Corporate Research E-Letter No. 20, January 2002
BARRIERS TO ACCOUNTABILITY:
LESSONS FROM THE ENRON MELTDOWN
by Mafruza Khan
As the Enron scandal continues to unfold, corporate accountability looms large in the minds of the American public. Even President Bush called for more accountability in his State of the Union address. The collapse of Enron illustrates very clearly the systemic problems – lack of adequate safeguards to prevent fraud; abuse of power by individuals and institutions; and conflicts of interest at every turn, from campaign contributions to politicians by companies, to accounting firms auditing and consulting for the same companies, to securities analysts analyzing companies for which they are also performing investment brokerage services. Add to that the continued assault on oversight by deregulation lobbyists, and we have the perfect set-up for an Enron style meltdown.
With half of American households invested in the stock market directly or indirectly, the crisis of faith in capital markets, while reaching new proportions with Enron, has been growing for a while. Over the last six years, investors have lost close to $200 billion in lost market capitalization after earnings restatements following audit failures. The number of companies retracting and correcting earnings reports has doubled in the last three years to 233 in 2001. Along with high-profile cases of accounting irregularities such as Waste Management, Sunbeam, Rite-Aid and Microstrategy, and bankruptcy filings by K-Mart and Global Crossing, the fundamentals of the market economy – transparency, accountability and trust – are being called into question.
THE PROBLEMS
Aside from Vice President Dick Cheney refusing to disclose information to the General Accounting Office on the energy task force’s meetings with Enron, many other problems plague the current system that allow individuals and corporations to run amok to the detriment of public interest. These include:
Relaxation of Securities Laws and Lax Accounting Practices
According to Bill Lerach, a lawyer with a reputation for battling with corporate America on shareholder lawsuits, “There’s been an unprecedented surge in financial and accounting fraud, accompanied by an unprecedented upsurge in insider trading. With the benefit of hindsight, it’s fairly easy to see that all of this was stimulated at least in part by the relaxation of securities laws in 1995.” The number of class-action securities cases, 487 in 2001, has actually risen since the passage of the Private Securities Litigation Reform Act in 1995, which was supposed to have reduced the number of supposedly frivolous class-action claims.
Several factors have encouraged companies to become more lax in their accounting. This includes “pro forma” accounting, which permits companies to structure their earnings statements to disguise poor performance by excluding certain one-time quarterly gains or expenses. Following Enron, the SEC has issued a number of statements warning public companies that they would be sued if they mislead investors by using pro forma accounting. Pro forma accounting departs from generally accepted accounting principles or GAAP. Similarly, “forward looking statements,” used by most publicly-traded companies often have little basis in accounting reality.
The Securities and Exchange Commission and Chairman Harvey Pitt
After news of Enron hit the headlines, Securities and Exchange Commission chairman Harvey Pitt said that he wanted new laws that require more thorough and real-time disclosure of financial reporting. Pitt, a former attorney for the accounting firm Arthur Andersen, has been often criticized for being a tool of the accounting industry. He believes that accounting firms should continue to be allowed to accept consulting contracts for the companies they audit. He led attacks against his predecessor Arthur Levitt Jr.’s attempts to tighten accounting regulations and lobbied to relax federal oversight of corporate accounting issues.
More recently, after the collapse of Enron, the five-member Public Oversight Board that oversees ethics and disciplinary issues for the accounting profession announced that it had resigned after Pitt proposed creating another body dominated by experts from outside the accounting profession that could render the board irrelevant. Former comptroller general of the United States, Charles L. Bowsher, who leads the Public Oversight Board called the proposal a sham intended to give the industry more power to discipline itself rather than submit to outside scrutiny. He alleged that the effect would be to put the board more under the control of the industry’s main trade association, the American Institute of Certified Public Accountants.
Since Enron, former chairman Levitt has also called for adequate funding of the SEC so that it can carry out its watchdog-role more effectively; confidence in the financial market is tied to confidence in the industry’s watchdog. In 2001, the SEC collected $2.5 billion in fees for its services, but Congress gave the commission only $423 million to operate – “a paltry sum that makes it impossible for the SEC to update itself into a twenty-first century institution,” according to Levitt.
