PBS's FRONTLINE: The Arthur Levitt Interview:
Chairman of the SEC from 1993 to 2000, Levitt says the Enron scandal is "symptomatic of a breakdown of the ethical values of business over a period of perhaps 20 years." He is very critical of what he calls "accounting hocus-pocus" or how companies have become more creative in their interpretations of accounting standards. In this interview, he describes the political heat he took during the three big accounting battles of the 1990s, and calls for an independent agency with subpoena power to oversee the accounting industry. This interview was conducted by FRONTLINE correspondent Hedrick Smith on March 12, 2002.
Mr. Levitt, what's the significance of the Enron scandal and collapse for the markets as a whole? Is this just a group of bad guys who broke the law maybe in one company? Or is this symptomatic of something larger?
I think the Enron scandal is symptomatic of something much broader than Enron. I think it's symptomatic of a breakdown of the ethical values of business over a period of perhaps 20 years, a gradual erosion of business ethics that brought us to an Enron, but might very well bring us to a whole host of Enrons as we move down the road.
How do you account for that? Is that the go-go 1990s? Or Wall Street pressure?
... Part of it, I believe, is a function of a bull market, which made every decision appear to be absolutely the right decision. Part of it is a function of the complexity of new instruments that are available to create investments -- derivative products, options, instruments -- which were never available before.
Part of it, I think, is a function of the greed factor that's involved. American business is extraordinarily competitive. And if Company A and B are moving close to the line in a given tax treatment, are given business devices, Company C, D, and E can't be very far behind.
By "close to the line," do you mean the law? What's permissible?
Exactly. And what we have seen happening is companies have become more and more creative in terms of the way they present their numbers to the public. Their interpretation of what accounting standards are has become more and more creative, rather than using the numbers the way they really were intended to be used -- as a means of telling investors about the health of a particular company.
In your speeches, you talk about "the numbers game." Just in laymen's terms, what's "the numbers game?"
The numbers game represents the effort of managements to take the earnings of the company and paint them in the most creative light possible.
You mean the most positive?
To try to persuade investors that the company is in a lot better shape than it really is; to take out of the numbers certain factors which would have lowered the earnings as far as investors were concerned; to deal with something that companies now call "pro forma numbers," rather than the numbers as they really are. What are pro forma numbers? They are numbers the way management hopes the company has done and will do, rather than giving the picture as the company did.
Well, wait a second. The picture you're painting is something, I think, that most ordinary investors really don't understand; maybe the pros do, isn't that right? I always thought there are costs, and there's income. You put your books together, and that's it. But you're suggesting there's a lot of leeway here.
That's absolutely right. I think because of the different ways that companies can use financing techniques to present their earnings, the different interpretations of accounting standards, and because of the more than cozy relationship which has developed between the accountants who are supposed to be the gatekeepers of the numbers insofar as investors are concerned, those numbers had become less trustworthy than they had always been in the past.
"Less trustworthy," because they don't represent economic reality?
That's exactly right. They are less trustworthy because very often they depart from economic reality. They represent hopes; they represent wishes. They don't very often represent the picture as it really is. They program earnings in a way that investors believe that a company which has sold a product but hasn't been paid for it can book those earnings as if they had been paid. Companies, on the other hand, may very well be booking earnings on products that can be returned. ...
Let's take two or three quick examples. ... When you talk about creative accounting, what kinds of things do you mean?
Creative accounting, I think, is easily symbolized by taking a look at two recent scandals: Sunbeam and Enron.
In the case of Sunbeam, the company had booked earnings on products that really hadn't been sold, or products that were sold and could be returned subsequently. So they really weren't earnings.
The case of Enron was even more creative. The investment bankers came to Enron and said, "Look, we can really create a structure which will hide your obligations from the general public by creating subsidiaries. Those subsidiaries will borrow, and those borrowings, under our interpretation of the accounting rules, will not flow up to the parent."
So they don't show up on Enron's financial statement?
Exactly. So Enron showed a financial statement that was a great deal healthier than, in fact, it really was, because of this creative device to hide the obligations of the parent in subsidiary corporations.
You made this speech up in New York, which I was rereading this morning. You use these terms: "Abuses, trickery, and accounting hocus-pocus." Are things that bad?
