[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]
LESSONS LEARNED FROM ENRON'S COLLAPSE: AUDITING THE ACCOUNTING INDUSTRY
=======================================================================
HEARING
before the
COMMITTEE ON ENERGY AND COMMERCE
HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
FEBRUARY 6, 2002
__________
Serial No. 107-83
__________
Printed for the use of the Committee on Energy and Commerce
Available via the World Wide Web: http://www.access.gpo.gov/congress/
house
__________
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COMMITTEE ON ENERGY AND COMMERCE
W.J. ``BILLY'' TAUZIN, Louisiana, Chairman
MICHAEL BILIRAKIS, Florida JOHN D. DINGELL, Michigan
JOE BARTON, Texas HENRY A. WAXMAN, California
FRED UPTON, Michigan EDWARD J. MARKEY, Massachusetts
CLIFF STEARNS, Florida RALPH M. HALL, Texas
PAUL E. GILLMOR, Ohio RICK BOUCHER, Virginia
JAMES C. GREENWOOD, Pennsylvania EDOLPHUS TOWNS, New York
CHRISTOPHER COX, California FRANK PALLONE, Jr., New Jersey
NATHAN DEAL, Georgia SHERROD BROWN, Ohio
STEVE LARGENT, Oklahoma BART GORDON, Tennessee
RICHARD BURR, North Carolina PETER DEUTSCH, Florida
ED WHITFIELD, Kentucky BOBBY L. RUSH, Illinois
GREG GANSKE, Iowa ANNA G. ESHOO, California
CHARLIE NORWOOD, Georgia BART STUPAK, Michigan
BARBARA CUBIN, Wyoming ELIOT L. ENGEL, New York
JOHN SHIMKUS, Illinois TOM SAWYER, Ohio
HEATHER WILSON, New Mexico ALBERT R. WYNN, Maryland
JOHN B. SHADEGG, Arizona GENE GREEN, Texas
CHARLES ``CHIP'' PICKERING, KAREN McCARTHY, Missouri
Mississippi TED STRICKLAND, Ohio
VITO FOSSELLA, New York DIANA DeGETTE, Colorado
ROY BLUNT, Missouri THOMAS M. BARRETT, Wisconsin
TOM DAVIS, Virginia BILL LUTHER, Minnesota
ED BRYANT, Tennessee LOIS CAPPS, California
ROBERT L. EHRLICH, Jr., Maryland MICHAEL F. DOYLE, Pennsylvania
STEVE BUYER, Indiana CHRISTOPHER JOHN, Louisiana
GEORGE RADANOVICH, California JANE HARMAN, California
CHARLES F. BASS, New Hampshire
JOSEPH R. PITTS, Pennsylvania
MARY BONO, California
GREG WALDEN, Oregon
LEE TERRY, Nebraska
David V. Marventano, Staff Director
James D. Barnette, General Counsel
Reid P.F. Stuntz, Minority Staff Director and Chief Counsel
(ii)
C O N T E N T S
__________
Page
Testimony of:
Chanos, James S., Kynikos Associates, Ltd.................... 71
Dharan, Bala G., Rice University............................. 87
Lev, Baruch, New York University............................. 96
Longstreth, Bevis, Debevoise & Plimpton...................... 111
Raber, Roger W., National Association of Corporate Directors. 79
Sokol, David L., Midamerican Energy Holdings Company......... 122
Weil, Roman L., University of Chicago........................ 82
Material submitted for the record by:
Chanos, James S., Kynikos Associates, Ltd., letter dated
March 8, 2002, enclosing response for the record........... 169
Tauzin, Hon. W.J. ``Billy'':
Letter dated February 19, 2002, to Baruch Lev, enclosing
questions, and responses to same....................... 165
(iii)
LESSONS LEARNED FROM ENRON'S COLLAPSE: AUDITING THE ACCOUNTING INDUSTRY
----------
WEDNESDAY, FEBRUARY 6, 2002
House of Representatives,
Committee on Energy and Commerce,
Washington, DC.
The committee met, pursuant to notice, at 12:53 p.m., in
room 345 Cannon House Office Building, Hon. W.J. ``Billy'
Tauzin (chairman) presiding.
Members present: Representatives Tauzin, Bilirakis, Barton,
Stearns, Gillmor, Greenwood, Cox, Deal, Largent, Burr,
Whitfield, Ganske, Norwood, Shimkus, Shadegg, Pickering, Blunt,
Davis, Bryant, Ehrlich, Buyer, Radanovich, Bass, Pitts, Walden,
Terry, Dingell, Waxman, Markey, Hall, Boucher, Towns, Pallone,
Brown, Gordon, Deutsch, Rush, Eshoo, Stupak, Engel, Sawyer,
Wynn, Green, McCarthy, DeGette, Barrett, Capps, Doyle, John,
and Harman.
Staff present: Jim Barnette, general counsel; David
Cavicke, majority counsel, Shannon Vildostegui, majority
counsel; Brian McCullough, majority counsel, Jon Tripp,
assistant press secretary; Will Carty, legislative clerk, Jill
Latham, staff assistant; David R. Schooler, minority general
counsel and deputy staff director; Sue Sheridan, minority
counsel; Consuela Washington, minority counsel; Candy Butler,
minority professional staff; Nicole Kenner, minority
legislative clerk; and Jessica McNiece, minority intern.
Chairman Tauzin. Let me announce the order of business. We
will begin opening statements on the full committee hearing
this morning, but we will suspend and interrupt those opening
statements as soon as staff informs me that we have a full
quorum of the committee present to do business. At that point,
we will introduce a resolution before the full committee with
the concurrence of the minority, which will authorize the Chair
with again the concurrence of the minority to issue subpoenas
in this case as we further need them in our investigation. And
then we will go back to opening statements and introduce our
witnesses and finish the hearing.
The Chair will first recognize himself for an opening
statement. Today, we're taking the extraordinary step of
holding a full Energy and Commerce Committee hearing to
consider some of the most important policy issues that relate
to Enron's collapse. These issues include corporate governance,
accounting and governance of the auditing profession and very
importantly, the health of our energy interest and markets. We
take this step because of the profoundly troubling things we've
discovered in the investigation of Enron. Most significantly we
have learned that first, senior Enron management engaged in
self-dealing transactions, and second, Enron transacted with
partnerships controlled by CFO, the Chief Financial Officer,
Andrew Fastow, his associate, Michael Kopper and others, and
that Enron appeared to shift the risk of loss on risky
investments in these partnerships, but in fact, remained fully
liable for their investments and those risks.
And third, Enron went ahead and reported fictitious gains
on these transactions with the LJM and Raptor entities when the
hedged investments declined in value, and that these gains were
illusory. The partnerships lacked the economic resources to
make good on the transactions. The effect of these sham
transactions was to inflate Enron's publicly reported earnings
in 1999, 2000 and 2001 significantly by more than $1 billion.
We have found substantial evidence of illegal activity by
Enron and its management. And this activity served to deceive
the public about Enron's financial condition. It artificially
pumped up Enron's stock price and allowed these same executives
to enrich themselves with the sales of Enron stock.
We have also found that Enron's auditor, Andersen, knew or
should have known or should have discovered the fraudulent
nature of the Fastow transactions and we have found that
Enron's financial statements violated numerous existing
accounting rules. These statements misled investors about
Enron's financial condition and over-estimated that net income
by over $1 billion. In the end it turns out that the Enron
debacle is an old fashioned example of theft by insiders and a
failure of those responsible for them to prevent that theft. We
believe this is a huge aberration of corporate behavior in
America. For example, in one transaction, Fastow and Kopper
informed the investors in LJM2, a partnership at the center of
this theft, that the expected rate of return on the transaction
was 2,503 percent to be realized in just 8 days.
In each of the so-called Raptor transactions, Fastow
extracted all of his equity, along with additional fees in the
tens of millions of dollars before any transactions that
involved any economic risk took place. In this way, Enron was
doing business with an entity with only one asset and that was
Enron's shares that Enron had contributed. This was not a
hedging transaction. Enron was merely issuing shares and
calling the issuance earnings. This clearly violated existing
law and the most basic norms of corporate behavior.
Enron's Board of Directors, its Finance Committee and its
Audit Committee failed to exercise due care with respect to
these transactions and it simply boggles the mind that the
Chief Financial Officer of a company was allowed to organize
partnerships and simultaneously take the other side of deals
with this company. Such an arrangement should never have
happened and does not ordinarily happen in any corporation that
I know of in America.
Additionally, we have learned that the SEC conducted no
meaningful review of Enron disclosures from 1997 through 2001,
so before we rush to impose new laws and regulations in the
wake of the scandal, we want to be sure that we're actually
enforcing existing law and today, we're going to look at some
of the broader implications of Enron and what it means for the
controls and safeguards we have built into our capital raising
system.
We'll hear from experts in corporate governance, in
accounting, in the governance of auditors and we'll hear from
an energy firm. We'll look at the state of current law and the
current practice to see if reforms are necessary.
Now I want to also make some other comments. Next week,
I've asked the Energy Subcommittee, chaired by Joe Barton to
suspend action on his energy package, the electricity package,
until we can thoroughly understand the effect of this Enron
collapse under the energy markets. And he will conduct a
hearing next week on that issue.
I've also asked the chairman of our Commerce, Trade, and
Consumer Protection Subcommittee, Mr. Stearns to conduct a
hearing into FASB's Rules, the accounting principles involved
here and the accounting rules that may need improvement as we
go forward and learn more from today's hearing and other
hearings about this important area.
In short, this hearing today will feed into the hearing
tomorrow by the Oversight and Investigations Subommittee in
which we will have the principals whom we are investigating at
Enron and who may have been responsible for some of this mess
before us, and into the substantive committees on the Enron
energy market's effect, as well as the effects on FASB and the
need for changes in accounting principles or rules or
governance in this country.
Today's hearing will give us a chance to look into those
three areas and to get a clear understanding of what happened
at Enron, what perhaps ought to be happening in the governance
of accounting, and what perhaps ought to be happening in terms
of board memberships and the quality and the capacity of board
members to serve in America, and finally, the situation in the
energy markets as a result of the collapse of Enron.
After the hearing or some time in the middle of the
hearing, we will conduct the disposition of the resolution
authorizing subpoenas, and then we will take up our witnesses.
Let me again, as I've done throughout this process, offer
my sincere and deep appreciation to the ranking minority member
of this committee, Mr. Dingell, for his extraordinary
cooperation and for the fact that this investigation is being
conducted in such a truly bipartisan fashion. Our joint
investigators are doing a superb job, not simply for this
committee, but I think for our country, and again I want to
thank the ranking member as I recognize him for his opening
statement.
Mr. Dingell.
[The prepared statement of Hon. W.J. ``Billy'' Tauzin
follows:]
Prepared Statement of W.J. ``Billy'' Tauzin, Chairman, Committee on
Energy and Commerce
Today, we are taking the extraordinary step of holding a full
Energy and Commerce Committee hearing to consider some of the most
important policy issues raised by Enron's collapse. These issues
include corporate governance, accounting and governance of the auditing
profession and the health of our energy markets.
We take this step, because of the profoundly troubling things we've
discovered in our investigation of Enron. Most significantly, we've
learned that:
1. Senior Enron Management engaged in self-dealing transactions.
2. Enron transacted with partnerships controlled by CFO Andrew Fastow,
his associate Michael Kopper and others. And that Enron
appeared to shift the risk of loss on risky investments to the
partnerships, but in fact it remained fully liable for those
investments.
3. Enron went ahead and reported fictitious gains on these transactions
with the LJM and Raptor entities when the hedged investments
declined in value. These gains were illusory; the partnerships
lacked the economic resources to make good on the transactions.
The effect of these sham transactions was to inflate Enron's
publicly reported earnings in 1999, 2000 and 2001
significantly--by more than a billion dollars.
We have found substantial evidence of illegal activity by Enron and
its management. This activity served to deceive the public about
Enron's financial condition. It artificially pumped up Enron's stock
price and allowed these same executives to enrich themselves with sales
of Enron stock.
We have also found that Enron's auditor, Andersen, knew or should
have discovered the fraudulent nature of the Fastow transactions. We
have found that Enron's financial statements violated numerous existing
accounting rules. These statements mislead investors about Enron's
financial condition and overestimated Enron's net income by over $1
billion.
In the end, it turns out that the Enron debacle is an old fashion
example of theft by insiders, and a failure by those responsible for
them to prevent that theft. For example, in one transaction, Fastow and
Kopper informed the investors in LJM2--a partnership at the center of
this theft--that the expected rate of return on the transaction was
2,503%, to be realized in just eight days.
In each of the so-called Raptor transactions, Fastow extracted all
of his equity, along with additional fees in the tens of millions of
dollars, before any transactions that involved any economic risk took
place. In this way, Enron was doing business with an entity whose only
asset was Enron shares that Enron had contributed. This was not a
hedging transaction; Enron was merely issuing shares and calling the
issuance earnings.
This clearly violated existing law and the most basic norms of
corporate behavior.
Enron's board of directors, its Finance Committee and Audit
Committee failed to exercise due care with respect to these
transactions. It simply boggles the mind that the chief financial
officer of a company was allowed to organize partnerships and
simultaneously take the other side of deals with his company. Such an
arrangement should never have happened.
Additionally, we have learned that the SEC conducted no meaningful
review of Enron disclosures from 1997-2001. So before we rush to impose
new laws and regulations in the wake of this scandal, we will want to
be sure that we are actually enforcing existing law.
Today, we are going look at some of the broader implications of
Enron and what it means for the controls and safeguards we have built
into our capital-raising system.
We will hear from experts in corporate governance, accounting,
governance of auditors and an energy firm. We will look at the state of
current law and current practice and to see if reforms are necessary.
In the area of corporate governance, we will examine the proper
role of a board, and the role of outside directors. We will consider
what incentives are necessary to get the outside directors to invest
the time and effort necessary to oversee a company in times of
difficulty. We will compare that effort to the woeful performance of
the Enron board.
In the area of accounting, we will examine existing rules governing
disclosure of these now notorious Special Purpose Vehicles, the so-
called 3% test, and mark-to-market accounting. We will consider whether
FASB, which has been considering changes to the rules governing
accounting for off-balance sheet transactions for the better part of a
decade, should be encouraged to expedite those changes.
We will also consider the changes that need to be made in the area
governance of the accounting profession. We need to restore public
confidence in the important work performed by the accountants. We also
need to be certain that adequate regulation of accounting firms is in
place to encourage them to put investor's interest ahead of getting a
particular deal done.
In the vital area of energy policy, we will consider what effect,
it any, Enron's collapse had on the market for electricity and natural
gas and its effect on consumers. We will also consider the implications
for reliability on an ongoing basis and whether prudent regulatory
changes are called for.
After this hearing of the full Committee, our bipartisan
investigation will continue under Subcommittee Chairman Greenwood.
Importantly, both Subcommittee Chairmen Barton and Stearns will begin a
more detailed review of the policy implications in these areas and work
to ensure that there are no future financial calamities of this type.
I welcome our witnesses, and look forward to their knowledgeable
testimony.
Mr. Dingell. Mr. Chairman, I thank you. I commend you for
this hearing and I join you in the comment you have just made
about the bipartisan character of this inquiry.
I commend you for that and I say that we on this side look
forward to continuing the fine relationship which we have had
in connection with this investigation. It has been a bipartisan
investigation and it is something which has been most welcome
to me and to us over here.
Mr. Chairman, I want to commend you for scheduling this
full committee Hearing on the lessons of Enron. A week ago
today, the Kids Post Page of the Washington Post summed it up
nicely under the banner headline, ``Greedy Liars, the Enron
Scandal'', perhaps showing that while figures don't lie, liars
can figure.
There was a picture of Enron's CEO, Kay Lay, with the
caption, ``Did this Man Get Rich . . . '' and a picture of a
former Enron employee and his wife with the caption, ``. . .
while These People Got Poor?''
Then there was a little box at the bottom on the
accountants with a caption, ``The Watchdog Doesn't Bark.'' In a
nutshell, these comments accurately sum up what happened here.
And I join you, Mr. Chairman, in beginning to discuss it.
Last month, SEC Chairman Harvey Pitt made a profound
declaration: ``There's nothing rotten in the accounting
profession.'' This is just plain hooey. There are many honest
accountants, and there are many fine and honest accounting
firms. I happen to retain one accountant and accounting firm to
deal with my affairs and I find them to be completely honest
and worthy of respect and admiration.
There are, however, systematic problems with the way the
profession is governed and compensated, coupled with corrosive
pressures put on honest auditors to bring in nonaudit business
at almost any price and to satisfy their clients and employers,
by coming up with acceptable answers.
It is almost impossible for many honest people to stand up
and blow the whistle on management. I held hearings on these
matters in the late 1980's and early 1990's. The accountants
said that I was wrong, but now history says they were wrong.
The accountants promised that they would reform themselves.
They did not.
So, Mr. Chairman, we must now do it for them. And in so
doing we must recognize that this action constitutes protection
of our entire economic system which functions on facts, truth
and, most importantly, on the trust of the people.
Today we start the process of looking broadly at regulatory
issues. As I said, Mr. Chairman, I welcome this event and I
commend you for it and I welcome this morning's distinguished
panel witnesses and I look forward to their testimony and
guidance.
I note that amongst others we have before us today a
witness suggested by the minority, Mr. James Chanos, who
recently appeared on the cover of Barron's as ``The Guy Who
Called Enron.'' I ask unanimous consent to include a copy of
that article in the hearing record.
Chairman Tauzin. Without objection, so ordered.
Mr. Dingell. Thank you, Mr. Chairman. Along with a copy of
Bethany McLean's March 5, 2001, Fortune article entitled, ``Is
Enron Overpriced?''
Chairman Tauzin. Without objection, so ordered.
Mr. Dingell. Apparently, there were red flags waving all
over Enron's financial statement, if you wanted to see them.
Was everybody else blind? Why did the accountants not see them
and if so, why?
We also have at the minority's request, Mr. Bevis
Longstreth, who had a distinguished career as an SEC
Commissioner during the Reagan Administration. He recently
served 2 years on the O'Malley Panel on Audit Effectiveness
which reported a number of critical findings and
recommendations in August 2000 for improving the performance of
the profession and its governance system.
All the witnesses are here today because Enron is not
unique. It is huge. Indeed, the biggest bankruptcy in history,
but it is not unique. Similar events may well be out there at
this time, waiting to happen after similar or identical causes
and reasons.
The SEC has been reporting in increasingly record numbers
of financial fraud in cases involving bad accounting. Enron is
only an exclamation point in a long list of accounting frauds
that include Waste Management, Sunbeam--and I note that those
were both matters which were under the trust of, guess who,
Arthur Andersen--Cendant, Rite Aid, Microstrategy, just to name
a few. I supported Arthur Levitt's efforts to rein in the abuse
and I supported FASB's efforts to write tough accounting
standards. Others saw fit to bully the SEC and FASB on behalf
of special interests who were opposed to what the regulators
were trying to do.
I hope today, Mr. Chairman, that we will all stand
shoulder-to-shoulder in our resolve to do the right thing by
the American people and to fix a badly broken system.
Mr. Chairman, this system smells bad enough for either
repair or early burial and I suggest that the continued health
and well-being of our financial system depends upon it.
Mr. Chairman, I thank you for this recognition and we on
this side will support the motion on subpoena authority at the
proper time.
[The prepared statement of Hon. John D. Dingell follows:]
Prepared Statement of Hon. John D. Dingell, a Representative in
Congress from the State of Michigan
Mr. Chairman, I commend you for scheduling this full Committee
hearing on the lessons of Enron. A week ago today the KidsPost page of
the Washington Post I think summed it up nicely under the banner
headline ``Greedy Liars? The Enron Scandal.'' There was a picture of
Enron CEO Ken Lay with the caption ``Did this man get rich . . .'' and
a picture of a former Enron employee and his wife with the caption ``.
. . while these people got poor?'' Then there was a little box at the
bottom on the accountants with the caption ``The Watchdog Doesn't
Bark.'' In a nutshell, that pretty accurately sums up what happened
here, and it's disgusting.
Last month SEC chairman Harvey Pitt declared: ``There is nothing
rotten in the accounting profession.'' This is bunk. There are many
honest accountants--I happen to think that I retain one--and many
honest accounting firms. But there are systemic problems with the way
the profession is governed and compensated. Coupled with the corrosive
pressures put on honest auditors to bring in nonaudit business at
almost any price, it is almost impossible for honest people to stand up
and blow the whistle on management. I held hearings on these issues in
the late '80s and early '90s. The accountants said I was wrong, but we
now know they were wrong. The accountants promised that they would
reform themselves. They did not. We will now do it for them.
Today we start the process of looking broadly at regulatory issues.
I welcome this morning's distinguished panel of witnesses and I look
forward to their testimony and guidance. I note that, among others, we
have before us today a witness suggested by the Minority, Mr. James
Chanos who appeared on the cover of a recent Barron's issue as ``The
Guy Who Called Enron.'' I ask unanimous consent to include a copy of
that article in the hearing record, along with a copy of Bethany
McLean's March 5, 2001, Fortune article, ``Is Enron Overpriced?''
Apparently, there were red flags waving all over Enron's financial
statements if you wanted to see them. Was everybody else blind? And, if
so, why?
We also have, at the Minority's request, Mr. Bevis Longstreth who
had a distinguished career as an SEC commissioner during the Reagan
Administration. He recently served two years on the O'Malley Panel on
Audit Effectiveness which reported a number of critical findings and
recommendations in August 2000 for improving the performance of the
profession and its governance system.
All the witnesses are here today because Enron is not unique. It is
huge but it is not unique. The SEC has been reporting annually
increasingly record numbers of financial fraud cases involving bad
accounting. Enron is the exclamation point in a long list of accounting
frauds that include Waste Management, Sunbeam, Cendant, Rite Aid, and
Microstrategy, to name just a few. I supported Arthur Levitt's efforts
to rein in the abuse, and I supported FASB's efforts to write tough
accounting standards. Others in the Congress, however, saw fit to bully
the SEC and FASB on behalf of special interests who were opposed to
what the regulators were trying to do. I hope today we all stand
shoulder-to-shoulder in our resolve to do the right thing by the
American people and fix this badly broken system. The continued health
and wellbeing of our financial system depends upon it.
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Chairman Tauzin. I thank my friend for his statement. We
obviously have a different view of some of that history, but we
do stand shoulder to shoulder, Mr. Dingell.
The Chair will now interrupt the opening statements for the
business meeting of the committee which is the resolution on
subpoena power.
[Business meeting.]
Chairman Tauzin. The Chair will now ask if there are any
other members who seek recognition first on this side? The
gentleman from Florida, Mr. Bilirakis, is recognized for 5
minutes.
Mr. Bilirakis. Thank you very much, Mr. Chairman. I won't
take anywhere near that much time. I have no prepared
statement. I would just merely like to thank you and
particularly the witnesses for their willingness to come here
today to give us this broad overview of the implosion, if you
will, of Enron and what led up to it. I know we're all
concerned about the lack of confidence and the lack of
credibility which has suddenly taken place in our minds,
particularly regarding the accounting industry and the auditing
industry. Hopefully you gentlemen here today may help us to
back away from that lack of confidence and credibility so that
some of the things that we see happening today not only to
employees, but also in the stock market, will change course.
I appreciate being here, Mr. Chairman, and again, thank you
very much.
Chairman Tauzin. The gentleman yields back his time. Under
our rules, our members will be recognized for 3 minutes under
our rules. The Chair asks if there are any members on this side
seeking recognition. The gentleman from California, the
gentleman, Mr. Boucher, is recognized for 3 minutes.
Mr. Boucher. Thank you very much, Mr. Chairman. I want to
commend you and Ranking Member Dingell for the very thoughtful
way in which you have handled our committee's investigation
into the Enron collapse. It is a seismic event. It resulted
from a total system failure. The safeguards upon which we have
traditionally relied were inadequate to prevent this collapse
and to warn that it was coming. Enron's accountants did not
detect and require reporting of more than $1 billion of
inflated earnings over a 15-month period as recently revealed
in the report prepared by the Dean of the University of Texas
Law School. Banks extended credit without determining the
corporation's true, financial condition. Stock analysts who
should have achieved a deeper understanding of the company's
off the balance sheet liabilities continued to recommend the
stock.
Chairman Tauzin. Excuse me, Mr. Boucher. The Chair will ask
for the cooperation of all the members and guests present. This
room is cavernous and even small whispers and talk is
exaggerated here. Let's give the speakers the courtesy of
listening to them, please.
Mr. Boucher is recognized to complete his statement.
Mr. Boucher. Thank you, Mr. Chairman. Stock analysts who
should have achieved a deeper understanding of the company's
off the balance sheet liabilities continued to recommend the
stock as recently as a few months ago. The ERISA law did not
prevent Enron employees from losing their retirement funds and
even allowed a freeze on their ability to sell Enron shares in
their 401(k) accounts while the shares lost value throughout
the fall and became almost worthless. The corporation's
directors failed in their duties as representatives of the
stockholders. They apparently took no actions. They were either
unaware of the corporation's precarious financial condition or
complicit in permitting that condition to continue. Either way,
they failed in their duties. And some company executives who
had front line responsibility for the financial success of the
company were making huge profits from the businesses they were
doing themselves with the company, as the self-serving
arrangements they created sent Enron on a path to corporate
collapse.
This committee's careful investigative work has contributed
greatly to the public understanding of what went wrong and I
again commend Chairman Tauzin for his stewardship of that work.
Many of the events contributing to the failures at Enron are
within the purview of this committee's legislative
jurisdiction. Today, we will hear from knowledgeable witnesses
who will speak to many of these matters from corporate
governance to the use of derivative financial instruments to
accounting practices. As we assess the steps that need to be
taken to assure that other companies do not suffer the same
fate as Enron.
I look forward to the examination of those issues and to
the recommendations of these witnesses and others from whom our
full committee and various cubcommittees will hear concerning
appropriate steps for this committee to take.
Thank you, Mr. Chairman.
Chairman Tauzin. I thank the gentleman. Further requests
for opening statements on this side? The gentleman, Mr. Brown
from Ohio is recognized with 3 minutes for an opening
statement.
Mr. Brown. Thank you, Mr. Chairman, for calling this
hearing and for your dogged investigation of this scandal. We
all know that Enron was the seventh largest corporation in
America. We all know that it was the largest energy trading
company in the world. We all know that the company was a Wall
Street powerhouse and the darling of the Bush Administration.
Now we know that Enron is a company predicated on little more
than greed and deceit. It was no more than a pyramid scheme, a
company that vastly overstated profits and concealed
liabilities while using political and financial clout to free
themselves from accountability, to rig the energy markets in
their favor, then use their position to ravage consumers,
investors and employees. Some have called this crony
capitalism, others Enron conservatism.
Its fall has had a devastating impact on its employees and
its retirees, as we know. The Public Pension Fund in my home
State of Ohio lost $62 million in Enron investments. Florida's
Public Pension Fund managed by that State's very own Bush
Administration lost $300 million. One of the Nation's most
esteemed accounting firms, Arthur Andersen, has also been
implicated in this scandal.
We'd be remiss to avoid discussion of Enron's relationship
with the Bush White House and how that may have influenced the
Federal response to the company's decline. Before his company's
spectacular flameout, Ken Lay, the former Chair and CEO of
Enron, was a close friend of President Bush's, such a close
friend that he was referred to as Kenny Boy. Kenny Boy had
unfettered access to the White House and enormous influence
within the administration. He contacted Curt Hebert, the
Chairman of the Federal Energy Regulatory Commission and told
him that if he wanted to keep his job, he would do well to
bring his thinking into line with Enron's. Mr. Hebert declined.
He's no longer FERC's Chairman.
When Vice President Cheney wrote the administration's
energy plan, he met with Enron officials six separate times.
He's declined to release information about that.
While none of us is eager to see a return to the witch hunt
mentality that surrounded the White Water investigation, we
should carefully examine the closeness of the relationship
between the White House and Enron and the impact it's had on
that company's demise. The President's friends at Fox News and
elsewhere have assured the American people that because the
President did not rush to save Enron from failure, that the
President did nothing wrong.
But it isn't the administration's lack of action during
Enron's death throes that concern me most. What concerns me is
what this administration and its allies on Capitol Hill did
before Enron's collapse to create a permissive culture, a
permissive culture for large corporations in America and to
encourage rapacious behavior at companies like Enron. The Bush
White House last year called off a Clinton Administration
initiative to stop money laundering through offshore banks. The
manipulation of our tax laws through offshore bank accounts and
partnerships reduced Enron's 5-year tax liability to
substantially less than zero. In four of the last 5 years Enron
paid no taxes at all.
Ironically, on the very same day that we are here
investigating the spectacular collapse of Enron, we're being
asked to confirm on the House floor right this minute the
appropriateness of last year's Bush tax cut plan. Enron and Ken
Lay were one of the plan's greatest proponents. Instead of
wasting time affirming a plan that gives billions in tax breaks
to corporate giants like Enron, $256 million in the tax plan, a
plan that has, in essence, spent the Nation's surplus, we
should instead, Mr. Chairman, be worrying--we should worry
about preventing the collapse of the next Enron.
I'm hoping that his hearing will be a first step toward
that goal.
I thank the chairman.
[The prepared statement of Hon. Sherrod Brown follows:]
Prepared Statement of Hon. Sherrod Brown, a Representative in Congress
from the State of Ohio
Good afternoon. Chairman Tauzin, thank you for calling this hearing
into Enron's collapse, and for your dogged investigation of this
scandal.
Less than a year ago, Enron was the seventh largest corporation in
America and the largest energy trading company in the world. The
company was a Wall Street powerhouse and a darling of the Bush
Administration.
Then a couple of months ago, Enron abruptly declared bankruptcy and
was exposed as a company predicated on little more than greed and
deceit.
Enron was no more than a pyramid scheme--a company that vastly
overstated profits and concealed liabilities--while using political and
financial clout to free themselves from accountability, rig the energy
markets in their favor, and then use their position to ravage consumers
investors, and employees. This style has been called ``Enron
conservatism''
Enron's fall has had a devastating impact on its employees and
retirees, on its shareholders and customers, and on the confidence many
Americans have in private equity markets and their government.
Average workers and investors were cheated out of their life
savings--while a small group of executives and insiders made off with
over a billion dollars from well-timed stock sales.
The public pension fund in my home state of Ohio lost $62 million
on Enron investments--and Florida's public pension fund--managed by
that state's very own Bush Administration, lost $306 million.
One of the nation's most esteemed accounting firms, Arthur
Andersen, has also been implicated in this scandal--accused of helping
to conceal its client's deceit.
Despite internal misgivings about Enron's methods of financial
reporting, Andersen continued to certify the company's required
financial disclosures as ``full and accurate.''
At a time when over 60 percent of Americans own stock, concerns
about the lack of transparency in financial disclosures--and a lack of
independence among auditors--has damaged the confidence of the
investing public.
The Powers Report, released earlier this week, makes clear that the
series of complex transactions that brought Enron down were not well-
intentioned deals that went bad. They were deliberate gimmicks created
to conceal losses and to deceive investors.
This committee has a responsibility to the American people to
conduct a comprehensive investigation into the malfeasance of Enron's
executives, its auditors, and its board of directors.
And to better protect the thousands of employees and investors who
have suffered from Enron's untimely and unnatural demise, this
committee must also ask if the relevant federal agencies did everything
they could have to protect the public.
I am confident that we will discharge these responsibilities.
We would be remiss, however, to avoid discussion of how Enron's
relationship with the Bush White House may have influenced the federal
response to the company's decline.
Before his company's spectacular flame-out, Ken Lay, the former
Chairman and CEO of Enron was such a close friend of President Bush's
that the President referred to him as ``Kenny-boy.''
Kenny-boy had unfettered access to the White House and enormous
influence within the Administration, and he wielded this influence
freely.
At one point last year, Mr. Lay contacted Curt Hebert, the Chairman
of the Federal Energy Regulatory Commission--the agency that regulated
much of Enron's business--and told him that if he wanted to keep his
job he would do well to bring his thinking into line with Enron's.
Mr. Hebert declined to do so, and is no longer FERC's chairman.
When Vice-President Cheney ``wrote'' the Administration's energy
policy, he met with Enron officials six times. Not surprisingly, the
plan favored the same energy goals that Enron did.
Since May, the Vice President has refused to turnover the records
of his meetings with Enron on the grounds that Congress and the GAO
have no right to this information.
Vice President Cheney has also said that any similarities between
Enron's recommendations and the Administration's Energy Plan are just a
matter of (right-mindedness) like-mindedness.
In December, columnist Molly Ivins wrote that if Bill Clinton were
still in the White House--and he were as close to Ken Lay as this
President is--``we'd have four congressional investigations, three
special prosecutors, two impeachment inquiries and a partridge in a
pear tree by now.''
While none of us is eager to see a return to the witch hunt
mentality that surrounded the Whitewater investigation, we should
carefully examine the closeness of the relationship between this White
House and Enron, and the impact it had on that company's demise.
The President's friends at Fox News and elsewhere have assured the
American people that because the President did not rush to save Enron
from failure that he couldn't have done anything wrong.
Treasury Secretary Paul O'Neill and Commerce Secretary Don Evans
have said they were aware of Enron's difficulties before the company
went bankrupt--and have celebrated their decisions to do nothing on the
company's behalf.
Secretary O'Neill even went so far as to say this incident was
emblematic of ``the genius of capitalism.''
Tell that to Enron's former employees.
It isn't the Administration's lack of action during Enron's death
throes that concern me most.
What concerns me most is what this Administration and its allies on
Capitol Hill did before Enron's collapse to create a permissive culture
for large corporations in America, and to encourage rapacious behavior
at companies like Enron.
Last year, the Bush White House called off a Clinton Administration
initiative to stop money-laundering through offshore banks.
The manipulation of our tax laws through offshore bank accounts and
partnerships reduced Enron's five-year tax liability to substantially
less than zero, and in four of the last five years--Enron paid no taxes
at all.
These same activities ultimately led to Enron's implosion, but they
went unreported by the company's independent auditors--and the
initiative to prevent this behavior was deemed unnecessary by President
Bush.
Ironically--on the very same day that we are here investigating the
spectacular collapse of Enron we are also being asked to confirm the
appropriateness of last year's Bush tax cut plan. Enron was one of the
plan's greatest proponents.
Instead of wasting time affirming a plan that gives billions in tax
breaks to corporate giants like Enron--a plan that has helped to
eliminate the nation's surplus--we should worry about preventing the
collapse of the next Enron.
I am hopeful that this hearing will be the first step toward that
goal.
Chairman Tauzin. I thank the gentleman. The gentleman's
time has expired. The Chair would ask if there are other
members present who want to make a statement. The Chair does
not see any member present and the Chair will announce that the
committee will suspend until Mr. Greenwood is in the Chair.
It's my understanding, Mr. Brown, that we have about 4
minutes to make this vote, if you have not made it yet.
So I will patiently wait and see that Mr. Greenwood arrives
and then I will make the vote.
Mr. Greenwood [presiding]. The Chair recognizes himself for
90 minutes for the purpose of an opening statement.
The captains of American industry in the early 20th century
were not without serious flaws and yet they also left us a
remarkable legacy of new ideas, new technologies and in many
cases enduring enterprises. Simply taking a roll call of some
of the more illustrious and in some cases notorious of these
industrialists bears witness to this truth. Henry Ford, John D.
Rockefeller, Andrew Carnegie, John and Horace Dodge, George
Westinghouse, Henry Firestone, Thomas Edison, George Eastman
and Henry Heinz. What they built, they built to last. But in
many ways, they were also rapacious and grasping men whose
monopolistic tendencies trampled on the legitimate rights of
smaller businesses, threatening free enterprise and the birth
of new technologies.
The first Republican President of the 20th century,
Theodore Roosevelt, rightly called them malefactors of great
wealth. But for all their faults, it was the wealth they
themselves had created. It is not clear that even this much can
be said of the authors of the Enron debacle. If they were
malefactors of wealth, it appears it was largely the wealth of
many unsuspecting others and in this reckless enterprise they
were enabled and empowered, if not openly encouraged, by the
accountants who were supposed to serve as watchdogs, sadly, at
the time investors failed to notice these watchdogs' peculiar
behavior. They did not bark.
Perhaps our witnesses today are familiar with the demand
that Cuba Gooding, Jr.'s character makes in the movie, Jerry
MaGuire, ``show me the money.'' Surely this is the question
Enron's shareholders are asking from the pension fund in my own
Commonwealth of Pennsylvania, to the President's mother-in-law,
nearly all those who had invested in this darling of Wall
Street, got hurt.
Winston Churchill once observed that some people regard
private enterprise as if it were a predatory tiger to be shot.
Others look upon it as a cow that they can milk. Only a handful
sees it for what it really is, the strong horse that pulls the
whole cart. How surprised he would have been to discover that
the system of free enterprise for honest profit which lies at
the core of our Republic's greatness and success was assaulted
not by its enemies, but by those who profess the greatest
allegiance to it. This was perhaps their greatest betrayal.
For the triumph of free markets and the wealth they create,
depend on the confidence of the investor, more and more of whom
are average Americans. In 1960, only 18 percent of American
households had any investments in the stock market. By 1999,
that number was nearly 50 percent. And here we get to the heart
of the matter, for all their vaunted talk of aggressive
accounting, an oxymoron that would be amusing if it had not led
to such terrible consequences. Their failure is about so much
more than money lost or money gained. These were men who in the
single minded pursuit of personal wealth apparently jettisoned
any shred of personal morals or business ethics and replaced
them with the morals of a dealer in a game of Three Card Monte.
The antidote to this behavior is not difficult to find. In 1913
in a thoughtful essay on the lessons of history and free
enterprise, former President Theodore Roosevelt wrote this,
``First and foremost, we must stand firmly on a basis of good,
sound ethics. We intend to do what is right for the ample and
sufficient reason that it is right.'' He then continued with
these prophetic words. ``If business is hurt by the stern
exposure of crookedness and the result of efforts to punish the
crooked man, then business must be hurt, even though good men
are involved in the hurting.'' In this matter, too, the
reputations of many who sought to do their best will be
swallowed up in the bad dealings of the few. Sadly, this too is
part of the unfolding Enron tragedy.
The Chair recognizes the gentlelady from California, Ms.
Eshoo.
[The prepared statement of Hon. James Greenwood follows:]
Prepared Statement of Hon. James Greenwood, Chairman, Subcommittee on
Oversight and Investigations
The captains of American industry in the early 20th century were
not without serious flaws. And yet they also left us a remarkable
legacy of new ideas, new technologies and in many cases enduring
enterprises. Simply taking a roll call of some of the more illustrious,
and in some cases, notorious, of these industrialists bears witness to
this truth.
Henry Ford, John D. Rockefeller, Andrew Carnegie, John and Horace
Dodge, George Westinghouse, Henry Firestone, Thomas Edison, George
Eastman, and Henry Heinz . . . what they built, they built to last.
But, in many ways, they were also rapacious and grasping men, who's
monopolistic tendencies trampled on the legitimate rights of smaller
businesses, threatening free enterprise and the birth of new
technologies.
The first Republican president of the 20th century, Theodore
Roosevelt, rightly called them malefactors of great weatlh. But for all
their faults, it was the wealth they themselves had created.
It is not clear that even this much can be said of the authors of
the Enron debacle. If they were malefactors of wealth, it appears it
was largely the wealth of many unsuspecting others.
And in this reckless enterprise they were enabled and empowered, if
not openly encouraged, by the accountants who were there to serve as
watchdogs. Sadly, at the time, investors failed notice their peculiar
behavior--they did not bark.
Perhaps our witnesses today are familiar with the demand that Cuba
Gooding Jr's character makes in the movie Jerry McGuire. ``Show Me the
Money''?
Surely this is the question Enron's shareholders are asking. From
the pension fund in my own Commonwealth of Pennsylvania to the
President's mother-in-law, nearly all those who had invested in this
``darling of Wall Street'' got hurt.
Winston Churchill once observed that, some people regard, ``private
enterprise as if it were a predatory tiger to be shot. Others look upon
it as a cow that they can milk. Only a handful sees it for what it
really is--the strong horse that pulls the whole cart.''
How surprised he would have been to discover that the system of
free enterprise for honest profit--which lies at the core of the
Republic's greatness and success--was assaulted not by its enemies, but
by those who professed the greatest allegience to it.
This was their greatest betrayal.
For the triumph of free markets and the wealth they create, depend
on the confidence of the investor . . . more and more of whom are
average Americans. in 1960, for example only 18% of American households
had any investment in the stock market. By 1999, that number was nearly
50%.
And here we get to the heart of the matter. For all their vaunted
talk of aggressive accounting, an oximoron that would be amusing if it
had not led to such terrible consequences, their failure is about so
much more than money lost or money gained.
These were men who, in the singleminded pursuit of personal wealth,
aparently jettisoned any shred of personal morals or business ethics.
And replaced them with the morals of the dealer in a game of three-
card monte.
The antitote to this behavior is not difficult to find. In 1913, in
a thoughtful essay on the lessons of history and free enterprise,
former President Theodore Roosevelt wrote this: ``First and foremost,
we must stand firmly on a basis of good sound ethics. We intend to do
what is right for the ample and sufficient reason that it is right.''
He then continued with these prophetic words ``If business is hurt
by the stern exposure of crookedness and the result of efforts to
punish the crooked man, then business must be hurt, even though good
men are involved in the hurting . . .''. In this matter too, the
reputations of many who sought to do their best, will be swallowed up
in the bad dealings of the few.
Sadly, this too is part of the unfolding Enron tragedy.
Ms. Eshoo. Thank you, Mr. Chairman. I appreciate the
thoughtful comments that you have made since this issue has
imploded and I have confidence that what you will do as Chair
of the Oversight and Investigations Subcommittee is going to
cast more light and help the Congress come to grips with what
needs to be done relative to Enron, the abuses that are now
known, and the areas where we need to make reforms.
As a member of California's Congressional Delegation, I
have a very special interest in this issue of Enron and what
went wrong, as do my constituents and as do all Californians.
As early as November of 2000, the Federal Energy Regulatory
Commission, FERC, declared that consumers in California had
been and were paying ``unjust and unreasonable rates'' yet
nothing substantive was done about it. Some estimate that the
gouging amounted to hundreds of millions of dollars, perhaps a
billion. The California's ISO says it was in the ballpark of $9
billion.
When the 107th Congress convened in January of 2001, a year
ago, I introduced bipartisan legislation that allowed the
Secretary of Energy to control price gouging. In the following
months, I called for hearings. I called on the Attorney General
to investigate. I introduced legislation that would have
imposed cost of service based pricing. I introduced bipartisan
legislation to provide refunds to consumers. Enron and the rest
of the industry in opposition said that these calls should go
unheeded. And the process then became politicized.
So in this hearing and in other hearings, we're not only
going to examine what went wrong inside, what did Enron do
wrong inside and anyone, the professions included, that were
associated with them, but also I think a worthy area of
exploration is what they did wrong to others.
I believe that if the Congress had heeded the call of many
of us on this very committee, on this issue, that we could have
cast light on some of the wrongdoing of Enron at the time.
Californians paid. Other people's pockets were lined.
Californians paid as did shareholders and Enron's employees. So
this is tragic not only in the fall of supposedly the seventh
largest corporation in the country, but what they imposed in
terms of policy, in terms of their lobbying, in terms of public
policy and what was left unheeded, including the calls that
some of us made right here in this Energy and Commerce
Committee.
So I look forward to being part of the solution. We know we
have to have campaign finance reform. We know that we need to
have reforms relative to the accounting industry. We know that
we have to have reforms relative to the Securities and Exchange
Commission, but I also think that it is worthwhile, very
worthwhile in terms of my constituents and Californians to
place on the record today that some of us were on to this a
long time ago. It went unheeded. It's high time that the
Congress come to grips with it.
Thank you, Mr. Chairman. And I yield back any balance of my
time.
[The prepared statement of Hon. Anna Eshoo follows:]
Prepared Statement of Hon. Anna G. Eshoo, a Representative in Congress
from the State of California
Thank you, Mr. Chairman.
As a member of California's Congressional delegation, I have a
special interest in these hearings. Enron and other energy marketers,
generators and gas suppliers gouged the people of California and my
district for more than a year.
According to Administrative Law Judge Curtis Wagner, consumers in
California were gouged by ``hundreds of millions of dollars, probably
more than a billion in aggregate sum'' (Report and Recommendation of
Chief Judge and Certification of Record, Federal Energy Regulatory
Commission, July 12, 2001). I think this is a rather conservative
estimate. According to the California Independent System Operator, the
sum was closer to $9 billion. One day my constituents may recover a
portion of these overcharges, but I have my doubts and Enron's collapse
certainly does not help this effort.
The fact is that Enron and its business go to the heart of the
gouging and its collapse.
What was Enron's business? While all Americans know that Ford and
GM make cars, I doubt many people could explain what Enron, seventh on
the Fortune 500, actually did. Enron was an energy company that really
didn't produce or distribute energy. Instead, it acted as a middleman,
making deals between producers and users. These were paper transactions
that added no value to the product it sold. It was corporate alchemy;
it was like producing gold from straw. Maybe this explains why other
participants in the electricity market didn't suffer after Enron
collapsed and why the industry doesn't seem to miss the company today.
Perhaps Enron's mysterious business explains why some call Enron's
glass-walled headquarters in Houston ``the Black Box''--a more apt name
might be Oz. By stretching and breaking complex accounting rules, Enron
wove a mystical shroud. The mystery of what lay behind that curtain
made Enron even more appealing to investors, as did its majestic
profits.
Many Congressional committees, including this one, have focused on
Enron's corporate structure and governance and acts of malfeasance that
allowed Enron to convert debt for profit whenever it wished. However,
it seems that nobody is asking questions about the transactions between
Enron and its clients. It seems to me that the same creative minds that
created Chewco, one of Enron's corporate shells, might also have one or
two tricks to raise artificially the price of electricity in the West.
I hope this Committee and other investigators will be looking at these
activities and transactions.
Last March I called upon Attorney General Ashcroft to look into the
pricing practices of Enron and other energy companies operating in the
West. At that time, massive amounts of electricity were being withheld
from the market, and wholesale energy costs rose by as much as 1,000%.
Yet to my knowledge, the Department of Justice did not investigate. As
the DOJ and Committees conduct a postmortem of Enron, the company's
day-to-day business operations must be examined. I've called on just
written to Deputy Attorney General Larry D. Thompson (who has taken
over the oversight of the Enron investigation following Attorney
General Ashcroft's recusal) to explore fully this line of inquiry.
But accounting is only part of the Enron story. While Enron
exploited the complexity of accounting rules to manufacture profits, it
also tried to exploit its political connections to create a business
environment--an environment without rules--in which it could thrive. To
do this, Enron greased the wheels with millions in campaign
contributions to both parties. That bought access and arguably more.
In interviews for the television program Frontline last year,
former Enron CEO Kenneth Lay acknowledged that he provided the
Administration with a list of Enron-favored nominees for the Federal
Energy Regulatory Commission (FERC). He also acknowledged that he and
Enron executives interviewed potential nominees to judge their
suitability.
This was Ken Lay's casting couch, and a candidate's suitability was
judged by how likely he or she was to agree with Enron's view of how
the energy market should operate. Several news reports indicate that
Mr. Lay's top choices for FERC were accepted by the Administration.
These reports are extremely disturbing.
Citing potential bias, this Administration broke with a half-
century tradition begun by President Eisenhower when it decided to
refuse independent advice from the American Bar Association about the
professional qualifications of potential nominees to the federal bench.
But, the Administration seemed more than willing to accept the same
kind of advice from Enron in the selection of the regulators who are
charged with overseeing the company.
Mr. Lay was not only lobbying the White House. He attempted to
influence FERC directly. Mr. Lay himself called then-FERC Chairman
Curtis Hebert to discuss issues of policy and to talk about whether the
President would retain Mr. Hebert as the Chairman of the Commission.
Mr. Hbert described these conversations as unusual, noting that he
never had similar conversations with other industry chief executives.
In the end, Mr. Hbert resigned from FERC after Vice President Cheney
told reporters that Patrick Wood would replace him as Chairman.
In an interview for Frontline in 2001, Mr. Hebert was told, ``Our
sources tell us that he [Mr. Lay] offered to talk to the President on
your behalf if you would go along with what he wanted [open access to
wholesale and retail markets].'' Mr. Hebert responded, ``I don't think
there's any doubt he would be a much stronger supporter of mine if I--
were willing to do what he wanted.''
Perhaps this heavy lobbying didn't amount to anything, but I think
we're beyond accepting ``trust me'' as an answer when it comes to
matters involving Enron. The Administration must be more forthcoming
about its dealings with Mr. Lay and his company.
Mr. Chairman, the collapse of Enron is a tragedy for the company's
employees and an embarrassment for the energy and accounting
industries. It's obvious that Congress must legislate a number of
reforms. Chief among these are campaign finance reform, pension reform,
and accounting reform.
What we should not do is enact legislation that fundamentally
restructures the electricity market until we have all the answers about
Enron. California made a huge mistake in hastily adopting a
restructuring bill in 1996. We should not make a similar mistake in
Congress.
Mr. Chairman, thank you, for holding this Committee hearing on
Enron. I hope that along with today's examinations that you call a
Committee hearing on the role of Enron in electricity pricing and
practices.
Mr. Greenwood. The Chair thanks the gentlelady and
recognizes the gentleman from Florida, Mr. Stearns for 3
minutes for an opening statement.
Mr. Stearns. Thank you, Mr. Chairman, and let me just say
that--commend you and the staff for all the hard work you're
doing on the Oversight Committee on which I serve. I ask by
unanimous consent that my complete opening statement be part of
the record.
Mr. Greenwood. Without objection, the gentleman's statement
will be entered into the record.
Mr. Stearns. And also, Mr. Chairman, as chairman of my
Subcommittee on Commerce, Trade, and Consumer Protection, I
wrote to the Financial Accounting Standards Board shortly after
this fiasco, this debacle and I asked in that letter that they
answer some questions and they wrote back to me on December 18,
2001 and I ask unanimous consent that the reply by the
Financial Accounting Standards Board President be made part of
the record.
Mr. Greenwood. Without objection, that document will be
entered into the record.
Mr. Stearns. Mr. Chairman, what we have seen so far is that
Enron's collapse was a result of a complete failure and
meltdown of fundamental responsibilities and oversight and
thereby allowing what appears to be unscrupulous Enron
executives, the opportunity to reap fortunes on questionable
transactions, ultimately draining the retirement security of
thousands of employees and investors. Professor Dharan of Rice
University appearing before us today, directly states that
``Enron's collapse may be the biggest case of security fraud.''
I believe he may be the first witness before the committee to
unequivocally state what many have been surmising over the past
few months, especially with more Enron executives invoking the
fifth amendment. So perhaps we're just scratching the surface
here, the complexity is very astounding. We've heard the term
aggressive accounting. Accounting isn't just math. It also
means making judgment calls about what the rules allow.
Aggressive accounting isn't illegal, but it should be when it
tells investors that red is black and so we hear the term
aggressive accounting or cutting edge accounting to justify
Enron's pursuit of these partnerships and Arthur Andersen has
also used those terms. But I think we need to get beyond the
rhetoric here and get to what standards are adequate. Is the
private sector handling enforcement of these standards
properly? Are these standards in line with economic innovation
or is the accounting industry lagging behind with new rules?
In regards to Enron's practices, Paul Brown, Chairman of
the Accounting Department of New York University, has been
quoted as saying, ``It's the old adage of a FASB rule, it takes
4 years to write it, and it takes 4 minutes for an astute
investment banker to get around it.'' And that is not right. So
Mr. Chairman, I look forward to the hearing and again, I
compliment the staff for their developing this hearing and
others. I yield back.
Chairman Tauzin. I thank the gentleman. Is there anyone
from this side? The gentleman from California, Mr. Waxman is
recognized for 3 minutes.
Mr. Waxman. Mr. Chairman, thank you for holding this
hearing and for your efforts to get to the bottom of the Enron
scandal. Our committee has a proud history of oversight and the
investigation you and Representative Dingell are leading is in
keeping with that tradition. A small group of executives have
robbed thousands of American families of their financial
security and we are holding these hearings to find out who did
it and how they did it. But I don't think we can just look at
Enron and Arthur Andersen and stop there. We also have to look
at ourselves. When I've said that before, others have accused
me of playing a partisan blame game that would divert attention
from other issues. I couldn't disagree more.
To prevent future Enrons we have to understand how Ken Lay
and other executives operated in the political system. We need
to know how they acquired political influence and how they
asserted the power they accumulated.
We must, of course, scrutinize Enron and Arthur Andersen.
We have to scrutinize the regulators and we should scrutinize
how Enron and Arthur Andersen exploited the political system.
And even though I believe we must look at both parties, some of
my Republican colleagues have told me that I'm being partisan.
Now that we have a Republican President and a Republican House,
I'm told that it's wrong to raise these issues and in doing so
will only feed public cynicism. I don't buy that. We can't sit
here sanctimoniously and browbeat Enron and Arthur Andersen
executives and question every decision they made if we're not
willing to give the same scrutiny to ourselves, to the Clinton
Administration and to the Bush Administration. And if we don't
examine how the political system broken down, the public will
see through us and that, in truth, will only deepen cynicism.
Washington created the regulatory environment that allowed
Enron executives to steal from thousands of families and Arthur
Andersen auditors looked the other way and we in the Congress
need to examine how that happened.
The Enron scandal is a searing indictment of a business
culture that values stock prices over honesty and integrity and
it elevates fictional performance over actual productivity. The
Enron scandal is also an indictment of an accounting profession
that has lost its way in values, profits and new business
opportunities over honoring the public trust, and the Enron
scandal is an indictment of a political system that allowed
this calamity to happen.
