How Enron Points Up the Need for Better Disclosure of Investment Risks
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The Enron/Arthur Andersen scandal has spawned a raft of Congressional hearings and is sure to be front-page news for months, as regulators and lawmakers seek remedies. But are there really flaws in the system, or is this just a unique case? After all, now matter how tight the laws and severe the penalties, there are always a few renegade companies - and people - out there.
At Wharton, several professors suggest that, while some regulatory and accounting rules may need change, better disclosure of investment risks would resolve many of the problems presented by the Enron case. At its heart, the Enron situation involves a range of business dealings set up to conceal the company's enormous debts from investors, analysts and regulators.
"The interesting question is why, after all these years, we still permit firms to account for things in a fashion that lets them leave [information] off their financial statements," says accounting professor Robert E. Verrecchia. "Why do we let firms deviate from transparency? What objective is being served by this?"
Many elements of the Enron case are familiar, adds legal studies professor Thomas W. Dunfee. What is unusual is that "there were so many failures in the system." Enron executives held positions in partnerships whose interests were not necessarily aligned with Enron's; many Enron executives were former Arthur Andersen employees; the auditors failed to crack down on Enron's questionable numbers, and the Enron directors on the audit committee failed to supervise the auditors. All this, says Dunfee "seems pretty crass."
Amid almost daily revelations about the consequences of Enron's actions, the company earlier this week named bankruptcy specialist Stephen Cooper as interim CEO. Cooper, head of consulting firm Zolfo Cooper L.L.C. in New York, replaces Kenneth Lay, who resigned January 23 under pressure from Enron's creditors.
By all accounts Cooper, who has been involved in the bankruptcies of such well-known companies as Federated Department Stores, Trans World Airlines and Greyhound Lines, will have his hands full. He begins work at a time when lawmakers, shareholders groups, regulators and other commentators are looking at a number of areas where many feel that new regulations might be appropriate: Accounting: Some argue that auditors have been compromised because accounting firms increasingly rely on lucrative management consulting businesses with the same firms they audit. Critics say auditors should not be allowed to do consulting.
Corporate disclosure: Many trace the Enron debacle to arcane rules that allow companies to use partnerships, subsidiaries and other outside entities to hide debts that otherwise would undermine reported earnings. Enron appears to have violated these rules, but some critics argue that, even when obeyed, the rules allow companies to deceive shareholders and regulators.
Enforcement: Like many stock-market scandals, the Enron case raises questions about whether penalties are tough enough to discourage wrongdoing. People who violate securities laws often get off with negotiated settlements, remain in business and do not even have to acknowledge guilt.
Derivatives regulation: Enron was a pioneer in the trading of energy-related securities, and it successfully lobbied Congress to escape the kind of oversight and regulation that are common with other types of security trading.
Campaign financing: Some critics contend that Enron used generous campaign contributions and aggressive lobbying to stave off better regulation and oversight.
401(k) rules: Enron employees lost in excess of $1 billion after the company's stock collapsed, partly because the company prohibited them from selling during a crucial period when the stock was tumbling last fall. Two bills in Congress would limit the amount of employer stock that could be held in an employee's 401(k) and give employees the right to sell the stock.
While cases can be made for change in any of these areas, it seems likely that accounting and disclosure will ultimately be deemed the areas that need the most attention. The Enron debacle might have been avoided, or its consequences might have been less severe, had the company's regular SEC filings disclosed more about the true nature of Enron's business, much of which was hidden behind a complex web of "off-balance-sheet" transactions.
If outsiders have a clear view of a company's debts, its methods of valuing assets and the potential conflicts of interest among key executives, directors and accountants, then investors can assess the risks. Had all this been easy to see, Enron stock probably would never have soared so high - and the collapse then would not have been so devastating. Had everyone known what Enron was up to, this might be just another case of an interesting business model that didn't work out.
The whole purpose of accounting is to give parties with a legitimate interest a clear view inside a company - and, ultimately, to determine how much it is making, says Verrecchia. Companies often use off-balance-sheet transactions and similar techniques "to make their financial statements look better," he adds. In other words, they do it to deceive their owners and potential owners.
Verrecchia also points out that many companies do have legitimate reasons for using partnerships, subsidiaries and other entities for certain transactions. But the assets, debts and risks involved in these transactions should be made clear in the parent company's financial statements. As it was, Enron did not disclose, and Arthur Andersen did not blow the whistle, apparently because it was not in Andersen's interest to do so.
Former SEC Chairman Arthur Levitt has long argued that auditors like Arthur Andersen should be banned from consulting because it makes them go easy when they audit their consulting clients. But Verrecchia says that might not solve the conflict-of-interest problem. In 2000, Arthur Andersen made about $27 million in management consulting fees from Enron, giving it plenty of reason to keep on the company's good side. But it also earned $25 million in audit fees - enough, by itself, to make it worth Andersen's while to keep Enron happy. "A man on the street would ask the question, 'How can someone be paid $25 million and still be independent?'" Verrecchia says.
Many of the accounting shortcomings in the Enron case have long been a problem, he adds. "The only thing that's different about this case is the suddenness with which Enron collapsed. But this is not the first time that a firm has had to restate its financial statement."
The first serious auditing done in the U.S. was performed in the late 19th century by British accountants who were overseeing their country's interests in America, according to accounting professor emeritus Peter H. Knutson. "They were hired by the investors and they reported to the investors, and I think we've gotten away from that," he says. "The task of auditing has become immensely complicated, and it's a question of bringing it in on-budget and on time. I think the interests of the readers - the users - of audits have been forgotten, to a large degree."
SEC Chairman Harvey Pitt recently proposed a new accounting oversight board that would, unlike the current oversight bodies, be dominated by people from outside the industry. "What Harvey Pitt is proposing is nice," Knutson says, "but it's a band-aid. We've got to figure out a way for the people who use the information to pay for the information, so they can exercise some control." Just how such a system could be set up is not clear, but this should be the chief thrust of the post-Enron regulatory reforms, he suggests.
In the federal government, Dunfee adds, there are rules prohibiting former officials who go to industry from dealing with their old agencies. It might be possible, he said, to establish a similar restriction in the private sector to prevent the kind of incestuous relationship that developed between Enron and Arthur Andersen.
Some critics argue that the Enron case also underscores the need for more regulation in the energy-trading market, which Enron pioneered. Much of this trading involves complex contracts for future delivery of gas, oil or electricity, with prices often depending on a variety of changeable factors, such as the weather. Such contracts can be extremely volatile, presenting enormous risks for traders.
But Paul R. Kleindorfer, co-director of Wharton's Risk Management and Decision Processes Center, says new regulation seems unnecessary, given that the Enron collapse did not lead to widespread problems in the energy markets. "I think the markets, the energy market in particular, will draw appropriate lessons from this case," he suggests. "I'm not in favor of putting screwdrivers into that fairly complicated mechanism."
If energy traders concluded that their market needed to operate in a more traditional fashion, they already have an alternative in the New York Mercantile Exchange, he adds.
Some critics say Enron shows that anti-fraud statutes are inadequate, or inadequately enforced. But it's too soon to judge, Kleindorfer says. In addition to the SEC's criminal investigation, there are a number of class-action lawsuits. Successful plaintiffs in such cases can win compensatory damages as well as punitive damages of three times the amount they lost, he points out. Top Enron executives could well be wiped out financially.
"The fabric of law - the law that as it relates to both fraud and such other misdemeanors as have been alleged in this case - is a fabric that has to apply to many different situations," Kleindorfer says, adding that by the time the Enron case is over, it may turn out that the current laws are good enough to send a stern warning to other companies tempted to do the same.
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