Market Reforms After 1929

From the 1929 crash to the early 1980s, the stock market was not a major part of most Americans' daily lives. After the crash, financial reforms created the Securities and Exchange Commission (SEC) and stricter disclosure rules to prevent fraud and unfair practices. However, favoritism remained common, with corporate boards often filled with the CEO's allies. Although the new rules reduced obvious fraud, executives were rarely removed for poor performance.

In the 1970s, falling stock markets and rising inflation led to more hostile takeovers. In the early 1980s, leveraged buyouts (LBOs), where companies were bought using borrowed money, became popular. These methods were often used against companies with weak or slow-growing stock prices. To avoid being taken over, executives tried to increase stock prices by cutting jobs, selling parts of the company, and buying back shares. These actions were called downsizing, cost-cutting, and share buybacks. The idea of "shareholder value" helped support these changes.

More people started investing in stocks than ever before, making the stock market a part of everyday life for ordinary people. Mutual fund managers became famous, and some politicians even suggested investing Social Security funds in stocks. As investors began closely watching company reports and news, stock prices became more affected by negative information. CEOs also started giving more importance to increasing stock prices, especially through strong quarterly earnings reports. Earlier, CEOs mainly focused on improving company operations and believed stock prices would rise naturally. By the 1990s, many leaders began viewing a higher stock price itself as a sign of successful business decisions.

How Stock Options Affected CEO Pay

Companies began connecting CEO salaries to stock prices to motivate leaders to improve company performance. Stock options had been available for many years, but they became common during the 1980s. Executives received large stock option rewards when they joined companies, performed their duties, or left with big severance payments. However, these rewards did not always reflect real success. A CEO could earn a lot from stock options even after the company's stock price had dropped, because the options were set at a lower price. For example, Disney CEO Michael Eisner made over $800 million from stock options in 13 years, even though Disney's stock price only increased two times.

Stock options became a serious issue because companies did not include their cost when showing profits. When the Financial Accounting Standards Board wanted companies to count these costs, some politicians tried to stop the change. Stock options remained widely used and were still supported by compensation experts. CEOs received large rewards even when their companies did not perform well, and they were rarely punished for poor decisions. This made them more willing to take risky actions because they had little to lose.

How Companies Manage Earnings

Earnings management means using legal ways to make company profits appear to grow steadily and help increase stock prices. Companies can delay payments, show income earlier, or move assets and debts to other subsidiaries. As controlling financial information became more important, the chief financial officer (CFO) became a top leader in the company, almost as important as the CEO.

As companies faced more pressure to increase their stock prices, they began using more questionable accounting methods. Stock options gave executives a strong reason to increase profits, even if it meant stretching the rules. Many executives were praised for these actions. Xerox is one example. Its executives did not commit crimes, but the company used misleading methods to make its earnings appear higher. In 2002, the SEC fined Xerox $10 million for providing false information to investors. Tyco International went further by buying more than 200 companies in eight years and using each purchase to increase its stock value for the next deal. This behavior made Tyco's later fraud problems less surprising, but the actions were still against the law.

Some companies hid their financial problems by using special entities to conceal assets and debts. This practice became common, and many firms later crossed ethical and legal boundaries. Between 1998 and 2000, CFO Magazine honored executives from WorldCom, Enron, and Tyco International, who were later charged with fraud.

The SEC, which works to protect investors, did not take enough action to make needed changes. Many ideas to help small investors were ignored. Powerful business and government leaders, including Fed chairman Alan Greenspan and Treasury Secretary Robert E. Rubin, were against adding more rules to financial markets. They supported removing important protections created after the 1929 market crash. Since the economy was doing well and investors were making profits, there was not much support for new reforms.