Auditors as Consultants and Other Conflicts of Interest
Auditing firms often make more money from providing consulting services to the same companies that they audit. 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 on other services from those same auditing firms. Within the accounting business, consulting is widely regarded as being more glamorous and lucrative than auditing.
Former SEC chairman Levitt believes that auditors must be independent so that they are free to expose irregularities that inflate or distort companies’ earnings. Others opine that consulting fees may magnify the potential conflict, but they don’t create it. Reuven Lavahy, accounting professor at the University of California at Berkeley, sees merit in separating consulting and auditing functions. According to him, “The problem is comparable to establishing a wall between the underwriting and research sides of an investment bank. The biggest issue is to identify the core problem, if enforcement of existing rules is the main problem, then lessening auditors’ conflict of interest would do some good.” If accounting rules are not sufficiently tight to ensure detection of off-balance-sheet loans, and companies can hide large amounts of debt and underperforming assets, then “the core issue is disclosure, and that can be fixed with new accounting rules.”
Ratings Services and Financial Analysts
Wall Street analysts are compensated based on their ability to bring in and support investment banking deals. But investors rely on the same analysts’ reports for unbiased assessments of companies. As long as analysts are paid based on the deals they bring in rather than on the quality of their analysis, there will always be a conflict of interest in their investment advice. One author underscores the power of analysts, “What moves financial markets is the published expectations of Wall Street analysts. Analyst expectations have become, in effect, a company’s reported earnings.”
Former chairman Levitt recommends disclosing all such conflicts of interest and changing the way analysts are compensated. Enron’s complex and duplicitous dealings were not flagged by analysts. Days before Enron filed for bankruptcy, 14 of the 16 analysts who covered the company still recommended that clients buy or hold the stock.
Rating services such as Moody’s and Standard and Poor’s seem to have conducted business as usual. A recent Business Week editorial commented, “If they [the rating companies] couldn’t penetrate Enron’s complex financial engineering, the rating agencies should have said so.”
The Association for Investment Management and Research, the trade group for investment analysts began an initiative last year to support more independent research reports and investment recommendations. The initiative was a response to criticism of analysts’ reports following the decline of the dot-coms and technology stocks.
Independence of Directors
Corporate governance activists have long called for truly independent outside directors, directors who have no direct or indirect links with the company. The separation of management and board members representing shareholder interests is critical to accountability. The board of directors needs to be strictly independent so it can ask management the necessary tough questions and serve as watchdogs for shareholders and other stakeholders. Former SEC chairman Levitt proposes that stock exchanges, as a listing condition, should require at least a majority of directors on company boards to meet a strict definition of independence. In Enron’s case, at least three board members would have been disqualified under such a test of independence.
Campaign Contributions and Other Donations
The Enron debacle has brought campaign finance reform to the front burner again. A January 23 Washington Post editorial states, “The existing system of soft-money donations allowed Enron to buy access to the administration and Congress. Although it is not clear yet whether this access corrupted the policy of the Bush administration, it appears likely that it did corrupt Congress in the late 1990s, contributing to a misguided decision not to regulate the financial instruments that triggered Enron’s bankruptcy. Moreover, the soft money system has allowed Enron’s auditor and other big accounting firms to sway Congress on the issue of audit regulation, contributing to the lax standards that made the Enron scandal possible.” Enron spent $2.4 million in the last election cycle.
CONCLUSION
The Enron saga is emblematic of publicly-traded companies in the 1990s yielding to the pressure to inflate their stock prices by whatever means possible. Enron’s captains engaged in $1.1 billion in insider trading; reported $618 million in falsified earnings; and created $1.25 billion in falsified shareholder equity. As one shareholder activist has said, “Once in a while a strange confluence of factors come together and there’s a scandal that changes things. This will likely change things.” Enron, hopefully is the clarion call that will keep us united in our efforts to foster public accountability, transparency and participation.