Arthur Levitt's sensible accounting reform proposals didn't
die an accidental death. They were a victim of the political
system and it was that same system that allowed derivatives to
go unregulated.
Last year, Enron was the most politically powerful company
in Washington. Even as its foundation was rotting away, it was
able to influence energy policy in a number of areas. It's
leader, Ken Lay was able to screen potential FERC Commissioners
and lead a successful House effort to retroactively repeal the
corporate minimum tax which would have brought Enron $254
million. We owe it to all the victims and their children to
hold Enron accountable. We owe it to them to hold Arthur
Andersen responsible, and we owe it to them to hold ourselves
accountable as well.
Chairman Tauzin. The Chair thanks the gentleman. Further
requests for statements on this side? The gentleman, Mr. Ganske
from Iowa, is recognized for 3 minutes.
Mr. Ganske. Thank you, Mr. Chairman. I'll be brief. Mr.
Chairman, I am a Star Wars fan, a story about the triumph of
good over evil. So I think it was sort of hypocritical when
Enron subsidiaries had names out of Star Wars like Jedi and
Chewco. Well, Mr. Chairman, today Mr. Ken Lay is looking like
Darth Vader and Enron like the Death Star to investors and all
those company employees who have had their pensions evaporated.
The auditor should have been the real Jedi, policing evil
doings. Instead, it appears like they were the bounty hunter,
Boba Fett, doing the bidding of the evil empire.
Mr. Chairman, let us use our light sabers to cut to the
quick of this galactic scandal. May we have the wisdom of Yoda
to fix whatever accounting and pension laws needs strengthening
in order to protect the innocent, punish the greedy and prevent
clone wars in other companies like we've seen in Enron. I yield
back, Mr. Chairman.
Chairman Tauzin. May the force be with you.
I thank the gentleman for his statement. Further requests
on this side? The gentleman, Mr. Green from Texas, is
recognized for 3 minutes.
Mr. Green. Thank you, Mr. Chairman, and I appreciate you
calling not only this hearing today, but the efforts of the
full committee and the subcommittee to explore the
circumstances surrounding the collapse of Enron.
As the only member of the Commerce Committee from Houston,
I'm angered by the continuing disclosures of financial
wrongdoing by the company. Enron was the largest company in
Houston, employing over 20,000 Houstonians and helped make our
city the energy capital of the world. Enron's position in our
community and around the world has been permanently and
probably irreparably damaged by the shenanigans of a few. Enron
is now the buzz word for financial funny business. Enron's Ken
Lay, Jeff Skilling and Andrew Fastow are all household names
known for this financial funny business. They used Enron like a
giant Monopoly game to enrich both themselves and their friends
at the expense of their shareholders and employees and they
were not able to accomplish this historic meltdown alone. They
had the help from Arthur Andersen, the New York banking
community, even their own legal counsel. Together, these
entities were either blinded by the green of Enron's billions
or just simply incompetent and allowed Enron to fool everyone.
So what have we learned about this tragedy? We need
stronger accounting standards, better corporate financial
disclosure and more Federal oversight by the Securities and
Exchange Commission. Congress needs to take a hard look at
forcing companies to file bankruptcy in the community or the
State at least where their corporate headquarters reside. Enron
made a corporate decision to file bankruptcy in New York which
is a great deal, a long way away from small creditors and
former employees to be able to address the bankruptcy. Enron
was allowed to walk through loopholes in the law and conduct
their illegal business practices. They used business practices
which should be rarely used and created hundreds of off-the-
book partnerships which enriched a few at the expense of the
many. These holes need to be patched. Apart from these changes,
I do want to take a minute and highlight what I believe has
been one of the positive actions resulting from the collapse,
probably the only positive action. Houston's remaining energy
trading companies were able to weather the storm and I want my
colleagues to understand that Enron is a unique case and not
the model for the energy community.
Enron's entire trading business was efficiently absorbed by
competitors without any interruption of service to their
consumers. In addition, the demise of Enron has created more
competition in the sector which will benefit consumers with
lower energy prices.
Mr. Chairman, I want to thank you again for your hard work
on the issue and I'm looking forward to continuing this process
in the future. The people of Houston, the stockholders and the
current and former employees deserve a clear answer to what
happened here and to see that those responsible are held
accountable and that we pass legislation to prevent these type
of scams in the future and thank you again. I yield back my
time.
[The prepared statement of Hon. Gene Green follows:]
Prepared Statement of Hon. Gene Green, a Representative in Congress
from the State of Texas
Mr. Chairman: I want to commend you for calling this important
hearing today, and I again appreciate the opportunity to participate
with the Subcommittee.
I believe today will be our first real chance to receive firsthand
information about what truly went on at Enron.
Let me begin by saying that I am pleased Mr. Skilling has decided
to come forward and give the American people some insight into the
inner workings of Enron and Enron's off-book partnerships.
I am truly disappointed that the rest of Enron's ``Masters of the
Universe'' crowd failed to come forward and instead chose to exercise
behind the Fifth Amendment.
While no American can be forced to testify against his or her will,
I believe failing to provide answers to the Subcommittee is an
indication that the witnesses are trying to hide and obscure their
roles in this debacle.
The Powers Report that this Subcommittee received over the weekend
outlined a pattern of malfeasance that spread from the Board of
Directors, through the upper management and finally to the auditors and
outside legal counsel.
The Board of Directors, Arthur Andersen, and Vinson & Elkins
provided the enabling ability to Ken Lay, Jeffrey Skilling, and Andrew
Fastow to manipulate the financial records of this once great company.
Along the way, each of these individuals began to see themselves as
a new Rockefeller or J.P Morgan of the 21st century.
In reality, the upper management of Enron turned out to be only
pretenders.
Their accomplishments were based on smoke and mirrors and their
accomplishments did not rival those of our country's greatest
industrialists.
However, their accomplishments do bare a striking similarity to a
group of infamous financiers.
Ken Lay, Jeffrey Skilling and Andrew Fastow are now in the same
league as Ivan Boesky, Michael Milken, and the true inventor of the
complicated Rube Goldberg.
Mr. Chairman, I look forward to hearing from this witness panel,
and I again want to thank you for allowing me to participate here
today.
Chairman Tauzin. I thank my friend. The Chair asks if any
members on this side--the gentleman, Mr. Shimkus, is recognized
for 3 minutes.
Mr. Shimkus. Thank you, Mr. Chairman, and I'll be brief.
Along with my good friend, Gene Green from Texas, I room with
Kevin Brady who's also really been involved with this for his
constituents and he's fighting a good fight and I appreciate
the lessons he's told me, about his neighbors and the problems
that they've fallen into.
As you said in your opening statement, this is old
fashioned theft by insiders. We need to make sure we have
things in place to protect our folks. That's why the subpoena
power is so important and I'm glad we did that as a first order
of business. I ask unanimous consent that my additional
comments be submitted in the record and I look forward to the
hearing and I yield back my time.
[The prepared statement of Hon. John Shimkus follows:]
Prepared Statement of Hon. John Shimkus, a Representative in Congress
from the State of Illinois
Thank you Mr. Chairman for holding this hearing today. I am looking
forward to hearing from the witnesses on their take of what exactly has
happened here and what can be done to prevent it from happening again
in the future.
This hearing should focus on the accounting problems that occurred
in the Enron collapse, because that is what falls under the
jurisdiction of Committee. Congress may need to address possible
changes in accounting laws and any loopholes that need to be closed
regarding allowing accountants to also perform auditing functions. I am
happy to hear that Chairman Tauzin has stated that the Committee will
be holding future hearings on the Financial Accounting Standards Board.
Aside from Enron, accounting concerns are being raised about other
recent bankruptcies, including Kmart and Global Crossing, where
insiders sold $1.3 billion in stock in the years prior to the
bankruptcy.
So much in fact that accounting firms are looking at ways to change
their business structure. PricewaterhouseCooper and Deloitte & Touche
both have recently announced that they will spin off their consulting
businesses.
The Illinois Department of Regulation has been investigating Arthur
Andersen since before the Enron collapse over its business practices.
Andersen was the auditor for Waste Management in 1998, when the company
admitted that it had overstated its earnings by more than $1.4 billion.
The Committee also needs to look into the role of the states.
Accountants are regulated in every state and many state regulators are
believed to be looking at Andersen. Connecticut, for example, has taken
steps that officials there say could lead to Andersen being banned from
doing business in that state. These state investigations are in
addition to federal probes being conducted by the Justice Department
and the Securities and Exchange Commission.
One question that was asked in a hearing yesterday needs to be
answered. Were Andersen's accountants and consultants involved in the
complex deal by which Enron bought out its JEDI partnership by creating
a new one called Chewco--one of the off-balance-sheet deals that
greatly contributed to Enron's collapse?
Mr. Chairman, thank you for holding this hearing and I yield back
the balance of my time.
Chairman Tauzin. I thank my friend. Members on this side?
The gentleman from Ohio, Mr. Sawyer, I think has sought
recognition.
Mr. Sawyer. Thank you, Mr. Chairman, and thank you for your
work with our ranking member, Mr. Dingell, to bring this
opportunity before us today. The collapse of Enron is really
almost inconceivable in its magnitude and its suddenness. It's
like a mighty edifice now fallen that seems to have disappeared
like a column of smoke. It is an extraordinary event. The
nature and scope of this company's collapse is both multi-
faceted and complex, but in the end, I have the sense that this
is really a case about disclosure.
Our Federal securities' laws are there to protect
shareholders, investors, not officers, not directors, not the
companies' bottom line and it's designed to work through a
system, yes, grounded in trust, but based on transparency,
transparency through disclosure of relevant financial
information. This framework is designed so that employees,
shareholders and prospective investors could make sound and
informed decisions about how they invest their money. In this
case, where they were dealing with energy derivatives rather
than securities, we simply didn't have that disclosure. For
nearly a decade these complex, financial transactions escaped
regulatory review and were exempt from the same disclosure and
reporting requirements that their securities counterparts were
subject to from the beginning. It seems to me that at its base
that is what we must change.
Enron's bankruptcy has triggered visceral responses in all
of us. We're dismayed that this could have happened and more
importantly, we must ask ourselves if it could happen again.
In the end, it's our role to ensure that it does not. And
as tragic as this incident has been for our Nation and
particularly for the thousands of Enron employees, it does
raise important public policy questions for us to address.
That's our job here today and in order to get on with it, I'm
going to yield back the balance of my time, Mr. Chairman.
[The prepared statement of Hon. Thomas C. Sawyer follows:]
Prepared Statement of Hon. Tom C. Sawyer, a Representative in Congress
from the State of Ohio
Good morning Mr. Chairman, Mr. Dingell.
First, I would like thank you for the opportunity to be here today
to address an issue of such importance to our nation. Mr. Chairman, I
am grateful for both your leadership and insight in bringing this issue
before the Committee.
The collapse of Enron--only one year ago--the seventh largest
company in the world, a leader in energy trading and distribution, is
almost inconceivable to us as we sit here today. It illustrates to all
of us the vulnerability of American corporations--even the most
seemingly solid--and the importance of government oversight to ensure
that employees, shareholders and the American public receive adequate
information upon which to make their investment decisions.
To ensure that employees have some degree of protection when it
comes to their retirement and life savings.
The nature and scope of this company's collapse is both multi-
faceted and complex. It involves myriad issues such as: the degree of
regulation the federal government should assume over complex financial
arrangements, the role that accounting firms play with the corporate
clients they audit, and the degree to which we oversee 401(k)
retirement plans.
In my opinion, this is a case about disclosure. The purpose of our
federal securities laws, enacted in 1933 and 1934, is to protect
shareholders--not officers--not directors--and not the company's bottom
line. Our federal securities laws protect shareholders through a system
that is based on disclosure--disclosure of all relevant financial
information that a rational investor would use to assess the status of
a company. We set up this framework so that employees, shareholders,
and prospective investors could make sound decisions about how they
invest their money.
In this case, where we were dealing with ``energy derivatives''
rather than ``securities'', we simply did not have that disclosure. For
nearly a decade, these complex financial transactions escaped
regulatory purview and were exempt from the same the disclosure and
reporting requirements their securities counterparts were subject to
from the beginning. This is what we must change.
It is not our role as members of Congress to legislate the nature
of business transactions or the degree of risk that a company--or its
investors for that matter--should assume. It is not our role to tell
employees which funds to invest their retirement dollars or the degree
of diversification that is necessary. However, we can, as members of
Congress, set parameters. We can set the framework--so that employee
pensions and 401(k) plans are protected and investors and employees are
given clear and accurate information about a company's financial
performance. It is our role set guidelines for auditors--to ensure that
they are free from the inherent conflict of interest associated with
both auditing and consulting for a client at the same time.
Enron's filing for bankruptcy has triggered visceral responses in
all of us. We wonder how this could happened--and more importantly, if
it could happen again. It is our role to ensure that it does not happen
again. And, as tragic as this incident has been for our nation, and
particularly for the thousands of Enron employees, it does raise
important public policy issues for us to address:
Is it necessary for there to be some federal oversight of
``energy derivatives''? And, if so, who is the most logical
body to oversee these transactions?
What the scope of the auditors' role with their clients?
Should accounting firms be restricted from providing
information technology and ``other consulting services'' to the
clients they audit?
What amount of stock should own employees own of their
company? Should employees be subject to a 10% cap as other
federally-insured plans are?
These are the questions that I hope this Committee can answer and
address in public policy. These are the answers I seek today in this
proceeding.
Thank you, Mr. Chairman for giving us the opportunity to delve into
these issues and provide some sort of solution for our country.
Chairman Tauzin. I thank my friend for yielding and for his
statement. The Chair seeks anyone on this side who seeks
recognition? The chairman of the Environmental Subcommittee.
Mr. Gillmor. Thank you very much, Mr. Chairman, and I
appreciate your affording another opportunity to sort out the
recent events, as well as focus on possible reforms regarding
Enron's collapse. As we delve into the destruction of
documents, listen to the findings of a special investigative
committee concerning the illegal transactions between Enron and
partnerships, controlled by its chief financial officer, I
welcome the witnesses today and look forward to hearing the
testimony.
My motivation regarding this issue lies with the well being
of shareholders and employees and the reckless actions of those
in corporate management should not come at their expense. In my
own State of Ohio, the State Teachers Retirement System
invested $4 million in Enron in late October 2001, and a month
later it was worth $100,000 leaving the Teachers Pension Fund
with 2.5 percent of its original investment. Their total loss
stands at over $55 million and added to the Public Employees
Retirement System, a loss of $59 million. Ohio's two principal
employee pension systems were among the Nation's largest
pension fund losers in Enron stock and while it is a sizable
loss, fortunately both Ohio pension funds have assured teachers
and public employees that it will not endanger member benefits.
However, the illegal transactions of a few at Enron turning
thousands into millions in a matter of weeks, the same can't be
said of other State funds of Enron employees and individual
shareholders. Enron stands as a company comprised of improperly
structured transactions, faulty accounting, lack of internal
oversight and an overall attempt to misrepresent the company's
financial condition. And most importantly, Enron hid its
behavior from all those who had an interest in it.
Unfortunately, I think Enron is just an extreme example of
a change of attitude over the last couple of decades of too
many corporate managements in large publicly held companies
where you have an atmosphere of management enrichment,
regardless of whether the company does well, of management
enrichment at the expense of the shareholders and at the
expense of the employees. There has been, I think, a continuing
breakdown in corporate management responsibility, whether it's
the way options are turned into a game where management can
only win, they can't lose, so that they don't have a community
of interest with the shareholders, whether it's the disguising
or the failure to disclose corporate charitable contributions
which may or may not be made for any corporate purpose, so
there are a number issues here and I look forward to hearing
the witnesses' viewpoint today and I thank you, Mr. Chairman.
[The prepared statement of Hon. Paul E. Gillmor follows:]
Prepared Statement of Hon. Paul E. Gillmor, a Representative in
Congress from the State of Ohio
Thank you Mr. Chairman, for yet another opportunity to sort out the
recent events as well as focus on possible reforms regarding Enron's
collapse. As we have delved into the destruction of documents and
listened to the findings of a Special Investigative Committee
concerning the illegal transactions between Enron and partnerships
controlled by its Chief Financial Officer, I welcome the witnesses
today and look forward to hearing their testimony.
As I stated before, my motivation concerning this issue lies with
the well-being of the shareholders and employees--The reckless actions
of those in corporate management should never come at their expense.
In my home state of Ohio, the State Teachers Retirement System
invested $4 million into Enron stock in late October of 2001. A month
later it was worth just $100,000, leaving the teachers' pension fund
with 2.5% of its original investment. Their total loss stands at $55.6
million. Added to the Public Employees Retirement System's (PERS) loss
of $58.8 million, Ohio's two principal public employee pension systems
were among the nation's largest pension fund losers in Enron stock at a
combined $114.4 million.
While it can be perceived as a sizable loss, both Ohio pension
funds assured teachers and public employees that it would not endanger
the funds' bottom lines or affect member benefits. However, with the
illegal transactions of a few at Enron, turning thousands into millions
in a matter of weeks, the same cannot be said by other state funds,
Enron employees, and individual shareholders.
In the end, Enron stands as a company comprised of improperly
structured transactions, faulty accounting, lack of internal oversight,
and an overall attempt to misrepresent the company's financial
condition. Most importantly, Enron hid its behavior from all who had an
interest in them.
I look forward to hearing the witnesses' viewpoints from their
respective sectors as well as further congressional oversight regarding
this issue.
Chairman Tauzin. I thank my friend for his statement.
Further members on this side? The gentleman from Texas, first,
will be recognized, I think for unanimous consent.
Mr. Green. Mr. Chairman, I ask unanimous consent to put my
opening statement in the record and for all others to put an
opening statement in the record.
Chairman Tauzin. Without objection, the gentleman's
unanimous consent request is granted. His statement and all the
members' written statements will be part of the record, and I
thank the gentleman. Anyone else on this side, first of all, in
the order of seniority? Mr. Stupak, I believe would be next.
You are recognized for 3 minutes.
Mr. Stupak. Thank you, Mr. Chairman, and thanks for once
again holding his hearing. I greatly appreciate our
distinguished panel for coming before us today to help to
explain the many complex and technical issues related to the
Enron transactions. I look forward to hearing from various
industry perspectives on how and why this happened as well as
what can be done to prevent this from happening in the future.
Mr. Chairman, over the past several weeks, the Oversight
Investigation Subcommittee has held hearings to explore this
house of cards that was once the mighty Enron Corporation. We
have heard from Andersen employees about the shredding of
documents, the destruction of e-mails that went on in an
effort, I'm sure, to cover up their whole mess.
We have heard from Mr. Powers about his Commission's
findings and the actions of several Enron employees who set up
the special purpose entities to assist in cooking the financial
books at Enron. We have heard and read about the totally lax
oversight of Mr. Lay and Mr. Skilling and other executives on
the Enron Board of Directors.
The Board of Directors gave dangerous flexibility to Mr.
Fastow in allowing him to establish several of these special
purpose entities. They supposedly put a number of checks and
balances in place when they waived their conflict of interest
provisions. But thus far all we have seen of the checks are
tens of millions of dollars worth going into Mr. Fastow's bank
accounts. There certainly were no balances in the equation and
no follow up to make sure the company wasn't being bilked.
We've learned new terms like aggressive accounting which in
this case relates in my interpretation into making fat cats of
Enron richer while sticking it to the shareholder. This
aggressive accounting, I believe, was the result of a new
cavalier attitude in corporate America since the passage of the
Securities Litigation Act of 1995.
You know, back then in 1995, many of us referred to this as
the Securities Rip Off Act as I and others fought against this
bill, because it insulates corporations from legal actions by
putting up roadblocks, making it difficult for shareholders and
employees to take action against them.
Mr. Chairman, this committee and the Powers Report have
only scratched the surface of a thick veneer on Enron's house
of cards. We have not had the time or the cooperation from the
parties involved to get to the root of this cancerous corporate
greed. We have not looked into allegations of corruption in
Enron's worldwide holdings, corporations and partnerships. We
do not know who got bilked overseas who may have been cooking
the books. We do not know who all the investors were in these
special purpose entities and what role, if any, they may have
played in the aiding and abetting the leaders of this
corporation.
Mr. Chairman, the top executives and board at Enron have
allowed the seventh largest corporation in America to collapse.
In their wake, lies thousands of Enron employees and retirees
with shattered financial lives while the corporate executives,
many of whom are still working at Enron today, have lined their
pockets. It will be difficult, if not impossible for Enron to
emerge as a credible company from bankruptcy without a
comprehensive purging of Enron executives and board members who
were at the helm during this debacle. They must be held
accountable and I hope the investors in Enron will get
themselves a true board of directors and new senior management
team.
Thank you again, Mr. Chairman, for holding these hearings.
I look forward to learning from our panel's perspective on the
Enron transactions. I'm sure they'll provide us additional
insight that will be useful in questioning many of the key
players in this Enron scheme at tomorrow's oversight hearing.
Thank you, Mr. Chairman.
[The prepared statement of Hon. Bart Stupak follows:]
Prepared Statement of Hon. Bart Stupak, a Representative in Congress
from the State of Michigan
Mr. Chairman, thank you for holding this full committee hearing
today. I greatly appreciate our distinguished panel for coming before
us today to help explain the many complex and technical issues related
to the Enron transactions. I look forward to hearing their various
industry perspectives on how and why this happened as well as what can
be done to prevent this from happening again in the future.
Mr. Chairman, over the last several weeks the Oversight and
Investigations Subcommittee has held hearings to explore this house of
cards that was once the mighty Enron Corporation. We have heard from
Andersen employees about the shredding of documents and destruction of
e-mails that went on in an effort, I'm sure, to cover-up their role in
this mess. We have heard from Mr. Powers about his Commission's
findings and the actions of several of Enron's employees to set up
these Special Purpose Entities to assist in cooking the financial books
at Enron. We have heard and read about the totally lax oversight by Mr.
Lay, Mr. Skilling, other executives and Enron's Board of Directors. The
Board of Directors gave dangerous flexibility to Mr. Fastow in allowing
him to establish several of these Special Purpose Entities. They
supposedly put a number of ``checks and balances'' in place when they
waived their conflict of interest provisions, but thus far all we have
seen are checks--tens of millions of dollars worth--into Mr. Fastow's
bank accounts. There certainly were no balances in the equations and no
follow-up to make sure the company wasn't being bilked.
We have learned new terms like ``aggressive accounting'' which in
this case translates in my interpretation into making fat cats in Enron
richer while sticking it to the shareholders. This aggressive
accounting I believe is the result of a new cavalier attitude in
corporate America since the passage of the Securities Litigation Reform
Act of 1995--or the Securities Rip Off Act as I refer to it--which
insulats corporations from legal actions by putting up roadblocks--
making it difficult for shareholders and employees to take legal action
against them.
Mr. Chairman, this committee and the Powers report have only
scratched the surface of a thick veneer on Enron's house of cards. We
have not had the time or the cooperation from parties involved to get
to the root of this cancerous corporate greed. We have not looked into
allegations of corruption in Enron's world-wide holdings, corporations,
and partnerships. We do not know who got bilked overseas or who may
have been cooking the books. We do not know who all of the investors
were in the Special Purpose Entities and what role--if any--they may
have played in aiding and abetting the leaders of this corporate scam.
Mr. Chairman, the top executives and Board at Enron have allowed
the 7th largest corporation in America to collapse. In their wake lies
thousands of Enron employees and retirees with shattered financial
lives while the corporate executives, many of whom are still working at
Enron today, have lined their pockets. It will be difficult--if not
impossible--for Enron to emerge as a credible company from bankruptcy
without a comprehensive purging of Enron executives and Board members
who were at the helm during this debacle. They must be held accountable
and I hope the investors in Enron will get themselves a new TRUE Board
of Directors and new Senior Management team.
Thanks you again Mr. Chairman for holding this hearing. I look
forward to learning our panel's perspective on the Enron transactions.
I'm sure they will provide us with additional insight that will be
useful in questioning many of the key players in this scheme at
tomorrow's Oversight hearing.
Chairman Tauzin. I thank my friend for his statement and
for yielding back. The Chair now recognizes the soon to be
leaving us, in fact, the gentleman from Oklahoma, whom we'll
sorely miss from my committee and from the Congress, but I know
he's going on to bigger and bigger things in the great State of
Oklahoma. The gentleman from Oklahoma, Mr. Largent, is
recognized for 3 minutes.
Mr. Largent. Thank you, Mr. Chairman. I want to commend you
for holding these important hearings this week. The Enron
debacle is of particular importance to my constituents in
Tulsa, many of whom are employed by the energy industry. As you
may have heard from various news reports, the Enron bankruptcy
is having a ripple effect on many other energy companies,
specifically Williams Company, one of the largest employers in
my District realized that $100 million fourth quarter loss due
to unmet obligations by Enron. Further, Williams' stock prices
have fallen significantly, due to the fear of many on Wall
Street that companies who engage in complicated transactions
cannot be trusted to accurately list their assets and
liabilities. This is a guilt by association type mentality.
The purpose of these hearings should be to find out what
went wrong at Enron and to make sure that it never happens
again. The backbone of a free market economy rests on the clear
and transparent display of information that allows investors
and employees the ability to make accurate decisions on how to
invest their money. Congress must now take a good look at
corporate American and our accounting standards to see if we
can prevent the type of shell games that created the largest
bankruptcy in American history.
At the same time, the Department of Justice should
vigorously prosecute any one and every one who violated the law
with respect to Enron. It is important to remember though, as
horrible as the Enron bankruptcy is, for the most part our
energy markets seem to be weathering the storm. The fact is
that markets formerly served by Enron are quickly being
absorbed by other companies without widespread price or supply
disruption. This is an industry that is far from broken or in
need of repair.
I understand that in the coming weeks the committee may
consider legislation to reform our Nation's electricity
markets. I am concerned, however, that some of my colleagues
might want to use the Enron bankruptcy as a means to advance an
unneeded regulatory barrage on the energy industry. I hope that
we will resist that temptation and focus on the task at hand.
Let's not forget that in the end free markets do work.
Thank you, Mr. Chairman. I yield back.
[The prepared statement of Hon. Steve Largent follows:]
Prepared Statement of Hon. Steve Largent, a Representative in Congress
from the State of Oklahoma
Mr. Chairman, I want to commend you for holding these important
hearings this week. The Enron debacle is of particular importance to my
constituents in Tulsa, many of whom are employed by the energy
industry. As you may have heard from various news reports, the Enron
bankruptcy is having a ripple effect on many other energy companies.
Specifically, Williams Companies, one of the largest employers in my
district, realized a $100 million fourth quarter loss due to unmet
obligations by Enron. Further, Williams stock price has fallen
significantly due to the fear of many on Wall Street that companies who
engage in complicated transactions cannot be trusted to accurately list
their assets and liabilities. This is a guilt by association type
mentality.
The purpose of these hearings should be to find out what went wrong
at Enron and to make sure that it never happens again. The backbone of
a free market economy rests on the clear and transparent display of
information that allows investors and employees the ability to make
accurate decisions on how to invest their money. Congress must now take
a good look at corporate America and our accounting standards to see if
we can prevent the type of shell games that created the largest
bankruptcy in American history. At the same time, the Department of
Justice should vigorously prosecute anyone and everyone who violated
the law with respect to Enron.
It is important to remember though, as horrible as the Enron
bankruptcy is, for the most part, our energy markets seem to be
weathering the storm. The fact is that markets formerly served by Enron
are quickly being absorbed by other companies without widespread price
or supply disruption. This is an industry that is far from broken or in
need of repair.
I understand that in the coming weeks the Committee may consider
legislation to reform our nations electricity markets. I am concerned,
however, that some of my colleagues might want to use the Enron
bankruptcy as a means to advance an unneeded regulatory barrage on the
energy industry. I hope that we will resist that temptation and focus
on the task at hand. Lets not forget, in the end, free markets work.
Chairman Tauzin. I thank the gentleman for his statement
and ask if there are members on this side, the gentleman from
New York, Mr. Engel, is recognized for 3 minutes.
Mr. Engel. Thank you, Mr. Chairman. There's an old saying
and it goes like this, ``Oh what a tangled web we weave, when
first we practice to deceive.''
It's evident to me and to all of us that there's has been a
concerted effort by the top brass of Enron to create an
intricate web of lies, so intricate in fact, that it will take
months and years to discover the whole truth.
Our ability to learn the truth would be greatly facilitated
by the assistance of Enron's top brass. Thus, I'm saddened by
the fact that Mr. Lay has chosen not to testify. I believe that
Mr. Lay, Mr. Skilling and Mr. Fastow should be doing everything
they can to help us uncover the truth. Instead, they're doing
everything they can to cover their own proverbial backsides.
I'm especially interested in knowing for what purposes Mr.
Lay used the money he was loaned by Enron. As I understand, Mr.
Lay had a $4 million line of credit with Enron. I have to
wonder if he used any of this money to set up any of the
hundreds of partnerships. These partnerships took on debt for
Enron, thus making Enron's bottom line look better. This, in
turn, caused Enron stock to increase in price and finally Mr.
Lay paid off these loans with Enron stock. A tangled web
indeed.
Then we come to the other player in this tragic comedy,
Arthur Andersen. Arthur Andersen in the terms of addiction was
an enabler. And as Enron's auditor they enabled Enron to set up
hundreds of partnerships, enabled Enron to hide debt in the
hundreds of millions of dollars, enabled Enron's top executives
to personally profit through this tangled web of deceit, and
enabled thousands of investors and employees to be misled and
victimized.
During the oversight investigation hearings I questioned
some of the Andersen employees about their code of professional
conduct. They responded that they did not view their actions as
violation of the AICPA's code but as, and I quote, ``a gross
error.''
I again quote from AICPA's code of professional standards
that the code ``cannot accommodate deceit or subordination of
principle.''
I must beg to differ with Andersen in its assessment of its
culpability in this matter. Andersen was a party to and did
accommodate deceit. The Powers report not only states that
Andersen failed in its role as auditor, but that it directly
participated in the structuring and accounting of the Raptor
transactions.
Luckily for Andersen there is little chance that the AICPA
will take any action against it. AICPA has failed time and time
again to properly oversee its members in the industry.
I have with me two articles from the Washington Post that
delve into the poor performance of the AICPA. They detail a
history of lax oversight. In fact, often when an individual was
cited and fined by the SEC, the AICPA did nothing. For an
industry that has fought tooth and nail for the power of self-
regulation, this is a shameful track record.
Mr. Chairman, I ask unanimous consent that the articles be
added to the official record.
Chairman Tauzin. Without objection, so ordered.
Mr. Engel. Already we have a number of proposals to deal
with some of the aftermath of this failure. I strongly support
preventing auditing companies from providing consulting
services at the same time. I believe we must take a serious
look at how well AICPA, FASB and the SEC enforce ethical
standards. I think we should make companies disclose at the
very least all of their partnerships and the debt and assets
thereof. The Federal Reserve has expressed its concerns about
SPEs and how they are being used to hide the true nature of so
many corporations' debt. This is material information that is
constantly being hidden from the view of the investor and the
general public.
Chairman Tauzin. The gentleman's time----
Mr. Engel. I read in today's paper that the Houston Astros
baseball team is trying to change the name of Enron Field.
Chairman Tauzin. The gentleman's time is expiring.
Mr. Engel. It's no wonder. I thank you, Mr. Chairman, and I
look forward to these hearings.
[The prepared statement of Hon. Eliot L. Engel follows:]
Prepared Statement of Hon. Eliot L. Engel, a Representative in Congress
from the State of New York
Mr. Chairman: There is an old saying ``Oh what a tangled web we
weave, when first we practice to deceive!''
It is evident to me that there has been a concerted effort by the
top brass of Enron to create an intricate web of lies. So intricate, in
fact, that it will take months, possibly years to discover the whole
truth.
Our ability to learn the truth would be greatly facilitated with
the assistance of Enron's top brass. Thus, I am saddened by the fact
that Mr. Lay has chosen not to testify. I believe that Mr. Lay, Mr.
Skilling, and Mr. Fastow should be doing everything they can to help us
uncover the truth. Instead, they are doing everything they can to cover
their own proverbial backsides.
I am especially interested in knowing for what purposes Mr. Lay
used the money he was loaned by Enron. As I understand, Mr. Lay had a
$4 million line of credit with Enron. I must wonder if he used any of
this money to set up any of the hundreds of partnerships. These
partnerships took on debt for Enron, thus making Enron's bottom line
look better. This in turn caused Enron stock to increase in price.
Finally, Mr. Lay paid off these loans with Enron stock.
A tangled web indeed!!
Then we come to the other player in this tragic comedy.
Arthur Andersen.
In the terms of addiction was an ``enabler.'' Andersen, as Enron's
auditor:
enabled Enron to set up hundreds of partnerships
enabled Enron to hide debt in the hundreds of millions of
dollars
enabled Enron's top executives to personally profit through
this tangled web of deceit
enabled thousands of investors and employees to be misled and
victimized
During the Oversight and Investigations hearing, I questioned some
of the Andersen employees about their code of professional conduct.
They responded that they did not view their actions as violation of the
AICPA's code, but--and I quote-- a gross error!
I again quote from AICPA's code of professional standards that the
code ``cannot accommodate deceit or subordination of principle'''
I must beg to differ with Andersen in its assessment of its
culpability in this matter. Andersen was a party to and did accommodate
deceit. The Powers report not only states that Andersen failed in its
role as auditor, but that it directly participated in the structuring
and accounting of the Raptor transactions.
Luckily for Andersen, there is little chance that the AICPA will
take any action against it. AICPA has failed time and time again to
properly oversee its members and the industry. I have with me two
articles from the Washington Post that delve into the poor performance
of the AICPA. They detail a history of lax oversight. In fact, often
when an individual was cited and fined by the SEC, the AICPA did
nothing. For an industry that has fought tooth and nail for the power
of self regulation, this is a shameful track record.
Mr. Chairman, I ask unanimous consent that the articles be added to
the official record.
Already, we have a number of proposals to deal with some of the
aftermath of this failure. I strongly support preventing auditing
companies from providing consulting services at the same time. I
believe we must take a serious look at how well AICPA, FASB, and the
SEC enforce ethical standards.
I think we should make companies disclose at the very least all
their partnerships and the debt and assets thereof. The Federal Reserve
has expressed its concerns about SPE's and how they are being used to
hide the true nature of so many corporations' debt. This is material
information that is constantly being hidden from the view of the
investor and general public.
I thank the Chairman and the Ranking Member and pledge to work with
them to ensure that such unabashed abuses of accounting never occur
again.
Chairman Tauzin. I thank my friend. The gentleman's time
has expired. Is there further request at this time? The
gentleman, Mr. Buyer, is recognized from Indiana for 3 minutes.
Mr. Buyer. Mr. Chairman, thank you also for holding the
hearings on the Enron collapse. I appreciate your leadership
and that of Mr. Dingell and Mr. Greenwood. Like others on the
committee have stated, it is very serious if financial books
were altered, if investors were intentionally misled, if
employees were intentionally given false information and
treated differently than executives. It is appropriate for this
committee to review all these allegations.
There are two things that trouble me at this time about the
Enron collapse. First, how employees were treated. Executives
were given the opportunity to sell stock when they knew the
price was tumbling, but used the rules to prevent employees
from doing the same. This stabs at the most basic ideals of
fairness. If the rules were utilized to aid and abet this
unfair treatment of employees, then we need to correct the
wrong. 401(k)s are an important tool in retirement planning.
This one instance of abuse should not be used to dismantle
401(k)s, but to strengthen them and I'm confident that Congress
will address pension reform.
The second most troubling item to me at the moment is the
scandal of culture that has a foundation, an architecture, in
Washington, DC and how this scandal of Enron feeds into it.
This is a business scandal, not a political scandal. There are
those in this town that want to transfer it to the latter,
rather than the former. It's important for us to put the
microscope on this so we can understand the marketplace and a
company and what went wrong.
This is a matter of a business failure. Despite the
financial losses to thousands, and I am not minimizing this
loss, I note that the free market economy, the most successful
in the world that we've ever seen, lets businesses fail if they
deserve to fail. We often hail victors of free markets and
great innovators like Thomas Edison who developed an idea to
benefit us all, but we must also realize that if the market
rewards excellence, it also punishes failures. And in the Enron
case, it was brutal. If Enron engaged in illegal and unethical
business practices, then that is exactly what should happen in
the end. There is a failure in the marketplace.
Some may question whether it is the responsibility of
government to guarantee success in the marketplace. I submit it
is not. The responsibility of government is to make sure the
marketplace is fair, free, open and competitive. If, in fact,
someone is not operating in that marketplace under those
standards, we then can bring the microscope in and find out
what went wrong. And if, in fact, there are rules that need to
be corrected, that is the responsibility for us to engage. So I
want to thank you Mr. Chairman and Mr. Dingell, Mr. Greenwood
and others. I think it's going to take time. It will take some
patience. What I've learned is follow the facts, it will
determine where the law should go and for the best result for
the American society.
I return my time.
Chairman Tauzin. I thank the gentleman for his thoughtful
statement and I ask if there are members on this side who wish
to be recognized first in order of seniority. The gentleman,
Mr. Rush, would be in line from Chicago. Mr. Rush? He is
recognized for 3 minutes.
Mr. Rush. Thank you, Mr. Chairman, for holding today's----
Chairman Tauzin. Bobby, would you turn your mike on? Thank
you.
Mr. Rush. I want to again thank you, Mr. Chairman, for
holding this full committee's hearing on the Enron collapse.
Mr. Chairman, today, I hope today's hearing will allow the
committee to gain a panoramic view of the Enron debacle so that
when all is said and done and we in the Congress can make the
legal and policy changes necessary to prevent this disaster
from ever occurring again. Today's hearing will be an
opportunity to hopefully shed light on the various industry-
wide accounting, corporate governance and energy concerns
raised by the Enron collapse. And while I commend the committee
for calling witnesses to discuss the roles and responsibilities
of the executives, auditors and accountants, I fear that we
have left out an important player in the story of Enron and its
fall from grace. I feel that the lawyers should be also a focus
of our deliberations and our investigations.
In Enron's own limited investigations of its shady business
practices, Vinson & Elkins confirmed that the procedures for
monitoring those practices was uniformly overseen, not only by
accountants and executives, but lawyers as well. The legal
department at Enron had a role to play. Unfortunately, the
Vinson & Elkins investigation which was meant to root out
mismanagement and illegality, seemed to be marked by a cloud
mismanagement and missed opportunity. In its finding, Vinson &
Elkins describe the monitoring procedures for its LJM
transactions as generally adhered to, accounting as creative
and aggressive and the working conditions as awkward. Even
though Enron's SPE-related transactions and I quote ``created a
serious risk of adverse publicity and litigation'', Vinson &
Elkins nonetheless concluded that there was no need for an
expanded investigation. In short, while the building was aflame
and burning down around its client, Vinson & Elkins called for
business as usual.
In the written testimony given today by the panelists, by
one of our panelists, he tells of a corporate climate in which
aggressive mismanagement, there's the accountant to ``show me
where it says I can't twist and stretch the rules to show a
profit.'' Accountants were under the gun. They were dared to
show management where it said they couldn't bend the rules and
stretch the rules to accomplish what they wanted to accomplish.
Certainly this component to the Enron collapse must be part
of our public debate. What was the lawyers' role in this? The
outside attorneys and also Enron's own legal department. And
however, Mr. Chairman, in conclusion, it may be equally as
important to discuss the importance of sound, legal advice that
would have guided Enron to a very different place than where it
is today. Again, where were the lawyers, what were they doing
and why did they not advise Enron to do differently than they
did.
[The prepared statement of Hon. Bobby L. Rush follows:]
Prepared Statement of Hon. Bobby L. Rush, a Representative in Congress
from the State of Illinois
Mr Chairman: Thank you for holding today's Full Committee hearing
on the Lessons Learned from Enron's Collapse.
Today's hearing will allow the Committee to gain a panoramic view
of the Enron debacle, so that when all is said and done, we in Congress
can make the law and policy changes necessary to prevent this disaster
from ever happening again.
Today's hearing will hopefully shed light on the various, industry
wide accounting, corporate governance, and energy concerns raised by
the Enron collapse.
And while I commend the committee for calling witnesses to discuss
the roles and responsibilities of the executives, auditors, and
accountants, I fear that we have left out an important player in the
story of Enron and its fall from grace . . . The lawyers.
In Enron's own limited investigation of its shady business
practices, Vinson and Elkins confirmed that the procedures for
monitoring those practices was uniformly overseen, not only by
accountants and officers, but lawyers as well.
Unfortunately, the very investigation meant to rout out
mismanagement and illegality, seemed marked by a cloud of mismanagement
and missed opportunity.In its findings Vinson and Elkins described the
monitoring procedures for its LJM transactions as:
generally adhered to,
The accounting as, creative and aggressive and
the working conditions as awkward.
Even though ENRON's SPE related transactions ``created a serious
risk of adverse publicity and litigation,'' . . . Vinson and Elkin's
nonetheless concluded that, there was no need for an expanded
investigation.
In short, while the store burned down around its client Vinson and
Elkins called for business as usual.
In the written testimony given by one of today's panelists, he
tells of a corporate climate in which aggressive management dares the
accountant to ``show me where I can't'' bend twist and stretch the
rules to show a profit. Certainly, this component to the Enron collapse
must be a part of the public debate. However, it may be equally as
important to discuss the importance of the sound legal advice that
would have guided Enron to a very different place than where it is
today.
Chairman Tauzin. The gentleman's time is expired. The Chair
thanks the gentleman for his statement. The Chair recognizes
the gentleman from Oregon, Mr. Walden, for an opening
statement.
Mr. Walden. Thank you very much, Mr. Chairman. Mr.
Chairman, let me start by quoting some material from Robert
Vigil, a constituent of mine living in Madras, Oregon,
testifying in front of the Senate Committee on Commerce,
Science and Transportation during their hearing on Enron. Mr.
Vigil is an electrical machinist working as foreman for
Portland General Electric, PGE. He works at PGE's Pelton Round
Butte Hydroelectric Project in Central Oregon. He's 47 years
old and has been employed by PGE for 23 years. Here's what he
said. ``Enron purchased PGE in 1997 at which time all of the
PGE stock we had in our accounts automatically converted to
Enron stock. At first this looked like good news for the
employees. Enron was riding high and as we saw the company
officers and supervisors investing in company stock, we felt
assured that our own investments were solid. As you're probably
aware by August of 2000 Enron's stock had shot up to all time
high of $90.56. At that time, my 1800 shares were worth
$163,000.'' Continuing with Mr. Vigil's comments: ``We were all
barred from trading our stock during the critical period this
last fall. It seemed strange to me that as soon as the really
bad news came out on Enron, we found ourselves unable to move
out of the stock. Enron suddenly changed account managers and
our investment accounts were locked down. I've seen that Enron
says we were only locked out of our accounts for 10 trading
days, from October 29 through November 12, but as early as
September 26 my co-workers were finding they could get access
to their accounts, but they could not conduct any transactions.
As the truth about Enron started to come to light and as the
officers at the top cashed out, we, the employees had no choice
but to ride the stock into the ground.''
Mr. Chairman, I encourage everyone here to read the
entirety of Mr. Vigil's statement because it puts a human face
on what we're talking about today. No longer is the giant
energy marketing company Enron or the Big Five accounting firm
Arthur Andersen. We can see how far reaching this collapse is
from Houston, Texas, the fourth largest city in America to
Madras, Oregon, population, 5,080.
We have to get to the bottom of this, Mr. Chairman, and I
commend you and others in this committee for these hearings.
Too many workers saw their retirement vanish, too many
shareholders were misled, too many years of financial
statements were misleading at best or downright fraudulent at
worst. Credibility of companies and auditors has been lost. The
impact on the financial markets and investor confidence has yet
to be determined and it comes at a critical time of our
economy.
What did the top execs at Enron and Arthur Andersen know
and when did they know it? Particularly troubling is the timing
of actions of both Enron and Arthur Andersen. Also, were they
intentionally misleading investors and employees? Why were the
blackout dates for employees inconsistent? Is it usual to
destroy documents like Enron and Arthur Andersen did? Were
there side letters that were made by Enron with its partners in
relation to risk sharing and structure of those same
partnerships? Has the FASB failed to issue regulations that may
have prevented some of this from happening in the first place?
Has the SEC failed to issue enhanced financial statement
disclosure requirements describing partnerships? Do the
disclosures need to be more comprehensible to the reader at
large? Do auditor independence requirements need to be reviewed
again in light of the current situation?
Any time there's a declining business environment,
transactions inherently become more complicated. Companies like
Enron and their auditors will continue to find ways to get
around returns to their investors. The FASB and SEC must
continue to evolve with these complex transactions. Delay is
not an option.
Thank you, Mr. Chairman.
[The prepared statement of Hon. Greg Walden follows:]
Prepared Statement of Hon. Greg Walden, a Representative in Congress
from the State of Oregon
Thank you Mr. Chairman.
Mr. Chairman, let me start by quoting some material from Robert
Vigil, a constituent of mine living in Madras, Oregon, testifying in
front of the Senate Committee on Commerce, Science and Transportation
during their hearing on Enron. Mr. Vigil is an Electrical Machinist
Working Foreman for Portland General Electric (``PGE''). He works at
PGE's Pelton/Round Butte Hydroelectric Project, in Central Oregon. He
is 47 years old, and has been employed by PGE for 23 years.
``Enron purchased PGE in 1997, at which time all of the PGE stock
we had in our accounts automatically converted to Enron stock. At
first, this looked like good news for the employees. Enron was riding
high, and as we saw the company officers and supervisors investing in
company stock, we felt assured that our own investments were solid. As
you are probably aware, by August 2000, Enron's stock had shot up to an
all-time high of $90.56. At that time, my 1800 shares were worth
$163,000.
``. . . we were all barred from trading our stock during a critical
period this last fall. It seems strange to me that as soon as the
really bad news came out on Enron, we found ourselves unable to move
out of the stock. Enron suddenly changed account managers, and our
investment accounts were `locked down.' I have seen that Enron says we
were only locked out of our accounts for ten trading days--from October
29 through November 12. But as early as September 26, my coworkers were
finding that they could get access to their accounts, but they could
not conduct any transactions. As the truth about Enron started to come
to light--and as the officers at the top cashed out--we, the employees,
had no choice but to ride the stock into the ground.''
Mr. Chairman, I encourage everyone here to read the entirety of Mr.
Vigil's statement. It puts a human face on what we are talking about
today. No longer is it the ``giant energy marketing company Enron'' or
the ``big five accounting firm Arthur Anderson.'' We can see how far
reaching this collapse is. From Houston, TX, the fourth largest city in
America to Madras, OR: population 5,080.
I intend to get to the bottom of this. Too many workers saw their
retirement vanish. Too many shareholders were misled. Too many years of
financial statements were misleading at best, or downright fraudulent
at worst. The credibility of companies and auditors has been lost. The
impact on the financial markets and investor confidence is yet to be
determined and comes at a critical time of our economy.
What did the top execs at Enron and Arthur Anderson know and when
did they know it?
Particularly troubling is the timing of actions by both Enron and
Arthur Anderson. Also, were they intentionally misleading investors and
employees? Why were the blackout dates for employees inconsistent? Is
it usual to destroy documents like Enron and Arthur Anderson did? Were
there side letters that were made by Enron with its partners in
relation to risk sharing and structure of those same partnerships? Has
the FASB failed to issue regulations that may have prevented some of
this from happening in the first place? Has the SEC failed to issue
enhanced financial statement disclosure requirements describing
partnerships? Do the disclosures need to be more comprehendible to the
reader at large? Do auditor independence requirements need to be
reviewed again in light of the current situation?
Anytime there is a declining business environment, transactions
inherently become much more complicated. Companies like Enron and their
auditors will continue to find ways to get the most return for their
investors. The FASB and SEC must continue to evolve with these complex
transactions. Delay is not an option.
Thank you for the time Mr. Chairman. I look forward to the question
session in the hopes that I can provide answers to my constituents.
Chairman Tauzin. The gentleman's time has expired. The
Chair thanks the gentleman. The Chair is pleased to welcome and
recognize the gentleman fresh from his victories in New
Orleans, took the town by storm, chief sponsor and supporter of
the Patriots, Mr. Markey.
Mr. Markey. I thank you, Mr. Chairman, very much, and I now
realize why 9 of the 36 Super Bowls have been played in New
Orleans. I think once you're there, you want to go back as
quickly as you can.
Chairman Tauzin. Glad you enjoyed it, Mr. Markey.
Mr. Markey. It was beautiful.
Chairman Tauzin. It was truly a great Super Bowl and again,
I think we all owe thanks to the United States securities
forces for making it such a safe and amazing event for America.
I think we're all very grateful and quite a game, Mr. Markey,
congratulations.
Mr. Markey. For us, it was the expurgation of so many
ghosts of years gone back, beginning with Bill Buckner, but
then back so far into time that we can't remember them all and
all of them now, the cloud has passed. Not unlike what we're
going to have to do with Enron and Arthur Andersen in terms of
the cloud that it's placed over the capital markets. For many
of us the most striking thing about the Enron debacle is that
the time these transactions were being put together no one ever
appears to have stepped forward to say you can't do this. No
one appears to have stepped forward to say that would be wrong.
No one ever appears to have stepped forward said what you're
trying to do is unethical and possibly illegal. Instead, every
single financial professional who was supposedly there to
protect the public investors, the outside auditors, the
attorneys, the Wall Street investment banks and the corporate
insiders, all of them got together and conspired with one
another on how to structure deals that could evade or flout the
rules.
And what about the Wall Street expert securities analysts
who were supposedly scrutinizing Enron's performance and the
credit rating agencies or supposedly evaluating the company's
credit worthiness? Where were these when the shenanigans were
taking place? The public wants to know how could this happen?
Where was Enron's Board? Where was its senior management? Where
were the risk management systems? Where was the outside
auditors? Where were the lawyers? Where were the regulators? It
wants to know why it was that so many of the internal and
external checks and balances that were supposed to protect the
public failed so catastrophically?
Traditionally, many have thought of accounting as an
incredibly dull and arcane subject. The stereotype of the
accounting profession has been that it is pretty much a bunch
of nerdy geeks with an inexplicable fascination with obscure
and abstruse rules and regulations. And let's face, accounting
is boring. Unless, of course, you wish to engage in financial
fraud. In which case, accounting is an absolutely fascinating
subject. Successfully cooking the books is the key to getting
away with financial fraud and at Enron and at Arthur Andersen,
new and innovative recipes appear to have been devised.
This week the Powers Committee Report was released and
provided us with an exhaustive review of Chewco, Raptor and LJM
transactions and these transactions' insiders appear to have
constantly flouted the rules.
Back in the 1930's Will Rogers said that from what he could
tell a holding company was where you hide the money when the
cops show up. Today, for Enron and for possibly many other U.S.
companies, special purpose entitles are where you hide your
debts, disguise your nonperforming assets, boost your earnings,
conceal your losses and avoid paying your taxes. And so I think
our committee must look at this issue. We are not at--we have
not found the iceberg yet, Mr. Chairman. We are at the tip of
the iceberg.
When accountants want to keep score and play the game at
the same time, we'd all love to do that if we could get away
with it. But once you start doing that, you are setting
yourself up for big problems.
I thank you for your leadership in conducting these
hearings.
Chairman Tauzin. I thank my friend for his statement. And
the Chair is pleased to recognize the gentleman from Nebraska,
Mr. Terry, for an opening statement.
Mr. Terry. Thank you, Mr. Chairman. I want to highlight a
couple of points and I'll submit the rest of my statement for
the record. And while the statement is chock full of pithy
quotes, I sadly have no Star Wars references.
I do want to point out two things, in the role of Omaha,
Nebraska in this hearing today. First of all, I welcome a
friend and constituent, Mr. David Sokol. Mr. Sokol is an expert
in energy policy since that's his life and I think he's world
renowned for his knowledge of the industry and we welcome him
here today to share his expertise with us. So welcome, Mr.
Sokol.
The other, sad, part about Omaha is that in the late 1970's
we enjoyed a great company called Internorth and Internorth had
arranged a merger with a small Houston company named Enron.
Well, as it ended up, the small fish gobbled up the big fish.
Mr. Lay moved to Omaha promising great things for our
community, all the while secretly plotting its removal from
Omaha to Houston. Nonetheless, while hundreds of people were
ripped from their jobs and either forced to move to Houston or
retire, they did keep a small division in Omaha, their pipeline
division. We have about 400 employees in Omaha and several of
those people are friends of mine. And I've heard from several
people in the Enron Division in Omaha who told me stories about
how they had hundreds of thousands of dollars built up for them
from their years of service with Enron in their 401(k) and now
as they are looking toward retirement, have nothing.
Now Mr. Chairman, it's said that there are two kinds of
light. The glow that illuminates and the glare that obscures.
Obviously, we thought Enron was a company with an illuminating
glow, but we have found out that they have used that glow to
obscure their tactics and we're here today to try and uncover
those tactics.
Mr. Chairman, I appreciate your outspokeness on behalf of
the employees in Omaha, Nebraska and in Houston, because I
think it's our duty today to find those tactics, fill the
policy void so this can never happen again and make sure that
the Justice Department vigilantly pursues those who have broken
the law.
I yield back the balance of my time.
[The prepared statement of Hon. Lee Terry follows:]
Prepared Statement of Hon. Lee Terry, a Representative in Congress from
the State of Nebraska
Thank you Mr. Chairman. Today's hearing will primarily examine the
lax accounting practices Andersen employed in its auditing of Enron. I
am pleased, though, that we will also hear testimony regarding the
status of our energy markets. I think it's worthy to note that although
the largest energy trading company in America collapsed, energy prices
have remained fairly stable, and I'm looking forward to the testimony
of my good friend David Sokol, chairman of MidAmerican.
