enron and Sarbanes-Oxley, 71 Mo. L.
Rev. 367, 381 (2006).
168. See, e.g., William W. Bratton, Enron, Sarbanes-Oxley and
Accounting: Rules Versus Principles Versus Rents, 48 VlLL. L.
REV. 1023, 1032 (2003) (discussing the PCAOB, "[t]he agency
delegation model works well only so long as the agency
successfully resists capture by the interests of the actors it](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-261-320.jpg)
![U.S.C. § 78j- 1(b).
178. 17C.F.R. §201.102(e)(iv).
179. Gatekeeper Failure, supra note 27, at 336 (noting that
Sarbanes-Oxley does nothing to increase the deterrent threat for
gatekeepers).
180. Helene Cooper, Obama Signs Overhaul of Financial
System, N.Y. TIMES, July 22, 2010, at B3, available at
http://www.nytimes.com.ezproxy.nu.edu/2010/07/22/business/
22regulate.html?_r=0&pagewanted=print.
181. Dodd-Frank Wall Street Reform and Consumer Protection
Act, Pub. Law 111203, § 9290, 124 Stat. 1376, 1861 (codified
at 15 U.S.C. § 78t(e)) [hereinafter DoddFrank],
182. Tuch, supra note 10, at 1655.
183. See infra notes 186-87.
184. Dodd-Frank § 933(b), 124 Stat. 1883 (codified at 15 U.S.C.
§ 78u-4(b)(2)(B)).
Footnote
185. Id. § 933(a), 124 Stat. 1872 (codified at 15 U.S.C. § 78o-
7).
186. See id. § 929Z (instructing the GAO to "conduct a study on
the impact of authorizing a private right of action against any
person who aids or abets another person in violation of the
securities laws").
187. See Macey, supra note 12, at 18.
188. Coffee, supra note 2, at 3.](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-263-320.jpg)
![280. See supra Part Il.B.2.d.
281. See supra Part II.D.
282. See Coffee, supra note 2, at 16.
283. See generally In re Refco, Inc. Sec. Litig., 609 F. Supp. 2d
304 (S.D.N.Y. 2009) (fraud occurred after Sarbanes-Oxley was
enacted), aff'd sub nom. Pac. Inv. Mgmt. Co. LLC v. Mayer
Brown LLP, 603 F.3d 144 (2d Cir. 2010); see also Macey, supra
note 12, at 19 (credit ratings agencies gave overly favorable
ratings to the securities of high fee-paying clients in the period
after Sarbanes-Oxley was enacted).
284. See Coffee, supra note 2, at 78.
Footnote
285. See 15 U.S.C. §§ 7214-7215; HAZEN, supra note 30, §
1.4[6],
286. See supra Part II.D.
287. Cf. In re Refco, 609 F. Supp. 2d at 319 n.15 ("It is perhaps
dismaying that participants in a fraudulent scheme who may
even have committed criminal acts are not answerable in
damages to the victims of [their] fraud ....").
288. Tuch, supra note 10, at 1608-09.
289. See Klock, supra note 18, at 467.
290. See supra Part I.B.
291. See supra Parts I.B.2.e-f.
AuthorAffiliation
Daniel R. Tibbets, CAIA*](https://image.slidesharecdn.com/courseoutline-221113075208-aa306817/85/course-outline-docPHONEI-prefer-to-be-contacted-via-ema-docx-271-320.jpg)
course outline.docPHONEI prefer to be contacted via ema.docx
- 1. course outline.doc PHONE: I prefer to be contacted via email. TEXT:Rittenberg, Johnstone, and Gramling, Auditing – A Business Risk Approach, 9th edition PLEASE DO NOT PURCHASE THE INTERNATIONAL EDITION COURSE DESCRIPTION: This course is the second in a two course sequence. It contains lectures on auditing procedures (compliance and substantive) for cash, receivables, inventory, payables, long-term debt, equity balances and related income statement accounts. Topics also include writing of auditor's reports, including special reports, and review/compilation reports in accordance with AICPA standards. LEARNING OUTCOMES: Upon successful completion of this course, students will be able to: 1. Assess and resolve deficiencies that may be present in financial statement audit reports and other types of reports commonly prepared by CPAs. 2. Analyze one or more cases that involve the evaluation of
- 2. internal control 3. Analyze one or more cases that involve risk assessment and resolution of client issues. 4. Analyze one or more cases that involve accounting fraud, litigation and auditor liability. 5. Analyze one or more cases that involve the assessment of information technology controls. 6. Research a topic related to the audit of financial statements or management fraud relating to financial reporting, and writes a paper with appropriate content and format. D. RESEARCH PAPER ( CLO 6) due on or before Saturday of the 4th week, 11:00 PM PT During week one each student is to notifiy me as to their chosen topic. Your topic should be related to an integrated audit of financial statements with respect to management fraud. Please find a true life case where management fraud actually existed and report on it utilizing at least 15 resourses dealing with the issues in your paper. This assignment requires the use of the Library/Internet research to locate and study reference materials, preferably journal articles. The paper should be APA 6th edition style, minimum 1,500 words,12 pt. font, double spaced, Times New Roman) . The objective of this activity is for you to be aware of what is happening in the real world that relates to auditing and to practice your writng skills and make the study of auditing more meaningful. Post the assignment under the RESEARCH PAPER Assignment Link as a Word Doc. attachment. You may call the library for assistance in locating articles for your references. Wikipedia is not an acceptable article reference—not reliable. PLEASE LOOK UNDER “COURSE RESOURCES” to find Research Paper Guidelines in Bb. OTHER COURSE REQUIREMENTS AND INFORMATION: PROFESSIONAL ASSOCIATIONS: American Institute of CPA’s
- 3. Institute of Internal Auditors California State Society of CPA’s (CALCPA.org) Institute of Management Accountants WEB SITES: Directory of acctg. Web site resources: http://www.rutgers.edu/accounting/raw Financial Accounting Standards Board (FASB): http://www.fasb.org Government Accounting Standards Board (GASB): http://www.gasb.org American Institute of CPA’s (AICPA): http://www.aicpa.org Institute of Management Accountants (IMA) http://www.imanet.org Financial information on public companies: http://www.sec.gov/edgar Federal tax code research: http://www.tns.lcs.mit.edu:80/uscode/ NU Library System: http://www.nu.edu/library Annual Reports:
- 4. http://reportgallery.com http://www.bloomberg.com Financial Analysis: http://marketguide.com PAGE 1 Research Paper Guidelines.docx Research Paper Guidelines Paper is to address the following in good writing format. Use this as an outline. Separate these things into paragraphs in the paper. Write a conclusion. 1)Introduce the company where the fraud occurred. Give the background and where the company is place in the world. 2)Who are the players? Who committed the fraud, how, why, over what time period. HOW DID THEY DO IT AND WHAT WAS THE MOTIVATION? What was the monetary damage? Address the farad issues that you have learned in classes. Were the 3 elements of fraud there? 3)Who discovered it? 4)What was the reaction by the company? 5)What happen with respect to internal control? Did it fail? Was it ever in place etc.? 6) What happened to the person/people who committed the fraud? 7)Who were the attorneys? 8)What changed in the company after the fraud…if there were
- 5. any changes? If you find any additional information that we should know, add it. worldcom research.docx EUROPEMEDIA-21 July 2002-Extent of WorldCom audit problems unknown (C)2002 Van Dusseldorp & Partners - http:// www.vandusseldorp.com/ The disgraced telecoms group, WorldCom, may not know the scale of its audit problems before the end of the year, its president and CEO has said. The "best guesstimate is by the end of the year, but that could slip," said CEO John Sidgmore. "We really have no idea what the magnitude is at this time." The news came just hours after WorldCom applied for bankruptcy protection following its USD3.85bn (E3.82bn) accounting debacle. The bankruptcy filing will not be affecting the European operations of the company. Sidgmore stated that WorldCom's first priority is to stabilise the company financially. USD2bn (E1.99bn) has been sourced by the company to keep it going during restructuring, according to reports. The firm stressed that the filing will not apply to its non-US operations. Mr Sidgmore said the company will look at selling some of its non-core assets, and which "potentially includes some of our Latin American facilities" and wireless resale business. The main question facing investigators and investors is whether the accounting fraud was an aberration, or a sign of a diseased company. There is also concern as to whether or not holders of WorldCom's USD30bn (E29.82bn) in bonds will be able to swap their debt for shares in the restructured firm. Bankruptcy had been hoped to be avoided by the firm, which was valued at USD175bn (E173.99bn) at its height in 1999. Today's Chapter 11 filing by WorldCom eclipses that of collapsed energy trader Enron as the largest bankruptcy in US history. ((Distributed via M2 Communications Ltd - http://www.m2.com))
- 6. Word count: 272 (Copyright M2 Communications Ltd. July 21, 2002) It took a routine internal audit to uncover one of the biggest suspected corporate frauds ever perpetrated. But just why billions of dollars of suspect costs had gone unnoticed before is something that will hang over WorldCom, its auditor Andersen, and some of Wall Street's most prominent banks for a long time. The scandal that could sink one of the world's biggest telecommunications companies came to a head last weekend, after an internal auditor employed by WorldCom had discovered something strange. The amount WorldCom had spent on capital investment since the beginning of last year appeared to have been boosted by substantial amounts that did not look like capital spending at all. Instead, some $3.8bn had simply been transferred out of the company's normal operating expenses and classified instead as capital investment - something that kept it off WorldCom's profit and loss account. On Monday, as the company's board was told of the problem, WorldCom's internal investigation went into high gear and a powerful outside legal team was brought in. On Tuesday, the Securities and Exchange Commission was told - just as WorldCom's technology workers were working to cut the access that Scott Sullivan, the company's chief financial officer, had to the company's internal computer network. By that evening, Mr Sullivan had been sacked and the fraud was laid bare. Yesterday, the company was investigating whether Mr Sullivan had ordered the money in question to be transferred to capital expenditures from operating expenses. And it added that it would not know who else - including Bernie Ebbers, former chief executive - knew about the accounting irregularities until its investigation was completed. The breath-taking simplicity and apparent brazenness of it all was brushed aside by a WorldCom spokesman yesterday. "Unfortunately you cannot audit every journal entry every quarter," he said. But for many people at the company, or close
- 7. to it, the questions may not be brushed away so lightly. High on that list is Andersen, the audit firm that has already been laid low by the collapse of Enron. Andersen, which had approved the company's 2001 accounts and reviewed its figures in the first quarter of this year, sought to lay the blame squarely on Mr Sullivan, accusing him of having failed to disclose the transfers that are at the centre of the investigation. Though Andersen did not perform internal audit work at WorldCom, it had the sort of close involvement across a wide range of advisory roles that has prompted questions about the independence of auditors to some of the biggest US companies. Of the $16.8m in fees that WorldCom paid Andersen last year, only $4.4m was in connection with the annual audit. WorldCom's independent directors - particularly those on its audit committee, and its chairman Bert Roberts - are likely to come under scrutiny in the months ahead. None could not be reached or did not return calls to comment yesterday. "What they knew, and when they knew it, are very important questions," said Charles Elson, professor of corporate governance at the University of Delaware. Many of the board members had close ties to Mr Ebbers - either as WorldCom executives or as officers of other telecoms companies that had been acquired by WorldCom over the years. The chairman of the audit committee is Max E. Bobbitt, an old friend of Mr Ebbers with long experience in the industry. Mr Bobbitt, a consultant who has been involved in numerous telecoms start-ups, joined the board in 1992 after WorldCom took over another company where he was a director, Advanced Telecommunications. The audit committee also includes James Allen, a Denver-based telecoms industry venture capitalist, who has sat on WorldCom's board since 1998; Francesco Galesi, a real estate, oil and telecoms magnate and a board member since 1992; and Judith Areen, dean of the Law Center at Georgetown University and a board member since 1998. Also in the spotlight yesterday was Jack Grubman, the Salomon
- 8. Smith Barney analyst who had been WorldCom's biggest Wall Street cheerleader and who only withdrew his "buy" recommendation on the stock earlier this year. Mr Grubman had put out a note as recently as Friday sounding a caution about WorldCom and its precarious finances - something that prompted speculation about whether he had an inkling of what was to come. In an interview with CNBC, the analyst said: "Nobody saw this coming. I am as shocked about this as everyone else." Salomon's work in helping Mr Ebbers assemble WorldCom through a string of acquisitions has already brought it extensive unwanted attention since the company's decline set in, while a string of other banks are set to come under scrutiny for their role in helping the company with a giant bond issue a year ago - a time when it may have been in the midst of perpetrating a giant fraud, it has now emerged. Copyright Financial Times Limited 2002. All Rights Reserved. Word count: 817 Copyright Financial Times Information Limited Jun 27, 2002 x Prosecutors had no comment on whether they plan to arrest ousted WorldCom chairman Bernard J. Ebbers or indict WorldCom as a corporation. They also declined to comment on widespread speculation that they hope to get [Scott D. Sullivan] or [David Myers] to provide incriminating information against Ebbers, who grew WorldCom from a no-name Mississippi long- distance reseller into a dominant global telecom provider through a string of 60 deals over 17 years. Many of the biggest deals were engineered by Sullivan. An internal WorldCom auditing memo filed with court papers yesterday gave some details of how Sullivan and Myers shifted operating expenses known as "line costs" over to capital accounts where they could be written off over years, improving WorldCom's reported cash flow. 1. Scott D. Sullivan (center), former chief financial officer of bankrupt telecommunications giant WorldCom, and former controller David Myers (not shown) surrendered to federal
- 9. agents yesterday to face securities fraud, conspiracy, and false- statement charges. The two allegedly shifted $3.9 billion in operating expenses to capital accounts in order to post more than $1 billion in bogus profits. E2. Photo ran on Page A1. / REUTERS PHOTO 2. Ex-WorldCom controller David Myers sitting in a car after surrendering to federal authorities yesterday in New York. / AP PHOTO Full Text · TranslateFull text · Material from Globe wire services was used in this report. WorldCom's former top two financial executives were arrested yesterday on fraud charges related to the bankrupt telecommunications giant's $3.9 billion accounting scandal and were paraded handcuffed past television crews for the latest "perp walk" in the government's crackdown on corporate abuses. Scott D. Sullivan, 40, WorldCom's former chief financial officer and master merger strategist, and David Myers, 44, the company's former controller, surrendered to the FBI in New York early yesterday morning to face securities fraud, conspiracy, and false- statement charges that could send them to prison for as long as 65 years each and cost them millions of dollars in fines. The spectacle of Sullivan and Myers being led to court from the FBI's New York headquarters came a week after federal agents brought former Adelphia Communications chairman John Rigas and two of his sons in handcuffs past a phalanx of television cameras. The Rigases were indicted on charges they looted hundreds of millions of dollars from Adelphia, driving the cable television company to bankruptcy and costing investors and creditors $60 billion. Reacting to yesterday's arrests, Attorney General John D. Ashcroft said: "With each arrest, indictment and prosecution, we send this clear, unmistakable message: Corrupt corporate executives are no better than common thieves."
- 10. Sullivan was released on $10 million bail secured by the waterfront mansion he is having built in Boca Raton, Fla. Myers posted $2 million bail. US Magistrate Judge Richard Francis ordered both men to surrender their US passports to prevent them from fleeing the country. Their lawyers said they will plead not guilty to charges. Federal authorities allege Sullivan and Myers shifted $3.9 billion in operating expenses to WorldCom capital accounts in order to enable the number two long-distance company to post more than $1 billion in bogus profits during 2001 and the first quarter of this year. They are accused of filing false statements with the Securities and Exchange Commission five times in the last two years. They were fired in June, hours before WorldCom chief executive John W. Sidgmore disclosed the accounting moves to Wall Street and triggered a SEC civil fraud complaint against WorldCom. Prosecutors had no comment on whether they plan to arrest ousted WorldCom chairman Bernard J. Ebbers or indict WorldCom as a corporation. They also declined to comment on widespread speculation that they hope to get Sullivan or Myers to provide incriminating information against Ebbers, who grew WorldCom from a no-name Mississippi long-distance reseller into a dominant global telecom provider through a string of 60 deals over 17 years. Many of the biggest deals were engineered by Sullivan. Ebbers, in a statement issued by his lawyers, said he knew nothing of the accounting moves and called Sullivan and Myers "competent, ethical, and loyal employees, devoted to the welfare of WorldCom." Ebbers became a lightning rod for WorldCom investor outrage after revelations the Clinton, Miss., company's board loaned him $408 million to buy company stock that has lost 99 percent of its value in the last three years and closed yesterday at 15 cents a share. Last month he and Sullivan refused to answer questions at a congressional hearing, invoking their Fifth
- 11. Amendment rights against incriminating themselves. WorldCom filed for Chapter 11 bankruptcy protection 11 days ago, the largest filing in US history. It listed $41 billion in debt and assets of $107 billion. Besides long-distance carrier MCI, WorldCom operates key Internet facilities such as UUNet that handle an estimated half of all US Net traffic. WorldCom spokeswoman Julie Moore said the company was cooperating fully with the government probe. "Nobody wants to get to the bottom of this quicker than WorldCom," she said. An internal WorldCom auditing memo filed with court papers yesterday gave some details of how Sullivan and Myers shifted operating expenses known as "line costs" over to capital accounts where they could be written off over years, improving WorldCom's reported cash flow. "David [Myers] acknowledged that the line costs should probably not have been capitalized and stated that it was difficult to stop once started. David indicated that he has felt uncomfortable with these entries since the first time they were booked," the internal auditors' memo said. A WorldCom staff accountant who began raising questions about the moves, Cynthia Cooper, was urged this spring by Sullivan to delay completing an audit of the line costs until this summer. Sullivan's attorney, Irv Nathan, accused federal prosecutors of turning the "honest and honorable" Sullivan into a scapegoat. "We deeply regret the rush to judgment and the political overtones involved," Nathan said. Noting that the men were the subject of a criminal complaint, not a formal indictment, Nathan said, "All of this suggests this is a lot of politics. Unfortunately, politics are intruding into the criminal justice system." Reid Weingarten, the attorney representing Ebbers, said the made- for-TV arrests of Sullivan and Myers may have been "good theater." But Weingarten said prosecutors have yet to "prove that Sullivan and Myers ever acted with criminal intent,
- 12. an essential element we doubt the government will ever be able to prove in this case." Emphasizing the public-relations value of the WorldCom arrests in the wake of President Bush's signing a new law toughening penalties for white-collar crime, White House spokesman Ari Fleischer said the president is "determined that people who break America's laws and engage in corporate practices that are corrupt will be investigated. [They] will be held liable, will be held accountable and will likely end up in the pokey, where they belong." Ashcroft said, "When financial transactions are fraudulent and balance sheets are falsified, the invisible hand that guides our market is replaced by a greased palm. Information is corrupted, trust is abused and the . . . ruthless and corrupt profit at the expense of the truthful and law-abiding." But Senator Tom Daschle of South Dakota, the Democratic majority leader, said, "There hasn't been anyone in handcuffs from Enron, and we don't know the reason why." Executives of the Houston energy giant, which filed for Chapter 11 bankruptcy protection in January, had been key political patrons of Bush in Texas. Enron collapsed amid questions about phony profits and elaborate accounting ruses to hide debt. Also yesterday, the Justice Department nominated former US Attorney General Richard Thornburgh to serve as its independent examiner in the WorldCom bankruptcy proceedings, charged with investigating mismanagement and fraud. If approved by federal bankruptcy judge Arthur J. Gonzalez, Thornburgh would have 90 days to file a report detailing what caused WorldCom to fall into bankruptcy. Peter J. Howe can be reached at [email protected]Abstract (summary) TranslateAbstract WorldCom is under investigation by the Justice Department and the Securities and Exchange Commission. Scott Sullivan, WorldCom's former chief financial officer and Ms. [Cynthia
- 13. Cooper]'s boss, has been indicted. He has denied any wrongdoing. Four other officers have pleaded guilty and are cooperating with prosecutors. Federal investigators are still probing whether Bernard J. Ebbers, the company's former chief executive, knew about the accounting improprieties. Since the initial discoveries, WorldCom's accounting misdeeds have grown to $7 billion. Behind the tale of accounting chicanery lies the untold detective story of three young internal auditors, who temperamentally didn't fit into WorldCom's well-known cowboy culture. Ms. Cooper, 38 years old, headed a department of 24 auditors and support staffers, many of whom viewed her as quiet but strongwilled. She grew up in a modest neighborhood near WorldCom's headquarters and had spent nearly a decade working at the company, rising through its ranks. She declined to be interviewed for this story. Mr. [Morse], 41, was known for his ability to use technology to ferret out information. The third member of the team was Glyn Smith, 34, a senior manager under Ms. Cooper. In his spare time he taught Sunday school, took photographs and bicycled. His mom had taught him and Ms. Cooper accounting at Clinton High School. The confrontations put Ms. Cooper in a sticky position. Mr. Sullivan was her immediate supervisor. Plus, her vague discomfort with the way WorldCom was handling its accounting led her into areas that were not normally her bailiwick. Although her department did a small amount of financial auditing, it primarily performed operational audits, consisting of measuring the performance of WorldCom's units and making sure the proper spending controls were in place. The bulk of the company's financial auditing was left to Arthur Andersen. But neither of those things dissuaded Ms. Cooper from following her nose to the root of the ill-defined problem.Full Text · TranslateFull text · CLINTON, Miss. -- Sitting in his cubicle at WorldCom Inc. headquarters one afternoon in May, Gene Morse stared at an
- 14. accounting entry for $500 million in computer expenses. He couldn't find any invoices or documentation to back up the stunning number. "Oh my God," he muttered to himself. The auditor immediately took his discovery to his boss, Cynthia Cooper, the company's vice president of internal audit. "Keep going," Mr. Morse says she told him. A series of obscure tips last spring had led Ms. Cooper and Mr. Morse to suspect that their employer was cooking its books. Armed with accounting skills and determination, Ms. Cooper and her team set off on their own to figure out whether their hunch was correct. Often working late at night to avoid detection by their bosses, they combed through hundreds of thousands of accounting entries, crashing the company's computers in the process. By June 23, they had unearthed $3.8 billion in misallocated expenses and phony accounting entries. It all added up to an accounting fraud, acknowledged by the company, that turned out to be the largest in corporate history. Their discoveries sent WorldCom into bankruptcy, left thousands of their colleagues without jobs and roiled the stock market. At a time when dishonesty at the top of U.S. companies is dominating public attention, Ms. Cooper and her team are a case of middle managers who took their commitment to financial reporting to extraordinary lengths. As she pursued the trail of fraud, Ms. Cooper time and again was obstructed by fellow employees, some of whom disapproved of WorldCom's accounting methods but were unwilling to contradict their bosses or thwart the company's goals. WorldCom is under investigation by the Justice Department and the Securities and Exchange Commission. Scott Sullivan, WorldCom's former chief financial officer and Ms. Cooper's boss, has been indicted. He has denied any wrongdoing. Four other officers have pleaded guilty and are cooperating with prosecutors. Federal investigators are still probing whether Bernard J. Ebbers, the company's former chief executive, knew
- 15. about the accounting improprieties. Since the initial discoveries, WorldCom's accounting misdeeds have grown to $7 billion. Behind the tale of accounting chicanery lies the untold detective story of three young internal auditors, who temperamentally didn't fit into WorldCom's well-known cowboy culture. Ms. Cooper, 38 years old, headed a department of 24 auditors and support staffers, many of whom viewed her as quiet but strongwilled. She grew up in a modest neighborhood near WorldCom's headquarters and had spent nearly a decade working at the company, rising through its ranks. She declined to be interviewed for this story. Mr. Morse, 41, was known for his ability to use technology to ferret out information. The third member of the team was Glyn Smith, 34, a senior manager under Ms. Cooper. In his spare time he taught Sunday school, took photographs and bicycled. His mom had taught him and Ms. Cooper accounting at Clinton High School. Frightened that they would be fired if their superiors found out what they were up to, the gumshoes worked in secret. Even so, their initial discrete inquiries were stonewalled. Arthur Andersen, WorldCom's outside auditor, refused to respond to some of Ms. Cooper's questions and told her that the firm had approved some of the accounting methods she questioned. At another critical juncture in the trio's investigation, Mr. Sullivan, then the company's CFO, asked Ms. Cooper to delay her investigation until the following quarter. She refused. Ms. Cooper's first inkling that something big was amiss at WorldCom came in March 2002. John Stupka, the head of WorldCom's wireless business, paid her a visit. He was angry because he was about to lose $400 million he had specifically set aside in the third quarter of 2001, according to two people familiar with the meeting. His plan had been to use the money to make up for shortfalls if customers didn't pay their bills, a common occurrence in the wireless business. It was a well- accepted accounting device. But Mr. Sullivan decided instead to take the $400 million away
- 16. from Mr. Stupka's division and use it to boost WorldCom's income. Mr. Stupka was unhappy because without the money, his unit would likely have to report a large loss in the next quarter. Mr. Stupka's group already had complained to two Arthur Andersen auditors, Melvin Dick and Kenny Avery. They had sided with Mr. Sullivan, according to federal investigators. But Mr. Stupka and Ms. Cooper thought the decision smelled funny, although not obviously improper. Under accounting rules, if a company knows it is not going to collect on a debt, it has to set up a reserve to cover it in order to avoid reflecting on its books too high a value for that business. That was exactly what Mr. Stupka had done. Mr. Stupka declined to comment. Ms. Cooper decided to raise the issue again with Andersen. But when she called the firm, Mr. Avery brushed her off and made it clear that he took orders only from Mr. Sullivan, according to the investigators. Mr. Avery and Mr. Dick declined to comment. Patrick Dorton, a spokesman for Andersen, said his firm thought that the $400 million wireless reserve was not necessary. "That was like putting a red flag in front of a bull," says Mr. Morse. "She came back to me and said, `Go dig.' " Some internal auditors would have left it at that and moved on. After all, both the company's chief financial officer and its outside accountants had signed off on the decision. But that was not Ms. Cooper's style. One favorite pastime among the auditors who reported to her was applying the labels of the Myers-Briggs & Keirsey personality test to their fellow staffers. Ms. Cooper was categorized as an INTJ -- introspective, intuitive, a thinker and judgmental. "INTJs," according to the test criteria, are "natural leaders" and "strong-willed," representing less than 1% of the population. And so Ms. Cooper decided to appeal the decision. As head of auditing, it was her responsibility to bring sensitive issues to the audit committee of WorldCom's board. She brought the reserves question to the attention of the committee's head, Max Bobbitt. At a committee meeting at the company's Washington
- 17. offices on March 6, she and Mr. Sullivan presented their cases, according to minutes from the meeting. Mr. Sullivan backed down, according to people familiar with his decision. The next day he tracked down Ms. Cooper. Unable to reach her immediately, Mr. Sullivan called her husband, a stay-at-home dad to their two daughters, to get her cellphone number. He finally caught up with her at the hair salon. In the future, she was not to interfere in Mr. Stupka's business, Mr. Sullivan warned, according to people familiar with the reserves question. The confrontations put Ms. Cooper in a sticky position. Mr. Sullivan was her immediate supervisor. Plus, her vague discomfort with the way WorldCom was handling its accounting led her into areas that were not normally her bailiwick. Although her department did a small amount of financial auditing, it primarily performed operational audits, consisting of measuring the performance of WorldCom's units and making sure the proper spending controls were in place. The bulk of the company's financial auditing was left to Arthur Andersen. But neither of those things dissuaded Ms. Cooper from following her nose to the root of the ill-defined problem. On March 7, a day after Ms. Cooper had visited with the audit committee, the SEC surprised the company with a "Request for Information." While WorldCom's closest competitors, including AT&T Corp., were suffering from a telecom rout and losing money throughout 2001, WorldCom continued to report a profit. That had attracted the attention of regulators at the SEC, who thought WorldCom's numbers looked suspicious. But investigators had grown frustrated as they combed through public filings looking for evidence of wrongdoing, according to people familiar with the inquiry. So they asked to see data on everything from sales commissions to communications with analysts. Concerned about why the SEC was sniffing around, Ms. Cooper directed her group to start collecting information in order to comply with the request. She also was growing concerned about another looming
- 18. problem. Andersen was under fire for its role in the Enron case, which soon would lead to the accounting firm's indictment. It was clear that WorldCom would have to retain new outside auditors. Ms. Cooper set off on an unusual course. Her own department would simply take on a role that no one at Worldcom had assigned it. The troubles at Enron and Andersen were enough to warrant a second look at the company's financials, she explained to Mr. Morse one evening as they walked out to WorldCom's parking lot. Her plan: her department would start doing financial audits, looking at the reliability and integrity of the financial information the company was reporting publicly. It was a major decision, which would necessitate a lot more work for Ms. Cooper and her staffers. Still, Ms. Cooper took on financial auditing without asking permission from Mr. Sullivan, her boss, according to investigators and a person familiar with Ms. Cooper's decision. "We could see a strain in her face," recalls her mother, Patsy Ferrell, about that time period. "She didn't look happy. We knew she was working late and some of the other people were working late. We would call and say, `Can we bring some sandwiches?' and her father would bring them sandwiches." Several weeks later, Mr. Smith, a manager under Ms. Cooper, received a curious e-mail from Mark Abide, based in Richardson, Texas, who was in charge of keeping the books for the company's property, plants and equipment. Mr. Abide had attached to his May 21 e-mail a local newspaper article about a former employee in WorldCom's Texas office who had been fired after he raised questions about a minor accounting matter involving capital expenditures. "This is worth looking into from an audit perspective," Mr. Abide wrote. Mr. Smith, who declined to be interviewed, forwarded the e-mail to Ms. Cooper, according to investigators and a lawyer involved in the case. The e-mail piqued Ms. Cooper's interest. As part of their initial foray into financial auditing, Ms. Cooper and her team had
- 19. already stumbled on to the issue of capital expenditures, a subject that would prove to be crucial to their quest. The team had run into an inexplicable $2 billion that the company said in public disclosures had been spent on capital expenditures during the first three quarters of 2001. But they found that the money had never been authorized for capital spending. Capital costs, such as equipment, property and other major purchases, can be depreciated over long periods of time. In many cases, companies spread those costs over years. Operating costs such as salaries, benefits and rent are subtracted from income on a quarterly basis, and so they have an immediate impact on profits. Ms. Cooper and her team were beginning to suspect what was up with the mysterious $2 billion entry: It might actually represent operating costs shifted to capital expenditure accounts -- a stealthy maneuver that would make the company look vastly more profitable. When Ms. Cooper and Mr. Smith asked Sanjeev Sethi, a director of financial planning, about the curious adjustment, he told them it was "prepaid capacity," a term they had never heard before. Further inquires led them to understand that prepaid capacity was a capital expenditure. But when they asked what it meant, Mr. Sethi told them to ask David Myers, the company's controller, according to Mr. Morse and a person familiar with Ms. Cooper's situation. Mr. Sethi did not return phone calls. Ms. Cooper and Mr. Smith opted instead to call Mr. Abide, who had pointed out a capital expenditures problem in his e-mail. When they asked him about "prepaid capacity," he too answered very cryptically, explaining that those entries had come from Buford Yates, WorldCom's director of general accounting. While perusing records looking for accounting irregularities later that same day, May 28, Mr. Morse made the big discovery of the $500 million in undocumented computer expenses. They also were logged as a capital expenditure. "This stinks," Mr. Morse recalls thinking to himself. He immediately went to Ms.
- 20. Cooper to tell her what he'd found. She called a meeting of her department. "I knew it was a horrific thing and she did too, right off the bat," says Mr. Morse. Several days later, Ms. Cooper and Mr. Smith met to try to make sense of their growing list of clues. Particularly puzzling were the cryptic comments made by Mr. Sethi and Mr. Abide. Finally the two auditors came up with a plan of action to test their sense that when it came to the booking of capital expenditures, something was very wrong at WorldCom. Ms. Cooper would send Mr. Smith an e-mail saying she wanted to know more about prepaid capacity as soon as possible, and asking how much harder they should press Mr. Sethi. They would copy Mr. Myers on the e-mail. Mr. Myers shot back an e-mail. Mr. Sethi should be working for him and did not have time to devote to Ms. Cooper's inquiries, he wrote. Ms. Cooper had been stonewalled yet again. Ms. Cooper and Mr. Smith didn't know it, but they had stumbled onto evidence that some executives were keeping two sets of numbers for the then-$36 billion company, one of them fraudulent. By 2000, WorldCom had started to rely on aggressive accounting to blur the true picture of its badly sagging business. A vicious price war in the long-distance market had ravaged profit margins in the consumer and business divisions. Mr. Sullivan had tried to respond by moving around reserves, according to his indictment. But by 2001 it wasn't enough to keep the company afloat. And so Mr. Sullivan began instructing Mr. Myers to take line costs, fees paid to lease portions of other companies' telephone networks, out of operating-expense accounts where they belonged and tuck them into capital accounts, according to Mr. Sullivan's indictment. It was a definite accounting no-no, but it meant that the costs did not hit the company's bottom line -- at least in the version of the books that were publicly scrutinized. Although some staffers objected, the scheme progressed for the next five
- 21. quarters. Ms. Cooper, Mr. Smith and Mr. Morse didn't know this. They only knew that accounting entries had been hopscotching inexplicably around WorldCom's balance sheets and that nobody wanted to talk about it. To put all the pieces together, they would need to plumb the depths of WorldCom's computerized accounting systems. Full access to the computer system was a privilege that normally had to be granted by Mr. Sullivan. But Mr. Morse, a bit of a techie, had recently figured out a way around that problem. Without explaining what he was up to, Mr. Morse had asked Jerry Lilly, a senior manager in WorldCom's information technology department, for better access to the company's accounting journal entries. Mr. Lilly was testing a new software program and gave Mr. Morse permission to road test the system, too. The beauty of the new system, from Mr. Morse's perspective, was that it enabled him to scrutinize the debit and credit sides of transactions. By clicking on a number for an expense on a spreadsheet, he could follow it back to the original journal entry -- such as an invoice for a purchase or expense report submitted by an employee, to see how it had been justified. Sifting through the data for answers to still-vague questions about capital expenditures amounted to a frustrating task, Mr. Morse says. He combed through an account labeled "intercompany accounts receivables," which contained 350,000 transactions per month. But when he downloaded the giant set of data, he slowed down the servers that held the company's accounting data. That prompted the IT staff to begin deleting his requests because they were clogging and crashing the system. Mr. Morse began working at night, when there was less demand on the servers, to avoid having his work shut down by the IT department. During the day, he retreated to the audit library -- a windowless, 12-by-12 room piled with files from previous
- 22. projects and tucked away in the audit department -- to avoid arousing suspicion. By the first week of June, Mr. Morse had turned up a total of $2 billion in questionable accounting entries, he says. Having found the evidence they were looking for, the sleuths were suddenly faced with how serious the implications of their endeavor really were. Mr. Morse grew increasingly concerned that others in the company would discover what he had learned and try to destroy the evidence, he says. With his own money, he went out and bought a CD burner and copied all the incriminating data onto a CD-Rom. He told no one outside of internal audit what he had found. Mr. Morse even kept his wife, Lynda, in the dark. Each night, he'd bring home documents he was studying. He instructed his wife not to touch his briefcase. His wife thought the usually gregarious father of three looked drained. Ms. Cooper had begun confiding in her parents, with whom she was especially close. Without going into detail, she told her mother that she was worried about what her team was finding, and that it was definitely a very big deal, according to a person close to Ms. Cooper. Meanwhile, Mr. Sullivan began to ask questions about what Ms. Cooper's team was up to. One day the finance chief approached Mr. Morse in the company cafeteria. When Mr. Morse saw him coming, he froze. The auditor had only spoken to Mr. Sullivan twice during his five-year tenure at WorldCom. "What are you working on?" Mr. Morse later recalled Mr. Sullivan demanding. Mr. Morse looked at his shoes. "International capital expenditures," he says he replied, referring to a separate, and less-threatening auditing project. He quickly walked away. Days later, on June 11, Ms. Cooper got an unexpected phone call from Mr. Sullivan. He told her that he would have some time later in the day, and invited her to come by and tell him what her department was up to, according to a person familiar
- 23. with Ms. Cooper's situation. That afternoon, Ms. Cooper, Mr. Smith and another auditor arrived at Mr. Sullivan's office. They talked about pending promotions and other administrative matters, according to lawyers involved in the case. As the meeting was breaking up, Ms. Cooper turned to Mr. Smith and suggested that he tell Mr. Sullivan what he was working on. It was meant to seem like a casual comment. In fact, the two auditors had planned it out beforehand, so that they could gauge Mr. Sullivan's reaction, according to a person familiar with Ms. Cooper's situation. Mr. Smith briefly described the audit, without going into the explosive material they already had found. Mr. Sullivan urged them to delay the audit until after the third quarter, saying there were problems he planned to take care of with a write-down, according to several people familiar with the meeting. Ms. Cooper replied that no, the audit would continue. Mr. Sullivan didn't respond, and the meeting ended in a stalemate. Concerned now that Mr. Sullivan might try to cover up the accounting improprieties, Ms. Cooper and Mr. Smith appealed to Mr. Bobbitt, the head of WorldCom's audit committee. Mr. Bobbitt had to travel to Mississippi from his home in Florida for a board meeting scheduled for June 14, so the day before he met with Ms. Cooper and Mr. Smith at a Hampton Inn in Clinton. The two auditors told Mr. Bobbitt what they had found. He asked Ms. Cooper to contact KPMG, the company's new outside auditors, and brief them on what was happening. Mr. Bobbitt did not raise Ms. Cooper's suspicions at the board meeting the next day, according to a document WorldCom later submitted to the SEC. James Sharpe, Mr. Bobbitt's lawyer, declined to comment. Farrell Malone, the KPMG partner in charge of the WorldCom account, urged Ms. Cooper to make sure she was right. On June 17, Ms. Cooper's team began a series of informal confrontations meant to convince themselves that there was no
- 24. legal explanation for the accounting entries. That morning, Ms. Cooper and Mr. Smith went to the office of Betty Vinson, director of management reporting, and asked her for documentation to support the capital-expense-accounting entries. Ms. Vinson told the two that she had made many of the entries but did not have any support for them, according to an internal memo prepared by Ms. Cooper and Mr. Smith. Ms. Vinson's lawyer did not return phone calls. Next they walked a few feet to Mr. Yates's office. He said he was not familiar with the entries and referred Ms. Cooper and Mr. Smith to Mr. Myers. The duo then paid a call on Mr. Myers. When confronted, he admitted that he knew the accounting treatment was wrong, according to the memo. Mr. Myers said that he could go back and construct support for the entries but that he wasn't going to do that. Ms. Cooper then asked if there were any accounting standards to support the way the expenses were treated, according to the memo, which was later made public by a Congressional committee. Mr. Myers answered that there were none. He said that the entries should not have been made, but that once it had started, it was hard to stop. Mr. Smith asked how Mr. Myers planned to explain it all to the SEC. Mr. Myers replied that he hoped it wouldn't come to that, according to the memo. An hour or so later, Ms. Cooper returned to her department to brief Mr. Morse and her other auditors. "They have no support," she told them, according to Mr. Morse. It was clear to Ms. Cooper's team that their findings would be devastating for the company, and the prospect of going before the board with their evidence was sobering. They worried about whether their revelations would result in layoffs and obsessed about whether they were jumping to unwarranted conclusions that their colleagues at WorldCom were committing fraud. Plus, they feared that they would somehow end up being blamed for the mess.
- 25. Ms. Cooper's staffers began to notice that she was losing weight. Mr. Morse's wife noticed he was preoccupied and short tempered. During the third week in June, Mr. Smith called his mother, who was vacationing in Albuquerque, according to a person familiar with the conversation. Without providing specifics, he told her that he was about to take actions at WorldCom that were not going to make people happy. He asked his mother, Ms. Cooper's former high school accounting teacher, to remember him in her prayers and to pray for him to be strong. Ms. Cooper prepared for several meetings with the audit committee. At one, on June 20, Mr. Sullivan was scheduled to defend himself. One evening, as Ms. Cooper worked late with accountants from KPMG, she suddenly dropped her head into her arms on the conference-room table. Mr. Malone of KPMG led her onto a balcony, put his arm around her and showed her the sunset, according to a person familiar with the meeting. Ms. Cooper, Mr. Smith and Mr. Malone headed to Washington to brief the board's audit committee. At the meeting on Thursday, June 20, Mr. Malone described the transfer of line costs to capital accounts and told the audit committee that, in his view, the transfers didn't comply with generally accepted accounting principles, according to a document WorldCom later submitted to the SEC. Mr. Sullivan tried to give an explanation for the accounting adjustments but asked for more time to support the line-cost transfers. The committee gave Mr. Sullivan the weekend to explain himself. He got to work constructing what he called a white paper that argued that the accounting treatments he used were proper, according to the document. It didn't work. On June 24, the audit committee told Mr. Sullivan and Mr. Myers they would be terminated if they didn't resign before the board meeting the next day. Mr. Sullivan refused and was fired. Mr. Myers resigned. The next evening, WorldCom stunned Wall Street with an
- 26. announcement that it had inflated profits by $3.8 billion over the previous five quarters. Afterward, Ms. Cooper drove to her parents' house, which was near WorldCom's headquarters. She sat down at the dining-room table without saying anything, says Ms. Ferrell, her mother. "She was deeply, deeply pained. She was grief stricken that it was true and that all these people would feel the consequences of having gone astray," Ms. Ferrell says. "We were all so proud of WorldCom and it's just been the saddest, most tragic thing." Mr. Morse worked late that night, and his wife phoned after she watched the news. The anchors were calling the company World-Con, she reported. Did he know anything about it? The SEC on June 26 slapped the company with a civil fraud suit, and trading of WorldCom's stock was halted. Ultimately the company was delisted by the Nasdaq Stock Market. Mr. Sullivan is preparing to go to trial. "We will demonstrate at the appropriate time that a number of the negative points that WorldCom's internal auditors have recently suggested about Mr. Sullivan are not accurate," says Irvin Nathan, a lawyer for Mr. Sullivan. "The fact is that he was always supportive of internal audit and was instrumental in the promotion of Cynthia Cooper and securing resources for her staff." Mr. Myers, Mr. Yates, Ms. Vinson and Troy Normand, the director of legal entity accounting, have all pleaded guilty to securities fraud and a variety of other charges. David Schertler, an attorney for Mr. Yates, says that while his client pleaded guilty, "all the evidence would suggest he was acting under the orders of supervisors." Ms. Cooper and her team have continued to work at WorldCom's Clinton headquarters and are responding to requests related to the various investigations of the company. Ms. Cooper, Mr. Smith and Mr. Morse have been interviewed by FBI agents in connection with the Justice Department's investigation. Some WorldCom employees have told the auditors that they wish they had left the accounting issues alone.
- 27. --- Journal Link: See further coverage of the WorldCom scandal, including bios of key players, in the Online Journal at WSJ.com/WorldCom.Abstract (summary) TranslateAbstract The report, which also criticized the company's outside auditors and Salomon Smith Barney's former telecommunications analyst Jack Grubman, hints that the extent of the improper accounting at WorldCom, this time relating to revenue, could be more extensive than the $7.2 billion restatement the company already has said it will make. Now, the report indicates, WorldCom also is under fire for accounting methods used in recording revenue, an entirely new avenue for investigators. Those investigators also are looking at what the report refers to as "fraudulent journal entries and adjustments" made by WorldCom executives. The report also provides new details about Mr. [Bernard Ebbers]'s $1 billion in borrowings and makes the argument that the leverage Mr. Ebbers placed on his huge WorldCom holdings put the interests of WorldCom shareholders at risk since the company's shares could plummet if he tried to sell the stock. "Furthermore by using his WorldCom shares to collateralize massive debt obligations, Mr. Ebbers placed himself under intense pressure to support WorldCom's share price," the report says. The report also points to Mr. Ebbers's role in determining bonuses and other compensation for WorldCom executives. Though WorldCom's disclosure documents suggest that bonuses were paid to top executives based on performance, the report says that Mr. Ebbers could adjust performance bonuses received by individual employees. "Some individuals, even at lower ranks, were paid massive performance bonuses equal to many times their base salaries, while others received bonuses equal to only a small percentage of their salaries." Mr. [Richard Thornburgh] intends "to inquire whether these bonuses were indeed based on quantitative performance factors or were used instead for some improper or other purpose."Full Text
- 28. · TranslateFull text · WorldCom Inc. is in talks with the Securities and Exchange Commission are in talks to settle SEC fraud charges against the company amid rapid developments in the case, according to people familiar with the talks. The broad outlines of an agreement in the massive accounting- fraud case, hammered out a week ago, would include a court injunction barring WorldCom from violating securities law. WorldCom would also agree to a consent decree of those terms, under terms of the settlement. The SEC is also expected to settle charges against several individuals. The individuals' names aren't known, but people close to the situation say they are low- to mid-level executives who wouldn't be subject to charges by federal prosecutors who are also conducting an investigation. Some of those people have already worked out or are working out plea agreements. The amount of the fines against WorldCom -- and potentially against individuals as well -- under the settlement terms is unclear. One of the considerations the SEC is said to be looking at is how potential fines would affect shareholders and creditors of WorldCom. A deal could be announced within the next week or so. A WorldCom spokesman declined to comment. On a separate front yesterday, a special bankruptcy-court examiner accused WorldCom of a "smorgasbord" of fraudulent accounting adjustments and disclosed that ousted Chief Executive Bernard Ebbers personally guaranteed or pledged WorldCom stock in order to receive $1 billion in loans -- an amount considerably higher than previously believed. In a highly critical report that is the most sweeping to date of WorldCom's massive accounting problems, former U.S. Attorney General Richard Thornburgh describes a company culture rife with conflicts of interest and lacking proper controls. Mr. Thornburgh, appointed in August by the bankruptcy court to examine wrongdoing, mismanagement and
- 29. incompetence at WorldCom, found some of each. The "report indicates a trifecta," he said in an interview after releasing his 118-page preliminary document. Many details were excised from the report so that it doesn't compromise continuing inquiries by the Justice Department and Securities and Exchange Commission, Mr. Thornburgh said. The report, which also criticized the company's outside auditors and Salomon Smith Barney's former telecommunications analyst Jack Grubman, hints that the extent of the improper accounting at WorldCom, this time relating to revenue, could be more extensive than the $7.2 billion restatement the company already has said it will make. Now, the report indicates, WorldCom also is under fire for accounting methods used in recording revenue, an entirely new avenue for investigators. Those investigators also are looking at what the report refers to as "fraudulent journal entries and adjustments" made by WorldCom executives. Details from the report also imply that Mr. Ebbers's financial condition is greatly weakened. At the end of 2001, Mr. Ebbers's net worth was $295 million while his stock holdings were valued at $286.6 million. Now that stock is worthless, leaving him with a net worth of $8.4 million, if all his other assets remained the same. Mr. Ebbers couldn't be reached for comment. The report also provides new details about Mr. Ebbers's $1 billion in borrowings and makes the argument that the leverage Mr. Ebbers placed on his huge WorldCom holdings put the interests of WorldCom shareholders at risk since the company's shares could plummet if he tried to sell the stock. "Furthermore by using his WorldCom shares to collateralize massive debt obligations, Mr. Ebbers placed himself under intense pressure to support WorldCom's share price," the report says. In all, the report said, Mr. Ebbers personally guaranteed or pledged WorldCom stock as security for more than $1 billion in personal and business loans. The company itself lent Mr. Ebbers $415 million, which contributed to his ouster. Though the money was intended to help him cover margin calls on bank
- 30. loans that he had collateralized with WorldCom stock, Mr. Ebbers, according to the report, used $27 million of the proceeds for other personal reasons. According to the report, those personal uses included "payments of $1.8 million for the construction of his new house, $2 million to a family member for personal expenses, approximately $1 million in loans to his family, his friends, and a WorldCom officer, and payments of $22.8 million to his own business interests." At the same time, the report notes, the company gave him loans before they were "reduced to writing" and some loan documentation may have been backdated. In a statement, John Sidgmore, the current CEO, said: "We are working to create a new WorldCom. We have developed and implemented new systems, policies and procedures," including doubling the internal-audit staff, to correct the company's past problems and to ensure that they don't recur. Mr. Thornburgh portrays WorldCom, a telephone and data- services concern bloated by its speedy acquisition of more than 70 companies, as a company where management and internal controls couldn't keep pace. He says the company's board of directors and audit committee were ineffective while the compensation committee "seemed to abdicate its responsibilities to Mr. Ebbers." Arthur Andersen LLP, the company's external auditor, was too lackadaisical given WorldCom's risk category, the report says, and one of its bankers, Salmon Smith Barney had a relationship so close that it is "potentially problematic." By the second quarter of 2001, WorldCom's revenue was declining, hurting its ability to meet quarterly revenue-growth targets, the report says. "Accordingly, the company undertook an analysis of ways to boost the company's quarterly revenues. Ultimately, it appears that improper additions to revenue were later booked in connection with this process," the report says. The report also describes a series of false internal reports that were generated at WorldCom to support the doctored financial reports that would later be given to Wall Street. The report said Mr. Thornburgh -- who conducted interviews with employees
- 31. and reviewed internal company documents -- would present his findings on the false entries later, "in deference to governmental investigations." Meanwhile, other lawyers in the case have described the preparation of what amounted to a second set of books that were prepared for David Myers, controller, and Scott Sullivan, chief financial officer. At the end of each quarter, Buford Yates, director of general accounting, would prepare two charts, with one showing accurate results from operations. Next to those numbers would be a series of accounting adjustments necessary to hit Wall Street estimates. Mr. Yates would then prepare a second chart with doctored results after the adjustments had been made, these lawyers say. Those doctored results would then be presented to the public each quarter, they say. The report also provides insight into the company's "manipulation of reserve accounts" to meet Wall Street earnings estimates. Reserves are typically set up to meet certain expected, but not yet realized, costs. If reserves are determined to be in excess of what is needed, companies are allowed, under accounting guidelines, to "release" those reserves into earnings. Mr. Thornburgh is continuing to investigate the company's accounting practices regarding the establishment of reserves for seven financial items, including reserves for taxes, depreciation, legal costs and bad debts, among others, the report says. The release of reserves added particularly heavily to the company's earnings before interest, taxes, depreciation and amortization, or Ebitda, during 2000. In that year, the release of reserves added between $374 million and $661 million each quarter to the company's reported Ebitda. The Thornburgh report also chastises the company for limiting the role of its internal auditors to audits of the company's operations. At the same time the report applauds three internal auditors who first investigated the company's fraudulent accounting and brought the matter to light with the board and outside auditors. The report also raises questions about whether Arthur Andersen,
- 32. WorldCom's auditors before its collapse, "should have done more to determine whether the risks of abuses were adequately taken into account" by the company. Arthur Andersen, according to the report, had identified WorldCom as a "maximum risk client." It doesn't appear, the report says, that Andersen took measures that were appropriate for the risk profile it ascribed to the company. The report also points to Mr. Ebbers's role in determining bonuses and other compensation for WorldCom executives. Though WorldCom's disclosure documents suggest that bonuses were paid to top executives based on performance, the report says that Mr. Ebbers could adjust performance bonuses received by individual employees. "Some individuals, even at lower ranks, were paid massive performance bonuses equal to many times their base salaries, while others received bonuses equal to only a small percentage of their salaries." Mr. Thornburgh intends "to inquire whether these bonuses were indeed based on quantitative performance factors or were used instead for some improper or other purpose." In his report, Mr. Thornburgh also discusses the relationship between WorldCom and former Salomon Smith Barney analyst Jack Grubman. The report reiterates much of the allegations previously leveled against Mr. Grubman and his former company: That Salomon granted Mr. Ebbers and WorldCom directors lucrative shares in initial public offerings in exchange for investment-banking business, which generated fees of $107 million for 23 deals between October 1997 and February 2002. Vowing to investigate further, Mr. Thornburgh noted that Mr. Grubman routinely rated WorldCom stock as a buy and urged investors at one point to "load up the truck" with the company's stock. He didn't change his "risk factor" rating until a week after the SEC initiated an inquiry, the report said. A spokeswoman for Citigroup, parent of Salomon, said that "in light of ongoing discussions with the various regulators, we are declining to comment." A lawyer for Mr. Grubman couldn't be reached.
