[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]
THE ENRON COLLAPSE: IMPACT ON
INVESTORS AND FINANCIAL MARKETS
=======================================================================
JOINT HEARING
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE, AND
GOVERNMENT SPONSORED ENTERPRISES
AND THE
SUBCOMMITTEE ON
OVERSIGHT AND INVESTIGATIONS
OF THE
COMMITTEE ON
FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
FIRST SESSION
__________
DECEMBER 12, 2001
__________
Printed for the use of the Committee on Financial Services
Serial No. 107-51, Part 1
U.S. GOVERNMENT PRINTING OFFICE
76-958 WASHINGTON : 2001
________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa JOHN J. LaFALCE, New York
MARGE ROUKEMA, New Jersey, Vice BARNEY FRANK, Massachusetts
Chair PAUL E. KANJORSKI, Pennsylvania
DOUG BEREUTER, Nebraska MAXINE WATERS, California
RICHARD H. BAKER, Louisiana CAROLYN B. MALONEY, New York
SPENCER BACHUS, Alabama LUIS V. GUTIERREZ, Illinois
MICHAEL N. CASTLE, Delaware NYDIA M. VELAZQUEZ, New York
PETER T. KING, New York MELVIN L. WATT, North Carolina
EDWARD R. ROYCE, California GARY L. ACKERMAN, New York
FRANK D. LUCAS, Oklahoma KEN BENTSEN, Texas
ROBERT W. NEY, Ohio JAMES H. MALONEY, Connecticut
BOB BARR, Georgia DARLENE HOOLEY, Oregon
SUE W. KELLY, New York JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio MAX SANDLIN, Texas
CHRISTOPHER COX, California GREGORY W. MEEKS, New York
DAVE WELDON, Florida BARBARA LEE, California
JIM RYUN, Kansas FRANK MASCARA, Pennsylvania
BOB RILEY, Alabama JAY INSLEE, Washington
STEVEN C. LaTOURETTE, Ohio JANICE D. SCHAKOWSKY, Illinois
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, North Carolina CHARLES A. GONZALEZ, Texas
DOUG OSE, California STEPHANIE TUBBS JONES, Ohio
JUDY BIGGERT, Illinois MICHAEL E. CAPUANO, Massachusetts
MARK GREEN, Wisconsin HAROLD E. FORD, Jr., Tennessee
PATRICK J. TOOMEY, Pennsylvania RUBEN HINOJOSA, Texas
CHRISTOPHER SHAYS, Connecticut KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona RONNIE SHOWS, Mississippi
VITO FOSELLA, New York JOSEPH CROWLEY, New York
GARY G. MILLER, California WILLIAM LACY CLAY, Missiouri
ERIC CANTOR, Virginia STEVE ISRAEL, New York
FELIX J. GRUCCI, Jr., New York MIKE ROSS, Arizona
MELISSA A. HART, Pennsylvania
SHELLEY MOORE CAPITO, West Virginia BERNARD SANDERS, Vermont
MIKE FERGUSON, New Jersey
MIKE ROGERS, Michigan
PATRICK J. TIBERI, Ohio
Terry Haines, Chief Counsel and Staff Director
Subcommittee on Capital Markets, Insurance, and
Government Sponsored Enterprises
RICHARD H. BAKER, Louisiana, Chairman
ROBERT W. NEY, Ohio, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
CHRISTOPHER COX, California NYDIA M. VELAZQUEZ, New York
PAUL E. GILLMOR, Ohio KEN BENTSEN, Texas
RON PAUL, Texas MAX SANDLIN, Texas
SPENCER BACHUS, Alabama JAMES H. MALONEY, Connecticut
MICHAEL N. CASTLE, Delaware DARLENE HOOLEY, Oregon
EDWARD R. ROYCE, California FRANK MASCARA, Pennsylvania
FRANK D. LUCAS, Oklahoma STEPHANIE TUBBS JONES, Ohio
BOB BARR, Georgia MICHAEL E. CAPUANO, Massachusetts
WALTER B. JONES, North Carolina BRAD SHERMAN, California
STEVEN C. LaTOURETTE, Ohio GREGORY W. MEEKS, New York
JOHN B. SHADEGG, Arizona JAY INSLEE, Washington
DAVE WELDON, Florida DENNIS MOORE, Kansas
JIM RYUN, Kansas CHARLES A. GONZALEZ, Texas
BOB RILEY, Alabama HAROLD E. FORD, Jr., Tennessee
VITO FOSSELLA, New York RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois KEN LUCAS, Kentucky
GARY G. MILLER, California RONNIE SHOWS, Mississippi
DOUG OSE, California JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania STEVE ISRAEL, New York
MIKE FERGUSON, New Jersey MIKE ROSS, Arizona
MELISSA A. HART, Pennsylvania
MIKE ROGERS, Michigan
------
Subcommittee on Oversight and Investigations
SUE W. KELLY, New York, Chair
RON PAUL, Ohio, Vice Chairman LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York KEN BENTSEN, Texas
ROBERT W. NEY, Texas JAY INSLEE, Washington
CHRISTOPHER COX, California JANICE D. SCHAKOWSKY, Illinois
DAVE WELDON, Florida DENNIS MOORE, Kansas
WALTER B. JONES, North Carolina MICHAEL CAPUANO, Massachusetts
JOHN B. SHADEGG, Arizona RONNIE SHOWS, Mississippi
VITO FOSSELLA, New York JOSEPH CROWLEY, New York
ERIC CANTOR, Virginia WILLIAM LACY CLAY, Missouri
PATRICK J. TIBERI, Ohio
C O N T E N T S
----------
Page
Hearing held on:
December 12, 2001............................................ 1
Appendix:
December 12, 2001............................................ 67
WITNESSES
Wednesday, December 12, 2001
Berardino, Joseph F., Managing Partner/CEO, Arthur Anderson, LLP. 47
Herdman, Robert K., Chief Accountant, U.S. Securities and
Exchange
Commission..................................................... 17
Hill, Charles L., Director of Research, Thomson Financial/First
Call........................................................... 49
Trumka, Richard L., Secretary-Treasurer, AFL-CIO................. 52
APPENDIX
Prepared statements:
Kelly, Hon. Sue W............................................ 68
Oxley, Hon. Michael G........................................ 72
Bentsen, Hon. Kenneth E., Jr................................. 75
Boehner, Hon. John........................................... 77
Ford, Hon. Harold E. Jr...................................... 80
Gutierrez, Hon. Luis V....................................... 81
Jones, Hon. Stephanie........................................ 84
Kanjorski, Hon. Paul E....................................... 85
Moore, Hon. Dennis........................................... 86
Berardino, Joseph F.......................................... 113
Herdman, Robert K............................................ 90
Hill, Charles L.............................................. 125
Trumka, Richard L. (with attachments)........................ 135
Additional Material Submitted for the Record
Baker, Hon. Richard H.:
Enron Insider Trading chart.................................. 89
Enron Stock Value Over Time chart............................ 88
Kelly, Hon. Sue W.:
Financial Regulators letter to Speaker Hastert, October 31,
2001....................................................... 70
Berardino, Joseph F.:
Letter of clarification to Hon. Richard Baker, December 13,
2001....................................................... 122
Written response to a question from Hon. Michael Oxley....... 123
JOINT HEARING: THE ENRON COLLAPSE:
IMPACT ON INVESTORS AND FINANCIAL MARKETS
----------
WEDNESDAY, DECEMBER 12, 2001
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance
and Government Sponsored Enterprises,
joint with the
Subcommittee on Oversight and Investigations,
Committee on Financial Services,
Washington, DC.
The subcommittees met, pursuant to call, at 10:50 a.m., in
room 2128, Rayburn House Office Building, Hon. Richard H.
Baker, [chairman of the Subcommittee on Capital Markets,
Insurance, and Government Sponsored Enterprises], and Hon. Sue
W. Kelly, [chairwoman of the Subcommittee on Oversight and
Investigations], presiding.
Present from Subcommittee on Capital Markets, Insurance,
and Government Sponsored Enterprises: Chairman Baker;
Representatives Shays, Paul, Bachus, Royce, Oxley, Shadegg,
Weldon, Fossella, Miller, Ose, Toomey, Rogers, Kanjorski,
Bentsen, Sandlin, J. Maloney of Connecticut, Hooley, Mascara,
S. Jones of Ohio, LaFalce, Capuano, Sherman, Inslee, Moore,
Ford, Lucas, Shows, Israel, Ross, and Hinojosa.
Present from Subcommittee on Oversight and Investigations:
Chairwoman Kelly; Representatives Cantor, Gutierrez,
Schakowsky, W. Jones of North Carolina, Tiberi, and Clay.
Also Present: Representatives C. Maloney of New York,
Jackson-Lee, and Sanders.
Chairman Baker. I would like to call this hearing to order.
To begin our proceedings this morning, there are a couple
of matters of business, procedural matters to which I would
like to attend. The first is that by prior agreement with Mr.
LaFalce and Mr. Kanjorski, each Chair and Ranking Member of the
subcommittees and Full Committee will be recognized for opening
statements of 5 minutes. Then each side will be given an
additional 10 minutes for a delegation of opening statement
time for whichever Members each side so chooses. By utilizing
this method, we will still consume at least 45 minutes of
subcommittee time before we begin discussion with the
witnesses, so I think it very important that the subcommittees
will adopt, without objection, this plan for proceeding.
Any objection?
Without objection, so ordered.
In addition, we have two Members here present, Mr. Sanders,
as well as Ms. Jackson-Lee from Texas, who will be recognized
in regular order pursuant to recognition of all Members of the
subcommittees for purposes of questions. Without objection,
there is agreement on that matter.
We are here today to examine and begin the process of
understanding the most stunning business reversal in recent
history. At one moment, an international corporation with a
diversified portfolio enjoying an incredible run-up of stock
prices, the darling of the financial press and analysts which,
by the way, contributed to the view that Enron had indeed
become the new model for the business of the future, indeed a
new paradigm. One edition of Fortune Magazine called it the
``best place in America for an employee to work.'' Analysts
gave increasingly creative praise while stock prices soared.
The corporate mission statement perhaps says it best, I
take from page 53 of Enron Annual Report 2000: ``We are
satisfied with nothing less than the very best in everything we
do. We continue to raise the bar for everyone. The great fun
here will be for all of us to discover just how good we really
can be.''
Enron even redefined fun. The sad fact, while having too
much fun, it was really all too good to be true. Not only were
investors and creditors left with lawsuits as their only
assets, lifelong employees lost their jobs, retirement and
savings, virtually left to start completely over in the midst
of a national recession.
While there were apparent indicators of potential
difficulty to a few insiders, virtually all observers were
shocked by a surprising statements of earnings expectations and
then the incredibly fast demise of the huge enterprise. Now, in
retrospect, it is clear, at least to me, that while Enron
executives were having fun, it actually became a very large
hedge fund, which just happened to own a power company. While
that in itself does not warrant criticism, it was the
extraordinary risk-taking by powerful executives which rarely
added value, but simply accelerated the cash burn-off rate.
Executives having Enron fun were apparently very costly.
All the while, they were aggressive in the exercise of
their own stock options, flipping acquisitions for quick sale.
One executive sold a total of $353 million in the 3-year period
preceding the failure. What did he know? When did he know it?
And why didn't we? Again, referring to the mission statement of
the corporation's annual report 2000, on communication: ``We
have an obligation to communicate. Here we take time to talk
with one another and to listen. We believe that information is
meant to move and that information moves people.''
Apparently so. It moved this executive to sell $353 million
worth of stock.
Then we learned of the multiple special purpose
enterprises, SPEs, as they are known, in which some executives
apparently set up businesses which contracted with Enron,
usually on exceptionally profitable terms. Everyone seemed to
have their own place to go for self-dealing at great cost to
employees and shareholders. Another concern, even though I must
admit when times were good, single stock 401K seemed to be an
advantageous thing to do when stock prices were soaring. Have
you actually ever met a financial advisor who would tell you to
have the most fun, be sure to put all your eggs in one basket?
Some things are too risky, even for the purpose of having
fun. We are here today to begin to grapple with just how all of
this could happen. A lot of smart people with no conflicts of
interest just missed it. Our task is to establish the facts,
change the rules where needed, and assist the SEC in the
pursuit of those who apparently have violated the law. This
will not be fun, and it won't happen as quickly as Enron's
demise. We will do this the old fashioned way, with a lot of
hard work and a lot of time.
In the end, our goal is to assure individual investors that
there is real value in the marketplace, credibility and
professional conduct and consequences for those who abuse the
system. I wish to express my appreciation to Chairman Oxley and
Ranking Member LaFalce for their significant interest in these
matters, to Chairwoman Sue Kelly, who Chairs the Oversight and
Investigation Subcommittee of Financial Services, who has
graciously agreed to join with us in this hearing today, and
use their subcommittee resources to take on important aspects
of this inquiry, and to announce on our return in late January,
and possibly early February, the subcommittees will continue a
series of hearings to look at a number of elements.
One, this certainly rekindles prior subcommittee interest
in the conduct of analysts and their role in this matter to
evaluate the potential for an SRO for the CPA profession. A
review of the 1933 and 1934 Securities Acts to determine where
there are inadequacies, to examine Reg FD and its' failure to
protect investors in this current debacle.
And a special word to Mr. Kenneth Lay, the CEO of Enron
who, after numerous requests by the subcommittees, sent a
letter, which I do not have in my possession at the moment, but
will be entered into the record at a later time, indicating
that his appearance before a bankruptcy proceeding today
obviated his ability to respond to the subcommittees' request.
On the record, I wish to make it clear the subcommittees will
have additional meetings should Mr. Lay's social obligations
preclude his participation, the subcommittees also have the
power to subpoena. At such time as we deem it appropriate, the
subcommittees will take action to get the appropriate
information from Mr. Lay and other executives of Enron.
I do have a letter dated December 11th, which I will enter
into the record at this time without objection.
When we're finished, I hope we will establish a methodology
in which all participants will understand when a corporation is
just having too much fun, it won't result in the loss of
personal fortunes for innocent third parties, investors,
shareholders, and most importantly, innocent employees.
At this time, I'd like to recognize Mr. Kanjorski for an
opening statement.
Mr. Kanjorski. Thank you, Mr. Chairman.
Today's hearing will help us understand at least some of
the factors that contributed to the downfall of Enron, a once
mighty international conglomerate that recently filed the
largest corporate bankruptcy in American history. Our hearing
will also help us to discern whether Congress needs to take
steps to restore the faith and trust of investors in the
American dynamic capital markets.
Although I have not yet arrived at any conclusions about
the disturbing downfall of a corporate icon, I have already
identified a number of concerns that I expect we will address
during our investigations.
First, I would like to learn more about the serious
financial harm done to thousands of Enron employees and the
many others who owned Enron stock. Some press reports suggest
that the company rules blocked rank-and-file employees from
selling Enron stock in their 401K retirement plans in the days
and weeks following the announcement that Enron had overstated
its earnings by $583 million in the past 4 years. Those
hardworking Americans had to watch helplessly as their savings
shrank without any recourse while Enron's executives could
apparently sell their stock options and avoid the financial
pain. That is wrong.
Second, I have concerns about whether the accounting
industry experiences any conflicts of interest in serving its
customers. In recent years, many have noted that an accounting
firms' consulting fees from one company may exceed its auditing
receipts from the same company. This practice calls into
question whether shareholders can rely on earnings reports and
other indicators of the company's health and its future stock
price. In order to provide transparency for investors, auditors
should actively work to limit potential conflicts.
Third, we return today to the issue of analyst
independence, a topic we have closely studied this last year.
From our past hearings, we have learned that an analyst working
for a firm that handles investment banking for a company the
analyst covers could receive a more favorable rating to attract
new business. I am therefore interested in learning why of the
15 analysts covering Enron on the day following the failed
merger with Dynegy, only one had a ``sell'' rating on the
company stock. These ratings misled investors.
Finally, in hindsight, it appears that the Enron board of
directors failed to serve Enron's shareholders. Several news
stories have detailed how gifts, contributions and other
activities may have compromised some members of Enron's board.
I expect that, as time goes on, we will learn that Enron is not
the only company where these questions arise. Members of a
corporate board must retain their independence and hold
management accountable.
In closing, Mr. Chairman, I typically prefer private sector
regulation to Federal regulation. But if the private sector
fails in its responsibilities and creates a vacuum, then the
Federal Government has a duty to protect its citizens by
addressing the market failure. More Americans than ever have
their savings invested in the stock market, and we have an
obligation to protect them from the conflicts of interest we
are investigating in the Enron collapse.
[The prepared statement of Hon. Paul E. Kanjorski can be
found on page 85 in the appendix.]
Chairman Baker. Thank you, Mr. Kanjorski.
At this time, I recognize the Chairwoman of the Oversight
and Investigations Subcommittee, Mrs. Kelly.
Mrs. Kelly. I want to thank Chairman Baker and Ranking
Members Kanjorski and Gutierrez for agreeing to hold this joint
hearing on the recent collapse of Enron and its impact on
investors and the financial markets. In this hearing, I hope we
can all gain a better understanding of why Enron collapsed so
quickly, and why Enron's public filings and Andersen's audit
reviews failed until it was much too late to give any
indication of the problems they were experiencing.
Transparency is the goal of the disclosures a company is
required to make, and a fundamental necessity to a properly
functioning open market. Unfortunately, the disclosures made by
Enron did not give any indication of the problems they were
experiencing until October 16th. News reports have had many
different versions of what may or may not have happened.
I've read about a partnership that hid the level of
leverage the company had incurred, mistakes and misstatements
that may have occurred in the audits, certain Brazilian
investments that also may have contributed to Enron's fall.
What is clear is that people have been hurt by the collapse
of Enron, from the thousands of investors whose retirement and
other investment savings have been devastated to the thousands
of employees who now find themselves without a job and with a
jeopardized pension plan.
We have on our hands what appears to be the largest
bankruptcy ever, which could have far-reaching implications for
our economy. We have the duty and the responsibility to ensure
that safeguards are in place to prevent a disaster of this
magnitude from ever being repeated. We must determine when the
accountants, executives and regulators knew what was happening,
what they did to rectify the problems. While it would be
impossible to ever have in place a system that would prevent
failures in the future, we always must try to improve on the
current system of disclosures and enforcement that is the
responsibility of the SEC.
Enron's collapse underscores how important it is for
Congress to act immediately to pass the netting provisions of
the bankruptcy bill which have already passed the House
numerous times.
For the record, Mr. Chairman, I would like to ask unanimous
consent to have a letter signed by seven financial regulators
who support the netting provision made part of the record. This
legislation would reduce the uncertainty for financial market
participants about the disposition of their contracts in the
event one of their counterparts becomes insolvent. In this
letter, the financial regulators state that ``failure to enact,
these financial contract netting provisions would unnecessarily
place the financial system at greater risk.''
Chairman Oxley has been working on this. I want to add my
strong support for enacting these needed provisions before we
adjourn this year. I want to thank all the witnesses for taking
time out of their busy schedules to share their views with us,
and I look forward to discussing these issues with them.
I yield back the balance of my time, and I do thank those
Members of my subcommittee who are here today.
[The prepared statement of Hon. Sue W. Kelly can be found
on page 68 in the appendix.]
Chairman Baker. Thank you very much, Mrs. Kelly. We
certainly appreciate your cooperation and assistance in this
important matter.
The Ranking Member, Mr. Gutierrez.
Mr. Gutierrez. Good morning Chairman Baker, Chairwoman
Kelly and the Ranking Member Mr. Kanjorski, and I want to thank
Mr. LaFalce for joining us also here this morning, and for
holding this hearing.
We are gathered here today because of a series of
unfortunate events that culminated on December 2nd with the
filing for bankruptcy of Enron. In Houston alone, Enron has
laid off more than 4,500 of its 7,500 employees as part of a
corporate restructuring program. The victims of this
catastrophe, Enron's employees, have been left wondering how
bankruptcy will affect their severance pay, health insurance,
and financial futures. For the vast majority of them, the
spectacular collapse of their company causes a financial and
personal tragedy. Many feel betrayed and angry. Sadly, many
workers didn't even know they were about the lose their jobs.
They just came in one day to work, and were simply given 30
minutes to pack up their belongings and leave.
In addition to the layoffs, a great number of Enron
employees lost, in a matter of months, almost all the value of
the stocks they owned, which plunged into levels below one
dollar. Enron employees may have lost 70 to 90 percent of their
retirement funds, which translates into more than $1 billion.
Many of Enron's employees had invested all of their 401K funds
into Enron stock. And why shouldn't they? Just months ago,
Enron was the country's seventh-largest company in terms of
reported revenue, I say reported revenue. Enron was a fast-
rising star that had turned the dreary business of energy
trading into one of the world's vastest corporate empires. It
reported quarterly revenues of nearly $47 billion.
The Enron case brings to the fore an issue that has long
worried pension and benefits experts: a retirement plan hugely
dependent on the health of the company that provides it.