When I contemplate the Enron saga I am reminded of a line from
Shakespeare's Henry The Eighth, ``Thy ambition, Thou scarlet sin,
robb'd this bewailing land.'' What I'm concerned about are Enron's
accounting practices: are they the exception to the rule, or are they
the rule in Corporate America? We've seen the collapse of Enron late
last year, and last week Global Crossing declared bankruptcy--who's
next?
Enron's story is reminiscent of a Shakespearean tragedy: a hugely
successful company responsible for transforming an entire industry
engaged in an elaborate scheme of complicated, unprofitable, and
possibly illegal business partnerships; a politically connected CEO; a
precipitous financial collapse of immense proportions; and the recent
tragic death of its former Vice Chairman.
How could a company so well reputed, employing so many hardworking
Americans, and with such a prolific stature in Corporate America just
crumble?
As we begin to investigate what happened here and why, it's
important to keep in mind people's motives. My interest is twofold:
first as a member of this Committee, but more importantly because Enron
was formed by merging two companies--Houston Natural Gas and
Internorth--the latter headquartered in my home district of Omaha,
Nebraska.
Enron employs more than 20,000 people, or at least did before this
past Fall. 400 or so of those employees are located in Omaha. They
joined thousands in trusting Enron's officers to make decisions that
were good for the firm's employees, retirees, shareholders, and not
merely to enrich its executives' bank accounts. Until late last year,
it appeared Enron's expansion knew no boundaries. The company grew to
titanic proportions, spanning 40 countries, operating 30,000 miles of
pipeline, holding nearly $50 billion in assets, and taking in revenues
in excess of $100 billion in 2000 alone. This seemed like a company
playing out that fabled American dream, and its employees and
shareholders were reaping the rewards.
On Sunday, the Special Investigative Committee of Enron's Board of
Directors released the Powers Report, detailing intricate schemes that
created assets that never existed, coaxing investors and employees to
invest in a retirement future that would never be. For those who have
not read the Powers Report, I'd like to read a brief excerpt of how
people like Chief Financial Officer Andrew Fastow, Michael Kopper, and
others made millions.
``We were charged with investigating transactions between
Enron and partnerships controlled by its Chief Financial
Officer, or people who worked in his department. That is what
our Report discusses. What we found was appalling.
``First, we found that Fastow--and other Enron employees
involved in these partnerships--enriched themselves, in the
aggregate, by tens of millions of dollars they should never
have received. Fastow got at least $30 million, Michael Kopper
at least $10 million, two others $1 million each, and still two
more accounts we believe were at least in the hundreds of
thousands of dollars.
``Second, we found that some transactions were improperly
structured. If they had been structured correctly, Enron could
have kept assets and liabilities--especially debt--off its
balance sheet. But Enron did not follow the accounting rules.''
Now we're here to determine how this charade was allowed to happen.
Who dropped the ball? A lot of finger pointing has taken place, and yet
no one has come forward to say, ``I'm responsible. I was the one making
millions of dollars, all the while knowing that what I was doing was
illegal, malicious, and a complete breach of public trust.'' I hope our
witnesses here today can shed some light on what happened in the
accounting world to have allowed such a corporate calamity to occur.
It has been said that there are two kinds of light--the glow that
illuminates, and the glare that obscures. For years, Enron seemed to be
that illuminating glow. Today, we seek uncover the tactics they used to
glare their investors and obscure the reality of their condition. If
the only result of these hearings, though, is placing blame on the
appropriate parties, we have not fulfilled our duties. We must seek
solutions to the problems exposed by this unfortunate collapse and
implement reforms on a bipartisan basis to ensure this does not happen
again. Therefore, I look forward to this Committee and others in
Congress exploring further the relationship Enron had with Andersen. It
may make sense that one firm should never hold the duplicitous roles of
both auditor and consultant. Congress may need to closely examine the
possibility of closing this loophole.
I hope the issue of reporting earnings, and the practice of
restating earnings, is further explored. We must ensure American
investors have accurate, transparent, and timely information when
making their investment decisions. I am also hopeful we make some
meaningful reforms to how 401(k) plans are administered--not knee-jerk
reactions, but commonsense, pro-active legislation that creates safe
plans for both employers and employees. It's unfortunate that these
reforms are too late for some, but hopefully will benefit future
American employees and retirees.
In the 1980's there was a popular movie entitled Wall Street. One
of the primary characters, Gordon Gecko, while speaking to a group of
shareholders proclaims the memorable line, ``Greed is Good.'' However,
it should be remembered that greed is one of the seven deadly sins. And
unfortunately in Enron's case--it has proved to be prophetic.
Thank you again, Mr. Chairman, and I look forward to the testimony.
Chairman Tauzin. I thank my friend. The Chair is pleased
now to recognize the gentleman from New York, Mr. Towns, for an
opening statement.
Mr. Towns. Thank you very much, Mr. Chairman. This is a sad
day for this committee and the shareholders of Enron and the
families that were employed by Enron. It is clear that the
leadership of Enron Corporation did nothing to protect their
investors, their shareholders or the employees of the company.
The executives put their own interest ahead of the workers and
their families and the company's shareholders. Unfortunately,
they were able to use regulatory loopholes to accomplish this
deceit. It appears that they also broke a lot of rules and
laws.
We look to the leadership of our present Chairman, Billy
Tauzin from Louisiana in guiding our efforts to plug the
loopholes and make sure that such an ungodly mess never happens
again in this country.
The financial losses resulting from Enron's collusion to
defraud everyone except a few executives cannot be understated.
While Enron employees lost some $1.6 billion, let me just
briefly discuss the impact on some New York institutions.
Amalgamated Bank of New York shareholders lost an estimated
around $500 million. J.P. Morgan Chase and CitiGroup could lose
over $3 billion from loans made to Enron and finally the losses
of the New York Common Retirement Fund will lose approximately
$58 million. In the past the SEC had argued that budgeting and
staffing constraints limited their regulatory capability.
Mr. Chairman, you probably remember, in the 106th Congress
I was the first member to propose a fee reduction and pay
parity bill for the SEC. I'm pleased to say that the President
recently signed into law the legislation which provides pay
parity for SEC staff. However, I'm deeply troubled that the
President's budget for fiscal year 2003 does not provide
funding for either the pay parity to stem the loss of
experienced staff or additional resources to hire the staff
attorneys, staff accountants, economists and examiners
necessary for safeguarding America's investors. Since we can't
find the money for the SEC, I cannot understand how all of a
sudden we can find funds for Chairman Pitts' new oversight
board. That just bothers me. It is up to us, here in the
Congress, to ensure that no American investor or employee is
ever again victimized by the corporate greed practiced by
Enron.
I look forward to hearing from our witnesses today about
how we can strengthen our existing regulatory system. I yield
back the balance of my time, Mr. Chairman, and thank you for
holding this hearing.
Chairman Tauzin. I thank my friend. Let me interrupt to
explain to our witnesses, it is our practice to do these
opening statements for several reasons. One is it's the first
opportunity for all the members of the full committee to make
comments, even those who do not serve on the Oversight
Subcommittee that is doing the investigation, and to give their
observations and their perspectives on this issue. That is
valuable to the Chair and to the subcommittees who are going to
have to produce the legislation, hopefully, to repair some of
the damage that has been done, and as many members have said,
to see to it that this does not happen again.
Second, I hope it helps the witnesses in terms of
understanding either the correct impressions we have or give
you a chance to correct any misimpressions we have about the
state of some of these concerns. And so I hope it's helpful to
both of us.
Again, I apologize that we've kept you waiting, but this is
an extraordinarily important part in the way in which our
committee hears from one another, understands one another's
perspectives and then prepares for the solution phase of our
process which is to produce the legislation, hopefully, that
will repair this damage.
The Chair now asks if there are members on this side of the
aisle who seek recognition for an opening statement. Mr. Deal,
are you prepared at this time? The gentleman from Georgia is
recognized for 3 minutes.
Mr. Deal. Thank you, Mr. Chairman, and thanks to the
distinguished panel. We look forward to your testimony.
Obviously, there are many points of view that have been and
will be expressed during the course of this hearing and others
that will follow. As many of us in the legislative branch have
always heard, there is an admonition that I think is important
here and that is that bad facts sometimes make bad law.
The Enron debacle is bad facts of historic proportions. I
think our challenge is not to react to bad facts by tempting to
solve the problem with bad law. Certainly those who have
violated the existing laws should be prosecuted as those laws
provide. If there is a requirement that Congress act to provide
further legislative safeguards that, to me, is the thrust of
what we need to do and what we need to understand.
Certainly, the confidence of the American public and others
in the safeguards and the oversight of the business community
in its private capacity has been shaken as a result of these
events. Obviously, I think it would be a mistake for us to
attempt to pre-empt those by simple governmental action or
governmental rules and regulations. But I think we need to have
assurances from the private business community that they will
take the kind of corrective action that would not make further
legislative, detailed legislative action necessary, but that
they as a good part of our overall business community are
willing to do some of the policing themselves.
I think those are the challenges that we face. I look
forward to the testimony of the witnesses.
Thank you, Mr. Chairman.
Chairman Tauzin. I thank the gentleman for an opening
statement. He yields back and the Chair is pleased to
recognized the gentleman from New Jersey, Mr. Pallone, for an
opening statement.
Mr. Pallone. Thank you, Mr. Chairman. I want to say that
I'm amazed at how many public policy crises are Enron-related.
I'd just like to list, for example, campaign finance reform,
energy deregulation, SEC reform, bankruptcy protection and
pipeline safety measures. And I don't have time to review all
these, but the first point I'd like to make is aimed directly
at Enron's political influence. On January 24, USA Today said
it best. They said ``Enron's aggressive lobbying drove the
deregulation of markets for energy and other commodities that
allowed it to escape scrutiny and outdistance its rivals.'' The
New York Times noted that ``Enron and its executives have been
President Bush's most generous contributors.'' But we aren't
hearing much about House Majority Whip Tom DeLay's well-known
relationship with Enron and his bold, fundraising campaigns
created in part by his former Chief of Staff, turned Enron
lobbyist, Ed Buckham.
A Washington Post article from October 1999 noted that
``DeLay's fundraising deals are straight forward. A seat at the
table to plot legislative and political strategy in exchange
for help in passing the Republican's agenda and financial
support for GOP candidates.''
Well, what was Enron's role when this committee drafted
industry-supported energy restructuring legislation that would
have provided FERC full authority over all transmission and
interstate commerce? According to an Energy Daily article
printed October 21, Enron lawyers argued this very issue before
the Supreme Court supporting FERC's order opening access to
transmission and further arguing that it did not go far enough.
Did Enron work with Mr. DeLay in an attempt to undermine the
activities of this committee or try to push legislation that
would remove consumer protections?
Another point is aimed directly at the SEC and its role in
corporate disclosure, 401(k) and pension reform. Enron's
collapse caused New Jersey's Public Worker Pension Fund $60
million in loss and 20 jobs in my District in Edison, New
Jersey. It wasn't the largest loss, but it's the proof of the
impact of Enron's collapse around the country.
Finally, Mr. Chairman, I'd like to mention the need for
bankruptcy reform in light of the effects it has on Enron's
wholly owned subsidiary, San Juan Gas Company's 1996 pipeline
explosion that killed 33 and injured 80 others. In 1996, Enron
lobbied in support of the Accountable Pipeline Safety
Partnership Act. I didn't support this bill with many of my
colleagues and we called upon President Clinton to veto the
bill because it gutted pipeline safety laws. Shortly after it
became law, Enron's San Juan Pipeline exploded and NTSB
reported this explosion noted that Enron knew that the gas
company's operations did not comply with pipeline safety
requirements and recommended industry practices had knowledge
of failure to meet safety standards on this pipeline since
1985.
Today, Enron and its subsidiaries are being held
accountable for financial loss, wrongful death, personal injury
and post-traumatic stress disorder caused by this pipeline
explosion, but according to the January 21 New York Times,
``Enron's bankruptcy case has frozen settlement negotiations
and the first scheduled trials for hundreds of victims.''
First, this provides us a clear example of why we must
strengthen pipeline safety laws and further ensure improvements
and reform in corporate bankruptcy.
I know there are a lot of other issues, but I just wanted
to highlight those, Mr. Chairman. Thank you.
[The prepared statement of Hon. Frank Pallone, Jr.
follows:]
Prepared Statement of Hon. Frank Pallone, Jr., a Representative in
Congress from the State of New Jersey
Mr. Chairman, I want to say that I am amazed at how many public
policy crises are Enron related.
ENRON was the Lone Star of Texas, shining blindingly bright. But,
in truth, each of the Lone Star's points of light was aimed squarely at
the American public like a weapon. Each point represents significant
public policy crises that warrant our immediate and thorough attention:
campaign finance reform, energy deregulation, SEC reform, bankruptcy
protection and pipeline safety measures.
The first point of this Lone Star is aimed directly at Enron's
political influence. On January 24, USA Today said it best, ``Enron's
aggressive lobbying drove the deregulation of markets for energy and
other commodities that allowed it to escape scrutiny and outdistance
its rivals.'' The New York Times noted that Enron and its executives
have been President Bush's most generous contributors giving more than
$550,000 to President Bush's various campaigns, the vote recount
coffers and the inaugural committee. Enron's political connection to
and relationship with President Bush through Mr. Lay, has been tight.
But, when asked about his relationship with Mr. Lay, President
Bush's initial reaction was to fib. In a Texas newspaper, the Dallas
Morning News, President Bush claimed that Kenneth Lay was ``a supporter
of Ann Richards'' whom he ``first got to know'' when he decided to
retain Mr. Lay as the head of the Governor's Business Council. In fact,
according to a 1994 article published in The Nation, President Bush
lobbied on behalf of Enron in 1988 when he called Rodolfo Terragno, a
former Argentine Cabinet Minister and pressured Mr. Terragno to award a
contract worth hundreds of millions of dollars to Enron. To what extent
has Enron held onto this level of influence with President Bush and
been able to influence public policy created by this Administration
during the past year?
According to a Businessweek report in December 2000, transition
scouts were eyeing Ken Lay to serve as Treasury Secretary and just a
few months later they reported that Ken Lay was a key Bush advisor on
energy and was named a ``transition adviser'' to the Energy Department.
But, we also aren't hearing much about House Majority Whip Tom
DeLay's well-known relationship with Enron and his bold fundraising
campaigns created in part by his former chief of staff turned Enron
lobbyist, Ed Buckham. A Washington Post article from October 1999,
noted that DeLay's fundraising deals are straightforward: a seat at the
table to plot legislative and political strategy in exchange for help
in passing the Republicans' agenda and financial support for GOP
candidates. What was Enron's role when Rep. DeLay attempted to
undermine the work of this committee last July by drafting industry-
supported energy restructuring legislation that in part would have
provided FERC full authority over all transmission in interstate
commerce? According to an Energy Daily article printed October 21,
Enron lawyers argued this very issue before the Supreme Court--
supporting FERC's order and further arguing that it did not go far
enough. Was it Enron that instigated the attempt to undermine the
activities of this committee and push legislation that would remove
consumer protections?
This ties in very closely with the Lone Star's second bright point,
the need to examine energy markets. Did deregulation of the electricity
market assist Enron in its ability to operate under the radar of
regulatory oversight? The industry maintains that a deregulated
electricity market is necessary. However, did deregulation allow
Enron's executives more flexibility in what Chairman Wood calls,
``questionable non-core business investments''? To what extent do we
need to implement more transparency in the electricity trading market?
I think it is also important to keep in mind the expanding web of
relationships as well. Last year, Vice President Cheney told Frontline
that he did not hear from Mr. Lay regarding FERC appointments. However,
the White House last week admitted that it received a letter signed by
Mr. Lay that included suggestions for new FERC commissioners. Mr. Lay's
suggestions included Pat Wood and Nora Brownell, now the FERC Chairman
and a Commissioner respectively. Is this mere coincidence?
The third Lone Star point is aimed directly at the SEC and its role
in overseeing accounting and auditing activities, corporate disclosure,
401K and pensions. Enron's collapse caused New Jersey's public-worker
pension fund $60 million in loss and 20 jobs in the Edison, New Jersey
office--not the largest loss of a state but proof that the impact of
Enron's collapse was broad. We need to take action to prevent mega-
corporations from undermining the retirement savings of their
employees. Employees must have accurate information about the pension
benefits they have earned, including employer stock holdings in their
plans, and vested employees must have the right to diversity employer
contributions. Employers should also have to provide clear notice
before ``locking down'' pension account, and allowed to do so for only
a limited time. Finally, employees must be able to use the Labor
Department and the courts to recover losses if their retirement funds
are misused. We cannot allow such financial losses to fall upon
misinformed workers again.
The fourth and fifth points of the this Lone Star's saga are
related, the need for bankruptcy reform in light of the effects it has
had on Enron's wholly owned subsidiary San Juan Gas Company's 1996
pipeline explosion that killed 33 and injured 80 others.
In 1996, Enron lobbied in support of the Accountable Pipeline
Safety Partnership Act. I did not support this bill and with many of my
colleagues and called upon President Clinton to veto this bill--it
gutted pipeline safety laws. Shortly after it became law, Enron's San
Juan pipeline exploded. An NTSB report of this explosion noted that
Enron knew ``that the gas company's operations did not comply with
pipeline safety requirements and recommended industry practices had
knowledge of failure to meet safety standards on this pipeline'' since
1985.
Today, Enron and its subsidiary are being held accountable for
financial loss, wrongful death, personal injury and post-traumatic
stress disorder caused by the pipeline explosion. But, according to a
January 21 New York Times article, Enron's bankruptcy case has frozen
settlement negotiations and the first scheduled trials for hundreds of
victims. First, this provides us a clear example why we must strengthen
pipeline safety laws to prevent corporate negligence as well as ensure
that corporate bankruptcy protection does not undermine the ability of
innocent victims to receive compensation for such loss.
Thank you.
Chairman Tauzin. The gentleman yields back his time and the
Chair will recognize Mr. Cox, if he's ready for his opening
statement, for 3 minutes.
Mr. Cox. Thank you, Mr. Chairman. On September 11, the men
and women who worked at the World Trade Center, Wall Street
analysts, traders, investment bankers, accountants were heroes.
We recognize that among the 3,000 souls who perished that day
were some of our best and brightest, extraordinary individuals
whose creativity, energy and leadership helped power the
economic miracle that is our free enterprise system.
Today, America's men and women of Wall Street are under
deep suspicion. The problems at Enron, K-Mart and Global
Crossing and at their accounting firms have deeply damaged the
credibility of every accountant, every corporate manager, every
analyst.
Today, accountancy is in the dock. The essence of the Enron
fraud is accounting. According to the Powers Report, the
accounting for Chewco was flatly wrong from its inception. The
purpose of the many SPEs that Enron created was to keep debt
and risk hidden from investors, from regulators and from the
public. The audited financial statements were misleading. The
only questions that remained are the various levels of
culpability and the number of people knowingly involved.
It is my hope that as we explore accounting issues today,
we can learn not only how to inform remedial legislation, but
also how to inform better regulation, both by the industry and
by the Securities and Exchange Commission.
I hope that we also keep uppermost in mind our
responsibility to protect the livelihoods of those people who
are not guilty of any wrong doing and who participate honestly
every day in the business of America at other places of work,
in other firms. I hope that we do everything possible to
restore the confidence of the investing public, of workers and
their own retirements and of people and their own employers so
that we can get about the business of America.
I thank you, Mr. Chairman.
Chairman Tauzin. The Chair thanks the gentleman whose time
has expired and the Chair will recognize--who's next? Mr.
Barrett.
Mr. Barrett. Thank you, Mr. Chairman.
Chairman Tauzin. You are recognized for 3 minutes.
Mr. Barrett. I want to thank you for holding this hearing
and thank our witnesses for being here today. We should learn
lessons about the administration of Enron's 401(k) plan today.
As a result of what may prove to be willful deception,
thousands of workers lost not only their family supporting job,
but also their retirement savings. Those families deserve
answers from this Congress.
We should learn lessons about the limits of Wall Street's
securities analysis capabilities. Because of America's
investment advisor and brokerage houses took Enron at its word,
America's families and large institutional investors suffered
untold losses. Wisconsin State employees alone lost over $45
million in pension fund assets when Enron stocks held by
Wisconsin Investment Board became virtually worthless.
Wisconsin employees and participants in other large
institutional investment plans have worked hard to earn their
pension benefits. And Mr. Chairman, they deserve answers from
this Congress.
We should learn lessons about the effectiveness of the
accounting and audit system that helps investors and creditors
to value one business venture against another. Enron's chief
work product appears to have been a web of dummy corporations
and mislabeled accounts. With literally thousands such sham
devices, the company's wrong doing appears to have been as
inconspicuous as a bulldozer at a tea party. But Arthur
Andersen signed off on Enron's reports and investors around the
world took Enron at its word, in part, because Andersen had
looked over the books.
Some of Andersen's reactions to allegations concerning its
role in Enron's failure have been disappointing. In comments
appearing in the February 3 Washington Post, Andersen spokesman
Charlie Leonard responded to Enron's internal audit by setting
Enron's failure to provide information about its money-pit
partnership Chewco. ``We attempted to speak with them and they
didn't speak with us'' Mr. Leonard told the Post.
Now it's been a while since I worked as a Federal bank
examiner, but as I recall when a responsible auditor does not
get the information he needs to be satisfied that the numbers
add up, he refuses to sign off on the audit. He doesn't rubber
stamp it and then complain after the fact that he hadn't gotten
all the information.
To borrow a phrase from President Bush, Enron's math was
not just fuzzy, it was hairy, wooly, shaggy, downright furry.
But whether it was willful complicity or just shoddy work,
Arthur Andersen was the watchdog that never barked.
We can take lessons from these failures too. The current
system of auditor accountability based on peer review may no
longer serve the public interest. I am hopeful that our
witnesses will help us consider whether an independent, self-
regulatory organization might better safeguard American
investors.
We can also take a broader lesson from the Enron debacle
about the importance of honest and complete information
disclosure. A capitalist economy, like America's, requires a
certain basic level of trust between business associates. One
party must believe that information provided by the other is
accurate and complete or the system cannot work.
In this case, this was forgotten. We should learn from
these failures and assure that America's business transactions
are more transparent, more accessible and more responsible than
before.
Thank you, Mr. Chairman.
[The prepared statement of Hon. Tom Barrett follows:]
Prepared Statement of Hon. Tom Barrett, a Representative in Congress
from the State of Wisconsin
Thank you, Mr. Chairman.
And I want to thank all of our witnesses for appearing today. I
expect that we will find your testimony enlightening.
Mr. Chairman, the focus of today's hearings is certainly an
appropriate one. We should be looking for lessons from Enron's
collapse, because there is a lot at stake.
We should learn lessons about the administration of Enron's 401(k)
plan. As the result of what may prove to be willful deception,
thousands of workers lost not only a family-supporting job but also
their retirement savings. Those families deserve answers from this
Congress.
We should learn lessons about the limits of Wall Street's
securities analysis capabilities. Because America's investment advisors
and brokerage houses took Enron at its word, American families and
large institutional investors suffered untold losses. Wisconsin state
employees alone lost over $45 million in pension fund assets, when
Enron stocks and bonds held by the Wisconsin Investment Board became
virtually worthless. Wisconsin employees and participants in other
large institutional investment plans have worked hard to earn their
pension benefits, and Mr. Chairman, they deserve answers from this
Congress.
We should learn lessons about the effectiveness of the accounting
and audit system that helps investors and creditors to value one
business venture against another. Enron's chief work product appears to
have been a web of dummy corporations and mislabeled accounts. The
company's wrongdoing appears to have been as inconspicuous as a
bulldozer at a tea party. But Arthur Andersen signed off on Enron's
reports, and investors around the world took Enron at its word, in part
because Anderson had looked over the books.
Some of Arthur Andersen's reactions to allegations concerning its
role in Enron's failure have been disappointing, to say the least. In
comments appearing in the February 3rd Washington Post, Anderson
spokesman Charlie Leonard responded to Enron's internal audit by citing
Enron's failure to provide information about its money-pit partnership,
Chewco. ``We attempted to speak with them, and they didn't speak with
us,'' Mr. Leonard told the Post.
Now, it's been a while since I worked as a federal bank examiner.
But as I recall, when a responsible auditor does not get the
information he needs to be satisfied that the numbers add up, he
refuses to sign off on the audit. He doesn't rubber-stamp it, then
complain after the fact that he hadn't gotten all of the information.
To borrow a phrase from President Bush, Enron's math was not just
fuzzy--it was hairy, woolly, shaggy--downright furry. But whether
because of willful complicity or just shoddy work, Arthur Anderson was
the watchdog that never barked.We can take lessons from Andersen's
failures, too. The current system of auditor accountability, based on
peer reviews, may no longer serve the public interest. I am hopeful
that our witnesses will help us to consider whether an independent,
self-regulatory organization might better safeguard American investors.
We can also take a broader lesson from the Enron debacle, about the
importance of honest and complete information disclosure. A capitalist
economy like America's requires a certain basic level of trust between
business associates. One party must believe that information presented
by the other party is accurate and complete, or the system cannot work.
In this case, this was forgotten. We should learn from their
failures and ensure that America's business transactions are more
transparent, more accessible, and more responsible than before.
Chairman Tauzin. I thank the gentleman. The Chair
recognizes Mr. Blunt of Missouri.
Mr. Blunt. Enron went down with a bang not a whimper and
the ripple effects have been felt in communities nationwide. In
my hometown of Stratford, Missouri--one of the largest
employers and you don't have to be a very big employer in
Stratford, Missouri, but one of the largest employers--went out
of business on Friday because their owner had a contract and a
loan with Enron. Enron couldn't hold up their end of the
bargain and now 130 Southwest Missourians are looking for work.
This is a complicated story with ramifications spilling over
into many legislative and regulatory areas. It would be easy
for me and for all of us on this panel to propose a mountain of
changes to prevent what happened to Enron. Subsequently, what
happened to businesses like Midwest Products in Stratford from
ever happening again. That's why I'm so pleased that the Mr.
Chairman has chosen to hold these hearings so that we, as a
committee, can find out what new regulations really are
warranted or whether we're simply creating obstacles to
solutions in the future.
Much of this mess may have been attributed to illegal
business practices or individual misconduct, but we can't, of
course, legislate scruples. Some of this bankruptcy could be
the result of bad business decisions and we can't legislate
good business judgment either. But the true scandal of this
case may be cutting bookkeeping tricks and promises of
retirement security that ultimately weren't worth the paper
they were written on.
It's clear that we need to shine some light on corporate
practices and then enforce corporate disclosure requirements.
SEC regulations and accounting rules already require disclosure
in situations that are likely to have a material effect on a
company's financial condition, but in this case, Enron's
financial disclosures were vague at best or criminal at worst.
Wall Street continued to overvalue Enron stock based on
this pattern of misleading reports. If adequate information had
been available about the true state of Enron's finances, Enron
employees would have made informed decisions about their
financial futures. After all, fully 62 percent of their 401(k)s
consisted of Enron stock and that stock plummeted from over $80
a share in January 2001 to less than $.80 a share by January
2002.
They never had a real chance, based on the reassurances
they apparently were receiving about the future state of the
company. I'm co-sponsoring legislation as many on this panel
are. The legislation I'm working on with Congressman Portman
and Congressman Carden will be legislation that will help
workers avoid over-concentration in stock of their own
companies. Enron's been a case in point for enhanced employee
control of retirement security. We need to look closely at a
bill of rights for retirement security.
Look at all the Enron-related problems that could have been
avoided had we had this type of regulation already on the
books.
I look forward to the committee's investigation of
corporate disclosures at Enron and at all companies. We need to
get to the bottom of what changes need to be made and then
enforce them so that workers aren't left trading years of
service for empty promises and uncertainty in their retirement
years.
[The prepared statement of Hon. Roy Blunt follows:]
Prepared Statement of Hon. Roy Blunt, a Representative in Congress from
the State of Missouri
Mr. Chairman, I want to thank you for calling these hearings. We
have an excellent opportunity to use Enron's collapse to effect some
significant change in the way our nation's businesses do business.
Enron went down with a ``bang--not a whimper,'' and the ripple
effects have been felt in communities nationwide. In my hometown of
Strafford, Missouri, one of our largest employers went out of business
on Friday because their owner had a contract and a loan with Enron, and
Enron couldn't hold up their end of the bargain. Now 130 Southwest
Missourians are looking for work.
This is a complicated story with ramifications spilling over into
so many legislative and regulatory areas. It would be easy for me and
for all of us on this panel, Mr. Chairman, to propose a mountain of
changes to prevent what happened to Enron--and subsequently to
businesses like Midwest Products in Strafford--from ever happening
again. That's why I'm so pleased that you're conducting these
hearings--so we as a committee can find out which new regulations are
warranted, or whether we'd simply be creating obstacles to the real
solutions.
Much of this mess may be attributable to illegal business practices
or individual misconduct, and we can't legislate scruples. Some of this
bankruptcy could be the result of imprudent business decisions.
And we can't legislate good business judgment either. But the true
scandal in this case may be that which is perfectly legal--cunning
bookkeeping tricks and promises of retirement security that ultimately
weren't worth the paper they were written on.
It's clear that we need to shine some light on corporate practices
and enact, and then enforce, corporate disclosure requirements. SEC
regulations and accounting rules already require disclosure in
situations that are likely to have a material effect on a company's
financial condition, but, in this case, Enron's financial disclosures
were vague at best and criminal at worst. Wall Street continued to
overvalue Enron stock--based on this pattern of misleading reports.
If adequate information had been available about the true state of
Enron's finances, Enron employees could have made informed decisions
about their financial futures. After all, fully 62 percent of their
401(k)s consisted of Enron stock, and that stock plummeted from 80
dollars a share in January 2001 to less than 80 cents a share in
January 2002. They never even had a chance.
I signed on yesterday to a bill Congressmen Portman and Cardin have
introduced to avoid workers' over-concentration in the stock of their
own companies. Enron has been a case-in-point for enhancedemployee
control of retirement security. This legislation would provide for new
diversificationrights, new disclosure requirements and new tax
incentives for retirement planning and education. It's a bill of rights
for retirement security.
Look at all of the Enron-related problems that could have been
avoided had we had this type of regulation already on the books to
allow employees to take control of their own financial futures. This
bill will prohibit companies from forcing employees to invest in
employer stock. It will grant new diversification rights for 401(k)
matching contributions in employer stock. The bill will require
companies to notify employees within 21 days of so-called ``blackout''
periods, so they can rearrange their investments if they see fit. And
it will require companies to make sure employees know about general
investment principles when they enroll in a retirement plan, so they
can make knowledgeable decisions about their futures.
Mr. Chairman, I look forward to the Committee's investigation of
corporate disclosure--at Enron and in all companies. Let's get to the
bottom of what changes need to be made and then enforce them, so that
workers aren't left trading years of service for empty promises and
uncertainty in their retirement years.
Thank you, Mr. Chairman.
Mr. Blunt [presiding]. I recognize Ms. DeGette for an
opening statement.
Ms. DeGette. Thank you, Mr. Chairman. I guess I'll
filibuster until everyone else comes back.
Mr. Blunt. Then we have Mr. Ehrlich to follow you who has
to vote as well.
Ms. DeGette. I have an opening statement which I will
submit for the record, but I have a few comments I'd like to
make. I'm privileged to sit on the Oversight and Investigations
Subcommittee which has been investigating the Enron mess over
the last few weeks and a few of my observations are as follows:
when we started this investigation several weeks ago, we were
told that the entire collapse of the house of cards that was
Enron was due to just a few bad actors and as we have gotten
deeper and deeper into this issue, it has become clear to all
of us that the problems go deep and wide, both in Enron and all
of its advisors.
Let me give a few examples. First, Enron's auditors, Arthur
Andersen. We were told in the Oversight and Investigations
Subcommittee that one renegade at Arthur Andersen, David
Duncan, the project manager, on his own decided to simply shred
documents using an appropriately named company, Shredco. And we
were told that he just decided this should be done.
As we went through the hearing it became immediately clear,
that the shredding was done with the tacit understanding and
the not-so-tacit advice of Andersen's in-house legal department
and of Mr. Duncan's supervisors. Mr. Duncan was told to use
Andersen's regular policy and destroy all backup documentation.
He was told this, even after Andersen and Enron knew of pending
litigation.
Second, the limited partnerships. We've heard much today
and in the last week about the complex web of limited
partnerships and other financial entities which were designed
to boost up Enron's balance sheet while at the same time hiding
fantastic losses. We were told at first this was just a few
greedy individuals. But as we sat through the Oversight an
Investigations Subcommittee hearings this week, it became
immediately clear that Andersen's senior management and their
board were either asleep at the switch or worse.
This is the diagram of the Chewco transaction. You can't
see it too well from the witness table, but it doesn't make
much difference because this transaction is so complex it's
difficult for even fairly well trained lawyers like me to
understand what was going on. But the bottom line was to shift
Enron's debt off the books to run it through limited
partnerships and other entities and in the end to inflate what
it looked like the bottom line was. There were thousands of
entities not all structured like this. In fact, many structured
quite differently than this. This is a diagram of the first
financial entity put together which I have an interest in since
it was a Colorado company, Rhythms. As you can see, these two
are very different transactions. And as we sat there and
listened to the web of very complicated partnerships and
accounting slight of hand, I could only help but think of one
thing, what would a low level Enron employee with all of their
401(k) retirement plan in stocks make of these? The Enron
investors relied upon Arthur Andersen, the Board of Directors
and senior management of Enron to make sure that all of these
transactions were legitimate and that any conflicts of interest
were disclosed.
Finally, the huge personal gains made by Enron employees
and offices. Again, we were told this was just one or two
people making a lot of money. As we sat in the Oversight and
Investigations Subcommittee, we realized many senior level
employees, several officers were benefiting unbelievably from
these. Let me just give a couple of examples. People who
invested a few thousand dollars in the limited partnership and
received $1 million in compensation 6 months later. People who
invested a few tens of thousands of dollars and received $30
million in compensation, just a few months later, all
undisclosed. It's clear we must know exactly what happened. How
did Enron senior executives and board members hide these losses
while getting personal gains like this? What can Congress do?
And most importantly, perhaps, what can our society do to
protect the small investors who have lost everything while the
executives gained.
[The prepared statement of Hon. Diana DeGette follows:]
Prepared Statement of Hon. Diana DeGette, a Representative in Congress
from the State of Colorado
Thank you, Mr. Chairman. In the past few weeks all of us have been
stunned by the revelations surrounding Enron's bankruptcy and the
involvement of Arthur Anderson. These hearings may help us get to the
bottom of the matter. The arrogant web of lies and deception must be
untangled.
We must restore investor confidence, mandate greater transparency,
deter other corporations from flimsy fiscal practices, and find just
recompense for employees who lost their savings.
Enron was the largest corporate implosion in history. And while
those charged with fiduciary duty protected their money, loyal
employees and trusting investors were scammed. The American people have
lost confidence that Enron will provide the truth. They have learned
that Arthur Anderson, which functioned as an auditing safeguard, failed
in its duty. Now, the American people are looking to us for an honest
accounting. It is our duty to use these hearings to answer the many
questions at hand.
We must know exactly what happened. How did Enron's senior
executives and board members hide such fantastic losses while
themselves realizing some breathtaking gains? How can shell
partnerships be created that bury huge losses? How did Enron get away
with annual reports filled with half-truths, even lies, omitting key
information and transactions? What kind of corporate mentality creates
a climate to ignore the law with seeming impunity, especially in an
organization that in many ways was so visible?
We know Enron was a hard-charging, rapid-growth company that
constantly pushed the envelope. The Powers Report detailed a litany of
problems, compounded by a corporate mentality where executives thought
that the law was an inconvenience to be over-ridden, not a legitimate
public demand for honest practices and transparent dealings.
Arthur Anderson helped Enron, of course. How did a reputable,
internationally recognized firm like Arthur Anderson fail to provide a
credible, transparent, honest audit of the company? How did Arthur
Anderson hope to remain objective and credible when they were receiving
astronomical consulting fees?
I am most mindful of the many investors here who have lost their
money, and the employees who lost their retirement funds. What can
Congress do to protect these employees and shareholders, many of whom
have lost their entire retirement savings. We have had two Oversight &
Investigation hearings which have provided extensive illumination. I
look forward to learning more today so that we may begin to untangle
the web which Enron left us.
Thank you.
Mr. Blunt. The gentlelady's time has expired. The Chair
recognizes the gentleman from Maryland, Mr. Ehrlich, for 3
minutes.
Mr. Ehrlich. Thank you, Mr. Chairman. I have a sense of
compassion for our witnesses. I'll give you the Cliff Notes
version of my opening statement because you all have certainly
gotten the spirit of the day.
We all know Enron is the largest corporation in American
history to file for bankruptcy. In addition to the type of
investor losses the gentlelady just discussed, there was a
dramatic and sudden fall in Enron stock prices that stripped
retirement accounts of many current and retired Enron employees
whose savings were based on Enron's stock.
Our committee colleagues from both sides of the aisle
support this committee's efforts to discover whether or not
Enron engaged in illegal business practices. We want to
understand a lot. We want to understand why executives received
large bonuses and compensations during a period of financial
decline while other employees were prevented from selling their
stock. We want to understand how such a large corporation was
able to hide its debt and collapse without any warning from
responsible regulatory agencies and auditors.
Yet additional questions must be answered. Did Enron's use
of a large number of partnerships contribute to its collapse?
Was there a complete failure of Federal regulators? Did Federal
regulators have authority to adequately oversee complex
commodity trading and financial transactions, the foundation of
Enron's rapid growth?
Through your guidance we'll certainly come to some
conclusions, hopefully, solid conclusions with regard to these
issues.
Chairman Tauzin's efforts to promote dependable, affordable
and environmentally friendly production and distribution of
energy are well known. Some, and you've heard a sampling here
today, but not most members of this committee, may try to
confuse deregulation and the need for sound energy policy with
illegal and duplicitous actions. I continue to believe that the
competitive market protected from potential abuse through
proper oversight and the law remains the foundation for a
strong economy, the basis for our national security and
provides the best products and services for our citizens.
We look forward to what you all have to say and thank you
for being here. I yield back.
[The prepared statement of Hon. Robert Ehrlich follows:]
Prepared Statement of Hon. Robert Ehrlich, a Representative in Congress
from the State of Maryland
Thank you, Mr. Chairman. Mr. Chairman, the failure of any business
is deeply disappointing. In most cases, employees and their families
bear the brunt of this failure with many experiencing a profound sense
of loss, anger, and shame. As the failure ripples through related
enterprises, rocking businesses and communities--disillusionment and
loss is left in its wake. Unfortunately, the tempest of a failed
enterprise is in direct proportion to its size, and, accordingly, I
applaud your conducting this inquiry of Enron, once our nation's 7th
largest company.
On December 2, 2001, energy-giant Enron shocked the energy and
financial communities by filing for Chapter 11 bankruptcy. Enron is the
largest corporation in American history to file for bankruptcy. In
addition to investor losses, the sudden and dramatic fall in Enron's
stock price has stripped the retirement accounts of many current and
retired Enron employees, whose savings were largely based on Enron
stock.
Mr. Chairman, my colleagues and I support the committee's efforts
to discover whether or not Enron engaged in illegal business practices.
We want to understand why executives received large bonuses and
compensation during Enron's financial decline while other employees
were prevented from selling their stock. We want to understand how such
a large corporation was able to hide its debt and collapse without any
warning from responsible regulatory agencies and auditors. Yet
additional questions must be answered: Did Enron's use of a large
number of partnerships contribute to its collapse? Was there a failure
re the performance of federal regulators? Did federal regulators have
authority to adequately oversee complex commodity trading and financial
transactions--the foundation of Enron's rapid growth? Through your
guidance, these and many other questions will be answered.
Mr. Chairman, I applaud your efforts to review accounting
standards, practices, and services and their effects in the Enron
collapse. If there are flaws in the regulatory system, then the laws
must be changed to guarantee that a debacle of this magnitude will
never happen again. I agree with President Bush's State of the Union
statement that through stricter accounting standards and tougher
disclosure requirements will make corporate America more accountable to
employees and shareholders alike. This must be an era of corporate
responsibility.
The deliberate destruction of evidence by an employee in an ongoing
investigation brings its own State and Federal criminal and civil
penalties, as does failure to comply with SEC regulations and
directives. Our court system will resolve the many lawsuits seeking
justice and compensation. Illegal and duplicitous actions should not
and cannot be tolerated. Further, it is clear that some may attempt to
use this business scandal that has hurt so many as a tool for petty
politics and opinion manipulation. We owe those who have worked hard,
played by the rules, and have lost so much a strong, bipartisan
investigation, or risk victimizing them a second time.
Mr. Chairman, your efforts to promote dependable, affordable, and
environmentally-sound production and distribution of energy are well
known. Opponents may try to confuse deregulation with illegal and
duplicitous actions. I continue to believe that the competitive market,
protected from potential abuse through proper oversight and legal
protections, remains the foundation for a strong economy, the basis for
national security, and provides the best products and services to our
citizens.
Finally, this committee's investigation into Enron's business
practices will prevent future business collapses of this nature,
determine the effectiveness of Federal oversight and regulatory
agencies, and make clear whether changes to Federal law are necessary
to protect employees and shareholders. We must and will get to the
bottom of Enron's failure, and work to ensure it never happens again.
Thank you Mr. Chairman.
Chairman Tauzin. I thank the gentleman for his statement.
The Chair is pleased to recognize the gentlelady, Ms. McCarthy,
for an opening statement.
Ms. DeGette, I was not here to recognize you and I did want
to take a moment to personally thank you for the extraordinary
work you're doing on the subcommittee and I deeply appreciate
the attention you've given that work. Thank you.
Ms. McCarthy is recognized for 3 minutes.
Ms. McCarthy. I thank you very much, Mr. Chairman. I thank
you for conducting this hearing. I would like the panelists to
know that I arrived at 12:15, 2\1/2\ hours ago and so I'm going
to submit the bulk of my text to the record, but I want to
thank you for taking the time to be here with us today. I think
what the committee is about is lessons learned and I'm pleased,
Mr. Chairman, that that is how you have framed this hearing,
because while all of us have been consumed by this in the news,
and our committee staff has done 2 months of investigation and
they've come up with some very serious determinations for us to
look to, I look forward to your presentations because I think
you're going to help us understand that many of the things that
we feel we might need to fix can be done through regulatory and
statutory mechanisms already in place, but that we might need
to revisit some of the ideas that former Chairman Levitt and
others presented to us over time that might tighten those
regulatory processes to avoid this in the future.
I'm particularly interested in hearing your thoughts on how
corporate boards can reform themselves because I think they can
go a long way toward finding or being part of the solution to
this kind of activity so that it doesn't happen anywhere else
and I think too, Mr. Chairman, that all of us on this committee
can learn from this experience that we're going to have, how we
can shape national energy policy that we are working on very
diligently, to make sure that we in the Congress also are
working together with the regulatory agencies and existing
statutory law and the boards to make sure we have sound energy
policy in the future. So I thank you and I will submit my
formal remarks for the record.
Chairman Tauzin. I thank the gentlelady for always very
thoughtful comments and she yields back. Are there further
requests for time? I believe we have the vice chairman of the
full committee, the gentleman from North Carolina, Mr. Burr,
who has done such an excellent job for our committee for 3
minutes.
Mr. Burr. I thank the Chair. I don't want to prolong
opening statements. I only want to make a comment about the
work of this committee. This committee has a long history and
certainly in the 7 years that I have been here to tackle tough
issues. And even though the Oversight and Investigations
Subcommittee has been asked to look at numerous things in those
7 years and prior to that under other leadership, also
difficult issues, I personally have not been as challenged as I
think we have been so far with the Enron issue, nor do I think
we will be any more challenged as we head through this.
This is clearly like peeling an onion and with every layer
we see something different. We see something new and in many
cases we find something even more ugly than we saw in the last
layer. We owe it to the American people to fulfill our
commitment of oversight, of understanding, but most
importantly, of assurance that we have gotten at the cancer
that exists.
I'm confident, Mr. Chairman, under your leadership and with
the commitment of all members, and hopefully, hopefully, with
the cooperation of more directly involved in this whole issue
we can get at the truth and move on to the solution much
faster.
I yield back.
Chairman Tauzin. I thank the gentleman for his statement
and the Chair yields to the gentlelady, Ms. Capps, from
California for an opening statement.
Ms. Capps. Thank you, Mr. Chairman. I'm so pleased the
committee is holding this wide ranging hearing about Enron.
It's important that we begin now to look into steps Congress,
the regulatory agencies and corporate players must take to
protect the public from future Enrons. The distinguished panel
of witnesses we have here will certainly be helpful in shedding
light on this scandal and how we might prevent future ones.
I share the outrage of my colleagues and my constituents
over this whole affair. The various actions of Enron and
Andersen executives has been inexcusable, immoral and maybe
illegal. As we all know, Enron's meltdown has cost thousands of
the company's employees some or all of their life savings. It
has burned millions more investors across the country. It has
highlighted some glaring inadequacies in the accounting
profession and its ineffective system of oversight that has
allowed and even encouraged corporate shenanigans. And of
course, Enron has shown us, once again, the ugly face of greed
and dishonesty.
Every day, congressional hearings in the media bring out
more details about this sordid affair. We know, for example,
that Enron executives set up thousands of partnerships to help
the company hide its debts. We know that many of these
executives made fortunes through these partnerships. We know
that Arthur Andersen was involved in some or all of this and we
now know that Enron, once touted as a management innovator, was
apparently not much more than a sophisticated pyramid scheme.
But there's a lot we still don't know. For starters, Mr.
Chairman, we still don't know exactly who approved all these
complex relationships and what they knew when they did it, who
were all the partners and how much money they made. We don't
know how deeply Enron may have been involved in the California
electricity crisis. These are my constituents. How Enron's
actions may have exacerbated that situation? We know there's a
strong connection. We still are paying that price and will be
paying it for a long time in California.
Until we know answers to these and many other questions our
work here will not be complete. So this committee must continue
its aggressive investigation and I applaud all of the efforts
into doing that.
The unanswered questions, however, do not excuse us from
taking actions immediately. I would hope that we can look into
the idea of limiting the amount of time an accounting firm can
do audits for the same company to a set number of years.
Perhaps that's worth exploring. The attempt of our former SEC
Chairman Arthur Levitt to stop accounting firms from performing
auditing and consulting for the same client is now clearly seen
as something that should be pursued in Congress. Some have
suggested that the stock exchanges be responsible for hiring
the accounting firms to audit companies. These ideas should be
explored and I would like to hear from our witnesses on these
and other ideas.
These kinds of changes may be necessary to give investors
more responsible and accurate accounting of corporate books. I
think it's important to note, however, that at the bottom of
all this are not seemingly mundane accounting problems. At the
bottom appears to be simple greed and dishonesty at the highest
levels of a corporation. It was Enron executives who were in
charge when the company was going to say what was happening
regarding its profits and losses. It was Enron executives that
chose to stretch and finally break the bounds of propriety. And
so it must be the goal of this committee to take whatever steps
are necessary to make sure that the next set of executives in
Enron or any other of our large corporation or any of our
business executives think twice before they do the same thing.
Thank you, Mr. Chairman. I yield back the balance of my
time.
[The prepared statement of Hon. Lois Capps follows:]
Prepared Statement of Hon. Lois Capps, a Representative in Congress
from the State of California
Thank you, Mr. Chairman.
I am pleased the Committee is holding this wide ranging hearing
about Enron.
It is important that we begin now to look into steps Congress, the
regulatory agencies and corporate players must take to protect the
public from future Enrons.
The distinguished panel of witnesses we have here will certainly be
helpful in shedding some light on this scandal and how we might prevent
futures ones.
I share the outrage of my colleagues and my constituents over this
whole affair.
The varoius actions of Enron and Andersen executives has been
inexcusable, immoral and probably illegal.
As we all know, Enron's meltdown has cost thousands of the
company's employees some or all of their life savings.
It has burned millions more investors across the country who bought
Enron stock based on false premises.
It has highlighted some glaring inadequacies in the accounting
profession and its ineffective system of oversight that has allowed and
even encouraged corporate shenanigans.
And, of course, Enron has shown us once again the ugly face of
greed and dishonesty.
Every day Congressional hearings and the media bring out more
details about this sordid affair.
We know, for example, that Enron executives set up thousands of
partnerships to help the company hide its debts and artificially boost
its profits.
We know that many of these executives made fortunes through these
partnerships.
We know that Arthur Andersen was involved in either setting up the
accounts or approving them or somehow giving some cover to Enron's
misdeeds.
And we now know that Enron--once touted as a management innovator--
was apparently not much more than a sophisticated Pyramid scheme.
But there is an alot we still don't know.
For starters, Mr. Chairman, we still don't know exactly who
approved all these complex partnerships and what they knew when they
did it.
We don't know who were all the partners in the partnership, how
they became partners, or how much money they made.
We don't know how deeply Enron may have been involved in the
California electricity crisis and how its actions may have exacerbated
that situation.
And until we know the answers to these and many other questions,
our work here won't be complete.
This Committee must continue its aggressive investigation into
these questions and many others.
The unanswered questions do not, however, mean that there are no
clear actions we should take.
For example, the former SEC Chairman Arthur Levitt's attempt to
stop accounting firms from performing auditing and consulting for the
same client is now clearly seen as correct.
I think that we should look into the idea of limiting the amount of
time an accounting firm can do audits for the same company to a set
numer of years is worth exploring.
Some have suggested that the stock exchanges be responsible for
hiring the accounting firms to audit companies.
That idea might be worth exploring as well and I would like to hear
from our witnesses on all these ideas.
These types of changes may be necessary steps to give investors a
more responsible and accurate accounting of corporate books.
However, I think it is important to note that at the bottom of all
this are not just seemingly mundane accounting problems.
At the bottom of this mess appears to be simple greed and
dishonesty in the highest levels of a corporation.
It was Enron executives that were in charge of what the company was
going to say regarding its profits and losses.
It was Enron executives that chose to stretch and finally break the
bounds of propiety.
I hope that this Committee can take steps to make sure that the
next set of executives think twice before doing the same thing.
Thank you, Mr Chairman.
Chairman Tauzin. The Chair thanks the gentlelady. The Chair
is now pleased to recognize the gentleman from Arizona, Mr.
Shadegg, for an opening statement.
Mr. Shadegg. Thank you, Mr. Chairman. I want to commend you
for holding this hearing. I'm pleased that our committee is
going to look into these critically important issues.
It simply cannot be stated how important this inquiry is to
our Nation and to its free market system. If people do not have
confidence in the market place, if they do not have confidence
in the financial documents which describe the companies in
which they are asked to invest, then we will not have a
functioning free market in this country and we will not have
the capital to move forward as a Nation and to sustain the
lifestyle we have. So I commend you, Mr. Chairman, for holding
these hearings.
I think I want to jump off of the point that Ms. Capps just
made. There are clearly some things wrong in the system. When I
listen to the bureaucratese about special purpose entities and
then you go behind those and you discover that they really are
off-balance sheet entities which in this instance were used to
hide debt and create a false impression about the financial
security of this company, it is clear that we need to take a
close look at the accounting standards of this country. We need
to take a close look at the role for the SEC. We need to take a
close look at the role of FASB and whether or not we're doing
the right things there. I commend you for bringing in this
particular panel of witnesses.
But in our effort to examine this, we need to discern
between that which was a regulatory failure where we did not
have bright lines in the rules that govern misconduct and as
Ms. Capps put it simple greed, because in this instance it
looks to me fairly clear that there was a great deal of simple
greed. No one I believe reading the documents and studying what
happened can fail to recognize that members of the board of
directors had to know what was going on, officers had to know
what was going on, they had to know that the public was being
deceived.
Now someone should have caught that before now and we
should make sure that the enforcement mechanisms are there to
do so, but we should not just enact new regulations to replace
the regulations that failed the last time and thereby burden
the economy. This is a critically important inquiry. I commend
you, Mr. Chairman, for conducting it.
Chairman Tauzin. I thank the gentleman. Further requests
for statements? Mr. Doyle is recognized for an opening
statement.
Mr. Doyle. Thank you very much, Mr. Chairman, and in
deference to our panel members I'll submit my entire statement
for the record.
Chairman Tauzin. Without objection, so ordered.
Mr. Doyle. And just state that this member, along with all
members of this committee and the Nation are not only shocked,
but outraged by what transpired here and one of the things we
have to make sure of in this committee is that this can never
happen again.
Thank you, Mr. Chairman.
[The prepared statement of Hon. Mike Doyle follows:]
Prepared Statement of Hon. Mike Doyle, a Representative in Congress
from the State of Pennsylvania
Mr. Chairman, thank you for providing today's forum to examine
issues that demand this Committee's prompt attention; accounting
standards reform and auditor oversight.
Malcolm Forbes once said: ``Too many people overvalue what they are
not, and undervalue what they are.''
Some of Enron's top leadership knowingly and systematically
reported an income and financial stability that simply did not exist,
and thus betrayed consumer trust by portraying a greater value of the
company than actually existed. To make this matter all the more
onerous, Enron accountants appear to have exploited loopholes in
existing law governing the disclosure of relevant material financial
information to achieve their deception. I am troubled by the
allegations that top management officials with Enron capitalized on the
lack of effective and enforceable accounting standards, and thus
bullied their accountants into misrepresenting numbers to public
investors to hide the fact management had made terrible business
decisions.
The debt incurred by these deals was obscured from investors in
special purpose entities, and what real income Enron was realizing from
other SPE deals was being pocketed by a select few at the top. Enron
officials knew this was occurring, but did nothing to alert the public.
Investors took such information in good faith and heavily invested
pension plans in Enron stock. The results were catastrophic for working
class Americans, as the value of employee pension plans a worker had
invested in and counted on for years were wiped out in an instant.
