School for scandal: 2002

In retrospect, we should have paid more attention to 2002. It was a year racked by scandal, insolvency and feverish regulatory and legal maneuvering; but it was also a time when foundations for the next big, and fateful, boom were quietly laid. Indeed, what is most striking about 2002 was what we failed to see.

The year was defined by breakdowns, each of which generated a government response: big bankruptcies that began with Enron, and that drew attention to corporate (particularly accounting) malfeasance; conflicts on Wall Street, embodied in analyst scandals and driven by Eliot Spitzer; and the bear-market remedy of low interest rates from the Federal Reserve. None of these responses was particularly controversial -- in fact, they were widely applauded -- but each spawned unintended consequences.

Enron collapsed into bankruptcy in December 2001, but 2002 revealed something stranger. There was the public Enron, Jeff Skilling's assetless wonder. Then there was the real Enron: a maze of off-balance-sheet vehicles with names out of "Star Wars," driven by complex -- and fraudulent -- accounting and faith in quantitative finance as an anti-gravity device. By the end, Enron was building an Indian power plant, trading broadband, manipulating energy markets, notably in 2001's California energy crisis, and losing money.

Retribution came swiftly, if bluntly. Executives like chairman Kenneth Lay and former CEO Skilling were excoriated by Congress. Enron's auditor, Arthur Andersen, was dragged into court by the Justice Department, convicted on June 15 of obstruction of justice and banned from auditing public companies, putting 85,000 Andersen employees out of work; the fact that the Supreme Court overturned the decision in 2005 did not soften that blow. The feds also began building a case against senior Enron execs, from Lay to Skilling to CFO Andrew Fastow and even his wife.

Enron and Andersen were not alone. Several weeks before Andersen was convicted, Dennis Kozlowski, the CEO of Tyco International, was indicted; more charges followed. That same month, cable company Adelphia filed; a month later, five executives, including three members of the founding Rigas family, were arrested for fraud. Then, on July 25, WorldCom, a telecom built by Bernard Ebbers in deal after deal, filed for bankruptcy, admitting it overstated earnings by more than $3.8 billion.

Congress responded. The House had begun to work on a bill in April. As uproar mounted, the Senate Banking Committee under Paul Sarbanes offered its own version. With WorldCom fresh in their minds, The Corporate and Auditing Accountability, Responsibility, and Transparency Act, otherwise known as Sarbanes-Oxley, sailed through 97-0 on July 15. The bill mandated new federal rules for corporations and auditors and was both a major federal incursion into corporate law and a massive new regulatory burden. Ironically, auditors thrived off Sarbanes, though it was less clear whether it helped investors. Meanwhile, from a regulatory perspective, it clearly threatened state powers, particularly raising Delaware's greatest fear, the federalization of corporate law.

Oddly enough, if Sarbanes represented advancing federal power, a state attorney general, New York's Eliot Spitzer, undermined an already shaky Securities and Exchange Commission. The issue arose from the now-dead dot-com boom: conflicts, both in the issuance of initial public offerings and investment research, on Wall Street. Spitzer was no ordinary state attorney general: He wielded New York State's Martin Act, which gave him subpoena power, with swashbuckling élan. In April, Spitzer released e-mails from Merrill Lynch & Co. Internet analyst Henry Blodget, which derided his own recommendations, referring to them in that immortal phrase, "putting lipstick on a pig." By May, Spitzer had bludgeoned Merrill into settling, and for the remainder of the year and into 2003, he hounded the rest of Wall Street, focusing primarily on another analyst, Jack Grubman of
Citigroup, who, among other things, Spitzer accused of trading entrance to a tony nursery school for his kids with Citi chief Sandy Weill for positive
recommendations.

Still, for all the hue and cry, Wall Street shrugged off Spitzer, though research never recovered. While an increasingly leveraged Street powered past charges of abetting fraud at Enron, "spinning" IPOs and corrupting research, the Fed's policy of easy money worked its magic. Pension funds pumped up hedge funds, and buyout firms feasted off cheap funding and low prices. That liquidity began to seep into real estate. Indeed, for all of the scandal, moral breast-beating and new rules in 2002, fundamental problems were ignored: deepening trade imbalances, perverse incentives and a rising tide of liquidity and leverage.