Although the Employee Retirement Security Act of 1974 states
that an employer with a traditional pension plan cannot invest
more than 10 percent of the plan's assets in the employer's
stocks, traditional pension plans are rapidly falling out of
favor, with the newer 401Ks replacing them. Currently, there
are no limits yet on how much an employee's pension plan may be
comprised of the employer's stock, nor are there any caps on
investments in employer stock with employer-contributed funds.
Enron's own stock accounted for more than 60 percent of the
assets in the $2.1 billion defined benefit 401K plan several
months ago. It is widely known that some companies have even
higher levels, creating an even worse scenario should these
companies fail. Indeed, these amounts are situated well beyond
what would be described as prudent diversification.
The dangers of over-concentrating company stock in a 401K
plan have been made vividly clear by Enron Corporation's
debacle. But despite the perils, millions of American workers
have little choice but to bet their retirement savings, as well
as their jobs, on the fortunes of their employers.
However, Enron is hardly alone in its high exposure to its
own stock. Almost 120 of the largest U.S. companies, as
represented by the Committee on Investment of Employee Benefit
Assets, have seen their own stock rise to an average one-third
of plan assets.
Hardest hit will be Enron's 21,000 workers. For 3 weeks,
starting in late October, all Enron retirement plan
participants were locked into their current allocation when the
firm decided to go ahead with a switch to new plan
administrators. Enron's stock lost 35 percent of its value
during the freeze, but the workers' pain was not shared by top
executives. According to press reports, many of them cashed in
millions of dollars worth of Enron stock while the employees
were locked into those stocks.
For instance, Enron Chairman, Mr. Kenneth Lay, who refused
to come before these subcommittees, alone took $23 million of
Enron stock and sold it in the year 2001, a year in which the
price of the stock plummeted from $82 to 26 cents a share,
while the employees were stuck with the stock.
The only mistake these employees have committed was being
loyal to their company and wanting their own small, but well-
deserved, share of the riches Enron executives habitually
pocketed during their years at the company. Of Enron's 21,000
employees, the approximate 12,000 who participated in the Enron
401K plan now have virtually nothing.
Another source of problems is the companies that make their
own matching contributions in stocks, and usually place
restrictions on the trading of these shares by the employees.
Generally, workers cannot sell their shares until they are near
the age of retirement, making them captive investors.
Enron prevented its workers from selling the shares they
had accumulated until they reached the age of 50. Although this
did not save the stock from collapse, it did major harm to the
employees. It's alarming to consider that Enron is not alone in
such a requirement. Other big companies lock workers into their
401K company shares until a certain age. We all know that you
are not supposed to put all your eggs in one basket.
Mr. Chairman, to conclude, I would like to touch on an
issue that I think is key to this affair. Under my perspective,
transparency of information must be enforced in publicly-traded
firms, such as Enron.
Transparency in financial reporting plays an essential role
in making financial markets fundamentally efficient. This is
absolutely necessary if we want to have healthy markets.
Last, Mr. Chairman, we should give them what Members of
Congress have. I can pick up the phone and today I can change
my 401K, we all can, as Members of Congress. All of our
employees can make one simple phone call and we can change our
investment strategy at an instant. The employees of America
should have the same right and the same prerogatives that
Members of Congress and Federal employees have.
Thank you very much, Mr. Chairman.
[The prepared statement of Hon. Luis V. Gutierrez can be
found on page 81 in the appendix.]
Chairman Baker. Thank you, Mr. Gutierrez.
The Chairman of the Full Financial Services Committee,
Chairman Oxley.
Mr. Oxley. Thank you, Mr. Chairman. Thank you for chairing
this subcommittee hearing, as well as Chairwoman Kelly. Today,
we'll begin the subcommittees' investigation of the facts and
circumstances surrounding the largest corporate failure in
history. Today, we will hear about the dramatic collapse of
Enron Corporation, once the seventh largest company in the
United States, riding high as recently as 6 months ago. The
company has since lost more than 99 percent of its market
capitalization, and now trades below $1.
Until all the facts are known, it is prudent for these
subcommittees to avoid reaching sweeping conclusions about the
causes and persons responsible for Enron's collapse. But that
does not mean we should refrain from asking the difficult
questions that demand answers.
We will ask the difficult questions. We will delve
thoroughly into the facts and circumstances surrounding Enron's
collapse. And we will get answers.
This subcommittee, and the Subcommittees on Capital Markets
and Oversight, will vigorously pursue this matter to ensure
that the Congress, and the American public, know who to hold
accountable.
We need to learn whether millions of investors were
intentionally misled by Enron's financial engineering and
reluctance to disclose information.
We need to learn why financial statements that provided
less than a complete picture of Enron's financial situation
were certified.
We need to learn why almost all of the securities analysts
following Enron failed to warn investors, and why exactly half
of them continued to rate the company a ``buy'' or a ``strong
buy'' even after it had plunged below $1.
We need to learn whether the current reporting and
financial disclosure system needs to be overhauled.
We need to learn why the accounting rules permit companies
to keep important information off their balance sheets.
Above all, we need to reduce the likelihood that this will
happen again.
The effects have been devastating, as one might expect,
when a $75 billion company files for bankruptcy. Hit hardest by
the meltdown, of course, were Enron's employees. Thousands have
already lost their jobs, and more will undoubtedly follow. And
the 11,000 employees who participated in the company's 401K
plan have seen their retirement savings practically eliminated.
In addition, beyond the impact on Enron employees
themselves, Enron's collapse has drained the investment savings
of investors across the country who put their retirement and
other investments into mutual funds, pension funds, and other
vehicles that invested in Enron. Thankfully, at this point,
there does not seem to be a systemic threat to the financial
markets as a result of Enron's collapse, but the damage the
collapse has done to the financial position of thousands of
Americans will be very difficult to quantify.
Some may use Enron's bankruptcy as a vehicle to make big
Government arguments against electricity markets. But it wasn't
the electricity consumer who was hurt by Enron's fall, it was
their workers and investors.
Furthermore, Congress must pass the netting provisions of
the bankruptcy reform legislation. Enron and its subsidiaries
were party to tens, if not hundreds of thousands, of different
financial contracts. The identification of these contracts and
verification that they are eligible for netting will require
vast expenditures of time and money and divert the attention of
Enron and the court from the task of reorganizing. Meanwhile,
creditors will remain uncertain as to the enforceability of
their contracts and the ultimate status of their claims against
Enron.
Let's eliminate the uncertainty, the waste of valuable
court time and estate funds, and allow institutions to
eliminate exposure more thoroughly.
We are pleased to welcome the distinguished Chief
Accountant of the Securities & Exchange Commission, Bob
Herdman, to discuss the reporting and financial disclosure
system mandated by the Federal Securities laws. I'm
particularly pleased that Mr. Herdman is here today, because
the central issues that the Enron collapse raises are issues of
investor protection and accounting rules, about which there are
few better experts than the Chief Accountant of the Commission
on which to opine.
Mr. Herdman, welcome to the subommittees for your first
appearance since you've been appointed.
I would like to remind the Members of the subcommittees
that Enron, as well as Arthur Andersen, are the subjects of a
formal investigation by the SEC, so Mr. Herdman will not be
able to provide any specific information about those
investigations, and I'd ask the Members to please phrase your
questions accordingly.
On the second panel, we will hear from the Chief Executive
of Arthur Andersen, Joseph Berardino, who serves as Enron's
auditor. We welcome back Chuck Hill to the subcommittees to
discuss the performance of Wall Street research analysts in
this matter. Finally, we will hear from the AFL-CIO on the
impact to investors.
Unfortunately, Enron's Chief Executive, Kenneth Lay, was
not able to testify before the subcommittees today. Mr.
Chairman, you entered the letter into the record. He is
participating in the first hearing of creditors in the
bankruptcy proceeding.
I want to assure the Members of these subcommittees, as
well as the public, that I am confident Mr. Lay, and Enron,
will provide answers to us and to the public as the
subcommittees continue their investigation into this matter.
Mr. Chairman, I yield back the balance of my time.
[The prepared statement of Hon. Michael G. Oxley can be
found on page 72 in the appendix.]
Chairman Baker. Thank you very much, Mr. Chairman.
Ranking Member of Financial Institutions, Mr. LaFalce.
Mr. LaFalce. Thank you very much, Mr. Baker. Thank you also
for acceding to my request to have a representative of the
employees, Mr. Trumka, testify at today's hearing. He's also a
1974 graduate of Villanova Law School, and I had the pleasure
of graduating from the same law school just a few years
earlier.
Enron is a wake-up call. Enron gives us a very important
glimpse of what is necessary to hold our markets together. The
integrity, the adequacy, the clarity of information provided by
public companies to the public. When the adequacy and accuracy
of that information is compromised, devastation can and does
occur, devastation to large and small investors alike. And how
many more Enrons are out there? And what are the systemic
factors that made this collapse and may make other future
collapses possible?
Today, we will get but a small glimpse of that. But when
our committee returns in January, we must, and I'm confident we
will, conduct a comprehensive review of all of the policy
issues this debacle raises, including at least the following:
First, earnings management or earnings manipulation. To
what extent did Enron's management bend or break accounting
conventions to distort their financial condition? And most
important, is this practice widespread? And are there more
Enrons out there?
Second, corporate governance. The board of directors, and
particularly the audit committee and the compensation
committee, have a fiduciary responsibility to the shareholders.
Did they meet that responsibility in this case? Are audit
committees in corporate America meeting their responsibilities
to vigorously review the financial statements of companies and
hold management accountable to the standards of the law, as
well as sound business practices? And what reforms should the
SEC, SROs, and this Congress consider?
Related party transactions: What was the nature of the
related party transactions in what was basically a publicly-
traded hedge fund? Were those transactions proper? Were they
properly disclosed to investors and to the board of investors?
Accounting and auditing: Are the accounting standards, as
they apply to a company of this type, too difficult to apply,
and do such rules incentivize companies to exploit unintended
loopholes? To what extent, if any, should we rely on the
accounting industry to protect shareholders and assure that
companies disclose the true nature of their financial
conditions, or the desire to keep clients affect accountants'
ability to conduct their audit objectively and their
willingness to bring accounting irregularities to the attention
of management, the board of directors, and the SEC?
Analysts and market expectations: It's clear that the Enron
collapse was in large part due to a crisis in confidence
throughout the market after Enron made material adjustments to
the financial statements. Should financial analysts have known
by their own critical analysis of the company's financial
statements at their regular meetings with management that
something was fundamentally wrong?
Data analysts, whose firms have significant business with
Enron, maintained a favorable rating even after it became clear
that the company was in serious trouble. It would be useful, in
fact, I think imperative, for our subcommittees to hear
testimony from independent research analysts not affiliated
with investment banks, and then with research analysts from
investment banks to compare their ratings on Enron at different
points in time over the last several years.
For it is my understanding that there were some independent
analysts issuing negative recommendations on Enron. What did
they know that others did not and should have known? We need to
understand the quality and objectivity of their research and
how well such analysts communicated with investors.
Employee pension plans: People didn't have money in their
401Ks, they had their lives in the 401Ks. Were they encouraged
to invest in those 401Ks by management to buttress the stock?
Did management tell them what they knew, or did management tell
them what they thought was necessary to stabilize the price of
the stock? What laws exist under ERISA? Is it possible for a
company to say ``we will contribute matching moneys only if you
invest in our stock,'' as opposed to others? If that's true,
should the law be changed?
Lastly, the sufficiency of regulation. Has the SEC
fulfilled its oversight obligation in this case? Is the current
framework of self-regulation adequate? Does the SEC have
sufficient resources to effectively fulfill its oversight
responsibility, whatever it perceives its oversight
responsibilities to be? There was a day when people had
virtually all their money in a bank, in a thrift, in a credit
union, and we mandated that the Federal Reserve, the FDIC, the
OTS, the OCC basically live with those institutions examining
the books. But today, people have most of their wealth in
publicly-traded companies. And there is very little
governmental oversight, if any at all. Should this change?
Mr. Chairman, I look forward to pursuing all these
questions very aggressively in the future. Thank you.
Chairman Baker. Thank you, Mr. LaFalce.
For the record, Mrs. Kelly had a letter that she wished to
have introduced in the record relative to contract netting.
Without objection, it is included.
[The information referred to can be found on page 70 in the
appendix.]
Chairman Baker. I have two charts distributed to Members. I
just realized the charts are mine relative to Enron's stock
value over time, and the trading record of those documents I've
had distributed to the Members, and are also being made part of
the record without objection.
[The information referred to can be found on page 88 in the
appendix.]
Chairman Baker. At this point, we will begin to recognize
Members on each side for opening statements to be limited to no
longer than 2 minutes with 5 Members per side. The first I have
on my recognition list is Mr. Shays for 2 minutes.
Mr. Shays.
[No response.]
Chairman Baker. The next I have is Mr. Paul. This is by
time of arrival. Mr. Paul, no statement?
[No response.]
Mr. Fossella, we're on a roll here.
[No response.]
Chairman Baker. Mr. Ose.
[No response.]
Chairman Baker. Mr. Toomey.
Mr. Toomey. Thank you, Mr. Chairman. It appears that the
complex nature of the large volume and some question reporting
of numerous transactions introduced uncertainties, significant
uncertainties as to the leverage and the nature of the risks,
even the solvency of Enron, and the market responded. It
responded severely, shutting off credit, allowing Enron to
collapse with breathtaking speed. But I would remind my
colleagues that we tolerate another kind of uncertainty, that
is the legal uncertainty that credit exposures could be
properly netted and resolved according to the documents under
our Bankruptcy Code.
I want to join with some of my colleagues who have
emphasized the importance of passing the netting bill. I
introduced a bill that would make the necessary changes to the
bankruptcy code, and we should do that this year.
I would just briefly like to make one other point. Several
of my colleagues have strongly criticized the practices that
cost employees of Enron to lose large sums of the money that
they invested in Enron stock. I share that criticism generally.
But I would remind all of us that we contribute to that very
problem in some respects when you consider that last year, we
passed a bill that forbids people of ordinary means from
engaging in the very transactions which could have allowed them
to hedge their exposure. Retail swaps would allow people to
preserve the value of their retirement savings, and these
subcommittees and the Federal Government should not continue to
restrict the use of these vital risk management tools only to
institutions and to the very rich, as we do today.
With that, I yield the balance of my time.
Chairman Baker. Thank you, Mr. Toomey.
Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman. This hearing today
will begin the process of unraveling the reasons for the
collapse of the Enron Corporation. While the impact of Enron's
collapse will be felt in many quarters, not the least of which
is Houston, where thousands of employees have lost their jobs,
and apparently their savings, this hearing will focus on the
failure of the company's corporate governance structure to
properly oversee management, along with serious questions
regarding the performance of Enron's outside auditor. The
subcommittees need to begin to understand whether the fall of
Enron from its perch, as one of the largest public corporations
in the United States, with its market capitalization at $75
billion, and stock trading at $84 a share a year ago, to
bankruptcy and the stock at about 25 cents today was a failure
wholly inside the company with its outside advisors within the
financial market, or our regulatory and legal structure.
As a Houstonian, this is not just a failure within the
marketplace, but also a tremendous loss to our community.
Thousands of employees have been laid off just before Christmas
into a down economy. Their savings and pensions wiped out. Our
city has lost not just a corporate icon, but a corporate
partner in civic affairs, a company which transformed the
Nation's energy markets from a State-regulated structure into
an innovative efficient marketplace, collapsed under its own
weight, apparently due not to the new trading markets that it
helped create and nurture, but apparently because of old
economy corporate mistakes.
While it is doubtful in my mind that Enron will survive,
the energy marketplace it helped to found will, and it is
telling that throughout its fall, those markets still have
remained steady and calm. The scope of our hearing today must
determine whether Enron's management knowingly violated
securities laws regarding disclosure or whether those laws
allowed for the company to limit disclosure of certain
financing structures which have the effect of understating
liabilities and overstating assets and revenues. We must
determine whether the corporate governance structure of Enron
broke down or whether the laws providing for outside directors
of public companies are flawed. We must determine whether
Enron's auditors properly stated its financial condition or
ignored warning signs to the detriment of investors and
employees.
The increasing volume of corporate earnings restatements,
not just Enron, should be alarming to the investing public,
capital markets and the Congress. Are the disclosure laws
lacking in providing investors and regulators with accurate
data regarding a company's true financial condition?
Is Enron an anomaly or a preface of the things to come at
the end of the roaring 1990s and its period of so-called
``irrational exuberance,'' and I hope we have many more
hearings on this and the pension effects of this. And I ask
unanimous consent to present my whole statement for the record.
Chairman Baker. And don't forget to yield back the balance
of your time.
[Laughter.]
Chairman Baker. Mr. Shays has returned. Mr. Shays.
Mr. Shays. Thank you, Mr. Chairman. I want to associate my
remarks with the remarks of the Full Committee, your remarks
and Mrs. Kelly's. They express my views quite well. I would
then yield to my colleague, Mr. Ose.
Mr. Ose. Thank you, Mr. Shays.
Mr. Chairman, if I might, I do have a couple of questions
before I make a statement. There was a comment about the
defined benefit plan at Enron, which was another means by which
people could protect their retirements. We've checked that out
through the Pension Benefit Guarantee Corporation and those
assets are guaranteed by the Pension Benefit Guarantee
Corporation. That's the defined benefit plan.
I appreciate the gentleman from Connecticut yielding. My
particular interest has to do with the special purpose entities
and the rules that govern them. I read the various statements.
As near as I can tell, that 3 percent threshold is considered
on the basis of each separate transaction rather than in
aggregate. I'm hopeful that in the course of these hearings,
we'll get into that a little bit further.
I yield back the balance of Mr. Shays' time.
Chairman Baker. Thank you very much, both you gentlemen.
Ms. Jones. Thank you, Mr. Chairman. Good morning to
Chairmen Baker and Kelly, Ranking Members Kanjorski, Gutierrez,
and LaFalce. I'm glad to have an opportunity to give a brief
opening statement this morning. We are here to find out, as
best we can, within the public view, what happened with Enron.
I would suggest Chairpersons and Members that our efforts must
run deeper than that, and that is to find out not just what
happened, but how did it happen and where did our regulation
policies and opportunities to oversee this particular public
company went wrong. Never before in our recent memory has a
company's stock fallen so quickly. I'm concerned about the loss
of jobs and the possibility of pension loss that will come as a
result of the loss of dollars from people's investments.
I'm as concerned about Enron as I am concerned about a
company called LTV still in the City of Cleveland in bankruptcy
with 3200 employees being laid off and the steel workers stand
on Capitol Hill today saying to the Congress, ``pass some
legislation that would help us and save our industry and give
us some legacy fees.''
So today, as Members of Congress, we're asked to do a
number of things, and one of those would be to look at some of
the agencies and organizations that are responsible for
providing oversight over the accounting methods of this company
and what people have to rely upon when they make investments. I
trust that at the end of the day, we will be able to move
forward and say that we're doing all within our power as
Members of Congress to provide oversight, to provide
regulation, and give insight and protection to the American
public that uses Enron and any other company to do their
investments and save for the future.
I yield the balance of my time, Mr. Chairman.
Chairman Baker. Thank you very much. I thank the
gentlelady.
Mr. Bachus.
Mr. Bachus. I thank the Chairman. I commend you and
Chairwoman Kelly for holding this important hearing. We have
very transparent and strong capital markets so when a failure
of this magnitude comes, it takes all of us by surprise. I
think it's important that, as opposed to pointing fingers or
rushing to judgment, that we take a hard look at this and study
it, and not really rush to conclusions until we've done that.
In studying what happened, I want to first commend Arthur
Andersen for bringing their CEO today. I wish that Enron had
done the same thing. The fact that Arthur Andersen's Mr.
Berardino is here, I congratulate Arthur Andersen. I wish Enron
had done the same thing. It would have made it easier for us.
I would like to focus on three real quick things. First of
all, we know that Enron was at one time a very successful
company. They were willing to take risks, they had creative
business planning, aggressive expansion. That contributed to
their growth. Obviously, on the flip side, that contributed to
their demise because they grew too fast, got into areas they
didn't understand.
Second, quite apart from the accounting, whether they
complied with accounting rules, we know that this company, I
think this is part of the bottom line, had a history of not
being forthcoming about their business operations. I just want
to give you one quote that I think shows this. This is from the
former CFO of Enron, Andrew Fastow. He told Fortune Magazine in
March, 7 months before he was forced out, ``We don't want
anyone to know what's on our books. We don't want to tell
anyone where we're making money.'' Obviously, we didn't need to
wait till today to find that out. Their lack of transparency
was a significant contributor to what happened. We owe it to
the shareholders, to the pension holders, to get to the bottom
of this, and I feel under your leadership, Chairman and Mrs.
Kelly, and with the help of our witnesses, we'll begin to do
that.
Thank you.
Chairman Baker. Thank you very much, Mr. Bachus.
Mr. Mascara.
