Enron? We're Missing The Point
By Lanny J. Davis
Sunday, January 6, 2002; Page B01
Here's a paradox: Despite predictions of doom from many financial writers, it doesn't matter very much that Enron -- at one time touted as the seventh-largest company in the nation -- failed. What matters is why it failed.
Enron's demise will be little more than a blip on the U.S. economy, with the big losers confined to the same financial speculators who rode the bubble on the way up. But the underlying cause of Enron's fall -- a corporate culture of secrecy and obfuscation -- is not unique to that company. Far from it. Enron's problems are emblematic of myriad public companies in the 1990s, from dot-com start-ups to some of America's biggest corporations, who yielded to the pressure to inflate their stock by whatever means possible.
If that culture isn't replaced by more transparency and accountability, regulated and enforced by the Securities and Exchange Commission (SEC) and U.S. prosecutors, the credibility and integrity of the various stock markets in which millions of Americans are now invested could be seriously undermined. That's why I hope that Sen. Joseph I. Lieberman (D-Conn.) meant it when he said Wednesday -- after his Senate Governmental Affairs Committee announced it would subpoena Enron's top executives and directors -- that the committee's focus will be "to make sure that something like this never happens again."
I know something about the culture of obfuscation. I have spent much of the past three years representing public companies and executives accused of accounting and financial fraud. Sometimes I have been lucky enough to be called in before the bad news hit the fan. But more frequently, I arrived after information had begun to leak out.
In one instance, the new CEO of a Nasdaq-listed company, Lernout & Hauspie Speech Products, retained me and my law firm. He told me he suspected that the books of the language translation software company had been cooked by the company's former CEO. The company, he said, had created the appearance of dramatic growth by establishing outside entities -- investment companies in which money from investors was being used to purchase what turned out to be mostly nonexistent products and services. Liabilities and losses were being hidden in these entities and not included in the company's financial statements.
The new CEO suspected that some members of the board of directors might be complicit. The Wall Street Journal had been writing bits and pieces of the story, but the company, based in Belgium, had either stonewalled or had given out misinformation.
We quickly initiated a two-part strategy based on complete transparency: First, we decided to support an investigation by outside auditors and a new law firm, with a commitment to publish the results and cooperate fully with the SEC; second, we proposed a program of internal reform to clean up the last vestiges of misleading financial reporting. While we knew the company's high-flying stock would take a major beating once we made these disclosures, we believed this strategy offered the only hope for the survival of the company.
However, we ran into a glitch. The company's board of directors opposed full disclosure. The new CEO defied the board and directed me to give the report to the Wall Street Journal and to other newspapers and to post it on the company's Web site. We both agreed he had no alternative if he were to avoid becoming part of the coverup. One immediate result of our strategy: The new CEO was summarily fired by the board -- as were my law firm and I. Another result: A short time later, the company filed for bankruptcy and was liquidated. The former CEO and some board members were charged with fraud and stock manipulation. All have denied these allegations. The investigation is continuing.
So you can see why I took such an interest in the rise and fall of Enron. As Yogi Berra would say, "It's déjà vu all over again." Enron, too, developed outside entities that supposedly generated revenues for the company, while keeping the expenses and contingent liabilities associated with those transactions off the books. And Enron's business, like Lernout & Hauspie's, didn't focus on selling real products to consumers with real profit margins. Rather, Enron was essentially a broker: It bought, resold and invested in commodities futures contracts, gambling on future prices and market conditions. One example of this business model is a brokerage company such as Goldman Sachs. But perhaps a more apt analogy is Las Vegas.
It really didn't matter what commodities Enron was betting on. Although it was known as an energy company, trading in natural gas and electricity contracts, it also speculated in water contracts, advertising and time contracts, complex derivatives, broadband capacity futures and weather derivatives (whatever that means). Its former chief executive, Jeffrey K. Skilling, actually once boasted about the company's absence of hard assets. He proudly described its approach as "asset lite," adding: "In the old days, people worked for assets. We've turned it around -- what we've said is, the assets work for people."