- 33. Word count: 1588 Copyright Dow Jones & Company Inc Nov 5, 2002Abstract (summary) TranslateAbstract WorldCom filed for Chapter 11 bankruptcy protection in July after acknowledging an initial $3.7 billion fraud. The bulk of the fraud so far involved booking billions of expenses in line costs, the fees that telephone companies pay to use local landline networks, as capital expenditures instead of operating expenses, thereby boosting profits. WorldCom also boosted revenue with so-called cookie-jar accounting in which it used reserves for bad accounts.Full Text · TranslateFull text · The accounting fraud at WorldCom Inc. is likely to reach approximately $11 billion as the company's auditors and investigators continue to pore over financial statements that already detail the biggest case of accounting fraud in U.S. history, according to people familiar with the situation. The exact amount of the fraud hasn't yet been determined because the company doesn't expect the investigation to be completed until the summer. The actual losses WorldCom will have to restate could be smaller if they are offset by tax credits or other factors. Already, WorldCom has said it expects the fraud to exceed $9 billion. "We won't have the restatement process complete until this summer," said WorldCom spokesman Brad Burns. "At this point, it is not possible to know what the final number will be." WorldCom filed for Chapter 11 bankruptcy protection in July after acknowledging an initial $3.7 billion fraud. The bulk of the fraud so far involved booking billions of expenses in line costs, the fees that telephone companies pay to use local landline networks, as capital expenditures instead of operating expenses, thereby boosting profits. WorldCom also boosted revenue with so-called cookie-jar accounting in which it used reserves for bad accounts.
- 34. The additional $2 billion in overstated profits, reported by Bloomberg News yesterday, relates to a number of different accounting issues, a person close to the situation said. So far, two dozen employees of WorldCom, Clinton, Miss., the nation's second-largest long-distance company, have been dismissed or resigned over the fraud, including its chief financial officer, Scott Sullivan. Mr. Sullivan and four other former executives have been indicted or charged by New York prosecutors in connection with the probe. All have pleaded guilty, except for Mr. Sullivan. Word count: 284 Copyright Dow Jones & Company Inc Apr 1, 2003Abstract (summary) TranslateAbstract Seven years of attempted deregulation of telecommunications in the US yield several lessons. First, the transaction costs of the regulatory process have grown since enactment of the Telecommunications Act of 1996. Second, despite its micromanagement of competition in local telecommunications, the FCC missed WorldCom's fraud and bankruptcy. WorldCom's accounting fraud may have destroyed billions of dollars of shareholder value in other telecommunications firms. In addition, WorldCom's misconduct may have been intended to harm competition by inducing exit (or forfeiture of market share) by the efficient rivals. Chapter 11 reorganization of WorldCom would further distort competition in the long- distance and Internet backbone markets. The FCC has a unique obligation to investigate the harm that WorldCom caused the telecommunications industry. If WorldCom is unqualified to hold its FCC licences and authorizations, that legal conclusion would promptly, and properly, propel WorldCom toward liquidation.Full text · TranslateFull text · Headnote Seven years of attempted deregulation of telecommunications in
- 35. the United States yield several lessons. First, the transactions costs of the regulatory process have grown since enactment of the Telecommunications Act of 1996. Second, if the Federal Communications Commission ("FCC") had used a consumer- welfare standard rather than a competitor-welfare standard when interpreting the Act, the agency's regulations on mandatory unbundling of local telecommunications networks would have been simpler and more socially beneficial. Third, despite its micromanagement of competition in local telecommunications, the FCC missed WorldCom 's fraud and bankruptcy. WorldCom 's false Internet traffic reports and accounting fraud encouraged overinvestment in longs-distance capacity and Internet backbone capacity. Because Internet traffic data are proprietary and WorldCom dominated Internet backbone services, and because WorldCom was subject to regulatory oversight, it was reasonable for rival carriers to believe WorldCom 's misrepresentation of Internet traffic growth. WorldCom 's accounting fraud may have destroyed billions of dollars of shareholder value in other telecommunications firms. In addition, WorldCom 's misconduct may have been intended to harm competition by inducing exit (or forfeiture of market share) by the efficient rivals. Chapter 11 reorganization of WorldCom would further distort competition in the long- distance and Internet backbone markets. The FCC has a unique obligation to investigate the harm that WorldCom caused the telecommunications industry. If WorldCom is unqualified to hold its FCC licenses and authorizations, that legal conclusion would promptly, and properly, propel WorldCom toward liquidation. Introduction The United States has spent seven years trying to deregulate telecommunications. We are not in the "transition" any longer. It is time to take stock. In this Article, I address three topics. The first, addressed in Part I, is the administrative cost of deregulation under the Telecommunications Act of 1996.1 Next, I examine in Part II the consequences of the Federal
- 36. Communications Commission's ("FCC's") use of a competitor- welfare standard when formulating its policies for local competition, rather than a consumer-welfare standard. Beginning in Part III, I address at greater length my third topic. I offer an early assessment of the harm to the telecommunications industry from WorldCom's fraud and bankruptcy. I explain how WorldCom's misconduct caused collateral damage to other telecommunications firms, government, workers, and the capital markets. WorldCom's false Internet traffic reports and accounting fraud encouraged overinvestment in longdistance capacity and Internet backbone capacity. Because Internet traffic data are proprietary and WorldCom dominated Internet backbone services, and because WorldCom was subject to regulatory oversight, it was reasonable for rival carriers to believe WorldCom's misrepresentation of s Internet traffic growth. WorldCom's accounting fraud may have destroyed billions of dollars of shareholder value in other telecommunications firms and eroded investor confidence in equity markets. Using event-study analysis, I estimate the harm to rival carriers and telecommunications equipment manufacturers resulting from WorldCom's restatement of earnings. WorldCom's false or fraudulent statements also supplied state and federal governments with incorrect information essential to the formulation of telecommunication policy. State and federal governments, courts, and regulatory commissions would thus be justified in applying extreme skepticism to future representations made by WorldCom. Part IV explains how WorldCom's fraud and bankruptcy may have been intended to harm competition, and in the future may do so, by inducing exit (or forfeiture of market share) by the company's rivals. WorldCom repeatedly deceived investors, competitors, and regulators with false statements about its Internet traffic projections and financial performance. At a minimum, WorldCom's fraudulent or false statements may have raised rivals' costs by inducing inefficient investment in
- 37. capacity or inefficient expenditures for customer acquisition and may have artificially reduced WorldCom's cost of capital and thus facilitated its long string of acquisitions. During the pre-bankruptcy period, WorldCom's business strategy may have been designed to harm rival providers of Internet backbone or long-distance services. Because WorldCom's real costs were unknown, its pricing of Internet backbone services bore no relation to cost. Recoupment of losses was unnecessary as a condition for plausible predation by WorldCom because its management had other ways to profit personally. The coordinated actions of WorldCom's management, its investment bankers, and its auditors may have injured competition in the telecommunications industry. Part V argues that the FCC has a unique obligation-distinct from the mandate of the bankruptcy court or the Securities and Exchange Commission-to investigate the effect of WorldCom's misconduct on the telecommunications industry. For WorldCom, Chapter 11 bankruptcy can be a means to distort competition m the long-distance and Internet backbone markets. Because Chapter 11 bankruptcy is not designed to eradicate anticompetitive business models or to establish policy for the telecommunications infrastructure, the FCC is uniquely empowered to defend the competitive process. After Chapter 11 reorganization, WorldCom's freedom from debt would enable the firm to underprice rivals that are as, or more, efficient than WorldCom. Economic efficiency would suffer because consumers would pay less than the true social cost required to supply the services offered by WorldCom. Moreover, the competitive advantage conferred upon WorldCom by the U.S. bankruptcy court's elimination of WorldCom's debt (in whole or in part) could constitute state aid in violation of Article 87 of the European Community Treaty. In Part VI, I argue that WorldCom's exit from the market would not carry significant social costs. WorldCom's value as a going concern is dubious, and other carriers could readily absorb WorldCom's Internet and long-distance; customers. The FCC
- 38. should investigate the ramifications of WorldCom's fraud for telecommunications policy. The outcome of that investigation may include the finding that WorldCom is unqualified to hold its FCC licenses and authorizations. That legal conclusion would promptly, and properly, propel WorldCom toward liquidation. I. The Administrative Cost of Deregulation My first point is a simple one: deregulation has actually increased regulation. That is not a reason to reject deregulation, but it may be a useful indicator of whether we are on the right trajectory for true deregulation. Consider first the growth of regulatory inputs. Figure 1 shows the FCC's annual budget in inflation-adjusted dollars. Real expenditures quickly rose by about one-third after enactment of the Telecommunications Act of 1996, from $158.8 million to $211.6 million, and they have stayed at that higher level. The increase is thirty-seven percent if one includes 1995 in the post-deregulation period-perhaps on the rationale that the FCC both saw new legislation coming and sought to get an early jump on some of the expected regulatory detail. What happened to regulatory output? The FCC, of course, produces many regulatory products. Some, such as inaction, are particularly difficult to quantify. But a simple, albeit imperfect, measure of output is the number of pages per year of the FCC Record, the official compendium of all FCC decisions, proposed rulemakings, adjudications, and the like. As Figure 2 shows, the number of pages per year nearly tripled in the post-1996 period. During that period, the FCC Record averaged 23,838 pages per year. So, at a very crude level of analysis, it would appear that deregulation permanently increased the inputs and outputs of the FCC. Indeed, on the back of the envelope, it appears that a one percent increase in real expenditures for the FCC would produce about a nine percent increase in output. How did the near tripling of the FCC's output in the post-1996 period affect the transactions costs that private firms incurred in
- 39. connection with telecommunications deregulation? This question is hard to answer because the relevant data are by definition private rather than public. One anecdotal measure that is publicly available is the number of lawyers who belong to the Federal Communications Bar Association. As Figure 3 shows, this measure of the number of telecommunications lawyers grew seventy-three percent between December 1994 and December 1998. If one assumes (very conservatively) that the average income of an American telecommunications lawyer is $100,000, then the current membership of the FCBA represents an annual expenditure on legal services of at least $340 million. Of course, some of these telecommunications lawyers may have been laid off by now, and others may have redeployed their talents in more promising specialties-such as bankruptcy, securities litigation, and white-collar criminal defense. But the raw data do suggest that the stock of telecommunications lawyers experienced a substantial and enduring shift upward after 1996 that tracked the increase in the FCC's real budget and the increase in its annual output as measured by the size of the FCC Record. I have analyzed the growth in the FCC's inputs and outputs, as well as in its attorney constituency, as proxies for transaction costs. One might object that my time horizon coincided with dramatic growth in the telecommunications industry, and that these data might look quite different if one considered instead a measure of transactions costs per revenue dollar (or transactions costs per bit of data transmitted). I have not attempted such a calculation in the belief that it is reasonable to expect the transactions costs of telecommunications regulation to exhibit some increasing returns to scale. One would not expect the costs of regulatory compliance and strategy to be twice as high for a carrier with twice the revenues of another. Regardless of whether one considers particular FCC policies to be good or bad, there can be no dispute that the public and private transactions costs of implementing the Telecommunications Act of 1996 have been significant.
- 40. II. Mandatory Unbundling Under the Competitor-Welfare Standard What about the substance of deregulation? The centerpiece of the Telecommunications Act of 1996 was the opening of the local network. My second major point is this: Following a consumer-welfare model would have made unbundling policy simpler and more socially beneficial. Unbundling means that the owner of a network will offer competitors the use of pieces of the network on a disaggregated, wholesale basis.2 The principal policy questions that arise under unbundling are "What shall be unbundled?" and "How shall the unbundled network element be priced for sale to competitors?" Through its mandatory unbundling policies, the FCC affirmatively promoted preferred forms of market entry. Those modes of entry-and the business models predicated upon them-might have been immediately rejected in a truly deregulated marketplace rather than one that was subject to managed competition. It would not be credible to lay all the blame at Congress's feet by saying that the Telecommunications Act of 1996 compelled the FCC to follow an unbundling rule that ensured perverse economic consequences. Writing in his memoir in 2000, former FCC Chairman Reed Hundt said the following about the congressional compromises made to pass the Telecommunications Act of 1996: The . . . compromises had produced a mountain of ambiguity that was generally tilted toward the local phone companies' advantage. But under principles of statutory construction, we had broad . . . discretion in writing the implementing regulations. Indeed, like the modern engineers trying to straighten the Leaning Tower of Pisa, we could aspire to provide the new entrants to the local telephone markets a fairer chance to compete than they might find in any explicit provision of the law.3 Mr. Hundt's stratagem worked. By a 7-1 margin in Verizon Communications Inc. v. FCC,4 the FCC's lawyers successfully convinced the Supreme Court in 2002 of the reasonableness of
- 41. the agency's pricing rules for unbundled network elements ("UNEs"). Those rules are predicated on the novel concept of total element long-run incremental cost ("TELRIC").5 The TELRIC concept was so nuanced that the FCC devoted more than 600 pages to explaining it. Even if the FCC's TELRIC pricing model was not the best possible interpretation on economic grounds, it was deemed by the Court to deserve deference on review under the Chevron doctrine.6 How much leeway did that imply? A great deal, for Justice David Souter wrote for the Court that the Telecommunications Act of 1996 created a "novel ratesettmg designed to give aspiring competitors every possible incentive to enter local retail telephone markets, short of confiscating the incumbents' property."7 And what if those incentives led to a trillion dollars or more of wasted investment? That was not the Supreme Court's problem. With the exception of Justice Stephen Breyer, the Court would defer to any method, even one never contemplated by Congress in the Telecommunications Act of 1996, that the FCC might devise for pricing UNEs-that is, as long as the Court did not think that the method constituted a government taking of private property. And the Court signaled in the same opinion that it had no appetite for deciding that constitutional question anytime in the foreseeable future.8 The Court confirmed what the FCC's leadership had believed since 1996: That the agency had the wisdom to devise, and the authority to impose, the means to promote competition in local telephony. But those same officials and their successors were slow to acknowledge that the FCC correspondingly possessed the power to distort competition and investment in the telecommunications industry. On the question of wasted investment, there is a puzzle. There currently exists excess capacity in the telecommunications industry despite FCC policies that created an incentive for underinvestment by both incumbent local exchange carriers ("ILECs") and competitive local exchange carriers ("CLECs").9
- 42. The answer to this puzzle lies in the data. Eventually, research by empirical economists may give us a definitive autopsy. It will be necessary to examine the level of investment in local network facilities (including cable television systems and wireless systems) versus the level of investment in Internet backbone facilities, undersea cables, and other long-haul fiber- optic networks. For some investments, unrealistic predictions of demand may have more explanatory power than regulatory distortions. A powerful factor contributing to excess capacity in long- distance telecommunications was the unexpected degree of improvement in dense wave division multiplexing. At first, a given strand of fiber was split into two channels. The technology rapidly advanced to where a given strand of fiber now has over 100 channels, with the possibility of over 1000 channels in the future. Thus, as companies installed new long- distance networks, technology improved so dramatically that capacity outpaced growth in demand, even with the Internet's rapid growth. The connection between this fact and the WorldCom bankruptcy will be apparent later in this Article. It bears emphasis, however, that this excess capacity exists at the long-distance level, which is virtually unregulated in the United States. At the local level, relatively little new facilities investment by CLECs took place. Indeed, when Rhythms and Northpoint (the second and third largest CLECs offering DSL service) went bankrupt, their networks sold for under $50 million each. Similarly, Global Crossing's worldwide fiber optic network, which consumed $15 billion in financing to construct in the late 1990s, was implicitly valued in March 2003 at only $406.5 million.10 Thus, we observed overinvestment in long- distance networks with no regulation, and underinvestment in regulated local networks, where the FCC (and state regulators) set prices for unbundled elements and wholesale services. For the sake of argument, suppose that those policies were lawful but foolish. What should the FCC have done? Under Chairman Michael Powell's leadership, the FCC in 2002
- 43. undertook a "Triennial Review" of its policies on mandatory unbundling of local exchange networks. At that time, the agency continued to embrace the proposition that, in its words, "access to UNEs would lead to initial acceleration of alternative facilities build-out because acquisition of sufficient customers and necessary market information would justify new construction."11 This is a testable hypothesis. After seven years of implementing the Telecommunications Act of 1996, does empirical evidence support it? What would the FCC have to find empirically to continue to make this hypothesis the basis for its UNE rules? Empirical research by Robert Crandall of the Brookings Institution12 suggests that CLECs that built their own facilities were more likely to produce what the FCC calls "sustainable competition."13 In New York and Texas, for example, where CLEC market share is higher than elsewhere, is there any empirical evidence that there was a greater rate of reliance on UNEs by CEECs? Answers to such questions are essential to knowing whether, as the FCC assumes, mandatory unbundling at regulated TELRIC-based prices achieves its intended purpose. And what exactly is that purpose? Section 251(d)(2) of the Telecommunications Act requires an incumbent local exchange carrier to unbundle at a regulated price any network element which, if not offered on an unbundled basis at the regulated price, would "impair" the CLEC's ability to compete.14 The meaning of "impairment" is critical. Not surprisingly, the definition was litigated in the Supreme Court after the FCC essentially said that any UNE that can be unbundled must be unbundled. The Supreme Court concluded that such a definition had no limiting principle, and it therefore remanded the rulemaking to the FCC.15 The FCC then decided to use the phrase "materially diminishes" to limit the scope of the statutory phrase "impairs."16 In May 2002, in U.S. Telecom Association v. FCC, the FCC's impairment rule was again struck down on judicial review, this time by the U.S. Court of Appeals for the District of Columbia
- 44. Circuit in an opinion by Judge Stephen F. Williams.17 At that time, the FCC was already in the midst of its Triennial Review of its unbundling rules. The FCC thus already had a proceeding underway to answer the following kinds of questions that would give economic content to the definition of "impairment." If FCC regulation succeeded in reducing the CLECs' level of "impairment," what variable would we observe changing: Prices? Output? Investment? CLEC profit? Sales of complementary hardware and software? The FCC said that it wanted to review its UNE policies "in light of [its] experience" since 1996.18 Experience implies empiricism, and unless the FCC clearly states its hypothesis concerning the predicted effects of its particular unbundling policies, such as the impairment test, it cannot know what changes to expect or the method by which to measure them. The standard economic metric is consumer welfare, yet that is the one conspicuous variable that the FCC excluded from its laundry list of five factors that were supposed to unpack the phrase "materially diminishes."19 I submit that no reasonable understanding of "the public interest" can be reconciled with the FCC's exclusion of consumer welfare from the list of relevant considerations. A cynic might speculate that the reason for the omission is that consideration of consumer welfare would vitiate many of the FCC's conclusions on the essentiality of unbundling particular network elements. Consideration of consumer welfare would undo the competitor-welfare standard by which the FCC hoped to straighten the Leaning Tower of Pisa. In this sense, the unbundling debate illustrates the potential circularity of regulation. "Impairment" cannot be defined without reference to the price regulation to which UNEs are subject. Impairment is thus endogenously determined by UNE price regulation. Moreover, impairment is endogenously affected by the allowed duration of the lease. Under existing TELRIC pricing, would a CLEC be impaired if it were required to lease a UNE for its useful life (more precisely, for the
- 45. duration of its depreciable life for regulatory purposes), instead of being free to lease the UNE for a period that is terminable at will by the lessee and capped by regulators? Furthermore, what is the fundamental economic characteristic of "impairment?" Increasingly, the bottleneck of the telecommunications network is regarded as the trench in the street. The costliness of digging holes is a breathtakingly unpersuasive justification for mandating the unbundling of telecommunications networks, especially next-generation services. It is regrettable that only a fraction of regulatory energy was devoted to the coordination of the actual trenching and sizing of conduit as was devoted to estimating the forward- looking cost of an unbundled loop in a hypothetical network. A CLEC faces no barrier to entry with respect to the provision of a service if the ILEC itself is overlaying existing facilities or if it is building new facilities or totally rehabilitating previous facilities. The ILEC faces the same sunk cost that a CLEC would. This analysis would seem to answer the FCC's central question in its Triennial Review: should the FCC "modify or limit incumbents' unbundling obligations going forward so as to encourage incumbents and others to invest in new construction[?]"20 The FCC would clarify the meaning of "impairment" if it assessed the magnitude of the real option conferred on the CLEC by mandatory unbundling of a particular network element at a TELRIC-based price.21 The value of the real option held by the CLEC increases with three factors: uncertainty concerning technology, consumer demand, and regulation; the duration of the lease; and the degree to which the leased assets are investments by the ILEC that are sunk rather than salvageable. The real option view of mandatory unbundling meshes neatly with two of the five factors that the FCC had been using to determine the scope of unbundling-that is, before the D.C. Circuit's May 2002 decision in the U.S. Telecom Association case.22 The first factor is, in the FCC's words, "whether the [unbundling] obligation will promote facilities-based
- 46. competition, investment, and innovation," and the second, again in the FCC's words, is "whether the unbundling requirements will provide uniformity and predictability to new entrants and market certainty in general."23 With respect to the second factor, a lack of uniformity and predictability will increase the standard deviation of returns for the ILEC, which increases the value of the real option that the ILEC is implicitly forced by the FCC to confer on CLECs. That increased value of the real option represents the value to the CLEC of waiting to see whether the ILEC's investments in new technologies pan out before the CLEC commits itself to making sunk investments in the acquisition of particular UNEs. The real option has the effect of discouraging ILEC investment. To the extent that innovation flows from investment, innovation is jeopardized by a rising value of the real option inherently conveyed to CLECs through mandatory unbundling.24 In contrast to such economic analysis, the FCC's definition of "impair" as meaning "materially diminishes" does nothing to reduce the regulatory risk that drives the value of the real option that the ILEC must give CLECs when the FCC mandates unbundling at TELRIC-based prices. A "materiality" standard places enormous discretion in the hands of the regulator, which increases regulatory risk for those making decisions on investment in network infrastructure. That greater risk increases the value of the real option that the FCC forces the ILEC to confer on CLECs. To its credit, the FCC in 2002 proposed what it called a "more granular statutory analysis" of the unbundling requirements in Section 251 of the Telecommunications Act. That recommendation is consistent with the proposal that Jerry Hausman and I made in 1999.25 In our article, we advocate an impairment standard that is product-specific, geographically specific, and limited in duration. In essence, a competitive analysis of each desired network element is required, with an antitrust-style examination of competition in the relevant product and geographic market over the relevant time horizon.
- 47. This approach, incidentally, is consistent with the new regulatory framework that the European Union has adopted for telecommunications. In that framework, competition law principles (of which consumer welfare maximization is the most elemental) are supposed to guide decisions about what and how to regulate on a sector-specific basis. Under the Hausman-Sidak test, once the CLEC has demonstrated that the network element meets the basic requirements of the essential facilities doctrine, it would then need to show also that an ILEC could exercise market power in the provision of telecommunications services to end-users in the relevant geographic market by restricting access to the requested network element. Thus, the regulator would mandate unbundling of a network element if, and only if, all of the following conditions exist: * It is technically feasible for the ILEC to provide the CLEC unbundled access to the requested network element in the relevant geographic market; * The ILEC has denied the CLEC use of the network element at a regulated price computed on the basis of the regulator's estimate of the ILEC's total element long-run incremental cost; * It is impractical and unreasonable for the CLEC to duplicate the requested network element through any alternative source of supply; * The requested network element is controlled by an ILEC that is a monopolist in the supply of a telecommunications service to end-users and that employs the network element in question in the relevant geographic market; and * The ILEC can exercise market power in the provision of telecommunications services to end-users in the relevant geographic market by restricting access to the requested network element. In its practical application, this test would replace the FCC's current competitor-welfare standard with a consumer-welfare standard. The Hausrnan-Sidak analysis also answers the FCC's request in
- 48. its Triennial Review for an unbundling framework that incorporates what the Commission calls "intermodal competition."26 The test would consider the effect of declining prices and growing subscribership for wireless as a factor bearing on the extent to which wireless-wireline displacement, rather than unbundling rules, have impaired CLECs.27 The FCC's own statistics show that the number of wired access lines in the United States fell by two million between 2000 and 2001.28 In August 2002, Forbes magazine reported on the competitive implications of that fact,29 and the New York Times reported that wireless was displacing wireline telephone access.30 By early 2002, nearly eighteen percent of Americans considered wireless service to be their primary means of voice communication.31 Figure 4 shows the growth of wireless subscribership relative to local access lines. Figure 4 shows that the growth of wireless subscribers exceeded the growth of access lines between 1985 and 2002. Also, between 2000 and 2002, the growth rate of access lines was negative, whereas the growth rate of cellular subscribers remained positive. It would seem inescapable, therefore, that the wireless industry has stolen customers from the wireline industry. In other words, the local loop bottleneck is not a bottleneck. Competition occurs on the margin. So why does the FCC not acknowledge that cell phones now substitute for landlines for significant numbers of consumers? Even the Interstate Commerce Commission, the whipping boy of deregulators, managed to acknowledge intermodal competition between railroads, barges, and pipelines in the 1980s, when it revised its policy on rate regulation for railroads serving captive shippers.32 Of course, intermodal competition between wireless and wireline telephony depends critically on the FCC's allocation of sufficient spectrum to accommodate the shift in demand. This dependency on government spectrum allocation is another example of the regulation-induced endogeneity of perceived market failure. Without enough spectrum allocated, the local
- 49. loop looks like a bottleneck. That appearance of market failure is then considered evidence of the continued need for regulation. In the United States, we have never permitted the necessary counterfactual to come into existence, so as to assess without regulatory endogeneity whether the local loop really is a natural monopoly or an essential facility. If the FCC were to acknowledge the actual and potential displacement of wireline access by wireless, the exercise of mandating the unbundling of incumbent local exchange networks would sooner or later fade away. * * * On February 20, 2003, as this Article was going to press, the FCC announced its decision in its Triennial Review on unbundling policy. In a 3-2 vote in which Chairman Powell and Commissioner Kathleen Abernathy strenuously dissented from the majority led by fellow Republican, Commissioner Kevin Martin, the FCC announced a new impairment standard to be administered by the state PUCs. The procedure by which the FCC announced this new policy was bizarre, as the agency did not actually have an order to issue at its meeting. Evidently, because of the last-minute negotiations among the commissioners, the FCC voted on a "term sheet" for an order, not an actual draft order. Commissioner Michael Copps said in his separate statement: "Although the bottom lines have been decided, the devil is more often than not in the details. I am unable to fully sign on to decisions without reservations until there is a final written product."33 Clearly, changing a "shall" to "may" here and there in an order running several hundred pages could escape notice but have a substantial impact on the order's practical meaning. Given, for purposes of administrative procedure, the absence of the text of an order at the time of the February 20, 2003 meeting, it is fair to ask whether the FCC actually issued an order that day. If it did not, the old unbundling rules expired on February 20, 2003, pursuant to the lifting of the stay by the D.C. Circuit in the U.S. Telecom Association case.34 From that
- 50. day until the FCC ultimately publishes the text of its Triennial Review order in the Federal Register, only the bare statutory language of Section 251 of the Telecommunications Act defines the government-created rights of CLECs and the government- created obligations of ILECs. Similarly, if the devil is truly in the details, then the commissioners' final agreement on the language of the Triennial Review order would seem to be a different "meeting" for purposes of administrative law, separate from their decision to reduce to writing their broad-brush agreement on "the bottom lines." If so, then this subsequent meeting would trigger the usual public notice and ex parte procedures. The high school civics rendition of administrative law would posit that Congress, a political body, established the FCC to be an expert independent agency to set telecommunications policy. Because of such agency expertise and independence, the Supreme Court has instructed the D.C. Circuit and other federal appellate courts to defer, through the Chevron doctrine, to the reasoned analysis of an agency like the FCC. The FCC's decision in the Triennial Review, however, plainly was not based on reasoned analysis, as there was no document explaining why various lines were being drawn in one place and not another. The decision exhibited neither expertise nor independence. The commissioners could not be sure what they were voting for, and their statements accompanying the decision radiated politics. The possible dimensions of political struggle in the Triennial Review are multiple: There are the economic interests of the RBOCs in conflict with those of AT&T and the other CLECs; the personal ambitions of Commissioner Martin versus those of Chairman Powell; and, even though they seem far fetched, White House concerns about the ramifications of unbundling and TELRIC pricing for the 2004 presidential election.35 Given so much politics surrounding what can only be fairly characterized as a desiccated matter of pricing regulation, it is worth asking why Congress needs the FCC at all. Why should
- 51. Congress delegate the making of transparently political decisions concerning telecommunications to a body whose comparative advantage is not supposed to be politics? Why not leave political decisions with the elected federal legislature? If the FCC's review of mandatory unbundling policy ultimately will turn on politics, why should Congress permit the FCC to waste more than a year compiling a record by which the agency might pretend to have reached its decision by a more disinterested means? The Triennial Review also incidentally suggests how Chevron can cheapen the constitutional role of the judiciary with respect to oversight of the administrative state. Agencies and the litigants before them engage in highly strategic use of the administrative process in which the sustainability of regulations on appeal is a major component. If the purpose of appellate review is to determine whether a supposedly expert independent agency has managed to produce one "reasonable" reading of its statute, then how much is really left for appellate judges to do in administrative law? It does not require a penchant for judicial activism to believe that Chevron can diminish the proper role of the Judiciary as the interpreter of acts of Congress. How much deference is due an agency decision like the Triennial Review, which mocks the administrative process? Turning to the substance of the FCC's decision, the Commission's press release redefined "impairment" such that "[a] requesting carrier is impaired when lack of access to an incumbent LEC network element poses a barrier or barriers to entry . . . which are likely to make entry into a market uneconomic."36 This analysis, the FCC said, "specifically considers market-specific variations, including considerations of customer class, geography, and service."37 The only UNE that the FCC removed from the unbundling list was switching for high-capacity loops (which principally serve business customers), and even that national finding may be rebutted by individual states.38 With the exception of high-capacity switching, the new status quo would seem to be that all UNEs
- 52. still must be unbundled unless the state PUC decides otherwise. It is not clear that there is any time limit on how long a state may take to determine whether to remove a UNE (other than high-capacity switching) from the list of elements subject to mandatory unbundling at regulated prices. The FCC's new approach to implementing the impairment test (though certainly not its results, judging from the number of UNEs that remain on the unbundling list) sounds compatible with the Hausman-Sidak test, which would evaluate these same kinds of competitive factors on a granular, geographically disaggregated basis. The Hausman-Sidak framework also envisions that the state PUCs have the resources and fact- finding experience to assist the FCC in conducting the analysis that is essential to administer the impairment standards with the requisite degree of geographic specificity. In addition to redefining impairment, the FCC stated that it would modify the calculation of TELRIC in two respects: it would direct the state PUCs to use a higher cost of capital to reflect an ILEC's competitive risk, and it would permit the states to use accelerated depreciation that more closely tracks the useful life of telecommunications equipment.39 Both of these adjustments move the calculation of TELRIC (though perhaps only incrementally) in the direction of reflecting the real option value of mandatory access at a regulated price. In other words, using a combination of Chevron deference and the Supreme Court's 2002 TELRIC decision, the FCC may be trying to redefine TELRIC so that new-TELRIC produces higher UNE prices than old-TELRIC. The possible means to do so are as numerous as they are arcane, and they definitely could not be discerned from a press release. III. The Collateral Damage to the Telecommunications Industry from WorldCom's Fraud and False Statements WorldCom's accounting fraud poses a serious question for telecommunications regulators. Over the past twenty years, the principal economic insight in the regulation of network industries has been the asymmetric information between the
- 53. regulator and the incumbent. The incumbent is typically cast as a dominant firm, if not an outright monopolist in law or fact. The concern over asymmetric information led to both incentive regulation and dominant-carrier regulation. Because the regulator's access to information was imperfect, the dominant carrier was subjected to greater obligations of disclosure, tariffing, and reporting. The proposition that competitors were sophisticated veterans of antitrust and regulatory battles did not fit comfortably within this model. On September 26, 2002, the former controller of WorldCom pled guilty to criminal fraud in connection with the company's accounting scandal and bankruptcy.40 The same day, the Wall Street Journal reported that government reports unintentionally dignified WorldCom's false claim that Internet traffic was doubling every one hundred days.41 The government thus contributed to the hype that caused tens, if not hundreds, of billions of dollars to be invested in long-distance fiber optic networks that go unused. Despite the intensity of the FCC's demands for information from the incumbent carriers, the agency was blindsided by the disaster caused by WorldCom's dissemination of false information. To appreciate the extent of the harm that WorldCom has caused in the telecommunications industry, it is necessary to understand the breadth of services that the company offers. WorldCom is a major provider of Internet services, which include Internet backbone, hosting, virtual private networks, and wholesale Internet service provider services.42 WorldCom's consumer offerings are long-distance service, local service, and prepaid calling cards. WorldCom's business offerings are voice, data, international, and government services. WorldCom's misconduct reached private parties who consume, or supply inputs for, each of these services. A. False Internet Traffic Reports That Encouraged Overinvestment in Long-Distance Capacity Rival telecommunications carriers would have found it reasonable to believe WorldCom's Internet traffic projections
- 54. because (1) such data are proprietary and WorldCom dominated Internet backbone services, and (2) WorldCom was subject to regulatory oversight and was submitting those same estimates to regulators. WorldCom's competitors subsequently directed billions of dollars in capital expenditures for long-distance and Internet backbone capacity. It is also possible that WorldCom's accounting fraud, which I discuss in the following section, contributed to excessive capital expenditures by WorldCom's competitors. WorldCom's claim that Internet traffic was doubling every one hundred days misled government officials and the business press. The claim first surfaced in 1996 and has been traced to the chief scientist of UUNet, a subsidiary of WorldCom.43 In 1997, WorldCom issued a press release stating that Internet traffic was "almost doubling every quarter."44 John Sidgmore, the chief executive officer of WorldCom, repeated the claim in 1998.45 In September 2000, Kevin Boyne, the chief operating officer of UUNet, told the Washington Post: "Over the past five years, Internet usage has doubled every three months. We're seeing an industry that's exploding at exponential rates."46 According to Professor Andrew Odlyzko, WorldCom's executives were "more responsible for inflating the Internet bubble than anyone."47 The Appendix to this Article is a chronology of this erroneous "factoid." WorldCom's Internet traffic myth was widely repeated by several important government officials (including Vice President Al Gore, FCC Chairman William Kennard, former FCC Chairman Reed Hundt, Secretary of Commerce William Daley, and Representative Edward J. Markey of the House Telecommunications Subcommittee) and media outlets (including the Financial Times, Business Week, the New York Times, the Washington Post, ABC News, the BBC, CNN, and Reuters). WorldCom's misrepresentation of the growth of Internet traffic had the air of credibility because data on Internet traffic volumes, unlike data on voice telephone traffic, are regarded to be highly proprietary and consequently are not shared among
- 55. Internet service providers or backbone carriers. When it sought to acquire Sprint's sixteen percent share of the Internet backbone business, WorldCom controlled thirty-seven percent or more of the Internet backbone market.48 Consequently, investors, competitors, and the public had good reason to take WorldCom's representation about Internet traffic growth on its face, since the company was uniquely positioned at the time to know this information. WorldCom surely understood how heavily the marketplace and government agencies relied on its Internet traffic reports. In his testimony to Congress in January 2003, Commissioner Michael Copps explained how the FCC is forced to rely on honest reporting by telecommunications carriers: [W]e must use our current authority to reduce the chance that, in a competitive market, corporate misdeeds and mismanagement will injure American consumers or the competition that Congress sought to promote in the 1996 Act. In light of all the accounting depredations we have witnessed in the financial world regulated by the SEC, we need to reassure ourselves that our own accounting procedures and requirements are in good stead. Our accounting data inform our decisions about the reality of competition and the protection of consumers. Commissioner Copps argued that the FCC must reduce its dependency on regulated carriers for data: We have come to rely over the years perhaps too much on self- reported industry data or Wall Street analysts for information to make critical decisions. We must commit to doing the hard work of collecting our own data rather than relying on potentially misleading and harmful financial, accounting, and market information produced by corporate sources subject to clear biases and market pressures.50 In retrospect, it appears that WorldCom used this asymmetry of information to exaggerate the value of its stock by overstating the growth in Internet traffic volumes. WorldCom's misrepresentation of that growth encouraged
- 56. excessive investment in long-distance capacity. AT&T Labs reported in 2001 that rival telecommunications carriers made investment decisions in reliance on WorldCom's faulty projections: Whether Internet traffic doubles every three months or just once a year has huge consequences for network design as well as the telecommunications industry. Much of the excitement about and funding for novel technologies appear to be based on expectations of unrealistically high growth rates.51 Some industry analysts attribute much of the enormous decline in market capitalization in the telecommunications sector to WorldCom's misconduct.52 The Eastern Management Group found that: At the time, the returns from the long haul data market seemed almost beyond estimation due to repeated claims of (then market leader) UUNET (later WorldCom) executives that 'Internet traffic was doubling every 90 to 100 days-an assumption that drove much of the overbuilding and proved to be wildly exaggerated.53 The Eastern Management Group also determined that a significant percentage of the $90 billion invested by carriers in the long-haul industry was misallocated because of WorldCom's false projections.54 B. WorldCom 's Accounting Fraud May Have Destroyed Billions of Dollars of Shareholder Value in Other Telecommunications Firms WorldCom's accounting fraud harmed telecommunications equipment manufacturers and other telecommunications carriers. WorldCom's accounting restatements may have even contributed to a much broader loss of shareholder value across the equity markets as a whole. In congressional testimony in January 2003, Commissioner Kathleen Abernathy partially attributed the downturn in the telecommunications sector to WorldCom's fraudulent behavior: Not only did the economy suffer from devalued businesses and widespread layoffs, but several companies-most notably,
- 57. WorldCom-appear to have resorted to financial deception to mask poor performance. This fraud compounded the downturn by shaking investors' confidence in the truthfulness of financial statements.55 Anecdotal evidence supports Commissioner Abernathy's view, as the financial community blamed WorldCom's financial improprieties for severe market declines in the telecommunications industry.56 Empirical evidence also supports Commissioner Abernathy's view that WorldCom's fraud destroyed shareholder value in other telecommunications firms. To estimate the magnitude of that destruction of wealth, I performed an event study. One can use event-study analysis to assess whether the capital market, when controlling for general movement in the broader stock indices, considered WorldCom's accounting errors to be "good news" or "bad news" for rival telecommunications providers. I focused on the reaction of the stock prices of WorldCom's long- distance competitors (AT&T and Sprint) and U.S. telecommunication equipment manufacturers (Lucent, Nortel, Corning, Cisco, JDS Uniphase, and Tellabs). My hypothesis is that the market interpreted the announcement of WorldCom's accounting error as "bad news" for the telecommunications industry for a variety of reasons. WorldCom's accounting error likely had a negative impact on its long-distance competitors because bad news for one firm may be bad news for other firms in the same market. On the other hand, the financial market may have interpreted the collapse of WorldCom as an opportunity for AT&T and Sprint to gain market share. Hence, the expected net effect of WorldCom's fraud on its direct competitors is ambiguous. Telecommunication equipment manufacturers' stock prices, by contrast, would have suffered unambiguously from WorldCom's news because the accounting scandal raised doubts about the growth of the telecommunications and Internet market that had been predicted through WorldCom's statements and success.57 I used the market model to estimate the predicted returns to a
- 58. particular company on the event day of June 26, 2002, when WorldCom initially announced a $3.8 billion accounting restatement.58 The market model is given by the following equation: where R^sub it^ represents the return to company i on day t, R^sub mt^, represents the return to the S&P 500 Index on day t, and [epsilon]^sub it^ represents an error.59 The estimate of [alpha] "alpha," is the average rate of return the stock would expect on a day when the S&P 500 Index realized a zero return. The estimate of [beta]^sub i^, or "beta," represents the sensitivity of company i's returns to general market movements, or its "systematic risk." Betas and alphas were estimated using the ordinary least squares method for the market model equation over a 200-trading-day estimation period (which is t = -250 to - 50, where t = 0 is the event date, June 26, 2002). The "expected return" of a stock is defined as the stock's estimated alpha plus the product of the actual daily return of the S&P 500 Index and the stock's estimated beta. I calculated the "abnormal returns" for each firm by subtracting the expected returns from the actual returns. That is, the daily abnormal returns are the residuals for each observation in the regression analysis. Consider now an unexpected announcement when t = 0, or the event day. I consider two windows. The first is a window of three days, from one day before the announcement to a day after the announcement. The second is a one-day window that considers the abnormal returns solely on the event day itself. For each window, I compute the cumulative abnormal returns for that period. I also compute abnormal returns for value- weighted portfolios of affected firms. Finally, for each window, I compute the standard errors of the abnormal returns (for each company and each portfolio) by using information covering the 200-day estimation period. The first news of WorldCom's accounting error came on the evening of June 25, 2002. By the next morning, Nasdaq had suspended trading in WorldCom's stock. WorldCom's stock had closed at 83 cents on June 25, 2002. Trading resumed on July 1,
- 59. 2002, when WorldCom's stock price opened at 8 cents and closed at 6 cents, an overall decrease of 93 percent. News of WorldCom's revision of its accounting errors was released on the evening of August 8, 2002. That news did not have as great an impact as the initial news of accounting errors, and WorldCom's stock fell from 12.5 cents on August 8, 2002, to 10.94 cents on August 9, 2002-a decrease of 12.5 percent. After the subsequent September estimated revision to the accounting error, WorldCom's stock price fell from 12.11 cents on September 18, 2002, to 11.33 cents on September 19, 2002-a decrease of 6.4 percent. The price movements in WorldCom's stock for the August and September events do not appear to differ from the movements of most stocks that have fallen to "penny-stock" status. Any price change is large in percentage terms. In addition, the last two event dates occurred after WorldCom had declared bankruptcy. Therefore, the market had already assigned a high probability to the prospect that WorldCom's common stock would eventually become worthless, whether or not the firm emerged from bankruptcy. Because investors likely expected WorldCom to revise its earnings after the first disclosure, I do not consider the second and third revision of WorldCom's losses to be event days for the purpose of the event study. The first announcement of WorldCom's accounting errors likely had the greatest impact on other firms' share prices. Table 1 shows the value-weighted abnormal returns for long- distance providers and equipment manufacturers upon the first news of WorldCom's accounting restatement on June 26, 2002. Table 1 shows that the AT&T and Sprint portfolio experienced significant negative abnormal returns on both the day of WorldCom's initial announcement and during the three-day window surrounding the announcement.60 The disaggregated results in Table 2 show that WorldCom's initial announcement affected Sprint more than AT&T. Table 1 also shows that the portfolio of U.S. equipment manufacturers experienced negative cumulative abnormal returns over each time period. Table 3
- 60. presents disaggregated results. Corning, JDS Uniphase, Lucent, Nortel, and Tellabs experienced significant negative abnormal returns on the day of WorldCom's initial announcement. Corning, Lucent, and Nortel experienced significant negative cumulative abnormal returns during the three-day window surrounding the announcement. Cisco did not experience a statistically significant abnormal return, perhaps because the demand for its principal products (routers) was for some reason less affected by WorldCom's initial announcement than was the demand for the products of the other telecommunications equipment manufacturers. However, because of its large market capitalization, Cisco swamps the results of a value-weighted portfolio of telecommunications equipment manufacturers. For that reason, Table 1 reports findings with and without Cisco included in the value-weighted portfolio of telecommunications equipment manufacturers. The negative cumulative abnormal returns experienced by AT&T and Sprint around the date that WorldCom first revealed its accounting problems amounted to $2.5 billion in losses in market capitalizations (equal to $49.2 billion * -5.0%). The negative cumulative abnormal returns experienced by telecommunications equipment manufacturers around the same date amounted to $5.3 billion in losses in market capitalizations (equal to $127.4 billion * -4.2%). In other words, event study analysis indicates that WorldCom's accounting fraud destroyed at least $7.8 billion of shareholder wealth in other American telecommunication companies. C. Incorrect Information Supplied to State and Federal Governments That Was Essential to Formulating Telecommunications Policies Reasonable minds can differ over whether telecommunications regulation is excessive or insufficient. But as long as the United States continues to regulate telecommunications at all, it is essential that companies give regulators truthful, complete, and accurate information. Otherwise, the FCC cannot make policies that reflect actual market conditions. Chairman Powell stated in
- 61. September 2002 that "[r]egulatory accounting data and related information filed by telecommunications carriers is used by federal and state telecommunications policymakers to fulfill various responsibilities, such as determining interstate access charges, evaluating federal-state jurisdictional separations, setting rates for unbundled network elements and calculating universal service support."61 WorldCom must report data on gross billed revenues on an annual and quarterly basis.62 Those data are filed on FCC Form 499-A or 499-Q, signed by an officer of the company, along with revenue information collected on FCC Form 159 submitted in September of each year. The Commission uses those data to calculate regulatory fees as well as contributions to support the Universal Service Fund, Local Number Portability Administration, North American Numbering Plan Administration, and Telecommunications Relay Service.63 To the extent that WorldCom provided false information, those public programs and services might not be funded appropriately. WorldCom's false statements to regulators influence the investment decisions of its rivals. For example, WorldCom and MCI have actively participated over the years in FCC proceedings determining whether AT&T should be released from price regulation or whether the Bell companies should be allowed to offer long-distance service. If false or unreliable information in such proceedings skews the FCC's development of regulations, the investment decisions and competitive strategies of telecommunications carriers will also be misdirected, all to the ultimate detriment of consumers. D. Can Federal Courts, Regulators, Congress, and Cabinet Departments Trust WorldCom's Filings? WorldCom's accounting fraud destroys the company's credibility in proceedings before the federal courts, regulatory commissions, Congress, and cabinet departments. Since 1996, for example, WorldCom has argued to state and federal regulators that the cost of an unbundled loop is much less than incumbent local exchange carriers say it is. Yet a central thrust
