With the beginning of the trial of former Enron leaders Ken Lay and Jeff Skilling, corporate scandals are back in the news. Not only was the Enron meltdown the largest and most visible corporate bankruptcy, complete with its own documentary and Playboy spread on the “women of Enron”, but prosecutors allege that its fraud was the most intentional and calculated. (The prize for the most incomprehensible wrongdoing has to go to former Wal-Mart vice chairman Thomas Coughlin, who misappropriated $500,000, including handfuls of Wal-Mart gift cards, for his personal use. His defense – that he was merely reimbursing himself for expenses incurred in secret anti-union activities – is equally fantastic.)
Many of the other accounting scandals were much more subtle, and may have started innocently enough. Indeed, it is unlikely that there were clandestine meetings to hatch a grand scheme to misinform investors to the tune of billions of dollars. Rather, the pressure to grow and meet targets compelled employees to wade into gray areas. When these initial transgressions were not punished, but were rewarded for meeting financial goals, they quickly became accepted practices and began to snowball. Once the fraud became large enough to have real impact, nobody had the courage to stop it and it just kept growing.
When rewarded behavior rather than ethical behavior becomes the driving force in any organization, there will inevitably be problems. It is the challenge of management to persevere through business cycles and balance long-term success with the temptation to cut corners. It is an increasingly difficult balance to strike.
Even when corporate behavior is clearly legal, there are daily conflicts between common practice and common sense. I am familiar with a real estate investment trust (REIT) that was organized in 1997 and has performed very well for its investors. It is a non-public REIT, which means that its shares are not listed on any exchange. This makes it more difficult for investors to sell their shares, and the REIT’s by-laws require it to become listed on an exchange within ten years or dissolve.
A separate entity serves as the investment advisor to the REIT, but the advisor is 90% owned by officers and directors of the REIT. In fact, the advisor was organized solely to advise the REIT and the REIT is the advisor’s only client. This means that the advisor’s expenses were fully paid by the fees paid by the REIT and the advisor had absolutely no financial risk. The advisor has operated profitably from its inception.
The REIT proposed to become listed on an exchange, and as part of its proposal it also wanted to merge with the advisor. The proxy statement contained multiple analyses by Wall Street firms and many pages of justification for the merger. In paying almost $300 million to acquire the advisor, the REIT explained that to hire another advisor would be expensive and would forfeit the experience and familiarity the advisor had with the REIT.
We questioned the cost of the merger and were told that this was a very typical transaction and that the advisor deserved to be compensated for the loss of future profits. It was also suggested that in my practice as an investment advisor, wouldn’t I want to be paid something for my firm if a client wanted to buy it?
And this is where the light bulb goes on. Imagine if I had started my practice with one large client and had operated profitably for nine years with just that one client, and that client’s business had grown steadily. If that client decided to conduct his investment management “in-house” rather than contract with me, I would be thrilled if the client were to buy my firm. But he’d be a fool to do that, because he is my firm’s only client. The right thing to do would be for the client to hire me as his employee to conduct his investment management, and I would be happy to have the job.
The REIT was left with two reasons to propose the $300 million merger. First, this is the way these things are done (and who are we to question it?). Second, they are doing this blatantly self-serving transaction because they can, and the investors are more interested in having the shares publicly traded than they are about the logic, cost or propriety of the merger.
The REIT ultimately cancelled its entire proposal, not because of the merger but because the price at which the REIT wanted to value its shares was considered too high by the institutional investment community. In the grand scheme of things, who really cares if a $3 billion REIT wants to needlessly spend $300 million – a full 10% – of its investors’ money, especially if the REIT generates good investment returns? But if business as usual is allowed to go unchecked, investors will always be treated as an afterthought and will be left to bear the brunt of management whims.