This characterization is the key to understanding both the breathtaking speed of Enron's collapse and the reason its failure will not have much impact on the nation's economy. Enron's geometric growth from a sleepy natural gas pipeline company in the '80s to a global giant -- with 21,000 employees, 3,500 subdivisions around the world and, by the summer of 2000, a total "market capitalization" value of more than $80 billion -- was based on perception rather than reality. As long as everyone saw the stock price going higher and higher, people were willing to bet their money (through loans, equity investments and credit on trades) on Enron. J.P. Morgan Chase & Co., for example, lent Enron $500 million without security and another $400 million purportedly secured by something.
But if you live by the perception and the illusion of growth, then you die by it once reality sets in. Being "asset lite" meant that once Enron's numbers and disclosures became suspect, there was no foundation of hard assets -- real products with real value -- to fall back on. Not surprisingly, once the first card of credibility was lost, the rest of the house collapsed quickly. On Oct. 17, Enron was forced to announce that it had hidden $1 billion of losses resulting from the outside entities; the next day it reduced its assets by $1.2 billion. Just six weeks later, on Dec. 2, after weeks of putting out deceptive information, Enron filed for bankruptcy. Its stock price had fallen from $90 a share in the previous year to just 87 cents.
The fallout? Thousands of Enron employees who lost their jobs and much of the value of their 401(k)pension plans, which included now-worthless Enron stock, will feel a deep impact. Because of decisions made by senior management, these employees were not allowed to sell the stock as it was dropping in value, though those same managers had sold nearly $1 billion worth of shares throughout the year. Others likely to suffer from the company's failure are the banks, investors and trading partners who willingly advanced Enron their money as the stock soared.
But it's hard to feel much sympathy there. Consumers won't really notice the difference. The electricity, natural gas and water supplies that were the subject of Enron futures contracts will still be delivered to their homes one way or the other. Speculators in Enron's "weather derivatives" may have lost some money, but that's not likely to have much effect on whether it rains or shines each day.
So if Enron's fall doesn't really matter in macroeconomic terms, why should we care? Because the corporate culture that bred that failure has undermined trust in the integrity of the public markets. The goal of "meeting the numbers" projected by analysts for each quarter has too often become the overriding goal -- to be achieved in the accounting department if it cannot be achieved in the marketplace. As Michael R. Young has written in "Accounting Irregularities and Financial Fraud," his seminal book, "What moves financial markets is the published expectations of Wall Street analysts." They "are perceived to establish, within a very narrow margin, the parameters for the upcoming actual financial results. Analyst expectations have become, in effect, a company's reported earnings."
With millions of Americans now invested in the stock market, this is no longer a concern limited to financial elites. We cannot afford to preserve a system in which perception is more important than reality.
The solutions are as obvious as they are unlikely to be met. The rule of thumb must be transparency, in word as well as deed. On a technical level, accounting rules and disclosure requirements have to be tightened up. Off-balance-sheet entities that create even the slightest contingent liabilities should be incorporated into the company's publicly filed financial information. We must also move to a system of real-time financial disclosures, with online access to the latest financial information. This is what SEC policymakers and congressional investigators should concentrate on.
In addition, white-collar criminals who cook the books should be prosecuted, sent to jail and required to disgorge profits from all stock sales made during the period of fraud, rather than receiving what is too often a slap on the wrist and a reminder to the corporate world that crime can pay.
Finally, corporate managers must practice the basic rules of crisis management -- which may mean defying the advice of many of their lawyers -- when they learn about bad news that could hurt the company's stock price. The truth will come out anyway, and dribs and drabs will only make its impact worse. So you might as well put it out yourself -- and then do something to fix the problem.
Of course, this advice to tell all the truth has been rejected, time and again, and not only by business executives. It has been ignored by politicians as well. The effect on the public's trust -- whether shareholders' or voters' -- has been the same.
Lanny Davis, special counsel to President Clinton from 1996 until 1998, is partner at the law firm of Patton Boggs and serves on its legal crisis management team. He is the author of "Truth to Tell: Tell It Early, Tell It All, Tell It Yourself" (Free Press).
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