- 62. of the SEC's investigation of WorldCom concerns its understatement of its own costs of local access. Similarly, the costs of interconnection and unbundling are central to the Commission's Triennial Review of local competition policies. The FCC cannot take at face value the representations that WorldCom makes in such a proceeding. The U.S. Trade Representative cannot take at face value what WorldCom says the cost of local interconnection should be in Japan. The Supreme Court cannot take at face value what WorldCom asserts to constitute "impairment" under Section 251. And Congress cannot take at face value what WorldCom claims about the importance of UNE-P for local competition. All those governmental bodies are rightly concerned with the proper meaning of "cost" in local telecommunications, and that is the fundamental question around which WorldCom spun its enormous accounting fraud. All those other governmental bodies are justified in approaching what WorldCom has to say with skepticism, particularly in light of the fact that the New York Times reported that, as recently as January 2003, the carrier was still failing to report its true financial condition.64 IV. Were WorldCom's Fraud and Bankruptcy Intended To Achieve an Anticompetitive Purpose? The FCC should investigate whether WorldCom's fraud and subsequent bankruptcy had an anticompetitive purpose. In other words, the fraud may have been intended to exploit not only WorldCom's investors, but also its customers and competitors. A. Repeated Misrepresentation of Financial Performance In addition to making the false claims of Internet traffic growth explained above, WorldCom provided the FCC and the sec with false information regarding line costs and hence earnings. WorldCom subsequently acknowledged that corporate officers and other senior executives knew that those submissions were without foundation.65 In its june 2002 complaint against WorldCom, the SEC explained the nature of WorldCom's deceit: WorldCom reported on its Consolidated Statement of Operations contained in its 2001 Form 10-K that its line costs
- 63. for 2001 totaled $14.739 billion, and that its earnings before income taxes and minority interests totaled $2.393 billion, whereas, in truth and in fact, WorldCom's line costs for that period totaled approximately $17.794 billion, and it suffered a loss of approximately $662 million.66 Hence, WorldCom exaggerated its earnings in 2001 alone by nearly $3 billion. WorldCom later admitted that $3.055 billion in line costs (which represent fees paid by WorldCom to third parties for network access) were improperly transferred from expense to capital accounts during 2001.67 WorldCom further admitted that, despite the company's representations, those transfers did not comply with generally accepted accounting principles.68 Since the filing of the SEC's complaint on June 26, 2002, WorldCom admitted additional improprieties in years before 2001. WorldCom admitted that in 1999, 2000, 2001, and the first quarter of 2002, thecompany "improperly reported"69 an additional $3.3 billion in earnings. Hence, the earlier Form 10- Ks that WorldCom submitted to the SEC and FCC for those accounting periods also contained misrepresentations. B. Fraudulent or False Statements as a Means To Raise Rivals ' Costs WorldCom's fraudulent behavior may have raised rivals' costs by inducing inefficient investment in capacity and inefficient expenditures for customer acquisitions. A carrier makes investment decisions based on expected use of its network. If a carrier expects constantly increasing demand, it will invest in capacity. To the extent that carriers relied on WorldCom for information concerning future demand for Internet or long- distance services, those carriers may have made inefficient investment decisions. Because capacity in a telecommunications network is irreversible, the carrier could not downsize in the face of revised expectations. The costs would be forever sunk. WorldCom's fraud also has likely caused inefficient expenditures for customer acquisition. A carrier expends resources on customer acquisition on the basis of expected
- 64. profits from winning the customer net of the acquisition costs. An example of such acquisition costs at the residential level is the offer of a $100 check to a customer who switches long- distance carriers. As demonstrated above, WorldCom misrepresented its line costs, which are the fees paid by WorldCom to third parties for network access. Because a rival carrier could overestimate the expected profits of acquiring a local customer (equal to the expected revenues less expected line costs), the rival camer might pay too much for customer acquisition. As with capacity investment, customer acquisition is a sunk cost that cannot be recovered. If allowed to continue operating as a carrier in good standing with the FCC, WorldCom's deceptive reporting could contaminate the beliefs of the investment community and force competitive carriers to pay higher capital costs. Like most competitive industries, the investment community judges telecommunications carriers on the basis of relative performance. If carrier's A's earnings are growing more slowly than the earning of carrier B, then carrier A is considered to be underperforming. Inflating one's books in this setting is analogous to grade inflation among rival academic departments: If one's competitors are exaggerating their performance, then choosing not to inflate your books may result in a lower stock price. Understanding this perverse competition for respectability, investors might discount the reported earnings of all telecommunications carriers, not just the reports by those with tarnished reputations. This problem is commonly recognized in the economics literature as the "lemons problem." As defective cars drove out good cars from the used car market in Nobel laureate George Akerlof's famous example,70 fraudulent carriers might drive out honest carriers in the telecommunications industry. The result would be higher capital costs for the surviving carriers and less investment in the telecommunications network. C. Reduced Cost of Capital and Facilitation of Acquisitions
- 65. A firm's cost of capital is the expected return on a portfolio of all of that firm's securities.71 If WorldCom had preferential access to capital because of its fraudulent accounting, then the firm's cost of capital would be lower than it otherwise would be, all other factors being equal.72 By exaggerating its earnings, WorldCom may have lowered its average borrowing rate owing to the false impression that WorldCom would cover its loans. WorldCom also could have lowered its beta (or sensitivity of its stock price to changes in the market index), which in turn would have lowered its average return on equity. This artificial reduction in WorldCom's cost of capital helped it to make a series of costly acquisitions of long-distance, Internet backbone, local telephone, paging, and web application/hosting companies. WorldCom paid for the acquisitions with its own inflated stock.73 Table 4 summarizes WorldCom's acquisitions from December 1996 through July 2001. As Table 4 shows, from December 1996 through July 2001, WorldCom spent $66.5 billion in acquisitions. Had the Department of Justice approved the firm's offer for Sprint, WorldCom would have spent $195 billion on acquisitions. D. During the Pre-bankruptcy Period, WorldCom's Fraud Facilitated a Business Strategy That May Have Been Designed To Harm Rival Providers of Internet Backbone or Long- Distance Services Before its bankruptcy, WorldCom's business strategy may have been designed to use the company's accounting fraud to harm rival producers. Because WorldCom's real costs were unknown, its pricing of Internet backbone services bore no relation to cost. Unlike standard applications of predation theory, recoupment of losses in the instant case was unnecessary because WorldCom's management had other ways to profit personally and because Chapter 11 bankruptcy was readily available if the strategy failed. WorldCom's strategy may be novel, but it was not irrational. And, in any event, novelty and irrationality are not defenses to the antitrust laws. 1. Because WorldCom's Real Costs Were Unknown, Its Pricing
- 66. of Internet Backbone Services Bore No Relation to Cost and Thus Served To Distort Competition It is entirely plausible that WorldCom priced its Internet backbone service below its actual long-run average incremental cost ("LRAIC"). WorldCom was reporting lower costs than it actually incurred. In his first report as the court-appointed Examiner of the WorldCom bankruptcy, former Attorney General Dick Thornburgh observed that over the course of five quarters in 2001 and 2002 WorldCom "took the brazen and radical step of converting substantial portions of its line cost expenses into capital items," a step that overstated capital investment and understated expenses.74 WorldCom's rivals could not detect that WorldCom was engaged in predation. WorldCom's rivals were forced to cut their prices and possibly incur actual losses on their books or forfeit market share to a rival whose lower prices were not the result of superior efficiency. According to Sprint's former chairman and chief executive officer, William Esrey, the pressure to compete in the market, and to match the growth claimed by companies that later turned out to be falsifying their accounting, pushed telecommunications companies into unreasonable expansion, foolish investments, and unsustainably low pricing. Esrey notes "[w]e kept asking ourselves what we were doing wrong because we couldn't generate the numbers WorldCom reported . . . . As we discovered, the margins were a hoax but the devastating effect on our industry was very, very real."75 That deception explains how WorldCom could use "low-ball" bids to secure lucrative government contracts. If competitors were bidding on the basis of actual costs, while WorldCom was bidding on the basis of fictitious costs, the most efficient carrier would not necessarily win the bidding. For example, in 2001, before WorldCom admitted that it was falsifying its books, WorldCom earned $1.7 billion, or eight percent of its revenue, from state and federal government contracts.76 In November 2002, the federal government awarded WorldCom a contract to provide telecommunications
- 67. services for veterans hospitals.77 In the same month, WorldCom also won an extension of a contract with the General Services Administration ("GSA") to provide long-distance telephone service for seventy-seven federal agencies, a deal that WorldCom reported was worth $331 million per year.78 In December 2002, WorldCom was awarded a contract to provide global communications services to the State Department, a concession reportedly worth up to $360 million over ten years.79 To the extent that WorldCom can or did reduce its competitors' output by fraudulently winning government contracts, it is plausible that WorldCom possessed and continues to exert the power to discipline competitors or induce them to exit the industry. This manifestation of market power is unfamiliar to telecommunications regulators and antitrust enforcers. But the fact that this unprecedented strategy does not fit comfortably within traditional economic theories of anticompetitive behavior in no way mitigates its demonstrated injury to economic efficiency and the competitive process. 2. Recoupment of Losses Was Unnecessary as a Condition for Plausible Predation by WorldCom Because Its Management Had Other Ways To Profit Personally WorldCom's management did not need the company to recoup predatory losses by subsequently raising prices.80 This feature of predation by WorldCom is in direct contrast to the scholarship81 and jurisprudence82 on predatory pricing by private firms, which has emphasized that, after the exit or disciplining of competitors or the prevention of entry, the dominant firm will raise its price high enough above the competitive level for a long enough time to recoup the earlier profit sacrifice and more. The key insight with respect to WorldCom is that a divergence of interests developed between the company's shareholders and management. Consequently, WorldCom's management had the opportunity to devise strategies by which to benefit privately from a pricing policy that might never have envisioned that WorldCom would recoup
- 68. its losses from pricing without regard to cost. By analogy, economists and policymakers have recognized that public enterprises may not need to recoup predatory losses.83 The Organization for Economic Cooperation and Development has drawn the distinction that, in the case of a public enterprise, predatory pricing is a subset of "distortionary" pricing, which does not necessarily require conventional recoupment of losses: It is convenient . . . to label pricing below cost as "distortionary." "Predatory" pricing is a temporary form of distortionary pricing. Even where distortionary pricing does not lead to prices subsequently being raised above cost, it may still be of public policy concern, because of the effect on productive efficiency. Distortionary pricing might induce a more efficient firm to leave or to not enter the competitive market.84 One can extend this reasoning to WorldCom's case, where a serious principal-agent problem decoupled shareholders' interest in profit maximization from management's interest in personal wealth maximization. WorldCom's managers could have personally benefited without recoupment of losses in three ways. First, insiders may have sold WorldCom stock (or tipped others to sell) in anticipation of the stock's collapse. Second, WorldCom may have extended sweetheart loans to WorldCom's senior executives that were collateralized by WorldCom stock. At the time of WorldCom's bankruptcy, Mr. Ebbers owed the company more than $400 million in personal loans having long repayment terms and interest rates of 2.18 to 2.21 percent.85 The Financial Times reported that "[t]he loans were made to cover a series of margin calls on personal loans Mr. Ebbers had guaranteed with his significant WorldCom shareholding."86 As of December 2002, Mr. Ebber had not repaid the loan.87 In addition, Mr. Ebbers himself personally loaned $650,000 to his chief operating officer, Ron Beaumont, whom WorldCom's board relieved of operating responsibilities on October 1, 2002.88 Since its bankruptcy, WorldCom has been forced to sell, among other assets, a shipyard and the largest cattle ranch in Canada, both of
- 69. which Mr. Ebbers purchased with loans from WorldCom that were collateralized by his stock in the company.89 Third, given how WorldCom's business strategy affected the market value of its competitors, WorldCom's management had the opportunity to take long or short positions in the securities of other telecommunications companies so as to exploit the market-moving potential of WorldCom's false statements. It is not obvious that such trades would constitute unlawful insider trading. WorldCom's fraud may have been purposefully designed to depress the share values of potential acquisition targets. If so, WorldCom could have benefited in two ways. First, the company would have lowered its acquisition costs. Second, it would have enhanced its own valuation-generally a result of WorldCom's using acquisitions to boost earnings through pooling-of-interest accounting.90 This strategy, of course, would not require a divergence of interests between WorldCom's management and shareholders. 3. The Coordinated Actions of WorldCom's Management, Its Investment Bankers, and Its Auditors May Have Injured Competition in the Telecommunications Industry WorldCom's management, its investment bankers, and its auditors may have conspired in a manner that unlawfully restrained trade.91 Competition can suffer even when conspiracies occur among parties that do not compete against one another in the relevant market. Hence, although they obviously do not supply Internet backbone or long-distance services, WorldCom's auditors and its investment bankers still could have directly injured competition in the telecommunications industry by participating in agreements with WorldCom's management that had the effect of facilitating WorldCom's fraud.92 Figure 5 shows how each party stood to benefit from two possible conspiracies. As Figure 5 shows, Salomon Smith Barney, one of WorldCom's principal investment bankers, may have supplied WorldCom's management false and misleading equity research for public
- 70. dissemination, as well as preferred participation in initial public offerings ("IPOs") of other companies, in exchange for lucrative investment banking work.93 Attorney General Thornburgh reported to the bankruptcy court in November 2002 that he had found evidence that Jack Grubman, the lead telecommunications equity analyst at Salomon Smith Barney, had "alerted [WorldCom] ahead of time to the questions he would ask in conference calls between securities analysts and WorldCom management."94 Mr. Thornburgh also reported that his examination would continue to investigate "the wildly enthusiastic analyst reports issued by [Salomon Smith Barney] and others with respect to WorldCom at a time when the stock was plummeting."95 Based on his examination as of November 2002, Mr. Thornburgh reported: "In the transactions we have reviewed to date, [Salomon Smith Barney] and its predecessors, Salomon Brothers and Smith Barney, collectively received more engagements from WorldCom than any other investment banking firm during the past five years."96 Similarly, WorldCom's auditor, Arthur Andersen, may have provided WorldCom's management false and misleading audits in exchange for lucrative consulting work.97 In his November 2002 report, Mr. Thornburgh questioned "the extent to which Arthur Andersen should have done more to determine whether the risks of abuses were adequately taken into account by the Company's internal control systems, most pointedly its internal audit function."98 In addition, to increase the likelihood of keeping WorldCom's investment banking work, conglomerate financial institutions may have supplied WorldCom's chairman, Bernard Ebbers, and the company's other senior executives with hundreds of millions of dollars of personal credit lines that were inadequately collaterized with those managers' individual holdings of WorldCom stock. Mr. Ebbers obtained over $800 million in personal loans from conglomerate financial institutions over a period of seven years, using his personal holdings of WorldCom stock as collateral.99 Citigroup lent Mr. Ebbers $499 million in
- 71. 1999 for the purchase of timberland. At the time, this amount represented more than thirty-five percent of Mr. Ebbers' total worth, and Mr. Ebbers had already used his holdings of WorldCom stock as collateral for sizeable loans from other financial institutions.100 In total, Citigroup lent Mr. Ebbers $552 million, of which over $450 million had not been repaid by the end of 2002.101 Either of the possible conspiracies depicted in Figure 4 would reflect the serious principal-agent problem between WorldCom's management and its investors. The conspiracies would have eliminated the need for WorldCom's management to recoup losses from any predatory strategy directed at rivals in the long- distance market or Internet backbone market. Put differently, WorldCom's managers would gain despite the fact that WorldCom's shareholders would never recoup the company's losses. V. The FCC's Unique Obligation To Investigate WorldCom's Harm to the Telecommunications Industry In January 2003, FCC Chairman Michael Powell gave Congress his policy agenda for the new year. An important component, if not the centerpiece, of that agenda was the Commission's "Triennial Review" of local competition policies.102 Conspicuously absent from Chairman Powell's written testimony, however, was any mention of WorldCom's fraud and bankruptcy. At a minimum, that omission implies that the adjudicatory implications of WorldCom's fraud take a backseat to the rulemaking questions of unbundling and access pricing. At a deeper level, the omission suggests that at least some key decisionmakers at the Commission do not recognize even now that unbundling and access pricing rules are intimately related to the substance of WorldCom's fraud. Because WorldCom is one of the two largest CLECs in the United States, the FCC cannot change unbundling and access pricing policies without directly affecting WorldCom's financial condition.103 A. After Chapter 11 Reorganization, WorldCom Could Underprice Efficient Rivals
- 72. Using Chapter 11 bankruptcy to lower costs cannot induce exit among one's rivals in an industry that lacks economies of scale or network effects. If higher-cost rivals can survive with miniscule market share, then the predatory strategy fails. On the other hand, if a critical share of customers is necessary to remain viable, predation becomes a plausible means to discipline rivals or induce their exit. Because the Internet backbone market exhibits both economies of scale and network effects, the loss of customers due to higher costs (and hence higher prices) can be fatal for a carrier. Even if the target of predation itself declares Chapter 11 bankruptcy, it will struggle to compete effectively against WorldCom in future periods. WorldCom's continued operation after Chapter 11 reorganization would artificially depress prices for long- distance and Internet backbone services below their true cost of production. In a well-functioning market, prices adjust until demand aligns with supply. Overcapacity arises when supply exceeds demand. To eliminate excess capacity, prices must fall. If capacity is fixed and durable in nature, as is a fiber-optic network, then it cannot be eliminated from the market. Instead, falling prices induce the least efficient firms to exit first, selling their companies or assets to the more efficient survivors. Which carriers does the FCC wish to see as the survivors? Even if the FCC declines to answer that question, it still has made a choice. Long-distance carriers and providers of Internet backbone services enjoy economics of scale. Price must exceed marginal cost to recover fixed costs. If WorldCom, having shed the fixed cost of its debt, emerges from bankruptcy, it could underprice efficient competitors. Lack of capacity would not constrain WorldCom's acquisition of market share. The severity of the excess capacity plaguing the telecommunications industry is well known. According to one account by the Wall Street Journal, only three percent of the fiber-optic capacity in the United States was being used in May 2001.104 WorldCom's continued operation after Chapter 11 reorganization would depress prices for long-distance and
- 73. Internet backbone services. Although low prices are tempting for policymakers, economic efficiency would suffer because consumers would pay less than the true social cost required to supply the services offered by WorldCom. In the long run, consumers would forgo the benefits from innovation and investment that flow from efficiently priced telecommunications services. Robert W. Crandall argues that the FCC would run a significant risk of sending the entire telecommunications industry into a spiral of bankruptcies akin to the rail industry in the mid-1800s and the airline industry in the 1980s.105 If excess capacity must be taken off the market, it would be unjust and inefficient for it to be AT&T's or Sprint's because WorldCom's reorganization drove them under. Why should AT&T and Sprint shareholders suffer because of WorldCom's accounting fraud? And how would the FCC propose to keep the next bankrupt carrier afloat? B. Chapter 11 Reorganization as State Aid in Violation of Article 87 of the European Community Treaty WorldCom's reorganization under Chapter 11 has implications for international telecommunications. The European Union outlaws state aid within its common market. Under Article 87 of the European Community Treaty, "any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favoring certain undertakings or the production of certain goods shall, insofar as it affects trade between Member States, be incompatible with the common market."106 The underlying objective of the prohibition against state aid is to prevent trade from being affected by advantages granted by public authorities, which, in various forms, distort or threaten to distort competition by favoring certain undertakings or certain products.107 The phrase "or through State resources" might encompass actions by the U.S. government that affect commerce within the European Community. If the European Union were to take that interpretation, then it is entirely possible that the competitive advantage that a reorganized WorldCom would have in Europe
- 74. would constitute state aid in violation of Article 87. The state aid would take the form of the American bankruptcy court's elimination of WorldCom's debt (in whole or part) as part of the reorganization plan. As discussed earlier, the economies of scale in telecommunications imply that WorldCom's ability to shed debt would dramatically reduce its costs relative to the costs of competitors that otherwise would be equally or more efficient. The relevant standard under Article 87 is distortion of competition, which obviously differs from the more demanding monopolization standard in American antitrust law.108 One can make little dispute that WorldCom's artificial cost advantage resulting from its reorganization under Chapter 11 would "threaten[] to distort competition" in European telecommunications markets, even if that state-conferred advantage did not have the effect of reducing or destroying competition. C. The Differing Responsibilities of the Securities and Exchange Commission, the Bankruptcy Court, and the FCC An opaque process could result from the FCC's failure to place WorldCom's fraud squarely on its agenda for 2003. The Commission can proceed, in its Triennial Review, to rewrite unbundling and access pricing as if WorldCom will remain a legitimate competitor in the local telecommunications market. Yet that rulemaking approach implicitly assumes that the Commission has already determined that WorldCom is still qualified to hold its licenses. To make matters worse, it is more likely than not that regulators would coddle a reorganized WorldCom, lest they fail by allowing it to collapse a second time. The ramifications would be serious for innocent parties. The Commission can sculpt the arcane contours of general policies affecting the ILECs and the CLECs-such as price regulation of an already competitive market for switched access or the restatement of TELRIC pricing principles for unbundled network elements-so as to give WorldCom an implicit bailout. For example, on the day that the FCC announced the outcome of its Triennial Review on
- 75. unbundling policy, the New York Times reported that "what appears to be emerging will be regulations that give something to each sector of the phone industry and do not further hurt the ailing long-distance providers-AT&T and WorldCom-as they had feared, at least until after the 2004 election."109 The ILECs, of course, would bear the burden of that hidden bailout in the form of lower prices for access to their networks than they otherwise would receive if one of the two largest CLECs were not bankrupt and in danger of liquidation. The Securities and Exchange Commission ("SEC") and the bankruptcy court are not proxies for the FCC, as neither is empowered to eradicate anticompetitive business models or to establish policy for the telecommunications infrastructure. Chapter 11 bankruptcy can be used to lower a firm's cost structure relative to its competitors' cost structure. Applied here, Chapter 11 bankruptcy is used by WorldCom to lower the relative long-run average incremental cost ("LRAIC") of its network. With a lower LRAIC, the firm emerging from Chapter 11 bankruptcy could price its services below its competitors' costs to capture market share.110 Despite the short-term lower prices, consumers would be worse off in the long term because efficient firms would be forced to exit or forfeit market share. Clearly, the bankruptcy court is not responsible for preventing that anticompetitive outcome. The Bankruptcy Code provides legal processes by which a failed business is provided with an opportunity to reorganize its financial affairs so that the business can continue for the benefit of its creditors.111 The Bankruptcy Code also provides a framework for distribution if the plan contemplates liquidation.112 The bankruptcy court's mandate is the fair and efficient administration of the Bankruptcy Code with respect to the conflicting interests of the debtor and its creditors. Consumers and the competitive process are not within the bankruptcy court's purview. Nor are they within the SEC's purview. The main role of the SEC is to protect investors in securities and to maintain the integrity of the securities markets through disclosure of important
- 76. information and efficient administration of the Securities Act of 1933 and the Securities Exchange Act of 1934.113 Moreover, neither the bankruptcy court nor the SEC would be qualified to establish policy for the telecommunications infrastructure even if either tried to do so. Congress gave the FCC the unique mandate to promote "a rapid, efficient, Nation-wide, and world-wide wire and radio communication service with adequate facilities at reasonable charges."114 Accordingly, the agency is empowered to regulate communications by wire and by radio. The duty to guard the welfare of consumers and preserve competition among producers of telecommunications services falls squarely on the FCC. Plainly, neither the SEC nor the bankruptcy court has the responsibility and expertise to investigate the competitive ramifications of WorldCom's fraud and bankruptcy. Wireless communications require a license, and even the common carriage of voice and data over wired networks must get certified.115 Some common carriers use wireless, so they need both a certificate and a license. In practical terms, the FCC's power to regulate comes from its power to deny or condition certification or licensure. By statute, wireless licensees must have "character" as a basic qualification.116 The FCC has written lengthy policy statements on the conduct that constitutes a lack of good character.117 Criminal behavior is not required. Although character issues usually have involved radio or television broadcasters, the FCC has investigated wireless common carriers as well.118 The FCC refused to license a company that concealed the fact that it started building towers for microwave transmission before the agency had approved their construction.119 The FCC has said that "where there has been a pattern of deliberate misrepresentation, revocation is the only appropriate remedy."120 The closest analogy to WorldCom may be a series of cases from the late 1980s involving RKO, an established broadcaster that lost its radio and television stations (or was forced to sell them at distressed prices) because of
- 77. misconduct that demonstrated a lack of good character.121 Nothing that RKO did can approach the billions of dollars of harm that WorldCom's accounting fraud appears to have caused other telecommunications carriers and equipment manufacturers. VI. Revocation and Liquidation as the Proper Result If the FCC did strip WorldCom of its licenses and certifications, the company would lose its value as a going concern and probably be forced into Chapter 7 liquidation. The FCC might wish to avoid that outcome in the belief that consumers would benefit from the agency's preserving a competitor in the market. That reasoning would be mistaken, for the result would be the introduction of a "failing-competitor welfare standard" at the FCC. It is implausible to expect consumers to benefit from FCC policies that were predicated on keeping failing competitors in the market. It is unlikely that consumers of long-distance and Internet services would suffer harm if WorldCom exited the market and its assets were sold to other carriers. A. The Negligible Social Cost from WorldCom 's Demise as a Going Concern As noted earlier, WorldCom was a patchwork of acquisitions. Attorney General Dick Thornburgh reported to the bankruptcy court in November 2002 that the company "did not achieve its growth by following a predefined strategic plan, but rather by opportunistic and rapid acquisitions of other companies."122 This rapid growth had a detrimental effect on the integration of WorldCom's acquisitions: "The unrelenting pace of these acquisitions caused the Company constantly to redefine itself and its focus. The Company's unceasing growth and metamorphosis made integration of its newly acquired operations, systems and personnel much more difficult."123 So it would be no surprise if few economies of integration were sacrificed by WorldCom's Chapter 7 liquidation rather than its Chapter 11 reorganization. In August 2002, the Washington Post described how "poorly WorldCom absorbed the companies, gaining their revenue but doing little to integrate them
- 78. operationally to eliminate overlapping costs."124 The Eastern Management Group compared WorldCom to a shopping mall: WorldCom is, in fact, more a shopping mall of products and services rather than a department store. Like many large enterprises, WorldCom's history is rooted in merger and acquisition, but unlike global behemoths like Deutsche Bank and Sony, or even the company's industry peers, Verizon and SBC, WorldCom has done little to integrate its divisions and operating units into a monolithic entity. The same report concluded that the "disembodiment of WorldCom could be effected without jeopardizing or compromising national security, the Internet, network service reliability, or the telecom sector as a whole."126 Industry analysts eventually discerned WorldCom's failure to generate efficiencies from its collection of companies.127 One analyst in February 2003 described the aggregation of WorldCom's acquisitions as being "like a bowl of spaghetti."128 If WorldCom could not realize economies of integration across its companies, then the disaggregation of those companies through Chapter 7 liquidation would not cause any appreciable loss of efficiencies. Furthermore, the FCC should consider whether fraud has rendered WorldCom's brand name worthless. Brand names have value when they credibly signal a firm's good reputation.129 In WorldCom's case, its brand name signals deceit. The brand name is worthless-if not an actual liability on WorldCom's balance sheet-because of the taint of fraud. WorldCom's new chief executive officer admitted as much in January 2003, when he revealed that he was considering changing the company's name.130 On March 13, 2003, WorldCom wrote off all of its goodwill-a total of $45 billion.131 At the same time, the company wrote down its property and equipment and its intangible assets from $44.8 billion to $10 billion.132 Of that write-off, $39.2 billion was property and equipment.133 Sunk costs are, of course, sunk costs. Nonetheless, it says something significant in economic terms that WorldCom's new
- 79. management would write off a brand name that surely had been the object of millions of dollars of advertising and promotion in recent years. Such a decision supports the conclusion that the value of WorldCom as a going concern is less than the value of the sum of its (devalued) assets. B. Other Carriers Could Competitively Supply WorldCom's Customers With so much excess capacity in long-distance networks, other carriers will eagerly court WorldCom's customers.134 Telephone solicitations at dinnertime are not likely to cease, and many of WorldCom's large business customers surely have relationships with backup suppliers of telecommunications services. Moreover, between December 1999 and April 2003 the Bell operating companies ("BOCs") received regulatory approval to provide in-region interLATA service in thirty-eight states-that is, long-distance service from one "local access and transport area" to another, within the region in which the BOC is the incumbent provider of local service.135 As Figure 6 shows, those interLATA authorizations enable the BOCs to reach seventy-seven percent of the nation's access lines. The BOCs are thus well positioned to replace WorldCom as competitors to AT&T and Sprint. Indeed, by January 2003 Verizon had already surpassed Sprint as the third largest interexchange carrier in the United States-even though Verizon had not yet received Section 271 authorizations for the District of Columbia, Virginia, and West Virginia.136 Moreover, as the FCC has recognized in other proceedings, the WorldCom network will still exist even after liquidation, should a completely new entrant want to buy all or part of the network and light its dark fiber.137 The Commission has recognized that the same reasoning applies with equal force to spectrum. Even if WorldCom were to surrender its licenses, it would not cause the corresponding spectrum to evaporate.138 Consequently, the telecommunications marketplace will have no less capacity- wireline or wireless-than it does today.139 VII. Lessons Learned
- 80. There is a familiar saying in Washington: "there is enough blame to go around." The idea seems to be that individual culpability is inversely related to the size of the debacle. When some government policy goes horribly awry in the United States, it is rarely the case, as it is in the United Kingdom, that a senior official promptly resigns. High-profile government positions in the United States are perceived to have only a professional upside. While the U.S. telecommunications industry lies enervated, the FCC is again occupied with the question of which network elements an ILEC must unbundle under legislation enacted seven years ago. And despite the WorldCom accounting fraud and bankruptcy, the Commission evidently misses the irony in its pronouncements about what an incumbent's forward-looking costs of operating a hypothetical telecommunications network would be. Ethical conduct is essential to creating the trust that permits markets to function-let alone to function with the extraordinary efficiency that has long distinguished the American markets for goods and services, for capital, and for labor. WorldCom violated that trust. WorldCom's fraud is the largest deception ever perpetrated in the telecommunications industry. In addition to harming its investors, WorldCom harmed the telecommunications industry. It is appropriate for the FCC to act. Since Congress passed the Telecommunications Act of 1996, the FCC has routinely questioned the accuracy of information supplied to it by incumbent local exchange carriers, whose networks it was trying to open to competition. Yet the FCC was oblivious to the largest accounting fraud in history, committed by a principal beneficiary of those very market- opening efforts. WorldCom's accounting fraud and false statements distorted competition and investment in the telecommunications industry. If, for whatever reason, the Commission turns a blind eye to WorldCom's misconduct, then the agency will aid and abet that misconduct after the fact. The FCC will compound the harm from WorldCom's misconduct-and
- 81. add conscious neglect to the agency's previous inattention-if it allows the company to emerge from Chapter 11 reorganization without ever having to answer this fundamental question: How does it serve the public interest for the FCC to allow WorldCom to continue holding its licenses and authorizations? The FCC has a duty to determine promptly whether WorldCom must surrender its licenses and authorizations. If so, regulators should not interfere if the capital markets soon cause WorldCom to cease to exist. What did seven years of good intentions teach us? At least three things. First, the journey from regulation to a truly deregulated market is costly, and the alternative of managed competition is surely costlier. Second, a consumer-welfare approach to the mandatory unbundling of telecommunications networks would have been simpler, more intellectually coherent, and more beneficial to society than the competitor-welfare standard that has permeated FCC policy from 1996 through 2002. Third, policy makers who cling to caricatures of incumbents and competitors risk missing the big picture. Let me conclude by invoking the wisdom of Jim Quello, who served two decades as an FCC commissioner. He is widely credited with saying, "What this industry needs is a whole new set of cliches." It is reminder of the failure of good intentions that audiences in 2002 groaned at that quip instead of laughing. Let us hope that it does not take another seven years for the joke to evoke laughter once more. Footnote 1 Telecommunications Act of 1996, Pub. L. No. 104-104, 110 Stat. 56 (codified as amended in scattered sections of 47 U.S.C.). Footnote 2 Unbundling is the shorthand used to describe a method of entry into local telephony that relies on "the leasing of unbundled network elements, [which are] the building blocks of the local network," including loops and switches. Jerry A. Hausman & J. Gregory Sidak, A Consumer-Welfare Approach to
- 82. the Mandatory Unbundling of Telecommunications Networks, 109 YALE L.J. 417, 432 (1999). "The entrant can then build its own network a la carte by buying some inputs from the ILEC and procuring other inputs from rivals already in the market (such as local transport services provided by competitive access providers) or directly from equipment vendors (such as manufacturers of switches)," id. at 432-33. Footnote 3 REED E. HUNDT, YOU SAY YOU WANT A REVOLUTION: A STUDY OF INFORMATION AGE POLITICS 154 (2000). 4 535 U.S. 467 (2002). 5 Implementation of the Local Competition Provisions in the Telecommunications Act of 1996, First Report and Order, 11 F.C.C.R. 15,499 (1996), vacated in part Iowa Utils. Bd. v. FCC, 120 F.3d 753 (8th Cir. 1997), rev'd in part and aff'd in part sub nom. AT&T Corp. v. Iowa Utils. Bd., 525 U.S. 366 (1999). 6 See Chevron U.S.A. v. Natural Res. Def. Council, 467 U.S. 837, 842-45 (1984). 7 Verison, 535 U.S. at 489. 8 Id. at 523-28. Footnote 9 These policies are principally the FCC's 1996 rules concerning the mandatory unbundling of elements of the ILEC's local access network at regulated prices based on regulators' estimates of the ILEC's TELRIC for the network element in question. 10 In March 2003, Hutchison Whampoa and Singapore Technologies Telemedia had an outstanding offer to buy 61.5% of Global Crossing for $250 million and take the carrier out of bankruptcy. See Simon Romero, Hong Kong Company May Alter Deal To Buy Global Crossing, N.Y. TIMES, Mar. 1, 2003, at Cl. This price implies a total valuation of $406.5 ($250 million divided by 0.615). Footnote 11 In re Review of the Section 251 Unbundling Obligations of Incumbent Local Exchange Carriers Implementation of the
- 83. Local Competition Provisions of the Telecommunications Act of 1996 Deployment of Wireline Services Offering Advanced Telecommunications Capability, Notice of Proposed Rulemaking, CC Dkt. Nos. 01-338, 96-98, 98-147, [para] 23 n.69 (2001) [hereinafter UNE Triennial Review NPRM]. 12 See ROBERT W. CRANDALL, AN ASSESSMENT OF THE COMPETITIVE LOCAL EXCHANGE CARRIERS FIVE YEARS AFTER THE PASSAGE OF THE TELECOMMUNICATIONS ACT (2002), available at http://www.criterioneconomics.com/documents/Crandall%20CL EC.pdf. 13 UNE Triennial Review NPRM, supra note 11, [para] 25. 14 47 U.S.C. [sec] 251(d)(2) (2000). 15 AT&T Corp. v. Iowa Utils. Bd., 525 U.S. 366 (1999). Footnote 16 Implementation of the Local Competition Provisions of the Telecommunications Act of 1996, Third Report and Order and Fourth Further Notice of Proposed Rulemaking, 15 F.C.C.R. 3696, 3725 (1999). 17 United States Telecom Ass'n v. FCC, 290 F.3d 415 (D.C. Cir. 2002). 18 UNE Triennial Review NPRM, supra note 11, [para] 4. 19 Id. [para] 19. Footnote 20 Id. [para] 24. 21 See Hausman & Sidak, supra note 2; Jerry Hausman, Valuing the Effect of Regulation on New Services in Telecommunications, 1997 BROOKINGS PAPERS ON ECON. ACTIVITY: MICROECONOMICS 1. 22 United States Telecom Ass'n v. FCC, 290 F.3d 415 (D.C. Cir. 2002) (vacating and remanding FCC's impairment test) stayed by No. 00-1012, 2002 WL 31039663 (D.C. Cir. Sept. 4, 2002). 23 UNE Triennial Review NPRM, supra note 11, [para] 9. Footnote 24 This line of analysis is directly responsive to the FCC's
- 84. request in its Triennial Review for comments on "whether [the Commission] can balance the goals of Sections 251 and 706 by encouraging broadband deployment through the promotion of local competition and investment in infrastructure." Id. [para] 23. 25 Hausman & Sidak, supra note 2. Admittedly, a product- specific, geographically specific analysis would require greater administrative resources than a blanket rule that required a particular network element to be unbundled everywhere in the nation. But weighing in the opposite direction are two considerations. First, it may be possible to use the Hausman- Sidak analysis to eliminate a particular network element from the mandatory-unbundling list on a nationwide basis, or very nearly so. Switching would be a leading candidate for such treatment. Second, the purpose of the Hausman-Sidak inquiry is to produce an unbundling result that maximizes consumer welfare. One might quibble that the proper social welfare function should be the difference between consumer welfare and the transactions costs of regulation. But an unbundling rule that sought only to minimize transactions costs (without regard to the impact on consumer welfare) would be a very constricted interpretation of "the public interest," and not one that would coincidentally protect consumer welfare. Footnote 26 UNE Triennial Review NPRM, supra note 11, [para][para] 27-28. Footnote 27 This analysis is relevant to "the rapid introduction of competition in all markets," which is one of the five factors that the FCC had been using to judge impairment at the time of the U.S. Telecom Association decision. Id. [para] 21. 28 FCC, LOCAL TELEPHONE COMPETITION: STATUS AS OF DECEMBER 31, 2001 tbl.5 (2002); FCC, LOCAL TELEPHONE COMPETITION AT THE NEW MILLENNIUM tbls.2-3 (2000). 29 Scott Wooley, Bad Connection, FORBES, Aug. 12, 2002, at
- 85. 84. 30 Simon Romero, When the Cellphone Is the Home Phone, N.Y. TIMES, Aug. 29, 2002, at G1. In addition to noting this growing phenomenon of wireless displacement of landlines, the business press observed in September 2002 that AT&T Broadband and Cox Communication had signed up over 1.7 million local telephone customers and were adding 60,000 every month, Peter Grant, More Consumers Answer Call of Cable for Phone Service, WALL ST. J., Sept. 5, 2002, at B1. 31 See Implementation of Section 6002(b) of the Omnibus Reconciliation Act of 1993, Annual Report and Analysis of Competitive Market Conditions with Respect to Commercial Mobile Services, Seventh Report, 17 F.C.C.R. 12,985, 13,017 (2002) (citing survey results in Michelle Kessler, 18% See Cellphones as Their Main Phones, USA TODAY, Feb. 1, 2002, at B1). Footnote 32 See, e.g., Burlington N. R.R. Co. v. Interstate Commerce Comm'n, 985 F.2d 589, 595-99 (D.C. Cir. 1993) (discussing ICC policy of rate regulation of railroads serving captive shippers). Footnote 33 Press Release, Michael J. Copps, Commissioner, Federal Communications Commission, Review of the Section 251 Unbundling Obligations of Incumbent Local Exchange Carriers, Approving In Part, Concurring In Part, Dissenting In Part 4 (Feb. 20, 2003), available at http://hraunfoss.fcc.gov/edocs_public/attachmatch/DOC- 231344A5.doc. 34 United States Telecom Ass'n v. FCC, 290 F.3d 415 (D.C. Cir. 2002) (vacating and remanding FCC's impairment test) stayed by No. 00-1012, 2002 WL 31039663 (D.C. Cir. Sept. 4, 2002). Footnote 35 See Alan Murray, FCC 'Palace Coup' Creates More Work for the Lobbyists, WALL ST. J., Feb. 24, 2003, at A4.
- 86. AT&T's top lobbyist, James Cicconi, a veteran of the first Bush administration, also is said to have encouraged the view that [Commissioner Kevin] Martin['s] plan [to decide the Triennial Review on unbundling] is good politics for President Bush, because it prevents chaos and bankruptcies before the 2004 election. That spawned rumors that it was a coup masterminded by White House aide Karl Rove. Id. 36 Press Release, Federal Communications Commission, FCC Adopts New Rules for Network Unbundling Obligations of Incumbent Local Phone Carriers 1 (Feb. 20, 2003), available at http://hraunfoss.fee.gov/edocs_public/attachmatch/DOC- 231344A1.doc. Footnote 37 Id. 38 Id. at 2. 39 Attachment to Press Release, Federal Communications Commission 4 (Feb. 20, 2003), available at http://hraunfoss.fcc.gov/edocs_public/attachmatch/DOC- 231344A2.doc. Footnote 40 WorldCom's Myers To Plead Guilty, WALL ST. J., Sept. 26, 2002, at A3 (reporting that David Myers, former controller of WorldCom, is expected to plead guilty). More guilty pleas soon followed. See Susan Pulliam & Jared Sandberg, Two WorldCom Ex-Staffers Plead Guilty to Fraud, WALL ST. J., Oct. 11, 2002, at A3 (Betty Vinson, former director of management reporting, and Troy Normand, former director of legal entity accounting). 41 Yochi J. Dreazen, Wildly Optimistic Data Drove Telecoms To Build Fiber Glut, WALL ST. J. ONLINE, Sept. 27, 2002, at http://online.wsj.com/public/us. 42 See, e.g., EASTERN MANAGEMENT GROUP, IS WORLDCOM TOO BlG TO FAIL? LIQUIDATION COULD IMPROVE TELECOM SECTOR 4 (2003). Footnote 43 Dreazen, supra note 41.
- 87. 44 The Power of WorldCom's Puff, ECONOMIST, July 20, 2002, at 61. 45 Dreazen, supra note 41. 46 Peter Behr, On or Off the Bandwidth Bandwagon?, WASH. POST, Sept. 24, 2000, at H1. 47 The Power of WorldCom's Puff, supra note 44. Footnote 48 Press Release, U.S. Dept. of Justice, Justice Department Sues To Block WorldCom's Acquisition of Sprint: Unless Blocked, Deal Would Result in Higher Prices for Millions of Consumers (June 27, 2000), available at http://www.usdoj.gov/opa/pr/2000/June/368at.htm ("WorldCom operates the largest internet backbone network, which carries approximately 37 percent of all internet traffic."). The European Commission estimated that WorldCom's share of the Internet backbone market at that time was between 32 and 36 percent. Case COMP/M.1741-MCI WorldCom/Sprint, Commission Decision of June 28, 2000 Declaring a Concentration Incompatible with the Common Market and the CHA Agreement [para] 116, available at http://europa.eu.int/comm/competition/mergers/cases/ decisions/m1741_en.pdf. Because WorldCom and Sprint formally withdrew their application for Transfer of Control of Licenses and Section 214 Authorizations in July 2000, the FCC was not able to present its market share estimates. 49 Statement of Michael J. Copps, Commissioner, Federal Communications Commission, Before the Senate Committee on Commerce, Science, & Transportation (Jan. 14, 2003), available at http://hraunfoss.fcc.gov/edocs_public/attachmatch/DOC- 230241A4.doc. 50 Id. Footnote 51 K-.G. COFFMAN & A.M. ODLYZKO, AT&T LABS, INTERNET GROWTH: IS THERE A "MOORE'S LAW" FOR DATA TRAFFIC 7 (2001), available at http://www.dtc.umn.edu/~odlyzko/doc/internet.moore.pdf
- 88. (citing L. Bruno, Fiber Optimism: Nortel, Lucent, and Cisco Are Battling To Win the High-Stakes Fiber-Optics Game, RED HERRING, June 1, 2000). 52 For an example of analysts' linking Internet growth to excess telecommunications network capacity, see Joelle Tessler, Telecom Companies Struggle with Glut of Fiber-Optic Networks, SAN JOSE MERCURY NEWS, Apr. 13, 2002, at A1 (attributing to Scott Cleland, chief executive of the Precursor Group, a telecommunications investment research firm, the view that "[m]uch of the great fiber build-out was based on a big miscalculation" owing to WorldCom). 53 EASTERN MANAGEMENT GROUP, supra note 42, at 2 (quoting Joelle Tessler, WorldCom Spine UUNET Is Critical Part of Internet, SAN JOSE MERCURY NEWS, Sept. 1, 2002). 54 Id. Footnote 55 Statement of Kathleen Q. Abernathy, Commissioner, Federal Communications Commission, Before the Senate Committee on Commerce, Science, & Transportation (Jan. 14, 2003), available at http://hraunfoss.fcc.gov/edocs_public/attachmatch/DOC- 230241A3.doc. 56 Two days after WorldCom's first accounting restatement, one business reporter wrote, "WorldCom Inc.'s disclosure [that] it improperly accounted for $3.8 billion in expenses has wreaked much havoc in the financial markets this week," Ross Snel, WorldCom's Pain May Eventually Prove AT&T's Gain, DOW JONES NEWS SERV., June 28, 2002. According to one investment banker, WorldCom's accounting revisions caused the bond market to be "skittish and paranoid," WorldCom Crash Brings Fear and Loathing to Markets, EUROWEEK, June 28, 2002. Footnote 57 One could hypothesize that telecommunications equipment manufacturers experienced negative abnormal returns because they were among WorldCom's creditors. The increased risk of nonpayment to these creditors would arise from the fact that
- 89. expectations concerning WorldCom's future net cash flows had been revealed to rest on a false assessment of the company's growth in revenue and profits. That false assessment exaggerated the demand for WorldCom's services, and hence it exaggerated as well the derived demand for the telecommunications equipment that WorldCom and other carriers would need to purchase to provide those services. Hence, this alternative hypothesis is not fundamentally different from the one stated above. 58 Jared Sandberg et al., WorldCom Admits $3.8 Billion Error in Its Accounting, WALL ST. J., June 26, 2002, at A1. 59 Dividend payments are counted as returns to a particular stock on the ex-dividend date. Footnote 60 The statistic in an event study is the abnormal return, which is the predicted residual from a least-squares regression. See, e.g., ZVI BODIE, ALEX KANE & ALAN J. MARCUS, INVESTMENTS 339 (4th ed. 1999). In large samples, the residual from a least-squares regression is distributed according to the normal probability distribution. See, e.g., GEORGE G. JUDGE, W. E. GRIFFITHS, R. CARTER HILL, HELMUT LUTKEPOHL & TSOUNG-CHAO LEE, THE THEORY AND PRACTICE OF ECONOMETRICS 153-57 (2d ed. 1985). Dividing a normally distributed random variable by its standard deviation yields a variable with a "standard normal distribution." See, e.g., RICHARD J. LARSEN & MORRIS L. MARX, AN INTRODUCTION TO MATHEMATICAL STATISTICS AND ITS APPLICATIONS 215-16 (2d ed. 1986). A Z-score refers to a particular value along the horizontal axis of the standard normal distribution. There exists a 10 percent probability that a point greater than 1.28 will be drawn from a standard normal distribution, id. at 576-77. Similarly, there exists a five percent probability that a value greater than 1.64 will be drawn from the standard normal, id. Therefore, a Z- score between 1.28 and 1.64 implies statistical significance at the ten percent level of confidence. A Z-score that exceeds 1.64
- 90. indicates statistical significance at the five percent level of precision or beyond. Footnote 61 Press Release, Michael K. Powell, Chairman, Federal Communications Commission, Federal-State Joint Conference on Regulating Accounting Issues (Sept. 5, 2002), available at http://hraunfoss.fcc.gov/edocs_public/attachmatch/DOC- 225969A1.doc. 62 47 C.F.R. [sec][sec] 54.706, 54.711, 54.713, 64.604 (2002). All telecommunications carriers providing interstate telecommunications service, interstate telecommunications providers offering interstate telecommunications for a fee on a non-common-carrier basis, and payphone providers that are aggregators must contribute to the Universal Service Fund and file a Telecommunications Reporting Worksheet annually (on FCC Form 499-A) and quarterly (on FCC Form 499-Q), 47 C.F.R. [sec][sec] 54.706, 54.711, 54.713 (2002). 63 Every common carrier providing interstate telecommunications services is required to contribute to the Telecommunications Relay Services ("TRS") Fund on the basis of its relative share of interstate end-user telecommunications revenues. 47 C.F.R. [sec] 64.604 (2002). The calculations are based on the Telecommunications Reporting Worksheet. 47 C.F.R. [sec] 64.604(c)(5)(iii)(B) (2002). Moreover, all telecommunications carriers in the United States are required to contribute to the costs of establishing a numbering administration, and the contributions are based on the Telecommunications Reporting Worksheets. 47 C.F.R. [sec] 52.17 (2002). All telecommunications carriers must contribute to the costs of long-term number portability. 47 C.F.R. [sec] 52.32 (2002). Footnote 64 See Seth Schiesel, WorldCom Report Adds to the Size of Its Sales Drop, N. Y. TIMES, Jan. 30, 2003, at C1 (reporting that "sales at five important divisions of WorldCom, the troubled long-distance communications carrier, withered far faster in the
- 91. second half of 2002 than the company has publicly reported, according to an internal WorldCom document"). Footnote 65 Press Release, WorldCom, WorldCom Announces Intention To Restate 2001 and First Quarter 2002 Financial Statements (June 25, 2002), available, at http://www.worldcom.com/ global/about/news/. 66 Plaintiffs Complaint at 2, Sec. and Exchange Comm'n v. WorldCom, Inc., Case No. 02 CV 4963 (JSR) (S.D.N.Y. June 26, 2002) [hereinafter SEC Complaint]. 67 WorldCom, supra note 56. 68 Id. Footnote 69 Press Release, WorldCom, WorldCom Announces Additional Changes to Reported Income for Prior Periods (Aug. 8, 2002), available at http://www.worldcom.com/global/about/news/. Footnote 70 George A. Akerlof, The Market for "Lemons": Quality Uncertainty and the Market Mechanism, 84 Q.J. ECON. 488 (1970). 71 See RICHARD A. BREALEY & STEWART C. MYERS, PRINCIPLES OF CORPORATE FINANCE 457 (4th ed. 1996). 72 This conclusion follows from a priori economic reasoning. It could be difficult, however, to establish this proposition empirically because one cannot yet say (for purposes of time- series analysis) when the fraud at WorldCom began. Therefore, it is not possible to compare WorldCom's cost of capital during a fraud-free period with its cost of capital during the fraud. 73 See, e.g., Kurt Eichenwald, Corporate Loans Used Personally, Report Discloses, N.Y. TIMES, Nov. 5, 2002, at C1 (discussing the results of the initial report by former Attorney General Dick Thornburgh, WorldCom's bankruptcy examiner). Footnote 74 WorldCom, Inc., First Interim Report of Dick Thornburgh, Bankruptcy Court Examiner, Case No. 02-15533 at 8 (Bankr. S.D.N.Y.) (Nov. 4, 2002) [hereinafter Thomburgh Report].
