CHAPTER FIVE
The Book of Virtues is the kind of bestseller phenomenon that comes along only a few times a decade. Published in 1993, it is a mammoth collection of “moral stories” edited by William Bennett, who served as Secretary of Education under Reagan and drug czar under George Bush. For eighty-eight weeks The Book of Virtues held a spot on the New York Times bestseller list and helped establish Bennett as the premier moral commentator of the 1990s. This book and others, along with frequent lectures, have made him a rich man—rich enough to gamble away some $8 million at casinos and still have plenty of money. Bennett says his gambling days are over, not that this is any of our business. Now, when he needs downtime, Bennett often heads south from his home in Washington, D.C., to a beach house on the Outer Banks of North Carolina—a place he sometimes calls “the house that virtue built.”
Like Bennett’s other books—such as The Moral Compass and The Devaluing of America—the themes of The Book of Virtues track with conservative jeremiads of the past two decades: that America has lost its moral way because of a decline in traditional values like self-discipline, religious faith, and devotion to marriage. Bennett and other conservatives lay blame for this moral crisis on bad liberal ideas and a paternalistic government that has usurped the traditional roles of family and civil society. (The religious right adds proliferating casinos to this list of corrupting influences; Bennett, obviously, has a different opinion.)
Bennett—himself a former liberal who once had a blind date with Janis Joplin—is rare among conservatives in that he has occasionally targeted the free market for criticism. “There’s obviously a tension between the market and virtue,” Bennett once said. “The market is all about creating desire and gratifying it. Virtue is mostly about postponing gratification.” These criticisms, however, have been muted, and Bennett hasn’t had much to say about corporate scandals or the other areas of cheating in American life related to money and career.1
There is, in fact, little in the broad conservative critique of America’s moral decline that can explain the rise of cheating across U.S. society in the past quarter of a century. Even as conservatives warned us through the 1990s about the pathologies of single mothers on welfare and the dissipation of young people with drug habits picked up from their pot-smoking baby-boomer parents, they ignored the negative effects of intensifying competition for money and status across all sectors of society. One reason that the corporate scandals took America by surprise is that conservative diatribes about the “cultural war” directed attention away from the morally corrosive potential of extreme capitalism. Thus distracted, Americans weren’t expecting the many ugly excesses that seem, in retrospect, to have been inevitable.
For example, in his 1996 bestseller, Slouching Toward Gomorrah, Robert Bork bemoaned the decline of America culture within a framework better suited to the ’70s than to the ’90s. Bork charged that “the enemy within is modern liberalism,” that the dangerous left-wing orthodoxies of “radical egalitarianism” and “radical individualism” were bringing out the worst in Americans. The sins that concerned Bork included crime and drugs and illegitimate children, as well as “feminism, homosexuality, environmentalism, animal rights—the list could be extended almost indefinitely.” Quite apart from the corrosion of family and community, Bork worried that liberal orthodoxies would destroy America’s economic vitality. He wrote that “it seems highly unlikely that a vigorous economy can be sustained in an enfeebled, hedonistic culture, particularly when that culture distorts incentives by increasingly rejecting personal achievement as the criterion for the distribution of rewards.”2
What country was Bork living in? While Bork’s book made some astute observations about the pull of radical individualism in America, he got just about everything else wrong. Egalitarianism didn’t thrive in the 1990s; it was pushed further to the sidelines of U.S. society as harsh norms of economic competition took center stage. And the most potent fuel for bad behavior in the ’90s was not the temptations of sexual pleasure or altered conscious, much less indulgent sympathies for baby seals or redwoods; it was the lure of wealth, status, and luxury. Like most conservatives, Bork was so enthusiastic about the free market that he didn’t grasp the ways in which an escalating money culture could corrupt even the most upstanding citizens.
It’s now more obvious than ever that being moral in narrow conservative terms is no protection from sinning in other ways. Take someone like Bernard Ebbers. As head of WorldCom, Ebbers was known as one of the most religious CEOs in the high-tech sector. He invoked God regularly in speeches and press interviews, and started each board meeting with a prayer. He was a deacon at his Baptist church, where he also led a weekly bible study class. According to those who took the class, he was remarkably fluent in scripture. If someone missed the class, Ebbers would be on the phone to see if they were okay. And yet, Ebbers presided over the largest fraud in U.S. history, a fraud that wrought massive financial pain on present and future retirees across America. After the revelations of this crime, a tearful Ebbers told his congregation: “More than anything else, I hope this doesn’t jeopardize my witness for Jesus Christ.”3 Ebbers is now under indictment in Oklahoma, but has yet to face federal charges.
Or look at John Rigas, who headed Adelphia Communications, one of the largest cable television companies in the United States. The son of Greek immigrants, Rigas was a regular churchgoer guided by social conservatism. He raised his four children in a small town in upstate New York with a strict set of traditional values. His sons went to work with their father after graduating from the nation’s best colleges and they, too, became pillars of the upstate community where Adelphia was headquartered. The sons, like the father, were social conservatives. No porn channels were allowed on Adelphia’s cable system.
A very different morality guided the Rigases in business. By the time investigators caught on, the Rigases had appropriated hundreds of millions of shareholder funds for their personal use through various shady loans and frauds. Prosecutors accused father and sons of “systematically looting” Adelphia; the Rigases are currently fighting the indictment.4
Philip Anschutz is yet another business leader who publicly embraced religion and “family values”—while indulging in greed and financial chicanery at the office. A billionaire who is the largest owner of movie screens in America, Anschutz is a religious man who has crusaded against homosexual rights and the medical use of marijuana. He has bankrolled a variety of Christian conservatives and invested in prayer radio. Yet as the founder and chairman of Qwest Communications, a telecommunications firm, Anschutz ranks among the most corrupt insiders of the late 1990s. He sold nearly $2 billion of Qwest stock as it plunged in value from $63 a share to $3. As these sales took place, many in a secretive fashion, Qwest was encouraging its employees to hold on to their own stock and to build their retirement plans around 401(k)s heavy with Qwest shares. Anschutz was later investigated by Eliot Spitzer’s office and eventually agreed to give up $4.4 million in illegal gains from his shady business dealings without admitting any wrongdoing.5
AS LEAD ADVOCATES of downsizing and defanging government, conservative politicians and intellectuals helped create the kind of permissive environment where corporate scandals occurred. Even as they claimed to be tackling America’s “moral crisis,” the Borks and Bennetts ignored the temptations that are naturally part of capitalism and pushed policy ideas that raised these temptations to a new level. Regulatory checks shriveled at the same time that a booming economy increased the rewards for lying and cheating. The SEC found that it lacked the resources—and legal authority—to police increasingly complex financial markets, while an underfunded IRS was outgunned by ever-more sophisticated tax cheats. During the deregulation craze the government scaled back rules governing utilities, banking, telecommunications, airlines, trucking, and other industries. A zeal for privatization led to more government functions being turned over to private contractors—often with few safeguards to prevent abuse. The flood of money into politics, deeply corrupting both parties, partly explains why government enforcers were sidelined during the boom. Free-market ideology explains even more.
