[Senate Hearing 107-724]
[From the U.S. Government Publishing Office]
S. Hrg. 107-724
AN OVERVIEW OF THE ENRON COLLAPSE
=======================================================================
HEARING
before the
COMMITTEE ON COMMERCE,
SCIENCE, AND TRANSPORTATION
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
FIRST SESSION
__________
DECEMBER 18, 2001
__________
Printed for the use of the Committee on Commerce, Science, and
Transportation
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SENATE COMMITTEE ON COMMERCE, SCIENCE, AND TRANSPORTATION
ONE HUNDRED SEVENTH CONGRESS
FIRST SESSION
ERNEST F. HOLLINGS, South Carolina, Chairman
DANIEL K. INOUYE, Hawaii JOHN McCAIN, Arizona
JOHN D. ROCKEFELLER IV, West TED STEVENS, Alaska
Virginia CONRAD BURNS, Montana
JOHN F. KERRY, Massachusetts TRENT LOTT, Mississippi
JOHN B. BREAUX, Louisiana KAY BAILEY HUTCHISON, Texas
BYRON L. DORGAN, North Dakota OLYMPIA J. SNOWE, Maine
RON WYDEN, Oregon SAM BROWNBACK, Kansas
MAX CLELAND, Georgia GORDON SMITH, Oregon
BARBARA BOXER, California PETER G. FITZGERALD, Illinois
JOHN EDWARDS, North Carolina JOHN ENSIGN, Nevada
JEAN CARNAHAN, Missouri GEORGE ALLEN, Virginia
BILL NELSON, Florida
Kevin D. Kayes, Democratic Staff Director
Moses Boyd, Democratic Chief Counsel
Mark Buse, Republican Staff Director
Jeanne Bumpus, Republican General Counsel
C O N T E N T S
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Page
Hearing held on December 18, 2001................................ 1
Statement of Senator Boxer....................................... 28
Statement of Senator Burns....................................... 6
Statement of Senator Dorgan...................................... 1
Statement of Senator Fitzgerald.................................. 25
Statement of Senator Hollings.................................... 3
Statement of Senator McCain...................................... 3
Statement Senator Nelson......................................... 8
Statement of Senator Wyden....................................... 5
Article from The Oregonian, dated November 29, 2001, entitled
Enron's Rise and Fall July 1985: Houston Natural Gas Merges
With InterNorth............................................ 22
Witnesses
Andrews, C. E., Global Head of Auditing and Business Advisory,
Andersen....................................................... 31
Prepared statement with attachment........................... 33
Cleland, Scott, Chief Executive Officer, the Precursor
Group'.............................................. 40
Prepared statement with attachments.......................... 42
Coffee, Jr., John C., Adolf A. Berle Professor of Law, Columbia
University School of Law and Joseph Flom Visiting Professor of
Law, Harvard University Law School............................. 68
Prepared statement........................................... 71
Eri, Donald, Special Tester (Retired), Portland General Electric. 16
Prepared statement........................................... 17
Farmer, Janice, Enron (Retired).................................. 6
Prepared statement........................................... 7
Mann, III, William H., Senior Analyst, The Motley Fool........... 75
Prepared statement........................................... 78
Pearson, Mary Bain, Enron Shareholder............................ 8
Prepared statement........................................... 9
Prestwood, Charles, Enron (Retired).............................. 10
Prepared statement........................................... 12
Silvers, Damon A., Associate General Counsel, AFL-CIO............ 82
Prepared statement........................................... 85
Vigil, Robert, Electrical Machinist Working Foreman, Portland
General
Electric Pelton/Round Butte Hydroelectric Project.............. 13
Prepared statement........................................... 15
Appendix
Berman, Steve W., Hagens Berman LLP, prepared statement.......... 91
Enron: Let Us Count The Culprits, Business Week, December 17,
2001, article.................................................. 92
Enron: The Lessons For Investors; Hindsight, shmindsight. There's
much to learn when a stock loses $67 billion in value, Money,
January, 2002, article......................................... 93
AN OVERVIEW OF THE ENRON COLLAPSE
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TUESDAY, DECEMBER 18, 2001
U.S. Senate,
Committee on Commerce, Science, and Transportation,
Washington, DC.
The Committee met, pursuant to notice, at 9:30 a.m. in room
SR-253, Russell Senate Office Building, Hon. Byron L. Dorgan,
presiding.
OPENING STATEMENT OF HON. BYRON L. DORGAN,
U.S. SENATOR FROM NORTH DAKOTA
Senator Dorgan. This hearing will come to order. This is a
hearing of the full Commerce Committee. I am the Chairman of
the Subcommittee on Consumer Affairs, Foreign Commerce and
Tourism. Senator Hollings has asked that I chair the hearing
today. We will be joined by other colleagues on the Committee
shortly, but we do want to begin on time. The subject of the
hearing is the meltdown and bankruptcy of the Enron Corporation
over the past four months. This raises many serious and
troubling issues, and we want to, in this hearing, explore some
of these issues.
This will be the first of several hearings on this matter.
Mr. Ken Lay, the Chief Executive Officer of Enron, did not
accept our invitation to testify at this hearing. However, we
have been informed this morning that Mr. Lay has committed to
appear before our Committee and present testimony at a second
hearing which will be held on February 4.
We also intend to request at that hearing the attendance of
Mr. Skilling and Mr. Fastow, former top executives at Enron,
and others, who can help explain what happened. I spent many
hours in recent days reading and learning about the events that
preceded the collapse of one of the world's largest
corporations.
Frankly, the more I have learned, the more troubled I have
become. This is not your average business failure. This is a
tragedy for many, including workers and investors who, it
appears to me, have been cheated out of billions of dollars.
This is about an energy company that morphed itself into a
trading company involved in hedge funds and derivatives. It
took on substantial risks, created off-the-books partnerships,
and in effect cooked the books under the nose of their
accountants and investors.
At a time when the executives, board members, and other
insiders were selling nearly $1 billion in stock in recent
years and were profiting handsomely, employees and investors
were set up to take the financial beating. Was this just bad
luck, incompetence, or greed? Were there some criminal or
illegal actions, as have been suggested by the accounting firm
that reviewed Enron's books? Where was the board of directors
when this was happening? How much did they profit from it? Were
they brain dead, or just kept in the dark? What about the
accounting firm? Were they duped? Incompetent? How on earth can
there be adjustments of billions of dollars? Is it not a
conflict of interest for the accounting firm to depend on the
company they are auditing for tens of millions of dollars in
consulting contracts? Where were the Federal agencies? Did they
bear some responsibility, those in Congress who derailed
efforts at Federal regulations for this type of trading
activity? Did the stock analysts who kept recommending a strong
buy know what they were doing? Was there a conflict of interest
there?
This is a company that operated between the cracks of
Federal regulations. It created secret, off-the-books
partnerships with names like Jedi, Chewco, LJM and others, and
allowed a top executive to take ownership in these
partnerships, which seems to me to be a clear conflict of
interest. Who in the company approved these transactions? Who
are the investors, besides Enron, in these partnerships? How
much were their investments, and what was their return?
These are some but not all of the questions the American
people deserve to have answered, and we intend to search for
those answers.
If this were just another business failure, there would be
no need for congressional hearings, but it is anything but just
another failure. More than $60 billion in value has been lost
in just months. Some at the top of the pyramid got rich, many
at the bottom lost everything. It appears to me to be a
combination of incompetence, greed, speculation with investors'
money, and, perhaps, some criminal behavior. Investigations
will sort out all of that, but the tens of thousands of
employees and investors in the end will have lost billions of
dollars.
It is my hope these hearings and other investigations will
help us determine whether laws need to be changed. If they do,
we should change them. They will help us determine whether laws
have been broken. If they have, those who did so will be held
accountable.
I would like to read a quote from Business Week's editorial
page, which I think goes a long way in summarizing why this
hearing is so important, and why the work of this Committee is
necessary. The editorial goes, and I quote, ``Enron Corp.'s
bankruptcy is a disaster of epic proportions by any measure--
the height from which it fell, the speed with which has
unraveled, and the pain it has inflicted on investors,
employees, and creditors. Virtually all checks and balances
designed to prevent this kind of financial meltdown failed.
Unless remedied, this could undermine public trust, the capital
markets, and the nation's entire equity culture.'' That is from
Business Week, and I certainly agree with those sentiments, and
that describes the importance of this hearing. It sums up why
we are here today, and I look forward to hearing from many of
our witnesses, many of whom traveled some long distance to be
here.
Let me call on the Chairman of the full Committee, Senator
Hollings.
The Chairman. I yield.
Senator Dorgan. Let me call on the Ranking Member, Senator
McCain.
STATEMENT OF HON JOHN McCAIN,
U.S. SENATOR FROM ARIZONA
Senator McCain. I thank the Chairman for convening today's
hearing to provide us with an overview of the Enron collapse. I
hope that the witnesses can provide a better understanding of
the facts leading up to the company's bankruptcy and allow us
to understand whether U.S. investors and employees may face
similar situations with other companies.
The losses experienced by Enron's shareholders,
particularly those who lost a substantial portion of their life
savings so close to retirement, is a tragic example of losses
that appear to be due not to poor investment decisions but to
misplaced reliance on those entrusted to protect the integrity
of their investment, the company's executives and independent
auditors. The purpose of this hearing is to examine how such a
situation can happen and what, if anything, the federal
government can and should do to prevent future instances from
occurring. Whether the law has been violated is not for us to
decide. Rather, the issue for Congress is whether existing
controls, if adhered to, are sufficient to protect
shareholders.
Thank you, Mr. Chairman. I look forward to today's hearing.
Senator Dorgan. Senator McCain, thank you. The Chairman of
the full Committee, Senator Hollings.
STATEMENT OF HON. ERNEST F. HOLLINGS,
U.S. SENATOR FROM SOUTH CAROLINA
The Chairman. Well, Mr. Chairman, thank you very, very much
for chairing this hearing for our full Committee.
I have been engaged full-time in trying to make certain
that they did not give away the broadband spectrum. We have got
a Chairman of the Federal Communications Commission that is
determined to divest ownership in spectrum, and they have got a
$5 billion kitty for the K Street crowd to make sure it happens
by December 31, so that has kept me very, very busy.
Otherwise, they have got the full court press over there on
the outside with Tauzin-Dingell to make sure they extend
monopolies rather than engage in competition. That has kept me
busy, along, of course, with the conference committees that are
going on right now between the defense appropriations and the
labor, health and human resources appropriations and then, of
course, Mr. Chairman, this Committee has jurisdiction over
terrorism insurance. We got together a bipartisan bill after
hearings with the Secretary of the Treasury and would've
otherwise reported it out. It is on the calendar, and then the
political maneuvering started.
I was called one morning by the Secretary of Treasury, and
he and I talked informally. We agreed that we could get at
least, without all of these differences, a 1-year terrorism
insurance bill, so everyone would have security here in the
renewal of policies at the first of the year. Our staff started
working early the next morning, but the Republican conference
came in to the working session and pulled all the Members out,
and we have not heard from them since.
Trying to get your job done around here is next to
impossible in these closing days, and by your holding this
hearing it is quite an eye-opener to this particular Senator. I
noticed that Money magazine reported that Lay made $66 million
in selling shares, while Jeff Skilling garnered another $60
million, and 16 board members had made $164 million in selling
their shares by June. Money magazine quotes, ``While insider
sales do not automatically spell trouble for a company . . .
the selling of Enron was prolific. And the fact that the
selling persisted even as the stock fell throughout 2001 was a
`screaming red flag,'. . . If Skilling and Lay believed the
stock was undervalued--as they repeatedly told investors--then
why were they cashing in?''
And then I never had heard, until Enron, of a special
purpose entity (SPE). In fact, I am determined to put in a bill
to eliminate that thing. I do not know what it is. Its best
description by the SEC in the hearing before the House, and I
quote, ``An SPE is an entity created by a sponsor to carry out
a specified purpose or activity, such as to consummate a
specific transaction or series of transactions with a narrowly
defined purpose. SPEs are commonly used as financing vehicles
in which assets are sold to a trust or similar entity in
exchange for cash or other assets funded by debt issued by the
trust. In many cases SPEs are used in a structured transaction
or series of transactions to achieve off-balance sheet
treatment.''
Well, Enron's board of directors have been accused of
allowing the board members and officers of the company to run
these SPE's. Arthur Andersen has been accused of engaging in a
conflict of interest when it served both as a consultant and an
accountant. That thing ought to be stopped. Arthur Andersen
claims they were paid $25 million for its accounting services
and $27 million for its consulting services. If that is not a
conflict on its face, I do not know what is.
Between October 1998 and November 2001, Arthur Andersen
received over $100 million in accounting and consulting fees,
including $52 million in 2000 alone, and then you have got
Salomon Smith Barney. They rated Enron a buy until October 26,
when it went to neutral, where it remained until, of course,
they filed for Chapter 11.
So you can go on and on. There is no doubt about the
shenanigans that have been going on. I hesitated when you
mentioned the need for us to hold this hearing in light of the
jurisdictional concerns regarding this subject. Frankly, by
asserting the jurisdiction over insurance in this Committee,
and with the Banking Committee taking over with a reinsurance
loan guarantee bill, that is a sweetheart deal for the
insurance companies, I wanted to make sure that our inquiry was
not interpreted as a response to the Banking Committee
encroaching on Commerce Committee's jurisdiction. The Consumer
Subcommittee that you head has a responsibility to investigate
this matter, and we rightfully are in our rights here in
holding this hearing, but the truth of the matter is that all
of these financial deals and these SPEs, are Banking issues
that are within the Banking Committee's purview. We must work
together, and support the Banking Committee's efforts to craft
possible solutions to the problems at hand. Brooksley Born
suggested tighter regulation of the securities, but not only
was Enron successful in blocking this action in the Congress,
but it was able to get Congress to pass legislation exempting
energy derivatives that are traded without rigid regulations.
So we might get the members of the Commission up here and hear
what has been going on here. This is a cancer.
When you see in Business Week in August of 2000, last year,
the company was worth $90 billion and today it is worth $1
billion, that thing has got to stop, and we are all guilty in
letting it happen.
I thank you.
Senator Dorgan. Senator Hollings, thank you very much.
Senator Wyden.
STATEMENT OF HON. RON WYDEN,
U.S. SENATOR FROM OREGON
Senator Wyden. Thank you, Mr. Chairman, and let me thank
you for holding this hearing. You have a long record of
advocating for the consumer and workers and investors, and I
just appreciate the chance to work with you and especially
appreciate you including the Oregon witnesses we will hear from
today.
Because of what happened at Enron, Mr. Chairman, there are
Oregon families going to grief counseling rather than holiday
parties this year. These are Oregonians who lost retirement
security because its Enron stock plunged like the Titanic. In
effect, the senior executives on the deck locked the workers in
the boiler room, preventing them from selling off 401(k) shares
while they dumped their own.
What is especially unsettling to me is, there is a law on
the books right now that was designed to prevent the sort of
carnage that took place at Enron. I wrote this law. It is
called the Financial Fraud Detection and Disclosure Act, and it
stipulates that there would be significantly stiffer
requirements on accountants to search for fraud at publicly
held companies like Enron and disclose it when they find it.
I am going to withhold my judgment on this case until the
Securities and Exchange Commission and criminal investigators
have completed their inquiry, but given what is already on the
record it sure does not look like much was done to detect and
disclose the very conduct that the Financial Fraud, Detection,
and Disclosure Act was designed to root out. This law was
written after more than 30 hearings into the accounting
profession, hearings chaired by John Dingell, and I intend to
see to it that this law is complied with.
For example, the Financial Fraud, Detection, and Disclosure
Act requires that every single audit include procedures
designed to detect illegal acts, and that they specifically
identify related party transactions that are essential to the
integrity of the financial statements. Here, there were clearly
related party transactions that had financial hide-and-seek
written all over them, and yet the auditors failed to have
procedures in place to identify them.
When Enron's chief financial officer set out a special
purpose entity funded primarily with Enron's stock bought at a
discount while continuing to serve as an officer of Enron, that
should have set off the warning lights required by the
Financial Fraud, Detection, and Disclosure statute. Certified
financial statements are not supposed to be a game of financial
hide-and-seek, and our review should pay particular attention
to how it was that Enron transactions big enough to bring down
this financial house of cards were not big enough to clearly
and visibly be reported by the auditors.
Mr. Chairman, I thank you, and again I appreciate all of
your leadership.
Senator Dorgan. Senator Wyden, thank you. Senator Burns.
STATEMENT OF HON. CONRAD BURNS,
U.S. SENATOR FROM MONTANA
Senator Burns. Mr. Chairman, I am looking forward to
listening to the witnesses. Thank you.
Senator Dorgan. Senator Burns, thank you very much.
I would like to ask the first panel to come forward. I will
call your name as you come to the table. Ms. Janice Farmer, Ms.
Mary Bain Pearson, Mr. Charles Prestwood, Mr. Robert Vigil, and
Mr. Donald Eri, if you would come forward and take seats at the
table we would appreciate that.
The Committee thanks you for being here today. We know many
of you have traveled many miles, and we will benefit from your
testimony. We will ask Ms. Janice Farmer to go first. Ms.
Farmer, you are, I understand, accompanied by your daughter. Is
that correct?
Ms. Farmer. Yes, that is correct.
Senator Dorgan. Ms. Farmer, why don't you proceed, and we
will include the entire statement you have produced for the
record. You may summarize. Thank you very much.
STATEMENT OF JANICE FARMER, ENRON (RETIRED)
Ms. Farmer. Dear Members of the Commerce Committee, thank
you for inviting me to speak today. Although in some ways it is
an exciting experience for an average American to be appearing
before the Senate, I wish the circumstances were such that I
was not here. My name is Janice Farmer, and I am from Orlando,
Florida. I spent 16 years in the natural gas industry, starting
with Florida Gas Transmission Company, which later became a
part of Enron. I worked in the Right of Way Department and also
at the training center, where people were trained to handle
natural gas safely.
One year ago, I retired from Enron Corporation with nearly
$700,000 in Enron stock. This was my life savings, my nest egg.
I am a single woman, and I am proud that I was able to amass
this amount in the Enron 401(k) plan. I did without many things
that I would like to have spent money on in order to
participate in this plan. I thought that I had prudently
planned for my financial future and that of my children and of
my grandchildren.
I was proud to invest in Enron stock. The company
encouraged me and others to do so, saying that employee
ownership would help prevent any possible hostile corporate
takeovers. We were a loyal and hardworking group of employees.
We lived, ate, slept, and breathed Enron, because we were
owners of the company. I trusted the management of Enron with
my life savings.
Senators I will not mince words here. They betrayed that
trust. My life savings are gone. I am now left, a year away
from Social Security, with a $63 a month pension check from
another company. On top of all of this is the lockdown. By
October 22, 2001, I was upset and dismayed over the news of
Enron's financial status. When I saw the stock drop, I called
to sell and was told that I was locked out, so I had to stand
by and watch my savings disappear. In the end, I received a
check for $4,000. That is all that was left.
I leave it to you and the courts, I guess, to decide if
locking me and other employees out was a breach of trust by
those running the plan. I know that many other employees share
my financial pain, and the sense of betrayal.
Senators I am not a lawyer, but I understand there is a law
called ERISA, and that this law imposes some fiduciary
obligations on those in charge. I cannot help but feel that I
and thousands of employees like me have been lied to and we
have been cheated. Instead of being rewarded for my hard work
and loyalty, I am left with a lawsuit against my employer and
those responsible. It may be too late for you to help me, but
it is not too late for you to take some action to help make
certain that this does not ever happen to anyone else again.
Thank you very much.
[The prepared statement of Ms. Farmer follows:]
Prepared Statement of Janice Farmer, Enron (Retired)
Dear Members of the Commerce Committee,
Thank you for inviting me to speak today. Although in some ways it
is an exciting experience for an average American to be appearing
before the Senate, I wish the circumstances were such that I was not
here.
My name is Janice Farmer. I am from Orlando, Florida. I spent
sixteen years in the natural gas industry starting with Florida Gas
Transmission, which later became a part of Enron. I worked in the Right
of Way Department and also at the training center, where people were
trained to handle natural gas safely.
One year ago, I retired from the Enron Corporation with nearly
$700,000 in Enron stock. This was my life savings, my nest egg. I am a
single woman and am proud that I was able to amass this amount into the
Enron 401(k) plan. I did without many things I would have liked to have
spent money on, in order to put money in that plan. I thought that I
had prudently planned for my financial future and that of my children
and grandchildren.
I was proud to invest in Enron stock. The company encouraged me and
others to do so, saying that employee ownership would help prevent any
possible hostile corporate takeovers.
We were a loyal and hard-working group of employees. We lived, ate,
slept and breathed Enron because we were owners of the company.
I trusted the management of Enron with my life savings. Senators, I
won't mince words here. They betrayed that trust. My life savings is
gone. I am left now a year away from Social Security and am living off
a $63.00/month pension check from another company.
On top of all this is the lockdown. By October 22, 2001, I was
upset and dismayed over the news of Enron's financial status. When I
saw the stock drop, I called to sell and was told I was locked out. So
I had to stand by and watch my savings disappear. In the end, I
received a check for $4,000. That's all that was left. I leave it to
you and the courts, I guess, to decide if locking me and other
employees out, was a breach of trust by those running the plan.
I know that many other employees share my financial pain and sense
of betrayal.
Senators, I am not a lawyer, but I understand there is a law called
ERISA and that this law imposes some fiduciary obligations on those in
charge. I cannot help but feel that I and thousands of employees like
me have been lied to and cheated.
Instead of being rewarded for my hard work and loyalty, I am left
with a lawsuit against my employer and those responsible. It may be too
late for you to help me, but it is not too late for you to take some
action to make certain that this does not happen again.
Thank you very much.
STATEMENT OF HON. BILL NELSON,
U.S. SENATOR FROM FLORIDA
Senator Nelson. Mr. Chairman, I just want to point out that
the lady is from my home town area of Central Florida, and
there is a great deal of concern among the retirees that live
in Florida that are suffering as has been stated here. I will
get into some specifics later on, but I just want to thank Ms.
Farmer for being here.
Ms. Farmer. Thank you. It is an honor to be here.
Senator Dorgan. Senator Nelson, thank you. Ms. Farmer,
thank you for your testimony.
Next, we will hear from Ms. Mary Bain Pearson. Ms. Pearson.
STATEMENT OF MARY BAIN PEARSON, ENRON SHAREHOLDER
Ms. Pearson. My name is Mary Bain Pearson. I am a 70-year-
old Latin teacher and tutor. I am a widow of G. P. Pearson, who
was a Representative in the Texas Legislature from Grimes
County, Texas.
I have always tried to handle my business in a logical
manner, like you conjugate a verb or decline a noun. I am also
a child of the Depression, when my father was working in a bank
and the bank failed during the Depression, and he never got
over that, and for the next 50 years he used to always warn me
to save something for an emergency or an illness, and not to
put all my eggs in one basket, and be careful with my money. I
used to laugh at him and kid him, but you know what, he was
right.
After a while, I decided I would invest in Enron stock.
Now, I do not want you to think I am too naive. I did a lot of
work investigating it, and learned about its history. Finally,
I bought 100 shares so I could go to the board meeting, and I
did go to some board meetings and met some of the members of
the board, who I held in the highest esteem.
We had Charles Lemaistre, who I still hold in the highest
esteem, who is a very wonderful man, and Mrs. Phil Gramm was
there that day, and I thought she was smart, because she
already had a job in the economy up here in Washington, and I
thought she was smart. There were other people on the board in
Houston that I knew, and I always held them in high esteem, and
so I thought, well, this must be a good company to invest in,
so I bought some more stock.
Many times I would pick up the newspaper and see Ken Lay's
name in it. He was very generous. He was always at charity
parties and giving millions of dollars to this and hundreds of
thousands of dollars to that, and it was a wonderful thing, and
it made the company look very, very good.
I am just a pebble in the stream, a little bitty
shareholder. I did not lose billions. I did not even lose a
million, but what I did lose seems like a billion to me. In
fact, what really hurts is, I bought my granddaughter some
Enron stock, and she is 10 years old, so I feel real bad about
that.
I was going to use my Enron stock as my long-term health
care. I had taken my father's advice and put that aside in case
of an emergency if I got sick. I had nursed my husband for 7
years with cancer, day and night, and been happy to do it, but
after he passed away I did not want that to fall on my
children's shoulders, so I put this stock aside so that I could
call on it and use it in case I had a long-term disease.
Well, I do not know what I am going to do now. I am going
to have to go home and reevaluate my life and see what I can
do. I am not a big stockholder, just a little person, but when
they asked me how I felt about Enron I said, well, at first I
was in a state of shock for a while. I could not believe that
it happened so quickly. I asked my accountant if I should not
sell the stock and he said no, hold onto it. I can hardly wait
till April 15 when I go to see him.
[Laughter.]