- 92. 75 Stacy Cowley, Sprint CEO Blasts WorldCom, IDG NEWS SERVICE, Oct. 2, 2002 (quoting William Esrey's keynote address at Internet World), available at http://www.nwfusion.com/news/2002/1002sprintceo.html (last visited Oct. 8, 2002). 76 Christopher Stern, WorldCom Wins Another U.S. Contract; Third Award in Two Months Reflects Government's Confidence in Firm, WASH. POST, Dec. 20, 2002, at E5. Footnote 77 Id. 78 Id. 79 Id. 80 Traditional predation models usually have assumed recoupment of short-run losses. For a review, see JEAN TIROLE, THE THEORY OF INDUSTRIAL ORGANIZATION 373 (1992); Janusz A. Ordover & Garth Saloner, Predation, Monopolization, and Antitrust, in 1 HANDBOOK OF INDUSTRIAL ORGANIZATION 537 (Richard Schmalensee & Robert D. Willig eds., 1992). 81 See Phillip Areeda & Donald F. Turner, Predatory Pricing and Related Practices Under Section 2 of the Sherman Act, 88 HARV. L. REV. 697 (1975); William J. Baumol, Predation and the Logic of the Average Variable Cost Test, 39 J.L. & ECON. 49 (1996). 82 See Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209, 221-25 (1993). Footnote 83 See COMMITTEE ON COMPETITION LAW AND POLICY, ORGANIZATION FOR ECONOMIC COOPERATION AND DEVELOPMENT, PROMOTING COMPETITION IN POSTAL SERVICES (Series Roundtables on Competition Policy No. 24, DAFFE/CLP(99)22, Oct. 1, 1999); JOHN R. LOTT, JR., ARE PREDATORY COMMITMENTS CREDIBLE? WHO SHOULD THE COURTS BELIEVE? (1999); J. GREGORY SIDAK & DANIEL F. SPULBER, PROTECTING COMPETITION FROM THE POSTAL MONOPOLY 116 (1996); John R. Lott, Jr.,
- 93. Predation by Public Enterprises, 43 J. PUB. ECON. 237 (1990); David E. M. Sappington & J. Gregory Sidak, Are Public Enterprises the Only Credible Predators?, 67 U. CHI. L. REV. 271 (2000); DAVID E. M. SAPPINGTON & J. GREGORY SIDAK, COMPETITION LAW FOR STATE-OWNED ENTERPRISES (AEI Working Paper, Dec. 2002); David E. M. Sappington & J. Gregory Sidak, Incentives for Anticompetitive Behavior by Public Enterprises, REV. INDUS. ORG. (forthcoming 2003). 84 COMMITTEE ON COMPETITION LAW AND POLICY, supra note 83, at 55. 85 Stephanie Kirchgaessner, Ebbers Set To Clear His Desk at WorldCom, FIN. TIMES, Oct. 29, 2002, at 30 (London ed.). Footnote 86 Stephanie Kirchgaessner, Sullivan 'Could Testify Against Ebbers', FlN. TIMES, Nov. 13, 2002, at 22 (London ed.). 87 See Stephanie Kirchgaessner, Hernie Ebbers Could Get Tax Break on College Gift, FIN. TIMES, Dec. 9, 2002, at 28 (London ed.). 88 See Stephanie Kirchgaessner & Richard Waters, WorldCom Strips Executive of Operating Responsibilities, FlN. TIMES, Oct. 2, 2002, at 17 (London ed.). 89 See Susan Pulliam et al., Easy Money: Former WorldCom CEO Built An Empire on Mountain of Debt, WALL ST. J., Dec. 31, 2002, at A1. 90 In a pooling-of-interests acquisition, the book values of the assets and liabilities of the acquired firm are consolidated with those of the acquiring firm. See, e.g., CLYDE P. STlCKNEY & ROMAN L. WEIL, FINANCIAL ACCOUNTING 624 (9th ed., 2000). WorldCom accounted for its acquisitions of MCI Communications Corp., Intermedia Communications Inc., CompuServe Corp., ANS Communications as purchases, but accounted for its acquisitions of Skytel Communications and Brooks Fiber Properties, Inc. as pooling-of-interests. WORLDCOM INC., 2001 SEC FORM 10-K, at 2-4 (Mar. 13, 2002); see also Dale Wettlauter, WorldCom Hoping for Pooling
- 94. in Merger Accounting, at http://www.fool.com/LunchNews/1997/LunchNews971008.htm (stating that if it recognized the purchase of MCI as a pooling- of-interests transaction, WorldCom's "reported earnings would be about 28% higher than under a purchase treatment"). Footnote 91 See 15 U.S.C. [sec] 1 (2000). 92 The fact that parties to an agreement happen to compete in wholly different markets from one another would not preclude a finding that there existed a conspiracy in violation of Section 1 of the Sherman Act, 15 U.S.C. [sec] 1 (2000). The Fifth Circuit, for example, has recognized that, even when conspirators who are not competitors of the victim have no interest in curtailing competition in a market in which they do not compete, "when they have been enticed or coerced to share in an anticompetitive scheme, there is still a combination within the meaning of [Section 1] of the Sherman Act." Spectators' Communication Network, Inc. v. Colonial Country Club, 253 F.3d 215, 221 (5th Cir. 2001); see also Perington Wholesale, Inc. v. Burger King Corp., 631 F.2d 1369, 1377 (10th Cir. 1979) ("The fact that [the defendant's] coconspirators competed in markets different from [the defendant's] market does not preclude finding a conspiracy to monopolize [the defendant's] market."). For purposes of doctrinal antitrust analysis, a possible conspiracy between WorldCom and Salomon Smith Barney does not differ from the garden-variety vertical agreement (between a distributor and a retailer, for example). A conspiracy in violation of Section 1 need not be, to borrow Judge Richard Posner's paraphrasing of George Bernard Shaw, "the vertical expression of a horizontal desire." Valley Liquors, Inc. v. Renfield Importers, Ltd., 678 F.2d 742, 744 (7th Cir. 1982). It is sufficient that the common scheme has an anticompetitive effect. See, e.g., McLain v. Real Estate Bd., 444 U.S. 232, 243 (1980) ("[I]n a civil action under the Sherman Act, liability may be established by proof of either an unlawful purpose or an anticompetitive effect."); United States v. United States Gypsum Co., 438 U.S. 422, 436 n.13
- 95. (1978) (noting same). 93 On September 3, 2002, the Wall Street Journal reported: Mr. [Jack] Grubman [of Salomon Smith Barney], who earned an average of $20 million a year during recent years, and received a severance package of about $30 million, has been criticized for staying wildly bullish on many telecommunications company clients of Salomon-including WorldCom, Inc., Global Crossing Ltd., and Winstar Communications Inc.-even as their troubles deepened. . . . The close relationship between Mr. Grubman and WorldCom has drawn special scrutiny in the wake of confirmation last week that Salomon allocated hard-to-get IPO sharesto WorldCom executives and directors, such as former CEO Bernard Ebbers, who made millions of dollars in profits when the stocks shot up. Charles Gasparino, Salomon Probe Includes Senior Executives, WALL ST. J., Sept. 3, 2002, at C1; see also Susanne Craig, Offerings Were Easy Money for Ebbers, WALL ST. J., Sept. 3, 2002, at C1 (reporting on the House Financial Service Committee's investigation into whether Salomon Smith Barney won investment-banking work from WorldCom by issuing WorldCom executives shares of "hot IPOs" that it was underwriting). A subsequent Wall Street Journal story specifically addressed Salomon Smith Barney's "buy" recommendation on WorldCom: Mr. Grubman kept his "buy" on WorldCom as it slid to $4 from $64.50, not downgrading it until a week before the company ousted founder Bernard Ebbers [in the spring of 2002], Meanwhile, over four years Salomon collected $107 million in fees for advising WorldCom on 23 deals, says [New York Attorney General Elliot] Spitzer's suit [against WorldCom]. Although Mr. Grubman was so close to WorldCom that he helped plan its strategy, he has said he saw no sign of the $7 billion accounting fraud now engulfing the company. Charles Gasparino et al., Wildcard: Citigroup Now Has New Worry: What Grubman Will Say, WALL ST. J., Oct. 10, 2002, at A1. During the summer of 2002, the National Association of
- 96. securities Dealers ("NASD") initiated an enforcement proceeding against Mr. Grubman. See Charles Gasparino, NASD Prepares Action Against a Star Analyst, WALL ST. J., July 22, 2002, at A1 ("[NASD's decision to pursue regulatory action against Mr. Grubman] marks the first major crackdown by federal securities regulators investigating how big securities firms obtained investment-banking business with overly rosy stock picks."). Footnote 94 Thornburgh Report, supra note 74, at 7. Footnote 95 Id. 96 Id. at 82. 97 According to the Wall Street Journal, a WorldCom executive notified Arthur Andersen in 2000 that the company was improperly accounting for expenses, yet the practice continued undiscovered by Arthur Andersen for two years. Yochi J. Drcazen & Deborah Solomon, WorldCom Alerts About Accounting Went Unheeded, WALL ST. J., July 15, 2002, at A3. 98 Thornburgh Report, supra note 74, at 51. 99 See Pulliam et al., supra note 89. Mr. Ebbers used his loans to purchase, among other things, a soybean plantation, a 500,000 acre cattle ranch (the largest private ranch in Canada), 460,000 acres of timberland, a shipyard, and a 132-foot yacht christened "Aquasition," and WorldCom lent Mr. Ebbers $415 million to pay back some of these loans when declines in WorldCom's slock price prompted margin-calls from certain banks. Id. According to an interim report by a federal bankruptcy examiner, however, $27 million of those loans from WorldCom were used by Ebbers for personal reasons, including the construction of a $1.8 million private home and $3 million in gifts and loans to friends and family. Eichenwald, supra note 73. 100 See Pulliam et at, supra note 89. Mr. Ebbers' total worth is taken from Forbes' 1999 list of the 400 Richest Americans,
- 97. which is available at http://www.forbes.com/lists/2003/02/26/ billionaireland.html. Footnote 101 Pulliam et al., supra note 89; see also Kirchgaessner, supra note 85 and accompanying text. Attorney General Thornburgh reported in November 2002: When Mr. Ebbers left WorldCom [in 2002], the [company's Compensation] Committee negotiated, and the Company approved, a severance package that included a cash payment of $1.5 million per year for life, lifetime medical and life insurance, lifetime use of a corporate jet and conversion of approximately $408 million in demand notes into 5-year non- callable term notes with a significant annual interest rate subsidy. Thornburgh Report, supra note 74, at 65. 102 Competition Issues in the Telecommunications Industry: Hearing Before the Senate Comm. on Commerce, Science, and Transportation, 108th Cong. (2003), available at http://hraunfoss.fcc.gov/edocs_public/attachmatch/DOC- 230241A1 .pdf (statement of Michael K. Powell, Chairman, Federal Communications Commission). 103 MCI reported that it acquired over 1 million subscribers in its Neighborhood Plan as of October 2002. See Press Release, WorldCom, MCI Welcomes Arkansas to the Neighborhood (Oct. 8, 2002), at http://www.worldcom.com/global/about/news. As of January 2003, AT&T claimed that it had acquired over two million households. See Press Release, AT&T, AT&T to Offer Residential Local Service in Washington, D.C. (Jan. 13, 2003), at http://www.att.com/news. Footnote 104 Gregory Zuckerman & Deborah Soloman, Telecom Debt Debacle Could Lead to Losses of Historic Proportions, WALL ST. J., May 11, 2001, at A1. Footnote 105 ROBERT W. CRANDALL, WOULD A DEBT-FREE WORLDCOM WRECK THE TELECOM INDUSTRY? (Working
- 98. Paper, 2002). Similarly, Professor Todd Zywicki has argued that the "traditional bankruptcy approach of looking at a company's bankruptcy in isolation is not possible in the telecom industry because these bankrupt firms have a competitive impact on each other." Ron Orol, Domino Effect, THE DAILY DEAL, Jan. 16, 2003, at 27 (quoting Professor Todd Zywicki of George Mason University). 106 Consolidated Version of the Treaty Establishing the European Community, 1997 O.J. (C 340)173, 208. 107 See, e.g., Case C-39/94, SFEI v. La Poste, 1996 E.G.R. 1- 3547, at [para] 58. Footnote 108 See, e.g., United States v. Microsoft Corp., 253 F.3d 34 (D.C. Cir. 2001). 109 Stephen Labaton, F.C.C. Ruling Is Expected To Favor Bells, N.Y. TIMES, Feb. 20, 2003, at C1; see also Murray, supra note 35. Footnote 110 Because the telecommunications industry is characterized by large fixed costs and negligible marginal costs, the textbook rule of marginal-cost pricing does not apply. See William J. Baumol & David F. Bradford, Optimal Departures from Marginal Cost Pricing, 60 AM. ECON. REV. 265 (1970). 111 See, e.g., In re Eagle Bus Mfg., 158 B.R. 421 (Dist. Ct. S.D. Tex. 1993). 112 Century Glove, Inc. v. First Am. Bank of N.Y., 860 F.2d 94, 102 (3rd Cir. 1988). 113 Sec. & EXCHANGE COMM'N, THE INVESTOR'S ADVOCATE: HOW THE SEC PROTECTS INVESTORS AND MAINTAINS MARKET INTEGRITY, at http://www.sec.gov/about/whatwedo.shtml. 114 47U.S.C. [sec] 151 (2000). Footnote 115 Id. [sec] 214. 116 Id. [sec] 308(b). 117 Policy Regarding Character Qualifications in Broadcast
- 99. Licensing, Amendment of Part 1, the Rules of Practice and Procedure, Relating to Written Responses to Commission Inquiries and the Making of Misrepresentations to the Commission by Applicants, Permittees and Licensees, and the Reporting of Information Regarding Character Qualifications, 7 F.C.C.R. 6564 (1992). 118 Policy Regarding Character Qualifications in Broadcast Licensing; Amendment of Rules of Broadcast Practice and Procedure Relating to Written Responses to Commission Inquiries and the Making of Misrepresentations to the Commission by Permittees and Licensees, 1 F.C.C.R. 421, 424 (1986) ("[C]ommon carriers are distinguished from broadcasters for purposes of character qualifications because no content regulation is involved and because such issues are adjudicated on a case -by-case basis without the guidance of a specific policy statement. As a result, reference is occasionally made in common carrier cases to broadcast policies and precedents as aids in resolving character issues."). For an example of a recent revocation proceeding, see Application of Alee Cellular Communications, 17 F.C.C.R. 3237 (2002). 119 TeleSTAR, Inc., 3 F.C.C.R. 2860 (1988). 120 Revocation of the Licenses of Pass Word, Inc., 86 F.C.C.2d 437, 449 [para] 29 (1981). 121 See, e.g., RKO Gen'l, Inc. (KHJ-Television), 3 F.C.C.R. 5057 (1988). Footnote 122 Thornburgh Report, supra note 74, at 6, 58-63. 123 Id. at 6. 124 Jonathan Krim, Fast and Loose at WorldCom, WASH. POST, Aug. 29, 2002, at A1. Footnote 125 EASTERN MANAGEMENT GROUP, supra note 42, at 3. 126 Id. at 1. 127 See MERRILL LYNCH, WORLDCOM GROUP 4 (Jan. 4, 2002); cf. MORGAN STANLEY DEAN WITTER, WORLDCOM GROUP 3 (October 15, 2001).
- 100. 128 Christopher Stern, WorldCom To Lay Off 5.000 More Employees, WASH. POST, Feb. 4, 2003, at 125 (quoting Susan Kalla, telecommunications analyst at Friedman, Hillings, Ramsey Group Inc.); see also id. (attributing to Ms. Kalla the view that "[w]hen WorldCom gobbled up competitors in the 1990s, it did not integrate the separate networks into a single operation"). 129 See, e.g., Benjamin Klein & Keith Leffler, The Role of Market Forces in Assuring Contractual Performance, 89 J. POL. ECON. 615 (1981). 130 Christopher Stern, WorldCom CEO Rolls Out Turnaround Plan, WASH. POST, Jan. 15, 2003, at E2 ("[WorldCom's new CEO, Michael] Capellas also said yesterday that WorldCom will eventually change its name in an effort to separate itself from its now-tainted past."). 131 WorldCom, Inc., Press Release, WorldCom Completes Preliminary Review of Goodwill, Intangibles, and Property Equipment (Mar. 13, 2003), available at http://www.worldcom.com/global/news/news2.xml?newsid=721 2&mode=long&lang=en&width=530 &root=/global/. 132 Id. 133 Id. Footnote 134 See Stephanie Kirchgaessner, WorldCom Set To Restate Dollars 2bn of Its Accounts, FIN. TIMES, Sept. 20, 2002, at 27 (London ed.) ("While [WorldCom's] bondholders have said the additional [accounting] restatements do add uncertainty to the company's future prospects, they are more concerned with WorldCom's ability to retain contracts and not lose customers."). Cf. Stephanie Kirchgaessner, WorldCom Cuts UK Jobs as Cash Reserves Dwindle, FIN. TIMES, Sept. 17, 2002, at 21 (London ed.) ("On a conference call to senior executives in August [2002], Lucy Woods, senior vice-president of [WorldCom's] international operations, said the group was having difficulty attracting new customers."). 135 As of March 31, 2003, the states and dates of Section 271
- 101. authorization were: Alabama (Sept. 18, 2002), Arkansas (Nov. 16, 2001), California (Dec. 19, 2002), Colorado (Dec. 23, 2002), Connecticut (July 20, 2001), Delaware (Sept. 25, 2002), Florida (Dec. 19, 2002), Georgia (May 15, 2002), Idaho (Dec. 23, 2002), Iowa (Dec. 23, 2002), Kansas (Jan. 22, 2001), Kentucky (Sept. 18, 2002), Louisiana (May 15, 2002), Maine (June 19, 2002), Massachusetts (Apr. 16, 2001), Mississippi (Sept. 18, 2002), Missouri (Nov. 16, 2001), Montana (Dec. 23, 2002), Nebraska (Dec. 23, 2002), North Dakota (Dec. 23, 2002), New Hampshire (Sept. 25, 2002), New Jersey (June 24, 2002), New York (Dec. 22, 1999), North Carolina (Sept. 18, 2002), Oklahoma (Jan. 22, 2001), Pennsylvania (Sept. 19, 2001), Rhode Island (Feb. 24, 2002), South Carolina (Sept. 18, 2002), Tennessee (Dec. 19, 2002), Texas (June 30, 2000), Utah (Dec. 23, 2002), Vermont (Apr. 17, 2002), Virginia (Oct. 30, 2002), Washington (Dec. 23, 2002), and Wyoming (Dec. 23, 2002). See RBOC Applications To Provide In-Region InterLATA Services Under [sec]271, at http://www.fcc.gov/Bureaus/Common_Carrier/in- region_applications. Footnote 136 Press Release, Verizon, Verizon Now Third Largest Long- Distance Company (Jan. 7, 2003), at http://newscenter.verizon.com/proactive/newsroom/release.vtml ?id=78494. 137 Implementation of the Non-Accounting Safeguards of Sections 271 and 272 of the Communications Act of 1934, 11 F.C.C.R. 18,877, 18,943 [para] 137 (1996). Footnote 138 Applications of Voicestream Wireless Corp., Powertel, Inc., Transferors, and Deutsche Telekom AG, Transferee, for Consent To Transfer Control of Licenses and Authorizations Pursuant to Sections 214 and 310(d) of the Communications Act, 16 F.C.C.R. 9779 [para] 90 (Apr. 27, 2001). 139 Purchasers of WorldCom's assets would likely employ some of WorldCom's former employees. Certainly WorldCom
- 102. employees have the most experience operating WorldCom's networks. AuthorAffiliation J. Gregory Sidak[dagger] AuthorAffiliation s[dagger] F. K. Weyerhaeuser Fellow in Law and Economics Emeritus, American Enterprise Institute for Public Policy Research. This Article is based on my Beesley Lecture in Regulation, delivered at the Royal Society of Arts in London on October 1, 2002. I thank Colin Robinson of the Institute of Economics Affairs and Leonard Waverman of London Business School for inviting me to speak. In the months following my lecture, several telecommunications companies retained me to analyze the WorldCom fraud and bankruptcy in greater depth. They have permitted me to incorporate that additional analysis into this Article. I thank Allan T. Ingraharn, Hal J. Singer, and workshop participants at Yale Law School for valuable comments and Brian Fried, Daniel Nusbaum, Brian O'Dea, and Adelene Tan for excellent research assistance. I thank Jerry Hausman for suggesting the title of this Article. The views expressed here are solely my own and not those of the American Enterprise Institute, which does not take institutional positions on specific legislative, regulatory, adjudicatory, or executive matters. Copyright (C) 2003 by Yale Journal on RegulationAbstract (summary) TranslateAbstract Humanity is maturing slowly and is soaked in blood, passing through his age of childhood and adolescence. He is now going through the last stages of his adolescence - producing, distributing, and trying to manage weapons of mass destruction; grabbing all he can for his selfish interests while millions starve in other lands and in our own neighborhood; holding also tightly to his ancestor's dogmas, superstitions, and divisive ideals of race, nationalism, and religion. Such mindset has recently manifested itself in huge scandals in the Catholic
- 103. Church, and previously in Protestant denominations, and embezzlements in billions by the likes of Enron, Worldcom, and Arthur Anderson, and ultimately by the fundamentalist ideologies manifested in the likes of Osama Bin Laden and the Al-Quaida organization. The democratic systems, while hanging on to old ideas, have necessitated what George Orwell foresaw as the need for "double-speak" and "correct-think" to be able to keep the illusion of democracy and at the same time control the passions of the masses. Wars, in the meantime, have continued, have brought devastation to the world and have claimed the lives of some 200 million people in the twentieth century alone. Man is at the brink. The question of business ethics cannot be addressed in a vacuum if he has lost a bigger truth - his humanity. One must either learn to grow up quickly or perhaps, perish. [PUBLICATION ABSTRACT]Full Text · TranslateFull text · Headnote Keywords Ethics, Democracy, Religion, Politics, Economics, War Abstract Humanity is maturing slowly and is soaked in blood, passing through his age of childhood and adolescence. He is now going through the last stages of his adolescence - producing, distributing, and trying to manage weapons of mass destruction; grabbing all he can for his selfish interests while millions starve in other lands and in our own neighborhood; holding also tightly to his ancestor's dogmas, superstitions, and divisive ideals of race, nationalism, and religion. Such mindset has recently manifested itself in huge scandals in the Catholic Church, and previously in Protestant denominations, and embezzlements in billions by the likes of Enron, Worldcom, and Arthur Anderson, and ultimately by the fundamentalist ideologies manifested in the likes of Osama Bin Laden and the Al-Quaida organization. The democratic systems, while hanging on to old ideas, have necessitated what George Orwell foresaw as the need for "double-speak" and "correct-think" to be able to
- 104. keep the illusion of democracy and at the same time control the passions of the masses. Wars, in the meantime, have continued, have brought devastation to the world and have claimed the lives of some 200 million people in the twentieth century alone. Man is at the brink. The question of business ethics cannot be addressed in a vacuum if he has lost a bigger truth - his humanity. One must either harn to grow up quickly or perhaps, perish. Bird's eye view of the past East Asia gave to the world, Hinduism, Confucianism, Buddhism, Shintoism, and Taoism - all promoting virtues and the fundamentals of virtuous and decent human living. Athens with Socrates, Plato, and Aristotle gave to humanity an inkling of democracy and freedom of thought and the merits of reason and wisdom (Durant, 1961). Pharaohs ruled Egypt and most of the known world, followed by Persians (sixth century BC), Greeks (fourth century BC), Romans (second century BC), Christianity (sixth century AD), Islam (eight century AD), Ottomans (fourtheenth century AD), and the warring colonialists of Europe (eighteenth and nineteenth centuries). Middle East gave to the world, Judaism, Zoroastrianism, Christianity, Islam, and the Baha'i Faith - all promoting belief in one God, obedience to His manifestations and His commandments[1]. Arnold Toynbee (1971) concludes (not including the recent phenomenon of Baha'ism) that while Buddhism, that did not claim particular allegiance to an unreachable God, appears to have been the most tolerant among the higher level religions and lived in harmony with Taoism and Shintoism in China and Japan and Eastern Asia, Christianity and Islam proved to be the most intolerant of each other and their own internal denominations through history, as evidenced by the wars between Shiis and Sunnis among Moslems from the eighth century on and the religious wars of Europe during the sixteenth century when one-third of the European population were slaughtered to the current conflicts as manifested in Afghanistan and Iraq, as well as the infamous Crusades that
- 105. lasted some two centuries from the eleventh to thirteenth centuries, resulting in the slaughter of an untold number of people: The greatest paradox of the twentieth century is that in this age of powerful technology, the biggest problems we face internationally are problems of the human soul (Ralph Peters). Europe contributed to the age of Renaissance (fifteenth century), Reformation (sixteenth century), Enlightenment (seventeenth century), Industrial Revolution (eighteenth century), Freedom and Liberty (nineteenth century), and unprecedented technological advances (twentieth century)[2]. The new freedom released a huge level of energy and precipitated the birth of Colonialism, Imperialism, Individualism, Communism, Fascism, Nazism, Socialism, and Capitalism[3]. By the end of twentieth century, Capitalism with the ideals of individualism, free enterprise, and relentless competition was only standing, while with an unprecedented level of death and destruction, other ideologies were virtually vanquished. oil and most lethal armaments now have their hold on the humankind. Church and State are totally divorced from one another on the national scene, and the question of who dies and who lives is essentially decided and determined through the power of human logic in board meetings and through political maneuverings. Might is right is the final arbiter in human relations[4]. A little detail To be ignorant of what occurred before you were born is to remain always a child. For what is the worth of human life, unless it is woven into the life of our ancestors by the records of history (Cicero, 46BC). Emperor Constantine (fourth century AD) of the Byzantine Empire became Christian and his domain (most of the Middle East and North Africa) accepted the Christian faith. Rome was defeated and disintegrated (sixth century AD). The Christian church dominated Europe and to a lesser extent the Byzantine Empire until the sixteenth century. Uniformity was achieved at
- 106. the cost of suppression of any deviation from the Church's standards through harsh inquisitional practices. Outside threats were met through organized violence and generational wars. Prophet Muhammad introduced the religion of Islam which conquered the area from Arabia to the whole Middle East and beyond from the East and all North Africa to Spain and Southern Europe, promoting the oneness of God, compassion in human dealings, and justice through adherence to the tenets of the Koran. Pope Gregory (Urban II) commenced 200 years of crusades to conquer Jerusalem and annihilate "Sarasans"(eleventh century). An untold number of Moslems and local Jews and Christians were killed in this religiously motivated warfare[5]. Mongol herds attacked the Middle East from three directions during the thirteenth century AD, and brought with them devastation and an unprecedented level of cruelty and conquered the whole of Asia up through Eastern Europe (Armstrong, 2001): In trying to make themselves angels, men transform themselves into beasts (Michelle de Mountaine). Inquisition and burning non-believers and those who had deviated from the chosen path and strict obedience to the Church was the rule in Europe, while the Middle East advanced in art, philosophy, and sciences. Italy saw the beginning of the Renaissance in art, culture, and other scientific endeavors (fifteenth century). Ottoman Turks defeated the Byzantine Empire, Arabs, and to a large extent Persians and ruled the Middle East and North Africa from the fourteenth through nineteenth centuries. The Middle East was a safer place to live compared to Europe. Hundreds of thousands of Christians, Moslems, and Jews escaped and resettled in the Middle East in this time period. The Middle East was called the land of peace while Europe was referred to as the land of war (Lewis, 1997). Printing press and Martin Luther's revolt (sixteenth century AD), known as · Reformation and the Protestant Movement, contributed to diffusion of ideas and serious clashes of religious and nationalistic forces that left about one-third of Europe dead
- 107. within the course of one century. An outburst of thoughts led to scientific revolution and appearance of Copernicus, Galelio, Newton, Bacon, and philosophers such as Kant, Espinoza, Voltaire, and Russou (seventeenth-eighteenth centuries). This was the age of European Enlightenment and the age of reason: Your soul is often times a battlefield upon which your reason and your judgment wage war against your passion and your appetite. Would that I could be a peacemaker in your soul, that I might turn the discord and the rivalry of your elements into oneness and melody. But how shall I, unless you yourselves be also the peacemaker, nay, the lovers of all elements (Khalil Gibran). Advances in military science and the passion for movement and power led to the military might, east and southward expansion of France and its final defeat and withdrawal a short while later (1800s). Europeans (Portugal, Spain, France, England, Russia, Germany, Italy, Belgium, Denmark, etc.) also ventured to conquer and dominate all the continents of the globe. The age of Colonialism and Imperialism was on us. Millions of Africans were enslaved and brought to the fields of America for hard and free labor. At least nine million died in this cruel transport. Millions of others died working in the fields. American Indians were slaughtered and their lands confiscated by the resettling Europeans[6]: Killing is forbidden except if it is to the sound of the trumpet and marching of the band (Voltaire) 1776 - Industrial Revolution was introduced with the Watts steam engine. Adam Smith authored Wealth of Nations. American Revolution succeeded and a nation was born. Europe was devastated by the Napoleonic wars. Revolutions ensued in other parts of Europe including France, Portugal, Spain, and Italy: I have sworn upon the altar of God eternal hostility against every form of tyranny over the mind of man (Thomas Jefferson). 1800s - some 700,000 Americans were killed in the Civil War
- 108. between the South and the North. Colonialism of Asian and African and South American countries by the European forces continued with unprecedented exploitation and suffering for the masses. Humanitarian causes to end slavery and promote the rights of women and children and assist the deprived took root in Europe and in America. Religious movements in Europe and the USA such as the Seventh Day Adventists and the Millerites sought for signs of a new return and a new millennium. In 1863, Baha'u'llah, the founder of the Baha'i Faith, and a life-time prisoner of the Persian and Ottoman Empires, pronounced that he is the Messiah as promised not only by Krishna, Moses, Buddha, Zoroaster, Jesus, and Muhammad. He envisioned a short-term chaos but a long-term stability for the humankind leading to the unity and peace on earth. He proclaimed: Ye are all the fruits and the branches of one tree; this span of the earth is one country and mankind its citizens; let not a man glory in this that he loves his country, let him rather glory in this that he loves the universe (Abdu'l-Baha, 1975). According to the Baha'i view, humanity is going through that age of adolescence and will soon reach the age of maturity. If the age of adolescence is prolonged so would the turmoil and clashes that surround us: Let not a man glory in this that he loves his country. Let him rather glory in this that he loves the entire universe (Baha'llah, 1880s). 1900s - Industrial giants such as John D. Rockefeller, J. P. Morgan, Henry Ford, Dupont, and others created a lot of wealth, promoted a lot of industries, and the USA was brought to the forefront of industrialized nations. Exploitation of workers led to strikes and sometimes killing of those who stood up for their minimal rights. Electricity, railroads, telephone, cars, highways, banking, and oil discovery promised to change the face of America and the whole world. Industrial progress brought new advances to the military: Violence is immoral because it seeks to humiliate the opponent rather than win his understanding; it seeks to annihilate rather
- 109. than convert... it creates bitterness in the survivors and brutality in the destroyers (Dr Martin Luther King). 1914-1918 - some 20 million people, mostly civilians, were killed in this war. The defeated powers were humiliated and pushed to pay huge reparations[7]. This provided the basis for the start of the second World War that resulted in the death of some 50 million people and destruction of thousands of cities and villages - mostly Christians killing Christians, but now under the name of Nazism and Fascism. The Middle East was partitioned into some 20 plus countries. Some 40, non- homogeneous, and artificially created entities within Africa claimed independence. After 200 years of Colonialism, little hope for stability and progress appeared to be in sight for these regions. Russian Revolution brought Bolsheviks and Communists to power (Fromkin, 2001): The nations put him [Hitler] where he belongs, but don't rejoice too soon at your escape. The womb he crawled from is still going strong (Bertold Brecht). 1945 - the USA dropped two atom bombs over Hiroshima and Nagasaki. Some 200,000 Japanese perished and hundreds of thousands of others were impaired for the rest of their lives. Japan surrendered. The second World War ended. President Truman stated that he did not lose any sleep over the bombing. Otherwise, more people would have to be killed. Fifty years later, most history books tell us that Japan was already destroyed and defeated, and it could have been a matter of days before the surrender would have taken place. It is now argued that the bombing was necessary to scare the Soviets under Stalin. In the meantime, Stalin killed some 50 million Russians to promote uniformity in thinking and Mao killed 50 million Chinese for essentially the same reason. Russia and China could not reconcile the nationalistic sentiments with the global vision of Communism. Another 30 million people were slaughtered in all other regional wars of the twentieth century including the wars in Korea, Vietnam, Afghanistan, Iran, Iraq, former Yugoslavia, and various regional wars in Africa[8]. Europe with
- 110. the Marshall plan was on the road to recovery. Japan and South Korea assisted by the USA were geared up for economic success. China and India with one-third of the world's population gained true independence and struggled for survival; one through a totalitarian system and the second through a democratic form of government: The greatest obsolescence of all in the Atomic Age is national sovereignty (Norman Cousins). George Orwell (1949, 1996) authored two classics - Animal Farm and 1984. Writing Animal Farm in 1943 during the second World War, at the peak of Stalin's popularity in the West, he criticized this totalitarian and brutal regime that stripped humans of their humanity, dehumanized them, and allowed total evil to succeed and rule. After the second World War, he composed 1984 and predicted that it was time now for three superpowers, Europa, Asiana, and Oceana. Population was learning the new language of Newspeak which, particularly in political terms, included doublespeak where solid truth did not exist anymore; everything could be argued in two ways; and anything goes. Big brother was everywhere and deviations would be considered as Crimethink. "War is peace; Freedom is slavery; and Ignorance is strength." There are three ministries: Ministry of Love which is in charge of war, Ministry of Truth which is in charge of lies and misinformation, and Ministry of Plenty which provides the means for human starvation. Many who read the book were happy that Orwell's book is just fiction. 1984 came and passed and nothing of that sort ever happened - or did it?: Our lives begin to end the day we become silent about things that matter (Martin Luther King). 1950s - the Korean conflict left some 140,000 US soldiers and over four million Koreans dead, resulting in the partition of Korea. Under-secretary of State, John Foster Dulles, and his brother, Alien Dulles, as the head of Central Intelligence Agency, several low cost coup d'états were engineered across the globe from Iran to South America with short-term success
- 111. and no shedding of American blood. Arnold Toynbee and Will Durant commenced their celebrated and most prolific writings with an analytical view of history and philosophy (Tyonbee, 1966, 1971, 1978): Sixty years ago, I knew everything. Now I know nothing. Education is the progressive discovery of our own ignorance (Will Durant). 1960s - huge unsettlement in the USA about the draft, the Vietnam War, the rights of Negroes and the Civil Rights Movement, and the opposition of segregationists such as governor Wallace of Alabama created tremendous tensions and imbalance in the fabric of the American democracy. The decade ended with the assassination of President Kennedy, his brother Robert Kennedy, and civil rights leader, Martin Luther King. Young people, alienated and angry about the Vietnam War, turned to sex and drugs as their refuge and solace, perhaps with a nod from the ruling elite: The general prey of the rich over the poor is the devouring of people in wars (Thomas Jefferson). 1970s - President Nixon ordered acceleration of bombing in Vietnam in order to bring about peace. Cambodia fell under the rule of Pol Pot regime. Some 40 per cent of the country's population of 7 million were slaughtered. Nixon ordered the infamous Watergate burglary and was forced to resign to avoid impeachment. He later stated that he was not sorry for any of the lying and cheating. He was sorry that he was caught[9]. The decade ended with the defeat of the Shah and takeover of Iran by Islamic militants and taking of some 70 Americans hostage for 444 days until inauguration of President Reagan (Mackey, 1998). 1980s - Soviets invaded Afghanistan. The USA funded and supported "freedom fighters" who turned into Talibans and terrorists and battled America some 20 years later. Some 500,000 Afghans were killed and some 6 million became refugees in Iran and Pakistan (Brzezinski, 1983). Saddam (Iraq) attacked Iran. The USA supported Iraq openly and Iran covertly
- 112. - what became known as Iran-Contra Affair. The period was an arms sales bonanza for the USA and her European allies with sales of sophisticated weapons to Saddam Hussein, an equal amount to Saudi Arabia for their protection against potential threats and an inflated amount covertly to Iran in order for them not to totally lose in the war (Hiro, 1991). Both the president and vice-president deny any involvement in the affair, while Reagan's team in the affairs (Admiral Poindexter and Colonel Oliver North) were summoned to Congress for questioning, and they were eventually removed from their posts. New terms were coined in politics and political science such as, plausible deniability and dual containment - supporting enemy of my enemy, etc. The war lasted for some eight years leaving over 2- 3 million people killed or maimed for life. Beirut disintegrated. CIA staff and 243 marines were killed. The USA pulled out. Clashes between Israel and her Arab neighbors continued. By the end of the decade, the Soviet Union collapsed and disintegrated and the USA remained the only viable super power: It is not a sign of good health to be well adjusted to a sick society (J. Krishnamurti). Some current challenges with ethical implications College MBA programs flourished. The topics of inquiry seemed to be shifting in this time-period from scientific management, efficiency, productivity, and accountability to just-in-time inventory, total quality management, customer satisfaction, activity-based costing, and activity-based management, and to a greater extent to the questions of hostile takeover, off-balance sheet reporting, maximizing shareholder value, stock options, and the like. The latter, as we see a couple of decades later, led to unprecedented frauds and unsettlement in the economy. Congress and the President go through a frenzy of deregulation and tax reduction for the higher earners. Interest groups keep effective legislation at bay. Efficiencies created and computer advances result in huge unemployment for the middle management employees in various industries. Lower cost
- 113. of production in Southeast Asia and elsewhere forces many US manufacturing facilities to be closed and to be moved elsewhere: Democracies die behind closed doors. Selective information is misinformation (Judge Damon J. Keith). The West, freed from the shackles of the Catholic Church, encouraged by the advances in industrialization, and allowed to think and reason without being subdued and controlled by a higher authority, left the world of religion and authoritarian rule for a new era of democracy, freedom, individualism, selfishness, and cut-throat competition. In many corners, the ideals of greed and selfishness were actively promoted as the engine for ultimate human progress. Professor Hayeck of the University of Chicago together with the Nobel prize winner, Milton Freedman, promoted the ideals of free market and less government interference[10]. The ideals were promoted by politicians from Reagan in the USA to Margaret Thatcher in the UK. The last revolution in Western politics and economics brought with it certain additional efficiencies at a huge cost to those who had gained some rights and equity in the course of the last 100 years and resulted in a much wider gap between the haves and the have-nots both within the · country and among nations. The disparities, disappointments, and hopelessness appeared to be too much to handle or to overcome: More compassion automatically opens our inner self. Too much self-centered attitude closes our inner door. The very concept of war is out of date. Destruction of your neighbor as an enemy is essentially a destruction of yourself (Dali Lama). The age of individualism and greed was at its peak, leading to several scandals, insider trading, and dissolution of savings and loan association resulting in billions of dollars of loss. Professor Paul Kennedy (1988) authored his famous work, The Rise and Fall of Great Powers, illustrating the mix of economic superiority with military strength and argues that the civilization that has the last dollar is the one that stands and the one who falls short of money ultimately falls. However, those
- 114. who overextend themselves in military terms (Soviet Union) ultimately make the economy bankrupt and fall. Professor Alan Bloom (1987) writes his famous work, Closing of the American Mind, lamenting that in this age of reason and liberty we may have lost something far more precious. Quoting Nietsche, he elucidates that in the process we may become either truly liberated or go mad and eventually destroy ourselves: We must pursue peaceful ends through peaceful means (Martin Luther King). Lord Kenneth Clark completed his award winning series titled Civilization[11] in which he took us through the ages of Renaissance, Enlightenment, Industrial Revolution, Colonialism, Humanism, Wars, revolutions, and present scientific advances and concluded that while freedom of thought was the vehicle for all the human (primarily Western) advances of the past five centuries, we seem to have lost, in this "post- Christian era", that sense of awe, discipline, obedience to God and authority that became manifest in the works of Raphael, Leonardo di Vinci, and Michael Angelo. We may be at the edge of a cliff now, and we could very well destroy ourselves in the process. He ultimately thinks that order is better than disorder and that our age of reason must need to be supplemented with some higher purpose to hold the civilization together: The only thing for the triumph of evil is for good men to do nothing (Edmund Burke). 1990s - Iraq invaded Kuwait. A coalition was formed. Iraq was defeated, but Saddam was not removed. The USA pulled out of Somalia after some marines were brutally killed and paraded through the streets. A US ship was targeted and attacked near the coast of Yemen. There were several other terroristic targets of US embassies in East Africa and the Middle East. A few years earlier, 243 marines were killed in Lebanon and the US forces pulled out immediately then after: The saddest lesson of history is that we never learn anything from history (Hegel). Republicans fought Democrats in the Congress. The federal
- 115. government was almost shut down in such maneuvers. Eight hundred thousand Tutsis are hacked to death by the dominating tribe Huttos in Rwanda while Americans were busy watching the OJ Simpson trials on television. President Clinton was threatened with impeachment due to his sexual relations and supposedly lying about it. The stock market advanced to the roof. Americans on average were happy with their newfound paper wealth. The post Second World War period accelerated the scientific revolution. Transportation (ships, railroads, cars, trucks, and airplanes) and communication methods (telegraph, telephone, fax machines, computers, Internet, e-mails, etc.) created unprecedented opportunities and accelerated the possibilities and dangers of clashes between the old and the new, the haves and the have-nots, the East and the West, and either destroying the current world order or bringing about an era of global interaction leading to a unified humankind: It may be that the only type of defensive war the Christian can wage today is on war itself (Leslie Dewart). Professor Fukuyama (1992) authored his famous book, The End of History and the Last Man, concluding that the second World War ended a major conflict of ideologies and the West is on the road to conquering the hearts and minds of people all across the globe through liberal democracy. Professor Huntington (1996) wrote his most celebrated book, The Clash of Civilizations, providing a persuasive historical/political analysis of civilizations, including that of India (Hinduism), China (Confucianism), Southeast Asia (Budhism), Middle East and North Africa (Islam), South Europe and South and Central America (Catholicism), Russia and Eastern Europe (Orthodox Christianity), Japan and other Islands (Shintoism), and finally Western Europe (except the South), South Africa, Australia and New Zealand as well as North America (Protestantism), and conveniently concluded that the final outcome of the 4,000 years in clash of civilizations is that the West has won and will be the enduring civilization of the future. Karen Armstrong authored several books starting in 1980s on Buddhism, Islam,
- 116. History of God, and finally The Battle for God (Armstrong, 2000) concluding that the twentieth century trouble spots have been among Shi'i Moslem fundamentalists, Sunni Islam fundamentalists, Jewish fundamentalists in Israel, and Protestant fundamentalists with leaders such as Jerry Faldwell and Robert Patterson all spewing hate, division, animosity, and turmoil in the name of God - insisting that it is their God who speaketh the real truth: Never doubt that a group of thoughtful committed citizens can change the world; it is the only thing that ever has (MararetMead). 2000s - Al Gore got the majority vote but there was a showdown in Florida where there appeared to be a tie. Gore fought and asked for a recount. The Republican dominated Supreme Court voted in favor of Bush and his presidency started. The stock market was now on a free-fall. The 11 September 2001 terrorist attacks of the major economic and military centers of power in the USA brought the DJIA to an all-time low of below 7,000 in over a decade. The USA attacked Afghanistan and then Iraq. Catholic Church scandals and major misdeeds of corporations such as Waste Management and Sunbeam in 1990s and Enron, Worlcom, Arthur Andersen, Tyco, Medco, and Global Crossing in 2002 brought havoc to an already edgy nation (see, for example, Toffler and Reingold, 2003). After invading Afghanistan and rooting out Talibans, the USA attacked Iraq to get rid of weapons of mass destruction (WMD) and Saddam Hussein (Mackey, 2002). Over 7,000 US servicemen were killed and another 3,000 or more wounded plus an untold number of Iraqi casualties. No weapons of mass destruction that were financed and sold to Saddam in 1980s were found. Saddam wass captured, his sons killed, but no WMD were found as of this date. There is no closure as of yet on the question of Iraq. Was the invasion for freeing Iraqis, for capturing Saddam Hussein, for protecting oil, or for discovering the weapons of mass destruction? We do not have a clear picture as of yet: There can be no happiness if the things we believe in are
- 117. different from the things we do (Freya Stark). Accounting and auditors The Big-five CPA firms with their consulting partners dominate the corporate world. Their signatures in audit of the firms are worth a lot and companies pay huge fees to obtain that signature. In the process, all of these firms were fined or condemned by courts for not detecting certain irregularities or having colluded with their clients in unprecedented levels of misdeeds. Arthur Andersen, one of the Big-five, with its impeccable reputation for quality audits, also aggressively pursued the schemes of wealth generation and accumulation through any means possible (Toffler and Reingold, 2003). Consulting brought considerably more revenue for the firm as compared to audit of company books. As there was a limit on what companies could produce and sell, new schemes were devised to provide the appearance of wealth and success. In the case of Waste Management, Andersen went along with the idea of extending the life of depreciable assets to show millions more profit than the company realistically could muster. The scheme was discovered, the company and the auditor paid millions in fines. Sunbeam brought "Chainsaw Ale" on board to rescue the firm. As the common scheme among the CEO con- artists, he commenced his job with huge write-offs and losses to "clean" the books. Then, he posted million of dollars in future sales and inventory transfers as actual sales to give the appearance of profitability. The scheme was later discovered with additional fines and adjustments. In the Enron case, the auditors colluded with the firm bosses to hide millions of losses in off-balance-sheet reporting schemes and many more sophisticated tools of trade while the top guns in the firms pocketed millions of dollars in bonuses that were not recorded as company expense and paid millions more to Andersen for their audits and consulting services. In case of Worldcom, the company and the auditors reverted back again to slow-term depreciation and capitalization of expenses and losses and pocketed millions more in bonuses and fees for both parties.
- 118. Congress all along stalled the Financial Accounting Standards Board and the Securities and Exchange Commission under Arthur Levitt who had insisted on expensing stock options and separating audit task from management consulting. But in this age of Orwellian "doublespeak", when the companies collapsed, all the perpetrators washed their hands from any misdeeds and point to some nebulous and unreachable enemy as the culprit. The same Congress then gets busy writing new legislation to deal with the problem. The questions of the role of Arthur Andersen, the federal government, the Financial Accounting Standards Board, and the Securities and Exchange Commission is well documented in a comprehensive 2003 video by the Public Broadcasting System, BeyondEnron. Hundreds of articles have chronicled and explained the misdeeds of the firms mentioned in this section of the article. They will be analyzed specifically in a separate article: We must become the change we wish to see in the world (Gandhi). The risks Here is the broad picture of human civilization or lack of it - two steps forward and a step backward for some 4,000 years. Lots of atrocities are perpetrated in the name of religion, race, economic advantage, or nationalism. Religion is put either on a backburner or banished to mosques, synagogues, and churches for our Fridays, Saturdays, or Sundays. The "double-speak" phenomenon works at full speed and with full force. The culture of tribalism transformed into religious identity and then subverted by an unrelenting force of nationalism is now fueled by the culture of greed, money, and selfish pursuits for its own sake. We have been colonizing the defenseless people from Africa to Asia in the name of peace and civilization. The dogmas of nationalism have further been eroded with the more powerful gods of ideology from Nazism, Fascism, Communism, and now Capitalism - in the name of any of which we have been too willing and quite ready to kill: Democracy is the worst kind of government ever conceived by
- 119. the wit of man except that the alternative is even worse (Sir Winston Churchill). The phenomenon of democracy in the age of mass media has been hijacked with political manipulators with two or three stripes. The masses are brainwashed to follow one or another similar camp. Voltaire said it best when he wrote, "Killing is forbidden unless it is to the marching of the soldiers and the sound of the trumpet." No longer constrained by the phenomenon of religion and no longer harnessed by the idea of public opinion, the politicians maneuver through mass propaganda, intimidation and scare tactics to tell a cowed public what they should know and how they should think. Truth is either hidden or becomes known to a few educated élite - some who are willing to spend hundreds of hours in the basement of libraries to dig out what really happened 25 or 50 years ago and are content to write more about it and pile it up in dead libraries for future students. Some facts may have been sealed from public scrutiny forever. Deviations from acceptable thinking are censored quickly and harshly by the unsophisticated but well- trained public on a daily basis. Self-censorship is the most effective phenomenon in these dark alleys: All power corrupts, and absolute power corrupts absolutely (Lord Acton). With more people killed by their own governments or by regional and global wars in the course of the past century compared to the rest of human history, and more property destroyed during the same time period, the human race is now clearly divided into the camps of haves and have-nots. Religious fanatics, particularly in the Islamic and Christian camps, are once again at each other's throats. Children out of wedlock are at an all-time high. The gun lobby frustrates any meaningful legislation for gun control in spite of daily homicides and high school shootings across the country. The sex trade is flourishing in all major cities. Virtually everything, including murder, is rationalized to the extent that day is subject to lawyer's proving that it might have been night after
- 120. all, and our mind may not have clearly understood the situation: The life which is not examined is not worth living (Plato). The promise Yet the twentieth century has also had its heroes - although not enough of them. John D. Rockefeller realized that he is not going to take anything with him and devised a sophisticated plan of giving to communities and important humanitarian causes for generations to come. In fact one of his four sons manages philanthropic causes full time giving away millions of dollars every year. Women got the right to vote in 1920 after a half century of struggle and somewhat earlier in some European countries. Mahatma Gandhi struggled for India's independence without bloodshed, in which he finally succeeded - although he gave his own life in this process. Martin Luther King became the champion for African American civil rights and he finally achieved it - although he also had to give his own life during this struggle. Mother Theresa became the symbol of human sacrifice for the plight of the poor and dispossessed in far away lands such as India. Bill Gates, the famous CEO and initiator of Microsoft, introduced a new level of commitment to giving and education of the masses through computers all across the globe. Many other individuals decided that they could do good through philanthropic and humanitarian organizations or through professions such as medicine or nursing. Programs such as the Marshall Plan, Point IV, and John Kennedy's Peace Corps gave some hope to a lost generation. Advances in technology have brought about cures, longer lives as well as most lethal weapons for the destruction of man: I love my country too much to be a nationalist (Norman Cousins). The challenge For the most part, the twentieth century politician, it seems to me, was void of humanitarian, cosmic, and spiritual connection to the decisions that were being made which had significant consequences with regard to people of certain regions across the globe. Under the current democratic practices of interest
- 121. groups, propaganda, campaigning, relentless competition, and nationalistic agendas, and in an environment where the essence of religion is divorced from the public arena, that is probably all that the best of people can do under such political and social constraints. The century is also the century of Mafias, Al Capone, and drug lords who put all conventions aside in reaching their goals at any cost and through any and all means necessary. Our psyche has been played with too viciously and too uncaringly in the past 200 years. A philosopher who gave the subject serious thought was Nietzsche, who lost his own mind in this process (Nietzsche, 1989). The life of sex, drugs, parties, gun battles, and cross fire is perhaps more bearable than having to think about these serious issues and wanting a way out for the human race from the catastrophe of self destruction: The most tragic paradox of our time is to be found in the failure of nation-states to recognize the imperatives of internationalism (Chief Justice Earl Warren). One person who saw this century of light and darkness coming was Baha'u'llah, the prophet founder of the Baha'i Faith (Effendi, 1980). Writing in the period of 1852 to 1892 as a prisoner of Persian and Ottoman Empires, he foresaw the calamities in a series of Tablets addressed to the kings, rulers, and high ecclesiastics of both Moslem and Christian countries, and he came up with a new model for the human society (Baha'u'llah, 1975a). He foresaw the imperative of a global vision, the need for arms control, the need for finding spiritual solutions to the current economic problems of the world, the need for elevating the human spirit and promoting equality in rights among, sexes, races, nations, and religions all across the globe, and the need for a functioning global world order (Baha'u'llah, 1975b). He wrote about the imperative that science and religion should work hand in hand for the elevation of both. Otherwise, the former may become dogmatic and the latter may become cruel and heartless. He emphasized the importance of global education with global values and the necessity for abolishing the extremes of wealth and poverty for a stable and
- 122. prosperous global order. He envisioned the necessity of an auxiliary language that all people can speak to promote intercultural communication, and he saw the necessity of establishing the fundamentals of a functioning global world order. He also proposed reconciliation in human thought in accepting the premise that if God is one and humanity is His children, if all the major manifestations share the same basic truths with mankind, therefore, they are all from the same God provided through ages for his good, concluding that we have now reached the age of maturity. Our minds need to be healed. Rather than always wanting to find evil and fighting evil in distant lands, we have to start fighting the evil inside ourselves. When we achieve this, then, we can reach out and start solving the world's problems compassionately and holistically. He also foresaw the impending financial chaos in the twentieth century and beyond. The remedy that he envisioned was essentially spiritual through the means of education, self-sacrifice, equity, true justice, honesty, integrity, sharing, compassion, and virtuous living. At the beginning of my college career in this country, 45 years ago, these thoughts were summarily dismissed as Utopian and idealistic. Today, many think of them as good ideas and perhaps necessary or even mandatory to save ourselves from an impending menace. But do we have any other choice?: Two roads diverge in the wood and I took the road less traveled by and that is what made all the difference (Robert Frost). Although we are passing through the most perilous and uncertain period in human history, there are opportunities and possibilities for changing course for a better tomorrow for the humankind. Whether we can reach the destination safely depends on what we do today and how we tread on this fragile earth. With acceleration in production and dissemination of the weapons of mass destruction and with huge disparities in wealth, opportunities, and possibilities within countries and among nations, and with the possibilities of instant communication and easy travel across the globe, we may have
- 123. no choice but to work fervently and feverishly for a functioning global world order that reconfirms our basic chore principles as a noble species that must be working diligently toward an ever advancing global civilization with ethical guidelines and with moral and universal norms and criteria. The possibilities are there. The impediments must be overcome to save us from ourselves and avoid an impending self destruction. The problems are much broader than a mere revision of accounting and auditing rules of conduct. We must overcome the current hurdles in order to truly advance: No man shall attain the shores of the ocean of true understanding except he be detached from all that is in Heaven and on Earth. Sanctify your souls, O ye people of the Earth, that haply ye may attain the station that God hath destined for you (Baha'u'llah - The Book of Certitude). My first counsel is this: Possess a pure, kindly and radiant heart, that thine may be a sovereignty ancient, imperishable and everlasting (Baha'u'llah - The Hidden Words). Ye are all the fruits and the branches of one tree; this span of the Earth is one country and mankind its citizens (Baha'u'llah). Footnote Notes 1. Public Broadcasting Systems (PBS) provides an excellent series on religions (Hinduism, Buddhism, Christianity, and Islam) as well as major civilizations of Egypt, Greeks, Romans, Ottomans, and the Catholic Church. Videos on the Baha'i Faith may be obtained from the Baha'i Publishing Trust, Chicago. 2. Teacher's Video Company provides an excellent series on Industrial Revolution, John D. Rockefeller, Henry Ford, Sam Walton, Bill Gates, etc. 3. PBS provides an excellent video series on Martin Luther, Galileo, Eastern and Western philosophy, the First World War, the Second World War, Korea, Vietnam, War over Iraq, and the question of Saddam Hussein. 4. See, for example, PBS Video, Lawrence of Arabia, and Fromkin (2001)
- 124. 5. Islam, a PBS video series. 6. Important video series on Martin Luther, Voltaire, Napoleon, Ku Klux Klan and Martin Luther King. 7. PBS provides an excellent video series on World War I and its aftermath. 8. See, for example, the riveting PBS video series on Korea and Vietnam. 9. See, for example, PBS's video special on Watergate. 10. See, for example, PBS video series, The Commanding Heights. 11. This celebrated PBS video series on Civilization covers a period from the Renaissance to the modern times, from Europe to America. References References Abdu'l-Baha (1975), Promulgation of the Universal Peace, Baha'i Publishing Trust, Chicago, IL. Armstrong, K. (2000), The Batik for God, Ballantine Books, New York, NY. Armstrong, K. (2001), Holy War: The Crusades and Their Impact on Today's World, Random House, New York, NY. Baha'u'llah (1975a), Tablets to Kings and Rulers of the World, Baha'i Publishing Trust, Chicago, IL. Baha'u'llah (1975b), Epistle to the Son of the Wolfe, Baha'i Publishing Trust, Chicago, IL. Bloom, A. (1987), The Closing of the American Mind, Simon & Schuster, New York, NY. Brzezinski, Z.K. (1983), Power and Principle: Memoirs of the National Security Adviser 1977-1981, Smithmark Pub., New York, NY. Durant, W. (1961), The Story of Philosophy: The Lives and Opinions of the Greater Philosophers, Washington Square Press, New York, NY. Effendi, S. (1980), World Order of Baha'u'llah, Baha'i Publishing Trust, Wilmette, IL. Fromkin, D. (2001), A Peace to End All Peace, Henry Holt &
- 125. Company, New York, NY. Fukuyama, F. (1992), The End of History and the Last Man, Macmillan, New York, NY. Hiro, D. (1991), The Longest War: The Iran-Iraq Military Conflict, Routledge, New York, NY. Huntington, SP. (1996), The Clash of Civilizations: Remaking of World Order, Simon & Schuster, New York, NY. Kennedy, P.M. (1988), The Rise and Fall of the Great Powers: Economic Change and Military Conflict from 1500 to 2000, Random House, New York, NY. Lewis, B. (1997), The Middle East: A Brief History of the Last 2,000 Years, Simon & Schuster, New York, NY. Mackey, S. (1998), The Iranians: Persia, Islam, and the Soul of a Nation, Penguin Group, New York, NY. Mackey, S. (2002), The Reckoning: Iraq and the Legacy of Saddam Hussein, W.W. Norton & Company, New York, NY. Nietzsche, F. (1989), Beyond Good and Evil (trans. Walter Kaufman), Random House, New York, NY. Orwell, G. (1949), 1984, Harcourt Brace Jovanovich, New York, NY. Orwell, G. (1996), Animal Farm, Penguin Press, New York, NY. Toffler, B.L. and Reingold, J. (2003), Final Accounting: Ambition, Greed, and the Fall of Arthur Andersen, Broadway Publishing Company, New York, NY. Toynbee, A. (1966), Change and Habit: The Challenge of Our Time, Oxford University Press, New York, NY. Toynbee, A. (1971), Surviving the Future, Oxford University Press, New York, NY. Toynbee, A. (1978), A Selection from His Works, Tomlin, E.W.F. (Ed.), Oxford University Press, New York, NY. AuthorAffiliation Roger K. Boost School of Accountancy and Legal Studies, Clemson University, Clemson, South Carolina, USA Word count: 7304 Copyright MCB UP Limited (MCB) 2004Abstract (summary)
- 126. TranslateAbstract WorldCom, Inc. perpetrated the largest accounting fraud in U.S. history. WorldCom, now called MCI, emerged from bankruptcy protection on April 20, 2004 after being fined $750 million. In total, WorldCom reported accounting irregularities of $11 billion. While employees and investors look for individual culpability, much of WorldCom's organizational structure and culture potentially contributed not only to the fraud but also to the length of time over which it occurred. In many ways, groupthink may help explain some of the issues and fraudulent activities at WorldCom as well as the pressures that were placed on employees extending the period over which the fraud occurred. [PUBLICATION ABSTRACT]Full text · TranslateFull text · Headnote WorldCom, Inc. perpetrated the largest accounting fraud in U.S. history. WorldCom, now called MCI, emerged from bankruptcy protection on April 20, 2004 after being fined $750 million. In total, WorldCom reported accounting irregularities of $11 billion. While employees and investors look for individual culpability, much of WorldCom's organizational structure and culture potentially contributed not only to the fraud but also to the length of time over which it occurred. In many ways, groupthink may help explain some of the issues and fraudulent activities at WorldCom as well as the pressures that were placed on employees extending the period over which the fraud occurred. We were duped, how could we have been so stupid, and the more humorous my 401K is now a 101K. These and many others are all sentiments heard around the halls and coffee machines at WorldCom (now named MCI) after the largest accounting fraud in history occurred. Currently the nation's second largest long- distance phone company, MCI is headquartered in Ashburn, VA. MCI emerged from bankruptcy protection on April 20, 2004 reporting accounting irregularities of $11 billion (Young, 2004).
