[Senate Hearing 107-376]
[From the U.S. Government Printing Office]

                                                        S. Hrg. 107-376


                               before the

                              COMMITTEE ON
                          GOVERNMENTAL AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED SEVENTH CONGRESS

                             SECOND SESSION


                            JANUARY 24, 2002


      Printed for the use of the Committee on Governmental Affairs

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               JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan                 FRED THOMPSON, Tennessee
DANIEL K. AKAKA, Hawaii              TED STEVENS, Alaska
RICHARD J. DURBIN, Illinois          SUSAN M. COLLINS, Maine
MAX CLELAND, Georgia                 PETE V. DOMENICI, New Mexico
THOMAS R. CARPER, Delaware           THAD COCHRAN, Mississippi
JEAN CARNAHAN, Missouri              ROBERT F. BENNETT, Utah
MARK DAYTON, Minnesota               JIM BUNNING, Kentucky
           Joyce A. Rechtschaffen, Staff Director and Counsel
                     Cynthia Gooen Lesser, Counsel
               David M. Berick, Professional Staff Member
         Hannah S. Sistare, Minority Staff Director and Counsel
           William M. Outhier, Minority Investigative Counsel
                     Darla D. Cassell, Chief Clerk

                            C O N T E N T S

Opening statement:
    Senator Lieberman............................................     1
    Senator Thompson.............................................     4
    Senator Levin................................................     6
    Senator Collins..............................................     9
    Senator Durbin...............................................    11
    Senator Cochran..............................................    12
    Senator Torricelli...........................................    12
    Senator Voinovich............................................    14
    Senator Cleland..............................................    16
    Senator Bennett..............................................    18
    Senator Carper...............................................    19
    Senator Bunning..............................................    20
    Senator Carnahan.............................................    21
    Senator Dayton...............................................    23

                       Thursday, January 24, 2002

Hon. Arthur Levitt, Jr., former Chairman, U.S. Securities and 
  Exchange Commission............................................    26
Lynn E. Turner, former Chief Accountant, U.S. Securities and 
  Exchange Commission............................................    29
Bruce B. Henning, Director, Regulatory and Market Analysis, 
  Energy and Environmental Analysis, Inc.........................    54
John H. Langbein, Sterling Professor of Law and Legal History, 
  Yale Law School................................................    56
Frank Partnoy, Professor of Law, University of San Diego School 
  of Law.........................................................    58

                     Alphabetical List of Witnesses

Henning, Bruce B.:
    Testimony....................................................    54
    Prepared statement with attachments..........................    84
Langbein, John H.:
    Testimony....................................................    56
    Prepared statement...........................................    93
Levitt, Hon. Arthur Jr.:
    Testimony....................................................    26
    Prepared statement...........................................    75
Partnoy, Frank:
    Testimony....................................................    58
    Prepared statement...........................................   103
Turner, Lynn E.:
    Testimony....................................................    29
    Prepared statement with an attachment........................    78


Chart entitled ``Market Losses to Investors After Corporate 
  Restatements'' (submitted by Senator Torricelli)...............   135
Chart entitled ``Corporate Restatements Have Increased 
  Dramatically in the Last Three Years'' (submitted by Senator 
  Torricelli)....................................................   136
Chart entitled ``Corporate Overstatements in the Past Decade'' 
  (submitted by Senator Torricelli)..............................   137

Questions for the Record with responses from:
    Mr. Levitt...................................................   138
    Mr. Langbein.................................................   142
    Mr. Partnoy..................................................   150



                       THURSDAY, JANUARY 24, 2002

                                       U.S. Senate,
                         Committee on Governmental Affairs,
                                                    Washington, DC.
    The Committee met, pursuant to notice, at 10:07 a.m., in 
room SH-216, Hart Senate Office Building, Hon. Joseph I. 
Lieberman, Chairman of the Committee, presiding.
    Present: Senators Lieberman, Thompson, Levin, Collins, 
Durbin, Cochran, Torricelli, Cleland, Carper, Carnahan, Dayton, 
Voinovich, Bennett, and Bunning.


    Chairman Lieberman. This hearing will come to order.
    Good morning. With this hearing, the Senate Governmental 
Affairs Committee begins its investigation of the Enron 
scandal, the spectacular rise and fall of an American 
corporation and the devastating effects its collapse has had on 
its employees and retirees, on its shareholders and customers, 
and on the confidence many Americans have in the markets and in 
their government.
    The basic facts of this story are now well known. Less than 
a year and a half ago, Enron was ranked as the seventh largest 
corporation in America. The energy trading company was a bright 
star on Wall Street, a juggernaut trading at $90 a share at its 
height, with revenue over $100 billion. Stock analysts could 
not recommend it fast enough, and the company made millionaires 
of many loyal employees who invested their life savings in its 
    Then last month Enron's bright star collapsed into a black 
hole, when it abruptly declared bankruptcy and was exposed as a 
house of cards built on greed and deceit. To add insult to 
injury, average workers and investors were cheated out of their 
life savings, while a small group of executives and insiders 
made off with hundreds of millions of dollars from well-timed 
stock sell-offs.
    Today, the company's stock is worth pennies, and it is no 
longer traded on the New York Stock Exchange. Five thousand of 
its employees are out of a job, and thousands more are reeling 
in the ruin of their retirement dreams. One of the Nation's top 
accounting firms, Arthur Andersen, is accused of helping to 
conceal Enron's liabilities instead of reporting them. Public 
and private employee pension funds from Florida to California 
have lost billions of dollars, and at a time when over 60 
percent of Americans own stock, in one way or another, the 
confidence of the investing public in the stock market has been 
    So this is not just a tempest in a teapot. It is an 
unprecedented corporate storm that has already hurt thousands 
of people and now leaves dark clouds over America's economy and 
American's confidence in their future personal economic 
security. This scandal cries out for thorough congressional 
investigation to make sure that nothing like this ever happens 
    Yet, because Enron has made substantial political 
contributions to Members of Congress and the Executive Branch, 
some have questioned the capacity of any congressional 
committee to conduct an independent, thorough investigation of 
    Now I think there are two things we in Congress can do to 
overcome that skepticism and rebuild public trust. One is 
simply to do a completely independent and demanding 
investigation, and that is the intention of this Committee. The 
second is to pass campaign finance reform.
    As for this Committee, we have a clear duty, under the 
rules of the Senate, to investigate, and we will carry out that 
duty by conducting an investigation that is independent, 
comprehensive, aggressive, fair and nonpartisan. We should 
neither jump to conclusions before the facts justify them, nor 
hesitate to ask tough questions of those in the public and 
private sectors who can produce the facts that we need in order 
to get answers, and we will follow the facts wherever they lead 
    This is a big and complicated investigation. So our 
Committee has divided it between the full Committee and our 
lead investigative committee. The Permanent Subcommittee on 
Investigations, chaired by Senator Levin, with Senator Collins 
as Ranking Republican, will investigate the internal 
malfeasance of Enron and its auditors, the role of the board of 
directors, conflicts of interests, off-shore tax havens and 
insider trading.
    Here at the full Committee level, we are going to focus on 
the external controls and protectors, the Federal agencies and 
laws, and ask why, in this case, they could not better protect 
the thousands of employees and investors who have suffered from 
Enron's untimely and unnatural demise.
    As the Senate's chief oversight committee, it is our 
responsibility, again, under the Senate rules, to make sure the 
Federal Government is as effective as it can be in protecting 
the public interest. Because in this case so many have lost so 
much, this Committee must ask if the relevant Federal agencies, 
the Securities and Exchange Commission, the Labor Department, 
the Commodity Futures Trading Commission, and the Federal 
Energy Regulatory Commission did everything they could have 
done to protect the public and, if not, why not.
    At least one of those agencies was formed way back in the 
most serious crisis American capitalism has ever faced, the 
Great Depression. It and those other watchdog agencies that 
have followed it, have been established, I think, to require 
the fullest disclosure and fairest play that are necessary to 
make our market economy work for the benefit of the many, the 
broad middle class and not just the privileged insider few.
    Now, in the context of the Enron scandal, people are 
asking, and we will ask, whether these agencies need to be 
strengthened to perform this critically important function. 
Here are some of the questions we are going to ask:
    How was Enron allowed to hide its debt and losses in shady 
accounting from SEC oversight?
    Could the Labor Department have intervened when Enron 
barred its employees from selling company stock in their 401(k) 
plans and blocked them from salvaging what was left of their 
retirement nest eggs?
    Could FERC and the CFTC have exercised more oversight to 
rein in abuses that might have contributed to Enron's collapse?
    We have got to ask, also, if the regulatory agencies need 
additional powers to prevent this kind of massive investor rip-
off from occurring again.
    We have got to ask, and we will, and Senator Levin's 
Subcommittee will, why the private sector checks and balances 
that we rely on to keep the markets honest and open, the 
auditors, analysts, and independent corporate directors, did 
not do their part to make sure that the Enron investors and 
employees were getting the true story.
    Are the auditors, with their enormous consulting fees, too 
beholden to management to protect the shareholders' interests?
    Are stock analysts too concerned about protecting the 
lucrative business relationships of their firms to be objective 
in their assessments of companies?
    Are independent directors, with their stock options, and 
consulting contracts and corporate perks, truly independent?
    Is the system, in sum, so rife with conflicts of interest 
that the average American, trusting his or her future to the 
stock market, is inadequately informed and, therefore, poorly 
    We are going to begin our oversight and investigation 
during a series of hearings during the next several weeks on 
the most important public policy questions that have emerged 
from the Enron scandal. At the same time, we will also issue 
written interrogatories to the agencies of the Federal 
Government that have had jurisdiction over Enron and to the 
White House to determine what they knew and did regarding 
Enron's regulation by the four agencies I mentioned earlier 
over the last several years.
    We also plan to request, by subpoena, that Enron and Arthur 
Andersen turn over documents related to their context with the 
same Federal agencies and offices. After we have collected that 
information and conducted additional interviews, we will report 
our findings to the public in hearings to be conducted later 
this year.
    In the end, I hope that this Committee will have specific 
recommendations to make to change the law and regulation, 
recommendations that will strengthen the watchdogs, both in and 
out of the Federal Government, so, I repeat, nothing like the 
Enron scandal ever happens again.
    In today's hearing, we are going to set the stage for what 
will follow and try to put the Enron story into context by 
defining a set of the most important policy issues that have 
come into question as a result of Enron's collapse. The sudden, 
wholly unanticipated failure of the Nation's seventh largest 
corporation, under infuriatingly suspicious circumstances, with 
grave consequences for thousands of people, is a clarion call 
for all of us in government to make sure we are doing all we 
can to protect the integrity of our markets, that in their way 
have allowed the growth of the great American middle class, and 
the savings and investments of the American people. That is 
what our Committee intends to do.
    I would like to say just a few words, briefly, to my fellow 
Members of the Committee. We are beginning a journey today, one 
that will be long, and complicated and often controversial, but 
it is a very important journey. It is not a journey that was on 
our Committee agenda for this year, but then Enron happened, 
and now this Committee, which is uniquely charged with 
oversight and investigation by the Senate Rules, has a duty to 
    Along the way, there will be people outside the Committee 
who will try to distract us and divide us. For my part, I 
pledge to you that I will do everything possible to make sure 
they do not succeed. I want to end this journey together, as we 
begin it together today, having found the truth, as best we 
could, and proposing reforms that are the best we can.
    I am very privileged to have Senator Fred Thompson as the 
Ranking Republican on this Committee. We have worked closely 
together over the years. I have great respect for Senator 
Thompson. I might even say I like him. [Laughter.]
    I even, occasionally, enjoy his company.
    I would say, in specific regard to this matter, I have 
consulted with him, as we have shaped our investigative plan, 
and I look forward to working closely with him as the 
investigation proceeds.
    I am also pleased that Senator Levin, Senator Collins, and 
their staffs are working closely together on the work of the 
Permanent Subcommittee on Investigations.
    Senator Thompson.


    Senator Thompson. Thank you, Mr. Chairman.
    I believe it is correct to say that this marks the first 
day of the first full Senate Committee hearing on the Enron 
matter, and it clearly is an appropriate matter for the 
Governmental Affairs Committee. How our government agencies and 
institutions perform is a vital part of the inquiry that needs 
to be made, as Congress works its way to the bottom of this.
    Mr. Chairman, I think you have set exactly the right tone, 
and I would like to say that I am pleased that you are chairing 
these hearings. Having worked closely with you in the past, I 
know of no one who has a more proven record of fairness and 
objectivity, and I look forward to working with you on this 
    I think we really have an opportunity to do some good here, 
to examine what went wrong and to consider constructive changes 
to the governance of our public capital markets, which appear 
to be inadequate to the demands of the 21st Century and the 
complex financial transactions that now take place on a daily 
    It is true that not every aspect of the Enron matter is 
either unusual or especially a cause of great concern. For 
instance, to what extent is this simply a case of individual 
misconduct or illegal conduct? No system known to man can 
prevent unscrupulous and clever individuals from manipulating 
the system and even getting away with it for a period of time.
    Also, how much of this financial disaster was simply the 
results of bad business judgment and legitimate risk taking 
that simply did not pan out? This is not the first big company 
to go belly up with losses to stockholders and employees, and 
when it happens it is not always because of illegal or 
unethical conduct.
    But while it may be that part of what we are seeing here is 
individual misconduct or simple bad business judgment, both of 
which our system is very capable of dealing with, and we are in 
the process of dealing with it right now, there also seems to 
be some systematic failures that are much more troubling.
    Our free markets and our public financial system--much as 
our government--are dependent upon certain checks and balances. 
Some of the unfortunate tendencies of human nature that were of 
concern to our Founding Fathers, are just as prevalent in the 
corporate world, as they are in the political world. People 
entrusted with power need watchdogs and must be required to 
operate under public scrutiny. We must ask ourselves where were 
the watchdogs here? Where were the auditors, the law firms, the 
board of directors, the analysts, and the government agencies?
    As an economist recently pointed out, we must especially 
look at the role played by auditors. As they said, ``The 
capital markets and, indeed, capitalism itself can function 
efficiently only if the highest standards of accounting, 
disclosure and transparency are observed. In America, well-
policed stock markets, fearsome regulations at the SEC, stern 
accounting standards in the form of generally accepted 
accounting principles, and the perceived audit skills of the 
Big 5 accounting firms have long been seen as crucial to the 
biggest, most liquid and most admired capital markets in the 
    The most troubling feature of this issue to me is not so 
much how these entities or gatekeepers, watchdogs failed in the 
Enron matter, as the fact that this may be indicative of 
problems with auditors, boards, and gatekeepers in general. For 
one thing, we have learned that most of them are up to their 
necks in conflicts of interest. One way or another, all of 
these people, especially the private entities, have tremendous 
financial incentive for the company to make the numbers and to 
keep the stock price high.
    This, of course, plays right into the hands of the 
unscrupulous corporate executive, who is willing to cover up 
the financial realities of the corporation through 
nondisclosure, taking corporate debt off the books and any 
number of things that would raise a question in the mind of an 
average high school bookkeeping student.
    As is often the case, the real scandal here may be in the 
form of not what is illegal, but what is totally permissible. 
If the generally accepted accounting principles allow the 
bookkeeping shenanigans that have been reported in the press, 
then we should all go into the derivative business.
    It seems that all too often the name of the corporate game 
is to conceal the true financials, while doing the minimum 
amount of disclosure to avoid legal exposure. The system is 
clearly not designed with the primary interests of the general 
public or the investor in mind.
    Also, what about the role of the government agencies? What 
should they have caught? Do they have an adequate staff? We 
have 17,000 public companies in this country. Is the SEC 
supposed to keep up with all of them? Is it necessarily just an 
after-the-fact proposition? Perhaps it is. Can we put a 
government official in every board room in the Nation?
    Also, what about those rare instances where the government 
catches wrongdoing? Are penalties sufficient to deter this kind 
of behavior?
    So, while issues such as individual wrongdoing and who made 
contacts with the administration are interesting and 
titillating, the issue of most long-term importance to our 
country has to do with the integrity of our systems.
    It is also the area in which we have the most 
responsibility as legislators. We must address our legal and 
regulatory framework, not as what we thought it was, but as we 
now know it to be, and work together toward reforming it.
    As I said, I believe we have an opportunity here, Mr. 
Chairman, to do some real good on a bipartisan basis, and who 
knows, in the process, we may even finally decide that allowing 
huge amounts of soft-money contributions to public officials is 
not really such a good idea. We may even come to the conclusion 
that this practice is always just a scandal waiting to happen, 
and we do ourselves and the institution we serve a disservice 
by tolerating it.
    So, Mr. Chairman, I look forward to working with you and 
other Members of this Committee toward a really constructive 
set of hearings. Thank you very much.
    Chairman Lieberman. Thank you, Senator Thompson. Thanks 
very much.
    I am now going to give each of the Members of the Committee 
an opportunity for an opening statement, which I ask them, as 
best as they are able, to keep it close to 5 minutes.
    Senator Levin.


    Senator Levin. Thank you very much, Mr. Chairman and 
Senator Thompson, for your statements, which I thought were 
really on target.
    The Enron debacle has stirred the passions of Americans 
nationwide. The deceptions and the accounting gimmicks, the 
shredding of documents that have occurred shake the very 
foundation of our confidence in corporate America. What a 
travesty. Enron's management made out like bandits, while tens 
of thousands of average people saw their savings, retirement 
funds or jobs go down the drain. People are now concerned that 
the marketing of the stock of other U.S. corporations may be no 
more than ``pump and dump'' schemes writ large.
    Enron's abrupt collapse from corporate star to disgraced 
bankrupt is crucial for all of us to understand, because each 
and every American's future is tied to the success or failure 
of corporate America. Publicly traded companies employ millions 
of Americans. They are the key to U.S. international 
competitiveness. Over half of all U.S. households are now 
investing in American capital markets, placing their hopes for 
a college education for their children, quality care for their 
parents, and adequate money for their retirement, in the hands 
of our publicly traded companies.
    I was, frankly, surprised when Treasury Secretary O'Neill 
said, ``Companies come and go. Part of the genius of capitalism 
is people get to make good decisions or bad decisions, and they 
get to pay the consequences or enjoy the fruits of their 
    Well, Ken Lay and his colleagues at Enron got the fruits. 
The employees and stockholders are the ones who suffered the 
    We have laws and regulations designed to ensure that our 
publicly traded corporations are managed for the benefit of 
stockholders and employees. We require boards of directors to 
serve as a check on overreaching and bad judgment by corporate 
offices. We require outside auditors to make sure company 
accounting practices are accurate and trustworthy. We require 
transparent financial reporting so that investors can track 
their investments and decide when to buy or sell stock.
    Yet, in the case of Enron, we have misleading financial 
statements, corporate conflicts of interest, insider profits at 
the same time employees were losing their shirts, off-shore 
shenanigans, hidden debt, and what I call tax laundering--that 
is, taking earnings that are taxable in the United States and 
somehow creating off-shore paper entities in the Caribbean or 
elsewhere through which to route them and, presto, convert them 
to nontaxable earnings.
    Enron also avoided hundreds of millions of dollars in taxes 
by its use of stock options. Some years ago some of us fought 
to require corporations to treat stock options on their 
financial statements the same way they treat them on their tax 
returns. Corporate executives receive large quantities of stock 
options from their companies. When they exercise those options, 
the companies can claim a compensation expense on their tax 
return, while accounting rules let them omit that same expense 
from the corporate earnings statement.
    The company can tell Uncle Sam one thing, but its 
shareholders or future stock buyers the opposite. That is one 
of the means by which Enron avoided paying taxes for 4 out of 
the last 5 years, while bragging to investors about 
skyrocketing revenues.
    Enron is far from unique in that regard, since other 
corporations use the same technique. The stock-option loophole 
that Enron used makes no sense to me. But when the Financial 
Accounting Standards Board or FASB, the entity that decides the 
accounting standards, tried to change the rules, audit firms 
and major corporations fought the board tooth and nail.
    It may be that Enron and Andersen broke laws or it may be 
that the principal scandal is what passes for legal conduct in 
today's marketplace. Some of our witnesses will be telling us 
today that it is not just Enron, that our entire system of 
corporate management, auditing, stock analysis, investment 
banking needs a top-to-bottom shake-up and major repairs.
    Many have been raising flags, shouting warnings for years, 
including the witnesses before us today. Arthur Levitt, former 
SEC Chairman, for one, carried on an intense and often lonely 
battle to curtail the conflicts of interest that are inherent 
in the practice of permitting our largest auditors to serve as 
both outside auditor and management consultant to the same 
    Mr. Chairman, I am very fortunate that Senator Collins is 
the Ranking Republican on our Permanent Subcommittee on 
Investigations. The legislative effort that is needed to turn 
this travesty into a positive force, to clean up some long-
festering problems in U.S. corporate governance and accounting 
practice will require a sustained effort from all of us.
    I know that she, with her history and experience of 
chairing hearings in such a distinguished, fair, and thoughtful 
way when she was Chair of the Permanent Subcommittee on 
Investigations, will help us a great deal to make the best 
contribution that we can to that sustained effort which must be 
made if we are going to clean up the mess that we, indeed, all 
face. Thank you.
    [The prepared statement of Senator Levin follows:]
    The Enron debacle has stirred the passions of Americans nationwide. 
The deceptions and accounting gimmicks and shredding of documents that 
occurred shake the very foundation of our confidence in corporate 
America. What a travesty. Enron's management made out like bandits 
while tens of thousands of average people saw their savings, retirement 
funds or jobs go down the drain. People are now concerned that the 
marketing of the stock of other U.S. corporations may be no more than 
``pump and dump'' schemes writ large.
    Enron's abrupt collapse from corporate star to a disgraced bankrupt 
is crucial for all of us to understand, because--like it or not--each 
and every American's future is tied to the success or failure of 
corporate America. Publicly traded companies employ tens of millions of 
Americans; they are the key to U.S. international competitiveness. Over 
half of all U.S. households are now investing in American capital 
markets--placing their hopes for a college education for their 
children, quality care for their elderly parents, and adequate money 
for their retirement in the hands of our publicly traded companies.
    I was surprised when Treasury Secretary Paul O'Neill said, 
``Companies come and go. Part of the genius of capitalism is people get 
to make good decisions or bad decisions and they get to pay the 
consequences or enjoy the fruits of their decisions.'' Well, Ken Lay 
and his colleagues got the fruits and haven't yet suffered the 
consequences; the employees and stockholders have done that.
    We have laws and regulations designed to ensure that our publicly 
traded corporations are managed for the benefit of stockholders and 
employees. We require Boards of Directors to serve as a check on 
overreaching and bad judgment by corporate officers. We require outside 
auditors to make sure their accounting practices are accurate and 
trustworthy. We require transparent financial reporting so that 
investors can track their investments and decide when to buy or sell 
stock. We require of our public accountants and corporate directors a 
fiduciary responsibility to act in the best interest of the investing 
public and the corporation's stockholders, and not in their own 
financial interest.
    Yet in the case of Enron we have misleading financial statements; 
corporate conflicts of interest; insider profits at the same time 
employees were losing their shirts; offshore shenanigans; hidden debt, 
and what I call tax laundering--that is, taking earnings that are 
taxable in the United States and somehow creating offshore paper 
entities in the Caribbean through which to route them and voila--
convert them to nontaxable earnings.
    Enron also avoided hundreds of millions of dollars in taxes by its 
use of stock options. Some years ago some of us fought to require 
corporations to treat stock options on their financial statements the 
same way they treat them on their tax returns. Corporate executives 
receive large quantities of stock options from their companies. When 
they exercise those options, the company can claim a compensation 
expense on their tax returns, while accounting rules let them omit that 
same expense from the corporate earnings statement. The company can 
tell Uncle Sam one thing and its shareholders the opposite. That's one 
of the means by which Enron avoided paying taxes for four out of the 
last five years, while bragging to investors about skyrocketing 
revenues. The stock option loophole Enron used makes no sense, but when 
the Financial Accounting Standards Board or FASB--the entity that 
decides the accounting standards--tried to change the rules, audit 
firms and major corporations fought the Board tooth and nail. In the 
end, the best FASB could get was a footnote noting the earnings charge 
on a company's books. But that stock option footnote--like so many 
Enron footnotes--doesn't tell the true financial story of a company.
    It may be that Enron and Andersen broke laws or it may be that the 
principal scandal is what passes for legal conduct in today's 
marketplace. Some of our witnesses will be telling us today that it's 
not just Enron--that our entire system of corporate management--
auditing, stock analysis, investment banking--needs a top-to-bottom 
shake-up and major repairs. The Big 5 accounting firms admitted in a 
recent petition to the SEC that when it comes to financial disclosure 
many ``public companies provide boilerplate or very high-level 
disclosures that provide little or no meaningful information.'' And 
that's from the accountants themselves--the very group charged with 
ensuring that companies issue fair financial statements. What an 
indictment that is of our financial disclosure system.
    Many in the industry have been raising red flags and shouting 
warnings for years. Arthur Levitt, the former SEC Chairman for one, 
carried on an intense and often lonely battle to curtail the conflicts 
of interest inherent in the practice of permitting our largest auditors 
to serve as both outside auditor and management consultant to the same 
company. Mr. Levitt knew what he was talking about, but not many wanted 
to listen. The question now is whether we've learned the lesson Mr. 
Levitt is still trying to teach.
    Just about all the various failures in our corporate governance 
systems have coalesced in the Enron saga. Hopefully Enron's implosion, 
while damaging to so many lives, may serve as the engine for reforms 
long overdue. We already have some sense of what needs to be done: 
Insisting on greater auditor independence; a stronger Financial 
Accounting Standards Board; fairer accounting, including consistent 
treatment of stock options; ending the use of offshore tax havens; more 
accountable corporate governance; and employee pension protections.
    A large number of investigations are ongoing in the Congress and 
the Executive Branch, because we have a lot of ground to cover and 
different responsibilities to fulfill. The Permanent Subcommittee on 
Investigations, which I chair, and on which Senator Susan Collins 
serves as the Ranking Member, will be paying particular attention in 
the months ahead to the role of the Enron Board of Directors and 
officers, the role of Arthur Andersen ,particularly with regard to 
Enron's Special Purpose Entities, and Enron's use of offshore entities 
and tax havens.
    Our hearings in the Permanent Subcommittee on Investigations will 
come later in the year, after our analysis of the thousands of 
documents that we receive as a result of the 51 subpoenas issued two 
weeks ago. I look forward to the hearings in our full committee, which 
will examine what federal agencies could have and should have done to 
detect or prevent the Enron debacle. The legislative effort needed to 
turn this travesty into a positive force to clean up some long-
festering problems in U.S. corporate governance and accounting practice 
will require a sustained effort from all of us.