I am very concerned that our current accounting and auditing
practices can be manipulated and exploited to hide fraudulent
activities. This committee must look at ways to improve and strengthen
our accounting standards to prevent intentional circumvention by
unscrupulous individuals whose greed overshadows principle. Such
individuals are compromising the integrity of their professional and
personal reputations, while ruining the trust of a public that relies
on information they provide to make investment decisions. If this is
the best that accounting industry self-regulation can do, then Congress
has no choice but to step in with real regulation.
In my view, allowing the same firm on a company payroll to do the
auditing for that company is a practice that is ripe for exploitation,
especially when laws prohibiting this exploitation are vague or
nonexistent. We must empower the Securities and Exchange Commission
with the proper resources and authority to enforce accounting and
auditing standards, and I sincerely hope this Committee explores ways
to reduce or eliminate this conflict of interest in industry practice.
My colleagues, one of prime directives of this Committee is to
ensure that American consumers are protected from harmful goods and
services. Clearly, Enron violated the rights of consumers by reporting
false or misleading information through the use of ``pro-forma''
earnings reports, whereby disclosure laws are skirted through the use
of creative accounting terms and practices. We must act to reform our
ability to regulate and enforce disclosure laws so that investors know
and clearly understand the financial shape of a company before making
investments.
Chairman Tauzin. Further requests on this side? Then the
Chair is pleased to announced to our very patient panel of
witnesses that he's going to recognize the last member on this
side of the aisle, Mr. John of Louisiana. We've come full
circle.
Mr. John. Thank you, Mr. Chairman. I know that you're very
happy that I'm giving an opening statement only because I'm the
last one, right? Thank you, Mr. Chairman.
I really appreciate the on-going efforts that you and the
other ranking members of O&I have put together to educate the
members of this committee, most of which are not accountants
nor attorneys, and the public about really what went wrong at
Enron and the steps we can take in Congress to prevent
employees and investors at other companies from experiencing
some of the same problems.
There are many lessons to be learned from Enron's collapse.
Some are very simple. But some are very complex. The expert
panel that we have today, that you've assembled on auditing and
accounting practices will greatly assist us and this committee
in distinguishing between what transpired at Enron versus what
takes place in corporate America on a day to day basis. The
witnesses have made lots of concrete recommendations in your
testimony, a lot of which have merit and we're going to discuss
them today. And we'll enact, possibly enact, legislation at the
end of our investigation.
I think Enron's collapse revealed a complex, corporate web
of related party transactions and off-balance partnerships that
beg the question: ``how could this have happened to a publicly
traded company?'' The Powers Report of which we had many hours
of testimony yesterday reveals a company that was plagued with
flagrant conflicts of interest, as he called them walking
conflicts of interest through the doors of Enron, lax oversight
of auditing and reporting processes, a complete disregard for
their own code of ethics, and collusion among members of senior
management to distort the true financial picture of the company
in its public filings.
Mr. Chairman, I believe the Justice Department will bring
justice to the individuals that played any role in defrauding
the millions of investors and for destroying the retirement
dreams of thousands of employees, some of whom live in my
District in Louisiana.
However, I believe that it is the responsibility of this
committee to determine what role the auditing and accounting
professions have played in the collapse of Enron. I think that
is our role. For example, is there enough self-regulation in
the industry to convince investors that accurate and relevant
information is being disclosed? Or does Congress need to take
legislative action to ensure auditor independence?
I think before we take any legislative action, it's
important to be sure that we have not learned the wrong lessons
here. We must make sure that we do not harm consumers or
investors with our good intentions or the hasty movements of
this committee.
I look forward to the testimony with our witnesses here
today, and I yield back the balance of my time.
[The prepared statement of Hon. Chris John follows:]
Prepared Statement of Hon. Chris John, a Representative in Congress
from the State of Louisiana
Mr. Chairman, I appreciate your ongoing efforts to educate members
of this committee and the public about what went wrong at Enron and the
steps we can take in Congress to prevent employees and investors at
other companies from experiencing the same fate. There are many lessons
to be learned from Enron's collapse, some simple and others more
complex. The expert panel you have assembled today on auditing and
accounting practices will greatly assist the committee in
distinguishing between what transpired at Enron versus what takes place
every day in corporate America. The witnesses have made many concrete
recommendations in their written testimony which merit discussion today
and possible legislative enactment at the end of our investigation.
Enron's collapse has revealed a complex corporate web of related-
party transactions and off-balance-sheet partnerships that beg the
question: how could this happen to a publicly traded company? The
Powers Report reveals a company that was plagued with flagrant
conflicts of interest, lax oversight of the auditing and reporting
process, a complete disregard for their own code of ethics, and
collusion among members of senior management to distort the true
financial picture of the company in public filings.
Mr. Chairman, the Justice Department will determine which Enron
executives should be put on trial for their roles in defrauding
millions of investors and for destroying the retirement dreams of
thousands of employees. However, it is the responsibility of this
committee to determine what role the auditing and accounting profession
played in Enron's collapse. For example, is there sufficient self-
regulation in the industry to convince investors that accurate and
relevant information is being disclosed, or does this Congress need to
take legislative action to ensure auditor independence?
However, before we take legislative action, it is important to make
sure we have not learned the wrong lessons. We must make sure that we
do not harm consumers, investors or businesses with our good
intentions. I look forward to the testimony of our panel to ensure we
stay on the right track.
Thank you, Mr. Chairman. I yield back the balance of my time.
Chairman Tauzin. I thank my friend for yielding and I think
we're through with opening statements. I'm sorry, the chairman
of the Energy Subcommittee, Mr. Joe Barton of Texas has
arrived. I wish to recognize him for an opening statement.
Mr. Barton. For once I timed it right. I got here right at
the end of the opening statements, so I apologize to our panel
for having to wade through all of this. I have just a few brief
comments. I am very glad that we're holding this hearing. I
think the American public needs to understand if it's possible
to understand exactly what happened at Enron. I think the
accounting practices are paramount to that understanding. I
took six different accounting classes in undergraduate and
graduate school. And for the first 10 years out of college I
could understand an annual report about as well as anybody. I
took a look at the Enron annual report and I can't understand
it. I spent an hour attempting to really understand what they
were doing and it's impossible by a layman reading their annual
report.
I am very interested to learn how some of these accounting
practices came to be generally accepted. The mark to market
accounting seems to me murky at best. How in the world you can
book a revenue this year for something you may not get for 10
or 15 years at 100 percent face value is beyond the
comprehension of the average American. I also would be very
interested if the panel is allowed, to discuss this practice of
an audit firm with a consulting arm, both consulting and
auditing the same firm. It would seem to me that one pretty
straight forward change would be you could do one or the other,
but you can't do both.
So again, Mr. Chairman, I thank you for holding this
hearing. I have followed very closely the collapse of Enron.
I'm one of the stockholders that has now got stock that if I
were to trade it would probably be trading at pennies on the
dollar, so I want to get to the bottom of this as well as the
next person and do whatever we need to do as a committee to
prevent this from happening to future companies and future
stockholders.
Chairman Tauzin. I thank the gentleman. I also thank the
gentleman for agreeing to examine the energy markets next week
at a hearing. I think we've scheduled it for the 13th or 14th,
Joe?
Mr. Barton. The 13th, I think.
Chairman Tauzin. The 13th, so stand by for that one.
[Additional statements submitted for the record follow:]
Prepared Statement of Hon. Tom Davis, a Representative in Congress from
the State of Virginia
Mr. Chairman, I would like to first thank you for calling this
hearing into the Enron collapse and all of the ramifications it holds
for our economy and financial paradigm.
To say the Enron situation is troubling is, of course, an
understatement. Beyond being another episode of self-enrichment by
rogue employees and careless oversight by senior officers and board
members, this case has possible severe implications for our capitalist
system. This is because the accounting and auditing procedures
currently in place are now being questioned. As we have heard over the
past several weeks, if the numbers on the financial reports are
meaningless, or if there is widespread gimmickry in use to conceal true
financial status of an enterprise, then we are in deep trouble. If
investors cannot rely upon the information available to them, then the
equities markets devolve into little more than games of chance, where
smoke and mirrors prevail over reason and rational decision-making.
While it is not the role of Congress to try and convict those
charged with wrongdoing, it is the duty of Congress to conduct
effective oversight and strengthen regulation to ensure as little
chicanery as possible goes on in the marketplace. If, as evidence
becomes available and as events unfold, it becomes apparent that the
officers and former officers of the Enron Corporation were guilty of
gross negligence and/or criminal activity, then it is my personal
desire to see them prosecuted to the fullest extent of the law. If the
Powers report is to be believed, it is unfortunately likely that such
misdeeds and derelictions of duty did, in fact, occur. What is also
troubling--perhaps more so--is the role the auditors of Arthur
Anderson, LLP played in this whole affair. Can we believe that simple
human error is to blame for the basic accounting mistakes attending the
creation of the Special Purpose Entities created by Mr. Fastow in an
effort to conceal debts and liabilities of the Enron Corporation? Or
was something more sinister at play?
We are now left with the aftermath of this debacle. Recently,
doubts have been cast regarding the accounting procedures of other
large and heretofore extremely successful companies. While the
fluctuations of the stock market should never be used as the basis for
policy decisions, the underlying investor doubt in financial reporting
is something to take very seriously. Most unfortunate of all, however,
are the employees and other innocents who were forced to stay on board
the SS Enron while the top officials jumped like rats off the sinking
vessel. While it may be impossible to make their retirement accounts
whole again, this unseemly episode does give added impetus to thorough
review of pension laws so that this does not happen to anyone else.
In summary, there was enough shoddy oversight by all responsible
parties, enough self-enrichment, enough complicity on the part of
auditors and senior management, to warrant an exhaustive investigation.
I look forward to hearing the testimony today and to the ongoing
efforts of the committee to bring the actions of the Enron board and
executives to light.
______
Prepared Statement of Hon. George Radanovich, a Representative in
Congress from the State of California
Mr. Chairman, today's hearing is a very important step in building
confidence in our U.S. capital markets. Without consumer confidence our
American market system, based in part on trust, will not operate. While
trust is a key, we need to fix the system to abide by the principle
tenant of ``trust but verify.''
We must uncover all the secret Enron partnerships that were
designed to enrich top executives and defraud stockholders. The Enron
Special Investigation Committee report has uncovered secret and
possible illegal dealings between Enron and partnerships controlled by
its top executives. We owe a thorough investigation to the people who
worked all their lives at Enron only to retire with a handful of change
while top executives made millions.
Enron's attempt to trade water rights in my home state of
California through their subsidiary Azurix Inc. is a perfect example of
Enron's appalling business deals. It is unjust for a company to
dissolve losses of $326 million in one transaction alone, while
executives who leave just prior to the downfall receive millions in
severance pay at the time of their departure. Huge severance payments
paid out to former executives played a part in Azurix's downfall and
left many Californians broke and unemployed.
Due to the Enron failure and the scandalous events surrounding the
company, the accounting profession has also been tarnished. Arthur
Anderson has shown that the regulatory model that governs their
profession is in dire need of reform. The conflict of interest when
auditors provide other services, especially management consulting
services, to their audit clients, require changes that are vital to the
survival of the industry.
In the end, I hope we collect enough information to determine the
real purpose behind the creation of these secret Enron partnerships.
And if their purpose was to have a friendly third party with which
Enron could engage in various financial transactions in order to
improve Enron's balance sheet, those involved should be brought to
justice.
For the sake of our markets, our investors, and our pension plans
this problem must be fixed. I thank you Mr. Chairman for holding this
hearing, and I yield back the balance of my time.
______
Prepared Statement of Hon. Joe Pitts, a Representative in Congress from
the State of Pennsylvania
Thank you Mr. Chairman. Before I begin, I would like to thank you,
Chairman Tauzin, Chairman Greenwood, the Ranking Members, and your
staffs for all the hard work you have been doing on behalf of this
Committee.
So far, this Committee's investigation of the Enron collapse has
been very thorough and meticulous, thanks to the careful work and long
hours put in by your staff.
Mr. Chairman, like all of us, I am disheartened what happened with
Enron. It seems that every day reveals new information and evidence
about this collapse that makes this case even more serious and
complicated.
Enron's collapse is not just about corporate mismanagement,
accounting standards, or regulatory failure, but about thousands of
American working men and women who lost their jobs and saw their
pensions shrivel to nothing.
As we move forward on this investigation, we shouldn't forget
them--those whose futures have been affected by this mismanagement.
I am hopeful that this hearing will help us get to the bottom of
what happened, and obviously, how we can avoid this from happening in
the future.
I look forward to hearing from this panel of experts today about
the transactions behind the company's collapse.
Specifically, I am interested in learning more about audit
practices and current standards for Audit Committees and whether these
standards are adequate to ensure meaningful oversight for shareholders.
I am also hopeful that the witnesses will discuss the current state
of corporate disclosure and make recommendations for improvements.
Unfortunately, in the case of Enron, it seems there was a failure to
communicate essential information about the real risks facing the
company to the people who needed it most--the investors.
As I mentioned before, our final goal in this investigation should
be to make sure this doesn't happen again, to protect the hard-earned
pensions of the American people and to restore their trust.
Mr. Chairman, I believe we should be careful not to rush to
legislative responses to the Enron bankruptcy. However, I do look
forward to looking into President Bush's plan and others which address
federal laws governing worker pensions and 401(k) plans.
I appreciate the witnesses taking the time to share with us today
and look forward to hearing their testimony.
I yield back the balance of my time.
______
Prepared Statement of Hon. Mary Bono, a Representative in Congress from
the State of California
Mr. Chairman: Thank you for holding these hearings.
Enron created more than 3,000 partnerships, restated nearly $600
million of profit over four years and went from one of this country's
top companies to a source of controversy and shame.
Seeking to look more profitable, the creation of these 3,000
partnerships allowed Enron to move its debts off its financial
statements and out of the public eye. In doing so, the company
allegedly sought to mislead investors and shareholders and betrayed the
trust and confidence of its very own employees. In fact, Enron
officials went beyond keeping quiet about the company's financial
woes--top officials allegedly encouraged further investment by its
employees when they knew this house of cards would collapse.
It is unfortunate that Congress must now look at enacting
safeguards for 401(K) plans not only because a business failed, but
because of the callousness of the men and women who ran it.
Another player in this disturbing turn of events is the Arthur
Andersen firm. Arthur Andersen seemed to either bless these business
practices of Enron or was oblivious to it. But what makes this
relationship even more tenuous is the fact that not only was Arthur
Andersen Enron's auditor, but also its consultant. Arthur Andersen
collected audit fees of $25 million but earned even more for its
consulting work.
Therefore, the role played by auditors in our capital markets
should also come under scrutiny. The ``Big Five'' have long served as a
sort of ``Good Housekeeping'' seal of approval for investors in our
capital markets. High standards of disclosure and transparency are the
keystones to a healthy and vibrant market. Unfortunately, it has become
apparent that Congress needs to discuss implementing stricter
accounting standards and more thorough disclosure requirements.
But these troubles do not end in the questionable business
practices of Enron and Arthur Andersen. It is now apparent that
individuals at both firms decided to shred documents after the Security
and Exchange Commission launched a formal investigation on October 31,
2001.
Mr. Chairman, I look forward to this hearing and ones to come in
order to understand exactly what went wrong and how Congress can
address these problems in a responsible and well thought out manner.
______
Prepared Statement of Hon. Ralph M. Hall, a Representative in Congress
from the State of Texas
Mr. Chairman and Members of the Committee--I thank you for holding
this hearing today on accounting issues and questions that have been
raised in the wake of the collapse of Enron. Let me state at the outset
that I fully support the Committee's inquiries and investigations of
Enron to determine what, if any, laws, rules and regulations have been
broken or evaded. While it is important that we understand fully what
happened at Enron so that we may carry out our obligations to make
whatever changes are needed in law and policy--we should recognize that
ultimately the courts and the regulatory agencies will deal with what
happened there.
The title of this hearing--``Lessons Learned . . .'' is an
appropriate one that is in keeping with our role. However, I suggest
that this may be only the first ``Lessons Learned''' hearing. As facts
continued to be uncovered, obviously there will be a need for more
hearings of this type by the Full Committee. The witnesses before us
today have a great deal to teach us based on what they have observed
thus far, and I trust that we will benefit greatly from their
observations and experience. Perhaps we ought to have them back six
months from now and ask them how their views may have changed as the
Enron saga continues to unfold.
Analysts are telling us that investors are becoming uneasy about
the truthfulness and veracity of financial statements issued by major
corporations. As corporate securities are more widely held now by
individuals than ever before, it is even more incumbent on us to work
carefully but fast to find and identify the problems in accounting and
reporting and take all actions necessary to remedy them in this
Congress. Some people are frightened about the security of their life's
savings in 401(k) and similar plans, so we need to work carefully and
calmly to ascertain the facts and take appropriate action in order to
calm the markets and those who invest in them.
In closing, Mr. Chairman, as a member from the oil patch, let me
urge my colleagues not to tar all other energy companies with the Enron
brush. There are many, many well-run energy companies that are
conservatively managed and treat their creditors, employees and
shareholders fairly. Oil, natural gas, and--yes--electricity markets
are evolving. But let's be careful that we don't act hastily to undo
the progress that these markets have made. As problems are uncovered,
let's correct them, but don't throw out the premise that competitive
markets are innately bad.
I yield back the balance of my time.
Chairman Tauzin. It is now time for us to turn to our
distinguished panel, again, with my deep appreciation for your
patience. I hope you have gathered from all the discussions of
the members how deeply members are concerned to find solutions,
not just to understand what went wrong in this case, which is
our first tour of duty, but also then move on and find
solutions. I want to thank again Mr. Dingell and the minority
for helping us to assemble this panel who will begin the
process of telling us what we might want to do in order to fix
these problems and we start with an understanding of what
happened at Enron and we move from an understanding of what
happened at Enron coming from Mr. James Chanos, who was the
first, I think, of the analysts who actually could see this
coming. He was recommending a sell while everybody else was
recommending a buy. And we move on to experts in the accounting
field, Mr. Robert Raber, who is the President and Chief
Executive Officer of the National Association of Corporate
Directors who first talked to us about the role of directors in
a major corporation. What is their responsibility? What is
their training? What is their expertise, what might we do to
enhance the capacity of directors of America's publicly traded
corporations to do a better job than we see was done at Enron?
We'll move on to accounting issues and we'll hear from Dr.
Roman Weil, who is a Ph.D., Professor of Accounting at the
University of Chicago who will talk to us about general
accounting issues and we'll move on to special purpose
vehicles, the SPEs and the market-to-market accounting issues
that my friend from Texas finds it difficult to follow in an
annual report. I think all Americans would find difficult to
follow. We will hear from Dr. Bala Dharan who is a professor in
the Graduate School of Management at Rice University in Texas.
We'll also then move to Mr. Baruch Lev who is the Philips
Bardes Professor of Accounting and Finance at the Department of
Accounting Taxation and Business Law at the Stern School of
Business in New York. I'm told that Mr. Lev is an
extraordinarily gifted individual in this area and who can
teach us about accounting policy and possible remedies and we
look forward to your recommendations, Mr. Lev. We'll move then
to governance of accounting. Many suggestions as to how we
might oversee the accounting industry, who audits the auditors
has been the question raised and we're going to get some
recommendations from another witness recommended by the
minority, Mr. Bevis Longstreth of New York, who also has some
expertise in this area and I would be deeply interested in your
suggestions and observations, Mr. Longstreth. Finally, I want
to thank David Sokol, Chairman and CEO of MidAmerican Energy
Holdings Company for coming to give us a perspective on the
energy markets and the energy business and how it reacted to
the collapse of Enron and whether or not it worked well as Mr.
Largent has indicated in working around the financial collapse
and still delivered electricity and gas to customers across the
country served by the seventh largest corporation in America as
it collapsed. So we get a sense of the effect of the Enron
collapse on the energy markets. Indeed, a distinguished panel.
We turn to you and we welcome Mr. James Chanos, for your
testimony, sir.
STATEMENTS OF JAMES S. CHANOS, KYNIKOS ASSOCIATES, LTD.; ROGER
W. RABER, NATIONAL ASSOCIATION OF CORPORATE DIRECTORS; ROMAN L.
WEIL, UNIVERSITY OF CHICAGO; BALA G. DHARAN, RICE UNIVERSITY;
BARUCH LEV, NEW YORK UNIVERSITY; BEVIS LONGSTRETH, DEBEVOISE &
PLIMPTON; AND DAVID L. SOKOL, MIDAMERICAN ENERGY HOLDINGS
COMPANY
Mr. Chanos. Good afternoon, my name is James Chanos. I
would like to take this opportunity to thank the House
Committee on Energy and Commerce for allowing me to offer my
perspective on this tragic Enron story. I'm the president of
Kynikos Associates, a New York private investment management
company that I founded in 1985. Kynikos Associates specializes
in short selling, an investment technique that profits in
finding fundamentally overvalued securities that are poised to
fall in price. Kynikos Associates employs seven investment
professionals and is considered the largest organization of its
type in the world, managing over $1 billion for its clients.
Prior to founding Kynikos Associates, I was a securities
analyst at Deutsche Bank Capital and Gilford Securities. My
first job on Wall Street was as an analyst at the investment
banking firm of Blyth Eastman Paine Webber, a position I took
in 1980 upon graduating from Yale University with a B.A. in
Economics and Political Science. Neither I nor any of our
professionals is an attorney or a certified public accountant,
and none of us has had any direct dealings with Enron, its
employees or accountants.
On behalf of our clients, Kynikos Associates manages a
portfolio of securities we consider to be overvalued. The
portfolio is designed to profit if the securities it holds fall
in value. Kynikos Associates selects portfolio securities by
conducting a rigorous financial analysis and focusing on
securities issued by companies that appear to have (1)
materially overstated its earnings; (2) been victims of a
flawed business plan; or (3) that engaged in outright fraud. In
choosing securities for its portfolios, Kynikos Associates also
relies on the many years of experience that I and my team have
accumulated in the equity markets.
My involvement with Enron began normally enough. In October
of 2000, a friend asked me if I had seen an interesting article
in The Texas Wall Street Journal, which is a regional edition,
about accounting practices at large energy trading firms. The
article, written by Jonathan Weil, pointed out that many of
these firms, including Enron, employed the so-called ``gain-on-
sale'' accounting method for their long-term energy trades.
Basically, ``gain-on-sale'' accounting allows a company to
estimate the future profitability of a trade made today and
book a profit today based on the present value of those
estimated future profits.
Our interest in Enron and other energy trading companies
was picked because our experience with companies that have used
this accounting method has been that management's temptation to
be overly aggressive in making assumptions about the future was
too great for them to ignore. In effect, ``earnings'' could be
created out of thin air if management was willing to push the
envelope by using highly favorable assumptions. However, if
these future assumptions did not come to pass, previously
booked ``earnings'' would have to be adjusted downward. If this
happened, as if often did, companies addicted to the crack
cocaine of ``gain-on-sale'' accounting would simply do new and
bigger deals--with a larger immediate ``earnings'' impact--to
offset those downward revisions. Once a company got on such an
accounting treadmill, it was hard for it to get off.
The first Enron document my firm analyzed was its 1999 Form
10-K filing, which it had filed with the U.S. SEC. What
immediately struck us was that despite using the ``gain-on-
sale'' model, Enron's return on capital, a widely used measure
of profitability, was a paltry 7 percent before taxes. That is,
for every dollar in outside capital that Enron employed, it
earned about seven cents. This is important for two reasons;
first, we viewed Enron as a trading company that was akin to an
``energy hedge fund.'' For this type of firm, a 7 percent
return on capital seemed abysmally low, particularly given its
market dominance and accounting methods. Second, it was our
view that Enron's cost of capital was likely in excess of 7
percent and probably closer to 9 percent, which meant from an
economic point of view, that Enron wasn't really earning any
money at all, despite reporting ``profits'' to its
shareholders. This mismatch of Enron's cost of capital and its
return on investment became the cornerstone for our bearish
view on Enron and we began shorting Enron common stock in
November of 2000 for our clients.
We were also troubled by Enron's cryptic disclosure
regarding various ``related party transactions'' described in
its 1999 Form 10-K as well as the quarterly Form 10-Qs it filed
with the SEC in 2000 for its March, June and September
quarters. We read the footnotes in Enron's financial statements
about these transactions over and over again, and like
Representative Barton, we could not decipher what impact they
had on Enron's overall financial condition. It did seem strange
to us, however, that Enron had organized these entities for the
apparent purpose of trading with their parent company, and that
they were run by an Enron executive. Another disturbing factor
in our review of Enron's situation was what we perceived to be
the large amount of insider selling of Enron stock by Enron's
senior executives. While not damning by itself, such selling in
conjunction with our other financial concerns added to our
conviction.
Finally, we were puzzled by Enron's and its supporters'
boasts in late 2000 regarding the company's initiative in the
telecommunications field, particularly in the trading of
broadband capacity. Enron waxed eloquent about a huge, untapped
market in such capacity and told analysts that the present
value of Enron's opportunity in that market could be $20 to $30
per share of Enron stock. These statements are troubling to us
because our portfolio already contained a number of short ideas
in the telecommunications and broadband area based on the
snowballing glut of capacity that was developing in that
industry. By late 2000, the stocks of companies in this
industry had fallen precipitously, yet Enron and its executives
seemed oblivious to this. Despite the obvious bear market in
telecommunications capacity, Enron still saw a bull market in
terms of its own valuation of the same business, an ominous
portent.
In January 2001, we began contacting a number of analysts
at various Wall Street firms with whom we did business and
invited them to our offices to discuss Enron. Over the next few
months a number of them accepted our invitation and met with us
to discuss Enron and its valuation. We were struck by how many
of them conceded that there was no way to analyze Enron, but
that investing in Enron was instead a ``trust me'' story. One
analyst, while admitting that Enron was a ``black box''
regarding profits, said that, as long as Enron delivered, who
was he to argue. It was clear to us that most of these analysts
were hopelessly conflicted over the investment banking and
advisory fees that Enron was paying to their firms. We took
their ``buy'' recommendations, both current and future, with a
very large gain of salt.
Something else that caught our attention was a story that
ran in The New York Times about Enron in early February of
2001. In light of the California energy crisis, Enron was
invoking a little-noticed clause in its contract with its
California retail customers. This clause allowed Enron to
directly match its retail buyers of power in California with
the power providers with whom Enron had contracted on its
customers' behalf. Most of these power providers were in
bankruptcy now. In effect, Enron was telling a number of very
prominent California companies and institutions ``This is now
your problem, not ours.'' This was done despite the fact that
Enron was paid by its customers a middleman fee precisely so
that Enron would accept what is called counter-party risk,
something Enron now backed out of doing. As a result, Enron's
credibility in the entire energy retail business began to
crumble simply because the company refused to recognize sure
losses in California. One of my analysts said at the time,
``Gee, it's as if Enron can never admit to a losing trade.''
Future revelations would prove that remark prophetic.
It was also in February 2001 that I presented Enron as an
investment idea at our firm's annual ``Bears in Hibernation''
conference. As I recounted Enron's story to the conference
participants, most of them agreed that the fact pattern and
numbers presented were very troubling. Most also agreed that
Enron's stock price left no room for error. Following our
conference, the short position in Enron reported monthly began
to move higher.
In the spring of 2001, we heard reports, confirmed by
Enron, that a number of senior executives were departing from
the company. Further, the insider selling of Enron stock
continued unabated. Finally, our analysis of Enron's 2000 Form
10-K and March 2001 Form 10-Q filings continued to show low
returns on capital as well as a number of one-time gains that
boosted Enron's earnings. These filings also reflected Enron's
continuing participation in various ``related party
transactions'' that we found difficult to understand despite
the more detailed disclosure Enron had provided. These
observations strengthened our conviction that the market was
still is over-pricing Enron's stock.
In the summer of 2001, energy and power prices,
specifically natural gas and electricity, began to drop. Rumors
surfaced routinely on Wall Street that Enron had been caught
``long'' in the power market and that it was moving
aggressively to reverse its exposure. It is an axiom in
securities trading that no matter how well ``hedged'' a firm
claims to be, trading operations always seem to do better in
bull markets and to struggle in bear markets. We believe that
the power market had entered a bear phase at just the wrong
moment for Enron.
Also in the summer of 2001, stories began circulating in
the marketplace about Enron's affiliated partnerships and how
Enron's stock price itself was important to Enron's financial
well-being. In effect, traders were saying that Enron's
dropping stock price could create a cash-flow squeeze at the
company because of certain provisions and agreements that it
had entered into with affiliated partnerships. These stories
gained some credibility as Enron disclosed more information
about these partnerships in its June 2001 Form 10-Q which it
filed in August of 2001.
To us, however, the most important story in August of 2001
was the abrupt resignation of Enron's CEO, Jeff Skilling, for
``personal reasons.'' In our experience, there is no louder
alarm bell in a controversial company than the unexplained,
sudden departure of a chief executive officer no matter what
``official'' reason is given. Because we viewed Skilling as the
architect of the present Enron, his abrupt departure was the
most ominous development yet. Kynikos Associates increased its
portfolio's short position in Enron shares following this
disclosure.
The events affecting Enron that occurred in the fall of
2001, particularly after October 16, have been recounted
seemingly everywhere in the financial press. Kynikos Associates
cannot add much to that discussion, but I have tried to provide
an overview of what our firm thought were significant
developments and revelations during the preceding 12 months.
And while this testimony is mainly about our firm's
assessment of Enron and the basis for that assessment, we would
be remiss if we did not share a few observations about what
happened.
First and foremost, no one should depend on Wall Street to
identify and extricate investors from disastrous financial
situations. There are too many conflicts of interest, all of
them usually disclosed, but pervasive and important
nevertheless. In addition, outside auditors are archaeologists,
not detectives. I can't think of one major financial fraud in
the United States in the last 10 years that was uncovered by a
major brokerage house analyst or an outside accounting firm.
Almost every such fraud ultimately was unmasked by short
sellers and/or financial journalists.
In addition, a company's adherence to GAAP, generally
accepted accounting principles, does not mean that the
company's earnings and financial position are not overstated.
GAAP allows too much leeway in the use of estimates, forecasts
and other inherently unknowable things to portray current
results. In the hands of dishonest management, a rapidly
growing subset in my opinion, GAAP can mislead far more than
they inform. Further, I believe that certain aspects of GAAP,
particularly accounting for stock options in the United States,
are basically a fraud themselves. Such obvious accounting scams
should be ended immediately without any interference by third
parties.
While no fan of the plaintiffs bar, I must also point out
that the so called ``Safe Harbor'' Act of 1995 has probably
harmed more investors than any other piece of recent
legislation. The statute, in my opinion, has emboldened
dishonest managements to lie with impunity, by relieving them
of concern that those to whom they lie will have legal
recourse. The statute also seems to have shielded underwriters
and accountants from the consequences of lax performance of
their ``watchdog'' duties. Surely, some tightening of this
legislation must be possible, while retaining the worthy
objective of preventing obviously frivolous lawsuits.
Our current system of self-monitored disclosure is first-
rate in my opinion, with one important exception. In this day
and age of EDGAR, the internet and real-time disclosure, our
system for disclosing insider stock purchases and sales remains
antiquated. Insiders buying or selling shares should disclose
such transactions immediately. And esoteric collars, loan/stock
repurchase deals and other derivatives that are in the ``gray
area'' of insider disclosure should be treated for what they
are, another way to either buy or sell shares. The structure of
an inside transaction should never hinder its immediate
disclosure.
Finally, I want to remind you that despite 200 years of
``bad press'' on Wall Street, it was those ``unAmerican,
unpatriotic'' short sellers that did so much to uncover the
disaster at Enron and at other infamous financial disasters
during the past decade. While short sellers probably will never
be popular on Wall Street, they often are the ones wearing the
white hats when it comes to looking for and identifying the bad
guys.
Thank you very much for this opportunity to tell our story.
[The prepared statement of James S. Chanos follows:]
Prepared Statement of James S. Chanos, Kynikos Associates, Ltd.
Good afternoon. My name is James Chanos. I would like to take this
opportunity to thank the House Committee on Energy and Commerce for
allowing me to offer my perspective on the tragic Enron story.
I am the President of Kynikos Associates, a New York private
investment management company that I founded in 1985. Kynikos
Associates specializes in short-selling, an investment technique that
profits in finding fundamentally overvalued securities that are poised
to fall in price. Kynikos Associates employs seven investment
professionals and is considered the largest organization of its type in
the world, managing over $1 billion for its clients.
Prior to founding Kynikos Associates, I was a securities analyst at
Deutsche Bank Capital and Gilford Securities. My first job on Wall
Street was as an analyst at the investment banking firm of Blyth
Eastman Paine Webber, a position I took in 1980 upon graduating from
Yale University with a B.A. in Economics and Political Science. Neither
I nor any of our professionals is an attorney or a certified public
accountant, and none of us has had any direct dealings with Enron, its
employees or accountants.
On behalf of our clients, Kynikos Associates manages a portfolio of
securities we consider to be overvalued. The portfolio is designed to
profit if the securities it holds fall in value. Kynikos Associates
selects portfolio securities by conducting a rigorous financial
analysis and focusing on securities issued by companies that appear to
have (1) materially overstated earnings (Enron), (2) been victims of a
flawed business plan (most internet companies), or (3) been engaged in
outright fraud. In choosing securities for its portfolios, Kynikos
Associates also relies on the many years of experience that I and my
team have accumulated in the equity markets.
My involvement with Enron began normally enough. In October of
2000, a friend asked me if I had seen an interesting article in The
Texas Wall Street Journal (a regional edition) about accounting
practices at large energy trading firms. The article, written by
Jonathan Weil, pointed out that many of these firms, including Enron,
employed the so-called ``gain-on-sale'' accounting method for their
long-term energy trades. Basically, ``gain-on-sale'' accounting allows
a company to estimate the future profitability of a trade made today,
and book a profit today based on the present value of those estimated
future profits.
Our interest in Enron and the other energy trading companies was
piqued because our experience with companies that have used this
accounting method has been that management's temptation to be overly
aggressive in making assumptions about the future was too great for
them to ignore. In effect, ``earnings'' could be created out of thin
air if management was willing to ``push the envelope'' by using highly
favorable assumptions. However, if these future assumptions did not
come to pass, previously booked ``earnings'' would have to be adjusted
downward. If this happened, as it often did, companies addicted to the
crack cocaine of ``gain-on-sale'' accounting would simply do new and
bigger deals (with a larger immediate ``earnings'' impact) to offset
those downward revisions. Once a company got on such an accounting
treadmill, it was hard for it to get off.
The first Enron document my firm analyzed was its 1999 Form 10-K
filing, which it had filed with the U.S. Securities and Exchange
Commission. What immediately struck us was that despite using the
``gain-on-sale'' model, Enron's return on capital, a widely used
measure of profitability, was a paltry 7% before taxes. That is, for
every dollar in outside capital that Enron employed, it earned about
seven cents. This is important for two reasons; first, we viewed Enron
as a trading company that was akin to an ``energy hedge fund.'' For
this type of firm a 7% return on capital seemed abysmally low,
particularly given its market dominance and accounting methods. Second,
it was our view that Enron's cost of capital was likely in excess of 7%
and probably closer to 9%, which meant, from an economic cost point-of-
view, that Enron wasn't really earning any money at all, despite
reporting ``profits'' to its shareholders. This mismatch of Enron's
cost of capital and its return on investment became the cornerstone for
our bearish view on Enron and we began shorting Enron common stock in
November of 2000.
We were also troubled by Enron's cryptic disclosure regarding
various ``related party transactions'' described in its 1999 Form 10-K
as well as the quarterly Form 10-Qs it filed with the SEC in 2000 for
its March, June and September quarters. We read the footnotes in
Enron's financial statements about these transactions over and over
again but could not decipher what impact they had on Enron's overall
financial condition. It did seem strange to us, however, that Enron had
organized these entities for the apparent purpose of trading with their
parent company, and that they were run by an Enron executive. Another
disturbing factor in our review of Enron's situation was what we
perceived to be the large amount of insider selling of Enron stock by
Enron's senior executives. While not damning by itself, such selling in
conjunction with our other financial concerns added to our conviction.
Finally, we were puzzled by Enron's and its supporters boasts in
late 2000 regarding the company's initiatives in the telecommunications
field, particularly in the trading of broadband capacity. Enron waxed
eloquent about a huge, untapped market in such capacity and told
analysts that the present value of Enron's opportunity in that market
could be $20 to $30 per share of Enron stock. These statements were
troubling to us because our portfolio already contained a number of
short ideas in the telecommunications and broadband area based on the
snowballing glut of capacity that was developing in that industry. By
late 2000, the stocks of companies in this industry had fallen
precipitously, yet Enron and its executives seemed oblivious to this!
Despite the obvious bear market in telecommunications capacity, Enron
still saw a bull market in terms of its own valuation of the same
business--an ominous portent.
In January 2001, we began contacting a number of analysts at
various Wall Street firms with whom we did business and invited them to
our offices to discuss Enron. Over the next few months a number of them
accepted our invitation and met with us to discuss Enron and its
valuation. We were struck by how many of them conceded that there was
no way to analyze Enron, but that investing in Enron was instead a
``trust me'' story. One analyst, while admitting that Enron was a
``black box'' regarding profits, said that, as long as Enron delivered,
who was he to argue! It was clear to us that most of these analysts
were hopelessly conflicted over the investment banking and advisory
fees that Enron was paying to their firms. We took their ``buy''
recommendations, both current and future, with a very large grain of
salt!
Something else that caught our attention was a story that ran in
The New York Times about Enron in early February of 2001. In light of
the California energy crisis, Enron was invoking a little-noticed
clause in its contract with its California retail customers. This
clause allowed Enron to directly match its retail buyers of power in
California with the power providers with whom Enron had contracted on
its customers' behalf. Most of these power providers were in
bankruptcy. In effect, Enron was telling a number of very prominent
California companies and institutions ``This is now your problem, not
ours.'' This was done despite the fact that Enron was paid by its
customers a middleman fee precisely so that Enron would accept what is
called counter-party risk--something Enron now backed out of doing. As
a result, Enron's credibility in the entire energy retail business
began to crumble simply because the company refused to recognize sure
losses in California. One of my analysts said at the time, ``Gee, it's
as if Enron can never admit to a losing trade!'' Future revelations
would prove that remark prophetic.
It was also in February 2001 that I presented Enron as an
investment idea at our firm's annual ``Bears In Hibernation''
conference. As I recounted Enron's story to the conference
participants, most of them agreed that the fact pattern and numbers
presented were very troubling. Most also agreed that Enron's stock
price left no room for error. Following our conference, the short
position in Enron (reported monthly) began to move higher.
In the spring of 2001, we heard reports, confirmed by Enron, that a
number of senior executives were departing from the company. Further,
the insider selling of Enron stock continued unabated. Finally, our
analysis of Enron's 2000 Form 10-K and March 2001 Form 10-Q filings
continued to show low returns on capital as well as a number of one-
time gains that boosted Enron's earnings. These filings also reflected
Enron's continuing participation in various ``related party
transactions'' that we found difficult to understand despite the more
detailed disclosure Enron had provided. These observations strengthened
our conviction that the market was mispricing Enron's stock.
In the summer of 2001, energy and power prices, specifically
natural gas and electricity, began to drop. Rumors surfaced routinely
that Enron had been caught ``long'' the power market and that it was
moving aggressively to reverse its exposure. It is an axiom in
securities trading that, no matter how well ``hedged'' a firm claims to
be, trading operations always seem to do better in bull markets and to
struggle in bear markets. We believed that the power market had entered
a bear phase at just the wrong moment for Enron.
Also in the summer of 2001, stories circulated in the marketplace
about Enron's affiliated partnerships and how Enron's stock price
itself was important to Enron's financial well-being. In effect,
traders were saying that Enron's dropping stock price could create a
cash-flow squeeze at the company because of certain provisions in
agreements that it had entered into with its affiliated partnerships.
These stories gained some credibility as Enron disclosed more
information about these partnerships in its June 2001 Form 10-Q, which
it filed in August of 2001.
To us, however, the most important story in August 2001 was the
abrupt resignation of Enron's CEO, Jeff Skilling, for ``personal
reasons.'' In our experience, there is no louder alarm bell in a
controversial company than the unexplained, sudden departure of a chief
executive officer no matter what ``official'' reason is given. Because
we viewed Skilling as the architect of the present Enron, his abrupt
departure was the most ominous development yet. Kynikos Associates
increased its portfolio's short position in Enron shares following this
disclosure.
The events affecting Enron that occurred in the fall of 2001,
particularly after October 16th, have been recounted seemingly
everywhere in the financial press. Kynikos Associates cannot add much
to that discussion, but I have tried to provide an overview of what our
firm thought were significant developments and revelations during the
preceding twelve months.
some observations post-enron
While this testimony is mainly about our firm's assessment of Enron
and the basis for that assessment, we would be remiss if we did not
share a few observations about what happened.
First and foremost, no one should depend on Wall Street to identify
and extricate investors from disastrous financial situations. There are
too many conflicts of interest, all of them usually disclosed, but
pervasive and important nevertheless. In addition, outside auditors are
archeologists, not detectives. I can't think of one major financial
fraud in the United States in the last ten years that was uncovered by
a major brokerage house analyst or an outside accounting firm. Almost
every such fraud ultimately was unmasked by short sellers and/or
financial journalists.
In addition, a company's adherence to GAAP (generally accepted
accounting principles), does not mean that the company's earnings and
financial position are not overstated. GAAP allows too much leeway in
the use of estimates, forecasts and other inherently unknowable things
to portray current results. In the hands of dishonest management (a
rapidly growing subset in my opinion), GAAP can mislead far more than
they inform! Further, I believe that certain aspects of GAAP,
particularly accounting for stock options in the United States, are
basically a fraud themselves. Such obvious accounting scams should be
ended immediately without any interference by third parties.
While no fan of the plaintiffs bar, I also must point out that the
so called ``Safe Harbor'' Act of 1995 has probably harmed more
investors than any other piece of recent legislation. That statute, in
my opinion, has emboldened dishonest managements to lie with impunity,
by relieving them of concern that those to whom they lie will have
legal recourse. The statute also seems to have shielded underwriters
and accountants from the consequences of lax performance of their
``watchdog'' duties. Surely, some tightening of this legislation must
be possible, while retaining the worthy objective of preventing
obviously frivolous lawsuits.
Our current system of self-monitored disclosure is first-rate, in
my opinion, with one important exception. In this day and age of EDGAR,
the internet and real-time disclosure, our system for disclosing
insider stock purchases and sales remains antiquated. Insiders buying
or selling shares should disclose such transactions immediately. And
esoteric collars, loan/stock repurchase deals, etc., that are in the
``gray area'' of insider disclosure should be treated for what they
are--another way to either buy or sell shares. The structure of an
insider transaction should never hinder its immediate disclosure!
Finally, I want to remind you that, despite two hundred years of
``bad press'' on Wall Street, it was those ``unAmerican, unpatriotic''
short sellers that did so much to uncover the disaster at Enron and at
other infamous financial disasters during the past decade (Sunbeam,
Boston Chicken, etc.). While short sellers probably will never be
popular on Wall Street, they often are the ones wearing the white hats
when it comes to looking for and identifying the bad guys!
Thank you very much for this opportunity to tell our story.
Chairman Tauzin. Thanks for your patience, Mr. Chanos, it's
interesting testimony. We normally limit our witnesses to 5
minutes. You can see I'm being rather generous after you've
waited so long, but I would encourage to try to keep it at
least within a 10 minute frame if you can.
We'll now turn to Mr. Roger Raber who is the President of
the trade association of Boards of Directors, correct, Mr.
Raber?
STATEMENT OF ROGER W. RABER
Mr. Raber. Good afternoon, Mr. Chairman. I'm honored to be
here as the President and CEO of the National Association of
Corporate Directors founded in 1977 to enhance the education
and development of corporate directors.
Corporate directors are an important key to the success of
our free enterprise system. True, some aspects of our corporate
system such as disclosure do require continuous improvements
that directors alone cannot accomplished. Directors must work
with others such as institutional investors and regulators to
ensure this improvement. But improvements to the system are not
enough. Good corporate governance requires, above all, the
presence of independent informed directors who have the courage
and integrity to ask difficult questions.
With such directors, any reasonable system can work.
Without such directors, any system, no matter how excellent can
and will fail.
NACD was founded in 1977 as a membership organization for
corporate directors committed to improving board effectiveness.
Today, NACD is still the only membership organization of its
kind in this country. At this time, the NACD has more than
10,000 active members and participants. These are individuals
or entire boards who read our publications, attend our seminars
or receive training in their board rooms. Most of our members
and participants are directors, but some are board advisors
such as attorneys and accountants. Many distinguished corporate
directors add to our knowledge and practice as members of our
governing board, advisory board and faculty.
NACD services cover both basic and emerging issues. We
promote high board standards and create forums for peer
interaction. We have 12 chapters throughout the country where
directors meet to learn, discuss and respond to current issues.
NACD also conducts research on governance trends, tracking over
100 issue over time and across company sizes and industries.
Now the board of directors has an important place in the
corporate systems. Corporations are owned by shareholders.
Boards are accountable to shareholders and management is
accountable to the board. Corporations are chartered through
State corporation laws. Their laws vary by state, but they
share some common features. One common feature in State
corporation law is the notion of director, duty of care and
duty of loyalty. The duty of care says that corporate directors
must exercise care in their decisions, just as they would do in
their own decisions process. The duty of loyalty says that
directors must be loyal to the company, remaining free of any
conflicts of interest as they vote on particular matters. A
judicial doctrine called the business judgment rule shields
directors' decisions from liability as long as the directors
exercise care and were free of conflicts of interest.
As companies grow, boards form committees such as an audit
committee, a compensation committee and a nominating committee.
They may also form special committees to look at sensitive
issues. The NACD recommends that these committees be composed
of qualified independent directors. Our recommendations have
made a difference. For example, today, part of the result of
concepts advocated by a member of our board of directors in a
blue ribbon committee report to the SEC and stock exchanges,
the boards of publicly listed companies must have an audit
committee composed entirely of independent directors who are
financially literate. This is one of the many reforms NACD has
advocated over the past 25 years.
But in closing, I would like to explain how directors can
be a solution to the kinds of problems that allegedly occurred
at Enron. I believe that there are three keys to board
effectiveness: independence, information and integrity,
especially the courage to ask tough questions.
Independence. NACD commends the SEC and stock exchanges for
requiring independent audit committees. Meanwhile, independent
nominating and compensation committees are now on the rise.
Unless this beneficial trend continues, we anticipate stock
exchange requirements mandating the independence of these
committees.
Information. Directors need to be well informed about
governance and about the companies and industries they serve. A
vital source of information is financial statements. Overall,
the financial statements of U.S. companies do a good job of
disclosure, keeping up with such new challenges of financial
reporting, but we want to make sure that oversight groups for
accounting standards remain free from undue influence by any
particular constituency.
On-going education for directors is also important if not
mandatory. A number of major institutional investors actively
encourage director education in their portfolio companies.
Integrity. Last, but not least, there is integrity.
Directors should have the duty of curiosity to have difficult
questions such as do these numbers reflect our true
profitability? What will this policy do for the employees in
our 401(k) program? Isn't it risky to have our auditors do some
of our internal auditing work? After Enron, more directors will
be asking such questions. We will do our part to make sure that
they do.
In summary, directors play an important role in the
governance of corporations. Whatever actions you recommend as a
committee, I ask you to remember that in the long run corporate
directors can be an important part in helping your actions
succeed.
I thank you for your time.
[The prepared statement of Roger W. Raber follows:]
Prepared Statement of Roger W. Raber, President and CEO, National
Association of Corporate Directors
I am honored to be here today as President and CEO of the National
Association of Corporate Directors (NACD), a not-for-profit
professional association founded in 1977 to enhance the education and
development of corporate boards.
summary statement
In my remarks this afternoon I will cover three main subjects.
First, I will explain the work and mission of the NACD,
especially our longstanding commitment to improving board
leadership through director education.
Second, I will define the role of the corporate board of
directors, explaining the duty of care, the duty of loyalty,
and the business judgment rule, and showing how the board is
accountable to shareholders, and management is accountable to
the board.
Third, I will explain how corporate directors can be a
solution to the kinds of problems that contributed to the
collapse of Enron.
My main point in all of this is that corporate directors are an
important key to success of our free enterprise system. True, some
aspects of our corporate system--such as disclosure--do require
continuous improvements that directors alone cannot accomplish.
Directors must work with others, such as institutional investors and
regulators, to ensure this improvement. But improvements to the system
are not enough. Good corporate governance requires above all the
presence of independent, informed directors who have the courage and
integrity to ask difficult questions. With such directors, any
reasonable system can work. Without such directors, any system, no
matter how excellent, can fail.
the mission and work of the nacd
NACD was founded in 1977 as a membership organization for corporate
directors committed to improving board effectiveness. Today, NACD is
still the only membership organization of its kind in the United
States. At this time, the NACD has more than 10,000 active members and
participants. These are individuals or entire boards who purchase our
publications, attend our seminars, and receive training in their
boardrooms. Most of our members and participants are directors, but
some are board advisors such as attorneys and accountants. Many
distinguished corporate directors add to our knowledge and practice as
members of our governing board, advisory board, and faculty.
Through our publications, seminars, and services, which cover both
basic and emerging issues, NACD promotes high board standards and
creates forums for peer interaction. We have 12 chapters where
directors meet to learn about, discuss, and respond to current issues.
Since 1977, our Director's Monthly publication has featured ``best
practice'' articles by and for corporate directors--over 2,000 articles
to date. Also, for the past decade, NACD has issued annual ``Blue
Ribbon Commission'' reports on issues such as director professionalism
and evaluation, executive and director compensation, and the board's
role in strategy, among other topics. Furthermore, NACD also conducts
research on governance trends, tracking over 100 issues steadily over
time and across company sizes and industries. Finally, our members,
directors, and officers also communicate with the media, regulators,
institutional investors, and others where needed to improve
understanding of board issues.
the role of the corporate board of directors
The board of directors has an important place in the corporate
system. Corporations are owned by shareholders. Boards are accountable
to shareholders, and managers are accountable to the board.
Corporations are chartered through state corporation laws. These laws
vary by state, but they share common features.
One common feature in state corporation laws is the notion of
director duty--namely the twin duties of care and loyalty. The duty of
care says that corporate directors must exercise care in their
decisions, just as they would in their own decisions. The duty of
loyalty says that directors must be loyal to the company, remaining
free of any conflicts of interest as they vote on particular matters. A
judicial doctrine called the business judgment rule shields directors'
decisions from liability as long as the directors exercised care and
were free of conflicts of interest.
Another common feature in state corporation laws is the notion that
corporations are ``managed under the direction of a board of
directors.'' The nature of this direction varies. A small new
corporation may just have a few key officers, who are all directors and
owners as well. If a corporation sells stock to the general public,
however, ownership shifts to non-managers. These non-manager-owners
need protection. This is the role of state and federal securities laws.
For example, securities laws require full, timely, and clear disclosure
of important (``material'') information. Also, securities laws ensure
that owners have representation on boards, through voting on
nominations of particular directors.
As companies grow, boards often grow, and form committees, such as
an audit committee, a compensation committee, and a nominating
committee. They also may form special committees to look at sensitive
issues. The NACD recommends that these committees be composed of
qualified, independent directors. Our recommendations have made a
difference. For example, today, partly as the result of concepts
advocated by a member of our board of directors, in a Blue Ribbon
Committee report to the Securities and Exchange Commission and stock
exchanges, the boards of publicly listed companies must have an audit
committee composed entirely of independent directors who are (or who
will spend time to become) financially literate. This is only one of
the many reforms NACD has advocated in the past 25 years.
lessons learned: directors as a solution
In closing, I would like to explain how directors can be a solution
to the kinds of problems that allegedly occurred at Enron. (For a
detailed response to the specific issues raised in the Enron case, I
refer the committee to the January 31, 2002, issue of our newsletter,
DM Extra, which can be viewed on our web site, nacdonline.org. I
include a copy for the record.)
In general, I believe that there are three keys to board
effectiveness: independence, information, and integrity--especially the
courage to ask the tough questions.
Independence. NACD commends the SEC and stock exchanges for
requiring ``independent'' audit committees. Meanwhile, independent
nominating and compensation committees are now on the rise. Unless this
beneficial trend continues, we anticipate stock exchange requirements
mandating the independence of these committees.
Information. Directors need to be well informed about governance,
and about the companies and industries they serve. A vital source of
information is financial statements. Overall, the financial statements
of U.S. companies do a good job of disclosure, keeping up with new
challenges of financial reporting, but we want to make sure that
oversight groups for accounting standards remain free from undue
influence by any particular constituency. Ongoing education for
directors is also important. A number of major institutional investors
actively encourage director education in their portfolio companies. The
late Jean Head Sisco, in her speech as NACD Director of the Year in
2000, went so far as to suggest that the stock exchanges require newly
listed companies to provide evidence of ongoing director education.
Integrity. Last but not least, there is integrity. Directors should
have the ``duty of curiosity'' to ask difficult questions, such as, `Do
these numbers reflect our true profitability?' ``What will this policy
do for the employees in our 401-k plan?'' ``Isn't it risky to have our
auditors do some of our internal auditing work?'' After Enron, more
directors will be asking such questions. We will do our part to make
sure that they do.
In summary, directors play an important role in the governance of
corporations. Whatever actions you recommend as a committee, I ask you
to remember that in the long run, corporate directors can be an
important part in helping your actions succeed.
I thank you for your time.
Chairman Tauzin. I thank you.
The Chair is now pleased to recognize Dr. Roman Weil, Ph.D.
from Chicago School of Business for his testimony.