- 127. Young (2004) reported that the company, as part of a settlement with the Securities and Exchange Commission (SEC), will pay fines totaling $750 million and former bondholders will receive 36 cents on the dollar in stock and bonds in the new company. According to U.S. District Judge Jed Rakoff, Richard Breeden, the court appointed bankruptcy monitor, will probably stay on for an additional two years (Lublin & Young, 2004) A recent SEC report (2003) found that WorldCom's ex-Chief Executive Officer (CEO), Bernie Ebbers, initiated much of the culture and pressure that allowed the fraud to transpire. In concurrence with this finding, on March 2, 2004, Ebbers was charged with conspiracy to commit securities fraud, securities fraud, and falsely filing with the securities and Exchange Commission (Davidson, 2004; Moritz, 2004) after Scott Sullivan, WorldCom's ex-Chief Financial Officer (CFO) agreed to testify against him (Pulliam, Latour, & Brown, 2004). On the same day, Reuters television reported that Sullivan stated, "as CFO at WorldCom I participated with other members of WorldCom to conspire to paint a false and misleading picture of WorldCom's financial results." On May 24, 2004, six additional counts were filed against Ebbers (Davidson, 2004). Each additional charge alleges that Ebbers filed false quarterly documents with the SEC from the fourth quarter 2000 through the first quarter 2002. In total, Ebbers now faces charges with a maximum penalty of 85 years in prison and an $8.25 million fine (Davidson, 2004). Although employees and investors look for individual culpability, WorldCom's organizational structure, group processes, and culture contributed to the fraud and the length of time over which it occurred. Within WorldCom, there was a great deal of focus on teamwork and being team players. In hindsight, however, were many of the senior level managers being team players or was it a well-orchestrated scheme to perpetrate a fraud for the personal gain by a handful of executives? Morgan (1997) equated the type of behavior at WorldCom to the
- 128. metaphor of employees being held in a psychic prison. He associated the psychic prison to Plato's cave whereby individuals could only see the shadows, or illusions of reality, on the wall in front of them. Plato's cave dwellers, even when faced with a truth that their reality was flawed and only revealed the shadow of reality, would reject that paradigm change to the point of ostracizing the individual attempting to change their reality. In business, Morgan (1997) suggested that any attempt to change these organizational norms would create "all kinds of opposition as individuals and groups defend the status quo in an attempt to defend their very selves" (p. 245). Analogous to Morgan's (1997) psychic prison, Irving Janis laid the foundation and basis for groupthink in a 1971 article in Psychology Today. According to Janis (1982), groupthink is a "mode of thinking that people engage in when they are deeply involved in a cohesive in-group, when the members' strivings for unanimity override their motivation to realistically appraise alternative courses of action" (p. 9). Further, Sims (1992) found that the indicators of groupthink include "arrogance, over commitment, and excessive or blind loyalty to the group" (p. 652). Janis (1982) contended that some well-known examples of groupthink were America's decision to escalate the war in Vietnam, President Kennedy's decision to invade Cuba at the Bay of Pigs, and President Nixon's Watergate cover-up. Whyte (1989) added some more contemporary examples of groupthink as the space shuttle Challenger disaster and President Reagan's Iran-Contra arms for hostages dealings. Each of these examples displays the symptoms or characteristics of groupthink and each ended in disaster. The characteristics of groupthink include a feeling of invulnerability, ability to rationalize events and decisions, moral superiority within the group, group pressure on dissenters, use of stereotypes, self-censorship within the group, and unanimity. Janis (1982) broke these major characteristics into three major types or categories (see figure 1). When groups display most of
- 129. the characteristics of groupthink in each category, the group is likely to engage in concurrence seeking resulting in insufficient examination of other courses of action. Not only do groupthink organizations inadequately examine alternate course of action, they also avoid examination of the risks involved in the selected course of action. These factors lead to an overall low probability of a successful outcome to decision making. Whyte (1989) posited that groupthink also involves a "choice in the domain of losses" (p. 47). For example, according to Whyte (1989), the pressure on NASA to launch the Challenger was so great that the option to delay or not launch was seen as an unacceptable alternative. However, just because a group's decisions resulted in a poor outcome, does not insinuate that it resulted from groupthink behaviors. Likewise, defective decisions caused by groupthink do not always result in a disaster. Groupthink, however, may help explain many of the issues and fraudulent activities at WorldCom as well as the pressures that were placed on employees to be team players, especially in the highly competitive telecommunications industry. During the late 1990s, there was strong pressure on WorldCom to maintain historic cash flow levels or EBIDTA (earnings before interest, depreciation, taxes, and amortization) while orders for new telecommunications equipment declined. This pressure resulted in several WorldCom executives engaging in unethical and fraudulent behavior. In general, the sec report (2003) found three major areas of fraud. (1.) The unauthorized movement of line costs to capital as prepaid capacity. Line costs are paid to local telephone companies for originating and terminating long distance calls and account for the largest single expense for long distance companies. By moving these costs to capital, the costs could be depreciated over time thereby increasing the current year's EBIDTA. (2.) The improper release of accruals. This improper release effectively reduced current year expenses and increased
- 130. earnings. (3.) Additional minor questionable revenue entries resulting in increased operating earnings. Figure 2 displays an organization chart identifying many of the major players documented by the SEC investigation. Each of these individuals was indicated in at least one of the fraud findings (SEC report, 2003). Nietzsche, as cited by Von Bergen and Kirk (1978), wrote that madness was rare in individuals and widespread in groups. A variety of group madness at WorldCom will be explored in this article by reviewing Janis' characteristics of groupthink, which created a kind of psychic prison for many employees at WorldCom. Janis (1971, 1982) indicated that it is not necessary for all the groupthink characteristics to emerge for it to be present; however, this paper will review each of these characteristics and relate them to the SEC's findings at WorldCom. Invulnerability Cohesive groupthink organizations build an aura of invulnerability amongst their members. This invulnerability leads to a kind of unmatched bravado or superiority among group members. Janus (1971) stated that this illusion provides "some degree of reassurance about the obvious dangers and leads them to become overoptimistic and willing to take extraordinary risks. It also causes them to fail to respond to clear warnings of danger" (p. 44). In hindsight, it is obvious that many of the senior executives at WorldCom were extremely optimistic and more than willing to assume extraordinary risks up to and including fraud. Historically above average stock and revenue appreciation, or the external awards some of the executives received could have triggered this invulnerability. Scott Sullivan, for example, in a 1998 CFO magazine cover story was called a "37-year-old whiz kid" (McCafferty, 1998, para. 3) and awarded the CFO Excellence Award. To illustrate this invulnerability during the time when the fraudulent activities were occurring, according to the SEC
- 131. report (2003), one manager wrote an email to her employees referring to some of the irregular accounting charges. The email stated, "[t]hese documents are sensitive and confidential and should not be distributed outside of the department without advising [her] or myself first" (p. 69). One of her direct reports replied: "Opps! [sic] I sent it to AA [Arthur Andersen]. IT'S A JOKE. I fully agree with your concerns" (p. 69). The manager then replied, "smart ass. Just trying to be dramatic and liven things up a bit" (p. 69). This email string identifies two of the underlying realities at WorldCom. First, while most of the 65,000 WorldCom employees had no knowledge of the accounting irregularities, it was not limited to only a handful of executives. To support this assertion, WorldCom, since these activities were uncovered, has fired over 400 finance and accounting employees. Secondly, while it is apparent that these employees did not want the fraudulent reports and charges going to Arthur Anderson for review, the email string displays a certain level of audacity and bravado that usurping the external auditors was considered appropriate even at the lower levels of the company. Rationalizations In addition to a sense of invulnerability, groupthink organizations in the past have manufactured outrageous fabrications and rationalizations to justify their behavior. According to Sims (1992), under stress, members of an organization may develop certain defenses including: "(1) Misjudging relevant warnings, (2) inventing new arguments to support a chosen policy, (3) failing to explore ominous implications of ambiguous events, (4) forgetting information that would enable a challenging event to be interpreted correctly, and (5) misperceiving signs of the onset of actual danger." (p. 653.) The SEC (2003) found that Scott Sullivan had the misguided reputation among employees for his impeccable integrity. Many of the finance and accounting employees who were aware of the
- 132. irregularities may have rationalized that because of Sullivan's unquestionable integrity he must have found some new methodology or loophole in the Generally Accepted Accounting Principles (GAAP) to support the entries he was directing. The numerous awards Sullivan received probably reinforced these feelings as well as the clean audit reports from Arthur Anderson, the company's external auditor, and the consistent buy recommendations sent throughout the company from financial analysts. Even after Sullivan's indictment, many finance employees' initially felt that he must have been setup or was being made a scapegoat. While Ebbers put very little on electronic mail, one memo remains where Ebbers discussed his rationalization of "those one-time events that had to happen in order for us to have a chance to make our numbers" (The Economist, 2004, para. 5). Beyond the accounting fraud, both Ebbers and Sullivan engaged in very questionable dealings with their employees. For example, according to the SEC (2003), over an eighteen month period ending in 2002, Ebbers gave Ron Beaumont, WorldCom's ex-Chief Operating Officer (COO), a total of $650,000 whereas Sullivan wrote personal checks to seven of his managers giving them $20,000 each by writing one check to the employee for $10,000 and another to the employee's spouse for the same amount. Sullivan rationalized these payoffs as a company bonus even though they were written on his personal checking account and no additional bonus was authorized by the company's board of directors. The SEC (2003) stated that these acts were "not necessarily improper in themselves... [they] created conflicting loyalties and disincentives to insist on proper conduct" (p. 23). It is difficult to believe that the seven employees receiving checks from Sullivan did not see these payments as highly questionable, especially when Sullivan wrote personal checks to their spouses as an alleged company bonus. Yet each of these employees must have rationalized the validity of these payments because none came forward. In addition to these one-time payouts, there were also a select number of employees who
- 133. were compensated above WorldCom's salary guidelines to promote loyalty to the company (Zekany, Braun, & Warder, 2004). Morality Janis (1982) observed that highly cohesive groups might rely unquestionably in the morality and self-righteousness of their group. Janis noted, "in a sense, members consider loyalty to the group the highest form of morality" (p. 11). According to St. Augustine, as cited by Handy (1996), "in ethics, to mistake the means for the ends is to be turned in on oneself, one of the greatest of sins" (p. 62). Many of the senior executives of WorldCom appear to be guilty of Augustine's greatest of sins by focusing on maintaining some arbitrary financial goal instead of doing what was right. To illustrate, one example of the lack of moral compass occurred when efforts were being made to establish a corporate Code of Conduct. Ebbers reportedly described this effort as a "colossal waste of time" (SEC, 2003, p. 18). Yet an ethics office, code of conduct, and an enhanced internal audit division may have precluded much of what occurred at WorldCom. Beginning in 1999 WorldCom commenced making large offsetting accounting entries after the quarterly close in order to achieve the aggressive revenue targets established by the company and the financial community. The SEC Report (2003) found handwritten documentation at WorldCom that recalculated the difference between the actual results (found on the monthly revenue, or as it was internally called at WorldCom, the MonRev report) and the target or needed numbers. Once the variance was calculated, accounting entries were made to cover the shortfall so that financial targets would be met. In support of this finding, the SEC investigation uncovered a voicemail message from Sullivan to Ebbers recorded on June 19, 2001 to confirm many of their initial findings: "Hey Bernie, it's Scott. This MonRev just keeps getting worse and worse. The copy, um the latest copy that you and I have
- 134. already has accounting fluff in it . . . all one time stuff or junk that's already in the numbers. With the numbers being, you know, off as far as they were, I didn't think that this stuff was already in there . . . . We are going to dig ourselves into a huge hole because year to date it's disguising what is going on." (SEC, 2003, p. 15) The SEC Report (2003) noted that knowledge of the irregularities was not limited to a few high level executives. Many lower level employees were aware that the accounting entries being posted were not supportable and that the prepared financial reports were false or, at a minimum, very misleading. "Remarkably, these employees frequently did not raise any objections despite their awareness or suspicions that the accounting was wrong, and simply followed directions or even enlisted the assistance of others" (SEC, 2003, p. 7). These are classic examples of groupthink. Although some employees probably felt self-righteous, others possibly felt pressured to keep quiet. During this period, most of the finance and accounting employees were in located in Clinton, Mississippi and relatively well paid for the area. During a mild recession, these employees were aware that their prospects for finding similar paying opportunities in the region were limited. Pressure Victims of groupthink feel pressured, either directly or indirectly, to agree with the group and not express opinions that would differ with the overall group consensus. In many situations, the group leader or manager by stating their opinion up front, before soliciting feedback can build pressure leading the organization to groupthink. Many employees, regardless of the company, lack the self-confidence to stand up to their supervisor once the individual has stated their opinion on a matter. The pressure on lower level employees at WorldCom must have been even greater since many of these entries were found to be directed by executives at the highest levels of the company, including the CFO and Controller. Zekany et al. (2004) concluded that Ebbers and Sullivan created a culture
- 135. where leaders and managers were not to be doubted or questioned. The SEC Report (2003) came to a similar conclusion; that "Ebbers created the pressure that led to the fraud. He demanded the results he had promised, and he appeared to scorn the procedures (and people) that should have been a check on misreporting" (p. 18). Moreover, the SEC Report (2003) concluded that: "WorldCom's continued success became dependent on Ebbers' ability to manage the internal operations of what was then an immense company, and to do so in an industry-wide downturn. He was spectacularly unsuccessful in this endeavor. He continued to feed Wall Street's expectations of double-digit growth, and he demanded that his subordinates meet those expectations. But he did not provide the leadership or managerial attention that would enable WorldCom to meet those expectations legitimately." (p. 5) Due to WorldCom's culture, employees felt that they risked losing their jobs by disagreeing with executives or policies that were implemented. Even Sullivan appeared to feel some of this pressure. When asked specifically if Ebbers pressured him to make the incorrect accounting entries, his response was "you know Bernie [Ebbers], he could put pressure on you indirectly" (SEC, 2003, p. 127). Further, David Scherler, a lawyer representing Buford Yates, WorldCom's ex-Director of General Accounting, stated that Sullivan and Ebbers placed his client in an untenable position. Although it is difficult to view any WorldCom executive with years of experience as low level employee who could not stand up for their rights, Scherler remarked that "I think that Vinson, Normand and Yates are all low-level players in this who wound up being the victims of unscrupulous higher managers" (Pullman, 2003, p. A1). Stereotypes Janis (1971) found that "victims of groupthink hold stereotyped views of the leaders of enemy groups: they are so evil that genuine attempts at negotiating differences with them are unwarranted" (p. 46). These negative views are not necessarily
- 136. against members of competing companies, in many instances, they are negative opinions of anyone deemed not a member of the inner circle or group within the larger organization. To support the view of stereotypes, Von Bergen and Kirk (1978) found that groupthink organizations view any external group "as generally inept, incompetent, and incapable of countering effectively any action by the group, no matter how risky the decision or how high the odds are against the plan of action succeeding" (p. 46). The SEC Report (2003) found that financial information was only shared within a close inner circle of senior executives. However, they did find at least two specific instances where employees questioned the legitimacy of some of Sullivan's, Myers', and Ebbers' actions. Steven Brabbs, a Finance Director in Europe, questioned the reduction of United Kingdom line costs by $33.6M and was told that Sullivan directed the reduction. When he pushed harder, it prompted an email from Buford Yates, Director of General Accounting, to David Myers, Controller, which stated, "have him deal with this in the U.K. . . . I can't see how we can cover our own ass, much less his big limey behind" (SEC, 2003, pp. 78-79). Secondly, in 1999 when Cynthia Cooper, the Vice President of Internal Audit and ultimate WorldCom whistleblower, requested a copy of the MonRev report to audit; Sullivan wrote Ron Lomenzo, Senior Vice President of Financial Operations, stating: "do not give her the total picture-i.e. she does not need international, other revenues, etc" (SEC, 2003, p. 20). These examples clearly show, not only the stereotyped behavior at WorldCom, but a clear trend by high level executives of covering up the wrong doing from many of the groups with the charter to find this type of wrongdoing like Cooper's internal audit department. Self-Censorship The sixth major symptom of groupthink is self-censorship where members of the group avoid deviating from what appears to be the group's consensus. Building consensus may be a function of many healthy organizations and not all attempts to gain
- 137. concurrence should be misconstrued as groupthink (Eaton; 2001 ; Janis, 1982). However, managers at all levels should be aware of the risks involved with concurrence seeking. One study found that 37 percent of group participants "felt pressure to express an opinion with which they did not agree" (Johnson, 1992, p. 145). Another study found that 64% of the groups surveyed gave unanimous answers to questions notwithstanding instructions to ignore the group's prior discussions and that the final reports did not need to be unanimous (Von Bergen & Kirk, 1978). These studies highlight the difficulty management has in receiving constructive feedback in healthy organizations. When groupthink is present, the opportunities are far fewer. This is especially true when a leader has already expressed a strong opinion on the matter at hand. Throughout the SEC Report (2003), investigators found individuals in the finance and accounting departments that were aware, to varying degrees, of the fraudulent activities of their senior executives, yet no one came forward. The report concluded that: "The answer seems to lie partly in a culture emanating from corporate headquarters that emphasized making the numbers above all else; kept financial information hidden from those who needed to know; blindly trusted senior officers even in the face of evidence that they were acting improperly; discouraged dissent; and left few, if any, outlets through which j employees believed they could safely raise their objections" (p. 18). The culture and atmosphere at WorldCom was to strictly discourage dissenting opinions or what Morgan (1997) would call a psychic prison. As one WorldCom vice-president indicated when questioned about a human resource policy, "if you don't like the policy, you can leave" (personal communication, 2002). As a result, most employees felt incapable of, or too insecure to bring up or push forward with items that, at face value, now appear to be obviously incorrect and fraudulent. Unanimity
- 138. Many managers interpret silence as concurrence. With groupthink, employees may feel so loyal to the group that they do not raise objections or reservations to the decisions being made and simply seek unanimous decisions. According to Manz and Neck (1995), "group members striving to agree with one another; overwhelms adequate discussion of alternate courses of action. Defective decision making results" (p. 12). As supported previously, as time passed and the accounting irregularities grew, a greater number of WorldCom employees became aware of the accounting improprieties, yet no one raised an objection. Ron Beaumont, WorldCom's ex-COO, at one point asked Sullivan for an explanation of the differences between what he was seeing and what was being publicly reported. Beaumont never received a reply and reportedly dropped the inquiry due to his overwhelming confidence and faith in Sullivan (SEC Report, 2003). This faith and trust in Sullivan appears to have been observed throughout the company (Zekany et al., 2004). Whether the lack of inquisition in these questionable practices was caused by overconfidence or insecurity, at a minimum, it appears that it contributed to the length of time over which the fraud occurred. Combating Groupthink Group decisions and the process of gaining concurrence may reduce the risk of making incorrect decisions in many situations. However, it has been observed by many scholars that groups must actively seek to minimize and eliminate the effects of groupthink. A few suggestions for defending against groupthink include: (1) establishing multiple groups to study the same issue, (2) training all employees in proper ethical conduct, (3) initiating programs organizationally wide to clarify and communicate ethical conduct, (4) increasing the staff and scope of internal audit departments, (5) using outside experts to review decision processes and ethical conduct, (6) displaying impartiality by not stating preferences at the onset of a project, and (7) rotating new members into the group and old ones out. Janis (1971, 1982) indicated that open discussions to promote
- 139. differing opinions and the devil's advocate technique are additional methods for minimizing groupthink behaviors. The devil's advocate technique involves someone in the group being assigned the role to critique and identify the risks involved in any proposed course of action. This type of critique is intended to foster a more in-depth review of the issues surrounding the proposal, ensure all alternatives are equally reviewed, and identify any underlying pitfalls or unethical practices. Cosier and Schwenk (1990) proposed that the devil's advocate position should be rotated among group members to avoid any one individual being seen as a critic on all issues. However, another study did not find any decrease in defective decision making by the use of a devil's advocate. That study found that the most significant decrease in defective decisions was through participative leadership practices (Chen, Lawson, Gordon, & Mclntosh, 1996). In support of this finding, Von Bergen and Kirk (1978) found that 98% of successful organizations that they surveyed used participative leadership methods. To foster a participative environment where alternatives are encouraged, Honda Motor Company developed the slogan listen, ask, and speak up (Cooper & Sawaf, 1996). An environment that values open and dissenting opinions helps minimize the risks of groupthink and unethical behavior. Glyn Smith, MCI's new Director of Internal Audit, noted that individuals should follow a three-step method, or the three Ss, to ethical decision making. Individuals should scrutinize if a specific decision meets with their moral and ethical values; next individuals should socialize that decision with peers and others to get their feedback. Finally, decisions should be sanitized, meaning that if an individual feels that a decision should be kept quiet, it is probably not ethical. MCI Vice President of Internal Audit, Cynthia Cooper, and WorldCom whistleblower, recommends ensuring internal audit is an integral role in evaluating and improving corporate governance (Barrier, 2003) Sims (1992) found that "groupthink occurs in organizations that knowingly commit unethical acts when the group is cohesive, a
- 140. leader promotes solutions or ideas even if they are unethical, and the group has no internal rules or control mechanisms to continually prescribe ethical behavior" (p. 654). Similarly, Morgan (1997) found that the psychic prison metaphor is seen in organizations displaying "aggression, greed, hate, and libidinal drives" (p. 246). The evidence presented in this paper suggests that WorldCom's executive management fostered groupthink and psychic prison types of environments. Although not to the extent observed at WorldCom, most managers have probably experienced or witnessed groupthink at one time or another. Groupthink is not inherent in most group decisions; however, special care must be made when a group is highly cohesive to avoid the effects of groupthink. Group members must feel free to disagree and should be encouraged to voice minority views. In 1916, Henri Fayol remarked that "a good leader should possess and infuse into those around him courage to accept responsibility" (Shafritz & Ott, 2001, p. 49). Fayol noted that the best defense against abuse or deception on the part of higher level managers was an individual's strength of character and integrity. These attributes continue to be essential at all levels of the organization to avoid groupthink. Unlike many other companies and his predecessors at WorldCom, MCI's current CEO, Michael Capellas, has cooperated with government investigations, and has terminated all of the employees implicated in wrongdoing. He has adopted a one strike and you're out rationale. Past terminations within MCI include the entire board of directors, the CEO, COO, CFO, controller, general counsel, along with over 400 finance and accounting employees. Most of these individuals were located at the company headquarters in Clinton, Mississippi. Capellas, since taking over as CEO of MCI, has established an ethics office, hired a Chief Ethics Officer, and required all MCI employees to have extensive ethics training. Additionally, for company directors and finance managers the company has developed ongoing ethics and finance training through the State University of New York. Capellas has been traveling to all
- 141. major MCI locations and appears to be genuinely interested in comments and opinions from his employees. He has established a set of new guiding principles, which can be found on the walls and inside cubicles throughout the company. These principles include: building trust and credibility, respect for individuals, creating a culture of open and honest communications, setting the tone at the top, avoiding conflicts of interest, reporting accurately, promoting substance over form, being loyal, and doing the right thing. Capellas appears to be well on the way to eliminating many of the factors that led to the groupthink environment, which allowed the accounting fraud to occur. As an outward sign of the improvement, on January 7, 2004, the General Accounting Office (GAO) lifted the ban it had in place restricting MCI from obtaining new government contracts (Haddad, 2004). The ban was in force until the company created and implemented internal financial reporting controls and made their ethics programs more robust. Even with a greater sense of teamwork and dedication to previously marginalized voices, Capellas faces an uphill battle leading MCI and attempting to regain public and customer trust. Many do not believe he can accomplish this task. With its history of acquisitions MCI remains a company comprised of 222 legal entities with numerous conflicting billing, collection, and accounting systems (Haddad, 2004). Just days prior to emergence from bankruptcy, MCI was dealt another blow when a secret side deal with two of its largest creditors was uncovered. The deal would have given these creditors a better return than the general population (Pacelle & Young, 2004). This occurred while MCI faces enormous challenges in the marketplace. Their market share in the US has dropped from 32 to 28% in the last year (Haddad, 2004) and reported an operating loss of $205 million in the first quarter of 2004 compared to a profit of $634 million a year ago (MCI, 2004). The future for MCI is at best uncertain and in recent days has received merger offers from both Quest Communications and
- 142. Verizon. If MCI ultimately rejects these offers, Capellas is attempting to reposition MCI to become the network of choice "connecting everything from cell phones to computers, to MP3 players" (Haddad, 2004, para. 5). While MCI does not have this technology available today, according to Capellas, the company is working toward that goal. References References Barrier, M. (2003, December). One right path. The Internal Auditor, 60(6), 52-57. Chen, Z. Lawson, R. B., Gordon, L. R., & McIntosh, B. (1996, Fall). Groupthink: Deciding with the leader and the devil. The Psychological Record, 46(4), 581-590. Cooper, R. K., & Sawaf, A. (1996). Executive EQ: Emotional intelligence in leadership and organizations. New York: Pergee. Cosier, R. A. & Schwenk, C. R. (1990, February). Agreement and thinking alike: Ingredients for poor decisions. Academy of Management Executive, 4(1), 69-74. Davidson, P. (2004, May 24). Ex-WorldCom CEO Ebbers faces 6 more counts. USA Today. Retrieved May 25, 2004, from http://www.usatoday.com/tech/news/2004-05-24-ebbers- charges_x.htm Eaton, J. (2001). Management Communication: The threat of groupthink. Corporate Communications, 6(4), 183-192. Haddad, C. (2004, February 9). Expert repairman, tough assignment; Capellas has strong credentials to save MCI, but this game may be unwinnable. Business Week, 3869. Retrieved May 11, 2004, from ProQuest Handy, C. (1996). Beyond certainty: The changing worlds of organizations. Boston, MA: Harvard Business School. Hellriegel. D. Slocum, J. & Woodman, R. W. (2001). Organizational Behavior (9th ed.). Cincinnati, OH: South- Western. Janis, I. L. (1971, November). Groupthink. Psychology Today, 43-84. Janis, I. L. (1982). Groupthink: Psychological studies of policy
- 143. decisions and fiascoes (2nd ed.). Boston, MA: Houghton Mifflin. Johnson, V. (1992, September). The groupthink trap: When groups stifle dissent in decision making. Successful Meetings, 47(10), 145-146. Lublin, J. S., & Young, S. (2004, April 20). Even as MCI makes strides, monitor stays. Retrieved June 15, 2004, from ProQuest MCI (2004, May 10). MCI announces first quarter 2004 results. Retrieved May 11, 2004, from http://global.mci.com/pe/news/news2.xml?news id=10530&mode=long&lang=en&width=530&r oot=/pe/&langlinks=off Manz, C. C. & Neck, C. P. (1995, January). Teamthink: Beyond the groupthink syndrome in self-managing work teams. Journal of Managerial Psychology, 10(1), 7-15. McCafferty, J. (1998, September). Scott Sullivan: The force behind the deals that have made WorldCom king of M&A. CFO, 14(9), 2. Morgan, G. (1997). Images of organization (2nd ed.). Thousand Oaks, CA: Sage. Moritz, S. (2004, March 2). The Feds charge Ebbers with fraud and conspiracy. Retrieved May 11, 2004, from http ://www.thestreet.com/tech/scottmoritz/1014 6447.html Pacelle, M., & Young, S. (2004, April 19). MCI rescinds deal with investors after criticism. Wall Street Journal, B-5. Pulliam, S., Latour, A., & Brown, K. (2004, March 3). Reaching the top: U.S. indicts WorldCom chief Ebbers; in switch, CFO Sullivan pleads guilty, agrees to testify against boss; prosecutors gain momentum. Wall Street Journal, A-1. Retrieved May 11, 2004, from ProQuest Pullman, S. (2003, June 23). Over the line: A staffer ordered to commit fraud balked, then caved. The Wall Street Journal, A1. Securities and Exchange Commission (2003). Report of investigation by the special investigative committee of the board of directors of Worldcom, Inc. Washington, DC. Shafritz, J. M. & Ott, J. S. (2001). Classics of Organization
- 144. Theory (5th ed.). Fort Worth, TX: Harcourt. Sims, R. R. (1992). Linking groupmink to unethical behavior in organizations. Journal of Business Ethics, 11, 651-662. The Economist (2004, March 6). Business: Bernie's turn; corporate crime. The Economist, 370, 70. Retrieved June 15, 2004, from ProQuest Von Bergen, C. W., & Kirk, R. J. (1978, March). Groupthink: When too many heads spoil the decision. Management Review, 67(3), 44-49. Whyte, G. (1989, January). Groupthink reconsidered. The Academy of Management Review, 14(1), pp. 40-56. Young, S. (2004, April 20). MCI to emerge from bankruptcy: Telecom firm is to issue new securities and pay $750 million for investors. Wall Street Journal, B5. Retrieved May 20, 2004, from ProQuest Zekany, K. E., Braun, L. W., & Warder, Z. T. (2004, February). Behind closed doors at WorldCom: 2001. Issues in Accounting Education, 19(1), 101-117. AuthorAffiliation M. M. Scharff, University of Phoenix Copyright Baker College 2005Abstract (summary) TranslateAbstract Securities class actions are often criticized as wasteful strike suits that target temporary fluctuations in the stock prices of otherwise healthy companies. The securities class actions brought by investors of Enron and WorldCom, companies that fell into bankruptcy in the wake of fraud, resulted in the recovery of billions of dollars in permanent shareholder losses and provide a powerful counterexample to this critique. An issuer's bankruptcy may affect how judges and parties perceive securities class actions and their merits, yet little is known about the subset of cases where the company is bankrupt. This is the first extensive empirical study of securities class actions and bankrupt companies. It examines 1,466 securities class actions filed from 1996 to 2004, of which 234 (16 %) involved companies that were in bankruptcy proceedings while the class
- 145. action was pending. Securities class actions cannot be adequately understood without examining the subset of cases with a bankrupt issuer.Full Text · TranslateFull text · Headnote Securities class actions are often criticized as wasteful strike suits that target temporary fluctuations in the stock prices of otherwise healthy companies. The securities class actions brought by investors of Enron and WorldCom, companies that fell into bankruptcy in the wake of fraud, resulted in the recovery of billions of dollars in permanent shareholder losses and provide a powerful counterexample to this critique. An issuer's bankruptcy may affect how judges and parties perceive securities class actions and their merits, yet little is known about the subset of cases where the company is bankrupt. This is the first extensive empirical study of securities class actions and bankrupt companies. It examines 1,466 securities class actions filed from 1996 to 2004, of which 234 (16 percent) involved companies that were in bankruptcy proceedings while the class action was pending. The study tests two hypotheses. First, securities class actions involving bankrupt companies ("bankruptcy cases") are more likely to have actual merit than securities class actions involving companies not in bankruptcy ("nonbankruptcy cases"). Second, bankruptcy cases are more likely to be perceived as having merit than nonbankruptcy cases, regardless of their actual merit. The study finds stronger support for the second hypothesis than for the first, suggesting that judges and parties use bankruptcy as a heuristic for merit. Even when controlling for various indicia of merit, bankruptcy cases are more likely to be successful in terms of dismissal rates, significant settlements, and third-party settlements than nonbankruptcy cases. These results are evidence that judges use heuristics not only to dismiss cases but also to avoid dismissing cases. Securities class actions cannot be adequately understood
- 146. without examining the subset of cases with a bankrupt issuer. The perception that securities class actions merely harass healthy companies should be revised in light of the significant number of bankruptcy cases in which shareholders have a greater need for a securities fraud remedy. Introduction When securities class actions target temporary stock price declines, they often create unwarranted costs for otherwise healthy companies. Stock price fluctuations often reflect market overreaction to short-term developments. Shareholder value will recover once the market reassesses the situation.1 Investors are aware that stock prices change frequently and can protect themselves in part through diversification.2 However, securities class action attorneys, who receive a substantial percentage of any recovery, have significant monetary incentives to link such fluctuations to a theory of securities fraud. The defendant company must spend significant resources in litigating the truth of the asserted fraud claim, reducing shareholder wealth.3 Securities class actions directed at frauds involving large public companies that suddenly filed for bankruptcy, such as Enron and WorldCom, present a powerful counterexample to this pessimistic account. The stock prices of these companies did not just fluctuate and recover-they precipitously and completely collapsed in light of revelations that their financial statements were overstated by billions of dollars. Though shareholder wealth is typically wiped out in bankruptcy, Enron and WorldCom investors recovered billions of dollars through securities class actions.4 In the wake of Enron and WorldCom, it has become more difficult to argue that securities class actions never serve a useful purpose for shareholders. Though the Enron and WorldCom cases were the focus of much attention, very little is known about the subset of securities class actions involving bankrupt companies. While many studies have examined the question of whether securities class actions tend to have merit,5 none have extensively examined the frequency and characteristics of securities class actions
- 147. involving a bankrupt issuer. This subset of cases should be interesting to scholars of securities litigation because it includes those cases in which shareholders have suffered the greatest harm. The resolution of securities class actions in which a bankrupt company is the issuer may shed light on the way in which context affects how parties and courts assess the merits of lawsuits. There are two competing views as to the relationship between bankruptcy and securities fraud. One view is that companies approaching bankruptcy have greater incentives to commit fraud in order to save the company or the jobs of managers. There thus might be a causal relationship between bankruptcy and securities fraud. The second view is that the context of bankruptcy leads parties and judges to more readily assume that fraud was present in bankrupt companies. This perception might reflect hindsight bias, the tendency to overestimate the predictability of events, leading to the conclusion that management knew of the danger of bankruptcy but failed to disclose it. Class action attorneys may try to exploit this perception by bringing a strike suit against the management of the bankrupt company as well as third parties such as the company's auditor. This study assesses the relationship between bankruptcy and securities fraud by analyzing a data set of 1,466 consolidated class actions filed from 1996 to 2004, of which 234 (approximately 16 percent) cases involved a company that was in bankruptcy during the pendency of the class action ("bankruptcy cases"). The study tests two hypotheses: (1) bankruptcy cases are more likely to have actual merit than cases in which the issuer is not bankrupt ("nonbankruptcy cases") and (2) bankruptcy cases are more likely to be perceived as having merit than nonbankruptcy cases, regardless of the actual relative merits. In testing these hypotheses, this study hopes to shed light upon the nature and purpose of securities class actions.6 The results of the study indicate stronger support for the second hypothesis. With regard to the first hypothesis, the evidence is
- 148. mixed as to whether bankruptcy cases are more likely to involve valid allegations of fraud than nonbankruptcy cases. While bankruptcy cases are somewhat more likely to involve accounting restatements than nonbankruptcy cases, they are not more likely to have other indicia of merit such as insider trading allegations, parallel Securities and Exchange Commission ("SEC") actions, or a pension fund lead plaintiff. On the other hand, bankruptcy cases are more likely to succeed than nonbankruptcy cases. Bankruptcy cases are less likely to be dismissed and are more likely to result in third-party settlements and in settlements of $3 million or more than nonbankruptcy cases. Regression analysis shows that this bankruptcy effect persists even when controlling for factors relating to the merit of the case. Logistic regressions were estimated with various measures of success as the dependent variable and indicia of merit, case controls, and a bankruptcy variable as independent variables. For all three regressions, the bankruptcy variable was statistically significant at the 1 percent level. This bankruptcy effect is evidence that bankruptcy cases are treated differently by parties and courts. The most likely explanation is that bankruptcy is a heuristic judges use to avoid dismissing cases, perhaps counteracting the tendency of judges to use heuristics to dismiss securities class actions. Though the use of the bankruptcy heuristic is troubling to the extent that it reflects hindsight bias, it is not so problematic if bankruptcy cases serve a more useful purpose than nonbankruptcy cases. Indeed, in bankruptcy cases, shareholder losses are permanent rather than temporary, and compensation to shareholders for fraud does not reflect a meaningless circular payment from shareholders to themselves. Judges may be influenced not only by hindsight bias but also by policy considerations in favoring bankruptcy cases. In addition to its main finding-that there is a bankruptcy effect impacting the adjudication of bankruptcy cases-this study makes a number of findings relevant to understanding the nature of
- 149. securities class actions. The bankruptcy effect fades with respect to the largest settlements, those above $20 million, likely reflecting the influence of directors and officers ("D&O") insurance policy limits. Moreover, bankruptcy cases do not seem to do much to determine the responsibility of individual defendants for the fraud, even when vicarious liability for the bankrupt issuer is not a possibility. This Article shows that securities class actions involving bankrupt companies are an important subset of securities class actions. Far from just harassing healthy companies, securities class actions often involve companies troubled enough to have fallen into bankruptcy. There is evidence that judges and parties view these bankruptcy cases as more likely to have merit than nonbankruptcy cases. This tendency perhaps reflects an intuition that when fraud masks the impending bankruptcy of a company, there is a stronger case for providing shareholders with a remedy through a securities class action. This Article is divided into four Parts. Part I describes the mechanics of securities class actions in the bankruptcy context. Part II describes the data set and provides some descriptive statistics. Part III tests two hypotheses: (1) bankruptcy cases are more likely to have merit than nonbankruptcy cases, and (2) bankruptcy cases are perceived as having more merit than nonbankruptcy cases. It finds more support for the second hypothesis than for the first. Part IV analyzes the significance of these findings with respect to how securities class actions are resolved as well as the general nature of securities class actions. I. Background Securities class actions involving a bankrupt issuer are of interest because there is an intuitive relationship between bankruptcy and securities fraud. There are two possible accounts of this relationship. First, there could be an actual correlation between bankruptcy and securities fraud. Managers might have greater incentive to commit fraud when a firm is heading toward bankruptcy. Second, there could be no such correlation but rather a tendency to jump to unwarranted
- 150. conclusions of guilt when a bankrupt company is accused of fraud, even when the company is actually innocent. This Part discusses these alternative accounts of the relationship between bankruptcy and securities fraud and summarizes past empirical studies on this topic. An important consideration in studying bankruptcy cases is that the bankruptcy process often precludes the issuer from directly contributing to any settlement, leaving as contributors only individual defendants covered by an insurance policy and perhaps third-party defendants such as underwriters and auditors. A. Bankruptcy and Securities Fraud This Section discusses the possible relationship between bankruptcy and securities fraud. Companies heading toward bankruptcy might be more likely to have managers who commit fraud. Alternatively, companies that end up bankrupt may not be more likely to commit fraud, but hindsight bias may lead to the perception that bankruptcy is associated with fraud. 1. Actual Fraud Bankruptcy is a context in which we may see a greater incidence of fraud than with respect to solvent companies. Managers have greater incentives to commit fraud in the period leading up to bankruptcy. Managers of companies that fall into bankruptcy might also be more likely to commit fraud because of incompetence. There are many reasons why a company could find itself filing for bankruptcy. 7 Some developments leading to bankruptcy are the result of unavoidable macroeconomic trends, but others are at least partly the result of managers making bad strategic decisions and failing to make necessary investments.8 A new company could find that expected demand for its product never materializes.9 The market for an established company's products and services could shiftunexpectedly, leaving the company without enough revenue to cover its expenses.10 A company could overexpand, making it difficult to cover larger expenses such as financing costs.11 The managers of a company have incentives to mask
- 151. developments that foreshadow bankruptcy.12 Management could genuinely believe that the company's poor performance is an aberration that is not indicative of future performance. The managers might fear that if disappointing results are released, the market will overreact. Instead of reporting bad results, managers can stretch ambiguous accounting standards to report results they believe are more indicative of future performance, hoping to buy some time to save the company. On the other hand, managers can be motivated by selfish personal interest rather than a genuine belief that what they are doing is best for the company. Misrepresenting the company's performance will give managers time to exercise options or sell stock before the company's collapse. Fraud might allow managers to keep their jobs while hoping that a miracle will turn the company around.13 Jennifer H. Arlen and William J. Carney have identified these "last period agency costs" as a primary driver of securities fraud.14 There might also be a correlation between bankruptcy and securities fraud because managers presiding over bankrupt companies are more likely to be incompetent and thus more likely to misrepresent material facts about the company. Bankruptcy may not cause fraud, but the same factors that cause companies to go bankrupt can make it more likely that there is fraud in such companies. Competent managers are more likely to avoid bankruptcy and are also more likely to avoid committing fraud. If that is the case, there would be a greater likelihood of fraud in bankrupt companies. 2. Perception of Fraud Even if fraud is not more likely in bankrupt companies, there might be a perception that bankruptcy is associated with fraud. One reason for this perception is the risk of hindsight bias, the tendency to "overstate the predictability of outcomes."15 Because bankruptcy is a significant and calamitous event for a public corporation, factfinders might assume that insiders with superior knowledge relative to investors must have known that bankruptcy was imminent. If that is the case, the failure to
- 152. disclose the developments that ultimately caused the bankruptcy is more likely to be perceived as fraudulent.16 To survive a motion to dismiss, any securities class action complaint alleging a violation of Rule 10b-5 must "state with particularity facts giving rise to a strong inference that the defendant acted with" scienter.17 This burden to describe fraudulent intent can be met by alleging that the defendant acted recklessly with respect to a disclosure.18 Recklessness has been defined by one circuit as "an extreme departure from the standards of ordinary care to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it."19 Given the high subjective standard for liability in Rule 10b-5 cases, hindsight bias might not be a factor in all cases.20 But in a close case, hindsight bias can lead decisionmakers to conclude that, in light of a company's bankruptcy, management must have been aware of a risk that was not disclosed to investors. The possibility of hindsight bias with respect to bankrupt companies has long been acknowledged in the accounting literature. A number of studies assessing various cases against auditors find hindsight bias in the way that judges and juries assess auditor liability.21 In particular, the fact that an audited company filed for bankruptcy may influence perception of the auditor's conduct.22 However, there is some evidence that hindsight bias does not uniformly influence decisions and liability may instead depend on an assessment of the foreseeability of bankruptcy.23 The risk of hindsight bias may also influence the decision of defendants to settle cases for significant amounts. Tom Baker and Sean J. Griffith have found through interviews of participants in securities class action settlement negotiations that D&O insurers focus on what they call "sex appeal" in determining settlement amounts.24 Bankruptcy is an obvious fact that will add "sex appeal" to a case, resulting in a greater likelihood that settlements in bankruptcy cases will be significant. Defendants themselves are subject to hindsight bias,
- 153. or are at least wary of the effects of hindsight bias, in determining the value of a claim. B. Mechanics of Securities Class Actions Involving Bankrupt Companies Regardless of the precise cause, the impact of misrepresentations relating to the performance of a company heading toward bankruptcy can be serious. If the market is fooled by the fraud, the stock price will not adequately reflect the risk that the company will go bankrupt. Investors who purchase stock at the fraudulent price will overpay by the amount the stock would have been discounted if the truth were known. Management is less likely to make necessary adjustments to their strategy without the pressure of a declining stock price. The disciplining effect of a takeover is also less likely when the stock price is inflated, possibly depriving the company of a more competent management team that could turn the situation around. Revelation of significant misrepresentations can result in substantial stock price declines that destabilize the company as investors lose faith in the credibility of management. As a result, a bankruptcy that might have been avoidable can become unavoidable. Securities class actions provide a remedy for the harm caused by misrepresentations made by a company in the period leading up to its bankruptcy. Investors can bring suit against the company, its directors and officers, as well as third-party gatekeepers such as auditors and underwriters under section 10(b) of the Securities Exchange Act,25 SEC Rule 10b-5,26 and section 11 of the Securities Act of 1933 (if the company issued securities pursuant to a registration statement during the relevant timeframe).27 One complication with bringing a securities class action against a bankrupt issuer is that such litigation is generally subject to the Bankruptcy Code's automatic stay, which typically halts litigation against a company upon its filing for bankruptcy.28 Any judgment or settlement in a securities class action against a company would be an unsecured claim,29 and any recovery by
- 154. shareholders from the bankruptcy estate would be subordinate to recovery by the company's more senior creditors.30 Though at times there are deviations from this absolute priority rule,31 studies find that even when shareholders receive a recovery, it is small.32 Reorganization plans often discharge and release the bankrupt company from any obligations arising from securities class actions.33 Therefore, it is rare, though not unheard of, for a bankrupt company to contribute to the settlement of a securities class action. As discussed below, most bankrupt issuers are not named as defendants or are later dismissed from the securities class action once the trial court becomes informed of the bankruptcy filing. However, most public companies have insurance for their directors and officers intended to cover the costs of securities litigation. Individual directors and officers are almost always covered by D&O insurance, and many issuers purchase D&O insurance to cover the issuer's direct liability and indemnification payments.34 Courts have generally found that D&O insurance payments made directly on behalf of directors and officers are not part of the bankruptcy estate and are therefore not subject to the automatic stay.35 Indeed, such "Side A" policies appear to be specifically meant to cover situations in which the issuer is bankrupt.36 On the other hand, D&O policies covering the company's indemnification obligations to directors and officers have been found to be part of the bankruptcy estate.37 Similarly, while the courts have not definitively ruled on whether D&O insurance covering the company's direct liability is part of the bankruptcy estate, commentators have argued that payments made on behalf of the issuer are likely considered part of the bankruptcy estate.38 Thus, securities class actions can often proceed despite the automatic stay, but only Side A policies directly covering directors and officers can fund any litigation or settlement costs. In virtually all cases, even when a company has filed for bankruptcy, the securities class action will proceed against some of the directors and officers of the corporation, and in
- 155. some cases, against third parties such as underwriters and auditors who are not covered by the automatic stay. However, because the action is dismissed or stayed with respect to the bankrupt company, it is less likely that the company will directly contribute to the settlement. We thus might expect that bankruptcy cases tend to involve smaller settlements than comparable nonbankruptcy cases. C. Prior Studies Perhaps the first empirical study examining the relationship between securities fraud and bankruptcy was a 1992 study by Arlen and Carney in which they set forth and attempted to verify their "last period agency costs" hypothesis. As noted earlier, that hypothesis predicts that securities fraud tends to involve managers attempting to save their jobs when their firms are heading toward bankruptcy.39 The Arlen and Carney study examined a sample of 111 reported decisions in securities class actions.40 In that sample, 24.3 percent of the cases involved bankrupt companies.41 The study found support for the last period agency costs hypothesis in that most of the cases involved allegations of fraud that masked stock price declines.42 However, as acknowledged by the authors, a major limitation of the study was that it did not have significant information on settlements, making it difficult to assess whether bankruptcy cases were more likely to involve valid allegations of fraud than nonbankruptcy cases.43 More recent studies have looked at larger samples with more comprehensive settlement data but have not found any link between bankruptcy and valid allegations of securities fraud. Two studies examined in passing the effect of bankruptcy on the size of a securities class action settlement.44 In a study of the impact of pension fund lead plaintiffs on settlement size based on a sample of 731 securities class action settlements, Michael A. Perino found that bankruptcy was associated with smaller settlements.45 In another study of lead plaintiffs, James D. Cox, Randall S. Thomas, and Lynn Bai examined a sample of 773 settled securities class actions and found that the bankruptcy of
