The coronavirus pandemic hit the Cheesecake Factory hard. Like millions of restaurants, the company watched as most of its business disappeared overnight. By April 2020 the chain — with over 220 restaurants and 46,000 employees — was near death. The company was losing $6 million a week with just 16 weeks of cash on hand. Cheesecake Factory informed its landlords that it would not pay rent that month, and management went begging to private equity for a cash infusion that could save the company.
But regular investors who were trading the company in the public market had little inkling that Cheesecake Factory was in a tailspin. In public disclosures on March 23 and April 3, management told them that the company was “operating sustainably.” There was no mention of how the company was stiffing its landlords and hemorrhaging cash.
Why lie? If the Cheesecake Factory told the truth, its stock would have gone down, reducing the value of its business and potentially sinking its chances for a bailout from those investors rich and privileged enough to get the truth about the state of its affairs. And yet, despite this blatant attempt to deceive public investors, the Securities and Exchange Commission fined the company an embarrassingly small $125,000. Cheesecake Factory did not admit or deny guilt.
The SEC is supposed to be one of the cops monitoring businesses in the US and policing white-collar crime. When a corporation commits fraud — that is to say, steals from its customers or vendors, or lies about the state of its business — regulators could punish wrongdoers with Old Testament justice, sending a message to corporate America that criminal misbehavior will not be tolerated.
But instead of fulfilling their duties, watchdogs like the SEC have seemingly given up on the task. Instead of levying heavy penalties and imprisoning corporate criminals, financial regulators are giving wrongdoers a slap on the wrist, fining their companies a paltry sum, and allowing them to consider the penalties a cost of doing business. Even worse, by turning a blind eye to corporate crime, the SEC is paving the way for a quiet, white-collar crime wave that is building hidden risks into our economy.
If we don’t get a real cop on the corporate America beat soon, these risks are going to cause far-reaching implosions — collapses of businesses that seemed healthy, sudden stock market disasters, ugly stuff. The risks and frauds are already there, it’s just that the Feds are letting companies sweep it under the rug. That only works for so long.
Stock Market If you’re a CEO they let you do it
Instead of instilling fear, the cops on the corporate beat are teaching America’s CEOs that crime pays.
Last month the SEC announced the results of an investigation into sportswear giant Under Armour. The regulator determined that beginning in 2015, Under Armour lied to investors for a year and a half about how much revenue it was bringing in. Instead of taking a hit on its books when an unseasonably warm winter led to poor sales of its lucrative cold weather apparel, the company reported sales of goods that customers had requested for the future — pulling forward $408 million worth of revenue.
Under Armour did not tell investors that it was stealing from the future to pad its revenue in the present, not even as CEO Kevin Plank was unloading $138 million worth of company’s stock during the period. And yet, despite the grievous fraud, the SEC fined Under Armour only $9 million — a minuscule sum compared to the company’s $1.3 billion in revenue during the first quarter of this year. Nor did the company have to admit its guilt. It was as if the crime never happened.
There is no company too big or too storied for this type of fraud. General Electric pulled essentially the same trick as Under Armour in 2016 and 2017. But not only did it steal from the future by pulling forward revenue, it also misled investors about its costs in order to make its business look even healthier. All told, GE lied its way into an additional $2.5 billion worth of profit during the period. When investors finally found out about the scam, the company’s stock fell 75%.
“In the past, when somebody used to do the stuff that GE did, that was massive,” Francine McKenna, a CPA and blogger who teaches at American University told me “That was criminal fraud. People went to jail.”
And I’ll tell you another insightful observation that McKenna shared with me: “There’s no such thing as a sudden cash-flow crisis.”
Translation: Honest businesses die slowly. They hemorrhage cash and report the bleed out quarter by quarter, until one day shareholders get tired of throwing money into a pit and lose faith.
Fraudulent businesses — companies that lie to hide the poor state of their finances — can seem to die quickly. But it’s only because they were obfuscating. Regulators are supposed to investigate companies that engage in deception before they have a chance to pretend that their demise came suddenly, dealing unforeseen trauma to shareholders and employees. But America’s corporate cops are not doing their job, and so right now, the United States is a white-collar scammer’s paradise.
According to the Federal Trade Commission, 40 million Americans were victimized by some form of consumer fraud in 2017, up 50% from only six years before. Accounting firm PricewaterhouseCoopers estimates that the recent flurry of white-collar crime — from tax fraud to bribery to insider trading — cost the world $42 billion in 2018 and 2019.
The crime wave was a direct result of the Trump administration’s decision to cut back on enforcement, though the government has been softening its hand on white collar crime for decades. In 2020 the SEC charged the lowest number of defendants with insider trading since the Reagan administration, down 17% from the previous low set in … 2019. The fraudsters the SEC has gone after, Daniel Taylor — a professor at UPenn’s Wharton School — explained to me, tend to be small-time crooks.
And what happens when you stop locking up criminals? “My research indicates that there is an increase in opportunistic trading by [corporate] officers and directors,” Taylor said. “And it’s as aggressive as it was during the 2007-2008 financial crisis.”