Mr. Mascara. Thank you, Mr. Chairman. Thank you for calling
these hearings. What I'd like to say in my 2 minutes is to pose
some questions that hopefully I'll have an opportunity to do
later, but if not, they'll be on the record.
One is whether the SEC approves the prospecti filed by
Enron on the various SPE filings in an attempt to ascertain
whether complete financial disclosure was revealed. The other
is, given that the SEC representative here, the CEO cannot
disclose, according to his statement anyway, that I read--is
that information that has to deal with this investigation? And
if not, apparently we're not going to get many answers today--
is whether a grand jury should be formed and empaneled to
investigate this economic calamity.
Regarding the pensions, I'm looking for answers. Whether
the large number of Enron employees who had 401K pension plans
and Enron stock, why they could not sell their stock. We call
it down here a thrift plan, open season. And at the same time,
the management people were cashing in their 401Ks. And now that
Enron has declared bankruptcy, does the bankruptcy law provide
any special protection to employees in the pension plan. I
understand that before Enron declared bankruptcy, the stocks in
these 401Ks were traded, and whether the SEC required that the
accounting firms involved complied with all of the FASB,
Financial Accounting Board Standards.
Those are some of the questions that I need to have
answered, and hopefully I'll have an opportunity to ask those
questions. If not, I would hope that the respective firms and
the SEC involved will provide those answers to me.
Thank you, Mr. Chairman, I yield back.
Chairman Baker. Thank you, Mr. Mascara.
Mr. Miller.
Mr. Miller. Thank you, Mr. Chairman.
To be honest, I'm less interested in what we have to say
and more interested in listening to what the witnesses have to
say. I'm personally going to focus on questions following that.
I would yield back my time.
Chairman Baker. Thank you very much, Mr. Miller.
Mr. Sherman.
Mr. Sherman. Thank you. I'm interested in the pension plan
issues where workers invest their entire work life and their
retirement savings in the same basket, but I would point out
that we in this Congress are very much promoting the ESOP
concept which encourages the same thing, but with an additional
element, and that is worker control. And I think ERISA should
require in a pension plan diversification or worker control, if
the workers are over invested in the stock of their employer.
I am a CPA and I am particularly interested in the
accounting issues. Fundamentally, responsibility rests with
Enron management which engaged in highly complex and
questionable transactions and then misstated them in their
financial statements. But we need to see whether Generally
Accepted Auditing Standards were sufficient to allow the
accounts, the outside auditors to know what the facts were and
whether the auditors applied those standards correctly. And if
the auditors did know the facts, then we need to look at
whether Generally Accepted Accounting Principles serve were
employed, and if so, whether they need to be changed. I'm
particularly interested in these special purpose entities which
seem a wonderful way to enrich management through self-dealing
and conflict of interest, plus a method of manipulating
financial statements. The only legitimate use that I'm familiar
with for SPEs is to shift risk from the public shareholders to
a special purpose entity. But you hardly shift risk when the
chief asset of the SPE is stock in the company that they are
supposedly ensuring or protecting against risk.
Also, I have to wonder whether the 3 percent independent
equity rule is sufficient. It seems to beg for manipulation
with insufficient risk protection for the company. I think we
have a bit of an analogy here--wrap it up?--and that is we may
discover not only that the auditors did not apply the
accounting standards correctly, but that the company actually
came very close to complying with those standards and that it
is the standards that need to be changed even more than making
sure that we had adherence, what I think will worry us most as
we discover that Enron, had they just been a little different,
could have complied with all the technical rules and still gone
down the drain.
I yield back.
Chairman Baker. Thank you, Mr. Sherman.
Mr. Weldon.
Mr. Weldon. Thank you, Mr. Chairman. I want to thank you
and the Ranking Member and all those involved in putting this
very important hearing together. This failure of this company
has shaken the American confidence in our investment system and
I feel very strongly that we will need to, either through a
self-regulating process or a legislative process, make changes
in the way accounting practices and stock analysts operate in
the United States. I would like to particularly associate
myself with the remarks made by Mr. Gutierrez. I think we will
seriously need to consider modifying ERISA legislation to
prohibit the situation that we had with Enron. It's tragic
enough that these employees had been laid off, but the fact
that their entire retirement savings was wiped out, is totally
unacceptable.
I yield back.
Chairman Baker. Thank you, Mr. Weldon.
Our last participant opening statement is Mr. Sanders for 2
minutes.
Mr. Sanders. Thank you, Mr. Chairman. Thank you for holding
this hearing. It seems to me that Enron's collapse raises
several very important issues, some of which have already been
discussed by my colleagues. Clearly, we must protect employees
from seeing their retirement funds ripped off and their life
savings go down the tubes. We've got to look at this in terms
of the implications on the privatization of Social Security as
some would have us do, and also understand that other companies
around this country in different ways are ripping off the
retirement plans and the pensions of their workers.
Second of all, we want to examine the role of accounting
firms like Arthur Andersen. As many know, Andersen recently
settled a suit brought against them by the SEC for $7 million
as a result of a failed audit at Waste Management Incorporated.
The question arises, what was Arthur Andersen doing when Enron
was cooking its books. How much confidence should the American
people have in companies like Andersen?
But the third issue, Mr. Chairman, that has not yet been
raised, it seems to me perhaps to be the most important. That
is the role of big money in the political process and the need
for real campaign finance reform. Since 1992, Enron has
contributed over $5 million to Republicans and Democrats.
During the last 2 years, Enron has spent $4 million lobbying
Congress and the White House. The Chairman of Enron, Kenneth
Lay, his wife contributed close to $800,000 to the Republican
party since 1988. During the 2000 presidential campaign, Enron
made available its fleet of corporate jets for political travel
by candidate Bush.
What did Enron get in return for their campaign
contributions from the Federal Government? Amazingly enough, as
far as I understand, Mr. Chairman, they are still in line today
for a $254 million tax rebate if the Republican House version
of the Economic Stimulus Bill becomes law. Thank you Enron, for
all the good work you are doing, and you're going to get a
check for $254 million from the American people. Clearly,
that's an outrage.
Several months ago, the Bush Administration refused to
assist California and other States cope with severe energy
crises.
Chairman Baker. If you can begin to wrap up, Mr. Sanders.
Mr. Sanders. Costing consumers tens of millions of dollars.
There is no question but Enron, through their political
contributions and influence, has had an enormous impact on
energy policy and the way this Government does business. That's
wrong and it's got to be changed.
Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Sanders.
For the record, I have several documents relating to
political contributions by the Enron Corporation to Republicans
and Democrats. I will admit those for the record as well, just
to keep balance in the hearing record. Thank you, Mr. Sanders.
At this time, I would like to finally turn to our esteemed
witness on our first panel, Mr. Robert K. Herdman, Chief
Accountant of the Securities & Exchange Commission, your first
appearance before these subommittees, Mr. Herdman. I am very
pleased to learn of your acceptance of this position. Your
reputation for good work is outstanding, and we are pleased to
hear your comments. Welcome.
STATEMENT OF ROBERT K. HERDMAN, CHIEF ACCOUNTANT, U.S.
SECURITIES AND EXCHANGE COMMISSION
Mr. Herdman. Chairman Oxley, Chairman Baker, Chairwoman
Kelly, Ranking Members LaFalce, Kanjorski and Gutierrez,
Members of the subcommittees, thank you for the opportunity to
testify today on behalf of the Commission regarding recent
events relating to Enron. Your letter of invitation asked me to
address the regulatory matters and accounting issues that have
been publicly raised by Enron's collapse. My written testimony
does address those matters. I ask that it be included in the
record.
As you know, the SEC is investigating the Enron matter. The
Commission appreciates the subcommittees' recognition of the
non-public nature of its investigation, and as Chairman Oxley
alluded to, the Commission also asks that in light of its
ongoing investigation, the subcommittees understand our
reluctance to address specific issues relating to compliance
with the Federal Securities Laws at this time.
If I might add, the reason for this, as I understand it
from my General Counsel, Mr. Becker, behind me, is that if
there is public disclosure about the particulars of an
investigation, while it's still in process, that runs the risk
of appearing to prejudice the outcome and it might, in fact,
jeopardize the investigation. But let me assure you that at the
conclusion of this investigation, we will deal swiftly and
completely with any wrongdoing and wrongdoers to ensure full
protection of investor interests. I want to assure the
subcommittees that the Commission shares your grave concern
over these events.
The sudden collapse of a Fortune Ten company gives pause to
all of us who care about financial reporting and the tragic
consequences of these events for Enron investors, including the
many Enron employees whose retirement savings have been
decimated, simultaneously with losing their jobs, is a sober
reminder to all of us of the importance of reliable and
transparent financial reporting. It is axiomatic that
confidence in our markets begins with the quality and
transparency of the financial information available to help
investors decide whether, when and where to invest their hard-
earned dollars. The goal of the Federal Securities Laws is to
promote honest, efficient markets and informed investment
decisions through full and fair disclosure of all material
facts.
The SEC is tasked with ensuring that markets are
transparent and hospitable to all investors. Congress wisely,
in the Federal Securities Laws, adopted the philosophy that
investors have the right to be fully informed of all material
facts, and choose markets that are free from fraudulent,
deceptive and manipulative conduct.
Transparency in financial reporting, that is the extent to
which financial information about a company is visible and
understandable to investors and other market participants,
plays a fundamental role in making our markets the most
efficient, liquid and resilient in the world. Transparency
enables investors, creditors, and the markets to evaluate any
publicly owned entity. Transparency helps investors make better
decisions and by doing so, it increases confidence in the
fairness of markets. It is critical that all public companies
provide an understandable, comprehensive, and reliable
portrayal of their financial condition and performance. If the
information in financial reports is transparent, then no one is
surprised by unknown transactions or events.
It also is critical that auditors, standard setters, audit
committee members and the SEC perform our respective roles with
respect to financial statements. My written statement includes
information on the accounting standards setting process that
exists in our country, the self-regulatory process in the
accounting profession, and the role of the SEC in reviewing
filings.
As you know, last month Enron disclosed several errors in
its' previously issued financial statements and announced its
intention to restate its financial statements dating back to
1997. As the subcommittees have requested, my written statement
provides an explanation of the accounting and auditing
literature and several of the issues discussed in Enron's
recent filing. Specifically these deal with restating
previously issued financial statements account for special
purpose entities or SPEs, and the $1.2 billion reduction in
shareholders' equity.
Also at the request of Members of the subcommittees, my
written statement explains the mark-to-market accounting
applied to contracts for the purchase or sale of energy
contracts. As I said at the outset, the Commission will move
expeditiously in its investigation in the Enron matter and will
take appropriate actions.
Regardless of the outcome of the issues surrounding the
Enron situation, the SEC is working to improve and modernize
our financial disclosure system. Our goals are to make
financial statements more transparent, easier to understand, to
foster private sector standard setting that deals appropriately
with current and immediate needs, and to work with the
accounting profession to ensure comprehensive and effective
self-regulation.
Chairman Pitt's op-ed piece in the Wall Street Journal
yesterday outlined these and other of the Commission's planned
improvements to our current reporting and financial disclosure
system. We believe these are extremely important initiatives
that will constitute much of the Commission's work in the
coming weeks and months. And I am pleased to advise you that
today the Commission is issuing cautionary advice regarding the
need for corporations to make full and fair disclosure about
what we're calling ``critical accounting policies.'' As we
continue to move forward, the Commission looks forward to
working closely with the Congress on these and other issues of
importance to the investing public.
Thank you for the opportunity to appear today. I'm happy to
try to respond to any questions Members of the subcommittees
may have.
[The prepared statement of Robert K. Herdman can be found
on page 90 in the appendix.]
Chairman Baker. Thank you, Mr. Herdman.
The Committee will return next month to review practices
which have been initiated in the last session. There has been
ongoing staff work and research effort and efforts to come to
closure with my staff on recommendations which should be
forthcoming early next year. I hope we will be initiating a
similar process with regard to at least consideration of the
SRO approach with regard to the CPA industry, or whatever might
be the appropriate recommendation from the SEC to consider.
Although the current body of law, in my view, would seem to
be adequate, I think the complexity of modern business
structures may have surpassed the rules we currently have in
place, which would then lead us to a discussion of a rewrite of
the 33-34 codes, which would be a long-term, obviously
extensive process. The short term issue for me, though, is
without regard to a fact finding in the matter of Enron, does
current law provide sufficient penalty and what is the nature
of the penalty for self-dealing either inaccurate disclosure or
withholding disclosure or violation of meeting the duty of care
standard or your fiduciary responsibility.
Can you tell us without making a statement as to a finding
relative to the performance of Enron officials not related to
the question. If someone were found to violate those standards,
what would be the penalties available to the Commission today
in pursuit of bringing someone to responsible justice?
Mr. Herdman. Mr. Baker, I'm aware that the Commission has a
wide range of sanctions that it can impose against companies,
and in certain cases against individuals. I really have to
defer the discussion of the specifics, because that is not my
area of expertise.
Chairman Baker. We've got a couple more and we may get back
to this, but let me just save that for the record, and at an
appropriate time, to keep us moving, perhaps a response
pursuant to the hearing would be helpful.
With regard to regulation in the current environment, it
seems an element that works for compliance is simply not to
disclose if there is a question in your mind if you can do it
properly as opposed to an affirmative responsibility in the law
to make disclosure of material elements without having to make
the judgment. If it's material, you disclose it. Had we had
that standard, in fact, would that have helped with the
transparency concerns and the current concern.
Mr. Herdman. I really can't speculate about how things
might have affected the particular matters with respect to
Enron. The entire question of moving to a system of current
disclosure with affirmative obligations to disclose is one of
the important parts of our program to improve financial
reporting coming up----
Chairman Baker. Let me characterize it this way. A
statutory or regulatory requirement for affirmative disclosure
certainly would not have made the matter more difficult. It
possibly could have helped.
Mr. Herdman. Certainly.
Chairman Baker. With regard to the adequacy of current
disclosures, and they are extraordinarily sophisticated, in
trying to wade through the financial statement of Enron, well,
it put me in my place. I don't know--is there anybody within
the SEC that really goes through, from A to Z, the entire
document on their own without outside help who can read these
things and understand what business risks are presented? Or
have we gotten information that's so convoluted that a person
in good faith, who is reasonably educated still is rather lost.
Make me feel better, please.
[Laughter.]
Mr. Herdman. I assure you that we have on the staff of the
Commission people who are quite expert in these matters and do
go through documents filed with us from A to Z. Having said
that, I won't deny that at times that can be a daunting task,
because financial statements today are very complicated.
Chairman Baker. Let me ask it this way. If you had had the
time and the staff available and someone in the casual review
of the data currently required under law to be disclosed, could
they have determined that financial reversals were in the
future from the current disclosure format, or do we need to be
looking at a different way of making relevant information more
understandable?
Mr. Herdman. Without commenting on Enron here, Mr.
Chairman, I think most financial statements today are not
designed to provide information about the future. However, our
rules for disclosure and management's discussion and analysis
does require a certain forward looking focus particularly with
respect to matters that have occurred in the past that might
not be reasonably expected to occur in the future.
Chairman Baker. For example, we're going to buy a
waterworks company in England--I'm just making up something
here--and we don't know much about waterworks and we're going
to spend a lot of money, that's a material thing, it doesn't
necessarily mean it's adverse, but disclosures of where you
might be going in business judgment could have been helpful to
people trying to understand the scope of business which a hedge
fund-like business might engage in.
Mr. Herdman. Disclosure is designed to provide
transparency.
Chairman Baker. Lastly, because I've exhausted my time,
with regard to pro forma reporting, as opposed to cap
standards, will there be recommendations, further
recommendations with regard to revision of the pro forma
methods of accounting or reporting as opposed to the current
Generally Accepted Accounting Principles?
Mr. Herdman. At the present time, I'm hopeful and expect
that the cautionary advice that the Commission issued just
several weeks ago will take care of any abusive practices that
have existed in the past.
Chairman Baker. Let's assume we're going forward without
looking historically. There would be pro forma reporting, which
would have led to a misunderstanding in the marketplace. Under
current rule, given your recent advisory, what would be the
consequences for a corporation or a CFO issuing those pro forma
advisories that were found to be inappropriate?
Mr. Herdman. I can't generalize, but if such disclosures
are made in a way that violates the anti-fraud provisions of
the Securities Laws, then I expect that there will be vigorous
enforcement action taken.
Chairman Baker. I can surmise, given the sensitivity of the
response to the current environment, you feel adequately armed
to respond to inappropriate conduct in current circumstance
once you have made a factual determination of wrongdoing?
Mr. Herdman. I believe that that's correct. I'm not sure
that I can speak for the entire Commission.
Chairman Baker. We want to make sure you have the tools you
need to do the job that's ahead of you. If that is not the case
on further reflection, please advise the subcommittees as to
areas of concern that you can identify that may warrant the
subcommittees' assistance.
Mr. Herdman. We will certainly do that.
Chairman Baker. Thank you very much, Mr. Herdman.
Mr. Kanjorski.
Mr. Kanjorski. Mr. Herdman, looking over the overall
policy, is it your belief, as a professional accountant of the
SEC, that we have sufficient transparency or as the
sophistication and possible manipulation of disclosure
statements by corporations becomes so fuzzy as to really not
constitute true transparency.
Mr. Herdman. Congressman, I think that our capital markets
are clearly the best in the world, and our accounting and
financial reporting are widely acclaimed as the best in the
world as well.
Mr. Kanjorski. So is it your interpretation that this is a
singular occurrence that occurred because of economic
situations, or did this occur because of stock being
artificially bid up and played because of an over accentuation
of revenues and the hiding of debt?
Mr. Herdman. I really can't say at this point what has led
to Enron's demise with any certainty. That's something that we
certainly hope to learn as part of our investigation. As that
progresses, as we learn things, we'll be looking to see whether
there are indications that there may be other problems out
there.
Mr. Kanjorski. Are there other Enrons out there or do you
feel this is a unique situation?
Mr. Herdman. I think at this point, it is premature for me
to answer that question one way or the other.
Mr. Kanjorski. I may assume there may be other Enrons out
there?
Mr. Herdman. There may be.
Mr. Kanjorski. What is the SEC doing to determine whether
that's the case, and how will you disclose that to the public
or to the Congress?
Mr. Herdman. Well, when problems are found in a particular
industry, the staff of the Division of Corporation Finance,
which does review filings, makes it a practice to take a look
at the filings made by other companies in that industry and
proceeds, if there are indications of non-compliance with
Generally Accepted Accounting Principles, unclear disclosures,
and so forth, enters into a common process back and forth with
the registrant. If there's not a satisfactory resolution of
those matters, and if the staff of the Division of Corporation
Finance believes that it's warranted, there are instances where
a referral is made to the Division of Enforcement for follow-up
by them.
Mr. Kanjorski. With regard to the special purpose entities,
is this a widely used methodology in large corporations,
specifically to avoid disclosure of the true nature and
condition of the main corporation?
Mr. Herdman. It's not an uncommon practice, Congressman,
for special purpose entities to be engaged. While special
purpose entity transactions have the effect of excluding
certain things from a corporation's financial statements, there
are a number of very valid reasons why corporations do enter
into them, including the fact that they often offer the
potential for reduced interest costs as well as certain tax
advantages in some instances.
Mr. Kanjorski. So from your general overall view of the
occurrence here at Enron, you would say that the investing
public doesn't have to have a fear that this may be endemic to
the system, but this is just a unique, separate situation that
just happened?
Mr. Herdman. I don't think any of us can say that at this
point, Congressman. I think that the Enron situation raises
questions about an entire system of financial reporting and
confidence in that system.
Mr. Kanjorski. I notice, as I looked at the Chairman's
chart of Enron Insider Trading, you can almost see a picture
that the insiders were getting out at the absolute top point,
and they did it in several instances. They took their life
rafts and got out about 6 months ahead of when the ship was
finally going down. Are you looking at insider trading to be an
indicator that there may be something that the insiders are
aware of that the investing public isn't aware of?
Mr. Herdman. With respect to Enron, I can't comment
obviously. With respect to whether that's a procedure that
might be useful, that's something that we would consider. I
don't have any personal knowledge of whether that's an accepted
practice today among the staff of the commission.
Mr. Kanjorski. I'm just trying to see what we can do as a
Committee in the Congress to make sure there aren't other
innocent investors out there in the public. Should they be
somewhat alarmed when they start seeing the insiders getting
out in large bulk? They may not want to go in. Obviously, the
analysts didn't bring this to anybody's attention. The
accountants didn't bring this to anybody's attention and the
SEC didn't bring it to anybody's attention. So there are a lot
of babes in the woods out there that own stock, and they are
trading in these securities thinking that they were a very
secure corporation, and all the insiders are handing out life
jackets.
Mr. Herdman. I think the question of whether shareholders
should pay particular attention to trading by insiders is an
interesting one, but frankly, Congressman, that's outside of my
area of expertise, really to comment.
Mr. Kanjorski. Do you clearly by the disclosures made on
insider dealing disperse that information to the general public
sufficiently?