- 156. a company did not have a statistically significant effect on the size of the settlement.46 These findings might be evidence that securities class actions against bankrupt companies are not likely to have more merit than securities class actions against nonbankrupt companies. On the other hand, as discussed earlier, the fact that a company is in bankruptcy is likely to impact the potential size of the settlement. In cases where the company is not bankrupt, it could contribute to a securities class action settlement so that the total settlement could exceed the limit of the D&O insurance policy. When a company is bankrupt, the automatic stay would likely prevent settlement payments that supplement those made by D&O insurance policies. Of course, third-party defendants such as auditors and underwriters could contribute to the settlement, but such third-party settlements can be difficult to obtain. Class action attorneys are aware of D&O insurance limits and may take a smaller settlement in bankruptcy cases to avoid the risk that the D&O policy may be exhausted by litigation. The Notice of Settlement for one securities class action observed the following: In this Action, there was the additional risk that even if Plaintiffs ultimately prevailed, any recovery could well be substantially less than that obtained in the proposed Settlement because of CHS' filing in bankruptcy. Under the provisions of the Bankruptcy Code, the filing means that the Action cannot proceed against the Company. Thus, any recovery obtained would be against the Individual Defendants alone and the insurance coverage available to satisfy a judgment would be greatly depleted, if not exhausted, by the costs of prosecuting the Action through trial and the subsequent appeals which would surely follow if Plaintiffs prevailed at trial.47 Therefore, settlement size may not be a good indicator of the merits of the underlying suit in bankruptcy cases. Understanding the relationship between securities class actions and bankruptcy requires analyzing other indicators of merit. II. Data Set and Descriptive Statistics
- 157. This Part describes the data set used in this study. The data set consists of 1,466 consolidated securities class actions filed from 1996 to 2004.48 The cases were drawn primarily from the Stanford Securities Class Action Clearinghouse and supplemented with information from the Public Access to Court Electronic Records ("PACER") database, the LoPucki Bankruptcy Research Database, Westlaw, LexisNexis, and other internet sources. The data set consists of traditional Rule 10b-5 and section 11 securities class actions alleging that issuers inflated their stock price by reporting misleading information about themselves in their periodic disclosures or registration statements. It therefore does not include securities class actions relating to research analyst fraud, investment adviser fraud, initial public offering ("IPO") tying, mutual fund market timing, merger approval, or proxy fraud.49 Excluding such cases makes it possible to compare similar cases in assessing the influence of bankruptcy. Apart from the excluded cases, the data set contains virtually all of the securities class actions filed from 1996 to 2004. Unlike some prior studies, the data set includes not only settled cases but also cases that ended in dismissal. The data set contains 234 securities class actions involving companies that were in bankruptcy during the pendency of the class action. Bankruptcy cases thus make up 16 percent of the securities class actions in the data set. On average, from 1996 to 2004, there were about twenty-five securities class actions per year with a bankrupt issuer. Table 1 summarizes the number of bankruptcy cases filed from 1996 to 2004: The fact of a bankruptcy filing was evident in a number of ways. A case was only classified as a bankruptcy case if there was clear evidence that the court was informed of the bankruptcy because the bankrupt company was not named as a defendant or the bankruptcy was referenced in a pleading such as a complaint or notice of bankruptcy.50 In 198 of the 234 bankruptcy cases (85 percent), as a result of the automatic stay, the securities class action against the bankrupt company was formally dismissed or stayed, or the bankrupt company was not
- 158. named in the complaint.51 Of the 234 bankruptcy cases, 54 (23 percent) of the bankruptcy filings occurred before the filing of the complaint, and 180 (77 percent) of the bankruptcy filings occurred after the filing of the complaint.52 The bankrupt companies in the sample were modest in size, averaging approximately $3 billion in total assets with a median of $400 million in total assets.53 Nonbankrupt companies by comparison tended to be larger, averaging approximately $9 billion in total assets with a median of $3 billion in total assets. The data set also collects information on various measures such as whether a public pension fund was named as one of the lead plaintiffs, whether the complaint included a section 11 claim, whether the complaint alleges that the defendant restated its financial statements, whether the complaint alleges insider sales as a motivation for the fraud, and whether there was a parallel SEC proceeding. These variables are relevant in assessing the merit and success of securities class actions. Table 2 presents summary statistics for some of these characteristics: Consistent with findings from other studies, a high percentage of the cases in the data set settled or were dismissed. Almost a third of the cases in the data set, 30.8%, ended in dismissal.54 Almost half of the cases in the data set, 47.7%, ended in a settlement of $3 million or more, a common threshold used in determining whether a settlement is significant in size. A relatively small percentage of the cases, 7.6%, resulted in settlement payments from parties other than the issuer such as auditors, underwriters, and individual directors or officers. III. Empirical Analysis Using the data set of securities class actions just described, this Part tests two hypotheses regarding the relationship between securities fraud and bankruptcy. To the extent that a securities class action reflects a valid allegation of fraud, we can say that the action has merit. The study thus frames the hypotheses in terms of the merit of securities class actions: (1) securities class actions against bankrupt companies are more likely to have merit than securities class actions against nonbankrupt
- 159. companies, and (2) securities class actions do not have more merit than securities class actions against nonbankrupt companies but are perceived as having more merit. Stronger support exists for the second hypothesis than for the first. A. Hypotheses The first hypothesis, that there is some actual correlation between bankruptcy and securities fraud, predicts that bankruptcy cases have more merit than nonbankruptcy cases and might be framed as follows:55 H(0): Bankruptcy cases are not more likely to have merit than nonbankruptcy cases. H(A): Bankruptcy cases are more likely to have merit than nonbankruptcy cases. The second hypothesis, that hindsight bias leads parties to perceive the existence of a relationship between bankruptcy and securities fraud, predicts that parties perceive bankruptcy cases as having more merit than nonbankruptcy cases and might be framed as follows: H(0): Bankruptcy cases are not more likely to be perceived as having merit than nonbankruptcy cases. H(A): Bankruptcy cases are more likely to be perceived as having merit than nonbankruptcy cases. Perhaps the most obvious way to test these hypotheses would be to compare the outcomes of bankruptcy and nonbankruptcy cases. If bankruptcy cases succeed more often than nonbankruptcy cases, there is evidence supporting both the actual-merit and perception-of-merit hypotheses. Indeed, if litigation results do not differ, it would be difficult to conclude that either hypothesis is supported. However, looking solely at litigation results does not help decide between the actual-merit and perception-of-merit hypotheses. To do that, one must also assess whether plaintiffs in bankruptcy cases are more likely to allege credible evidence of fraud. Of course, it is difficult, if not impossible, to determine whether a complaint describes actual fraud. However, as will be discussed further below, certain allegations may be
- 160. more likely to objectively indicate a valid fraud claim. If bankruptcy cases are more likely to contain such indicia of merit than nonbankruptcy cases, we might conclude that they have more actual merit than nonbankruptcy cases. B. Measures of Merit This Section describes the various ways this study measures the merit of securities class actions. Common measures of litigation results include whether the case avoids dismissal, leads to a significant settlement, or results in a settlement from a third party. Common indicia of merit include whether the complaint alleges an accounting restatement, alleges insider sales, has a lead plaintiffthat is a public pension fund, and whether there is a parallel SEC proceeding.56 1. Litigation Results The end result of a securities class action is an obvious measure of merit. If a group of cases has a higher rate of successful outcomes than another group of cases, we might conclude that the first group has more merit than the second. Dismissal rates are an indicator of what courts think of a set of cases.57 If courts dismiss a set of cases at a high rate, it might be evidence that those cases are less likely to have merit. If the dismissal rate of a set of cases is low, it might be evidence that those cases are more likely to have merit. At the same time, dismissal rates can reflect the difficulty of meeting heightened pleading requirements, prejudice by judges against certain types of cases, bad luck, or poor lawyering. Dismissal rates also do not necessarily measure what the parties themselves think of a case. A court often has im- perfect information relative to the parties and can come to the wrong conclusion in deciding whether to dismiss a case. Because plaintiffs do not have access to discovery until after the motion to dismiss is decided, the defendant may have information relevant to the merits of the case that is unknown to the court. Thus, dismissal rates are a useful but limited measure of merit. Settlements are a rough indicator of what the parties think of a case. A defendant generally will not settle a case unless it
- 161. believes that the case has some merit and that there is a risk that it will face higher costs absent a settlement. Of course, not all settlements signal a suit with merit. Parties also take into account litigation costs in negotiating a settlement. Small settlements could only indicate that the defendant is willing to pay an amount less than its litigation costs to make the suit go away.58 Thus, other studies often consider only settlements over a certain threshold,59 often a threshold of $3 million,60 as significant enough to reflect merit. Of course, the $3 million threshold is an imperfect measure since potential litigation costs vary among cases. A settlement of less than $3 million can be high for some cases, while a settlement of more than $3 million can be low for other cases. But as a rough measure, the $3 million threshold can serve as a way of assessing the success of a securities class action.61 As discussed earlier, another way of measuring success is to compare the size of settlements. Very large settlements can indicate greater merit than small settlements. Absent bankruptcy, parties look at the potential damages that could result from a judgment against the defendant in negotiating the amount of the settlement.62 But as noted before, when a company is bankrupt, the size of any settlement is more likely to be below insurance policy limits because the company is unlikely to contribute to the settlement. Instead of comparing the size of settlements, this study thus focuses on whether a case ended in a significant settlement. A settlement with a third party other than the company or the company's insurance company is also a sign of merit. I define third-party settlements to include settlements by parties unassociated with the company such as auditors and underwriters, as well as individuals associated with the company, such as directors and officers, when those individuals personally contribute to the settlement. Such third-party settlements are relatively rare (representing only 7.6 percent of the sample), reflecting the high legal standard for finding third- party gatekeepers such as auditors liable63 and the reality that
- 162. directors and officers almost never personally contribute to securities class action settlements.64 Thus, payments by these parties could indicate that the merits of a case are unusually strong. It is important to acknowledge that these measures of success are related. For example, significant settlements should result in part because parties know that certain cases are likely to survive dismissal. Certainly, third-party settlements are more likely in cases involving significant settlements than cases without significant settlements. However, each measure of success looks at the case from a different perspective. Judges decide whether to dismiss a case, defendants and insurance companies decide whether there will be a significant settlement, and third-party defendants decide whether a third-party settlement occurs. Examining all three measures of success can allow for a more comprehensive assessment of the relationship between bankruptcy and litigation results than looking at just one measure can. 2. Indicia of Merit If a group of cases has a higher rate of common indicia of merit than another group of cases, we might conclude that the first group is more likely to have merit than the second. The fact that a defendant company has restated its financial statements is widely considered to be an indicator of a securities class action's merit.65 A restatement essentially concedes that there is a material misstatement in the financial statements that the markets have relied upon in valuing a company. Of course, a restatement by itself does not establish that the defendant acted with fraudulent intent,66 but it does provide a starting point for a successful securities class action. Consistent with these intuitions, prior studies have found that restatements are associated with successful securities class actions. 67 Evidence of insider trading during the class period can also be an indicator of merit. Many complaints allege that insiders were motivated to commit fraud so they could sell their stock before
- 163. the stock price collapsed. Allegations of insider sales during the class period may be evidence that defendants personally profited from misleading the market, making it easier to satisfy the Private Securities Litigation Reform Act ("PSLRA") requirement that the complaint plead a strong inference of scienter with particularity.68 On the other hand, given the frequency of insider sales, it could be that such sales were coincidental rather than part of a fraudulent scheme. Courts could be wary of concluding that an allegation of normal insider sales is in itself a good indicator of merit. At least one study has found that an allegation of insider sales does not correlate with a complaint's survival of a motion to dismiss.69 Nevertheless, the inclusion of an insider trading allegation in the complaint is a rough measure of whether a case has meritorious evidence of fraudulent intent. The involvement of a public pension fund as lead plaintiffcan also be an indicator of merit.70 With the rising role of institutional plaintiffs in securities litigation, a number of commentators have posited that pension fund lead plaintiffs are associated with successful securities class actions.71 Pension funds are sophisticated institutions that can assess the merits of a suit and make an informed choice about whether to become involved. A pension fund's choice to serve as lead plaintiffmay be an additional signal that the case is persuasive. One study finds some evidence that pension funds are likely to be involved in cases with stronger evidence of securities fraud (reflecting the indicia-of-merit approach).72 A number of studies also find that pension fund lead plaintiffs are associated with higher settlements (reflecting the litigation-results approach).73 However, it is unclear whether settlements in these cases are higher because pension funds push for better results or because they tend to be involved in cases with merit. Either way, the presence of a pension fund lead plaintiffis a signal that the case has characteristics of merit. Finally, the existence of a parallel SEC proceeding, regardless of whether it is an investigation or enforcement action, can
- 164. indicate that a securities class action has merit.74 The fact that a government enforcer without economic incentive to over- enforce the securities laws has taken action is evidence that the plaintiff's claim is not frivolous. In some cases, private securities class actions are filed after an SEC enforcement action has been filed. The SEC has subpoena powers allowing it to investigate allegations prior to filing a case. A securities class action can include the evidence from an SEC investigation in the complaint, making it more likely to survive a motion to dismiss. C. Tests for Association This Section finds that bankruptcy cases are more likely to succeed than nonbankruptcy cases in terms of litigation results. However, the evidence is mixed with respect to whether bankruptcy cases are more likely to have indicia of merit than nonbankruptcy cases. The study used a simple test for association that compares bankruptcy and nonbankruptcy cases with respect to litigation results and indicia of merit. Using a Pearson's chi-squared test, it assessed whether any difference in the success rates of bankruptcy and nonbankruptcy cases is statistically significant. On the one hand, the higher success rate of bankruptcy cases provides support for both the actual- merit and perception-of-merit hypotheses. On the other hand, the fact that bankruptcy cases succeed without clear evidence of greater indicia of merit indicates that there is stronger support for the perception-of-merit hypothesis than the actual-merit hypothesis. 1. Litigation Results Table A2 of the Appendix compares the litigation results of bankruptcy cases and nonbankruptcy cases. By all three measures, bankruptcy cases are more likely to end successfully than nonbankruptcy cases. A lower percentage of bankruptcy cases (18%) were dismissed than nonbankruptcy cases (33%). A higher percentage of bankruptcy cases (59%) resulted in significant settlements than nonbankruptcy cases (46%). A higher percentage of bankruptcy cases (24%) had third-party
- 165. settlements than nonbankruptcy cases (5%). All of these differences were statistically significant at the 1 percent confidence level. Figure 1 summarizes these results: Judged by success, there is evidence supporting the two hypotheses that bankruptcy cases are more likely to have merit or are perceived to have more merit than nonbankruptcy cases. The difference appears to be most pronounced with respect to third-party settlements. 2. Indicia of Merit Table A3 of the Appendix compares rates of indicia of merit between bankruptcy and nonbankruptcy cases. There was a statistically significant positive association between bankruptcy cases and restatements, though the difference was not large (39 percent of bankruptcy cases have an accounting restatement compared to 30 percent of nonbankruptcy cases). There was no statistically significant difference in the percentage of pension fund lead plaintiffs and parallel SEC actions for bankruptcy cases. There was a statistically significant association between bankruptcy cases and insider sales, but the association was negative, meaning that bankruptcy cases were less likely to have allegations of insider sales that could support a scienter requirement than nonbankruptcy cases. Figure 2 summarizes these results: Thus, because bankruptcy cases are more likely to have restatements, there is some support for the hypothesis that there is a difference in actual merit between bankruptcy and nonbankruptcy cases. However, the support is not unambiguous, suggesting that the success of bankruptcy cases may reflect perceived merit rather than actual merit. D. Logistic Regression Analysis Comparing rates of success and indicia of merit gives a rough sense of whether bankruptcy cases have more merit, but fully understanding the relationship between bankruptcy and merit requires additional analysis. Though we know that bankruptcy cases are more likely to succeed than nonbankruptcy cases, simple comparisons do not explain why bankruptcy cases are
- 166. more successful. Is it because they have actual merit, or does the mere fact that a company is bankrupt impact the result? Many factors can influence whether a securities class action succeeds, and fully understanding the relationship between bankruptcy and the outcome of securities class actions requires analysis of additional variables that can affect the outcome of a case. Regression analysis can help us further understand why bankruptcy cases are more likely to succeed than nonbankruptcy cases. Though we have examined litigation results and indicia of merit separately until this point, there is an obvious relationship between the success of a lawsuit and the presence of indicia of merit. A suit is more likely to succeed if it has indicia of merit such as allegations of a restatement or a pension fund lead plaintiff. Judges are less likely to grant motions to dismiss if indicia of merit are present. Moreover, parties are more likely to settle cases for significant amounts and third parties are more likely to contribute to a settlement if indicia of merit are present. In addition to indicia of merit, the fact that a company is bankrupt could have an effect on the success of a lawsuit. As noted earlier, the fact of bankruptcy might itself influence the decisions of judges and parties independently from the existence of objective indicia of merit. Simple models can be constructed that test the relationship between success and indicia of merit. A bankruptcy variable can be included to test whether the fact of bankruptcy influences the success of a securities class action. If the bankruptcy variable is not statistically significant, we might conclude that bankruptcy cases are generally decided the same way as nonbankruptcy cases. If the bankruptcy variable is statistically significant, there might be evidence that the fact of bankruptcy has an impact apart from the merits. I estimated logistic regressions75 with the various measures of litigation results (dismissal, significant settlements, and third- party settlements) as the dependent variable and independent
- 167. variables reflecting indicia of merit such as restatements, pension fund lead plaintiffs, insider sales, and parallel SEC actions. I included an independent variable reflecting whether the case is a bankruptcy case. The regressions also had case controls such as the size of the company measured by total assets, whether the complaint alleged section 11 claims, the length of the class period, and whether the case was filed in the Second or Ninth Circuit.76 Variables such as the year the case was filed, as well as industry of the issuer, were also included though they are not reported in the tables that follow. Definitions of these variables are set forth in the Appendix at Table A1. Equations for the estimated regressions are set forth below: (1) Dismissal = α + β1iBankruptcy + β2iIndicia of Merit + β3iCase Controls + εi (2) Significant Settlement = α + β1iBankruptcy + β2iIndicia of Merit + β3iCase Controls + εi (3) Third-Party Settlement = α + β1iBankruptcy + β2iIndicia of Merit + β3iCase Controls + εi Table 4 reports the results of the regressions. For all three regressions, the bankruptcy variable is statistically significant at the 1 percent confidence level. As the perception-of-merit hypothesis might predict, even when controlling for indicia of merit and other factors, bankruptcy is negatively associated with dismissal and positively associated with significant settlements and third-party settlements. Thus, the study finds support for a "bankruptcy effect" where bankruptcy cases are more likely to succeed than nonbankruptcy cases.77 In addition, the restatement, pension fund lead plaintiff, and section 11 variables were all statistically significant at the 1 percent or 5 percent confidence level for all three regressions. As might be expected, the sign of these variables was negative with respect to dismissal and positive with respect to large settlements and third-party settlements. These results confirm the intuition that these variables are valid indicia of merit. The insider sales variable was not statistically significant with
- 168. respect to dismissal and third-party settlements, but was positive and statistically significant with respect to large settlements. The lack of a statistically significant relationship between insider sales and dismissal is consistent with earlier studies.78 It may be that courts are not fooled by rote assertions that a securities fraud was motivated by the desire of insiders to sell their stock at a high price. With respect to third-party settlements, the fact that an issuer's management sold its stock is unlikely to affect a case against gatekeepers who did not benefit from such sales.79 On the other hand, the fact that insider sales are positively associated with significant settlements might indicate that the parties themselves assess such evidence in deciding whether a case has merit. Surprisingly, the SEC variable is not statistically significant in any of the logistic regressions. This likely reflects the broad definition of this variable, which included not only cases that resulted in an SEC enforcement action but also cases where there was an informal investigation that may not have resulted in formal action. Because these were logistic regressions, some translation is necessary to interpret the regression results. In order to quantify the bankruptcy effect, I calculated the marginal effects of selected variables. The marginal effects are a way of measuring the impact of an independent variable such as bankruptcy on a dependent variable such as dismissal rates. For the dismissal regression, the marginal effect for the bankruptcy variable was - 0.14, meaning that a bankruptcy case was 14 percent less likely to end in dismissal than a nonbankruptcy case. As points for comparison, in the dismissal regression, the marginal effect for a pension fund lead plaintiffwas -0.10 and the marginal effect for a restatement was -0.19. For the significant settlement regression, the marginal effect for the bankruptcy variable was 0.11, meaning that a bankruptcy case was 11 percent more likely to end in a significant settlement than a nonbankruptcy case.80 For the third-party settlement regression, the marginal effect for the bankruptcy variable was 0.10, meaning that a
- 169. bankruptcy case was 10 percent more likely to end in a significant third-party settlement than a nonbankruptcy case.81 In addition to estimating three separate logistic regressions, I also estimated an ordered logistic regression in which the dependent variable was equal to 2 if the case ended in a significant settlement ($3 million or more), 1 if the case ended in a settlement that was not significant (less than $3 million), or 0 if the case ended in dismissal. This method takes into account the possibility that the fact of settlement, regardless of size, can be a signal of merit. The results are reproduced in the Appendix at Table A4. As with the logistic regressions, the bankruptcy variable for the ordered logistic regression is positive and statistically significant at the 1 percent level. By all three measures of success for securities class actions, controlling for other variables that are predictors of a successful suit, bankruptcy is associated with successful securities class actions. E. The Disappearing Bankruptcy Effect An additional finding of this study is that the bankruptcy effect disappears with respect to very large settlements, providing further insight into the relationship between bankruptcy and securities class actions. As noted earlier, a number of studies have found either no association or a negative association between the size of a settlement and the fact that a securities class action involves a bankrupt company. To verify these results, I estimated a multiple linear regression in which the dependent variable was the natural log of the size of the settlement, and the independent variables were the same as those used for the earlier logistic regressions.82 The equation for this regression is below: (4) ln (Settlement Size) = α + β1iBankruptcy + β2iIndicia of Merit + β3iCase Controls + εi Table A5 in the Appendix presents the results of the regression. As with the prior studies cited, the bankruptcy variable was not statistically significant, while other variables such as the restatement and pension fund lead plaintiffvariables retained
- 170. their statistical significance. Earlier, I noted that these results may be explained by the fact that companies do not contribute to settlements when in bankruptcy. The size of settlements in bankruptcy cases are often limited by D&O policy limits. The study thus used in its main analysis a different measure of merit-the fact of a significant settlement, defined as those settlements of $3 million or more, rather than the size of the settlement-and found a statistically significant relationship between bankruptcy and settlements of $3 million or more. If D&O policies are affecting the size of settlements, one might expect that the bankruptcy effect would fade as settlements grow larger. Though significant in size, a $3 million settlement should fit well within the D&O policy limits of almost all public companies.83 I grouped settlements into different categories by size. As can be seen from Figure 3, bankruptcy settlements represent a smaller proportion of the larger settlements than they do of smaller settlements: Bankruptcy cases represented about 20 percent of the settlements over $3 million, $15 million, and $20 million. Considering that the overall percentage of bankruptcy cases in the sample was approximately 16 percent, bankruptcy cases were overrepresented relative to their overall proportion of the overall data set. In contrast, bankruptcy cases represented 12-13 percent of the settlements over $50 million and $100 million. For the largest settlements, bankruptcy settlements were underrepresented relative to their proportion of the overall data set. In order to further determine the point at which D&O policies affect the fact of a significant settlement, I estimated logistic regressions with higher settlement thresholds of $10 million, $15 million, $20 million, and $50 million as dependent variables. Table 6 reports the results of these regressions: The results show that while there is still a bankruptcy effect for settlements of $10 million or more and $15 million or more, the bankruptcy effect disappears for larger settlements of $20
- 171. million or more and $50 million or more. This suggests that, on average, D&O policies begin affecting the size of settlements in bankruptcy cases as they reach that $20/$50 million threshold. Of course, there are still settlements in bankruptcy cases above those thresholds, but there is not a statistically significant difference compared to nonbankruptcy cases. It is likely that bankruptcy cases lose their advantage over nonbankruptcy cases with respect to settlements over $20 million or so because of the lack of an issuer defendant. It appears that there are two groups of securities class action settlements. One set of settlements reflects payments within the limits of D&O policies. Of the 700 or so settlements in the data set that are $3 million or greater, about 200 are $20 million or greater, meaning that 500 of 700 (about 70 percent) of significant settlements were below $20 million and likely to fit within D&O insurance policy limits. In addition, there are many settlements below even the $3 million threshold. The second set of settlements reflects payments that may exceed D&O policy limits. Only about 100 of the 700 settlements that were $3 million or more (14 percent) were above $50 million, likely requiring a significant contribution by the issuer. Put another way, over the nine-year span of the data set, about eleven cases per year settled for $50 million or more, representing less than 10 percent of the 1,466 cases in the data set. Further study of settlements that do not settle within D&O insurance policy limits may be fruitful. IV. Discussion The evidence indicates that bankruptcy cases are more likely to succeed than nonbankruptcy cases, though they are not likely to have greater rates of most indicia of merit. The regressions confirm that bankruptcy has an independent influence on the success of a bankruptcy case, apart from indicia of merit. This Part assesses these results and concludes that there is stronger support for the hypothesis that bankruptcy cases are perceived to have merit than the hypothesis that bankruptcy cases are actually more meritorious. Bankruptcy is a heuristic that judges
- 172. use to avoid dismissing cases. Finally, the study of bankruptcy cases has significance for a number of issues relating to securities class actions. A. Bankruptcy Effect: Merits or Perception? The bankruptcy effect likely reflects some difference relating to the merits of bankruptcy cases. The question is whether the difference is real or perceived. On balance, there is some support for both possibilities, though the evidence more clearly supports the perception-of-merit hypothesis. Perhaps the strongest evidence in support of the actual-merit hypothesis is that bankruptcy cases are more likely to be associated with accounting restatements than nonbankruptcy cases. Such a difference reflects an actual difference in merits consistent with the Arlen and Carney last period agency costs hypothesis. Bankruptcy cases are more likely to involve situations where last period agency costs are in play, leading to a greater incidence of actual fraud than nonbankruptcy cases where the incentive to commit fraud may not be as strong. On the other hand, the difference is arguably not a large one (39 percent of bankruptcy cases have restatements as compared to 30 percent of nonbankruptcy cases). The most powerful evidence against the actual-merit hypothesis is that measurable indicia of merit such as allegations of insider trading, SEC proceedings, and pension fund lead plaintiffs are not present at statistically significant higher rates in bankruptcy cases.84 Some of these indicia, such as the presence of a pension fund lead plaintiff, are arguably stronger indicators of merit than the simple existence of a restatement. Restatements can occur by mistake and a showing of fraudulent intent is usually necessary to prevail in a securities class action. Pension funds presumably evaluate cases holistically, weighing all possible indicia of merit, both obvious and nonobvious. The presence of a credible party who can assess the merits of a case is a stronger indicator of merit than the presence of a restatement. The regression results, moreover, are evidence that perception
- 173. of merit rather than actual merit explains the tendency of bankruptcy cases to succeed at higher rates than nonbankruptcy cases. By controlling for various indicia of merit that might explain lower dismissal rates and higher rates of significant and third-party settlements, the logistic regressions isolate an independent bankruptcy effect that is evidence that the greater success of bankruptcy cases is not solely explained by the actual merits. A skeptic might respond that the regressions only control for obvious indicia of merit. There could be nonobvious measures of merit that cannot be easily scrutinized through empirical study.85 Such nonobvious indicia of merit could be correlated with bankruptcy and thus explain the bankruptcy effect. This argument, however, is ultimately unpersuasive without the identification of particular nonobvious indicia of merit associated with bankruptcy. Moreover, some of the obvious indicia of merit, such as the pension fund lead plaintiffvariable, also reflect assessment of nonobvious indicia of merit. This study's analysis of obvious indicia of merit indicates that perception rather than actual merit is driving the success of bankruptcy cases. B. The Bankruptcy Heuristic The perception-of-merit hypothesis is consistent with the intuition that judges tend to decide complex cases using mental shortcuts. The fact of bankruptcy is likely a heuristic that influences how judges and parties perceive the merits of bankruptcy cases, leading to higher success rates for those cases relative to nonbankruptcy cases. In the bankruptcy cases in this data set, judges and parties knew of the issuer's bankruptcy and could have used the fact of bankruptcy as a way of sorting good cases from bad cases. The "bankruptcy effect" found through regression analysis is evidence that in some cases, a bankruptcy heuristic tilts the scales against dismissal or in favor of a significant settlement. The use of bankruptcy as a heuristic for merit is somewhat different from the judging heuristics that scholars have focused on. For the most part, heuristics have been discussed as a way
- 174. by which judges can dismiss cases quickly to clear their dockets.86 In contrast, the use of a bankruptcy heuristic is a way by which judges allow certain cases to proceed. The bankruptcy effect counteracts the tendency of judges to dispose of securities class actions at an early stage.87 The existence of heuristics that make it less likely that cases will be dismissed might make it more difficult to conclude that judges always discriminate against securities class actions. The use of a bankruptcy heuristic can be problematic insofar as it leads to unjust results. As noted earlier, hindsight bias leads to a tendency to overestimate management's knowledge of factors resulting in a business failure. It can be unfair to predicate liability on the happenstance that a defendant was associated with a bankrupt company.88 If judges are less likely to dismiss bankruptcy cases, parties may take this into account in settling a case. A bankruptcy provides a hint of scandal that influences parties to settle for significant amounts. Defendants are especially risk averse in these situations, leading to preemptive settlements. Knowing this, plaintiffs could be more aggressive in bringing securities class actions against bankrupt companies so that they can extort settlement payments. On the other hand, the bankruptcy effect may not be as problematic if there are stronger policy reasons for securities class actions when the issuer has filed for bankruptcy. The compensatory rationale for securities class actions is more compelling when the issuer is a bankrupt company. The loss by shareholders is likely significant and permanent rather than fleeting. Without a securities class action, shareholders typically receive little or nothing to cover their losses.89 Bankruptcy cases avoid the circularity problem that has commonly been associated with securities class action settlements involving nonbankrupt companies.90 As a number of commentators have noted, settlements of securities class actions involving claims of secondary market fraud are circular because injured shareholders pay for part of their own remedy.91 In bankruptcy, because shareholders are wiped out,
- 175. payment does not come from their own pockets in the form of a payment from the issuer they own. One alternative source of payments is D&O insurance. Of course, shareholders fund the costs of D&O insurance over time, but the payout to shareholders can exceed the amount in premiums paid by the shareholders. Moreover, when a company is bankrupt, there is greater incentive and ability to pursue third-party wrongdoers.92 Rather than solely targeting the company, a securities class action may be more likely to target auditors and underwriters who stood by while the fraud proceeded.93 Payments by such third parties to shareholders are not circular because they do not come from the company (which is owned by the shareholders). And indeed, as this study shows, bankruptcy cases obtain third-party settlements at a higher rate than nonbankruptcy cases (24 percent of the time versus only 5 percent of the time). Compensation from a successful securities class action provides shareholders with value that they would not have otherwise obtained and thus is more difficult to characterize as a meaningless transfer from shareholders to themselves.94 Perhaps judges treat bankruptcy cases differently because they believe the policy reasons are stronger for securities class actions when such actions involve bankrupt rather than solvent companies. To come to this conclusion, judges need not have a full appreciation of the nuances of shareholder compensation for securities fraud but only an intuition that the context of bankruptcy provides a better case for compensation. Judges could be dismissing these cases at lower rates because they believe that greater scrutiny of the facts through discovery is necessary to unpack the relationship between the bankruptcy and the securities fraud allegations, and that such inquiry is more likely to be worthwhile than when the case involves a healthy company. Bankruptcy cases might thus succeed because judges take a broad view of merit that includes policy considerations and not just indicia of merit relating to the existence of fraud.
- 176. Indeed, there is reason to believe that judges are not easily duped by hindsight bias, and that policy reasons are at least part of the reason why judges are allowing such cases to proceed. Judges have long been aware of the dangers of hindsight bias and have dismissed complaints that solely allege "fraud by hindsight."95 Judges use the fraud-by-hindsight doctrine to screen out cases that do no more than allege the occurrence of some bad event.96 Though it is unlikely that the fraud-by- hindsight doctrine totally solves the problem of hindsight bias,97 the existence of the doctrine raises the possibility that judges are not declining to dismiss bankruptcy cases out of ignorance, but because in their judgment, such cases deserve close scrutiny. 98 The study finds some evidence supporting the idea that judges are wary of concluding that bankruptcy is always associated with fraud. The bankruptcy effect tends to be primarily associated with cases in which the complaint was filed prior to the bankruptcy announcement.99 In other words, the plaintiffwhen filing the complaint does not necessarily know that the case will involve a bankrupt company. A judge in those circumstances may be less likely to conclude that the case is targeting an issuer mainly because it happened to file for bankruptcy. On the other hand, the bankruptcy effect disappears with respect to bankruptcy cases in which the bankruptcy filing occurs prior to the filing of the complaint. In other words, the plaintiffknew at the time of the filing of the complaint that the case involved a bankrupt company. It may be that judges are wary of cases in which plaintiffs appear to be exploiting the fact of bankruptcy by filing a complaint. However, it is difficult to draw firm conclusions from smaller subsamples of bankruptcy cases that distinguish between case filings before and after bankruptcy. The use of bankruptcy as a heuristic is a likely explanation for the bankruptcy effect. Though hindsight bias is a factor, policy reasons might also be why bankruptcy cases are decided differently. Whatever the reason, given the ambiguity of the
- 177. concept of securities fraud, we can expect judges and parties to rely on context in assessing the merit of these cases. C. Alternative Explanations for the Bankruptcy Effect It is important to recognize that there are explanations other than merit or perception of merit for the higher rate of success for bankruptcy cases. There is less incentive to vigorously contest a case when the issuer is bankrupt. A company is unlikely to be required to cover the costs of a settlement because any such obligation is typically discharged in bankruptcy.100 Because management is often replaced after bankruptcy,101 there is little incentive for the company to aggressively defend the reputation of management. Managers who are moving on from their jobs at the issuer do not have a significant incentive to fight the suit as long as a settlement is covered by D&O insurance.102 It can be more difficult for insurers to coordinate a defense when managers are no longer with the company. Higher rates of significant settlements for bankruptcy cases could simply reflect that it is in the best interest of the parties to settle the case rather than exhaust insurance policy limits through litigation. On the other hand, D&O insurers, auditors, underwriters, and directors and officers who may have to personally contribute to a settlement, all have an incentive to fight a securities class action. The cost of filing a motion to dismiss is modest, and with the heightened pleading requirement for scienter, there is an incentive to at least contest a securities class action with a motion to dismiss. A motion to dismiss focuses on procedural issues such as pleading requirements and thus only needs minimal involvement from managers who may have leftthe company. Indeed, a motion to dismiss is filed in virtually every case in the data set. A motion to dismiss is filed in 90 percent of the bankruptcy cases and 89 percent of the nonbankruptcy cases. Because motions to dismiss are made at similar rates in bankruptcy and nonbankruptcy cases,103 lower dismissal rates are an indication that bankruptcy cases are more likely to have merit from the perspective of the judges deciding those motions
- 178. to dismiss. Moreover, a D&O insurer will not settle a case for significant sums unless there is some evidence of merit. A D&O insurer would likely fight for a nominal settlement rather than one that approaches policy limits. The greater percentage of significant settlements in bankruptcy cases is thus evidence that the parties involved believe these cases are more likely to have merit. Finally, the higher rate of third-party settlements cannot be explained solely by a lack of willingness to fight bankruptcy cases. Third parties have incentives to resist securities class actions because they may be paying out of their own pocket.104 On the other hand, the higher rate of significant thirdparty settlements might partly reflect that class action attorneys are more aggressive in seeking third-party settlements in bankruptcy cases to supplement settlements because the issuer cannot contribute. D. Implications What are the implications of these findings? This Section summarizes the ways in which the results of this study have significance for our general understanding of securities class actions. First, a significant percentage of securities class actions involve failed companies. Sixteen percent of securities class actions describe a situation in which shareholders have lost virtually their entire investment. In addition, there are many cases in which a company has not formally filed for bankruptcy but is in financial distress. In these cases, criticisms such as the circularity problem, which mainly apply to securities class actions against solvent companies, are less of a concern. Second, empirical support for the Arlen and Carney last-period hypothesis is mixed. The finding that bankruptcy cases are more likely to have restatements indicates that accounting fraud may be driven by a desire to mask last-period developments. On the other hand, it is evident that securities class actions involving nonbankrupt companies are just as likely to have other indicia of merit. If these securities class actions are an accurate
- 179. reflection of the incidence of securities fraud, these results indicate that securities fraud is not just a last-period problem, but is also a significant problem with respect to solvent companies. Judges and parties should not readily assume that securities class actions against nonbankrupt companies are necessarily weaker than those against bankrupt companies. Third, it is likely that in some cases, motions to dismiss and decisions to settle are influenced by something other than the merits. Whether it is because of the pressure to settle in the context of a bankruptcy, hindsight bias, or a sense that shareholders have a greater need for a remedy in bankruptcy, bankruptcy cases are decided differently than nonbankruptcy cases. This might be a troubling development, and perhaps judges should be educated about these tendencies to reduce hindsight bias. On the other hand, to the extent that bankruptcy cases serve a more compelling policy reason, the best course may simply be to allow judges to use their discretion with respect to bankruptcy cases. Fourth, the Supreme Court should be wary of completely eliminating secondary liability in Rule 10b-5 cases,105 though the findings of this study indicate that it is prudent to make the standard for finding such liability high. In bankruptcy cases, defendants such as auditors are important sources of compensation because the issuer cannot contribute to the settlement. On the other hand, there may be a tendency to conclude too quickly in bankruptcy cases that third parties are liable even without strong evidence of actual fraud. Judges who are deciding motions to dismiss with respect to auditors in bankruptcy cases should be wary of the danger of hindsight bias. E. Additional Observations Relating to Vicarious Liability This study of bankruptcy cases also has implications for the desirability of vicarious liability in securities class actions. These observations, however, are not the focus of this study and need more research to fully develop. In a typical securities class action, the issuer is responsible for
- 180. misstatements made by individual agents. A number of commentators have suggested eliminating such vicarious liability for securities fraud-on-themarket cases.106 Part of the rationale for this proposal is that entity liability creates incentives not to target individual managers who might be responsible for the fraud. Focusing securities fraud liability on these individuals could better deter securities fraud. Bankruptcy cases shed some light on cases in which vicarious liability is not a basis for liability. As noted earlier, because the issuer is typically not a defendant, the securities class action can only proceed against managers and third parties such as auditors. Bankruptcy cases are thus a setting where individuals rather than the company should be the focus of liability. In the bankruptcy cases identified in this data set, there does not appear to be additional inquiry into the responsibility of individuals for securities fraud. Groups of directors and officers collectively settle and litigate suits and it does not appear that courts look any deeper into establishing individual liability. Though there is a smattering of cases in which individuals personally contribute to the settlement, the number is an insignificant percentage of the data set. These results may indicate that vicarious liability is not the determinative factor in the lack of scrutiny of individuals in securities fraud cases. The nature of securities fraud could be such that systemic rather than individual causes are responsible. Establishing individual liability might simply be too difficult and costly in most cases, regardless of whether there is vicarious liability. Conclusion This study began by advancing two hypotheses relating to the difference between bankruptcy and nonbankruptcy cases. The first was that there is a difference in actual merits consistent with the view that fraud is more likely in a last-period context. The second was that there is no actual difference in merits but that bankruptcy cases are perceived to have more merit than nonbankruptcy cases. Stronger support was found for the second hypothesis. Even when controlling for various indicia of merit,
- 181. there is a bankruptcy effect that makes it more likely that bankruptcy cases will succeed. This finding likely reflects a form of hindsight bias on the part of judges who decide bankruptcy cases. This study has implications for understanding the role of securities class actions. Perhaps the most compelling cases brought by investors involve companies that fall into bankruptcy in the wake of a fraud. The study of bankruptcy cases shows that judges use heuristics not only to dismiss securities class actions but also to deny motions to dismiss. This tendency could reflect hindsight bias as well as the belief that there is a core set of cases where there is greater consensus as to the utility of securities class actions. Certainly, context matters in the way that judges and parties assess the merit of securities class actions. Footnote 1. See, e.g., Baruch Lev & Meiring de Villiers, Stock Price Crashes and 10b-5 Damages: A Legal, Economic, and Policy Analysis, 47 Stan. L. Rev. 7, 35 (1994) ("[S]tock price crashes are short-term phenomena . . . . [B]uilt-in forces, namely the informed investors' realization that the stock price is below fundamentals, will start operating in a crash and return the price to its fundamental or equilibrium value."). 2. See, e.g., Frank H. Easterbrook & Daniel R. Fischel, Optimal Damages in Securities Cases, 52 U. Chi. L. Rev. 611, 641 (1985) (observing that diversified investors are protected from impact of securities fraud). 3. See, e.g., Janet Cooper Alexander, Do the Merits Matter? A Study of Settlements in Securities Class Actions, 43 Stan. L. Rev. 497, 572 (1991) (arguing that shareholder compensation shifts losses "from current . . . to former shareholders" and that "the net result is simply the destruction of shareholder value in the amount of the transaction costs of the litigation"). 4. See In re Enron Corp. Sec., Derivative & "ERISA" Litig., No. MDL-1446, 2008 WL 4178151 (S.D. Tex. Sept. 8, 2008) (approving $7 billion settlement fund including settlements by
- 182. gatekeepers); In re Worldcom, Inc. Sec. Litig., No. 02 Civ. 3288 (DLC), 2005 WL 2319118 (S.D.N.Y. Sept. 21, 2005) (approving $6 billion in settlements including settlements by gatekeepers). 5. See infra note 44. 6. There is another interesting relationship between securities class actions and bankruptcy. An empirical study by Lynn Bai, James Cox, and Randall Thomas finds evidence that companies settling securities class actions are more likely to have liquidity problems and a greater propensity to file for bankruptcy. See Lynn Bai et al., Lying and Getting Caught: An Empirical Study of the Effect of Securities Class Action Settlements on Targeted Firms, 158 U. Pa. L. Rev. 1877 (2010). In contrast, this study focuses on the impact of bankruptcy filings prior to the resolution of securities class actions as opposed to after their resolution. 7. See, e.g., Douglas G. Baird, Bankruptcy's Uncontested Axioms, 108 Yale L.J. 573, 580-81 (1998); Hubert Ooghe & Sofie De Prijcker, Failure Processes and Causes of Company Bankruptcy: A Typology, 46 Mgmt. Decision 223, 227-34 (2008). 8. See, e.g., Ooghe & De Prijcker, supra note 7, at 234-35 (discussing poor management as a cause of bankruptcy). 9. See, e.g., id. at 228. 10. See, e.g., id. at 233. 11. See, e.g., Baird, supra note 7, at 580-81; Ooghe & De Prijcker, supra note 7, at 228-30. 12. See, e.g., Thomas Lys & Ross L. Watts, Lawsuits Against Auditors, 32 J. Acct. Res. (Supplement) 65, 68 (1994) ("We argue that managers' incentives to mislead increase when the firm is in financial distress."). 13. E.g., Jennifer H. Arlen & William J. Carney, Vicarious Liability for Fraud on Securities Markets: Theory and Evidence, 1992 U. Ill. L. Rev. 691, 701 (noting that a manager may benefit from fraud through "possible preservation of employment as well as the value of the manager's assets related to the firm's stock, if by committing fraud he is able to buy
- 183. sufficient time to turn the ailing firm around"). 14. See id. at 715 ("Under our last period hypothesis, Fraud on the Market usually results from the efforts of a few desperate managers to hide the fact that the corporation is ailing or has done sufficiently badly relative to reasonable expectations that senior managers can expect to be replaced."). 15. Mitu Gulati et al., Fraud by Hindsight, 98 Nw. U. L. Rev. 773, 778 (2004); see also Jeffrey J. Rachlinski, A Positive Psychological Theory of Judging in Hindsight, 65 U. Chi. L. Rev. 571, 571 (1998) ("[P]sychologists have demonstrated repeatedly that people overstate the predictability of past events-a phenomenon that psychologists have termed the 'hindsight bias.' "). 16. See, e.g., Zoe-Vonna Palmrose, Litigation and Independent Auditors: The Role of Business Failures and Management Fraud, Auditing: J. Prac. & Theory, Spring 1987, at 90, 96 ("In the context of business failures, allegations usually include the assertion that business difficulties were hidden by the use or manipulation of financial information, so that either the existence or degree of financial distress was unexpected when finally disclosed."). 17. 15 U.S.C. § 78u-4(b)(2) (2006). 18. E.g., Rothman v. Gregor, 220 F.3d 81, 90 (2d Cir. 2000) (noting that "to plead scienter . . . a complaint may . . . allege facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness"); In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 974 (9th Cir. 1999) (finding that plaintiff"must plead, in great detail, facts that constitute strong circumstantial evidence of deliberately reckless or conscious misconduct"). Of course, in some circuits, plaintiffs can also plead scienter by alleging motive and opportunity, Rothman, 220 F.3d at 90, an arguably easier standard to meet. 19. Rothman, 220 F.3d at 90 (quoting Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978)). The standard for finding an auditor liable in a Rule 10b-5 case is an even higher standard of recklessness. See, e.g., PR
