IN EARLY 2001, GE Capital was buying up real estate assets in varied markets, spending billions per deal to scoop up operations in every corner of the country. These were some of the last deals under Jack Welch, and they injected GE into the world of lending money to restaurant chains like Burger King and Cracker Barrel, as well as businesses like Midas Muffler Shops and the Circle K convenience stores.
The acquisitions brought in thousands of loans connected to properties sprinkled across the land and were a far cry from making jet engines and selling refrigerators. It was just the kind of business needed to feed the fire of GE Capital, which was now one of the world’s largest nonbank finance operations.
A year later, Moody’s put $164 million of GE’s asset-backed securities on watch for downgrade, citing “a rising percentage of problem loans in the pools” behind those instruments. But it was size that mattered, and GE wasn’t slowing down in its plunge into real estate.
The push into real estate didn’t stop with Immelt taking the reins. In December 2001, GE paid $4 billion for Security Capital Group, adding to its real estate holdings in GE Capital. It also formed a joint venture with Kimco Realty Trust to buy up neighborhood shopping centers. By the end of that year, GE’s commercial real estate group had grown to about $24 billion.
Inside GE’s legendary management machine was a complex mechanism that used these deals to help the company meet its profit goals. Cash flow wasn’t as important as the all-important earnings per share results that made Wall Street swoon for GE every quarter. In the summer of 2001, Immelt had even declared on CNBC that GE wouldn’t disappoint Wall Street in the near future. “There is not going to be [an earnings] miss,” he said on the air.
He spoke with confidence for a reason: GE Capital had his back. Managing financial results wasn’t unique to GE, but the degree of GE’s reliance on the practice was. Management, with its customary swagger, treated the frenzy of last-minute tweaks and transactions each quarter as entirely natural.
This way of managing financial results wasn’t Immelt’s invention, and it wasn’t a secret. GE executives have acknowledged that they worked to make sure earnings were always growing in a nice smooth trajectory. “We think consistency of earnings and no surprises is very important for us,” former CFO Dennis Dammerman, one of Welch’s most essential lieutenants, told Fortune magazine.
A rotund Iowan who joined GE in 1967, Dammerman became CFO in 1984 and oversaw much of the financial services growth. For some, Dammerman was the safety net that kept the financial side of GE from spinning out of control. He collected classic cars and racehorses and used GE’s fleet of corporate jets more than any other executive. He was “aggressive in every sense of the word,” said those who worked with him, and he also kept the rank and file in line. Upon hearing a proposal for a project, he might bark back, “That is the dumbest fucking idea I’ve ever heard.” The shocked recipient would then be forced to defend their reasoning, and Dammerman could soften his stance upon hearing a convincing argument. But Dammerman’s rough style discouraged new ideas that were not thoroughly vetted.
Dammerman defended GE’s opaque structure and its curiously solid profits with a dismissive confidence that bordered on hubris. Only GE could understand how its businesses made money, and investors should simply be happy with the results.
“We’re a very complex, diverse company that no one from the outside looking in can reasonably be expected to understand in complete detail,” he said. “Our story to the investing world is, we have a lot of diverse businesses, and when you put them all together they produce consistent, reliable earnings growth.”
To achieve this, performance targets were set first, and only then was the method for achieving them determined. The contributions to making the numbers were spread around the various businesses, and compliance was required.
A steady stream of acquisitions fed the earnings momentum. GE could use its unusually high price-to-earnings ratio for an industrial company as high-value currency to pay for deals. By acquiring companies with a lower price-to-earnings ratio, GE was getting an automatic earnings boost.
As an example, if GE was trading at a price-to-earnings ratio of 40, that meant that, if its stock was $40, it was earning $1 per share every year. If GE then bought a company with a price-to-earnings ratio of 10—that company was earning $4 per share for every $40 of stock—GE was essentially trading $1 of earnings for $3 of new earnings without doing anything except making the deal.
Using cheap financing can perform the same trick. GE could buy a company that produced profits at a rate exceeding GE’s cost to borrow, which was very low.
GE shares weren’t going to stay valued that way forever. It would have to do more deals or use other methods to produce earnings. One way to do this was by contorting accounting rules to make acquisitions seem even more profitable.
For example, it could buy a real estate company with thousands of properties and appraise them at a low value, a strategy that reduced the earnings hit from depreciation and brought a huge profit if the property was sold at a higher price. But that method works only if the buyer is willing to pay. GE Capital had a solution.
Meanwhile, one of the biggest companies in America was imploding. Enron, a Texas pipeline company that had moved into energy trading and other ventures, including broadband, was a self-proclaimed symbol of corporate ingenuity at its peak, bringing in more than $100 billion in revenue. But now Enron had been brought down, seemingly overnight, in a massive accounting fraud.
Enron executives were self-dealing, earnings were manipulated, and its books were a mess. Complex structures had been used to hide debt, and valuations of assets were pure fantasy. The company would arbitrarily decide when an investment was going to produce earnings in the future, then calculate its current value. Enron’s stock collapsed as the scheme became apparent, sending investors and other corporations running for cover.
The corporate accounting world had looked very different before the fall of Enron. Enron had seemed unbreakable, with direct connections to the White House, and enjoyed widespread approval for using what it said were innovative strategies to supercharge its profits in the internet age.
Most worrying to some investors was the fact that Enron hadn’t been a total sham. It owned plenty of real assets and businesses, many of which survived the fall. It had been riven by bad behavior and bad actors, like the CFO Andy Fastow, who went to prison for his scheme of creating and secretly running complex business partnerships to do business with the company and to enrich himself. Such fraud was rightfully uncovered and prosecuted, but there was much about how Enron ran its business units and balanced its books that was perfectly legal. That had some people worried about the risks of fraud that could be hiding at other companies.