Mr. Herdman. I can't answer your question.
Mr. Kanjorski. If I were on a boat and I saw some water on
the floorboards and I saw the captain and the crew jump off the
boat real fast, normally at sea I think I'd grab a life jacket
and jump too, because they must know something I don't know. It
seems to me in stock transactions it's somewhat similar. And if
it isn't, if we're not getting that disclosure out there, the
fact that the captain and crew are jumping overboard, then
we've got to find a vehicle to alert people.
Mr. Herdman. I am aware that there are requirements for
disclosure determined by insiders, and that information is made
public.
Mr. Kanjorski. I yield back my time.
Chairman Baker. Thank you, Mr. Kanjorski. I'm sure those
dispositions were purely coincidental and in time will prove
there was no relationship.
Mrs. Kelly.
Mrs. Kelly. Thank you, Mr. Chairman.
Mr. Herdman, I'm interested in the mark-to-market
accounting standards that energy traders are given. It's a
sophisticated kind of thing. A lot of people who invest are not
really, I think, aware of what's going on there. I wonder,
given the difficulties in ascribing a value to some of these
transactions with this policy, don't you think it's led to some
misleading information that's been provided to investors? I'm
not asking specifically about this, but investors in general?
Mr. Herdman. I don't know that there's any evidence to
indicate that mark-to-market accounting has led to misleading
information to investors. The broker-dealers in this country
have used mark-to-market accounting to account for their
activities for many, many years. They have sophisticated
financial instruments that aren't quoted on exchanges that need
to be accounted for at market value. And so estimates need to
be made of value in order to accomplish the mark-to-market
process. Energy trading contracts can be and are very, very
complicated and they sometimes go on for periods of time as I
understand it that go beyond the period of time where there are
quotes, either for purposes of forward contracts, or broker-
dealer type contracts, and therefore they require that a model
be developed that takes into account recency of other
transactions and mechanics such as that, leading to an estimate
of fair value.
That really is the difficult part of it. It's fairly easy
to mark-to-market a financial instrument that is traded on the
New York Stock Exchange. Even I can calculate that. But the
calculation of the market value of a third year contract to
supply electricity requires a great deal of specialized
expertise.
Mrs. Kelly. Is the SEC looking into changing any of these
rules with regard to the energy policies, the energy companies?
Mr. Herdman. As I said at this time, Chairwoman, we haven't
seen any indication that the mark-to-market accounting has
caused problems for companies within the energy industry. If we
do, we would certainly expect that there might be a need to
tighten up the accounting rules here.
Mrs. Kelly. Do you think that the investors and
transparency would be helped if the SEC and the FASB clarified
the principles of mark-to-market accounting?
Mr. Herdman. I think the principles of mark-to-market
accounting are quite clear in the accounting literature that
exists today, and the circumstances under which it should be
done.
Mrs. Kelly. Yes, you said earlier that this was a bit murky
with regard to energy.
Mr. Herdman. What's not rigid in the accounting rules today
is a specified methodology for how to calculate the market
values.
Mrs. Kelly. And perhaps you might be looking into that.
Mr. Herdman. That's a possibility.
Mrs. Kelly. I also understand that FASB has been reviewing
standards related to the consolidation of the financial
statements by parents and the SPEs for 10 years. Do you find it
a little troubling that FASB still is looking and has taken
that long to address this?
Mr. Herdman. The policy FASB has had on consolidations
includes considerations of the treatment of special purpose
entities. We are encouraged at this point that the FASB
announced just recently that it is refocusing its project on
consolidations to address a number of issues that really are at
the heart of the SPE question, and we're very hopeful that they
will proceed apace with that and get it done, however, subject
to all of the due process procedures.
Mrs. Kelly. Perhaps, sir, you could at the SEC make sure
that it's sooner rather than later. It has been. We need to see
a little sooner on this, I think. If I understood your
testimony correctly, you said you've issued new cautionary
advice with regard to critical accounting policies today. Could
you describe that for us?
Mr. Herdman. Certainly. What we're doing is getting
something out for this year end to encourage companies to make
disclosures of a type that really have not been made before.
We're doing this with a view toward accomplishing better
disclosure in the 2001 annual reports, as well as facilitating
work that we're going to be doing in 2002 to move to very
definitive rulemaking in this area. But what these particular
disclosures would relate to, critical accounting policies,
which we are characterizing as those that really make a
difference in a company's financial statements, but also
require extremely complex and subjective judgments to be made
by management in their application. And often the complexity
and subjectivity is due to the fact that there needs to be very
sophisticated estimation processes in order to take into
account the fact that a lot of accounting has to grapple today
with the uncertain effects of the future. So better disclosure
about those kinds of things we think will help to mitigate the
potential for surprises in the future.
Mrs. Kelly. My time is up. Thank you very much.
Chairman Baker. Thank you, Mrs. Kelly.
Mr. Gutierrez.
Mr. Gutierrez. Thank you very much. Thank you for
participating this afternoon with us. Some in the accounting
industry have argued that the accounting rules have become too
complicated for companies to apply rationally and for auditors
to apply in connection with their audit. Do you believe this is
true?
Mr. Herdman. Congressman, accounting rules have become
very, very complicated, but let me also point out that the
world is very, very complicated in terms of the types of
transactions that are engaged in today which are also very
complicated. At the same time, I think that the fact that the
FASB is in the process of studying a project that they want to
put on their agenda to deal with complexity in the accounting
rules is very encouraging. I think that's terrific, because the
accounting literature we have today rivals--in fact, exceeds--
the size of the Internal Revenue Code and all the various
regulations that pertain to that. Ultimately the accounting
rules have to be applied by people. Simplification would be a
good thing.
Mr. Gutierrez. Is the goal of a meaningful disclosure to
provide investors with an accurate and complete picture of a
company's financial condition? And has the SEC considered a top
down review of accounting disclosure rules? You talked about
them a little bit earlier on today.
Mr. Herdman. One of the critical projects we're going to be
working on in the coming months is a real look at the nature of
financial information that is conveyed to shareholders.
Certainly at this point, we are considering things in addition
to the current system of periodic disclosure, and we'll be
working with many, many people that are interested in this and
are providing and will provide input to us about things like
disclosure by companies of trend information on a more current
basis than just quarterly disclosure about changes in those
types, those kinds of trends that might give earlier warnings
about the company's prospects of going up or going down, and
all those kinds of things.
Mr. Gutierrez. I think that's excellent. I look forward to
working with your team, and obviously, the Members of these
subcommittees on doing that, because an accurate picture might
have helped a lot of people at Enron, because given what we
know today, we didn't get an accurate picture.
I would just suggest that maybe--and this is a humble
suggestion on my part, Mr. Herdman--as you look at the
situation, the specific situation with Enron, that you look at
the relationship--it's simply a suggestion on my part that you
simply look at the relationship between insiders and selling
their stock options. The Chairman has been very, very kind to
share with us this form, this graph. I mean, January of 2001,
you've got the insiders at Enron selling over $160 million
worth of stock. Maybe you should look at that, and maybe we
could find a way so that, as Mr. Kanjorski said, because it
sounds to me that's kind of like the captain jumping off the
ship, when the insiders are selling all their stock options,
they are obviously not keeping them. And as we look at the
sheet, they sold it at the highest point and then they went in
May is the next time, and it seems that they sell things at the
highest point. They know what's going on, they're inside
obviously. That's why we call them insiders. Those are the
executives.
And if you have a CEO, as in the case of Enron, that's
going to sell $100 million worth of his own stock, and it would
be good and prudent, in my humble opinion, it would be good and
prudent and advisable for the public to know, hey, the CEO is
selling all the stock, selling $100 million and we know about
it in January so that everybody knows, at least to that extent,
what he knows. We can't put him there like his wife wanted a
new yacht or his college kid's tuition came up, although I
don't know what college you would send someone to for $100
million, but you never know.
We don't have to know why they did it, but at least know
that they did it and when they did it. It's a simple
suggestion, because I think that way we would all know.
Mr. Ose. Would the gentleman yield?
Mr. Gutierrez. Sure, I would.
Mr. Ose. The insider trading by the Board of Directors of a
Fortune 500 who are members of the management team are in fact
tracked by the SEC. You can read them in the Wall Street
Journal on a regular basis.
Mr. Gutierrez. I would yield, but you know something, if
you can read them, then it's interesting that nobody knew about
it, and nobody read about it and nobody made a note about it,
and maybe our friends here should take a note about it and what
kinds of action they can take when somebody's doing
specifically that. I know there are Members of these
subcommittees that want capitalism to thrive at any extent. I'm
certainly a capitalist, but when you have tens of thousands of
employees losing their jobs, I think it's a regrettable
situation and we should look at ways to correct that situation.
Chairman Baker. Thank you, Mr. Gutierrez. You will note on
the form that the document made reference to in the left hand
corner, this source is the insider and Form 144 filings, so to
support Mr. Ose, there are mechanisms by which this information
is publicly available. The real question is as to timing and
understanding and I think that perhaps is the bigger concern.
Mr. Herdman. Congressman Ose is correct. It's published in
the Wall Street Journal periodically, but certainly I'll follow
up on your suggestion, Congressman.
Chairman Baker. Chairman Oxley.
Mr. Oxley. Thank you, Mr. Chairman.
Mr. Herdman, the Enron collapse clearly points out the need
for Congress to act on netting legislation. Our good friend
from Pennsylvania, Mr. Toomey, has that legislation ready to
go. Does the SEC have a position on that issue, and if so, what
is it?
Mr. Herdman. The Commission is in favor of the netting
provisions of the Bankruptcy Bill. Chairman Pitt did sign that
letter in November that was also signed by the Chairmen, I
believe, of six other regulatory agencies. He signed it on
behalf of the SEC and the Commission is very much in favor of
that legislation.
Mr. Oxley. Mr. Herdman, is it your understanding that if
we're able to pass the Toomey legislation before Congress
adjourns for the year, that the court would be able to use the
netting provisions in the law in the Enron case specifically?
Mr. Herdman. I can't answer that question, Mr. Chairman.
I'm not an expert on that in bankruptcy law.
Mr. Oxley. We'll follow up. Thank you very much.
Mr. Herdman, as you know, there have been a series of
accounting shortfalls. Waste Management, ZZ, Sunbeam, and now,
of course, Enron--the grandaddy of them all. Does this suggest
a systemic problem? If it may, what is the SEC planning to do
to alleviate that systemic problem?
Mr. Herdman. I think it's premature, Mr. Chairman, to
conclude about whether there are systemic issues here. I also
believe that it would be premature to look to only one
potential source of whether there might be a systemic issue.
Instead, there's work that needs to be done by all concerned in
these processes.
Like Chairman Pitt's op-ed piece in the Journal the other
day points out that things need to be done with respect to
faster standard setting. Things need to be done with respect to
the analyst community, the Big Five accounting firms and the
NCPA have already stepped up and said they're going to take a
look at self-regulation, the self-regulatory structure that
exists today to determine what types of improvements might be
needed so there are issues here. The SEC can and will work hard
to improve our review process for the review of filings with
us, so there are lessons to be learned here for everyone.
But, I think it's premature to say that that translates
into a particular, or a series of particular, systemic issues.
Mr. Oxley. I too read the op-ed piece in the Wall Street
Journal by Chairman Pitt. I was most impressed with the breadth
and scope of what recommendation that he gave. Obviously we
will be pursuing that as a committee, particularly when we take
up SEC reauthorization early next year. But indeed, it's fair
to say that even before all of the bad news came out of
Houston, that the Chairman had already put on the table
numerous modernization efforts, and indeed, as you know, many
of the regulations date back to the 1934 Act in a modern world
of instant communications. In many ways, we still rely on the
quarterly report, and I think one of the best ideas he had was
more timely disclosure. And obviously the technology and the
infrastructure is there today to do that. Maybe even Mr.
Gutierrez will be able to pick up some insider trading
information electronically instead of having to leaf through
the Wall Street Journal.
My friend from California here is apparently flogging the
Wall Street Journal for whatever reason, but I think it does
point out that the new Chairman has recognized that we are in a
new environment here, and that modernization of our structural
regulation is clearly called for. And for that end, we thank
you and the Chairman for their aggressive work in that area,
and I yield back.
Chairman Baker. Mr. Chairman, I would just point out that
if it is not a systemic regulatory problem in the matter of
Enron, then one would not have a large leap to assume that
there's at least significant fraud or criminal conduct. I can't
imagine that every person in Enron engaged in that activity.
It's got to be one or the other. I would hopefully land on the
systemic side for necessary reform and review, and then assume
than everybody engaged in activities there was not aboveboard.
Mr. LaFalce.
Mr. LaFalce. With respect to netting, this is not a new
issue. The House of Representatives has passed netting
legislation not only in this Congress, but in the Congress
before this and in the Congress before that, and so has this
Senate. But the leadership of the House and Senate has put this
in a bankruptcy bill that is destined to go down to defeat. We
need to extricate the netting provisions that have passed three
successive Congresses and simply pass it independently if
there's such bipartisanship in support of netting. And I was a
co-author of all the bills. Let's do it.
Mr. Herdman, you recently came from the private world of
accounting from Ernst & Young, and you are the Chief Accountant
now for the SEC. My first question is, very briefly, what are
your responsibilities as opposed to the Chief Accountant within
the Enforcement Bureau?
Mr. Herdman. The chief accountant in the Enforcement
Division works strictly on enforcement matters. As the Chief
Accountant of the Commission, I am the principal advisor to the
Commission on accounting and auditing matters and----
Mr. LaFalce. Would you be more involved with policies,
procedures, and general practices, and your counterpart would
be more involved with the specifics of individual situations?
Mr. Herdman. That's a fair generalization, Congressman.
Mr. LaFalce. Let's go back to your days at Ernst & Young.
There are basically five big accounting firms worldwide I
believe. You vie with each other. You want to represent clients
because that's the only way you make money, so you have to be
competitive. But there's a tension that exists, because you
have certain fiduciary responsibilities as members of the
accounting profession, and you have other fiduciary
responsibilities either to your clients or to the public at
large. Tell me a little bit about what you do when a CFO is
engaging in practices that are not black and white, but are
very grey and make you feel ill at ease. And how could the
system be improved to make sure that the grey comes out white
rather than black?
Mr. Herdman. First of all, Congressman, auditors have a
code of ethics that they follow. As part of doing that----
Mr. LaFalce. Accountants do, lawyers do, and doctors do,
and virtually every professional organization does. One of the
difficulties is sometimes that the code is not too clear or
it's not enforced too well.
Mr. Herdman. The code in this case is quite clear,
Congressman. Accountants and auditors owe a duty and care and
professionalism to their client, and also a duty to make sure
that the financial statements that they certify are according
to Generally Accepted Accounting Principles and that their
audits are performed in accordance----
Mr. LaFalce. The CFO is about to do something or is doing
something and the audit committee is either unaware of it or
goes along with it. And you really don't think they should,
although you suppose they could push the envelope that far.
What do you do under those circumstances?
Mr. Herdman. You should keep in mind that recently the
accounting profession, as part of its part to implement the
recommendations of a blue ribbon panel on audit committees from
several years ago, implemented a requirement that auditors meet
and discuss with audit committees and management the audit
partner's assessment of the quality, not just the acceptability
of the accounting principles that companies are following.
Recently in a speech that I gave last week----
Mr. LaFalce. You know, sometimes there's a tendency to say
what you think they want to hear, especially if you want to
keep them as clients. I'm not saying that it's never once done,
but when you're dealing with a firm, and Arthur Andersen I
believe is the smallest of the big five, 85,000 employees, how
many employees worldwide does Ernst & Young have?
Mr. Herdman. One-hundred-and-fifty-thousand.
Mr. LaFalce. I would imagine it's difficult to monitor the
activities of 150,000 people, try as hard and best as you can.
I'm just wondering how we could improve the system. I know Mr.
Pitt wants to improve the system. I'm just wondering if self-
regulation is going to be good enough.
Mr. Herdman. Congressman, that certainly is a topic that
has to be considered at this point. I also would encourage you
to think about the fact that big public accounting firms do
have numerous controls and procedures to ensure that their
people do follow the firm's policies and positions.
Mr. LaFalce. But every now and then, there's a little bit
of a slip that amounts to $90 billion, and an awful lot of
people get hurt. And I'm not sure how many more $90 billion
blips are out there. I do know that your predecessor, Mr. Lynn
Turner, referred to the restatements that existed thus far as
the tip of the iceberg, and I'm wondering whether Enron is the
tip of the iceberg.
Mr. Herdman. I think it's premature to come to that
conclusion.
Mr. LaFalce. I think it might not be.
Mr. Herdman. I think it's very important at this point that
we recognize the seriousness of the Enron matter, but at the
same time we should neither under react to it, nor should we
overreact to it.
Mr. LaFalce. We ought to react to it very aggressively.
Chairman Baker. Thank you, Mr. LaFalce.
Mr. Shays.
Mr. Shays. Thank you, Mr. Chairman.
Enron's collapse is obviously heartbreaking for the
investors and the employees and the retirees who are dependent
on it. I don't invest in these individual stocks if I'm not
going to do due diligence, but it amazes me that the people who
do due diligence--I'm interested in Enron, but I'm also
interested in the implications for other investments in other
companies. I'm particularly interested in the special purpose
entity and I'm new at this and I'm trying to understand it.
I gather that if you have more than 3 percent ownership,
you have to consolidate and I gather that one of the values of
these funds is that it enables you to apply assets.
What I want to understand first is basically the 3 percent
rule was established by the SEC. FASB declared it, but it was
SEC generated. And the issue of the controlling test or the
risks versus rewards your people in the SEC have been over the
last 10 years trying to describe different tests with
qualitative factors as well as quantitative factors. I'm
looking at one speech that was delivered to the 28th Annual
Convention of the current SEC Development by Dominick Ragone, I
guess who works for you, a professional accounting fellow. And
he went through all of these, which seems to me to almost set
up a confusing process for the accounting firms and others.
And one is I want to know why the SEC doesn't just step in
and get this resolved and why it doesn't do it sooner. And I
carry with me the basic view that it used to be ``the large ate
the small,'' but now it's ``the fast eat the slow.'' And it
seems to me you can't have a system that takes so darn long to
resolve.
Mr. Herdman. I think, Congressman, actually the first
statements that were made by the SEC staff with respect to
special purpose entities were directed particularly toward
certain leasing transactions.
Mr. Shays. Towards what?
Mr. Herdman. Towards leasing transactions. Those statements
were made in the late 1980s. The Emerging Issues Task Force of
the FASB put together a working group which I chaired.
Mr. Shays. So what's your point?
Mr. Herdman. We got rules that were pretty quick with
respect to special purpose entities back in 1990. There have
been some ongoing comments by the staff with respect to that,
but on balance, I think that the special purpose entity
accounting is working as well as could be expected right now,
but it does cry out for the FASB to finish their project and
conclude whether a different set of rules should be enacted.
Mr. Shays. I'm a little confused. What confuses me is my
sense is the SEC has been injecting itself in this debate and
looking at a standard different than the 3 percent. Isn't that
accurate?
Mr. Herdman. Congressman, I'll have to look into that. I've
been on board for 2 months. In the time that I've been here we
have not been injecting ourselves particularly in that debate.
Mr. Shays. In his speech he said the staff believes that
the registrant should not apply any specific factor to
determine the sponsor of an SPE and believes that all the facts
and circumstances of each transaction should be considered
carefully. In this regard, the staff believes registrants
should consider the following qualitative and quantitative
factors in evaluating who was the sponsor, who the sponsor is
of an SPE. And then basically it has a number of qualitative
factors and then you have a few quantitative factors.
Bottom line, do you think we're going to be able to
continue to exist with FASB and the SEC not resolving issues
more quickly?
Mr. Herdman. We do need to and it's one of the major points
that was made the other day in Chairman Pitt's op-ed article.
We need to foster an environment where private sector standard
setting moves quickly and decisively to deal with the important
issues.
Mr. Shays. Tell me to someone like myself who isn't an
investor, tell me what the purpose is of a special purpose
entity. I mean, I look at it and I think, why does it exist?
Mr. Herdman. Special purpose entities exist in order to
finance--this is a generalization. There are many types of
special purpose entities that engage in different types of
things. As you may be aware, the banking industry, the credit
card aspect of the banking industry relies extensively on
securitization, thus providing for the bank a source of
liquidity to carry on their ongoing operations.
This is a huge market. It's done with a great deal of
transparency, and there are other types of special purpose
entities that are created perhaps to finance particular
investments. There are special purpose entities that are
created to provide leasing facilities to a company. It's a way
to achieve financing, and oftentimes there are some tax
advantages associated with the use of these types of entities.
Chairman Baker. Would the gentleman yield?
Mr. Shays. Yes.