Stock Market Back to the Roaring 20s
We, as a nation, have been here before. I know many of you are excited about a return of the Roaring 20s, but from a fraud perspective nothing could be less welcome. The cheerful telling of the 1920’s is that it was a post-war, post-pandemic party fueled by jazz music and illicit alcohol. The reality of the age is far darker, and its parallels to our time more disquieting.
When I think of the 1920’s, I think of massive wealth inequality, the rise of fascism and gang violence, and endemic public corruption. Over the course of the decade,Treasury Secretary and industrial magnate Andrew Mellon turned government coffers into his own personal bank, declaring that any tax on the wealthy was “a menace to the future.”
All the while, 1920’s Americans idolized the wealthy — the business of the United States was business, after all. The stock market was ripping ever higher. And — as millionaire John Jakob Raskob wrote in Ladies Home Journal in 1929 while pitching his plan to create a highly leveraged stock market fund that anyone could buy into for $15 a month — “Everybody outta be rich.” Regulation, whether it was to curb fraud or monopolization, was ditched in favor of a laissez faire approach to business.
The parallels are not perfect, but you get the idea. A recent survey found that more Americans trust CEOs than their own government. In the 1920’s a group of investors secretly pooled their money to run up the price of RCA; now we have Reddit traders running up the prices of meme stocks with their “diamond hands.”
When regulators abdicate their responsibility to ensure that business is conducted lawfully, tragic things can happen. Take the 2008 financial crisis: a few years of regulators ignoring predatory mortgage lending practices and failing to provide adequate oversight of Wall Street and boom! — we had a worldwide depression on our hands. And today, just like then, and just like in the 1920s, we have the cops of the market asleep at the switch.
Trung Nguyen, an assistant professor of business administration at Harvard Business School, found that “white-collar criminals respond quickly … to any reduction in enforcement activity.” Her study focused on the FBI, and its diversion of resources from white-collar crime to counter-terrorism since 9/11. She found a “significantly greater increase in wire fraud, illegal insider trading activities, and fraud within financial institutions” in areas where FBI field offices shifted their focus.
Conversely, a 2014 study by Terrence Blackburne, now an assistant professor at Oregon State University, found that where SEC offices are better resourced, CEOs play it more by-the-book with accounting standards, are more accurate in their financial reporting, and preside over companies with more stable stock prices.
Jay Clayton, the Trump-era head of the SEC who spent his career as a white-collar defense attorney, made no secret of his hands-off approach to regulating big business. During his tenure, only two people at the SEC had the authority to initiate cases and issue subpoenas. Trump appointees also changed rules to allow for a reduction in financial penalties for white-collar criminals. The message to Wall Street crooks was clear: break whatever laws you want, because we have no intention of trying to catch you.
The Biden administration has taken a few small steps to increase enforcement. In February, it expanded the number of SEC officials with subpoena power to 36. And it replaced Clayton in the top cop job with Gary Gensler, a former Goldman Sachs banker who — despite his Wall Street past — was known as a tough regulator when he served the Obama administration after the financial crisis.
Gensler has pledged to enforce the rules of the market “aggressively.” But he has also said that his areas of focus will be investor education, market structure, and enhancing transparency. None of these speak to deterring executives from abusing their power. Tesla CEO Elon Musk violated an agreement with the SEC, and when the agency tried to call him on it, his lawyers simply stopped answering the SEC’s emails. After that, according to the WSJ,the problem basically went away.
In a recent speech to the Financial Industry Regulatory Authority, Gensler urged lawyers and accountants who are considering engaging in illegal behavior to “step back from the line.”
To that I can only respond: Oh yeah, Gary? Or you’ll do what?
Stock Market Caveat empty
There are debatable explanations for the SEC’s lack of enforcement. Some people blame it on a revolving door between attorneys on the side of corporate defense and those on the side of corporate regulation. The cops in Washington who are supposed to police corporate America often go on to work for the same companies they’re overseeing. And no one wants to bring a lawsuit against their future clients, let alone send one of them to jail.
Economist Luigi Zingales — a professor at the University of Chicago who studies this phenomenon of “regulatory capture,” as it’s known — thinks we should mitigate the problem by diversifying the expertise of those on staff at the SEC — adding more economists, for example, who won’t be looking forward to lucrative careers in corporate defense. He also suggests we pay SEC attorneys to engage in a longer cooling-off period between when they join the agency and when they return to the private sector.
“This fast process contributes to an aura of impunity for big companies,” Zingales told MarketWatch. “Even without a revolving door system it’s very difficult to go after big companies since they have very good lawyers, and the SEC may end up losing even if it is right. If on top of all this you add the revolving-door problem, it becomes excessive.”
What is not debatable is the fact that the SEC and other regulators are undermanned and underfunded. If the federal budget is a reflection of our values, what it is reflecting back at us is an overwhelming tolerance of corruption and abuse from the rich and powerful. In the 1920’s a similar tolerance led to a massive stock market bubble bursting and sucking up all the cash from banks around the country. Americans ignored risk, companies levered up, and the government let rich scammers run wild. Over the following decade we paid for that greed with the Great Depression — the most painful example of a “sudden cash-flow crisis” that really wasn’t sudden at all.