    Chairman Lieberman. Thank you, Senator Levin. Senator 


    Senator Collins. Thank you, Mr. Chairman.
    Mr. Chairman, I want to thank you and Senator Levin for 
convening this important investigation into some of the key 
issues involved in the Enron bankruptcy, the largest corporate 
failure in our Nation's history.
    It is my hope that, with the help of our witnesses today, 
we can begin to gain a better understanding of how the 
financial and regulatory systems utterly failed to protect the 
company's shareholders, employees and customers, while top 
executives apparently walked away with handsome profits on the 
sale of their Enron stock.
    A common theme in many of the issues we will examine is 
conflicts of interest. Corporate officers, outside accountants, 
board members, and security analysts all have duties, both 
legal and ethical, to investors, to clients, to employees, to 
regulators and to the public. To be more specific, we impose on 
corporate managers and financial professionals a fiduciary 
obligation to act in the best interest of those who provide the 
    A brief review shows just how pervasive the role of the 
nongovernmental protector of investor interests is in our 
capitalist system. We impose, for example, on auditor, the 
obligation to ensure that investors have access to financial 
statements that accurately and fairly describe the finances of 
the companies in which they invest. We impose on corporate 
managers the obligation to act in a fashion that will maximize 
the benefits received by the firm's stockholders. We impose on 
corporate directors the obligation to safeguard investor 
interests by monitoring the conduct of those managers, and we 
impose on retail brokerage firms the obligation to give their 
clients competent and objective advice about the companies they 
    For a system that places such heavy reliance on the 
obligation of some private citizens to safeguard the interests 
of other private citizens, we are remarkably lenient, perhaps 
even lax, in allowing conflicts of interest. The potential for 
such conflicts to cause trouble in the accounting arena, in 
particular, has attracted considerable attention not just in 
the Enron case, but over the past few years, as the number of 
companies restating their earnings has increased significantly.
    Indeed, Enron is only the latest in a string of well-known 
large corporations whose books were blessed by auditors, 
despite questionable accounting. Financial data, compiled in 
accordance with generally accepted accounting principles, 
certified as such by an independent auditor, and fully 
disclosed under securities laws, are fundamental to the 
integrity of our financial markets.
    If a company's financial statements do not accurately 
represent its financial health, investors cannot make prudent 
decisions on whether or not to purchase its stock. Without the 
confidence engendered by fully disclosed financial data, our 
vibrant capital markets, which help businesses finance new 
plants and create new jobs, and which many Americans rely on 
for their children's college tuition and their own retirement, 
will be ultimately undermined. The very health of our economy 
hinges on the integrity of our financial markets.
    A champion of small investors and strong capital markets, 
former SEC Chairman Arthur Levitt will be testifying before the 
Committee today. Chairman Levitt was very helpful to me when I 
held hearings with Senator Levin on penny stock fraud and day 
trading. He has long pressed for a prohibition on accounting 
firms providing both consulting and auditing services for the 
same client, to prevent the kinds of conflict of interest that 
contributed to the collapse of Enron.
    Although the Enron bankruptcy raises many important issues, 
perhaps the most important to the individual investor may be 
what it has to teach us about the 401(k) plans relied upon by 
so many Americans as a future source of retirement income.
    Private pensions governed by ERISA are intended to help 
Americans reach the goal of retirement security. Because of the 
rapid decline in Enron's stock price, however, thousands of its 
employees find themselves in dire straits, having lost nearly 
all of their savings from a lifetime of hard work.
    Like Enron's employees, many American workers have a 
disproportionate share of their employer's stock in the 401(k) 
plan. In fact, at some companies, workers have as much as 90 
percent of their retirement assets in their employer's stock. 
One issue that I am very interested in is whether employees 
have access to impartial financial advice, and Senator Jeff 
Bingaman and I have introduced legislation to try to achieve 
that goal.
    Although it is not perfect, it is important to remember 
that our systems of accounting and financial regulation are the 
best in the world. That makes the Enron case all that much more 
troubling because it simply should not have happened. It 
represents a colossal failure of virtually every mechanism that 
is supposed to provide the checks and balances on which the 
integrity of our capital markets depend.
    I look forward to working with the Chairman, as well as the 
Chairman of the Subcommittee, my distinguished colleague, 
Senator Levin, as we proceed with these issues.
    Chairman Lieberman. Thank you very much, Senator Collins. 
Senator Durbin.


    Senator Durbin. Thank you very much, Mr. Chairman.
    With Biblical certainty, the United States preaches the 
gospel of free markets and capitalism to the unconverted around 
the world. Third-world nations, former command and control 
economies, and socialist governments alike are all exhorted to 
let the laws of supply and demand run their course.
    As proof of the truth of our message, we can point to our 
own experience--a frontier nation which joined democratic 
government to a market economy and created the freest, most 
stable and prosperous nation in history.
    But the American story also includes a chapter where we 
came to realize that the rule of law and the guiding hand of 
government were critical to a just result in the world of 
    Theodore Roosevelt was the first President to acknowledge 
that the genius of capitalism could also be a triumph of greed 
without rule and regulation to save us from our baser 
    Today this Committee joins a chorus of Congressional 
critics pecking at the carrion of Enron. When the mightiest 
fall, the politically curious scramble over the ruins. What we 
know is this: A flawed and fraudulent business concept failed. 
But there are other things we also know:
    When the corporate insiders at Enron realized the ship was 
sinking, they grabbed the lifeboats and left the women and 
children, their workers and investors, to drown. When the 
accountants and auditors responsible for policing Enron were on 
the beat, they were also on the take--a badge in one hand, an 
open palm in the other.
    When workers and investors were captivated by too-good-to-
be-true profits and fraudulent claims by the corporate bigwigs 
in Houston, they made decisions they could not escape. And when 
the high-flying corporate executives became political high 
rollers, they left a lot of embarrassed people in their wake.
    After all of the sound and fury of these investigations, 
the bottom-line questions are: Is Congress willing to amend the 
law to rein in the greed of the next Enron? Are we willing to 
concede that the genius of capitalism can result in ruthless 
behavior without our oversight and the protection of law? Can 
we save pensioners and investors--who were outsiders believing 
in the fairness of the market--from the corporate insiders who 
walk away from these colossal business train wrecks with their 
pockets full and without a scratch?
    Over 100 million Americans who own stock and 42 million who 
own 401(k)'s will be watching to see if these hearings and many 
others on Capitol Hill are about more than just face time on 
the nightly news.
    To me, this national debate is about more than a failed 
corporate giant. It is about the values of our Nation. Enron is 
a big story not just because of its bankruptcy. Sadly, 
bankruptcies occur every day. Enron is a big story because it 
reminds us of our vulnerability. It reminds us that without the 
enforcement of fair and just laws, the average American doesn't 
have a fighting chance.
    Mr. Chairman, I welcome the opportunity in the coming weeks 
and months to transform what we learn into legislation that 
will guard against a repeat of this shameful chapter in 
American business history. Thank you.
    Senator Lieberman. Thank you very much, Senator Durbin. 
Senator Cochran.


    Senator Cochran. Mr. Chairman, I commend you for having 
this hearing to learn the facts surrounding the collapse of the 
Enron Corporation. While business failures are common, it is 
not at all common to see a company of Enron's size driven to 
bankruptcy and virtually unheard of to see it happen as quickly 
as it did, that a company like Enron could fail so 
precipitously and with such devastating consequences is both 
puzzling and troubling.
    Particularly devastated are Enron's employees, many of whom 
have lost their jobs and nearly all of whom have seen their 
pensions and 401(k)'s disappear. While business ventures and 
investments in them always entail risk, the government has a 
role in assuring that there are safeguards in place to keep 
employees and investors from being victimized by inappropriate 
    With Enron's failure, we must ask whether such safeguards 
were adequate and, if they were adequate, were they improperly 
circumvented? We should also find out if any Federal agencies 
failed to carry out their responsibilities.
    This is a very complex case, and I hope we use these 
hearings to learn the facts and understand the complexities so 
we can determine what we need to do to help avoid this kind of 
unfortunate event in the future.
    Senator Lieberman. Thank you, Senator Cochran. Senator 


    Senator Torricelli. I thank you, Mr. Chairman, Mr. Levitt, 
and Mr. Turner.
    The matter of Enron is going to be addressed in a variety 
of forums. Some of these are going to be criminal proceedings 
because laws have obviously been violated. Creditors will be in 
bankruptcy court for many years seeking redress, and there will 
be civil suits in courtrooms across the country involving 
thousands of people.
    The responsibility of this Committee and this Congress is 
somewhat different. Allow the criminal and the civil 
proceedings to run their course, but our responsibility is to 
set what happened with Enron in some perspective. My hope is 
the testimony this morning begins that process. The collapse of 
Enron has been an individual tragedy for 5,000 employees and 
thousands of investors, people have lost their jobs, many will 
lose their homes, their families are in peril, and thousands of 
other Americans have lost their retirement savings.
    This Committee and this Congress needs to recognize the 
impact on an even larger scale. Many of my colleagues have 
commented about the uniqueness of the American capital market. 
Those comments are well stated today. It is no exercise in 
hyperbole to note that we have become the world's largest 
economy in large measure because we created confidence in the 
world's most transparent equity markets.
    The uniqueness of our system is that the individual worker, 
the retiree, the family planning their finances, feels that 
they stand in an equal position with members of the board, 
large firms, and management. All have access to equal 
information. They can make individual judgments--good or bad, 
we stand together. If that confidence is shaken, it is at 
enormous perils, to the financial future of the country.
    Senator Lieberman noted that our duty is to ensure that 
what happened with Enron must never happen again. Perhaps, but 
the simple truth is it is happening all of the time. Enron has 
brought a dirty little lie into the light of day. The system of 
confidence and transparency in our markets has been steadily 
    Mr. Levitt, the purpose of these opening comments by 
Members of the Senate, if they serve any purpose at all, is to 
tend to direct testimony, to set a stage where you might 
respond. Here is the stage I would like to set. I have three 
charts I would like you to see.
    Market losses to investors after corporate restatements.\1\ 
Now every American knows about Enron, their restatements, their 
false accounting. What was a $17-billion issue in 1998 has 
risen to a $31-billion question in what has become a habit, a 
routine of corporate restatements. Some are undoubtedly 
required, some are necessitated by changing events, but the 
changing culture of corporate reporting to investors is at 
least suspicious.
    \1\ Chart entitled ``Market Losses to Investors After Corporate 
Restatements'' appears in the Appendix on page 135.
    The second chart \2\ will give you an idea as well of what 
this means in terms of the number of corporations. It may have 
been proper in 1998 that 116 corporations needed to do 
restatements. Markets change, situations are altered. But it is 
at least suspicious that by the year 2000, 233 needed to do the 
same. Is Enron unique?
    \2\ Chart entitled ``Corporate Restatements Have Increased 
Dramatically in the Last Three Years'' appears in the Appendix on page 
    Well, the third chart,\1\ I think, illustrates Enron is not 
even the largest of what have become a series of outrageous 
corporate overstatements to the tunes of billions of dollars in 
recent decades.
    \1\ Chart entitled ``Corporate Overstatements In the Past Decade'' 
appears in the Appendix on page 137.
    Enron is now in bankruptcy, so is Sunbeam, largely, 
unrecognized outside of the investor community, Waste 
Management being even larger. These companies are not alone.
    Mr. Levitt, I hope you will address these questions in your 
testimony. We would all prefer that the markets are able to 
regulate themselves. We all believe it would be better if 
professions could engage in self-management. We are being 
reminded that there is a reason for government regulation. Mark 
Twain once said that before he takes down a fence, he likes to 
ask why somebody put it up.
    It is not so long ago you reminded the country and the 
Congress the reason for some additional regulations in the 
accounting industry. The country may not have listened, the 
Congress did not respond. We were wrong. You were right. Now we 
need to discover what else it is that we should be doing. Thank 
you, Mr. Chairman.
    Senator Lieberman. Thank you, Senator Torricelli. Senator 


    Senator Voinovich. Thank you, Mr. Chairman, for holding 
this hearing today.
    The story of Enron's collapse into bankruptcy has dominated 
the headlines nationwide this month and has replaced the war on 
terrorism as the most common news story. It was just last month 
that we were having hearings on terrorism. Enron is the most 
covered news event so far this year.
    As such, this Committee, along with at least nine other 
congressional committees, the Department of Justice, the 
Securities and Exchange Commission, and the Department of Labor 
are looking into the causes of the corporation's collapse and 
any wrongdoing that may have taken place.
    Our Nation's financial market is composed of a multi-
layered system of checks and balances. Within a public company, 
the executives are obligated to report honest earnings in their 
books. Internal auditors are responsible for publishing fair 
and independent reports on the company's financial situation. 
Audit committees are responsible for ensuring that the auditors 
produce fair and accurate statements.
    Outside of a public company, the external auditors are 
hired to make sure the company's finances present an accurate 
picture of what is going on. Financial analysts scrutinize the 
company's financial situation to recommend to investors whether 
or not the company is a smart investment. Credit lenders 
analyze a company's financial reports to determine the level of 
risk associated with lending to the company, and the Securities 
and Exchange Commission and other Federal regulators are 
responsible for monitoring the financial markets and the public 
companies that compose this market.
    This system usually works pretty well. Mr. Chairman, in the 
case of Enron, the multi-layered system of checks and balances 
failed. It calls out for Congress to consider overhauling the 
whole system to guarantee that we are not going to have any 
more situations like Enron.
    The aspect of Enron's collapse that bothers me most, 
however, is the dishonesty and disloyalty that appears to have 
existed at the top of the corporation, conduct which has dealt 
a lethal economic blow to thousands of shareholders and 
employees and cast a dark shadow on corporate America. It will 
take a long time for people's faith in investing to be 
    Our country has the best system of civil and criminal laws 
in the world, and if there was any wrongdoing--and I suspect 
there was--at Enron, we must utilize that system to the fullest 
extent to make an example of executives and warn other public 
companies and their executives not to gamble with the life 
savings of thousands of American families and the investing 
    In Ohio alone, the Public Employees Retirement System, of 
which I am a member, and the State Teachers Retirement System 
estimate their losses as a result of investments in Enron at 
approximately $127 million. The State has filed a class action 
lawsuit against Enron in coordination with a number of other 
States that invest in Enron as a result of the company's 
misleading financial statements.
    I am equally concerned about the allegations I read in the 
paper about Arthur Andersen's failure to do its job. I know a 
little bit about this company from my experience with them as 
Governor, and it was not very good. I think we should take a 
careful look at our accounting system and evaluate it if we 
can, under the current system, provide the unbiased assessment 
which the public expects and is entitled to. Is a new 
independent oversight of the profession needed? At the very 
minimum, we must prevent the inherent conflict of interest that 
arises when a company hires the same firm to audit its books 
and then provide consulting services.
    In the midst of headlines about the Enron scandal, there is 
some good news, and that is, the condition of our Nation's 
energy markets. The biggest corporation in the world collapsed 
within a few weeks, and I did not hear about a single blackout 
that resulted from that crash, nor have I seen a tremendous 
fluctuation in gas prices, as some would have predicted. I 
think it says a lot about the country's efforts to deregulate 
our energy markets, and I think we need to continue with 
deregulation in the smartest way possible.
    In closing, I look forward to hearing from our witnesses 
today and from our witnesses in the future on what steps the 
Federal Government must take to guarantee that there are not 
going to be any more Enrons and how should we restore the 
public's faith in our financial markets. Thank you, Mr. 
    Chairman Lieberman. Thank you, Senator Voinovich. Senator 


    Senator Cleland. Thank you very much, Mr. Chairman, Mr. 
Levitt, and Mr. Turner. Thank you very much, ladies and 
    Let me just say that, before I came to this position in the 
Senate, I was Secretary of State in Georgia for some 12 years. 
In that State, the Secretary of State is the commissioner of 
securities, that is, the State regulator of securities, 
primarily responsible for looking after the small investor. I 
am fortunate to be served now as my administrative assistant by 
Wayne Howell, who was then the assistant commissioner of 
securities. So we have been together in this business of 
securities regulation or trying to detect fraud and prevent it 
for quite a while.
    I will say that while I was Secretary of State, we saw 
various examples of fraud. We were the first State to put First 
Jersey Securities out of business. We were the first State to 
come with a major fine against Drexel Burnham Lambert. We were 
the first State to really run the penny stock industry out of 
our State. So I have been dealing with the question of fraud 
and securities malfeasance for quite a while.
    I will say that if the allegations here in this case of 
Enron are true, it is the worst case of lying, cheating, and 
stealing that I have come across in my public life and in 20 
years, almost, of dealing with the securities industry.
    We, in the Congress, will be hearing volumes of testimony 
and evidence related to this collapse, but it really does come 
down to this: Enron possibly lied, cheated, and stole from its 
own investors and employees. That is the bottom line.
    It is interesting that in combat, officers eat last. It is 
obvious in the combat in the marketplace, Enron officers ate 
first and left the troops to fend for themselves. That is 
unconscionable. It is unconscionable in war, it is 
unconscionable in peace, and it is unconscionable in our 
    We are actually here in this Committee to see if this is 
true, if these allegations were indeed the case. We have got 
hearings, subpoenas, and so forth. The bottom line is that this 
is real. It is real in my State. We have a teacher retirement 
system there. We have an employees' retirement system there. 
They have already lost $127 million from the Enron collapse.
    There are people in my State who worked for Enron. I came 
across a family the other day that, through their 401(k) 
program that they thought was very solid and sound, they 
invested their life savings. The head of that family is now 
sacking groceries--in the background himself--and does not 
really have a substantial future.
    There were really two Enrons: One run for the insiders and 
the big boys at the top; the other Enron run for the employees 
and the public.
    Some interesting facts: If you were an Enron insider, from 
the sale of company stock last year, you made $130 million. But 
if you were just a shareholder, you took a $63 billion hit.
    The average compensation for just a board member of Enron, 
$400,000--but the average loss if you were just an investor was 
71 percent.
    If you were an insider and one of the big boys that ran 
that operation, you put together 900 partnerships that were 
based offshore, and then Enron itself paid no Federal taxes 
last year.
    These numbers really paint a tale of two corporations, 
basically a corporation that the average citizen and the 
average employee could not get a handle on in truth. But there 
is Ken Lay giving employees in an online chat in September 
these words, when he said about Enron stock it was ``an 
incredible bargain.''
    Now, basically, the two Enrons had a powerful negative 
effect. It is fascinating that over $1 billion has been lost by 
retirement funds, pension funds of people like teachers, 
firefighters, and other public employees. What an irony. The 
very first responders we depend on in case of a terrorist 
attack were the first to get hurt by the Enron collapse.
    Most pension funds, mutual funds, and institutional 
investors held some Enron stock, and when one out of every two 
Americans are invested in the market, most small investors in 
America now have lost money over the Enron collapse, whether 
they know it or not.
    A sound investment is based on sound information. Georgia 
is a full-disclosure State. One of the things that bothers me 
most about the Enron situation is the lack of full disclosure, 
the lack of transparency. What kind of information did Enron 
investors have? Again, they had assurances from Ken Lay in 
September that ``the company is fundamentally sound.'' An 
outright lie. They had recommendations from Wall Street's top 
investment firms recommending Enron as a strong buy. Wrong. And 
they had a stamp of approval from auditor Arthur Andersen 
saying that information in Enron's financial statements was 
reliable. False and fraudulent.
    Of course, we all know what is the situation now. Having 
been Secretary of State as I was in charge of professional 
boards also, and one of those was the CPA Board in Georgia. I 
find it hard to believe that professional people, CPAs, sworn 
to do a professional job, would not only be analyzing the books 
but cooking the books at the same time. What an American 
    Mr. Chairman, as I go over these reams of documents, and go 
through these hearings, I will try to keep an open mind. But I 
am shocked at the revelations already disclosed to the 
Committee, not only what were potentially illegal, but also 
what were the legal actions taken by the corporations, actions 
which were perfectly legal but designed to hide losses, evade 
regulators, enrich corporate insiders.
    Despite all these accounting irregularities, Enron's most 
recent annual report included two statements from its 
accounting firm, Arthur Andersen. One stated Andersen's opinion 
that Enron's internal accounting system was ``adequate to 
provide reasonable assurance as to the reliability of financial 
statements.'' A lie. The other stated Enron's financial reports 
``present fairly in all material aspects the financial 
condition'' of the company. Wrong.
    Why would Andersen make these statements? The real question 
is: Why not? They were both Enron's accountant and its 
strategic business consultant. The fox was truly guarding the 
chicken coop, and ultimately the people of America have had to 
pay a great price.
    Interesting that this is not isolated. Twenty years ago, 
consulting fees added up to about one-tenth of the revenues for 
major accounting firms. Today, those consulting firms--they 
account for about half of the revenues for these consulting 
    So the safeguards we thought we had in place have become 
little more than window dressing. Our confidence is shaken. But 
hopefully this Committee can address this and, through real 
legislation and real sunlight on the problem and real 
transparency in securities markets, can restore some of the 
lost confidence we have all suffered.
    Thank you, Mr. Chairman.
    Chairman Lieberman. Thank you very much, Senator Cleland. 
Senator Bennett.