Ms. Pearson. And then after that wore out, a veil of
disappointment fell over me. I was disappointed in the people
that I put my trust in years ago. 1986 is when I bought my
first stock. And then after a little time passed on, bitterness
came into being, and bitterness will eat you alive if you let
it, but sometimes at night I do feel real bitter over what I
have lost, because it was a big part of my future, and I do not
know how I am going to handle the future now. All I can do is
hope and pray I do not get sick.
So thank you for letting me pour my heart out to you.
[The prepared statement of Ms. Pearson follows:]
Prepared Statement of Mary Bain Pearson, Enron Shareholder
My name is Mary Bain Pearson. I am 70-years of age. I am the widow
of G.P. Pearson, formerly a state representative from Grimes County,
Texas. After my husband passed away, I tried to follow the teachings of
my husband and my father by setting aside money for the eventual
downturn in the economy which always seems to occur. I am a child of
the depression and my father had told me after having worked in a bank
that failed, that I should set aside my money in safe investments for
my retirement and for needed medical expenses.
After attending a board meeting, I was impressed with what the
leaders of the company had to say and decided to buy more stock for my
granddaughter. I have been adding to my stock over the years and have
not sold because my accountant also believed Enron was a good company
and that I shouldn't sell. I believed what the people at the company
said, not only in their public statement, but in the annual reports and
believed in the people who were on the board of directors such as Dr.
Charles LeMaitre, former Chancellor of the University of Texas and
Wendy Gramm, wife of U.S. Senator Phil Gramm. I knew some other members
of the board who resided in Houston and believed them when they
represented that they were running the company in the best interest of
the shareholders.
Many times when I picked up the newspaper Ken Lay was either giving
money to charities or helping raise money for some worthy purpose. I
believed he was a good man and kept my money with his company because I
thought he and the people he had placed in positions of trust in the
company were honest.
I am just a pebble in the stream, just a little bitty stockholder,
but both my granddaughter and I have lost money we had set aside for
our future and do not know how we will replace those losses. I
specifically set aside my stock for my long-term health care needs
because I took care of my ailing husband for seven years before he
passed away. I was happy to take care of him, but I do not want my
grown children to have the responsibility to take care of me if
something should happen to me health wise.
Thank you for taking the time to listen to me and to consider my
plight which is not nearly so bad as many of the people who worked for
Enron for many years and had their life savings disappear.
Senator Dorgan. Ms. Pearson, thank you very much for being
here.
Next, we will hear from Mr. Prestwood.
STATEMENT OF CHARLES PRESTWOOD, ENRON (RETIRED)
Mr. Prestwood. Thank you, Mr. Chairman, and all the
Committee members and other Senators that are here. My name is
Charles Prestwood, and I have come from Conroe, Texas, which is
about roughly 50 miles north of Houston, I am 63 years old, and
I have been with Enron ever since the beginning. I have been
with the Houston Natural Gas System before that. Internorth and
Houston Natural Gas, they merged, and that is where Enron was
formed, and I have been there the whole way, all the way from
the beginning to the end.
Senator McCain. How many years is that, Mr. Prestwood?
Mr. Prestwood. 33\1/2\ years that I was in the gas
business, in Enron most of that time, and I am a very broke
person. I lost everything I had.
I was what I call very loyal. The word loyalty to a
company, you know, is something that we helped build. We worked
real hard on building the corporation of Enron to be the number
1 gas supplier, or the number 1 energy supplier for which we
achieved that goal, and we were very happy to achieve that
goal, and then just to see it evaporate right in front of our
eyes, and I had all my savings, everything in Enron stock. I
lost $1.3 million, and I hope and pray that it can be
recovered, or I hope and pray that--my solemn prayer is that no
other company will ever go through what we did, because Enron
was a good corporation.
We made lots of money. We were trained to believe that we
were number 1 no matter what we did, and we achieved every goal
we set out to achieve, and everything was just so lovey-dovey,
you know what I mean, with our financial standing and stuff. In
other words, I reached the age of retirement at 62. I retired
October 1 in the year 2000, and I had everything kind of
financially under control. In other words, I could take my
retirement. I could take my social security and bridge it with
a little out of my savings account and live a fairly decent and
happy life, you know, but all those plans have changed now. In
other words, it was from rags to riches and back to rags, and
that is a simple way of explaining it.
In other words--and the way that the company prospered, the
bookkeeping and the accountants, and the way they did things
was way over our heads. We did not know anything about that, us
retirees in 99 percent of the Enron employees they did not know
anything was wrong with our company. They had no idea. I had no
idea that our company was in trouble, that our company was on
the verge of collapse, but you know, it does not take long.
And then we get back to the lockdown. The strategy that was
used there, they called it a coincidence, you know.
Coincidences happen, you know, and everybody understands that,
but when we were locked down we could not get to our stock. We
could not get to our broker to move our stock out because it
was in the process of being transferred to another company. All
we could do was just sit there and watch it melt down.
I still have all my stock, but the most important thing
about that stock is the ink on it. That is about what it is
worth, and it is very touching to be in a predicament like
this, because a lot of people have asked me, Charlie, why in
the world didn't you get out beforehand?
I go back to that one simple word of loyalty. Loyalty to a
corporation, loyalty to something that I helped build, that I
strived and worked a lifetime to build, and that is the reason
I did not, and the revenues are simply stunning, of our
company. In other words, how a company--well, let me just read
a little quotation here.
It says, that is how Chief Executive Officer Jeff Skilling
described Enron's strong financial operating performance in
2000. Every major business pipelines, wholesale services,
retail, and broadband turned in strong performances in the year
that were reflected in record volumes, contract value, and
profitability. In other words, we reached $101 billion in the
year 2000. That was our sales, and right now, in other words,
that was the business that we had done across the Nation and
across the world, all of the foreign works we have got overseas
and stuff.
We had a great year in the year 2000, and now we are down
to the year of 2001, when our stock started just falling. We
thought it was just the economy. You know, the economy is bad,
and so everybody's stock is going down. It did, but then when
the balance sheet started coming out we still--we thought we
had the best.
In other words, if there is a good accountant, we will hire
him. That was our goal, our motto. We were supposed to have the
best, and not get things messed up like they did, and back on
January 26 is another illustration of why the employees and the
retirees did not sell their stock. It was--I pulled a copy of
it off of the computer that the estimated value of the Enron
stock at the close of the year of 2001 would be between $122
and $126, with an average of $124 to $125, and at the end of
2002 the value of the Enron stock would be $145 on the average.
Well, you know, common sense will tell you you do not get
rid of stock like that. You hang onto it, and try to achieve
those goals, and another just common sense way I see it, they
said, well, you could have rolled out of that and rolled it
into something else, but who wants to get off a winning horse?
So where does that leave me? I can tell you without pulling
punches something stinks here, and it really does. There are
people at Enron who made millions selling Enron stock,
encouraging the retirees and encouraging the Enron employees to
just hang on to it, it is going to get better. It will get up
there and our stock will split again, for which I have been
very fortunate. I have been very fortunate, but the fact is
that I have seen two or three stock splits, 2 for 1. The stock
would come up and split, and it would come back up, and that is
where I gained mine.
But in other words, I lost it a whole lot quicker than I
made it, and I and my coworkers, and I am speaking for the
Enron employees that are still working for Enron. I am speaking
for the employees that got discharged here a few days back, and
all the retirees that are not here. I am honored to be here and
get to say a few words on our behalf that you all will know the
actual truth of what actually is happening to us in this good
old U.S.A., and I hope and pray that there is something that
can be done about it, and I hope and pray that there are some
laws that can be set up to where every corporation in the
United States will be on the same page on keeping books, that
there will not be any of this thing happening again.
So I thank all of you for listening, and that is my story.
[The prepared statement of Mr. Prestwood follows:]
Prepared Statement of Charles Prestwood, Enron (Retired)
Thank you, Mr. Chairman, for the opportunity to appear before you
today.
My name is Charles Prestwood. I am from Conroe, Texas and I am 63
years old.
I built my retirement fund over the course of a long career in the
natural gas industry, most of which I spent in the field with Houston
Natural Gas working on pipelines. In the 1990s, when Enron acquired
HNG, all my retirement investments were automatically converted to
Enron stock.
Enron stock was aggressively promoted by executives within the
company. I continued to receive part of my compensation from Enron in
company stock and stock options. Enron promoted employee stock
ownership verbally and through internal publications. Here is a quote
from an internal publication sent to all employees in early 2001:
Simply stunning. That's how Chief Executive Officer Jeff
Skilling describes Enron's strong financial and operating
performance in 2000. Every major business--pipelines, wholesale
services, retail and broadband--turned in strong performances
for the year that were reflected in record volumes, contract
value and profitability. Revenues increased two-and-a-half
times, reaching $101 billion. For the first time, Enron's pre-
tax net income exceeded $1 billion, a 32 percent increase over
last year, and shareholders received an 89 percent gain on the
stock price. Other significant highlights included:
Fourth quarter revenues of $40.75 billion, exceeding
1999's entire reported revenues of $40 billion;
25 percent increase in earnings per diluted share to
$1.47;
59 percent increase in marketed energy volumes to 52
trillion British thermal unit equivalents per day; and
Nearly doubling of new retail energy contracts to $16.1
billion.
Enron Business met with Jeff to discuss last year's results and his
outlook for 2001.
EB: Enron had a great 2000. How did we do it?
Jeff: Every one of our businesses performed beyond our
expectations.
We believed in the story in this publication and it is typical of
the type of promotion by Enron executives. I recall when the company
did particularly well, these types of internal publications would be
circulated. I also recall attending a breakfast with Mr. Lay where he
told us not to sell our Enron stock.
As a result of this type of promotion, I and many others continued
to invest in Enron up until the bitter end. To me, this is the American
way, loyalty to your employer.
I retired from Enron Corp. in October 2000 feeling that after a
lifetime of hard work, my retirement account with Enron provided
financial stability. I could no longer keep pace with the physically
demanding work required in plant operations. I expected that Enron
stock would support me. I worked hard to make it so. I had $1.3 million
in savings, all in Enron stock.
Let me mention the lockdown. The lockdown started, to the best of
my knowledge on October 17, 2001. At this point, Enron had just
announced the bad news that shocked us all. Much to our chagrin, we
were locked out of our accounts. So folks who bought Enron on the
street could trade, but we could not.
So where does that leave me? I can tell you, without pulling
punches, something stinks here. There are people at Enron who made
millions selling Enron stock, while we, the rank and file, got burned.
It's that simple. I am left with a tiny fraction of my $1.3 million, or
about $8,000. It's too late in my life to start over to build up my
funds.
I don't know the law, but I know what is right and what is wrong.
There is something terribly wrong here. I thought someone was supposed
to be looking out for our interests. I thought that people had to treat
us honestly and deal fairly with us. In my neck of the woods, what
happened is not right.
I am only one of thousands who have been wiped out. I hope you can
do something about it for me and the many like me.
I and my co-workers are proud of the industry we helped build,
including the work we did for Enron and its predecessors. For most
ordinary workers, Enron's failure taints lifetimes of dedicated work as
well as striking a devastating blow to our futures.
Thank you all for listening to me today.
Senator Dorgan. Mr. Prestwood, thank you very much.
Next, we will hear from Mr. Vigil. Mr. Vigil, will you
proceed?
STATEMENT OF ROBERT VIGIL, ELECTRICAL MACHINIST WORKING
FOREMAN, PORTLAND GENERAL ELECTRIC PELTON/ROUND BUTTE
HYDROELECTRIC PROJECT
Mr. Vigil. Good morning. Thank you for allowing me to be
here. My name is Bob Vigil. I am an Electrical Machinist
working for Portland General Electric (PGE). I work at PGE's
Portland Hydroelectric Plant in Central Oregon. I am 47 years
old and have been employed by PGE for 23 years.
I come to you representing hundreds of hardworking PGE
employees who have been financially devastated by Enron's
recent stock price collapse and bankruptcy. I am one of 911
current PGE employees representing the Local 125 International
Brotherhood of Electrical Workers. In addition to the members
of our bargaining unit there are 1,870 other employees at PGE.
Since 1981, all of PGE's employees have participated in a
401(k) plan which we expected to provide us with a comfortable
retirement. For every $1 that we individually contribute to the
plan, up to 6 percent of our income, the company has committed
to contribute an equal amount in stock.
Enron purchased PGE in 1997, at which time all of PGE's
stock we had in our accounts automatically converted to Enron
stock. At first, this looked like good news for the employees.
Enron was riding high, and as we saw the company officers and
supervisors investing in company stock we felt assured that our
own investments were sold.
As you probably are aware, by August 2001 stock had shot up
to an all-time high of $90.56. At that time, my 1,800 shares
were worth $163,000. Little did those of us working hard every
day to help make the company successful know what was going on
at the top of Enron. We trusted management's glowing reports of
strong financial growth and opportunity with Enron. Then in
October 2001, Enron's house of mirrors came crashing down in
the largest bankruptcy in history.
There are a few things you need to understand about our
401(k) plan to understand the impact of Enron's collapse.
First, we are free to make various kinds of investments with
our own contributions, but the plan prohibits any employee
under age 50 from trading the company's contributions. In other
words, the company puts in its own stock, and until we reach
age 50 they hold that stock.
Second, until very recently, even after age 50 we could
only trade 25 percent of the company's contributions per year.
Third, I said before that the company is committed to
contributing stock equal in value to our cash contributions.
The company's practice, however, has been to purchase blocks of
stock at the beginning of the year which it then uses to match
our contributions over the course of the year. In making those
contributions, Enron uses the cost of the stock when it
purchased it, not the value when it makes the contributions. In
good years, this certainly has been advantageous, but over the
course of the last year our employer has been contributing
stock worth a fraction of the contribution it is supposed to be
matching.
Finally, as all of you well know, we were all barred from
trading our stock during a critical period this last fall. It
seems strange to me that as soon as the really bad news came
out on Enron we found ourselves unable to move out of the
stock. Enron suddenly changed account managers, and our
investment accounts were locked down. I have seen that Enron
says we were only locked out of our accounts for 10 trading
days, from October 29 through November 12, but as early as
September 26 my coworkers were finding that they could get
access to their accounts but they could not conduct any
transactions.
As the truth about Enron started to come to light and the
officers at the top cashed out, we, the employees, had no
choice but to ride the stock into the ground. We were all
somewhat hopeful that the proposed Dynegy buy-out of Enron
would at least give us relief from the $5 per share range, but
when Dynegy pulled out on November 28, 2001, Enron's stock
dropped below the $1 per share range, where it currently stays.
Every PGE employee tells a tale about his or her losses.
All of them are tragic, and most of them are life-changing. All
of us regarded the 401(k) plan as a way of investing our hard-
earned wages for future security, and we assumed that in
matching our contributions our employer was giving us something
of value. It all now appears to have been a cruel illusion. As
a result, retirees are finding their nest eggs gone. Older
employees are facing having to work much longer than they had
intended, and younger workers are being forced to revise their
financial and career plans.
To give you an idea of the magnitude of the overall losses,
a number of my coworkers at PGE have agreed to allow me to give
their names, ages, years of service with PGE and losses in
Enron stock. Keep in mind that the losses I am about to list
represent only the lost stock value since we were locked out of
our accounts in mid-September:
Tim Ramsey, age 55, 33 years with PGE, $995,000 loss;
Roy Rinard, age 53, 22 years with PGE, $472,000 loss;
Al Kaseweter, age 43, 21 years with PGE, $318,000 loss;
Joe and Diane Rinard, age 47, 12 years with PGE,
$300,000-plus loss;
Dave Covington, age 32, 22 years with PGE, $300,000
loss;
Tom Klein, age 55, 30 years with PGE, $188,000 loss;
Mike Schlenker, age 41, 10 years with PGE, $177,000
loss;
Patti Klein, age 47, 24 years with PGE, $132,000 loss.
Just eight employees who have together invested 188 years
with PGE have together lost $2,882,000. You can imagine how
this catastrophe has affected us. Now multiply that feeling
across thousands of our homes.
Rest assured that our experience represents just the tip of
the iceberg of the heartache and family devastation caused by
Enron's collapse. It is estimated that Enron's collapse
resulted in employee pension plan losses of up to $1 billion.
If my eight coworkers alone lost $2.8 million that estimate is
probably low.
I came from across the country today to urge you to fully
investigate the circumstances surrounding Enron's collapse. We
are not looking for a handout. We are looking for solid,
truthful answers as to what happened here so that we may
possibly recoup some of this money, maintain our dignity, and
prevent further theft occurring to others who worked their
entire lives only to become victims of robbery.
In addition, the working people in this country need your
assurances that neither the future solvency of their social
security benefits nor any greater share of their pension
benefits will depend on the goodwill of corporate traders.
Thank you sincerely.
[The prepared statement of Mr. Vigil follows:]
Prepared Statement of Robert Vigil, Electrical Machinist Working
Foreman, Portland General Electric Pelton/Round Butte Hydroelectric
Project
Good morning. My name is Robert Vigil. I am an Electrical Machinist
Working Foreman for Portland General Electric (``PGE''). I work at
PGE's Pelton/Round Butte Hydroelectric Project, in Central Oregon. I am
47 years old, and I have been employed by PGE for 23 years.
I come to you today representing hundreds of hard-working PGE
employees who have been financially devastated by Enron's recent stock
price collapse and bankruptcy. I am one of 911 current PGE employees
represented by Local 125, International Brotherhood of Electrical
Workers. In addition to the members of our bargaining unit, there are
some 1870 other employees at PGE. Since 1981, all of PGE's employees
have participated in a Sec. 401(k) plan, which we expected to provide
us with a comfortable retirement. For every dollar that we individually
contribute to the plan, up to 6% of our income, the company is
committed to contributing an equal value in its stock.
Enron purchased PGE in 1997, at which time all of the PGE stock we
had in our accounts automatically converted to Enron stock. At first,
this looked like good news for the employees. Enron was riding high,
and as we saw the company officers and supervisors investing in company
stock, we felt assured that our own investments were solid. As you are
probably aware, by August 2000, Enron's stock had shot up to an all-
time high of $90.56. At that time, my 1800 shares were worth $163,000.
Little did those of us working hard every day to help make the
company successful know what was going on at the top of Enron. We
trusted management's glowing reports of strong financial growth and
opportunity with Enron. Then, in October 2001, Enron's house of mirrors
came crashing down in the largest bankruptcy in history.
There are a few things you need to understand about our Sec. 401(k)
plan to understand the impact of Enron's collapse. First, we are free
to make various kinds of investments with our own contributions, but
the plan prohibits any employee under age 50 from trading the company's
contributions. In other words, the company puts in its own stock, and
until we reach age 50, we hold that stock. Second, until very recently,
even after age 50, we could only trade 25% of the company's
contributions per year. Third, I said before that the company is
committed to contributing stock equal in value to our cash
contributions. The company's practice, however, has been to purchase
blocks of stock at the beginning of the year, which it then uses to
match our contributions over the course of the year. In making those
contributions, Enron uses the cost of the stock when it purchased it,
not the value when it makes the contributions. In good years, this
certainly has been advantageous. But over the course of the last year,
our employer has been contributing stock worth a fraction of the
contribution it is supposed to be matching.
Finally, as you all well know, we were all barred from trading our
stock during a critical period this last fall. It seems strange to me
that as soon as the really bad news came out on Enron, we found
ourselves unable to move out of the stock. Enron suddenly changed
account managers, and our investment accounts were ``locked down.'' I
have seen that Enron says we were only locked out of our accounts for
ten trading days--from October 29 through November 12. But as early as
September 26, my coworkers were finding that they could get access to
their accounts, but they could not conduct any transactions. As the
truth about Enron started to come to light--and as the officers at the
top cashed out--we, the employees, had no choice but to ride the stock
into the ground.
We were all somewhat hopeful that the proposed Dynegy buyout of
Enron would at least give us relief in the $5-per-share range. But when
Dynegy pulled out of the deal on November 28, 2001, Enron's stock
dropped below the $1-per-share range, where it currently stays.
Every PGE employee has a story to tell about his or her losses. All
of them are tragic, and most of them are life changing. All of us
regarded the Sec. 401(k) plan as a way of investing our hard-earned
wages for future security. And we assumed that, in matching our
contributions, our employer was giving us something of value. It all
now appears to have been a cruel illusion. As a result, retirees are
finding their nest eggs gone; older employees are facing having to work
much longer than they had intended; and younger workers are being
forced to revise their financial and career plans.
To give you an idea of the magnitude of the overall losses, a
number of my co-workers at PGE have agreed to allow me to give you
their names, ages, years of service with PGE, and losses in Enron
stock. Keep in mind that the losses I am about to list represent only
the lost stock value since we were locked out of our accounts in mid-
September:
1. Tim Ramsey, age 55, 33 years with PGE: $995,000 loss.
2. Roy Rinard, age 53, 22 years with PGE: $472,000 loss.
3. Al Kaseweter, age 43, 21 years with PGE: $318,000 loss.
4. Joe and Diane Rinard, age 47, 12 years with PGE: $300,000-
plus loss.
5. Dave Covington, age 32, 22 years with PGE: $300,000 loss.
6. Tom Klein, age 55, 30 years with PGE: $188,000 loss.
7. Mike Schlenker, age 41, 10 years with PGE: $177,000 loss.
8. Patti Klein, age 47, 24 years with PGE: $132,000 loss.
Just these eight employees--who have together invested 188 years
with PGE--have together lost $2,882,000.
You can imagine how this catastrophe has affected us. Now multiply
that feeling across thousands of other homes. Rest assured that our
experience represents just a tip of the iceberg of the heartache and
families' devastation caused by Enron's collapse. It is estimated that
Enron's collapse resulted in employee pension plan losses of up to $1
billion. If my eight co-workers alone lost nearly $2.8 million, that
estimate is probably very low.
I come from across the country today to urge you to fully
investigate the circumstances surrounding Enron's collapse. We are not
looking for a handout. We are looking for solid, truthful answers as to
what happened here so that we may possibly recoup some of this money,
maintain our dignity and prevent further theft from occurring to others
who work their entire lives only to become victims of robbery. In
addition, the working people in this country need your assurances that
neither the future solvency of their Social Security benefits nor any
greater share of their pension benefits will depend on the good will of
corporate traders.
Thank you sincerely.
Senator Dorgan. Mr. Vigil, thank you very much.
Finally, we will hear from Mr. Eri. Mr. Eri, you may
proceed.
STATEMENT OF DONALD ERI, SPECIAL TESTER (RETIRED),
PORTLAND GENERAL ELECTRIC
Mr. Eri. Good morning. My name is Don Eri. I am 57 years
old. I retired from Portland General Electric (PGE) in April of
2001, after 33 years of company service. I joined the company
in December 1967, and worked my way up the ranks, retiring as a
Senior Tester. I come to you today representing the thousands
of PGE retirees who have been financially devastated by Enron's
recent stock price collapse and bankruptcy.
Enron purchased PGE in 1997. Because of the sale, the PGE
stock that my coworkers and I had in our 401(k) accounts
automatically converted to Enron stock, and from that time to
the present PGE met its obligation to match employee
contributions to the 401(k) plan by giving us Enron stock. For
a time, that looked real good. As you probably are aware, by
August of 2000, Enron stock had shot up to an all-time high of
$90.56 a share. Before I retired in April of 2001, I sold all
but 600 of my Enron shares. I expected the remaining stock to
provide me with some growth in my retirement and give me a
cushion to provide for the basics in my later life, such as the
rapid rise in medical cost.
How wrong I was. It turns out the people at the top of the
company seriously misrepresented the financial picture of the
company's future to those of us who worked to keep the lights
on for over 700,000 customers. We took pride in what we did. We
worked in all kinds of adverse weather conditions for days at a
time without rest to make sure that our Oregonians had light
and heat when they needed it. Since I had the shear luck of
getting out of Enron before it collapsed completely, my
exposure was, as I mentioned, only 600 shares, but Enron's
smoke and mirrors still cost me over $40,000. Next to the
stories you have heard from my coworkers, who have lost
hundreds of thousands of dollars, $40,000 may not sound like
much to you, but to me it is a significant amount of money that
I had counted on to help support me through my retirement.
Moreover, if I had not retired and cashed out in late April I
probably could not afford to retire now, since far more of my
pension would have disappeared.
The money I lost represents past earnings that I invested
on my own, as well as contributions toward my pension that the
employer was committed to provide for me. Now it is gone. With
Enron in bankruptcy, it will be something short of a miracle if
I ever get any of it back. PGE retirees who had Enron stock are
hurting. They do not know what the future holds. For some of
them a substantial portion of their retirement portfolio has
simply disappeared.
What they want from our country's leaders are some straight
answers about what happened at Enron. Then they can make their
own decisions whether there are any realistic means for trying
to recover their hard-earned money. We are not looking for
handouts. We just want to be heard, and help this Committee and
others to determine the truth so we can get on with our lives.
Thank you.
[The prepared statement of Mr. Eri follows:]
Prepared Statement of Donald Eri, Special Tester (Retired),
Portland General Electric
Good morning. My name is Donald Eri. I am 57 years old. I retired
from Portland General Electric--PGE--in April 2001, after 33 years with
the company. I joined the company in November 1968 and worked my way up
the ranks, retiring as a Special Tester.