These days, the SEC has not only abdicated its enforcement of fraud and insider trading. It has also abdicated its responsibility for ensuring that companies entering the public markets have solid corporate governance and a promising business model that can pass regulatory muster. Instead of forcing companies to leap over these hurdles, the SEC is allowing companies to go public as long as they disclose massive issues with their businesses in fine print — taking caveat emptor to the extreme.
Consider Coinbase, for example, a cryptocurrency exchange that went public in April. It is a disaster of a stock, and not just because it’s down almost 30% since then. The problem is that its corporate governance structure is so rife with conflicts of interest that it would not have been allowed to trade on the stock market 15 years ago — and should not have been allowed today.
Two of Coinbase’s three “independent directors” — Fred Wilson and Fred Ersham — are also members of its audit committee. The same two gentlemen are also major shareholders of Coinbase, and one of them — Ehrsam — is a founder of the company. Instead of doing any “auditing” or serving as an “independent” guide for the company, Wilson and Ersham are incentivized to deliver the best possible news to investors. When there are this many insiders overseeing governance, shareholders should understand that any cash flow crisis will be “sudden” — at least for them.
Before it went public, the company also disclosed that it faces tons of litigation uncertainty — basically there are a dizzying number of lawsuits that it could be hit with — and its financial future is effectively tied to the price of Bitcoin, which has been trading with all the stability of a bag of scorpions on meth.
Apparently the SEC thinks this (frankly) stupid level of risk is permissible as long as it’s all written down somewhere.
“The SEC has a responsibility to make sure companies have ironed out all their issues before they go public,” said McKenna, the CPA. “But they’re not kicking the tires. They’re not forcing the companies to get their act together before they go public. This is basic governance stuff.”
In her newsletter, The Dig, McKenna takes a deep dive into all sorts of accounting and governance issues at public companies. What she’s found is that more and more of the market’s most recent IPOs should never have made it to market.
“Snowflake, Palantir, Airbnb, DoorDash … every one I’ve looked at is a loser,” she said. “It used to be that you had to grow a company, prove that you could stay in business, and have a product and people bought it for more than it cost to make it. All that stuff they teach you in school, it doesn’t matter anymore.”
Stock Market Fear the walking dead
What all of this lawlessness leaves us with is a situation that famed short seller Jim Chanos (yes, the guy who first called out the Enron fraud) predicted years after the financial crisis — a situation where the reward of committing fraud far outweighs the risks.
“If now, as the senior member of a bank, or the board of a bank, I know that there are no criminal penalties for breaking the rules, don’t I have a fiduciary responsibility to my shareholders to actually play fast and loose?” Chanos told Salon.”Because if I get caught, that’s just the cost of doing business? I know it’s a frightening thought, but if carried to its logical extreme — if truly people believe that because of their size, they can’t be prosecuted — it actually brings forth a new issue of moral hazard extreme: illegal behavior.”
The largest banks in the US have been wise to Chanos’ logic for some time now. A study from Better Markets — a nonprofit founded after the financial crisis to advocate for financial reform — found that Wall Street’s six biggest banks have paid $195 billion worth of fines for breaking the law over the last 20 years. And they are still doing it. Occasionally it costs shareholders money, and occasionally a mid-level investment banker loses their job, but by and large this is simply their cost of doing business — a rounding error on their criminally obtained profits.
No one fears the SEC anymore. Taylor told me that the agency has become too consumed with thinking like a lawyer. It has become afraid of losing cases, so it only takes on slam dunks. Instead, he argued, it should think more like a behavioral economist. Instead of being focused on winning, the SEC should try to make life miserable for public figures who lie — win or lose. That’s what deterrence is about.
“The damage to letting public figures who make blatantly false and misleading statements off the hook is far greater than pursuing the individual and losing,” Taylor explained. “It sends the message that the agency is easily intimidated and erodes investor confidence. I’d argue there’s societal benefit from making examples, and from pursuing public figures even if you think the odds are not in your favor. Better to get in the ring and fight, than to avoid the fight for fear of losing.”
We don’t want corporate anarchy to take over our markets — and not only because it creates volatility in the stock market when a “sudden cash-flow crisis” grips a company. This isn’t just about investors losing money. It’s not even just about making sure everyone is equal under the law (though that is extremely key). This is about how we put money to work in America.
When companies lie about their health, they’re masking a lack of productivity in order to gain or maintain capital. This ultimately leads to a misallocation of capital, as people are deceived into throwing good money at bad companies. Investors think they’re sending money to a company that will turn it into more money, or more goods. But because of fraud, that money instead goes toward perpetuating a lie, toward enriching the rats fleeing a sinking ship.
It is not productive to throw money at the walking dead. We need the SEC to enforce the law and stop this perversion of corporate governance and investment. If they don’t, that ominous rumbling we hear in the stock market will turn out to be the sound of our economy imploding yet again.
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