- 184. Diamonds, Inc. v. Chandler, 364 F.3d 671, 693 (6th Cir. 2004) ("[T]he meaning of recklessness in securities fraud cases is especially stringent when the claim is brought against an outside auditor."); DSAM Global Value Fund v. Altris Software, Inc., 288 F.3d 385, 391 (9th Cir. 2002) (requiring allegation of "such an extreme departure from reasonable accounting practice that [the auditor] knew or had to have known that its conclusions would mislead investors" (internal quotation marks omitted)); Rothman, 220 F.3d at 98 (noting that to find that an auditor acted recklessly, the conduct must "approximate an actual intent to aid in the fraud being perpetrated by the audited company" (internal quotation marks omitted)). In 1994, the Supreme Court rejected a more lenient standard of aiding and abetting for holding auditors liable under Rule 10b- 5. See Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 191 (1994). 20. See, e.g., Rachlinksi, supra note 15, at 592 ("Even if subjective standards invite biased judgments, the hindsight bias probably has less influence on judgments made under subjective standards than it does on judgments made under objective standards."). 21. See, e.g., John C. Anderson et al., The Mitigation of Hindsight Bias in Judges' Evaluation of Auditor Decisions, Auditing: J. Prac. & Theory, Fall 1997, at 20, 21 ("[W]e established the existence of hindsight bias with judges and then attempted to mitigate it with two individual debiasing methods."). The hindsight bias may also affect auditors who evaluate the work of other auditors. See Jane Kennedy, Debiasing the Curse of Knowledge in Audit Judgment, 70 Acct. Rev. 249, 257 (1995) ("This experiment finds that subjects- auditors and MBA students-are susceptible to outcome knowledge that should be ignored . . . ."). 22. See, e.g., Thomas A. Buchman, An Effect of Hindsight on Predicting Bankruptcy with Accounting Information, 10 Acct., Orgs. & Soc'y 267, 274 (1985) ("Reporting bankruptcy increased the perceived likelihood that it would happen, as
- 185. would be expected from prior research."); D. Jordan Lowe & Philip M.J. Reckers, The Effects of Hindsight Bias on Jurors' Evaluations of Auditor Decisions, 25 Decision Sci. 401, 417 (1994) ("In spite of receiving instructions to base their responses on information available before learning of an outcome, jurors tended to make auditor evaluative judgments in the direction of the negative (bankruptcy) outcome. Outcome knowledge of the audit client's bankruptcy resulted in lower evaluations of the auditor's performance."). 23. See Marianne M. Jennings et al., Causality as an Influence on Hindsight Bias: An Empirical Examination of Judges' Evaluation of Professional Audit Judgment, 21 J. Acct. & Pub. Pol'y 143, 161 (1998) ("[J]udges' assessments of the external auditor's responsibility to anticipate the outcome was directly related to the degree of outcome foreseeability."). 24. Tom Baker & Sean J. Griffith, How the Merits Matter: Directors' and Officers' Insurance and Securities Settlements, 157 U. Pa. L. Rev. 755, 787 (2009). 25. See 15 U.S.C. § 78j (2006) (prohibiting manipulative and deceptive devices). The Supreme Court has recognized an implied private right of action for investors harmed by violations of section 10(b). See Tellabs, Inc.v. Makor Issues & Rights, Ltd., 551 U.S. 308, 318 (2007). 26. See 17 C.F.R. § 240.10b-5 (2011) (SEC Rule enacted pursuant to section 10(b) of the Securities Exchange Act). 27. See 15 U.S.C. § 77k(a) (providing cause of action against issuer and other parties for misstatements in the registration statement). 28. See 11 U.S.C. § 362 (2006). 29. E.g., Notice of Proposed Settlement of Class Action, Motion for Attorneys' Fees, and Settlement Fairness Hearing at 1, In re Eagle Bldg. Techs., Inc. Sec. Litig., No. 02-80294- CIV- RYSKAMP (S.D. Fla. Jan. 31, 2006) ("Bankruptcy counsel for Eagle and counsel for the Settlement Class have agreed that the Settlement Class shall have an unsecured claim of $8,000,000 in Eagle's liquidation. However, secured and unsecured claims
- 186. exceed the available proceeds for liquidation and the Settlement Class is likely to receive only a small fraction of its claim against Eagle from the bankruptcy estate."). 30. Section 510(b) of the Bankruptcy Code provides the following: [A] claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 on account of such a claim, shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security, except that if such security is common stock, such claim has the same priority as common stock. 11 U.S.C. § 510(b). For a critique of this provision, see generally Kenneth B. Davis, Jr., The Status of Defrauded Securityholders in Corporate Bankruptcy, 1983 Duke L.J. 1 (1983). 31. See, e.g., Kenneth M. Ayotte & Edward R. Morrison, Creditor Control and Conflict in Chapter 11, 1 J. Legal Analysis 511, 522 (2009) (finding that equityholders recover in only 9 percent of chapter 11 cases when creditors have not been paid in full, marking a shiftfrom recovery rates during the 1980s). 32. See, e.g., Lynn M. LoPucki & William C. Whitford, Bargaining over Equity's Share in the Bankruptcy Reorganization of Large, Publicly Held Companies, 139 U. Pa. L. Rev. 125, 143 (1990) (finding equity recoveries of between $400,000 and $63 million). 33. See, e.g., Notice of Class Action, Proposed Settlement and Hearing Thereon at 1, In re Mpower Commc'ns Corp. Sec. Litig., No. 00-CV-6463t(b) (W.D.N.Y. Feb. 20, 2003) ("On April 8, 2002, defendant Mpower Communications Corp. ('Mpower' or the 'Company') filed a petition for relief under Chapter 11 of the Bankruptcy Code. As of the effective date of Mpower's First Amended Joint Plan of Reorganization (the 'Plan'), Mpower was discharged and released from any claim,
- 187. debt and interest, except as otherwise stated in the Plan, as set forth in the final confirmation order entered by the United States Bankruptcy Court for the District of Delaware on July 17, 2002."). 34. See, e.g., Sean J. Griffith, Uncovering a Gatekeeper: Why the SEC Should Mandate Disclosure of Details Concerning Directors' and Officers' Liability Insurance Policies, 154 U. Pa. L. Rev. 1147, 1163-68 (2006). 35. See, e.g., Gillman v. Cont'l Airlines (In re Cont'l Airlines), 203 F.3d 203, 216-17 (3d Cir. 2000) (implying that D&O insurance proceeds are not property of bankruptcy estate when nondebtor directors and officers are beneficiaries); La. World Exposition, Inc. v. Fed. Ins. Co. (In re La. World Exposition, Inc.), 832 F.2d 1391, 1400-01 (5th Cir. 1987) (finding that D&O policy proceeds belonged to the directors and officers and were not part of the estate). But see Amended Notice of Pendency and Proposed Settlement of Class Action at 4, In re Team Commc'ns Grp., Inc. Sec. Litig., No. 01-02312-DDP (SHx) (C.D. Cal. Dec. 6, 2004) ("The Trustee opposed the previous settlement reached by the parties on the grounds that the settlement released claims belonging to Team against the Individual Defendants and others, and that the insurance proceeds designated to fund that settlement were the property of Team's bankruptcy estate, and could not be used to fund the settlement. On September 18, 2002, the Bankruptcy Court denied a motion by one of the Insurers for relief from the Automatic Stay under 11 U.S.C § 362, inter alia, on the grounds that the policy proceeds were the property of Team's bankruptcy estate."). 36. See Tom Baker & Sean J. Griffith, The Missing Monitor in Corporate Governance: The Directors' & Officers' Liability Insurer, 95 Geo. L.J. 1795, 1803 (2007) ("Side A coverage typically comes into play only when the corporation is bankrupt or insolvent . . . . "). 37. See, e.g., Minoco Grp. of Cos., Ltd. v. First State Underwriters Agency of New Eng. Reinsurance Corp. (In re
- 188. Minoco Grp. of Cos., Ltd.), 799 F.2d 517, 519 (9th Cir. 1986) (finding that particular D&O insurance proceeds are "property of the estate . . . because the policies insure [the corporation] against indemnity claims"); Circle K Corp. v. Marks (In re Circle K Corp.), 121 B.R. 257, 259 (Bankr. D. Ariz. 1990). 38. See, e.g., Richard M. Cieri & Michael J. Riela, Protecting Directors and Officers of Corporations that Are Insolvent or in the Zone or Vicinity of Insolvency: Important Considerations, Practical Solution s, 2 DePaul Bus. & Com. L.J. 295, 333-34 (2004); Nan Roberts Eitel, Now You Have It, Now You Don't: Directors' and Officers' Insurance After a Corporate Bankruptcy, 46 Loy. L. Rev. 585 (2000); see also Kelli A. Alces, Enforcing Corporate Fiduciary Duties in Bankruptcy, 56 U. Kan. L. Rev. 83, 119-125 (2007) (noting that derivative suits are controlled by the bankruptcy estate). 39. See Arlen & Carney, supra note 13, at 715. 40. See id. at 723. 41. Id. at 726. 42. Id. at 725. 43. See id. at 731 ("[A] sample of six firms is too small a sample from which to generalize."). 44. See, e.g., Alexander, supra note 3; James Bohn & Stephen Choi, Fraud in the New- Issues Market: Empirical Evidence on
- 189. Securities Class Actions, 144 U. Pa. L. Rev. 903 (1996); Stephen J. Choi, Do the Merits Matter Less After the Private Securities Litigation Reform Act?, 23 J. L. Econ. & Org. 598 (2007); Stephen J. Choi et al., The Screening Effect of the Private Securities Litigation Reform Act, 6 J. Empirical Legal Stud. 35 (2009); Marilyn F. Johnson et al., Do the Merits Matter More? The Impact of the Private Securities Litiga Litigation Reform Act, 23 J. L. Econ. & Org. 627 (2007); A.C. Pritchard & Hillary A. Sale, What Counts as Fraud? An Empirical Study of Motions to Dismiss Under the Private Securities Litigation Reform Act, 2 J. Empirical Legal Stud. 125 (2005); see also Roberta Romano, The Shareholder Suit: Litigation Without Foundation?, 7 J. L. Econ. & Org. 55 (1991) (studying merit of derivative suits). 45. See Michael Perino, Institutional Activism Through Litigation: An Empirical Analysis of Public Pension Fund Participation in Securities Class Actions, 9 J. Empirical Legal Stud. 368, 382 (2012). 46. James D. Cox et al., There Are Plaintiffs and . . . There Are Plaintiffs: An Empirical Analysis of Securities Class Action Settlements, 61 Vand. L. Rev. 355, 377 (2008) ("We also find that class period length and bankruptcy filing are not significant explanatory variables for settlement size."). Cox et al. observe that the absence of significance for the bankruptcy variable in their regressions may result from the fact that D&O policies are
- 190. the primary source of funding settlements in bankruptcy cases. Id. at 377 n.73. 47. Notice of Pendency of Class Action, Proposed Settlement Thereof, Settlement Fairness Hearing and Right to Share in Settlement Fund at 2, In re CHS Elecs., Inc. Sec. Litig., No. 99- 8186-CIV-GOLD/SIMONTON (S.D. Fla. Nov. 29, 2001). 48. Typically, multiple securities class actions are filed against a company. The court will consolidate these class actions into one action and choose a lead plaintifffor the class action. 49. See, e.g., Arlen & Carney, supra note 13, at 722 (excluding cases involving allegations relating to mergers and hostile takeovers); Choi, supra note 44, at 604-05 (excluding IPO allocation cases from sample); Michael A. Perino, Did the Private Securities Litigation Reform Act Work?, 2003 U. Ill. L. Rev. 913, 932 ("The allegations in the [IPO] allocation cases are markedly different from the traditional securities fraud class actions."). 50. A notice of bankruptcy is a pleading filed by a party to apprise the court of a defendant's bankruptcy. See, e.g., Yang v. Odom, 392 F.3d 97, 99 n.1 (3d Cir. 2004) (noting that with the filing of a notice of bankruptcy, a securities class action was stayed against the issuer but could proceed against individual defendants). 51. In some cases, the parties and court recognize that the bankrupt company will not contribute anything to the
- 191. settlement, but the company is not formally dismissed from the case. In a small number of cases, the bankrupt company makes a contribution to the settlement that is usually minimal. 52. This is consistent with an earlier study finding that auditor "litigation tends to precede bankruptcy." See Joseph V. Carcello & Zoe-Vonna Palmrose, Auditor Litigation and Modified Reporting on Bankrupt Clients, 32 J. Acct. Res. (Supplement) 1, 25 (1994) ("[L]itigation following bankruptcy has the lowest occurrence rate . . . . "). 53. It appears that a substantial percentage of large public companies filing for bankruptcy face a securities class action. According to the LoPucki Bankruptcy Research Database, 448 "large" public companies filed for bankruptcy from 1996 to 2004, the period of the data set. Not all of the bankruptcy cases in the data set involved "large" companies. However, a comparison of the data set with the cases listed in the LoPucki database found that at least 135 of 448 (30 percent) of the large public companies that filed for bankruptcy from 1996 to 2004 were also the subject of a securities class action. Of course, these rates may not be transferable to bankruptcies of smaller public companies as large companies may be more susceptible generally to securities class actions. The 30 percent rate of suit for large bankrupt companies is slightly higher than the 24 percent litigation rate for bankrupt companies found in a study by Joseph V. Carcello and Zoe-Vonna Palmrose. See id. at 2
- 192. (studying a sample of 655 public companies that declared bankruptcy between 1972 and 1992); see also Palmrose, supra note 16, at 96 (examining a sample of 458 companies declaring bankruptcy from 1970-1985 and finding that 21 percent were involved in auditor litigation). It is also lower than the 38 percent litigation rate for companies restating their earnings found in a study by Zoe-Vonna Palmrose and Scholz. Zoe- Vonna Palmrose & Susan Scholz, The Circumstances and Legal Consequences of Non-GAAP Reporting: Evidence from Restatements, 21 Contemp. Acct. Res. 139, 145 (2004). 54. I do not classify cases that are voluntarily dismissed by the plaintiffas "dismissed" and limit the term "dismissal" to cases in which the court decides a motion to dismiss against the plaintiffand enters a judgment dismissing the plaintiff's claims that is not later overturned on appeal. 55. H(0) designates the null hypothesis and H(A) designates the alternate hypothesis. 56. See, e.g., Baker & Griffith, supra note 24, at 787 ("[O]ur participants frequently mentioned earnings restatements, insider selling, and SEC investigations as highly significant in determining settlement outcomes."); Choi et al., supra note 44, at 43 (noting that a restatement, SEC investigation, or enforcement action is "hard evidence" of fraud); Perino, supra note 49, at 948 ("[S]cholars and courts often consider allegations of accounting misrepresentations or unusual trading
- 193. by insiders during the class period as generally stronger, all other things being equal, than allegations that a company's forecasts or other predictive statements were fraudulently made."). 57. For an example of a study that uses dismissal rates as a measure of merit, see C.S. Agnes Cheng et al., Institutional Monitoring Through Shareholder Litigation, 95 J. Fin. Econ. 356, 357-58 (2010). 58. See Joseph A. Grundfest, Why Disimply?, 108 Harv. L. Rev. 727, 740-41 (1995) ("[A] key statistic in the merits debate is the difference between the observed settlement amount and the amount a defendant would be willing to pay simply to avoid the costs of mounting a defense."). 59. See, e.g., Choi, supra note 44 at 613-14 (using $2 million threshold). 60. See, e.g., Cox et al., supra note 46, at 381 (using $3 million threshold). 61. In addition to the $3 million threshold, I use higher thresholds in some calculations. See infra Table 6. 62. See Baker & Griffith, supra note 24, at 791-96. 63. The Supreme Court has erected significant barriers to suits against gatekeepers. The Central Bank case precluded aiding and abetting liability during the period of this data set. See Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 191 (1994). The impact of the Court's
- 194. decision in Stoneridge, which was decided four years after the last year of the data set, is likely limited with respect to this study, though some of the later cases in the data set may have been affected. See Stoneridge Inv. Partners, LLC v. Scientific- Atlanta, Inc., 552 U.S. 148, 166-67 (2008). 64. See John C. Coffee, Jr., Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation, 106 Colum. L. Rev. 1534, 1551 (2006) ("The reality is that corporate insiders are sued in order for the plaintiffs to gain access to their insurance, but their personal liability appears not to be seriously pursued."). 65. See, e.g., Stephen J. Choi et al., Do Institutions Matter? The Impact of the Lead PlaintiffProvision of the Private Securities Litigation Reform Act, 83 Wash. U. L.Q. 869, 892 (2005) ("[W]e consider one measure of the pre-filing strength of the cases . . . the presence of an accounting restatement . . . . "); Johnson et al., supra note 44, at 633-34 ("Some of the strongest evidence to satisfy [the requirement of a material misstatement or omission] . . . is a violation of generally accepted accounting principles (GAAP) that results in an earnings restatement, which is required only when earnings have been materially misstated."). 66. Indeed, a restatement might also indicate that management is conscientious about acknowledging mistakes. Ideally, a distinction would be drawn between voluntary and involuntary
- 195. restatements, but it can be difficult to find data that makes such a distinction. 67. See, e.g., Johnson et al., supra note 44, at 646-47 ("[L]awsuits in the post-PSLRA period are significantly more likely to result in a settlement if the firm restated class period earnings."); Perino, supra note 45, at 382-83. 68. See 15 U.S.C. § 78u-4(b)(2) (2006). 69. See Pritchard & Sale, supra note 44, at 146. 70. This study focuses on public pension funds as lead plaintiffs because private pension funds may not be as publicly minded as public pension funds. When the study refers to a pension fund, it is referring only to public pension funds. However, I also estimated regressions using a broader definition of pension fund that included private pension funds, and the results of the study did not differ. 71. See, e.g., Choi et al., supra note 65; James D. Cox & Randall S. Thomas, Does the PlaintiffMatter? An Empirical Analysis of Lead Plaintiffs in Securities Class Actions, 106 Colum. L. Rev. 1587 (2006); Perino, supra note 45. 72. See Choi et al., supra note 65, at 892 ("These results . . . suggest that public pensions tended to target both larger stakes cases and those with stronger evidence of fraud."). 73. See id. at 896 ("[P]ension funds correlate with a significantly greater outcome for the class in the post-PSLRA period . . . . "); Cox & Thomas, supra note 71, at 1636 ("Our
- 196. data shows that institutions increase settlements by 0.04% for every 1% increase in Provable Losses."); Perino, supra note 45, at 369. 74. See, e.g., Choi et al., supra note 65, at 892 (using existence of an SEC investigation as an indicator of merit). 75. A logistic regression is a regression where the dependent variable is binary-that is, can only take on the value of 0 or 1. 76. The total assets and class period variables are proxies for measuring potential damages awards. Larger damages are more likely in cases involving larger companies and longer class periods. The section 11 variable controls for the fact that it is easier for a plaintiffto establish liability under section 11 because that provision does not require a showing of scienter. The circuit variable assesses whether judges in different circuits are more or less willing to allow securities class actions to proceed. See, e.g., James D. Cox et al., Do Differences in Pleading Standards Cause Forum Shopping in Securities Class Actions?: Doctrinal and Empirical Analyses, 2009 Wis. L. Rev. 421, 430-38 (2009) (describing differences in circuit pleading standards for securities class actions). 77. It may be that different types of bankruptcies have different associations with the measures of success. I estimated a number of logistic regressions in which the bankruptcy variable was defined in different ways. For example, I estimated a regression in which the bankruptcy variable was limited to bankruptcies
- 197. where the company was liquidated. I also estimated a regression where the bankruptcy variable was limited to bankruptcies where the company was reorganized. I also distinguished between cases in which the bankruptcy filing occurred prior to the filing of the complaint and cases in which the bankruptcy filing occurred after the filing of the complaint. For the most part, these limited bankruptcy variables retained their statistical significance. The exception was the limited bankruptcy variable in which the bankruptcy filing occurred prior to the filing of the complaint. 78. See, e.g., Pritchard & Sale, supra note 44, at 146 (finding that allegations of insider trading are positively associated with dismissal and concluding that "courts are skeptical of the rather noisy signal provided by such trades"). 79. Of course, insider sales might make it more likely that directors and officers are held personally liable, but directors and officers almost never personally contribute to settlements. See Coffee, supra note 64, at 1550-51. 80. For the significant settlement regression, the marginal effect for a pension fund lead plaintiffwas 0.13 and the marginal effect for a restatement was 0.17. 81. For the third-party settlement regression, the marginal effect for a pension fund lead plaintiffwas 0.09 and the marginal effect for a restatement was 0.08. 82. The average size of settlement in all settled cases (excluding
- 198. the Enron and World- Com settlements) was approximately $40 million while the median settlement was approximately $6 million. The average size of settlement in settled cases involving a bankrupt company (excluding the Enron and WorldCom settlements) was approximately $21 million while the median settlement was approximately $7 million. The average size of settlement in settled cases involving a nonbankrupt company was approximately $44 million while the median settlement was approximately $6 million. 83. See, e.g., Baker & Griffith, supra note 36, at 1806 (citing average D&O limits of $28.25 million for small-cap companies, $64 million for midcap companies, and $157.69 million for large-cap companies). 84. Some of these variables were not statistically significant in all of the regressions. However, the pension fund variable was consistently statistically significant for all regressions. 85. Choi, supra note 44, at 601 (discussing nonobvious indicia of merit). 86. See, e.g., Stephen M. Bainbridge & G. Mitu Gulati, How Do Judges Maximize? (The Same Way Everybody Else Does- Boundedly): Rules of Thumb in Securities Fraud Opinions, 51 Emory L.J. 83, 87 (2002) ("[J]udges are using substantive heuristics to dispose of securities cases at the motion to dismiss stage."); Hillary A. Sale, Judging Heuristics, 35 U.C. Davis L. Rev. 903, 946 (2002) ("[C]ourts are, consciously or
- 199. unconsciously, utilizing the heuristics to clear complex cases that would otherwise remain on the dockets for lengthy periods of time."). 87. Stephen Choi finds that nonnuisance claims without "hard evidence" are more likely to be dismissed post-PSLRA. Choi, supra note 44, at 598. Bankruptcy may be one setting in which the PSLRA bias toward obvious indicators of fraud is not as influential. 88. See, e.g., Rachlinski, supra note 15, at 602 ("[R]epeat players might notice the tendency of biased judgments to raise standards after the fact, as might judges. This could undermine the perceived fairness of the system of civil liability."). 89. Shareholders only receive recovery after creditors are paid. See 11 U.S.C. § 1129(a)(8)(A), (b)(2)(B)(ii) (2006). 90. See, e.g., James J. Park, Shareholder Compensation as Dividend, 108 Mich. L. Rev. 323 (2009) (describing and critiquing circularity problem). 91. Coffee, supra note 64. Another version of the circularity problem states that because shareholders are diversified, they are as likely to be winners as they are to be losers from securities fraud. In some cases, investors buy stock inflated by fraud but in others, they sell stock inflated by fraud. However, if a company in an investor's portfolio goes bankrupt, it is more difficult to offset such a loss with gains from securities fraud. Because the universe of bankrupt companies is smaller than
- 200. solvent companies, it is less likely that the loss from buying inflated stock in a company that later goes bankrupt would be offset by a corresponding gain from selling inflated stock in a company that later goes bankrupt. Notwithstanding this argument, it is important to acknowledge that a sufficiently diversified investor will be shielded from significant losses from a bankrupt issuer, simply by virtue of the fact that no one stock will be a large percentage of the portfolio. 92. As a general matter, gatekeepers are rarely named in securities class actions. See, e.g., John C. Coffee, Jr., Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms, 84 B.U. L. Rev. 301, 320 (2004). 93. See, e.g., Coffee, supra note 64, at 1550 ("Although large settlements involving accounting firms do occur, these often involve the insolvency of the corporate defendant (as in Enron and WorldCom) so that the auditor becomes the defendant of last resort-namely, the remaining defendant with a deep pocket."). 94. Bondholders may also be more likely to be plaintiffs in bankruptcy cases than nonbankruptcy cases. In the data set, 32 of 234 (14 percent) bankruptcy cases involved bondholder plaintiffs. When a company is solvent, it is less likely that bondholders will suffer losses than when a company is insolvent. The WorldCom case is an example where bondholders recovered billions of dollars after a bankruptcy through a
- 201. securities class action. When bondholders recover compensation, such payment is not a circular transfer. The transfer is likely to come from a third party such as an underwriter or auditor, or from D&O insurance that is funded by the shareholders. 95. Denny v. Barber, 576 F.2d 465, 470 (2d. Cir. 1978) (Friendly, J.) ("[T]he complaint is an example of alleging fraud by hindsight."); see also DiLeo v. Ernst & Young, 901 F.2d 624, 627-28 (7th Cir. 1990) (Easterbrook, J.) (applying the fraud-by- hindsight doctrine and noting that "[b]ecause only a fraction of financial deteriorations reflects fraud, plaintiffs may not proffer the different financial statements and rest"). 96. See DiLeo, 901 F.2d at 627-28 (dismissing a complaint under the fraud-byhindsight doctrine because it alleged "nothing other than the change in the stated condition of the firm"). One group of commentators describes the fraud-by-hindsight doctrine as "another way of saying that plaintiffs must have more in their complaints than just backward induction from the fact that a problem subsequently surfaced-there have to be facts showing awareness at the time of the fraud." Gulati et al., supra note 15, at 820. 97. E.g., Rachlinski, supra note 15, at 617 ("The 'fraud by hindsight' doctrine guards only against a severe abuse of the hindsight bias; it does not entirely purge the system of the bias's influence.").
- 202. 98. It is interesting that hindsight bias does not appear to affect the SEC and pension fund lead plaintiffs. The SEC does not investigate cases involving bankrupt companies at rates greater than it investigates cases involving nonbankrupt companies. Pension funds do not appear as lead plaintiffs at higher rates in bankruptcy cases. On the other hand, perhaps the SEC and pension funds are more sophisticated in assessing securities fraud than generalist judges. 99. As noted earlier, in 54 out of the 234 bankruptcy cases (23 percent), the bankruptcy filing occurred before the filing of the complaint, and in 180 out of the 234 bankruptcy cases (77 percent), the bankruptcy filing occurred after the filing of the complaint. I estimated regressions where the bankruptcy variable was defined as including only the cases where the bankruptcy occurred prior to the complaint. In those regressions, the bankruptcy variable was not statistically significant. On the other hand, when I estimated regressions using only the cases where the bankruptcy filing occurred after the filing of the complaint, the bankruptcy variable retained its statistical significance. 100. See 11 U.S.C. § 1141(d)(1)(A) (2006) ("[T]he confirmation of a plan . . . discharges the debtor from any debt that arose before the date of such confirmation . . . ."). Equity holders often receive little to no distribution under a chapter 11 plan. See, e.g., Ayotte & Morrison, supra note 31, at 522. Civil
- 203. actions by equity holders against a chapter 11 debtor for securities fraud will generally be treated as equity claims. See 11 U.S.C. § 510(b) (subordinating claims "arising from the purchase or sale of such a security" to the priority of distribution associated with that security). Thus, the prospect of recovery for such claimants is low. 101. E.g., M. Todd Henderson, Paying CEOs in Bankruptcy: Executive Compensation when Agency Costs Are Low, 101 Nw. U. L. Rev. 1543, 1596 (2007) (finding that 60 percent of CEOs are replaced in the zone of insolvency); Lynn M. LoPucki & William C. Whitford, Corporate Governance in the Bankruptcy Reorganization of Large, Publicly Held Companies, 141 U. Pa. L. Rev. 669, 729 (1993) (finding that 95 percent of CEOs leftoffice before or during reorganization). 102. There is some evidence that managers do not suffer a reputational penalty for being the subjects of a securities class action. Eric Helland, Reputational Penalties and the Merits of Class-Action Securities Litigation, 49 J. L. & Econ. 365 (2006). 103. Baker and Griffith find through interviews of participants in securities litigation "that defendants filed a motion to dismiss in every case with which [the participants] were familiar." Baker & Griffith, supra note 24, at 775. 104. Most of the third-party settlements involving bankrupt companies involve complaints that only allege Rule 10b-5 claims. In thirty-two of the fifty-six (57 percent) third-party
- 204. settlements in bankruptcy cases, there were no section 11 claims. Thus, third parties in those cases would have substantial defenses under Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 177-78 (1994), and Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 158-61 (2008), both of which limit secondary liability in Rule 10b-5 cases. 105. As noted earlier, the trend has been to make it more difficult to find secondary liability in Rule 10b-5 cases. See supra note 104 (citing cases in which the Court rejected aider- and-abettor liability and scheme liability, two potential forms of secondary liability under Rule 10b-5). 106. See Arlen & Carney, supra note 13, at 720 ("We conclude that enterprise liability should not be applied to Fraud on the Market cases."); Coffee, supra note 64, at 1582 ("The SEC can and should exempt the non-trading corporate issuer from private liability for monetary damages under Rule 10b-5."). AuthorAffiliation James J. Park* * Associate Professor of Law, Brooklyn Law School. Thanks to Stephen Choi, Sean Griffith, Minor Myers, Michael Perino, Adam Pritchard, Amanda Rose, and participants of presentations at the 2011 Canadian Law and Economics Association, 2010 Conference on Empirical Legal Studies, 2011 Junior Business Law Scholars Conference at the University of
- 205. Colorado Law School, 2012 Federalist Society Junior Scholars Colloquium, 2012 Conference of the International Society for New Institutional Economics, 2011 Midwest Law and Economics Association, NYU Law School Topics in U.S. and Global Business Regulation Seminar, and St. John's University School of Law for helpful comments. Thanks to Kelly Kraiss, Victoria Su, and Bradley Wanner for helpful assistance in compiling the data set for this study. The Brooklyn Law School Dean's Summer Research Fund provided support for this project. Appendix (ProQuest: Appendix omitted.) Word count: 17891 Copyright Michigan Law Review Association Feb 2013Abstract (summary) TranslateAbstract Courts have long recognized the role of the securities industry's accountants, lawyers, securities analysts, and credit-rating agencies as "gatekeepers" -- reputational intermediaries who, for a fee, effectively rent their reputations for honesty, accuracy, and integrity to their corporate clients in order to provide confidence to the clients' investors. Under this reputational model, a gatekeeper's reputation is its chief capital asset. While it seems that gatekeepers would need very little incentive to avoid risking this asset by helping their clients
- 206. commit securities fraud, debacles such as Enron, WorldCom. Refco, and the 2008 Financial Crisis demonstrate that this is not true. Notable commentators suggest that if gatekeepers face a low risk of litigation, then the expected value derived from risking their reputations by committing fraud increases. To effectively curtail securities fraud committed by gatekeepers, private aiding and abetting liability must be reinstated.Full text · TranslateFull text · Headnote Abstract Courts have long recognized the role of the securities industry's accountants, lawyers, securities analysts, and credit-rating agencies as "gatekeepers"-reputational intermediaries who, for a fee, effectively rent their reputations for honesty, accuracy, and integrity to their corporate clients in order to provide confidence to the clients' investors. Under this reputational model, a gatekeeper's reputation is its chief capital asset. While it seems that gatekeepers would need very little incentive to avoid risking this asset by helping their clients commit securities fraud, debacles such as Enron, WorldCom, Refco, and the 2008 Financial Crisis demonstrate that this is not true. Notable commentators suggest that if gatekeepers face a low risk of litigation, then the expected value derived from risking their reputations by committing fraud increases. Yet ever since
- 207. the Supreme Court's 1994 decision in Central Bank of Denver v. First Interstate Bank of Denver, even when gatekeepers knowingly assist their clients to commit securities fraud, the clients' investors cannot bring aiding and abetting claims against these gatekeepers in Rule 10b-5 actions. Unsurprisingly, the period after Central Bank is marked by an increase in risky accounting practices and less conservative reporting strategies. Furthermore, in both Stoneridge Investment Partners, LLC v. Scientific-Atlanta (2008) and Janus Capital Group, Inc. v. First Derivative Traders (2011), the Supreme Court further limited theories by which gatekeepers could be held liable as primary violators under Rule 10b-5. Congress had several chances after Central Bank to restore the aiding and abetting private right of action under 10b-5 but declined to do so. As a result, gatekeepers who aid and abet fraud face a substantially reduced risk of litigation and therefore a substantially reduced risk to their reputational capital. Headnote To effectively curtail securities fraud committed by gatekeepers, private aiding and abetting liability must be reinstated. This Note will examine the history of gatekeeper liability under the securities laws, particularly the rise and fall of the private right of action for aiding and abetting liability under Rule 10b-5. It will then explore theories from several notable commentators of why gatekeepers would rationally risk
- 208. their reputational capital by knowingly acquiescing to their clients' securities frauds. In concluding that the current state of securities law does not provide the market with enough incentive to demand that gatekeepers invest in and maintain their reputations, this Note argues that Congress must restore the right of private plaintiffs to bring aiding and abetting claims under 10b-5. Introduction It is perhaps dismaying that participants in a fraudulent scheme who may even have committed criminal acts are not answerable in damages to the victims of [their] fraud .... However, ... the fact that the plaintiff-investors have no claim is the result of a policy choice by Congress .... This choice may be ripe for legislative re examination.1 This quotation from Judge Gerald Lynch of the Southern District of New York neatly sums up the state of securities law today and its treatment of aiding and abetting liability for the securities industry's gatekeepers-accountants, lawyers, securities analysts, and credit-rating agencies.2 Judge Lynch made these remarks in In re Refco, Inc. Securities Litigation in which a lawyer, Joseph Collins, a partner at the law firm of Mayer Brown LLP, was alleged to have knowingly helped his client, Refco, fraudulently conceal its massive debts from its shareholders through an elaborate financial scheme.3 While Mr. Collins was later found to be criminally liable for his actions,4
- 209. the law does not currently allow any private plaintiff to collect damages from him, Mayer Brown, or any other gatekeeper who aids and abets fraud.5 When financial market participants learn about gatekeeper-aided fraud, the effect on stock prices can be devastating.6 Investors, who rely on the work product of gatekeepers to evaluate the market, lose faith in the market and shift stock prices downward because they no longer trust that work product.7 This penalty is usually very severe.8 One study shows that public companies that announce financial statement restatements due to revenue recognition issues (an indicator of fraud) lose on average over 25% of their market value.9 Many such companies become insolvent, a fact which many commentators claim justifies private liability for gatekeepers.10 Courts have long recognized the important role of gatekeepers in the financial markets as "reputational intermediaries."11 In essence, gatekeepers use their reputations for accurate reporting, thorough due diligence, and trustworthiness to assure investors that their capital will be used wisely by the companies in which they invest and that it will have the true potential to produce a good return on investment.12 In effect, gatekeepers "rent" their reputations to issuers.13 This enables an issuer to raise more capital at a lower expense than it otherwise would have incurred had it been necessary to build a reputation on its own (this is especially true if the issuer is smaller or more
- 210. unknown). At the same time, gatekeepers serve investors by reducing informational asymmetries between issuers and the investors.14 If the reputation of a gatekeeper is good, the investor trusts the information being provided and will use it in deciding whether and how much to invest in an issuer or in the market as a whole.15 It would seem then that gatekeepers would have very little reason to risk their valuable reputations by knowingly aiding their clients to commit fraud.16 However, as high profile gatekeeper failures in debacles such as Refco, Enron, and WorldCom prove, this is not always the case.17 These debacles took place during an era in which the threat of litigation against gatekeepers was substantially reduced, an era that continues to this day.18 In 1994, the Supreme Court held that plaintiffs could no longer bring civil actions for aiding and abetting securities fraud.19 A year later, Congress enacted the Private Securities Litigation Reform Act of 1995 ("PSLRA"),20 which restored the SEC's ability to bring aiding and abetting claims, but not those of private plaintiffs.21 In the years that followed, evidence suggests that accounting firms lowered risk management standards and adopted less conservative reporting policies.22 Few gatekeepers took precautions to protect their reputational capital and many relaxed risk management standards that had previously been in place.23 In seeking to answer the question of why gatekeepers help their
- 211. clients commit fraud, notable commentators such as Professor John C. Coffee, Jr. of Columbia University School of Law, Professor Jonathan Macey of Yale University School of Law, and Professor Frank Partnoy of the University of San Diego School of Law have looked to the theory of reputational capital.24 The theory puts forth that a firm's reputation is a valuable capital asset that is "pledged or placed at risk by the gatekeeper's vouching for its client's assertions or projections."25 And just like any other form of capital, the value of reputational capital can rise or fall depending on several factors, including (significantly) the risk of litigation.26 When the risk of litigation is low, the expected cost to a gatekeeper of acquiescing to a client's fraud is decreased.27 For this reason primarily, the private right to bring a Rule 10b-5 action for aiding and abetting liability should be restored by Congress.28 Part I of this Note will examine gatekeeper liability under the federal securities laws and its development since the enactments of the '33 Act and '34 Act. Part II will examine current theories about reputational capital and why gatekeepers choose to acquiesce to their clients' securities frauds. In Part III, I argue that if one accepts the theory that gatekeepers serve as reputational intermediaries, as the courts seem to do, then the case for reinstating private liability gains new urgency. I. The Rise and Fall of Gatekeeper Liability Under the Federal
- 212. Securities Laws In response to the stock market crash of 1929 and the subsequent Great Depression, Congress enacted The Securities Act of 1933 ("the '33 Act") and the Securities Exchange Act of 1934 ("the '34 Act).29 The '33 Act established registration requirements for securities issued on the primary market.30 The '34 Act provided for the regulation of securities trading, exchanges, and broker-dealers, and it established the Securities and Exchange Commission ("SEC").31 The four most important provisions for the imposition of liability upon gatekeepers for securities violations are Sections 11, 12(a)(1), and 12(a)(2) of the '33 Act, and Section 10(b) under the '34 Act.32 A. The Securities Act of 1933 1. Section 11 Section 11 of the '33 Act imposes strict liability on issuers for any material misstatement or omission in a registration statement.33 It also provides an express private right of action against "every accountant, engineer, or appraiser, or any person whose profession gives authority to a statement made by him, who has with his consent been named as having prepared or certified any part of [such] registration statement. . . ,"34 Through this provision, Congress arguably recognized a deterrence role for the gatekeeping professions in preventing the filing of materially false or misleading registration statements.35 However, Section 11 also provides a due
- 213. diligence defense for gatekeepers which can relieve them of liability if the defense is properly established.36 So while Section 11 is a strict liability regime for issuers, it is only a fault-based liability regime for gatekeepers.37 Furthermore, the courts will find gatekeepers liable under Section 11 only in very specific circumstances.38 In McFarland v. Memorex Corp., the district court held that "there is no accountant liability unless . . . misleading data [certified by the accountant in the registration statement] can be expressly attributed to the accountant."39 Therefore, Section 11 liability will not apply to an accountant unless she is an auditor or has otherwise lent her name to a registration statement.40 Similarly, attorneys who help prepare a registration statement generally cannot be held liable under Section 11 unless they act as "experts"41 or if they also serve as directors or officers of the company.42 A non-director, non-officer attorney is an "expert" within Section 11's statutory meaning only if she "expertises" a portion of the registration statement, usually by providing a legal opinion that is included within the statement.43 2. Section 12(a)(1) Section 12(a)(1) of the '33 Act provides that "[a]ny person who ... offers or sells a security in violation of [Section 544]... shall be liable .. . to the person purchasing such security from him . . . ,"45 This provision makes available an express private right of
- 214. action for a purchaser against a seller of securities found to be in violation of Section 5.46 In effect, Section 12(a)(1) was designed to enforce the registration requirements of Section 5.47 In Pinter v. Dahl, the Supreme Court held that "'seller' is not limited to an owner who passes title ... but extends to a broker or other person who successfully solicits a purchase of securities, so long as he is motivated at least in part by a desire to serve his own financial interests or those of the securities owner."48 So, theoretically, a gatekeeper as agent for the securities owner could be held liable under Section 12(a)(1) so long as she solicits the purchase of a security that is in violation of Section 5.49 However, on its face, Section 12(a)(1) imposes a privity requirement, and the Pinter Court recognized such in its opinion.50 Thus, the mere participation by a gatekeeper in the preparation of a registration statement is not enough to trigger liability under Section 12(a)(1).5' Indeed, even the substantial involvement in such preparation will not create liability unless the gatekeeper is also actively involved in the negotiations leading to the sale in question.52 Damages under Section 12(a) are limited to "the consideration paid for [the] security with interest thereon, less the amount of any income received thereon."53 3. Section 12(a)(2) Section 12(a)(2) of the '33 Act imposes the same level of
- 215. liability as 12(a)(1) for those who offer or sell securities and, in doing so, make omissions or untrue statements of material fact in prospectuses or oral communications.54 Just as in actions under 12(a)(1), gatekeepers must also be "sellers" under § 12(a)(2) in order to be found liable.55 Section 12(a)(2) is viewed as a strict liability provision,56 and unlike fraud claims under Rule 1 Ob-5,57 it is not necessary for the plaintiff to show either his or her own reliance or scienter on the part of the defendant.58 However, Section 12(a)(2) also offers defendants an affirmative defense if they can "sustain the burden of proof that [they] did not know, and in the exercise of reasonable care could not have known, of [the] untruth or omission."59 "Reasonable care" connotes negligence liability for gatekeeper sellers facing an action under § 12(a)(2).60 Such gatekeepers will be held liable unless they can show that their actions were reasonable, not just without recklessness or intent.61 B. The Securities Exchange Act of 1934 - Section 10(b) and Rule 10b-5 As can be seen, the '33 Act provides liability for gatekeepers only under specific limited circumstances.62 Gatekeepers have liability under the '33 Act (1) where the gatekeeper has made false statements in a registration statement that can be attributed to her, and (2) where the gatekeeper is an active seller of a security and the security is either unregistered and nonexempt, or the gatekeeper has made material misstatements
- 216. or omissions in oral communications or in the security's prospectus.63 Gatekeepers who commit securities fraud outside of these circumstances are most often subject to liability under Section 10(b) of the '34 Act.64. Section 10(b) makes it "unlawful for any person, directly or indirectly, . . . [t]o use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe . . . ."65 In 1942, the SEC promulgated Rule 10b-5 pursuant to its statutory authority under 10(b).66 Rule 10b-5 makes it unlawful through the use of an instrumentality or interstate commerce: (a) [t]o employ any device, scheme, or artifice to defraud, (b) [t]o make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) [t]o engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.67 The language of Rule 10b-5 has been described as open-ended and adaptable, allowing it to reach a wide variety of fraudulent schemes.68 1. Primary vs. Secondary Liability Generally, most securities violations have multiple participants,
- 217. ranging from directors, officers, and employees of a corporation to members of the gatekeeping professions whose services are employed by such a corporation.69 In a securities fraud action, the participants are classified as either primary violators or secondary violators.70 "A primary violator commits the act proscribed by the statute or rule; a secondary violator either assists or supports the primary violator ... ."71 A primary violation of Rule 10b-5 consists of six elements that a plaintiff has the burden of showing: "(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation."72 In Central Bank of Denver v. First Interstate Bank of Denver, the Supreme Court noted in dicta that gatekeepers such as lawyers, accountants, and bankers could be held liable as primary violators provided that "all of the requirements for primary liability under Rule 10b-5 are met."73 However, most gatekeeper defendants are alleged to be secondary violators.74 2. Aiding and Abetting Liability Gatekeeper defendants in Rule 10b-5 actions are generally alleged to be liable under aiding and abetting theories of secondary liability.75 Prior to the enactment of the Private Securities Litigation Act PSLRA of 1995 ("the PSLRA"),76 the SEC brought aiding and abetting claims mostly under concepts
- 218. that were well-established in criminal law77 and under joint tortfeasor liability theories developed in tort law.78 Later, in Brennan v. Midwestern United Life Insurance Co., the court concluded that the failure of Congress to enact specific language pertaining to aiding and abetting liability did not establish that such liability could not be imposed under Rule 10b-5.79 Therefore, the court held that aiding and abetting claims could proceed in actions under the Rule.80 A gatekeeper is found to be liable for aiding and abetting when she has knowingly or recklessly81 provided "substantial assistance" to a primary violator.82 The courts have generally required the satisfaction of three elements in order to successfully bring an aiding and abetting claim: "1) a violation by a primary violator; 2) knowledge by the secondary violator of the violation; and 3) the rendering of substantial assistance by the secondary violator."83 a. The Private Right of Action for Aiding and Abetting Liability The '34 Act does not expressly provide a private right of action under section 10(b).84 However, shortly after the SEC promulgated Rule 1 Ob-5, the federal courts beginning with Kardon v. National Gypsum Co. started recognizing an implied private right of action for violations of the rule.85 The Kardon court applied the tort law principle that the performance of an act prohibited by a statute that is meant to protect a third party's interest makes the actor liable for the invasion of that
- 219. interest.86 The court reasoned that since the entire '34 Act disclosed a broad purpose to eliminate manipulative or deceptive practices from securities transactions of all kinds, then the intention of the '34 Act therefore could not be to deny a remedy for such practices to private plaintiffs.87 In 1971, the Supreme Court gave formal recognition to this private right of action in Superintendent of Insurance of the State of New York v. Bankers Life and Casualty Company(TM) With this recognition came the ability for private plaintiffs to bring Rule 10b-5 actions against gatekeepers under aiding and abetting theories of liability, and plaintiffs routinely did so.89 However, shortly after recognizing the implied right of action, the Supreme Court began to pare it back.90 The Court's recognition in Superintendent came at a time when its willingness to recognize implied private rights of action had started to wane.91 Four years after Superintendent, in Blue Chip Stamps v. Manor Drug Stores, the Court ruled that in order to maintain a private action under Rule 1 Ob-5, the plaintiff must be either a purchaser or seller of the security or securities at issue.92 In a seeming rebuke to the reasoning of the Kardon court, Justice Rehnquist in his majority opinion expressed reservations about implying any Congressional intent to provide a private remedy under Section 10(b).93 A year later, in Ernst & Ernst v. Hochfelder, the Court held that plaintiffs must show that the defendant acted with scienter;
- 220. mere negligence would not be enough.94 In that case, the plaintiffs brought an action against the defendant accounting firm for aiding and abetting a brokerage in conducting a fraudulent securities scheme.95 In light of its holding that a showing of scienter is required for such claims, the Court reserved the question of whether civil liability for aiding and abetting was appropriate under Rule 10b-5.96 However, eighteen years later, the Court finally addressed that issue.97 b. Central Bank By 1994, every circuit court that considered the question recognized the existence of aiding and abetting liability under Rule 10b5.98 But to the surprise of the litigation bar99 and other observers,100 the Supreme Court reversed the course of such jurisprudence in Central Bank of Denver v. First Interstate Bank of Denver.'01 In that case, the Court held that "a private plaintiff may not maintain an aiding and abetting suit under section 10(b)" because "the text of § 10(b) does not prohibit aiding and abetting."102 In doing so, the Court explicitly rejected the holding and reasoning of Brennan v. Midwestern United Life Insurance.103 The Court noted its more recent decisions in Ernst & Ernst and another case,104 where it paid "close attention to the statutory text in defining the scope of conduct prohibited by § 10(b). . . ,"105 The Court ruled that the text of the statute controls its decision regarding such scope and that a "private plaintiff may not bring a 10b-5 suit against a
- 221. defendant for acts not prohibited by the text of § 10(b)."106 Thus, private plaintiffs could no longer bring aiding and abetting claims against gatekeepers in Rule 10b-5 actions.107 c. The Private Securities Litigation Reform Act ("PSLRA") While the Court's decision in Central Bank only expressly prohibited private plaintiffs from bringing aiding and abetting claims under section 10(b), the Court's reasoning that such claims were not within the scope of section 10(b)'s statutory text also on its face applied to SEC enforcement actions under 10(b).108 Fearing that this was now the case,109 Congress enacted the Private Securities Litigation Reform Act of 1995 ("the PSLRA").110 The act amended section 20(e) of the '34 Act to give the SEC the express authority to bring aiding and abetting claims against those who provided "substantial assistance" to primary violators.111 However, the PSLRA failed to reinstate the private right of action to bring such claims.112 At the time of publication of this Note, private plaintiffs still cannot bring aiding and abetting claims under Rule 10b-5 against gatekeepers; only the SEC can do so."3 Not only did the PSLRA fail to restore a private right of action for Rule 10b-5 aiding and abetting claims, it also heightened pleading standards for scienter by requiring that plaintiffs "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind."114 Congress was concerned that securities litigation had become too
- 222. "lawyer-driven," leading to excessive legal fees and plaintiffs who were unrepresentative of the class in which they served as the named plaintiff.115 Under this standard, a plaintiff must plead with particularity each statement alleged to be misleading and the basis of the plaintiffs belief as to why the alleged statements were misleading.116 Additionally, the PSLRA replaced joint and several liability with proportionate liability.117 d. The Aftermath of Central Bank and the PSLRA After the enactment of the PSLRA, there was a significant drop- off in the number of securities class action suits filed against at least one type of gatekeeper: accountants.118 A 1997 SEC study of the PSLRA's impact on securities litigation found a substantial decrease in the number of securities class actions following passage of the PSLRA.119 From 1990 through 1992, the study found that the total number of auditrelated suits filed against the then Big Six accounting120 firms each year were "192, 171, and 141, respectively."121 However, the study found that in 1996, the year after the PSLRA was enacted, out of 105 total classaction securities suits that year, accounting firms were named in just six of them.122 In his book, Gatekeepers: The Professions and Corporate Governance,123 Professor John C. Coffee Jr. of Columbia University discusses other accounting studies that show an increase in risky practices in the accounting industry.124 In the
- 223. early 1990s, major accounting firms were trying to reduce their exposure to litigation by adopting more cautious risk management policies.125 This included eliminating riskier companies from client rosters.126 However, after the passage of the PSLRA, the industry relaxed its risk management policies, took on riskier client portfolios, and its reporting strategies became less conservative.127 Professor Coffee summarizes these findings by remarking that "litigation exposure and accounting conservatism seem to be positively correlated."128 Indeed, there was also a marked increase in the number of financial restatements (i.e. companies issuing corrections to previously reported financial statements) in the years immediately following passage of the PSLRA.129 One study shows that financial restatements increased from an average of forty-nine per year from 1990 to 1997, to a total of ninetyone in 1998, 150 in 1999, and 156 in 2000.130 Another study from the General Accounting Office (GAO) found that from January 1997 to June 2002, approximately "ten percent of all listed companies announced at least one restatement."131 Companies that issued a restatement during this time period suffered on average an immediate ten percent decline in their stock prices,132 suggesting that investors were surprised and reacted by selling shares and sharply lowering the market value of restating companies.133 In 2002, eighty-five percent of all identified restatements came from companies listed on the
- 224. NYSE or NASDAQ,134 suggesting that such restatements were not confined to small inexperienced companies but instead reflected increased risktaking at larger more mature firms.135 The GAO found that the dominant reason for financial restatements from 1997 to 2002 was revenue recognition (i.e. misreported or non-reported revenue) issues, which accounted for thirty-nine percent of restatements.136 Restatements involving revenue recognition led to greater market losses than other types of restatements, accounting for over half of immediate market losses.137 Attempts by management to prematurely recognize revenue became the dominant cause of financial restatements.138 This period of lower risk management and riskier business practices by accounting firms culminated with the back-to-back accounting scandals of Enron and WorldCom, respectively.139 e. Stoneridge After Central Bank and the passage of the PSLRA, plaintiffinvestors sought new theories to hold secondary actors liable for securities violations.140 One such theory was "scheme liability."141 Under this theory, plaintiffs sought to use Rule 10b-5(a) and 10b-5(c)142 to hold secondary actors primarily liable if they commit a deceptive act in the process of aiding a primary violation.143 However, in Stoneridge Investment Partners, LLC v. ScientificAtlanta, the court held that such a theory of scheme