    Senator Bennett. Thank you, Mr. Chairman.
    We have had a lot of conversation about Enron and Enron 
executives, and I won't repeat any of that, but will just add 
this reflection:
    Had the Enron business plan worked, of course, they would 
all be heroes. That is a little like saying had the roulette 
wheel come up red instead of black, the investor who put his 
money on red would be considered a really smart guy, because 
what Enron management was doing was almost as dangerous, if not 
as dangerous, as going to Las Vegas and putting their chips on 
one number or another as far as the roulette table is 
concerned. But they were the management. They were running the 
company, and they decide that was the right thing to do.
    What distresses me is that nobody who was looking over 
their shoulders pointed out that they were gambling in such a 
high-risk circumstance.
    We have heard about Arthur Andersen. The auditors didn't. 
We have heard about the analysts who didn't look as deep as 
they should but were anxious to hang on to their relationships. 
We haven't heard anything about the outside directors. I have 
served on boards of public companies, and I can give examples, 
as everyone in the room can, of outside directors who said, 
``Wait a minute, we have a fiduciary responsibility as outside 
directors to call a halt to this.''
    My first experience with a major bankruptcy was when I was 
serving in the Nixon Administration on the Penn Central 
Railroad, which in its own way was as glittering an example of 
corporate success as Enron was, and it ended up going belly up.
    The people who called that shot, who blew that whistle, who 
raised the specter of bankruptcy were the outside directors. I 
remember very clearly when they came to the Nixon 
Administration and said there is a serious problem. And I won't 
go into the details of what we then dealt with in trying to 
ameliorate the failure of the then Nation's largest railroad, 
with all of the implications that had for transportation policy 
throughout the country. But it was the outside directors who 
said we have a fiduciary responsibility to the shareholders to 
point out the fact that management is on a very dangerous 
course and this railroad is going to go under.
    So there is a broader blanket to be thrown out here than 
just beating up on the top executives of Enron, and I concur in 
the beating up that has gone on. I am not trying to defend 
them. But we investors depend on auditors; we depend on the 
analysts from the big investment firms; and we depend on the 
system of outside directors. I think there is a requirement 
that X percentage of the directors be outside directors, not 
insiders. And that system has failed us.
    I am not sure we can resolve it by passing laws that say 
every outside director will henceforth take his duty seriously. 
I know some outside directors, potential outside directors who 
refused to accept appointments because they said you don't have 
adequate insurance for the kind of class action lawsuits if I 
take this on.
    But this is an opportunity for us to examine all aspects of 
the way public companies work in this country and see what we 
can do to improve it.
    Thank you, Mr. Chairman.
    Chairman Lieberman. Thank you, Senator Bennett. Senator 


    Senator Carper. Thank you, Mr. Chairman. I will not attempt 
to match the outrage or the eloquence of my colleagues who have 
spoken before me. I would observe that I have never had the 
pleasure of hearing Mr. Levitt or Mr. Turner testify. I am 
going to get that chance, and I am looking forward to that 
opportunity, and I am going to be real brief.
    Mr. Chairman, I have a statement I would like to enter for 
the record, if I could.
    Chairman Lieberman. Without objection, so ordered.
    [The prepared statement of Senator Carper follows:]
    I know we've all read a lot in recent weeks about Enron's collapse 
and I know most of my colleagues and I will have multiple opportunities 
to study more closely what happened and what we can do to prevent it 
from happening again. The Justice Department and a number of 
congressional committees are also looking into this matter. As we go 
about our work, however, I believe it is important to recognize that 
Enron is not an isolated incident but instead the latest, and certainly 
the largest and most high-profile in a series large-scale corporate 
accounting mishaps. While not on the same scale, Sunbeam, Waste 
Management, Rite Aid, Lucent and Xerox have all had problems similar to 
    We're not here this morning to hunt down the juicy details about 
who at Enron, Arthur Andersen or even the Bush Administration knew what 
and what they were doing about it. What we are doing is taking a look 
at some of the broader public policy questions raised by this company's 
    While the United States still has the best auditing and accounting 
standards in the world, and thus the strongest capital markets, Enron 
illustrates areas where these standards must be improved. I don't know 
yet which is the best course of action but we need to take steps before 
we hear about the next Enron to address the independence of auditors 
and analysts, the oversight of the accounting profession and the 
transparency of corporate disclosures.
    In recent years, more and more Americans at all income levels have 
put more and more of their retirement savings in the stock market. 
Enron's failure raises serious questions about the accuracy of the 
information investors have access to when making investment decisions. 
Investors have lost millions on their Enron stock, and countless Enron 
employees have watched their retirement savings vanish as their company 
collapsed in a matter of months. Congress, regulators and the 
accounting profession must act now to restore investors' confidence.

    Senator Carper. Senator Voinovich, alluded earlier to his 
participation in the State of Ohio's pension plan for its 
employees when he was governor. My guess is he also nominated 
those who served as members of the board of trustees to oversee 
that pension plan. I had a similar responsibility as governor 
for Delaware for a number of years. I took that responsibility 
seriously, as I am sure he did.
    There is more to this than the outrage that we feel on 
behalf of those Enron employees who have lost their life 
savings. There is more to this than the outrage we feel for 
those who might be members of the Ohio or Delaware State 
employee pension plans who have lost measurably their 
retirement savings.
    There is a bigger question, and that is the confidence that 
the rest of the world, which is looking for places to invest 
their money to ensure that we continue to enjoy their 
confidence; and as trillions of dollars move throughout the 
investment community and many of them end up here, that we 
continue to be an attractive environment in which to invest 
those funds.
    One of the best ways that we can do that, once we have 
completed flogged verbally those who have caused this disaster, 
is to bear down and stay with this issue when the media maybe 
loses attention and to continue to probe and to find the 
answers to the questions so that we can ensure that not only 
have we just gotten some satisfaction from venting our spleen 
at the outrages we have learned of, but we have actually done 
something real to ensure that other employees of companies but 
also other investors from around the world will continue to 
invest in the securities within this country with the kind of 
confidence that has enabled us to be the most successful Nation 
on Earth.
    Thank you, Mr. Chairman.
    Chairman Lieberman. Thank you, Senator Carper. That is 
certainly our intention, which is to be judged by the ultimate 
product of our oversight and investigation.
    Senator Bunning.


    Senator Bunning. Thank you, Mr. Chairman.
    Obviously what we have before us today is a mess. There is 
no other way to look at it. We have an energy trading company 
basically in ruins, thousands of employees with little or no 
retirement savings, a major accounting firm under a cloud, and 
investors left holding the bag.
    We have heard allegations of shredding documents, shady 
business deals, and insider trading. Every day it seems a new 
revelation comes to light.
    As it has been mentioned, in the year 2000, Fortune 
magazine listed Enron as the seventh largest corporation in 
America. Now the company has filed bankruptcy, the largest 
business ever to do so in U.S. history.
    Enron's fall was relatively quick, but it seems to come on 
the heels of several years of questionable business deals. 
Enron's financial transactions are also extremely complicated, 
and we are only beginning to understand exactly what happened 
to this company.
    We are going to be asking who, what, when, where, and why 
for a long time. I am confident that Congress and the Federal 
agencies will move as quickly as possible to get the answers to 
these questions.
    This is just the first of, I imagine, many hearings the 
Governmental Affairs Committee will hold, and at last count, 
there were almost a dozen other congressional committees 
digging into this Enron problem. Combine that with the 
investigations by the SEC, Justice, Labor, the IRS, and all the 
private lawsuits that have been filed, and you have definitely 
got a full-blown financial meltdown.
    Some people have already started offering ideas about ways 
we can prevent this from happening again. While ideas are 
always helpful, the last thing we need is a knee-jerk reaction.
    Before we charge in the middle of it and start making 
changes, we have to understand exactly what happened before we 
can seriously propose legislation or regulatory changes. The 
story of Enron employees who not only lost their jobs but also 
their retirement savings should be a major wake-up call for all 
of us to look at the companies that require their employees to 
invest their 401(k)'s in their own stocks.
    I am looking forward to working with the Committee as we 
get to the bottom of this Enron mess and consider the changes 
that need to be made.
    Thank you, Mr. Chairman.
    Chairman Lieberman. Thank you, Senator Bunning. Senator 


    Senator Carnahan. Thank you, Mr. Chairman.
    America has the most vibrant and dynamic economy in the 
world. The foundation of our economy is our capital markets, 
which are robust and resilient. But the success of these 
markets depends on the free flow of accurate and reliable 
information. Our markets are the envy of the world because of 
the confidence that investors have in the private and public 
institutions that produce, verify, and analyze this 
    The collapse of Enron, however, represents a dramatic 
failure of these institutions. These failures will have 
repercussions for years to come. There were a number of 
failings, and let me mention just three.
    The first failing was committed by the company executives 
who had a legal duty to act in the best interest of the 
shareholders. And while I do not want to prejudge the facts in 
this case, based on what we now know, it is fair to say that 
Enron executives did not make full and candid disclosures of 
the company's financial condition until they were forced to do 
    The next failure came when the accountants who were charged 
with auditing the information that Enron presented certified 
that it was consistent with the generally accepted accounting 
principles. In this instance, the same firm who was auditing 
Enron's financial records was also advising Enron on its 
business operations and accruing lucrative fees. We do not know 
the total effect of this blatant conflict of interest, but we 
know that the accountants failed to protect investors.
    And, finally, there was the failure of government agencies. 
The SEC is charged with regulating the financial activities of 
publicly traded companies. They should ensure that the 
information provided to investors is accurate.
    But with all of these safeguards in place, what went wrong? 
Why didn't the alarm bells go off sooner? These multiple 
failures have created multiple victims. I feel for the 
employees who worked for Enron, those who dedicated themselves 
to that company for so long and now find themselves financially 
    And I sympathize with those who invested in Enron. They had 
no reason to mistrust the information that Enron published to 
the world. The massive debt hidden in partnerships was not 
known to them or to the hundreds of analysts and advisors upon 
whom they relied.
    Public employees in Missouri have suffered large losses. 
The Missouri State Employees Retirement System has an 
impeccable record of making conservative, prudent investments 
of employees' pension funds. Still, the system owned just under 
750,000 Enron shares prior to the collapse and lost $8.7 
million. Missouri teachers fared even worse. Their retirement 
plan lost $22.8 million from investments in Enron.
    If these sophisticated investors could not detect that 
Enron was in poor financial condition, how could the average 
investor, putting aside money for college or for retirement, 
how could they have known?
    Let me also suggest that the victims are not limited to 
those who invested in Enron. Every person who owns stock or a 
mutual fund or has a pension will suffer due to the collapse of 
Enron. The action of Enron's executives and its accountants 
together with the failure of our oversight agencies have eroded 
investor confidence in our markets.
    Investors never had to consider that a large, reportedly 
profitable company might go belly up in a span of months. Now 
they do.
    Investors never had to question whether a prestigious 
accounting firm would certify balance sheets that were grossly 
misleading. And now they do.
    Investors never had to wonder whether respected, highly 
compensated executives were playing a risky shell game with 
billions of dollars. But now, thanks to Enron, they do.
    This scandal will have an impact on investors' confidence, 
stock prices, and access to capital for many years to come. The 
task of this Committee and the Congress as a whole is to 
identify where the system failed, fix those problems, and begin 
to remedy them.
    We need a greater transparency and an earlier warning 
system. One warning system that a company may be in trouble is 
when its executives are selling large amounts of stock. I have 
learned, however, that information about insider trading is not 
easily accessible. When I directed my staff to request 
information from the SEC about sales by Enron executives, they 
were told that I would have to file a written request and wait 
15 days. The SEC also stated that 95 percent of the reports of 
insider trading were not filed electronically. This is 
unacceptable in a computer age.
    So, today, I will introduce legislation that requires 
information about insider sales of publicly traded companies to 
be filed electronically on the day of the sale. The bill will 
also require the SEC to make this information available to the 
public on the Internet.
    This single reform could dramatically level the playing 
field between insiders and ordinary investors. Never again 
would company executives be able to dump large amounts of 
company stock without facing immediate scrutiny about the 
financial health of their company.
    I know my colleagues will be proposing many other new ideas 
in the coming days, and I hope these hearings will result in 
reforms, for never again should workers and investors be 
violated as they have been by an American corporation.
    Thank you, Mr. Chairman.
    Chairman Lieberman. Thank you, Senator Carnahan. Senator 


    Senator Dayton. Thank you, Mr. Chairman. I want to commend 
you for holding this very important hearing. I also want to say 
to my colleague, Senator Carnahan, please put me down as a 
cosponsor of your bill.
    Mr. Chairman, I hope that this and subsequent hearings will 
discover and disclose the truth about this financial debacle, 
especially the actions of Enron's officers and directors who 
caused it and of the auditors at Arthur Andersen who abetted 
its concealment. The recent shredding of documents by both 
Enron and Andersen personnel shows how much they don't want us 
to know about their irresponsible and possibly illegal actions.
    This hearing properly focuses on the failures of government 
regulation and oversight which permitted or failed to detect 
the company's questionable dealings, the mounting losses, and 
the resulting financial collapse.
    While we must identify those regulatory shortcomings and 
propose the necessary remedies, it is very important, I 
believe, not to imply that they bear the primary responsibility 
for Enron's disastrous collapse. In my view, that blame and 
shame belong first and foremost to the Enron officers and 
directors who devised, approved, and then concealed these 
unwise and unsound financial schemes; and, second, to the 
Andersen auditors who abetted them.
    These were not a few honest corporate mistakes. They appear 
to be a multitude of deliberate actions taken over several 
years to maximize profits--nothing wrong with that--but also to 
cover up losses, evade taxes, enrich company insiders, and then 
deceive employees, stockholders, and regulators.
    These corporate misdeeds have caused enormous damage to 
thousands of Enron employees. It is heartbreaking to read about 
the honorable, hard working Americans who have lost their jobs, 
their retirement savings, and their life's security, and who 
also were lied to by Enron's top management about the company's 
actual condition.
    Enron's investors have lost over $80 billion from the 
stock's collapse. Like the employees, they didn't know about 
the company's concealed dealings, 881 offshore accounts, 
successive disasters, and mounting debt. Enron's top executives 
certainly knew. They unloaded over $1 billion of their stock 
before its collapse.
    Someone who should have known about Enron's true financial 
condition, and who was responsible for telling everyone else 
about it was the supposedly independent auditor, Arthur 
Andersen. I know something about auditing from my 4 years as 
Minnesota's State Auditor. The auditor exists and is paid for 
one essential purpose: To assure everyone else that a company 
is reporting its financial condition completely, honestly, and 
    Whatever the complexities of corporate transactions, the 
auditor has one simple standard: The truth. Is the client 
telling the truth and all of the truth? Everyone else in our 
economic system, financial institutions, capital markets, 
investors, and other companies, all rely upon the auditor's 
ability and integrity. There is mounting evidence that Arthur 
Andersen in this instance violated that trust.
    In 1997, the auditors reportedly determined that Enron's 
stated earnings of $105 million were $51 million too high. 
Nevertheless, Andersen agreed to invoke a materiality provision 
and signed off on $105 million as Enron's reported earnings. 
That is deceitful, dishonest, and wrong. And no one needs an 
accounting manual to know it.
    Last October, when Enron reported a third-quarter loss of 
$618 million, it also disclosed that it had overstated its 
profits by nearly $600 million during the prior 5 years. 
Enron's CEO also mentioned that the company's value had 
declined by $1.2 billion as a result of its deals with certain 
    Those disclosures precipitated the stock's collapse, and at 
the time both Enron and Andersen employees were reportedly 
shredding documents.
    If time permitted, Mr. Chairman, I would present more 
damning evidence. However, I also want to address the 
inadequacies in government rules, disclosure requirements, and 
oversight which permitted and then failed to detect these 
egregious abuses.
    I believe that this and subsequent hearings must 
investigate the following matters: In 1993, the Chairwoman of 
the Commodity Futures Trading Commission, just before her 
departure, persuaded that board to exempt energy futures from 
its regulation and oversight. Shortly after her departure, that 
Chairwoman joined Enron's board of directors.
    Then 2 years ago, when Congress was updating these 
commodity regulations and oversight responsibilities, Enron 
reportedly lobbied aggressively and successfully to keep energy 
financial transactions exempted from any government regulation 
or oversight. William Rainer, then the Chairman of the 
Commodity Futures Trading Commission, testified that he was 
``deeply concerned'' about exempting energy trades from 
regulation, because those dealers had no one else regulating 
them, whereas the dealers in financial derivatives were still 
subject to other Federal financial regulation. His warning went 
unheeded and proved to be prophetic.
    Recently, Charles Bowsher, who served as the Comptroller 
General of the United States from 1981 to 1996, observed, 
``Money allowed the Enron leadership to come to town. If you 
look back over the last 5 years, what they did get was no 
    In another area, then-Chairman of the Securities and 
Exchange Commission, Mr. Levitt, tried repeatedly and 
courageously to pass legislation that would prohibit an auditor 
from both conducting the annual independent audit and also 
providing extensive accounting services. Andersen pocketed $52 
million from that dual role in its last reported year. Yet, the 
accounting industry has strongly opposed this and other 
proposed reforms.
    And now the person who led the industry's successful 
opposition has been appointed by President Bush to chair the 
Securities and Exchange Commission. Addressing an accounting 
industry conference, the new chairman lamented that previously 
the SEC had not been a ``kinder and gentler place for 
accountants,'' but that would change. Henceforth, he told them, 
the SEC will have a ``continuing dialogue and partnership with 
the accounting profession, and we will do everything in our 
power to evidence a new era of respect and cooperation.''
    Unfortunately, what is needed now is a new era of higher 
standards and stricter accountability for the accounting 
industry. Financial relationships which compromise auditors' 
independence should be prohibited. Existing peer reviews in 
which firms exonerate each other must be replaced with a 
strong, independent governing board. That board or another 
independent entity must regularly review and update existing 
audit standards and the generally accepted accounting 
principles which comprise them. And neither the standards nor 
the principles nor the enforcement of them should be 
adjudicated by Congress.
    If these shortcomings are not swiftly remedied, there will 
be more Enrons, not in the sense of companies failing, which is 
an unpleasant but inescapable feature of capitalism, but in the 
sense that these failures are caused by mistakes and misdeeds 
previously hidden or misreported. This oversight laxity 
benefits a relatively few but well-connected corporate cowboys, 
who want to play fast and loose with other people's capital and 
the people they pay to lie with them. But it is terribly 
harmful to everyone else in this country, the millions of 
businessmen and businesswomen, company employees, and investors 
whose livelihoods depend upon an honest and reliable economic 
system. It is our responsibility to ensure that system.
    Thank you, Mr. Chairman.
    Chairman Lieberman. Thank you very much, Senator Dayton.
    I want to thank all my colleagues on the Committee for 
their opening statements. I appreciate them. As Chairman of the 
Committee, I am proud of them. I think what is reflected here 
is a shared sense of outrage about what happened as we know it 
now in the Enron scandal and a shared desire to end this 
investigation, whenever we conclude it is ended, with a series 
of proposals for reform that will do as best as we can to 
ensure that the Enron scandal or anything like it never happens 
    So I appreciate very much what was said in reflection of 
the experience and the insight that is here on the Committee, 
and it gives me confidence that the goal that all of us have, 
which is to conduct a rigorous, nonpartisan investigation 
producing concrete proposals for reform, will be accomplished.
    We will go now to our witnesses. Mr. Levitt and Mr. Turner, 
thanks very much for your patience as this Committee begins 
what I have described as a long journey, an important journey 
ahead of us. Arthur Levitt, we couldn't have a better witness 
to start this off than yourself. You worked on Wall Street. You 
were the chairman of the American Stock Exchange, worked as 
chairman of the New York City Economic Development Corporation. 
In an unusual chapter of your life, you owned the Roll Call 
newspaper here on Capitol Hill, but then most directly and 
significantly related to these matters, for 8 years, from 1993 
to 2001, you were the Chair of the Securities and Exchange 
    Lynn Turner, a background in education and in business 
accounting, served for 3 years as chief accountant of the 
Securities and Exchange Commission during the time that Arthur 
Levitt was chairman.
    I would say, as you have heard these statements, that I 
appreciate very much that both of you are here. There are 
several investigations of Enron going on. They are fact-
intensive. We have begun one ourselves, and those are going on 
both in Congress and in prosecutorial offices around the 
country. But it seemed to me that as we started our 
investigation, we would benefit greatly from having you two and 
the expert witnesses on the panel to follow, if you will, to 
take us up to the mountaintop and, based on what we know about 
Enron and what happened to it today, help us understand the 
facts as we know them, looking backward, but also give us some 
guidance as we begin our investigation as to what the most 
critical questions are we should ask and perhaps even suggest 
to us what you would guess based on your considerable 
experience some of the answers to those questions might be.
    So, with that, and our thanks, I now welcome the testimony 
of Arthur Levitt.


    Mr. Levitt. Mr. Chairman, Senator Thompson, and Members of 
the Committee, thank you for the invitation to share my 
thoughts on the failure of Enron and its implications for our 
financial markets.
    \1\ The prepared statement of Mr. Levitt appears in the Appendix on 
page 75.
    Today, there is an emerging crisis of systemic confidence 
in our markets. What has failed is nothing less than the system 
for overseeing our capital markets. I do think we have an 
opportunity to repair trust in those on whom investors depend, 
and in the process, trust in the numbers that are the backbone 
of our markets. But our response must be comprehensive. Healthy 
and resilient financial markets depend on the accountability of 
every single one of its key actors--managers, auditors, 
directors, analysts, lawyers, rating agencies, standard 
setters, and regulators.
    Enron's collapse did not occur in a vacuum. Its backdrop is 
an obsessive zeal by too many American companies to project 
greater earnings from year to year. When I was at the SEC, I 
referred to this as a ``culture of gamesmanship''--a 
gamesmanship that says it is OK to bend the rules, to tweak the 
numbers, and let obvious and important discrepancies slide; a 
gamesmanship where companies bend to the desires and pressures 
of Wall Street analysts rather than to the reality of the 
numbers; where analysts more often overlook dubious accounting 
practices and too often are selling potentially lucrative 
investment banking deals; where auditors are more occupied with 
selling other services and making clients happy than detecting 
potential problems; and where directors are more concerned 
about not offending management than with protecting 
    Any reforms must recognize the importance of the 
gatekeepers in safeguarding the interests of investors and the 
fundamental need to preserve and enhance those gatekeepers' 
independence. Certainly these steps, or any steps, are not a 
panacea, but we have got to begin to reinvigorate the financial 
checks and balances that over the years, as a result of nothing 
less than a cultural change, has eroded in America.
    First, we must better expose Wall Street analysts' 
conflicts of interest. For years, we have known that analysts' 
compensation is tied to their ability to bring in or support 
investment banking deals. In early December, with Enron trading 
at 75 cents a share, 12 of the 17 analysts who covered Enron 
rated the stock either a hold or a buy.
    Two years ago, I asked the New York Stock Exchange and the 
National Association of Securities Dealers to require 
investment banks and their analysts to disclose clearly all 
financial relationships with the companies they rate. That 
rulemaking--still not finalized--should go further and mandate 
that analysts disclose how their compensation is affected by 
their firm's investment banking relationships. And Wall 
Street's major firms--not its trade group--need to take 
immediate steps to reform how analysts are compensated.
    As long as analysts are paid based on banking deals that 
they generate or work on, there will always be a cloud over 
what they say. Analysts also should not be allowed to trade the 
stock of any company for which they have issued a 
recommendation in the last 30 days.
    Second, company boards, unhappily, fail to confront 
management with tough questions. Stock exchanges, as a listing 
condition, should require at least a majority of the directors 
on company boards to meet a strict definition of independence. 
That means no consulting fees, use of corporate aircraft 
without reimbursement, support of director-connected 
philanthropies, or the kinds of corporate seductions that are 
present in all too many board rooms in this country. In Enron's 
case, at least three so-called independent board members would 
have been disqualified under this test of independence.
    Third, many accounting rules need to be updated to better 
reflect changing business practices to give investors a better 
understanding of the underlying health of companies.
    Because the Financial Accounting Standards Board is funded 
and overseen by accounting firms and their clients, its 
decisions have become agonizingly slow. This well-meaning group 
must defend itself as well from congressional pressure, which 
is often applied when powerful constituents hope to undermine a 
rule that might hurt their rulings. FASB's funding should be 
secured not just through the accounting firms and the 
corporations for whom they establish standards, but also a 
number of market participants from the stock exchanges, to 
banks, and to mutual funds.
    The Financial Accounting Foundation, which chooses FASB 
members, should be composed entirely of the best qualified 
people, the people with the best judgment, not merely those who 
neatly represent constituent interests. I have never favored 
constituent boards and I think the way this board is structured 
really defies the kind of standard setting that is cried out 
for in this situation. The FASB should then be able to focus 
more on getting the standards right and avoiding delays and 
compromises that ill serve investors.
    I will turn briefly to probably the most urgent area of 
reform. Like no other, the accounting profession has been 
handed an invaluable but a fragile franchise. From this Federal 
mandate to certify financial statements, the profession has 
prospered greatly. But as an edict for the public good, this 
franchise is only as valuable as the public service it provides 
and as fragile as the public confidence that gives it life.
    It is well past time to recognize that the accounting 
profession's independence has been compromised. Two years ago 
the SEC proposed significant limits on the types of consulting 
work an accounting firm could perform for an audit client. An 
extraordinary amount of political pressure was brought to bear 
on the Commission. We ended up with the best possible solution, 
given the realities of the time. I would now urge, as a 
minimum, that we go back and reconsider some of the limits 
originally proposed, namely, a prohibition on the auditor 
designing or installing information technology systems and 
performing the internal audit.
    Auditors, I believe, should also be barred from consulting 
on precisely how to structure transactions, such as the kinds 
of special purpose entities that Enron engaged in. This type of 
work only serves to help management get around the rules.
    I also believe that the audit committees, not company 
management, should pre-approve all other consulting contracts 
with the audit firm. Such approvals should be granted rarely 
and only when the audit committee decides that a consulting 
contract is in the shareholders' best interests.
    And last, I propose that serious consideration be given to 
requiring companies to change their audit firms, not just the 
partners, every 5 to 7 years to ensure that fresh and skeptical 
eyes are always looking at the numbers.
    More than 3 decades ago, Leonard Spacek, a visionary 
accounting industry leader, stated that the profession could 
not survive as a group, obtain the confidence of the public 
unless, as a profession, we have a workable plan of self-
regulation. Yet all along the profession has resisted 
meaningful oversight. Rarely, of all the groups that the 
Commission oversees, has this group ever spoken of the public 
    We need a truly independent oversight body that has the 
power not only to set the standards by which audits are 
performed, but also to conduct timely investigations that 
cannot be deferred for any reason, and the ability to 
discipline accountants. All of this needs to be done with 
public accountability, not behind closed doors.
    To preserve its integrity, this organization cannot be 
funded in any way by the accounting profession. The rise of the 
baby-boomer generation, changing retirement patterns and 
markets that sometimes defied the laws of gravity brought more 
and more first-time investors into our markets. These are our 
friends. These are our neighbors, whose hopes and aspirations 
became inextricably linked to the health, the resiliency of our 
    We assault those dreams if company executives sell out our 
shareholder faith and if those purporting to be independent are 
anything but. Enron, like every other financial failure before 
it, proves that investors bear the ultimate cost. It is time to 
repair what has been lost.
    Thank you.
    Chairman Lieberman. Thank you, Mr. Levitt, for an excellent 
statement. Mr. Turner.