Cheating thrives in an era of big loopholes and drugged watchdogs. If you run a business that generates waste, you might be more tempted to spoil the environment because you know that strapped EPA enforcers aren’t going to bother with you—or because a friendly administration has changed the law in your favor. If you’re selling power during an energy crunch, you might be tempted to manipulate the energy market and artificially drive up electricity prices in order to make a killing. Why? Because you can—because deregulated energy markets and unsophisticated enforcers allow you to get away with profiteering. If you’re a landlord in New York City, with its perpetual housing crisis, you’ll be tempted to cut all sorts of corners because you know that these days the city has the resources to send out investigators only if there’s a flood or a collapse, leaving much illegal behavior unpunished.
If you’re Wal-Mart, America’s biggest company, you’ll be tempted to continue the pervasive practice of forcing workers in your stores to put in overtime without paying them for it or using illegal immigrants. While your friends in Washington have not yet closed down the Department of Labor, they’ve at least kept it on a starvation diet for the past twenty years, leaving its investigators outgunned. If you are fined, the damage is sure to be less than the money you’ve made by flouting the most elementary of American labor laws.
And if you’re an accountant like Michael Conway, you may be tempted to let your clients cheat their shareholders by telling multibillion-dollar lies.
Conway lives in Westport, Connecticut, an exclusive suburb known for celebrities such as Martha Stewart and Robert Redford. Outside of the accounting world, nobody’s ever heard of Conway. Inside that dry and arcane world, everyone has. Conway is a longtime senior partner at KPMG, one of the nation’s largest accounting firms. He has served on a variety of boards and committees within accounting associations, as well as at KPMG, where he is a member of the firm’s partnership board and chairman of its audit and finance committee. As a respected leader in the field, Conway has helped shape accounting policies and practices, both in his own firm and at the national level.
Lately, though, Conway has been getting the kind of attention that no accountant wants. He’s embroiled in a major legal mess stemming from SEC charges and could face prison time on multiple felony counts. His days are often spent cloistered with lawyers.
The story of how Michael Conway ended up in the crosshairs of SEC investigators has become a familiar one in recent years. Conway and three other senior members of KPMG are charged with playing dumb while the Xerox Corporation wildly overstated its earnings, thus misleading investors about the company’s profitability. Xerox did this for the same reason that numerous other companies misstated their earnings during the 1990s and into the twenty-first century: to meet its “performance expectations” on Wall Street and thus boost the price of its stock.
Xerox’s top executives, like many leaders of big companies, had an urgent financial interest in the stock price thanks to the widespread practice of compensating executives with large numbers of stock options. In theory, stock compensation is supposed to help align the interests of company leaders with those institutions and individuals who own stock in the company. At Xerox and elsewhere, it had the opposite effect. It gave corporate leaders reason to cheat and mislead investors in the quest to rack up huge personal fortunes. And, in case after case, the accountants serving as watchdogs had their own financial motives for looking the other way.
Xerox has one of the best-known brand names in corporate America. The company shot to the top ranks of big business during the 1960s, after it introduced the 914 office copier. Peter McColough, the CEO who charted Xerox’s rise, believed that large corporations had a responsibility to do good even as they did well, and distinguished himself as among the most socially responsible business leaders of the 1970s.
Xerox’s powerful brand identity helped it through tough times in the ’80s, and the company had rebounded by the late ’90s. One might think that the stewards of the hallowed Xerox name would protect the company’s reputation with their lives. Instead, according to the SEC, company leaders focused obsessively on protecting Xerox’s stock price and their own fat pay packages. When the stock price was in jeopardy, they engineered a far-reaching fraud to misreport Xerox’s earnings. The fraud was complex, as these schemes tend to be, and involved misreporting revenues generated by Xerox’s leases of copying machines around the world. Ultimately, according to the SEC, “the company defrauded its shareholders and the investing public by overstating its true equipment revenues by about $3 billion and its true earnings by approximately $1.5 billion” between 1997 and 2000.6
This large-scale fraud, investigators say, would not have been possible without the complicity of Michael Conway and his colleagues at KPMG.
Auditors are supposed to prevent fraud from occurring, not facilitate it. They are among the most important sentinels within modern capitalism, charged with keeping business numbers honest. Without reliable financial data, investors both large and small cannot have confidence that they are putting their money in a safe or profitable place. Quite apart from the havoc that bogus numbers can wreak on the economic well-being of individual stockholders, at stake is the broader functioning of the economy. Without investor confidence, money flees financial markets and growth slows.
For all these reasons, accountants have solemn obligations to be honest. Their professional code of conduct—as well as the terms of their government licenses and of federal securities law—obliges them to follow a set of established rules known as the Generally Accepted Accounting Principles (GAAP).
Michael Conway and KPMG ignored the rules when they signed off on Xerox’s cooked books, according to the SEC. “The KPMG defendants were not the watch dogs on behalf of shareholders and the public that securities laws and the rules of the auditing profession require them to be,” the SEC charged. The specifics of the SEC charges revolved around Xerox’s use of “self-serving, untested assumptions, and improper accounting methods” to boost earnings, and the willingness of KPMG to endorse these methods, even though they violated basic standards of accounting.7
Michael Conway was not part of the scheme when it began in 1997, but he signed off on a 2000 audit of Xerox that allegedly perpetuated the bogus accounting. Conway was brought to the Xerox account in 2000 after another KPMG accountant, Ronald Safran, was taken off the job because Xerox’s top executives complained about him to KPMG chairman Stephen Butler. Safran, who lives in the leafy suburb of Darien, Connecticut, is a hardworking CPA who has been with KPMG since graduating college in 1976. His sin was that he had questioned Xerox’s management about its fraudulent accounting practices. It was the second time in six years that KPMG’s lead auditor for Xerox had been sacked. To keep Xerox happy and to keep a lid on questions about the company’s cooked books, Butler turned to a trusted senior lieutenant in the form of Michael Conway.