- 225. liability was not valid under section 10(b).144 The plaintiffs alleged that defendants Motorola and Scientific-Atlanta knowingly falsified contracts with defendant Charter Communications, Inc. in a scheme to artificially inflate earnings figures on Charter's financial statements.145 The court found that the plaintiffs did not establish the reliance element of primary liability because they did not rely on the statements of Motorola and Scientific-Atlanta.146 Therefore, the two defendants were not liable under Rule 10b-5.147 The Court reasoned that if it adopted scheme liability, it would in substance revive the private right of action for aiding and abetting that Central Bank had struck down and Congress had declined to revive in the PSLRA.148 The Court stated that the decision to expand the private right of action is for Congress, not the Court.149 Thus, a potential theory for holding gatekeepers liable under Rule 10b-5 as primary violators was quashed.150 f. Janus In Janus Capital Group, Inc. v. First Derivative Traders, the plaintiff shareholders contended that Janus Capital Group, Inc. (JCM) and its subsidiary, Janus Capital Management LLC (JCM) "materially mislead the investing public" with statements that they made in prospectuses for a family of mutual funds organized in a trust under the name Janus Investment Funds.151 After the Fourth Circuit reversed the lower court's dismissal of
- 226. the plaintiffs' claims, the Supreme Court granted certiorari "to address whether JCM can be held liable in a private action under Rule 10b-5 for false statements included in Janus Investment Fund's prospectuses."152 The Court stated that "[u]nder Rule 10b-5, it is unlawful for 'any person, directly or indirectly,... [t]o make any untrue statement of a material fact' in connection with the purchase or sale of securities, [citation omitted.]."153 To be liable, therefore, the Court said that JCM must have "made" the material misstatements in the prospectuses."154 The Court held that JCM, even though it administered the fund and prepared the prospectuses, did not "make" the statements within them that the plaintiffs alleged were false.155 The Court ruled that for claims under Rule 10b-5 alleging that a person made false statements, the "maker" of a statement "is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it."156 The Court further stated that "[o]ne who prepares or publishes a statement on behalf of another is not its maker."157 The Court analogized its rule tothe relationship between a speaker and a speechwriter: "[e]ven when a speechwriter drafts a speech, the content is entirely within the control of the person who delivers it[, a]nd it is the speaker who takes credit-or blame-for what is ultimately said."158 In a footnote, the Court explained that it was drawing
- 227. a clean line between [those who are primarily liable (and thus may be pursued in private suits) and those who are secondarily liable (and thus may not be pursued in private suits)]-the maker is the person or entity with ultimate authority over a statement and others are . 159 not. Thus, to be held primarily liable under Rule 10b-5 for a materially false or misleading statement, a gatekeeper must have "ultimate authority" over that statement.160 C. SARBANES-OXLEY AND DODD-FRANK Two recent major pieces of legislation have attempted to increase liability for and regulation of gatekeepers. This subsection examines them. 1. Sarbanes-Oxley Congress passed the Sarbanes-Oxley Act of 2002 in response to the waves of massive corporate accounting scandals from that time period such as Enron and WorldCom.161 The purpose of the legislation was to redesign the network of institutions and intermediaries that served investors in the capital markets in order to reduce deception and fraud.162 Sarbanes-Oxley created the Public Company Accounting Oversight Board (PCAOB).163 The PCAOB is charged with establishing quality control, auditing, and independence standards for accountants that perform auditing services for public companies.164 It is also charged with inspecting registered public accounting firms and establishing disciplinary
- 228. procedures for auditors and their firms.165 Section 102 of Sarbanes-Oxley requires all accounting firms that conduct audits of public companies to be registered with the PCAOB.166 This section essentially gives the PCAOB jurisdiction over every accounting firm in the industry.167 Commenters have suggested that the key to the PCAOB's success is its resistance to agency capture.168 Sarbanes-Oxley also took several steps to curtail conflicts of interest for auditors.169 Section 201 prohibits accounting firms from providing specific services to its audit clients, including management functions, human resources, appraisal services, fairness opinions, and legal services.170 The same section also prohibits accounting firms from performing audits on companies whose officers used to work for the accounting firm and participated in their current companies' audits.171 Finally, Section 301 called for issuers' independent audit committees to handle control and supervision of their outside auditors.172 Sarbanes-Oxley also gave the SEC greater authority to regulate securities lawyers.173 Section 307 of the law authorizes the SEC to establish "minimum standards of professional conduct for attorneys appearing and practicing before the Commission."174 Sarbanes-Oxley also established a "reporting up" requirement for securities lawyers.175 Attorneys are required to report evidence of "material" securities law violations by a company to its chief legal counsel or the
- 229. CEO.176 If the latter two parties do not "appropriately respond," then the attorney is required to report the evidence to the independent auditing committee of the company's board of directors.177 As a result of Sarbanes-Oxley, the SEC promulgated Rule 102(e) enabling the Commission to sanction gatekeepers for negligent behavior.178 However, Sarbanes-Oxley did nothing to enhance litigation remedies for private plaintiffs under Rule 10b-5.179 2. Dodd-Frank In response to the 2008 Financial Crisis, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act ("DoddFrank") in 2010.180 Its primary impact on gatekeeper liability was to expand the scienter requirement of aiding and abetting liability from "knowingly" to "knowingly or recklessly."181 This was done to counter "plausible deniability" defenses by gatekeepers who would argue that they merely served as functionaries to primary violators and did not meet the "knowledge" requirement of scienter.182 Dodd-Frank also affects credit ratings agencies in two ways.183 First, it lowers pleading standards for plaintiffs in actions against credit rating agencies.184 Second, it expressly establishes that "the enforcement and penalty provisions of the '34 Act shall apply to statements made by a credit rating agency in the same manner and to the same extent as such provisions
- 230. apply to statements made by a registered public accounting firm or a securities analyst under the securities laws."185 Once again though, Congress deferred reinstating the private right of action for aiding and abetting liability.186 II. Gatekeepers and Reputational Capital This Part explains the theory developed by several noteworthy commentators that gatekeepers serve as reputational intermediaries. It examines the theory that a gatekeeper's reputation is a capital asset and explains why it is sometimes rational for a gatekeeper to deplete its reputational capital by acquiescing to a client's fraud. A. The Reputation Model Under reputation theory, in industries where trust is essential, a gatekeeper's reputation is considered a valuable capital asset.187 It can be "pledged or placed at risk by the gatekeeper's vouching for its client's assertions or projections."188 Gatekeepers are trusted to the extent that they are repeat players who possess significant reputational capital that may be lost or destroyed if they are found to have condoned or aided wrongdoing.189 The model assumes that new companies begin without any reputation and must build it over time.190 If they wish to stay in business for the long-run, then they must invest in, develop, and maintain a good reputation.191 As long as the value of that reputational capital exceeds the expected profit from the client, the gatekeeper
- 231. should remain faithful to shareholders and refrain from supplying false or misleading certifications.192 Significantly, the reputation of gatekeepers is essential to the functioning of the capital markets.193 Investors rely on the information provided by gatekeepers to reduce information asymmetries between investors and issuers, thereby increasing transparency and reducing the cost of capital.194 Likewise, issuers make use of gatekeepers as "reputational intermediaries" in order to efficiently bolster their reputations for trustworthiness at a cost lower than if they attempted to build their reputations on their own.195 The reputation of the intermediary assures the investor that a company will use the investor's capital wisely and produce a good rate of return.196 Courts have recognized the role of gatekeepers in the capital markets as reputational intermediaries197 as well as the value of reputational capital.198 But in order for this model to work, investors need to trust that they are receiving objective and accurate information from gatekeepers.199 Information from an untrustworthy gatekeeper is worth little or nothing.200 In an economy with a dispersed ownership structure (i.e. companies with many diffuse shareholders like those in the U.S.), the role of reputational intermediaries becomes even more important.201 B. DISINCENTIVES FOR DEVELOPING A GOOD REPUTATION Conventional wisdom suggests that rational gatekeepers should
- 232. not be willing to risk losing their reputational capital on behalf of just one client.202 However, in theory, a rational gatekeeper will risk depleting at least some reputational capital so long as it seems that the gains from inaccurate or misleading statements exceed the costs.203 I. Conflicts of Interest Gatekeepers can face conflicts of interest that can cause them to rationally engage in reputation-depleting activities.204 This is largely due to what is arguably the source of gatekeeper conflicts of interest: the manner in which gatekeepers are compensated.205 Although they are hired to assure shareholders, gatekeepers are compensated by and take instructions from corporate management.206 One major conflict of interest that arose in the 1990s stemmed from accounting firms expanding their offerings by cross- marketing consulting services to their audit clients.207 This provided an additional incentive for these firms to acquiesce to their clients' demands.208 If they did not, the corporate client could not only cease its auditing business with that firm but also its consulting business.209 Professor Coffee points to the sharp rise in financial statement restatements in the late 1990s as strong evidence that auditors changed their behavior in the face of these new incentives that conflicted with the duties of a neutral auditor.210 He also notes that in spite of the market's clear aversion to financial restatements based on revenue
- 233. recognition issues, they became the most common form of earnings restatement in the late 1990s.211 Another possible source for conflicts of interest is the segmentation by gatekeeping firms of their clients into "regular" client groups and "special" (i.e., more profitable) client groups.212 Even though clients in both groups generally have similar contractual relationships with a given gatekeeping firm, the gatekeeper will invest more heavily in building relationships with the special, more profitable clients.213 While there is nothing illegal or unethical about this practice, if gatekeeping firms do not have proper internal controls in place, then this client segmentation can result in favoring clients in the special group at the expense of clients in the regular group.214 For instance, Professor Jonathan Macey points to persuasive evidence from the 2008 Financial Crisis that the credit rating agencies were less effective at rating structured assets for lucrative clients than they were for the bond issues of their traditional corporate and municipal customers.215 It is suspected that since the credit rating agencies received substantially higher fees from the former group, they exercised a lower standard of care in evaluating the risks of their structured products.216 2. The Last Period Problem Evidence also suggests that if a gatekeeper's large favored client is facing a "last period" scenario, the gatekeeping firm is
- 234. more likely to participate in the client's fraudulent scheme to artificially avoid or delay bankruptcy.217 Derived from game theory, the "last period problem" postulates that when a player knows that he is in the final period of a given timeframe, then any cooperative undertaking in which the player had engaged during the previous time periods deteriorates.218 The system of rewards and punishments that governed his behavior during the previous time periods no longer applies, and the player considers himself free to pursue more selfish objectives.219 For instance, in the classic prisoners' dilemma game, in which two prisoners in separate interrogation rooms must decide whether or not to inculpate the other, a cooperative strategy is appealing at first.220 However, if the prisoners are told that they only have one more chance to make a move, then the rational choice becomes to abandon the cooperative strategy and inculpate the other prisoner.221 In the business world, when an ordinarily risk-averse rational officer realizes that her firm is under potentially catastrophic stress due to business declines, she will suddenly become risk- prone and take aggressive and clandestine measures in order to avoid bankruptcy.222 Committing fraud to shore up her firm's stock price, preventing creditors from calling in debts, or simply buying more time becomes more appealing.223 Enron and Refco seem to fit this pattern, as managers, accountants, and lawyers at both companies were attempting to conceal
- 235. massive liabilities that would have most likely triggered bankruptcy.224 Theoretically, the dynamics of the end period problem apply to gatekeepers just as they do to issuers.225 If a gatekeeper finds itself in a last-period scenario, its reputational capital becomes virtually worthless.226 3. Competition Competition among gatekeepers can also significantly affect the quality of gatekeeper performance.227 Too much competition can pressure gatekeepers to acquiesce more to their clients' preferences out of fear of being replaced, while too little competition can cause gatekeepers to underperform.228 In the world of gatekeepers, the legal and securities research industries are characterized by active competition, while the accounting and credit rating industries are not.229 In a noncompetitive market, gatekeepers have reduced incentives to enhance existing controls, invest in new technology, or make overall improvements to their practices.230 Credit-ratings agencies (of which there are only two major ones231), for example, are slow to provide updated monitoring of financial instruments after their initial rating.232 Alternatively, in a highly competitive market, a gatekeeper may feel compelled to acquiesce to her corporate client's demands out of a fear of being easily replaced.233 However, a gatekeeper's willingness to resist client demands in a
- 236. competitive industry, or the temptation of complacency in a noncompetitive industry, depends on whether the gatekeeper faces either the loss of its reputational capital or litigation from investors.234 Competition can also induce desired behavior from gatekeepers but only to the extent that gatekeepers want to compete on the basis of reputation.235 However, up until the Enron debacle, it became clear that auditing firms at least were not competing on the basis of integrity or reporting accuracy but rather on flexibility and cooperation with clients.236 Issuers demanded that their accounting firms assist them with maximizing the firm's stock price by using any accounting methods that were not prohibited.237 Such incidents show that in a competitive market, a gatekeeper's maintenance of its reputational capital may lose out to other interests.238 C. The Market for Reputational Capital Professor Jonathan Macey theorizes that for market participants, laws and regulations are substitutes for reputational capital.239 As the amount of seemingly effective regulation for issuers and gatekeepers increases, the demand for reputational capital decreases.240 Consequently, gatekeepers in markets that are perceived to be effectively regulated, such as the United States, will be less willing to invest in their reputations.241 As proof of this theory, Professor Macey cites surveys showing that corporations in emerging economies (where regulations are less
- 237. developed) rank very high in terms of their reputations, and that corporate trust is higher in emerging economies and lower in developed economies (where regulation is more robust and effective).242 He argues that demand for reputation in the United States has collapsed since investors have become so heavily reliant on regulation, rather than the reputations of issuers or their gatekeepers, when making investment decisions.243 According to Professor Coffee, firms left with "excess" reputational capital cannot profit from it.244 D. PRIVATE LITIGATION AS A DETERRENT TO REPUTATION-DEPLETING ACTIVITIES Just as reputation theory explains why gatekeepers would choose to deplete their reputational capital, deterrence theory focuses on the expected liability of gatekeepers who do so.245 Prior to Central Bank and the PSLRA, auditors faced a very real risk of liability enforced by class action litigation.246 The plaintiffs bar was entrepreneurially motived by contingency fees and stood ready to act as private attorneys general for victims of securities fraud.247 However, once private plaintiffs could no longer bring aiding and abetting lawsuits against gatekeepers, the risk of liability became substantially less.248 Enforcement of such liability now fell to one overburdened agency, the SEC, who in the late 1990s was scaling back enforcement against the major accounting firms and who was also facing budgetary shortfalls.249
- 238. 1. The Expected Value of Fraud In describing how Sarbanes-Oxley failed to reinstate a private right of action for aiding and abetting liability,250 Professor Coffee concludes that: while the potential benefits from acquiescing in accounting irregularities appear to have been reduced for auditors, the expected costs to them from such acquiescence also remain low because the level of deterrence that they once faced has not been restored. 251 Implicitly, Professor Coffee is invoking the finance principle of "expected value" or "expected return."252 Expected value is calculated by multiplying each possible outcome of a given scenario with the likelihood that the given outcome will occur and then summing the totals.253 Inferentially, in the world of gatekeeping liability, the expected value of acquiescing to an issuer's accounting fraud is a scenario with two possible outcomes: (1) the gatekeeper has a successful civil action filed against it, or (2) the gatekeeper does not have a successful civil action filed against it.254 The following hypotheticals will illustrate two possible expected values for these outcomes.255 Hypothetical #1 An accounting firm is contemplating whether to acquiesce to its biggest client's demand to help it commit fraud.256 If the firm acquiesces and is not caught, then the client will contribute a
- 239. fifteen percent increase in the firm's net worth over the next year.257 However, if the firm is caught and a successful civil action is filed against the company, the firm will face a huge loss of seventy percent of its net worth, with fifty percent of that loss constituting payments of damages, fines, and penalties, and the other twenty percent consisting of lost business due to the firm's tarnished reputation.258 With a private right of action for aiding and abetting liability in place, the risk of litigation (i.e. the probability of being caught) is thirty-five percent, which means the chance that no litigation will occur is sixty- five percent.259 Therefore, the expected value of acquiescing to the client's demand is (0.35 x -0.7) + (0.65 x 0.15) = -0.15. (See Table 1 below).260 With a negative expected value of acquiescing, the accounting firm would rationally choose not to do so.261 Hypothetical #2 This hypothetical has the same conditions as Hypothetical #1 except there is no private right of action for aiding and abetting liability.262 This has the effect of reducing the risk of litigation (i.e. the risk of being caught) to ten percent, which means that the chance of no litigation occurring is ninety percent.263 Therefore, the expected value of acquiescing to the client's demand here is (0.10 x -0.7) + (0.90 x 0.15) = 0.07 (see Table 2 below).264 With a positive expected value of seven percent, the accounting firm would rationally choose to acquiesce to its
- 240. client's demand to help it commit fraud.265 These scenarios suggest that under the right circumstances, even with the possibility of massive losses resulting from being caught, gatekeepers can be rationally motivated to aid and abet their client's fraudulent endeavors if the risk of being caught is low enough.266 III. CONGRESS SHOULD RESTORE THE PRIVATE RIGHT OF ACTION FOR AIDING AND ABETTING LIABILITY If courts and law enforcement officials truly expect gatekeepers to serve as reputational intermediaries,267 then the need to reinstate private aiding and abetting liability gains additional urgency.268 The current legal framework does not provide the market with a strong enough incentive to demand that gatekeepers invest in their reputations.269 In fact, assuming that Professor Macey's theories are correct, it is quite the opposite.270 The increase in regulation on gatekeepers from recent reforms such as Dodd-Frank and Sarbanes-Oxley is having the effect of further driving down the value of gatekeepers' reputational capital.271 Perversely, this can provide an even larger incentive for gatekeepers to aid and abet a client's fraud, especially if that client is, for instance, a large favored client facing a "last period" scenario.272 The problem is also compounded for gatekeepers either in highly competitive industries273 or who have conflicts of interest that encourage reputationdepleting activities.274 Under a decreased threat of
- 241. litigation, the expected costs of participating in fraud decrease, making its expected value more positive.275 To prevent such temptations and increase the incentive for gatekeepers to act as reputational intermediaries, Congress must restore the private remedy.276 It would be perfectly reasonable for Congress to cap damages under such a regime.277 After all, the goal ultimately is deterrence for gatekeepers, not insolvency.278 But regardless of damages, by providing investors the ability to hold gatekeepers accountable for the market information they generate, one improves the functioning of the securities markets by creating more trust in an industry where trust is essential.279 It was surely no coincidence that a period of major accounting scandals followed shortly after Central Bank and the PSLRA significantly reduced the threat of litigation for gatekeepers.280 Basic principles of finance and economics show that when the probability of a negative outcome to an action decreases, its costs relative to its benefits also decrease.281 While Sarbanes- Oxley was enacted in part to mitigate this more "permissive" environment for gatekeepers,282 the Refco debacle and the Financial Crisis provide strong evidence that its reforms were not enough.283 A plaintiffs' bar acting as private attorneys general and supplementing the efforts of the SEC and the PCAOB may have averted or at least somewhat alleviated these crises.284 As it stands now though, these two government agencies are the only entities with the power to civilly enforce
- 242. the relevant securities laws.285 Therefore, the likelihood and frequency of litigation that holds gatekeepers accountable for aiding and abetting fraud is substantially decreased.286 As Judge Lynch's comments in In re Refco seem to suggest, it is incongruous that while most criminal defendants convicted under accomplice liability theories can also be held civilly liable by their victims, the victims of criminal securities frauds cannot similarly sue the gatekeeper "accomplices" who helped perpetrate them.287 Since the defendant corporation is most likely insolvent in such cases, aiding and abetting liability could potentially provide private plaintiffs with their sole means of restitution.288 But victims of securities frauds with judgment proof bankrupt defendants are currently stymied by the lack of a private aiding and abetting remedy.289 Unless they can successfully develop theories of liability under sections 11 or 12 of the '33 Act or of primary liability under section 10(b) of the '34 Act, then the courthouse door is effectively shut for them.290 The holdings of Stoneridge and especially Janus ensure that holding a gatekeeper liable for a primary violation will be very difficult.291 CONCLUSION Gatekeepers in the United States currently have little incentive to build or preserve the reputational capital necessary to effectively serve in their expected roles of reputational intermediaries. In a highly regulated securities market like the
- 243. United States, regulation must be combined with the credible deterrent threat of litigation in order to provide that incentive. History and mathematics show that when the risk of litigation decreases, the incidence of fraud and accounting irregularities increases. The private remedies under the '33 Act are too limited in scope to provide effective deterrence for gatekeepers who are tempted to acquiesce to their clients' fraudulent schemes. Also, the SEC and PCAOB are vulnerable to agency capture, budget cuts, and other limitations. The scope, scale, and the profusion of securities and accounting frauds are too much for only one or two agencies to handle, regardless of how competent and diligent they are. Plaintiffs as private attorneys general can provide much needed reinforcements. Therefore, Congress should restore the private right of action under Rule 10b-5 for aiding and abetting liability. Footnote 1. In re Refco, Inc. Sec. Litig., 609 F. Supp. 2d 304, 319 n.15 (S.D.N.Y. 2009), aff'd sub nom. Pac. Inv. Mgmt. Co. LLC v. Mayer Brown LLP, 603 F.3d 144 (2d Cir. 2010). 2. John C. Coffee, Gatekeepers: The Role of the Professions and Corporate Governance 103 (2006). 3. In re Refco, 609 F. Supp. 2d at 306-09. 4. Bob Van Voris, Ex-Refco Lawyer Guilty of Aiding $2.4 Billion Fraud, Bloomberg (Nov. 17, 2012), available at http://www.bloomberg.com/news/print/ 2012-11-16/ex-refco-
- 244. lawyer-guilty-of-aiding-2-4-billion-fraud.html. Footnote 5. See In re Refco, 609 F. Supp. 2d at 318-19. 6. Coffee, supra note 2, at 55. 7. See id. 8. See id. at 83 ("When a restatement calls management's credibility into question ... the market reaction is ... severe."). 9. See Richardson et al., Predicting Earnings Management: The Case of Earnings Restatements, at 16 (Oct. 2002), available at http://ssm.com/abstract=338681 (measured over a time period of 120 days before the announcement of the restatement to 120 days after the announcement). 10. See Andrew F. Tuch, Multiple Gatekeepers, 96 Va. L. Rev. 1583, 1608-09 (2010). 11. See, e.g., Pac. Inv. Mgmt. Co. LLC v. Mayer Brown LLP, 603 F.3d 144, 156 (2d Cir. 2010) ("Where statements are publicly attributed to a well-known national law or accounting firm, buyers and sellers of securities (and the market generally) are more likely to credit the accuracy of those statements."); see also, e.g., United States v. Arthur Young & Co., 465 U.S. 805, 817-18 (1984) ("By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function
- 245. owes ultimate allegiance to the corporation's creditors and stockholders, as well as to investing public."); DiLeo v. Ernst & Young, 901 F.2d 624, 629 (7th Cir. 1990) ("An accountant's greatest asset is its reputation for honesty, followed closely by its reputation for careful work."). Footnote 12. Jonathan Macey, The Value of Reputation in Corporate Finance and Investment Banking (and the Related Roles of Regulation and Market Efficiency), 22 J. Applied Corp. Fin. 18, 18 (Fall 2010), available at http://ssm.com/abstract= 1733798. 13. Jonathan Macey, The Demise of the Reputational Model in Capital Markets: The Problem of the "Last Period Parasites", 60 Syracuse L. Rev. 427, 436 (2010) [hereinafter Demise of the Reputational Model]. 14. Coffee, supra note 2, at 9. 15. See Macey, supra note 12, at 19. 16. See Coffee, supra note 2, at 4 (noting that "reputational intermediaries face losses that exceed the likely one-time gain from acquiescence in fraud ... "). 17. See generally In re Refco, Inc. Sec. Litig., 609 F. Supp. 2d 304 (S.D.N.Y. 2009), aff'd sub nom. Pac. Inv. Mgmt. Co. LLC v. Mayer Brown LLP, 603 F.3d 144 (2d Cir. 2010) (lawyers helped to fraudulently conceal massive company debt); In re Enron Corp. Sec., Derivative & "ERISA" Litig., 439 F. Supp. 2d 692 (S.D. Tex. 2006) (accountants helped to fraudulently
- 246. conceal debt and create the appearance that Enron was healthy); In re WorldCom, Inc. Sec. Litig., 352 F. Supp. 2d 472, 480 (S.D.N.Y. 2005) (auditors aided fraud by certifying company's fraudulent financial statements). 18. See Mark Klock, Improving the Culture of Ethical Behavior in the Financial Sector: Time to Expressly Provide for Private Enforcement Against Aiders and Abettors of Securities Fraud, 116 Penn St. L. Rev. 437, 467 (2011) (lamenting that without a private right of action, only the SEC can enforce aiding and abetting liability, but the SEC cannot pursue all such cases). Footnote 19. Cent. Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 191 (1994). 20. Pub. L. No. 104-67, 109 Stat. 737 (codified as amended in scattered sections of 15 U.S.C.). 21. See id. § 104 (codified as amended at 15 U.S.C. § 78t(e) (2012)). 22. See, e.g., United States General Accounting Office, GAO- 03-138, Report to the Chairman, Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Financial Statement Restatements: Trends, Market Impacts, Regulatory Responses and Remaining Challenges, 6 (October 2002), available at http://www.gao.gov/new.items/d03138.pdf (last accessed Nov. 28, 2014) [hereinafter GAO Study], 23. Coffee, supra note 2, at 317.
- 247. 24. See generally Coffee, supra note 2; Macey, supra note 12; Demise of the Reputational Model, supra note 13; Frank Partnoy, Barbarians at the Gatekeepers?: A Proposal for A Modified Strict Liability Regime, 79 Wash. U. L.Q. 491 (2001) (elaborating on the theory of reputational capital and how the theory helps to explain why gatekeepers would aid and abet fraud). 25. Coffee, supra note 2, at 3. 26. See infra Part II. 27. See John C. Coffee, Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms, 84 B.U. L. Rev. 301, 337 (2004) [hereinafter Gatekeeper Failure]. Footnote 28. See Klock, supra note 18, at 493 (calling for the same action by Congress). 29. Erin L. Massey, Control Person Liability Under Section 20(a): Striking A Balance of Interests for Plaintiffs and Defendants, 6 Hous. Bus. & Tax L.J. 109, 11112 (2005). 30. Thomas L. Hazen, The Law of Securities Regulation § 1.2[3][A] (6th ed. 2009). 31. Id. § 1.2[3][B], 32. Carsten Gemer-Beuerle, The Market for Securities and Its Regulation Through Gatekeepers, 23 Temp. Int'l&Comp. L.J. 317, 333 (2009). Footnote
- 248. 33. 15 U.S.C. § 77k(a)(l) (2012). 34. Id. § 77k(a)(4). 35. See Shuenn (Patrick) Ho, A Missed Opportunity for "Wall Street Reform Secondary Liability for Securities Fraud After the Dodd-Frankact, 49 HARV. J. ON LEGIS. 175, 184 (2012) ("In the past, Congress has recognized that gatekeepers are uniquely placed to detect and block fraudulent transactions and explicitly adopted a strategy of imposing civil liability on gatekeepers such as accountants and appraisers to deter the filing of false securities registration statements.") (citing 15 U.S.C. § 77k(a)(l)(4)). 36. 15 U.S.C. §77k(b)(3). 37. Tuch, supra note 10, at 1636. 38. See, e.g., Herman & MacLean v. Huddleston, 459 U.S. 375, 386 n.22 (1983); McFarland v. Memorex Corp., 493 F. Supp. 631, 643 (N.D. Cal. 1980) (holding that "there is no accountant liability unless . . . misleading data can be expressly attributed to the accountant"); Escott v. BarChris Const. Corp., 283 F. Supp. 643, 683 (S.D.N.Y. 1968) (attorneys who help prepare a registration statement generally cannot be held liable under Section 11 unless they act as "experts"). 39. McFarland, 493 F. Supp. at 643. Footnote 40. Hazen, supra note 30, § 7.3[10]. 41. Huddleston, 459 U.S. at 386 n.22.
- 249. 42. Hazen, supra note 30, § 7.3[ 10]. 43. Ben D. Orlanski, Whose Representations Are These Anyway? Attorney Prospectus Liability After Central Bank, 42 UCLA L. Rev. 885, 904 (1995); see also BarChris, 283 F. Supp. at 683 ("To say that the entire registration statement is expertised because some lawyer prepared it would be an unreasonable construction of the statute."). 44. Section 5 of the '33 Act provides that all securities not exempted from doing so by other provisions in the Act must be registered. 15 U.S.C. § 77e(c) (2012). 45. 15 U.S.C. § 771(a)(1). 46. Id.; see also Hazen, supra note 30, § 7.2[ 1 ]. 47. Hazen, supra note 30, § 7.2[1], 48. Pinter v. Dahl, 486 U.S. 622, 623 ( 1988). Footnote 49. See id. 50. See id. at 642 ("At the very least... the language of § 12[(a)](l) contemplates a buyer-seller relationship not unlike traditional contractual privity."). 51. Hazen, supra note 30, § 7.2[2]. 52. See In re DDi Corp. Sec. Litig., No. CV 03-7063, 2005 WL 3090882, at *18 (C.D. Cal. July 21, 2005); see also Junker v. Crory, 650 F.2d 1349, 1360 (5th Cir. 1981) (holding an attorney to be "an active negotiator in the transaction" and liable under Section 12(a)(1)).
- 250. 53. 15 U.S.C. § 771(a) (2012). 54. See id. § 771(a)(2); Wright v. Nat'l Warranty Co., 953 F.2d 256, 262 n.3 (6th Cir. 1992) ("In order to establish a section 12(2) violation, a plaintiff must show that (1) defendants offered or sold a security, (2) by the use of any means of communication in interstate commerce; (3) through a prospectus or oral communication; (4) by making a false or misleading statement of a material fact or by omitting to state a material fact; (5) plaintiff did not know of the untruth or omission; and (6) defendants knew, or in the exercise of reasonable care could have known of the untruth or omission."). 55. See In re Morgan Stanley Info. Fund Sec. Litig., 592 F.3d 347, 359 (2d Cir. 2010) (". . . the list of potential defendants in a section 12(a)(2) case is governed by a judicial interpretation of section 12 known as the 'statutory seller' requirement.") (citing Pinter, 486 U.S. at 643-47). 56. See Jack E. Kams et. al., Accountant and Attorney Liability As "Sellers " of Securities Under Section 12(2) of the Securities Act of 1933: Judicial Rejection of the Statutory, Collateral Participant Status Cause of Action, 74 Neb. L. Rev. 1, 3 (1995) ("The reason that investors have persistently sought to establish liability against attorneys and accountants under section 12, is that the provision is viewed as imposing strict liability on anyone violating it."). Footnote
- 251. 57. See infra Part II.B. 58. Hazen, supra note 30, § 7.6[1]; see also Wright, 953 F.2d at 262 ("... reliance on alleged misrepresentations or omissions is not an element of a section 12[(a)](2) cause of action."). 59. 15 U.S.C. § 771(a)(2). In 2005, the SEC promulgated a rule clarifying that the "know, and . . . could not have known" language of § 12(a)(2) means "knowing at the time of sale." 17 C.F.R. § 230.159(c). 60. 15 U.S.C. § 771(a)(2); see also Partnoy, supra note 24, at 515 (". . . § 12(a)(2) imposes negligence liability on issuers and gatekeepers selling a security using a prospectus (or oral statement) that is false or misleading ...."). 61. Partnoy, supra note 24, at 515. 62. See supra Part I.A. 63. See infra Part II.A. 64. Cf. John C. Coffee, Jr., Partnoy 's Complaint: A Response, 84 B.U. L. Rev. 377, 378 (2004) (". . . most securities class actions are brought . . . with respect to the secondary market (where scienter must be proven before the issuer can be held liable under Rule 10b-5)."); Assaf Hamdani, Gatekeeper Liability, 77 S. Cal. L. Rev. 53, 62 (2003) ("The general prohibition on fraud under Rule 10b-5 covers an unlimited number of transactions and an undefined range of capital-market participants."); Evaluating S. 1551: The Liability for Aiding and Abetting Securities Violations Act of 2009: Hearing Before the
- 252. Subcomm. on Crime and Drugs of the S. Comm, on the Judiciary, 111th Cong. 2-4 (2009) (testimony of Professor John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia University Law School) (commenting that most fraud by gatekeepers will go undetected if the private right of action for aiding and abetting liability under § 10(b) is not restored) [hereinafter Hearing on S. 1551], Footnote 65. 15 U.S.C. § 78j(2)(b). Section 10(b) is often described as a "catchall" provision. See, e.g., Chiarella v. United States, 445 U.S. 222, 234-35 (1980) ("Section 10(b) is aptly described as a catchall provision, but what it catches must be fraud."). 66. James D. Cox et al., Securities Regulation Cases and Materials 695 (7th ed. 2013). 67. 17 C.F.R. § 240.10b-5 (2015). 68. See Donald C. Langevoort, Rule I Ob-5 As an Adaptive Organism, 61 Fordham L. Rev. S7, S19-S21 (1993) (describing the benefits of the ambiguity of Rule 10b-5's language). Footnote 69. Cox ET al., supra note 66, at 795. 70. Id. 71. Id. (italics in the original). 72. See Janus Capital Grp., Inc. v. First Derivative Traders, 131 S. Ct. 2296, 2301 n.3 (2011). 73. Cent. Bank of Denver v. First Interstate Bank of Denver,
- 253. 511 U.S. 164, 191 (1994). 74. See Cox et al., supra note 66, at 795 (listing secondary violators as "lawyers, accountants, and banks, to mention just a few . . . ."); see also Ho, supra note 35, at 183-84 (discussing the rationale for extending secondary liability to gatekeepers such as "auditors, credit rating agencies, investment bankers, and lawyers ... "). 75. Cox ET AL., supra note 66, at 796. 76. See infra Part II.B.2.C. 77. See, e.g., SEC v. Timetrust, Inc., 28 F. Supp. 34, 43 (N.D. Cal. 1939) (permitting aiding and abetting due to the precedent set in criminal cases). Footnote 78. William H. Kuehnle, Secondary Liability Under the Federal Securities LawsAiding and Abetting Conspiracy, Controlling Person, and Agency: Common-Law Principles and the Statutory Scheme, 14 J. Corp. L. 313, 321-22 (1989) ("Although aiding and abetting liability generally is not provided expressly for under the federal securities laws, courts almost universally have been willing to infer joint tortfeasor liability for aiding and abetting, utilizing the statement of liability in section 876(b) of the Restatement.") (internal citations omitted). Restatement (Second) of Torts § 876 (1979) provides that "[f]or harm resulting to a third person from the tortious conduct of another, one is subject to liability if he ... knows that the other's conduct
- 254. constitutes a breach of duty and gives substantial assistance or encouragement to the other so to conduct himself...." 79. Brennan v. Midwestern United Life Ins. Co., 259 F. Supp. 673, 680-81 (N.D. Ind. 1966). 80. Id. 81. The Dodd-Frank Act added the words "or recklessly" after the word "knowingly" in § 20(e) of the '34 Act. See infra note 181. 82. See 15 U.S.C. § 78t(e) (2012). 83. Kuehnle, supra note 78, at 322 (citing cases articulating various formulations of the three elements). 84. Ronald J. Colombo, Cooperation with Securities Fraud, 61 Ala. L. Rev. 61, 67 (2009). Footnote 85. Kardon v. Nat'l Gypsum Co., 69 F. Supp. 512, 513-14 (E.D. Pa. 1946). 86. Id. at 513. 87. Id. at 514. 88. 404 U.S. 6, 13 n.9 (1971) ("It is now established that a private right of action is implied under § 10(b)."). 89. See Cox ET AL., supra note 66, at 796 ("For three decades [before Central Bank in 1994], accountants, lawyers, underwriters, banks, and others were routinely held liable under Section 10(b) and Rule 10b-5 of the ['34 Act] on the ground [that] they had aided and abetted their client's violation.").
- 255. 90. See, e.g., Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 754-55 (1975) (discussed herein); Emst & Emst v. Hochfelder, 425 U.S. 185, 187-88 (1976) (discussed herein). 91. See Corr. Servs. Corp. v. Malesko, 534 U.S. 61, 67 (2001) (". . . we have retreated from our previous willingness to imply a cause of action where Congress has not provided one .... Just last Term it was noted that we 'abandoned' the view of Borak decades ago, and have repeatedly declined to 'revert' to 'the understanding of private causes of action that held sway 40 years ago.'" (quoting Alexander v. Sandoval, 532 U.S. 275, 287 (2001))). 92. Blue Chip Stamps, 421 U.S. at 754-55. Footnote 93. See id. at 737 ("... it would be disingenuous to suggest that either Congress in 1934 or the Securities and Exchange Commission in 1942 foreordained the present state of the law with respect to Rule 10b-5. It is therefore proper that we consider . . . what may be described as policy considerations when we come to flesh out the portions of the law with respect to which neither the congressional enactment nor the administrative regulations offer conclusive guidance."). Rehnquist also stated that "[w]hen we deal with private actions under Rule 10b-5, we deal with a judicial oak which has grown from little more than a legislative acorn." Id. 94. Ernst & Ernst, 425 U.S. at 187-88.
- 256. 95. Id. at 188-90. 96. Id. at 191 n.7. Six years later, the Court had another chance to reach the question but again declined to do so. See Herman & MacLean v. Huddleston, 459 U.S. 375,379 n.5 (1983). 97. See Cent. Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 191 (1994) (discussed herein). 98. Hazen, supra note 30, § 7.13[1][A], 99. Cox ET AL., supra note 66, at 796. 100. Hazen, supra note 30, § 7.13[1][A], 101. Cent. Bank of Denver, 511 U.S. at 191. Footnote 102. Id. at 191. 103. See supra Part LB.2. 104. Santa Fe Indus, Inc. v. Green, 430 U.S. 462,477 (1977). 105. Cent. Bank of Denver, 511 U.S. at 169. 106. Id. at 173. 107. Id. 108. See id. at 192 (reasoning that the text of section 10(b) itself does not prohibit aiding and abetting). 109. Matthew P. Wynne, Rule I0b-5(b) Enforcement Actions in Light of Janus: Making the Case for Agency Deference, 81 FORDHAM L. Rev. 2111, 2120 (2013). 110. Pub. L. No. 104-67, 109 Stat. 737 (codified as amended in scattered sections of 15 U.S.C.). 111. Id. § 104 (codifiedas amended at 15 U.S.C. § 78t(f)
- 257. (2012)). 112. Wynne, supra note 109, at 2120. 113. Klock, supra note 18, at 467. Footnote 114. 15 U.S.C. § 78u-4(b)(2)(A); see also Elizabeth Cosenza, Is the Third Time the Charm? Janus and the Proper Balance Between Primary and Secondary Actor Liability Under Section 10(b), 33 Cardozo L. Rev. 1019, 1029-30 (2012) (PSLRA was enacted in 1995 and included "a heightened pleading standard for allegations of scienter in section 10(b) cases."). The accounting industry lobbied aggressively for the passage of the PSLRA. See Coffee, supra note 2, at 363. 115. See Coffee, supra note 2, at 337. 116. Cosenza, supra note 114, at 1030. 117. Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67 § 201, 109 Stat. at 758-62. 118. Office of the Gen. Counsel, U.S. Sec. & Exch. Comm'n, Report to the President and the Congress on the first Year of Practice Under the Private Securities Litigation Reform Act of 1995, at 2, 73 (1997), available at http://www. sec.gov/news/studies/lreform.txt [hereinafter SEC Study]. 119. Id. at 1. 120. "The Big Six firms were Arthur Andersen LLP, Deloitte &Touche LLP, Ernst & Young LLP, KPMG LLP, Price Waterhouse, and Coopers Lybrand." Coffee, supra note 2, at 73
- 258. n.33. Footnote 121. SEC Study, supra note 118, at 21. 122. Id. 123. Coffee, supra note 2, at 61. 124. Id. 125. Id. 126. Id. 127. Id. 128. Id. 129. Id. at 57. 130. See George B. Moriarty & Phillip B. Livingston, Quantitative Measures of the Quality of Financial Reporting, 17 Fin. Exec. 53, 54 (July/August 2001), available at EBSCOhost, Accession No. 11873640. 131. See GAO Study, supra note 22, at 4. Footnote 132. Id. at 5 (measuring stock prices on the basis of a company's three-day price movement starting from the trading day before the announcement and ending at the trading day following the announcement). 133. Coffee, supra note 2, at 59. 134. GAO Study, supra note 22, at 4. 135. Coffee, supra note 2, at 58. 136. GAO Study, supra note 22, at 5. The other reason
- 259. categories were "Cost/Expense" (15.7%), "Other" (14.1%), "Restructuring/assets/inventory" (8.9%), "Acquisition/merger" (5.9%), "Securities-related" (5.4%), "Reclassification" (5.1%), "In-process research and development" (3.6%), and "Related- party transactions" (3.0%). See id. at 21-22 (figures and full definitions of these reason categories). 137. Id. at 5. 138. Coffee, supra note 2, at 59. 139. See id. at 16 (discussing how Congress increased regulations on auditors with the Sarbanes-Oxley Act after the Enron and Worldcom scandals). 140. Cosenza, supra note 114, at 1050. Footnote 141. Id. at 1051-52; see also In re Enron Corp. Sec., Derivative & "ERISA" Litig., 439 F. Supp. 2d 692, 723 (S.D. Tex. 2006) (court considers "the issue of loss causation in scheme liability"). 142. See infra Part II.B. 143. Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 552 U.S. 148,162 (2008). 144. Id. at 162-63. 145. Id. at 153-55. 146. Id. at 159. 147. Id. 148. See id. at 162-63 ("Petitioner's view of primary liability
- 260. makes any aider and abettor liable under § 10(b) if he or she committed a deceptive act in the process of providing assistance. Were we to adopt this construction of § 10(b), it would revive in substance the implied cause of action against all aiders and abettors except those who committed no deceptive act in the process of facilitating the fraud . . . .") (citation omitted). 149. Id. at 165. 150. Klock, supra note 18, at 453. Footnote 151. 131 S.Ct. 2297, 2301 (2011). 152. Id. 153. Id. 154. Id. 155. Id. 156. Id. at 2302. 157. Id. 158. Id. Footnote 159. Id. at2302n,6. 160. See, e.g., SEC v. Garber, 959 F. Supp. 2d 374, 381 (S.D.N.Y. 2013); SEC v. Merkin, No. 11-23585-CIV, 2012 WL 5245561, at *6 (S.D. Fla. Oct. 3, 2012); SEC v. Boyd, No. 95- CV-03174-MSK-MJW, 2012 WL 1060034, at *7 (D. Colo. Mar. 29, 2012), reconsideration denied, No. 95-CV-03174-MSK-
- 261. MJW, 2012 WL 4955244 (D. Colo. Oct. 17, 2012) ("Under Janus, an attorney who prepares a false statement to be disseminated to investors can be liable for the contents of that statement if the attorney has the ultimate authority over the contents and dissemination of the statement, but not where the attorney is simply preparing the statement at the direction of a client who is controlling the contents of that statement."). 161. Coffee, supra note 2, at 16. 162. Id. 163. Sarbanes-Oxley Act of 2002, Pub. Law 107-204 § 101, 116 Stat. 745, 750 (2002) (codified at 15 U.S.C. § 7211(a) (2012)). 164. Id. § 103, 116 Stat. at 755 (codified as 15 U.S.C. § 7213). 165. Id. §§ 104-105, 116 Stat. at 757-759 (codified as 15 U.S.C. §§ 7214-7215). Footnote 166. Id. § 102(a), 116 Stat. at 753 (codified at 15 U.S.C. § 7212(a)). 167. Celia R. Taylor, Breaking the Bank: Reconsidering Central Bank of Denver After Enron and Sarbanes-Oxley, 71 Mo. L. Rev. 367, 381 (2006). 168. See, e.g., William W. Bratton, Enron, Sarbanes-Oxley and Accounting: Rules Versus Principles Versus Rents, 48 VlLL. L. REV. 1023, 1032 (2003) (discussing the PCAOB, "[t]he agency delegation model works well only so long as the agency successfully resists capture by the interests of the actors it
- 262. regulates"). 169. Coffee, supra note 2, at 333. 170. Sarbanes-Oxley Act § 201(g), 116 Stat. 771 (codified at 15 U.S.C. § 78j-l(g)). 171. Id. § 206(1) (codified at 15 U.S.C. § 78j-l(l)). 172. Id. § 301(m)(3)(A) 116 Stat. 771 (codified as amended at 15 U.S.C. § 78jl(m)(3)(A)); see also Gatekeeper Failure, supra note 27, at 336 (explaining how Sarbanes-Oxley transferred control and supervision of auditors to the audit committee to address concerns about management compromising auditors). 173. Sarbanes-Oxley Act § 307, 116 Stat. 784 (codified at 15 U.S.C. § 7245) (discussed herein). 174. Id. 175. Taylor, supra note 167, at 383. 176. Sarbanes-Oxley Act § 307, 116 Stat. 784 (codified at 15 U.S.C. § 7245). Footnote 177. Id. Section 10A of the '34 Act imposes similar duties on auditors. The auditor is required to report evidence of a material illegal action to the issuer's management. If the auditor later discovers that the illegal act is material, the auditor must report this fact to management, who then has one business day to inform the SEC and to provide notice to the auditor of doing so. If the auditor does not receive such notice, then she must either resign or provide the SEC with a report of her findings. See 15
- 263. U.S.C. § 78j- 1(b). 178. 17C.F.R. §201.102(e)(iv). 179. Gatekeeper Failure, supra note 27, at 336 (noting that Sarbanes-Oxley does nothing to increase the deterrent threat for gatekeepers). 180. Helene Cooper, Obama Signs Overhaul of Financial System, N.Y. TIMES, July 22, 2010, at B3, available at http://www.nytimes.com.ezproxy.nu.edu/2010/07/22/business/ 22regulate.html?_r=0&pagewanted=print. 181. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. Law 111203, § 9290, 124 Stat. 1376, 1861 (codified at 15 U.S.C. § 78t(e)) [hereinafter DoddFrank], 182. Tuch, supra note 10, at 1655. 183. See infra notes 186-87. 184. Dodd-Frank § 933(b), 124 Stat. 1883 (codified at 15 U.S.C. § 78u-4(b)(2)(B)). Footnote 185. Id. § 933(a), 124 Stat. 1872 (codified at 15 U.S.C. § 78o- 7). 186. See id. § 929Z (instructing the GAO to "conduct a study on the impact of authorizing a private right of action against any person who aids or abets another person in violation of the securities laws"). 187. See Macey, supra note 12, at 18. 188. Coffee, supra note 2, at 3.
- 264. 189. See id. at 4. 190. See Macey, supra note 12, at 21. 191. See id. Professor Macey postulates that the existence of gatekeepers such as credit rating agencies and accounting firms can only be explained by reputation theory. See id. 192. See Coffee, supra note 2, at 3. Footnote 193. See Macey, supra note 12. 194. See COFFEE, supra note 2, at 371. 195. See Macey, supra note 12, at 19 (defining "reputational intermediary" as "a firm whose business it is to 'rent' its own reputation to client companies that are not large or established enough to have their own, or that obtain added value from burnishing their reputations by associating with a reputational intermediary"). "Investment banks, credit rating agencies, accounting firms, law firms, and organized stock exchanges like the NYSE have all served as reputational intermediaries at one time or another." Id. 196. See id. at 23. 197. See, e.g., Pac. Inv. Mgmt. Co. LLC v. Mayer Brown LLP, 603 F.3d 144, 156 (2d Cir. 2010) ("Where statements are publicly attributed to a well-known national law or accounting firm, buyers and sellers of securities (and the market generally) are more likely to credit the accuracy of those statements."). 198. See, e.g., DiLeo v. Emst & Young, 901 F.2d 624, 629 (7th
- 265. Cir. 1990) ("An accountant's greatest asset is its reputation for honesty, followed closely by its reputation for careful work."). 199. See COFFEE, supra note 2, at 371. 200. See Macey, supra note 12, at 19. 201. Coffee, supra note 2, at 8. Footnote 202. Id. at 8. 203. Partnoy, supra note 24, at 497-98. 204. See COFFEE, supra note 2, at 317 (mentioning conflicts of interest as a reason that gatekeepers may risk or willingly sacrifice their reputational capital). 205. See id. at 371. 206. Id. at 3-4. 207. Id. at 322-23. 208. Id. at 323. Coffee acknowledges that empirical studies show no correlation between a high ratio of non-audit services to audit services and a higher probability of a financial statement restatement. However, he also makes the point that in a highly concentrated industry such as auditing, an auditor might still be deferential to her client as long as there was the potential of receiving consulting income sometime in the future. Auditors still had a motivation to acquiesce. 209. John C. Coffee, Understanding Enron: "It's About the Gatekeepers, Stupid", 57 Bus. Law. 1403, 1411-12 (2002). 210. See COFFEE, supra note 2, at 323.
- 266. Footnote 211. Id. at 60. 212. Macey, supra note 12, at 19. 213. Id. 214. Id. 215. Id. 216. Id. Macey cites an article by Martin Fridson which stated that "89% of the investment grade mortgage-backed securities ratings that Moody awarded in 2007 were subsequently reduced to speculative grade." See Martin Fridson, Bond Rating Agencies: Conflicts and Competence," 22 J. OF Applied Corp. Fin. 56, 56 (Summer 2010), available at http://ssm.com/abstract= 1684896. 217. Enron accounted for 27% of audit fees collected by Arthur Andersen's Houston office. Andersen earned $27 million in consulting fees and $25 million in audit fees from Enron. Professor Coffee cites these figures as evidence of the loss of Andersen's professional independence with Enron, leading the accounting firm's Houston office to ignore or overrule internal recommendations designed to prevent the 'capture' of a local office or audit partner by a powerful client. See Coffee, supra note 2, at 28. Footnote 218. Sean J. Griffith, Afterward and Comment: Towards an Ethical Duty to Market Investors, 35 Conn. L. Rev. 1223, 1239
- 267. (2003). 219. Id. 220. Id. 221. Id. 222. William W. Bratton, Enron and the Dark Side of Shareholder Value, 76 Tul. L. Rev. 1275, 1328 (2002). 223. See Jennifer H. Arlen & William J. Carney, Vicarious Liability for Fraud on Securities Markets: Theory and Evidence, 1992 U. III. L. Rev. 691, 702-03 (1992). 224. See In re Refco, Inc. Sec. Litig., 609 F. Supp. 2d 304, 306 (S.D.N.Y. 2009) (hundreds of million in "uncollected receivables"); In re Enron Corp. Sec., Derivative & ERISA Litig., 235 F. Supp. 2d 549, 613 (S.D. Tex. 2002). 225. Partnoy, supra note 24, at 501; see also Ken Brown & Ianthe J. Dugan, Arthur Andersen 's Fall From Grace Is a Sad Tale of Greed and Miscues, Wall St. J. (June 7, 2002), http://online.wsj.com/articles/SB1023409436545200 (detailing accounting firm Arthur Andersen's collapse from participating in Enron's Fraud). Footnote 226. See Partnoy, supra note 24, at 501. 227. Coffee, supra note 2, at 104. 228. Id. 229. Id. at 318. 230. Id.
- 268. 231. Moody's and S&P. See COFFEE, supra note 2, at 35. 232. Coffee, supra note 2, at 324-25. 233. Id. at 104. 234. Mat 318. 235. Id. at 321. Footnote 236. Id. at 327. 237. Id. 238. See id. 239. See Demise of the Reputational Model, supra note 13, at 429. 240. Id. 241. Id. at 445. 242. Id. at 446, 446 n.39-40 (citing multiple surveys conducted by the Reputation Institute). 243. Id. at 429. 244. Coffee, supra note 2, at 329-30. Footnote 245. Id. at 60. 246. Id. 247. Id. at 78. 248. Id. at 62. 249. See id. 250. See supra Part I.B.2.a. 251. Gatekeeper Failure, supra note 27, at 337.
- 269. 252. See Ross et al., Essentials of Corporate Finance 325-27 (5th ed. 2007). Footnote 253. Id. For example, in a scenario with only two possible outcomes, Expected Value (EV) = (value of possible outcome 1) x (probability of outcome 1) + (value of possible outcome 2) x (probability of outcome 2). 254. For simplicity's sake, criminal liability is not considered here. 255. These hypotheticals are derived from Professor Coffee's comments regarding the level of deterrence that accountants now face from acquiescing in accounting irregularities as well as the calculation for expected value. See generally Gatekeeper Failure, supra note 27; Ross, supra note 252. 256. See generally Gatekeeper Failure, supra note 27 (explaining that accountants face a lower level of deterrence due to the decreased threat of litigation). 257. Id. 258. Id. 259. Id. 260. Ross, supra note 252. Footnote 261. See id. 262. See generally Gatekeeper Failure, supra note 27 (explaining that accountants face a lower level of deterrence
- 270. due to the decreased threat of litigation). 263. Id. 264. Ross, supra note 252. 265. See id. Footnote 266. See generally Gatekeeper Failure, supra note 27 (suggesting that deterrence and the threat of litigation are positively correlated); ROSS, supra note 252. 267. See supra note 11. 268. See Klock, supra note 18, at 492-93. 269. See supra Part II.C. 270. Id. 271. Id. 212. See supra Part II.B.2. Footnote 273. See supra Part II.B.3. 274. See supra Part II.B. 1. 275. See supra Part II.D. 276. See generally Hearing on S. 1551, supra note 64, 103-13 (laying out the argument that restoring the private right of action will decrease gatekeepers' incentives to acquiesce to fraud). 277. Id. at 111. 278. Id. at 112. 279. Macey, supra note 12, at 18.
- 271. 280. See supra Part Il.B.2.d. 281. See supra Part II.D. 282. See Coffee, supra note 2, at 16. 283. See generally In re Refco, Inc. Sec. Litig., 609 F. Supp. 2d 304 (S.D.N.Y. 2009) (fraud occurred after Sarbanes-Oxley was enacted), aff'd sub nom. Pac. Inv. Mgmt. Co. LLC v. Mayer Brown LLP, 603 F.3d 144 (2d Cir. 2010); see also Macey, supra note 12, at 19 (credit ratings agencies gave overly favorable ratings to the securities of high fee-paying clients in the period after Sarbanes-Oxley was enacted). 284. See Coffee, supra note 2, at 78. Footnote 285. See 15 U.S.C. §§ 7214-7215; HAZEN, supra note 30, § 1.4[6], 286. See supra Part II.D. 287. Cf. In re Refco, 609 F. Supp. 2d at 319 n.15 ("It is perhaps dismaying that participants in a fraudulent scheme who may even have committed criminal acts are not answerable in damages to the victims of [their] fraud ...."). 288. Tuch, supra note 10, at 1608-09. 289. See Klock, supra note 18, at 467. 290. See supra Part I.B. 291. See supra Parts I.B.2.e-f. AuthorAffiliation Daniel R. Tibbets, CAIA*
- 272. AuthorAffiliation * J.D. Candidate, Fordham University School of Law, 2015; Member of the Chartered Alternative Investment Analyst (CAIA) Association. This Note would not have been possible without the invaluable advice and guidance from my note advisor, Prof. Caroline Gentile. I would also like to thank my family and friends for their support and the editorial staff and members of the Fordham Journal of Corporate and Financial Law for their efforts. Copyright Fordham Journal of Corporate & Financial Law 2015