‘Black World’ of Defense Cloaks Firms in Secrecy
When Perkin-Elmer Corp. reported a sharp drop in sales in the early 1970s, financial analysts on Wall Street were dumbfounded by the sudden and unexplained event.
“It turned out that about a quarter of their revenues were coming from highly secret work on optical surfaces for spy satellites,” recalled Wolfgang Demisch, an analyst at Union Bank of Switzerland. “It wasn’t a problem until those sales disappeared and nobody knew what was happening.”
Outside of the military and its contractors, access to information about top secret weapons programs is rare, if not non-existent. Government securities policies are meant to exclude, rather than include, institutions and individuals who would normally have an interest in multibillion dollar contracts.
Until recently, that was not a problem, because the so-called black world of defense was just a small, though militarily important, part of the defense procurement system. But today, secret weapons programs have moved into the mainstream of the Pentagon’s industrial activities.
An estimated 39% of Air Force procurement in the next fiscal year will be in black programs, in which outsiders’ access to financial and technical information is limited or non-existent. U.S. industry is producing secret aircraft, spacecraft and electronic systems, employing tens of thousands of aerospace workers in a shadowy world.
The tremendous growth of secret military programs during the past decade has in some cases cut off important financial information sought by commercial bankers and investors. Even members of the boards of directors of aerospace firms are not always cleared to review a large part of the business that they are elected by shareholders to govern.
The trend raises the critical question of how commercial bankers, investment managers and directors can intelligently fulfill their fiduciary duties when they do not have access to information about a growing portion of their own companies’ business.
“If directors and investors are not informed on black programs, I don’t see how they can make informed and rational decisions about the financial health of their corporations,” said Rep. John D. Dingell (D-Mich.), chairman of the House Energy and Commerce Committee’s subcommittee on oversight and investigations. “And the proliferation of these secret programs within corporations only makes the situation worse.”
Complicated Problem
Many government officials agree that the military has too many secrets, but they discount the importance of the problems that causes in financial markets.
“There is far too much information being classified at too high a level,” said Maynard C. Anderson, Defense Department director of security plans and programs. “Some of these special-access programs don’t need to be under special access.”
But he added: “We never tell a company how to do its business. If a company bids on some business and if they are successful in getting a contract, they tell us who needs clearance.”
Privately, some aerospace officials say the problem is more complicated than that. They say that military officials in special-access programs oppose each high-level clearance and impose iron controls on what information contractors release about their business.
As a result, some Wall Street securities analysts are putting pressure on the military services to loosen restrictions on black world financial information.
Joseph Campbell, an influential aerospace analyst at the investment firm of Paine Webber Inc., said he has met with a dozen top Pentagon officials, including Air Force Undersecretary James F. McGovern, to press for a relaxation in the restrictions covering financial reporting on a growing portion of military contracts.
“I have been telling them that there is a real cost to classification and that they should seriously consider the cost in the financial markets,” Campbell said. “None of them say it is his job to change things, but I am hoping the pressure will force a re-evaluation.”
Cost of Secrecy
The cost that Campbell cites can be most directly measured in terms of uncertainty within financial markets that causes investors to discount the value of stocks and bonds that aerospace firms issue.
The philosophy of capitalist free markets is that they should operate on perfect knowledge, but the intent of military classification is to maximize ignorance. Measuring the cost of secrecy is difficult, if not impossible--but the degree of uncertainty is clearly growing.
According to a recent study by the Center on Budget and Policy Priorities, 28% of Air Force procurement money is being spent in the black world during the current fiscal year and 39% of it will go black in fiscal 1989. The Pentagon will spend $24.1 billion on secret programs next year, according to the center’s estimates. A similar study by the Center for Defense Information reached virtually the same conclusion.
A study of the black world by the U.S. General Accounting Office, issued in February, found that the Department of Defense’s “management structure was not initially set up for activities of such magnitude.”
Lockheed, Northrop, TRW and Hughes Aircraft are the major prime contractors who have the largest segments of classified work and, among those, Northrop clearly has the largest proportion of its revenues derived from contracts for “special-access” programs.
More than 50% of Northrop’s revenue comes from such programs as the stealth bomber and the Tacit Rainbow missile. Northrop Chairman Thomas V. Jones said the company has attempted to deal with the situation with such measures as arranging for security clearances for a few outside directors and an outside auditor as well as the use of a standardized accounting system for both black and white programs.
TRW derives an estimated 50% of its defense-connected revenues from classified programs, and Lockheed Missiles & Space is close to that figure, according to analysts. Hughes Aircraft derives 20% of its work from the black world, analysts say.
Fostering Suspicion
Historically, an aura of technical excellence has accompanied secret military work, but that is increasingly giving way to uneasy suspicion.
“Northrop stock is lower than it would otherwise be if we knew more,” Campbell, the aerospace analyst at Paine Webber, said. “The market cannot tolerate the uncertainty.”
Moreover, it is not just analysts who are concerned.