    Mr. Turner. Mr. Chairman, Senator Thompson, and Members of 
the Committee, Enron highlights two issues. The first is that 
accounting standards are meaningless unless fully complied with 
and enforced through a rigorous, unbiased, and independent 
audit. The process needs to be improved so as to yield more 
timely and higher quality standards. That is our accounting 
standard setting process.
    \1\ The prepared statement of Mr. Turner with an attachment appears 
in the Appendix on page 78.
    But keep in mind that no matter how quickly information is 
reported to the public, or what information is reported, if it 
is inaccurate its value is lost. Even worse, bad information 
leads to counterproductive decisions.
    To the first issue, we know that under the existing rules, 
Enron's financial statements should have presented a clearer 
picture than when they were first presented to investors. Based 
on filings the company made with the Securities and Exchange 
Commission in November of last year, there were four instances 
of non-compliance with existing rules. Three of these errors 
have resulted in Enron restating its financial statements for 
improperly recording an approximately $1.2 billion in 
additional equity; the company failing to book audit 
adjustments, decreasing income by $51 million or 48.6 percent 
of the reported net income of $105 million in 1997, as we 
already heard from Senator Dayton; and the company failing to 
consolidate or include the numbers, including debt, from 
partnerships commonly referred to as special purpose entities 
in Enron's financial statements.
    These special purpose entities, or SPEs, are typically 
designed for a specific transaction. SPEs come in various 
forms, including partnerships like Enron established, 
corporations, or even trusts. SPEs are used for many purposes 
such as financing buildings or equipment, raising capital by 
transferring receivables, and providing capital to a bank that 
has troubled loans that are shifted out at the bank. While SPEs 
are sometimes used for legitimate business purposes, they are 
also used to hide liabilities away from the unwary investor.
    SPEs usually involve at least four parties when they are 
set up: The company who sets it up, called the sponsor, in our 
case Enron; the SPE itself, as you have read about in the 
paper, with names like LJM1, Chewco or Jedi; a lender to the 
SPE, who is willing to finance its activities; and an investor 
from the outside who will own the SPE. In a nutshell, the 
sponsor establishes the SPE which in turn acquires or builds an 
asset. The funding is provided by the lender who in turn may 
look to the sponsor for some form of support for the loan such 
as a guarantee or credit enhancement.
    The SPE is owned by an independent investor who puts in, in 
the form of equity, at least 3 percent of the amount of capital 
needed to acquire the asset. The debt of the lender is then 
paid back through lease payments or securitization of the SPE's 
assets. There is an expanded discussion of SPEs in my written 
statement. I would be happy to respond later to any questions 
you might have.
    The fourth question raised with respect to the financial 
statements of Enron involves the adequacy of the disclosures, 
the transactions Enron entered into with related parties such 
as SPEs. The description and discussion of these related party 
transactions are significantly greater in detail in the 
November 2001 filings than had previously been disclosed. One 
can only ask if now, why not before?
    New accounting rules were not needed to prevent the 
restatements of Enron's financial statements or to improve the 
quality of some of its disclosures. Compliance with and 
enforcement of the accounting rules that have been on the books 
for years would have given investors a timely and more 
transparent picture of the trouble the company was in. And the 
security rules also currently require disclosures that are 
intended to give the investor an opportunity to look at the 
company ``through the eyes of management.''
    While Enron has correctly been described as a business 
failure, in the end it was also a failure that the audited 
numbers did not report the true economic condition of the 
company in an accurate or timely manner to the investors. To 
correct this lack of compliance with accounting standards I 
urge you to consider the imperative need for an effective, 
independent professional oversight body for the accounting 
profession that has the following critical elements: It is 
conducted by an adequately funded organization. Its members are 
drawn from the public and not currently practicing accountants. 
It has the ability to effectively and expeditiously investigate 
and then effectively and expeditiously discipline those who 
failed to follow the rules. It must have the power to establish 
auditing and quality control standards that serve the interests 
of investors, especially those when these vary from the 
interest of the profession. And it inspects the work of 
auditors on an ongoing basis to ensure they have made the 
investing public, and not the amount of consulting fees they 
can generate, their number one priority.
    In studying this issue, I would encourage you to consider 
various types of regulatory organizations that have already 
been established, including the NASDR, the National 
Transportation Board and the recently created foundation in the 
United Kingdom.
    Let me just briefly mention the second issue, which deals 
with accounting disclosures. We need to enhance disclosures 
regarding events and transactions that, should they occur, 
would result in a company being required to make payments to a 
third party. We have now seen this type of meltdown, as we have 
seen in Long-Term Capital Management, in Enron, and those 
disclosures need to be made to prevent that in the future.
    In addition, greater disclosure should be required of key 
performance indicators that provide investors with the ability 
to identify at an early stage trends in the business that may 
have predictive ability about what is going on.
    Second, as Chairman Levitt has noted, our standard-setting 
process for issues such as SPEs has taken longer than it has 
taken my children to graduate from high school. If the SEC is 
to continue to look to the private sector to set standards, 
which I do very strongly support, then the SEC and investors 
have the right to expect timely resolution of this and other 
important issues. If the FASB were unable to rectify the SPE 
issue by the end of 2002, then I would urge the SEC to take 
    Third, FASB can accomplish its goal of publishing guidance 
in a timely fashion only if unimpeded by the constant lobbying 
of special interests who seek to slow down its processes with 
issues that lack relevance and who too often run to our 
government to seek its intervention in order to keep investors 
in the dark about the numbers.
    Fourth, the FASB's emerging task force is comprised 
entirely of representatives of industry and the accounting 
profession and lacks representatives from the investing public 
and community. Its mission does not mandate standards that 
result in the most transparent reporting for investors. In 
fact, it has at times seemed to be more intent on 
grandfathering poor accounting from the past. This should 
    And finally, one of the stark realities the FASB has faced 
in the past when setting standards is that before the ink 
dries, the investment banking community and accountants are 
joining forces to find ways to structure transactions, just as 
we have seen in the Enron case, to get around new rules. It is 
time to get away from this mentality and a good starting point 
would be to prohibit auditors from designing and structuring 
transactions that result in less rather than more transparency 
for investors.
    Thank you.
    Chairman Lieberman. Thank you, Mr. Turner, for a very 
helpful statement. We are going to go around now and have 7 
minutes for each Senator to ask you questions.
    I wanted to start with a broader baseline question, if I 
can, Mr. Levitt, and put it in this context: Congress and, in 
fact, State legislatures, etc., all over the country pass laws 
which are aimed at encoding our best aspirations for our 
behavior, encouraging good behavior and prohibiting and 
ultimately punishing bad behavior. Notwithstanding that, human 
nature being what it is, people will violate those laws.
    So as you look at what we know now about the Enron 
collapse, which we now call the Enron scandal, is this one of 
those situations where these folks were just going to do what 
they did regardless of what the law was? Or is it a situation 
where we can now look back and say if the laws had been 
different, perhaps--as your opening statement indicated--self-
regulation of professions had been different, if the agencies 
had had more authority, we could have prevented the collapse of 
Enron? Or we certainly could have prevented some of the damage 
that was done to the thousands of employees and investors who 
lost their life savings?
    I think you understand what I am asking. If the laws and 
agencies were better prepared, could we have protected a lot of 
the people who were hurt by Enron's collapse?
    Mr. Levitt. I have thought about that very question many 
times, and I think it is another case of the nail in the shoe 
of the horse. Any of the elements around the rating agencies, 
the standard setters, the regulators, the board, the analysts, 
the auditors, at different points in time could have blown the 
whistle, could have turned up what a sham this really was.
    But these things, I do not think, happen in a vacuum. The 
fact that any one of them might have been able to do it says 
something about the confluence of all of them in this unhappy 
event, which I believe occurs only when there is a kind of 
cultural economic erosion created by a business community that 
is highly competitive, certainly a desirable characteristic, 
but where some of them begin to push toward the lines, and go 
over the line, others cannot afford not to follow. And almost 
everybody else is playing catch up.
    And when you have an incidence of guile of this magnitude, 
playing catch up just is not enough.
    Chairman Lieberman. Of course, one of the functions or 
effects of law often is to effect the kind of culture that you 
have talked about. I think in one sense that comes to mind we 
have done that with regard to the environment over the years. 
We have changed the ethic out there so that a lot of what used 
to pass as business as usual now does not, and it does not 
require law everywhere. Potential polluters are cleaning up on 
their own. So part of the question is can we change the ethic 
that you have described quite correctly by what we do here?
    Mr. Levitt. Absolutely, you can change behavior. You can 
begin to get lots of those of us in this game to focus on it 
differently, to deal with our responsibilities differently. 
Right now this event has been a clarion call to America's 
boards of directors. Whether they stay with it depends on 
whether you can be focused in terms of a direction which will 
encompass the elements that led to this background. And they 
are very broad.
    To focus merely on the auditors I think would be a mistake. 
This goes far beyond that.
    Chairman Lieberman. I agree. That is one of my hopes for 
this investigation and the others that are occurring, that by 
trying to tell the story--and obviously we are being assisted 
greatly by the media at this point--about what happened with 
Enron, we create a fact situation, an exposure, that presumably 
will alter the ethic as well. And then it is up to us and the 
professional groups that are out there, in terms of self-
regulation, to encapsule that ethic as we go forward.
    You talked in your opening statement about the importance 
of shoring up the independence and resolve of the gatekeepers 
which keep our markets honest--and, of course, I agree with 
you--the auditors, the analysts, the corporate directors, and 
the folks who set accounting standards.
    I want to ask you, as a former Chairman of the SEC, about 
what its role is. Because I would guess that most investors, 
average investors, assume that it is the Securities and 
Exchange Commission that is the watchdog that makes sure that 
disasters like Enron do not occur. So I would like to ask you 
to give us a baseline here about what the SEC's role is in the 
system of gatekeepers guarding the integrity of the markets. 
And tell us if you think there is anything that should be done, 
particularly in the light of what we know about Enron now, to 
alter that role?
    Mr. Levitt. The SEC's role is multifaceted. It ultimately, 
I believe--and every chairman will view this from a different 
perspective. I think the most important constituent that this 
government agency has is America's individual investors. Nearly 
all of you have commented on confidence in our markets, and 
preserving that confidence by protection of the American 
investor is the primary goal of the SEC.
    It is done in many different areas. The Commission has the 
responsibility for maintaining markets where competition is 
both fair and fierce. They have the responsibility for 
overseeing the standard-setting process which we delegated to 
the FASB. We have the responsibility that our regulation is 
based not on merit regulation but on full and on fair 
disclosure. And in that connection, we monitor thousands of 
filings every year. We have the responsibility when the system 
fails, when fraud enters into the picture, of bringing 
enforcement action.
    Those are the multitude of responsibilities. Now I have 
learned through years in the private and public sector that to 
expect any government agencies to operate so comprehensively 
that they can eliminate all fraud and deception simply will not 
work. The SEC and investor protection in the United States is 
determined by a trilogy of private rights of action, of self 
regulation, and of the SEC's enforcement arm. Any one of those 
three could not do it alone.
    Chairman Lieberman. I believe my time is up. There is a 
question that maybe someone else will ask--and perhaps we can 
talk about it another time--which is whether there is a larger 
role here for the SEC, including as I gather occurs--and I am 
not proposing this, I am raising it. I gather it occurs in some 
developed economies in Europe, for instance, where there is a 
public auditor. There are public employees who audit the books 
of publicly held corporations, so that they are obviously 
thoroughly independent and do not have any of the conflicts 
that we have seen occur here with regard to private auditors. I 
am going to hold on that and just leave the question with you.
    I will now yield to Senator Thompson.
    Senator Thompson. Thank you, Mr. Chairman. And, gentlemen, 
thank you for your analysis and suggestions as to what we might 
do. It is remarkable the things that are so self-evident that 
need to be done have to really hit home to us in the context of 
a crisis like this. But now we have the crisis, and perhaps we 
can do some things that we should have done a long time ago.
    I think you rightfully point out the problem with the 
gatekeepers and what seems to be just an inherent conflict of 
interest for all of them. I guess a lot of it cannot be 
avoided. But we have a situation here where the numbers are so 
great, a tremendous amount of dollars with so many people 
dependent on the company making the numbers, the analysts 
pushing it. And obviously the accountants and the auditors have 
a great deal of responsibility.
    But I guess even more perplexing to me are these outside 
analysts. We criticize Mr. Lay for touting his own stock. I 
think the latest was September 26. Then October 16 Enron posted 
a loss of $618 million. And then, as you pointed out, Mr. 
Levitt, you may be looking at another date, but as late as 
October 25, when Enron stock was in free fall, 15 out of 17 
analysts tracking the stock still had buy or strong buy 
recommendations, despite the fact that analysts for more than a 
year were complaining that they could not figure out how Enron 
made money. Plus, you had the corporate executives selling 
stock. Plus, you had the CEO leaving in August.
    What in the world were these analysts looking at when they 
made these buy recommendations? Was their desire to be deceived 
so great that they refused to look at the facts before them? Or 
were the transactions so complicated that they just could not 
figure it out and went ahead on hope and expectation that 
things would work out in the end? What do you think?
    Mr. Levitt. I think that it is a little of all of that. I 
used to run a large brokerage firm which had many analysts. And 
an analyst, I have found, hates to prove himself wrong. So if 
an analyst is recommending a stock at 80 and it goes to 60 and 
50, boy, it was a good buy then, it is a better buy now. And 
sell-side analysis has become both conflicted--and one of you 
mentioned the multitude of conflicts in this whole system. They 
clearly have been conflicted, and there is every reason that 
they might not want to interfere with an important investment 
banking client.
    Senator, you said something which struck me as being 
critically important as we work through this process over the 
course of coming weeks and months. You said that real scandal 
is not what is illegal but what is permissible. And certainly, 
with respect to analysts and their conflicts which are hidden 
from public view, that is one of many examples that responds, 
that resonates to that statement of yours.
    Senator Thompson. Can an American investor today depend on 
Wall Street analysts?
    Mr. Levitt. I think Wall Street sell-side analysis has lost 
virtually all credibility. So much of the revenues of firms 
depend upon investment banking that the importance of the 
analyst to acquiring and maintaining an investment banking 
relationship becomes a primary concern.
    Senator Thompson. And, of course, the average investor 
certainly cannot analyze these complex financial statements.
    Mr. Levitt. It is difficult.
    Senator Thompson. So they are basically left with total 
guesswork in the end, it would seem to me.
    With regard to the auditors, it looks to me like one could 
make the case that the era of self-regulation should be over. I 
am not sure what the alternative would be. Obviously, the SEC 
would turn into a different organization, in some respects. But 
we have these outside entities now supposedly conducting 
oversight. I think some try to do a good job. The Financial 
Accounting Standards Board, as you say, are very slow on things 
such as rules with regard to some of these complex new-type 
transactions, special purpose entities, and so forth.
    Now, Chairman Pitt and I would appreciate your views for 
his recent suggestion for yet another independent entity that 
perhaps is financed differently and so forth. What difference 
that would make? What do we need to do in that regard? Do we 
need to continue to try to develop some kind of pristine entity 
out there that can oversee these boards, that will finally get 
it right?
    And last, what is SEC's role in this? As I understand it, 
since the 1930's, the SEC has had the authority to set 
standards themselves, if you want to step in, if FASB is that 
slow in doing something that important, why does the SEC not 
step in?
    So two or three or four questions in there for you.
    Mr. Levitt. I think the SEC does have the authority to set 
standards. I have found several areas of public policy in which 
the political process simply does not work. One is closing 
military bases and the other is setting accounting standards. I 
have just resisted getting the SEC directly involved in that. 
In this effort to work toward auditor independence, the 
pressure on us was so enormous that if you get to----
    Senator Thompson. But if you are getting that kind of 
pressure, and with your stature and ability to withstand it and 
resist it, think of the pressure that these so-called 
independent boards of citizens will be getting.
    Mr. Levitt. Well, there is no perfect solution. What I 
would suggest, however, is a group similar to the POB, which is 
made up of some of the finest citizens in our community----
    Senator Thompson. Who just retired en masse, as I 
    Mr. Levitt. But who had such an amorphous mandate and 
funding by the industry cheerleaders, rather than independent 
sources, that they were absolutely impotent. But if you gave a 
group of that caliber a firm mandate and the responsibility 
that only Congress can give to them to get at documents, to 
subpoena them, to get at it not just from the auditors but from 
the clients as well, because doing it otherwise is doing half 
the job. Give them the mandate, give them the funding.
    Will that answer the problem? It is one important link, and 
it is one that I believe would begin to reassure the public.
    Three years ago if you asked the typical American what he 
knows about accountants, they would shrug their shoulders. I 
went to my dentist here in Washington about 7 months ago, and 
before I began the painful process, the dentist turned to me 
and said, Arthur, those accountants are really scalawags, are 
they not? Well, when dentists begin to understand what 
accountants are, we have got a problem.
    Senator Thompson. Maybe even we might, right? Is that what 
you are suggesting?
    What do you think about Mr. Pitt's recommendation?
    Mr. Levitt. I would have to hear more about how the funding 
would take place, whether there could be the kind of deferral 
that I think has held up processes for years. I would have to 
know whether this would be a truly independent group. There are 
many more details to be worked out.
    Senator Thompson. Mr. Turner, do you have ideas on that?
    Mr. Turner. I actually commend Chairman Pitt for heading, I 
think, in the right direction and trying to pull that all 
together in one organization. I think, as Chairman Levitt said, 
it is a step in the right direction, and I think it can work if 
we give it the independent funding and we have a real public 
board of the nature that you just heard about.
    I think probably there are a lot of details to still hear 
about that we do not know. From what we have seen, I would say 
we probably have advanced the ball out of the end zone and up 
to about the 30, and we have probably still got about 70 yards 
to go.
    Senator Thompson. Thank you, Mr. Chairman.
    Chairman Lieberman. A very seasonally appropriate metaphor. 
So you have told us what dentists think about accountants. What 
do you think accountants think about dentists?
    Mr. Turner. My wife is a dentist.
    Chairman Lieberman. So you want to recuse yourself. Senator 
    Senator Levin. Thank you, Mr. Chairman.
    I would like to press you a little bit further on the Pitt 
proposal because it has been severely criticized, it seems to 
me. When we have a former U.S. Comptroller General and head of 
the GAO who is resigning apparently in protest in a mass 
resignation, as I understand, it is intended to be a protest to 
this new Pitt proposal because it does not have the features of 
independence which you both proclaim are so important. That has 
got to resonate a bit with us.
    So I would like to press you a little bit further frankly 
on that issue. I know there are a lot of details still to be 
unveiled, but from what you know of the Pitt proposal, does it 
have the characteristics of an independent oversight body that 
has the power, in your words, not only to set the standards by 
which audits are performed but to conduct timely investigations 
that cannot be deferred for any reason, and to discipline 
accountants? From what you know, does it meet that standard?
    Mr. Levitt. If you had asked me that question a year ago, I 
probably would have answered in the affirmative. The 
environment today calls for very different remedies, very 
different actions. A year ago had you asked me whether I felt a 
legislative solution was desirable, I would have said no 
because of the unintended consequences. Today I would answer 
that in the affirmative.
    You have to be, and I do not have to tell you because you 
often are in a situation where a crisis erupts right underneath 
you. And you have got to come out with an instant response. The 
press is at you, the legislature is harassing you. The world at 
large is demanding an action. I think in those instances 
perhaps the first action is not as thoughtful as it could be.
    So I think that we have got to put a lot more teeth into 
the proposal than the initial proposal would appear to have 
come out.
    Senator Levin. You are talking about the initial proposal 
of Mr. Pitt?
    Mr. Levitt. The initial Pitt proposal I think needs more 
teeth. Frankly, I need to see more about how it will be 
    Senator Levin. As you would approach it, which is now 
legislatively, as I understand it, that issue of having an 
independent board oversee the auditors to make sure that there 
are, in fact, teeth, as you put it, who would select the 
members of that independent board? What should we look at? 
Should it be selected by the SEC? Should we try to set forth 
some kind of representation of various kinds of backgrounds and 
experiences? Give us some hint. Who, first, would make the 
    Mr. Levitt. Every time I have gone down the road of 
selecting boards--and I have done this many times and I worked 
out a formula--I have always regretted it. There is no perfect 
way of doing it.
    I certainly think that the SEC would be in a good position 
to start the ball rolling. And I know that Chairman Pitt has 
great confidence in the members of the POB. I think the POB 
might be a logical starting point for this. I have no doubt 
that Chairman Pitt will be in consultation with Mr. Bowsher, 
who is recognized for integrity and probity and understanding 
of these issues. He has the public's confidence.
    Senator Levin. The Federal Accounting Standards Board, 
FASB, as you pointed out, has had tremendous pressures placed 
upon it and has not moved quickly in terms of the adoption of 
accounting standards. For instance, what should be on the 
balance sheet, what should be off the balance sheet. This is 
not the discipline side, which we have just discussed, but the 
standards as to what accountants should go by in making 
accounting decisions.
    How would you change FASB to give it greater independence, 
an independent source of financing, and to represent, for 
instance, the investing public which has not been represented 
and to overcome other kinds of shortfalls? Should that be 
looked at legislatively? How do we go about that?
    Mr. Levitt. I believe that the FASB must be--the structure 
of it which is, their members are chosen by a constituent board 
made up of the securities industry, the accounting profession, 
a whole group of people not known necessarily for competence, 
although they are headed by a very effective leader, but known 
because of whom they represent. So I think the way the board is 
chosen should be reconsidered.
    The fact that the board is funded by the very firms for 
whom they set standards, who often come back to them and say if 
you are going to set this standard we are going to cut off your 
funding. That is wrong. We have got to change their funding.
    But ultimately, I think the SEC must get a little bit more 
involved in terms of being ready themselves to create a 
standard in the event that FASB is too slow to do their job. It 
is not something that I think is a comfortable position for the 
Commission to be in, but I see no other way around it.
    Senator Levin. As you know, Mr. Levitt, I proposed a bill 
about 10 years ago which would have required stock options be 
treated the same way in company tax returns and in their 
earnings statements. Now they are allowed to treat them 
differently, not show them as an expense in their earnings 
statements, and therefore give a very different impression, a 
much more positive impression of the company in terms of its 
earnings and profits, at the same time taking a tax deduction 
in their tax returns.
    What is your reaction to that? Should we change that? Treat 
them one way or the other, but to treat them consistently? So 
that when executives get these huge amounts of stock options--
which resulted, in part, by the way, in Enron being able to 
show itself as being highly profitable--that they have got to 
then reflect it on the books the same way they reflect it on 
their income tax returns so that investors and stockholders 
understand that those options are a cost to the company?
    Mr. Levitt. I believe that clearly options have great value 
or we would not have seen the lobbying effort that we saw when 
this issue came up. During my first 4 months at the Commission, 
I had a policy of seeing anyone that wanted to see me. I spent 
nearly half my time talking to the business community that 
objected to that treatment, partially correctly because at that 
point the board was unable to establish a way of creating a 
value for those options.
    I look back upon that period now and say that my greatest 
mistake was not pushing FASB harder to do that. Right now we 
have the International Accounting Standards Board ready to go 
down that road where international standard setters are doing 
that very thing. So I would be, in general, supportive of your 
recommendation, and I regret that I was not more aggressive in 
that area when I was at the Commission.
    Senator Levin. Thank you. Thank you for your service, as 
    Just in closing, I will point out that in the October 1999 
issue of the magazine that is put out by the chief financial 
officers, the so-called CFO Magazine, they handed out awards 
for the finest in finance. One of their winners was the chief 
financial officer of Enron, Arthur Fastow, who was applauded 
for developing ``remarkably innovative financing'' techniques. 
    That is what we are investigating right now, but there is a 
lot of work to be done in terms of both setting independent 
standards and making sure that the accountants themselves are 
held accountable to those standards. That is going to require a 
lot of action on our part and I think your support for that 
kind of legislative action here today is really critical.
    Thank you.
    Chairman Lieberman. Thank you, Senator Levin. Senator 
    Senator Collins. Thank you, Mr. Chairman. Mr. Levitt, it is 
nice to see you once again and to hear your testimony.
    I have a particular concern for the small investor who 
relied on a strong buy recommendation from a sell-side analyst, 
who relied on a system that let the investor down totally, and 
then bought Enron stock for a retirement savings or for any 
other purpose. In that regard, I want to go back to the issue 
that Senator Thompson raised about the conflicts of interest 
that affect the analysts.
    We allow retail brokerage firms to earn enormous sums of 
money underwriting the securities of companies about which they 
are expected to give objective and disinterested advice to 
their clients. That seems to me to be an inherent conflict of 
    When you look at Enron's case, if you look at the 
recommendations of the sell-side analysts, most of them stayed 
with a buy or a strong buy recommendation. By contrast, 
however, the independent analysts were telling their 
subscribers through the fall to dump their Enron stock.
    I think it is very significant that the two brokerage 
houses that did downgrade Enron were those that had fewer ties 
to Enron or its potential merger partner. By contrast, the firm 
that advised Dynergy in merger negotiations, which stood to 
make a large sum of money had the merger gone through, rated 
Enron a strong buy throughout the fall. So it seems to me that 
the whole system is just rife with conflicts of interest that 
make it very difficult for the small investor to rely on the 
advice of the analysts.
    Now you have mentioned that you think we need greater 
disclosure. Is something beyond the disclosure of business 
relationships needed?
    Mr. Levitt. I would be very reluctant to go beyond that. 
The tensions that exist in our society between legitimate 
business interests and what is a conflict, I find is best 
resolved by embarrassment and humiliation rather than by 
rulemaking and legislation, unless it becomes so pernicious and 
so obscure that it cannot come to the public's attention.
    The analysts' problem is, I think, on the margin of what 
went wrong at Enron. I think it is an important problem. I 
think there are, because it goes way beyond Enron, and I think 
the way to deal with it would be to disclose much more clearly 
when they have a conflict and see to it that they cannot trade 
in the stock that they are recommending for a longer period of 
time. I think it is unfortunate that the self-regulating 
organizations have not yet gotten to this. It has been 2 years 
since we talked to them about it. I think that is the way to 
deal with them.
    They are not, in my judgment, really at the core of this. 
The core of this, we are talking about boards, we are talking 
about auditors and how they are supervised. We are talking 
about regulators and standard setters and how they work 
    Senator Collins. Let me move to one of the core issues that 
you just mentioned and ask you and Mr. Turner your opinion. Mr. 
Turner, you mentioned briefly in your statement that in 1997 
Andersen wanted Enron to make a change that would have reduced 
Enron's annual income from I think it was $105 million to $54 
million. Despite Enron's refusal to make that change, Andersen 
nevertheless approved and certified its financial statements. 
Yet, later on, that $51 million was part of the $591 million 
adjustment that Enron made last November. Had Andersen held its 
ground we might not have gone down the road that has led us to 
these hearings today.
    I asked the CFO of a large non-profit entity in Maine how 
this could have happened. And his response to me was: ``Oh, 
that is easy. Whenever we get an audit finding that we do not 
like, we sit down with our auditors and we negotiate what the 
findings are going to be.''
    I must say I was surprised to learn this and his assumption 
that this is very common. Should not the auditor be reporting 
to the audit committee and not to the managers of the entity, 
whether it is a for-profit corporation or a non-profit group?
    Mr. Turner. Senator, I could not agree with you more, and I 
have been out there as an audit partner on hundreds of these 
audits myself, and I think your observation is right on point. 
A couple of years ago there was a very prestigious panel of 
businessmen that came out and said we really need to create a 
system where the auditor does, in fact, report to the audit 
committee directly. I think if we can get it to where it is the 
audit committee who turns around and engages the auditor, if it 
is the audit committee who turns around and pre-approves any 
consulting contracts so that they can find whether or not these 
really do benefit the shareholders, I think that would be a 
tremendous help.
    At the Commission we have seen time and time again, 
including some of the cases that were cited on Mr. Torricelli's 
board, where the auditors actually identified the issue. It was 
not that they were bamboozled by the management team. They saw 
it and they knew it was there and yet continued to issue the 
    I think they are out there. They are humans. They also know 
they are trying to get the consulting. They are trying to serve 
two masters. They are trying to serve a management team. I have 
been a CFO. They are trying to impress you because they want 
the next contract and they know what it takes to get that.
    At the same time, they have to serve the investors. That is 
a tough job. There is a lot of good people in the industry that 
do a good job, but we put them in one of the most difficult 
jobs you could be in. I would encourage people to look at tying 
this more into the audit committee than the management team.
    Senator Collins. Thank you. Mr. Levitt, would you like to 
add anything to that response?
    Mr. Levitt. No.
    Senator Collins. Thank you, Mr. Chairman.
    Chairman Lieberman. Thank you very much, Senator Collins. 
Senator Cleland.
    Senator Cleland. Thank you very much.
    Mr. Turner, maybe I am missing something here. There is a 
lot of this that is just unbelievable to me. Back in my life as 
Secretary of State, I not only was the commissioner of 
securities but, as I said, handled the professional licensing 
boards. These boards were made up of professionals. They had a 
staff, they had investigators.
    And in the case of the accountancy board in Georgia, it is 
a very strong board made up of wonderful professionals, all 
CPAs. And they administered the CPA exam, I mean certified 
public accountant.
    What I am hearing here is that somehow, some way the public 
interests of accountancy in America has gone by the wayside 
here. I cannot believe a lot of what I am hearing, not just in 
terms of Enron but in this sense that there is so much conflict 
of interest, how in the world do you get a clear audit now? And 
that the public is actually dependent on that in its investment 
    I think we have just slipped a long way from the public 
entity, the public interest here. But there are a lot of good 
people, the CPAs around America. You would think that 
somewhere, some way, some certified public accountant that was 
licensed by the State, that was accountable in a professional 
way to the public for their license, and they are all licensed, 
would stand up and say this is ridiculous. This violates 
everything I learned on the first day I went to accountancy 
    I mean, it is hard for me to believe, for instance, that 
the average small business person in my State would be treated, 
as Enron was treated, by their auditors and accountants. For 
instance, it has been alleged that Enron overstated $1.2 
billion in shareholder's equity since 1997, including listing 
$172 million as an asset instead of a reduction for the year.
    Now, Joseph Berardino, CEO of Arthur Andersen, has stated 
that this transaction ``fell below the scope'' of their audit. 
Do you not think any average American who has been subjected to 
an audit in this country would have a hard time understanding 
how $172 million escaped the notice of an auditor?
    Mr. Turner. That is what my dentist tells me. The answer is 
yes. And in fact, while the chairman and I were at the SEC, we 
put out some guidelines that said when people are doing these 
type of things and they are intentional, it did not matter 
whether it was $100 billion or $1 million. For a CPA to be 
intentionally cooking the books like this, and for the auditor 
to pass on it when they know it is an intentional-type error, 
and in the $1.2 billion, that is quite simply Accounting 101. 
That is black and white, there is no gray to it. I cannot 
comprehend that.
    The rule that we put in place back in August 1999 would 
clearly say that something like this you just can not do.
    Mr. Levitt. Senator Cleland, I would have to call to your 
attention, as you go through the airport at National or in 
Atlanta, just look at the signs on the walls that the 
accounting firms put up. They call themselves multi-
disciplinary professional firms. If this was your first day on 
Earth walking through those airports, and you were asked what 
these people did, the last thing in the world you would say is 
they had their roots in public auditing.
    Senator Cleland. Yes, I agree. Good point.
    By the way, Mr. Levitt, I appreciate your public service. I 
have been in hearings where you have testified over the last 
few years, and we appreciate all you have brought to the table 
with your public service. Thank you for your testimony today.
    Mr. Turner, one more point here. One of the things I am 
learning here, and it is hard for me again to believe that just 
the average person or the investor or small business person in 
my State would think OK, you have things that are on the books 
and then whoops, you have things that are off the books. And it 
is OK to have things off the books. They are called special 
purpose entities.
    Do you think the SEC rules should require disclosure of all 
special purpose entities in order to allow credit rating 
agencies and analysts the information to provide sound advice 
to their clients?
    Mr. Turner. First of all, as a former business executive, I 
think those financial statements should, without a doubt, 
provide clear transparency with what is going on with the 
business. And if I am going to go out and finance something and 
I am going to have the obligation to pay it, whether I do it in 
an SPE or not, that should be on my financial statements. 
Otherwise, quite frankly, I am just lying to my investors, and 
I think that is a shame.
    So I do think the rules need to be quickly changed here to 
bring all of these back onto the balance sheet. Let us make the 
balance sheets look like the business actually looks like. And 
to the extent we need additional disclosure so that someone can 
read this and understand it, which I clearly do not think the 
average investor could in these cases, yes, we need to enhance 
those disclosures.
    Senator Cleland. I hate to say it, but it sounds like we 
are having a hard time finding out what ``is'' is.
    Steve Shepherd, the editor-in-chief of Business Week 
Magazine has stated, ``Enron was really a systemic failure of 
all the checks and balances we have on corporate governance.''
    That is kind of scary. Basically the editor of Business 
Week Magazine says this is just kind of a failure of the 
system. There are a lot of corporations out there. Are we 
looking at more Enrons, Mr. Levitt? Do we have such a systemic 
failure going on here that there are not checks and balances 
any more out there?
    Mr. Levitt. I am not certain as to the presence or extent 
of fraud in the Enron case, so I cannot say whether that is a 
factor. And I certainly have no reason to believe that there is 
that kind of potential fraud in other companies.
    I can say, however, that with respect to managing the 
numbers, to massaging the numbers, to deceiving the public, in 
effect, by talking about pro forma numbers, earnings after 
certain charges, I think that is prevalent throughout the 
system. And I think the restatements that we are about to see, 
that Senator Torricelli mentioned in his chart, that the 
frequency of these restatements which have cost America's 
investors billions and billions of dollars is a phenomena that 
will be on the business pages for the foreseeable future.
    So that Enron's problems, apart from fraud, are problems 
that exist, in my judgment, in many other American companies, 
some of them really great companies whose competitive zeal has 
moved them to embrace some of the kind of obfuscation that I 
think represents a systemic problem.
    Senator Cleland. Thank you very much for that very strong 
testimony. Thank you very much, Mr. Turner.
    Mr. Chairman, I would like to ask unanimous consent for my 
opening statement to be put in the record.
    Chairman Lieberman. Without objection, so ordered.
    [The prepared statement of Senator Cleland follows:]