Conway had been warned by Safran about Xerox’s dishonest numbers. Safran told him that Xerox was scurrying at the end of reporting quarters to “bridge the gap” between the earnings it promised and the earnings it achieved. Safran said that something had to be done to raise a red flag. Nothing ever came of these warnings.
Conway did more than just sign off on false numbers for 2000, according to the SEC. He also participated in the cover-up that followed. In early 2001, when KPMG learned that the SEC investigation was under way, it advised Xerox to restate its earnings. Xerox hired outside consultants who came up with a new set of numbers aimed at appeasing the SEC—but the numbers were still fraudulent. KPMG then endorsed these new numbers, even though they had no reason to believe that they were legitimate. It wasn’t until KPMG was replaced later in 2001, and Xerox went along with a truly legitimate audit, that an accurate restatement of earnings occurred. The new numbers made headlines; at the time they were the largest restatement of earnings in U.S. history. And this latest episode of brazen fraud had not occurred at some company down South filled with high-tech cowboys—it involved a blue-chip pillar of America’s eastern business establishment.
The SEC’s sweeping charges against KPMG for its role in the massive Xerox fraud were filed less than a year after the restatement of earnings. The complaint was hardly the first time that KPMG had caught the attention of the SEC. The firm has been embroiled in countless scandals over the years. For example, it paid a $9 million settlement in 2001 for its role in facilitating a $600 million Medicare fraud by the health-care giant Columbia/HCA. The Xerox complaint was also not the first time that Michael Conway had been slammed by the agency. Just two years earlier, the SEC had reprimanded Conway and KPMG for compromising their auditor independence in unsavory dealings with a firm called Porta Systems Corp. Conway, the SEC concluded, was “alarmingly careless in not learning what he needed to know and in not appreciating the significance of what he knew.” The Porta case never resulted in federal charges.8
Not surprisingly, KPMG tells a different story of its relationship with Xerox and about Michael Conway’s professional integrity. It praised Safran for standing up to Xerox and said he had forced the company to make a number of adjustments to its financial statements. Safran was taken off the account not for being too tough on a company committing fraud but rather because of “Xerox’s professed inability to communicate effectively” with him. (Xerox: “Back off, pal.” Safran: “Que? No comprendo.”)
And, says KPMG, Michael Conway wasn’t brought in as a reliable cover-up man; he came in and tried to make Xerox clean up its act, forcing them to get real with their numbers in the “face of massive client resistance.” Conway was a hero in the KPMG story, and KPMG itself said it “did the right thing. We stood up to the client and asked the tough questions. . . . It is astonishing to us that the SEC would choose to bring this action.”9
In June 2003, six former Xerox executives settled with the SEC, agreeing to pay $22 million but—you guessed it—admitting to no wrongdoing. The SEC and KPMG remain in litigation. Yet assuming that the SEC’s charges are correct—and that this badly overstretched agency wouldn’t pursue a case that it wasn’t certain of winning—one naturally asks: What was KPMG thinking? Why would it go along with massive cheating? Why would Conway, a distinguished leader in his field, sign off on numbers that were outrageously bogus?
None of this is much of a mystery. Xerox was a top client of KPMG, which had been the company’s auditor for forty years. During the four years that KPMG turned a blind eye to Xerox’s fraud, it earned $26 million in auditing fees from the company. This stream of revenue itself might have been worth lying to preserve. But KPMG billed Xerox more than twice as much in the same period, $56 million, for a wide range of consulting services. Nobody at KPMG was willing to stand up to Xerox and place this revenue stream in jeopardy. Hefty year-end bonuses were at stake for partners like Conway, who had long been involved in nurturing the relationship with Xerox. When Xerox turned bad, everyone had every reason to look the other way. See no evil, hear no evil—make a lot of money.
Life at a big accounting firm can be extremely stressful. While partners worry about their bonuses, accountants down the ladder worry about their jobs. The pressures to play ball in unseemly situations can be immense. Erik Hille, a former manager at KPMG, describes the situation this way: “The question is how far do you want to push each rule? How many loopholes do you want to find? Nobody says this firm has an aggressive or conservative approach to their audit on the front page of their disclosure. The new hire has no power to say ‘no.’ Their job is on the line to get a ‘yes’ answer. . . . The new hires fear very strongly for their job.”
The dance between auditors and clients is often very delicate, especially when corporate managers are under intense pressure to put out positive earnings numbers. William Ezzell, a partner at Deloitte & Touche, and a leading figure in the accounting profession, describes the interaction around a company’s skewed numbers this way: “Sometimes they just do it without consulting the accountant, and if the accountant raises a question you’re at a pressure point—a point where they’ve convinced themselves they’re right. From my personal experience, the dialogue that takes place is ‘You need to help me get it right.’ But what is meant is ‘Help me figure out a way around the rule.’ Or, ‘How can I do what I want to do? If this isn’t right, give me another answer to get to the result I want.’ . . . They will often say, ‘You’ve got to be more aggressive.’”
Like corporate law firms, accounting companies have been transformed in the past few decades by greed and a harsh bottom line. Life has become far more insecure at august accounting firms that no longer offer most young associates a good shot at making partner. “There are few partners at the top and the promotion to become partner is very stiff,” comments Erik Hille. Yet partners, too, have begun to feel much more heat as they constantly try to prove themselves and justify large bonuses. Partners are “under pressure to keep their revenue up and to keep their clients happy,” says Hille. “A large percentage of the partners’ income is based on the revenue they generate.” The more money at stake with a client, the more auditors might be willing to go along with bogus numbers. And in the 1990s, as accounting firms increasingly ventured outside the auditing business, consulting for the same companies they audited, the financial stakes in client relationships rose dramatically.10
KPMG’s ties with Xerox exemplified these profound conflicts of interest. This recipe for cheating existed despite constant warnings from government regulators. But with a Democratic president declaring in the 1990s that “the era of big government is over,” with Washington awash in special interest money, and with Congress controlled by conservative ideologues, government regulators found themselves largely impotent as the most basic safeguards of modern capitalism were removed.