The situation involved stock analysts and mutual fund managers, who were once trusted to judge companies' financial health. Analysts often promoted certain stocks because their employers could earn money from banking deals and mergers. Fund managers focused on showing strong results to attract more investors and could change investments to improve their performance. Accounting firms, which were supposed to check company records fairly, also became part of the problem. Since consulting services paid more than auditing, accountants avoided upsetting clients who brought them extra business. This led them to approve financial reports without properly questioning them.

Growth of Market Focus

By the mid-1990s, the market became the main priority. Investors focused more on stock prices and short-term shareholder gains than on building strong, lasting businesses. This market-based system spread around the world, causing developing countries to face unstable markets and currency problems.

Netscape's IPO in 1995 started a wave of Internet companies going public. Many of these companies had little experience, unclear plans, and no profits, but investors still believed they would succeed. Investment banks relaxed their strict IPO rules because they earned large fees and wanted to keep important clients. They also gave shares of popular IPOs to attract and reward customers.

Venture capital firms put huge amounts of money into new Internet businesses because they wanted to invest early. Investors focused more on future growth than on real profits. Older companies with steady income and physical assets were seen as outdated and lost market value. Many traditional companies also wanted to benefit from the Internet boom because rising stock prices helped increase their value and gave executives bigger rewards through stock options.

Enron's Growth and Risky Decisions

In 1985, InterNorth, a pipeline company, merged with Houston Natural Gas to create Enron. After the merger, Enron changed from an energy supplier into an energy trading company by using risky accounting methods. CFO Andrew Fastow created special companies to hide Enron's debts and assets, which helped the company borrow more money. Jeffrey Skilling, who managed Enron's trading business, promoted new and untested ideas and created a workplace culture that valued big risks over careful work. CEO Kenneth Lay supported these changes while focusing on building political relationships and presenting Enron as a modern, successful company.

By 1997, Enron's special purpose entities (SPVs) were being used to commit fraud. Enron created complex business deals to sell assets to companies it controlled and falsely show profits. Company leaders cared more about increasing the stock price than following rules. They owned stock options worth about 5% of Enron's shares, which motivated them to keep the stock price high. The board and accounting firm Arthur Andersen failed to stop these actions. A Merrill Lynch analyst raised concerns about Enron's practices but faced pressure from Enron and his own company, forcing him to leave early. In 2000, Enron moved into broadband fiber trading and became a major name in the growing telecom industry, following companies like WorldCom.

Tyco and WorldCom used big mergers to increase their stock prices, but this method could not continue forever. Every new merger had to be bigger than the one before, and another deal had to be made before the costs of the previous mergers were paid. Problems on Wall Street spread through the telecom industry, involving bankers, accountants, lawyers, and banks that helped hide financial problems through misleading loans.

Collapse of Major Tech Deals

The AOL-Time Warner merger in January 2002 was the last huge deal of the boom and exposed the problems that followed. In March, the Internet bubble burst, causing many Internet company stocks to lose up to 90% of their value. Telecom stocks fell later, while some company insiders sold their shares because they knew the prices were too high. Enron reached its highest point in early 2001. Kenneth Lay continued to encourage people to buy Enron stock while selling his own shares. The company went bankrupt in December.

The Sept. 11, 2001, attacks made a falling economy even more difficult. They also increased people's focus on the government's responsibility to protect ordinary citizens. As more companies went bankrupt and accounting fraud cases increased, many people demanded action from President Bush. Congress investigated Enron in early 2002, but the government was slow to respond. The problems continued as the stock market fell, company leaders made large profits, and public trust decreased. WorldCom's bankruptcy in June pushed Congress to act. A major reform law was passed, and Bush signed it because of strong public support. The Sarbanes-Oxley Act of 2002 created stricter company rules, improved audit committees, limited some services provided by auditors, and increased supervision of accountants. Even after these changes, new scandals appeared, and the market continued to drop.

Corruption became widespread even with strong financial reporting laws. The focus on raising shareholder value helped companies hide risky decisions that mostly rewarded top executives. Even after Sarbanes-Oxley reforms, the workplace culture that allowed fraud and weak controls remains.