Dr. Weil?
STATEMENT OF ROMAN L. WEIL
Mr. Weil. Thank you, Mr. Chairman. I have been privileged
to receive a fine education and I'm privileged to be a member
of the Graduate School of Business at the University of Chicago
Faculty for 35 years or so and it's a privilege to be here
today. I thank you very much.
Chairman Tauzin. Thank you, sir.
Mr. Weil. This is not a place I can tell for subtlety. I am
going to give you my broad brush view of what I think and I'll
be glad to meet with your staff later to talk about the
subtleties because there are a lot of subtle issues here.
I have some testimony that's been distributed here and some
of my co-authors who have looked at this in the last day or so
say I left some things out, so I brought a new version with me
today and I'll tell you what Congress has done well as well as
the accounting profession and what the SEC has done wrong as
well. So if you have the February 3 version, you don't have the
places with Congress in it. There's a February 5 version with
Congress.
Chairman Tauzin. Did you shred the last copy?
Mr. Weil. It's been turned over to your staff and if they
shred it, they're following standard document retention
policies, but I don't know.
What can I do here today in this unsubtle forum? Let me
tell you what I think the basic problem is in accounting. I'm
not here as an expert on the details of what Enron did or what
the auditing firm did. I don't know. But I do know, I believe,
what the underlying cause of getting us to where we've been is
and I think I know something to do about it. I agree a lot with
what Mr. Raber's done. I teach directors' college at the
University of Chicago where we ask directors to come to school
for a day or two and learn how to do their jobs better.
It is okay for Enron to bet the farm and lose. We don't
want to regulate within wide ranges what businesses do and
their business models. If they want to gamble and lose that's
okay. But we'd like to know, as shareholders, as outside
investors, as regulators when such bets are being undertaken
and what are the consequences of the outcomes. Now I think the
problem that we get here is a result of a process that started
about 1940 and got a boost in 1980 and the direction in which
accounting reports. When we first got the message from the
Securities and Exchange Commission back in the late 1930's to
begin regulating accounting, there were two paths that could
have been taken. The path not taken would be the path based on
axioms, principles the way we did it in geometry in high
school, the 12 Euclidian axioms. Here's what you can derive
from it. Accounting could have said here's what an asset is. My
students know what an asset is. Here's what an revenue is. My
students know what a revenue is, and derive the fundamental
accounting principles from those. Instead, we didn't do it that
way. We said we've got these myriad accounting problems, let's
write rules to deal with specific problems.
Now the first page of my testimony I've given you an
example. It's got nothing to do with Enron, but is the
quintessence of what this problem is all about. Let's look at
this. It's only two paragraphs long.
Imagine an asset, for the moment think of rights to use a
patent on a drug that defeats anthrax. Purchased by a dozen
different companies for a total of $500 million. Now suppose
that the Congress passes laws saying that any other company who
so chooses can use that patent to produce the anthrax defeating
drug, free of royalty to the owners. What do you suppose the
accountants for the firms who had purchased those patents for
$500 million would do? They would write off the assets to zero,
recognizing a collective loss of $500 million before taxes on
their income statements. Would you suppose that accountants
would need to look into their GAAP rule books to find out if
that write down were necessary. Well, I wouldn't think it was
necessary. What do you think? It seems obvious to me. If they
did look and couldn't find such guidance, do you think they'd
write off the assets anyway, recognizing the attendant losses?
Well, of course.
What has this got to do with the current situation? A lot.
Back in 1980, events paralleling those of the story I've just
told you actually occurred. The Congress passed deregulating
legislation liberalizing the granting of trucking rights,
effectively giving any truck the right to carry any commodity
from one place to another. Prior to that deregulating
legislation, Congress acting through the Interstate Commerce
Commission had limited those rights. People bought them in the
marketplace, traded them, had them on their balance sheet.
When Congress effectively destroyed the value of those
rights by allowing any trucker the right to carry the goods
previously protected by the monopoly rights, what did the
accountants of the trucking firms do? They wrote off the value
of those rights on the balance sheet, recognizing a loss. Do
you suppose trucking firm accountants needed a rule to tell
them to do that? You've got an asset. It's gone. Write it off.
But the Financial Accounting Standards Board felt compelled
to pass such a rule. It was a statement of Financial Accounting
Standards No. 44, passed in 1980 saying just that. That was an
important step along the road to where we are today. We are
getting evermore specific rules to deal with evermore specific
transactions. And it leads managements to say there are these
rule books out there. It's now this thick. Let me see where
there's a transaction that's not covered in the rule book. And
I'll invent one. I'll make one up. You can be sure that however
smart we accountants are, the investment bankers who make 30 to
40 times as much as we do each year, they're smarter, they're
nimbler. As fast as we can write rules, they can get around it.
And so the investment banker and the manager will devise a
new transaction and devise the accounting for it and say to the
accountant show me where it says I can't? If you can't show me
where this is forbidden, I'm going to do it and the auditor has
found that management has got a lot of power in this, the power
to go elsewhere with the business. The auditor goes to the
accounting rulemakers and says give me a rule, give me a rule
to forbid this and so we get some rules.
But the rules don't come fast enough to deal with the
transactions. I think it would be a mistake to ever think we
could get there. I do not believe that you want to pass laws
that lead to legislation attempting to govern the details of
accounting because the investment bankers are smarter than you
are. Smarter than I am. They're going to figure it out.
Now the SEC has had a hand in this. The SEC says we've got
this big rule book. If you want to do something, you show me
where it says you can and now accountants are afraid to do a
transaction without going to the SEC, without getting
preclearance for some transaction. We're bogged down in rule
books.
No speaker ever angered the audience by talking too short
of time on the appointed subject. I'll stop now, but I have
more stories for you, if you have time.
[The prepared statement of Roman L. Weil follows:]
Prepared Statement of Roman L. Weil, Graduate School of Business,
University of Chicago
Enron bet the farm and lost. It's OK to gamble, but shareholders
should know about the size and risk of bets undertaken as well as how
the nature of bets changes over time. Why didn't the accounting for
Enron's activities do a better job of alerting shareholders to the
risks and changes in them?
fundamental problem
Imagine an asset (for the moment think of rights to use a patent on
a drug that defeats anthrax) purchased by a dozen different companies
for a total of $500 million. Now, suppose that the Congress passes laws
saying that any other company who so chooses can use that patent to
produce the anthrax-defeating drug free of royalty to the owners.
What do you suppose the accountants for the firms that had
purchased those patents for $500 million would do? They would write off
the assets to zero, recognizing a collective loss of $500 million,
before taxes, on their income statements. Would you suppose that
accountants would need to look into their
GAAP rule books to find out if that write-off were necessary? (Not
necessary, wouldn't you think--it's obvious.) If they did look and
couldn't find such guidance, do you think they'd write off the assets
anyway, recognizing the attendant losses? (Of course.)
What has this to do with the state of accounting reflected in the
current Enron/Andersen shambles? A lot.
In 1980, events paralleling those of the imaginary two paragraphs
happened: Congress passed de-regulating legislation liberalizing the
granting of trucking rights, effectively giving any trucker the right
to carry any commodity between any two points. Prior to that de-
regulating legislation, Congress, acting through the Interstate
Commerce Commission, had limited those rights. The issued rights traded
in the market place and, once purchased by a trucking firm, appeared on
the firm's balance sheet at cost. When Congress effectively destroyed
the value of those rights by allowing any trucker the right to carry
the goods previously protected by monopoly rights, what did the
accountants at trucking firms do? They wrote off the value of the
trucking rights on the balance sheet, recognizing an amount of loss
equal to their then-current book value.
Did the trucking company accountants need a specific accounting
rule telling them to write off those trucking right assets? You
wouldn't think so, would you? But the Financial Accounting Standards
Board (FASB) felt compelled to pass a rule (Statement of Financial
Accounting Standards No. 44, 1980) saying just that. Accounting rule
makers took a first step on the road to the Enron accounting debacle.
Since the early 1980's, an aggressive company's management engages
in a transaction not covered by specific accounting rules, accounts for
it as it chooses, and challenges the auditor by arguing, ``Show me
where it says I can't.'' The auditor used to be able to appeal to first
principles of accounting. Such principles suggest, for example, that
post-deregulation trucking rights are no longer assets. Now, the
aggressive management can say, ``Detailed accounting rules cover so
many transactions and none of them covers the current issue, so we can
devise accounting of our own choosing.'' And they do.
Accounting rule making has become increasingly detailed as auditors
plead with standard setters for specific rules to provide backbone:
``Dear FASB or EITF [Emerging Issues Task Force, created by the SEC and
the FASB], Give us a rule for this new transaction.''
So, Enron transfers assets, reporting current profit and
debt,1 then challenges its auditor to ``Show me where it
says I can't.'' The auditor can't. The auditor considers nixing the
profit recognition but simultaneously considers the consequences of
saying, ``No'' to aggressive management: ``We might lose this client.''
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\1\ In addition, Enron appears to have promised to give Enron
shares to the purchaser if the transferred assets later turn into
losers. If this were true and the auditor knew about the additional
contingency, I suspect the auditor would have not allowed Enron's
accounting. I am less confident of these next two: it appears that
Enron may have strong-armed the auditors into avoiding the equity
method of accounting for investments and into questionably treating
some of its derivative transactions as hedges.
---------------------------------------------------------------------------
The near-majority of the rule-setting FASB comes from high-powered
audit practice. These members bring to the Board a mindset that the
accounting profession needs, and wants, specific guidance for specific
transactions. Three of them can meet privately and can effectively, if
not formally, guide, perhaps even set, the agenda for the Board. A
minority of the Board has spent careers dealing with fundamental
theory. This minority, with more faith in the conceptual basis for
accounting, appears to prefer to derive broadly applicable rules from
first principles of accounting, which the FASB developed in the early
1980s in its conceptual framework. The majority, the members from
auditing practice, less interested in deriving rules from conceptual
principles, appears to win most of the battles.
The emphasis on specific rules for specific issues gets more
pronounced over time. I concede that these specific rules for specific
issues leads to more uniform reporting of the covered transactions--all
else equal, a good thing. That uniformity comes at the cost: practicing
accountants have less need for informed intelligence and judgment. I
concede that part of the pressure on standard setters for specific
rules for specific transactions comes from the current litigation
environment. Auditors, in a rational pursuit of a full purse, want
unambiguous rules to stand behind when, inevitably, the trial lawyers
sue them for accountant judgments and estimates, made in good faith,
that turn out to miss the target.
That some good results from specific rules for specific
transactions doesn't make such rules a good idea. These rules have a
cost: ``Show me where it says I can't,'' demands management. ``Give me
more rules for these new transactions,'' pleads the auditor, ``so I can
combat aggressive management.'' This cycle continues: the increasing
number of specific rules for specific transactions strengthens
aggressive management's belief that if a rule doesn't prohibit it, then
it's allowed. This, in turn, increases the auditor's dependence on
specific rules.
what to do?
I want accountants to rely on fundamental, first principles in
choosing accounting methods and estimates. I want accountants not to
hide behind the absence of a specific rule. Whatever the detailed rules
accountants write, smart managers can construct transactions the rules
don't cover.
You might now think about the parallels of the above with our tax
collection system, where principles alone cannot suffice. The
principle: tax income. The principle requires 40,000 pages of tax code,
regulations, and court decisions to implement. Can financial accounting
be different? I think yes. The tax collector and the taxpayer play a
zero-sum game--what one pays, the other gets. Financial accounting
doesn't have that property and in addition has the auditor to interpret
the rule book.
What else, besides more spine in the auditor, do we need to reduce
the likelihood of more accounting debacles?
Reduce Conflict of Interests
In recent weeks, we hear about reducing conflicts of interest--two
recent ones: reduce the opportunities of the auditor to do consulting
and forbid the auditor from going to work for the audited company.
The basic conflict occurs because the audited pays the auditor and,
in practice, selects the auditor. In my opinion, everything else has
lesser effect.
Auditor Term Limits
First, let's mandate auditor rotation--term limits for auditors.
Seven years ought to do it, maybe five. Let the auditor know that, no
matter what, another auditor will take over the job in a few years and
will have the incentive to expose a predecessor's
carelessness.2 Mandatory auditor term limits have a cost--
audit costs might triple. Not just the actual audit bills, but the
costs the audited company incurs to show the new auditor where the
inventory records lie in the second file drawer of the cabinet two to
the left of the green door in the third room on the right of the
outside corridor.
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\2\ Talk about professional peer review. This will be real peer
review, not the pap we get now.
---------------------------------------------------------------------------
I imagine that known term limits will induce the Audit Committee to
begin the search for the subsequent auditor 18 months or so before the
engagement will start and will be able to bring that new auditor into
on-board, learn-from-observation mode early in the process. Those who
argue against mandatory auditor rotation adduce large transition costs.
Suddenly changing auditors does cause surprise costs that anticipated,
orderly transitions will reduce.
Prod the Audit Committee
Then, we need audit committees to exercise the power the SEC has
given them. Thirty years ago, Rod Hills, then Chairman of the SEC,
conceived the powerful modern audit committee. He has written that the
audit committee's most important job is to make the independent,
attesting auditor believe that the auditor's retention depends solely
on the decision of the audit committee. Most often, it doesn't work
that way.
Most audit committees consist of independent, smart, but
financially illiterate, members, with rarely more than one financial
expert.3 (If you don't believe me, look at the accounting
qualifications of the audit committee of any large company you follow.
Then, look at how seldom the large corporations change auditors.) Audit
Committees usually depend on management to recommend the independent
auditor and changes in the auditor. The auditor learns to take its
guidance from management, not from the audit committee. The SEC has
provided power to the audit committee; now, it can help empower the
audit committee by mandating auditor term limits and having the audit
committee report on its independent search to find the replacement and
its independent contacts with the auditor after engagement.
---------------------------------------------------------------------------
\3\ How do I know they are often illiterate? Because I teach them
in Directors' College classes where I start with pop quizzes.
---------------------------------------------------------------------------
Some of my colleagues doubt that the country has enough
independent, knowledgeable people to staff corporate America's audit
committees and ask them to do the job Rod Hill set for
them.4
---------------------------------------------------------------------------
\4\ At this point, I have three suggestions, all blatantly self-
serving. In earlier drafts of this testimony, I failed to flag these as
tongue-in-cheek and my friends called me to task for that. Let's
consider increasing the pay differential between audit committee board
members and the others. Let's encourage potential audit committee
members to attend Directors' College at the University of Chicago.
Let's educate audit committee members to demand of management a budget
to hire its own accounting consultants, such as professors from the
University of Chicago, to teach the accounting issues for the company's
operations and financial structure.
---------------------------------------------------------------------------
Consulting Conflicts
Management typically views audits as adding no value, purchased
merely because regulation requires them. Hence, management typically
wants the most cost/effective job it can get to satisfy the
regulations. This doesn't mean the cheapest audit. Capital markets will
guide a company in the S&P 500 not to hire me to do its audit, but to
hire one of the Big Five, because the resulting savings in the cost of
funds more than offsets the higher invoice cost. Once that firm decides
it needs a Big Five auditor, its Chief Financial Officer will prefer to
spend less, not more, for the service. The audit committee worries less
about a smaller audit bill.
The audit committee could say, ``We're going to pay top dollar for
a high quality audit.'' To the auditor it could say, ``Make a decent
profit on the audit; don't count on consulting fees to make up for thin
margins on the audit.'' This will drive up the cost of both the audit
and the consulting services, because the outside consultant will not
have the head start in understanding the client's specifics that the
auditor has. Management will not like this. The audit committee,
charged to be concerned primarily with the audit, should be unconcerned
about the higher cost of consulting fees. When did you last hear of an
audit committee asking for a higher-priced audit?
Does this require a regulation forbidding the auditor from
consulting? No, we already have regulations empowering the audit
committee to act, independent of management. Now, we need the audit
committee to act.
In the current environment, it's heresy to suggest that we need not
to forbid auditors from also providing consulting services. Despite
this pressure, I suggest to the Committee that mandatory auditor
rotation, with auditors chosen and beholden to the audit committee,
will solve the conflict of interest problem.
Another advantage to term limits for auditors is the ease of
specifying and enforcing the rule. All proposals to divorce auditing
from consulting contemplate exceptions. For example, the auditor can be
the most cost-effective preparer of income tax returns. I, and others,
see no need to waste resources by having firms different from the
auditor do the tax return. Where to draw the line? Let's don't mandate
one, but let the audit committee decide. I can imagine that the auditor
will prefer shorter terms to longer because the sooner the audit is
done, the sooner it can undertake consulting engagements.
Chairman Tauzin. I think I would have enjoyed your classes,
Professor. Thank you very much.
The next witness is Dr. Bala Dharan who is Professor of the
Graduate School of Management at Rice University in Texas. By
the way, my neighbor at law school was Daria Dharan, same
spelling. We welcome you, sir, and you're going to speak to us
about the special purpose vehicles and the market-to-market
accounting, all these new developments. We welcome your
testimony.
STATEMENT OF BALA G. DHARAN
Mr. Dharan. Thank you, Mr. Chairman, and members of the
committee for inviting me to present my analysis of the
accounting issues that you just mentioned that led to Enron's
downfall. I am very honored to be given this opportunity. Thank
you again.
I am a professor of accounting at Rice University. I've
also taught at Harvard Business School and University of
California, Berkeley and along with Roman Weil, I'm also a
Ph.D. from Carnegie Mellon, so I think we should mention those.
Given the limited time that you have given us for the oral
testimony, even though I have a big temptation to give a long
lecture, which we all do, as you know, I'm going to really
restrict myself and give mainly the summary of my findings.
My written testimony which has been submitted to the
committee contains extensive discussions of both special
purpose entities as well as mark-to-market accounting.
Chairman Tauzin. Could you move the mike a little closer,
Dr. Dharan? Thank you, sir.
Mr. Dharan. The Enron debacle will rank as one of the
largest securities fraud cases in history. Evidence to date
points to signs of accounting fraud involving false valuation
of assets, misleading disclosures and bogus transactions to
generate income. This failure is a result of an unparalleled
breakdown at every level of the usual system of checks that
investors, lenders and employees rely on.
Let me start with broken or missing belief systems and
boundary systems that companies need to have to govern the
behavior of their senior management. Weak corporate governance
by board of directors and its audit committee, and compromised
independence in the attestation of financial statements by
external auditors. As per your request in my testimony I'll
focus mainly on the accounting issues on the Enron use of
special purpose entities and mark-to-market accounting.
My analysis of the Enron debacle shows that while Enron's
fall might have been initiated by a flawed and failed business
strategy which many people have pointed out, it was ultimately
precipitated by the company's pervasive and sustained use of
aggressive accounting tactics to generate misleading
disclosures intended to hide bad business decisions from the
shareholders. As Dr. Weil pointed out, it's okay to bet the
farm and lose it, but it's not okay to mislead the investors
about what you are trying to do.
Enron's corporate strategy itself was flawed. Let's focus
on that for a second to see how they elected the accounting
problems. The strategy was to be an assetless company that
would buy and sell risk positions. This strategy when you
really think about it is virtually devoid of any boundary
systems that tell you what not to do. Essentially, the
management, the senior management gave its managers a blank
order to just do it, to do any deal origination that generated
a desired rate of return. And as Mr. Chanos pointed out, even
those returns were not adequate. This flawed business strategy
led to colossal investment mistakes in virtually every new area
that the company tried to enter. However, again, it's important
to remember that while bad business strategy can contribute to
a company's fall, it's often a company's desperate attempt to
use accounting tricks to hide bad business decisions that seals
its fate.
Confronted with normal business problems, a corporation can
generally use the right decisions to extricate itself out of
those problems. But when a firm loses their trust and
confidence of the investing public because of discoveries of
accounting wrongdoings, the net result on the stock prices is
mostly devastating and long lasting. This is what happened in
the case of Enron.
Let me start with the loss of investor faith and just give
an example of that to really illustrate this point. They had
their quarterly earnings release on October 16, 2001. This
release claimed a pro forma profit while the company was
actually losing money. Bad news to the tune of $1 billion was
conveniently labeled as nonrecurring. As earnings releases go,
this one must rank as one of the most misleading. Accounting
research suggests that the adoption of this pro forma earnings
reporting is often a company's desperate response to hide
underlying business problems. To prevent future Enrons from
hiding under similar pro forma reporting, we need to ensure
that the misleading pro forma disclosures are halted all
together.
The Securities and Exchange Commission should recognize all
pro forma disclosures for what they really are, a charade. The
SEC, the New York Stock Exchange and the NASDAQ should adopt
new rules restricting the format and the use of pro forma
reporting. The use of terms such as one time or nonrecurring
about past events, in earnings communications, in place certain
promises about the--to the investors about future performance
of the company and therefore should not be allowed to be used
in earnings communications, except in rare cases.
Enron's internal report released on February 1, 2002 makes
clear that Enron used dozens of transactions with special
purpose entities. While not all SPEs are bad, in Enron's case,
special purpose entities are mainly used in the last 5 years to
achieve dubious accounting goals, rather than genuine business
purpose. The accounting effects can be summarized in the
following four categories: (1) hiding of debt from the balance
sheet; (2) hiding of poor-performing assets with some of your
members mentioned also; (3) earnings management which is
reporting gains and losses when desired; and (4) quick
execution of transactions at desired prices. For example, Enron
used its own senior managers as part of special purpose
entities so that they could execute those transactions whenever
they desired at short notice.
To prevent the continued use of SPEs, the accounting
profession and the SEC need to act quickly to enact several
changes in the existing set of accounting rules. The Financial
Accounting Standards Board needs to accelerate its current
project on consolidation accounting and in particular fix the
consolidation rule for special purpose entities. The current
rules which includes the infamous 3 percent rule for
consolidation needs to be abandoned in favor of rules that
emphasize economic control, rather than specific numbers that
can be easily violated. Economic control should be assumed,
unless management can prove otherwise.
In the U.S. financial assets are reported under a method
that we call mark-to-market accounting. The values are reported
at current prices rather than historical costs. Normally, mark-
to-market accounting works, but we also use mark-to-market
accounting not just for assets that have readily determinable
market prices, but also for assets such as financial
derivatives that don't have traded market values. The bottom
line when you allow mark-to-market accounting for financial
contracts is that the mark-to-market accounting rule
essentially allowed, in the case of Enron for example, to pick
its own market value estimates and report them as gains to
shareholders, estimates that were supposed to be checked by
external auditors, but are hard to verify for anyone outside
the firm.
The mark-to-market methodology is theoretically sound, but
it needs to be modified in the light of what we have learned
from the use of mark-to-market accounting by Enron. Traditional
revenue recognition rules anchored in conservatism principle
should be extended to recognition of gains and losses from
mark-to-market accounting. As several of your members pointed
out, it really is very hard to understand how we could report
gains from transactions that are going to happen 20, 30 years
from now.
Mr. Chairman, the Enron meltdown is the result of massive
failure of corporate control and governance, out of focus
mainly on the accounting issues, and in particular on the
possible changes we need to make and the lessons we can take.
I'll be glad to answer questions from you and the committee
members and elaborate on my analysis. Once again, thank you for
giving me the opportunity.
[The prepared statement of Bala G. Dharan follows:]
Prepared Statement of Bala G. Dharan, PhD, CPA, Professor of
Accounting, Rice University
Mr. Chairman and members of the Committee, I want to thank you for
inviting me to present my analysis of the accounting issues that led to
Enron's downfall. I am honored to be given this opportunity.
I am Bala Dharan, professor of accounting at the Jesse H. Jones
Graduate School of Management, Rice University, Houston. I received my
PhD in accounting from Carnegie Mellon University, Pittsburgh. I have
been an accounting professor at Rice University since 1982. In
addition, I have taught accounting as a professor at Northwestern
University's Kellogg School of Management, and as visiting professor at
the Haas School of Business at University of California, Berkeley, and
the Harvard Business School. I am also a Certified Public Accountant
and a Registered Investment Advisor in the state of Texas. I have
published several articles in research journals on the use of financial
accounting disclosures by investors.
The Enron debacle will rank as one of the largest securities fraud
cases in history. Evidence to date points to signs of accounting fraud
involving false valuation of assets, misleading disclosures and bogus
transactions to generate income. I have had several invitations to
speak on Enron's accounting issues over the last few months. In my
talks and lectures, I am asked two questions most frequently: One, how
could this tragedy have happened while the company's management, board
of directors and outside auditors were supposedly watching over for
employees and investors? Two, what can we learn from this debacle so
that we can avoid future Enrons? Undoubtedly the first question will be
the focus of the many investigations currently under way, including
your Committee's efforts. In my testimony, I will focus on what we can
learn from the accounting issues related to Enron's use of mark-to-
market (MTM) accounting and special purpose entities (SPEs). These two
issues are very closely related, especially as they were practiced by
Enron. In addition, I will address the related accounting issue of pro-
forma disclosures, and also how Enron's failed business strategy
contributed to the accounting errors. I hope other invited panelists
addressing before this Committee will talk about the critical roles
played by Enron's management, board, auditors, lawyers, consultants,
financial analysts, and investment bankers in Enron's fall. I conclude
with recommendations for regulatory changes and improvements in the
accounting and auditing rules governing special purpose entities, mark-
to-market accounting, and financial disclosures in general.
1. loss of investor trust
My analysis of the Enron debacle shows that Enron's fall was
initiated by a flawed and failed corporate strategy, which led to an
astounding number of bad business decisions. But unlike other normal
corporate failures, Enron's fall was ultimately precipitated by the
company's pervasive and sustained use of aggressive accounting tactics
to generate misleading disclosures intended to hide the bad business
decisions from shareholders. The failure of Enron points to an
unparalleled breakdown at every level of the usual system of checks
that investors, lenders and employees rely on--broken or missing belief
systems and boundary systems to govern the behavior of senior
management, weak corporate governance by board of directors and its
audit committee, and compromised independence in the attestation of
financial statements by external auditor.
Enron started its transformation from a pipeline company to a
``risk intermediation'' company in the 1980s. It adopted a corporate
strategy of an ``asset-less'' company, or a ``frictionless company with
no assets.'' The company's Chief Financial Officer said in a 1999
interview to a management magazine (which awarded him ``CFO Excellence
Award for Capital Structure Management'') that the top management
transformed Enron into ``one engaged in the intermediation of both
commodity and capital risk positions. Essentially, we would buy and
sell risk positions.'' What this description of the company implies is
that unlike any other major company in the US, Enron's corporate
strategy was virtually devoid of any boundary system that defined the
perimeter of what is an acceptable and unacceptable investment idea for
managers to pursue. Since any business investment basically involves
some risk position, this strategy is not really a strategy at all but
an invitation to do anything one pleases. Enron's top management
essentially gave its managers a blank order to ``just do it'', to do
any ``deal origination'' that generated a desired return. ``Deals'' in
such unrelated areas as weather derivatives, water services, metals
trading, broadband supply and power plant could all be justified and
approved by managers under this concept of an asset-less risk
intermediation company. The company even briefly changed its tagline in
a company banner from ``the world's leading energy company'' (which
implies some boundary system for investments) to ``the world's leading
company.'' It is no wonder that this flawed business strategy led to
colossal investment mistakes in virtually every new area that the
company tried to enter.
While bad business strategy and bad investment decisions can and do
contribute to a company's fall, it is a company's desperate attempt to
use accounting tricks to hide bad decisions that often seals its fate.
My analysis of cases of major stock price declines shows that when news
of an unanticipated business problem, such as a new product competition
or obsolescence of technology, is released to the market, the company's
stock price does take a hit, but it often recovers over time if the
company takes appropriate and timely management actions. However, when
a company loses the trust and confidence of the investing public
because of discoveries of accounting wrongdoings, the net result on the
company's stock price and competitive position is mostly devastating
and long-lasting. This is because accounting reports are the principal
means by which investors evaluate the company's past performance and
future prospects, and a loss of trust effectively turns away investor
interest in the company.
My analysis also suggests that it is not possible to recover from a
loss of investor confidence by some quick management actions. Before
re-admitting the company to their investment portfolios, investors
would demand and seek evidence that the accounting numbers are again
reliable, and this process of rebuilding of trust often takes place
through several quarters of reliable financial disclosures. If the
company's finances are not fundamentally sound to begin with, then it
is quite likely that the company would not survive this long trust-
recovery phase intact. This is exactly what happened in the case of
Enron. Burdened with dozens of failing investments and assets hidden in
special purpose entities whose very existence and financing often
depended on high stock price of Enron's shares, the company quickly
entered a death-spiral when investors questioned its accounting
practices and pushed its share price down to pennies.
2. use of pro-forma earnings
Enron's loss of investor faith started with the company's 2001
third quarter earnings release on October 16, 2001. As earnings
releases go, this one must rank as one of the most misleading. The news
release said in an underlined and capitalized headline, ``Enron Reports
Recurring Third Quarter Earnings of $0.43 per diluted shares.'' The
headline went on to reaffirm ``recurring earnings'' for the following
year, 2002, of $2.15 per share, a projected increase of 19% from 2001.
But an investor had to dig deep into the news release to know that
Enron actually lost $618 million that quarter, for a loss of ($0.84)
per share. A net loss of $618 million loss was converted to a
``recurring net income'' of $393 million by conveniently labeling and
excluding $1.01 billion of expenses and losses as ``non-recurring''.
The practice of labeling certain earnings items as non-recurring or
``one-time'' has unfortunately become widespread in the US, and has
corrupted corporate disclosure environment to the detriment of
investors and the public. Companies ranging from General Motors to
Cisco mention some form of pro-forma earnings in their earnings
disclosures. Of course, there is nothing ``one-time'' or ``non-
recurring'' about the $1.01 billion of expenses and losses that Enron
chose to label as such in its 2001 third quarter earnings release. In
other words, neither accountants nor managers could assure that what
they call non-recurring would not recur.
My ongoing research also shows that the adoption of pro-forma
earnings reporting is often a company's desperate response to hide
underlying business problems from its investors. As an example, Enron
did not always use pro-forma earnings in its news releases. Its
earnings release as late July 24, 2000, for 2000 second quarter, did
not contain any reference to recurring earnings. In its 2000 third
quarter earnings release on October 17, 2000, Enron started using the
recurring earnings in the body of the news release. We know from the
Enron board's internal report dated February 1, 2002, that this was
also the time when the senior management started worrying about the
declining value of many of their merchant investments. By the following
quarter, recurring earnings had been elevated by Enron to news
headline.
Not all companies, of course, use pro-forma earnings or use them in
blatantly misleading way. Companies like Microsoft do report their
earnings without having to resort to misleading pro-forma disclosures.
However, we need to ensure that misleading pro-forma disclosures are
halted altogether. In a recent speech, the chairman of the Securities
and Exchange Commission has warned companies that pro-forma earnings
would be monitored by the SEC for misleading disclosures. However, this
does not go far enough. The SEC should recognize all pro-forma
disclosures for what they really are--a charade. They may differ from
one another in the degree of deception, but the intent of all pro-forma
earnings is the same--to direct investor attention away from net income
measured using generally accepted accounting principles, i.e., GAAP
earnings.
Enron's 2001 third quarter earnings press release on October 16,
2001, contained another major shortcoming--lack of information about
its balance sheet and cash flows. While the company's press release
provided information on net income, the company failed to provide a
balance sheet. This is inexplicable--we teach in Accounting 101 that
the income statement and the balance sheet are interrelated
(``articulated'') statements. This essentially means that we cannot
really prepare one without preparing the other. Not surprisingly,
almost every major company's earnings release contains the balance
sheet along with its income statement. Financially responsible
companies would also provide a cash flow statement. Analysts and
investors puzzled with Enron's lack of balance sheet disclosure had to
wait until after the markets closed on October 16, 2001, when the
senior management disclosed in response to a question during the
earnings conference call that it had taken a $1.2 billion charge
against its shareholders' equity (a balance sheet item), including what
was described as a $1 billion correction of an accounting error. The
experience suggests that along with reforms on pro-forma earnings
usage, we should mandate a fuller, more complete presentation of
financial statements in the earnings news releases so that investors
can truly be in a position to interpret the quality and usefulness of
the reported earnings numbers.
3. special purpose entity accounting
3.1. Business Purpose of SPEs
Enron's internal report released on February 1, 2002, makes clear
that Enron used dozens of transactions with special purpose entities
(SPEs) effectively controlled by the company to hide bad investments.
These transactions were also used to report over $1 billion of false
income. Many of these transactions were timed (or worse, illegally
back-dated) just near end of quarters, so that the income can be booked
just in time and in amounts needed, to meet investor expectations.
However, SPEs were not originally created as mere tools of accounting
manipulation. Surprisingly, the SPE industry did start with some good
business purpose. Before discussing the accounting issues related to
Special Purpose Entity (SPE) accounting, it would be useful to have a
brief description of what these entities are and how they arose.
The origin of SPEs can be traced to the way large international
projects were (and are) financed. Let's say a company wants to build a
gas pipeline in Central Asia and needs to raise $1 billion. It may find
that potential investors of the pipeline would want their risk and
reward exposure limited to the pipeline, and not be subjected to the
overall risks and rewards associated with the sponsoring company. In
addition, the investors would want the pipeline to be a self-supported,
independent entity with no fear that the sponsoring company would take
it over or sell it. The investors are able to achieve these objectives
by putting the pipeline into a special purpose entity that is limited
by its charter to those permitted activities only. Thus a common
historical use of SPE was to design it as a joint venture between a
sponsoring company and a group of outside investors. The SPE would be
limited by charter to certain permitted activities only--hence the
name. Such an SPE is often described as brain-dead or at least on auto-
pilot. Cash flows from the SPE's operations of the project are to be
used to pay its investors.
In the US, the use of SPEs spread during the 1970s and 1980s to
financial services industry. In the early 1980s, SPEs were used by the
financial services firms to ``securitize'' (market as securities)
assets that are otherwise generally illiquid and non-marketable, such
as groups of mortgages or credit card receivables. Because they provide
liquidity to certain assets and facilitate a more complete market for
risk sharing, many SPEs can and do indeed serve a useful social
purpose.
3.2 Accounting Purposes of SPEs
These examples illustrate that SPEs can be motivated by a genuine
business purpose, such as risk sharing among investors and isolation of
project risk from company risk. But as we have seen from the Enron
debacle, SPEs can also be motivated by a specific accounting goal, such
as off-balance sheet financing. The desired accounting effects are made
possible because of the fact that SPEs are not consolidated with the
parent if they satisfy certain conditions. The accounting effects
sought by the use of SPEs can be summarized into the following types:
1. Hiding of Debt (Off-Balance Sheet Financing). The company tries
to shift liabilities and associated assets to an SPE. The main purpose
of forming the SPE in this case is to let the SPE borrow funds and not
show the debt in the books of the sponsoring entity. The so-called
``synthetic leases'' are examples of this type of SPEs. In the 1980s
SPEs became a popular way to execute synthetic lease transactions, in
which a company desiring the use of a building or airplanes tries to
structure the purchase or use in such a way that it does not result in
a financial liability on the balance sheet. Though Enron's earlier use
of SPEs may have been motivated by this objective, the key SPEs formed
by Enron since 1997, such as Chewco, LJM1 and LJM2, were intended more
for the other accounting objectives described below.
2. Hiding of Poor-Performing Assets. This objective has a major
factor in several SPE transactions of Enron. For example, Enron
transferred poor-performing investments such as Rhythms NetConnections
to SPEs, so that any subsequent declines in the value of these assets
would not have to be recognized by Enron. In 2000 and 2001 alone, Enron
was able to hide as much as $1 billion of losses from poor-performing
merchant investments by these types of SPE transactions.
3. Earnings Management--Reporting Gains and Losses When Desired.
This accounting objective has also been a fundamental motivation for
several of the complicated transactions arranged by Enron with SPEs
with names such as Braveheart, LJM1 and Chewco. For example, Enron was
able to transfer a long-term business contract--an agreement with
Blockbuster Video to deliver movies on demand, to an SPE and report a
``gain'' of $111 million.
4. Quick execution of Related Party Transactions at desired prices.
Enron's use of SPEs such as LJM1 and LJM2, controlled by its own senior
managers, was specifically intended to do related party transactions
quickly and when desired, at prices not negotiated at arms length but
arrived at between parties who had clear conflicts of interest. For
example, the above Blockbuster deal was arranged at the very end of
December 2000, just in time so that about $53 million of the ``gain''
could be included in the 2000 financial report. (The rest of the gain,
$58 million, was reported in 2001 first quarter.) The purpose of this
and several similar transactions by Enron seems to have been to use
these transactions with SPEs controlled by its own senior executives to
essentially create at short notice any amount of desired income, to
meet investor expectations.
There are three sets of accounting rules that permit the above
financial statement effects of SPEs. One deals with balance sheet
consolidation--whether or not SPEs such as synthetic leases should be
consolidated or reported separately from the sponsoring entity. The
second deals with sales recognition--when should the transfer of assets
to an SPE be reported as a sale. The third deals with related party
transactions--whether transfers of assets to related parties can be
reported as revenue. Of these, the accounting problem that needs
immediate fixing is the one dealing with consolidation of SPEs. This is
addressed next. With respect to sales recognition rules and related
party transaction rules, the problem may lie more with Enron's
questionable accounting and corresponding auditor errors, rather than
the rules themselves. However, Enron's revenue recognition from SPE
transactions often depended on the so-called mark-to-market accounting
rules which gave Enron the ability to assign arbitrary values to its
energy and other business contracts. These rules do have certain
problems that need fixing, and this issue is addressed in section 4.
3.3. Consolidation of SPEs
Despite their potential for economic and business benefits, the use
of SPEs has always raised the question of whether the sponsoring
company has some other accounting motivations, such as hiding of debt,
hiding of poor-performing assets, or earnings management. Additionally,
the explosive growth in the use of SPEs led to debates among managers,
auditors and accounting standards-setters as to whether and when SPEs
should be consolidated. This is because the intended accounting effects
of SPEs can only be achieved if the SPEs are reported as unconsolidated
entities separate from the sponsoring entity. In other words, the
sponsoring company needs to somehow keep its ownership in the SPE low
enough so that it does not have to consolidate the SPE.
Thus consolidation rules for SPEs have been controversial and have
been hotly contested between companies and accounting standards-setters
from the very beginning. In the US, the involvement of the Financial
Accounting Standards Board (FASB), the accounting standards-setting
agency, in SPE accounting effectively started from 1977 when it issued
lease capitalization rules to control the use of off-balance sheet
financing with leases. Corporate management intent on skirting around
the new lease capitalization rule appeared to have led to the rapid
development of SPEs to do the so-called ``synthetic leases''. In the
first of several accounting rules directed at SPEs, in 1984 the
Emerging Issues Task Force (EITF) of the FASB issued EITF No. 84-15,
``Grantor Trusts Consolidation.'' However, given the rapid growth of
SPEs and their ever-widening range of applications, standards-setters
were always a step or two behind and were being reactive rather than
proactive in developing accounting rules to govern their proper use.
The question of whether a sponsoring company should consolidate an
SPE took a definitive turn in 1990 when the EITF, with the implicit
concurrence of the SEC, issued a guidance called EITF 90-15. This
guidance allowed the acceptance of the infamous ``3 percent rule'',
i.e., an SPE need not be consolidated if at least 3 percent of its
equity is owned by outside equity holders who bear ownership risk.
Subsequently, the FASB formalized the above SPE accounting rule with
Statement No. 125, and more recently Statement No. 140, issued in
September 2000.
An analysis of the development of the 3 percent rule suggests that
the rule was an ad-hoc reaction to a specific issue faced by the FASB's
Emerging Issues Task Force and was intended as a short-term band-aid,
but has somehow been elevated to a permanent fix. More importantly, the
rule, in many ways, was a major departure from the normal consolidation
rules used for other subsidiaries and entities. In the US, we generally
require full consolidation if a company owns (directly or indirectly)
50 percent or more of an entity. Thus the 3 percent rule is a major
loosening of the normal consolidation rule. The motivation for this
seems to have been that the SPEs were restricted in their activities by
charter and thus the parent company could claim lack of control. The
parent company only had to show that some other investors did indeed
join the SPE venture with a significant exposure (signified by the 3
percent rule) in order to make the SPE economically real and thus take
it off the books.
Clearly the accounting for SPE consolidation needs to be fixed,
starting with the abandonment of the 3 percent rule and its replacement
with a more strictly defined ``economic control'' criterion. The need
to fix consolidation rules has also been amply recognized by the FASB,
which has been working for several years on a comprehensive
``consolidation'' project. However, the Enron debacle should give our
standards-setters the needed push to rapidly complete this critical
project and issue new rules for the proper consolidation of SPEs whose
assets or management are effectively controlled by the sponsoring
company. The rules should emphasize economic control rather than rely
on some legal definition of ownership or on an arbitrary percentage
ownership. Economic control should be assumed unless management can
prove lack of control.
4. mark-to-market accounting and earnings management
In the US, financial assets, such as marketable securities,
derivatives and financial contracts, are required to be reported on the
balance sheet at their current market values, rather than their
original acquisition cost. This is known as mark-to-market (MTM)
accounting. MTM also requires changes in the market values for certain
financial assets to be reported in the income statement, and in other
cases in the shareholders' equity as a component of ``Accumulated Other
Comprehensive Income'' (OCI), a new line item that was required for all
public companies by FASB Statement No. 130 from 1997.
MTM was implemented in FASB Statement No. 115, issued in 1993, for
financial assets that have readily determinable market values, such as
stocks and traded futures and options. In 1996, FASB Statement No. 133
extended MTM to all financial derivatives, even those that do not have
traded market values. For some derivatives, a company may have to use
complex mathematical formulas to estimate a market value. Depending on
the complexity of the financial contract, the proprietary formulas used
by companies for market value estimation may depend on several dozen
assumptions about interest rate, customers, costs, and prices, and
require several hours of computing time. This means that it is hard, if
not impossible, to verify or audit the resulting estimated market
value. Of course, a consequence of this lack of verifiability is that
MTM accounting can potentially provide ample opportunities for
management to create and manage earnings. Thus MTM accounting
represents the classic accounting struggle of weighing the trade-off
between relevance and reliability--in this case the relevance of the
market value data against the reliability of the data. In the end, the
accounting standards-setters took the position that the increased
benefit from reporting the market value information on the balance
sheet justified the cost of decreased reliability of income statement
and the earnings number.
It will be useful to consider an example of how Enron recognized
with MTM accounting, in order to understand how MTM can be easily
manipulated by a company to manage earnings, especially with respect to
financial contracts that do not have a ready market. Assume that Enron
signed a contract with the city of Chicago to deliver electricity to
several office buildings of the city government over the next twenty
years, at fixed or pre-determined prices. The advantage to the city of
Chicago from this ``price risk management'' activity is that it fixes
its purchase price of electricity and allows the city government to
budget and forecast future outlays for electricity without having to
worry about price fluctuations in gas or electricity markets.
Enron sought and obtained exemptions from regulators to allow it
report these types of long-term supply contracts as ``merchant
investments'' rather than regulated contracts, and obtained permission
from accounting standards-setters to value them using MTM accounting.
Without MTM, Enron would be required to recognize no revenue at the
time the contract is signed and report revenues and related costs only
in future years for actual amounts of electricity supplied in each
year. However, MTM accounting permits Enron to estimate the net present
value of all future estimated revenues and costs from the contract and
report this net amount as income in the year in which the supply
contract is signed. The idea for such an accounting treatment seems to
be based on the notion that the financial contract could have been sold
to someone else immediately at the estimated market value, and hence
investors would benefit from knowing this amount in the balance sheet
and correspondingly in the income statement. Enron used similar MTM
procedures to not only value merchant investments on its books but also
to determine the selling price, and hence gain on sale, for investments
it transferred to the various SPEs it controlled.
A major problem with using MTM accounting for private contracts
such as the one described above is that the valuation requires Enron to
forecast or assume values for several dozen variables and for several
years into the future. For example, the revenue forecasts may depend on
assumptions about the exact timing of energy deregulation in various
local markets, as well as 20 years of forecasts for demand for
electricity, actions of other competitors, price elasticity, cost of
gas, interest rates, and so on.
While there are strong conceptual reasons to support MTM
accounting, the Enron crisis points to at least some need to revisit
and revise the current accounting rules for reporting transactions and
assets that rely on MTM values. In particular, MTM rules should be
modified to require that all gains calculated using MTM method for
assets and contracts that do not have a ready market value should be
reported only in ``Other Comprehensive Income'' in the balance sheet,
rather than the income statement, until the company can meet some high
``confidence level'' about the realization of revenue for cash flows
that are projected into future years. Normal revenue recognition rules
do require that revenue should be recognized after service is
performed, and moreover that revenue should be ``realized or
realizable'', meaning that cash flow collection should be likely. In
the absence of satisfying this condition, revenue rules (such as those
explained in SEC Staff Accounting Bulletin 101) normally compel a
company to wait until service is performed and cash collection
probabilities are higher. Extending this logic to MTM accounting would
protect the investing public from unverifiable and unauditable claims
of gains being reported in the income statement.
5. recommendations
The Enron Meltdown is a result of massive failure of corporate
control and governance, and failures at several levels of outside
checks and balances that investors and the public rely on, including an
independent external audit. In my testimony, I have focused on the
accounting issues, and in particular on the possible changes we need to
make in these areas in order to prevent future Enrons. My
recommendations are summarized below.
1. The SEC, the New York Stock Exchange (NYSE) and the Nasdaq should
adopt new rules severely restricting the format and use of pro-
forma earnings reporting. All earnings communications by
companies should emphasize earnings as computed by Generally
Acceptable Accounting Standards. Any additional information
provided by the company to highlight special or unusual items
in the earnings number should be given in such a way that the
GAAP income is still clearly the focus of the earnings
disclosure.
2. Companies should be reminded by regulators and auditors that the use
of terms such as ``one-time'' or ``non-recurring'' about past
events in earnings communications implies certain promises to
investors about future performance, and therefore should not be
used except in rare cases.
3. Companies should present a complete set of financial statements,
including a balance sheet and a cash flow statement, in all
their earnings communications to the general public, in order
to permit investors evaluate the quality of the reported
earnings numbers.
4. The FASB needs to accelerate its current project on consolidation
accounting, and in particular, fix the consolidation rules in
the accounting for Special Purpose Entities to prevent its
continued abuse by corporations for earnings management. The
current consolidation rules, including the ``3 percent'' rule
for SPEs need to be abandoned and replaced with an ``economic
control'' rule. The new rules need to emphasize economic
control rather than rely on some legal definition of ownership
or on an arbitrary percentage ownership. Economic control
should be assumed unless management can prove lack of control.
Similar rules should be extended to lease accounting.
5. The FASB and the SEC need to consider requiring new disclosures on
transactions between a company and its unconsolidated entities,
including SPEs. In particular, more detailed footnote
disclosures on the sale or transfer of assets to unconsolidated
entities, recognition of income from such transfers, and the
valuation of transferred assets should be required.
6. The mark-to-market accounting methodology, while theoretically
sound, needs to be modified in the light of what we have
learned from the Enron meltdown. Traditional revenue
recognition rules, such as the realization principle, should be
extended to the recognition of gains and losses from MTM
accounting. Forecasted cash flows beyond two or three years
should be presumed to have a low level of confidence of
collectibility. Gains resulting from present values of such
cash flows should be recorded in the Accumulated Other
Comprehensive Income in the balance sheet, rather than the
income statement, until the confidence level increases to
satisfy the usual realization criterion of collectibility.
Chairman Tauzin. Thank you, Dr. Dharan.
Now we turn to someone whom I'm told by the staff if they
did have a Nobel Prize for accounting, would be a recipient of
the Nobel Prize. In fact, Dr. Lev, the staff affectionately
called you the Britney Spears of accounting.
We welcome your testimony, sir.
STATEMENT OF BARUCH LEV
Mr. Lev. Thank you very much, Chairman. I'm deeply grateful
to be here. I was asked to speak about reforming accounting
auditing systems. I would like to state at the outset that my
ideas, concepts, suggestions that are included in my written
testimony were not shaped by Enron or Arthur Andersen. They
were shaped by more than 25 years of experience, observations
and extensive reach. Enron basically provides with, I think, a
great opportunity to do a much needed over due, overhaul of the
system.
I draw your attention to my testimony, the first two pages
provide diagrams of what I see as the problem. The second one
what I see as the solution, followed by 9 pages of elaborations
and then followed a quiz.
Starting with the problem, the first diagram, there is a
nexus there of three elements. I'm almost tempted to borrow a
phrase and call it an ``evil axis'' here and we have financial
reports, we have auditing and we have enforcement and I
characterize those financial reports by too narrow auditing,
it's too cozy and enforcement is too little, too late and too
opaque. Let me say a word about each of the three.
Financial reports, I'm sure that the gentleman that took
six accounting courses will agree with me, accounting is very
good at recording or portraying simple transactions like sales,
purchases, borrowing. Accounting is terrible in reporting more
complex things that are not regular transactions like
unexecuted obligations, for example, promises that Enron gave
to the special entities to cover losses if there will be
losses. All those things are to a large extent not reported,
not recorded in accounting.
Accounting does not portray the myriad network of
alliances, joint ventures, partnerships that corporations have,
most of them for legitimate, good economic reasons, but they
are not portrayed in accounting. Accounting is terrible in
portraying intangible assets like patents, like brands, like
human resources. Intangible assets now count for more than 80
percent on average of the values of companies and accounting is
completely useless in portraying the risk that the company is
exposed to, so we are speaking here about a really outmoded, to
a large extent, useless information system.
If I turn to auditing, you heard a lot about auditing. It's
basically an ``all-in-the-family'' affair. You heard about the
consulting and the revolving door and everything. Let me just
add one nugget here. Even the auditing standards which are
called generally accepted accounting standards, the rules that
auditors follow and on which they rely in their report are
basically set by their own trade association, by the American
Institute of Certified Public Accountants.
Enforcement, as I said before, too low, too slow. Let me
just quote form the Journal, it was the Journal yesterday to
speak about Global Crossing and they say the SEC tries to
determine whether accounting rules were violated. The decision
whether to bring a case can take at least 1 or 2 years. We are
speaking about the company that went bankrupt last week.
If I turn to the solution which is the next exhibit that
you have, speaking about financial reporting, we have to move
from the very narrow, as it is called financial reporting, to
the exclusion of everything else to a very broad, comprehensive
disclosure, to open a net which will capture and report
alliances and joint ventures and partnerships and all
obligations and intangible assets and will portray the risk
position or exposure of the company. This is a tall order. It's
not an easy thing to do, but it can be done.
When I turn to auditing, given my time limitation you heard
a lot about auditing. Let me just mention a couple of things.
It's not a secret that auditors for all practical purposes are
selected, chosen and reappointed by managers. We all know about
the board and the audit committee of the board, but board
members are also for all practical purposes chosen and selected
by managers. We have to break this link, this dependency of
auditors on managers and the only way I see that this can be
done is that auditors will be chosen, once in 5 years, by
shareholders. What a novel idea. Those that have to receive the
information are choosing the auditors and not the auditees.
Now I hear from people that it's not practical and a
condescending thing that shareholders don't know and they
cannot choose auditors. This is, excuse me, this is nonsense.
We have a very solid process which is called a contest, a proxy
contest which is used quite frequently to select, to change
board compositions, to change management, to change policies
and this can be used to select auditors, once in 5 years. Next
month shareholders of two giant companies, Hewlett Packard and
Compaq will vote on the largest acquisition ever in the high
tech sector. If they know how to do that, they will now how to
select auditors.
This will open the audit markets to competition. There will
be bids every 5 years. New teams will come with expertise,
something like auditors with expertise in energy trading,
something like that and if they won't perform, they'll be
thrown out. In this case, it will break this dependence between
managers and auditors.
The second element that was not discussed, at least
extensively is the audit report. The audit report is a
meaningless piece of paper with just one sentence and lots of
hedging and pushing, transferring the information to other
parties like the financial reports, the responsibility of
managers and we follow auditing standards and accounting
standards and so on and so on. We have to discard this report
for an open-ended report in which auditors will tell, sometimes
at length, to shareholders what is going on in the company. I
read that Mr. Berardino, the CEO of Arthur Andersen yesterday
even came close to these suggestions when he said the current
past/fail system, this qualified/nonqualified lets companies
get away with barely adequate accounting. I will say it gets
away with much less than that and he provides some kind of
suggestions for a rating.
Last thing I would say is about enforcement. I am for the
ideas that were raised by several people including Lynn Turner
of setting up, and it's the only body that I think has to be
set up, an investigatory body that will be mandated to
investigate and quickly, relatively quickly release results
with respect to failures and failures are not just Enron.
Failures, for example, are large restatements of earnings that
are now numbering in the hundreds per year.
All I can add to this is perhaps a novel idea about
funding. I don't want the funding for this body to come from
accounting firms which again will create dependence, all from
corporations. I calculated that if you'll charge every 100
shares traded one penny, just one penny which is really a
minuscule charge, you'll raise more than $70 million which
probably will be sufficient to fund such a body. The budget of
the National Transportation Board has year was $57 million. I'm
coming to a close.
I agree with the first speaker here that we have to change
completely the rules of disclosing insider trading. This is
incredibly important information to shareholders what insiders
do. Currently, you have to report to the SEC on the tenth day
or no later than the tenth day of the following month which
means a lag of 20 to 25 days. This is intolerable. This has to
be reported no later than the following day after the trade.
In closing, I think we have a great opportunity here. I
think we have really a moment of grace to initiate change
because what we are dealing with here is not just Enron and
Arthur Andersen. The problems afflict hundreds, to varying
degree, hundreds if not thousands of corporations in the United
States. You will soon hear from the awesome forces of the
vested interest of the status quo that the changes that will be
proposed can't be done, they're too radical and they really are
not needed. They are wrong and I hope you rise to the occasion.
Thank you very much.