ARTHUR LEAVITT IS NOW famous as the man who cried wolf about big bad accountants throughout the 1990s. Each time, Congress was paid handsomely not to listen.
Leavitt was Clinton’s SEC head for eight years, a job that entailed relentless political combat. Leavitt was in his early sixties when he took the SEC job. He had spent his years on Wall Street, but he was the son of a New York State politician and had long been drawn to public service. Little did he know what a blood sport politics had become.
Leavitt’s legacy is mixed. He was on the wrong side of important debates over derivatives regulation and accounting rules around stock options. Often he was too cozy with industry lobbyists. But as his tenure went on, Leavitt increasingly targeted the accounting profession for an overhaul. Serious reforms were long past due.
Accountants have been complicit in business crimes as long as there have been accountants. Arthur Andersen and other accounting firms were linked to some of the biggest scandals on Wall Street in the 1920s. The SEC’s security laws, created under FDR in the mid-1930s, were intended to keep the accountants, along with the CEOs, honest. Yet during the bull market of the 1960s, a rash of false earnings statements and other scams revealed widespread dishonesty among accountants and triggered outrage among investors. Members of Congress gave thundering speeches about dirty accountants. A huge congressional study blasted the industry in 1977 and demanded sweeping new regulations to keep accountants honest. Many of these recommendations were not enacted.11
Instead, safeguards on accounting grew weaker in the 1980s. The antigovernment zealots of the Reagan Administration wanted to dynamite the SEC, along with every other regulatory agency in Washington. “The other day I was asked if I knew what a ‘damn shame’ is,” commented John Shad, the right-wing Wall Streeter that Reagan picked to head the SEC. “I learned that a damn shame is a busload of government officials going off a cliff—with five empty seats.”12
Shad’s appointment was a classic case of the fox being asked to guard the chicken coop. He set out to gut the SEC in what the Wall Street Journal called “the most sweeping deregulation in the agency’s 50 years.” Shad oversaw the dismantling of stock registration rules, corporate disclosure requirements, and brokerage-house regulations. Even some Republicans were troubled by the abdication of the SEC’s role in enforcement. “Wall Street is a cesspool of hanky-panky and the biggest gambling casino in the country,” complained a Republican former commissioner in 1982. “The SEC has got to let the industry know that there’s a cop on the beat.” Shad sent the opposite message.13
Shad lost some of his fervor for gutting the SEC as a crime wave engulfed the business world during the mid-1980s. He went on to prosecute Ivan Boesky, Michael Milken, and other insider traders with considerable zeal. In many ways Shad was cleaning up his own mess. Deregulation not only sent a permissive signal to Wall Street, it also led to increased corruption among accountants. While overshadowed by the insider trading cases and big scandals involving defense contractors, the 1980s saw the largest wave of accounting abuses in history. By the early 1990s, accountants had paid out some $1.6 billion in damages in response to over 4,000 liability suits filed in the wake of their role in various scams, most notably the savings and loan scandals. Arthur Andersen paid tens of millions of dollars to settle a suit arising from its role in the failure of the notorious Lincoln Savings and Loan Association. KPMG, Deloitte & Touche, and Ernst & Young were also implicated in S&L collapses. “Accountants didn’t cause the S&L crisis,” said Senator Ron Wyden, “But they could have saved taxpayers a lot of money if they did their jobs properly and set off enough warning alarms for regulators.”14
As in the 1970s, the accounting scandals of the 1980s were followed by public recrimination and tough talk from Washington officials—and very little action to prevent future abuses. The first Bush Administration did next to nothing in the early 1990s to tighten rules or toughen penalties in order to keep accountants honest. After all, the administration’s goal was to fight “red tape,” not add more—even for the purpose of shoring up one of capitalism’s key foundations, namely honest numbers. The stage was set for history to repeat itself.
As the boom of the 1990s gathered steam after Clinton’s reelection, signs abounded that accountants were facilitating a new era of business scandals. The SEC’s chief accountant under Leavitt, Lynn Turner, later estimated that investors lost as much as $100 billion owing to corrupt audits in the 1990s, even before the meltdown of Enron.15 In 1997 alone, more than 100 companies filed restatements of their earnings to correct false information. A 1998 survey of CFOs at top companies found that more than half said they had resisted pressures to cook the books in one way or the other; 12 percent admitted falsifying financial data.16 “The brakes on the worst instincts of the business community weren’t working,” Leavitt said later. “The gatekeepers were letting down the gates.”
Leavitt was particularly worried about the growing conflict-of-interest problems that arose as the big accounting firms increasingly diversified into the non-auditing business. Accountants embraced consulting services in the 1980s and 1990s for a variety of reasons. A lax regulatory environment made it legal for them to take on consulting services for the same clients they audited, while the advent of personal computers decreased their revenues from auditing work. Who needed to bring in a bunch of geeks with green eye-shades when there was Lotus 1-2-3 and Quicken? As traditional accounting revenues shrank, the big firms sought to broaden their relationships with corporate clients. “Because of their training and experience, there was virtually no limit to the consulting services CPAs were asked to provide,” observed Philip Chenok, head of the American Institute of Certified Public Accountants during the 1980s and early 1990s. Chenok actively promoted his constituents’ credentials as strategic planners, marketing consultants, tax specialists, executive headhunters, lobbyists, financial planners, litigation experts, and even IT specialists and programmers. The accounting industry also labored hard to prove that there was nothing troubling about the consulting craze. As one industry white paper stated, there was “no linkage between providing such services and an impairment of auditor objectivity and independence.”17
Consulting became the mainstay of Big Five firms such as Arthur Andersen and KPMG, eventually bringing in 70 percent of their revenues. These firms often sought auditing work with a company simply as an entry point for more lucrative consulting deals.
