England. Enron, Tyco, and Parmalat Seen from the City

Has a financial adviser ever suggested you invest in weather derivatives? Weather derivatives?! That’s right: a financial product (like a bond) the return on which is determined by changes in the weather. Actually, this is not some bizarre speculative investment invented by Englishmen who only talk about the climate but a technique used by companies to manage their risk in raising loan finance where their profits depend upon changes in the weather. Power utilities are an example: if it is cold, people use more electricity and so power companies make more money and can pay a higher interest rate; if it is hot, they can afford to pay less.

Another example. Most people think nothing of taking a plane to go on holiday or visit relatives in another country. But aircraft are expensive. Most aircraft are bought using complicated financial structures using syndicates of banks and highly technical tax-driven leasing structures. Without these financing operations, air travel would be much more expensive.

What do these anecdotes tell us? The world of finance is not full of crafty people with no purpose in life except to defraud the unsuspecting public. It exists because financing a multinational enterprise is a complicated matter. An insolvency practitioner once told me that most companies (big or small) do not go bust because they do not have a good product or do not know how to sell it; they go under because they cannot get enough money, at the right price, to fund their activities. Conversely, a company which arranges its finances and manages its risk effectively is able to compete in the same way as it does by producing a better or cheaper service than its rivals.

So what has gone wrong with all the scandals we have seen in recent years–Enron, Tyco, WorldCom, and now Parmalat? I think we need to distinguish between two situations, which may become intertwined. Obviously, on the one hand, there are cases of plain fraud, where companies have clearly falsified profits or executives have literally stolen money. Some are suggesting this has occurred in the case of Parmalat. But on the other hand–and I believe this is the majority–there are situations where companies have pushed the rules to the limit to gain a competitive advantage and things have gone wrong. Reporting and accounting for many financial transactions is complicated and can involve the exercise of judgement. Naturally, a company will want to portray its situation in the best light and be cautious about revealing all the potential risks it faces. The problem is that this can lead to false expectations and to investors being misled. If boundaries are pushed too far and something goes wrong, a catastrophe ensues.

When the disaster happens, it is easy to blame greedy executives and advisers– and much of the blame may lie there. However, that is not necessarily the whole story. For example, during the nineties it became common to give executives bonuses in the form of share options. The idea is that if a manager’s remuneration is linked to the share price of his company, he will do his best to increase the value of the company and so benefit the investors. Simple enough. Shareholders eagerly bought the stocks that performed well and dumped those that did not. Which would you rather buy, shares in a company with average returns or one which promised spectacular growth? Inevitably, this led to executives focusing on short-term aims and using every technique available to increase their reported profits–and therefore the share price–year on year. This was compounded by quarterly reporting of profits in the US. So the problem lies not just with greedy executives, but with investors as well, and to some extent is inherent in a system that relies on competition.

Are there easy solutions?
Paradoxically, the scandals themselves are helping address the situation. After the collapse of Arthur Andersen following the Enron affair, firms are paranoid about damage to their reputation and desperate to appear “whiter than white”–although this does not mean that mistakes made in the past will not continue to emerge.
But maybe the only lasting answer, as in all walks of life, lies with the individual. What, ultimately do we work for? Is it just an ever-increasing take-home pay or is there something more essential on which professional integrity is founded? Tougher and more detailed rules will never truly address this question. As T. S. Eliot says, “They constantly try to escape/ From the darkness outside and within/ By dreaming of systems so perfect that no one will need to be good.” (Choruses from “The Rock,” VI, 21-23)
The author is a professional adviser in one of the largest City firms in London.