GE wasn’t Enron, but it used some tricks that were less than transparent. And like Enron, GE was a mystery to many investors and analysts. The company could explain some of its operations, but much of the company was a black box, albeit one producing strong and consistent results.
One of those tricks was the Edison Conduit, a massive special-purpose entity that was technically independent of GE and not on its balance sheet. The problem was that the Edison Conduit was controlled by GE and guaranteed by GE Capital, meaning that GE carried all the risk, while investors didn’t even know it existed.
A conduit is a structure commonly used to sell bonds called commercial paper—a form of short-term debt (as brief as a few days and no longer than nine months) that is typically purchased by corporations with excess cash looking for a short-term return. Companies invest in commercial paper to fund their operations. In a large company, money is coming and going but not always at the right time or in the right amount, so access to quick cash is essential to paying suppliers, meeting payroll, and so on. Commercial paper is considered easy to access, trustworthy, and essential. And buyers of commercial paper through the Edison Conduit were further reassured by the backing of GE and its triple-A rating that these deals were trustworthy. Meanwhile, the mix of assets in the Edison Conduit produced earnings that GE used to repay the commercial paper to investors as it matured.
The Edison Conduit, however, had another, more important purpose: it was used to buy assets from GE Capital at prices higher than the recorded book value, creating gains that could be used to improve earnings. Of course, GE wasn’t transferring the risk of owning the assets, so it was really selling them to itself to produce earnings. But at the time, this wasn’t an accounting violation.
In Stamford, Connecticut, the team behind the Edison Conduit took pride in the scheme: a massive earnings engine that was unknown to investors, who saw only steady profits without the risks going into producing them. Because GE backed the mechanism, GE itself would have to pay down the commercial paper it was selling to investors through the conduit—possibly billions of dollars in cash—if something went wrong. But inside GE Capital, this prospect was unthinkable. They were too smart to make such a miscalculation, and GE’s superb credit ratings ensured that it would always have access to cash.
GE had many special-purpose entities that weren’t on its balance sheet and were conducting transactions with the company or each other. As required, GE began dismantling these operations as post-Enron accounting reforms took hold.
In its 2000 annual report, GE asserted that Capital wasn’t a vehicle for off–balance sheet financing. The next year, in the wake of Enron’s collapse, the annual report disclosed more than $55 billion of assets in such special-purpose entities. It warned that credit rating downgrades could force it to pay a similar amount to cover issued commercial paper. It also revealed that GE’s asset sales to the entities brought in $1.3 billion that year. When GE finally had to bring these off–balance sheet entities onto its books in 2003, they added $36.3 billion in assets along with a disclosure that the entities would conduct no new business.GE wasn’t so reckless as to take massive gains that would require more and more deals to feed profits. As assets were sold for gains, into the Edison Conduit or elsewhere, the company could offset those gains with nebulous restructuring charges to offset the gain, effectively eliminating the gain. To most entities, a surge in profits would be welcome, but not to a public company whose results are compared to the previous year. One strong year and a few weaker years doesn’t look great to shareholders—it is much better to spread the profits around more consistently to give the impression of a well-oiled machine. That impression created by GE was a true one, but not in the way that people thought. This is the essence of earnings management.
CFO Dammerman acknowledged this practice of offsetting such windfalls to neutralize a big gain from an asset sale. “We have a pretty consistent record of saying, ‘Okay, we’re going to take these large gains and offset them with discretionary decisions, with restructurings,’ ” he told Fortune.
GE mastered the skill of matching accounting charges with similar gains. Sometimes it would roll in expected costs from the next year to build in even more cushion to future profits. The company pushed back against the suggestion that it was doing anything untoward. They denied that the company was using a “honeypot”—a stash of cash used to hide poor performance—but the scheme’s tricks had the same result.
GE’s pension funds provided another important tool for increasing earnings. Companies determine how much to set aside for future pension obligations by estimating the return on reserved funds and working backward to a present value. For example, if $1 million is due in ten years, a company needs to put aside far less cash now to ensure that the value increases to the required level. By increasing its expected return on the money in the plan, the company could seem to need less money now to meet future obligations and it could record that surplus as profits. GE boosted its estimated pension returns even in weak years when such outcomes seemed unlikely.
The company also put its own stock in the pension plan, where its high-flying shares increased the investment gains, producing more profit to sustain the stock price. It was a positive feedback loop.
Although the maneuvers involved in managing earnings sound devious, and there is no doubt that at GE they weren’t transparent to investors, the practice was largely in line with accounting and governance principles.
Fortune’s Carol Loomis wrote that, when she once told Welch that the smoothing practice was terrible, he vehemently disagreed with her. “What investor would want to buy a conglomerate like GE unless its earnings were predictable?” he asked.
But the winds were shifting. The fall of Enron and other accounting scandals prompted reforms in the rules about the information that public companies had to share with investors. Shareholders were the owners of these corporations, and they wanted to know what companies were doing. More transparency was inevitable for companies like GE. The chairman of the US Securities and Exchange Commission (SEC), Arthur Levitt, warned that at companies that seemed to be making poor decisions in order to meet profit goals, “wishful thinking may be winning the day over faithful representation.”
In 2002, the Sarbanes-Oxley Act was signed into law, bringing sweeping changes to corporate governance and internal company controls. It enacted more accounting scrutiny, increased disclosures, and higher penalties for fraud, and it also required that executives vouch for the results they reported. GE’s ability to manipulate its reported profits was greatly diminished.
As one GE board member said, “The worst thing to happen to Jeff wasn’t 9/11. It was Sarbanes-Oxley.”