It didn’t take a professional ethicist to see how the dual role of watchdog and consultant might lead accountants to turn into spineless yes-men when companies cooked their books. Even as accountants pledged undying allegiance to the GAAP, human nature suggested things could easily play out differently. In a business journal article entitled “The Impossibility of Auditor Independence” and filled with psychological data, two academics observed that auditors might cheat without even realizing it. “When people are called on to make impartial judgments, those judgments are likely to be unconsciously and powerfully biased in a manner that is commensurate with the judge’s self-interest,” the authors said. Even well-intentioned “auditors will unknowingly misrepresent facts and unknowingly subordinate their judgment to cognitive imitations.”18
Leavitt’s SEC was convinced that this dynamic was playing out across the accounting world. Wall Street wise men like former Fed chief Paul Volcker weighed in with the same view: “this is a clear, evident, growing conflict of interest, given the relative revenues and profits from the consulting practice.”19
If this problem was easy to identify, a solution was almost impossible to enact in the Washington of the 1990s. Like other industries, accountants had grown increasingly hip to the ways of Washington and put their money where their interests were. Between 1989 and 2000, accounting firms gave nearly $40 million in political contributions. As this money flowed into campaign coffers on both sides of the political aisle, accountants suddenly found themselves with a lot more friends on Capitol Hill. They hired D.C. lobbyists with fat Rolodexes to deepen these relationships, spending upwards of $7 to 8 million a year on lobbying by the late 1990s.20 They also found natural allies in the phalanx of well-funded conservative think tanks like the CATO Institute and the Heritage Foundation that opposed new regulations on principle.
Leavitt was initially open to the idea that the accounting industry could police itself and create new rules to insure auditor independence. But when the industry proved unwilling to do so, Leavitt sought to force change. The accounting industry responded by upping its spending on lobbying and campaign contributions and by hiring securities lawyer Harvey Pitt as its hatchet man in this fight. (Pitt was later George W. Bush’s choice to lead the SEC in a John Shad redux.) One of Leavitt’s many adversaries in this battle was Michael Conway of KPMG.
At the time that the battle over new auditor independence rules reached a peak in 2000, Conway was chairman of the SEC Practice Section Executive Committee of the American Institute of Certified Public Accountants. AICPA is the main professional organization of accountants and is responsible for establishing ethics for CPAs, including auditing standards. The Practices Section oversaw self-policing and peer review functions aimed at keeping accountants honest. Both Conway and many of his colleagues at AICPA opposed Leavitt’s new rules, which jeopardized the billions of dollars in fees that accounting firms made annually from consulting. They fought Leavitt at every turn.
When Leavitt asked an independent regulatory group, the Public Oversight Board (POB), to investigate the problems with auditor independence, Conway helped orchestrate a brazen move by which AICPA—which provided funding to the POB—tried to kill the investigation by cutting its funds to the POB. The move was darkly ironic, in that one of the POB’s mandates was to serve as a watchdog over the AICPA and keep it honest. Conway also tried to head off new government regulations by helping put together new—but largely toothless—measures by which the industry would police itself.21
Everyone knows how this story ends. Leavitt didn’t win his long battle for tough new rules for auditor independence, settling instead for a watered-down outcome. The bankruptcy of Enron—a company that paid Arthur Andersen half a million dollars a week in consulting fees while also having it police its books—was just one of the many scandals related to cooked books and rotten accountants. Compromised accountants have also been implicated in the scandals at WorldCom, Tyco, Global Crossing, and many other companies. Millions of Americans would have more money in their retirement accounts today, more money saved for their children’s education—more peace of mind and more security—if the accounting industry had been forced to clean up its act. “If there ever was an example where money and lobbying damaged the pubic interest,” Arthur Leavitt said later, “this was it.”22
The failure to ensure the independence of auditors was only one of three major regulatory failures that led to the corporate scandals. A second was the fall of the “Chinese Wall” that was supposed to separate stock research analysts from investment bankers, providing the incentive for star analysts like Henry Blodget and Jack Grubman to mislead investors on a massive scale. These analysts publicly rated the stocks of companies that also paid banking fees to the firms where they worked. In principle, analysts are supposed to spend their days buried in company earnings reports and economic data, emerging bleary-eyed from their offices to issue critical and independent judgments about stock values. They are supposed to be strictly walled off from the greedy bankers by unbreachable institutional barriers. Instead, many analysts spent the boom of the ’90s neck-deep in the investment-banking activities of their firms. Analysts didn’t just talk to the bankers; they were commonly compensated for bringing investment clients to the firms. When the “analysts” went on to publicly dissect the prospects of these companies, sometimes on television shows watched by millions of investors, they failed to disclose their massive conflicts of interest. It was an appalling game. Wall Street insiders knew all about the game and took everything that conflicted analysts said with a grain of salt. But most Main Street investors didn’t have a clue.
In 2003, government regulators led by New York State attorney general Eliot Spitzer reached an agreement with some of America’s top financial-services firms to stop these practices and rebuild the Chinese Wall. The question, of course, is why this didn’t happen earlier. The answer is that regulators didn’t have the resources or political muscle to make it happen.23
A third regulatory failure in the ’90s was the inability of regulators to compel corporations to report stock options as expenses in their earnings reports. This not only gave corporations more incentive to dole out huge numbers of options to top executives—thus providing temptations to concoct false earnings statements and boost stock prices—it also allowed many companies to report higher profits than they actually had, since one of their biggest personnel outlays was not formally listed as an expense.
A number of government officials in Washington, most notably Michigan senator Carl Levin, pressed in the early 1990s to have stock options categorized as expenses. Some business leaders like Warren Buffett also backed this idea. The SEC even took tentative steps in this direction. But a revolt against the move quickly gained steam, led by the high-tech industry, which relied heavily on options to compensate its employees. Democratic senators like Joseph Lieberman and Dianne Feinstein lined up with industry lobbyists to successfully block the proposal. Commonsense regulation suffered yet another setback.
As the boom of the ’90s got going, a deeply corrupt system was in place whereby executives had huge temptations to cheat on their earnings statements, accountants had huge temptations to sign off on these bogus statements, and top stock analysts had huge temptations to exaggerate the value of stocks that investors were buying. Respected CEOs, accountants, and stock analysts gave in to these temptations not because they were uniquely evil and greedy but because the rules of the system allowed it. In a very short time, as the ’90s boom reached a crescendo, that system enabled a small elite of insiders in corporate America and on Wall Street to become unbelievably wealthy—while ordinary Americans picked up the tab.
TAXES ARE ANOTHER area where government enforcers were disarmed during the ’90s and new temptations to cheat arose. Nobody knows this better than the people at the IRS.
Consider the vantage point of a top IRS official in 2001. During the months leading up to tax day, which fell on April 16, the IRS received tax returns for the biggest boom year in U.S. history. So much money was rolling into the Treasury that budget experts forecast trillions of dollars in surpluses over the next decade and beyond. But instead of celebrating, IRS officials were gnashing their teeth about all the money that got away—which was estimated to be over $250 billion, an amount that could have covered most of the Pentagon’s budget that year.