[The prepared statement of Baruch Lev follows:]
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Chairman Tauzin. Thank you very much, Mr. Lev. Excellent
testimony.
We turn now to Mr. Bevis Longstreth and Mr. Bevis
Longstreth is with the firm, this is a tough pronunciation,
Debevoise & Plimpton, right, in New York.
Mr. Longstreth.
STATEMENT OF BEVIS LONGSTRETH
Mr. Longstreth. I pronounce it Bevis.
Chairman Tauzin. I'm sorry.
Mr. Longstreth. That's okay.
Chairman Tauzin. And you will give us some idea about your
thoughts on the governance of accounting and auditing.
Mr. Longstreth. Yes. I'm going to cover some material that
my colleague to the right covered. Let me give you a little
background about my qualifications to be here. I have spent
most of my professional life at Debevoise & Plimpton, a New
York law firm, which I retired from about 8 years ago. I served
as an SEC Commissioner for 3 years, 1981 to 1984.
Chairman Tauzin. That was during the Reagan Administration,
correct?
Mr. Longstreth. It was. I was appointed twice by President
Reagan and being a registered Democrat, I felt that I could
serve both sides of the aisle.
Chairman Tauzin. And serve there with distinction.
Mr. Longstreth. Recently, I was a member of the panel on
Auditors----
Chairman Tauzin. Sir, Mr. Dingell, wanted to add that you
served there with great distinction as well.
Mr. Dingell. I just observe that you served there with
distinction.
Mr. Longstreth. Thank you. I recently served on the Panel
on Audit Effectiveness which published a report in 2000 which
vanished from sight as did the panel. The panel was appointed
by the POB, the Public Oversight Board, the group that recently
resigned en masse as a result of some suggestions coming out of
the SEC.
For 5 years after I retired, I taught a course on the
regulation of financial intermediaries at Columbia Law School
and presently I'm the chair of an audit committee of a large
public company. So those are the qualifications that bring me
here to talk to you.
What I want to say starts really with the leading role in
capital formation that is served by the audit and just to get a
definition down, the audit is, as you all know, the critically
important process by which a public company's financial
condition is vouched for by a firm of certified public
accountants as being worthy of the investing public's trust.
And a fundamental importance to the audit function is an iron
clad assurance that the auditor is independent of the client,
both in fact, and in appearance.
Now I'm going to invite you to consider two notorious
fictions that for years leaders of the auditing profession have
staunchly maintained and thereby have deflected efforts over
the years at any serious reform.
The first fiction is the claim that payment by an audit
client to its auditor for consulting another nonaudit services
no matter how large, will never impair independence, that is,
it will never have an adverse effect on the quality of the
audit or be seen to have such an effect in the eyes of the
investing public. Because of the rule that the SEC wrote a
couple of years ago requiring separate disclosure of audit and
nonaudit fees paid to its auditor, the public has recently
discovered how important nonaudit fees have become to an
auditor's bottom line. On average in the year 2001, nonaudit
services represented an astounding 73 percent of total fees
paid to auditors by their audit clients.
It just defies common sense to claim that large payments
for nonaudit services which management could easily purchase or
threaten to purchase from service providers other than its
auditor do not function as a powerful inducement to gain the
auditor's cooperation on how the numbers are presented.
One of the Big Five in explaining to its clients these SEC
new rules that were published a couple of years ago, carried
the fiction I'm describing to a breathtaking extreme. In the
published and widely distributed pamphlet on the rule, sent to
all its clients, and presumably prospective clients, the firm
wrote that the size of nonaudit fees paid by a single company
are relevant to the question of independence only if those fees
reach 15 percent of that auditor's total revenues from all
sources. Now in 2001, the smallest of the Big Five had total
revenues of over $9 billion. In other words, using the 15
percent rule threshold of concern, a Big Five firm was claiming
that a single client could pay annually at least $1.35 billion
to that audit firm before the audit committee of the firm, of
the company, the SEC or anyone else need trouble himself over
independence. In a practical sense, the statement was ``there's
no limit at all.''
Audit account partners are expected by their firms to
establish close relationships with the managements they serve.
They are expected to cross market to management as full a range
of services as they can and they are compensated by their firms
on how much revenue they produce from these audit clients.
Their stake in maximizing revenue from these clients through
cross marketing of nonaudit services is as natural and
compelling as any financial reward could be. To claim these
incentives have no adverse impact on independence is a fiction,
pure and simple.
The second fiction that I wish to address is the
profession's threefold claim: (1) that it has the ability and
motivation to regulate itself voluntarily; (2) that it has done
so effectively over the past several decades; and (3) that
there is no need for a legislatively empowered regulatory body
led by persons independent of the profession and who are
charged to regulate the profession and post discipline where
it's warranted.
In fact, the profession's voluntary scheme of self-
regulation is an oxymoron. It is a bewildering maze of
overlapping committees, panels and boards, piled one on top of
the other that collectively has failed in protecting the
investing public.
Even with the best intentions, these voluntary arrangements
would be incapable of achieving anything close to effective
self-regulation. The list of defects is long, but among them is
(1) lack of public representation; (2) lack of transparency;
(3) lack of assured funding; (4) lack of any credible system
for imposing discipline, and overall, a lack of any
accountability.
Enron makes it perfectly clear that these two fictions can
no longer be permitted to carry this once proud profession away
from its core responsibilities to the investing public and
those are responsibilities that are under our Nation's
licensing laws at the State level and the securities laws at
the Federal level, are reserved exclusively for this profession
to discharge. Any enterprise that has market exclusivity is a
blessing, but the blessings have to come with some burdens that
would flow from essentially a monopoly.
To address the conflicts of interest that are masked by
these two fictions, reform is necessary and I'm not a great
believer in writing law to solve every ill. In fact, I'm a
great believer that that's a mistake. But I am convinced that
legislative reform and nothing short of legislative reform will
meet this need because the profession has been enormously
effective in overwhelming efforts at reform by the SEC and
others. Indeed, its lobbying largesse has been so abundant here
on Capitol Hill that protective legislative voices have
repeatedly over the decades been raised whenever the SEC has
tried to effect serious reforms.
Now, on the back of the Enron disgrace, with public
investors, small and large, suffering deeply their losses, this
Congress has a wide open window of opportunity to do something
of lasting and immense value to the Nation and that something
is actually quite something. Only two reforms in my judgment
are needed. First, an effective rule preventing an auditor from
rendering nonaudit services to its audit clients. I describe
such a rule at page 18 to 19 of my written testimony. Second,
an effective legislatively empowered system of self-regulation
and I describe that and the essential elements of it at pages
31 to 35.
One final point if I may be permitted. In the wake of the
Great Depression with the failure of an immense number of banks
and the loss, huge losses to depositors, the Congress
recognized that the public's confidence in the Nation's banking
system had been badly shaken. Through hearings before this
House and the Senate it became clear to the Congress that the
public's earnings, when deposited in banks, simply had to be
safe and the public had to believe their deposits were safe.
And to meet this goal, of course, as you all know, the Congress
created the FDIC and the system of deposit insurance which has
stood the test of time down to today.
Since 1933, the public's earnings have gradually migrated
from the banking system to the capital markets, from bank
deposits to money market, mutual funds and increasingly to
equities. With this shift in how the public saves its earnings
must come a shift by lawmakers in fashioning the kinds of
protections these public investors need. The Congress should
not, of course, create a safety net to protect public investors
in equities against any loss. To do that would be to do more
harm to our system of capital formation than good. But the
Congress should act to ensure that the system by which our
corporations present their financial condition to the public is
worthy of trust. The auditors, often referred to as
gatekeepers, are simply the last line of defense against
management's inclination to fudge the numbers and in recent
years with increasing and disturbing frequency to present false
and misleading numbers.
Legislative action is needed now because with the growing
number of audit failures in recent years, culminating with
Enron, I hope culminating with Enron, the public's confidence
has again been badly shaken, just as in the Great Depression.
However, this time the loss of confidence is by the public in
its capacity as investors, not depositors, and its loss of
confidence is directed at the reliability of financial data
certified by auditors.
I hope that the Enron hearings will convince the Congress
that the public's confidence in the auditing system should be
restored by prompt and forceful legislative intervention, just
as the public's confidence in the banking system was restored
by forceful congressional action in 1933. The two reforms I've
summarized will do the job. My written testimony develops the
case for each in some detail. I thank you for your attention
and the opportunity to be here and I'm happy to answer any
questions you may have.
[The prepared statement of Bevis Longstreth follows:]
Prepared Statement of Bevis Longstreth
My name is Bevis Longstreth. I am a retired partner of the New York
law firm, Debevoise & Plimpton, where I spent the bulk of my
professional career. From 1981 to 1984, I served as a Commissioner of
the SEC, a post to which I was appointed twice by President Reagan.
Recently, I served as a member of the Panel on Audit Effectiveness,
which released its final Report and Recommendations in August, 2000.
For five years following retirement from law practice, I taught a
course on the regulation of financial institutions at the Columbia Law
School.
I welcome this opportunity to address the Committee on the subject
of reforming the audit profession. I am here because my professional
experience and background give me some basis for contributing to your
treatment of this urgent need for reform. I represent only myself, but
in so doing, I hope to offer opinions that will resonate with other
public investors in our nation's securities markets.
I want to speak about the audit profession, a once proud profession
now greatly in need of reform.
My thesis is simple. The profession needs reform in two major
respects:
1. An effective rule preventing the delivery of non-audit services to
audit clients; and
2. An effective system of self-regulation.
Despite the SEC's adoption of Rule 2-01, the threat to an auditor's
independence from performing non-audit services allowed by the Rule
remains palpable.
Despite the enlarged charter of the Public Oversight Board, until
recently the most promising vehicle for improving self regulation, an
effective system of self-regulation for the profession does not exist
and can not be achieved without legislative reform. No greater proof of
this fact could be found than the POB's unanimous vote on January 20,
2002 to terminate its existence in reaction to the efforts of the
profession's trade association and the CEOs of the Big Five, in private
meetings with the new Chairman of the SEC, to circumvent the POB by
proposing still another voluntary oversight entity.
While the reforms I advocate offer no guarantee against audit
failures, they should sharply reduce their size and number, without
impairing the ability of audit firms to prosper. Indeed, I believe
that, without these reforms, the profession, which has been its own
worst enemy, will continue to abuse its public trust, spiraling
downwards until legislation denies it the exclusive economic franchise
on which its success was built from the beginnings of the securities
laws in 1933 and 1934.
the need for an exclusionary rule for non-audit services
Arthur Levitt, with strong assistance from Lynn Turner, his Chief
Accountant, showed boldness in their efforts to achieve a lasting
solution to the vexing problem of independence. In the SEC's Proposing
Release, they invited comment on a simple rule excluding an auditor
from providing non-audit services to audit clients. To many people away
from the narrow corridor extending from the financial capital of the
world that is still New York City to the separated powers of government
in Washington, the idea that boldness, and even personal courage, would
be required for a governmental powerhouse such as the SEC to propose
such an obvious, and widely supported, rule is strange. Yet, I am
positive that it took both boldness and courage to issue the Proposing
Release. That's because, by so doing, the SEC knowingly unleashed an
unprecedented attack from those it was seeking to regulate, as it was
charged by Congress to do, for the protection of the investing public
and otherwise in the public interest. The ensuing battle, and it was
clearly a battle, pitted a legally created monopoly, dominated by five
global accounting firms, against the SEC. Three of the five,
representing solely their private business interests, rejected any
meaningful restrictions on the free play of those interests. Despite
the profession's multi-pronged assault, the SEC, acting upon the need
for greater independence, a need long recognized by virtually every
group that's considered the issue (and there have been many), went
ahead with its proposals, inviting comment and conducting four days of
public hearing.
There were almost 3000 comment letters. One hundred witnesses
testified for about 35 hours. The battle raged far beyond the
frontlines at 450 5th Street N.W. Given the sharpness of the debate,
and the transparency of the private vs. the public interest, there was
more at stake in the outcome than just the independence of auditors.
The independence of the SEC, itself, was being challenged as the
accounting firms did all they could, on Capitol Hill and throughout the
business and legal communities, to bring political pressure to bear
against a proposal, the exclusionary rule, that could not be defeated
by argument on the merits. At an informal meeting during the pendency
of the rule proposal, involving representatives of the SEC and the POB,
I was told by a veteran Washington insider that there wasn't a
significant law firm in DC that hadn't been lined up by the profession
to assist in its battle.
In the tumult of the moment, many leaders of the accounting
profession--and here I must say I am not including leadership of the
POB--forgot their profession's origins as one granted exclusive rights,
and reciprocal duties, to perform a vital public service. Although
affected by the public interest as much as, or more than, any public
utility, these leaders were demanding freedom from serious oversight or
constraint. From my vantage point as a member of the Panel on Audit
Effectiveness who had a career of experience working closely with
literally hundreds of responsible public accountants, I became
increasingly convinced that the leadership of the profession was
seriously, perhaps disastrously, disserving a worthy profession.
A rule on independence was adopted on November 21, 2000, shortly
before Arthur Levitt's term expired. The adopting release was 212 pages
long. It was meticulously detailed. In that detail a careful reader can
discern the parry and thrust of the battle that raged over each
principle sought by the SEC and every word and sentence by which each
surviving principle was to be expressed. I'm sure if Lynn Turner bared
his back and shoulders, we would find more wounds than we could count,
inflicted by a profession in the hands of hostile and short-sighted
people.
The release acknowledges in several places that, in the SEC's view,
the final rule struck a reasonable balance among the commenters'
differing views. The release also claims the rule achieves the SEC's
important public policy goals. I wish these statements were true. But,
it is my firm opinion they are not. There is a large gap between the
sound policy goals sought by the SEC and the actual accomplishments
that can realistically be anticipated by the rule. When the smoke had
cleared, it was apparent to this observer that the profession had won
the battle. Importantly, however, it was just one battle in a war the
outcome of which, when it comes, sooner or later, will be different.
About the rule, let me be clear. I am not saying that, on balance,
we would be better off without the rule. It is useful, despite its
breath-taking complexity, which has proven very costly for the best
intentioned issuers. I speak here as Co-Chair of the Audit Committee of
a large public company that is continually struggling to understand the
rules and assure that both it and its auditor are in compliance.
The rule is not even ``half a loaf;'' nonetheless, it is a step in
the right direction. I say that for three reasons. First, because it
was a bold and honorable battle hard fought by the SEC. In future
battles this effort will count for a lot, despite the many compromises.
Second, because the policy goals elaborated in both releases, and
supported by abundant testimony and comment, provide a compelling
foundation for carrying the battle forward in the halls of Congress,
where, it has become clear, the fight must now be taken. And third,
because the disclosure requirement is proving of particular use in
focusing public attention, not to mention the attention of audit
committees, on the amazing growth in non-audit fees paid to their
auditors.
In thinking of the disclosure requirement, it is important to
remember that the SEC in 1978, based on what it then saw as a growing
amount of non-audit services being performed for audit clients, adopted
a very similar disclosure rule, ARS 250, which was swiftly repealed in
1982 as the consequence of massive pressure from a profession that was
beginning to be adversely impacted by disclosure. Since then, as we now
know, non-audit services have increased exponentially.
So, what's wrong with the rule? I want only to address one big
problem. Here's what I'm talking about. The SEC adduced strong and
abundant evidence in the rule-making process, as summarized in
III(c)(2)(a) of the Adopting Release, that providing to one's audit
client non-audit services of any kind or kinds, if large enough in
terms of fees paid, may impair independence. Despite this powerful
predicate for rule-making, the rule adopted fails absolutely to address
this concern.
The SEC describes the rule as implementing a ``two-pronged''
approach:
1. Requiring separate disclosure of audit fees, financial information-
related service fees and other non-audit fees.
2. Prohibiting nine specific non-audit services believed by the SEC to
be, by their very nature, incompatible with independence.
Economic incentives derived from non-audit work, no matter what
their magnitude, were not defined as being, by their very nature,
incompatible with independence. In failing to address this matter, the
SEC ignored a mountain of persuasive argument.
It defies common sense to claim that large payments for non-audit
services, which management could easily pay to service providers other
than its auditor, do not function successfully in many cases as an
inducement to gain the auditor's cooperation on matters of financial
presentation.
Audit account partners are expected by their firms to establish
close relationships with the managements they serve. They are expected
to cross-market to management as full a range of non-audit services as
possible. And, they are compensated by their firms on the basis, among
others, of how much revenue they produce from their audit clients.
Their stake in maximizing revenue from these clients through cross-
marketing of non-audit services is as natural and compelling as any
financial reward could be. To claim these incentives have no adverse
impact on both the fact and appearance of independence is a fiction,
pure and simple.
To be fair, I should point out that the rule contains a general
standard, 2.01(b), that declares an accountant not independent if, in
fact, or in the opinion of a fully informed, hypothetical ``reasonable
investor,'' the accountant is not capable of exercising objective and
impartial judgment. Absent a ``smoking gun,'' this ``capability'' test
would seem to create a virtually insurmountable hurdle for the SEC.
The disclosure requirements of the rule, which enjoy the truth-
eliciting feature of proxy rule sanctions for misstatements, have
already illuminated the seriousness of the economic incentive problem.
On average, for every dollar of audit fee paid, clients paid their
auditors $2.69 in fees for non-audit services. In other words, non-
audit fees represent, on average, 73% of total fees paid to auditors.
This percentage is astoundingly large, even when one discounts it for
lumping together audit-related services such as work on financials in
registration statements. Of course, this is just the average. As The
Washington Post reported in a June 13, 2001 editorial: ``KPMG charged
Motorola $39 million for auditing and $623 million for other services.
Ernst & Young billed Sprint Corp. $2.5 million for auditing and $63.8
million for other services.''
If Rule 2-01 with all of its promise and detail, allows non-audit
service fees, as a percentage of total fees, to represent even a
fraction of the 73% average that we now know prevailed on the eve of
the rule's adoption, the rule must be counted a failure. Given the
compromises reached in defining the ``terrible nine'' services that may
not be provided, I am afraid the percentage will not be substantially
lessened by these so-called ``bright line'' exclusions. Of course,
there remains the often powerful effects of disclosure on corporate
behavior and, in this case, on the behavior of the audit committees.
Disclosure might encourage the growth of ``best practices,'' as
exemplified by TIAA/CREF, for example, which denies its auditor any
non-audit business. Over some period of years, the rule's disclosure
could cause a growing number of audit committees to back away from
using their auditors for any significant amounts of non-audit work.
But I wouldn't bet on it. I fear Rule 2-01 will turn out to be the
Maginot Line for Independence, crisscrossed with trenches, barbed wire
and gun emplacements, all pointing in one direction only, capable at
will of being thoroughly outflanked.
One indication of the rule's effectiveness can be found in the way
the Big Five presented it to their audit clients. I have been exposed
to only one sample, which I suspect may be illustrative of what others
did. Overall the message of this firm's booklet on the rule, provided
to audit committees and the managements of its audit clients, is that
the rule changes almost nothing. In the sweep of its misleading
characterization of what the SEC was seeking to accomplish, it leaves
an informed reader amazed at the firm's audacity. I want you to hear
only one statement taken from this document. It appears twice with only
slight variations. Here's one version:
``The real issue for audit committees is the nature of the work
performed, not its cost. The rules do not indicate that fees of any
magnitude alone impair independence. Nor did the SEC cite specific
ratios of audit to non-audit fees as being ``good'' or ``bad.''
``Historically, the size of non-audit fees paid to an audit firm
has been relevant to SEC independence considerations only to the extent
that the total fees earned from one client represent a disproportionate
percentage of the audit firm's total revenues. SEC guidance on this
point has established 15 percent of an audit firm's total fees as a
threshold of concern.''
In 2001, the smallest of the Big Five's total revenues was reported
in The New York Times to have been more than $9 billion. Using the 15%
``threshold of concern,'' a client could pay its Big Five auditor at
least $1.35 billion dollars per year in non-audit fees before the audit
committee or anyone else need trouble itself over independence. In
practical terms, there was no limit.
How any professional firm, let alone a closely regulated firm of
auditors, could so blatantly, so laughably, so absurdly, deceive its
audit clients in this way defies common sense. For me the only
plausible answer is that it's a reflection of the contempt that a
victor sometimes directs against the vanquished.
The Big Five surely know that the 15% ``threshold'' came out of a
1994 no-action position taken by the Office of the Chief Accountant to
address non-audit fees proposed to be paid to a very small auditor to
allow that auditor to take on as a client its first SEC registrant.
They know as well that this ruling was limited to its special facts and
contained no suggestion of being an authoritative statement with regard
to independence generally.
The basic problem with non-audit fees, which exists regardless of
their magnitude but grows more serious as the fees grow larger, is
conflict of interest. This conflict derives from the fact that, in
performing both audit and non-audit services, the audit firm is serving
two different sets of clients:
1. management, in the case of non-audit services, which typically are
commissioned by, and performed for, management, and
2. the audit committee, in the case of audit services, which now are by
rule commissioned by the audit committee and performed for that
committee, the shareholders and all those who rely on the
audited financials and the firm's opinion in deciding whether
to invest.
The audit firm is a fiduciary in respect to each of these two very
distinct client groups, duty-bound to serve each with undivided
loyalty. It is obvious, and a matter of common experience, that in
serving these different clients the firm will be regularly subject to
conflicts of interest. These conflicts tear at the heart of
independence. What is independence? It is the absolute freedom to
exercise undivided loyalty to the audit committee and the investing
public. When other loyalties tug for recognition, and especially when
they come from those in a position to enlarge or shrink one's book of
business, on which depends one's partnership share, the freedom
necessary to meet one's professional responsibilities as an auditor is
curtailed, and sometimes eliminated altogether.
Paul Volcker, in testimony on the rule, given in New York City on
September 13, 2000, made the same point:
``The extent to which the conflict has in practice actually
distorted auditing practice is contested. And surely, instances of
overt and flagrant violations of auditing standards in return for
contractual favors--an auditing capital offense so to speak--must be
rare. But more insidious, hard-to-pin down, not clearly articulated or
even consciously realized, influences on audit practices are another
matter.''
To highlight the size of the hole in the rule, consider that, in
addressing disqualifying financial and business relationships between
an accountant and its audit client, the rule declares in absolute terms
that an audit firm lacks independence if there exists (a) any
investment in the client, however small, by the firm or personnel
involved in the audit, or (b) any direct business relationship with
that client, however insignificant. Explicitly excluded from the term
``business relationships,'' is the provision of non-audit services by
the audit firm to its audit clients. Thus, one faces the absurdity of a
rule that is absolute in banning financial and business relationships
that are utterly inconsequential while appearing to permit any level of
non-audit fees to be paid to the audit firm.
My point is not to suggest that the finely textured concerns of the
SEC over the independence-impairing effects of various financial and
business relationships are misplaced. They reflect legitimate, albeit
immeasurable, concerns. But the important point is that they pale in
significance when compared to the potential for impairment that comes
from the financial and business stake that an audit firm, despite the
rule, is still free to develop in an audit client through provision of
a very wide variety of permitted non-audit services.
This brings me to argue for a simple exclusionary rule covering
virtually all non-audit services, in place of the deeply complex,
existing rule that I hope, by now, to have convinced you is
ineffective.
This rule would define the category of services to be barred as
including everything other than the work involved in performing an
audit and other work that is integral to the function of the audit. In
general, the touchstone for deciding whether a service other than the
straight-forward audit itself should be excluded from non-audit
services is whether the service is rendered principally to the client's
audit committee, acting on behalf of investors, to facilitate, or
improve the quality of, the audit and the financial reporting process
rather than being rendered principally to provide assistance to
management in the performance of its duties.
This exclusionary rule could include a carefully circumscribed
exception to permit certain types of non-audit services to be rendered
by the audit firm to its client where special circumstances justify so
doing. Use of such an exception should require at least the following:
(a) Before any such service is rendered, a finding by the client's
audit committee that special circumstances make it obvious that
the best interests of the company and its shareholders will be
served by retaining its audit firm to render such service and
that no other vendor of such service can serve those interests
as well.
(b) Forthwith upon the making of such finding by the audit committee,
submission of a written copy thereof to the SEC and the SRO
having jurisdiction over the profession.
(c) In the company's next proxy statement for election of directors,
disclosure of such finding by the audit committee and the
amount paid and expected to be paid to the auditor for such
service.
The rule would be refined, administered and enforced by the
legislatively empowered SRO that is the subject of my second
recommendation for reform (discussed below).
The fundamental argument for exclusion is the avoidance of
conflicts of interest. Beyond that, however, there are a number of
other points to be made. I summarize them below:
1. Given the conflict of interest, it is not realistic to expect the
firm, itself, to decide convincingly on its own independence.
Given its self-interest in the outcome, the credibility of this
process is highly suspect.
2. Nor is it feasible to expect independence to be assured by approval
of the audit committee. It is impossible for that committee to
identify when the problem exists. To challenge the auditor's
judgment on the matter is to challenge its integrity, something
audit committees are most unlikely to do. Independence is a
state of mind, necessary to maintain the skepticism and
objectivity that long have been the hallmarks of the accounting
profession. Being subjective and invisible, independence is not
something an audit committee can apply any known litmus test to
determine.
3. No one has suggested that the audit committee can be a substitute
for clear rules where the problem of conflicts is most serious.
Thus, for example, there is no suggestion that the audit
committee be accorded discretion to assess independence despite
the existence of financial or business interests between the
audit firm and its client. Stock or other financial interests
in one's audit client, for example, have long been viewed as
creating too clear a conflict of interest to become the subject
of discretion, even if exercised by an audit committee composed
only of outside directors. The need for an exclusionary rule is
rooted in the same ground: prospective revenues from the
provision of non-audit services, extending into the future,
create precisely the kind of financial stake that produces a
conflict of interest capable of impairing independence.
4. An exclusionary rule is easy to administer. It does not preclude an
audit firm from engaging directly or through affiliates in non-
audit services of any kind. All business entities other than
its audit clients are available for business. Since the rule
would apply to all audit firms, for each audit client put out
of bounds for non-audit services, many more clients of other
audit firms become available.
5. An exclusionary rule should correct the current system of
compensation, which was found by the Panel on Audit
Effectiveness to fail in giving adequate weight to performing
the audit function with high levels of skill and
professionalism. This situation adversely affects audit
effectiveness. Success in cross-marketing an audit firm's
consulting services is a significant factor in the compensation
system. The skills that make one successful in marketing non-
audit services to management are not generally consistent with
the professional demands on an auditor to be persistently
skeptical, cautious and questioning in regard to management's
financial representa-tions. As long as the marketing of non-
audit services by auditors to their audit clients is
encouraged, expected and rewarded, there will exist a tension
counterproductive to audit excellence. An exclusionary rule
would eliminate both this tension and its harmful effects.
6. An exclusionary rule would be effective in rewarding those audit
firms most sensitive to the independence issue and most
scrupulous in seeking to avoid a real problem or even the
appearance of a problem. Exhortation and even disclosure, by
itself, often encourage those willing to sail close to the
line, or even cross over it. This result has the real and
perverse impact of hurting the competitive position of the most
sensitive and scrupulous audit firms, and in time encourages
even those firms to drop their guard, and exploit the laxness
in standards as well.
7. Independence is given important meaning in many analogous situations
where potential conflicts, while not always certain to impair
independence, nonetheless are prohibited in the interest of
avoiding the problem entirely. For example, the Blue Ribbon
Committee on Improving the Effectiveness of Corporate Audit
Committees determined that, for a director to be independent
for purposes of meeting the membership requirements of the
audit committee, he or she must not accept compensation from
the corporation for any service other than service as a
director and committee member. The Blue Ribbon Committee noted
that ``. . . common sense dictates that a director without any
financial, family or other material personal ties to management
is more likely to be able to evaluate objectively the propriety
of management's accounting, internal control and reporting
practices.'' The common sense parallel to the auditor is both
exact and compelling. Compensation for any service other than
the audit would impair the auditor's independence.
8. An exclusionary rule is a low cost premium on an important insurance
policy for the whole profession, against governmental
intervention to deny audit firms the right to do any non-audit
work. In the Panel report we wrote, as of August 31, 2000, that
``an exclusionary rule would go far toward eliminating the
possibility of a major audit failure being linked to the
influence of non-audit service business on the audit firm's
diligence and skepticism, an event that would provide a basis,
and possibly the momentum, for some radical solution like a
total ban.'' Enron could turn out to be the failure we were
imagining.
the need for a legislatively empowered self-regulatory organization
The present form of self-regulation of the auditing profession
reminds one of military music, military intelligence or even, some
might argue, corporate governance--a classic oxymoron. Having looked
closely at the system of governance within the auditing profession, I'm
not prepared to be quite so simplistic. But, having studied the matter,
I am quite certain that the governance of this vitally important
profession is in an entirely unsatisfac-tory state. Moreover, this is
no trivial matter.
Overview of Governance. Today, governance is exercised from three
sources:
1. State boards of accountancy, which have licensing powers.
2. The SEC, which exercises potentially broad powers over those who
audit reporting issuers.
3. Private organizations of the profession, of which there are at least
seven important ones.
The profession claims that, through its various organizations,
effective self-regulation is achieved. Having looked closely at this
claim, I believe it to be false. The organizations are characterized by
complexity and ineffectiveness in matters of central importance to any
effective system of self-regulation.
Among the short-comings of the present system are the following:
1. Lack of any public representation.
2. Lack of unified leadership over the seven organizations.
3. Lack of transparency.
4. Fuzzy and often over-lapping areas of responsibility.
5. Conflict between self-interest (as in the American Institute of
Certified Public Accountants (AICPA), which is a trade
organization parading as an SRO) and protection of the public
interest.
6. Lack of any credible system for imposing discipline.
7. Lack of assured financing.
8. Overall, a total lack of accountability to anyone.
Given its importance, a further word on discipline. Here's all
there is. The Quality Control Inquiry Committee of the SEC Practice
Section of the AICPA (QCIC) is charged with investigating alleged audit
failures involving SEC clients arising from litigation or regulatory
investigations. However, it is only looking to see if there are
deficiencies in the firm's system of quality control. It is not
involved in assessing guilt, innocence or liability of the firm or any
individual. And its report is only prospective in its impact.
The Professional Ethics Executive Committee of the AICPA (PEEC) is
charged with such responsibility for discipline as exists. It is
supposed to pick up cases from the QCIC. However, out of alleged
``fairness,'' at the firm's request, the PEEC will automatically defer
investigation until any litigation or regulatory proceeding has been
completed, often many years later. This system results in long delays
in investigation and, as a practical matter, renders the disciplinary
function a nullity in almost all instances.
It was the Panel's hope to recast the POB as the central overseer
of self-regulation, with power and responsibility to effect changes
necessary to make self-regulation effective. With a new and energetic
chairman in Chuck Bowsher, this idea seemed achievable. As conceived by
the Panel, the POB would have had these new elements:
1. Public members, independent of both the profession and the SEC,
would constitute a majority of the board.
2. ``Strings attached'' funding would be provided by the profession in
amounts sufficient to carry out the POB's mission.
3. Absolute control over the nature of its work and the budget
necessary to carry out that work.
4. Power to oversee all of the profession's governance organizations.
5. Power of approval over appointments to the various organizations and
over hiring, compensation, evaluation and promotion decisions
by AICPA in respect of employees of key organizations.
6. Term limits for board members.
7. Nominating committee for selection of board members, composed of
representatives of public and private institutions especially
concerned with the quality of auditing and financial reporting.
8. Advisory council, composed similarly to the nominating committee,
responsible for annually reviewing the work agenda for the POB.
The new charter for the POB was the result of heavy negotiation
among the Big Five, the AICPA and the SEC. It fell short of the Panel's
recommendations in several important respects:
1. No POB approval over membership of governance organizations.
Concurrence rights over Chairs.
2. No oversight over PEEC's standard setting activities.
3. No nominating committee or transparency for POB board membership.
4. No oversight of staff of key governance organizations.
5. No power to change POB charter.
The POB believed it could work around its charter limitations by
the threat of going public with disagreements. A whistle-blower
technique. At the time I thought this a slim possibility. Making the
POB the central, responsible and empowered regulator of the profession,
which was the Panel's goal and similarly the goal of the SEC under
Chairman Levitt, was powerfully and effectively resisted by the AICPA.
Again, the battle was waged. Again, the AICPA and the big firms
asserted their immense power on behalf of unchecked self-interest. And
again, the profession's leaders came out on top.
However well intentioned Chuck Bowsher and his board might have
been, and I know they were well intentioned, there was no way they
could have achieved effective self-regulation of this profession under
the POB's charter as negotiated in 2000. Even if they had gotten all
that the Panel advocated, it wouldn't have worked. The reason is quite
simple. Like many other businesses, the profession, and particularly
its current leaders, apart from the POB, don't want self-regulation.
They want the shield of apparent self-regulation. But not anything
close to the real thing.
Now, as you know, the POB members have all resigned in protest over
the actions taken by the Big Five CEOs and the AICPA, in cooperation
with the new SEC Chairman and in complete disregard of the Panel's
recommendations and the modest efforts taken so recently to strengthen
the POB. The five members of the POB did, indeed, become whistle-
blowers, having no other choice even in the face of a palpable crisis
to the profession.
Whatever the explanation for the profession's nearly suicidal
attempt to evade the POB, which was the only plausible entity capable
of some self-regulation, and whatever the SEC Chairman's motives in
lending support to this effort, it will not stand scrutiny. On the back
of Enron, real reform will come at the legislative level. It must
emerge from the lawmakers on Capitol Hill not only because the SEC
appears unwilling to lead. In regard to an SRO, only legislation can
arm an SRO with the necessary powers to do the job. A review of the
essential elements common to all the existing SROs will explain why
this is so. Here they are:
1. Creation by legislation or by governmental agency pursuant to
legislation, with clear powers to write rules and conduct
enforcement and disciplinary proceedings.
2. Supervision by government agency, including registration with that
agency to operate as an SRO, agency approval of all rules
adopted by the SRO and agency power to adopt rules for the SRO.
3. Power in the supervising agency to sanction the SRO for failure to
perform its responsibilities, as, for example, failure to
comply with its self-governance rules or to enforce the rules
it imposes on those it has the chartered duty to regulate.
4. Requirement that all participants in the profession or industry
being regulated (e.g., brokers and dealers) become subject to
the SRO's jurisdiction and powers.
It will be instructive to examine further the workings of the
NASD's SRO, whose most important public duty is that of policing the
rules of financial responsibility, professional conduct and technical
proficiency. In carrying out this charge, the SRO is given essentially
the same range of sanctions available to the SEC, which must be applied
by the SRO in cases where a broker-dealer or its employees have
violated the securities laws or SEC-enacted rules or the rules of the
SRO. Of particular importance in achieving wide-spread compliance with
the rules of professional conduct is the power of both the SEC and the
SRO to discipline either or both the supervisory personnel and the firm
for a failure to supervise employees who misbehave. To avoid sanction
the firm must have in place procedures to deter and detect rule
violations and a system for the effective implementa-tion of those
procedures. It is hard to exaggerate the importance of this ``duty to
supervise'' in respect of its prophylactic effects.
To facilitate speedy investigation by the SRO of alleged
violations, and speedy judgment and imposition of sanctions where
warranted, the SRO has one critically important tool that it uses to
gain the cooperation of those it regulates, even those who are targets
of an investigation. Its rules require each of its registered firms and
individuals to turn over all requested documents and other information,
and to appear and testify, in connection with an SRO investigation.
Failure to cooperate in this way can result in expulsion from the
industry. Courts have held the Fifth Amendment privilege against self-
incrimination inapplicable to sanctions imposed by an SRO. Thus, as a
practical matter, those regulated by the SRO, including the target of
an investigation, must cooperate or lose their right to be in the
industry.
As a result of being vested with law enforcement powers in
combination with close supervision from a governmental agency, an SRO
is widely believed to possess three significant protections that
typically are only enjoyed by governmental agencies in the exercise of
enforcement powers. They are:
1. Immunity from suit.
2. Privilege from discovery of investigative files. It is important to
note here that this privilege is generally understood to
operate only during the investigation. This limitation holds
for the SEC too.
3. Protection from antitrust violation for group boycott or other
activity violative of antitrust principles.
These protections proceed from the fact, as reflected in
Congressional committee reports, that an SRO is delegated law
enforcement powers subject to supervision by the governmental agency
from whence those powers came. Effectiveness compels the delegation of
these protections as well.
From the foregoing brief summary of the common elements of an SRO,
it can be seen that a private organization such as the POB, voluntarily
organized by the accounting profession to self-regulate itself, cannot
do the job, no matter how well-intentioned its leaders might be.
To reiterate: the SROs are effective because they are accountable
to a governmental agency and derive from their relationship with that
agency immunity from suit and important protections against discovery
and antitrust laws, while at the same time preserving their private
status enough to avoid the Fifth Amendment's protections for those it
regulates.
The inescapable conclusion from this analysis is that, unless and
until a real, legislatively supported SRO is put in place to regulate
the accounting profession, little, if any, progress toward an effective
disciplinary system for accountants practicing before the SEC can be
made outside the SEC itself.
Chairman Tauzin. Thank you very much, Mr. Longstreth.
Our final witness who will testify on the issues of the
energy markets themselves and the effect of the Enron collapse
on those markets and he is Mr. David Sokol, Chairman and CEO of
MidAmerican Energy Holdings Company of Des Moines, Iowa.
Mr. Sokol.
STATEMENT OF DAVID L. SOKOL
Thank you, Mr. Chairman. I am for the record a registered
professional engineer and then an accountant. MidAmerican
Energy Holdings is a privately held company with about $13
billion in assets and our largest investor and roughly 75
percent investor is Berkshire Hathaway.
Mr. Chairman, the Enron disaster is inexcusable and your
efforts to fully explore it is essential to restoring the
credibility in the U.S. capital market system. I believe what
you'll find is arrogance, greed, accounting fraud and poor
governance.
As a chairman, president and CEO of a public company for
the last 16 years, I have seen on balance how well and how
terrific the U.S. capital markets are, but I've also been
witness to how badly people can misuse them. Some people ask
the question why--or someone once said why do people rob a bank
and someone answered because that's where the money is. And the
capital markets are where the money is today and they're what
Enron took advantage of.
But I think we have to be honest as we look back and say
that the past 8 years have been a period not only of irrational
exuberance by investors in the market, but also of irrational
expectations by stock analysts and of poor performance by
auditors, rating agencies and management of companies. That
irrational exuberance throughout that period has created a
loosening in the quality of our reporting systems and a
loosening in management's attention its obligations.
Accounting, as I was taught it, was to reveal information
on a fair and consistent basis for investors to make informed
decisions. Accounting today is about concealing information.
It's about keeping debt off balance sheets. It's about hiding
obligations called contingent obligations. That's a severe
twist to what accounting is supposed to be for America's
corporations and we have to fix it.
I would offer to you having turned in a corporation to the
SEC for breaking the rules, that one way you help solve this
problem in addition to many of the ideas given by this panel is
to enforce the rules against senior executives and against
auditing firms.
I watched a chief executive officer and a CFO get a slap on
the wrist by causing a very large U.S. corporation to go into
bankruptcy with over 6 years of accounting fraud and
manipulation of earnings. The investors lost their money,
employees lost their jobs, but senior executives often don't go
to jail and don't pay significant restitution and that needs to
change. We don't tell youngsters when they rob a convenience
store that if they give half the money back we'll let them go,
but that has been how we've treated executives when they steal
in the public markets.
And auditing firms have to be held liable for not doing
their job. Any CEO today will tell you that we spend more time
negotiating the audit engagement letter than we do spending
times with the senior management of auditing firms about what
they're actually going to do. And that auditing letter spends
very little time saying what the auditor is going to do to
audit the company. It spends a lot of time expressing what
they're not going to be liable for. And we need to change those
activities.
Directly in regard to the energy markets, I think it's most
enlightening to notice that through the Enron debacle, a
catastrophe of giant proportions in any measure, the energy
markets have continued to function. Electricity has flowed,
natural gas has flowed, the lights have stayed on and most
importantly, consumer prices have not been affected by the
Enron wholesale--the Enron debacle in the wholesale market. It
is, and I think it's fair, that people have asked questions
about whether or not Enron may have attempted to manipulate
wholesale markets in certain regions of the country. I don't
know if that occurred. If it did, again, it's another law
they've broken and they should be punished, but it's important
to recognize that some have estimated that Enron managed 25
percent or trade 25 percent of the U.S. electrical and gas
wholesale industry, and there's not a single period you can
find from September through December of last year where those
markets were dislocated even while Enron went bankrupt. So it's
a real tribute to the energy markets.
Another, I think, misnomer that's been raised is that
somehow Enron purportedly was trying to skirt the Public
Utility Holding Company Act and perhaps create an Insull-like
utility of the 1930's and that's just not the case. In fact,
Enron is not about the energy markets. It's about fraud,
corruption and poor governance. The Public Utility Holding
Company Act in many ways is actually today, if anything,
harming Portland General Electric which was the only electric
utility subsidiary Enron had and the reason it's harming it is
because Enron has been trying to sell it for 2\1/2\ years. We
wanted to buy it 2 years ago and we can't because Berkshire
Hathaway, even though they're a AAA-rated company, cannot make
another investment in the U.S. utilities sector because of
PUHCA. What that's requiring Enron today to do is to sell
Portland General Electric to Northwest Natural Gas, a company
roughly one third its size, in Portland, Oregon, and they're
having to leverage up using junk bonds to buy the utility from
Enron. The chairman of the Oregon Public Utility Commission
testified this morning in front of the Senate that Enron's
bankruptcy has caused no strain and no cost to consumers of
Portland General Electric, but that, in fact, PUHCA is today
making it more difficult for them to actually get another owner
in place of that utility. The energy markets continue to work
fine. We would mention that perhaps in the wholesale energy
markets that those markets should be overseen perhaps by the
CFTC going forward, but again it's important to recognize that
Enron didn't collapse because it was in the wholesale trading
market. It collapsed because of accounting fraud and
manipulation of earnings.
Last, we feel it's important to mention that this issue is
very much a bipartisan issue. It's about the trust and the
confidence in the United States capital markets. The integrity
of our capital markets underpin the great economy of the United
States and it's not about campaign reform. That may be
necessary. But this issue with Enron and the follow-on effects
of now the tightening, the proper tightening of accounting and
oversight, do draw to the credibility of our markets and we
must protect them and I think it's a very important function
for both Congress and us and industry to make sure that we
don't undermine those capital markets.
Thank you.
[The prepared statement of David L. Sokol follows:]
Prepared Statement of David L. Sokol, Chairman and CEO, MidAmerican
Energy Holdings Company
Thank you, Mr. Chairman. MidAmerican Energy Holdings Company is a
diversified, international energy company headquartered in Des Moines,
Iowa with approximately $13 billion in assets. Our largest investor is
Berkshire Hathaway, one of the only AAA-rated companies in the United
States.
The company consists of four major subsidiaries: CE Generation
(CalEnergy) a global energy company that specializes in renewable
energy development in California, New York, Texas and the West, as well
as the Philippines; MidAmerican Energy Company, an electric and gas
utility serving the states of Iowa, Illinois, South Dakota and a small
part of Nebraska; Northern Electric, an electric and gas utility in the
United Kingdom; and HomeServices.com, a residential real estate company
operating throughout the country.
I would like to commend you for your persistence in working with
Energy and Air Quality Subcommittee Chairman Barton to push for energy
legislation, including electricity modernization provisions. We cannot
pass a national energy plan for the new century while leaving in place
a regulatory system that was already outdated at the end of the last.
Your bill, H.R. 3406, does not seek to do everything, but it does
critical things that only Congress can do, and it will result in a
modernized electric infrastructure that will benefit consumers while
providing for fair competition.
As the American economy begins to recover, demands on our electric
system will increase once again, and if we have not moved forward with
the critical elements of market modernization, consumers may once again
pay the price for an outdated system. At the same time, we should
recognize that the pending recovery is tenuous and take steps to
encourage the markets and American consumers that there is bipartisan
support for positive, pro-investment initiatives.
My testimony this morning will focus on the Enron scandal's impact
on energy policy issues, specifically the relationship, if any, between
Enron's activities and the Public Utility Holding Company Act of 1935,
or PUHCA, including issues of consumer protection, barriers to
investment and market entry, and appropriate forums for regulatory
oversight.
These three issues are unavoidably linked. Ten years ago, Congress
passed the Energy Policy Act of 1992 in order to create open,
competitive wholesale electricity markets so that investors, not
consumers, would bear the risks associated with capital-intensive,
electric generation investment. That is when PUHCA changed from being
primarily a nuisance for companies to a burden for consumers.
By keeping investment dollars out of the industry and perpetuating
market fragmentation, PUHCA contributed to the failure of our electric
infrastructure to keep pace with the demands of the growing competitive
wholesale market. MidAmerican's largest investor, Warren Buffett, has
publicly announced his intention to invest as much as $15 billion in
the industry once PUHCA is repealed. However, PUHCA's barriers to entry
prevent him from making these investments, particularly in transmission
and distribution assets.
Last year, I testified in both the Senate and the House as to how
PUHCA blocked MidAmerican from making major investments in the
California utilities that could have helped stabilize their financial
positions during the early part of the energy crisis. PUHCA's ownership
limitations and physical integration requirements stood in the way.
PUHCA is also complicating attempts by the company to make a major
expansion of our geothermal development in the Imperial Valley in
Southern California. While we have begun a smaller project, we cannot
undertake any expansion that would require us to build significant new
transmission facilities to bring this power to the grid without
potentially running afoul of PUHCA.
Some have claimed in recent contacts to the SEC that one cannot
invest in a regulated utility asset and also make good non-utility
investments. No law can make a good investor or a bad investor. Nor
should any law determine that a person who invests in one industry
should not be able to invest in another provided there are no conflicts
of interest. And I can tell you about one investor who has done pretty
well in both arenas. His name is Warren Buffett, and his record speaks
for itself.
PUHCA and those who support its predetermined limitations on who
can invest in this industry take a shortsighted approach. The way to
protect consumers is not to maintain a Chinese wall around investment
in this industry it is to maintain effective separation of the
financing and rate structures of regulated utilities and their assets
and any affiliated operations.
There has not been much good news in energy markets in recent
months, and even conservatively managed traditional utilities are
feeling financial pressure. This will make it harder than ever for the
industry to raise capital and build new infrastructure. And, as
consumers in California and the West experienced in recent years,
market failure is the ultimate anti-consumer result.
PUHCA is not and never was designed to be primarily a consumer
protection statute. The overwhelming focus of the law is on preventing
corporate malfeasance that harms investors. By eliminating financial
abuses, Congress certainly expected that consumers would benefit, but
PUHCA does not address rates, and the implementing agency, the SEC, has
no rate setting function or expertise.
Simply put, if the issue is protecting consumers from unfair rates,
FERC and the states have developed the expertise over almost seventy
years to perform these functions. The SEC has absolutely no rate-
setting function and has emphasized this fact on many occasions before
Congress.
On the issue of cross-subsidies, the appropriate protection against
cross-subsidization is the books and records access provided in the
bill. Using my own company as an example, if the state of Iowa had
concerns that MidAmerican Energy was inflating rates in our retail
electric or gas tariffs to support a competitive business in some other
state, under the bill, state regulators would have an explicit right in
federal court to gain access to the books and records of any affiliated
business in any other state that had conducted business with the
utility.
At the same time, the Committee should be wary of attempts to make
FERC some type of super-regulator of retail rates in all fifty states
in the name of stronger protections against cross-subsidization. FERC's
expertise is wholesale rates. State commissions are closest to the
details of retail rate-setting and capital structure decisions.
Muddying the water on this fairly clear distinction would be a recipe
for disaster. We've already seen during the California crisis the
debilitating impact that finger-pointing between Washington and the
states can have on effective regulation. We should not go down that
road.
The only rate-related provision of PUHCA relates to ``at cost'''
pricing. While the law seeks to ensure that utilities and their
affiliates do not engage in inter-affiliate pricing schemes to inflate
consumer costs, the ``at cost'' requirement in the PUHCA law actually
limits the ability of state and federal regulators to require
registered holding companies to price some goods and services at the
lower of ``at cost'' or market rates.
Much of this ground has been well-covered in recent years. That is
why the PUHCA provisions included in this bill have been part of
virtually every electricity modernization bill introduced in the last
several Congresses, have enjoyed the support of the last four
Administrations and the regulatory agencies that enforce the laws, and
passed the Senate Banking Committee last year by a 19-1 vote.
What has changed then?
We are here this morning because a few long-time opponents of
updating the PUHCA law have made new claims arising from the Enron
collapse. It's worth noting that one of these advocates stated last
December that he could support the electricity provisions of this bill
in its present form. But, I suppose that Enron fell, and opportunity
knocked.
There are really two stories before this Committee today. The first
is the story of what actually happened to energy markets as a result of
the Enron collapse. These events should reassure the Committee that you
should move forward with this legislation.
The second story is the one spun by those who have long opposed
market modernization measures. It poses a series of events that did not
happen and attempts to force supporters of PUHCA legislation to prove
that these events could not have happened. Taken to its logical
conclusion, this ``expand PUHCA'' agenda would require Congress, FERC
and the states to unravel more than a decade's efforts to create open,
vibrant and transparent energy markets.
The reason why this is so is instructive. Virtually every element
of modern competitive electricity markets exists either as an explicit
statutory exemption from PUHCA or as a result of regulatory
determinations that gave flexible interpretations to PUHCA.
A ``fundamentalist'' view of PUHCA, that every electric or gas
company that sells on the grid should be registered, would result in
complete market concentration, elimination of the marketing industry
and gutting of the EWG exemption since almost all EWGs rely on either
an affiliated marketing company or independent marketers to sell
competitive electricity.
let's start with the first story. what happened to energy markets as a
result of the enron collapse?
Energy markets responded to the Enron collapse with little, if any,
disruption. The lights stayed on, natural gas flowed, and consumer
prices did not rise. This is true not only for the markets generally,
but also for wholesale and retail customers of Enron's subsidiary,
Portland General Electric.
In December, all four FERC Commissioners testified before your
Energy and Air Quality Subcommittee that electric and gas markets had
responded to the Enron collapse with remarkable resiliency. Chairman
Wood repeated that assessment before the Senate last week, along with
independent market analysts, market participants and a representative
of the state regulators.
In fact, the situation of the customers of Enron's retail electric
and gas pipeline subsidiaries proves the argument that PUHCA
legislation supporters have been making for almost twenty years, which
is that aggressive, effective state and federal regulation are the true
keys to consumer protection, not a statute that deals primarily with
details of corporate structure.
It's hard to imagine a company collapsing more swiftly or more
completely than Enron, yet the customers of Portland General have been
unaffected by the bankruptcy, because its PGE's assets and operations
have both regulatory and contractual safeguards. This is the result of
effective state and federal rate regulation and the ability of state
commissions to oversee issues of utility financing and cost recovery.
This is where real consumer protection occurs in electric and gas
markets.
In December, I met with members and staff on both sides of the
aisle of this Committee and shared my view that if there was any part
of Enron's energy assets that had the potential for abuse, it was that
company's domination of the ``mark-to-market'' exchange.
The allegations that Enron may have manipulated forward markets are
troubling, and I encourage the Committee to pursue these further.
However, I am not aware of any way these issues could be linked to
PUHCA. For those who argue that this shows that the Enron collapse did
impact energy markets, I would respond that, if these allegations are
proven true, it appears to have affected them in a positive direction
for consumers.
let's now look at the second story, what did not happen.
1. Enron was not working to build a multi-state Insull-like utility
empire.
To the contrary, it was looking to sell Portland General. In fact,
Enron probably would not even have been in the regulated utility
business at the time of its collapse if PUHCA had not hampered its
efforts to exit that business.
Why? PUHCA artificially and materially limits the number of
potential buyers of any utility to those utilities who can meet the
law's physical integration provisions, which requires that two utility
systems must be capable of interconnection to be legally combined under
PUHCA. This is one of the core problems of PUHCA. It serves as a
barrier to entry and investment and results in market concentration.
2. Enron did not lobby for PUHCA repeal.
It was a leading opponent of stand-alone PUHCA legislation and
testified before Congress that it would only support PUHCA repeal as a
trade-off for concessions it wanted.
Enron's overall policy position with regard to traditional
utilities can perhaps best be described as disqualify and dominate:
Work to keep asset-backed utilities out of emerging energy markets,
then dominate those markets.
The Committee should also be aware that in its most recent
congressional testimony on electricity policy, Enron opposed enhanced
access to books and records, provisions that we have long favored.
On July 22, 1999, Enron's Executive Vice President Steven J. Kean
testified before the House Energy and Power Subcommittee, ``we have
concerns that H.R. 2363 creates unneeded regulatory oversight of
affiliated companies that have no need for additional regulation of
their books and records.''
Supporters of PUHCA modernization and reform want more competitors
in the marketplace, not fewer, and support giving federal and state
regulators more tools to protect consumers.
3. Enron did not receive special exemptions from PUHCA.
Enron received two PUHCA exemptions from the SEC. Both were clear
cases under the law.
The first was a statutory exemption provided to more than 50 other
holding companies whose utility operations are primarily located in a
single state.
The second exemption concerned the question of whether a power
marketer should be considered a ``public utility'' under PUHCA. PUHCA
defines an ``integrated public-utility system'' as, ``a system
consisting of one or more units of generating plants and/or
transmission lines and/or distributing facilities, whose utility
assets, whether owned by one or more electric utility companies, are
physically interconnected or capable of interconnection.''
The claim that the ``no action'' letter Enron received for Enron
Power Marketing Inc. constituted a special exemption for Enron that
ultimately allowed the company to escape regulatory scrutiny is the
entire basis for the claim before the Committee today. However, for the
SEC to have found otherwise would have required it to find that the
assets of marketers--office equipment, paper contracts, and computer
data--are ``facilities'' of public utilities comparable to generating
plants and transmission lines.