I come to you today representing the thousands of PGE retirees who
have been financially devastated by Enron's recent stock price collapse
and bankruptcy. Enron purchased PGE in 1997. As an immediate result of
that sale, the PGE stock that my co-workers and I had in our 401(k)
accounts automatically converted to Enron stock, and from that time to
the present, PGE met its obligation to match employee contributions to
the 401(k) plan by giving us Enron stock.
For a time, this looked like a good deal. As you are probably
aware, by August 2000, Enron's stock had shot up to an all-time high of
$90.56 a share. When I retired in April of 2001, I sold all but 500 of
my Enron shares. I expected the remaining stock to provide me with some
growth in my retirement and give me a cushion to provide for basics in
my later life, such as the rapidly-rising medical costs most people can
no longer afford to insure against.
How wrong I was.
It turns out that Enron was really a sham. Here it was, the 10th-
largest company (in revenue) in the United States, a leader in the move
toward a deregulated energy market. Its top executive, Ken Lay, was a
personal friend of President George Bush and Vice President Dick
Cheney. Its directors were prominent people, with valuable political
and industrial ties. They were all making huge amounts of money,
apparently off of a highly successful company. We saw our supervisors
buying up the stock, and encouraged by the smell of success, we used
our own money in our 401(k) plan to do likewise.
Despite our employer's enthusiasm for deregulation, those of us who
have worked in the electric utility industry over the years have always
had serious misgivings about whether a deregulated industry would be
able to provide the kind of reliable service that the nation expects
and that we have taken pride in providing. But we had no idea how
unregulated the industry actually is--and that our employer's financial
dealings would completely escape any meaningful regulatory scrutiny.
It turns out that the people at the top of the company seriously
misrepresented the financial picture and the company's future to those
of us who worked to keep the lights on for over 700,000 customers. We
took pride in what we did. We worked in all kinds of adverse weather
conditions for days at a time without rest to make sure that Oregonians
had light and heat when they needed it. And this is how we get paid
back.
And they lied to you, and to legislators and regulators around the
country, painting a picture of an industry that could flourish without
government intervention.
Since I had the sheer luck to get out of Enron before it collapsed
completely, my exposure was, as I mentioned, only 500 shares. But
Enron's smoke and mirrors still cost me over $40,000. Next to the
stories you have heard of my co-workers who have lost hundreds of
thousands of dollars, $40,000 may not sound like much to you. But to
me, it's a significant amount of the money that I had counted on to
help support me through my retirement. Moreover, if I had not retired
and cashed out last April, I probably could not afford to retire now,
since far more of my pension would have disappeared.
The money I lost represents past earnings that I invested on my
own, as well as contributions toward my pension that my employer was
committed to provide for me. Now it's gone and, with Enron in
bankruptcy, it will be something short of a miracle if I ever get any
of it back.
PGE retirees who had Enron stock are hurting. They don't know what
the future holds now that, for some of them, a substantial portion of
their retirement portfolio has simply disappeared. What they want from
our country's leaders are some straight answers about what happened at
Enron. Then they can make their own decisions whether there are any
realistic means for trying to recover their hard-earned money.
What Enron's current employees want is the same as what employees
throughout this country want--some assurances that the pensions they
are promised, and in which they are investing today, will have some
real value when the time comes for them to retire.
We are not looking for a handout. We just want to be heard and to
help this Committee and others determine the truth so that we can get
on with our lives and--for some of us--retain our dignity.
Thank you.
Senator Dorgan. Thank you very much. Let me thank all five
of you. It is not easy to come to Washington and appear at a
Senate hearing. You represent, the five of you represent
thousands and thousands and thousands of employees and
investors across this country who could be here telling similar
stories, and you tell your stories on their behalf, and we
appreciate your willingness to do that.
Let me just ask one question, then I will call on my
colleagues. I will show a chart a bit later on that shows the
substantial amount of stock that was sold by the officers of
the company, directors of the company, and other insiders, a
very substantial amount of stock over a period of years,
especially in recent years, totaling nearly $1 billion.
Were any of you aware that there was very vigorous activity
among top officers of the company to sell stock at the time
they were suggesting to you you ought to buy stock? Was anyone
on the panel aware of the amount of selling that was going on
by those who were running the company, the board of directors,
officers, and others?
Mr. Vigil. We were aware that there was some activity going
on. As far as those individuals that are 50 years and less of
age, it did not make any difference. We could not do anything,
so we did watch, and we did see the executives dumping a lot of
stock, but we were bound by the plan. We could not do anything.
Senator Dorgan. Let me just ask one additional point on
that matter. I believe it was Ms. Farmer who talked about the
question of being locked out. Someone said--Mr. Vigil, you said
that the company is responding by saying that lock-out, with
respect to the change in plan, administrators really
effectively only caused about a 10-day problem, and you are
saying that employees did not have that experience at all. That
lockout was more prohibitive than that and much more costly
than that. Can anyone respond to that? The company is saying
there was just this narrow and short period, because of the
change in plan administrators, during which the employees were
not able to sell their stock.
Mr. Prestwood. Well, Mr. Chairman, I would like to respond
on that, because down in the Houston Chronicle we got a
statement last weekend where management was trying to confuse
some dates or something, but I know exactly the date that I got
my letter. The letter was written on October 8. The letter was
mailed on October 10, and from Conroe to Houston it normally
takes about 2 to 3 days for me to get my mail, and then I would
have then until October 19, from October 19 through November 19
it was locked down, so that is the dates that I have.
Senator Dorgan. So your notification was 30 days during
which you were locked out of transactions?
Mr. Prestwood. Yes, it was.
Senator Dorgan. Senator McCain.
Senator McCain. Mr. Prestwood, how much money did you lose?
Mr. Prestwood. Sir, I lost $1,310,000. That--sometimes
people might think that is not very much money, but to me it
was my life savings.
Senator McCain. It depends on what committee you serve.
[Laughter.]
Senator McCain. Mr. Prestwood, at any time, did you hear of
Enron executives selling off blocks of stock.
Mr. Prestwood. Yes, sir. Yes, sir. I saw it on the
computer, but they hold us normally a month behind times on the
channel. In other words, the page that I was pulling mine off
of, I never thought anything about it, because I had great
trust in our executives. In other words, I did not think
anything about it. If I had, that should have been the first
red flag that went up right there to me, but apparently it
never dawned on me that it was bail-out time, because who would
think there is anything wrong with Enron Corporation, the
largest energy company in the world.
Senator McCain. Ms. Pearson, you are familiar with Texas
politics?
Ms. Pearson. Just a little bit, by marriage.
Senator McCain. Do you think that the Texas regulators
should have had something to do with this, or do you think it
is a federal responsibility?
Ms. Pearson. Since so many shareholders are from all over
the country, I would think it would be Federal.
Senator McCain. Did you have any idea that Enron was in any
kind of difficulty?
Ms. Pearson. Why, no, of course not. The prediction was,
like he said, $100 now and $125 in the next 6 months, so you do
not think about selling the stock that has that bright outlook.
No, I had no idea. I am on the perimeter. I am not a member of
their employees. I am a stockholder, not an employee.
Senator McCain. But, as you said, you got to know some of
the board members.
Ms. Pearson. I did know some of them, yes, I did, but I
certainly thought if they were in there it was a good company,
and they were smart enough to run it well, but I was wrong.
Senator McCain. Mr. Vigil, do you think that the
stockholders should be reimbursed?
Mr. Vigil. I believe the employees that counted on the
Enron executives to maintain and protect something that we
considered a part of our wage package, there should be some way
to recoup some of that, yes. I do not know how the entirety of
all the stockholders can ever be repaid, but I think for the
employees there should be something done, and I think
legislation should be enacted to help that.
Senator McCain. I thank you.
Yes, Ms. Farmer.
Ms. Farmer. May I respond to the first question that was
asked? As far as the lockdown goes, I did not get the
notification from Enron that they were changing administrators
and that there would be a lockdown, and so I was totally
unaware of that. When I called the new administrator I was
transferred to their phone number in order to sell my stock on
October 22. That is when I found out that there was a lockout
of the employee's stock plan, savings plan, and when I pled
with the person I was speaking to, the main response that I got
was, yes, the timing is very unfortunate, and that was
basically the main response, and I cannot even begin to
describe to you how devastating that was to find out on that
telephone call that I could not do anything with my stock.
Enron had made all employees responsible for their own
retirement in mid-1990. They no longer wanted to be responsible
for paying a monthly pension check after their employees
retired. Therefore, when they made us responsible for our own
retirement, at the most crucial time they denied access to our
own money, and that is so wrong.
Senator McCain. Mr. Prestwood, let me get this straight.
You worked for 33\1/2\ years?
Mr. Prestwood. Yes, sir.
Senator McCain. And in those 33\1/2\ years you accumulated
stock worth $1.3 million?
Mr. Prestwood. Yes, sir.
Senator McCain. And how much do you have left now?
Mr. Prestwood. Well, for whatever it is per share. I
started out, I had about 16,500 shares. I have not figured it
up. Whatever the market closed yesterday. It would be roughly
$20,000 or less, zero you might say.
Senator McCain. I Thank you. Thank you, Mr. Chairman.
Senator Dorgan. Senator McCain, thank you.
I would like to just show a chart that describes part of
what you were asking about, if I might.
This chart, if I could just hold it up, shows--and this is
from November of last year to November of this year. This bar
shows insider and restricted shareholder transactions, and it
is very interesting that based on your testimony, management
was counseling you all that the future was going to be quite
wonderful and you need to hold onto your Enron stock, but at
the same time, it is interesting that those who really knew
from the inside moved their stock right at the top of the price
range. It looks like there was an interesting paradox here
about what they were doing with what they knew and what they
were telling you.
This somehow cannot be an accident, that the officers and
directors found the exact top of the price range to sell stock,
while at the same time as you say in your testimony Mr.
Prestwood, that assurances to employees are describing a simply
stunning future and financial performance and that you ought to
hang onto the Enron stock. I think it relates to the questions
you asked, Senator McCain, and I think that is a fascinating
chart.
Senator Hollings.
The Chairman. Thank you, Mr. Chairman, and I certainly
thank this panel, because it has been the most important
appearance we have had before this Committee this year. I say
that not just casually.
Mr. Prestwood, you have really emphasized the need for
Federal Government oversight. I have to listen to this nonsense
of deregulation as proposed by people like Enron's leadership
team who ran the company into the ground. You have got a whole
coterie of people that comes up here to the Congress wanting to
get rid of the Federal Government, as if the Government is the
enemy. They claim the Government is not the solution, the
Government is the problem. They succeeded in deregulating the
oversight of energy derivatives, and we can all see where that
has led.
You get the best of the best, Arthur Andersen, Salomon
Brothers and all of these highly credentialed financial
entities working with special purpose entities that you and I
do not know anything about, but we put all of those things in
the law because some people in government are persuaded to
deregulate and remove protections that are there for a reason.
They are there to protect loyal employees like you all. I have
been here for 50 years, since the late forties, working on
economically and industrially developing my little State, and I
know all about the balanced budget, transportation and the
market and tax system and everything else of that kind, but the
one thing that businesses come to South Carolina for is that
loyalty that you mentioned, loyalty to the employer.
We have a BMW plant in South Carolina with about 4,000
employees. They come from within 50 miles, a majority of them,
of that particular plant. They produce a quality car better
than what they produce in Munich, Germany, where they have been
making cars for years on end, but that employee loyalty, that
is the thing. We need Government up here to protect the loyalty
of you folks, because you all cannot tell what is going on. You
all are working hard, a day's work for a day's dollar, as we
say, and Enron's losses just emphasize that some businesses use
all these little gimmicks and you have just got to watch how
these things put everyday folks in peril. They say deregulate,
deregulate, deregulate, and here we are, the finest working
group in the world gone in a year's time from $90 billion to $1
billion and everybody is broke.
So your testimony here has been the best. We do not need
any more hearings, but we are going to have some more hearings.
We are going to find out from Lay and Skilling and all these
other fellows exactly what went on, and follow it right down to
affix individual responsibility as best we can, but overall,
you have emphasized our particular need, which I have to
constantly emphasize at every one of these endeavors up here,
the necessity for regulation.
There is no question that we have the Federal
Communications Commission to regulate, not to give away, or the
Federal Trade Commission to protect consumers, or the
Securities and Exchange Commission to protect the employees and
these 401(k) plans and everything else of that kind, and I hope
they will transmit your particular testimony time and again on
C-SPAN so the public will understand the necessity of all these
regulations.
They say get rid of the Government. They say the Government
is not the solution, that the Government is the problem. Well,
we have found what happens when Government does not deal with a
problem, because we are not following through with regulations
on the books. Thank you very much.
Senator Dorgan. Senator Hollings, thank you very much.
Senator Wyden.
Senator Wyden. Thank you, Mr. Chairman. First, I so
appreciate your coming. There is additional evidence that the
lockdown period where you all could not sell your shares and
your 401(k)s worked exactly how you all described it, and Mr.
Chairman, I will just ask unanimous consent to put into the
record an article from the newspaper, the Oregonian, that
indicates that the plan was frozen, as the workers suggested,
from October 17 until November 14, and that the stock price
dropped almost $24 per share during that period.
Senator Dorgan. Without objection.
[The information referred to follows:]
Enron's Rise and Fall July 1985:
Houston Natural Gas Merges With InterNorth
The Oregonian, November 29, 2001
(Copyright 2001)
July 1985: Houston Natural Gas merges with InterNorth, a
natural gas company based in Omaha, Neb., to form Enron, a
natural gas pipeline company.
1989: Enron begins trading natural gas commodities, later
becoming North America's largest natural gas merchant.
June 1994: Enron North America begins to trade electricity.
Enron goes on to become the largest U.S. electricity marketer.
July 1996: Enron announces a deal to buy Portland General
Electric for $3.23 billion in stock and assumed debt.
March 1998: FirstPoint Communications, a division of Portland
General Electric, becomes Enron Communications.
April 1999: Enron agrees to pay $100 million over 30 years to
name new Houston ballpark.
November 1999: Enron launches EnronOnline, the first global
commodity trading site.
January 2000: Enron Communications becomes Enron Broadband
Services, a bandwidth-trading subsidiary.
December 2000: Enron announces that President and Chief
Operating Officer Jeffrey Skilling will take over as chief
executive in February. Kenneth Lay will remain as chairman.
Shares hit 52-week high of $84.87 on Dec. 28.
July 13: Enron announces it will close its 100-employee Enron
Broadband office in Portland, then plans subsidiary's shutdown
by Oct. 1.
August: Skilling resigns; Lay becomes CEO again.
Oct. 16: Enron reports a $638 million third-quarter loss and
discloses a $1.2 billion decline in shareholder equity, partly
related to partnerships run by Chief Financial Officer Andrew
Fastow, who is later ousted.
Oct. 17: Enron's 401(k) plan is frozen so that the company can
change plan administrators. Employees can't sell their
holdings, including Enron stock.
Oct. 22: Enron acknowledges Securities and Exchange Commission
inquiry into a possible conflict of interest related to Enron's
partnership dealings.
Nov. 6: Enron's stock price drops below $10 a share after
reports that the company was seeking additional financing.
Nov. 8: Enron files documents revising financial statements for
past five years to account for $586 million in losses.
Nov. 9: Dynegy announces an agreement to buy its much larger
rival Enron for more than $8 billion in stock.
Nov. 14: Enron announces it is trying to raise an additional
$500 million to $1 billion. Enron 401(k) also reopens to
transactions; Enron stock is $23.86 a share lower than on Oct.
17.
Nov. 21: Enron reaches critical agreement to extend $690
million debt payment.
Nov. 28: Dynegy drops deal. Enron shares end at 61 cents.
Senator Wyden. You all have made the point. The fact of the
matter is that Enron was just sinking like the TITANIC, and you
have got the top officers up on the deck selling shares and all
of you are locked in the boiler room not able to get rid of the
stock. I really appreciate Mr. Vigil making the point as well
about the company barring the employees from selling in a
number of instances where they could have provided for their
future.
A question I wanted to ask all of you is that with respect
to 401(k)s, it is sort of Investing 101 that you diversify,
that you have a variety of stocks in your portfolio. In fact,
there are fiduciary standards that you have a diversified
portfolio. Did Enron ever, at any point, take the workers aside
and say, you know, you have really got to look at your 401(k)
in terms of putting your eggs in a lot of different places,
rather than just all going through Enron.
Mr. Vigil, I see you nodding your head.
Mr. Vigil. To the best of my knowledge, nobody from Enron
ever suggested that we diversify. In terms of the Enron stock,
that was being awarded to us on the matching contribution.
There is one little comment I would like to make here.
Those of us who were participating in the 401(k), we were
putting as much as 10 to 15 percent of our own money into that
401(k), and it was diversified in another separate portfolio,
or various portfolios, but what has been lost in this whole
discussion is that those portfolios lost money also, because
the people in Vanguard, Windsor II, and other places, they were
also buying Enron stock, and so there is more to the losses
here than just the 401(k) plan in terms of the company
contributions.
Senator Wyden. Ms. Farmer, did you ever get the word that
you ought to have a diversified portfolio?
Ms. Farmer. No, sir, never.
Senator Wyden. Well, we are going to look into that some
more, because as I say there is supposed to be a spread in
terms of investments in a 401(k), and that is just Investing
101. There are fiduciary standards with respect to these plans,
and I have real questions about whether they were complied
with.
A question for the PGE folks, and as you all know, this is
a bittersweet holiday for a lot of Oregonians. When PGE was
taken over by Enron your stock was automatically converted to
Enron stock, but obviously this is going to be a very different
company. Certainly Enron is much more aggressive, experimenting
with all of these financial derivatives. You do not just have a
basic utility stock any longer. Were all of you at PGE given
any warning or notification that when that change was made it
would change the nature of your 401(k) holdings, and in
particular that they would become more risky?
Mr. Eri. Not to my knowledge. The first that I realized
that my 401(k) needed to be adjusted was when I got ready to
retire in April, prior to April, when I went out and summoned
some financial advisors to look at my portfolio, and at that
time that is when they told me that I had way too much Enron
stock in my portfolio, and I needed to have that diversified
more than what it was.
Senator Wyden. One last question for you, Mr. Vigil. Did
the company provide any justification for forcing employees to
hold onto company-contributed Enron stock until age 50?
Mr. Vigil. None. Nobody under age 50 understood why we
could not roll that stock over. There was no justification ever
given.
Senator Wyden. Well, I want you to know I am also going to
look into whether this is another example of the double
standard at Enron, because its senior management did not have
that rule applied to it and the workers did. That would be more
evidence that there was one set of rules for folks like
yourselves, who did a lot of the heavy lifting, and another set
of rules for folks at the top. I appreciate your coming before
the Committee today.
I have real questions about whether the laws on the books
like the one I wrote on financial fraud are being complied
with, so we are going to stay at this, and stay at it until we
get to the bottom of it.
Thank you, Mr. Chairman.
Senator Dorgan. Senator Wyden, thank you.
Senator Burns.
Senator Burns. I have no questions for this panel. I think
what we have to do now is to find out the roots of the problem,
and it sounds like to me, with the work that Senator Wyden has
done, and a lot of other work that has been done, but it is
hard to legislate or pass laws that deal with conscience, and
responsibility. Just like, Mr. Prestwood, your loyalty to the
company should have been matched by the loyalty of the
management of the employees, and that is a hard thing to
legislate, as you well know, but it points out, I think, we
have to find out what went wrong and when it went wrong, to
prevent it from here on.
The recovery, of course, may be a more difficult thing, and
we are certainly aware of your circumstances, and so I think
what we have to do in the Senate is to find out what happened,
and when did they know it, and if their loyalty to the
employees was matched by the loyalty of the employees to the
company. That is what we have to find out.
So I am looking forward to the next panel, and to those
people who were a little bit closer to the fire, so to speak,
and find out what really happened, because it is a devastating
thing, and I thank the Chairman.
Senator Dorgan. Senator Burns, thank you.
Senator Fitzgerald.
STATEMENT OF HON. PETER G. FITZGERALD,
U.S. SENATOR FROM ILLINOIS
Senator Fitzgerald. Thank you, Mr. Chairman, and I
appreciate your convening this hearing. I think it is a very
important hearing. I have a question for all of you, both as
employees who held shares in Enron, and also Ms. Pearson, as an
outside shareholder.
To what extent were you relying on what financial analysts
were saying about Enron stock? I ask you that because my
understanding is that in the case of Enron, in September of
this year, when things were going south, you had 17 analysts
covering Enron, and of them, 16 had a ``buy'' or ``strong buy''
rating on the stock, one had a ``hold'', and none had a
``sell'' or a ``strong sell.''
In April 1999 the head of the Securities and Exchange
Commission, Arthur Levitt, gave a speech that cited a study
that found sell recommendations account for just 1.4 percent of
all analyst recommendations, compared to 68 percent of all
recommendations being buys, and I have to tell the panelist
from The Motley Fool who is up next that I am borrowing this
from some of his testimony, reading ahead, but I think it is
very good testimony.
Clearly, you have analysts out there hyping stocks. The
analysts work for some investment bank that meanwhile is
providing investment banking services to the corporation--in
this case, Enron. Does that, or did this play a role in your
decisions to hold the stock until you could not sell it and it
was locked down?
Ms. Farmer. Absolutely.
Senator Fitzgerald. Were you all following those ``buy''
recommendations and so forth?
Ms. Farmer. Yes.
Senator Fitzgerald. Did any of you think that you needed to
take those ``buy'' recommendations with a grain of salt, or did
you think of those recommendations as objective, nonbiased
opinions?
Ms. Farmer. Objective, nonbiased opinions, and I relied
upon them as a guidance.
Senator Fitzgerald. Does anybody say they did not rely on
them?
[No response.]
Senator Fitzgerald. Well, it seems to me those analysts'
recommendations are an issue that we want to get into.
Ms. Pearson. If you cannot rely on them, who can you rely
on? They are supposed to be smarter than we are.
Senator Fitzgerald. That is a good point. They are supposed
to know more than all the rest of us on this, and they were all
recommending ``buy'' or ``strong buy'', only one ``hold'', even
after Jeff Skilling, the Enron CEO, suddenly resigned and the
company stock had already lost 60 percent of its value from the
high of the year, and we, of course, saw the same thing with
the Internet stocks in some cases, too.
Well, thank you all very much. I appreciate your being
here, and let us hope that out of your misfortune, we can
create better controls and better laws to protect others from
having to experience the same financial fate. I know that is
not much of a consolation here, but that may be the most we can
do, and so we thank you for your contribution.
Ms. Pearson. Can I say one thing? As a sort of a funny side
point, one of the directors under question was building a new
house on a very valuable piece of property in a very valuable
part of Houston, and he built it about halfway, and I am
talking about a $4 million house, and it has stopped work.
There is no more being done on that house, and that gives me
great satisfaction.
[Laughter.]
Senator Burns. What about the carpenters that were working
on that house?
Ms. Pearson. I just hope they did not own any Enron stock.
[Laughter.]
Senator Dorgan. Ms. Pearson, one has to take satisfaction
where one finds it. We appreciate your answer.
Senator Nelson.
Senator Nelson. Thank you, Mr. Chairman. All of you have
been absolutely riveting in your testimony. Ms. Farmer, it
hurts when it comes close to home; that you would lose nearly
all of your nest egg of over $700,000 in your 401(k).
Unfortunately, we have got a lot of folks like you in our State
that are retirees that were relying on the same thing. I am
curious, tell us a little bit more about when you got wind that
the management had changed, and then you called the pension
plan because you had received no written communication.
Ms. Farmer. They had made a statement there that they were
going to, I believe on October 16 that they were going to have
to restate their earnings for the last several years, and at
that time the stock had dropped to a point to where I no longer
felt like I could maintain, and I was going to sell and keep
what I had, even though I had already lost about 50 percent of
my retirement fund, and that is when I called. On October 22
was the first point in time I could get through, and that is
when I learned that there was a lockdown.
Senator Nelson. Did they say how long the lockdown had been
in place?
Ms. Farmer. They said it had started on October 17 and
would go through November 20, and if I may, at this point I
would like to mention that on November 20, with the
Thanksgiving holidays, the phones at the Plan Administrator
were very busy, because I am sure there were a lot of other
people trying to get through. I could not sell my stock until
Monday, November 26, and therefore lost even more money,
because the stock had dropped even lower.
Senator Nelson. When you had called on October 22, it looks
like the stock was somewhere about the mid-twenties, and it was
precipitously dropping every day.
Ms. Farmer. Yes, sir.
Senator Nelson. You said that they told you October 17 that
the lockdown occurred, and Mr. Prestwood had testified that he
knew that the letter was written October 8 but not mailed until
October 10, and therefore if you figure 3 or 4 days for mail to
be delivered, that is bumping right up against October 17, the
very day that you said that they said the lockdown is in
effect. That does not give a participant in a 401(k) retirement
plan much time.
Ms. Farmer. Personally, in my opinion, I do not think that
is coincidence.
Senator Nelson. That is interesting. Well, we are going to
investigate that.