Chairman Baker. I think there are structural reasons why
SPEs have a legitimate purpose, but I think the analysis should
be, and I don't know that it has been, does the creation of the
SPE create real value for the underlying shareholder of the
principal corporation, or in this case, were the SPEs used for
self-dealing of the official to profit at the expense of the
taxpayer? That's what hasn't been determined.
Mr. Shays. And then the question would be does this happen
in other companies and in other areas? I thank the gentleman.
Thank you, Mr. Chairman.
Chairman Baker. I thank the gentleman for yielding.
Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman, Mr. Herdman. I want
to follow up on what Mr. Shays was talking about. But I also
want to say, a moment ago--and I can't remember who was asking
the question--on the issue of restatements--and I think you're
trying to be sincere of just being there for 2 months and
looking at this, I think the increasing--it may have been the
Chairman's question--I think the increasing volume of
restatements is somewhat alarming. And I hope that the SEC is
taking a harder look at that.
Now I don't know if it's systemic or not, and the more you
look at the Enron case, it really does seem to me this is not--
it's not certainly not--they didn't fail because of a cyclical
reason or a recessionary reason or an economic reason. It
certainly appears to me that they failed because of some severe
structural reasons in their corporate governance.
And I think the Chairman is right about the SPEs, and your
comments are as well. They can be an attractive, an efficient
financing vehicle. But in this case, isn't it a problem or
shouldn't it be a problem for the SEC or the auditors, which
the auditors did apparently find at one point, when on the one
hand you're calling debt an increase in equity and you're
really swapping what you're doing. They were double counting
notes receivable and double counting equity when it was going
the opposite direction. And the restatements were quite severe.
And isn't it also a problem in having a restatement of a
billion dollars plus of equity that's not just going back to
the beginning of the quarter that you were filing the 10-Q for,
but going back not just 4 quarters, but 4 years? And does it
appear--and I know you have to be circumspect on your comments
with respect to Enron because it's under investigation. But it
seems to me to have every appearance of either using the SPEs
as an artifice or self-dealing of some sorts. Even your own
chronology in your statement.
Mr. Herdman. I think, Congressman, you referred to the
double counting of the notes receivable in the stockholders'
equity. What has been disclosed with respect to that indicates
that it does not go back 4 years. About $170 million of it
arose in 2000 and the other $830 million arose in 2001.
Mr. Bentsen. But they reduced their net income going back 4
years as it related to----
Mr. Herdman. Reduction of that income----
Mr. Bentsen. ----as it related to--I think as it related to
both Jedi and Chewco. Right. In those they restated it going
back to 1997----
Mr. Herdman. That's correct.
Mr. Bentsen. ----to the point where they would have,
instead of having net income, they would have had a net loss,
which is somewhat substantial to the investing public.
Let me ask you this. When they went through the transition,
the CFO was out, the CEO was out. The chairman of the board
resumed the role of CEO. In a conference call with analysts,
the issue sort of came up, if I understand the chronology
correct, that $1.2 billion of equity basically had washed away,
no longer existed.
The chairman and now CEO states in response to a question
from analysts, ``Well, that's over my head. I'm not sure I know
the details of that and the special purpose entities.'' Isn't
it a problem when you have the chairman of the board of a
Fortune 500 company, publicly-traded company, and not a penny
stock company. It is today. But it certainly wasn't a penny
stock company then--who doesn't understand the financing
mechanisms of the company as it's operating?
Is there a question here of corporate governance and is the
SEC looking at that issue? Was the audit committee functioning
properly? Are we through the 1933 and 1934 Acts or through the
tools you have, are we sure that the boards of public companies
are operating efficiently for the benefit of shareholders and
the investing public and the pensioners, for that matter?
Mr. Herdman. Congressman, your question carefully weaved in
and out of Enron, and to the extent that it pertains to Enron,
as you understand, I can't address that.
Mr. Bentsen. Well, address it as a hypothetical.
Mr. Herdman. As to a generality, of course chairmen of
boards and audit committees should understand the important
elements, the material elements of financing for the entities
with which they're associated.
Mr. Bentsen. Is the SEC doing enough? I mean, obviously,
you can't sit and review every company's board minutes and all
of that. But, I mean, do you think that the SEC is providing
enough oversight in that area? I mean, if everything that has
been said turns out--or if half of everything that's been said
turns out to be true, the collapse of Enron is going to be one
hell of a story and what happened and a huge miss on the part
of the board and potentially its auditors.
I mean, I can see where certain things can be missed and
certain, you know, the contract with the copying machine
company maybe wasn't the best deal you could get----
Chairman Baker. Could you begin to wrap up, Mr. Bentsen?
Mr. Bentsen. But this is a pretty big deal.
Mr. Herdman. The processes that the SEC uses to review
filings have been basically based on a selective review process
now for 20 years. And we don't talk about the particulars of
that process in public, because we don't want companies to
know, frankly, when they'll be subject to review and when they
won't be subject to review.
I can assure you, Congressman, that continuous improvement
has been the hallmark of working with that review process. And
I can certainly assure that going forward, we will continue to
do that. We will learn the lessons that are out there to be
learned from what we might discern from the Enron matter, and
we'll apply those to improving our processes.
Mr. Bentsen. Thank you. Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Bentsen.
Mr. Toomey.
Mr. Toomey. Thank you, Mr. Chairman.
A question on the SPEs if I could. First of all, maybe you
could correct me if I have this wrong. But my understanding is
that if you own 2.9 percent of the equity, you as some
corporate entity own 2.9 percent of the equity of an SPE and
you meet the other criteria regarding the control of the SPE,
then your balance sheet is essentially silent on that fact. It
doesn't reflect it in any way. Is that incorrect?
Mr. Herdman. No. Congressman, the 3 percent doesn't have to
do with what the company that enters into a transaction with
the SPE owns. It has to do with the fact that many SPEs could
be formed and providers of capital would be quite comfortable
to provide 100 percent of the financing of an SPE in the form
of debt securities. Let's say that that SPE was formed to carry
out a sophisticated leasing program for a major program. This
SPE could be formed. It's a legal entity. It could borrow 100
percent of the money from banks or private.
What these rules say that in order for there to be enough
substance to the SPE, in order for it to be viewed as an entity
independent from the sponsor, somebody has to put in some
common equity to it.
Mr. Toomey. Right.
Mr. Herdman. And that common equity has to be at least
equal to 3 percent of the total capitalization of the SPE.
Mr. Toomey. OK. That's an important clarification. Thank
you. If the corporate entity that wants to create the SPE
provides a certain amount of that 3 percent equity and other
entities provide the rest, then is there a requirement that the
be represented on the balance sheet at all?
Mr. Herdman. Yes. That would have to be on the balance
sheet.
Mr. Toomey. That would have to be?
Mr. Herdman. If the 3 percent isn't owned by independent
entities, and the other conditions are met, of course, then the
SPE would have to be consolidated on the balance sheet.
Mr. Toomey. It would have to be consolidated when the sort
of sponsoring corporation has less than 3 percent?
Mr. Herdman. No. It has to be consolidated if the SPE
doesn't have at least 3 percent of its total capital owned by
outsiders.
Mr. Toomey. I understand.
Mr. Herdman. Independent third parties who have common
equity-type capital.
Mr. Toomey. Right. I understand that. I guess what I'm
getting at is there is a set of criteria, there are rules that
allow for someone to create an SPE. They follow all the rules
and they are allowed to change not to consolidate that SPE or
in fact they're required not to consolidate it, right? And my
question is, if the contribution, if you've made some kind of
contribution, say you've contributed your own equity to part of
the capitalization, but not so much that you would consolidate,
but if you do it in a fashion that has the additional proviso
that you'll top up that contribution in the event that the
value of your stock declines, then that creates a contingent
liability on the part of the sponsoring company, correct? Would
you consider that?
Mr. Herdman. In the rare event when a sponsoring company
would be part of the capital structure of an SPE, that's
potentially--you could view it as a contingency. I don't think
that it would consider it to be a contingent liability.
Mr. Toomey. Do you think it should be?
Mr. Herdman. It would have to be recognized on the
financials.
Mr. Toomey. Right. Well, it seems to me it certainly is a
contingent liability. It's equivalent to having sold a put
option on your own stock, and therefore it would be required to
be reported. Is that correct?
Mr. Herdman. They're really very complicated rules on the
accounting for put options and call options on your own stock.
And I'd be glad to get back to you on these issues if you'd
like to explore this further.
Mr. Toomey. Yes, I think I would, because it seems to me--
--
Mr. Herdman. There's a lot of detail here.
Mr. Toomey. And it seems to me that this was part of what
was going on with at least one of the SPEs that Enron had
created. And I'm just wondering whether that had contributed to
a larger exposure than perhaps was evident.
Mr. Herdman. I can't comment on the Enron aspect of it.
Mr. Toomey. I'll yield the balance of my time to my
colleague, Mr. Ose.
Mr. Ose. Thank the gentleman from Pennsylvania. Mr.
Chairman, I do want--it's ironic. I was reading through the
Wall Street Journal as I listened to some of the comments about
the insider trading spotlight, and in fact today, Wednesday,
December 12th, there's the most recent report on insider
trading listing the top eight or ten individuals, both on the
buy and the sell side and the top six or eight companies, both
on the buy and sell side. And there's a little footnote down
here. It's a Wall Street Journal link. ``See a list of
companies with the highest number of insiders filing Form 144
with the SEC disclosing their intention to sell restricted
stock.''
So it would seem to me that the information is being
collected at the present. It's in the public domain. There may
be some people who perhaps aren't aware of that fact. But as it
relates to any directorships or managerial positions
liquidating stock, it's a matter of public record by rule, if I
understand, that has to be disclosed.
Mr. Herdman. That's correct, Congressman.
Mr. Ose. Now there's also a secondary cut, if you will, and
that is that--correct me if I'm wrong, Mr. Herdman--that
members of the board of directors or members of a management
team only have specific windows during which they can sell
stock that they receive. Is that correct?
Mr. Herdman. I understand that to be true. But I couldn't
give you the particulars on that, because that is a matter of
law.
Mr. Ose. The reason I asked that is somebody put together a
very red document here that highlights the sales seemingly on
a--for some purpose, but I wonder whether the windows
correspond with the dates showing the large amounts of sales. I
think that's worthy of being checked out.
Chairman Baker. I can help you, Mr. Ose, because if you
look down at the left-hand corner it says ``Source: Insider and
Form 144 filings.'' That's all the corporate records. And what
happened is there were two different types of actors here, a
Mr. Lay who sold--I don't have the correct pronunciation--who
sold in large blocks. Mr. Lay, however, sold in $10- to
$100,000 blocks virtually every week, some every day. So if
there were windows that were closing, they took a long time to
close in the case of this particular matter.
Mr. Ose. But there are windows during which they----
Chairman Baker. Apparently so. There were a goodly number
of them in this case.
Mr. Ose. Are there different types of stock? This is where
I get beyond my level of knowledge. And that is, with respect
to senior management, do they hold restricted stock and
unrestricted stock? Is that what you're saying?
Chairman Baker. They were exercising stock options.
Normally they would be in an acquisition on the morning of the
day and the disposition of that same stock that afternoon, and
there were various classes of stock being exercised, I'm
assuming in accordance with their contractual relationship with
Enron, whatever their employment agreement guaranteed them,
they were entitled to receive and therefore make disposition
of.
Mr. Ose. And they were eligible to do that because they met
certain minimum financial requirements on a personal basis?
Chairman Baker. I'm certain that was----
Mr. Ose. Which are not necessarily available to someone
working lower down in the company?
Chairman Baker. It was clearly a benefit of their
contractual relationship as an employee of Enron, as an
officer.
Mr. Ose. OK. I understand I'm on Mr. Toomey's time. I want
to come back to that question. Because the issue of why certain
people are eligible to hedge their exposures and others aren't
has been the substance of significant debate in these
subcommittees and over in the Agriculture Committee on which I
sit, relative to the minimum financial standards a participant
must meet.
And coincidentally and quite interestingly, there's been a
lot of argument that people who are going to participate in
hedging of exposures must meet certain minimum financial
requirements. And in fact, that has been a demand from one side
of the aisle in particular. And I think that merits
investigation, because it's at the heart of people
participating in the 401Ks getting stuck, if you will, when
stock collapses. And I'm hopeful you'll come back to me,
because I know I'm on Mr. Toomey's time. So thank you, Mr.
Chairman.
Chairman Baker. And Mr. Toomey's exhausted time. Thank you,
Mr. Ose.
Mr. Sandlin.
Mr. Sandlin. Thank you, Mr. Chairman. Just briefly. And
thank you, Mr. Herdman, for being here today. The goal of
meaningful disclosure is to provide the investors and the
market with an accurate and complete picture of the financial
condition of the company. Is that correct?
Mr. Herdman. That's correct.
Mr. Sandlin. And the public is protected at least in part
by an independent audit and by SEC oversight. Is that correct?
Mr. Herdman. That's correct.
Mr. Sandlin. It's already been brought out today the issue
about the partnerships with SPEs. But it's not been brought
out--it's my understanding in this particular case, the
partnerships were run by the officers of the company. Is that
correct? Of Enron.
Mr. Herdman. That's what's been reported, yes.
Mr. Sandlin. And it's my understanding that these
partnerships also were unnamed partnerships. Is that correct?
Mr. Herdman. What kind of partnerships?
Mr. Sandlin. Unnamed. That they were not identified by
name.
Mr. Herdman. I believe that's correct from the disclosure
I've seen, yes.
Mr. Sandlin. Would this not cause--that's not in accordance
with normal business practice or generally accepted accounting
principles, is it?
Mr. Herdman. Congressman, I don't believe that there's a
generally accepted accounting principle requirement with
respect to related party transactions that specifically calls
to name the names of the partnerships.
Mr. Sandlin. So, you think it's fine, then, just to list
partnerships, but not by name and not to indicate that the
partnership is run by an officer of the company?
Mr. Herdman. No, that's not what I said.
Mr. Sandlin. That's what I'm asking.
Mr. Herdman. If that is the related party, is the officer,
and generally accepted accounting principles does require
disclosure of certain things with respect to----
Mr. Sandlin. That's what I thought. Disclosure of----
Mr. Herdman. ----the transactions.
Mr. Sandlin. Now these partnerships were treated in this
particular case as a separate entity, correct, from Enron?
Mr. Herdman. We're now starting to get far too specific.
Mr. Sandlin. OK. In the event that a SPE is set up or a
partnership is set up in this sort of situation, then that
partnership is considered as a separate entity from the
original company. Is that correct?
Mr. Herdman. An SPE or a partnership that meetings the
applicable accounting rules to be considered is separate.
Mr. Sandlin. And that allows debt to be moved away from the
original company. Is that correct?
Mr. Herdman. What that does, Congressman, is it says that
the debt that's incurred by the SPE doesn't have to be
consolidated in the financial statements of the company that
does business with the SPE.
Mr. Sandlin. But in the event that the company or SPEs are
set up properly or do not meet accounting principles, then
you're allowing the liabilities and equities of the company and
ultimately the stockholder be distorted. Is that correct?
Mr. Herdman. Could you repeat that question?
Mr. Sandlin. My point is, you're allowing debt of an
original company to be spun off into an SPE that's run by an
officer of the original company in order to move debt away from
the original company so that the stockholder equity appears
much higher than it is. Is that correct?
Mr. Herdman. My experience, Congressman, with respect to
SPEs is that they normally do their own borrowing.
Mr. Sandlin. Should auditors be involved in auditing
partnerships or SPEs that they have a part in setting up?
Mr. Herdman. I don't know what auditors would be doing in
terms of setting up partnerships. They're not lawyers.
Mr. Sandlin. If an auditor that's a part of an accounting
firm or a law firm is a member of that same firm and helps set
up an SPE or a partnership, should that same firm then
regardless of your artificial restrictions within the firm,
should that same firm be involved in auditing that setup?
Mr. Herdman. I don't think there would be any prohibition
against doing that.
Mr. Sandlin. You don't see a problem in the fact that an
accounting firm or a law firm would set up a partnership and
then turn around and audit its own work? You think that's fine?
Mr. Herdman. Accounting firms don't practice law, so they
don't set up partnerships.
Mr. Sandlin. I'm very aware of that. Well, let me ask you
this. Should it raise a red flag for an auditor, if a firm is
setting up a special purpose entity transactions in the firm's
own stock? Is that a red flag?
Mr. Herdman. If the transactions are material to the
company's financial statements and if the auditor is aware of
them, I would expect that that would be something that the
auditors would pursue diligently.
Mr. Sandlin. Now the press reported that the enforcement
division of the SEC sent a letter in October to Enron about
having questions about their disclosure. Could you tell us what
disclosures raised the red flags for you?
Mr. Herdman. The disclosures that prompted the letter were
those that were made in an October 16th press release in which
Enron released the results of its operations for its third
quarter of 2001.
Mr. Sandlin. What factors does the SEC consider to
determine what filings it's going to review?
Mr. Herdman. Congressman, as I said earlier, the selective
review process that's used by the staff of the Commission to
determine filings for review is not a topic that we discuss
publicly, because it would take what element of surprise is in
it out of it, and companies might know better when they might
expect to be reviewed.
Mr. Sandlin. I'm being tapped, and I think that means I'm
done. Thank you for your response.
Chairman Baker. Thank you, Mr. Sandlin.
Just make a brief announcement for the subcommittees. I
have to step out for a moment. Mr. Bachus will assume the
chair. We'll proceed with questions of Mr. Herdman until--I
understand there's a likely vote on the floor about 1:30. It's
my hope that all Members could get their questions in before
that vote.
And I'm making this announcement for our second panelists.
Pending that vote, we would take a few minutes for a lunch
break and probably try to come back around 2:15 if the vote
occurs around 1:30, which is a guess at this point. But to let
our panelists know they will have a few minutes from whenever
that vote occurs, and Members, a little time to grab a sandwich
and come back. Let's just make it 45 minutes from whenever the
bells first sound so we can get a vote in, get some lunch, and
then come back for the second panel.
Mr. Bachus. [Presiding.]
Mr. Royce.
Mr. Royce. Thank you, Mr. Chairman.
Mr. Herdman, are you troubled by Enron's use of
partnerships to keep significant liabilities off of the balance
sheet?
Mr. Herdman. Congressman, I can't comment about any of the
particulars of the Enron matter because of the pendency of our
investigation.
Mr. Royce. OK. Well, let me ask you then in a broader scope
here. Do you see ways in which the SEC can encourage or maybe
compel companies to provide financial information that's useful
to investors on more of a real time basis? Let's say for large
corporations monthly rather than quarterly financial
statements. Would that be helpful in your view?
Mr. Herdman. I don't necessarily think that a requirement
for monthly financial statements would be helpful. But the
things that we're going to be considering with respect to
improving the totality of financial reporting could very well
lead to disclosures of financial and other types of performance
indicator information on a more frequent basis than quarterly.
Mr. Royce. Well, we've had accounting problems now that are
almost systemic. Waste Management. We've had Sunbeam. We've now
had Enron. It would seem to me that there would be need to move
quickly on developing such changes.
Let me ask you a question about the ongoing investigation.
Let us say that fraud is discovered in this investigation with
respect to Enron in terms of insider trading. What is the
likelihood that the profits made through fraud through insider
trading would then be compelled to be paid back to Enron so
that the assets held by the employees of Enron and shareholders
of Enron who did not have access to this insider information
could then be at least partially benefited?
Mr. Herdman. That's beyond my personal expertise,
Congressman. I just don't know all of the particulars about the
specific remedies the SEC has available, including the
potential for disgorgement.
Mr. Royce. Well, let me just close by saying it seems to me
that investors need current information that is, in fact, true
on a real time basis, and we have not developed to date
apparently an effective system to make sure that it's delivered
on a timely basis to them, and I would suggest that the SEC
look at changing its procedures in a way that effectively does
that, because the Congress is certainly going to look at
finding ways to prod just such changes.
Mr. Herdman. Congressman, Chairman Pitt, since the time
he's assumed office, has been talking about modernization of
the financial reporting system, including more current
information. Congressman, if you'd like, I could ask our
general counsel, David Becker, to respond to your question
about remedies and recoveries.
Mr. Royce. Certainly I'd be happy to hear from the general
counsel. Thank you, Mr. Herdman.
Mr. Becker. Congressman, on remedies, we do have a variety
of remedies in cases in which we can go to court and get
disgorgement of ill-gotten gains. If the folks who misbehave
still have the proceeds of the fraud, we'll get them and
we'll----
Mr. Bachus. If you could lean a little closer to the
microphone.
Mr. Becker. Sure. If the folks who violated our anti-fraud
rules still have the proceeds of the fraud, we'll get them, and
we'll make them give it up.
Mr. Royce. Well, I would suggest that besides changing the
ground rules so that we can get this information to investors
on a more timely basis, that the other part of the equation is
to aggressively pursue just such actions so that there will be
a deterrent effect in the future. And I thank the gentleman for
his answer.
Mr. Herdman. I agree with you very much, Congressman.
Mr. Bachus. I thank the gentleman.
The lady from Ohio.