This raises the interesting question of how these types of
``facilities'' could meet PUHCA's ``physical integration'' requirement.
Obviously, they could not, and no other decision by the SEC seems
supportable under either the facts or the clear definition in the law.
More importantly, had the SEC decided otherwise, the entire power
marketing industry would probably not have developed.
It's hard to think of any single decision that would have had a
more negative impact on consumers and competitive wholesale markets.
4. What about the other exemption mentioned in the January 23, 2002 New
York Times article?
This exemption, to the Investment Company Act of 1940--not PUHCA--
is the exemption that some have claimed allowed Enron to engage is some
activities that played a significant role in the company's collapse.
This appears to raise some genuine issues--but these issues have
nothing to do with PUHCA, and attempts to use the Investment Company
Act exemption as a way to derail electricity modernization are clearly
opportunistic.
5. But couldn't the Enron collapse have been prevented had Enron
somehow been subjected to PUHCA?
Since it's clear Enron should not have been considered a registered
holding company, this could only be true to the extent that Congress
would apply PUHCA-like financial regulations to every other publicly-
traded company, energy or non-energy. There is nothing unique about the
energy industry concerning Enron's financial activities.
If, as has been reported, a company is willing to risk violating
the '33 and '34 Securities Acts, shred congressionally requested
documents, engage in highly questionable accounting practices,
knowingly mislead investors, and ultimately drive itself into
bankruptcy, why would we believe that PUHCA would somehow protect its
shareholders.
Congress can and should conduct a thorough review of all the
accounting, bookkeeping, pension and corporate governance issues raised
by this scandal. In some cases, laws and regulations may need to be
strengthened. But these changes should be applied to all publicly-
traded companies, not to a small subset of companies in one industry.
At the same time, it may be appropriate to address oversight of energy
futures trading.
FERC Chairman Wood is moving aggressively to bring the wholesale
electric energy market to an end-state of transparency and vibrant
competition. Some are concerned that he is moving too quickly; others
may believe he is moving too slowly. Few would disagree with his goal
of achieving that end-state or the benefits that consumers will gain
when we get there.
In his testimony before the Senate Energy and Natural Resources
Committee last week, he said, ``If Congress' policy goal is to promote
wholesale energy competition and new infrastructure construction, then
reform of the Public Utility Holding Company Act of 1935 (PUHCA),
supplemented with increased access by the Commission to the books and
state regulators to certain books and records, will help energy
consumers. Energy markets have changed dramatically since enactment of
PUHCA, and competition, where it exists, is often a more effective
constraint on energy prices. In the 65 years since PUHCA was enacted,
much greater state and federal regulation of utilities and greater
competition have diminished any contribution PUHCA may make toward
protecting the interests of utility consumers.''
This is not just the view of Chairman Wood, but also all the
members of the Commission, and all his predecessors in the last decade.
They have understood that this market will never achieve the depth,
transparency and level of competition we all seek if PUHCA's barriers
to entry and investment remain in place. The reasons why you must
eliminate the anti-competitive and anti-consumer aspects of PUHCA are
simple:
PUHCA's arbitrary limitations hurt consumers. Just last month, The
D.C. Circuit Court of Appeals remanded the SEC's approval of a large
utility merger that would provide consumers and the companies involved
more than $2 billion in savings, based solely on concerns related to
PUHCA's single region and physical integration requirements.
While some have claimed that this decision represented some form of
victory for consumer interests, I disagree. Quoting from the ruling,
the Court wrote, ``According to Petitioners, the Commission erred in
accepting (the two companies') projections that the proposed merger
would produce approximately $2.1 billion in cost savings. We disagree.
We owe considerable deference to the Commission's assertion that it
`reviewed the assumptions and methodologies that underlie' the
projections and found them `reasonable and consistent with . . .
precedent.' Moreover, Petitioners point to no evidence or expert
testimony supporting their assertion that the companies' calculations
were flawed.''
The law's ownership restrictions keep capital out of one of this
country's most critical industries at a time when needs in the
transmission sector alone will require tens of billions of dollars in
new investment. As I mentioned before, Mr. Buffett has publicly stated
his intent to invest as much as $15 billion in the industry if PUHCA is
repealed.
The law's counterproductive requirements of interconnection and
geographic proximity foster regional concentration, directly counter to
50 years of antitrust law. As I mentioned during testimony in the House
last year, one of the ironies of PUHCA is that the only other utility
that MidAmerican could purchase without running afoul of the Act are
the utility assets of the only other investor-owned utility in the
state.
As representatives of FERC have testified on numerous occasions,
PUHCA hinders their ability to establish large, multi-state regional
transmission organizations.
PUHCA also provides foreign companies which are not restricted by
the physical integration standard an advantage on their ``first bite''
entry into the U.S. market and, at the same time, sends overseas
American dollars that could be invested here. In view of the series of
negative events that have buffeted this sector beginning with the
crisis in California and the West, the overall economic downturn and
the negative financial impact of the Enron collapse on much of the
sector, I believe we could see a substantial increase in this trend in
the next several years.
Congress cannot fix PUHCA by tinkering around its edges. The SEC
concluded in 1995 that PUHCA had accomplished its goals by 1952, fifty
years ago. It is time to repeal this law's antiquated and arbitrary
physical integration requirement and ownership limitations. At the same
time, you can replace PUHCA with enhanced books and records authority
and the other consumer protection measures that are contained in H.R.
3406 and move the country forward toward a competitive, pro-consumer
market.
Chairman Tauzin. Thank you very much, Mr. Sokol.
Now it's our function at this point to allow members a
round of questions and the Chair recognizes himself very
briefly.
Let me say first of all, Mr. Chanos, I hope someone gets
into the question of why it is that you could see insider
selling of stock. You could see all these problems when the
accountants couldn't see it and the SEC was not seeing it in
their oversight function of looking at the Enron disclosures. I
won't have time to get into that, but I hope someone will get
into that. I think they will.
And Mr. Raber, I would love to get into a lot of questions
with you about how it is that you can expect any member of a
board of directors, outside board of directors who comes on and
is paid $250,000 to $350,000 to serve on that board of
directors to truly be a tough questioner, a tough insider, sort
of the whistle blower that we saw in Ms. Watkins, for example,
an employee who saw everything going wrong and tried to bring
it to senior management attention at Enron. How is that
possible when it might jeopardize their position on the board?
I believe that will come up in some questions too, so you might
get ready for that.
What I want to focus on, however, is the substance of the
questions of how we somehow fix the failure of disclosure of
relevant information to investors that might have encouraged
investors to make different decisions about Enron, rather than
seeing its stock inflated with this unreal value for so long
that it caused such a problem to so many people. In that
regard, I had a discussion this morning, very much in the line,
Professor Weil, of your comments that on whether or not we
ought to have rules, specific rules, a whole cast of them as
complicated as the IRS rules are today for the accounting
profession, or whether they ought to be principles, generally,
that the accounting profession follows, whether, for example,
that 3 percent rule is a good rule or we ought to just have a
principle that you ought to look to see who really controls the
outside entity, who is really in charge of it as opposed to
these very specific rules that say whether or not it fits the
categories that allow you to hide debt into that entity or to
make up income as we see in this case.
Here's a question I want you all to think about and answer
for me. We have been debating the question of whether or not we
should separate the consulting function from the audit
function. That came up several years ago. It certainly is
before us again today. What the SEC Chairman did several years
ago was to require disclosure as you pointed out, Mr.
Longstreth of the amount of monies being paid, for one function
as opposed to the other, as an indicator of whether the
possibilities of something going wrong might be to the short
sellers or anyone else who might say well, there's too cozy a
relationship between the consultant function, too much money in
there to trust those numbers, trust that audit in the end. But
the recommendation is now much stronger to separate those two
functions. Some of the accounting firms are voluntarily saying
they're going to get rid of one of those functions or separate
those functions. Disney, I think, announced today they wouldn't
hire the same auditors today to do both the auditing function
and the consulting function any more. I suspect other
corporations are going to make similar conclusions.
But here's the question, if we move toward general
principles rather than a whole host of specific rules by which
the accountants try to give us accurate information, and even
if Mr. Lev, we take your recommendations and broaden that
disclosure to include intangibles and all the other much more,
if you will, filled net of information, and then we leave it to
that consulting function, that on-going sort of advice to the
company about how to structure its special purpose entities and
its partnership, everything else it does, only to have some
third entity come in and judge later on whether they did it
right, do we open the door to two very subjective conclusions?
On the one hand the first set of accountants counseling with
the company under general principles that we think you can do
this, so go ahead and do it, and then someone entirely
different coming in and saying no, man, they gave you terrible
advice, our subjective interpretation of those general
principles says you can't do that. Now you have to go back in
and restate your earnings and declare debt that you didn't
declare before and is that going to create confusion for the
investing community, the investment community? Is that going to
do more harm than good is what I'm asking? Second, if we did
move to that kind of a frame and we may be moving to that sort
of a frame, will it create friction if, in fact, as you point
out, Mr. Longstreth, the counseling part of this, the
consulting part it is where the real money is and it seems to
be, 73, 75 percent of where the money is. If I'm hired as the
auditor and you've been hired as the consulting firm, isn't it
in my interest then to make you look as bad as I can in the
hopes that they'll fire you and hire me to the new set of
counselors? Is that going to create that sort of a friction
that is going to lead to more confusion and more contradictory
statements to the American investors? I don't know. Give me
some thoughts on that real quickly. That's what troubled us
throughout this period of discussion and frankly, that's why we
urged Arthur Levitt to have public hearings where corporations
could come in and accountants can come in and we can have a
full discussion of that. Perhaps it's time to have that now.
Let's start, any one of you.
Dr. Weil?
Mr. Weil. Consulting comes in a wide variety of cloaks. One
of the things we're trying to do is to conserve society's
resources. There is nobody better able to prepare a
corporation's tax return than its accountant. If you say to the
accountant, the auditor can't do the tax return, we're going to
waste resources.
A company decides they want to do just in time inventory
system. Nobody's better able to help them design it than
someone who knows where the inventory records are kept in the
green filing cabinet next to the door. We will waste society's
resources if we absolutely forbid that.
There's some place to draw a line. I think the heavy hand
of legislation is not the right way to draw the line. I
disagree with Mr. Longstreth. I think Mr. Raber has got the
right idea which is we need independent audit committees making
the decisions of their companies who should be the auditor, how
quickly we should rotate them out and I think we should
consider mandatory audit rotation. That's the kind of
legislative or regulated thing that you can do, and we can talk
about hiring the way Baruch Lev says, the new audit committee
via vote, but we can have overlapping terms so the new person
is learning as the old person is winding up. But if the audit
committee is independent and feels the responsibility that we
want the audit committee to have and haven't had, they can make
a reasoned judgment about when it makes sense to hire the
auditor. The most important thing is to have the auditor
believe that his retention, her retention as auditor is a
function of the audit committee's judgment, not the CFO's
judgment.
Chairman Tauzin. Yes, I'd like you to reply, Mr.
Longstreth. If anyone else wants to make a brief comment, then
I've got to move on.
Mr. Longstreth. Well, I think just to pick up on the last
comment, I think the critical analysis of consulting on the one
hand and the audit function on the other is to realize that
when an audit is performed, the client for the auditor are
really the shareholders and the investing public. The surrogate
for that body is the audit committee and so the audit
committee, acting as a surrogate for the shareholders is the
client of the auditor.
When the nonaudit services are undertaken, they are
undertaken for a different client, management. Management
retains the auditor to perform this range of services. And
maybe lots of times you can serve both those clients and not
get into trouble, but not always.
Chairman Tauzin. Not always.
Mr. Longstreth. And it's a dangerous situation. I think
that in coming to what can be legislated and what can't be or
shouldn't be, obviously Congress can't legislate generally
accepted accounting principles.
Chairman Tauzin. That's correct.
Mr. Longstreth. And they shouldn't regulate or try to write
laws for auditing principles, but there is a need for a clean
break between the audit function and the consulting function.
Chairman Tauzin. But I wanted to know what unintended
consequences might result when we do it.
Dr. Lev, I want to give you a chance and Dr. Dharan and
then I've got to move, please.
Dr. Lev.
Mr. Lev. Mr. Chairman, let me say something about rules,
you mentioned it. I don't think anybody has in mind getting rid
of all the rules. It's just impossible, but the current system
that we have now in accounting is really completely crazy. You
mentioned the IRS. It's much more complicated than IRS. I
brought you an example of the accounting rules in the United
States for just one item which is leasing, perhaps even not the
most important, there are 452 pages and they also add a CD ROM
to it. This is a system run amok. There is no doubt about this.
There's no doubt that we can do with much less. The UK is doing
with much less rule, more flexible, more general system,
financial markets operating well, but let me give you an
example. We are speaking in abstract terms. Let me give you
just one simple example, but an important one. The whole issue
of consolidation.
Chairman Tauzin. Yes.
Mr. Lev. Which relates to the networking activity of
software companies. I mean pharmaceutical companies like Merck,
like Pfizer have hundreds of R&D marketing alliances, joint
ventures, most of them for very good reasons. Accounting is
bogged down with how to consolidate and if to consolidate these
things with all kinds of absurd rules like if you have more
than 50 percent, then it should be consolidated so they do it
with 49.9 percent. If you have control, no one knows what is
control. You can have a simple rule which says you have to
consolidate everything based on proportion consolidation which
means that if you have a share of 10 percent in an alliance and
joint venture, you take 10 percent of the asset and the
liabilities and the profits of the alliance, period. In this
case and everything will be consolidated in this case. This can
be done.
Let me say a word about consulting and then I'm not going
to be very popular here. I'm, like my colleagues here, from the
point of view of an educator. It's not a secret that it's not
very exciting to work for accounting firms.
Chairman Tauzin. That's right.
Mr. Lev. And it's extremely difficult to get young,
talented, capable, venturesome, intellectually curious people
to work for accounting firms. We don't want to make accounting
firms even less attractive than they are now by putting all
kinds of restrictions and other things. Consulting is an
opportunity for an accounting firm--and they say it and in many
cases they even do it--to tell young people, our graduates,
telling them you know you start, you work 2 years in auditing,
we'll switch you to consulting work, and switch you back. We
have to be sensible here. I think and that's a suggestion that
I put in my testimony, if we kept consulting no more than 25 to
30 percent, let's say, the total of consulting fee, no, we can
argue about it, maybe 15 to 20 percent, it will--they'll have
something. It will not create significant independence problems
in this case, but you don't want to really, as I said before,
make auditing firms incredibly unattractive. We won't have the
quality of work that we need.
Chairman Tauzin. My time has grossly expired. So let me
just move in. We'll get into some more of this as we move
along. Let me recognize the ranking minority, Mr. Dingell, for
a round.
Mr. Dingell. This has probably harmed investors more than
any other piece of legislation. I take it you're advising the
Congress to revisit the law and the assumptions about corporate
professional behavior that underlies the Act, is that correct?
Mr. Chanos. I think that's accurate, Congressman. Just
preceding remarks about auditors and the focus here. I would
point out in the financial crime that is Enron, the auditors
were driving the getaway car, but I don't think they were
committing the crime.
I would point your attention to a Business Week article in
the summer of 1998 in which they held a conference for Chief
Financial Officers and they asked slightly under 200 of these
Chief Financial Officers of major corporations anonymously, if
they had been ever asked to knowingly misrepresent financial
results and if they did so.
Fifty-five percent answered yes, they had been asked to
misrepresent financial results, but declined to do so; 12
percent answered yes, and they had done so; and 33 percent said
they had not been asked to do so and therefore hadn't done so.
Two-thirds of these corporate CFOs had been asked to
misrepresent financial results in this survey. Well, by whom
are they being asked? It's corporate management. My view on
accountants is they're generally very cautious and even when
something controversial comes up before a company and the way a
transaction can be accounted for, almost every accountant I've
ever dealt with will present you with a palette of options and
say here is the most conservative, here is the most aggressive.
In the most controversial situations that happens and yet it is
management teams that generally impose their will in these
situations and whether the accountants go along because of the
consulting or not is beyond my area of expertise.
The Safe Harbor Act, I think, has only made these things
worse. In my practice of listing the conference calls, I've
seen a noticeable uptake since 1996 of companies that were
saying everything was fine in response to questions about the
current outlook, of things that they might know about and then
shortly thereafter news came out from the corporations that
turned out for that not to be the case. I think that the Safe
Harbor Act did a lot of admirable things, I really do on behalf
of frivolous lawsuits and other things. There's got to be some
middle ground here that I think could be reached to protect
investors.
Mr. Dingell. Thank you. Now you stated that you invited a
number of Wall Street analysts that followed Enron to discuss
the warning signs that you and the Wall Street Journal, Texas
edition, identified. Who are these analysts and which financial
institutions did they represent?
Mr. Chanos. The sell side analysts represented a number of
Wall Street firms, most of the largest ones. These were firms
such as Goldman Sachs Solomon Smith Barney, C.S. First Boston,
I believe, who represented the main force of these analysts and
they were all bullish on the company and generally remained so
throughout 2001.
Mr. Dingell. Now did these investment banks invest in any
of Enron's partnerships?
Mr. Chanos. I'm not an expert on this, Congressman. I think
there's been some reports in the press as to whether or not
they were investors.
Mr. Dingell. They are not barred from being investors in
Enron's partnerships, are they?
Mr. Chanos. To my knowledge, no.
Mr. Dingell. Did any of these investment banks have buy
recommendations on Enron stock?
Mr. Chanos. They all had buy recommendations on Enron
stock.
Mr. Dingell. Even after your presentation?
Mr. Chanos. Yes.
Mr. Dingell. What was their reaction to your presentation?
Mr. Chanos. These analysts were not stupid people. As I
mentioned in my testimony, they saw some troubling signs. They
saw some of the same troubling signs we saw. It was, with the
benefit of hindsight, I mean some of these things look very
clear now, but a year ago management had very glib answers for
why certain things looked troubling and why one shouldn't be
bothered by them. Basically, that's what we heard from the sell
side analysts. They sort of shrugged their shoulders. As I
mentioned in my testimony, one analyst said look, this is a
trust me story. One analyst even went further and said he
thought that Enron was hiding reserves that they were
understating their earnings which we found a little bit
remarkable, but that's what he said. So I think that we take
these sell side analysts with a grain of salt from our side of
the table. We've seen too many of them just ignore obvious
financial discrepancies or problems or funny accounting.
They're just hopelessly conflicted because of the fees that
their firms get on the investment banking side and then I think
a lot of investment professionals, maybe not retail investors,
feel the same way.
Mr. Dingell. Now in Mr. Longstreth's testimony with which I
happen to agree in large part, he says unless and until a real
legislative supported SRO is put in place to regulate the
accounting profession, little, if any progress toward effective
disciplinary systems for accountants practicing before the SEC
can be made outside the SEC itself. Starting with you, Mr.
Chanos and then going down the table, do you agree with this
just--and I apologize to this gentleman, but I have very
limited time and I'm not going to be able to ask many
questions. Do you agree or disagree with this statement,
starting with Mr. Chanos?
Chairman Tauzin. The gentleman's time is expiring, so if
you'd all take a turn at answering.
Mr. Dingell. Just give a yes or no response, if you please,
sir?
Mr. Raber. Yes.
Mr. Weil. I don't have an expert opinion on that subject.
Mr. Lev. I'm not sure about the statement. Can you rephrase
the statement?
Chairman Tauzin. Will you restate the question?
Mr. Dingell. Yes, the question, in Mr. Longstreth's
testimony with which I happen to agree, it says that unless and
until a real legislatively supported SRO is put in place to
regulate the accounting profession, little, if any progress
toward an effective disciplinary system for accountants,
practicing before the SEC can be made outside the SEC itself.
Do you agree with that, sir?
Mr. Lev. I don't think we need significant more regulation
on accounting, no.
Mr. Dingell. And I know, Mr. Longstreth, you agree with it.
The next gentleman, if you please?
Mr. Sokol. As an engineer, I'm probably not qualified to
comment on it.
Mr. Dingell. Gentlemen, Mr. Chairman, with your leave, this
has been a very fine panel. Gentlemen, you have my
congratulations and appreciation. Thank you.
Chairman Tauzin. Thank you very much, Mr. Dingell. The
Chair now recognizes the chairman of our Health Subcommittee
from Florida, Mr. Bilirakis.
Mr. Bilirakis. Yes, and we're talking about a very
unhealthy part of our society here, are we not?
Mr. Raber, very quickly, I commend and respect your support
of the corporate director community. You made the comment that
they play a leading role in the governance of corporations. I'm
not going to ask you a question in that regard, sir, because of
time limitations, but I would say it has been pointed out here
that due to the fees that have been given, in theory you're
right, they should play a leading role. In practice, frankly,
it's been my limited experience that they don't because certain
people are chosen to be directors. It's an honor to be a
director. There's money and other things of that nature
involved, and you pretty well go right on down the line. If I
have time maybe I'll ask you to respond to that.
But in the meantime let me get to Mr. Chanos. Sir, in the
poll to which you referred, of the approximately two thirds of
the auditors who indicated that they were requested by CEOs or
by management to come out with false statements or false
information, how many of those would you say received
substantial nonauditing fees?
Mr. Chanos. It was not auditors. It was chief financial
officers who were asked that question. These were actual
members of corporate management.
Mr. Bilirakis. But we don't have any similar information
regarding auditors?
Mr. Chanos. Not to my knowledge. This was a Business Week
poll, again in 1998, following their summit of CFOs, so they
might have that, but I don't.
Mr. Bilirakis. It sure would be interesting to know the
answer to that question and how many of them actually receive
substantial nonauditing fees. I suppose a logical, reasonable
person would assume that if you have received substantial
nonauditing fees, you're probably going to be more likely to be
cooperative. So it would be interesting to know that.
Mr. Dingell already asked the question that I had planned
to ask you on the Safe Harbor. I wonder if you could, for the
benefit of the committee and for the benefit of the people who
are tuning in, take an illustration of how safe market has hurt
investors and has hurt employees as is the case here.
Can you give us an illustration? Tell us briefly about the
Act. How does it protect these people who do something wrong?
Mr. Chanos. Well, we have disclaimers that are given by
corporate managements before they make presentations publicly
or in publicly open conference calls discussing earnings and
outlook and the disclaimer basically holds, tells investors
that they're about to make forward looking statements and can
therefore be shielded under the Act, my interpretation of the
Act from any legal liability when making such forward looking
statements.
Chairman Tauzin. Would the gentleman yield a second?
Mr. Bilirakis. Yes, of course.
Chairman Tauzin. I wanted to correct something on the
record. Mr. Chanos, you said something like everything is okay,
is covered by this, it's Safe Harbor, if the company says
everything is okay. That's a current statement, not a forward
looking statement not covered by the Safe Harbor, is that
correct?
Mr. Chanos. Well, forward looking statement would be in
response to the current outlook. Often managements talk about
earnings guidance and they would say we are okay with current
earnings guidance.
Chairman Tauzin. But we were very specific in the
legislation, if the gentleman will continue to yield, I will
make time for him. The legislation says only that forward
looking statements, that is, projections can only be safe
harbored if they are forward looking, No. 1, not statements of
current condition and second, if they contain statements of all
the elements that might make the forward looking projection
wrong if those elements are present. Isn't that correct?
Mr. Chanos. Again, I'm not an attorney, Congressman, but
that sounds correct to me.
Chairman Tauzin. I thank the gentleman for yielding. Please
proceed, sir.
Mr. Chanos. Well, the game that I see being played on Wall
Street regarding safeguard, current guidance and forward
looking statements often has to do with managements discussing
the period that they are in currently. Now that would be an
earnings that would be reported in the future for the period
they are in and for the fiscal year that they are in, which is
also by definition in the future. My problem is is that we have
a situation where people who often want to ask questions of
management in this area about these forward looking statements
and what colors their input to make such forward looking
statements are often excluded from these conference calls. They
may listen, but they may not ask. And again, I don't think
that's in the spirit of the Safe Harbor Act and what people
were trying to do to protect investors.
We've also seen a number of cases where managements have
reversed themselves rather abruptly following conferences or
conference calls to discuss earnings and accounting issues. And
again, it's hard for me from my vantage point on Wall Street to
believe that they didn't know days before revealing bad news
publicly when speaking to Wall Street analysts and investors
that they might not have known at that point.
Again, I think a lot of what this Act did was admirable
regarding frivolous lawsuits which I'm not fan of. I think
there's a middle ground somewhere.
Mr. Bilirakis. Well, all of you have made recommendations
to us in your written statements. When I conduct our hearings I
always ask the witnesses to furnish to us in writing
recommendations, the changes that they would suggest to us, and
I'm sure Mr. Tauzin is going to do the same thing. I would be
very much interested in your recommendations regarding the Safe
Harbor Act.
Mr. Raber, just very quickly, forgive me for picking on
you. Time won't allow me to go into it, but I would like to see
that, in fact, your confidence in the corporate director is
something that we can really live with and all have the same
confidence in. You might want to furnish us, and I certainly
would love to see them, some ideas that you might have and what
we can or should do, if, in fact, we should address it
legislatively, so that we might have a higher level of
confidence. Frankly, I don't have that much confidence. I know
I was selected years ago to be a director of a bank, and it was
a piddling amount, a couple hundred dollars for meetings or
something like that. But I was selected because I was probably
going to go along with any of the things that the management
wanted to go along with, as well as some of the prestige.
Mr. Raber. Congressman, more and more directors are sitting
on fewer boards. It's quickly disappearing where directors are
sitting are 8, 9, 10 boards. What's happening is that when a
director looks at a particular company where the person is
being nominated to sit on that board, the more astute director
will say I know it's well beyond the number of board meetings,
committee meetings. It's going to be phone calls and e-mails
back and forth and you see more and more companies they say
well my expectation is 200 hours or 250 hours, so there's a
realization, it's a commitment beyond the board meetings and
the committee meetings and it's also a sense, ``Do I know
enough about this industry and this company?'' That's key these
days. And third is disclosure.
Mr. Bilirakis. My time is up, but I still think, with all
due respect, that you're talking more theory than you are
realism and I wish I were wrong.
Chairman Tauzin. Thank you, gentlemen. His time is expired.
I wanted to point out to Mr. Chanos for the record that Arthur
Levitt endorsed legislation on security litigation reform. He
supported the Safe Harbor positions as they were written in the
bill, as we negotiated with him and others in that language.
Now if they can be improved, we'd love to hear from you and
others how we might improve them.
Let me make that a general request, by the way, because I
threw a question at you that I'm not sure you all had a chance
to think about an answer. We will give you specific questions
like that, all of you, Dr. Weil, Dr. Dharan, if you might
respond in writing, we'd deeply appreciate it as we go forward.
The gentleman from New York, Mr. Engel is recognized for a
round of questions.
Mr. Engel. Thank you, Mr. Chairman.
Chairman Tauzin. Am I missing seniority? Is Mr. Sawyer--I
think I'm correct, Mr. Engel is next, yes.
Mr. Engel. I'll sit and listen to his questions also. Thank
you, Mr. Chairman.
Mr. Chanos, you stated in your testimony and I'm going to
quote you, ``certain aspects of GAAP, particularly accounting
for stock options in the United States are basically a fraud
themselves.'' And then you refer to them as ``accounting
scams'' later on your testimony. That's a pretty strong
statement and I'd like you to please elaborate on it and why
you say that and what Congress can do or should be doing to
change the situation.
Mr. Chanos. Mr. Sokol has as his investor Warren Buffet who
said it far better than I ever could about stock option
accounting and I'm paraphrasing, but if stock options aren't
compensation, what are they? If compensation isn't an expense,
what is it? And if expenses shouldn't go into the calculation
of profit and loss, what should? And again, I'm paraphrasing
from the master, Mr. Buffet, but I agree with that whole
heartedly.
Stock options increasingly have skewed the risk/reward for
corporate managements in the United States today to basically
heads I win, tails, the shareholders lose, so we talk about the
rise in agency risk in investing in the United States. It used
to be that you were in the same boat with your corporate
management. They were shareholders as well, they were stewards
of your capital. They served at the board of directors'
pleasure. And now it seems as if the agency risk that's risen
is how can we enrich ourselves if the opportunity presents
itself without harming our earnings per share and therefore our
stock price?
Well, one way to do it is innovative compensation schemes
using stock options because as you know, stock options are not
calculated, the present value of stock options are not
calculated as an expense in the profit and loss statement of
U.S. corporations. No matter how lavish they are, no matter how
enormous the grants might be, they are contained in the
footnote to the financial statements as to what their value
would be under reasonable assumptions in terms of their
valuation and people can look through that and find out what
that number is. We do it automatically to figure out what the
real profitability of a company is if they expense their stock
options, but it's just simply not run through the P&L
statement. We see no reason why they shouldn't be. It's an
expense. It is compensation. And corporations are allowed a tax
deduction when the options are exercised by their executives.
Now it's not revenue neutral because the executives pay tax
when they exercise, but from an accounting point of view and
I'd be very curious to see what the accounting experts on my
left have to say, there is no reason that some attempt to value
these options at market prices should not be an expense item
when they're granted.
Mr. Engel. I see Dr. Weil would like to comment.
Mr. Weil. Thank you. The fault is your predecessors. The
Financial Accounting Standards Board wrestled with this problem
in the early 1990's and had a rule that would do just what Mr.
Chanos wants. It wasn't the best measurement technique, but it
allowed some good measurement techniques and the lobbying was
so intense from your constituents that you, your predecessors
came to the FASB and said you can't pass that rule.
The Chairman of the SEC at that time told the FASB to back
off. He later admitted that was a mistake. This is the time,
the first worst in my opinion, interference with accounting
standards from Congress. All you have to do is go back to the
rule that was about to be passed in 1994 and get it going
again. That was a good rule and I don't think there's going to
be a single accountant, accounting theorist who is going to
disagree with that. We had it and you took it away from us,
your predecessors.
Mr. Engel. Thank you. Mr. Raber, have you read the Powers
Report?
Mr. Raber. I'm sorry?
Mr. Engel. The Powers Report?
Mr. Raber. Yes, I read the Powers Report.
Mr. Engel. In your opinion, did the Board do its job in
overseeing the financial situation of Enron?
Mr. Raber. I think that the Board did not fulfill its
oversight obligations completely and I think they should have
asked more probing questions.
Mr. Engel. In the report it states that the Board approved,
the Enron board approved Mr. Fastow's waiver from the corporate
code of conduct and allowed him to serve as a general partner
in partnerships that participated in significant financial
transactions with Enron. Is it common for a board to allow an
officer of a company to be the manager of another?
Mr. Raber. This to me, is unconscionable for that to happen
and that gets back to disclosure and some of the conflict of
interest that I talked about in my testimony and I'm sure
people here would have other comments as well.
Mr. Engel. Mr. Longstreth, as I mentioned in my opening
statement, Andersen does not believe that it violated the
AICPA's code of professional standards, but instead they say
they committed a gross error. Do you agree with this?
Mr. Longstreth. Well, I don't think I know what standard
they think they did not violate, so I really can't answer that
question. They've admitted to a gross error.
Mr. Engel. Do you think that AICPA is monitoring, policing
its members properly, or do you think they failed in that
regard?
Mr. Longstreth. No, I said in my testimony, they are a
trade association and a lobbying vehicle for the profession and
to put, to charge them with writing and enforcing standards of
professional conduct is really expecting too much of an
organization that is chiefly designed to advance the bottom
line of the industry.
Mr. Engel. Well, then should the government play a greater
role in overseeing the industry?
Mr. Longstreth. What is needed is an adequately empowered
self-regulatory body in my judgment. You should understand that
the SEC has powers to discipline the accountants, but it's
never been a high priority for the SEC, so I think one needs
something comparable to the NASD. The reason the NASD works, it
hasn't worked perfectly over the years, but it's working better
recently, the reason it works is it has subpoena power, it has
disciplinary power. It has rulemaking power and it has the
power to tell every one in the industry when something happens,
turn over your documents, all your documents, come, appear,
testify. You have no fifth amendment rights and if you don't,
you're out of the industry. We bar you forever. That power is
essential for an SRO to function effectively.
Chairman Tauzin. The gentleman's time has expired and the
Chair recognizes the gentleman from Texas, Mr. Barton.
Mr. Barton. I thank the chairman. Just to let the record
show, my graduate degree is in management from Purdue in the
1970's, but I have a son who has got a graduate degree in
business from Stanford in the 1990's, so about 1\1/2\ or 1 year
ago, I kept reading all these stories that Enron had found a
new way to make money and it was the new way and I couldn't
understand it, but I asked my son to evaluate it because he was
working for a company that did venture capital analysis for a
group in Texas and he routinely had to review deals and he came
back to me after about a week and said don't touch it. I said
what do you mean don't touch it? Everybody on Wall Street is
for it. He said they don't have any assets. I don't understand
what they're doing, but sooner or later they're going to head
south and they're going to head south in a big way. So my
degree was 20 years old and I couldn't understand it, but my
son's degree is a little more recent and I was going to put
some money into Enron and my son told me not to. Eventually, I
did, anyway. As it headed south, I figured it can't go any
lower and of course, every time I bought it, it immediately
went lower, so anyway, that's that.
I lost everything, but fortunately for me everything for me
is not a lot so that's a good deal.
I want to try to put this in some sort of perspective
because never has a more important subject been presented in a
more boring fashion and we really need to kind of understand
this. So I'm going to use the analogy of me as an entity and
the old economy and the new economy. The old economy, I'm
Congressman Barton and I have an annual salary after taxes of
about $100,000 a year and I get that about $8,000 a month and
out of that I pay my household expenses and I try to save some
money and I have some assets, a savings account and a stock--
some thrift savings that we can join in. But I know every month
how much money is coming in and I know every month how much
money is going out. Now most of the money that's going out is
to my kids. I have a son who is now running for Congress,
fortunately, I'm limited to a $1,000 that I can give him, so
I've got a limit on that, a mandatory, Federal limit. I have a
daughter to who is about to be married. There is no limit on
that.
And I have another daughter who is in college and in a
sorority who wants to study overseas next year and there's no
limit to that. Okay? So that's my outgo.
So in the old economy I know how much money is coming in
and I know how much money is going out and where it's going and
I have to balance the books at least once a month, unless I go
to my banker in which case I can balance once a year, but I'm
tired of that. So I decide to develop TexasCon.com and I like
these new accounting rules that generally accepted, which means
if you can get away with it, do it. So I decide to go to
somebody and create a special entity, an SPE and I look around
and I see that former Congressman Livingston is making lots of
money and former Congressman Brewster and McCurdy and a lot of
our colleagues are making a lot of money. So I go out and say
if you'll put up 3 percent net equity and where that number
comes from I don't know, but we can go and say 5 years from now
I'm going to be making $1 million a year. So if you'll put up 3
percent of that which is what, $150,000, I guess, then I can
create a special purpose entity and I can book that as revenue
right now and then my children's outgo, I want to limit
liability so I create an SPE for each of them, you know, and so
I can take those liabilities off my balance sheet and all of a
sudden stodgy old Congressman Barton who has got an income of
about $8,000 a month, an outgo of about $8,500 a month, all of
a sudden I've got this mark-to-market of this revenue stream in
my special purpose entity of $5 million and I can book right
now, even though I haven't got it, and I can take that to the
bank and borrow money and I don't have any problems, as long as
nobody calls me on it. And as long as I can sell my stock on
the market and make my accounting and my annual report so
confusing that nobody understands it.
Chairman Tauzin. Will the gentleman yield before you ask
the question Mr. Barton. Yes, I'm going to ask a question. I've
set it up now. I'm about to ask the question.
Chairman Tauzin. Go ahead and ask it.
Mr. Barton. My question of you guys is which is better, the
old way where I'm stodgy and everybody understands it, or the
new way where I'm very unstodgy and I'm very hip and it's all a
mirage?
Mr. Sokol, you're a straight shooter, which way do you
prefer?
Mr. Sokol. The old way.
Mr. Barton. The old way. Mr. Longstreth?
Mr. Longstreth. Yes, I'm convinced by your rhetoric.
Mr. Barton. Okay, how about Mr. Lev?
Mr. Longstreth. I like the old way.
Mr. Barton. Does anybody like the new way?
Mr. Lev. I like the new way.
Mr. Barton. Which way? Mr. Lev likes the new way. Why do
you like the new way?
Mr. Lev. Let me first say that you really put some life
into the discussion of accounting and----
Mr. Barton. It's hard to do, but----
Mr. Lev. I commend you for this. I commend you for this,
but there is a new economy and the new economy is a place in
which there are many assets which are not old assets. If you
ask yourself what are the assets of Merck or Pfizer, these are
not old assets, these are not buildings or lab equipment. It's
patents and minds of people.
Mr. Barton. Well, there's always been minds of people,
there's always been ideas. Now Dr. Weil, he said that his
students understood what a revenue is. I think I understand
what a revenue is. It's something that comes in, somebody pays
me money.
Mr. Weil. I think you're confused. You think you know what
a receipt is and you have no idea what a revenue is, but a
revenue isn't necessarily a receipt.
Baruch here, Professor Lev, is getting to the right thing.
Your old economy is easy to account for because it's cash-flow,
it's cash in, cash out. There are enormous numbers of assets
like the patents of the drug companies where you spend the
money today, but you don't know for a year, or two or three,
whether there's going to be cash inflow and between now you
spend the money and later you might get it. We've got
uncertainty.
Mr. Barton. Well, I'll go with you, if you have a patent
you have a certain monopoly or a royalty right because of that
patent, but you don't necessarily have a revenue because you
have the patent, isn't that correct?
Mr. Lev. You can always license a patent.
Mr. Barton. But somebody has to buy it. Somebody has to pay
you money.
Mr. Lev. Yes, in the future.
Mr. Barton. I have three real questions here, everybody
else has had 10 minutes. Now you're not going to hold me----
Chairman Tauzin. You made 3 percent of $1 million at
$150,000, I think that was pretty innovative. So I'll give you
a couple of minutes.
Mr. Barton. Here are my questions, the first one is to Dr.
Dharan who gave quite a bit of testimony about mark-to-market.
What if we just prohibit mark-to-market?
Mr. Dharan. I don't think that's a good idea at all.
Again----
Mr. Barton. Okay, you just say no.
Mr. Dharan. I say no.
Mr. Barton. What about instead of having an independent
audit committee like one of the gentlemen said, what if we just
eliminate the whole idea of an independent audit committee but
say it has to be internal and you're liable for it?
The companies have to do the audits, but they're liable for
the audits instead of going through this outside independent
audit firm who's really not liable and it's based on generally
accepted accounting principles which have been stretched like
rubber bands for the last 20 years, why not just say you've got
do a real audit internally and you are liable for it. What's
wrong with that idea?
Mr. Raber. You have to have, at least from our perspective,
you should have an independent external auditor that has no
problems with some of the independence issues that--you're
looking at it objectively. You're bringing in the best people
insofar as skills and experience and that independent judgment,
independent from management, independent from the internal
auditor, that person needs to take a look and make an objective
assessment insofar as the audit.
Mr. Longstreth. The laws we have today would make the
company liable if they put out false statements, so we've got
that. I think the point is we've felt it necessary to have an
independent verifying process.
Mr. Barton. But you're really not independent because some
of these companies are so big you can't say no to them.
Chairman Tauzin. The gentleman's time has expired.
Mr. Barton. The auditor of Enron could not say no to Enron.
Chairman Tauzin. All right, Joe, got to move on. The Chair
recognizes the gentleman from Ohio, Mr. Sawyer, for questions.
Mr. Sawyer. Thank you very much, Mr. Chairman. I've got a
couple questions of corporate governance I'd like to pose. In
the Enron case, we had both an independent board and a common
law fiduciary duty imposed on that board. Do we need to have a
statutory fiduciary responsibility on investment retirement
plan administrators, similar to that which we have in ERISA?
Mr. Raber. That's part of the responsibility of the audit
committee is do what needs to be done to make sure the pension
plans are being dealt with appropriately, so you--that's part
of the risk audit of an audit committee, so I don't know if
that answers your question, but that's part of the due
diligence you do there is similar to what you do in other areas
of risk in the company.
Mr. Sawyer. In Federal pension plans, fiduciaries have a
responsibility, I quote ``to diversify the investments of the
plan so as to minimize the risk of large losses.'' Do we need a
similar kind of standard for 401(k) administrators?
Mr. Raber. I'd rather look to some of the accountants here
that may be able to give a judgment on that insofar as that is
concerned.
Mr. Sawyer. Anybody?
Mr. Weil. Well, here we go. Your predecessor did that one
to us too, back in the 1970's when you started with employee
stock ownership plans, employee stock ownership trusts, you
sort of forced the investments in your own company's stock. We
need diversification. You don't want to put all your eggs in
one basket. It's been a well-understood principle of financial
economists for decades and anything you can do to help the
shareholder diversify retirement funds is a good idea. I'm not
sure what the details needs to be, but the nondiversification
started with your predecessor's rules. Let's fix them.
Mr. Sawyer. Mr. Sokol, I was really interested in the last
page of your written testimony where you talked at some length
about a topic that is--I bored my colleagues to death with over
the last several years and that's the problems of capital
formation around truly modern regionally built markets
supported by a modern transmission system. And you talk about
PUHCA and how it can't be fixed by tinkering around the edges,
that it's 50 years out of date. I have some appreciation for
that. However, you don't talk in your testimony about elements
from PUHCA that need to be retained or transposed into other
settings in order to continue to preserve the protections that
they provide. Could you elaborate on that for me.
Mr. Sokol. Yes, it's a very good point, Congressman. PUHCA
was established in 1935, known as the 1935 Act to deal with two
sets of issues, a set of issues that are gone that the SEC has
said since the 1950's are gone and then a set of issues that
continue today which are consumer protections which I think
that's what you're speaking to. We strongly endorse and I think
the industry strongly endorse, although Enron opposed that.
When PUHCA is reformed, similar to Senate Bill 1766 currently
in front of the Senate, that the books and records for State
regulators, Federal regulators have to be enhanced for all not
only monopoly utilities, wires or pipes, but any affiliates of
those, so that any affiliate abuses or other transactions can
be properly monitored. We strongly agree with that because
really--and Enron is a good example of this. The consumers, a
problem with General Electric, which was owned by Enron, an
intrastate-exempt utility holding company, were protected by
the State of Oregon, the Public Utility Commission of the State
of Oregon and they did an excellent job, as almost every State
today does. It fences a utility within its State so that other
corporate activities cannot affect that activity. And that's
the situation. The reality is there's well in excess of 5,000
State regulators, professional regulators in the United States.
There's 22 employees of the SEC that oversee PUHCA. And so we
really strongly endorse both the consumer protections and
enhanced protections be moved both to the FERC and to the State
regulatory bodies.
Mr. Sawyer. Thank you very much.
Chairman Tauzin. Does the gentleman yield back the balance
of this time? The Chair recognizes Mr. Stearns of Florida.
Mr. Stearns. Thank you, Mr. Chairman. One of the purposes
of this hearing is not just to go into some of the details as
my good colleague from Texas talked about so that it just gets
so boring that no one can follow it, but we're trying, as
Members of Congress, to give confidence to the investor so that
the investor has full disclosure and can understand what he or
she is purchasing. And so the whole purpose is somehow to come
out of this Enron not necessarily with huge reregulation, but
to come out with some kind of platform in which we can say to
America, these Enrons won't continue. One of the gentleman here
has mentioned that the special purpose entities has been going
on for at least 5 years and I suspect other corporations are
using this and I suspect there will be a lot of people
including the people at the table here that would argue that
it's acceptable to use that if it's done in a proper way and we
don't have a conflict of interest. But I would like to get at
the heart of the problem which is the American people are
saying, ``What confidence will I have that when I go to invest
in any corporation today, there's not similar type of chicanery
or hiding smoke and mirrors of the debt and the revenue is
inflated?''
Now Dr. Weil, you're teaching MBAs at the University of
Chicago, Graduate School of Business. I could simply say to you
when you have a graduate from your MBA school, shouldn't he or
she be able to discern that Enron's books were bad? And I think
I would just ask you just plainly and I probably also should
ask this to Mr. Dharan at the Graduate School of Management at
Rice University. I mean these MBA graduates should be able to
understand this. Could they today pick up the Enron P&L
statement and understand it? Just give me a brief answer, the
two of you.
Mr. Weil. My co-author Clyde Stickney who is a Professor at
Dartmouth College, we've written a book for 30 years on this,
spent over a week dealing with the Enron financial statements
to write a case that he can use to teach the students. Mr.
Stickney is a pro and it's taken 40 man hours to get to the
bottom of things and he's not 100 percent to the bottom because
there's not full disclosure, but an MBA graduate is not going
to be able to do it.
Mr. Stearns. So the Tucker School of Management, Dartmouth,
one of the premiere guys could not understand it after weeks,
okay?
Mr. Dharan. Congressman, I agree with it totally and I
think the problem has to do with the way Enron reported the
numbers, not it's accounting itself. It was very misleading.
Mr. Stearns. Okay, so your MBA graduates couldn't
understand it either. Okay, so then the average person couldn't
understand it. So this goes to the main question of this
hearing, could FASB, the Financial Accounting Standards Board,
could they by themselves provide enough rules to clean this up
and put it in place without Congress doing anything?
Mr. Weil. I believe, yes, they could.
Mr. Stearns. Yes, they could.
Mr. Weil. Here is the rule that they proposed in 1999 that
was essentially all but passed, that would have solved the
problem and it was put aside for various----
Mr. Stearns. Is that the majority of the consensus? Let me
just go down the line, if you would, from left to right. Could
FASB on itself clean up this through accounting rules without
Congress. Just yes or no.
Mr. Chanos. Yes.
Mr. Raber. Not sure.
Mr. Stearns. Dr. Weil, you say yes?
Mr. Weil. Yes.
Mr. Dharan. I would say no, but if I could take a second to
explain why.
Mr. Stearns. I just want a no or yes. The chairman is going
to be ruthless with me here. Yes or no?
Chairman Tauzin. I'm not going to be ruthless with my
fellow Texan.
I'll give him all the time he wants.
Mr. Stearns. Is that a yes then?
Mr. Dharan. If I want to say no, I need to have a minute or
2 to explain why.
Mr. Stearns. Okay, I have a follow-up question, so let me
just go down to the rest of the fellows, yes? Yes or no.
Mr. Longstreth. No.
Mr. Sokol. No.
Mr. Stearns. Okay, this comes down to the next great
concern we have is that the Chairman of the Securities and
Exchange Commission has come out and has indicated that we're
going to have to go ahead and have an accounting industry
oversight board and I think Mr. Dingell mentioned on this that
he asked you this question already, but I judge from what you
say is we cannot expect FASB to do this by themselves. There's
some mixed reaction here. So what is the American public
supposed to do with the Financial Accounting Standards Board
cannot come up with a solution and provide enough disclosure
and your MBA, as it presently exist, cannot even understand
those reports and the man at Dartmouth spent weeks and he
couldn't understand it. So what are we supposed to do? And I
just would close, Mr. Chairman, by just asking them again to
answer this question that Mr. Pitt from the Securities and
Exchange Commission said, should there be a congressionally
mandated self-regulatory organization, an SRO like the National
Association of Security Dealers for accountants to give
government direct oversight of the accounting industry and just
yes or no?
Mr. Chanos. No.
Mr. Raber. There should be an oversight and it should be
strengthened. I'm not so sure what it should be though, whether
it should be the regulator or some sort of a public oversight
board.
Mr. Stearns. Dr. Weil?
Mr. Weil. I think there's a better way, but I don't have
time to tell you about it now.
Mr. Stearns. Okay.
Mr. Dharan. I think there should be an oversight board.
Again, I'm not very sure about the specifics of SRO that was
proposed.
Mr. Lev. We are really mixing two things here and we are
making disservice to the subject by having to answer yes or no.
Mr. Stearns. In all deference to you, in my job I have to
simplify things day in and day out. I do 800 to 900 votes a
day. I could sit and talk about each vote for 3 hours.
Mr. Lev. I respect it, but you started speaking of
accounting rulemaking, the FASB, and then you switch to the SEC
chair who spoke about oversight of the auditing profession.
Mr. Stearns. Right.
Mr. Lev. These are two entirely different things.
Mr. Stearns. Okay, I'll take your word for it, yes, okay,
and your answer should there be this congressionally mandated
self-regulatory organization over the accounting industry?
Mr. Lev. Yes.
Mr. Stearns. And last?
Mr. Sokol. I think it misses the bulk of the point.
Mr. Stearns. Okay. Mr. Chairman, I think that if any one of
the members would like to send a letter to outline more
specifically how they feel about it, we'd be more than happy
to, but I only have 5 minutes and as I say I have to
scintillate all this down, so at least the American public can
have a better appreciation for what we're talking about.
Thank you, Mr. Chairman, for your indulgence.
Chairman Tauzin. Thank you. It is a serious subject. I
would, before we go to Mr. Greenwood, like to Dr. Dharan and
Mr. Lev, it is a serious subject, all joking aside, if you want
to elaborate a little on Mr. Stearns. He didn't use as much
time as the other members.
Mr. Stearns. Mr. Chairman, if I still have time, I would
certainly offer them----
Chairman Tauzin. I'll give them a time to elaborate. We
need a full hearing record and this is an important subject.
Mr. Dharan. Thank you, Congressman. I think the question
was, ``Could the FASB in and of itself clean up the reporting
and disclosure rules?'' and the answer is no, because the FASB,
as was pointed out, only sets the accounting rules. It does not
enforce them. And we really need a combination of both good
accounting rules and good enforcement. The reliability of
accounting numbers comes from the enforcement system, not from
the accounting rules themselves, so that's why it really is
important to have a support function that really does the best
job of enforcement. That's really why FASB by itself cannot do
this.
Mr. Stearns. So enforcement is the key in your mind?
Mr. Dharan. Enforcement is the key, along with good rules.
Enforcement cannot make up for bad rules. And good rules cannot
make up for lack of enforcement.
Mr. Stearns. And FASB couldn't provide the enforcement?
Mr. Dharan. FASB has absolutely no power of any kind to do
enforcement. It's just a private group. It sets accounting
standards, but it does not enforce them.
Mr. Stearns. Okay. Mr. Lev, you are certainly welcome.
Mr. Lev. Let me just say about the FASB, the rulemaking
body for accounting. A group of good people basically moving in
the right direction, but too slow, too timid, they are now
working about 10 years on consolidation and still we don't have
really good rules in this case. In my opinion they need, maybe
not new regulations, they need some kind of a push or a shove
by the SEC or someone to get the act together. Regarding the
oversight of the auditing profession, I don't think we need any
oversight in this case. I think that if we get--we in
competition, in the auditing industry, along the line that I
mentioned before, that auditors will be chosen by shareholders
for a 5-year period, then you don't need any oversight. They'll
act and if they don't act, they'll be kicked out like any other
service providers. We don't need another regulatory body.
Mr. Stearns. How do you get enforcement then?
Mr. Lev. On what?
Mr. Stearns. When you said they need a push or a shove, is
that an enforcement mechanism or is that just a house
resolution from Congress?
Mr. Lev. I'm not even sure if--I'm not a lawyer, I'm not
sure if a resolution is needed, but the little I know about
laws, the SEC, according to the 1933 and 1934 laws was in
charge and still is in charge of setting accounting standards.
They delegated it to the FASB and from time to time they have
to provide an oversight whether the job is done well, in the
right pace, the right direction, the right speed and I think
they should do it.
Mr. Stearns. Thank you, Mr. Chairman.
Chairman Tauzin. Thank you. The gentleman from
Pennsylvania, Mr. Greenwood, is recognized for 5 minutes.
Mr. Greenwood. Thank you, Mr. Chairman, and thanks to all
of the panel members for a very long day.
I'd like to address a question to those who have the
expertise in accounting and I want to think about board members
and particularly the board members who are on the audit
committee. Now I haven't--I was just talking to the staff to
try to get a sense of the magnitude of the compensation that
the board members at Enron were getting. My understanding was
it was pretty nice. I've heard numbers of $400,000, in this
vicinity. When you look at the cash that they're given, you
look at the stock they're given, you look at the stock options
that they're given and then they fly them around first class
and put them in fancy hotels and all this stuff, and it's been
my experience and I don't know a whole lot about this, but it's
been my experience that board members are not necessarily
chosen by companies because of their great expertise in the
business that the company is engaged in. They're picked because
they've got some political juice or they've got some stature or
wisdom, but they don't necessarily know about all of the
intricacies of the business that the company is in.
Now when you're getting this kind of compensation and you
know that you serve fundamentally, I think one of you said
earlier at the behest of the CEO, you very likely don't want to
rock any boats because you can go. You can go pretty easily.
One question I have is should giving the board members
stock and stock options, is that a good idea because it's a way
of saying so the governance that you provide to this
corporation will affect the value of your stock and so this is
an inducement for you to really care about the value of the
stock, or does it, in fact, create a conflict, certainly if I
were on the board of directors of Enron and I had a lot of
stock in Enron or stock options in Enron and I knew that my
being deadly honest about the audit, that that might cause the
stock to drop, I might be in the same, put me in the same boat
as some of the management team that had stock and didn't want
to see its value drop. What do you think about that specific
question? Should board members--is it a good idea for board
members to be compensated with stock and stock options?
Mr. Raber. If I could comment on that since we track it
with public companies and we firmly believe and recommend that
40, 50, 60 percent of your compensation should be in equity,
the rest in cash. They are looking at that you're paid in
equity, you get the chance to feel the pain or the gain that
the shareholders feel. We want to pay you in cash to a certain
extent, so you take the long run, the long look at things,
rather than maybe the incentive would be if we were paid
entirely in stock, we have more of a short term perspective.
These are safeguards. But the practice is between 40 to 60
percent is in stock if you look at all public institutions,
with the larger institutions similarly paying more in stock.