Ms. Farmer. Thank you very much.
Senator Nelson. What did any of the managers tell you
concerning the reason for not allowing you to sell? In other
words, the reasons for the lockdown? What did they say to you?
Ms. Farmer. I did not hear from the managers. As I said, I
did not get the notification that there was going to be a
lockdown, but when I spoke to the new administrators of the 401
savings plan they were told that it was strictly for a change
in plan administrators, that it was going to take approximately
30 days in order to complete that change, and that I would have
to wait till the end of that period before I could transfer or
sell any of my stock.
Senator Nelson. Did you have any knowledge as to who had
made that decision there was going to be a 30-day lockdown?
Ms. Farmer. No, sir.
Senator Nelson. Were there any kind of internal company
newsletters to retirees like yourself that would give any
indication as to the financial condition of the company and of
the retirement savings plan?
Ms. Farmer. No, sir.
Senator Nelson. Well, Mr. Chairman, it is just very clear
we have got a lot to investigate here. Mrs. Farmer started with
the Florida Gas Corporation. It is headquartered in my old
congressional district of Winterpark, Florida when I went to
Congress in 1978. It was a good company. It had a gas pipeline
that came all the way from Texas right down the spine of
Florida to supply all the natural gas, and she started to work
for that--what year did you start?
Ms. Farmer. In 1981. I began with Florida Gas Transmission
Company.
Senator Nelson. Was Mr. Lay at Florida Gas when you
started?
Ms. Farmer. I do not believe he was. I believe Mr. Lay came
with Florida Gas in the mid-eighties, maybe 1983, some thing of
that nature, and then beginning in 1985 was when several
pipeline companies merged throughout the United States and
Enron was formed, and the home office was moved for Florida Gas
Transmission from the Winterpark, Florida location to Houston.
Senator Nelson. Well, in my opinion, each one of these
participants at our witness table today is very heroic. Here is
a lady from my home area, she worked hard, she played by the
rules, she saved, she believed in the company, and now she has
lost everything for her retirement years. I am looking forward
to finding out what this investigation is going to reveal, Mr.
Chairman.
Thank you.
Senator Dorgan. Senator Nelson, thank you.
Senator Boxer.
STATEMENT OF HON. BARBARA BOXER
U.S. SENATOR FROM CALIFORNIA
Senator Boxer. Thank you very much, Mr. Chairman. I want to
thank you and Senator McCain for having this hearing. I think
it is important that we listen and we learn, and we come out
with a plan that is well-thought-out. Let me say this is an
incredible panel. I would like to take Ms. Pearson home with
me.
Ms. Pearson. That could be arranged.
[Laughter.]
Ms. Pearson. Do you have any Enron stock?
Senator Boxer. That is another story for another day. We
will talk, but here is the point. These people have been
deeply, deeply, deeply hurt, their dreams shattered, and they
are here helping us, and I want to thank you so much.
In my former life, way back many years ago, I was a
stockbroker, and I saw many smiles and many tears and went
through a lot of ups and downs. The stock market in those days
was a little easier. There were only 12 million shares traded
per day back then, and I never saw anything like this. I never
saw anything with the depth of this.
Unfortunately, in my State, we had a couple of things that
were really the precursor to this. I want to see if my
colleagues remember the Color Tile failure where a company went
broke--some of you are nodding in the audience--and they forced
their employees to buy the company through their 401(k) plan,
so when the company went broke they had nothing. They had real
estate in the company which was gone, so they had nothing.
And then we had Carter Hawley Hale, which was a giant
retailer that had emporium stores. The same thing happened. No
one could believe this happened, the same thing, so as Senator
Wyden alluded, my other colleagues and I who worked in this
area, wrote a law that I think could come into play here, and I
want to tell you about it and tell you what I have done.
Sad to say, and I apologize, it was watered down. I could
not fight. I mean, I had to fight so hard to get what little I
got, but the law that passed in 1997 says that an employer--and
I want you to follow this--cannot force an employee to buy
company stock with the employee's contribution. Now, I know you
were not forced. They did not force you that I know, because I
have checked it. You did it of your own free will. However, I
believe that when the plan was locked down, in essence you were
forced to keep that company stock. Is there anyone on the panel
that would disagree with that? In other words, you wanted out,
some of you called, so my view is that they violated that law.
Now what is the punishment for that in the law? The
punishment for that is that the tax advantages that Enron got
could well be taken away from them in retrospect, putting the
IRS at the front of the line to collect some of this money and
hopefully, if we work together, maybe we can direct some of
that money back to the employees.
Now, we are looking at how much that would be, but I want
to tell you something. As I checked into this, when an employer
makes a contribution in stock to a plan they get a 100-percent
tax deduction, based on the value of the stock at the time, so
they took big, big write-offs, and they said that they were a
good actor, they were in good faith. Well, they were in good
faith until the lockdown, so we have written to the IRS, and I
am hoping to get some of my colleagues to work with me to see
if there is some hook here where we can get the employees more
to the front of the line to get some of this back.
Whether we have a shot, I am not sure. I feel that it is
true what Senator Burns said, you cannot legislate a conscience
or good character, or fairness in people. I mean, let us take a
look at this insider stuff. Kenneth Lay, Enron's Chairman, sold
1.8 million shares for $101 million. All this happened in a
period of a couple of years. Jeffrey Skilling--this is all
public information--former chief executive, sold 1 million
shares for $66 million, so when you asked, Mr. Prestwood, $1
million, I think $1 million is a lot of money, but it pales
compared to these people. $268 million for Lou Pai, and this
goes on, and you probably know these names. I do not. I am not
familiar with them.
Here is the thing. I think we need to do more. First, we
have to make sure that laws such as Senator Wyden's law and my
law and other pension laws are definitely followed here, and if
not, we have to come down hard and see what we can do to
recover some of these loss streams.
But Senator Corzine and I are introducing legislation which
I am very excited about, and in my remaining time I will tell
you the principles. It would limit to 20 percent the investment
an employee can have in an individual account, or individual
retirement plan. I mean, it is all the eggs in one basket. We
always know it is not right, but when we are sort of tempted
into it, and I think this would be a good thing.
Second, and this speaks to something that Mr. Vigil pointed
out, it would limit to only 90 days the time an employer could
force an employee to hold a matching employer stock
contribution. In other words, why should you have to wait till
you are 50? You are a grown person. If this is the way they are
helping you, and they are making stock contributions, that is
great, but why should you have to sit tight when the market
starts to change?
Third, we would change the tax deduction to 50 percent if
they made the contribution in stock. If they made the
contribution in cash, they could get 100 percent. Those are the
main points I want to make, and they are as a result of what
you have been telling us about your experience.
So Mr. Chairman, again my deepest thanks for your
leadership, and I thank the panel.
Senator Dorgan. Senator Boxer, thanks very much. This panel
has been extraordinary. As all of us know, public companies'
financial statements are supposed to be transparent and public.
We now know that in the case of Enron's secret off-the-books
partnerships they were neither transparent nor public. As a
result of that, as I indicated in my opening statement, it
appears to me that we have what some in my home town they would
say, ``cooked books'' here, and those that cooked the books
made off with a fair amount of money. I wanted to, in respect
to Senator Boxer's comments, display a chart that shows the
sale of stock by some of the key people at Enron from 1998 to
the present. I have, I think, 25 pages of this information.
But one individual, Kenneth Lay, sold $101 million; Mr.
Rice, $72 million; Mr. Skilling, $66 million; Mr. Horton, $45
million; and Mr. Fastow, $30 million. I might just again show
this chart, because I think it is important. This shows the
value of the stock, and the green line is when the insiders
were selling the stock, and so those folks that I just
described making money off the sale of stock actually managed
to find the top stock price for the largest block of sales.
They knew something, but they were telling the employees:
hang onto your stock, this company is going to get bigger and
better and stronger, and tomorrow is going to be better for
you. At the same time, they were selling their own stock. I
think that raises all of the questions that have been described
by my colleagues.
Senator Boxer. Would you yield for just a very quick point?
This is so discouraging and depressing, and what adds to it is,
you had these big companies which have been mentioned before,
and the auditors. It is one thing for a stock analyst to be fed
a bunch of baloney. We have seen that happen. It is another
thing for people who are paid to tell the truth and to be
honest, these big accounting firms that we rely on, that in my
day the first thing you look at when you make a recommendation
for a stock, what do these people say, they are the honest
ones, but their eyes were glazed over from these big contracts
they were getting from Enron. It is a whole other area.
Senator Dorgan. Senator Boxer, we will have the auditors
next.
Mr. Prestwood from Texas, you are familiar with Bob Wills
and his Texas Playboys and their rather famous refrain,
``Little bee sucks the blossom, but the big bee gets the honey.
Little guy picks the cotton, but the big guy gets the money.''
We understand those things happen in life all too often, but
there is much more at work with respect to this, so we intend
to pursue this as long as it takes to get to the bottom of it.
Again, thank you for spending the time to be with us.
Ms. Farmer, one final comment?
Ms. Farmer. Yes, I would like to have one final comment,
please. I was fortunate enough to have my daughter accompany me
here to Washington, D.C. to appear before this Committee. My
family, my son Jeffrey Farmer, he serves with the U.S. Marine
Corps, and he sends his thanks to you also for any help that
you can give us in this concern, and we do appreciate and I am
honored to have had the opportunity to appear here, and I thank
you from the bottom of my heart.
Senator Dorgan. Well, Ms. Farmer, you thank your son for
his service to our nation in this important time, and thanks to
all of you for being at the table today. You are welcome to
stay for the rest of the hearing.
We would now like to call the next panel, and I indicated
that Mr. Kenneth Lay was invited. He will not appear today, but
his representatives told me this morning that Mr. Lay will be
available for a second hearing scheduled for February 4. We
will also ask Mr. Skilling and Mr. Fastow to be present, along
with others.
The global head of auditing for Arthur Andersen, Mr. C. E.
Andrews is with us, and I am going to ask, because of the time
problem, Mr. Scott Cleland, Chief Executive Officer, Precursor
Group,' to join the second panel.
Following the second panel, we will have three individuals
on the third panel testify as well, but if we could ask Mr.
Andrews to please come forward, and Mr. Scott Cleland, if you
are here, would you please come forward and take a seat at the
table. My understanding is Mr. Cleland has a travel issue, and
so we want to move him up to the second panel.
Mr. Andrews, thank you very much for joining us today. You
have heard a generous amount of discussion today about a range
of questions that are asked about auditors, analysts' records,
secret partnerships, et cetera. We appreciate the fact that
your company went to a hearing in the U.S. House upon request
and have now appeared at a hearing in the U.S. Senate.
I understand that, given what has happened, it is not
pleasant to respond to these requests, but this Committee very
much appreciates your company's willingness to come when asked
and provide testimony. Why don't you proceed. Your entire
statement will be made a part of the permanent record, and you
may summarize.
STATEMENT OF C. E. ANDREWS, GLOBAL HEAD OF AUDITING AND
BUSINESS ADVISORY, ANDERSEN
Mr. Andrews. Chairman Dorgan, Chairman Hollings, Senator
Fitzgerald, Senator McCain, and members of the Committee, good
morning. Thank you for inviting me to appear before you. I am
the Managing Partner of Anderson's global audit practice. I am
here because faith in our firm and in the integrity of the
capital market system has been shaken. What happened at Enron
is a tragedy on many levels. We are very aware of the impact
this has had on investors and the pain that this business
failure has caused for employees and others, as you have heard
very poignantly this morning.
Many questions need to be answered. Some involve accounting
and auditing. I will do my best to address these. I ask you
keep in mind the auditing and accounting issues are very
complex and part of a bigger picture. None of us yet know all
the facts. Today's hearing is an important step in enlightening
all of us. If there is one thing you take away from my
testimony, I hope it is this. The public's confidence is of
paramount importance. Andersen will not shrink from its
responsibilities. If our firm has made errors in judgment, we
will acknowledge them. We will take the actions needed to
restore confidence.
In my written testimony, I have addressed two issues that
go to the heart of concerns about our role as Enron's auditor.
Did we do our job? Did we act with integrity?
To aid the Committee in its inquiry I have provided
detailed answers to these questions in my written statement,
but let me touch on some key points. On the accounting issues,
Enron has said it will restate its financial statements back to
1997 as a result of issues with two special purpose entities or
SPE's. These are sophisticated financing vehicles used by many
companies. They are well-known to the investment community. On
the larger of these, which was responsible for 80 percent of
the SPE-related restatement, it appears that important
information was not revealed to our team. We and the board's
special committee are looking into why.
As required by section 10A we have notified the audit
committee of possible illegal acts within the company. We have
not concluded that any illegal acts occurred. On the smaller of
the SPE's, which were responsible for 20 percent of the SPE
restatement, we now believe, based upon a second look, that our
team made an error in judgment, an honest error, but an error
nonetheless, but I do believe that we did a professional job
overall and that this error did not cause Enron's collapse.
There have also been questions about the sufficiency of
Enron's disclosures. It is true that Enron did not disclose
every transaction or contingency. It was not required to.
Accounting rules also do not require a company to disclose
remote contingencies such as the sudden rapid decline we
witnessed in Enron's stock price and credit ratings.
Finally, let me spend a minute on fees. We were paid $52
million by Enron last year, including $25 million for our
audit. There is the perception that the remaining $27 million
was for traditional management consulting work such as
installation of computer systems. In fact, the bulk of that $27
million was for audit-related work, tax work, and work that can
only be done by auditors. $13.3 million was for consulting work
done by Arthur Andersen.
Some may assert that even $13 million of consulting work is
too much, that it weakens the backbone of the auditor. There is
a fundamental issue here. Whether it is consulting work or
audit work, the reality is that auditors are paid by their
clients. For our system to work, you and the investing public
must have confidence that the fees we are paid, regardless of
the nature of that work, will not weaken our resolve to do what
is right and in the best interests of investors.
I do not believe the fees we received compromised our
independence. Some will disagree, and we have to deal with the
reality of that perception. I am very aware that our firm must
restore the public's trust. I do not have all the answers
today, but I can assure you that we are carefully assessing
this issue and will take the steps necessary to reassure you
and the public that our backbone is firm and our judgment is
clear.
Andersen will have to change to restore the public's
confidence, and we are working hard to identify the changes we
need to make. The accounting profession will also have to
reform itself. Our system of regulation and discipline will
have to improve, and others will have to do things differently
as well, companies, boards, audit committees, analysts,
investment bankers, credit analysts and others.
I believe we can work together to give investors more
meaningful, relevant, and timely information. Our firm will do
its part. Thank you.
[The prepared statement of Mr. Andrews follows:]
Prepared Statement of C. E. Andrews, Global Head of Auditing and
Business Advisory, Andersen
Chairman Dorgan, Senator Fitzgerald, Chairman Hollings, Senator
McCain, Members of the Committee.
I am the managing partner for Andersen's global audit practice. I
am here today because faith in our firm and in the integrity of the
capital market system has been shaken. There is some explaining to do.
What happened at Enron is a tragedy on many levels. We are acutely
aware of the impact this has had on investors. We also recognize the
pain this business failure has caused for Enron's employees and others.
Many questions about Enron's failure need to be answered, and some
involve accounting and auditing matters. I will do my best today to
address those.
I ask that you keep in mind that the relevant auditing and
accounting issues are extraordinarily complex and part of a much bigger
picture. None of us here yet knows all the facts. Today's hearing is an
important step in enlightening all of us. I am certain that together we
will get to the facts.
If there is one thing you take away from my testimony, I hope it is
this: The public's confidence is of paramount importance. Andersen will
not shrink from its responsibilities. If our firm has made errors in
judgment, we will acknowledge them. We will take the actions needed to
restore confidence.
Today, I would like to address two issues that go to the heart of
concerns about our role as Enron's auditor.
First, did we do our job? I want to explain what we knew and when
we knew it on several key issues, keeping in mind that our own review--
like yours--is still under way.
Second, did we act with integrity? I want to discuss the $52
million in fees we received and respond to concerns that have been
raised.
I also would like to cover what I believe are some of the lessons
we can already learn from Enron--for our firm, for the accounting
profession, and for all participants in the financial reporting system.
My firm has publicly discussed many of these already.
Let me start by telling you what we know about three particular
accounting and reporting issues:
the restatements caused by the consolidation of two Special
Purpose Entities, known as SPEs, and the recording of
previously ``passed'' adjustments as a required byproduct of
the restatement;
a $1.2 billion reclassification in the presentation of
shareholders' equity during 2001--of which $172 million was
misclassified in the audited 2000 financial statement, and;
the company's disclosures about its off-balance-sheet
transactions and related financial activities.
I want to emphasize that my remarks are based on the information
that is currently available. We have made our best efforts to be
complete and accurate in describing what we know. But our review, like
the work of the SEC, this Committee, Enron's board, and others, is not
yet complete. It is always possible that new information could be
developed that would change current understanding of events or uncover
new events.
Consolidation of Special Purpose Entities
Let me begin with the Special Purpose Entities. SPEs are financing
vehicles that permit companies, like Enron, to, among other things,
access capital or to increase leverage without adding debt to their
balance sheet. Wall Street has helped companies raise billions of
dollars with these structured financings, which are well known to
analysts and sophisticated investors.
Two SPEs were involved in Enron's recent restatement announcement.
On one, the smaller of them, we made a professional judgment about the
appropriate accounting treatment that turned out to be wrong. On the
one with the larger impact, it would appear that our audit team was not
provided critical information. We are trying to determine what happened
and why.
Let's begin with the larger SPE, an entity called Chewco. What
happened with Chewco accounted for about 80 percent of the SPE-related
restatement.
In 1993, Enron and the California Public Employees Retirement
System (Calpers) formed a 50/50 partnership they called Joint Energy
Development Investments Limited, or JEDI for short. Among other
factors, the fact that Enron did not control more than 50 percent of
JEDI meant that that partnership's financial statements could not be
consolidated with Enron's financial statements under the accounting
rules. In 1997, Chewco bought out Calpers' interest in JEDI. Enron
sponsored Chewco's creation as an SPE and had investments in Chewco.
The rules behind what happened are complex, but can be boiled down
to this. The accounting rules dictate, among other things, that
unrelated parties must have residual equity equal to at least 3 percent
of the fair value of an SPE's assets in order for the SPE to qualify
for non-consolidation. However, there is no prohibition against company
employees also being involved as investors, provided that various tests
were met, including the 3 percent test.
In 1997, we performed audit procedures on the Chewco transaction.
The information provided to our auditors showed that approximately
$11.4 million in Chewco had come from a large international financial
institution unrelated to Enron. That equity met the 3 percent residual
equity test. However, we recently learned that Enron had arranged a
separate agreement with that institution under which cash collateral
was provided for half of the residual equity.
What happened?
Very significantly, at the time of our 1997 procedures, the company
did not reveal that it had this agreement with the financial
institution. With this separate agreement, the bank had only one-half
of the necessary equity at risk. As a result, Chewco's financial
statements since 1997 were required to be consolidated with JEDI's
which, in a domino effect, then had to be consolidated in Enron's
financial statements. We identified the impact of this separate
agreement on Enron's financial statements in the course of examining a
number of documents provided to us by Enron management and the Board's
special committee in November 2001. Kenneth Lay and Richard Causey have
told us that they were not aware of this separate agreement until its
discovery in November 2001 and we do not know of any contrary facts.
It is not clear why the relevant information was not provided to us
in 1997. We and the Board's special committee are still looking into
that.
We have notified Enron's audit committee of possible illegal acts
within the company, as required under Section 10A of the Securities and
Exchange Act. Because the special committee is investigating all of
these matters, Section 10A does not require us to take any additional
action until the special committee finishes its work and the Board acts
upon any recommendations. We have not concluded that any illegal acts
occurred.
Now, about the second SPE structure; specifically, a subsidiary of
the entity known as LJM1. This transaction was responsible for about 20
percent--or $100 million--of Enron's recent SPE-related restatement.
In retrospect, we believe LJM1's subsidiary should have been
consolidated. I am here today to tell you candidly that this was the
result of an error in judgment. Essentially, this is what happened:
After our initial review of LJM1 in 1999, Enron decided to create a
subsidiary within LJM1, informally referred to as Swap Sub. As a result
of this change, the 3 percent test for residual equity had to be met
not only by LJM1, but also by LJM1's subsidiary, Swap Sub.
In evaluating the 3 percent residual equity level required to
qualify for non-consolidation, there were some complex issues
concerning the valuation of various assets and liabilities. When we
reviewed this transaction again in October 2001, we determined that our
team's initial judgment that the 3 percent test was met was in error.
We promptly told Enron to correct it.
We are still looking into the facts. But given what we know now,
this appears to have been the result of a reasonable effort, made in
good faith. I do believe that we did a professional job overall and
that this error did not cause Enron's collapse.
Adjustments previously not made to Enron's 1997 financial statement
As a result of the restatement for the SPEs, Enron was required to
address proposed adjustments to its financial statements that were not
made during the periods subject to restatement. Questions have been
raised about certain of these ``passed adjustments.'' Let me address
that issue next.
As part of the audit process, the auditor proposes adjustments to
the company's financial statements based on its interpretation of
Generally Accepted Accounting Principles (GAAP). A company's decision
to decline to make proposed adjustments does not mean that there has
been an intentional effort to misstate. If the auditor believes that
the company's actions result in either an intentional error or a
material misstatement, it may not sign the audit opinion.
Often, there is a timing issue to consider. These adjustments
typically are proposed by the auditor at the conclusion of the audit
work--usually one or two months after the close of the year-end. Some
companies, like Enron, choose to book those adjustments in the year
after the auditor identifies them, when they are immaterial.
Questions have been raised about $51 million in adjustments not
made in 1997 when Enron reported net income totaling $105 million. Some
have asked how adjustments representing almost half of reported net
income could have been deemed to be immaterial.
Auditing standards and SEC guidance say both qualitative and
quantitative factors need to be considered in determining whether
something is material. The Supreme Court has described this approach as
the ``total mix'' of information that auditors must consider.
In 1997, Enron had taken large nonrecurring charges. When the
company decided to pass these proposed adjustments, our audit team had
to determine whether the company's decision had a material impact on
the financial statements. The question was whether the team should only
use reported income of $105 million, or should it also consider
adjusted earnings before items that affect comparability--what
accountants call ``normalized'' income?
We looked at ``the total mix'' and, in our judgment, on a
quantitative basis, the passed adjustments were deemed not to be
material, amounting to less than 8 percent of normalized earnings.
Normalized income was deemed appropriate in light of the fact that the
company had reported net income of $584 million one year earlier, in
1996, $520 million in 1995 and $453 million in 1994.
It is also important to remind you that the restatement analysis
presented in Enron's recent 8-K filing was not audited. When Enron's
audited restatement is issued, the $51 million in adjustments presented
in 1997 will be reduced for the effect of adjustments proposed in 1996,
which were recorded in 1997.
Reclassification of $1.2 billion of shareholders' equity
Now let me turn to the issue of shareholders' equity. Shareholders'
equity was incorrectly presented on Enron's balance sheet last year and
in two unaudited quarters this year.
Auditors do not test every transaction and they are not expected
to. To do so would be impractical and would be prohibitively expensive.
EnronOnline alone handled over 500,000 transactions last year.
Auditing standards require an audit scope sufficient to provide
reasonable--not absolute--assurance that any material errors will be
identified. This testing is based on a cost-effective and proven
technique known as sampling. If appropriate accounting is found in a
properly chosen sample, this generally provides reasonable assurance
that the accounting for the whole population of transactions has been
done in accordance with GAAP and is free of material misstatement.
Shareholders' equity was initially overstated last year for a
transaction with a balance sheet effect of $172 million. This amount
was recorded as an asset, but should have been presented as a reduction
in shareholders' equity. We recognize that this is a large number in
absolute terms, but our work as auditors requires us to put such
numbers into their proper context. That amount, $172 million, was less
than one third of one percent of Enron's total assets and approximately
1.5 percent of shareholders' equity of $11.5 billion. It was a very
small item relative to total assets and equity and had no impact on
earnings or cash flow. Accordingly, the transaction fell below the
scope of our audit.
In the first quarter of this year, Enron accounted for several more
transactions in a similar way, increasing the size of the incorrect
presentation of shareholders' equity by about $828 million.
The quarterly financial statements of public companies are not
subject to an audit, and we did not conduct an audit of Enron's
quarterly reports. Consistent with the applicable standards, our work
primarily was a limited review of the company's unaudited financial
statements.
In the third quarter, Enron closed out the transactions that
included the $172 million and the $828 million equity amounts, and we
and Enron reviewed the associated accounting. This review included
third-quarter impacts on the profit and loss statement and on the
balance sheet. This is when the erroneous presentation of shareholders'
equity came into focus. (The remaining $200 million of this adjustment
in equity was the result of transactions that occurred during the third
quarter of 2001.)
We had discussed the proper accounting treatment for other
transactions affecting equity with Enron's accounting staff, and
therefore, the scope of our work on the year 2000 audit and this year's
quarterly reviews did not anticipate this sort of error. When we
informed the company of the error, the company made the necessary
changes in its financial statements.
