Close-up
The Enron mess: Energy giant's calamity spotlights regulatory loopholes
By Los Angeles Times and The Associated Press
DAVID J. PHILLIP / THE ASSOCIATED PRESS
Sue Nix, left, and Mildred Dworsky fill out paperwork at a meeting to help laid-off Enron employees last week in Houston. Along with their jobs, many of the bankrupt company's workers lost much of their retirement savings — which had been invested in Enron stock.
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Enron Corp.'s stunning slide into bankruptcy, the largest in U.S. history, met little resistance from the very safeguards that represent the first line of defense in the U.S. financial system for investors, employees and the general public, according to interviews with accounting, financial and corporate-governance experts.
The weaknesses that allowed Enron practices to destroy billions of dollars in investor funds were well-known before the energy-trading firm's collapse, but lobbying efforts by special interests stymied efforts to fix the system.
A U.S. House hearing this week made clear that the Enron debacle is a watershed that will foster a tougher corporate-oversight system that is less vulnerable to conflicts of interest and outside influence. A Senate hearing is scheduled Tuesday.
In its meteoric rise and crash, Enron employed loopholes in accounting regulations to hide debt and in some instances obtained the passive approval of its auditors, Arthur Andersen LLP, who were supposed to root out such practices, accounting experts say.
It hoodwinked Wall Street analysts and investors with stories of creating a "new" business for the new millennium. It convinced credit-rating agencies, which were supposed to pass judgment on the risk of Enron's debt, that the energy trader deserved a solid rating.
Enron's swift descent into federal bankruptcy court left countless investors burned and thousands of employees out of work and with damaged retirement savings.
Richard Baker
"Many people have been deeply hurt," said Rep. Richard Baker, R-La., chairman of the House Financial Services Committee's capital-markets panel, during this week's hearings.
Enron executives were "just having too much fun," he said. They cashed out more than $1 billion in company stock while ordinary employees were barred from selling it from their Enron-heavy 401(k) accounts as share prices plunged, Baker said. Worth more than $80 a year ago, Enron's stock tumbled to less than a dollar a share.
401(k) policy defended
Enron said yesterday that it froze employee retirement accounts packed with its stock while shares plummeted in October and November as part of a routine switch of administrators for the 401(k) program.
The former energy giant, faced with more than 60 401(k)-related lawsuits in state and federal courts, issued a statement that said employees had more than three weeks' notice of the 10-day freeze and that it was unrelated to the company's swift downfall.
Amid the company's strife, nearly 600 employees deemed critical to its operations received more than $100 million in bonuses last month as Enron faced a merger that unraveled and then bankruptcy.
Robert Herdman
The Securities and Exchange Commission itself faced lawmakers' questioning this week over its handling of the Enron case. House members asked Robert Herdman, the SEC's chief accountant, why the agency did not become concerned early this year when Enron executives dumped millions of dollars of stock.
The SEC's first action came Oct. 17 — a letter to Enron requesting more information after it reported big third-quarter losses, Herdman noted.
Stricter rules that could have detected Enron's problems were blocked by business and accounting lobbies, said Lynn Turner, former chief accountant of the SEC.
"The more you make the rules clear and concise, the more problems you make for management," Turner said. "Shareholders will hold management accountable when what's happening at a company is more transparent. Business doesn't want that."
Herdman said the SEC plans next year to adopt rules tightening disclosure requirements for companies.
Enron also is under investigation by the Justice Department. The Labor Department is looking into Enron's handling of its employees' retirement benefit plans.
Kenneth Lay
The company's practices were orchestrated by Chairman Kenneth Lay and former Chief Executive Jeffrey Skilling, who dazzled Wall Street with explosive growth but disclosed little about the company's businesses or practices. They recruited a cadre of executives, attorneys and outside financial advisers, who set up business deals so complex that outsiders were both mesmerized and blinded.
Accounting questions
In November, Enron disclosed that the profit it had reported to shareholders and government regulators over the past four years was overblown by 20 percent or $586 million, sending the stock tumbling. The meltdown cost more than 4,000 employees their jobs, jeopardized thousands more and destroyed the retirement savings of employees with company-sponsored savings plans.
The massive accounting adjustment was a public confession that the company had excluded losses at several partnerships on its financial statements. The event focused immediate attention on its auditors, Arthur Andersen, and its interpretation of accounting rules that allowed the company to exclude the partnerships from its reporting. Enron and Andersen dispute who is to blame for the faulty accounting.
Enron created numerous partnerships that held company assets and in many cases employed company executives as managers. Key financial details about the partnerships, which invested in energy companies, water facilities, telecommunications and other ventures, remain undisclosed, but it is known that some executives earned millions of dollars in fees operating them.
These partnerships are frequently used by businesses but are a long-standing source of controversy in the investment community.
The Financial Accounting Standards Board, which makes most accounting rules in the United States, looked at creating stricter rules for disclosing the finances of such ventures in the 1980s but failed to follow through because of the objections of the major accounting firms, said Turner, who sat on the committee.
They were scared of the backlash from their clients, he said.
Another key issue in the Enron case is the huge consulting fees that accounting firms collect from the same companies they are supposed to be auditing.
Major accounting firms have moved aggressively to expand their business from auditing and accounting to more general consulting on financial issues, personnel, management and information technology.
"The fear is that the auditor will fold in any disputes with the company because they want to keep all the fees coming in," said Harry DeAngelo, a University of Southern California professor of finance and economics.
Enron paid Andersen $27 million last year for nonaudit work and $25 million for its audit.
"Could that million dollars a week have played a role in their clouded judgment here?" Rep. John Dingell, D-Mich., asked in a recent letter about Enron to SEC Chairman Harvey Pitt.
Moreover, the accounting industry's self-regulatory system is toothless, according to critics.
The American Institute of Certified Public Accountants has a professional ethics board. But the board's most severe sanction is to kick members out of the trade association.
Joseph Berardino, Andersen's chief executive, said the accounting firm "will have to change ... the accounting profession will have to reform itself. Our system of regulation and discipline will have to be improved."
The credit raters
Although credit-rating agencies are neither regulators nor, like auditors, official overseers of corporate bookkeeping, their opinions about companies' financial strength carry enormous weight in the marketplace.
When Standard and Poor's finally downgraded Enron bonds to "junk" status Nov. 29, followed the same day by Moody's and smaller rival Fitch, it yanked out the last prop from Enron's stock and scuttled a planned acquisition by rival Houston energy company Dynegy Inc.
By that time, however, many Enron bonds had already lost more than half their value as many investors reached their own conclusions about Enron's stability and stampeded to sell.
Sean Egan, managing director of Saline, Mich.-based Egan-Jones Ratings, argues that the big agencies were conflicted because they take fees from the corporations whose debt they rate.
Egan-Jones, who dropped Enron's rating to junk status a month before the other agencies, accepts no fees from bond issuers, instead selling their opinions on a subscription basis to bond investors.
The 'story' stock
Every year some stock defies gravity. The company preaches why time-honored fundamentals such as earnings or conservative debt ratios no longer apply to its business model. Analysts swallow the story, the financial media gush praise and investors buy shares. In the end, however, the market always learns that there is no real substitute for a sound balance sheet and the stock plunges.
"Enron got so much favorable publicity that people bought into the story line," said DeAngelo, the USC business professor. "The stock market put enormous valuations on the company without regard to the prospect of what a liquidity crisis might do to Enron in the future."
The Enron case demonstrates that even savvy financial minds can become befuddled by these speculative bubbles.
The senior Democrat on the House Government Reform Committee has set up an Enron Internet tip line at www.house.gov/waxman/index.htm
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