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ENRON AND ON
The world’s biggest corporate bankruptcy has caused much soul-searching and many blueprints for reform. Roger Leeds wonders if it will be enough to restore public confidence.

Mr Leeds is a professor of international finance and director of the Center of International Business and Public Policy at the Johns Hopkins University School of Advanced International Studies (SAIS) in Washington, DC.

Trust is the bedrock of a well-functioning market economy. The public must have confidence that their decisions are based on accurate and complete information, that they are operating on a reasonably level playing field, and that the laws and regulations governing market behaviour are effective and enforced. When these tenets are systematically violated, and public trust begins to erode, momentum for change can snowball.

Enron has set the ball rolling – and how. Public alarm was sounded after the discovery of a widespread pattern of abuse: senior company executives involved in self-enrichment schemes to the detriment of other shareholders; accountants so closely entangled with their corporate clients that they seem to have lost sight of their public responsibilities to ensure full disclosure and validate the accuracy of financial reporting; outside corporate directors failing to fulfil their fiduciary responsibility to shareholders; investment bankers who play multiple roles, including creditor, underwriter, investment adviser, and sometimes investor in the deals they structure; analysts making recommendations on shares that are underwritten and traded by the same investment bankers who decide their level of compensation; lawyers offering legal opinions on financial transactions, who are then retained to investigate their propriety; and politicians passing judgment on the companies, accounting firms and investment banks that finance their campaigns.

Reformers’ knives are also being sharpened outside the US. The EU is actively considering tighter standards for auditors
All claim to be independent and objective professionals. But each also has a large financial interest in the outcome of the capital-raising process that could cloud their judgment, and victimise the one actor who is outside the loop: the investing public.

The key question is: what needs to change to restore some semblance of integrity to the capital-raising process?

The answer is complex and will take years to emerge. But there are already signs that many corporate-financing practices once taken for granted, and considered legal, are likely to change – and not only in the United States. Compared to any previous corporate scandal in the last 70 years, Enron has triggered an astounding array of investigations and self-analysis within governments and throughout the private sector. The intensity of public scrutiny suggests that big changes are coming that will affect the way business is conducted and financial markets function.

In the US, the feeding frenzy in Congress has resulted in some 30 legislative proposals advocating changes in financial reporting, accounting, the practices of investment banks and retirement plans. Not to be outdone, President George Bush hopped on the bandwagon with his own ten-point plan, including politically popular recommendations to stiffen the penalties for senior executives of public companies "who abuse their power", and more rigorous independent oversight of the accounting profession. Enron-related investigations are also under way at the Securities and Exchange Commission (SEC), the Internal Revenue Service, the Federal Reserve and the Department of Justice. In the first four months of this year, the SEC opened an unprecedented 49 new financial reporting cases, twice as many as in the same period in 2001.

Reformers’ knives are also being sharpened outside the US. The European Union is actively considering tighter standards for auditors, new codes of conduct for securities analysts and a new set of rules for the structuring and trading of derivatives. The International Accounting Standards Board (IASB) has begun to gain credibility and influence at the expense of Financial Accounting Standards Board (FASB) in the US. The pressure is now on the US to conform to a new set of international accounting standards, rather than on the world to adopt American ways.

This is not simply a story of over-zealous government officials trying to recapture the high ground from unchecked market forces. The private sector too is proposing changes, hoping to head off some of the potentially onerous legislation. Several blue-chip names have weighed in, including Goldman Sachs, Merrill Lynch (on new rules governing the behaviour of share analysts), and IBM and General Electric (on more detailed financial information included in annual reports). American and European stock exchanges are tightening disclosure requirements for listed companies and reviewing some financing practices that were commonplace and considered acceptable before the Enron controversy. Warren Buffett of Berkshire Hathaway said directors must be far more aggressive in holding senior managers and auditors accountable, particularly "when it is clear that the chief executive is not treating shareholders as partners".

THE PRIMARY FOCUS

There are two key concerns magnified by the Enron revelations. The first is the quality of corporate financial transparency, which is fundamental to an efficient market economy. The second, which is closely related to the first, is the effectiveness of corporate and public governance – the rules, standards and enforcement mechanisms that define how company managers are supervised and held accountable. Enron is a stark reminder that when transparency and governance break down, neither the self-correcting magic of the market nor the regulatory framework are enough to set things right.

Conflicts of interest are inherent in a market economy, especially when competition is intense and the financial stakes are enormous. That is why an elaborate system of formal and informal checks and balances has evolved to protect the investing public from corporate misconduct, expose wrongdoing and ensure equality before the law. Nor is this simply a story about one rogue company and its auditors. The scandal has focused global attention on an elaborate network of abuses that seems to be systemic and has undermined public trust in financial markets. As these conflicts of interests have moved to centre stage, so has the weakness of the safeguards to protect the public against abuse. No public company, financial institution or regulatory body is likely to escape the fallout from Enron.

