After Enron, we must win back investors' trust
Jan. 28, 2002, 6:03PM
By ARTHUR LEVITT JR.
When Enron filed for bankruptcy Dec. 2, it signaled the end of one of the most admired and successful companies
of the 1990s. But it would be myopic to see the collapse as just the story of a rogue business that manipulated its
books and co-opted its auditors and board of directors.
The fall of Enron is actually the story of the bull market of the 1990s -- and how the markets' failure to keep up
with a time of unrivaled prosperity and technological advances allowed competitive juices to bubble over into hype,
greed and immorality. The scandal marks the end of an era; the irrational exuberance of the last decade has
finally collided with the brick wall of rationality.
The damage from the Enron collapse extends well beyond those investors unfortunate enough to lose money on
the energy company. The cracks it exposed threaten to seriously undermine investor confidence in the capital
markets themselves. Without a comprehensive reform effort to re-establish transparency, accountability and
trust, we risk endangering the markets so vital to this country's economic health.
The unparalleled prosperity and enormous productivity gains of the 1990s were not illusions. They sprang from the
growth of the Internet, advances in microchip processing speed and sound fiscal policy.
At the same time, some of the same technological advances that were driving the economy were also making
investing easier, creating millions of new investors. Cable television and the Internet brought a constant stream
of market news, and online trading made it possible for just about anyone to join the party. At the Securities
Exchange Commission, we made it our mission to open up Wall Street to Main Street. We cracked down on
disparities in NASDAQ trading that gave big players the best prices; we passed a full-disclosure regulation that
made sure individual investors had access to the same information as the professionals, and we held dozens of
town meetings across the country to encourage people to invest.
But the system could not keep pace with the bubble of hype and hope. A culture of gamesmanship took hold in
which it was acceptable for corporations to bend the rules, tweak the numbers and let obvious problems slide in
order to meet Wall Street's desires and expectations. Boosting share price and beating expectations took
precedence over creating real value and real numbers. Analysts hyped the stock of companies with which their
banks did business. Auditors focused on selling profitable business services -- such as consulting -- rather than
on exposing potential accounting irregularities. And, too often, boards of directors were more concerned with not
offending management, than in protecting shareholders whose interests they have a duty to represent. Investors,
for their part, suspended disbelief and went along for the ride.
With the fall of Enron, it's clear the game is over. Although it is absolutely necessary that those who perpetrated
this fraud are brought to justice, that is not sufficient to undo the broader harm the scandal has done. In her
now-famous memo to Enron Chairman Kenneth Lay, company Vice President Sherron Watkins asked: "For those
of us who didn't get rich over the last few years, can we afford to stay?"
Right now, investors are beginning to ask that same question about our capital markets. With more than $1 billion
lost in Enron employee retirement accounts and billions more by individual investors, people are wondering: "Can
I afford to risk my savings in the market?" As people pine for the relative security of money beneath the mattress,
it is clear that there is an emerging crisis of confidence in our capital markets.
That crisis of faith didn't start with Enron. Over the last six years, investors have lost close to $200 billion in
earnings restatements and lost market capitalization following audit failures. That -- along with other cases of
high-profile accounting irregularities (such as at Waste Management and Microstrategy), the implosion of
high-flier tech stocks and the Enron scandal -- has combined to call into question the strength of the
fundamentals of our markets and market economy: transparency, accountability and trust.
With the financial markets increasingly contributing to our nation's well-being -- stoking the economy by
generating wealth -- we cannot afford to allow our markets to function at anything less than the highest level of
integrity and with the highest level of confidence.
So as we pick up the pieces of the Enron mess, we must strengthen the guardians of our financial system who
safeguard investors' interests. And that means taking affirmative steps to ensure the independence of these
gatekeepers.
First, Wall Street analysts' conflicts of interest must be exposed. For years, they have been compensated based on
their ability to bring in and support investment banking deals. Yet investors rely on analysts' reports for unbiased
assessments of companies.
Because of its large amount of investment banking business -- involving limited partnerships, loans and
derivatives -- Enron was known in the industry as the "deal machine." That may explain why only days before
Enron filed for bankruptcy, just two of the 16 analysts who covered the company recommended that clients sell
the stock.
As long as analysts are paid based on the deals they bring in or work -- rather than on the quality of their
analysis -- there will always be a cloud of suspicion over their recommendations. Not only should all conflicts be
disclosed to investors, but Wall Street firms should also reform how they compensate analysts.
Second, boards of directors need to be strictly independent so they are able to ask management tough questions.
The separation of corporate ownership and control is a critical part of our corporate culture, creating a natural
environment for accountability -- not just for financial performance, but accountability for management's decisions
as well.
Stock exchanges, as a listing condition, should require at least a majority of the directors on company boards to
meet a strict definition of independence. That means those directors can't accept sweeteners from the companies
they're supposed to oversee, seductions that include consulting fees and contributions to their favorite charities.
In Enron's case, at least three board members would have been disqualified under such a test of independence.
Third, auditors must be independent so they can catch and expose irregularities that inflate or distort companies'
earnings. By now, we all know the close ties that Arthur Andersen had with Enron, and that the accounting firm
was making more money consulting to Enron than auditing it. Unfortunately, this is not an isolated case. A recent
study found that 307 of the companies that make up the S&P 500 spent $909 million in audit fees, and $2.65
billion for other services from those same firms.
Two years ago, the SEC proposed significant limitations on the types of consulting work an accounting firm could
perform for an audit client. An extraordinary amount of political pressure was brought to bear on the commission,
and the restrictions we ended up with were the best possible solution given the realities of the time.
It's time to revisit what services auditors should be allowed to perform for their clients and to seriously consider
requiring companies to change their audit firms every five to seven years to ensure that fresh and skeptical eyes
are always looking at a company's numbers. We should also establish an oversight body for the accounting
industry with independent funding and real investigative powers.
Fourth, we can no longer starve the SEC for funds. Although the commission last year collected about $2.5 billion
in fees for its services, most of the money went to the Treasury. Congress gave the commission only $423 million
to operate, a paltry amount that makes it impossible for the SEC to update itself into a 21st century institution. If
it won't fully fund the SEC, Congress should empower the commission to use some of the fees it collects.
Confidence in the markets and in the financial industry is tied to confidence in the industry's watchdog. That
faith should not be allowed to be undermined.
Throughout American history, there has been a pattern to investing: exuberant bull markets end with crashes
that, in turn, sour people on the markets for a generation. It happened in 1873 and again in 1929. Whether it will
happen once more is the most important question facing us in the wake of Enron's collapse. For years, we have
worked to attract investors to the market, now we must work to keep them by winning back their trust.
Levitt is former chairman of the Securities and Exchange Commission.
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