JPRI Critique Vol. IX, No. 5, July 2002
Crony Capitalism Comes To America
by Marshall Auerback
"Investment banks helped create the [1990s stock market] bubble, issuing shares in companies unready to come to the market, selling them to their investment clients and supporting them with absurdly overoptimistic research." (Financial Times, June 7, 2002)
In a 1998 New Year’s commentary for the San Diego Union-Tribune, the American columnist Charles Krauthammer triumphantly proclaimed the victory of the American capitalist model, “which lies closer to the free market vision of Adam Smith than any other. Much closer, certainly, than Asia’s paternalistic crony capitalism that so seduced critics of the American system during Asia’s now burst bubble.” Perhaps Krauthammer proclaimed victory over the Asians prematurely in light of a June 5, 2002, speech at Washington’s National Press Club in which the chairman and CEO of Goldman Sachs levelled comparable charges against corporate America. In his speech, Henry “Hank” Paulson acknowledged the damage done to public trust in corporate America by Enron and other stock market scandals and said that this was forestalling a recovery in financial markets. He proposed several measures to rebuild trust, including restrictions on the ability of chief executives to sell shares of their own companies, as well as calling for changes in how public companies are run, audited, and regulated to help restore investor confidence.
Although Paulson himself ruefully acknowledged that his speech was “one to two months overdue”—changing “months” to “years” might be closer to the mark—many also view Paulson and Goldman Sachs as a darkened pot noting the general blackness. Asian governments and conglomerates recall the repeated lectures they had to endure from former Goldman Sachs CEO and later Treasury Secretary Robert Rubin on the virtues of the American economic model at the height of their own economic crisis in 1998. Paulson’s proposals would have been far more credible had the Goldman chairman—or, indeed, anybody from his industry—deigned to suggest them at the height of the bull market when the practices that he now lambastes were at their most extreme. The speech is equally conspicuous for what Paulson omitted to mention about his industry’s own role in contributing to the low repute in which corporate America is now held.
To read the speech out of context one would think that the Goldman Sachs chairman was simply a disinterested, public-spirited observer, keen to put American capitalism back on the right track. But the spectacle of Merrill Lynch chairman David Komansky being put through the public wringer by the New York State Attorney-General makes one wonder whether Paulson hoped to preempt any criticism of Goldman’s own role in perpetuating the current state of affairs. Throughout the stock market bubble, investment banks like Goldman were not very eager to tackle the obvious conflicts of interests that Paulson now suddenly recognizes. Paulson  alluded to the pressure chief executives feel to report bigger profits every quarter, but failed to acknowledge that this has long been part of an unholy bargain with Wall Street: so long as the Street’s favorite firms continued to “beat the numbers” each quarter, the banks tacitly condoned the questionable means by which these numbers were achieved, rather than aggressively disclosing them and stamping them out. Among the more egregious examples were clients of Goldman Sachs, such as Tyco and Global Crossing.

Widespread Collusion
If anything, the practices of many investment banks went beyond simply turning a blind eye: whistle blowers on Wall Street or the City of London who tried to do more were vilified and in many cases dismissed from their jobs. This created a climate that allowed degenerate practices to multiply. Analysts deemed to be “too bearish” were conveniently shunted aside during internal reorganizations and replaced by congenital optimists from whom a “sell” recommendation was as rare as a solar eclipse.
Examples abound. Back in the early 1990s, Terry Smith, then an analyst at Union Bank of Switzerland (UBS), wrote a book, Accounting for Growth (Random House Business Books, 1992) in which he criticized the accounting techniques of some of his employers’ own corporate clients. Once UBS was alerted to the book, it unsuccessfully tried to ban it, but not before Smith left their employ on very bad terms. The Wall Street attack machine came out in force when Ravi Suria, then a credit analyst with Lehman Brothers, wrote a report which described’s credit as “weak and deteriorating” at the height of the dotcom bubble, when Amazon was still a lucrative source of investment banking fees. John Succo, who ran the equity derivatives desk at Lehman Brothers, declared at a Grant’s Investors Conference in 1998 that many Wall Street firms had no idea of the risks being run by their young, rocket-scientist traders. For suggesting this heresy, he was forced to resign, even though the subsequent collapse of Long Term Capital Management amply vindicated his concerns (see Roger Lowenstein’s book on the LTCM failure, When Genius Failed, Random House, 2000, p. 131). 
What started with Enron—which, we were at first told, was an isolated case—has spread to accounting firms, Wall Street, Main Street, and virtually every aspect of American corporate life. In addition to the less savory aspects of JP Morgan Chase’s banking relationship with Enron, a whole array of objectionable accounting practices has been highlighted in the Arthur Andersen trial in Houston. We have also learned of the dubious sales of stock by Tyco’s Dennis Kozlowski (all the while publicly proclaiming that he rarely, if ever, sold shares) and the questionable behavior that has led to the resignations of WorldCom’s Bernie Ebbers, Adelphia’s John Rigas, and Global Crossing’s Gary Winnick. No wonder Eliot Spitzer, New York Attorney General, has felt compelled to step into the breach.
But to read Hank Paulson’s critical remarks one might assume that Mr. Spitzer was focusing on the wrong target. Although Paulson was surprisingly critical of the corporate executives and directors who make up the client base of major investment banks like Goldman, he never touched on whether Goldman, or any Wall Street firm, ever took a stand against the unethical behavior he now castigates.