Mrs. Jones. Thank you, Mr. Chairman. Lots of questions, not
enough time. You stated earlier that we should not overreact to
a situation such as Enron. What would be an overreaction, sir?
Mr. Herdman. An overreaction might be to say that financial
reporting is not trustworthy in this country. I think that
would be an overreaction.
Mrs. Jones. What should we say, then, if based on Enron,
financial reporting in this country is?
Mr. Herdman. I think we should say that financial reporting
in this country is challenged and appropriate steps need to be
taken to learn what needs to be done to improve it, and that
should be done quickly.
Mrs. Jones. OK. The filings that we're talking about on the
chart over there on insider trading, these insider and Form 144
filings. How often are they filed, sir?
Mr. Herdman. I'm not an expert. I believe that they're
filed on a transaction basis. In other words, if an insider
sells----
Mrs. Jones. Can your general counsel answer that question
for me?
Mr. Becker. I hope so. On the Section 144(a) transactions,
they have to be filed fundamentally contemporaneously on
general sales of stock they have to be filed, I believe,
monthly or within 10 days.
Mrs. Jones. Say that again, please. I didn't hear you.
Mr. Becker. Fundamentally, they all have to be filed within
30 days.
Mrs. Jones. Is there a level of insider trading that would
cause the SEC to say hello?
Mr. Becker. Well, the short answer is depending on what
else is going on, yes. If there's an extraordinary transaction
and folks have traded and we want to know why.
Mrs. Jones. OK. I'm Company Outwalk, so you don't have to
talk about Enron. And in January I had $180 billion million
worth of insider trading. Would that make you go ``Wooo''?
Mr. Becker. I suspect that that's something that we would
look at. I will tell you, though, that the fundamental
philosophy of the Federal securities laws is get the
information out and have investors evaluate the wisdom of their
investment decisions. We do look at a variety of sources,
including visual patterns of trading, to see if there is any
fraudulent conduct going on.
Mrs. Jones. But, the goal and purpose, Mr. Herdman, the
Chief Accountant, U.S. Securities and Exchange Commission, is
you have an oversight obligation over all these different
accounting firms and auditing firms and the OAB, which was the
office of--the POB, excuse me, the Public Oversight Board, to
sit with them and give advice and counsel on the standards of
what becomes appropriate accounting procedures. Wouldn't
something like that be part and parcel of something that you
would say to the world? Well?
Mr. Becker. This information--our fundamental mission is to
see to it that information relevant to investors is out in the
public and that financial statements and disclosures are fully
transparent to the public. And this type of information is
information----
Mrs. Jones. You know what? You could sit down if you'd
like.
Mr. Becker. Oh, thank you. Mr. Herdman's got his briefcase
here, so I wouldn't. So, in fact, this type of information is
information that's pushed out to the public quickly. One of the
paradoxes--not talking about Enron in particular--one of the
paradoxes, and this is where the role of analyst comes in, is
that often that there is information out in the public, but
people don't necessarily focus on it and take it as seriously
as in hindsight they should.
Mrs. Jones. Let me ask this, then. We've got a company--I
called myself Outwalk. And Outwalk, my company, not only is
showing $180 million worth of insider trading, but is--let me
back up. Is there an obligation to also show how many
subsidiaries or partners that you have as they become
partnerships under your or become what do you all call them?
The SPEs or something?
Mr. Becker. I think this is one for Mr. Herdman.
Mrs. Jones. OK. I'll take him.
Mr. Becker. But, the basic answer is, sometimes yes,
sometimes no.
Mr. Herdman. SPEs sometimes are accounted for as
subsidiaries, in which case there would be information about
them, and sometimes if they meet the appropriate standards,
they're not accounted for as subsidiaries, in which case there
wouldn't be information about them.
Mrs. Jones. Based on what we know about my company--
Outwalk--and perhaps it would not be an overreaction for us to
look how do we let the public know that there are a number of
FPEs or SBEs operating within a company that could, in fact,
camouflage the economic condition of a company such that poor
little me, who doesn't know anything about this area that I'm
investing in, might think twice before I would invest my money
in Outwalk Company?
Mr. Bachus. The lady's time has expired.
Mrs. Jones. Thank you, Mr. Chairman. Can I get a quick yes
or no on that question? Can I get quick yes or no on that
question?
Mr. Herdman. I'm sure that's something that the FASB, when
they finalize their rules on SBEs, will take into
consideration.
Mr. Bachus. Thank you.
Mr. Herdman, there's been some disturbing allegations with
respect to the failure of the board of Enron to monitor the
activities of management, in particular related to the special
purpose entities, the SPEs, as you've referred to them, and the
related party transactions. What would you recommend to
increase board oversight for these kinds of transactions and
entities?
Mr. Herdman. Congressman, there have been significant
developments in the various structures about audit committees,
about boards in recent years, particularly about audit
committees. And the Commission really has no plans to do
anything further with respect to rulemaking in that regard. And
once again, this is an area where I believe that if we learn
something as a result of our investigation that should be
applied more broadly, we'll move ahead aggressively with that.
But at this point, there have been significant changes in
what audit committees do, in the amount of their interaction
with auditors, and so forth. And those are all fairly recent
within the last year or two. And right now there's no
indication that that's an area that needs something to be done
with it.
Mr. Bachus. OK. How should a board react when they think
that generally accepted accounting principles or GAAP-compliant
disclosures are inadequate?
Mr. Herdman. Well, under the conditions today to be a
member of an audit committee--and these are encompassed in
rules--as I say, they were not that long ago enacted by both
the New York Stock Exchange and Nasdaq, is that members of
audit committees have to be quote/unquote: ``financially
literate'' and each understand enough about accounting and
about financial reporting and financial statements to be able
to critically engage management and the auditors in discussions
about the accounting principles that are used, the disclosures
that are made, and so forth.
That being the case, when these discussions occur, if there
are instances where the financial statements or where
management doesn't intend to follow generally accepted
accounting principles for some reason or it doesn't want to
make a disclosure that is required by generally accepted
accounting principles, the discussion has to be with the
members of the audit committee if discussions just between
management and the auditors haven't yet resolved the problem.
That's not to say that if the right accounting doesn't get used
and the right disclosures don't get made that the accountants
would give a clean opinion in dialogues that occur, these
sometimes are iterative, and the audit committees do have an
important role in those types of matters.
Mr. Bachus. Thank you.
Yesterday, Chairman Pitt called for a self-regulatory
organization for CPAs. Does the commission intend to issue a
rule proposal for public comment on this? Or do you know what
the timeline is?
Mr. Herdman. Actually, Congressman, the article today that
indicated that Chairman Pitt called for a self-regulatory
organization, I think, misspoke. And where the Chairman and
where the Commission are at this point is we've begun a
dialogue with the accounting profession, with the major firms
in the AICPA. They've indicated that they're going to take a
look at what changes are needed to the self-regulatory process.
We're eager to continue to work with them on that, and we're
not predisposed at this point to either a continuation of the
current system of self-regulation or to a statutory self-
regulatory organization.
Mr. Bachus. OK.
Mr. Herdman. If that were to go in the direction of an SRO,
I believe that in order to be enacted it would have to be a
matter that was put out for notice and public comment.
Mr. Bachus. Now are you also considering something like an
enhanced FASB or an enhanced AICPA or something like that? Or
are you talking about just an entirely new body?
Mr. Herdman. What we're talking about is the self-
regulatory structure that currently is housed within the AICPA
in its Division for Firms and is overseen by the Public
Oversight Board, which is comprised of individuals of high
integrity that are not practitioners of accounting and what
have you. That's the structure that exists today. It does
certain activities. They're outlined in my testimony. And the
questions have to do with are those activities sufficient? Does
more need to be done? Does discipline need to be more
transparent, and so forth. Those kinds of issues.
Mr. Bachus. OK. Thank you.
Mr. Mascara.
Mr. Mascara. Thank you, Mr. Chairman.
Mr. Herdman, when did the SEC suspect there was a problem
at Enron? And what action did the SEC take? And how soon
afterwards? I heard you mention in an earlier question the
third quarter, October of 2001, was it?
Mr. Herdman. The first letter Congressman, was a letter
that was sent to Enron on October 17th of 2001.
Mr. Mascara. And what action did you take?
Mr. Herdman. We sent them a letter requesting that they
provide more information about the losses that had been
reported in their earnings press release the prior day.
Mr. Mascara. What role does the SEC play in SPE filings? I
would imagine there is some kind of a filing someplace that
someone's required to file. Did you say earlier that these
liabilities do not appear if they have 3 percent invested in
the total offering? On a consolidated statement, do these
numbers appear there?
Mr. Herdman. What I said earlier was they do not appear on
the consolidated financial statements if the owner of the
special purpose entity has invested in equity capital of that
entity in an amount that's equal to 3 percent or more of its
total capitalization, and its total capitalization would
include the amounts that the entity borrowed from various
sources.
Mr. Mascara. It's my understanding that Enron had a
plethora of SPE filings. So if they invested a minimum of 3
percent, they would not be required to place that liability on
their balance sheet? I think that's outrageous if the answer is
yes.
Mr. Herdman. It's not, as I said earlier, Congressman, this
is complicated, but it's not how much Enron has invested in the
SPE or another sponsor of it. Let's not talk about Enron. When
a sponsor of an SPE invests it's--because they can't invest
anything. It's how much is invested in by independent third
party investors.
Mr. Mascara. So if any independent investor invests at
least 3 percent, Enron or any other company would not be
required to list the liability on their balance sheet on a
consolidated balance sheet?
Mr. Herdman. That's correct, Congressman. The sponsor
before the 3 percent requirement was put in place was quite
willing to lend 100 percent of the capitalization of SPEs in
order to effect these transactions.
Mr. Mascara. How is your staffing at SEC? Is it sufficient
to oversee the financial world of risk that's many times out
there? Do you have enough employees to oversee those
activities?
Mr. Herdman. I'm certain we have enough employees in the
Office of the Chief Accountant. With respect to the other
divisions, we're constantly looking to see where and how we can
use our resources better and to redeploy resources to
particular issues that--you know, radiate attention at a
particular point in time.
Mr. Mascara. I have an accounting license. I'm asking you
this question because I can't answer it. Does any of this have
to do with what went on recently in the dot.coms where people
were looking at anticipated revenues rather than anticipated
earnings? Is there any similarity between the----
Mr. Herdman. Based on what, Congressman, I don't see any
similarity at all to the dot.coms. The dot.coms were
speculative entities that generally didn't have much history in
their business. They frequently have enough cash to carry out
their money-losing activities as a result of the public
investing the cash. Notwithstanding the fact that there was
clear and transparent disclosure that these companies were
vulnerable, that they didn't have any, and so forth. That was
all out there on the table, and yet a lot people bought those
stocks and I guess today wished that they hadn't.
Mr. Mascara. Thank you, Mr. Herdman. I think we've just
touched the tip of the iceberg. I'm afraid what's coming. But I
thank you and I thank you, Mr. Chairman.
Mr. Bachus. Thank you, Mr. Mascara.
We intend to recognize Mr. Inslee and then Ms. Jackson-Lee.
There's probably about 7 minutes left on the floor, so for such
time as we have, I'm going to recognize Mr. Inslee first and
then Ms. Jackson-Lee.
Mr. Inslee. Thank you, Mr. Chair. I represent a district up
in the State of Washington. I can tell you that my constituents
have a lot of real hard questions here. And the reason is is
that they think of Enron as sort of a financial octopus with
tentacles not only just into the investor community, but that
touches Americans in a lot of different kinds of ways.
And one of those kinds of ways is in the energy field, the
energy prices and the like. And I heard one of my colleagues
say something I guess I'll take a little issue with to say that
somehow Congress should not get to the bottom of the question
of how this company hijacked America's energy policy. Because
it appears from the press reports that I'm reading that there's
good reason to believe that Enron's fingerprints are all over
the American energy policy that exposed my constituents in the
State of Washington to millions of dollars of overcharges last
year in the electrical market and have led us into the
situation where the country has huge failures in our energy
policy.
And there are questions that I think--and I hope you and
others help us answer--like, is the reason that we're giving
Enron $254 million in tax relief instead of investing in clean
energy is the answer Enron? We'd like an answer to that
question. Is the reason that the Administration is doing
nothing about global climate change, is the answer Enron? Is
the reason the Federal Government is not taking action to
improve automobile mileage standards, is the answer Enron?
Because there's a lot of evidence that at least we've been
hearing about, about the ability of Enron to affect our
Government's policy, and we're very concerned about that.
And there's a relationship between this financial world and
the energy world. I was just reading, I think it's in the Los
Angeles Times, it's talking about Mr. Lay's role in the
replacement of one of the FERC commissioners. And it says, as
the New York Times reported, ``Ebert [phonetic] had barely
settled into his new job this year when an unsettling telephone
conversation with Kenneth Lay prodded him to back a faster pace
in opening up access to electricity transmission grid to
companies like Enron.'' Lay admits making the call, but in an
unctuous defense of his influence peddling said: ``the final
decision on Abrams [phonetic] job was going to be the
President's, certainly not ours.'' Soon after, Ebert [phonetic]
was replaced by Texan Pat Wood, who was favored by Lay.
I think that there are a lot of questions here that are
going to be related to the abuse of stockholders to also the
abuse of energy payers, consumers, and those who care about our
whole energy world. And we encourage you and others to engage
in trying to answer those questions that Americans have.
And I want to ask you one specific question about abuse of
stockholders and employees. And I know you can't comment on the
investigation, so I'll ask you in a hypothetical form. If a
company on October 17th, the very same day the SEC announced it
was investigating that company, chose to change plan
administrators of their 401K, which thereby automatically
locked in their employees so they couldn't sell their product.
And then the insiders, including some of the executives that
were partially, in my view, responsible for the pathetic energy
policy we have in this country, to go on this binge of selling
their stocks to jump ship and leave their employees in a
sinking ship, is that, number one, legal? And number two, is
there disclosure required for that activity?
Mr. Herdman. Congressman, I think what happened to the
employees with that 401K plan is just one of the most terrible
things I can imagine. However, nothing about 401K plans comes
under the jurisdiction of the Securities and Exchange
Commission. Those are matters that have to do with the
Department of Labor. And as to whether there would be a need
for disclosure in SEC documents, I don't believe that there
would be.
Mr. Inslee. Well, should we consider requiring disclosure
that if executives are going to treat their employees, of
essentially getting into the lifeboat and leaving them on a
sinking ship, should we consider requiring disclosure on that
in some regard?
Mr. Herdman. I don't know whether there was disclosure made
to the employees in advance about the fact that the change in
administrator was going to prevent them from changing their
investment elections for a period of time. I just don't know.
Mr. Inslee. Let me ask a little broader question.
Mr. Bachus. I thank the gentlemen for his questions.
Mr. Inslee. Thank you, Mr. Chairman.
Mr. Bachus. Thank you.
Ms. Jackson-Lee. And at the end of her questioning, we're
going to recess for 45 minutes.
Ms. Jackson-Lee. Thank you very much, Mr. Chairman. I'm a
guest in this hearing and I want to thank the Chairman. I want
to thank the Chairman of the Full Committee, Mr. Oxley, the
Ranking Member, the Chairman and Ranking Members of the
subcommittees as well.
I am here because Enron is in the 8th Congressional
District of Texas, my District in Houston. The eyes of the
Nation, Mr. Herdman, are on these particular hearings, and more
specifically the eyes of Houston are on this particular hearing
because, of course, Enron was a very good civic and corporate
anguish in Houston, Texas now and I believe as it moves across
the Nation, in the Nation. As the SEC's responsibilities, if,
for example, in 2000 December a stock price of $84 and then
around October of 2001 it had a stock price of $33, why did the
SEC do more to that particular company--and particularly if
there was a loss of about $600 million?
Mr. Herdman. As I understand it, the loss that you may be
referring to wasn't reported until November when Enron
announced that it planned to restate its financial statements
back to 1997. Once again, as Mr. Becker pointed out earlier,
the purpose of the securities laws is to require disclosure, to
provide disclosure to investors so that they can make informed
decisions about whether to invest, when to invest, when to
sell, and so forth. And the fact that a stock price changes--
we'll look into this, but I'm not persuaded that that would be
an effective means for the SEC to screen filings and determine
whether a particular company's filings should be looked at as
contrasted to some other procedures that are applied in our
selective review process. But we'll certainly look into that.
Ms. Jackson-Lee. I appreciate your assessment on that. I
would think with the overwhelming--you just answered my
question. Wouldn't you think it's now time to reassess or to
look into what might be additional resources, regulations and
laws that might assist in that review on behalf of the SEC?
Mr. Herdman. We'll be taking a look at ways to improve our
processes as well.
Ms. Jackson-Lee. Let me close on this question because my
other duty is to cast my vote on the floor of the House, and I
will return for the second panel. I thank the Chair. With
respect to the law, the difficulty that they provide in
camouflaging the acts of a particular company. How do we
address that and treat that? I'm not using the correct
terminology, but truth in information. That is not truthful.
Mr. Herdman. Ma'am, I don't think you can conclude that
it's always not truthful. This is why we have the Financial
Accounting Standards Board to develop the appropriate criteria
as to when those assets and liabilities should be part of the
consolidated financial statements and when they should not be
part of their consolidated financial statements, and we will
urge them on to the swift completion of that task.
Ms. Jackson-Lee. Let me leave you just with this. Maybe we
will heighten the standards on the utilization or the
proctoring of those kinds of companies. It may not be a
question of truth in information, but maybe there needs to be a
higher bar.
Mr. Herdman. Perhaps.
Ms. Jackson-Lee. Thank you very much.
Chairman Baker. Thank you, Congresswoman Sheila Jackson-
Lee. We are now going to dismiss this panel. We want to thank
the witness for testifying today, and we also want to give the
Members of the Congress 30 days in which to put together any
additional questions that they might want to ask you. So I'd
like to acknowledge that for the record.
We are going to reconvene with the second panel at 2:15
after this vote is over. So, thank you again for your testimony
here today.
Mr. Herdman. Thank you.
[Recess.]
Chairman Baker. By way of advisory, Members will be
returning momentarily. I thought it would be helpful to proceed
with the receipt of testimony so that by the time we have a
full complement and get to our questions there will be
sufficient Members here to engage our panel.
Our first participant this afternoon is Mr. Joseph
Berardino, Chief Executive Officer, Arthur Andersen.
Before I recognize you for your comments, Mr. Berardino, I
just want to, by way of personal acknowledgment, express my
appreciation to you in the manner in which you have responded
to the subcommittees in this difficult manner.
I wish all officials who had similar participation in the
issues before the subcommittees had exercised your judgment and
expressed your willingness to cooperate with the subcommittees
in seeking a commonly beneficial resolution to this matter. So
I do appreciate your openness and your willingness to be here
today.
Thank you, sir.
STATEMENT OF JOSEPH F. BERARDINO, CHIEF EXECUTIVE OFFICER,
ARTHUR ANDERSEN, LLP
Mr. Berardino. That is very kind of you, Mr. Chairman.
Good afternoon. Thank you for inviting me to appear before
you today. I am here because faith in our firm and the
integrity of the capital market system has been shaken. What
happened at Enron is a tragedy on many levels. We are very
aware of the impact this has had on investors and the pain this
business failure has caused for Enron's employees and others.
Many questions need to be answered, some involve accounting
and auditing. I will do my best today to address these.
I ask you to keep in mind that the auditing and accounting
issues are very complex and are part of a bigger picture. None
of us yet know all the facts. Today's hearing is an important
step in enlightening all of us.
If there is one thing you can take away from my testimony,
I hope it is this: Andersen will not hide from its
responsibilities. That is why I am here today.
The public's confidence is of paramount importance. If my
firm has made errors in judgment, we will acknowledge them. We
will make the changes needed to restore confidence.
In my written testimony, I have addressed two issues that
go to the heart of concerns about our role as Enron's auditor:
did we do our job, did we act with integrity?
To aid the subcommittees in their inquiry, I have provided
detailed answers to these questions in my written statement and
I would like to touch on a few of the key points.
On the accounting issues, Enron has said it will restate
its financial statements back to 1997 as a result of issues
with two special purpose entities or SPEs. These are
sophisticated financing vehicles used by many companies. They
are well known to the investment community.
On the larger of these which was responsible for 80 percent
of the SPE-related restatement, it appears important
information was not revealed to our team. We have notified the
audit committee of possible illegal acts within the company.
On the smaller of the SPEs responsible for 20 percent, we
now believe, based on a second look, that our team has made an
error in judgment. An honest error, but an error nonetheless.
But I do believe we did a professional job overall and that
this error did not cause Enron's collapse.
There have been questions about the sufficiency of Enron's
disclosures. It is true that Enron did not disclose every
transaction or every contingency. It was not required to.
Accounting rules also do not require a company to disclose
losses, such as the sudden rapid decline we witnesses in
Enron's stock price and credit ratings.