    I was Georgia's Secretary of State for more than thirteen years and 
in my role as the Georgia Commissioner of Securities, I was charged 
with administering the provisions of the Georgia Securities Act 
including the registration of securities issuers, the licensing of 
broker-dealers, stockbrokers and investment advisers. I was also 
responsible for the disciplining of the professionals involved in the 
offer and sale of securities to Georgia residents. During my tenure I 
insisted on a vigorous enforcement program utilizing administrative, 
civil and criminal sanctions that were available to me under the law. I 
am concerned that the regulatory agencies have relaxed their monitoring 
and oversight functions without an increase in a focus on strong 
enforcement of our securities laws. A strong regulatory enforcement 
program and an expedited criminal prosecution of persons willfully 
engaging in fraud and deceits in our markets will provide a major 
deterrent against financially related misconduct.
    The securities markets are, and must continue to be, an integral 
part of our nation's economy. Unfortunately, the successes experienced 
in recent years have led to what appears to be an alarming increase in 
instances of major fraud and abuse. These markets exist as a result of 
the public confidence that we have demonstrated in the industry's 
integrity. Billions of dollars change hands every day on the markets as 
a result of a telephone call, head nod or a hand shake. Should this 
integrity be replaced with an era of mistrust, this confidence would 
quickly erode and the markets would suffer. The public confidence and 
trust has emanated, in part, from the confidence our citizens have in 
the regulatory system that has been in place for over sixty years.
    The market collapse and meltdown of Enron Corporation (``Enron'') 
has raised serious doubts and concerns over corporate and regulatory 
oversight of the securities markets, even for major corporations whose 
securities are listed on national exchanges.
    I am extremely upset and concerned that Enron was able to conceal 
financial practices that were not detected by our financial regulatory 
systems, our credit reporting agencies and financial analysts. As a 
result, Georgia's retirement systems suffered a loss of about 
$127,000,000 over the three year period preceding the bankruptcy filing 
by Enron. Thanks to the diligent work of our Georgia's analysts and 
investment officers, I was pleased to learn that this loss only 
resulted in a 2/10 of 1% decline in investment earnings over that 
period and that they were still able to report a 10.1% return on 
investment for this period. However, many individuals in Georgia and 
around the country suffered real economic hardship.
    Based on my review of documents and news reports, I am appalled at 
the alleged conduct of certain Enron executives. In my statement today 
I will outline some of the major problems that have come to light as a 
result of corporate conduct and serious financial irregularities 
engaged in by these officials.

                           Enron Corporation

    In July, 1985 Kenneth Lay (``Lay'') was appointed chairman and 
chief executive officer after Enron was formed from the merger of 
Houston Natural Gas and InterNorth, a natural gas pipeline company. In 
December of 1996 Jeffrey K. Skilling (``Skilling'') became Enron's 
president and chief operating officer. Kenneth Lay remained as Chairman 
of the Board.
    Enron conducted business as a pipeline company and grew to be a 
dominant force controlling major pipelines throughout the United 
States. During the 1990's Enron ventured into the trading of oil, gas 
and electricity. It was instrumental in the development of an energy 
trading system utilizing a relative new breed of financial instruments 
that allowed them to manage their risk such that they became the 
dominant energy trader in the United States. This quick success let 
Enron to move away from the traditional energy business into other 
emerging markets involving telecommunications, broadband and other 
Internet related businesses.
    Enron maintained its headquarters in Houston, Texas. Its securities 
were listed on the New York Stock Exchange and it was required to file 
reports with the United States Securities and Exchange Commission 
(``SEC'') pursuant to the federal securities laws. In August, 2000 
Enron was ranked by Fortune magazine as the seventh largest company in 
the United States based on market capitalization. At that time its 
common stock was trading in the $90 range, having increased 1,700% 
since its first shares were issued in the 1980's.
    On October 16, 2001 Enron reports its first quarterly loss in over 
4 years after taking charges of $1 billion on poorly performing 
businesses and a $1.2 billion charge against shareholder' equity 
relating to dealings with ``off-balance'' sheet entities. This 
disclosure resulted in the announcement of an SEC inquiry.

                         The Bankruptcy Filing

    In June 2001, after questions arose about the validity of Enron's 
stock valuation, the company's top executives were apparently engaged 
in a systematic effort to sell off many of their shares resulting in an 
estimated $1.1 billion return to these executives. CEO Skilling 
announced his resignation in August and Kenneth Lay resumed the 
position of chief executive officer.
    On October 22, 2001 Enron reported a third quarter loss of $618 
million and the SEC announced an inquiry into its operations. On 
November 8, the company amended and restated its financial reports back 
to 1997 showing that profits had been overstated by $586 million. As a 
result of its financial practices, credit reporting agencies, financial 
analysts and the investing public lost confidence in the company 
resulting in a total collapse of its business operations and its share 
    Sophisticated financial engineering, risky corporate ventures, 
overstatements of asset value and understatement of liabilities forced 
Enron into bankruptcy on December 2, 2001 in a New York bankruptcy 
court. This represents the largest bankruptcy filing in U.S. history. 
At the time of the petition, the assets of the company were estimated 
to be about $50 billion and its liabilities approximately $40 billion.

                             Energy Trading

    Enron engaged in a successful and sophisticated financial trading 
system involving the trading of energy contracts including oil, gas and 
electricity. By the development of a state of the art trading 
environment, Enron was able to engage in massive bilateral trading 
contracts that were outside the overview of the SEC or the United 
States Commodities Futures Trading Commission (``CFTC''). The CFTC 
overview of such contracts was excluded or exempted as the result of a 
recent amendment to the federal commodities futures trading law, even 
though these contracts are similar to other futures contracts regulated 
by the CFTC.
    This type trading is risky but apparently necessary in order to 
provide an open market in these commodities. For example, by engaging 
in appropriate risk management techniques a supplier can assure a 
future market for its products and a user can assure the availability 
of the product at an established price. In order to track supply and 
demand it is necessary to have state of the art hardware and software 
and the personnel resources trained in such trading environments.
    Even though energy futures contract trading is a risky business, 
the meltdown of Enron was accelerated as a result of action by credit 
reporting agencies that downgraded them from investment grade to junk 
status. An energy trading entity will not be able to remain in the 
market once they have lost financial integrity and confidence by their 
trading partners. The disclosure of their serious financial problems, 
the lost value in their shares, the off-balance sheet financial 
engineering and the decline in the broadband telecommunications 
business, all came to light much in the manner of the weather systems 
in the movie ``The Perfect Storm''.

    Enron's Questionable Corporate, Auditing and Financial Practices

 LThe use of off-balance sheet transactions involving entities 
that were formed by, and controlled by, Enron or its executives, that 
were created without complying with Rule 140 of Financial Accounting 
Standards Board. It has been reported that certain of these entities 
were created by Enron executives borrowing funds from Enron's bankers 
using Enron compensating balances and its shares as guarantees.

 LEnron failed to disclose the formation of these entities 
resulting in the failure to disclose material financial transaction and 
the understatement of corporate liabilities. This resulted in continued 
positive ratings by credit rating agencies and financial analysts.

 LThe use of mark to market evaluation reports of certain Enron 
assets by these entities resulted in false and significant valuations 
of Enron's assets.

 LOn October 17, 2001 Enron apparently decides to change plan 
administrators for its employee's 401(k) plan resulting in significant 
restrictions being placed on Enron's employees ability to dispose of 
their Enron shares. Enron later issued press releases stating that the 
lock-down period was from October 29 through November 12, 2001. This 
lock-down was eventually lifted on or about November 19, 2001 after 
Enron shares declined approximately 71% to $9.06 per share.

 LThe downgrading by major credit agencies of Enron's bonds to 
``junk'' status on November 28, 2001.

 LEnron's filing and disclosure of materially false financial 
statements that were relied on by the markets, credit reporting 
agencies and financial analysts.

 LThe financial practices engaged in by Enron may have resulted 
in its executive employing a device, scheme, or artifice to defraud 
market investors and engaging in acts, practices, or a course of 
business that operates or would operate as a fraud or deceit upon a 
purchaser or holder of Enron securities.

 LThe financial practices engaged in by Enron resulted in 
omissions to state material facts necessary in order to make the 
statements made, in the light of the circumstances under which they are 
made, not misleading.

 LEnron executives sold approximately $1.1 billion of their 
shares on the market. As an example, on August 14, 2001, Skillings, 
Enron's president and chief executive officer, resigns citing a decline 
of share price and personal reasons after selling shares for an 
aggregate value of approximately $17.5 million. The sale and 
distribution of Enron shares by its executive officers may constitute 
the offer or sale of securities by means of insider information not 
available to the investing public. The questions that must be answered 
regarding these transactions include what information the executive 
knew, or should have known regarding the questionable financial 
transactions engaged in by Enron and when did such information become 
known to each of them.

 LThe compensation and profits paid to Enron employees engaged 
in the off-balance sheet entities.

 LThe use of market appraisals from affiliated, off-balance 
sheet entities that resulted in inflated mark to market asset values.

 LThe use of over-valued and misleading broadband and 
telecommunications assets to maintain its bond rating status.

 LThe failure of the Arthur Andersen auditing team to explore 
and report on the questionable financial transactions and accounting 

 LThe destruction of audit records and documents by employees 
of Arthur Andersen.

 LThe payment of significant compensation, reported to be $55 
million to 500 executives, on the eve of the bankruptcy filing.

 LPossible conflicts of interest charges involving Enron, its 
accountants and consultants and an investment advisor's employee being 
a member of the Enron board.

 LThe untimely and questionable selection of a new plan 
administrator that resulted in Enron employees being unable to dispose 
of their Enron shares for an extended period of time when the Enron 
shares were declining in value as a result of newly reported material 
changes to Enron's financial condition.

 LThe use of plan restrictions limiting the ability of 
employees to dispose of their company match shares prior to age 50.

 LThe SEC oversight and reviews of the filings of public 

 LThe changes in the Commodities Futures Trading Act that 
exempted or excluded energy trading futures from CFTC oversight.

 LThe Enron campaign contributions further reveals the flaws in 
our system of financing the campaigns of candidates for the Congress, 
the President, and other federal officeholders.

                  The Rising Tide of Securities Fraud

    Top securities watchdogs in the United States have constantly 
warned investors that the explosion in the stock market has brought 
with it a sharp rise in securities sales fraud and stock price 
manipulation. The past year or so have proved them to be correct. At a 
town meeting in Los Angeles, Former SEC Chairman Levitt cautioned that 
investors are ``more vulnerable than ever to fraud.'' This concern 
continues to be echoed by others who point to a disturbing rise in the 
level of securities fraud and allegations.
    What is unusual about the increasing evidence of wrongdoing in the 
stock market is that shady practices usually go unnoticed in the heady 
days of a strong bull market. As in the Enron matter, the misconduct is 
normally uncovered only after a sharp market drop. This has many in the 
regulatory community wary about what they will be facing if we continue 
to see other Enron type market collapses.
    The challenge to government and industry self-regulators in keeping 
up with the job of policing a marketplace that is undergoing explosive 
growth was graphically illustrated several years ago in Forbes Magazine 
(``Swindlers' Paradise''). Forbes writer Gretchen Morgenson cautioned 
that ``greed makes people careless'' but that investors ``shouldn't 
count on the cops to protect them.'' In this regard you must also 
include the financial market regulators.
    Make no mistake about who it is that suffers at the hand of 
securities fraud. It is retirees living on fixed incomes, families 
struggling to make ends meet and save a little for their children's 
education, teachers, factory workers, bankers, and others; it is, in 
short, the everyday man and woman who works so hard for every dime they 
    The Enron matter, while considerably larger, compares to the losses 
suffered by the 8,000 shareholders who collectively lost more than $300 
million in the Comparator fiasco. Records reveal that although there 
were a smattering of well-to-do investors among the group, for the most 
part the investors were common folk: Retirees, school teachers, 
engineers, police officers, small-business owners, and maintenance 
    Poignant letters from victims of the recent Towers Financial Ponzi 
scheme--a scheme which defrauded investors of $460 million--demonstrate 
the personal hardship and financial ruin that follows in the wake of a 
securities fraud:

        L  ``This was almost all of [my mother's] retirement money. She 
        has now obtained a part-time job with Burger King restaurant to 
        supplement her Social Security income. . . .''