Had Paulson addressed his own firm’s failings, as well as those of his industry, he might have mentioned an inquiry, published by the British Government last year, into the affairs of the late publishing tycoon Robert Maxwell, one of the most corrupt businessmen ever to disgrace the London stock exchange. Goldman Sachs was one of his main bankers. The report damningly concluded that the bank bore “a substantial responsibility in respect of the manipulation that occurred in the market”—a manipulation that enabled Maxwell to loot hundreds of millions of pounds from his own employees’ pension fund (quoted by Matthew Lynn, “Watch That Kettle, Cries Hank Paulson, It’s Black,” Bloomberg News, June 10, 2002). By the same token, last March the U.S. Securities and Exchange Commission told Goldman that it planned to pursue a case against the firm for trading Treasury Bonds based on insider information.
The recent history of Goldman Sachs illustrates the evolution of a pristine investment bank eager to avoid conflicts of interest with its valued clients into aggressive traders who quickly shed themselves of such “wimpy” inhibitions. As Roger Lowenstein notes in his book on the Long Term Capital Management fiasco:
“Until recent times, Goldman has been known for the care that it lavished on blue chip corporate clients. An apostle of relationship banking, Goldman had disdained hostile takeovers and even eschewed trading for its own account, on the noble premise that trading could put the bank into conflict with its customers. But in the 1980s and early ’90s, such drawing room niceties were cast aside. The leadership duo of Stephen Friedman and Robert Rubin, later of Treasury fame, confidently expanded into trading, and as Goldman’s bankers removed their white gloves, conflicts with customers became common” (When Genius Failed, p. 171).
With Robert Rubin at the Treasury Department, these practices became far more widespread across the country. His move from Goldman Sachs to the Treasury, and his persistent championing of the interests of Wall Street to the exclusion of virtually everything else, facilitated the spread of a virus of immorality across corporate America.
No Improvement in Sight
Little has been done to address the conflicts of interest that have become endemic in Wall Street during the past decade. The former chairman of the Securities and Exchange Commission, Arthur Levitt, fought a lonely battle to elevate standards, as did organizations such as the Financial Accounting Standards Board (FASB). But with little support from the Administration or Congress (the SEC’s budget was cut by 60% under the Clinton administration) this proved an uphill struggle, particularly given the persistent lobbying against any meaningful reforms by Hank Paulson’s own industry. The June 10, 2002, New York Times headline said it all: “Enthusiasm Ebbs for Tough Reform in Wake of Enron.” Perhaps this institutional inertia will change in light of the June 14th verdict by a 12-member jury to convict Arthur Andersen LLP of a single felony count of obstructing an official government proceeding. But it is equally possible that Arthur Andersen will simply be offered up as a ritual sacrifice, thereby helping to curb any remaining inclination to reform. The Andersen verdict may be used by apologists as “proof” that the American system is fundamentally capable of self-correction with little need for more “government interference.”
The problem is personified in the form of Salomon Smith Barney’s Jack Grubman, the high-flying telecom power broker whose cozy relationships with a host of telecom companies used to net him $20 million a year. “What used to be a conflict is now a synergy,” Grubman graciously explained at a New York telecom conference last year. “Someone like me who is banking-intensive would have been looked at disdainfully by the buy side 15 years ago. Now they know I’m in theflow of what’s going on.” (Quoted by Arianna Huffington, “Analyze This: Wall Street Gives Investors the Finger,” Arianna Online, June 6, 2002.)
As Huffington noted, we learned how much “in the flow” Grubman was with reports that he acted as an unofficial—and undisclosed to investors—advisor to Global Crossing Chairman Gary Winnick. Apparently, at the same time that Grubman was telling investors how bullish he was on Global and a slew of other telecom issues, he was happily advising these companies on everything from merger deals to major hiring decisions.
Merrill Lynch has also had its dirty laundry conspicuously washed in public by New York Attorney General Eliot Spitzer, who fined the firm in an out-of-court settlement. But this was not the first black eye for Merrill: last year the firm—while acknowledging no liability—agreed to pay $400,000 to settle a claim by Debasis Kanjilal, a New York pediatrician who said he lost $500,000 investing in Infospace, an Internet service company recommended by the firm’s Henry Blodget. The doctor and his wife sued both Blodget and the firm for $10.5 million claiming that they bought Infospace at close to its peak of $133 and sold it for $11 based on Blodget’s recommendations. They also claimed that Merrill Lynch had a conflict of interest because it had done underwriting for a company that was later bought by Infospace (Matthew Ingram, The Globe & Mail, Aug. 4, 2001).
Et tu, Brute?
Perhaps most damning is the fact that the Indonesian government, once synonymous in the U.S. with crony capitalism, is now planning an inquiry into actions taken by Merrill Lynch in Indonesia. Officials in Jakarta are investigating Merrill’s recent sale of shares in PT Indonesia Satellite Corp. The minor complication here is that Merrill is advising Indosat on a rights offering of stock scheduled for later this year. Truly, we have come full circle from the days of Charles Krauthammer’s apotheosis of American over Asian capitalism.
The broader issue raised by Paul Krugman in the context of America’s apparent abandonment of free trade is also germane here: “The big danger when the U.S. flouts the rules isn’t retaliation, it’s emulation.” The emerging world would do well to consider some of the principles outlined in Paulson’s speech: the need for adequate corporate governance, the danger of conflicts of interest, the need for financial transparency. These are all issues with which Asia, Latin America, and the rest of the emerging world have had to grapple for years, usually under the intense scrutiny and tutelage of Wall Street and the Treasury. But for once, let us hope that these nations follow what the U.S. says, and not what it actually does, if the world is to preserve a modicum of the free market vision so extolled by Mr. Krauthammer and various other apologists of the American model.
MARSHALL AUERBACK is a British-based global strategist for David W. Tice & Associates, a global fund management firm.

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