I think they are. I think that the seduction of the boards of companies that are intended to protect investors ... the nexus between the accounting firms and the corporations, and the aggressive attitudes of CFOs and CEOs has created a pattern of deception that has created a situation which has eroded public confidence in the sanctity of the numbers which is the basis of our markets today.
Without public confidence, our markets are no better than any in the world. The only reason our markets are so superior is because the public has had confidence in the sanctity of the numbers, in the way the numbers have been produced, because they believed in what corporate America was saying to them. Enron and Sunbeam and a number of other recent accounting scandals have severely eroded that confidence.
When you look at Enron, when you look at Sunbeam, when you look at Waste Management, when you look at a series of these scandals, what's the heart of the matter? What's at stake here?
What is so serious about these recent scandals, in my judgment, is that it goes to the heart of America's markets, of our financial system, which, in my judgment, is public confidence. If investors lose confidence in the reliability of numbers that are presented to them, our markets will suffer grievously.
The reason that our markets are so vastly superior to any others in the world is because we have a pattern of full and fair disclosure. If investors can no longer believe in the sanctity of the numbers that are reported to them, they're going to extract a penalty from those markets. It will be more difficult to raise money. It will be more difficult to maintain public interest in our markets. The source of capital will dry up. It will have very severe economic and political consequences.
So if I understand you correctly, what you're saying is that Enron, Sunbeam, Waste Management, these companies that have misstated, overstated their earnings, are playing with fire, in terms of the whole integrity, honesty, openness and trustworthiness of our markets?
I think our markets have already suffered a very serious blow. And whether they recover from that, whether they can restore the kind of public confidence that is essential to America's markets, depends on how our policymakers deal with these issues. ...
It's stunning to see that in the last three years of the 1990s there was something like 400 corporations that had to restate their earnings or their net worth. Talk about that for a moment. What does this mean?
I think what's going on, again, is a function of the competitiveness of American business. If a company sees three other companies dealing with an accounting treatment in a fairly aggressive way, they're going to try to deal with it even more aggressively.
Now, what's the control point? The control point should be the accountants that provide the bookkeeping for the company. It should be the board, and particularly the audit committee of the company, which should make certain that those numbers are an accurate reflection of what the company is doing. It should be the standard setters who establish the standards by which the company reports its earnings.
And then ultimately it should be a function of the regulator, the SEC, which oversees the production of these numbers in these statements, and ultimately must come down hard on corporations that are playing games with their reported earnings.
But why are they playing games? What's driving them?
What's driving them is the price of their stock. What's driving them is the desire to see to it that, quarter by quarter, their earnings reach levels of a penny or two or three more than the quarter before that, so that analysts will deal with it in the most favorable way.
There is an obsession with short-term earnings and short-term results, and our stock markets reflect that obsession. A drop of one or two pennies per quarter in earnings that vary from expectations can result in a 30 percent decline in the price of the stock, virtually overnight. ...
So the Wall Street expectations game, in your opinion, is what's driving companies and accountants to go maybe over the line or at least up to the line?
We've developed a short-term culture in American business, where executives have become obsessed with the selling price of their stock. They drive earnings in whatever way they possibly can to meet the expectations of analysts, rather than presenting a picture that is totally accurate. ...
You make it sound as though accounting hocus-pocus is going on quite broadly.
There is much too much accounting hocus-pocus. I would not say that every American company practices this. It's a matter of degree. Many companies do practice accounting hocus-pocus. And accounting standards are insufficiently clear to make that argument hard and fast, so companies will argue the point as to whether their treatment is fair or not fair.
You mentioned the term "conflict of interest" before. Talk a minute about the conflicts of interest. Are there conflicts of interest of accounting firms? Of investment banks? Of the bond-rating agencies? Of the lawyers who advise corporations?
Yes. I think the Enron story was a story, not just of the failure of the accounting firm but also the traditional gatekeepers: the board, the audit committee, the lawyers, the investment bankers, the rating agencies. All of them had a part in this.
Take the rating agencies, for instance. They deferred downgrading Enron, pending a merger which they knew very well might never have taken place.
Take the investment bankers, who developed the elaborate scheme that Enron used to hide the obligations of the parent company in subsidiaries. That didn't come out of the blue; that was a scheme concocted between the investment bankers and the chief financial officer of Enron.
Take the accounting firm that Enron was the most important audit client that they had, and Enron was also the largest consulting client that they had -- a client that paid them over a million dollars a week in fees. In my judgment, that accounting firm was compromised. Their audit was compromised. Putting aside any fraudulent activity that may have been part of this, they were clearly compromised by the nexus of consulting with auditing.