WHAT IS LIKELY TO CHANGE?

A broad outline of potential reforms can already be discerned.

Auditor independence. Auditors’ traditional role as independent watchdogs for the investing public has increasingly taken a back seat to protecting the corporate clients that retain them. One explanation for this widely held view is that accounting firms’ revenue no longer comes primarily from the labour-intensive, low-margin auditing business. In 2001, 26 of the 30 blue-chip companies in the Dow Jones Industrial Average paid their accountants more for consulting and tax services than for the company audit. Though it is near-impossible to eliminate all conflicts of interest that might threaten the auditors’ independent judgment, widespread revelations about accounting irregularities have triggered a huge outcry for reform. Proposed reforms include separating consulting and auditing functions, new reporting standards for off-balance-sheet financial transactions, and eliminating the revolving door between auditors and their corporate clients.

Alan Greenspan lamented in a recent speech that there are "hardly any independent directors left" on company boards
The entire accounting profession is under siege. It will be subjected to more rigorous government oversight and supervision. Accountants can also expect closer scrutiny from their corporate clients and investors. As highly sophisticated investors have become sceptical and hyper-sensitive about the financial reporting of blue- chip companies, the consequences for corporate executives and their auditors are likely to be far reaching.

Corporate standards of public disclosure. An investigation by a special committee of Enron’s own board of directors described an intricate web of financial transactions that violated the most basic principles of public disclosure and insider dealing. The report concluded that several public disclosures approved by the auditors and attorneys "were obtuse, did not communicate the essence of the transactions completely or clearly, and failed to convey the substance of what was going on between Enron and the [special purpose entities]… The disclosures also asserted that the related-party transactions [between corporate insiders and the special purpose entities] were reasonable compared to transactions with third parties, apparently without any factual basis."

Enron’s use of off-balance-sheet finance was extreme. Yet it is clear that non-disclosure of material information has become rampant, and not just among greedy American executives. Europe received a wake-up call with the forced resignation of the once-venerated Percy Barnevik, the former chairman of ABB, a Swiss/Swedish industrial conglomerate. ABB’s board belatedly discovered that Mr Barnevik had awarded himself an $87-million tax-free, lump-sum "pension" when he stepped down as chief executive – a detail he had neglected to mention to the board, or in documents filed with stockmarket regulators. Once this hit the headlines, European legislators clamoured for more detailed disclosure of executive pay.

All this adverse publicity has forced senior managers to take a hard look at the accuracy, timeliness and completeness of their public disclosure of relevant financial information. The president of one large US firm acknowledged that after Enron, "companies [like ours] are becoming more diligent about trying to ensure that they have disclosed adequately anything of substance." This heightened level of diligence will also be applied by senior executives to the advice they receive from accountants, investment bankers and lawyers.

The limits of financial engineering. At first glance, the term "off balance sheet" is an oxymoron. In the lexicon of high finance, it describes a category of corporate transactions that can contradict the most basic standards of transparency and equal access to relevant information. How else to interpret a term that defines a rapidly growing number of deals structured explicitly to obscure the true nature of a company’s financial obligations?

Enron has cast a shadow on the practices of many firms that benefit from such sophisticated financial engineering. This blurs the distinction between debt and equity, disguises the true ownership and liability of "special purpose entities", and creates financing methods so mind-bogglingly complex that hardly anybody bar the financial whizzes themselves understand them. Most, if not all, of these financing techniques are legal.

The corporate beneficiaries of these financing techniques are not acting on their own. Each transaction requires the deep involvement, and ultimately the approval, of the firm’s auditors, investment bankers and legal counsel. It would be hard to name a Big Five accounting firm, major investment bank or large corporate law firm that has not advised on such financial transactions. After all, what company boss would not embrace opportunities to lower taxes, protect the firm’s credit rating, and improve earnings?

Regulators everywhere are crafting standards and laws to strengthen the oversight, tax treatment and disclosure requirements for such transactions. Big changes are in the offing. The upshot will be higher financing costs, more public disclosure and closer regulatory scrutiny.

REDEFINING OVERSIGHT AND ACCOUNTABILITY

Crony capitalism was once a term smugly reserved for emerging markets, where securities regulation and enforcement are relatively lax, corporate governance is often a burden deemed unnecessary and public disclosure is a pipe dream. But now, with the exposure of gaping loopholes in the world’s most advanced capital markets, a sweeping re-examination is under way of the performance of those charged with public and private oversight and enforcement.