Questions about disclosure
Questions have been raised about the sufficiency of Enron's
disclosures, especially about unconsolidated entities. I ask you to
keep in mind that the company disclosed in its financial statements
that it was using a number of unconsolidated structured financing
vehicles. Unconsolidated means, by definition, that the assets and
liabilities of these entities were not recorded in Enron's financial
statements. However, in certain circumstances, footnote disclosures are
required.
With that disclaimer, let me offer one man's view of what investors
were told. Enron had hundreds of structured finance transactions. Some
were simple; others, very complex. The company did not disclose the
details of every transaction, which is acceptable under GAAP, but it
did disclose those involving related parties and unconsolidated equity
affiliates.
JEDI and other entities are listed in footnote nine of
Enron's 2000 annual report.
LJM1 and LJM2, involving the company's former CFO, both were
described in the 1999 and 2000 annual reports and described
more fully in its annual proxy statements.
Enron's unaudited quarterly financial statements also
disclosed transactions with LJM1 and LJM2.
In footnote 11 to the 2000 annual report, Enron also disclosed
under the heading ``Derivative Instruments'' that it had derivative
instruments on 12 million shares of its common stock with JEDI and 22.5
million with related parties.
Some people say we should have required the company to make more
disclosures about contingencies, such as accelerated debt payments,
associated with a possible decline in the value of Enron's stock or
changes in the company's credit rating. The Company did disclose this
possible risk in its Management's Discussion and Analysis, or MD&A,
section of its annual report.
I ask you to keep in mind that the company's shares were coming off
near record levels when we completed our audit for 2000. No one could
have anticipated the sudden, rapid decline we witnessed in this stock
and its credit ratings, and accounting rules don't require a company to
disclose remote contingencies.
That said, we continue to believe investors would be better served
if our accounting rules were changed to reflect the risks and rewards
of transactions such as SPEs, not just who controls them. Putting more
of the assets and liabilities that are at risk on the balance sheet
would do more than additional disclosure ever could. We have advocated
changes in these accounting rules since 1982.
I offer an additional observation about Enron's disclosures. Press
reports indicate that some who analyzed the company's public
disclosures came to the conclusion that perceptions about the company--
and thus the market's valuation of Enron--were not supported by what
was in the company's public filings.
Fees paid to Andersen
Some are questioning whether the size of our fees, $52 million, and
the fact that we were paid $27 million for services other than the
Enron audit, may have compromised our independence. I understand that
the size of fees might raise questions, and I think our profession must
be sensitive to that perception.
With that in mind, it would be helpful for the Committee to have a
deeper understanding of the nature of the work we did for Enron, and
how the fees for that work were reported.
As a starting point, Enron was a big, complex company. Enron had
$100 billion in sales last year. It operated 25,000 miles of interstate
pipeline and an 18,000-mile global fiber optic network. Enron did
business in many countries. Its EnronOnline trading system was the
world's largest web-based eCommerce system and handled more than half a
million transactions last year--for 1,200 products. Enron was the
seventh largest company on the Fortune 500.
This was not a simple company. It was not a simple company to
audit. In addition to its operations and trading, Enron, as we know,
engaged in sophisticated financial transactions--hundreds of them.
Assets worldwide totaled $65 billion, both before and after Enron
adjusted for the restatements
Given this complexity, it should not surprise anyone that the fees
paid to our firm for Enron's audit were substantial. The $25 million
fee for Enron's audit last year is comparable to the amounts that
General Electric and Citigroup, two sophisticated financial services
providers, paid for their audits. It is slightly more than the audit
fees paid by two others--JPMorgan Chase and Merrill Lynch.
Additional questions have recently arisen about whether Andersen
served as Enron's internal auditor.
Enron has engaged Andersen to issue two separate reports: (1) a
report on Enron's financial statements, and (2) a report on
management's assertions about the reliability of Enron's system of
internal control. Andersen is Enron's external auditor in preparing
both types of reports. This second report is not required by federal
law but has long been recognized--by the GAO, among others--as a best
practice for large, complex companies like Enron. The standards for
issuing such reports on internal controls, which are a type of attest
work, are covered in the auditing literature. The fees associated with
our report on Enron's system of internal control were part of our
engagement as Enron's external auditor. These fees were properly
reported as ``audit'' fees in Enron's proxy statement since Andersen
performed the work as part of a single integrated audit.
From 1994-1998, Enron outsourced parts of its internal audit
function to Andersen. That arrangement ended in 1998. Enron then began
to add to its existing internal audit function under the umbrella of
Enron Assurance Services (EAS). Enron's Risk Assessment and Control
group also performs internal audit-type work.
From time to time after 1998, we were asked by Enron to perform
certain consulting projects related to prospective changes to the
control system. The fees for these projects in 2000 were disclosed as
``non-audit'' fees in Enron's proxy statement.
It is important to understand that internal auditing is not the
same as bookkeeping. Internal auditors do not prepare a company's
financial statements; those statements are prepared by the company--at
Enron, by the accounting and financial reporting function led by the
company's Chief Accounting Officer. An internal auditor does some of
the same activities that an external auditor does, such as testing the
company's system of internal control to assess whether it provides
``reasonable assurance'' that the company is accurately recording
transactions on its books. Internal auditors can also perform
additional functions such as operational auditing and reviews of
prospective changes to the control system.
Next, I would like to address questions about our fees for non-
audit services. Because of the way the fee categories for new proxy
statement disclosures on auditor fees were defined, many services
traditionally provided by auditors--and in many cases only provided by
auditors--now are classified as ``Other.'' Regrettably, without
knowledge of the underlying facts, this leads some to believe that such
fees are for ``consulting'' services. That is incorrect.
In fact, $2.4 million of the $27 million in ``other'' fees reported
by Enron last year related to work we did on registration statements
and comfort letters. This is work only a company's audit firm can do.
Another $3.5 million was for tax work, which has never been
mentioned as a conflict with audit work. Audit firms almost always do
tax work for clients.
Another $3.2 million of the ``other'' fees related to a review of
the controls associated with a new accounting system--a service highly
relevant to the auditor's understanding of the company's financial
reporting system. Another Big Five firm installed that financial
accounting system--for about $30 million. The scope and amount of this
work, which is a type of work sometimes performed by a company's
internal auditors, complied with the AICPA professional standards and
the SEC rules governing internal audit outsourcing which take effect
next August.
Finally, $4 million of the fees listed as having been paid to
Andersen were, in fact, paid to Andersen Consulting, now known as
Accenture. As most of you know, our firms formally separated last
August and had been operating as independent businesses for some time.
Nevertheless, the rules said Enron had to report any fees it paid to
Andersen Consulting as having been paid to its audit firm.
If you take all these factors into account, the total fees that our
firm received from Enron last year amounted to $47.5 million. And of
this, about $34.2 million, or 72 percent, was audit-related and tax
work. Total fees for other services paid to our firm amounted to $13.3
million. This was for several projects, none of which was for systems
implementation or for more than $3 million.
Some may still assert that even $13 million of consulting work is
too much--that it weakens the backbone of the auditor. There is a
fundamental issue here. Whether it's consulting work or audit work, the
reality is that auditors are paid by their clients. For our system to
work, you and the investing public must have confidence that the fees
we are paid, regardless of the nature of our work, will not weaken our
willingness to do what is right and in the best interest of the
investors as represented by the audit committee and the board.
I do not believe the fees we received compromised our independence.
Obviously, some will disagree. And I have to deal with the reality of
that perception. I am acutely aware that our firm must restore the
public's trust. I do not have all the answers today. But I can assure
you that we are carefully assessing this issue and will take the steps
necessary to reassure you and the public that our backbone is firm and
our judgment is clear.
Lessons for the Future
When a calamity happens, it is absolutely appropriate to ask what
everyone involved could have done to prevent it. By asking the other
witnesses and me to testify today, the Committee is working hard, in
good faith, to understand the issues involved and to help prevent a
recurrence with another company.
I believe that there is a crisis of confidence in my profession.
This is deeply troubling to me, as I believe it is a concern for all of
the profession's leaders and, indeed, all of our professionals. Real
change will be required to regain the public's trust.
Andersen will have to change, and we are working hard to identify
the changes that we should make.
The accounting profession will have to reform itself. Our system of
regulation and discipline will have to be improved. Our CEO discussed
some of the issues that the profession faces in an op-ed in the Wall
Street Journal, which is attached to my testimony.
Other participants in the financial reporting system will have to
do things differently as well--companies, boards, audit committees,
analysts, investment bankers, credit analysts, and others.
We all must work together to give investors more meaningful,
relevant and timely, information.
But our work starts with our firm. We are committed to making the
changes needed to restore confidence.
A day does not go by without new information being made available,
and I would observe that all of us here today--and many others who are
not here--have a responsibility to seek out and evaluate the facts and
take needed action. My firm will continue to do our part. I hope that
my participation today has been helpful to your efforts.
Thank you.
Attachment
Enron: A Wake-Up Call
By Joe Berardino
The Wall Street Journal, December 4, 2001
(Copyright 2001, Dow Jones & Company, Inc.)
A year ago, Enron was one of the world's most admired companies,
with a market capitalization of $80 billion. Today, it's in bankruptcy.
Sophisticated institutions were the primary buyers of Enron stock.
But the collapse of Enron is not simply a financial story of interest
to major institutions and the news media. Behind every mutual or
pension fund are retirees living on nest eggs, parents putting kids
through college, and others depending on our capital markets and the
system of checks and balances that makes them work.
My firm is Enron's auditor. We take seriously our responsibilities
as participants in this capital-markets system; in particular, our role
as auditors of year-end financial statements presented by management.
We invest hundreds of millions of dollars each year to improve our
audit capabilities, train our people and enhance quality.
When a client fails, we study what happened, from top to bottom, to
learn important lessons and do better. We are doing that with Enron. We
are cooperating fully with investigations into Enron. If we have made
mistakes, we will acknowledge them. If we need to make changes, we
will. We are very clear about our responsibilities. What we do is
important. So is getting it right.
Enron has admitted that it made some bad investments, was over-
leveraged, and authorized dealings that undermined the confidence of
investors, credit-rating agencies, and trading counter-parties. Enron's
trading business and its revenue streams collapsed, leading to
bankruptcy.
If lessons are to be learned from Enron, a range of broader issues
need to be addressed. Among them:
--Rethinking some of our accounting standards. Like the tax code, our
accounting rules and literature have grown in volume and complexity as
we have attempted to turn an art into a science. In the process, we
have fostered a technical, legalistic mindset that is sometimes more
concerned with the form rather than the substance of what is reported.
Enron provides a good example of how such orthodoxy can make it
harder for investors to appreciate what's going on in a business. Like
many companies today, Enron used sophisticated financing vehicles known
as Special Purpose Entities (SPEs) and other off-balance-sheet
structures. Such vehicles permit companies, like Enron, to increase
leverage without having to report debt on their balance sheet. Wall
Street has helped companies raise billions with these structured
financings, which are well known to analysts and investors.
As the rules stand today, sponsoring companies can keep the assets
and liabilities of SPEs off their consolidated financial statements,
even though they retain a majority of the related risks and rewards.
Basing the accounting rules on a risk/reward concept would give
investors more information about the consolidated entity's financial
position by having more of the assets and liabilities that are at risk
on the balance sheet; certainly more information than disclosure alone
could ever provide. The profession has been debating how to account for
SPEs for many years. It's time to rethink the rules.
--Modernizing our broken financial-reporting model. Enron's collapse,
like the dot-com meltdown, is a reminder that our financial-reporting
model--with its emphasis on historical information and a single
earnings-per-share number--is out of date and unresponsive to today's
new business models, complex financial structures, and associated
business risks.
Enron disclosed reams of information, including an eight-page
Management's Discussion & Analysis and 16 pages of footnotes in its
2000 annual report. Some analysts studied these, sold short and made
profits. But other sophisticated analysts and fund managers have said
that, although they were confused, they bought and lost money.
We need to fix this problem. We can't long maintain trust in our
capital markets with a financial-reporting system that delivers volumes
of complex information about what happened in the past, but leaves some
investors with limited understanding of what's happening at the present
and what is likely to occur in the future.
The current financial-reporting system was created in the 1930s for
the industrial age. That was a time when assets were tangible and
investors were sophisticated and few. There were no derivatives. No
structured off-balance-sheet financings. No instant stock quotes or
mutual funds. No First Call estimates. And no Lou Dobbs or CNBC.
We need to move quickly but carefully to a more dynamic and richer
reporting model. Disclosures need to be continuous, not periodic, to
reflect today's 24/7 capital markets. We need to provide several
streams of relevant information. We need to expand the number of key
performance indicators, beyond earnings per share, to present the
information investors really need to understand a company's business
model and its business risks, financial structure and operating
performance.
--Reforming our patchwork regulatory environment. An alphabet soup of
institutions--from the AICPA (American Institute of Certified Public
Accountants) to the SEC and the ASB (Auditing Standards Board), EITF
(Emerging Issues Task Force) and FASB (Financial Accounting Standards
Board) to the POB (Public Oversight Board)--all have important roles in
our profession's regulatory framework. They are all made up of smart,
diligent, well-intentioned people. But the system is not keeping up
with the issues raised by today's complex financial issues. Standard-
setting is too slow. Responsibility for administering discipline is too
diffuse and punishment is not sufficiently certain to promote
confidence in the profession.
All of us must focus on ways to improve the system. Agencies need
more resources and experts. Processes need to be redesigned. The
accounting profession needs to acknowledge concerns about our system of
discipline and peer review, and address them. Some criticisms are off
the mark, but some are well deserved. For our part, we intend to work
constructively with the SEC, Congress, the accounting profession and
others to make the changes needed to put these concerns to rest.
--Improving accountability across our capital system. Unfortunately, we
have witnessed much of this before. Two years ago, scores of New
Economy companies soared to irrational values then collapsed in dust as
investors came to question their business models and prospects. The
dot-com bubble cost investors trillions. It's time to get serious about
the lessons it taught us.
In particular, we need to consider the responsibilities and
accountability of all players in the system as we review what happened
at Enron and the broader issues it raises. Millions of individuals now
depend in large measure on the integrity and stability of our capital
markets for personal wealth and security.
Of course, investors look to management, directors and accountants.
But they also count on investment bankers to structure financial deals
in the best interest of the company and its shareholders. They trust
analysts who recommend stocks and fund managers who buy on their behalf
to do their homework--and walk away from companies they don't
understand. They count on bankers and credit agencies to dig deep. For
our system to work in today's complex economy, these checks and
balances must function properly.
Enron reminds us that the system can and must be improved. We are
prepared to do our part.
Mr. Berardino is managing partner and CEO of Andersen.
Senator Dorgan. Mr. Andrews, thank you very much.
Mr. Cleland, you represent--you are the Chief Executive
Officer of The Precursor Group.' We appreciate your
willingness to participate today. Why don't you proceed.
STATEMENT OF SCOTT CLELAND, CHIEF EXECUTIVE OFFICER, THE
PRECURSOR GROUP'
Mr. Cleland. Thank you for the honor to testify and
allowing me to go early. I am Scott Cleland, founder and CEO of
the Precursor Group'. We are an independent broker-
dealer. We provide investment research to institutional
investors. We do no investment banking, no proprietary trading.
We do not manage money, and none of our analysts are allowed to
own individual stocks.
Before entering the investment business, I worked for the
U.S. Government and gained experience in improving internal
controls at the U.S. Treasury Department and the U.S. Office of
Management and Budget.
My message to you is very simple today. There are more
Enrons out there ready to blow up and devastate more investors,
but you will know now about it because the system of internal
controls, the early warning systems, are so rampantly affected
by conflicts of interest, and it does not need to be that way.
Government and industry, if they would just officially
discourage the conflicts of interest, I think a lot of the
problem could be addressed.
If the system worked as designed, essentially we would not
have had the first panel. We would have had a couple of years
ago a stock that was battered, but we would not have had a
devastating meltdown with a frighteningly swift collapse. That
was because this thing had been going on for 3 or 4 years and
none of the watch-dogs spotted it.
The stakes are really high here. As baby boomers are
nearing retirement age, the Nation is increasingly depending
upon 401(k)'s and other types of market instruments to
supplement social security, so now more than ever we need to
restore the integrity of the markets.
The problem is obvious. Just like an ounce of prevention is
worth a pound of cure, unsanitary conditions breed disease.
Conflicts of interest now plague the system. Government and
industry have not been vigilant enough to keep the system
clean, because almost all of the watch-dogs supposedly watching
the system are not paid by investors, they are paid by somebody
else.
But what is this plague of conflicts of interest? Let me
briefly run through eight that are glaring. Companies routinely
now pay consulting fees to audit companies that are supposed to
keep the company honest. In Government, that would be a
violation of public trust.
2. Auditors are increasingly doing the company's inside
audit work and also doing their independent outside work. That
is like grading your own papers or hearing your own appeal.
3. Through the investment banking back-door, company
interests effectively pay for most of the research that is
produced in the United States. The problem is, the average
American does not get the joke that most all of the research
they are reading is paid for by investment banking, by the
companies.
4. It is common for analysts to have a financial stake in
the companies they are covering. That is just like essentially
allowing athletes to bet on the outcome of the game that they
are playing in.
5. Most payments for investment research is routinely
commingled in the process with more profitable investment
banking and proprietary trading. The problem with this is that
it effectively means most research analysts work for the
companies and do not work for investors.
6. Credit agencies may have conflicts of interest.
7. Analysts seeking investment banking tend to be more
tolerant of pro forma accounting, and the conflict there is
essentially the system is allowing companies to make up their
own accounting to describe their own financial performance that
no one then can compare objectively with other companies.
8. Surprise, surprise, companies routinely beat the
expectations of a consensus of research analysts that are
seeking their investment banking business.
Common sense suggests that conflicts of interest breed
trouble. I believe the focus of congressional and regulatory
oversight should be on how to improve the current system, how
to prevent future Enrons from happening, so I have five simple
common-sense recommendations.
1. Officially discourage conflicts of interest. Make it
U.S. policy to discourage financial conflicts of interest, and
definitely do not economically reward conflicts of interest in
the law or in regulation.
2. I think it is pretty simple. Prohibit auditors from
consulting for companies they audit, and from reviewing their
own work, doing the independent review of their own internal
review.
3. You really need to strengthen the objectivity of the
overall investment research system. Discourage the bundling of
banking, trading, and research, because the commingled nature
of commissions when there is not a transparent and official
separate accounting for each type of business, essentially what
it means is that the more profitable parts of banking and
trading are rewarded, and it discourages research objectivity.
One idea you have heard many times is the trading they
suggest, we need to get best execution for investors, best
execution of trading. I suggest there should be some evidence
or some emphasis getting best research execution for investors.
My last recommendation is there needs to be increased
awareness among the press and among the Government to stock
manipulation. Two instances. When the press headlines or gives
prominence in a story to pro forma accounting financial
results, the press is lending credibility to a serious conflict
of interest, because they are allowing public companies to make
up their own accounting so that they cannot be compared or
judged relative to other people.
The second thing is, the press lends credibility to another
conflict of interest by being allowed to be spun, and playing
along with the companies in the street in their quarterly
expectations game that inflates stock prices.
So I thank you very much for allowing me to testify to
avert future Enrons. It is very simple. Make the official U.S.
policy to discourage conflicts of interest where necessary.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Cleland follows:]
Prepared Statement of Scott Cleland, Chief Executive Officer, The
Precursor Group'
``Conflicts of Interest Are Eroding the Market's Integrity and the
Market's System of Internal Controls: Enron Is Not Unique, But
Part of a Growing Pattern of Missed Warning Signs''
I. Introduction
Mr. Chairman, thank you for the honor of testifying before your
Subcommittee and for the Subcommittee's interest in the perspective of
an independent investment research broker-dealer.
My testimony includes:
An explanation of the Precursor Group'
perspective;
Our assessment of why the system was surprised by Enron's
demise; and
Our recommendations help prevent future Enrons from
happening again.
II. Precursor Group' Perspective
I am Scott Cleland, founder and CEO of the Precursor
Group', an independent research broker-dealer, which
provides investment research to institutional investors. A year and a
half ago, my partner, Bill Whyman, and I founded the Precursor
Group' very intentionally as an independent firm in order to
better serve our investor clients' interests and not to serve
companies' interests or investment banking interests. We see a real
market opportunity for pure investment research uncompromised by
company conflicts of interest. We also have learned that the investment
research marketplace is thirsting for trust; and our business is trying
to quench a part of that thirst.
Our business is simple. We work for institutional investors; they
pay us research commissions on their trading to the extent that we help
improve their investment performance.
If our research helps investors identify opportunities or
avoid pitfalls, we get paid in trading commissions.
If our research does not help investors, we do not get paid.
We have a market-driven, merit-based business model.
We are unusual in that we are a pure research firm in a business
dominated by integrated full-service brokerage firms that bundle
investment banking, trading and research. We are exclusively an
investors' broker-dealer, akin to a buyer's broker in real estate. We
are not the traditional sellers' or company broker-dealer, which tries
to represent both companies' and investors' interests.
We have done our best to align our financial interests with
investors' interests. We are very serious about avoiding conflicts of
interest, actual and perceived, so we:
Do no investment banking for companies;
Do not manage money or own a stake in any companies;
Do not allow Precursor Group' researchers to
trade individual stocks--as a condition of employment (which
exceeds NASD rules); and
Do not trade securities for proprietary gain.
We get paid through agency trading commissions, which is the
primary payment mechanism that institutional investors use to
pay for investment research.
Our contracted-out agency trading is not a conflict of
interest because:
We do not act as an agent and never as a principal that
has capital at risk--so our contracted-out agents execute
stocks for others at their request, but we never actually
own a stock of a company.
Our clients have complete freedom to choose which of our
four contracted-out trading clearing firms they want to
use.
Our institutional investor clients completely control
whether and how we get paid with their shareholder or
pension fund resources.
This arrangement eliminates any financial conflict.
We are a pure research firm because we do not believe one firm can
well serve different masters at the same time: investors and companies.
We strongly believe true independence yields better research.
III. The Problem: Conflicts of Interest Erode the Integrity of Markets
(a) Systemic Conflicts of Interest
The U.S. capital markets system is playing with fire--effectively
ignoring rampant conflicts of interest--and investors are getting
burned. The U.S. capital markets system clearly failed thousands of
Enron investors, pension holders, creditors, employees and customers. I
believe it is clear that the system will continue to fail investors,
until the root cause--rampant conflicts of interest throughout the
system--are brought under control.
Hopefully Congress and regulators will hear the Enron collapse and
the tech bubble bursting as wake up calls, alerting us that the
market's system of internal controls have broken down and are no longer
effective. The system's internal controls are supposed to warn
investors, auditors and regulators of financial problems, before they
get out of hand and become an Enron.
Conflicts of interest abound where they should not:
Companies routinely pay consulting fees to the audit
companies that are supposed to keep the company honest.
Auditors are increasingly doing the companies' inside audit
work and the outside review of it--essentially grading their
own papers or hearing their own appeal.
Through the investment banking backdoor, companies
effectively pay for most of the research departments, providing
research on their company, of most all of the prominent
brokerage firms that offer research to most Americans.
It is common for analysts to have a financial interest in
the companies they are expected to cover objectively.
Credit agencies may have an indirect financial interest in
the companies that they rate.
Most payments for investment research is routinely
commingled with more profitable and dominant banking and
proprietary-trading commissions, effectively subordinating
research for investors to the promotion of company interests.
Analysts seeking investment banking are more susceptible to
company pressure to emphasize the company's preferred pro-forma
financial reporting.
And companies routinely ``beat the expectations'' of a
consensus of research analysts that seek their banking
business.
Systemic conflicts of interest are more pervasive and corrosive
than either Congress, regulators, investors or the press appreciate.
Conflicts of interest are eroding the integrity and resilience of our
capital markets, because they undermine the objectivity, integrity and
accountability of the ``watch dogs'' and the early warning systems that
markets depend on to prevent Enron-type situations from escalating to
disasters.
Congress and regulators should be very concerned because the
breathtakingly swift collapse of Enron is no isolated incident that can
be dismissed as unique, brushed under the rug and ignored. During the
last two years, the bursting of the dot.com and tech bubble produced
dozens of mini-Enron shareholder disasters (such as Excite@Home this
past month) that cost investors hundreds of billions of dollars, while
the capital markets routinely either ignored or missed the signals of
their demise. Unless the integrity of the financial checks and balances
in the system are restored, the Enrons and dot.com collapses will
happen again and again.
Millions of trusting American investors have lost big in the
markets in recent years in part because the system has become so
conflict-ridden that the system no longer effectively serves investor
interests but primarily serves company interests. It appears that the
oversight mood has now shifted to an ``investor beware'' attitude from
an ``investor protection'' attitude. An investor protection system
keeps investors adequately informed; identifies problems early;
protects investors from misrepresentation and fraud; and ensures
fairness in information dissemination.