The IRS has a formula known as the “tax gap” that is used for estimating revenues lost to tax evasion. The tax gap compares the money being earned by individuals and businesses to the money that gets paid in taxes. Over the past twenty years, the tax gap has soared.
Back in 1990, the IRS estimated the tax gap at $100 billion. Noting that tax evasion had increased in the 1980s, the IRS suggested that the likely cumulative value of tax avoidance since 1972—$1.6 trillion—was roughly equivalent to 60 percent of the 1990 federal debt. In 1998, IRS officials submitted their highest-ever estimate of the so-called tax gap—$195 billion annually. The figure represented an increase of nearly 100 percent since 1990. And it kept climbing. The IRS estimated the tax gap for 2001 at $250 billion. Outside experts put the annual total much higher. According to former commissioner Donald Alexander, the gap between what taxpayers owe and what the IRS collects could be as high as $500 billion a year. This staggering figure, it should be said, does not include evasion of state and local taxes.24
The IRS knew full well that the government wasn’t getting close to what it deserved in 2001. But it had few options for dealing with this problem, since for over twenty years the agency has been underfunded and undermined by Congress and the White House.
The first problem the IRS faced after April 16, 2001, was just trying to figure out the basics of who might be cheating. Stone Age technology and a lack of staff made the task nearly impossible. The central computer system at the IRS, built in the 1960s and maintained by a series of adjustments and improvements in the intervening years, relied on magnetic tapes to keep track of the records of the nation’s taxpayers. By the late 1990s, the system ranged across 147 different mainframes and employed 8,700 different software products. Testifying before Congress in 1999, IRS commissioner Charles Rossotti explained that the only reason IRS computer databases remained accessible was that longtime employees knew how to jerry-rig the system to produce results.25
Even with the best technology, the IRS would have been in a hopeless situation since it was understaffed in 2001 and remains so today. Between 1989 and 1999, the total number of IRS employees fell by 26 percent. The staff of the IRS Office of Examination, which includes tax auditors and revenue agents, fell by 34 percent during this period. And yet the number of tax returns filed by individuals increased by 14 percent in the same decade. Many people’s tax returns also became more complex. The number of taxpayers claiming $100,000 or more in income quadrupled during the 1990s boom, with many filers itemizing numerous deductions. The ranks of self-employed taxpayers rose dramatically as well—26 percent between 1988 and 1998, or twice the rate of those reporting wage income.26
Also challenging was the proliferation of tax returns with income from so-called K-1 partnerships, which include several different business arrangements. By 2001, tax returns were filed for around 13 million K-1 partnerships. This income is particularly difficult to verify because while employers file W-2s for wage earners and 1099 forms are typically filed for consultants and other kinds of self-employed people, there are often no third parties vouching for the income paid through K-1 partnerships. This leaves the IRS to laboriously track such income through other means.
Complex tax-shelter schemes proliferated during the 1990s, many of them offered by respected banks and brokerage firms that previously had steered clear of this shady practice. And the tax shelters used by corporations were even more byzantine than those used by individuals. A survey by the Institute for Taxation and Economic Policy found that 52 of the 250 largest U.S. companies paid taxes at a rate of 10 percent in 1998 even though the overall tax rate for corporations in the top ranks was 35 percent. In 1999, corporate profits surged 8.9 percent, even as corporations paid 2.1 percent less in income tax than they had the previous year. The use of illegal tax shelters by corporations was thought to cost the government about $10 billion a year in 2002.27
By the late 1990s, the IRS’s enforcement powers had become a joke. Its capacity for tracking and verifying income has been stretched as more Americans have come to play more sophisticated games with their money. In turn, the perception of a strapped IRS has led many Americans to think, correctly, that they can get away with tax evasion. Investigations and prosecutions by the IRS fell off sharply during the 1990s, dropping by half even as more returns were filed and cheating increased. In 2002, the IRS was aware of nearly 2.5 million individuals who had failed to file federal income tax returns. A surprising number of these nonfilers included affluent professionals, such as doctors, lawyers, and other self-employed professionals. Due to budget constraints, 75 percent of these cases would not be investigated.28
Though not everyone has benefited from the IRS’s new tolerance for tax evasion—wealthy taxpayers certainly have. The wealthier you are, in fact, the less the IRS bothers you. Since 1988, audit rates have increased by nearly a third for poor tax filers—while dropping 90 percent for the most affluent earners. In 2001, poorer individuals making under $30,000 who made use of the Earned Income Tax Credit had a 1 in 47 chance of being audited. Meanwhile, taxpayers making over $100,000 had a 1 in 145 chance of being audited. Lawyers, doctors, and other professionals with S corporations had a 1 in 233 chance of being audited. Those with partnerships had a 1 in 400 chance of having IRS agents show up at their door. Not surprisingly, wealthy Americans express much less concern about being audited than their lower-income counterparts. In a 2001 poll, 18.9 percent of taxpayers earning more than $100,000 reported worrying about audits, as compared to 32.7 percent of those earning less than $25,000.29 “It’s a risk-reward assessment,” says Gail Kenney, the IRS’s director of financial crimes. “If the likelihood is they won’t get caught, and that, if they do, there won’t be serious consequences, then they’ll do it.”
The IRS goes after less-affluent tax cheats because they are easy prey. Middle-class and lower-income Americans don’t have the resources to put up a lengthy fight against the IRS. But America’s wealthiest taxpayers, backed by top tax lawyers and accountants, are adept at tying IRS investigators up in knots for years. A 2001 investigation by the Center for Public Integrity, a Washington research group, observed that “hundreds of the best tax minds in the nation, including former [IRS] commissioners and other ex-IRS officials, reap millions of dollars annually by helping the largest corporations and the wealthiest citizens avoid paying their fair share of taxes.” In numerous cases in the ’90s, the IRS went after wealthy tax cheats seeking millions of dollars in unpaid taxes—only to end up with a fraction of this after years of investigation and negotiation. As one IRS lawyer has commented: “When there are ten thousand documents, some of which are bank statements containing thousands of transactions, and the opposition argues over the significance of every single item, the process becomes extraordinarily difficult.” In the face of battles like these, it simply makes more sense for the IRS to concentrate its enforcement efforts on vulnerable targets.30
The IRS’s enforcement priorities have long been well-known among the wealthy. In Leona Helmsley’s 1989 trial for tax evasion, Helmsley’s head housekeeper at her twenty-eight-room mansion in Greenwich, Connecticut—where a variety of improvements had been improperly claimed as tax deductions—testified on the stand about an exchange she had with the wealthy hotelier. “You must pay a lot of taxes,” the housekeeper said. Helmsley replied, “We don’t pay taxes, only the little people pay taxes.”