Take the lawyers that were paid vast fees. I think here you have a very interesting case where the American Bar Association prevents lawyers from revealing financial fraud of clients to regulators. And here we had a case in point where a major client of the law firm was obviously involved in practices that may well proved to have been fraudulent, and they didn't blow the whistle.
And [take] the analysts, who were claiming that Enron was a buy even after this story had broken and Enron had declared bankruptcy. These are analysts that were being paid by investment bankers that were receiving large fees from Enron for performing a variety of services. How independent could their research have been? And what could an investor have expected from an analyst who was recommending the purchase of Enron, while at the same time his employer was receiving millions of dollars in fees from that company? How likely was it that the analysts would tell it as it was? Very unlikely, in my judgment.
Let's go back to the whole idea of auditing, which I gather comes out of the Securities Exchange Act of 1933, 1934. What's the job given by law to auditors? Whom are the auditors supposed to serve?
... America's auditors were given a franchise by the Securities Acts of 1933 and 1934 to provide the public with accurate audited statements of companies that were public companies or about to become public companies. And their mission, the reason for all of that, was to protect the public investor from financial fraud.
When you look at the accounting profession today in the wake of the Enron, Waste Management, Sunbeam, and lots of other scandals, who are they working for? The public? Or somebody else?
I think up until now, there was a real question as to whether auditors represented the public as they should have, or represented the companies that paid them for audits and paid them even more for consulting services. They clearly had a conflict of interest, and some of them abused the public that they were supposed to protect.
If you take Waste Management for instance, Waste Management paid a $48 million annual auditing fee. Who are they working for?
You could make the point that, by virtue of the fact that the auditors are paid for by the company, that no audit is totally clean. I think our society really functions based upon balancing interests. It's one thing for a company to pay their auditor. But that auditor has its reputation at stake in every audit that it does. The payment for the audit is an anticipated fee in the same way that paying a lawyer his legal charges, in the same way that any service is paid for.
It's when the auditor goes beyond that and it is paid vast sums of money for consulting that I believe the audit becomes compromised. We're used to paying audit fees, they're fairly standard. And we've had a competitive environment for it.
But you've also seen an inflation in audit fees. If you start looking at some of the audit fees, and particularly the audit fees of companies that got in trouble, they're paying enormous audit fees -- $20 million, $25 million, $48 million. I mean, those are huge fees.
... Actually, audit fees in terms of hours put in it by a given accounting firm have gone down through the years. But what has happened is that we have fewer accounting firms today that are capable of providing world-class audits for companies that have international operations. The ordinary pressure that would come from competition from what were the Big Ten firms has moved down to the Big Five firms and may well be the Big Four firms very shortly.
But talk about the pressures in that environment where you've got so few firms. What's the pressure on Andersen's engagement partner in Houston who's dealing with Enron? What's the corporate pressure? Is it to do the toughest possible audit he could do? Or "Don't lose the Enron business, it's a big account."
I think clearly the Enron business was the motivating factor with the Houston office. Accounting firms today, their corporate set-up is such that they have separate fiefdoms all over the world. Most of them lack the kind of central control that will keep an office that depends so exclusively upon a client as large as Enron from doing virtually anything that Enron wanted them to do.
You talked about these conflict of interests. Let's bring it right down to a practical situation. You're the Andersen representative in Houston and you're dealing with Enron, both the consulting business at Enron and the auditing business at Enron. What are the pressures on you?
There are enormous pressures on the senior officer of Andersen in the Houston office whose major account, probably his only account, is Enron. The control factor there has to be a responsible board of directors, and particularly an audit committee which is sensitive to the responsibility of providing a clean, accurate statement for investors. But clearly the motivation of that local office, if left to its own devices, is to make Enron happy, rather than to keep the investors well informed. ...
You talk about conflicts of interest with the Enron board. What do you mean?
I'm talking about a board where certain members received consulting fees that were above and beyond their regular directors' fees. I'm talking about a board where some members received charitable contributions from Enron to their own institutions. I'm talking about a board that had the use of corporate aircraft. And it was a board that, in my mind, was defined by a culture of seduction characteristic of many American boards.
Seduction by whom?