“The issue has certainly come up, and it is of concern to outside directors,” Michael Berberian, a longstanding director of Lockheed, said recently. “The company executives have expressed sympathy with our concerns. We are developing a plan where a certain number of outside directors who have the necessary clearances will serve as a watchdog for the board.
“There is an awareness and concern by the outside directors to this exposure,” he added. “Within 60 to 90 days, we hope to have a plan. Even though no problems have cropped up, as these programs grow in size, the board is increasingly concerned about that exposure and has addressed the problem.”
Berberian asserted that secret or classified areas have historically had fewer technical problems than open programs, but whether that can continue is debatable.
Michael Rich, director of Rand Corp.’s National Defense Research Institute, noted that, as secret programs become the norm, rather than the exception, performance in those programs is more likely to resemble the average for all military programs.
“The size of these programs has meant that specialized management methods specific to the black world have not been possible,” he said. “The management structure and procedures used look a lot like the white world, and so it is not surprising that the results resemble the white world.”
Oversight Missing
Some critics of the Pentagon go much further, saying that investors are doubly exposed in companies with significant black programs because not only do they lack information to make their own judgments, but they cannot rely on the normal system of oversight that exists for the white world.
“The regulatory oversight, which is suspect in the best of times, is almost non-existent when a program is black,” said Gordon Adams, director for defense studies at the Center on Budget and Policy Priorities in Washington. “In a black program, (a defense contractor’s) performance problems will be out of the barn and into the next county before you see any evidence of them.”
Dingell, the House member whose subcommittee is deeply involved with federal securities laws, has complained to the Securities and Exchange Commission about lack of audit oversight in secret military programs. The subcommittee’s staff particularly faults the practice among aerospace firms of seeking clearance for a single senior partner of the outside auditing firm.
“We find the practice totally inadequate,” a subcommittee staff member said. “Senior auditors have to depend on their staffs. They don’t get their hands dirty auditing records.”
Not every analyst or director agrees that secrecy is causing measurable disruptions in financial markets.
Paul Nisbet, a leading analyst at Prudential-Bache Securities, said the accuracy of analysts in predicting financial performance of aerospace firms with large amounts of secret programs is “pretty darn high.”
“We are much more accurate in projecting the outlooks for these companies than we are in projecting most commercial businesses,” he said.
But others point to stunning surprises that have hit the financial community on some secret programs. Wall Street was caught unaware, for example, when Northrop was forced to take two writeoffs amounting to $214 million in its stealth bomber program in recent years. To this day, they still disagree about what caused the writeoffs and whether they are part of continuing problems.
“It was a painful surprise for everybody,” recalled Wolfgang Demisch, aerospace analyst in New York for Union Bank of Switzerland. “It is the classical example of the unknown unknown biting you in the rump.”
Informing Investors
Analysts have been forced to repeatedly reduce their projections of Northrop earnings and, partly as a result, Northrop stock plunged during the past year by more than 50%. It has since recovered partially but is still selling at a steep discount.
One continuing source of uncertainty, for example, is whether Northrop’s stealth bomber contracts were written under new tax laws and new procurement rules that could significantly increase the company’s cash needs. Northrop’s cash flow turned negative last year, and the company has been borrowing heavily to meet its cash needs.
Jones, the Northrop chairman, said he heard no complaints from investors about a lack of disclosure and that the company has won seven annual awards from the Financial Analysts Federation for its financial reporting.
Uncertainty is not confined to narrow financial issues in secret defense work. It can create economic disruptions in labor markets, as well.
TRW, for example, has laid off 1,300 workers at its Space Park facility in Redondo Beach this year. The company has not been able to discuss what prompted the layoffs, but interviews with workers indicate that reductions in a secret satellite program were the cause.
Corporate directors may have the knottiest problem of all because they are legally charged with looking out for the good of the corporation and its investors. Whether they have liability if things go wrong is open to question, however.
“As a director, I can rely on information from management as long as I ask the penetrating questions,” said John Nash, president of the National Assn. of Directors. “I can ask if we are conforming to the proper norms and if contracts are not operating at a loss. As long as I have asked, I have performed my due diligence. If the information is wrong, I am not at fault.”
Michael Diamond, a Los Angeles attorney at the law firm of Skaden, Arps, Slate, Meagher & Flom, agreed that a director probably could not be held liable for errors resulting from a lack of knowledge because of government-imposed restrictions. Nonetheless, he admitted, “It is a problem.”
Anderson, the Pentagon director for security plans and programs, said companies can seek as many security clearances for individuals as they choose. Under Pentagon rules, he said, clearance is granted to every OODEP, an acronym standing for “officers, owners, directors and executive personnel.”
The more pressing concern that Anderson has about the increases in special-access programs is the mounting cost of security.
“I am trying to figure out a way to construct budget exhibits for industrial security and facilities security,” he said. “In some programs we can tell how much is spent, but in most programs it is part of overhead. Some programs run on the basis of 2%, and some run 7% to 8% of cost.”
At that rate, the Pentagon is spending hundreds of millions, if not billions, of dollars on security for secret programs.