During the 1990s, judicial and legislative actions made it even easier for the rich to thumb their noses at the IRS. A 1991 Supreme Court ruling opened the door to more widespread tax avoidance by allowing tax evaders to exonerate themselves by citing ignorance of the law and forgetfulness. Under the principles outlined in the Cheek v. United States decision, prosecutors now bear the heavy burden of proving that individuals “willfully” violated the law.31 And Congress’s hostility toward the IRS has been legendary. In 1998, the Gingrich Congress passed the Taxpayer Bill of Rights, which limited the ways that the IRS could pursue tax cheats. Although the law curbed some actual abuses, the real agenda of House Republicans was to weaken the IRS. Money from corporations and wealthy individuals funded a “grassroots” campaign to help pass the law. In a rare public unmasking of the right’s tendency to disguise plutocratic goals in populist clothing, many of the “average people” who testified before Congress about IRS abuses were found to be phonies. According to a report in the Christian Science Monitor, most of the IRS sob stories turned out to be patently false.32
The Taxpayer Bill of Rights was a huge victory for all tax cheats, but its main beneficiaries are taxpayers wealthy enough to afford accountants or lawyers who know the ins and outs of the law, and can exploit its provisions to make the IRS back off. The year after the law went into effect, tax advisers were coaching clients on how to make the best use of its provisions to reduce tax burdens and postpone the payment of outstanding taxes. “These measures will diminish compliance with the tax law and the honest taxpayer will end up even more disgusted,” complained former commissioner Donald Alexander.33
The corporate scandals focused new attention on the problem of tax evasion, especially among CEOs and other wealthy Americans who were making widespread use of dubious tax shelters. The 2001 Bush Administration offered some response to this problem by modestly increasing the IRS’s budget. However, when departing IRS commissioner Charles Rossotti prepared his final report to Congress late in 2002, calling the budget increases grossly inadequate for deterring fraud, the Bush Administration successfully censored his remarks.34
HOW IS IT that wealthy insiders have been able to hijack America’s financial system and tax system for their own gain at the expense of everyone else? Much of the answer lies in the outsized political clout that economic winners have in our society today.
It is no secret that income gaps translate into unequal political muscle. Politicians pay attention to voters, but middle-class and low-income Americans are less likely to vote than those on the upper rungs of the economic ladder. Politicians pay attention to campaign contributors, but ordinary working Americans are far less likely to make political contributions than upper-income people. Politicians pay attention to citizens who write them letters or call them or show up at public hearings or attend protests or sign petitions or volunteer for a political campaign. But wealthier Americans do all of these things at higher rates than other citizens.35
Education is part of the problem. Less-wealthy Americans tend to be less educated and are less likely to keep up with politics or feel confident navigating their way through civic processes. Many of these Americans are also convinced that their vote and voice does not matter, that the system is rigged in favor of those at the top, and that the little people don’t count. This outlook can be a self-fulfilling prophecy. The more that ordinary Americans get cynical and tune out of politics, the more likely it is that politicians will ignore their interests altogether. The squeaky wheel gets the grease in politics, and there’s not much incentive to stand up for constituents who don’t stand up for themselves. Yet even when average citizens do stand up for themselves—even when they band together in large numbers—it’s hard to be as squeaky as special interest groups, with their fat-cat lobbyists and checkbooks open to politicians.
That the rich wield a megaphone in American politics is nothing new. But in the past two decades, not only have the rich gotten dramatically richer compared to everyone else, they have found many new ways to leverage that wealth in the political sphere. By influencing laws and regulations at every level of government, they use their wealth to bend rules to allow cheating, rewrite rules to redefine cheating as legitimate behavior, and walk away unpunished when they are caught cheating.
Consider the swollen river of money that now flows into our politics. Most Americans are mainly familiar with the cash that goes to political candidates and parties. This spending has increased dramatically in the past two decades. During the 2000 election, $4 billion was spent in all of the federal and state elections—some three times what was spent in 1992. Much of this money was in the form of very focused campaign gifts by industry and the number of corporate political action committees has doubled since 1980. For example, the $40 million that the accounting industry pumped into politics during the 1990s didn’t go to just any politicians; it went to politicians who sat on key committees or otherwise were in a position to do favors for accountants. (A total of $640,000 also went to George W. Bush’s 2000 campaign.) Ditto for the million that the pharmaceutical industry gave during this same period, or the real estate, oil and gas, and telecom industries. The favors done by politicians in return for this money underscore that writing checks is the form of political engagement that matters most these days—one that is beyond the means of the tens of millions of ordinary Americans who have more pressing checks to write every month.
Often, the sleazier a company is, the more it pays politicians to either look the other way or pass rules that permit bad behavior. Two of the biggest political contributors in the 2000 election cycle were Enron and MBNA. Enron is now well known to have been a cesspool of cheating. MBNA, the nation’s largest credit card company, has no such reputation. Why? Because many of the blatantly unethical practices of this and other major credit card companies—including deceptive advertising, usurious rates, hidden fees, and excessive penalties—have been legalized over the past quarter century through a deregulatory process lubricated by political contributions. MBNA’s heavy investment in politicians of both parties is aimed at keeping the favors coming.
Contributions to political campaigns are only one tributary feeding the mighty river of money in politics. Another is the growing influx of money into think tanks and advocacy groups.
The American Enterprise Institute is a good example of intellectuals for sale. Lodged in a modern office building in downtown Washington, AEI is the premier scholarly institution of the conservative movement. Founded in 1943, it initially came to distinguish itself over decades for its genuine commitment to advanced scholarship, albeit with a moderate rightward tilt. As it happened, though, that tilt was not nearly right enough for those who controlled AEI’s purse strings. In the mid-1980s, AEI’s main contributors threatened to cut off funding unless it turned much more conservative.