Seduction by management. A board that became so comfortable with the perks offered by management, and the relationship with management became more collegial, more fraternal. It lacked the kind of skepticism that I believe America's boards should manifest in terms of protecting investors' interests.
This was a board that, I believe, was far more supportive of management than they were of shareholders. The balance between their responsibilities was skewed seriously toward management, and that created much of the problem that eventually developed. ...
If you look at the statistics of more than 400 firms having to restate their values, do you have any idea how much the ordinary investors lost?
The restatement of earnings has cost America's investors in recent years in excess of $60 billion. That's an enormous amount of money. Now how did it come about? Why suddenly has all of this money evaporated from investor interest? I think it's come about through a variety of reasons.
I think corporate America has exaggerated their earnings, and they've been called to task by U.S. regulators causing them to restate those earnings. I think that the process of setting accounting standards has been imprecise and has been impacted by political pressure, so that the standards which would ordinarily be cut and dry and absolutely clear, in terms of what companies can do or can't do, have become vague and fuzzy. ...
And the third reason for restated earnings has been that the accounting firms that should have prevented the earnings from being presented the way they were simply didn't blow the whistle.
OK. Andersen is in a lot of trouble. Andersen cropped up on Global Crossing, on Enron, on Sunbeam, on Waste Management, on some others. Is Andersen a weaker firm than the other big accounting firms? Or is this typical of the accounting profession?
I don't personally believe that Andersen is any worse than any of the other firms. I can't speak to fraud, because we don't know the dimensions of that at this point. But in terms of how they deal with their clients, I think the kinds of problems Andersen has had, have developed and will develop in other firms in probably precisely the same way. ...
Is it going to be adequate to let the accounting firms do their own restructuring and their own reforms? Or are outside reforms going to be necessary?
Whether it's adequate to have the firms do their own reforms, I think, depends on the issue of perception as well as reality. As long as the American public perceives that they can't rely on America's accountants because those accountants have a conflict of interest, that speaks for itself. So I don't think that we can rely upon the firms themselves to do the job.
I think we need an oversight body to oversee the accounting firms in a way that gives them subpoena power. And that means legislative action. I don't think the firms can do it by themselves. I don't think the SEC can do it by themselves. I think the SEC cannot do the job that I think is necessary to restore public confidence today.
Because?
Because I believe we need an independent agency that consists of people of impeccable credentials that can oversee the accounting firms, that has subpoena power to go after not only the accounting firms, but also their clients, to assure the public that audits are being conducted fairly. And in those instances where audits are being compromised, that there is a mechanism for providing immediate relief in the form of sanctions against those accounting firms.
That doesn't exist today. There is no real mechanism aside from what the SEC can do, and that process takes an extended period of time.
It looks from the outside to somebody's who's trying to understand the situation that the accounting industry is essentially regulated by itself -- that various organizations that are supposed to do the oversight are, in effect, composed of people from the accounting industry. They're not outsiders. [It is] so unlike the aviation industry or some other industries where you actually have regulators that are appointed, they have official power, they have subpoena power. So has self-regulation worked, or failed?
There is no self-regulation that is working in the accounting industry today. There simply is no effective self-regulation. The SEC lacks the resources on their own to regulate this industry.
I think we need the same thing with the accounting industry that we have with the securities industry. That's a combination of self-regulation, which in the securities industry is represented by the stock exchanges, private rights of action which you do have the legal profession being able to sue accounting firms for malfeasance and the enforcement efforts of the SEC.
What you lack here is self-regulation that you have in other regulated activities. And without self-regulation, you cannot assure the public that this profession is being run effectively and cleanly and in their interest. ...
What's the importance of the Enron scandal for the American investor and for the American economy?
The Enron scandal has conveyed to the American investor that he can't have confidence in the traditional gatekeepers that protect America's markets. He can't have confidence in the auditor that presented him with the statements. He can't have confidence in the standard-setter that created standards which were so fuzzy that Enron was able to hide the obligations of the parent in subsidiaries. You can't have confidence in investment bankers, in the lawyers for the company. You can't have confidence in the rating agencies that should have given him a clear picture of what Enron's obligations were.
So what you're saying is Enron is not unique? It's a signal that the integrity and honesty of the American markets have been damaged?
I think Enron is symptomatic of something that's going on in a lot of American companies where there has been, in my judgment, an erosion in the culture of integrity that was so significant a part of America's corporate structure up until recent years. |