Now we're also encouraging, again this is part of a principal
of good corporate governance that when you come on the board
it's a good idea to purchase outright stock and some companies
do that. I know when I first got on my board back in 1980, I
had to make a purchase of X amount of stock and again there, if
the governance principle is you represent the shareholders, you
should feel the pain that the shareholders feel.
I also find, because we do a lot of education of directors,
this area is the area we spend the most time is on audit
committees and what I wanted to say before, getting behind the
numbers. There's no doubt you're seeing a lot more focus on
audit committee quality and independence by audit committees.
You're also seeing a lot more focus on enhancing their
financial competencies. So we're seeing a lot more focus on
tackling those issues, realizing longer days, longer hours----
Mr. Greenwood. What about the observation that had the
audit committee at Enron forced the issue and pushed these off-
book numbers back on book that the stock might have dropped as
a result of that.
Mr. Raber. I've got to tell you that the impact of Enron,
among other things, is to look at those off balance sheet
transactions, not that they haven't been in the past, again, a
lot of the people that belong to my organization are more
enlightened and more engaged in good governance practices, but
there's no doubt the implication of off balance sheet
transactions is going to take a heightened interest among audit
committees.
Chairman Tauzin. Would the gentleman yield?
Mr. Greenwood. The gentleman will yield.
Chairman Tauzin. I'd just like an explanation of the public
good of allowing off budget entities in this new market
economy. Why allow that if it hides the real value of the
company?
Mr. Raber. I agree with you. To get back to your question
before about the old and the new and if you can't understand it
and say you're an MBA, you have a certain amount of financial
sophistication and you have a finance background and you're
sitting on a board or an audit committee and you can't
understand it, that means you can't govern it and something has
to change.
Chairman Tauzin. Well, Enron was pretty up front to the
analytical community that the purpose of these SPEs was to
provide a hedge against volatility both on the upside of the
asset and the downside--they were pretty up front that that's
why they were creating the entity. So that wasn't a secret and
that wasn't buried in a footnote. Now how they funded them and
the equity they put in was confusing, but the purpose was to
protect the parent company balance sheet which would seem to me
to be contrary to general accepted accounting principles that
you want transparency and understandability.
Is the gentleman through with his questions?
Mr. Greenwood. I'm through questioning, but I would like
anyone who wanted to respond to my question to respond.
Mr. Longstreth. I'd like to respond to the, if I could
respond to the question you put, Congressman Greenwood, about
options for directors.
I think that they're not a particularly good idea. I think
the idea of having directors paid in whole or in significant
part as my colleague here has suggested ought to be done is a
very good idea because it aligns the director with the
shareholder and he pays for it in effect through the director's
fee. But options is it's a heads I win proposition. And in
England, options for directors are prohibited.
Mr. Weil. There's a tradeoff here where economists, if you
own an ownership interest, you go down with the ship. You have
interest in going forward and the company doing well. If you
have too much of your wealth in it, you're going to be tempted
to hide bad news to protect your own wealth. There is some
place in there where you want to draw a line, but it's probably
not at zero. Whether the compensation should be in options and
shares, we can equilibrate that and make them equivalent.
That's not an important distinction in my mind, but it is a
good idea for the director to care about the health of the
company. It is not a good idea for the director's entire wealth
to be at stake on the good of the company. It's a tradeoff.
It's a most simple answer.
Mr. Dharan. I just have a small comment to add. We have the
concept of independent directors and we always think of that
concept in terms of whether the director is part of management
or is the director coming from outside the company. I think we
should also start thinking in terms of the independence of the
director with respect to the stocks that he or she holds in the
company, so the director that's holding a huge amount of stock
that is a percentage of his or her wealth very significant,
then at that point to call the director independent is really
very difficult to convince in terms of the downside risk he or
she faces in exposing problems. So I think your point is
excellent. I think we really should think about what portion of
the wealth should be held in the director's portfolio of the
company.
Chairman Tauzin. The gentleman from Iowa is recognized.
We're going by seniority, just to let Mr. Shadegg know. Mr.
Ganske has got seniority on Mr. Shadegg. I was told to do that.
Mr. Ganske. Thank you, Mr. Chairman. I think the--I've
enjoyed the panel a lot and there are a lot of strong
personalities on this panel. I think it gives lie to the old
saying that you become an accountant if you lack the charisma
of an undertaker. But then maybe we have some accountant
teachers here on this Board as well.
You know, I'm thinking about a gentleman who lives on the
western edge of my District. His name is Warren Buffet, just
across the river from Council Bluffs and for a long time while
that high tech economy was rolling along, Mr. Buffet was kind
of viewed as being a stodgy guy because he said you know, I
just can't figure out how to evaluate those companies and what
a true evaluation. And we've talked a lot today about some of
the problems with accounting in terms of determining what the
actual worth is of some of those intellectual property ideas
that maybe yeah, aren't realizing any gains.
I don't know that we'll get into that in terms of Congress
looking at the rules. There very well may be criminal
prosecutions that arise out of this. The Justice Department is
looking at this. I share the feelings of some of the members on
this committee who have expressed frustration, for instance,
that the person who robs a convenience store gets put in jail
and isn't given the option of staying out of jail if he returns
half of what he stole. And I appreciate Mr. Sokol's comments on
this issue. We really, the Nation's attention will be
spotlighted on this, on the Justice Department probe.
We're sort of looking at what can we do right now to try to
shore up investor confidence because just looking at all sorts
of things that are going on Wall Street in terms of Global
Crossings, Tyco, bankruptcies, all up and down, and people
worrying whether, you know, their investments in particular
stocks haven't been reported accurately and that there's all
sorts of offshore entities going on. I think Congress does need
to do something like that. Several years ago I was sympathetic
to Arthur Levitt's proposal to somehow or other deal with the
potential, at least the potential conflict of interest between
entities that are doing the accounting and those that are
getting high fees for consultation. I guess I'm reading that
the Big Five now, if they haven't already, they're spinning off
their consulting services.
You know, when I ran my medical practice, I was running a
small business and I had a professional manager that helped me.
He was an accountant, kept my books, also did my tax prep. You
know, but that's a whole lot different entity. I wasn't a
publicly traded company. People weren't investing in my
business. And I do think that we need to go back, look at the
FASB rules. We need to go back and look at possibly
strengthening and going back to Mr. Levitt's original
proposition. I am not so worried about accounting firms being
able to or businesses being able to get the type of
consultation because you know, look, you hire one firm to do
your accounting and you get another firm to do your, of some
type to do your consultation. The specter was that maybe they
would be at odds with each other. Maybe they would badmouth the
other. I think you could also wonder whether they would be in
collusion with each other, since there may not be that many
large entities. I think the competition would be helpful and
would help restore some confidence in these companies that
we're dealing with.
I guess I don't have any particular questions right now,
except I do want to thank you for the indulgence, patience that
you've shown when all of us up here in Congress, up here on the
bench had our long statements. It's been a long day for you. I
look forward to going over in more detail the suggestions that
you submitted in your writings. Thank you very much.
Chairman Tauzin. We're going by order of seniority which
would give Mr. Deutsch the opportunity before Mr. Stupak,
although Mr. Stupak appeared before Mr. Deutsch. So Mr. Stupak
will be recognized.
Mr. Stupak. Well, thank you, Mr. Chairman, and thank you,
Mr. Deutsch.
Mr. Chanos, I did have a chance to read the article in
Barron's there and on the last page of that article that was on
our desk here it said that your correct prediction of Enron's
demise, it is reported that you suspected more will be
discovered. Specifically, the article says that you suspected
other Enron partnerships were used and I'm going to quote now
``to boost Enron profits by acting as a dumping ground for
losing trades, bad long-term investments and busted Enron
investment banking deals.'' The article also says that you
think ``once Enron's long-term energy trades are properly
marked to the market, other profits will simply melt away.''
Can you give us just a little bit more of what's the basis
for your concluding this in this article?
Mr. Chanos. Well, again nothing other than a pattern that
we saw which leads us to believe that if Enron was going to
great lengths to basically hide losses in its merchant banking
and other areas through the use of SPEs, it seemed to--and I
read the report that the company put out, just a simple
violation of accounting rules, well, why wouldn't they also
gain in the great, gray morass of the mark-to-market or gain on
sale area that we discussed a little earlier, be perhaps a
little bit too aggressive.
One note I point to there is in the now infamous or famous
Watkins memorandum that came out. She referred the use of
partnerships to--and again, I'm going from memory here, but to
act as a repository for EESMTM positions was, I believe, the
line she used and we took that to mean Enron Energy Services
mark-to-market positions. So that's one internal person who
seems to also believe that may indeed have happened.
Mr. Stupak. Well, let me ask you this, I mentioned the 1995
so-called Security Reform Litigation Act, one that I strongly
disagree with and when you talk about safe harbors for forward-
looking statements that Congress enacted as part of that so-
called reform in 1995, in what ways does that provision prevent
investors such as yourself from really obtaining accurate
information about a company's current and future prospects, how
are corporate insiders using this provision to avoid meeting
their duty of public disclosure responsibilities?
Mr. Chanos. How does this prevent us from getting
information?
Mr. Stupak. Right.
Mr. Chanos. I don't know how it prevents us from getting
information, Congressman. I think the problem I have with it is
on the back end of it. What happens when the system fails and
when you're providing some sort of umbrella against litigation
for the watchdogs for these kinds of things and for managements
that knowingly try to deceive their shareholders. That's the
problem I have with it. I'm going to still be able to do my
job. We're going to go through the footnotes and we're going to
ask questions and we're going to do everything we possibly can
on behalf of our investors which I have fiduciary
responsibility to, but my concern is more to other investors
who don't have the resources we do or the experience we do and
have been wronged where there's this asymmetric risk/reward for
corporate managements as we've talked about. If I give back
half, will you let me go free? I just don't think at the end of
the day that's fair.
Mr. Stupak. With these forward-looking statements, the 1995
reform, sort of use your words, ``provides an umbrella of
protection'' and in fact, I think 1995 reform goes so far as
saying even misleading statements in a forward looking
statement is not actionable after 1995. Is that correct?
Mr. Chanos. That's my understanding.
Mr. Stupak. I know of others and I've prepared some
legislation that would restore the joint and severable
liability for accountants that also provide consulting services
to the same clients and eliminate the current Catch-22
situation which plaintiffs can't get discovery against the
accountants needed to pursue claims against them and restore
liability for aiding and abetting securities fraud.
Would you support these types of reform or restoration of
the action that we had before this 1995 reform went in?
Mr. Chanos. I'd like to see some middle ground. I would not
like to see wholesale abolishment of that act because I do
think it accomplished some very good things on one end about
frivolous lawsuits that are filed and were filed prior to the
act.
I don't want to comment on the specifics of the joint and
severable question because I'm not an expert there. I just
think that to fall back to what I've said, there's got to be a
middle ground here to protect corporations and protect the
managements from making honest statements about what they know
about and not be sued and not be found liable and yet punish
those that use this as a way to defraud investors of the
marketplace. It's got to be better than all or nothing.
Mr. Stupak. When this whole thing shakes out, this whole
Enron, whether Enron aided and abetted Arthur Andersen or
Arthur Andersen aided and abetted Enron, under the 1995 reform,
again, that umbrella gives them protection that they did not
have before which help leads to this cavalier attitude that we
see at least in Enron and hopefully not in other corporations,
but possibly in other corporations too, according to your
article in Barron's. Is that a true statement?
Mr. Chanos. I think it's an accurate interpretation. I
would agree with it.
Mr. Stupak. Professor Dharan, some of the infamous Enron
partnerships apparently ran afoul of accounting standards which
used a so-called special purpose entities, the SPEs, to have at
least 3 percent outside equity. Now to me, that doesn't make a
lot of sense to have a 3 percent equity. That was not what it
was set up for. Before in accounting standards you always had
to have at least 50 percent before it triggered an accounting
standard. Would you be in favor of repealing this 3 percent
rule?
Mr. Dharan. Yes, I would be. The 3 percent rule as I
indicate in my written testimony really came about in a very ad
hoc accidental way. There was not really a whole lot of
discussion. It came about not even in the primary rulemaking
group, the FASB, but one of its emerging issues task force
group. I think in hindsight, it was pushed by the industry
group that benefited most from it, rather than any kind of a
good accounting analysis, so I would certainly support
repealing that.
Chairman Tauzin. Would the gentleman yield on that?
Mr. Stupak. Yes, I would, Mr. Chairman.
Chairman Tauzin. What industry groups benefited from such a
low equity requirement?
Mr. Dharan. I think definitely the companies that were
sponsoring them needed to have a very low threshold. They don't
have to report those partnerships and the industry groups that
would have supported them would be the liars in the accounting
firms that are supporting the companies to form those special--
--
Chairman Tauzin. So would you agree that the people that
pushed the rule were people that just wanted to have a leverage
transaction and not necessarily really have a true partnership?
Mr. Dharan. I think so. I mean definitely that's my
judgment, looking at the history of the 3 percent rule.
Mr. Stupak. This 3 percent rule, just so the record is
clear was really developed by the Financial Accounting
Standards Board, is that correct? And that gives advice to the
SEC. It wasn't something Congress created.
Mr. Dharan. That's correct. It was created by a group of
the FASB called the Emerging Issues Task Force.
Mr. Stupak. When you do a statement, a corporate statement
profit/loss, is it your impression all profit/all loss which
can be attributable to a company should be listed, even if
there's these partnerships? How would you list it?
Mr. Dharan. I think the answer if I control the
partnership, I should also report the gains and losses from the
partnership, but also we need to look at the collectability,
and what's the quality of these numbers? Do we have any
confidence that we are going to get the gains or are these
gains completely self-estimating numbers that cannot be
verified? If the gains are fairly reliable and there's a high
degree of probability that I can get the money, then it makes
sense for the company to report those gains. Currently, we
don't have that system in place.
Mr. Stupak. And in this case, these SPEs, because Enron
pledged its stock to secure the loans and everything else, they
had basically control of these and they should have put their
profits/loss there for----
Mr. Dharan. I think so.
Mr. Stupak. I guess it goes back to what Mr. Raber says. I
guess it's independence information and integrity and until we
get that, we're going to continue to have problems like Enron.
Chairman Tauzin. The gentleman's time has expired. I thank
the gentleman and the Chair recognizes the gentleman from
Arizona, Mr. Shadegg for a round of questions.
Mr. Shadegg. Thank you, Mr. Chairman. Gentlemen, let me
start by saying I've spent now 3 days in Enron hearings. I
began Tuesday afternoon, where we heard testimony from the head
of SEC and we also heard Dean Powers' Report. I then spent
hours yesterday with the head of Arthur Andersen and I want to
tell you by far and away this has been in terms of solving the
problem, that is, giving us help and guidance in what we should
do going forward, the most useful panel.
I also want to say that I strongly concur with Mr. Sokol
and Mr. Barton in contending that this is incredibly important.
I believe, indeed, the economy of the Nation and damage to the
economy of the world depends upon how this issue gets resolved.
If we do not have clear and understandable rules, if people
cannot rely on our markets as honest and fair, then we are in
serious trouble in a world economy. And so I do think this is--
Joe said he'd never seen a more important subject dealt with in
a more boring way. I do, in fact, think it's the most important
subject that I've heard while we've been here. I'm not certain
that it's the most boring way. I am convinced that it's the
most confusing way because you are all competing with each
other and giving different answers to the questions that we
have and I'm trying to get to some bottom lines and I don't
know if I'll have time to get to all of them.
First, some of the things in here are incredibly confusing
to me and Joe's simple analogy of the old economy and the new
economy, I'm really old economy, like Joe Barton, only instead
of $8,000 income and $8,500 outgo in my family, it's about
$8,000 income a month and $9,000 a month out. So my family and
I are struggling to get to where Joe and his family are.
Chairman Tauzin. You need one of those special purpose
entities.
Mr. Shadegg. Well, I'm going there. When I began my study
of this topic and read special purpose entities and then I
realized they were off balance sheet entities, as I said in my
opening statement, I thought well, gee, Shirley and I need to
create an off balance sheet entity. We'll put all our debt over
there, then we can qualify to buy to move to a much larger
mortgage to build the house we'd like to build. And really, my
initial reaction was why in the world should there be any off
balance entities? Why shouldn't all balance sheets be
completely consolidated. I've now come to the conclusion that
that's a too simplistic approach and that indeed there might be
circumstances under which you need a special purpose or off
balance sheet entity. But I am troubled by this. It seems to me
on the one hand if you don't set bright rules and you instead
use judgment which is the argument that I believe Dr. Dharan
you made for saying you shouldn't have a 3 percent rule,
obviously, too arbitrary; you need a judgmental rule about
control. The problem that I have with that is that when you
listened yesterday to the head of Arthur Andersen and you
realized that--and he made the same argument--we should use
judgment as to whether these really should be off balance
sheet. The problem is that the money involved, the amount of
money that the accounting firm gets to make this judgment call
of whether it's a bonafide or not a bonafide off balance sheet
entity, makes it I think, quite frankly impossible for those
individuals to be expected to make a fair call. So that gives
me serious trouble.
And then we get down into the next step of detail, let's
talk about FASB. FASB was involved in setting the 3 percent
rule and I think I completely agree with one thing here trying
to distill it. It seems to me that FASB is not, as I think
several of you have said, doing its job. It is not up to speed.
It is not performing its task quickly enough or aggressively
enough. Is there anybody here that disagrees with that?
Okay, good, we got a--Mr. Sokol?
Mr. Sokol. Congressman, just can I make a statement to
that? The accounting issues are complicated in some ways but
rather simple. The real issue is the misuse of accounting
principles to deceive investors and to deceive a balance sheet.
Mr. Shadegg. Okay, I agree with you there. There is misuse
and there is fraud and somebody ought to catch that and
somebody needs to supervise and we're going to get just a
minute to SEC's enforcement of the FASB rules, but I think I
just got agreement on everybody that the FASB rules aren't up
to speed, the 3 percent rule was ad hoc, it's out of date. I
think somebody mentioned that they're working on a
consolidation rule. I'm having real trouble with how anybody
can have any faith in this market if there isn't a clear set of
rules on what has to be consolidated on your financial
statement and what doesn't. And so again, I think FASB needs to
be kicked and moved forward and that seems to me that's one of
the things that comes out of this process and I assumed
everybody agreed.
Okay, second, Mr. Longstreth, you said SEC has enforcement
powers and I think it does have enforcement powers, but I think
everybody agrees that SEC is not aggressively enough enforcing,
using its enforcement power. That would certainly be your
position, would it not?
Mr. Longstreth. Yes, it is my position. Over the years,
they have not used those powers as effectively and as
aggressively as they should have.
Mr. Shadegg. So as a group, is there anybody on the panel
that disagrees with that and says no, SEC has been adequately
aggressive in its use of its enforcement powers? Nobody
disagrees with that.
One of the things I worry about and lose sleep over is that
we can--somebody said here already we screwed up a couple of
things in Congress by interfering in these things. We have no
direct control over FASB. The question is should we get
involved--should government take over FASB? I don't think so.
We have some control over SEC, but it is an independent entity
and we have some authority to help encouraging it to use its
oversight power. But I am most intrigued, Mr. Chanos, by the
point you made and that is in all of time or maybe you just
said in the last 10 years, you don't know of a single instance
where an inside auditor or any regulatory entity discovered at
the initial stage fraud or one of these problems and you said
it's always been discovered by either the press or short
sellers. And I'm fascinated by that because that basically says
look, the market is the answer here and the market will solve
these problems and I see that happening. I mean the sell-down
that occurred the day before yesterday shows a little bit of
that right now. And I guess I'd like you to expand on how we
can use that, not to create more regulation, but is there some
way that we can rely on short sellers? Is there--should the SEC
have a rule that says if there's a certain level of short
selling that should trigger an investigation? How do we take
advantage of the market scrutiny that short sellers are
performing to catch this kind of problem?
Chairman Tauzin. The gentleman's time is expiring, but
please answer the question.
Mr. Chanos. I'm not so sure how you would do that. I made
the point that Wall Street analysts and accountants were not
the--I can't find any instance where they were uncovering these
things. I don't know. It's--I think that the free market does
work. I'm a free market person myself. I think that there was
an editorial in the Journal today, Wall Street Journal today
about short selling in the free market, that I would commend
you all to read. I think it does provide an admirable function,
watchdog in its own free market way by pointing these kinds of
things out, but having said that, I think that I'm also in
favor of full and free disclosure so that any investor not just
people with our resources and expertise can go in and look at
the financial statements and make informed decisions and I just
feel that we're still falling short there.
Mr. Shadegg. Well, we're clearly falling short there and I
completely agree and I think consolidation of balance sheets is
a huge part of that. I think abuse of special purpose entities
is a huge part of that.
Mr. Chairman, I don't have any other questions, but
everybody else took a great deal of time. I do have one request
of each of you. As I said, I think in terms of what we do as a
Congress going forward and how not to overregulate, but how to
try to solve some of these problems is extremely important.
I'd like to make a request of you. I'd like each of you to
submit to me and to the committee a list of the three or four
specific things you believe Congress should do in response to
what has occurred here and the one or two things you think
Congress absolutely should not do. For example, everybody I
think on this topic so far has said well, we ought to separate
auditing and consulting. And yet here today I heard some
intelligent discussion of how doing that arbitrarily may not be
a prudent idea. So if you could just each take the time to give
us three or four suggestions of what you think we ought to do
and one or two suggestions if you have them of what we
absolutely should not do, would cause a problem, I would
greatly appreciate it.
Chairman Tauzin. And I'm particularly interested when you
do that, Dr. Lev, that you identify for us your projection,
your forward looking statements on consequences, if you will,
if you could do that.
Mr. Shadegg. Thank you, Mr. Chairman.
Chairman Tauzin. If you want to make some comments----
Mr. Sokol. Congressman, if I could make a comment about the
notion that no internal auditors and no internal managements
have ever uncovered fraud within their company and turned them
forward other than the press and short sellers. That's
nonsense. I think that's an offense to the best capitalist
system in America. In our own company last year, we found an
accounts payable person in a title business, had embezzled $1.7
million and it was found internally, it was dealt with. She's
being prosecuted and a good portion of the money has been
recovered. That goes on every day. The internal audit function
of a corporation is essential and to say that it has never
functioned properly is wrong.
Enron is a graphic example of the misuse of the system and
I think there again people need to be punished, but it would be
imprudent for me to sit here and say that there's no function
for an internal audit organization----
Mr. Shadegg. Well, by no means did I intend to imply nor do
I think that Mr. Chanos said there's no----
Mr. Chanos. That's not what I said. My statement said that
there hasn't been one major financial fraud in the United
States in the last 10 years that was uncovered by a major
brokerage house analyst or an outside accounting firm.
Chairman Tauzin. I've got to move on, but I should tell you
all that in our investigation we discovered that Arthur
Andersen did discover problems and unfortunately perhaps didn't
report it, timely or properly, but they did uncover the fact
that the first Chewco had not been capitalized correctly and
therefore they had to restate the earnings. I think this came
from the accounting firm at some point.
Mr. Shadegg. My only point was as a foundation I think
short sellers are something we ought to also be looking to.
Chairman Tauzin. I thank the gentleman. The Chair
recognizes the gentleman from Florida, Mr. Deutsch. While I do
that, I want you all to know that the Subcommittee on Oversight
and Investigations meets tomorrow with all the principals at
Enron invited, some of whom will take the fifth, some of whom
will testify and Jim Greenwood, the chairman of that
subcommittee, and his ranking member, Mr. Deutsch, have done a
fabulous job of bringing these facts to the attention of the
committee and I wanted to commend him for his excellent work
with Mr. Greenwood.
Mr. Deutsch?
Mr. Deutsch. Thank you, Mr. Chairman, and again, I
apologize for not being here the entire day, but having sat
through an entire day yesterday I'm looking forward an entire
day tomorrow. My staff has been here and I've read some of the
testimony. I want to focus on two very specific questions and
just in a general way, this is an issue, this is my twentieth
year as an elected official, my tenth year in Congress. As a
policy issue, I have been sort of fascinated in many ways, but
one is just the public's just absolute fascination, intense
interest in this and that's one of the reasons why we're driven
to some extent by not just issues, but really what our
constituents want us to look at. I think part of that is in the
real world people just see this as an incredible injustice
what's occurred and that really at the end of the day we don't
know how many, but probably thousands of people who lost their
retirement savings and are in terrible situations and people
can relate to that. I guess what I want to specifically focus
in on is that in the accounting profession, my understanding is
that when the accountant signs off on the audit, they say that
it fairly represents what is going on in the company. That's my
understanding what they're actually signing. And I think by
anyone's normal definition, that that was not, the books did
not fairly represent what was going on in Enron. And I'm not
convinced at this point that that Andersen violated the law or
violated accounting rules in terms of what they did, but I
think what they did by any normal definition is that it did not
fairly represent what was going on.
And I guess what I'd like to focus on is maybe there's
another way of looking at that. If, in fact, audits fairly
represented what was going on, then Enron wouldn't have
happened and obviously our concern is how many other Enrons are
there out there because if people are living on the edge and
gaming the system as obviously occurred here, I mean if you
can, if any of you could try to elaborate on that, that in the
existing rules, it should not have happened by normal
definitions, but obviously it did.
Dr. Chanos, you're nodding, so I welcome your comments.
Mr. Dharan. I could probably spend a second on that. The
existing rules do a fairly good job insofar as some problem
areas that I have pointed out earlier such as the extensive use
of mark-to-market accounting for items that really should not
have been applied to, and also the use of special purpose
entities.
Mr. Deutsch. I guess what I'm saying though that general
statement of fairly represent, that is something that Andersen
signed. They said that it fairly represents and how by any
normal definition it obviously didn't.
Mr. Dharan. I agree. I think they said two things and
typically this has been argued in courts quite a bit and again,
I'm not a lawyer, but there are two phrases that auditors use.
One is ``fairly.'' And then very next couple of words later
they say ``in conformity with generally accepted accounting
principles.''
Mr. Deutsch. Right.
Mr. Dharan. And surprisingly, Congressman, there is no in
between clause like ``and'' or ``or'' or ``except for'' so when
they say ``fairly'' and ``in conformity with generally accepted
accounting principles'' there's no real ``and'' there. So they
hang on to that accepted accounting principles. The investor,
the public, you are absolutely right, should be looking at the
word ``fairly'' in a different way, but I don't think my
understanding is that's not the way the courts look at it.
Mr. Deutsch. I guess what I'm struggling with is that's
really what the expectation is. That's what the system working
is that there's transparency, that it is fair. And obviously,
the big concern, the big policy issue that we're looking at is
if we lose investor confidence, the system that exists which is
by far the greatest economic system ever created and brings us
such positive things as a society, is challenged. It is being
challenged today and we're challenging it. That is really what
we're trying to get. And I don't know--I mean our job is to
legislate and try to figure out how to get to that point, but
it goes back to that's what people want. They want that
transparency. The accounting firms are saying that it fairly
represents and yet, it's not occurring.
Did anyone else want to comment I mean just about that?
Mr. Lev. I can make a comment on that. I mentioned it
before in my testimony. This report I have here an example of
the uniform report. It's filled with hedging. It starts by
saying ``this financial statement is the responsibility of
management'', hedging No. 1. Hedging No. 2, ``we conducted our
audits in accordance with auditing standards generally accepted
in the United States'' which means someone else directed us to
do what we do. And third one is what Professor Dharan
mentioned, ``represents fairly in conformity with accounting
principles generally accepted in the United States.'' This, in
my opinion, is not an informative report and it definitely has
to be replaced by an open ended report which will provide
information, which auditors will tell you what they found, what
they didn't find, what's their opinion on their internal
controls in the company, what's their opinion on the corporate
governance. Questions, something very important, questions that
they put to management and were not answered; suggestions that
they made that were not implemented. This has to go out. And
then people will have some degree of comfort that you
Congressmen are looking for.
Mr. Deutsch. In terms of suggestions, so obviously that
changes dramatically the way the public accounting system is
set up today?
Mr. Lev. Yes.
Mr. Deutsch. Is that specifically, I mean recommendations
that you will be providing us or that we're looking at at this
point? I mean----
Mr. Lev. I already provided it. I wrote about it and I
strongly believe in this. This is not a statement that is worth
much.
Mr. Deutsch. The one final question that I wanted to at
least offer the opportunity for you is again this sort of
common sense uses and it's on the security side in terms of
fraud. I mean as we--in the hindsight that we have now, I mean
we look at what Enron did, I mean at so many different levels,
that by any common usage would be fraud. And again, it
ultimately might be determined either through prosecution,
through SEC work, of actual criminal fraud.
But I guess the question is and I'm reminded, the thing
that I keep coming back to personally, as I'm looking at what
happened with Enron is a scene in the Godfather movie where the
attorney, Tom Hanks, comes to the Godfather and the Godfather
says to him I want you to always remember you can steal a lot
more with a briefcase than a gun. And when I look at this whole
episode of Enron, I mean we can add up how much they stole, but
it looks like they stole maybe as much as $4 billion, I mean
which is an incredible amount of money and obviously, I can't
think of a violent crime with a gun where anyone could conceive
of stealing that much money. And it was at that level in terms
of what they were doing day by day. And that, a very creative,
very, very bright people, but really almost evil people because
every dollar they were stealing, they were stealing from
someone else. It wasn't a value added business. We've gone
through enough stuff at this point that it really was not
value--I mean there's lots of people in America, thank God, who
have made billions of dollars, who have come up with some great
ideas and some investors or maybe even some shortsellers who
have been able to figure out the market through work of their
own, but in this case, I think we know enough now that
basically the money was stolen from other people Go ahead.
Mr. Raber. It's interesting and talking to some of our
directors who are reacting to Enron, there's an consensus that
many times throughout their life as a corporate director
something didn't smell right, something bothered them. And
we're starting to see more and I don't know enough about Enron
to know what happened, but I suspect that those board meetings
and committee meetings there were some board members who felt
something is wrong here. Now what's happening insofar as
corporate directors, they're going to be a lot more aggressive
in asking questions. And I also see, to go back to your comment
about audit committees. Audit committees want more than just a
testing, that this has been done appropriately, this particular
audit. They want it raised to quality and independence. As a
result of that, we're trying to provide guidance to them about
red flags, questions to ask and I have to say that's the
courage and integrity I talked about in my testimony is that
were there times during Enron board meetings and audit
committee meetings there was a sense that something was wrong
here. And go back to some of the fraudulent areas, we know that
outside board members, if they sense something is wrong, that's
where they refer to a special committee. Let's take it the next
step. It doesn't mean that there is something fraudulent, but
when something like that starts bothering you, even though you
may not have a sophistication in financial areas, you should
have enough to know this does not ring right.
Chairman Tauzin. The gentleman's time has expired. And I
might point out that we'll have tomorrow at our O&I hearing,
individuals who worked for Enron who did smell something wrong
and tried to do something about it. Stay tuned.
The gentleman, Mr. Shimkus, is recognized, for 5 minutes.
Mr. Shimkus. Thank you, Mr. Chairman, and I appreciate you
putting in a long day. Obviously, we are all very disheartened
and frustrated, but I want to talk about--I only have one
question and it kind of refers to the man on the street, the
individual who given clear and concise information can then
make decisions and be held accountable for the success of those
decisions or the failure of those decisions. When it's
disassociated through false information that's what's brought
us here today. Folks are--they had made the personal decision
of putting money in a gold mine, then they would say oh, I made
a stupid decision, but someone was managing this for them.
So I have a question for the folks who are addressing
questions on the accounting issues, Mr. Weil, Mr. Dharan and
Mr. Lev and Mr. Longstreth. And it deals with this whole issue
of pro forma disclosures and are they really useful? Are they
abused? I mean we understand spin here in Washington. The
question is are pro forma statements used more for spin or are
they used, or are they really an important accounting vehicle
to let the individual consumer know what's going on and then if
you would just try to answer that and give me your--and then if
anyone else wants to jump in, but that's how I'm going to use
my time----
Chairman Tauzin. Would the gentleman yield?
Mr. Shimkus. Yes.
Chairman Tauzin. The gentleman is talking about the
statement by Enron, for example, that the billion dollars was a
nonrecurring problem, was that spin, did that help anybody?
What's the story on that?
Mr. Weil. Let me work on this and it dovetails with the
previous gentleman's questions. We used to have a free market
in accounting. There were no regulations. Companies went out
voluntarily and hired accountants to do a report and we got
pro's statements of what was going on which is what Professor
Lev would like to see us have now. I don't see how to legislate
people using judgment. You invite them to do it.
Pro forma earnings have that characteristic. They're not
governed, they're not regulated. Some people find them useful.
Some think they're silly. My colleague professors who studied
these things scientifically are not persuaded of the
information merit therein, but I don't see that they do any
harm because you're alert of what it is. It's the company spin.
I think you've got the right adjective and I don't see anything
wrong with it. People get to do what they want to do and the
analysts get to decide what makes sense.
Mr. Shimkus. Just go down the table then, Mr. Dharan?
Mr. Dharan. I happen to disagree with that entirely,
unfortunately. I think the problem with pro forma earnings is
that we have a whole system we are trying to fix here which is
the generally accepted accounting principles. We want companies
to be able to properly calculate earnings and report it and we
want investors to be able to understand it, but as soon as we
allow companies to report in addition to their pro forma
earnings, the entire focus shifts to pro forma. So the entire,
the effort that we are all trying to do to strengthen the
system is completely taken away. It gets diluted. And there's
no reason to talk about lack of regulation for pro forma
earnings because these earnings releases should be looked at by
auditors, should be looked at by lawyers. These are numbers
that are being communicated to investors and they should be
regulated just like 10(k)s and 10(q)s because in the old days
you got the 10(q) in the mail and you read it and you decided.
Today, you look at the press release, you look at the internet
and the analysts look at it, the market reacts instantly. And
if you don't regulate this, we are simply ignoring the reality
that information is going out through these numbers more than
the 10(q)s.
Mr. Shimkus. Mr. Lev?
Mr. Lev. I don't have very strong feelings about pro forma.
I tend to agree with Roman Weil that I definitely don't think
they should be banned. As long as you get earnings or some kind
of regulated earnings, I don't' see any problem when managers
are saying that they think that there is another measure which
reflects better. They don't believe them. They don't look at
this measure. They don't use this measure. I don't think this
is a major problem here.
Mr. Longstreth. I think it's a problem of you can lead a
horse to water, but you can't make him drink. The earnings,
according to GAAP are filed by the corporations. They're
available to the analysts. The analysts call in the first call
or IBIS and give their estimates. The problem is that the
analysts have not bothered to look much at the earnings
according to GAAP. They prefer to take the advice from
management of what operating profits are going to be with very
substantial freedom on the part of management to define that
the way they want to define it. Then they pass it on to first
call and it gets cooked into the system and everyone says well,
the companies--the S&P 500 is going to grow at a certain rate.
The Wall Street Journal did kind of an expose comparing the P/E
ratios based on earnings as reported according to GAAP compared
to operating profits that were reported and cooked into the
first call estimates and it was a spread of something like 23
times earnings for the--on the basis of the operating profits
and about 40 times earnings on the basis of the filed earnings.
So I don't know, I think the private sector has got to get a
little more realistic in using the data. I don't think there's
anything to do there with rulemaking.
Mr. Shimkus. And Mr. Chairman, I yield back my time, thank
you very much.
Chairman Tauzin. I thank the gentleman. The Chair
recognizes the gentleman from Texas, Mr. Green, for a round of
questions.
We're coming to the end of this long afternoon and evening
and I want to thank you again for your patience, gentlemen.
Mr. Green.
Mr. Green. Dr. Weil, and frankly for everyone who has
experience in accounting, I've reviewed your testimony and I
have a question that's come up. Are you conceptually familiar
with the practice used by some law firms in our country to shop
around opinions, for example, that they find new loopholes or
what they think are loopholes in the tax law and that allows
companies to lessen their tax burden so they'll shop that
opinion around?
Is that something you're familiar with?
Mr. Weil. We have a phrase, ``opinion shopping'' in
accounting, but the SEC went after that a decade or two ago and
it's a lot less problem than you might think because if you go
opinion shopping and decide to get rid of this auditor and pick
that one, you've got to send a letter explaining why you fired
the first one.
Mr. Green. Well, let me--I've met with a former Arthur
Andersen employee who worked in the Houston office and he told
me that Andersen had a similar practice, they pitched for new
business development. I was told that the Houston office of
Arthur Andersen had something called the book of ideas and this
book was described as containing accounting suggestions that
while technically in compliance with Financial Accounting
Standards Board, was actually a manual for aggressive
accounting and like my other colleague from Texas I was a
business major and I think I took 12 or 18 hours in accounting
as an undergraduate. But I was wondering if this is a type of
material commonly compiled by our Big Five accounting firms to
encourage aggressive accounting?
Mr. Weil. I don't know and it would be dangerous to
speculate about that one.
Mr. Green. Someone never has heard of something similar
that maybe a firm, and again, I had up until Enron, I had
probably the highest respect for Arthur Andersen.
Mr. Dharan. I have never heard of this before, but it does
sound like it is pushing aggressive accounting in some way, if
it is true.
Mr. Green. Mr. Chairman, this information wasn't available
when our subcommittee had the Arthur Andersen folks, but I
would sure like to subpoena their records or maybe we can make
that available, that former staff member to our committee.
Chairman Tauzin. If the gentleman will yield. Will you make
the information available to our investigators and we'll chase
it down for you, obviously, we are going to have, as you know,
a FASB hearing and it might be appropriate to have that
information available for that hearing.
Mr. Green. Okay, thank you, Mr. Chairman. Mr. Chairman, I
have no other questions. It's been a long day for our witnesses
and I thank them for their time.
Chairman Tauzin. I thank the gentleman and for the last
round of questions, I'm pleased to recognize my friend from
Nebraska, Mr. Terry.
Mr. Terry. Thank you. You should be glad to know we go by
order of seniority and I have the least which means I'm the
last.
Mr. Sokol, you haven't participated much, mostly because
you offer an expertise in energy market and business practices,
but you stated something in your testimony that has gnawed at
me, even before you came here today. You said that Enron trades
25 percent of the natural gas, but yet you testified there were
no effects on the market, including especially to consumers.
Why? What went right in the market specifically that protected
the market, protected the consumers. You would think that an
entity that controls 25 percent of the trading market of
natural gas that there would be catastrophic effects. Certainly
we heard news reports that Kenneth Lay was projecting that
there would be catastrophic effects if someone didn't ride to
the rescue.
Mr. Sokol. Well, first, Congressman, both natural gas and
electricity was estimated at about 25 percent market share in
Enron's trading activities. I think the important point first
is that they didn't control it. They traded it. They did not
control the flow. They controlled the trading or they were
participants in that amount of trading.
What really occurred and what has shown itself to be,
frankly, I think surprising to all of us is the incredible
depth of the energy trading markets. Basically, within a 24-
hour period when it was pretty clear that Enron on-line was
going to be going off-line, the rest of the marketplace picked
up all those trades. What it really tells and actually it's
probably a point that Mr. Chanos would recognize as well, that
Enron really wasn't making very much money in those trades
because if they were, there would have been a significant
dislocation for at least a short period of time as all those
trades shifted to other people that wouldn't make them. The
reality was many of us believe they were kind of a trader of
last resort almost, just to have the volume because literally
when you're talking about billions of dollars of trading and
the market doesn't move a fraction of a percent when the
largest trader goes under, that can't happen if they're a large
market maker and so it's--I think it is a tribute to the depth
of the wholesale trading markets that are out there and
frankly, I don't think we're likely to see anyone else even
approach that level of involvement in the market now because
it's recognized that it's not necessary.
Mr. Terry. Interesting. One other aspect that you touched
on, but not as much as I expected, is PUHCA. One of the issues
that I want to ask you about today is one I've heard about from
some of my colleagues, especially, that Enron's failure
symbolizes why we shouldn't move forward with deregulation.
Within that deregulation genre, I've heard specifically PUHCA
and frankly, I don't understand any connection here to PUHCA in
Enron's failure. I want you to expand on whether you feel that
there's a connection. And second, there have also been
accusations that Enron has received exemptions from PUHCA and
other regulatory requirements that have led to its demise.
Do you have an opinion on whether or not there's a causal
link?
Mr. Sokol. I have a tough time staying in your timeframe.
First, in the testimony I think I do hit those points, but
there really is no relation to PUHCA. In fact, I would make two
points to the chairman about what you're doing here. One is
that energy modernization regulation has to continue forward.
The Senate is moving forward, hopefully House 3406 will move
forward because the Enron problem cannot stop us from crossing
the street. We're about halfway across it from 1992 when the
wholesale markets were opened and we need to modernize the
regulation for natural gas and electricity. That needs to
proceed.
What you're doing in regard to Enron is hugely important,
but I think important that these gentleman are making. There is
no simple fix to what happened to Enron. Enron, to me, taking
into account the criminality is the culmination of the excesses
of the 1990's. Now again, with criminality. It's not to say by
any means even a significant portion of corporations are doing
what they were doing. But it does, I think, cause all of us
including Congress to take pause and say can we do better?
These gentlemen who have much more expertise, obviously, in the
accounting side have numerous ideas. I mean proportional
accounting. Why should executives be allowed to sell stock and
report it 30 days later? Compensation accounting for options.
There are serious abuses out there and they need to be fixed,
but there's no single answer and I think holding hearings,
asking expert testimony and ideas is the only way you get to
fix the problems and move forward, but we would certainly urge
you in the energy industry not to slow down with energy
regulation modification because it's essential to keep that
part of our economy moving forward.
Mr. Terry. Thank you. That's all, Mr. Chairman.
Chairman Tauzin. If the gentleman, Mr. Terry, will yield?
Mr. Terry. Yes, I yield.
Chairman Tauzin. I think it's important to point out that
the work that has been done by the subcommittee by Mr. Joe
Barton's subcommittee on the energy markets, particularly the
work he's done in helping to ensure transmission facilities are
adequate and that there's adequate supplies in the marketplace
for it to function is going to go on and what's interesting
about the product he's got is that it doesn't contain the Enron
recommendations. It's very different from what Enron asked for
and wanted, but it is essential, Mr. Sokol, that you were here
today and it's essential that Joe have this hearing this week,
that we can literally elaborate on the Enron effect on those
markets. Get a clear picture of them so that Mr. Barton's
subcommittee has that as a background to its work, as it
continues its work toward making sure those markets are sound
and we don't have California-like problems in the rest of the
country. We're not going to stop that work. We simply want to
make sure with this Enron situation that they're not at loose
ends that need to be covered in that legislation as well.
I thank the gentleman for yielding. The gentleman is
complete, then I thank the gentleman for his time.
Let me conclude, first of all, just you and I, let me make
the point that 4 years ago if you had told me that we could
have 40 members of my committee attend so serious a session to
listen to a bunch of accounting professors talk to them about
these esoteric kinds of issues and that four cameras would be
here to cover this, I would have laughed. In fact, years ago,
several years ago when we talked about having public hearings
on the issue of separating the auditing functions and
accounting functions and there was not any takers, nobody was
willing to come to those public hearings and debate them and
discuss them.
The Enron situation has caused us all now to take this much
more seriously and to take your advice seriously. The record
will stay open for 30 days. Several members have indicated
they'd like you to respond in writing to some specific requests
for information. I have raised the question. I have not gotten
an answer to yet and I would love for you to respond to it.
That specific question is whether or not if we go to general
principles as opposed to specific rules do you have a problem
with two different accounting firms interpreting them so
differently that it causes friction and confusion rather than
clarity for American investors? I'd love you to think about
that and come back to us with some description.
Most importantly, when you do write recommendations to us,
1, 2, 3, 4 things we ought to do legislatively which is where
we're going to try to get to as rapidly as we can, I'm most
interested in you thinking through the unintended consequences
of changes we make. One of the things I have cautioned the
subcommittees who will be working on these issues is that if we
make too drastic a change in the way in which this is reported
and the way in which accountants have to classify income and
debt and the way companies have to report them, that we might
have some unintended consequences of making it appear as though
companies who have legitimately used devices like special
purpose entities and other alliances and partnerships, we may
make them look like they were doing something wrong when they
were not and therefore undermine integrity and confidence in
the marketplace. Those are serious kinds of concerns for me. I
hope you will think about those, give us some advice, for
example, as to transition, moving from this current way in
which we interpret an audit report, what's included in it. How
do we transition into a different kind of system? How do we
move from that forum, Professor Lev, you said is worthless to
one that's much more worthy of informing people and do it in a
fashion that doesn't shake the world of investment in the
meantime. Those are serious concerns I have for our committee
as we move forward. You have been extraordinarily patient. I
thank you for that. This has been, believe it or not an
extraordinarily interesting session for me and I know for many
members and I thank you for that.
The hearing stands adjourned.
[Whereupon, at 6:28 p.m., the committee was adjourned.]
[Additional material submitted for the record follows:]
U.S. House of Representatives
Committee on Energy and Commerce
February 19, 2002
Mr. Baruch Lev
Philips Bardes Professor of Accounting and Finance
Vincent C. Ross Institute of Accounting Research
Stern School of Business, NYU
40 West Fourth Street, Suite 312, Tisch Hall
New York, NY 10012
Dear Mr. Lev: Thank you for appearing before the Committee on
Energy and Commerce to present testimony on Accounting Issues.
Congressional hearings are used to build a record to assist with
the Committee's legislative initiatives. I would greatly appreciate the
benefit of your expertise in responding to some follow-up questions
surrounding issues raised at the hearing. So that your answers may be
included in the hearing record, please respond in writing to the
attached questions by March 4, 2002.
1. Your testimony regarding corporate disclosure points out that
the system only reflects past transactions. The Chairman of the SEC,
Mr. Pitt, recently spoke about supplementing disclosure with ``current
disclosure'' of significant information as it arises? Please comment on
the Chairman's proposal.
2. You testified that the reporting of unexecuted obligations is
deficient. What are the reasons for the deficiency in disclosure and
how would you remedy the deficiency?
3. You stated that our current system of accounting is geared for
an industrial era based economy of tangible assets and that it largely
ignores or misrepresents the value of intangible assets. Please discuss
the consequences of the current system and recommendations for
improvements.
4. You testified that the current disclosure of specific risk
exposure is insufficient. How would more accurate information or
disclosure benefit investors? How do you balance necessary disclosure
with a company's desire to keep secret its stragetic information?
5. The number of earnings restatements each year is in the
hundreds. Is this a recent phenomenon? Why is it occurring and what can
be done to curb errors that cause restatements?
6. You suggest mandatory auditor rotations every five years. What
are the costs and benefits of such a system? Please compare them to the
costs and benefits of the current system.
7. You suggest restricting audit firms to performing consulting on
a limited basis--25-30% of audit fees. Do you believe it is necessary
to limit the consulting to specific types of services? If so, which
services should definitely be excluded? Which should definitely be
included?
8. Under a regime that forecloses an auditor from performing
consulting work for an audit client, will there be perverse incentives
for the auditing firm to provide a poor opinion of the consulting
firm's work in the hope of replacing its own auditing contract with the
client's more lucrative consulting contract?
Sincerely,
W.J. ``Billy'' Tauzin
Chairman
New York University
Leonard N. Stern School of Business
March 4, 2002
Representative W.J. ``Billy'' Tauzin, Chairman
Committee on Energy and Commerce
U.S. House of Representatives
Washington, D.C. 20515-6115
Re: Response to your questions (from February 20, 2002), concerning my
testimony before your committee (February 6, 2002).
Dear Chairman Tauzin: The order of my answers follows your
questions.
1. Concerning SEC Chairman Pitt's comments about ``current
disclosures.'' In general, the more current and timely the disclosure
to capital markets, the more efficient and fair will these markets be.
So, I definitely encourage quick and unbiased (e.g., not only good
news) disclosure of business events.
This, however, differs from my testimony about a major limitation
of the accounting and financial reporting systems--the reflection of
past transactions only (with few exceptions). Thus, for example,
``unexecuted obligations,'' such as loss guarantees to special purpose
entities, or provisions for future availability of raw materials and
other inputs (known as ``take-or-pay contracts,'' or ``throughput
arrangements''), create obligations which are not reflected as
liabilities in the financial reports. (Unexecuted obligations arise
from agreements related to future transactions).
In my testimony, I strongly urged accounting standard-setters (SEC,
FASB) to expand the scope of financial reports to include most
unexecuted obligations. This can be done effectively and expeditiously
in my opinion.
2. Response include in (1), above.
3. The issue of intangible (intellectual) assets, which are by and
large not reflected in financial reports, is broad and obviously beyond
the confines of this response. It is, however, thoroughly presented and
analyzed in my recent book--Intangibles: Management, Measurement, and
Reporting (Brookings Institution Press, 2001).
For the record I will note that various estimates indicate that
intangible assets (e.g., discoveries, patents, brands, unique
organizational designs and processes, etc.) currently constitute 60-75
percent of corporate value, on average.
The socially harmful consequences of the failure to account
properly for those assets (which are mostly expensed immediately by the
accounting system), and disclose their attributes are numerous and very
consequential. They include: using intangibles (e.g., in-process R&D)
for widespread manipulation of financial information, excessive gains
to corporate insiders from trading the stock of their companies, high
volatility of stock prices, and not the least--excessive cost of
capital to intangibles-intensive companies, hindering innovation and
growth. (Elaboration on these social harms can be found in my book,
referenced in (1), above, Chapter 4.)
The accounting and financial reporting systems can, and should be
significantly modified--for example GAAP rules for asset recognition--
to reflect vital information about investments in intangible assets and
their consequences. At the minimum, corporations should be required to
routinely disclose information on their investment in key intangibles--
brands, human resources, information technology, major business
processes, and breakdown of R&D--and the consequences of such
investments. Investors should be able to assess the desirability and
productivity of such investments.
4. Concerning risk exposure. The SEC required in the early 1990s
some disclosure by corporations of risk exposure. This was a step in
the right direction, but a very modest step which was not pursued
vigorously.
A system of ``stress tests'' should be developed, to reflect the
consequences of foreseeable events on the company's operations and
economic condition. Thus, for example, a globalized corporation exposed
to foreign exchange fluctuations of the Euro or the Yen (relative to
the U.S. dollar), should be required to provide information on the
consequences of expected changes in the value of these currencies. For
example, the consequences of changes of plus/minus 2%, 5%, 10%,
relative to the exchange rates at the end of the year. Similarly, a
company exposed to interest rate fluctuations, should report the
results of ``stress tests,'' reflecting the consequences (gains/losses,
changes in assets/liabilities) of expected changes in interest rates of
0.25,0.5,1.0 percents.
Similar risk-related information is currently requires from
financial institutions. I favor expansion of such requirements to
include non-financial enterprises.
Concerning your questions about secrecy of strategic information, I
sincerely doubt that results of stress tests will harm the competitive
position of the corporation. To the contrary, I believe that a
requirement to publicly report risk exposure will focus the attention
of mangers and board members on a vital aspect of operations (i.e.,
risk) currently neglected in many corporations, as a result of the
failure of the accounting system to reflect risk.
5. You are perfectly right that the number of earnings restatements
has mushroomed in recent years. New York University Ph.D. candidate,
Ms. Min Wu, documented a sharp increase in restatements during 1998-
2001 (see attached graph from her dissertation).
The major reasons for the increase in restatements in the late
1990s are: the rise in uncertainty/volatility of the business
environment in the late 199s, and the pressure from Wall Street to meet
or beat the earnings forecast of financial analysts (the ``earnings
game''). These reasons led many executives to ``manage'' their volatile
earnings toward meeting the forecasts. Ultimately, however, reality
catches up with such managers, leading to restatements, and in extreme
cases to bankruptcies.
Restatements of earnings are just a symptom of the futile but
pervasive ``earnings game'' played by managers and analysts to the
detriment of investors and the economy. Fundamentally, the earnings
game, with its focus on short-term profits and a superficial concept of
companies' operations (undue focus on accounting earnings), should
stop. This is not an easy task, but expansion of the disclosure of
relevant information--a central theme of my testimony--should lessen
the adverse impact of the earnings game.
6. Regarding auditors' rotation. I suggest not only a rotation of
auditors, but mainly their selection and reappointment by shareholders
every five years. (See my testimony). If shareholders are satisfied
with the performance of auditors, they will reappoint them. So,
auditors will not necessarily be changed every five years. What will
happen every five years is a serious examination of auditors'
performance, and an opportunity for competitor auditors to publicly bid
for the audit engagement.
While I have no reliable cost estimates for the proposed system, I
doubt whether it will result in a significant cost increase. I am
familiar with the argument that there are some ``learning'' advantages
from repeating the audit over several years, but I am not familiar with
any estimates of the magnitude (cost savings) of such learning. The
benefits of my proposal in increased auditor diligence, knowing that
their performance will be seriously evaluated every few years, and in
the occasional dismissal of negligent auditors, will in my opinion far
outweigh the additional costs, if any.
7. Regarding consulting activities. I believe that if revenues from
non-audit activities will be limited to a reasonable fraction of audit
fees (I suggest 25-30 percent), then there will be no need to specify
which services should be excluded--a difficult task at best.
8. You ask: ``. . . will there be perverse incentives for the
auditing firm to provide a poor opinion of the consulting firm's work .
. . ?'' I doubt it. In general, auditors don't opine on managerial
issues (e.g., effectiveness of operations, quality of the product,
etc.), only on the faithful representation of financial reports. Most
consulting engagements, in contrast, deal with management issues (e.g.,
improving information technology, streamlining human resource
practices, etc.). Accordingly, I don't see a significant opportunity
for auditors to criticize consulting engagements by other firms.
Concluding Comment
The above responses are by necessity brief and hopefully concise. I
will be happy to elaborate, in person, on any issue of concern to your
legislative activities (within my range of expertise, of course).
My best wishes,
Baruch Lev
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