        L  ``I am a 69-year-old woman who has been a teacher in the 
        public schools . . . for most of my adult life. I invested 
        almost all of my life savings, $112,000. . . . Mr. Hoffenberg 
        has taken away what would have been a nice retirement income 
        for me. So, as a result, I have returned to teaching and will 
        probably have do so as long as I am able.''

        L  ``My husband and I were just married when we invested our 
        $12,500 with Towers, which was the first and only investment we 
        have ever made . . . In the last two years we have been 
        heartbroken . . . to learn that invitro fertilization is our 
        only hope for having a child. The $12,500 would have covered . 
        . . two full attempts at having a child. At this point, we have 
        no child and no hope of having the money it would take to try. 
        . .''

    Each day, equally devastating cases are brought to the attention of 
securities regulators, law enforcement officers, and attorneys 
representing the interests of defrauded investors. Financial fraud is a 
serious and growing problem that must be addressed by the United States 

          The Private Securities Litigation Reform Act (PSLRA)

    As Georgia's Secretary of State for more than twelve years, I dealt 
with securities regulation on a daily basis. It was my role to regulate 
the offer and sale of securities to Georgia residents and to license, 
regulate, and discipline issuers of securities, underwriters, broker-
dealers and stockbrokers. However, the monitoring and oversight of 
major corporate entities such as Enron was primarily the task of the 
SEC and the private bar.
    Georgia has long recognized the right of private investors to seek 
remedies against those persons selling fraudulent investment products. 
I have supported an investor's right to seek redress through mediation, 
arbitration and civil litigation. While we should work to streamline 
the registration and reporting process, I vigorously opposed, and will 
continued to oppose, any changes in the federal regulations that impair 
the ability of the SEC and state governments to protect its investors 
and for the right of investors to use state courts to redress their 
    I am not yet convinced that the PSLRA will provide sufficient 
protection to defrauded investors. If the courts ultimately interpret 
the PSLRA in a way that makes recoveries under federal law too 
difficult, state remedies will be the only means for defrauded 
investors to redress their injuries.
    The Enron collapse may provide the opportunity to determine whether 
the changes resulting from PLSRA will streamline procedure without 
having a detrimental impact on the right of individual investors 
ability to recover losses from fraudulent transactions.


    It is my firm belief that the United States Senate must fully 
explore the Enron financial collapse in order to present for debate and 
consideration changes in our financial and market regulatory programs 
that will deter the use of illegal and improper financial engineering 
practices to conceal losses and overstate assets resulting in a market 
confidence that is bound to collapse.
    In this regard I think the United States Senate should carefully 
consider the following areas:

 LA thorough examination of the facts and circumstances 
surrounding the rise and fall of Enron with a focus on determining

          Lwho knew what regarding the improper financial practices and 
        other material matters relating to the value of Enron shares;

          Lwhen these facts were known to them; and

          Lwhether or not such executive officers or others, knew or 
        should have known about such facts.

 LA regulatory program for accountants, credit reporting rating 
analysts, and financial analyst that will provide for competency 
standards, training, conflict standards, and a strong penalty for 
violations of established standards and fraudulent practices.

 LA review of accounting standards used in reporting ``off-
balance'' sheet transaction.

 LA thorough review of the destruction of records by Arthur 
Andersen employees to determine the destruction time table and whether 
or not such records were destroyed after notice of subpoenas or in 
clear anticipation of them.

 LA determination about when off-balance sheet transactions 
should be disclosed to the SEC, credit reporting rating agencies and 
financial analysts.

 LAn overview and examination of current SEC overview and 
monitoring programs of entities offering their shares to the public 
that will be traded on the national markets.

 LAn overview of the role of the self-regulatory organizations 
that are currently in place to assist the SEC and state regulators in 
their oversight responsibilities, as well as a major emphasis on 
investor education and awareness.

 LA review of the PSLRA and the current arbitration 
requirements, to determine if the recent amendments are adequate to 
offer access to the state and federal courts for recovery in the case 
of fraudulent activities.

 LA review of the disposition of share requirements and 
restrictions that are placed, or should be placed, on senior executive 
officers of major corporations.

 LA review of the 401(k) retirement programs to determine what 
restrictions, if any, should be placed on employee's shares by:

          Lregulatory authorities, such as limiting the % ownership of 
        company shares in their plan or by a requirement that an 
        employee's shares received in any manner must contain no 
        trading restrictions;

          Lthe retirement plan; and

          Lby unofficial employer coercion or representatives.

 LWhile the energy trading industry appears to have survived 
the Enron collapse, I think it is appropriate to review energy trading 
practices involving risk management practices, bilateral futures 
trading contracts and other sophisticated financial investment tools in 
order to determine whether or not the public interest requires CFTC or 
other federal oversight of such trading practices and transactions.

 LWhile I have not heard credible evidence of improper 
political influence or actions, I feel that we need a thorough review 
of the political contributions made by Enron and its senior officers to 
candidates from either political party to determine what, if any, 
improper influence may have existed as a result of such campaign 
contributions. The public reaction to such political contributions 
should be sufficient for the Congress to reform our campaign financing 

    Chairman Lieberman. Senator Bennett.
    Senator Bennett. Thank you, Mr. Chairman.
    I am having all kinds of reactions to all of this, some of 
it coming from my Senate activities, and some of it going back 
to my business experience. I have never run a company as big as 
Enron, and it may be that there is a dividing line somewhere in 
terms of size.
    Just picking a number of issues in the time I have, your 
suggestion that there be a prohibition of consulting activity 
in the part of auditors. In the company I ran, the auditor was 
enough of a partner in understanding what we had and where we 
were, it was PriceWaterhouse at the time, that I wanted to go 
to him to get his advice on certain things I was doing and have 
him say no, wait a minute, you cannot do that. No, that would 
not be a good idea. This is the better way to structure that. 
Instead of incurring the extra expense of going to somebody 
else and then taking the time to have the somebody else 
familiarize himself with our company as well as PriceWaterhouse 
    It would have been an extra cost that, in terms of the 
services to the company, would not have been a value. Now I was 
not creating any SPEs and so I can have sympathy with the idea 
that if you are going to create this separate set of 
transactions you ought to have an independent group do that and 
then have your auditor look over the shoulder. I have no 
problem with that.
    But with the generic sense that we have heard in the past 
that says if you are in auditing you should not be in 
consulting, and there should be a clear bright line and total 
separation, out of my own experience I have a little trouble 
with that because I think it does represent, for small and 
medium-sized firms like the one I ran, an unnecessary expense. 
I would like you to comment on that.
    And then while we are doing that, make another comment in 
the same area, Chairman Levitt, about your suggestion that 
every 5 to 7 years you change audit firms. I was involved in 
changing an audit firm and, quite frankly, it had nothing to do 
with we want fresh and skeptical eyes. What happened is that 
the partner that we were depending on got transferred. He got 
promoted. And we looked at the kind of service we were getting 
out of the audit firm and the new people that were put into the 
Salt Lake office, and we said we do not think these folks are 
competent anymore.
    Now it was the same Big 5 name on the door, but it was a 
different partner and a different set of folks come to see us. 
And we had a lot invested in the old partner and we were 
delighted he got promoted, glad to see him move on up. But we 
said we have got to get better service and more competence out 
of our auditor. And so we switched from one Big 5 firm to the 
    So these are two related issues that I have raised here, 
about the capacity of an accounting firm to add value to a 
client firm simply by virtue of the amount of expertise that 
they bring to the table and the amount of experience that they 
have with the firm.
    Mr. Levitt. I started with, I think all of us do, with the 
assumption that the accounting industry essentially is a 
private industry but with a public responsibility. And I am 
certain that you can take the position that a business person 
develops a relationship with his auditor that is comfortable 
and trusting.
    Senator Bennett. And synergistic, helpful to the 
    Mr. Levitt. In many instances, it is helpful to the 
    During our debate on this issue, as we imposed relatively 
modest change in this area and backed away from a change that I 
think is terribly important, which is to remove IT from the 
consulting services that can be performed for the audit client, 
two arguments were raised in opposition. One argument that was 
raised was, and we had public hearings on this and the heads of 
the firms testified to this and I attended hearings of the 
Banking Committee and the Energy Committee and I was confronted 
with the same issues on the part of members who said Arthur, 
this is a question of perception. That is all, it is just 
    And second, where is the smoking gun?
    Senator Bennett. I asked that question.
    Mr. Levitt. As you know, we had a briefing and members of 
the Banking Committee attended that briefing. We went over the 
details of cases that were about to be brought.
    Well, I do not think the question about the smoking gun is 
being asked any longer. There is an exploding gun and there are 
smoking guns yet to explode.
    With respect to perception, I think it matters enormously 
in terms of investor confidence, which is the basis of our 
markets. Now if you tell me, Senator, that PriceWaterhouse had 
the unique ability to provide a certain kind of consulting 
service, I would suggest to you that there are only four other 
firms today. Two of them have gone out of the business totally. 
There is someone else out there who could provide that service 
at no greater cost, in my judgment.
    I think the question, we could debate it at great length, 
about the relative value of perception to the relatively modest 
disruption to the company. But I can tell you, having been on 
audit committees and serving on a number of boards, that more 
and more independent directors are taking the position that it 
is wrong to hire a firm for consulting services that is the 
auditor for that firm. That it looks bad, it feels bad, and it 
smells bad. And if that is the case, whatever modest costs 
might be involved, I think, is a small price to pay for 
restoring public confidence.
    Right now we are in a crisis of public confidence.
    Senator Bennett. Thank you.
    Chairman Lieberman. Thank you very much, Senator Bennett. 
Senator Dayton.
    Senator Dayton. Thank you, Mr. Chairman. This degree of 
separation between us gives me a perspective on the expanse 
between a freshman Senator and a Committee Chairman.
    Chairman Lieberman. I feel very close to you, Mark.
    Senator Dayton. I am not even sure we are in the same time 
    I want to thank both of you for your very, very 
distinguished service and for all you have tried to accomplish. 
I have to ask first: Do you feel completely or absolutely, 
totally vindicated by the events, which, unfortunately have 
    Mr. Levitt. No, I think this is work in process. I think 
that what this Committee does is so important. I know that 
there are philosophic differences among all of us in terms of 
how far to go. I am a great believer in our markets and how 
they work. I have been a major beneficiary of that.
    But my conviction about public confidence and a system that 
has seen a cultural erosion suggests to me that you must be 
focused in terms of the few demonstrations that you give that 
you care about this issue and setting it right. And there is no 
rule or regulation that is going to do it in and of itself. It 
is going to require continual attention by an SEC that has the 
resources to do the job, and by the legislative process which 
will see to it that they are on target.
    Mr. Turner. Senator Dayton, I think Senator Lieberman 
absolutely had it right when he said you are beginning a long 
journey. And Senator Thompson had it absolutely on the nail 
when he said this is a systemic problem. It is pointed out, 
probably no better than the charts that Mr. Torricelli had, and 
I think Senator Carnahan highlighted one of many things that it 
is going to take to fix this systemic problem.
    This is not an issue of vindication. This is an issue of 
the fact that I would hope that you will be strong, you will 
aim high. Someone made the comment let us take you to the 
mountaintop. I think when you get to that mountaintop you are 
going to find out there is about 5,000 green eyeshades on the 
other side coming over the top of the hill.
    So you have got a big battle ahead of you. I would just 
urge you to stick to your guns, stay the course, and let us 
make this problem fix. The investors over the last half dozen 
or so years have lost close now to $200 billion. When you talk 
about the cost to a company, and I have been in the same 
position that Senator Bennett has in selecting auditors myself, 
when you start thinking about the cost to investors in this 
Nation at $200 billion, and what that does to our market, and 
the fact that that market is our crown jewel that no other 
country has, and it fuels this economy. We can no longer sit 
back and say are you vindicated or not. That is not the issue. 
The issue here is sticking with it, staying the course, and 
getting this fixed for the American public once and for all.
    Senator Dayton. Could each of you depart from your 
testimony and just give us, give the American people, a 
scorecard. What are the essential reforms, one, two, three, 
four, or more, that Congress must enact, in your view, so that 
people can have reasonable confidence in the integrity and 
truthfulness of these reporting systems?
    Mr. Levitt. I believe that the creation of an oversight 
body for the accounting profession with the appropriate powers 
to do the job of setting auditing standards and having 
disciplinary ability and subpoena ability and the ability to 
examine clients as well as accountants is something that I am 
now persuaded can only be done by legislation.
    I believe that other issues, such as the standard setting 
process, I would hope that could be addressed outside of a 
legislative framework but with strong legislative persuasion.
    I believe, with respect to the analysts, that is something 
that can be handled by the New York Stock Exchange and the 
    I think the issue of seeing to it that all corporate boards 
have a majority of independent directors is something that the 
Stock Exchange and the NASD can deal with effectively, again 
with appropriate persuasion.
    And I think there are marginal issues such as a 2-year 
cooling off period for employees of firms being able to join 
clients of the firms, and the question of changing auditors 
    I think these do not require a legislative fix, in my 
    Mr. Turner. I agree with the Chairman. I think that we need 
to create legislatively an honest to goodness oversight body 
under the supervision of the SEC. I do not believe the SEC, in 
itself, I do not think I would put it there. I agree with 
Chairman Pitt in trying to do something out there with active 
oversight by the SEC, though.
    I think the need to move forward by the stock exchanges on 
the analysts issues and disclosures will help a tremendous 
    I actually think the business community, too, needs to pay 
a key role here. A couple of years ago, on some of the 
corporate board and governance issues, there was an outstanding 
panel chaired by a couple of very distinguished businessmen and 
the former Deputy Secretary of State, John Whitehead, and Ira 
Milstein, head of Wilde Gottschalk. And they came up with some 
phenomenal recommendations that then the Commission and the 
stock exchanges and the profession acted on.
    And I would hope that we will see some leadership again 
from the business community and that they will play a role 
here, that it does not need to all be done by Congress, it does 
not all need to be done by the SEC. But to the extent that 
these things do not get fixed, then I think it would be 
appropriate, given how you have had thousands of lives 
impacted, hurt, I went into a classroom the other day----
    Senator Dayton. I have to squeeze in one more question.
    Help me to assess and evaluate this shredding of documents 
by auditors and accountants. My experience with them is that 
they are very thorough and factually oriented people. That is 
their profession. And shredding documents goes against that 
training; it may violate their professional standards; it may 
be illegal.
    For them to shred documents despite those inhibitions, says 
to me that there must be a huge amount of compelling and 
damaging information that they just do not want revealed.
    Mr. Levitt. I do not know exactly what the extent of that 
may be, but shredding documents obviously is a red flag to 
anybody in an enforcement capacity and is a criminal offense.
    Senator Dayton. Thank you, Mr. Chairman.
    Chairman Lieberman. Thank you, Senator Dayton. Senator 
    Senator Voinovich. Thank you. Most of the questions that I 
had have already been answered, but in this room I suspect that 
we have representatives of analysts, brokers, mutual fund 
managers, auditors, financial consultants, you name it.
    Mr. Levitt. Lawyers.
    Senator Voinovich. Lawyers. The question that I have is do 
you think they get it? What advice would you have to all of the 
people that are part of this financial market system that we 
have in this country, as to what they ought to be doing right 
    You are saying that we are going to have people on one side 
and the other, but what would your candid advice be to some of 
those people that are in this room today about the attitude 
they ought to take toward this hearing and the ones that we are 
going to be having and the new changes that you think need to 
be made to restore people's faith in this system. Because if it 
is not restored, I believe it is going to have irreparable 
damage to our financial markets, which have been the mainstay 
of this country for years and years, and frankly, impact on 
their respective pocketbooks.
    So I will give you a free shot at advice to all of those 
that are here in the room and maybe those that are watching on 
    Mr. Levitt. What a great question. I think that all of 
those parties, and I would throw in rating agencies as well to 
that package of people who are impacted by this. I would say to 
them all of us are in this together. And if there is a systemic 
problem, and I think there clearly is, while it may hit company 
A today, it is going to hit B, C and D very shortly.
    No amount of rulemaking or legislation will ultimately 
change human behavior except at the margins. And that those 
people who are parties to all of this themselves must consider 
their behavior and their attitude toward the public interest, 
recognizing the importance of the capital of the profitmaking 
motive in a capitalistic society.
    But we have to have a system that is trustworthy, and that 
begins with participants who are trustworthy. And too many 
elements of this system are not trustworthy today. Too many 
elements have failed us because of self-dealing and self 
    And to recognize that right now we are in a crisis mode, 
but this will be responded to. But if we do not learn a lesson 
from this, which is an enduring lesson, we will be back here. 
And we will be back here in ways where the primacy of America's 
capital markets will no longer be assured because too many 
other areas of the world are dealing with issues in different 
ways. And if you lose trust, you lose everything.
    So we are all in this together.
    Senator Voinovich. Mr. Turner.
    Mr. Turner. I do not think I could say it any better than 
what the chairman said, and I think it starts with each and 
every one of us. I grew up in the State that Senator Bennett is 
from and had a set of wonderful parents fortunately. And I 
think they made it clear to me the difference between what is 
right and what is wrong. And when I sit in there at the seat, 
as the CFO, even though the heat gets turned up at times, and 
you know it can get hot, you know if you are in the kitchen you 
have to make it work.
    And I think it starts with all of us. It cannot be done by 
just the auditors. There has been a lot of focus on Andersen. 
It is not just Andersen. It starts with the management team. 
Directors and everyone has to contribute here. And it has to be 
an effort of people. It cannot just be Congress. It has to be 
everyone working on this.
    Senator Voinovich. Thank you.
    Chairman Lieberman. Thanks, Senator Voinovich. That was a 
very important exchange and it does, in my opinion, go to the 
heart of what this is all about, this inquiry. As others have 
said before, and you have said, there has been a remarkable 
democratization of capitalism in our time with average people 
having the opportunity in this country to buy a piece of the 
rock through 401(k)'s, through mutual funds, through stock 
options, in fact.
    And there is, as you said now, a crisis of confidence. I 
will tell you what the question is that I get most asked, and I 
am going to ask you this and then I am going to thank you for 
your testimony and go on to the second panel.
    People have been shaken by the Enron story in this sense. 
The question they ask me is do you think my 401(k) is OK? The 
reason for that is we have now heard of tales of boards of 
directors that are not truly independent, of analysts who 
recommend stocks without understanding the books of the 
companies they are recommending, of auditors who have conflicts 
of interest, of regulatory bodies that--for one reason or 
another that we will get into as this investigation goes on--
were not there to be the watchdogs that presumably they were 
supposed to be.
    So how would you answer that question if people asked you? 
Is my 401(k) OK, or am I going to run the risk of having it 
tank the way Enron did?
    Mr. Levitt. I would not give them a blanket reassurance 
that their 401(k) is necessarily OK. I think one of the 
greatest needs we have in America, and it is a mission the SEC 
has undertaken in recent years, is to educate investors. The 
problem with the 401(k), and I know this will be the subject of 
extended discussion in the future, is that very often 
participants really do not understand what is going on in that 
401(k) and companies do not have the ability to legally explain 
to them what is going on.
    The 401(k) is kind of a stepchild of ERISA and I think 
there should be some thought of giving some kind of legislative 
certainty to the 401(k). I personally believe that there should 
be a prohibition on the amount of a company's stock that an 
employee can invest in. Not the employer, because that is all 
voluntary and I would not want to discourage that.
    But I think employees get caught up in the hype of the 
company and feel that if they are not putting the maximum in 
somehow or another management will look at them as being less 
than loyal employees. And that is wrong. The attitude of 
skepticism that is so important just does not exist there.
    No, I would not want to panic people who have participated 
in this very important program, but I would say that we cannot 
take it for granted and there have to be changes and we are 
looking into that and we are going to make changes and help 
investors become wiser investors.
    Chairman Lieberman. That is exactly what I hope will result 
from our deliberations and our investigations here. Senator 
    Senator Thompson. Just a comment. I think what Mr. Levitt 
said is very important, that it is not all a matter of 
skullduggery. You cannot guarantee the safety of a 401(k), for 
example, if the business involved is making bad business 
decisions. Sometimes when everybody is obeying the law and 
doing the best they can, in the stock market people lose money.
    Mr. Levitt. Yes, and always will.
    Senator Thompson. And we will never be able to, and never 
should try, to institute a system where people speculating in 
the stock market, either directly or indirectly, are guaranteed 
that there will not be any losses. I think it is important for 
the American public to understand that they have a 
responsibility to keep up with what is going on with their own 
company and the stocks that they invest in.
    Mr. Levitt. They need to trust the numbers.
    Senator Thompson. That is assuming that everybody else is 
doing their job. The gatekeepers are doing their job, and you 
can take a look at that and make your decision. But there is an 
awful lot of people who lose money in the stock market where 
people are not violating the law. They lose money the old 
fashioned way.
    Chairman Lieberman. I agree with what you have said, and, 
of course, I know we also all agree that the disclosure and 
transparency is critically important here to make the market 
function. Somebody said long ago that market capitalism is by 
far the best means ever devised by humans, not only to create 
economic growth, but to expand those who are enjoying the 
benefits of it.
    But market capitalism has inherently no conscience. That is 
why we set up gatekeepers and watchdogs. The gatekeepers were 
not keeping the gate here, the watchdogs were not watching; and 
average people got unnaturally taken advantage of.
    We can go on a long time. We will probably ask you back at 
the end of these deliberations as we shape the recommendations 
we want to make. In the meantime, I thank you both very much 
for your previous public service and frankly, for the public 
service you are doing today, even though you are out of public 
service. Have a good day.
    I will call the second panel now. Bruce Henning, Director 
of Regulatory and Market Analysis for Energy and Environmental 
Analysis, Incorporated. John Langbein, a Sterling Professor of 
Law at Yale Law School. And Frank Partnoy, Professor of Law at 
the University of San Diego School of Law.
    I thank you all for being here and for your patience. We 
look forward to your testimony now.
    This panel will give us a kind of focus briefing on some of 
the specific areas of concern that the Enron episodes raise in 
your minds. Just as the previous panel, hopefully they will 
help us understand what we know now, but also to guide us as we 
go forward in our investigation.
    Mr. Henning, thanks for being here.