As the Baby Boomers age, our Nation increasingly will depend on
market vulnerable 401(k)s and company pension plans to supplement
Social Security and adequately fund Americans' retirement. Now more
than ever, we need the internal controls capital markets rely on--
auditors, research analysts, and boards of directors--to function with
integrity to ensure the protection of investors' financial security.
(b) A Pattern of Conflicts
The system failed investors at multiple levels because conflicts of
interest have spread like a disease throughout the system of checks and
balances, and undermined independent voices and public watchdogs.
Auditors: The integrity and functioning of the entire
capital markets system depends on investors trusting publicly
reported numbers. However, auditors now routinely work as
consultants to the companies they are supposed to be
objectively auditing for investors. This is analogous to
expecting a judge to always be fair when judging someone who
directly pays half of his or her salary.
Investment Banks' Research Analysts: Research analysts of
all types are supposed to be objective, have an expert
understanding of the companies and identify material problems
early. However, it is now the norm that equity and debt
analysts' pay comes primarily from companies, not investors,
through investment banking and proprietary trading. About 95%
of the firms in the Wall Street Journal's ``Best of the
Street'' research rankings have investment banking conflicts of
interest. Conflicts of interest are pervasive on the Street.
(See attached survey.) Analysts also routinely have another
conflict in that they often have financial stakes in the
companies they are covering. (This is analogous to the
prohibited practice of an athlete betting on the outcome of the
game they are playing in.)
Role of the Press: The press exacerbates the corrosive
effect of rampant conflicts of interest by tacitly and
unwittingly condoning them. The press routinely headlines
``pro-forma'' or ``spin'' numbers that can't be relatively
compared to anything else, rather than headlining Generally
Accepted Accounting Principles or GAAP results that are readily
compared to every other investment. In essence, regulators and
the press are allowing companies to define their own success,
and run from an accountable benchmark.
Further, the press routinely plays along with the Street's
``expectations game,'' where the spin ignores actual
performance and redirects focus to how the company still
exceeded the ``consensus expectations'' of like-minded company
cheerleaders. The expectations game tends to decouple a
company's stock performance from its actual financial
performance.
Ask the average American if it is wise to:
Tempt auditors' objectivity by letting auditors moonlight
for those they audit;
Have companies pay for most of the investment research done
on them; and
Enable publicly-traded companies to make up their own
accounting and decide what liabilities they have to disclose to
investors.
Common sense suggests that conflicts of interest breed trouble.
Other systems that depend on the public trust discourage conflicts of
interest more strongly as the first line of defense against serious
problems. Government policymakers must avoid conflicts of interest and
our judicial system has very strict conflict of interest rules. The
most obvious way to prevent more Americans from being financially
devastated by Enron-like fiascos is to strengthen and improve the
integrity of the early warning signals and the structural checks and
balances in the system. Just like an ounce of prevention is worth a
pound of cure, unsanitary conditions breed disease.
IV. Recommendations: Emphasize Trust--Discourage Conflicts of Interest
I believe that the focus of Congressional and regulatory oversight
should be on how to improve the current system and prevent more Enrons
from happening in the future. I recommend some common sense changes
that can strengthen the integrity and functioning of U.S. capital
markets, and protect the financial retirement security of all investing
Americans.
(a) Officially discourage conflicts of interest.
Wherever possible, policies should encourage alignment of financial
service provider interests with investor interests, or at a minimum,
make it much more transparent when a person or an entity is not working
primarily for investor interests. Investors must be better informed of
the extent of the conflicts of interest. The Senate could pass a Sense
of the Senate Resolution reaffirming the importance of protecting the
integrity of capital markets by discouraging financial conflicts
whenever possible.
I don't believe it is wise, necessary or practical to prohibit all
conflicts of interest, but it sure is necessary to make it U.S. policy
to discourage financial conflicts of interest and not create economic
incentives that reward these conflicts through laws, regulations,
structure or oversight processes.
Self-regulatory organizations can be effective, if combined with
the strong discouragement of conflicts of interest in order to build
checks and balances that can actually work as designed. Self-regulation
combined with condoned conflicts of interest equals a recipe for more
Enrons.
(b) Prohibit auditors from consulting for companies they audit and from
conducting independent audits of their own internal audits.
Even better, encourage auditors to be only auditors. The public
trust in the accuracy of public financial reporting is so critical it
is not even worth the perception of a conflict of interest. Judges and
U.S. government employees cannot moonlight for those that they have a
public trust to police. Would it be a good idea for IRS divisions to do
paid tax consulting for the companies they audit on the side? Mixing
auditing and consulting is such a blatantly bad idea, it is amazing
that it is officially tolerated. Moreover, auditors are increasingly
conducting the outsourced internal audit function of the company,
essentially acting as contract employees while also being responsible
to investors for the outside audit to assure investors that all is well
financially. The government is allowing organizations to essentially
grade their own papers or handle their own appeals. There are probably
no more corrosive and counter-productive conflicts of interest in the
U.S. capital markets than these. The system is just asking for more
Enrons to happen, because it appears that it is no longer in some
auditor's primary interest to protect investors from fraud and
misrepresentation.
(c) Strengthen the overall objectivity of the investment research
system.
Discourage the bundling of banking, trading and research. The
commingled nature of commissions without transparent and official
separate accounting among trading, research and banking services has
the practical effect of rewarding conflicts of interest and
discouraging research objectivity. Investment funds go to great
lengths, including third party evaluations and industry self-
regulation, to get best trading execution for investors. Yet, there is
surprisingly little systematic effort to get ``best research
execution'' for investors. This could be encouraged through disclosure
of what percent of trading commissions are spent on conflicted vs. non-
conflicted research.
(d) Discourage analysts owning a financial stake in companies they
cover.
Industry standards should be fostered and enforced so that analysts
that present themselves to the investing public as ``objective research
analysts'' should not have a financial interest in the company they are
covering. Many in the industry condone the practice of analysts having
``skin in the game'' so they think like investors themselves. This is
analogous to saying it is a good idea to condone athletes betting on
the outcome of the games they play in. The extent to which analyst
compensation is linked to investment banking should also be examined.
(e) Increase awareness and vigilance of the press to stock
manipulation.
When the press headlines or gives prominence in a story to a
company's ``pro-forma'' financial results, the press tacitly lends
credibility to a serious conflict of interest, because public companies
should not be making up their own accounting results or creating a
public perception of their financial performance that can't be compared
or checked objectively. The whole rationale behind GAAP is to create a
transparent market, instilling investor confidence that reported
earnings are actually earnings. Pro-forma reporting at its best is
``spin'' or partial truth; at its worst, it is misrepresentation. Pro-
forma reporting has become more commonplace because the press has so
frequently played along.
The press also perpetuates and lends credibility to conflicts of
interest by being ``spun'' and playing along with the companies and the
``Street'' in the quarterly ``expectations game.'' The companies and
their potential investment banking firms have an interest in the stock
going up regardless of whether the financial performance warrants it.
The quarterly ``expectations game'' is one of the subtlest
manifestations of conflicts of interest. By headlining or leading a
financial story with how a company ``beat expectations,'' the press
lends objective credibility to the company sell-side cheerleading corps
that has a strong financial interest in the stock going up. The press
can limit the impact of this conflict of interest through an editorial
policy of reporting ``expectations'' after actual earnings results are
reported or by putting sell-side expectations in context with the
consensus expectations of independent analysts.
V. Conclusion
To avert future Enron-type disasters and protect public confidence
in the integrity and resilience of U.S. capital markets, Congress and
regulators need a policy to reemphasize integrity and trust in U.S.
capital markets. Congress can take a big step in that direction by
officially discouraging conflicts of interest within the system of
watchdog groups, auditors, analysts, and independent board members,
which the system depends on to protect investors. Conflicts of interest
are becoming so common and pervasive that they are becoming the norm
not the exception. Sadly, this could mean that investor disasters like
Enron could increasingly become the norm as well.
Thank you again Mr. Chairman for the honor and opportunity to
testify on this important matter.
Attachments
Precursor Group' Survey Shows Conflicted Investment Research
is Systemic and Pervasive
July 30, 2001
Washington, D.C.--A new survey by The Precursor Group', a
Washington-based independent investment research firm, shows that
almost all of the top investment research firms in the country have
multiple structural conflicts of interest that undermine research
credibility and investor confidence. In recent weeks, two top firms,
have announced new policies that restrict their analysts from owning
stock in the companies they cover. While analyst ownership of companies
they cover is the most obvious conflict, the deeper, more important
conflicts are investment banking and proprietary trading, according to
Precursor.
``The problem of conflicted investment research is more systemic
and pervasive than most investors appreciate,'' said Scott Cleland,
chief executive officer of Precursor, an independent research firm
based in Washington. ``Almost all of the top investment research firms
have structural financial conflicts of interest that undermine research
objectivity. At least 95% of The Wall Street Journal's top 2001 stock
picking firms and 100% of Institutional Investor magazine's 2000 All-
America Research firms have multiple conflicts of interest.''
Survey of Research Conflicts:
Precursor's survey (attached) of top investment research firms
shows that almost all have structural financial conflicts of interest
that create actual and perceived research conflicts and undermine
research objectivity: either through investment banking representation
of companies or through direct ownership of a company through
proprietary trading and money management.
Ninety-five percent of the 82 firms ranked by The Wall
Street Journal
(June 26, 2001) as the ``Best Stock Pickers on the Street''
have line of busi-
ness research conflicts: investment banking, proprietary
trading and money management (http://interactive.wsj.com/
public/resources/documents/best2001-firms.htm).
And 100% of Institutional Investor's 2000 top investment
research firms have line of business research conflicts:
investment banking, proprietary trading and money management
(http://www.iimagazine.com/activecontent/report.asp?rt=
leaders&teamid=1&iyear=2000).
The survey builds upon the two of the most-widely respected
and followed rankings of investment research quality. Each of
these well-respected business publications publishes their
rankings of investment research firms every year. Additional
details can be obtained at the source/website address for each
firm included in the survey results.
Precursor conducted the survey after Cleland testified before the
House Subcommittee on Capital Markets. The Congressional Subcommittee's
interest in part was prompted by the deterioration in the capital
markets over the last year. Many people questioned how U.S. companies
could plummet without more warning from investment research analysts
who are charged with watching market trends and making investment
decisions for their clients.
``How could American shareholders and pension plan beneficiaries
lose four trillion dollars in the NASDAQ when only 1% of analysts'
recommendations were `sell'?'' Cleland asked. ``One seldom-heard
explanation is that the entire brokerage system is structurally skewed
to put company interests before investor interests.''
In addition, Cleland pointed out that almost all of the largest and
best known brokerage firms that most Americans rely on for their
investment research have structural business conflicts of interest
which discourage the production of research that could have a negative
investment outlook for a company.
``More specifically, if a brokerage firm is either in the
investment banking business or owns stocks through proprietary trading
or money management, that firm has a financial interest in companies'
stocks going up, not down,'' Cleland added.
Precursor conceived of the survey to measure conflicts of interest
among investment research firms when it became obvious that conflicted
research was more pervasive throughout the industry than most people
realize.
``The real issue here is that the conflicted research problem is
systemic,'' Cleland said. ``The primary and most profitable purpose of
the brokerage industry is to raise capital and provide liquidity for
companies. So the structure, economics, compensation, and regulation of
the industry reinforce and perpetuate the purpose of selling companies
to investors. In a bull market there may be better alignment of
interests between companies and investors; in a bear market there is
often a stark divergence of financial interests between companies and
investors,'' he concluded.
The Precursor Group' is an employee-owned and -
controlled, independent research Broker-Dealer, which does no
investment banking, money management, proprietary trading or stock
picking. Precursor research' analysts, as a condition of
employment, may not trade individual stocks; independent third parties
must manage any Precursor analyst's personal portfolio. Precursor
products and services are designed for use by institutional investors
and are also used by senior decision-makers from government, industry
and other professional organizations.
The Precursor Group' is a Broker-Dealer registered with
the Securities and Exchange Commission (SEC) and is a member of the
National Association of Securities Dealers (NASD) and the Securities
Investor Protection Corporation (SIPC). ``Precursor Group,''
``Precursor Research,'' ``Precursor Watch,'' ``Investment Precursors,''
and ``Helping Investors Anticipate Change'' are registered trademarks.
The Wall Street Journal's ``Best on the Street'' Stock Pickers--``95% of These Top 82 Firms Have Research Conflicts''
--------------------------------------------------------------------------------------------------------------------------------------------------------
Investment Proprietary
Wall Street Journal Ranking June 26, 2001 Banking Trading Money Management Source
--------------------------------------------------------------------------------------------------------------------------------------------------------
1. Salomon Smith Barney X X X www.salomonsmithbarney.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
2. Merrill Lynch X X X www.ml.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
3. Morgan Stanley X X X www.morganstanley.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
4. Lehman Brothers X X X www.lehman.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
5. Goldman Sachs X X X www.gs.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
6. A.G. Edwards X X X www.agedwards.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
7. Credit Suisse First Boston X X X www.csfb.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
8. J.P. Morgan Chase X X X www.jpmorgan.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
9. Bear Stearns X X X www.bearstearns.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
10. Banc Of America Sec's X X X www.bofasecurities.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
11. UBS Warburg X X X www.ubswarburg.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
12. Deutsche Banc Alex Brown X X X www.deutsche-bank.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
13. William Blair X X X www.wmblair.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
14. McDonald Investments X X X www.key.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
15. SG Cowen Securities X X X www.sgcowen.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
16. Prudential Securities NO X X www.prudential.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
17. ING Barings X X X www.ingbarings.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
18. First Union Securities X X X www.firstunionsec.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
19. CIBC World Markets X X X www.cibcwm.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
20. ABN Amro X X X www.abnamro.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
21. Robertson Stephens & Co X X X www.robertsonstephens.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
22. Needham & Co X X X www.needhamco.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
23. Dain Rauscher Wessels X X X www.dainrauscherwessels.co
m
--------------------------------------------------------------------------------------------------------------------------------------------------------
24. Raymond James X X X www.raymondjames.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
25. BMO Nesbitt Burns X X X www.bmonesbittburns.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
26. Wit SoundView X X X www.witcapital.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
27. Wasserstein Perella X X X www.wassersteinperella.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
28. Morgan Keegan X X X www.morgankeegan.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
29. SunTrust Equitable Sec's X X X www.suntrust.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
30. Keefe,Bruyette & Woods X X X www.kbw.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
31. Ferris, Baker Watts X X X www.fbw.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
32. Buckingham Research NO X X New York ph# 212.922.5500
--------------------------------------------------------------------------------------------------------------------------------------------------------
33. Tucker Anthony X X X www.tucker-anthony.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
34. Robinson-Humphrey X X X www.robinsonhumphrey.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
35. Barrington Research X X X www.brai.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
36. D.A. Davidson X X X www.dadco.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
37. Stifel Nicolaus X X X www.stifel.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
38. Fahnestock X X X www.fahnestock.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
39. Midwest Research NO X NO Sarah O'Connor-Compliance
--------------------------------------------------------------------------------------------------------------------------------------------------------
40. First Analysis X X X www.firstanalysis.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
41. Thomas Weisel Partners X X X www.tweisel.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
42. Janney Montgomery Scott X X X www.janneys.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
43. First Albany X X X www.fac.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
44. Adams, Harkness & Hill X X X www.ahh.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
45. Jefferies X X X www.jefco.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
46. Ryan Beck X X X www.rbeck.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
47. U.S. Bancorp Piper Jaffray X X X www.piperjaffray.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
48. Sidoti NO NO X John Zolidis-Sidoti
--------------------------------------------------------------------------------------------------------------------------------------------------------
49. BB&T Capital Markets X X X www.bbandt.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
50. Pacific Growth Equities X X X www.pacgrow.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
51. Hibernia Southcoast Capital X X X www.hibernia.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
52. Argus Research NO NO NO www.argusresearch.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
53. Davenport & Co, LLC X X X www.davenportllc.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
54. Friedman,Billings,Ramsey X X X www.fbr.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
55. H.C. Wainwright X X X www.hcwainwright.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
56. Gerard Klauer Mattison X X X www.gkm.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
57. Robert W. Baird X X X www.rwbaird.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
58. Legg Mason X X X www.leggmasoncapmgmt.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
59. Brean Murray X X X www.bmur.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
60. Griffiths McBurney X X X www.gmponline.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
61. Hoak Breedlove Wesneski X X X www.hbwco.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
62. LJR Great Lakes Review NO NO NO www.ljr.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
63. RBC Dominion Securities X X X www.rbcds.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
64. Gruntal X X X www.gruntal.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
65. Lazard Asset Mgmt X X X www.lazardnet.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
66. Wedbush Morgan Sec's X X X www.wedbush.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
67. Credit Lyonnais X X X www.creditlyonnais.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
68. Hilliard Lyons X X X www.hilliard.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
69. Advest Group X X X www.advest.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
70. Sandler O'Neill X X X www.sandleroneill.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
71. Stephens Capital Mgmt X X X www.stephens.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
72. Fox-Pitt, Kelton X X X www.foxpitt.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
73. Miller Johnson X X X www.stockwalk.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
74. Josephthal X X X www.josephthal.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
75. Simmons X X X www.simmonsco-intl.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
76. WR Hambrecht X X X www.wrhambrecht.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
77. Frost Securities X X X www.frostsecurities.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
78. Johnson Rice X X X New Orleans 504.525.3767
--------------------------------------------------------------------------------------------------------------------------------------------------------
79. Kaufman Brothers X X X www.kbro.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
80. Wells Fargo Van Kasper X X X www.fsvk.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
81. Pacific Crest Securities X X X www.pacific-crest.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
82. Southwest Securities X X X www.swst.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
Totals 76/82=93% 79/82=96% 79/82=96%
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: The Precursor Group, July 30, 2001.
Institutional Investor Magazine's ``2000 All-America Research Team''--100% of These Top 16 Firms Have Research Conflicts
--------------------------------------------------------------------------------------------------------------------------------------------------------
Proprietary
Institutional Investor Magazine Ranking Investment Banking Trading Money Management Source
--------------------------------------------------------------------------------------------------------------------------------------------------------
1) Merrill Lynch X X X www.ml.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
2) Morgan Stanley X X X www.morganstanley.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
3) Salomon Smith Barney X X X www.salomonsmithbarney.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
4) Credit Suisse First Boston X X X www.csfb.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
5) Donaldson Lufkin Jenrette X X X www.dlj.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
6) Goldman Sachs & Co X X X www.gs.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
7) Bear Stearns & Co X X X www.bearstearns.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
8) Lehman Brothers X X X www.lehman.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
9) PaineWebber X X X www.painewebber.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
10) J.P. Morgan Securities X X X www.jpmorgan.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
11) Prudential Securities NO X X www.prudential.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
12) Sanford C. Bernstein & Co NO X X www.bernstein.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
13) Banc of America Securities X X X www.bofasecurities.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
14) Deutsche Banc Alex. Brown X X X www.deutsche-bank.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
15) ISI Group NO NO X www.morningstar.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
16) Robertson Stephens X X X www.robertsonstephens.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
Totals 13/16=81% 15/16=94% 16/16=100%
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: The Precursor Group, July 26, 2001.
White Paper: What Ails Investment Research?
Precursor Group', May 2001
Introduction
Why is there so much market volatility? Why are investors so often
surprised by companies? In large part because the ``sell-side''
investment research system is so biased toward the company view. The
Wall Street firms that produce most ``investment research'' are rife
with potential financial conflicts of interest. There is precious
little quality, independent investment research that serves as a source
of new ideas or as a check and balance on the ``Street/Company'' spin.
What Ails Investment Research?
Bundled Services: Most investment research is not sold separately, but
as part of a bundle of services including access to investment banking
and trading liquidity. As part of a financial bundle, research
functions largely as advertising for other more profitable lines of
business--banking and proprietary trading. Without separate pricing,
low quality research is concealed in the bundle of services.
Consequently, there is little accountability or measure of research
value in the marketplace, and little incentive to improve the quality
and objectivity of research. This suggests the current research system
simply does not value research much.
Conflicts of Interest: Investment research is compromised by financial
dependence on other lines of business with very different masters than
investors. Investment banking and proprietary trading heavily subsidize
Wall Street research, creating both real and perceived financial
conflicts of interest. Since a research analyst's compensation is often
largely driven by investment banking deals, there exists a stark
conflict between the analyst's responsibility to investors and
responsibility to the firm's corporate finance clients. The evidence of
this conflict of interest is powerful: according to First Call, of the
28,000 U.S. stock recommendations, only 1% are ``sells.'' This suggests
it is not in the interest of most investment research to warn investors
in advance of problems.
Expedient to Depend on Company Information: Companies are the easiest
source of information, and are also highly sophisticated in managing
their investment ``story'' through investor-public relations and
lobbying firms. Because original research is difficult, time-consuming,
costly and risky, it is simply easier to adopt the company's world view
and version of the facts. Securities & Exchange Commission (SEC) fair
disclosure regulations also give companies wide latitude to manage
information flow tightly--as long as they are equally stingy to all
parties. This suggests the investment research system implicitly
reenforces the incorrect assumption that companies know all, see all
and share all.
Rehash Rather than Research: Since an underlying purpose of most
investment research is to sell companies to investors, Wall Street
markets the positive and does not fully research the negative. The
large conflict between company and investor interests tends to produce
a superficial rehash of public company information or benign commentary
on industry developments. The result is a Wall Street system focusing
more on ``re'' than ``search''--more backward-looking reporting and
reformating, and not much forward-looking searching for what is new and
original in the market, the core value of research to investors. This
suggests most investment research has become an echo chamber for the
company line.
Conclusion
Former SEC Chairman, Arthur Levitt calls the problem with
investment research a ``web of dysfunctional relationships.'' The
result of a dysfunctional research system is biased and poor investment
research. This increases market volatility and surprises that blindside
investors, skews the market toward investment banking at the expense of
investor interests, and doesn't fully help investors anticipate change,
capture opportunities and avoid risk.
Quotes from the Industry & Academics
Bundled Services
``Research analysts have become integral members of the investment
banking units . . . [t]heir compensation is tied importantly to the fee
revenue that they generate for the investment-banking unit.'' Samuel
Hayes, professor emeritus at Harvard Business School, June 20, 2000,
Wall Street Journal.
``Research analysts have become either touts for their firm's corporate
finance departments or the distribution system for the party line of
the companies they follow.'' Stefan D. Abrams, Chief Investment Officer
for Asset Allocation, Trust Company of the West, December 31, 2000, New
York Times.
``[Y]ou can't get paid for research anymore, because the commissions
have been whittled down; you have to look elsewhere for money. . . .
Today, it's investment banking--looking for deals to do.'' Chuck Hill,
Research Director, First Call Thompson Financial, August 14, 2000,
Interactive Week.
Conflicts of Interest
``I see . . . a web of dysfunctional relationships--where . . . the
analyst attempts to walk the tightrope of fairly assessing a company's
performance without upsetting his firm's investment banking
relationships.'' Arthur Levitt, Former SEC Chairman, April 6, 2000,
Remarks at the Economic Club of Washington.
``Analysts must bring in deals, and there is an inherent conflict of
interest. . . . Quality becomes a function of the deal calendar. It's
only natural that the credibility of sell-side research falls as
banking steps up.'' Andrew Barth, U.S. Research Director, Capital
Guardian Trust Co., October 1, 2000, Institutional Investor.
``[A]nalysts affiliated with the lead underwriter of an offering tend
to issue more optimistic growth forecasts than unaffiliated analysts. .
. . [T]he magnitude of the affiliated analysts' growth forecasts is
positively related to fee basis paid to lead underwriters.'' Patricia
Dechow & Richard Sloan, University of Michigan; and Amy Hutton, Harvard
Business School, June 1999, Research Paper: ``The Relation Between
Analysts' Forecasts of Long-Term Earnings Growth and Stock Performance
Following Equity Offerings.''
``[T]he way an analyst can get fired is to damage an existing
investment banking relationship with a company or sour a future
investment banking relationship.'' Mitch Zacks, Vice President of Zacks
Investment Research, December 31, 2000, New York Times.
Expedient to Depend on Company Information
``They (analysts) get spoon-fed the information by investor relations
officers and they have a very strong tendency to put a positive swing
or twist on everything. . . . And like sheep they follow.'' Hugh
Johnson, Chief Investment Officer, First Albany Corporation, September
24, 2000, Reuters.
With the SEC Fair Disclosure regulations, ``nobody's going to have the
inside dope. Analysts now will distinguish themselves more on
scholarship and analytical ability rather than connections and
relationships.'' Ted Pincus, CEO, Financial Relations Board, October 1,
2000, Institutional Investor.
Rehash Rather Than Research
``[W]e find there's a lack of initiative; they rarely really
aggressively question what the company is telling them. What we get
instead of research is reporting.'' Gary Langbaum, Fund Manager, Kemper
Total Return Fund, December 11, 1997, Wall Street Journal.
``Our findings . . . [suggest] that analysts mostly react to changes in
market values rather than cause them.'' Eli Amir, Tel Aviv University;
Baruch Lev, New York University and Theodore Sougiannis, University of
Illinois, September 2000, Research Paper: ``What Value Analysts?''
