Random Thoughts

A Legal Scam, Blessed by the SEC & FASB

In any genuine democracy there are checks and balances to prevent the abuse of power. The internal checks are between the executive, legislative and judicial branches. These failed before the Iraq war when the supine congress gave the president a blank check. The judicial branch, which despite its much touted independence and lifetime tenure has been a handmaiden of the power elite throughout the history of the republic, plumbed new depths of irresponsible collusion when it interfered wrongly and injudiciously in the 2004 presidential election. 

The two non-governmental guardians of democracy and the republic are a free press and an informed and alert electorate. Due to the consolidation of the press in large corporations, the fourth estate has become a vested interest catering to the need of the owners and indirectly to the benefit of the advertisers and the prurient interest of the readers and viewers. All of us notice how the details of the wars in Iraq and Afghanistan barely make the evening news or front pages which are hogged by celebrity sex scandals, violent crimes, reality shows and feel good stories. The stress of earning a living and poor attention span, deteriorating education and limited time handicaps the apathetic public. The electorate has historically been the weakest link in all states past and present.

The present article details a legal scam in the stock markets. Tyco, Enron, Worldcom, Adelphi and other scandals highlight how the executives and directors illegally enriched themselves to the detriment of employees and shareholders. Sarbanes Oxley was supposed to put an end to that but the recent scandal of backdating options to a lower price to guarantee a windfall profit for the insiders, shows that there are more loopholes that need to be closed.

There is an even bigger legal scam that most investors are unaware of. The Financial Accounting Standards Board allows earnings to be legally manipulated by using changing and inconsistent standards for reporting earnings. It has finally ruled to expense options but still permits companies to report earnings pro-forma or use other shenanigans and once again the financial institutions, publications and reporters acquiesce silently in this scam. What is even worse is that while the insiders are unloading their cheap option related stock at high prices, they are using the precious cash of the company to buy back large quantities of the inflated stock. This allows the price to remain high and the insiders are absolved from bailing out when the stock tanks some moths later. The stock price is often taken higher by this strategy, even as the intrinsic value of the company deteriorates. The market makers passively follow along, thus facilitating the distribution of this overvalued security to mutual funds, whose managers are generally immune to financial losses from buying overvalued securities as they follow the herd instinct. Ultimately foolish individual investors jump on this bandwagon and soon after the party comes to an end.

In the meantime the insiders have wasted corporate cash by buying the inflated company stock, which they reissue as options at a cheaper price to the same insiders who made the disastrous decision full of conflict of interest. The cycle is repeated every few years. The SEC bears equal responsibility for this legal scam, since it changed its former rule that stock acquired by option exercise had to be held for three years before it could be sold. The new rules allow the executive or director to sell the stock on the same day that it is acquired and in fact impose a tax on the paper profit on the day of the exercise, thus promoting the behavior by the insider to minimize risk.

Brokerage houses and investment banks put out buy recommendations on stocks oblivious to its intrinsic worth or disparity between price and earnings growth, by using inflated discounted cash flow evaluations and assuming and projecting the inflated current temporary annual growth to infinite time. These same brokerage houses and investment banks may hold conflict of interest large long or short positions in the securities they praise or pan and also have a subsidiary that is a specialist or market maker in the same security. 

The whole enterprise stinks and is rife with conflict of interest, that the regulating body like the SEC blithely ignores to the detriment of the unknowing investor duped by public proclamations of strict oversight. The investors have been brainwashed to reject Graham and Dodd's value investing to rely entirely on momentum and technical trading which can be triggered by large capital to become a self-fulfilling prophecy. This is how major large American institutions make their profits and occasionally end up wrong to go belly up like the eight billion dollar hedge fund recently. Thus for the ignorant individual investor the market becomes a casino but with much greater personal financial consequences.


More by :  Gaurang Bhatt, MD

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