    Mr. Henning. Thank you, Senator. My name is Bruce Henning 
and I am Director of Regulatory and Market Analysis at Energy 
and Environmental Analysis.
    \1\ The prepared statement of Mr. Henning with attachments appears 
in the Appendix on page 84.
    For the past 24 years, I have been an analyst in natural 
gas, electricity, and energy markets, and I am here today to 
discuss the behavior of natural gas and electricity markets in 
the wake of the Enron bankruptcy.
    Enron has been an important player in energy markets. Enron 
was the largest marketer of natural gas and electricity in the 
United States, operating in both the wholesale and retail 
energy markets. Enron owns and operates interstate gas pipeline 
systems and has interests in electric generation in more than a 
dozen States.
    The Enron failure caused some disruptions in natural gas 
and electricity markets but these were relatively minor. Given 
the scope of Enron's activities, the absence of significant 
disruption in energy markets is a credit to the markets and to 
its people. Throughout the collapse of Enron supplies of gas 
and electricity have continued to be delivered to the 
consumers. The reliability of the energy delivery system has 
not been compromised.
    Moreover, gas and electricity prices that the retail 
customers have seen have not been significantly affected. 
Enron's retail gas customers have been able to migrate to other 
suppliers at prices that are substantially below what they were 
a year ago today.
    Under the regulatory oversight of the Federal Energy 
Regulatory Commission, natural gas has evolved into a highly 
competitive commodity market. Competitive wholesale electricity 
markets are less mature than their gas counterparts but 
significant progress has been made. Examination of the 
wholesale prices since September indicates that gas and 
electricity markets have behaved reasonably well during a 
period in which the largest market participant was in turmoil.
    The Enron bankruptcy impacted market participants in a 
number of ways. When Enron Online, Enron's electronic trading 
platform, went dark the market lost an important source of 
price information as well as a low cost transaction method of 
trading. Fortunately, there were other sources of price 
information and other, albeit much smaller, electronic trading 
platforms. Within weeks most participants had largely adjusted 
to the loss of Enron Online.
    The financial exposure to companies involved in 
transactions with Enron is a much more complicated issue. As a 
general matter, energy companies work to limit the size of 
their exposure to any individual company, even a company as 
large as Enron. As Enron came under increasing pressure, many 
participants began to reduce their exposure. Even so, these 
exposures remained large, but they are manageable for most of 
the companies and should not interfere with the physical 
delivery of energy to consumers.
    Beyond that, Enron had entered into a number of longer term 
contracts with buyers and sellers of gas and electricity. The 
status of these contracts is unclear and will be determined 
through the bankruptcy proceeding. It is possible that parties 
will find themselves back in the marketplace, even though they 
had thought that they had hedged their stream of future 
production or their future energy needs.
    The loss of Enron has created an opportunity for other 
companies to capture market share. However, the ability of 
these companies to act aggressively in pursuit of market share 
has been tempered with the need to ensure that these companies 
remain financially strong.
    The equity prices and bond ratings of a lot of energy 
companies have come under pressure in recent weeks. As a 
result, these companies have begun to take actions to 
strengthen their balance sheets and to restore lenders' 
confidence. As part of these actions, companies are reducing 
their capital budgets and cancelling or delaying power plant 
project constructions or delaying their commitments to new gas 
pipeline expansions.
    However, the cancellation of power plant projects does not 
necessarily foretell an impending electricity shortage. In our 
opinion, there was significantly more generation capacity 
proposed than was going to be needed for the next 5 years. We 
felt like many of these generation projects would be delayed or 
cancelled even without the Enron bankruptcy.
    That being said, the decline in the bond ratings and equity 
prices for many companies will increase the cost of capital for 
many of the needed infrastructure projects. This increase will 
have an effect on the energy markets for a number of years and 
if confidence is not restored in the relatively near future, 
the fallout from the Enron bankruptcy could be much more 
    The events surrounding the Enron bankruptcy have been 
tragic for thousands of Enron employees and investors and raise 
a number of serious questions regarding the corporate 
accounting and disclosure of corporate information. All of us 
who work in energy have seen individuals who have been hurt and 
I know the pain involved for those people. But from the 
relatively narrow perspective of energy markets, the events 
show an ability to respond to a major disruption without the 
interruption of delivery to energy consumers and without 
significant energy price increases.
    The electricity markets forged by Federal and State 
regulators, and in accordance with Federal and State laws, 
performed well in the face of an event that had never been 
seriously contemplated.
    I would like to thank the Committee and the Chairman for 
the opportunity to express my views, and I would be happy to 
answer any questions I can.
    Chairman Lieberman. Thanks, Mr. Henning. That was very 
interesting. I have some questions that I will ask when we get 
to that point.
    Professor Langbein, thanks for being here.


    Mr. Langbein. Thank you. Mr. Chairman, Members of the 
Committee, I have been asked to talk with you about the pension 
consequences of the Enron bankruptcy.
    \1\ The prepared statement of Mr. Langbein appears in the Appendix 
on page 93.
    The bad news is that there are millions of other American 
workers at risk of suffering similar losses in their 401(k) 
pension plans and in other types of defined contribution 
pension plans. Worse still, it does not take Enron-style 
corporate wrongdoing to cause such losses. Businesses fail all 
the time, for many reasons. Competition produces failures as 
well as successes. The bankruptcy of Kmart, currently in the 
news this week, illustrates that point. If Kmart had had 
pension arrangements which were of the character of Enron's, 
full of employer stock, the Kmart employees would have been as 
devastated as were the Enron employees.
    In other words, if Enron had been a bunch of angels, the 
problem would be the same. It is the bankruptcy that causes the 
loss. The cause of the bankruptcy, which is very important for 
some of your other purposes, is not what we are focusing on 
when we talk about the pension problem.
    The good news is that we know exactly what the problem is 
and how to fix it. Indeed, the particularly good news is that 
Congress already fixed it almost 30 years in the original 
enacting process that produced ERISA. Congress fixed it by 
imposing a diversification requirement on pension plan 
investments for defined benefit plans.
    Unfortunately, in 1974 when ERISA was enacted, in the early 
1970's when ERISA was working its way through Congress, defined 
contribution plans of the 401(k) sort and others, defined 
contribution plans were not important. They were regarded 
basically as supplementary plans, extra savings for fat cats. 
They were not important parts of the pension process.
    For very complicated, fascinating reasons, some of them 
troublesome, we have had across the last 20 years or so a major 
revolution in the way in which the private pension system is 
structured. The defined benefit system has matured. It is not 
growing. Almost all the growth in the pension system today, in 
the private pension system, is in the form of defined 
contribution plans, and they have many advantages.
    In my prepared testimony I have mentioned a couple of the 
most obvious: The tremendous transparency that people 
understand what is in an account when it is an individual 
account; it is mine; I get the numbers. That encourages more 
pension saving. There are other major advantages to defined 
contribution plans. It is not all a one-way story of danger.
    But the big danger, the big difference associated with a 
defined contribution pension plan is that instead of the 
employer bearing the investment risk, it is the employee. It is 
just in these plans, where the employer has now shifted the 
risk to the employee, that we now have practices that the 
employers do not follow and would not be allowed to follow by 
ERISA; namely, concentrating everything in employer stock. That 
is exactly what we do not allow in the defined benefit plans 
where the employers bear the risk. But in the defined 
contribution plan where the employee bears the risk, we let the 
employer stuff employer stock into these plans.
    There is just universal consensus in financial circles that 
concentrating all of your assets in the stock of any company, 
no matter what it is, is stupid. It is dangerous. We have a 
technical term for it in the financial literature. It is called 
uncompensated risk, bearing uncompensated risk. I do not want 
to go into the details of that. Delighted to take questions on 
it. But the key point is, nobody who knows anything about how 
to run a pension plan would ever do this.
    Yet we allow it to be done over in these 401(k) plans, and 
even worse in something called ESOP's, employee stock ownership 
plans. That is where the big congressional failure has 
occurred. It is the failure to bring over into this new world 
of employee-operated investment decisions the same basic norms 
that we are used to over in the world of defined benefit plans.
    Chairman Lieberman. I do not want to show preference to a 
Yale law professor, but if you are in the middle of making 
another argument, do not be deterred by the red light for a few 
    Mr. Langbein. Thanks so much. I think I probably ought to 
stand down, but let me just conclude this by saying, I have 
more detail in my prepared remarks. I have, in particular, the 
further suggestion that if Congress is not able to make the big 
fix which is needed, which is to get proper diversification 
standards over from the defined benefit world where you 
solved--remember, nobody is in here telling you about their 
losses. You solved it. You did a wonderful job.
    If you cannot fix it over in the defined contribution world 
in the way that I think you should, which is to go ahead and 
impose diversification, there is another alternative which I 
call the Surgeon General cigarette pack solution, which is to 
require the summary plan descriptions in defined contribution 
plans to warn employees about the dangers of employer stock so 
that they value it properly, and also exercise their own option 
to move away from it in the part of those plans that they 
    Let me just conclude, Senator, by saying that I can predict 
to you, with absolute certainty, that you will see many more 
pension catastrophes just like Enron, a similar sort of 
magnitude. We have already had them in the past: Color Tile, 
many others--until the basic rules get changed to stop allowing 
employers to stuff all this employer stock in these pension 
plans. And to move us toward a system in which the same 
diversification rules that are followed elsewhere in the 
financial community get imposed on defined contribution plans.
    Thank you.
    Chairman Lieberman. Thanks, Professor. That was very 
helpful and in its way riveting, because of the warning at the 
end. I will come back to you with some questions.
    Professor Partnoy.