References
Periodicals
Editorial Comment. ``Shoot All The Analysts.'' Financial Times, March
19, 2001. www.ft.com.
Fuerbringer, Jonathan. ``When Being Wrong Won't Hurt: Economists' Ideas
Are Valued More Than Their Forecasts.'' New York Times, October 15,
1999. www.nytimes.com.
Guglielmo, Connie, Cantwell, Rebecca, and Mulqueen, John. ``Special
Report: Analyze This.'' Interactive Week, August 14, 2000.
www.zdnet.com.
Hill, Miriam. ``Even Research Comes With Spin.'' The Philadelphia
Inquirer, August 1, 2000. www.phillynews.com.
Kawamoto, Dawn, and Kanellos, Michael. ``Stock Analysts Roll With The
Punches.'' CNET News, January 18, 2000. www.cnet.com.
Levitt, Arthur. Remarks at the Economic Club of Washington, April 6,
2000. www.sec.gov.
Maremont, Mark. ``As Wall Street Seeks Pre-IPO Investments, Conflicts
May Arise.'' Wall Street Journal, July 24, 2000. www.wsj.com.
McGee, Suzanne. ``After Oracle Misfire, Wall Street's Research Is
Blasted.'' Wall Street Journal, December 11, 1997. www.wsj.com.
Morgenson, Gretchen. ``How Did So Many Get It So Wrong?'' New York
Times, December 31, 2000. www.nytimes.com.
Pulliam, Susan. ``Goldman Raises Eyebrows With E-Commerce List.'' Wall
Street Journal, June 20,2000. www.wsj.com.
Roberts, Kristin. ``Wall Street Analysts Miss The Ball.'' Reuters,
September 24, 2000. www.reuters.com.
Rynecki, David. ``The Price Of Being Right.'' Fortune, February 5,
2001. www.fortune.com.
Sargent, Carolyn and Kenney, Jane. ``The 2000 All-American Research
Team.'' Institutional Investor, October 1, 2000.
www.iimagazine.com.
Vickers, Marcia. ``The Fall of the Net Analyst.'' Business Week,
December 11, 2000. www.businessweek.com.
Academic Research
Amir, Eli (Tel Aviv University), Lev, Baruch (New York University), and
Sougiannis, Theodore(University of Illinois). Research Paper:
``What Value Analysts?'' September 2000.
Dechow, Patricia, Sloan, Richard (University of Michigan), and Hutton,
Amy (Harvard Business School). Research Paper: ``The Relation
Between Analysts' Forecasts Of Long-Term Earnings Growth and Stock
Performance Following Equity Offerings.'' June 1999.
Michaely, Roni (Cornell University & Tel-Aviv University), and Kent
Womack (Dartmouth College). Research Paper: ``Conflict of Interest
and the Credibility of Underwriter Analyst Recommendations.''
February 1999.
Senator Dorgan. Mr. Cleland, thank you very much.
Mr. Andrews, when you indicated that there were some
mistakes in judgment, might I ask about Jedi? That partnership
kept Enron debt off its books, but Enron was improperly at risk
for its own Jedi stake. And the Chewco SPE had the same
problems, where it was used to hold Enron's debts off Enron's
books, but there were improprieties in its ownership. Is that
what you are referring to when you talk about mistake in
judgment by the accounting firm, by your firm?
Mr. Andrews. Senator, the Chewco investment is actually the
one that I referred to that is the subject of the 10A
reporting. That was actually an illegal act. The other SPE is
the one that was a mistake in judgment, the smaller of the two
that accounted for 20 percent of the restatement, and
essentially what occurred there is that dated back till 1997,
the information that our team reviewed in 1997 concluded that
it met the requirements of the SPE's, which not to get
technical on it, but if you have 3 percent, if an outsider has
3 percent and control you are allowed to, in fact required for
that entity to be off your books. We believed it met that test.
The company believed it met that test when it was set up.
Subsequent information, actually in October of this year,
was that it was revealed that we made an error in judgment. It
was not information that was withheld from us, but it was an
error in judgment. When we realized that error, we pointed it
out to the company and the company made that correction.
Senator Dorgan. How big was that correction?
Mr. Andrews. That correction was 20 percent of the
restatement amount. I do not have the exact dollar amount, but
it was 20 percent of the restatement amount.
Senator Dorgan. Let me ask, should it raise a red flag for
an auditor if a firm is setting up a special purpose entity
such as Jedi and Chewco? When a firm is setting up special
purpose entities for transactions in its own firm's stock,
should that raise a red flag for auditors?
Mr. Andrews. Senator, special purpose entities are
structured in accordance with the accounting rules. Generally
accepted accounting principles are, in fact, what provide the
guidance for those entities themselves, and you have to comply
with the structure of those rules. Obviously, those are rules
that the profession has that demand compliance.
Senator Dorgan. But you are answering a question I did not
ask. I am asking whether an auditor should see some areas of
concern if a firm is setting up a special purpose entity for
transactions in its own stock.
Mr. Andrews. Well, the company----
Senator Dorgan. I am asking for your judgment.
Mr. Andrews. The company should report it in accordance
with those rules, and it is our responsibility as auditors to
review that.
Senator Dorgan. Should it raise a red flag for the auditor
if the chief financial officer of a company is personally
involved in complex financial transactions in their own firm?
This was the case with Mr. Fastow, who had a personal stake, as
I understand it, in the success of these SPEs and was
compensated in that manner. Should that concern an auditor, and
did it concern Andersen?
Mr. Andrews. Senator, as it pertains to related party
transactions, again the accounting and disclosure rules
required that related party transactions be reviewed and
disclosed, where they would be material to the financial
statement. In this case, that related party transaction was
disclosed in the footnotes to the Enron financial statement.
Senator Dorgan. Do you have those footnotes with you?
Mr. Andrews. Mr. Chairman, I do not.
Senator Dorgan. The reason I ask is, I have read some of
those footnotes, and I think it would have been impossible for
even the most experienced analyst to understand what those
footnotes meant, and that is of concern.
Did Arthur Andersen in any way participate in structuring
or designing any of these special purpose enterprises for
limited partnerships that were the subject of the restatements
of earnings?
Mr. Andrews. Mr. Chairman, we performed our work as
auditors. We did not design or structure the transactions.
Senator Dorgan. Let me ask a question raised by Mr.
Cleland. I raised it in my opening statement. An accounting
firm that is reviewing the books in a fair manner for a company
and then represents that review to investors and others, if
that company is also under contract for other consulting
services--let us say they are paid $25 million for auditing
services and have a $27 million consulting contract. Is that
not an inherent conflict of interest?
Mr. Andrews. Mr. Chairman, we believe we are independent of
Enron and we accept the responsibility and the importance of
maintaining our independence and integrity. The rules related
to what an auditor can do and cannot do are subject to
regulation, and we conform and abide by those.
As I said, mentioned in some of my testimony, my opening
statement at least, the $27 million we were paid in terms of
consulting, a significant part of that actually was for work
that an auditor really must do or has to do. For example, we
performed the work related to Enron's registration statements,
corporate letters, the tax work, things of that nature that
really an auditor has to do the disclosure as to what goes into
which pot, if you will.
As to what is called an audit fee versus a nonaudit fee is
subject to the regulation of the proxy disclosures that the SEC
passed last year, and many audit-related services actually go
in the nonaudit-related category in that disclosure.
Senator Dorgan. Mr. Cleland, did I get any of my questions
just answered?
Mr. Cleland. It goes back to if it is tolerated, if it
abides by the letter of the regulation, then it is not
necessarily a violation of public trust. I think there is a
question of the letter of the law and the spirit of the law,
and what I am urging is, we need to get back to the spirit of
the integrity of markets and investor confidence in the system,
and that goes beyond the letter of the law.
Senator Dorgan. Senator McCain.
Senator McCain. Following up on Senator Dorgan's comments,
Mr. Andrews, do you believe that being paid for consulting as
well as auditing creates the appearance of conflict of
interest?
Mr. Andrews. Senator, again we believe we were independent
in terms of the appearance of conflict of interest, as I said,
and I believe it is important for us to have the public trust
and if public trust is shaken by the confidence of that it is
our responsibility to restore that.
Senator McCain. Do you believe it creates an appearance of
a conflict of interest?
Mr. Andrews. Many people have stated that it creates an
appearance of conflict of interest.
Senator McCain. Mr. Cleland, after reading your full
statement that was submitted for the record, which is a very
powerful statement, the next time I watch Lou Dobbs as a guest,
or someone on MSNBC or CNBC or Bloomburg, some so-called expert
that is recommending I purchase a stock, is it very likely that
that person has some financial interest in the stock they are
recommending?
Mr. Cleland. You betcha, and the reason why I think we were
asked to testify is we are a telecom tech research firm, and
this happened in the telecom tech. This is deja vu. I mean, if
you look in Fortune Magazine this week, there is a little thing
that said, dot-com death watch, and there are 591 dot-coms that
died, so Enron is a spectacular, huge hit, but this has been
happening for the last year, hundreds of times.
Senator McCain. And it may even be likely at the IPO stage
these individuals made a whole lot of money?
Mr. Cleland. A ton of money.
Senator McCain. That was the history of the stock. It would
go way up, and they had the initial purchases. Again, speaking
of the press, perhaps those guests who sound so convincing, and
are handsome men and women, very bright (smarter than anybody I
know), do you think that before they make these great
recommendations, including their overall confidence in the
future of the stock market (starting some 6 months ago), that
they should at least reveal any conflict of interest so that
the viewer with regards to television, or their radio or print
audience as well, would know?
Mr. Cleland. Certainly there should be greater disclosure,
but disclosure has kind of been viewed as the cure, and it
papers over the problem. The problem is, when people call them
research analysts, the connotation that the average American
has when they hear research, they think objective, they think
scientific, they think analytic, and they think conflict-free.
That is the connotation we are taught when we are in school of
what the definition of research is. That is not what investment
research is today.
Senator McCain. Do you believe that any auditing
corporation who receives consulting money, as well as auditing
money, creates an appearance of conflict of interest?
Mr. Cleland. Without question, it creates an appearance of
conflict, and from my years in the Government, at the Treasury
Department, the Office of Management and Budget, the State
Department--and you all know in the public eye the appearance
can be as damaging as the actual conflict, so that is why in
the Government policy the people that have the public trust,
you are supposed to avoid even the appearance of conflicts of
interest.
Senator McCain. Let us talk about SPEs for a second, Mr.
Andrews. Clearly, you say there was one illegal act and one,
``error in judgment.'' Why would your people not detect
something like this? As I understand it, it was a fairly large
amount of money--about $172 million, I believe. How do you miss
something like that?
Mr. Andrews. Senator, an audit, of course--well, first of
all, Enron is a large, complex company that had over 3,000
subsidiaries. It was at one point seventh on the Fortune 100
list, so a large complex company, and an audit, of course, is
performed on a sample of transactions to provide reasonable
assurance that the financial statements are not materially
misstated, so an audit does not look at every transaction.
In the case of Enron, they had a number of special purpose
entities, and the two that you mentioned, or two of those were
called into question. On one of those, the smaller of them,
when our team reviewed the information originally they did not
detect an element of that that would have required that entity
to fail that SPE test. It was an honest mistake in judgment.
When we found out about it subsequently we brought it to the
company's attention and they corrected that error.
The second one, which is the one you refer to as an illegal
act, actually information came to us, actually in early
November. We do not know if an illegal act has been performed,
but information came to us that would have required the
accounting for that item to be different than it was originally
done. Originally it was not recorded on the books, and it needs
to be consolidated with the entity.
We do not know why we did not have that information. That
was referred under 10A to the audit committee of the company,
and it is currently under investigation.
Senator McCain. How many SPEs did they have?
Mr. Andrews. I do not have the exact number, but there were
several hundred.
Senator McCain. Were there several hundred SPEs?
Mr. Cleland--and Mr. Andrews, I understand you are the
messenger here today, and I appreciate you coming forward to
testify and help us understand this situation. I thank you for
being here today.
Mr. Cleland.
Mr. Cleland. Just as a comment on that, the thing that I
think all of us should be just stunned and amazed at is, this
was a problem that should have been caught in 1997, in 1998, in
1999, and in 2000. That is what a system of internal controls
is supposed to be about.
Mistakes are made, but we have a system that they cannot
cascade hopefully more than 1 year, and when something cascades
for 4 years on top of each other you have an Enron, and
hopefully that is what you are gleaning from all of this, is
that the system that is supposed to catch these things and fix
them so they maybe Enron got a stock battering, but all these
people on the first panel did not need to be here. They might
have had a lower nest egg, but they would have still had a nest
egg.
Senator McCain. Efforts to reform the system of controls
have been stymied in several areas of government. Do you have
any comment about that?
Mr. Cleland. Well, I think that--you know that the legal
process--you all know better than anybody that if you try and
do it through legislation, there are all sorts of ways that it
can get stopped. I have simple suggestion. The U.S. Senate
should do a resolution that says, we stand up for the integrity
of the investment system. We think conflicts of interest are
not a good idea.
You ought to suggest to your House colleagues to do that,
and I will bet it is 100-0 and 435-0, and all of a sudden you
get a sense of the Congress real loud and clear that says yes,
integrity of the public markets is a good idea, and yes,
conflicts of interest tempt people in ways we should not tempt
them.
Why do I make sure that none of our research analysts may
own an individual stock? I do not want to tempt them. Human
nature is something in this. Now, why is Wall Street the way it
is? They have been tempted with not millions, we are talking
tens of millions, hundreds of millions of dollars. You are
tempted with that amount of money and there are all sorts of
reasons why you would look the other way.
Senator Dorgan. I am going to call on Senator Wyden, but I
want to follow up just for one moment on the point Senator
McCain made. Just to focus on one piece of this: Mr. Fastow, as
I understand it, received $30 million in management fees for
these off-the-books partnerships, and we do not know what the
ownership stake was, but the $30 million was just for
management fees.
Now, this was an officer of the company making a
substantial amount of money in management fees and perhaps an
ownership stake. When questioned about who were the other
investors in these partnerships, the answer is: they are
private. So among the answers we are requesting is, let us
allow some sunshine to come in here and find out who owned
these SPEs. How did they profit? When did they profit? How much
did they profit? That is what we are trying to get to, and I
think that is what Senator McCain was alluding to as well.
I would just ask Mr. Cleland the same question I asked of
Mr. Andrews. I do not think I got an answer, but do you think
it is an inherent conflict of interest for a CFO of a company
to have an ownership stake in these off-the-books partnerships
and be paid commissions for running them and so forth?
Mr. Cleland. Yes. That is a no-brainer. It is an
unbelievable conflict of interest, because one thing is public
and the other is private, and so there is no accountability.
That is why it is a conflict.
Senator Dorgan. Senator Wyden.
Senator Wyden. I participated in more than thirty hearings
regarding the accounting profession as a member of the House.
Those hearings were chaired by John Dingell, and after the
hearings I wrote a law with Mr. Dingell's assistance that was
designed to prevent this kind of problem. Everything about what
we did was designed to do what Mr. Cleland talked about which
was to set off those early warning lights. I'm going to take
you through that statute and have you tell me what your company
was doing to, in effect, comply with the law. I'm just going to
go through it step by step.
The first part of the law says that every single audit has
to have procedures in place to detect illegal acts. What did
you have in place and, in particular, did you revise those
procedures as more and more evidence came to light, suggesting
that there was a problem there?
Mr. Andrews. Senator, as you know I'm not the individual
that actually managed the individual Enron engagement, so I
don't have all the details of what we did on the audit. But our
audits on this engagement were performed in accordance with the
professional standards. I think our people did the appropriate
work, which includes, within that scope, the appropriate
consideration of establishing your audit scope to take into
account the responsibility for illegal acts.
Senator Wyden. But did you change it over time? I mean, my
knowledge at this point is that it would be one thing to have a
set of procedures at the beginning, but as Mr. Cleland said,
then all this evidence starts flowing in. You've got a law on
the books that would suggest to me that the procedures should
have changed over time. Did they?
Mr. Andrews. Senator, I do not know how our procedures
changed over time but I do want to make, point out one thing
that if my testimony in any way was misleading, is we, at this
point, have one item that came to our attention in November
that we have reported to the audit committee under 10A, as
required. We do not know if that was an illegal act or not. So
at this point in time we do not know if we have any illegal
acts at the company.
Senator Wyden. Let's continue to go through the law. The
second part of the law goes right to the heart of what all of
my colleagues are talking about. These related party
transactions are just a breeding ground for financial hide and
seek and conflicts of interest. The current law says that there
have to be procedures to identify related party transactions
that are material to the financial statements. What procedures
did you have so as to again identify those related party
transactions early on as Mr. Cleland is talking about?
Mr. Andrews. Senator again, our audit procedures
incorporated the audit steps, if you will, to identify related
parties and to discuss related parties and to see that related
party transactions, that the company disclose those related
party transactions in accordance with generally accepted
accounting principles. The responsibility for related party
transactions, first to identify them and to disclose them, is
foremost the company's and it's our responsibilities as
auditors to do appropriate auditing procedures related to that.
Again, a related party transaction is not wrong as long as it's
accounted for, approved properly and disclosed.
Senator Wyden. Well, again, it just seems to me that at
this point there is just the vaguest, most skimpy information
out there about these partnerships and if you look at section
two of this law that John Dingell and I wrote, it sure looks to
me like there wasn't a whole lot of disclosure of those related
party transactions.
Now the third part of the law says that when illegal acts
occur or may have occurred, you're supposed to bring it to the
attention of the authorities. You've described bringing it to
the attention of the authorities years after the warning lights
should have gone off. Years after the warning lights should
have gone off. Why did that happen?
Mr. Andrews. Senator, the particular transaction that
you're referencing, again if I have in any way been unclear on
that, that was a transaction that was entered into a few years
ago in which we did not have, the company did not provide us
with all the information to reach the right conclusion on that
transaction. It was actually November, early November of 2001
that upon a request for additional information that the special
committee of Enron's board had, we got a package of information
that contained information we did not previously receive when
that transaction was recorded. When we got that information, it
was, it was crystal clear to us that the accounting for that
transaction had been incorrect and within twenty-four hours we
took that information to the audit committee and asked that the
company appropriately investigate it and report those findings
back to us so that we could consider then our responsibilities
beyond that.
Senator Wyden. Well again, it just looks to me that the
firm moved after all the horses were out of the barn, and we
wrote a law that was designed to have the firm move years and
years earlier. Now let me, because time is short, ask you about
just a couple of other matters.
It's my understanding that Andersen served not only as
Enron's in-house auditor, but also as the outside auditor as
well. So in effect, it looks to me like Andersen is auditing
its own work. Do you think that's appropriate for an internal
in-house auditor to also serve as the outside person?
Mr. Andrews. Senator, in the case of Enron we did not audit
our own work and we certainly concur that we should not audit
our own work. What we did at Enron, actually our services that
are referred to as internal audit services, are actually part
of the external audit fee that, part of the $25 million. We
rendered two reports on Enron. One is a financial statement
audit, if you will, the opinion on the financials, and the
second is a report on internal controls, which many have
advocated. That's actually, that responsibility is codified
under the AICPA guidelines, so that's an external audit
activity. The only internal audit activity we did in 2000
really related to a request that Enron asked us to review a
system, the controls around the system, that another big five
firm had actually installed.
Now prior to 2000, in the 1994 to 1998 period, we did
perform internal audit services for Enron. But beginning in
1998 they rebuilt their internal audit department and since
that time what we have done is really render those two reports,
which are external audit activities and occasionally, when they
would request it, we would do additional services. But we do
not, we do not audit our own work.
I certainly concur with your statement that it's
inappropriate for an external auditor to audit its own work.
Senator Wyden. This is eye-glazing stuff, you know, Mr.
Andrews. I mean, I sat through thirty accounting hearings and I
saw just how this is sort of like prolonged root canal work.
But I will tell you, at the end of the day, people get hurt
when auditing firms take years to do what that law, which went
into effect several years before all of this went on, could
have brought to light.
Now let me ask you about a couple of other matters. In
testimony before the House the CEO of Andersen said it wasn't
clear why relevant information about one of the big special
partnerships was not provided to you. Under the Financial Fraud
Disclosure Act who bears the responsibility for obtaining the
relevant information?
Mr. Andrews. Well Senator, as an auditor we expect all
relevant information to be provided to us. In the case of these
transactions we believe that it's quite clear what relevant
information would be appropriate for us to review as well as
for the company to review. In this case, we don't know why, as
he stated in his testimony, as I did today, we do not know why
we did not have a component of that relevant information.
Again, when it came to our attention, we reacted instantly to
take the appropriate actions under, under 10A.
Senator Wyden. But again, under the law, shouldn't you have
been bearing down to get that relevant information? I mean,
what I am struck by is that, and I am sure we're going to run a
lawyer's full employment program and argue about this for some
time, there may have been a technical compliance here, but all
of this seems to me to be maneuvering that is different than
what the Congress intended when we passed that law. When we
passed that law it said you had to have all the relevant
financial information. I don't know how you certified the
accuracy of their books for years and years. How could you have
certified the accuracy of their books when you couldn't get the
information?
Mr. Andrews. Well Senator, obviously we do not know what we
do not know. We did not realize in this particular case, in
this one transaction, we did not realize that we did not have
the information. Again, an audit looks at a sample of
transactions, does not audit every transaction, and it is our
professional responsibility to do that. And when we obtained
the information, we reacted to it as required under 10A.
Senator Wyden. The point really is that the law changed,
Mr. Andrews. The law changed when we passed the law to detect
and disclose financial fraud on the books. But you all are
acting like very little has changed. When you say we did not
know what we did not know, the whole point was when you saw
suspicious activity you were supposed to set off the red
warning lights. The watchdogs were supposed to wake up from
their slumber and get it to the attention of the proper
authorities and it just seems to me, in this case, years were
taken before that was done. I thank you Mr. Chairman.
Senator Dorgan. Senator Wyden, thank you very much. You are
raising questions about an area that is critically important.
In fact, the number of restatements of earnings, very
substantial restatements of earnings, in this country today
ought to cause alarm here in Congress and across the country. I
do not understand how, what can happen after the fact is for
the best minds in the country could say: oh, we made, we made a
mistake of $100 million or a half a billion dollars. It's
happening all too often and maybe is the subject of another
hearing at another time. Senator Fitzgerald.
Senator Fitzgerald. Thank you, Mr. Chairman. Mr. Cleland, I
wanted to thank you for your testimony. I thought it was superb
and I would like to work with you implementing some of your
recommendations.
Mr. Cleland. Thank you Senator.
Senator Fitzgerald. And thank you for being here today. And
Mr. Andrews, I want to compliment your firm for having the
courage to come before our Committee and take your lumps. I
think you are being very forthright here in doing so. I would
have to say too that it really appears to me that your
restatement of the earnings seems to have caused Enron
ultimately to go into collapse, because once the earnings got
restated then people--creditors--really started questioning the
company and then it evolved into a liquidity crisis where they
couldn't get more credit and they couldn't keep going forward
without filing bankruptcy, and I think actually, your forcing
them to restate their earnings brought this whole thing to
light ultimately.
Now you did earn a lot of fees from Enron but I guess I
would want to ask, what are the overall fees that Arthur
Andersen earns in a year and what percentage would $52 million
that Enron paid you last year, what percentage of your total
revenues for the firm would that be?
Mr. Andrews. Well, our firm is approximately a $10 billion
business, so $52 million into $10 billion would be the relative
size of that.
Senator Fitzgerald. It wouldn't seem that it is really a
sizable fraction of your overall revenues and so, I guess it
would be hard for me to put all the blame on your firm because
it is hard for me to believe that your firm, because of that
$52 million, would have been compelled to cover up things in
Enron's financial statements and risk your whole firm.
Mr. Andrews. I think, Senator, I think that's an excellent
point. I'd like to comment on that and also one comment on the
restatement if I could.
We are confident we are independent of Enron and I think
the illustration that you just cited is an example of why I
think the public should be confident that we are as well. But
we are independent and our team performed professionally.
As it pertains to the restatement, I want to make sure I
clarify actually what took place there. We of course audited
Enron. The last audit we actually did was December 31, 2000. It
was subsequent to the third quarter of 2001, of course, which
we have not audited, that Enron concluded it would restate its
prior year statements.
We really, at this point, have not audited the restatements
and, in fact, we have withdrawn our opinion on the prior
restatements. So it's really Enron's restatement, and actually,
that occurred in early November, 2001 and really was not part
of the October 10Q at that point. It was filed actually in
November, 2001 but we have not audited those restatements.
Senator Fitzgerald. I guess I have a question in my own
mind, Mr. Cleland. Say that all of these SPE transactions had
been properly disclosed since 1997 through the future. I guess
all these analysts out there, my suspicion is, would still have
had buy recommendations on the stock. When you look at the
annual report of Enron and see pages and pages and pages of
their subsidiary corporations, 3,000 of them, and then they
have I don't know how many of these SPEs, you have an
impenetrable financial statement, that only maybe a handful of
people in the country with Ph.Ds in accounting would even have
the slightest possibility of understanding.
