Small Investors, Sitting Ducks

It remains too easy for insiders and middlemen to commit fraud

Labor Day is traditionally a time to assess the condition of wage workers. But in many ways, today's small investors have more affinity with the proletariat than either class has in common with the unscrupulous insiders, middle-men, and CEOs who have been fleecing both. Today, nonsupervisory workers have the same inflation-adjusted earnings they had in 2001, according to the Bureau of Labor Statistics -- no real raises for four years. Many voices have suggested that workers can cushion their vulnerability by joining the investor class. But investors, if anything, have taken a worse hit. The broad stock market is still down about 18% from its peak in 2000. And no prudent investment strategy is evident. Bonds are unattractive because of low yields and the risk of rising rates. Stocks are trading within a narrow range, dividend payouts are paltry, and there's no bull market in sight. Even real estate -- long a refuge for the little guy -- is suddenly a gamble.

Some small investors are tempted by hedge funds, currency and commodity plays, or other exotic vehicles ordinarily used by high rollers. But the apparent fraud and collapse of Bayou Group, a hedge fund that courted relatively small investors, should signal caution -- even as hedge funds resist minimal regulation.

AS THE WALL STREET SCANDALS so vividly demonstrated, small investors ought to be particularly wary of their supposed servants. The worst scoundrels were not the CEOs of outfits such as WorldCom (MCIT ), now finally starting prison terms. Far worse were the ostensible agents of investors, the accountants, investment bankers, and stock analysts who vouched for -- and profited from -- the deceptions. Regulators, with a few heroic exceptions, also let investors down. The much-extolled Sarbanes-Oxley Act, in the hands of a now docile Securities & Exchange Commission, could be a weak reed. There is already a massive campaign to roll back key provisions on the grounds that enforcement of honest capitalism is financially burdensome. (Compared to what? To trillions lost by investors in an artificially induced bubble?)

What every recent abuse had in common was that insiders and middlemen manipulated corporate books, inflating the value of stocks and getting rich at the expense of ordinary investors. Self-regulation and market discipline failed. And if enforcement against conflicts of interest is not vigilant, investors will be snookered again.

An important new book, The Best Way to Rob a Bank Is To Own One, introduces a valuable concept called "control fraud." The author, William K. Black, is a former Federal Home Loan Bank Board enforcement official who now teaches about corporate chicanery at the University of Texas. Black's book is partly the definitive history of the savings-and-loan industry scandals of the early 1980s. More important, it is a general theory of how dishonest CEOs, crony directors, and corrupt middlemen can systematically defeat market discipline and conceal deliberate fraud for a long time -- enough to create massive damage. Although the currently fashionable Law and Economics school of thought contends that regulation only causes inefficiencies, Black's analysis reminds us that history teaches otherwise.

In the S&L debacle, industry-engineered deregulation all but invited S&Ls to inflate balance sheets, overpay for brokered deposits, and make highly speculative loans. Insiders got rich. The market didn't correct the fraud, which ended when the industry was substantially re-regulated and bailed out by taxpayers to the tune of $200 billion -- or almost $500 billion if you count interest.

The S&L scandals foreshadowed the broader Wall Street manipulations that followed. As Black observes, despite a brief episode of S&L re-regulation, we did not learn the general lessons -- that financial markets and self-regulation can't police systematic efforts to defraud by those in control. So we were sitting ducks for the next barrage of control frauds by the Enrons and WorldComs, this time with blue-chip investment bankers and tame regulators as enablers. That vulnerability continues.

This Labor Day, wage workers are struggling to re-invent a labor movement. America also has lobbies for doctors, accountants, retired people -- indeed, it's only investors who lack an effective interest group. Investors sorely need a movement of their own to fight for transparent markets, honest books, and uncorrupted regulation. Whether in post-Soviet Russia or on Wall Street, the real specter that haunts capitalism is corruption. Investors of the world, unite!

Robert Kuttner is co-editor of The American Prospect and author of Everything for Sale.

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