                    SAN DIEGO SCHOOL OF LAW

    Mr. Partnoy. I want to thank Senators Lieberman and 
Thompson and the Committee for inviting me to testify. We have 
heard a great deal today and in previous months about various 
aspects of Enron's problems. I am here today to talk to you 
about what I regard as an even bigger problem: That is Enron's 
involvement in the unregulated derivatives market.
    \1\ The prepared statement of Mr. Partnoy appears in the Appendix 
on page 103.
    Please let me make three brief points. First, Enron was 
primarily a derivatives trading firm, not an energy firm.
    Chairman Lieberman. Take a minute to explain what that 
    Mr. Partnoy. Enron was involved in various aspects of 
derivatives markets, including what we call the over-the-
counter derivatives markets which are, at $95 trillion, 90 
percent of the derivatives markets. So derivatives are 
basically financial instruments whose value is linked to some 
other instrument or index. Enron was involved not in the 
exchange traded derivatives, which constitute about 10 percent 
of the markets and are regulated already. Those are not at 
issue here. Enron was involved in the over-the-counter markets, 
which are the bulk of derivatives trading right now.
    Chairman Lieberman. Are not regulated?
    Mr. Partnoy. Which are not regulated. It may surprise 
investors to learn that Enron was in fact a speculative trading 
house chock full of these derivative instruments. The best way 
to see that is just to look at this building, look at Enron's 
building. Executive offices overlook the crown jewel of Enron's 
empire which is essentially a cavernous derivatives trading 
    Chairman Lieberman. Like a trading exchange?
    Mr. Partnoy. Just like a trading exchange, except that it 
is not regulated.
    In fact Enron has been compared today and previously to 
Long-Term Capital Management. Long-Term Capital Management, as 
you know, is a hedge fund that collapsed, lost billions of 
dollars, and was rescued in a private bailout engineered by the 
New York Federal Reserve. There are some similarities, but what 
I am here to tell you today is that Enron makes Long-Term 
Capital Management look like a lemonade stand.
    Enron made more money from derivatives in 2000 than Long-
Term Capital made in its entire life. Enron lost 20 times more 
capital than Long-Term. Enron had 100 times more employees. It 
had public investors, and no one bailed out Enron.
    I have told you a little bit about what these derivatives 
are. Enron's derivatives ranged from natural gas prices and 
interest rates, to dot-com stocks, and rights to fiber-optic 
bandwidth. As I have mentioned, let me repeat, these markets 
are largely unregulated markets. That is point No. 1.
    Point No. 1, Enron shows we cannot trust derivatives 
disclosure more generally. Derivatives were the key to Enron's 
abuse of these special purpose entities we have talked about 
today. Enron's list of these entities, just the list is 60 
single-spaced pages long. Many companies have similar lists, 
and their disclosure is now suspect. If we cannot trust Enron, 
can we trust General Electric, or IBM, or Coca-Cola.
    Special purpose entities are very common and can be used 
for good or for ill. Unfortunately, Enron used them for ill. It 
hid spectacular losses on technology stocks, it hid billions in 
debts, it inflated the value of speculative assets. Many of 
these trades did not involve energy at all.
    Just let me give you one example. Enron bought a technology 
stock called Rhythms Net Communications that skyrocketed during 
1999. Enron sold that stock to one of these entities and 
recognized a gain of several hundred million dollars. Then 
Enron used a sham transaction with the entity, including--and 
this is the key--a $1 billion derivatives trade to avoid 
recognizing losses as the stock plummeted the next year. This 
was true even though Enron retained the economic risk of its 
investment in that stock.
    The important point here is that Enron, like many 
companies, manipulated its numbers to meet analysts quarterly 
    Chairman Lieberman. What is the source of your information 
on the story you have just told us?
    Mr. Partnoy. The troubling part about this is that much of 
the source of this information is from Enron's financial 
statements. If you look at Enron's financial statements you get 
a sense of how broad its involvement in derivatives is. The 
specific information about this company and some of the others 
that I allude to in my written testimony come from the more 
recent 10Q. If you just look at the difference in size--I will 
show you--just in thickness. This is the most recent 10Q Enron 
filed. This is where some of the information comes from.
    Chairman Lieberman. With the SEC.
    Mr. Partnoy. With the SEC. This is after information had 
already come out. But much of the information, and one of the 
troubling things about this, is alluded to in the documents and 
the gatekeepers failed to uncover some of that information.
    Chairman Lieberman. That was the point of my question. They 
had some of this information that you just relied on but did 
not either understand it or did not bother to report it to the 
investing public.
    Mr. Partnoy. That is exactly right. That, Senator, leads to 
my third point, which is that the gatekeepers failed to tell 
investors that Enron was so risky. Enron's officers and 
directors, of course, are to blame. But we should look 
carefully at the gatekeepers as well. Too much focus on Enron's 
officers misses the mark.
    If I could just finish this thought.
    Chairman Lieberman. Go right ahead.
    Mr. Partnoy. Enron's officers clearly knew that there was 
some derivatives use going on within the firm. Enron even 
distributed a derivatives training manual to new employees. But 
gatekeepers also had information. Gatekeepers include 
accounting firms, law firms, securities firms, and very 
importantly, credit rating agencies. They are supposed to 
monitor even conflicted managers. Gatekeepers, of course, 
should and will be held liable when appropriate. In Enron's 
case the accountants, as we know, already are at risk and 
others may or may not be.
    My point here is that credit rating agencies in particular 
have great market power. They have been given market power by 
the law, and they are largely undisciplined by the threat of 
liability, and that should change.
    In closing, ultimately Congress must decide whether after 
10 years of steady deregulation the post-Enron over-the-counter 
unregulated derivatives markets should remain in this 
regulatory black hole, exempt from the rule that covers most 
investment contracts. The basic message I would like to leave 
with you is that I believe it is time to shine some much-needed 
light on these unregulated derivatives markets.
    Chairman Lieberman. Thanks very much. Again, the three of 
you have been very helpful and I thank you, Professor Partnoy, 
and others, for what looks to me to be the fresh work that you 
have done in the testimony that you have presented to us, 
particularly in analyzing the Enron situation.
    Professor Langbein, I was thinking as you were talking, I 
once said to somebody about 10 years out of law school that I 
was ready to go to law school then because I thought I would 
understand better my professors. I think you helped teach me a 
lot today.
    Mr. Langbein. We have an LLM program if you would like to 
come back.
    Chairman Lieberman. It is beginning to look pretty good 
actually. [Laughter.]
    The question I wanted to ask you is about your main point 
which is that through ERISA Congress regulated so-called 
defined benefit, normal pension plans, but as the 401(k)'s 
defined contribution programs came along and expanded, millions 
of people now having their dreams of future security resting on 
them, we did not have similar protections.
    The one you have talked about is diversification. If you 
had your druthers, if you were King, what is the rule that you 
would promulgate with regard to defined contribution 401(k)'s?
    Mr. Langbein. It would take some technical drafting but I 
would basically insist that the same diversification standards 
apply to 401(k)'s as apply to ordinary pension plans.
    Chairman Lieberman. Just for the record, tell us--and I 
understand you cannot cover every nuance, but in basic terms 
what are they? In other words, some of the proposals that 
colleagues here have made is that there should not be more than 
20 percent, for instance, of a company's stock in a 401(k) of 
its employee. Is that an appropriate number?
    Mr. Langbein. That is roughly 20 percent more than I 
believe we ought to have. In other words, in a defined benefit 
plan today we have only trivial amounts of employer stock. That 
is the right answer. The single most important thing for 
workers to understand is that employer stock is the single 
worst investment you can possibly have.
    Chairman Lieberman. Why?
    Mr. Langbein. The reason is that the worker is already 
horribly underdiversified vis-a-vis the risks of that firm 
because he is what we call human capital. His employment 
relationship has him already deeply exposed to the risks of 
that firm. What ordinary finance theory tells you is, the last 
thing in the world you should do is to take the little sliver 
of diversifiable capital, your finance capital, namely your 
pension savings, take the one bit that you have that you can 
invest elsewhere and tie it back up with the employer. That is 
the fundamental fallacy of employer stock plans. They are a 
fundamentally bad idea.
    Chairman Lieberman. So if you had your druthers you would 
pretty much prohibit employers from putting its own stock in a 
    Mr. Langbein. I would not say it just that way. There are 
circumstances in which trace amounts show up. For example, you 
do not want General Motors in its pension plan not to be able 
to buy the S&P 500 type funds which have some General Motors 
stock in it. We get the result that we are talking about, 
basically no employer stock, without saying so, under existing 
ERISA rules for defined benefit plans by imposing a prudence 
requirement and then allowing that to sort itself out. No 
investor can prudently invest heavily in employer stock.
    Chairman Lieberman. Let me go on to another subject.
    Mr. Langbein. Senator, may I just say one other thing? Your 
question was about the 20 percent proposal in the Boxer-Corzine 
    Chairman Lieberman. Yes.
    Mr. Langbein. Look, it is a lot better than nothing. If you 
have got to compromise, compromise. There are a lot of 
political pressures out there, there are a lot of reasons why 
employers and their pals want to stuff employer stock down 
pension plans.
    Chairman Lieberman. You do not have to compromise so I 
appreciate hearing exactly what----
    Mr. Langbein. That is exactly right. I am just a 
schoolteacher. I can go home and leave you to have to cut the 
compromises. And if you have got to compromise, that is an 
awful lot better than we have got now.
    Chairman Lieberman. Incidentally, I do want to note for the 
record, as you know--and I have been reading this in the 
media--some of the great companies in America have 401(k)'s in 
which they have got 60, 70 percent of their stock. That alarms 
me as I hear your testimony.
    Mr. Langbein. Senator, as of 2 years ago Enron was one of 
the great companies in America.
    Chairman Lieberman. There you go; exactly.
    Mr. Langbein. That should tell you what the danger is.
    Chairman Lieberman. Good point. Anything else besides the 
diversification requirement that you would say we might do by 
law to protect people's investments in their 401(k)'s? If you 
want to think about it and submit later testimony, that is OK.
    Mr. Langbein. I think the main--99 percent of what has gone 
wrong here is having large quantities of any stock, especially 
employer stock, in these plans. If there is one piece of advice 
I could give your constituents it is, to the extent that you 
have discretion over your own employee contributions in these 
plans, resist the pressure to show your loyalty to the firm by 
investing back in the stock of your employer. Your loyalty 
should be shown by what a good employee you are, but not by 
concentrating investment risk back in employer stock.
    Chairman Lieberman. Let me ask one other question related 
to this. One of the parts of the Enron story that infuriates 
all of us is the question of the period of time during which 
the Enron employees were locked into their 401(k)'s. The stock 
price is falling. We now know from public records that the 
executives are selling their stock, cutting their losses, 
making a lot of money, and the employees cannot get out. They 
say this was because of a transition in plan administrators.
    I want to ask you whether as a matter of law, technology 
being what it is now, in terms of transition of plan 
administrators we should prohibit lockdowns of that kind to 
make sure that employees always have mobility as the market 
moves, and their company moves or other companies move, to sell 
their stock?
    Mr. Langbein. Senator, I think the answer is that the law 
is in place to deal with this. The basic way in which we handle 
these details of plan administration is to impose a 
requirement, which you have done, and done on defined 
contributions as well as defined benefit plans, that they be 
administered by people who are fiduciaries. Then we impose 
fiduciary duties in Section 404 of ERISA, including one of 
prudent administration.
    The question of whether or not Enron should have been 
changing plan administrators in a period in which its stock 
price was under great pressure is, in my view, a very serious 
one and one which I think is likely to raise fiduciary 
liability on them for having done so.
    Chairman Lieberman. You think they may be subject to 
lawsuits by their employees----
    Mr. Langbein. Those lawsuits are pending right now.
    Chairman Lieberman. Do those suits include this element?
    Mr. Langbein. Yes, the lockdown period is the subject of 
plaintiff's litigation ongoing right now.
    The precise question you have asked is, how long the period 
ought to be. In the case of the Enron plan there was, I think 
11 trading days involved, some such thing. I do not think 
Congress should attempt to micromanage this. I think the proper 
standard is the one which we have under fiduciary law, which is 
that which is reasonable in the light of all the circumstances, 
bearing in mind the fiduciary duty to maximize the best 
interest of the employees under Section 404(a)(1)(A) of ERISA. 
You have got this right already in the law.
    That is not where your efforts ought to go. Your efforts 
ought to go on the diversification problem.
    Chairman Lieberman. Thanks. My time is up. Senator 
    Senator Thompson. Thank you, Mr. Chairman.
    Mr. Partnoy, educate me a little bit further with regard to 
the use of derivatives. I take it derivatives are neither 
inherently good or evil, that they can be used for speculative 
purposes, they can be used as insurance policies to hedge. It 
seems that, as you pointed out, Enron used derivatives in deals 
with its own special purpose entities that it set up, and by 
trading with what looks like pretty much itself in many cases, 
it was able to hide debts and losses and to make sales to these 
special purpose entities at inflated prices and book the 
profits. So apparently that is the way they were using them for 
their purposes.
    Then you look at the regulatory structure, and as you 
pointed out, some derivatives are regulated and some are not. 
Apparently this has been the subject of a good deal of debate 
over the years and we have come up with a situation where 
energy derivatives, for example, are exempted, financial 
derivatives are exempted from regulation under the CFTC.
    The working group on financial markets under the previous 
administration recommended in 1997 that these exempt 
derivatives be exempt, as I understand it, for reasons that 
they were deep markets. Unlike the agriculture field, for 
example, there was likely price manipulation, and there were 
big, deep markets in these areas and so forth. So a lot of good 
people apparently thought that a lot of these things should be 
    So tell me what--and I am not trying to make a point here. 
I am really curious as to, when we talk about regulation what 
is it exactly that would be regulated with regard to the 
derivative markets, if they were regulated? I mean, they would 
have to go through an exchange and file certain reports, I 
guess. But what does it actually mean?
    More importantly, what would it mean to the Enron case? 
What part of what they did, which in large part seems to me to 
be a failure to properly disclose more than the inherent 
activity itself perhaps, which may have been legal and proper. 
What part of what they did that gave us bad results could have 
been avoided, in your opinion, had there been regulation of 
these derivatives?
    Mr. Partnoy. Senator, I think you have the story absolutely 
right; derivatives can be used for ill or for good, and there 
are perfectly valid reasons to say we should have some 
derivatives traded on an exchange, and some derivatives traded 
in some other venue. But I think you have isolated the key 
point, and that is disclosure.
    Whatever these investments and instruments were--and it 
turns out that what they were is quite troubling--they should 
have been disclosed. We easily could require that they be 
disclosed. There should not be an argument that just because 
these are something different that they can be left off the 
financial statements.
    Senator Thompson. Would regulation as such, in and of 
itself, bring about that disclosure? Or is it a disclosure 
issue and not necessarily a regulation issue?
    Mr. Partnoy. There is a separate matter which is, why is it 
that we are treating these sorts of financial contracts 
differently than other investments? What is the rationale for 
that? In some derivatives there is a very good rationale. 
Interest rate swaps, for example. There is a very deep market, 
trillions and trillions of dollars with sophisticated actors. 
There are not problems of somebody ripping off somebody else. 
There are not problems of public investors losing money. That 
actually is the vast majority of the over-the-counter 
derivatives market.
    But there is a decent chunk of the over-the-counter 
derivatives market that has problems. I think a lot of those 
problems could be corrected by recognizing the fact that these 
are investment contracts just like anything else, and 
recognizing that they should be disclosed.
    Senator Thompson. But I still do not understand what 
unpleasantries we could have avoided in this case had these 
derivative markets been regulated.
    Mr. Partnoy. I would draw your attention to footnote 16 of 
Enron's 2000 annual report.
    Senator Thompson. I am very familiar with it.
    Mr. Partnoy. If you can tell me what is going on----
    Senator Thompson. Just kidding.
    Mr. Partnoy. You should take a look at it. It is about a 
page long and it would be very well worth your time. It is 
chock full of derivatives transactions of all sorts. You 
literally cannot tell who the derivative transactions are 
between, what they are. If we had clear disclosure about those 
transactions then the Enron situation might not have happened.
    Senator Thompson. Couldn't we have disclosure without 
    Mr. Partnoy. If somehow magically companies were to say, 
and some hopefully will, we will tell you all of our 
derivatives contracts--this relates to accounting actually. 
This relates to the accounting issue. Because if we had strong 
accounting standards and strong auditors they would say, hey, 
just because these are derivatives contracts does not mean you 
can push them off over into this off-balance sheet transaction 
and not list them.
    So I think that it is possible you could accomplish what 
you want through more rigorous disclosure requirements that 
apply to derivatives.
    Senator Thompson. Mr. Henning, do you have an opinion on 
    Mr. Henning. Yes, I do, Senator. Appreciate it.
    One of the things to recognize is that derivatives, and 
basically the financial contracts, are very important in energy 
markets, in addition to the fact that the energy markets are 
quite liquid, and the data shows that we did not see great 
deviations in the prices as a result of that. It is very 
important to be able to trade in a whole variety of locations.
    Natural gas is exchange traded at the Henry Hub in 
Louisiana. But in order to move natural gas around the pipeline 
system and in order to be useful to hedge on the behalf of 
consumers you have to be able to deal with trades that are 
happening at lots of other places around the pipeline system. 
This happens in the over-the-counter market.
    Over this last summer there has been a big emphasis within 
the State regulatory commissions to look at ways to use hedging 
strategies in order to try to insulate customers from those 
kind of movements.
    Senator Thompson. So what? Are you making the case for 
these derivatives not to be regulated?
    Mr. Henning. I am making the case that they are very 
important. I am making the case that the regulated entity in 
terms of their involvement should not be forced into any 
additional disclosure that an unregulated entity is involved 
in, and that fundamental issue in my opinion is a broad 
accounting issue in terms of the disclosure of information and 
the way we get that disclosure out into the marketplace.
    Senator Thompson. I am not sure I know any more than when I 
started, Mr. Chairman, but we will revisit the issue.
    Chairman Lieberman. I think maybe you and I both should go 
back to that LLM program.
    Senator Thompson. Thanks.
    Chairman Lieberman. Thanks, Senator Thompson.
    I have some good news to report that my staff just informed 
me of. This is how terrible events sometimes produce in their 
wake also good results and reaction, which is that--you will be 
happy to hear this, Fred--that they have just obtained the 
218th signature in the House on the discharge petition for 
campaign finance reform.
    Senator Levin. Bravo.
    Chairman Lieberman. Bravo is right. So that bill will go to 
the House floor, and hopefully it can match up with the 
campaign finance reform bill that passed the Senate last year 
and we can at least close the loophole in the law through which 
the large unregulated, unlimited soft money contributions are 
    This goes back to something said before, I believe by 
Senator Thompson, about this matter, which was, sometimes the 
most scandalous behavior is legal. There is some scandalous 
behavior I think in Enron that is illegal. But in the campaign 
finance laws the most scandalous behavior is the legal end run 
of soft money. So anyway, good news.
    Senator Levin.
    Senator Levin. Thank you. That is good news indeed. I want 
to go back to footnote 16. I have not read it either, but you 
say that it does disclose something there, and that if certain 
people had really been on the ball perhaps they would have 
forced a greater disclosure. Auditors never should have agreed 
to it to begin with, but if analysts had been on the ball 
perhaps they would have asked questions about that disclosure 
because it was so obfuscating and unclear. Is that right?
    Mr. Partnoy. That is exactly right. I would not have 
recommended that anybody buy this based on that footnote. It is 
really only a page. Just take a look at it. Would you have 
recommended Enron stock if you read that footnote? I do not 
think anyone would have.
    Senator Levin. So what we are talking about here then is 
not just disclosure, you are talking about disclosure which 
meets certain standards of clarity. Is that why you want this 
to be regulated, because a regulator could force clearer 
disclosure standards? Is that the purpose of the regulation 
that you are proposing?
    Mr. Partnoy. Sure. Clearly, uniformity is important. If we 
just have people off making disclosures on their own we may not 
be able to understand or compare. One of the points of 
disclosure is to be able to compare companies, so that we can 
look at Company A and Company B and say, OK, they have this 
many derivatives and they have this many derivatives, so we 
should buy this one instead. We want it to be comparable.
    Senator Levin. Other than disclosure, which is what 
regulation could require in greater clarity, is there any 
specific action in the creation of these entities, in all of 
the havens, the offshore entities that were created as well as 
the special purpose entities, 800 or 900 entities that were 
created, are there any specific actions of Enron that a 
regulatory body in your judgment would have prohibited, other 
than the disclosure issue?
    Mr. Partnoy. Some of these derivatives transactions with 
the special purpose entities are very troubling and the 
question would be, if they were put in the context of a 
securities regulation, a standard investment contract, what 
would a securities regulator say about that? What would the SEC 
say about that? I think they would have problems with these 
transactions. They are very troubling.
    Senator Levin. Who, in your judgment, should regulate this 
over-the-counter derivatives market? Is it the SEC or the CFTC? 
Who would you recommend for that?
    Mr. Partnoy. That has been a very difficult question for 20 
years. As you know, I am sure, there was a turf battle between 
the SEC and the CFTC over some of these issues, and I do not 
have a lot of good answers. I would be happy to think carefully 
about it. I think the important point, and it sounds like the 
message has gotten through, is that these are unregulated 
markets and maybe that is not such a good idea.
    Senator Levin. I think that message has probably come 
through, but we have to take the next step. If they are going 
to be regulated, who would do the regulation? I think we need 
the advice of folks on that as well. Mr. Chairman, I would ask 
that perhaps this be supplied for the record, if you would just 
allow that to happen. That goes for any of our other witnesses, 
by the way.
    On the question of the 401(k)'s, you made a reference, 
Professor, to ESOP's.
    Mr. Langbein. Yes.
    Senator Levin. I am someone who has supported ESOP's. I 
remember Russell Long here talking about the importance of 
employee ownership, and we wanted people to have a stake in the 
enterprise because they would really feel then a keen interest 
in the quality of their work, and a number of other positive 
things. But ESOP's were viewed around here as something which 
would help those who worked to become owners of the enterprise. 
So your comment was somewhat disparaging, I think, about 
ESOP's, if I heard it right. But I would like to hear your--
please testify about ESOP's.
    Mr. Langbein. You have just repeated the standard theology 
of ESOP's, which is that they are wonderful things that help 
workers own their own firms, and therefore, cause them to 
identify with capitalism.
    Senator Levin. Could I just interrupt for one second? First 
of all, these are employee stock ownership plans, for anyone 
out there who does not know what an ESOP is. I should have said 
that. But, second, would you distinguish in your answer between 
stock which is owned now by an employee and stock that goes 
into a retirement fund; is there any distinction in that 
    Mr. Langbein. Yes. Let me take that one first. The most 
troubling part of the 401(k) phenomenon, and to some extent the 
ESOP phenomenon is that these concentrations of employer stock 
are coming in the form of a displacement of conventional 
pension plans. Russell Long and the other people who gave us 
ESOP's did not foresee or want that. It was always thought that 
ESOP's--that is, back in the days when they came into ERISA in 
1974--would be supplementary plans and that they would not have 
the effect that they have had in all too many companies of 
becoming really the substitute for a private pension plan.
    A very simple solution--simple to enunciate, difficult to 
draft, but it is doable--would be to insist that no firm run an 
ESOP without first having run an adequate private pension plan, 
a non-ESOP type plan.
    Now, with respect to the question, what is wrong with these 
plans, with ESOP's and with large concentration of employer 
stock, it is the point I made earlier, which is that the 
employee already has his future tied up with the firm. Remember 
that these ESOP's and 401(k)'s are, in an important way, public 
plans as well as private. They are privately created, but they 
would not exist in practical significance in their present 
extent, they would not exist but for the tax subsidy that is 
inherent in them.
    These are all what we call tax-qualified plans. There is a 
huge tax deduction for this employer stock, and there is the 
advantage of tax deferrals across the years which works out to 
be--I think it is the second largest so-called tax expenditure 
item in the tax expenditure budget. These are hugely 
subsidized. They are there for public purposes.
    The idea that somebody should come along and be able to 
relabel his own company's effort to get the employees to 
identify with it, whatever good that does for the company, to 
relabel that a pension plan entitled to have this massive 
Federal tax subsidy is a very peculiar notion.
    Senator Levin. My time is up. I think that I agree with 
what you say for the most part, but I am not sure that I would 
label this totally as employers stuffing stock into a plan, 
because I think there is a real legitimate public policy 
purpose in having people own a piece of the enterprise. I think 
that there is an added incentive there to make the enterprise 
successful that people might not realize to the same extent 
through simply being an hourly paid worker.
    Mr. Langbein. I agree with that completely, but I would say 
to you--I used to be in Chicago and at one point there was a 
proposal to build some power plant or something out in the 
lake, and the opposition group put together some bumper strips. 
When I was in Chicago all the guys had these bumper strips, and 
the bumper strips said, ``Don't do it in the lake.'' My 
suggestion for the bumper strip here is, ``Don't do it in the 
pension plan.''
    If you want people to have employer stock and you want to 
make it advantageous, we do that right now with discount stock 
purchase plans and so on, but they are not tax-qualified 
pension plans. What is wrong with the present structure is that 
we allow employers to get tax deductions and tax subsidies of 
other sorts for putting massive quantities of employer stock in 
things that employees are relying on as pension plans.
    Senator Levin. I think that is a very important 
distinction. So that you are not talking about employee stock 
ownership that does not have those tax benefits and are not 
part of pension plans, but only the ones that are. I think that 
is a huge important distinction.
    Mr. Langbein. Yes, and I will go further. For high level 
executives, I think it is particularly important that they be 
exposed, they be at risk with the company.
    Chairman Lieberman. Thanks. Very interesting. Senator 
    Senator Bennett. Thank you. I could engage in this 
conversation some more, but within the limited time let me 
switch to the issue of derivatives, because this has come up 
before. We were on the Banking Committee when the Orange County 
failure occurred and the headlines said, it was because they 
traded in derivatives. As we dug into it we found that the 
failure occurred because they made stupid decisions. As Alan 
Greenspan said to us, the use of derivatives simply made the 
effect of those decisions more efficient. If the man had made 
intelligent decisions, the use of derivatives would have been a 
wise thing because there would be greater efficiency in getting 
    What it boiled down to is he was making the wrong bet on 
interest rates. When the interest rates moved against, because 
he had always been right in the past, he doubled down on his 
bet, and he used derivatives to do it. Then he destroyed the 
entire pension plan of Orange County employees, and taxes had 
to go up in Orange County for decades after.
    In a sense, is that not what we have here, where the 
executives of Enron, filled with the hubris of their success 
said, we are so smart that everything we bet on is going to 
come up roses, so we will go bet on bandwidth, we will go bet 
on dot-coms, we will go invest. And we have figured out this 
nifty way to do it with somebody else's money and all we have 
to do is guarantee it with our own stock. And since our own 
stock is going to be going up perpetually forever, that is no 
risk. And it is too hard to explain to somebody so we will put 
it in a footnote that nobody can figure out. And everything is 
going to be wonderful.
    It turned out that they were as stupid as the controller of 
the Orange County pension plan and it all collapsed on them, 
and then they started shredding documents. But is that a 
correct description of what happened? If it is, then let's talk 
about the sunshine that we put on, or the spotlight that we 
shine on the derivatives trading. Instead of starting with the 
spotlight, let's go down to a base understanding of what 
happened. Am I correct in my description of what happened?
    Mr. Partnoy. Yes. Let's start with the facts. You are 
largely correct. The paradox of Enron is that the company 
actually made huge amounts of money from its derivative 
trading, even in the last year. Where it lost its money is on 
all of these other bets, many of which you have mentioned: 
Fiber optics--they have been covered in the media extensively. 
But at its core it actually made a lot of money trading 
    One of the problems that I have been trying to think about 
is what should be disclosed about that trading operation? Maybe 
Enron actually could have been a viable entity as a derivatives 
trading shop. But the problem is, investors did not know that. 
When you looked at Enron's financial statements it did not say, 
hey, we are a derivatives trading firm. It said, hey, we have 
all these other businesses going on, and by the way, it looks 
like we are making a lot of money over time.
    The reality is, the only thing Enron was making money on 
was trading its derivatives, and trading derivatives was making 
up for all the losses in all of these other bad bets that you 
just described.
    Senator Bennett. Losses in what was perceived by the 
investment community as being its core business?
    Mr. Partnoy. That is correct.
    Senator Bennett. So we come back to the old adage, where is 
the best place to hide a leaf? The answer is, in plain sight on 
the floor of the forest surrounded by all of the other leaves. 
I have had to produce 10Ks and 10Qs in my life and I know how 
impenetrable they are.
    Maybe the issue we should be focusing on with the 
accounting firm is how to write plain English sentences. Maybe 
the summary of the 10K or the 10Q should be: This is what is 
happening in the core business. This is what is happening in 
the areas we are experimenting with. This is where we are 
taking a risk, in bold print right up front rather than the 
arcane language of an accountant that drives you--and then the 
lawyers. By the time those two groups get through with the 
English language it becomes almost impossible for somebody who 
is not trained in both to understand what they are saying.
    Maybe the focus should be--General Grant. There is an 
anecdote. General Grant had as one of his closest staff a 
fellow who was not very bright. People would say to him, why do 
you have that dummy on your staff. He said, because I read my 
general orders to him first, and if he can understand them, 
then I know the commanders in the field will not misunderstand 
them. Maybe we ought to have a house dummy somewhere at these 
accounting firms that has to sift through this language and 
say, yes, it is now clear.
    Obviously, we cannot pass legislation to that----
    Mr. Partnoy. There is a plain English requirement and 
financial statements have gotten a lot clearer. But I went 
through Enron's financial statements, and my written testimony 
is 32 pages, and it is as clear as I could make it. And if you 
gave it to an average investor it would be quite daunting, I 
    Part of the problem is that these things really are very 
complicated and we have problems with the rules. So the rules, 
even if this was clearly described, an investor would say, this 
is crazy, do you mean to tell me the accounting does not match 
up at all with economic reality? But that is what the rules 
say, all of these complicated rules basically allow managers to 
have accounting statements that do not match up with economic 
    Even if that had been clear to investors I still think you 
would have this problem because within the clarity there still 
are things that can be moved off the balance sheet. In other 
words, say nothing; it is not on the balance sheet. And say 
nothing cannot be made any clearer, right? So improving 
clarity, I think, is a very important goal but will not solve 
the entire problem because many of these, the problematic 
transactions, are because of these rules.
    As Senator Thompson mentioned before, one of the problems 
is a lot of these accounting issues are arguably quite legal. 
If they are, even if they are clearly described they still 
would lead to these problems.
    Senator Bennett. My own problem with this process, a word 
that I never learned until I got to the stage in my career 
where I was dealing with 10Ks and 10Qs, was materiality. What 
is material? We would have towering arguments as to what was 
material. Basically what that comes down to is, we do not think 
this is important to disclose.
    We have just found out that you have done something really 
horrible, but we have put a dollar figure on it and the dollar 
figure compared to the total value of the enterprise says that 
it falls below the statistical level of materiality. So we say, 
the fact that you have just raped your secretary and stolen 
goods off of the company, etc., when we add up all of the 
dollars connected with that activity we say that is not 
material, so we are not going to disclose that. Whereas, 
somebody that was looking at you as a responsible executive 
would say, that is a very material fact.
    So I guess what I am saying here is that we ought to 
examine what we think people really need to know rather than 
the legal structure that is currently there that says, if you 
comply with this and this and this you are within the law, even 
though you are ignoring all of the rest of this, that we just 
say, it is not material.
    Mr. Partnoy. Senator, I think you are right. The problem, 
of course, is that what is really material, if it is bad, the 
managers do not want to tell shareholders because that will 
cause the stock price to go down. So the question for 
regulation has to be, how do we create incentives that will 
either force managers to give up that information, or to have 
gatekeepers who will effectively look at the managers and force 
the managers to give up that information?
    But I think you are absolutely right, there are all sorts 
of information that investors would think would be very 
important that is not reflected in that information. That is 
why, quite frankly, we have seen stocks going down in price 
recently, because investors are worried that there could be 
other disclosures that accountants said, this was not material, 
but it is still there and it is not reflected in the financial 
    Senator Bennett. Thank you.
    Chairman Lieberman. Very interesting. I could not agree 
with you more about the clarity of the reporting. Because part 
of what happened, because these are inherently complicated, is 
that the people we rely on to translate the complicated 
verbiage, the analysts, etc., failed as well.
    Incidentally, Senator Levin wanted me to clarify that when 
you used the term house dummy you were not referring to his 
brother. [Laughter.]
    Senator Levin. That was just a private joke. You just 
ruined a 66-year-old relationship.
    Senator Bennett. I have no comment, Mr. Chairman.
    Chairman Lieberman. A quick question and then Senator 
Thompson has a final question. This panel is too interesting.
    Professor Partnoy, do you have any idea of what the dollar 
value annually is of the over-the-counter unregulated trading 
in derivatives?
    Mr. Partnoy. It is estimated at $95.2 trillion. That is 
trillion with a ``T.'' The estimate is almost certainly an 
understatement. The over-the-counter derivative transactions 
that Enron privately would enter into, for example, with some 
of these special purpose entities, would not be included in 
that statistic. So we are talking about a number that is seven 
times the regulated exchanges. We are talking about a number 
that is significantly larger than the U.S. stock market, for 
    Chairman Lieberman. That is what I was going to ask you. 
When you said regulated exchanges, regulated sales, you are 
talking about derivative sales it is seven times greater than?
    Mr. Partnoy. Exactly, the regulated U.S. options----
    Chairman Lieberman. Can you compare it to--what is the 
annual volume of sales on the New York Stock Exchange?
    Mr. Partnoy. The total market capitalization fluctuates a 
lot but we are talking $15 trillion, $20 trillion, in that 
    Chairman Lieberman. So unregulated derivatives trading is 
that much larger every year?
    Mr. Partnoy. Yes, this is in notional terms. The amount at 
risk we are talking about in those contracts--even the people 
from the financial services firms, the lobbyists will come and 
say, no, that figure is wrong. It is the amount that is at 
risk. But we are still talking about trillions and trillions of 
dollars that are at risk.
    Chairman Lieberman. That is astounding.
    Mr. Partnoy. And in the U.S. stock market it is basically 
the same story.
    Chairman Lieberman. We will come back in a separate hearing 
to the question of whether that should be regulated or not. On 
that question, my final question, I will begin with you, Mr. 
Henning--Professor Partnoy, if you want to add anything, I 
welcome it--which is the whole question of deregulation of 
energy markets; not derivatives trading.
    Last summer we had these rolling power blackouts in 
California and price spikes all around the country. Now we have 
got Enron, the largest energy trader, which that trading was 
obviously growing in part, some of it, all because of the 
deregulation of energy, electricity, for instance, markets. So 
obviously some critics of deregulation point to these events as 
evidence that deregulation should be reversed. I wanted to ask 
you what you think the lessons are for the way in which--from 
Enron, and perhaps the California experience--for the way in 
which energy markets should be regulated?
    Mr. Henning. Senator, I think the movement towards 
competitive commodity markets for energy have benefited 
consumers. I think that if you look back at the history of 
natural gas and you look at the--even with last year's high 
natural gases, in real terms natural gas prices were lower than 
they were back in 1983. So it has moved to the benefit of 
consumers. It, in fact, prevented the need for the same kinds 
of situations that you had back in 1976 and 1977 where you 
literally had to close schools in the State of Ohio because 
there was not any natural gas to heat them that winter.
    So the lesson learned from deregulation was that you have 
to set up, and you have to set it up in a strong market. The 
FERC has been involved in doing that, and the one thing that, I 
guess, I believe is somewhat of a misnomer is energy is still 
highly regulated. The structures of the markets are being 
determined for electricity in regional transmission 
organizations. That is work in progress, but the FERC is doing 
a good job with that.
    The market monitoring that the FERC is doing is going 
forward. So from that perspective, yes, you had events, driven 
largely by inadequate infrastructure and a confluence of 
weather events and so forth that affected the California 
market, as well as perhaps a poor original market design in the 
State of California. But by in large, the marketplace has wound 
up working.
    The regulation has continued, and I guess I would just 
finish in saying that the FERC is doing its job in oversight 
for these energy markets. The question was asked earlier about 
where derivatives should be looked at, should it be CFTC or the 
SEC? I am not qualified to say, but the one thing I would say 
is, have the FERC continue to do what it is doing in energy 
markets and not have them impose additional things exclusively 
on the regulated entities there.
    Chairman Lieberman. I appreciate the answer. It is helpful. 
This Committee got into the crisis in California last year. I 
must say, there we felt that FERC was not doing its job. 
Ultimately, it did come in and create some regulation on the 
prices that were being charged by producers and wholesalers to 
people in California.
    Dr. Partnoy, do you want to add anything?
    Mr. Partnoy. Could I just add one brief point to this 
because I think you have hit on something very important.
    Chairman Lieberman. The basic question is, should we go 
back and urge the other State legislators around the country to 
go back and take a second look at deregulation--deregulating 
the energy markets?
    Mr. Partnoy. I think you have hit on a very important point 
and it is part of what Senator Bennett and I were talking 
about, which is how did Enron's derivatives operation make all 
this money? In your dealing with, when you are trading with 
people who are less sophisticated than you are it is a better 
business. You are going to make more money in those kinds of 
    That is one of the reasons--and Senator Thompson raised--
why should we have regulation here? One reason might be, when 
you have parties who are dealing with substantially less 
sophisticated entities--and the securities markets generally 
they have claims, and rightfully so, to make the markets more 
efficient. In the derivatives markets those claims are much 
more difficult to make. How is it that Enron was making 
billions of dollars a year trading? It had an advantage in 
trading those markets.
    Chairman Lieberman. OK, very helpful. Senator Thompson.
    Senator Thompson. Thank you, Mr. Chairman. It seems to me 
that Mr. Henning's earlier point is the valid one here, and 
that is that it is real proof that free markets do work and 
have worked. There has been no price spike and no lack of 
product or anything like that, at least not for these reasons.
    But Mr. Partnoy, you mentioned another entity here kind of 
in passing that I think is very important. The credit rating 
companies, bond rating companies which presumably have access 
to detailed company financial data, as recently as October both 
Standard & Poor's and Moody's gave solid ratings for Enron's 
debt. I do not see the conflict of interest with them that we 
have been talking about with these other gatekeepers and so 
forth. How do you, any of you, how do you account for that?
    Mr. Partnoy. They are paid directly by the issuers, first 
of all, and we do not know exactly how much they are paid.
    Senator Thompson. So there is a conflict issue there?
    Mr. Partnoy. There is an issue. The principal problem with 
credit rating agencies--and thank you so much for bringing up 
this question because I think it is critical to this story--is 
that credit rating agencies essentially have a legislative 
monopoly. Congress and the SEC and many regulators have given 
credit rating agencies a monopoly lock on their business. There 
is no one else who can enter and there are hundreds of legal 
rules that depend substantively on what rating you get. That is 
why they have so much power, from these legal rules.
    If we got rid of those legal rules and made credit ratings 
a competitive business, we would not have these issues where it 
is dramatic if you get downgraded below BBB. Why is that? Why 
does it matter if Standard & Poor's, this private agency, 
downgrades you below BBB? Because you are toast in financial 
markets if you are below BBB. It is much more expensive to 
borrow. It is more expensive for people to hold your debt.
    So that is where--there are two pieces to this. One is 
credit rating agencies make money. Moody's has a market 
capitalization of about $5 billion. It is a huge and very 
valuable franchise.
    The second point is, the reason they have that franchise is 
that we, I think quite lazily, adopted legal rules that defer 
judgments about investments to these credit rating agencies.
    Senator Thompson. Are these legislative enactments that we 
have passed or are they regulations coming out of the SEC or 
    Mr. Partnoy. They are regulations pursuant to various 
statutes that Congress has passed. It has been going on for 
almost 30 years. I would be happy to give you hundreds and 
hundreds of pages on this. I have been writing about this 
problem with credit rating agencies for many years and I think 
it is central to why Enron collapsed, especially at the end.
    Senator Thompson. We will follow up on that. Thank you very 
    Chairman Lieberman. Thank you. Senator Levin tells me that 
I asked the question he had in mind; not about his brother, but 
about the value of the over-the-counter unregulated derivatives 
    The three of you have been a superb panel. I appreciate 
very much the time you took in preparing your testimony and in 
being with us. Thank everybody who participated today. I think 
we are off to a good substantive start with a lot of work yet 
to do.
    The hearing is adjourned.
    [Whereupon, at 2:05 p.m., the Committee was adjourned.]
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