Finally, let me spend a minute on fees. We were paid $59
million by Enron, including $25 million for our audit. There is
a perception that the remaining $27 million was for traditional
management consulting work such as installation of computer
systems. In fact, the bulk of that $27 million was for audit-
related work, tax work and work that could only be done by
auditors; $13 million was for consulting work done by Arthur
Andersen.
Some may assert that even $13 million in consulting work is
too much, that it weakens the backbone of the auditor. There is
a fundamental issue here. Whether it is consulting work or
audit work, the reality is that auditors are paid by their
clients.
For a system to work, you and the investing public must
have confidence that the fees we are paid, regardless of the
nature of our work, will not weaken our resolve to do what is
right and in the best interests of investors. I do not believe
the fees we received compromised our independence. Some will
disagree and I have to deal with the reality of that
perception.
I am very aware that our firm must restore the public's
trust. I do not have all the answers today, but I can assure
you we are carefully assessing this issue and will take the
steps necessary to reassure you and the public that our
backbone is firm and our judgment clear.
Andersen will have to change to restore the public's
interest and confidence and we are working hard to identify the
changes we need to make. The accounting profession will also
have to reform itself. Our system of regulation and discipline
has to be improved and others will have to do things
differently as well: companies, boards, audit committees,
analysts, investment bankers, credit analysts among others.
I believe we can work together to give investors a more
meaningful, relevant and timely information. My firm, and I
personally as CEO, will do our part.
Thank you, Mr. Chairman.
[The prepared statement of Joseph F. Berardino can be found
on page 113 in the appendix.]
Chairman Baker. Thank you very much.
Our next participant is Mr. Charles Hill, Director of
Research, Thomas Edison Financial/First Call.
Welcome, Mr. Hill.
Mr. Hill. Thank you.
Chairman Baker. And grab that microphone and yank it around
toward you there. It needs to be pretty close.
STATEMENT OF CHARLES L. HILL, DIRECTOR OF RESEARCH, THOMSON
FINANCIAL/FIRST CALL
Mr. Hill. Chairman Oxley, Chairman Baker, Chairwoman Kelly,
Ranking Members LaFalce, Kanjorski and Guttierez, and Members
of the subcommittees, I welcome the opportunity to again
testify in front of the House Financial Services Committee. I
believe these subcommittees have been addressing substantive
issues that are important not only to the future health of the
investment community, but important to the general public's
perception of and confidence in the overall capitalist system.
The excesses associated with Enron that led to its
bankruptcy are more far-reaching than just their impact on
Enron. There is plenty of blame to go around in the mistakes
made in the Enron situation. I am here today to focus on the
role of the broker analysts in the debacle.
In my previous testimony before these subcommittees, I did
not tread lightly on what I thought were some serious problems
in analyst behavior that needed to be remedied. I am here this
afternoon, however, to say that analysts to some degree were
more victims rather than culprits in the Enron situation. Not
that they were without blame, particularly in the late stages
of the Enron collapse, but they were not the underlying cause
of the excessive rise in Enron's stock that later proved to be
irrational.
The performance of the analysts should be judged on two
fronts. The first is their analysis of Enron's fundamentals,
particularly in regard to earnings. The second is their
valuation assessment and recommendations of Enron stock.
The thing that stands out most visibly about the analysts'
analyses of Enron is over the 3 years up to October 2001, their
estimates at the beginning of each year for that year had
minimal changes. The few changes that did occur were always
upward and usually followed the guidance given by the company
when they reported quarterly earnings.
The narrowness of the spread of estimates among analysts
was remarkable, especially for an energy company. The
coefficient of variance for Enron estimates was consistently
below the average for the S&P 500 during the same period.
This pattern is highly suggestive that the analysts were
being spoon fed as to what Enron expected earnings to be. The
analysts might have been willing to accept company guidance, be
it overt or inferred, as long as the company kept meeting
expectations each quarter. Since at least the beginning of
1998, Enron has met or exceeded analysts' estimates every
quarter.
One reason that analysts may have been more willing than
normal to accept company guidance for Enron was that it was
becoming increasingly difficult to understand how Enron was
achieving its revenue growth and profitability. Extensive use
of derivatives, particularly when the company is using mark-to-
market accounting, is extremely difficult in the best of
situations.
We now know that a big additional reason for the
difficulties in analyzing Enron's financials was that there
were significant parts of Enron's business that were hidden
from the balance sheet.
Often, the way out for analysts when faced with difficult-
to-analyze situations like Enron is to drop coverage. Why take
the risk when there are plenty of companies that are
transparent enough to do meaningful analysis with confidence?
The problem with dropping Enron was that it had become the
giant in the industry. If you were an analyst covering that
industry, you essentially had to cover Enron. That was further
reinforced if your firm was one of Enron's investment bankers
or investment banker wannabees.
The real problem, though, was having sufficient information
about the off balance sheet items. Whether the accounting for
each of these items was within FASB rules or not is not yet
clear, although the announced restatement of prior periods
earnings is a strong signal that at least not all was kosher.
But what is clear is that Enron was not providing what
could even be considered minimum transparency in its financials
and that the analysts did not have all the tools necessary to
make a reasonable analysis.
In evaluating the analysts' performance on recommending
Enron stock, one first has to understand how the brokerage
community's recommendation system really works.
As I have testified before to these subcommittees, the
investor needs a two-level decoder. The first level of the
decoder gets all the brokers on a common recommendation scale.
The most common scale is a five-tiered one, where the top
category is a ``strong buy''; the second is a ``buy''; the
third is ``hold''; fourth, ``sell''; fifth, ``strong sell.''
Most brokers have a five-tiered scale, some have a four-tierd
one, and a few have a three-tierd scale.
In addition, many have very different terminology. The term
``buy'' may be the term used for the top category at some
brokers, or for the second-best category at many brokers, or,
in at least one case, for the middle category. There are more
than a dozen different terms used for each of the top three
categories and almost as many for the bottom two.
Unfortunately, getting all the firms on a common scale is
not the end of the decoding. Analysts are overly biased on the
positive side in their recommendations. The typical
distribution is about 33 percent of all recommendations are in
the top or ``strong buy'' category, about 33 percent in the
second or ``buy'' category, about 33 percent in the middle or
``hold'' category, and only about 1 percent in the remaining
``sell'' and ``strong sell'' categories combined.
If the recommendations are put in numeric terms where 1 is
a ``strong buy''--or whatever the broker's term is for that top
category--2 a ``buy,'' and so forth, using this numerical scale
consensus recommendations can be calculated for each company.
Most of the time, the average consensus recommendation for
either the companies in the S&P 500, or for the roughly 5,000
companies that analysts cover, is a 2.1. Occasionally, the
average may be a 2.0 or 2.2.
Therefore, the second level of the decoder would move the
recommendations into three more meaningful categories--those in
the 1 or ``strong buy'' category would really be saying
``buy,'' at least in relative terms. Those in the 2 or ``buy''
category would really be saying they were neutral on the stock,
and those in the 3 or ``hold,'' the 4 or ``sell,'' and the 5 or
``strong sell'' categories all would be saying sell the stock.
For Enron, the consensus recommendation, as shown on a
graph that is in the handout, was about a 1.5 from May 2000
until the end of September 2001. Even if we had our decoder to
compensate for analyst optimism, it is clear that the analysts
covering Enron were very positive with their recommendations.
But, during that same period, the analysts had similar or
higher consensus recommendations on competitors like Calpine
and Dynegy. While a consensus recommendation for Enron was much
better than the average for S&P 500 companies, their enthusiasm
was not limited to Enron.
In early October 2001, the consensus recommendation spiked
up from a 1.5 to a 1.3 as several analysts raised their
recommendations ahead of Enron's reporting its third quarter
earnings on 16 October.
On the day of the earnings announcement, one analyst raised
their recommendation, pushing the consensus to a remarkable
1.2. But as the Enron story began to unravel over the next few
days, the recommendation downgrades exploded, plus six of the
17 analysts dropped coverage.
In these kinds of situations, it is easy to point a finger
at the analysts for mistakes made. In my prior testimony, and
in other forums, I have taken the analysts to task for not
performing to an acceptable standard in certain situations.
While the analysts are certainly not without blame on Enron,
they are not the real culprits in this situation.
I am not an expert in doing the actual accounting at a
company, or in auditing a company's accounting, but having been
an analyst for 22 years, as well as closely observing analysts'
behavior at First Call for the last 10, I can say without
reservation that this was a situation where either the company
or its auditors or both were at fault in not providing
investors, especially including the analysts, with the tools
necessary to understand Enron's business.
Whether the letter of the accounting rules were met or not,
it is patently obvious that the spirit of the rules were
violated in that Enron's financial statements did not fairly
convey enough information for investors to reasonably analyze
the company's operations.
In that climate, it is hard to be too critical of the
analysts' optimism. Enron had a long history of showing
consistent and substantive earnings growth. If it had been up
to me, if I was in that situation, I would have dropped
coverage long before October 2001. The financial reports and
details of operations had become more and more inscrutable well
before then. But, as I mentioned earlier, most, if not all,
analysts did not have that option. All things considered, they
probably did as well as could be expected until October 2001,
although in hindsight it is easy to say that they could have at
least tempered their bullish recommendations to some degree.
However, once the issues of the off balance sheet items
became an unexplained issue on the 16 October 2001 conference
call on third quarter results, it does seem that the analysts
could have moved quicker to either suspend their recommendation
or dramatically drop the level of their recommendation. The
unexplained $1.2 billion balance sheet writedown was not a
caution flag, it was a red flag.
But Enron is not the situation on which to challenge
analysts' performance. There are far more significant
situations where analysts' conflicts and performance are at
issue.
The lessons to be learned here is how to ensure that
companies and their auditors can be relied on to openly provide
the necessary tools for investors to meaningfully analyze the
company's business.
Thank you.
[The prepared statement of Charles L. Hill can be found on
page 125 in the appendix.]
Chairman Baker. Thank you very much, Mr. Hill.
Our final participant is Mr. Richard Trumka, Secretary-
Treasurer, AFL-CIO.
Welcome, sir.
STATEMENT OF RICHARD L. TRUMKA, SECRETARY-TREASURER, AFL-CIO
Mr. Trumka. Thank you, Mr. Chairman.
Good afternoon, Chairman Baker and Chairwoman Kelly and
Ranking Members of the committee and subcommittees. My name is
Richard Trumka and I am Secretary-Treasurer of the AFL-CIO.
On behalf of the AFL-CIO and our 13 million members, I
would like to commend these subcommittees, and Chairman Baker
in particular, for his leadership in calling this hearing and
his foresight in looking at the issue of analyst independence
last summer.
I am here today first and foremost to make clear who the
victims were in the Enron catastrophe. Let us start with those
hurt worst by the conduct of the board and officers at Enron.
More than 12,000 Enron employees participated in Enron's 401K
plan. On October 17th, the same day that the SEC announced it
was investigating Enron, the company implemented a plan to
switch 401K administrators, knowing that their decision would
freeze employees' accounts and that freezing took three times
longer than is normal in these situations.
Meanwhile, Enron executives continued to sell their stock,
continuing a pattern of inside sales that netted a handful of
executives over a billion dollars.
Now, 5,000 of these same employees have been laid off and
Enron has tried to extract waivers of liability from these laid
off workers in exchange for their severance. Many of the 1,000
members of the International Brotherhood of Electrical Workers
at Enron's subsidiary, Portland Gas and Electric, suffered
catastrophic losses. Members like Roy Rinard, who watched
helplessly, his accounts frozen, as 22 years of retirement
savings dwindled from $472,000 to less then $3,500. Or Tim
Ramsey, a 33-year veteran, who lost $995,000 from his
retirement account.
Most pension funds and institutional investors held some
Enron stocks or bonds. The AFL-CIO's pension fund held Enron
bonds and watched them lose 75 percent of their value.
Much of this money was going to fund pension benefits for
working families, for the public employees we are counting on
to protect us during this period of national crisis, for the
pensions of the ironworkers, for instance, now clearing the
rubble at Ground Zero.
All of us who have S&P 500 index funds in our 401Ks or
mutual fund portfolios lost money in Enron, probably about one-
half a percent of the total assets in those type of funds.
Much of what happened at Enron, as has been stated earlier,
remains murky, but from what we know, this is a story first and
foremost about conflicts of interest, about a long list of
people and institutions that were supposed to look out for
workers' retirement savings and instead looked out for
themselves.
Now, what do I mean by a conflict of interest?
Let us begin with the first line of defense, when
management goes sour. That is the board of directors. At Enron,
most of the board was independent of the company, according to
the SEC filings. But look another layer deeper and you find
some of these ``independent'' directors were actually investing
in Enron-sponsored limited partnerships.
Then there were the auditors. Arthur Andersen, who
testified earlier, was the company's long-time auditor, but
management was funneling lucrative consulting contracts to
Andersen, as was stated, $59 million in fees.
Then we come to the Wall Street analysts. Practically every
Wall Street firm and post-Glass-Steagall commercial bank had an
interest in courting Enron. Out of the 13 Wall Street analysts
that covered Enron in October, according to Forbes Magazine, 11
were bullish, while the majority of independent investment
newsletters were bearish.
Finally, there were money managers. Alliance Capital, a
major money manager for pension funds, shared a director with
Enron. Alliance kept buying Enron shares this summer and this
fall, so many shares that Alliance ended up as Enron's largest
holder. Enron was a company that talked about a future of
transparent markets, but whose CFO openly bragged that, and I
quote: ``We don't want anyone to know what's on those books. We
don't want to tell anyone where we're making money.''
Enron's mantra was deregulation and privatization and now
Enron itself is a demonstration of why workers need both
defined benefit pension plans and a Social Security system safe
from the conflicts of interest that appear rampant in the
capital markets.
In response to these causes of the Enron fiasco, the AFL-
CIO is today submitting two rulemaking petitions to the SEC.
These proposals have the support of the Council of
Institutional Investors whose members have nearly $2 trillion
in assets. We ask in these petitions that the Commission act to
ensure independent directors are really independent.
In the accounting area, our proposals are aimed to keep
auditors independent and include a prohibition on accountants
reviewing transaction they themselves structured, direct audit
committee approval of any audit consulting arrangement, as well
as the audit engagement itself.
These proposals follow efforts in early November by the
AFL-CIO and the Amalgamated Bank, a large index manager of
union pension fund assets, to reach out to Enron's outside
directors.
Mr. Chairman, we did that immediately upon the announcement
of their losses. We wrote to those independent directors and
cc'd all the boards of directors.
We asked for more independent directors and more extensive
disclosure immediately, but we never received a substantive
reply. In fact, the independent directors never wrote back. The
company itself wrote back saying thanks for your letter.
In the wake of the Enron bankruptcy, the Amalgamated Bank
took the last step remaining open to investors, bringing suit
last week in Federal court on behalf of Enron shareholders.
Our funds will fight as hard as we can to get our money
back, but the truth is, only strong Government action, led by
the SEC and the Department of Labor, and the support of these
subcommittees, and Congress can ensure that investors are not
victimized again in this way.
Mr. Chairman, I and the AFL-CIO look forward to working
with you and these subcommittees in the coming days on these
very, very important tasks.
Thank you very much.
[The prepared statement of Richard L. Trumka can be found
on page 135 in the appendix.]
Chairman Baker. Thank you, sir, for your good testimony.
I just want to make a brief comment before asking my first
question and that is I can assure all of you that every Member
of the subcommittees, regardless of the philosophic
perspective, finds no comfort in the fact that thousands of
people are unemployed, their retirement benefits gone, their
401Ks vanished. Regardless of the circumstance and how it came
to be, this is a most unfortunate event over which there is no
happiness anywhere.
From here forward is the issue. How do we preclude it from
reoccurring? In order to do that, we must understand how this
came to be.
I happen to believe that within the capital markets most
people, as in politics, get up every morning and try to do the
best they can to do the job they are assigned to do. It appears
to me without knowing all the facts yet today that there were a
few individuals engaged at very high levels within the
corporate structure that did not provide the disclosures that
are required perhaps by law, but certainly by good moral
judgment, either to the accountants, to the analyst community,
to the journalists or to anybody else and that it appears from
the disposition of assets over the time preceding the
bankruptcy filing that their profiteering coincided with the
lockout of the employees' access to their own funds. If these
facts turn out to be the case, this is a travesty.
Now, could a change in our structural law have precluded
it?
I do not know, but that is what we are about.
To that end, Mr. Hill, you were making the comment that
some analysts, because of enthusiasm and the pressure of
prominence, take an LTCM, they were making hand over fist great
sums of money, very bright people, never had a back-to-back
trading loss, banks were throwing money at them, investors were
throwing money at them. It was almost as if you had a question
about their methodology, there must be something wrong with
you, because you did not understand the business model.
It would seem from what I know now that to a great extent
the Enron story is not too dissimilar. The principal
difference, however, is that in the closing days of LTCM the
principals believed in their own philosophy, they were putting
money in. In this case, the principals were taking money out.
That is a tremendous difference of great public policy
consequence which troubles me greatly.
But to your point about the independence of the analysts,
as of 2:40 today, December 12th, checking by Yahoo! finance
page, we have 13 analysts listed covering Enron, we have two
``strong buys,'' we have one ``buy,'' we have eight ``holds,''
one ``sell'' and one ``strong sell.''
How do you respond to that today? Is there something of
value that these subcommittees are missing? How could anybody
look at these events and come to the conclusion that this is a
``strong buy'' opportunity?
Mr. Hill. I have a problem with the ``strong buys.'' Again,
if you have your decoder, you know that the holds are really
meaning sell, so the majority of them are saying sell now to
those that--as we said last time----
Chairman Baker. But given these circumstances and the
public discussion and the pending investigations and all the
other matters that are out there, why not for the first time
break the code and say, for goodness sakes, to the American
public, ``sell this stuff''?
Mr. Hill. I agree.
Chairman Baker. If you can.
Mr. Hill. I agree. But this is not new, you know, this
whole thing. I mean, you brought up Long-Term Capital
Management, and I have in my notes here that when we got into
the questions to mention it, so you beat me to it on that one.
Not long after I got in the business, there was a company
that I was covering called Memorex. It was selling back then at
over 100 times earnings. I do not remember the exact date, but
it was some time in the early 1970s. Larry Spitters, the
Chairman of Memorex, came to Boston to explain to the financial
community their lease accounting and we have talked this
morning about the similarities between off-balance lease
accounting and off-balance derivatives, but same idea, there
was no transparency. Part way through the presentation--he was
using flip charts in those days--he got to the point where he
threw up his hands and said, ``I can't explain it, I can't
answer your questions.''
I think a lot of us either dropped coverage or went to
``sell'' on Memorex.
Chairman Baker. And let me ask on that point, what is the
significance in the market if someone drops coverage? What is
the decoding of that activity?
Mr. Hill. Well, assuming it is not because an analyst is
leaving or whatever, it is interpreted as there is a problem
here.
Chairman Baker. So what we also need----
Mr. Hill. And to me, that was the easy out, would be at
that point certainly once that restatement----
Chairman Baker. Well, are all these actions, the drop
coverage, the hold comment, is this the prominence problem? Is
that we do not want to downgrade someone because of the
consequences of that to the firm?
Mr. Hill. Absolutely. And the conflicts are threefold.
First is the obvious one that most everyone is aware of, is the
investment banking problem. And until we change the
compensation situation for the analyst, which means we have got
to find some way to go back, for the firms to get paid for
research.
When I was an analyst, my bonus was incentivized to do good
fundamental research, but that was when the commissions were
high enough that the firm was getting paid for research.
Chairman Baker. Well, let me interrupt you, if I may. I
want to get one question in to Mr. Berardino. My time is
expiring. If we have a chance for a second round, I really want
to come back.
Mr. Berardino, I think what troubles me, I am standing on
the presumption that the in-the-field auditor has no direct
benefit from a lucrative contract with the larger firm and that
in my view of the operative auditor function, he has a
contractual relationship with the company, certainly he wants
the company to be profitable. But, in the case of Arthur
Andersen, whose gross income per year is in the millions and
millions and millions of dollars, the relationship with Enron I
do not view as being a significant factor in the judgment of an
in-the-field auditor looking at the books.
What troubles me, I believe, is in this case it appears
that individuals who were responsible for disclosing the books
or the activities to the in-the-field personnel in most cases
may have not been providing you with the appropriate
information or insight.
If that is the case, what do we do about changing the
system to correct for that problem? How do you know the data
that the auditor is looking at is the real set of books?
Mr. Berardino. That is a very complicated question and a
very fundamental question, Mr. Chairman.
As you probably know, Enron was an extremely complex
company. They had over 20,000 employees. In fact, I recently
found out they had 600 CPAs. So they spent a lot of time trying
to keep their books. They had 3,000 subsidiaries all over the
world.
And as auditors, you know, we do not live there. We do test
checks, we do statistical samples to inspect the transactions
as the company presents us the information. And the company
does have a legal obligation to present us information that we
require.
