The Valuation Treadmill: How Securities Fraud Threatens the Integrity of Public Companies

This year marks the twentieth anniversary of the passage of the Sarbanes-Oxley Act of 2002. Sarbanes-Oxley essentially requires every large public corporation to dedicate substantial resources to preventing securities fraud. How did securities fraud become such a significant regulatory concern for public companies? While the bankruptcies of Enron and WorldCom were the proximate cause of Sarbanes-Oxley, the law addressed a broader set of pressures that emerged gradually over the decades and still persist today. My book, The Valuation Treadmill: How Securities Fraud Threatens the Integrity of Public Companies, traces the history of securities fraud regulation from the 1960s to the present to better understand the problem of public company securities fraud.

The book makes the novel argument that securities fraud emerged as a significant risk for public companies as investors changed how they valued stocks. As investors adopted modern valuation models and attempted to develop projections of a corporation’s ability to generate earnings into the future, it became more important for public companies to meet market expectations about their performance. Public corporations now have a structural incentive to issue misleading disclosure to create the appearance that their economic prospects are brighter than they really are.

Many books have examined individual cases and periods of securities fraud, but no book has looked at securities fraud in public companies over the decades. By studying different eras, this book reveals how the problem of securities fraud has changed and how earlier frauds compare and contrast with more recent frauds. The book is organized around six iconic securities fraud cases.

Xerox: The first chapter of the book starts in the middle of the story to provide readers with an introduction to the concept of securities fraud. Xerox was the target of one of dozens of accounting fraud investigations brought by the SEC around the early 2000s and was the first public company to pay a substantial SEC penalty for committing securities fraud. By the late 1990s, companies were increasingly under pressure to deliver results that met analyst forecasts of their quarterly earnings. As its core business declined, Xerox violated accounting rules to create the appearance that it was meeting ambitious earnings projections that predicted double digit growth. By imposing the first major penalty on Xerox rather than just its individual executives, the SEC signaled it believed that there was a corporate incentive to commit securities fraud.

Penn Central: The next chapter goes back to the 1970s to examine the early emergence of securities fraud as an issue in public companies. A little more than two years after it was formed through a merger in 1968, the Penn Central railroad filed for bankruptcy. Penn Central faced pressure to deliver financial results that showed it could survive the declining profitability of its core railroad business. It used a number of improper measures such as manipulating its accounting through an improper asset sale so that it could report a small profit rather than a loss for a quarter where it had promised significant improvement. In investigating Penn Central, the SEC for the first time set forth a detailed theory of public company securities fraud.

Apple: During the 1980s, the technology industry became the primary setting where the issue of corporate securities fraud was debated. In the mid-1980s, Apple’s stock fell by 25% upon the announcement that it would discontinue the defective disk drive of its Lisa computer. The plaintiff brought a Rule 10b-5 suit alleging that Apple knew of problems with the drive that made its optimistic predictions of success for the Lisa misleading. In May 1991, a jury found two executives of Apple Computer liable for $100 million in losses suffered by purchasers of Apple stock. As securities class actions were increasingly filed against companies that failed to meet a projection, critics argued that such suits were meritless. In 1995, Congress responded by passing the PSLRA, which limited the liability of public companies for issuing a false projection.

Enron: Less than a decade after the enactment of the PSLRA, the shock of the collapse of Enron helped spur Congress to pass Sarbanes-Oxley. Enron encouraged the view that it could create extraordinary revenue growth through innovation. As its projects failed, it used improper accounting techniques to create the appearance that its success was continuing. Enron’s executives argued that they did not know the company’s accounting was improper because it was approved by its auditors. But even if they did not know every detail of its questionable accounting transactions, they knew that the company was using questionable means to hide losses and inflate revenue to meet quarterly earnings projections. The securities frauds at Enron and WorldCom prompted criminal prosecutions that resulted in the conviction of their CEOs based on specific evidence that linked them to efforts to meet financial projections.

Citigroup: The relative lack of serious government sanction of the banks that were almost swept away in the collapse of the housing market and resulting financial crisis of 2008 helps illustrate the limits of securities fraud liability. For example, the massive financial conglomerate Citigroup clearly misrepresented its exposure to subprime mortgage assets by billions of dollars. Though it made civil payments, it was not penalized as harshly as companies like Enron and WorldCom. Citigroup argued it was just as surprised by the extent of the financial crisis as the public. Unlike the cases arising from the Enron era, courts and regulators viewed the misstatements of the financial crisis defendants as mistakes made in managing unprecedented turmoil in the markets rather than securities fraud.

GE: The final case study looks at how the concept of securities fraud may continue to evolve. The clearest cases of securities fraud involve a violation of accounting rules to meet an earnings projection. There is an open question as to when real earnings management, where companies make facially legal decisions that generate real revenue but are motivated primarily to meet earnings projections, can be considered fraudulent. Consider the case of General Electric (GE). For more than a decade, GE never missed a quarterly earnings projection. If performance in one business lagged in a quarter, GE might sell an asset in another division to generate revenue to offset the shortfall. By the 2010s, GE’s tactics pushed losses into the future periods until they grew so large that they could not be denied. In the investigation arising out of GE’s problems, the SEC required the company to pay a major penalty for conduct that included real earnings management practices.

Because valuation models are what separate stock markets from casinos, it is important to police the integrity of the valuation process. Since valuation pressure affects most public companies, there is a case for structural measures that require public companies to invest resources to prevent securities fraud. Public company securities fraud is not solely caused by corrupt managers acting to enrich themselves but is often committed by generally ethical corporate managers who issue a misleading portrayal of the corporation as they pursue corporate goals. Statutes such as Sarbanes-Oxley that require investment in ex ante measures counteract the valuation pressure exerted by modern stock markets.