It did. These days, AEI has a $17 million budget and provides a home to some of America’s most rabid right-wing ideologues, including Robert Bork, Newt Gingrich, and Charles Murray. AEI’s twenty-five-member board of directors includes exactly one scholar, James Q. Wilson. The rest of the board is packed with corporate CEOs, including the chiefs of ExxonMobil, Dow Chemical, State Farm Insurance, and American Express. These extremely busy men aren’t there because they enjoy a good intellectual conversation. They are on AEI’s board because their companies are among the dozens that donate handsomely to AEI, funding a steady stream of highbrow studies that trash government regulation, advocate repealing taxes on corporations and the rich, propose ways to dismantle America’s social safety net—and even seek to rehabilitate social Darwinist ideas about the innate superiority of some groups of human beings over others, as AEI did when it supported Charles Murray’s research for his controversial book on human intelligence, The Bell Curve. “Corporations provide important input to AEI on a wide variety of issues,” admits AEI’s annual report. Yet what serious think tank would want input from entities designed solely to maximize shareholder value? Self-interest is why so many corporations give money to AEI—over $5 million a year—but self-interest is antithetical to what sound scholarship is all about.
Even as the American Enterprise Institute has tacked to the right over the past two decades, it remains known as one of the more reasonable conservative think tanks. A number of well-respected scholars still reside at AEI. The Heritage Foundation, with nearly twice the annual budget of AEI, has no such reputation. Heritage is a factory for far right-wing ideas and a virtual arm of the GOP. It is heavily funded by wealthy conservative zealots, including the reclusive Richard Mellon Scaife, who also bankrolled a $2 million smear campaign against Bill Clinton. (All contributions to Heritage, it should be added, are tax deductible, because it is a nonprofit organization.) Heritage’s researchers grind out reports with titles like “How to Close Down the Department of Labor.” While Heritage’s research is widely criticized as biased and shoddy, other conservative think tanks suffer far worse credibility problems, at least among those in the know. The Employment Policies Institute, for example, exists almost strictly as a creature of the restaurant industry. And guess what? EPI’s research shows that raising the minimum wage is sure to trigger another Great Depression.
In all, the labyrinth of national and state conservative think tanks funded by wealthy interests now spends nearly $200 million a year to influence public policy. Social science, long a central tool of pragmatic reformers who first objectively studied problems and then developed solutions to them, is increasingly used as a weapon by wealthy elites to get their way. The media, committed to telling both sides of any story, play right into this strategy by placing the views of independent experts and corporate-funded intellectuals on an equal plane. An eminent university expert on pension systems will be quoted as saying that privatizing Social Security would hurt low-income seniors—and be contradicted a paragraph later by a “resident scholar” whose think-tank paycheck comes indirectly from a financial services industry that dreams of 150 million private accounts. A Nobel Prize–winning climate expert will be quoted as saying that global warming would have devastating consequences—only to be dismissed on Nightline by a “senior fellow” whose work is funded by an oil industry that couldn’t care less if Florida ends up under water in a hundred years. The public, which is prone to tune out whenever policy wonks start yammering on anyway, now has an even harder time sorting out objective research findings from sophisticated propaganda.36
Wealthy interests have also gotten much better in recent years at buying faux grassroots support. Take an outfit like Citizens for a Sound Economy, a deceptively named organization if ever there was one. Although it boasts 280,000 citizen members, CSE is purely a top-down creation of major corporations and rich donors who underwrite its operations. From headquarters in Washington, CSE specializes in orchestrating campaigns that make elected leaders think there’s a groundswell of grassroots support for a given policy position when, in fact, there is not.
If 150,000 faxes and e-mails arrive in congressional offices all advocating a repeal of the “death tax” because it hurts small farmers and businesses, you can bet that CSE is behind it. (In fact, the estate tax is paid almost exclusively by multimillionaires, although years of deceptive analysis have now convinced the public otherwise.) When protestors picket the offices of the Food and Drug Administration, complaining that its lengthy drug review process is harming sick children, CSE and its backers in the pharmaceutical industry are likely pulling the strings. CSE also uses television advertising and direct mail to blast away at politicians in their home districts who are unfriendly to corporate interests. One of CSE’s biggest backers is the Charles G. Koch Charitable Foundation, as in Koch Industries, the energy company that paid $40 million in fines in 2000 and 2001 alone for breaking environmental laws.37 In recent years, CSE’s success has been increasingly copied by other organizations, and there is now an impressive constellation of groups in Washington that purport to speak for ordinary Americans but actually speak for the very richest Americans. My favorite these days is the Seniors Coalition, a Beltway group that says it “represents the interests and concerns of America’s senior citizens at both the state and federal levels”—but which in fact is funded mainly by corporate interests to push a Republican freemarket agenda, including the privatization of Social Security.
Neither politicians nor intellectuals nor faux citizens activists come cheap. Yet the huge aggregation of wealth at the top of the income ladder means that there’s been no shortage of cash to pump into politics. And even as the two tributaries of campaign monies and funds for think tanks and advocacy groups have grown rapidly, a third tributary in the river of political money has overrun its banks—money for lobbying. Today, Washington is swarming with hired guns as never before. Money spent on lobbying climbed to $1.5 billion in 1999 (the last year for which there is current data) and Washington now has nearly forty lobbyists for every member of Congress. Many sleepy state capitals have also been overrun by the well-coiffed representatives of business.38
It would be one thing if all these lobbyists did nothing more than work the halls of Congress or the state legislatures, where a growing number of them once worked before they decided to make real money. The reality is that lobbyists do much more than that. They also actively participate in drafting legislation and regulations. This has been particularly true under the George W. Bush Administration, where industry representatives have been asked to participate in various tasks forces and internal commissions. In fairness to Bush and the Republicans, hands-on industry involvement in regulatory decisions is hardly new. It’s just become deeper and more pervasive.
In today’s Washington, those in power never forget whom they serve. And while the co-opting of America’s political leadership by wealthy interests helps explain why the SEC, the IRS, and many other watchdog agencies don’t stand up to wrongdoers, it also explains why conservatives get away with framing America’s debate on values so narrowly. Even as conservative politicians talk endlessly about the temptations that come from illegal drugs or sex education or no-fault divorce laws, there are far fewer politicians ready to discuss the moral hazards of an unregulated market.
After all, they have reelection campaigns to fund.