Securities market regulators. Companies have to submit reams of documents to regulators before and after raising capital from the markets. This costly and labour-intensive exercise is meant to ensure that investors have access to information considered vital to their risk assessment of the issuer and the offered securities. Regulators are supposed to review the documents, ensure they are complete and accurate, and red-flag any errors, omissions or misrepresentations. But they do not have the means to do so. In the US, 59,000 corporate filings were submitted to the SEC in 2000, 59% more than a decade earlier. Few are carefully scrutinised. Of the 14,000 annual reports filed with the SEC by public companies in 2001, only some 16% were subjected to staff review. (Enron’s annual report was last reviewed by the overwhelmed regulator in 1997.) Even in countries with far fewer public offerings, the Herculean task of keeping abreast of the endless flow of documentation is beyond the most diligent regulators.

One near-term consequence of the Enron saga will be a beefed-up SEC. Its chairman, Harvey Pitt, has asked for a doubling of his budget for the next fiscal year, in part to hire about 100 additional investigators to assist with oversight and enforcement. The SEC will also almost certainly broaden its supervisory reach, and become more engaged in overseeing accountants. Few politicians still think FASB’s record as the main self-regulator of accountants is satisfactory. Suddenly, the SEC is being called to play a more hands-on oversight role.

Board of directors. Even Alan Greenspan, the most high-profile champion of free markets, lamented in a recent speech that there are "hardly any independent directors left" on company boards. As Enron shows, independent directors are often incapable of holding senior management accountable and representing shareholder interests. The chief executive usually controls the board because he nominates the independent directors who are meant to supervise him. Stories of extraordinary negligence by the boards of several big companies have led to calls for a complete re-assessment of how independent directors are selected, as well as of their roles and responsibilities. Laws on directors’ liability where they fail in their fiduciary duty are also under renewed scrutiny.

Senior management. Jeffrey Skilling, Enron’s former chief executive, focused critical attention on the responsibilities and accountability of all senior executives when he disingenuously told congressional inquisitors: "I am not an accountant." As with other bosses threatened with criminal charges, Mr Skilling apparently intends to use his own ignorance as a defence, claiming that he did not knowingly make decisions or approve financial transactions that were illegal. But public officials are increasingly sceptical that company executives should be allowed to hide behind a plea of ignorance. One former regulator declared that "management has no right to include anything in its own financials that it does not understand." William McDonough, president of the New York Federal Reserve, agreed: "If the management and outside directors do not understand the risk transactions that a company is undertaking, they are incapable of exercising appropriate oversight." Given current public opinion, not even the strongly pro-business Bush administration would dare to disagree, which suggests that senior executives can look forward to tougher laws and standards governing their behaviour.

The press. If transparency is central to the efficient functioning of financial markets, the media’s oversight is crucial. The torrent of post-Enron activity has obscured the vital role of a few enterprising reporters whose digging and analysis exposed the skulduggery. But muckrakers were rare until the scandal was too obvious to ignore. Fortune, for example, proclaimed Enron the most innovative company in America five years in row. The media revered the financial magic of Andrew Fastow, its chief financial officer, almost until the day he was forced to resign in disgrace. Independent journalists can be a powerful checks on dodgy financial behaviour, but they need to be capable of reading a balance sheet and tracing the intricacies of complex derivatives contracts.

THE END OF THE BEGINNING

As the media hyperbole and political grandstanding begin to recede, the hard work of crafting constructive reform is only starting. Some argue that self-correcting market discipline should be allowed to clean up the mess. After all, financial markets are already heavily marking down the shares of companies with financial shenanigans. But the public clamour to do more is too loud for the political class to ignore.

It is easy to be sceptical about the chances of real change. Every reform proposal will run into a huge, well-financed lobbying campaign that will strive to protect the status quo. Harvey Pitt, the SEC chairman, was previously a lobbyist for the accounting profession’s industry body. He once insisted to Congress that accountants should be left to police themselves. How likely is it that congressmen, who received more campaign contributions in 2000 from the accountants’ trade body than from Enron, will now genuinely champion reform?

One danger is that nothing changes. Another is a counter-productive regulatory backlash. As with every big scandal that triggers public outrage, well-meaning reformers may open the floodgates to all kinds of government intervention that do more harm than good. Sooner or later, it will sink in that stricter regulation entails higher costs, which are typically passed on to consumers. What happens when the costs of raising capital increase, with a predictably negative impact on earnings? How will taxpayers respond to additional public spending to oversee and supervise auditors and financial institutions? Will investors who complain about tainted securities analysts be willing to pay for independent research?

Still, Enron has raised public awareness about the importance of transparency and effective governance from those who want access to financial markets. That is a big plus. Ultimately, better-informed investors should do as much to raise the level of integrity in the marketplace as the most diligent government regulator.

The public outrage generated by Enron is likely to force regulators to toughen their oversight of financial-market participants, and corporate executives to rethink how they raise capital from markets. Whether that is enough to restore public trust in markets is less sure.