Chairman Baker. Let me do this, because I do not want to
run inordinately time since I am trying to keep other folks on
the clock.
To put a simple point to it, must we make the consequences
of failing to properly disclose, to provide transparency so
severe that it ain't worth the risk?
Mr. Berardino. I think that would be very helpful. It will
add, though, and I made this comment in my testimony, it is an
illegal act to withhold information from an auditor.
Chairman Baker. Well, I understand that and, believe me, in
my experience in Louisiana political life, having something be
illegal is not necessarily a prohibition. I think we need to
have something a little more strenuous than just the fact that
you get written up in the books. And I do not know what that is
in this case, but it ought to be pretty significant.
Mr. Berardino. Well, that is worth investigating, sir.
Chairman Baker. Mr. Kanjorski.
Mr. Kanjorski. Yes. I was just thinking to myself as we
heard the dialogue between yourself and the Chairman, if this
were 1942, Nazi Germany, and people were talking about the
death camps, it seems like a tremendous establishment of
plausible deniability. If you do not know, you do not have to
answer and you are all home free, other than Mr. Trumka.
I do not quite sense----
I will give you a chance, Mr. Hill, are you not outraged?
Are you not outraged? Do you two gentlemen just not think this
is horrendous, what happened to the shareholders, what happened
to the investors, what happened to the employees?
I mean, do we not have to say something to the system?
If this system is so broken that the seventh largest
corporation in the United States can play these silly games and
everybody comes and just says, ``Well, I did not know,'' or
``we did not understand,'' or ``we have these complications,''
are we any different than any other nations in the world that
are having problems with transparency?
Mr. Hill. I think when you get into this derivatives issue,
we are in a whole new world and I do not know what the answer
is. I do not know whether we need another class of security or
whatever for people whose business is essentially driven by
derivatives. I do not know what the answer is, but I agree with
you, that we have to have some kind of different system because
the normal fundamental analysis really does not apply to these
kind of companies. I just do not know how you could really do
it.
Mr. Kanjorski. Let me ask something. You know, I thought
corporate statements were required to give an understanding of
what is going on and these special purpose entities, I have to
confess, I know very little about them as to how they operate
or derivatives. We have had hearings on it, everybody has come
in here and said they are so important, they balance and hedge
the market and do not worry about it and they get into the
trillions and trillions, it is all OK. But why not just
disclose it?
If there is a special purpose entity, why should it not be
disclosed? Unless it is constructed, and I think you gave an
indication to me yesterday when we talked about this, it is
particularly constructed so that it does not hurt the
disclosure in the company?
So here you are.
Mr. Berardino. Well, Congressman, you are obviously getting
right to the heart of the matter, which I appreciate. There is
no great answer to your question right now. These special
purpose entities have been in business for years.
Mr. Kanjorski. And I understand that. But, by God, did not
the accounting profession say, hey, by having these things, we
are not really giving transparency here and disclosure?
Mr. Berardino. Well, you know, there have been great
debates and there is a great irony, unfortunately, in all of
this. There is been a great debate within the accounting
profession as to what goes on off balance sheet and there are
two schools of thought, if I could just do a little accounting
101, maybe.
One school of thought is if you lose control, if you are an
Enron and somebody else has control over these SPEs,
simplistically defined as more than a 51 percent vote, these
transactions go off your balance sheet, assuming these other
tests, 3 percent, and so forth, are passed.
Mr. Kanjorski. In spite of the fact that by doing that you
lose transparency of what is really occurring in the company?
Mr. Berardino. If you will just bear with me for a second,
Congressman.
The second school of thought, which is the school of
thought Andersen has always been in, is that one ought to look
at risks and rewards. So even though these transactions went
off balance sheet, Enron could maintain 97 percent of the risks
and rewards.
Mr. Kanjorski. And we are arguing that in the accounting.
Mr. Berardino. We lost that debate within the accounting
profession.
Mr. Kanjorski. And it has been going on for years?
Mr. Berardino. Things go off balance sheet, it has been
going on for years, people know about it.
Mr. Kanjorski. Ten years, I think you told me yesterday.
And as a result of that not coming to some conclusion, we are
now faced with somebody lost $80 billion, I think a hell of a
lot of somebodies who Mr. Trumka was talking about that are
important, and innocent investors and a lot of bad guys who
were inside traders made billions while this thing was going to
hell in a basket.
And now you are putting Congress as representatives of the
people in the position that if we have had enough and we are
fed up, you are telling us the Government better come in and
regulate your profession, the corporations, disclosure, the
business interests of this country seem to me to make the most
compelling case in the world of we need heavy regulation.
And that sort of offends me, because I felt that we could
rely on the decency, the honesty and the professionalism that
the professions aiding these corporations and the corporate
executives would be using the highest moral and ethical
standards and I just--somebody was in the hen-house. And I
think it is up to you guys to tell us who that was. And then
let us find out--are we going to slap them on the wrist with a
$1,000 fine and put them in jail for a year so they can take
their billion dollars in jail and speculate and make two or
three billion? Or maybe set up some more special purpose
entities out there?
Mr. Berardino. Congressman, I am here voluntarily because I
want to be part of the solution. The points you raise are
valid. I understand them. I do not feel good about where we all
are. But I think the Chairman set the right tone here by saying
we have to learn from this. We are prepared to shed whatever
facts we can on the accounting and auditing side of this
because I think we can get it better.
Mr. Kanjorski. And I appreciate that and I want to tell you
I appreciate you having the--I am trying to use the right word
here--nerve to be here today. I think my patience at this point
is fully tested. I applaud the petitions for regulations filed
by the AFL-CIO. I think America is going to go back to a lot of
instances of re-regulation where it will be counterproductive
to the market if we do that, but it is going to happen because
people are not going to take it, $80 billion, what that means
to America, where we could go with it, and to allow----
I do not know whether this is a Ponzi scheme or what the
hell it is, but when the best analysts from the best investment
banking in the country are, at a time when everything is gone,
still recommending heavily that people buy and put their
pensions, their savings--I think we have to do something and I
think that is very unfortunate, that the business community
here is forcing the Congress on behalf of representing the
people to get involved with the accounting profession on
conflicts of interest, with the analysts and the way they get
paid. That should not even be an issue, as you indicated.
We have so many compromises out there it is amazing that
anything is working in this system.
I know I have had my time. Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Kanjorski.
Mrs. Kelly.
Mrs. Kelly. Thanks, Mr. Chairman.
First of all, I want to say thank you, Mr. Trumka, because
you represent a lot of people, not only in AFL-CIO, but by your
words today you represent a lot of other people out there in
the United States who also got involved, not because they were
in the union, but because they trusted. And I think it is
important that your testimony was heard.
I want to turn to you, Mr. Berardino. I want to follow up
on the mark-to-market situation.
Do you think that the mark-to-market accounting system has
yielded a situation where we have misleading information being
provided to investors?
I was not real happy with what I heard this morning. I
would like to hear it from your standpoint.
Mr. Berardino. I think it is an extremely important issue
and I will hide behind theory to start and then I will get real
life for you, if you do not mind.
Theoretically, it is a very appropriate way to account for
transactions. You get a more current valuation. I think what
you heard this morning is some of the difficulties in the
methodologies that go into evaluating something. It is easy to
evaluate something that might be due tomorrow than something
due 30 years from now.
We share your concern, and by ``we'' I mean the accounting
profession. We issued a statement, the five CEOs of the major
firms, just 1 week ago, where we called to the SEC and said we
need more disclosure so people know what is going on this mark-
to-market stuff. It is hard, it is complex and there are
different interpretations as to how to get there.
We think it is a real issue, we think it is an important
issue. It is on the agenda. We have put it on the SEC's agenda
and we are fully prepared as a profession to try to get some
guidance out before this year end as companies are ending their
years December 31 so that there will be more clarity this year
than there might have been last year.
Mrs. Kelly. Well, bear with me for a minute. How would you
really do that?
What are we talking about? How can you get a type of
transparency in that type of transaction so that people
understand why decisions were made to do the projections that
they have done and that they can evaluate the sensibility of
those projections?
Mr. Berardino. This is very difficult, very difficult,
because these are highly sophisticated transactions that
require a number of estimates and in some cases where there are
not active markets day to day that one can refer to. So it is
not going to be easy. But I do think it is an area worth
exploring and we are fully prepared to help in real time to
come up with some more clarity.
Mrs. Kelly. Did you ever ask the SEC for guidance on the
Enron audits?
Mr. Berardino. I do not remember.
Mrs. Kelly. Would there be somebody here who could advise
you about that?
Mr. Berardino. I was not directly involved. Perhaps. If you
do not mind, let me just check with my friends here.
Mrs. Kelly. Feel free.
Mr. Berardino. Thank you.
[Pause.]
Mr. Berardino. The answer is yes. On mark-to-market, we
were heavily involved with Enron back in the early 1990s and
working through with the SEC how they might do mark-to-market
on their portfolio. Very open conversations to try to get to
the best answer. And there have been consultations on many
different items, not just mark-to-market, since then.
Mrs. Kelly. Did you find them forthcoming? Maybe you want
to consult on that one, too.
Mr. Berardino. Did I find who forthcoming?
Mrs. Kelly. The SEC. Were they helpful? Did they have
guidelines? Were they able to give you what you needed in order
to do something that is complicated and bringing the mark-to-
market----
Mr. Berardino. Oh, again, these are hard issues that you
need a lot of smart people in a room to try to figure out what
is right, and in the early 1990s this was new, and the SEC was
very helpful in that conversation.
Mrs. Kelly. Do you think the kind of environment exists at
the SEC to encourage public companies to seek their advice?
Mr. Berardino. Well, I think that that has varied over the
years, quite frankly, and in the past, there has been
unfortunately more of an adversarial relationship and less of a
let us work this all out together relationship, which I think
the current chairman is trying to change and which, frankly, we
welcome because it is--you know, many people think accounting
is a science, where one number, namely earnings per share, is
the number and it is such a precise number that it could not be
two pennies higher or two pennies lower.
And I come from the school that says it really is much of
an art, that a company like Enron, $500 million transactions
going through Enron online, highly complex organizations where
there is no one number, and one of the challenges we have and
one of the reasons I think we have the opportunity for reform
here is the accounting model has traditionally been historic.
You know, we told you what happened 90 days ago or a year ago.
Most analysts, most investors are really interested in
predicting the future. And we do not have an ability in our
present financial reporting model, mark-to-market is an attempt
to get there, to give investors more current information on a
more timely, real time basis.
I think this is a time for change and I think some of the
stresses in the system we have seen at Enron, not to understate
them, will provoke all of us to be thinking outside the box. So
I think your questions are incredible. And I will tell you we
are prepared to be part of the solution.
Mrs. Kelly. Thank you very much. I appreciate your being
here.
Chairman Baker. Thank you, Mrs. Kelly.
Mr. LaFalce.
Mr. LaFalce. Thank you very much, Mr. Chairman. And I thank
all the panelists for coming here, especially you, Mr.
Berardino, for stepping up to the plate. It is not an easy task
to be the number one person at the accounting firm that is
being looked at right now, but I commend you for the integrity
of your comments and the approach you are taking.
Let me just ask a few questions. First of all, any of you,
what percentage of the CEOs, CFOs, and members of audit
committees have their compensation in large part based upon the
market valuation of their stock?
Mr. Berardino. Quite a few.
Mr. LaFalce. A very high percentage?
Mr. Berardino. Yes, sir.
Mr. LaFalce. I would think that that creates a tremendous
incentive on their part, both the officers and the directors,
especially the audit committee, to have a good market valuation
and therefore to report good earnings. Is that correct?
Mr. Berardino. Well, Congressman, this is a paradox, is it
not? The shareholders----
Mr. LaFalce. Well, it is a fact, I think.
Mr. Berardino. Well, but----
Mr. LaFalce. There may be a subsequent paradox that is
coming, but----
Mr. Berardino. Well, it is a fact to some, but to others as
shareholders, do you not want your CEO to help the stock price
go up? I hope you do not want him to have it go down.
Mr. LaFalce. So long as it is real rather than imaginary.
Mr. Berardino. Of course.
Mr. LaFalce. And that is the difficulty. So my point is
simply that there really is a need, it seems to me, for
improvement in the system and you have called for improvements.
The question is where do we start?
And it seems to me we have to start first with the issue of
corporate governance. And what do we--independence?
I do not think you could bring it into the management
itself, but what do we do to bring independence into the audit
committee of the board? Or can there be some audit committee
outside of the board? But some committee that does not have a
vested interest in doctoring earnings because of the market
valuation that will determine what their compensation is.
I mean, it is an outrageous conflict. And then my first
question is how do we deal with it?
Let me ask you to come back to that, but I do think that is
a very threshold question.
The second question or point is you made the statement, Mr.
Berardino, that it is a violation of the law to withhold
information from the accountant auditor, correct?
Mr. Berardino. Yes.
Mr. LaFalce. Is that a criminal or a civil violation?
Mr. Berardino. I am not sure. Probably criminal.
Mr. LaFalce. Well, in your prepared testimony, you said
with respect to the one SPE, the one that accounted for
approximately 80 percent, the one with the far larger impact,
our audit team was not provided critical information.
Now, applying the logic and syllogisms that I learned in my
Jesuit days, it would seem to me that you are therefore saying
and that therefore Enron violated the law in their relationship
with you.
Mr. Berardino. Congressman, I also have a Jesuit education.
Mr. LaFalce. That is why I am referring to it.
Mr. Berardino. I am also taught to believe that we need to
have all the facts. And if I could shed some----
Mr. LaFalce. But you did say it would appear.
Mr. Berardino. Yes. I mean, to shed some color commentary,
what had happened was that the requirement for 3 percent equity
from an outsider was met in one end of the Enron house and in a
completely distinct other part of the house a compensating
balance was offered to that same investor and when you look at
the two together it flunks the test.
Now, we do not know if that was willful or not, but once we
had all the facts and the company had all the facts, we had to
restate the financial statements.
Mr. LaFalce. OK. Mr. Hill, because my time is about to
expire, most companies who are doing an analysis of stocks, the
strong buy, buy, hold, accumulate, sell or what have you, it is
my understanding that in the year 2000, only 1 percent of all
the recommendations made by all the research firms were sell
recommendations and that if you go back a half-a-dozen years or
so, it was more like 6 percent. That is a considerable decline.
I have recommended to the SEC and others that every
recommendation be accompanied with at least one thing and that
is the number of recommendations a firm makes, if they make
200, and a statement, ``we are recommending a strong buy'' and
150 of our recommendations are ``strong buys,'' 25 are
``buys,'' 20 are ``hold,'' and 5 are ``sells,'' or whatever it
might be.
I think that would be a good idea. I would like to know
your thoughts on that.
Second, it took Mr. Baker two seconds to go to Yahoo!
finance and tell you that there are approximately 20 firms
analyzing the stock right now, of which two are ``strong
buys,'' and one is a ``buy'' or what-have-you.
What about if we required that any written recommendation
of an analyst's firm give you the number of firms covering it,
at least as of close of business yesterday, according to some
criteria, whether it is an SEC or First Call or what have you,
and if they are issuing a strong buy, it would be interesting
to know that there are 12 others that are recommending sells
and we would like to know who they are.
What are your thoughts on that?
Chairman Baker. Mr. LaFalce, let me suggest this, if I may.
I am trying to help Members get on the record on this issue,
particularly Mr. Bentsen and Ms. Jackson-Lee, before the
recess.
We have six votes and I am afraid we are going to be on the
floor for about an hour and I feel very badly about having kept
our witnesses here all morning and then keeping them here
another hour into the evening. And I understand perhaps one has
another appearance which cannot be missed anyway at 4:00.
With the subcommittees' understanding, Mr. Shays has waived
his time.
Mr. Shays. Well, just one quick question.
Chairman Baker. Yes, Mr. Shays.
Mr. Shays. I want to thank our witnesses. I understand that
we are going to have more hearings, so it makes sense to close
this hearing, but I just want to say to you, Mr. Trumka, that I
believe that you are going to take your retirement funds and
not invest them all in Treasury bills, thank God, and I just
have to say I hope with Social Security funds that we also do
the same.
Chairman Baker. Thank you, Mr. Shays.
I would like to suggest to the subcommittees 2 minutes to
Mr. Bentsen, 2 minutes to Ms. Jackson-Lee, call the meeting to
a conclusion and let our witnesses go, but with this caveat, we
have to have participation in future hearings. This matter is
too complex to have covered it even in a day. This has been
just a very light introduction to the subject.
Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman. I appreciate the
panel being here and I have comments with Mr. Hill and Mr.
Trumka, but I am going to have to do those another time.
Mr. Berardino, in your testimony, there are two things that
stick out. One, when you talk about the SPEs and particularly
the Jedi and Chewco SPE, you talk about no prohibition against
company employees being involved as investors.
That seems to me to be pretty closely related parties and
if the law does not address that now, it sure as hell ought to
address that in the future.
And, second of all, it would appear to me on the issue of
the international financial institution that--and you may not
want to answer this--that looks a lot like a pretty contrived
deal to create an off balance sheet financing vehicle that
really was not one. And if they did not disclose that you as
their auditor, then I think they have some real problems on
their hands and I think that may be a crux. And you may not
want to address that.
The other thing which I think is a serious issue is on page
6, where you talk about some people say we should have required
the company to make more disclosures about contingencies such
as accelerated debt payments, which did in part bring the
company down, associated with the possible decline in the value
of Enron's stock or changes in the company's credit rating.
They ran some very high octane structured deals that were--and
the credit consideration, the credit covenants were critical to
that company going because they were extremely highly
leveraged.
How that could not be a material item for disclosure, I do
not know and, again, you may not want to answer it. I assume
this issue will come up in other forums, but----
Mr. Berardino. Well, I will partially answer it and then
there is some disclosure. I will not say it is in neon lights,
but there is some disclosure in the derivatives area about the
fact that this company relied on the confidence of its trading
parties and, frankly, one of the issues was what happens when
your trading parties do not want to trade with you? Do you have
a business?
And there is no requirement to anticipate every possible
contingency in terms of where a company's stock price might go
and we obviously understand your point. I think it is one worth
further exploration.
Mr. Bentsen. Well, my time is up, but let me say this.
Stock is a pretty volatile instrument and to not treat it as
such in disclosure, disclosure is only as good as in the eye of
the beholder and so I would hope that the industry would look
at that.
Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Bentsen.
Ms. Jackson-Lee.
Ms. Jackson-Lee. Mr. Chairman, I cannot thank you and the
Ranking Members and the Full Committee chairs and Ranking
Member enough for your extreme courtesies to me and to the
colleagues on this committee for their extreme courtesy. Very
briefly, because we all are learning and I mentioned earlier
that the eyes of the Nation are on us, and Houston, and
particularly the pain and anguish that is experienced by those
in Houston.
Mr. Berardino, thank you for your presence. Very quickly, I
just want to know as it relates to the information that you
thought you got incorrectly or made a mistake on the SPEs, what
could have been done differently? Why did you probe further
when you thought you had the information or are you just
finding out you had incorrect information in your testimony?
Mr. Berardino. Well, thank you for your question. These are
not easy issues. On the 80 percent where we did not have all
the facts, this is a very complex company. They do lots of
these deals. It is not like there is one a year that everyone
looks at. There are, you know, scores and scores of them. And
unfortunately, we just did not have the information. And once
we and the company, the accounting department, had all the
information, we all knew what the right answer was and
unfortunately it resulted in a restatement.
On the other issue, where we made a mistake in judgment, at
the time, our team made a very good faith, reasonable decision
in terms of looking at these transactions and in hindsight they
made an error in judgment. And let me be clear, you know, in no
way do we think that this caused the collapse, but it is
unfortunate that with the thousands and thousands of hours of
work----
Chairman Baker. Twenty seconds, Ms. Lee, because we are
running out of time to make the floor vote.
Ms. Jackson-Lee. Thank you very much.
Let me just say, Mr. Trumka, I thank you very much for
being here. One quick word. How catastrophic is this to working
people?
Mr. Trumka. We do not know the entire answer, but we can
tell you that as far as Taft-Hartleys are concerned, the Taft-
Hartley pension funds have probably lost a minimum of $250
million in stock and another $250 million in bonds. When you
put all of the pension funds together, we are talking about
tens of billions of dollars. When you look at individuals, many
individuals have had their entire 401K retirement benefit wiped
out. They are penniless.
Ms. Jackson-Lee. Thank you, Mr. Chairman. We just have a
lot of work to do.
Thank you so very much.
Chairman Baker. Thank you. We will return after the
Christmas recess to this topic, the analyst topic, transparency
questions, a long litany of issues.
I wish to keep the hearing record open an unusually long
period, 30 days, for all Members not only to formulate further
questions, but for interested parties to make comment. I do
appreciate your courtesies in being here and your longstanding
patience throughout the day. We have to run. We have less than
2 minutes to make this vote.
Thank you.
[Whereupon, at 3:20 p.m., the hearing was adjourned.]
A P P E N D I X
December 12, 2001
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