And whenever you see stuff like this, at least in my own
mind, growing up as I did in a banking family, my father was a
small town community banker, if he ever saw something, somebody
came into him with a deal he could not understand, he said bye-
bye. He stayed away from anything that he could not understand.
Well, I think the fact of the matter is that you had
bankers that were lending to Enron, we have some big banks,
Citibank, JPMorgan Chase or, I have got to be careful, I am not
sure. I know Citibank was involved with over $500 million in
unsecured debt here. I wonder how many of the people at
Citibank even understood these financial statements. You had
analysts all over the country pumping the stock, and I do not
know that greater disclosure somewhere in the bowels of these
10K or 10Q's would have made any difference.
Mr. Cleland. You're exactly right. See, the problem isn't
whether it's disclosed, it's that you want some part of the
system to be totally aligned with investor interests. So
essentially, they are paid and have the responsibility and earn
an income for finding these things, and right now, we did a
survey earlier in the year where 95 percent of the Wall Street
Journal's top research firms had investment banking conflicts
of interest.
So all the brand names that everybody comes to understand
have these conflicts of interest. So, and also they all say
well, everybody does it, so how can it be wrong? Well, it's
only when you look at it in totality and you realize that
virtually all the research is done from a company perspective,
no one's checking their work. No one is assuming that there
might be something wrong. And no one is paid by the system to
assume something's wrong. We're a small firm. We're focused on
that. We're aligned totally with investor interests and in a
telecom text base, we do spot these things.
Senator Fitzgerald. Well, do you think we should require
analysts be separate from the investment banks or how would
they get paid? Who would pay for the services?
Mr. Cleland. I think, you know, I am not a pro-regulatory
guy in this. I think what you need to do is fix the system
which is commingled. If you put banking, trading and research
chits all in the same till, the one that has the most profits
and the one that generates the most, they rule the house.
And so, a very simple thing you all could do, and this is
not very regulatory, is what we're suggesting is say trading
should be trading. That's what best execution is all about in
our system and banking, we have all sorts of banking rules that
say the banking commissions need to be a certain way. We have
very little that says we want to encourage research to be
research, because until you allow research to be paid for just
research, you're not going to have very much of it, because if
it's commingled, the bankers go, no, no, no, we don't want that
kind of research because that research might make a stock go
down. That is not in our interest.
And so, the best research execution would be a good idea.
If you want to have a disclosure, you could also have a
disclosure where public companies would have to say what type
of research are they using? Maybe not specifically, but in
general. Are they buying conflicted research or they're buying
independent research.
Senator Fitzgerald. And you also believe, and this is my
final question, you also believe that auditors should not be
able to provide consulting services for their auditing clients?
Mr. Cleland. I think that auditing is such a public trust,
just like working for the government is such a public trust,
that there needs to be a higher standard and auditors ought to
be auditors, just like tax examiners should be tax examiners.
We wouldn't want IRS guys moonlighting on the side. We don't
want a judge moonlighting on the side for somebody they might
be judging. I think it's common sense. It begs problems if you
have conflicts of interest.
Senator Fitzgerald. Now, Mr. Andrews you don't agree with
that and generally the big accounting firms don't agree with
that, is that correct?
Mr. Andrews. Well, that is correct. I mean, there are rules
that guide what we can do and what we can't do, and we
certainly are very responsive to abiding by those rules. I will
say that, as I've said in my statement, we're very open. We
think we have a responsibility, the profession has a
responsibility, Andersen has a responsibility to restore public
trust. So we recognize that reform is needed in both the
regulatory process and the disciplinary process and we're open-
minded as to what that reform could be.
I think we have to look at it in its total context and if
it does two things I think we would be receptive to considering
any changes. Those two things are: Does it in fact build and
restore public trust and does it improve the quality of audits?
And if we can achieve those two objectives, we certainly are
open to consideration of a variety of alternatives, but we do
believe they should be looked at in the total context.
In the Enron situation, we did not have a conflict of
interest, we were independent and I believe our team did its
professional job.
Senator Fitzgerald. Thank you.
Senator Dorgan. The Senate will begin two votes at 12
o'clock. Those votes will last a period of time, so that means
we have about another half an hour here before we are going to
have to go and vote. I very much want to hear the other three
witnesses and Senator Wyden has a brief question prior to
asking the other witnesses to come forward.
Senator Wyden. Just one question. It sort of sums it up for
me, Mr. Andrews. Enron's board was allowing all of these
partnerships and all of these exotic financial entities that
were basically keeping the debt off Enron's books. That's what
it did, kept the debt off Enron's books. What was Arthur
Andersen doing during this whole period? This went on for
years. Again, it goes right to the question of why there
weren't any warning lights blaring?
Mr. Andrews. Well, Senator I think it runs to the basic
issue of, you know, why do entities like SPEs, why are there
rules within generally accepted accounting principles that
allow, not only allow, but require compliance as to where an
investment is or isn't. Is it on the books or is it off the
books? Is the debt on the books or off the books?
Those rules are the rules that exist within generally
accepted accounting principles. Neither the company nor
ourselves have the luxury of deciding which of the rules we
will follow. Those rules are there and I think your point is,
all right, as I listen to it, is that those rules are unclear
and un-complex and perhaps don't result in the disclosure that
you would like to see.
Senator Dorgan. Mr. Andrews, time will tell whether those
rules were bent or broken. I find it hard to believe that
somehow it's operating within the rules to have a CFO of a
company be involved in off-the-books partnerships with a
financial stake in them, making $30 million a year on
commissions. I think that is a preposterous situation. It's
full of conflict, and I think a lot of folks in this country
get hurt. They lose their life savings as a result of it and
Senator Wyden's inquiring, as I think most of America would
inquire about, where were the watchdogs and where were the
auditors?
Your appearance is appreciated. Some have chosen not to
appear. Your company has. We appreciate that. We, as I have
indicated, will have another hearing on February 4th. Mr. Lay,
we are told, will be available to testify at that hearing. We
will ask Mr. Skilling and Mr. Fastow to be present as well.
Mr. Cleland, we would like to be in further touch with you.
Mr. Cleland. Thank you.
Senator Dorgan. I appreciate your testimony. I think it is
very valuable to us, and we will excuse both of you and ask the
three final witnesses to come forward.
We are asking Mr. John Coffee, Adolf Berle Professor of Law
at Colombia University to come forward, Mr. Bill Mann, Senior
Analyst of The Motley Fool, and Mr. Damon Silvers, Associate
General Counsel of the AFL-CIO.
Let me say that I appreciate your patience and your
willingness to be with us during this period. If you will come
forward. I want to get your testimony before we break in order
to vote, because that will take a block of time and I think you
have waited some lengthy period of time already this morning.
Mr. Coffee, you are a Professor at the Columbia School of
Law.
Mr. Coffee. Actually this semester I'm a Professor at
Harvard Law School. I just want to make the dean happy by
indicating that I'm a visiting professor there this semester.
Senator Dorgan. I see. So you're not exactly disavowing
Columbia, you're simply giving credit to Harvard.
Mr. Coffee. I'll go back to Columbia in January. I'm very
loyal to Columbia.
Senator Dorgan. Both schools have now profited from this
public disclosure.
[Laughter.]
Senator Dorgan. We appreciate you being with us, Mr. Coffee
and why don't you proceed.
STATEMENT OF JOHN C. COFFEE, JR., ADOLF A. BERLE
PROFESSOR OF LAW, COLUMBIA UNIVERSITY SCHOOL OF LAW AND JOSEPH
FLOM VISITING PROFESSOR OF LAW, HARVARD UNIVERSITY LAW SCHOOL
Mr. Coffee. Well, when a debacle like Enron occurs, the
critical question for Congress and for regulators is to ask, as
you have been beginning to ask, where were the gatekeepers?
Where were the watchdogs? By gatekeepers I mean the independent
professionals whose job it is in American corporate governance
to analyze, verify and examine the financial statements and the
financial transactions that the company is engaged in. That's
both the auditors, the audit committee, the securities analysts
and the bond rating agencies.
Here all failed, and all failed fairly abysmally. This is a
pathological symptom. Now I do not want to overstate, I do not
purport to know whether Enron's auditors were complicit in
securities fraud. I think no one can tell at this stage,
there's not enough information and frankly I would be quite
surprised if we have a case of outright fraud. But I do know
that this is a case in which all the earmarks and symptoms are
present of a gatekeeper who was too conflicted to be an
effective watchdog on whom investors can confidently rely.
Arthur Andersen just told you they made an error in
judgment and I'm not accusing them of more than that, but I
will say that there are more errors of judgment made when
you're subject to serious conflicts of interest.
Rationalizations are much easier, particularly in the very gray
world of accounting principles, which are seldom black and
white and which always give enormous amounts of discretion to
the professional gatekeeper.
We heard earlier that $50 million was not that big for
Arthur Andersen. But I should remind you that auditing firms
are a lot like law firms, Partners are compensated on what I'll
call an eat what you kill basis, and for the Houston office of
Arthur Andersen this was a very, very big client. In fact, it's
much more than a $50 million client because within the
profession of auditing today, the growth is not on the auditing
side, the growth is on the management advisory services side.
In their own literature, their own professional journals
tell them over and over again that auditing is a portal of
entry, a way to get inside the client and then market the much
more lucrative consulting services. So an Enron is really a
potential market of $100 or $200 million to a firm that's
auditing it, because they're looking at what the future growth
was if Enron had remained solvent, and that does create a
serious conflict problem.
Most importantly, this case is not unique. Accounting
irregularities are now alleged in the majority of securities
class actions that are filed each year. The old days of stock
drops and missed projections, they're gone. They can't be sued
anymore because the Private Securities Litigation Reform Act
has basically closed down that type of litigation. Enron is
really no different than Cendent, Sunbeam, HBOCMcKesson,
Livent, Mercury Finance, Waste Management, Rite Aid. All of
these were large corporations with real assets that managed
either to conceal shortfall in earnings for several years, or
to postpone cost recognition for several years. Enron is simply
the decimal point moved two times to the right but the same
underlining fact pattern. In Yogi Berra's phrase, it's deja vu
all over again.
Now the best evidence of this is ironically a study by
Arthur Andersen, which I think you may have been referring to
earlier. Arthur Andersen has reported this year that the number
of accounting restatements by publicly held companies has gone
up sharply over the last 3 years, and this is not anecdotal
data, this is significant data. In 1998 there were 158
accounting restatements of earnings by publicly held companies.
That's a lot. But last year that number was up to 233. That's
over a 2-year period. It's a 47 percent rise. Something is
going on behind that. What is happening? I want to offer two
generalizations, and I'll be brief on both of these. First of
all, the legal threat that auditors and accountants face for
securities fraud liability has sharply decreased over recent
years for a variety of reasons. It's partly the Private
Securities Litigation Reform Act. It's partly the preemption of
state litigation, and it's even more the Supreme Court's
elimination of aiding and abetting liability, because that's
traditionally what accountants were sued on--aiding and
abetting liability, and that was abolished by the Supreme Court
in a judicial decision.
Now, I'm not suggesting that the answer here is simply to
maximize the legal threat. I think there can be too much
liability as well as too little liability. But, the pendulum
has swung sharply, to the point today that auditors are very
uninviting targets. They do get sued, but the cases against
them usually are dismissed or they settle for fairly small
damages, except frankly, in these highly publicized cases--like
Enron may prove to be. That's trend one.
Trend two is the incentive to acquiesce and to defer to
management has increased as the accounting profession has
transformed itself from old-fashioned staid auditors into
complex, diversified, management advisory conglomerates, which
view, again, auditing as basically a point of entry, a
mechanism by which you can maximize cross selling and by which
you can use auditing as a kind of loss leader to market more
lucrative services. Very briefly, what can be done? I won't
take you through a detailed legal analysis, but I would suggest
there are two things that you should focus on.
One is the current auditor independence rule is inadequate.
How do I know that? Last year the SEC proposed a much, much
tougher rule that would have largely prohibited auditing firms
from marketing non-audited services to their audit client. The
SEC thought that was the right rule. The SEC got a fire-storm
of resistance and the SEC, under and aggressive and bold
chairman, who I great respect, was unable to get that rule
through. And he got, frankly, great resistance from Congress
and others.
I think the time has come to recognize that Chairman Levitt
may have been right. There has been, as he publicly said, a
decline in the quality of financial reporting, and that it is
partly attributable to both the game of earnings management,
which is fairly pervasive, and the conflicts of interests as
auditors have transformed themselves into diversified,
financial conglomerates.
I think we should go back and re-examine that rule. And,
that's an SEC rule, which is much easier to change than trying
to go back and pass legislation or, God forbid, re-examine the
Private Securities Litigation Reform Act, which was probably
the most controversial legislation that I've seen over the last
10 years. That's something that's manageable.
The other thing that I think can be done and should be done
is a serious system of industry self-regulation. Let me focus
on a basic contrast. I want to contrast the broker-dealer
industry and the auditing profession. Both involve firms that
specialize in human capital and professional services, broker-
dealer advice or auditing.
Broker-dealers are regulated by the National Association of
Securities Dealers, the NASD, a self-regulatory body subject to
some SEC oversight. That body is tough, independent, and since
it was reformed in the mid-1990's, I think a very effective
agency that is not a captive agency.
Last week, they and the SEC imposed over a $100 million
dollar fine on Credit Suisse First Boston. That's not the ear-
mark of a captive agency. They impose thousands of penalties on
broker-dealers every year, literally thousands. And, they
impose penalties that are not trivial.
In contrast, on the accounting side, we have the AICPA and
a byzantine, convoluted system of regulation. But, the one
thing it does not do is ever impose discipline. None of the
regulatory agencies, the AICPA, the Public Oversight Board, or
any other agency of that sort, is empowered to impose
discipline. That's delegated down to the states where very
little happens. Enron is not a local problem. It's a problem on
a national level and we need a national, self-regulatory body.
Ultimately, the choice for the accounting profession is
between developing on their own, with Congressional assistance
and Congressional insistence on strong, independent directors--
so this wouldn't be a captive agency--a powerful, self-
regulatory agency that can impose real discipline, modeled
after the NASD which does work. Or, the alternative is that
over time in our common law system the courts will begin to
change the common law and impose much more punitive liability
through the tort system. That will take a long time. It won't
benefit any of the investors that were here today who are going
to receive nothing, frankly. But, the choice for the industry
is serious self-discipline or expect that over time the tort
system will gradually change the rules and we'll have
discipline through the class action.
Of the two, I would say that intelligent self-regulation
would be the far more sensible, far shrewder answer, if the
industry, pushed by Congress, were to pursue that. Thank you.
[The prepared statement of Mr. Coffee follows:]
Prepared Statement of John C. Coffee, Jr., Adolf A. Berle Professor of
Law, Columbia University School of Law and Joseph Flom Visiting
Professor of Law, Harvard University Law School
The Enron Debacle and Gatekeeper Liability:
Why Would the Gatekeepers Remain Silent?
The sudden and unexpected bankruptcy of Enron has generated
understandable concerns about our system of corporate governance--and,
in particular, about the integrity of financial reporting systems.
Although publicly held companies in the United States are subject to
uniquely high disclosure obligations, the Enron example shows that the
much vaunted transparency of the American securities markets can
sometimes prove illusory and that sometimes very material information
can be concealed behind opaque accounting.
When this happens, the inevitable question arises: Why didn't the
gatekeepers stop them? By ``gatekeepers,'' I mean the independent
professionals who verify and analyze the disclosures of publicly held
companies. These include the corporation's outside auditors, the
securities analysts that follow its stock, and the bond rating agencies
that review its bonds. Because these professionals have considerable
reputational capital, which can be damaged by involvement in a
corporate fiasco, because they face the prospect of legal liability for
securities fraud, and because they have much less incentive to lie or
acquiesce in fraud than do the corporate insiders, gatekeepers are the
primary safeguards on whom investors rely to assure that accurate and
meaningful disclosures reach the market. Yet, in the Enron case, all
these protective mechanisms failed: the accountants certified financial
statements that overstated Enron's financial results by over $500
million; the security analysts continued to recommend Enron's stock (in
some cases with a ``strong buy'' recommendation) right up to virtually
the moment of Enron's bankruptcy filing, and the credit rating agencies
did not detect that Enron's off-balance sheet financing hid very high
leverage.
Who is to blame? It would be premature at this point to even
attempt to attribute responsibility. Possibly, Enron's auditors were
deceived, and possibly they may have been lax and acquiescent. One
simply cannot conclude from the outside on the evidence now available.
What can be said, however, is that the Enron case does not stand alone.
In particular, cases involving accounting irregularities have
proliferated over just the last several years. Some of these cases have
made it to the front of the business page and the nightly T.V. news:
Cendant, Sunbeam, HBOCMcKesson, Livent, Mercury Finance, Waste
Management, and Rite Aid.\1\ Some of these cases have resulted in
criminal prosecutions and convictions, others in SEC enforcements
proceedings, and all in large settlements of private class actions. The
increase in accounting irregularities is not simply an anecdotal
impression. A study by Arthur Andersen has found that the number of
restatements of earnings by publicly held companies has risen steadily
and dramatically over the past four years from 158 in 1998 to 233 in
2000--or, a 47% increase over this brief period.\2\
---------------------------------------------------------------------------
\1\ A fuller list of recent ``accounting irregularity'' cases can
be found in Michael Young, ACCOUNTING IRREGULARITIES AND FINANCIAL
FRAUD: A Corporate Governance Guide (2000).
\2\ See Jonathan Glater, ``Flood of Lawsuits Puts Underwriters in
Cross Hairs,'' New York Times, December 2, 2001 at Section 3, p.4.
---------------------------------------------------------------------------
That corporate insiders will sometimes commit fraud and suppress
adverse information is not terribly surprising. After all, they benefit
from it. That securities fraud escapes the attention of the
professional gatekeepers may be more surprising--and alarming. Yet,
former SEC Chairman Arthur Levitt concluded in a famous 1998 speech
that there had been ``an erosion in the quality of earnings and
therefore the quality of financial reporting.'' \3\ Specifically,
Chairman Levitt focused on a variety of what he termed ``accounting
gimmicks'' that enabled companies to exploit the flexibility of
accounting rules to obscure actual financial results and risks. Since
the time of that 1998 speech, a small library of academic and empirical
studies of the phenomenon of ``earnings management'' have been
published, most of which confirm that earnings management is
pervasive.\4\ During his tenure, Chairman Levitt made accounting reform
a major priority, and, the SEC formulated a series of new accounting
rules and interpretations during the late 1990's, to restrict earnings
management; it also established a ``blue ribbon panel'' to improve
audit committee performance and persuaded both the NYSE and Nasdaq to
adopt its recommendations. Finally, in a bruising battle with the
accounting profession, the SEC revised its critical rule on ``auditor
independence.'' All of these measures were to varying degrees
controversial, and the last--the SEC's proposed auditor independence
rule--proved to be politically unobtainable, as the Commission was
forced to accept a considerably weaker compromise that left auditors
free to engage in most forms of consulting work for audit clients.\5\
---------------------------------------------------------------------------
\3\ See Arthur Levitt, ``The Number Game,'' Sept. 27, 1999 (`Speech
Given at NYU Center for Law and Business).
\4\ Many of these studies are available on the SSRN Electronic
Network. See, e.g., Mark Nelson, John Elliott and Robin Tarpley,
``Where Do Companies Attempt Earnings Management, and When Do Auditors
Prevent It?'' (SSRN no. id= 248129, October 22, 2000).
\5\ The final Commission rule is set forth in Securities Act
Release 33-7919 (November 21, 2000). An earlier and tougher rule was
proposed in Securities Act Release No. 33-7870 (June 30, 2000).
---------------------------------------------------------------------------
Nonetheless, the Enron episode and the general increase in
accounting restatements suggests that the SEC may not be winning its
war against accounting irregularities. What could explain this apparent
decline in the quality of financial reporting? A good case can be made
that both (1) the legal threat confronting the auditor has been sharply
reduced over recent years by a series of recent judicial and
legislative developments, and (2) the incentives for the auditor in
acquiesce in questionable accounting practices have grown, as the
nature of the industry has changed. I do not suggest that this
hypothesis has been proven beyond a reasonable doubt or that it fully
explains the Enron debacle, but I do suggest that Congress should be
aware of these developments and not view Enron as an exceptional case.
Enron is different only in that it is larger. Otherwise, it is in Yogi
Berra's immortal words ``deja vue all over again.'' Both the diminished
threat facing auditors and their increased incentive to acquiesce are
briefly reviewed below.
A. The Diminished Legal Threat
Auditors have long been subject to suit under Rule 10b-5 when they
certify that the financial results reported by an audit client comply
with generally accepted accounting principles (``GAAP''). Indeed,
auditors are named as defendants, in the majority of securities class
action lawsuits filed in recent years.\6\ To prevail in such a suit,
however, the plaintiffs must demonstrate not only that a materially
false statement was made by the auditor, but that the auditor acted
with the requisite ``scienter''--that is, a mental state embracing both
an intent to defraud or a reckless indifference to the truth or
accuracy of the statement made. The term ``scienter'' is defined
somewhat differently in different federal circuits, but the prevailing
definition defines scienter as:
---------------------------------------------------------------------------
\6\ See Glater, supra note 2.
``A highly unreasonable omission, involving not merely simple,
or even inexcusable negligence, but an extreme departure from
the standards of ordinary care, and which presents a danger of
misleading buyers that is either known to the defendant or so
obvious that the actor must have been aware of it.'' Sunstrand
---------------------------------------------------------------------------
Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1987).
The scienter requirements has long been a primary defense for
accountants in securities fraud litigation, who can escape liability if
they can convince the fact finder that they were merely negligent (even
if grossly so). But the protection of this defense has been recently
and greatly enhance by the following more recent developments:
1. The Enhanced Pleading Requirements of the Private Securities
Litigation Reform Act of 1995 (the ``PSLRA''). Under Section 21D(b)(2)
of the Securities Exchange Act of 1934, which added by the PSLRA, a
complaint in a securities fraud case must:
``state with particularity facts giving rise to a strong
inference that the defendant acted with the required state of
mind.''
In a Rule 10b-5 suit, this requires the plaintiff to plead with
particularly facts giving rise to a ``strong inference of fraud'' on
the part of the specific defendant. This pleading must be made at the
outset of the litigation before the plaintiff has obtained any
discovery. In practice, this provision is far more protective of
auditors than of other defendants. For example, in the Enron case,
plaintiffs can plead that the corporate officers at Enron withheld
material information in order to permit them to sell their large stock
holdings before the Enron market price collapsed. Evidence of such
insider sales may (if they are large enough in percentage terms)
satisfy the plaintiff's obligation to plead with particularity facts
giving rise to the requisite ``strong inference of fraud'' on the part
of Enron's insiders. But the same pleading cannot be made with respect
to the auditors, who by definition do not own stock in an audit client.
Although auditors may have been subject to conflicts of interest or may
have been pressured into accepting improper accounting presentations,
these facts will rarely be evident at the outset of the case. Hence,
the auditor benefits far more from this pleading requirements than do
other defendants, because the case against it must be dismissed if such
facts cannot be plead prior to discovery.
2. Proportionate Liability. Section 21D(f) of the Securities
Exchange Act of 1934, which was also added by the PSLRA, substituted
proportionate liability for joint and several liability as the normal
standard of damages in securities litigation. This change works
particularly to the advantage of auditors, who, even if culpable, are
usually much less so than members of management. As a practical matter,
an accounting firm now knows that, so long as its actual knowledge of
the fraud is not proven, its maximum exposure to damages has shrunk
from joint and several liability for 100% of the losses to a likely
much lower percentage, probably below 25%.\7\
---------------------------------------------------------------------------
\7\ There are two major exceptions to this generalization: (1) the
auditor is subject to ``joint and several'' liability if it made a
knowingly false statement, and (2) to the extent that a judgment
against another co-defendant is uncollectible, the auditor may be
required to pick-up a portion of that unsatisfied liability (up to 50%
of its original liability). This last point has special relevance in
the instant case, because Enron is insolvent and cannot be held liable.
---------------------------------------------------------------------------
3. Eliminating RICO Liability for Securities Fraud. The PSLRA also
ended the use of the private civil RICO statute as a means of seeking
treble damages in securities fraud cases. Where once a RICO claim was a
standard feature in securities class actions, because it increased the
potential damages by a factor of three, the PSLRA denied plaintiffs the
ability to assert a RICO claim in any case that could have been pled as
a securities fraud claim in connection with the purchase or sale of a
security.
4. Aiding and Abetting Liability. Even prior to the PSLRA, the
Supreme Court's decision in Central Bank of Denver, N.A. v. First
Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), eliminated
liability for aiding and abetting a securities law violation as a
potential cause of action that an auditor could face in private
litigation. This theory of liability had been the preferred weapon of
the plaintiffs' bar in Rule 10b-5 litigation against accountants,
because typically auditors aid the issuer in the preparation of its
financial statements (particularly its quarterly statements). Although
the SEC has regained the right to sue for some ``aiding and abetting''
violations pursuant to the PSLRA, private parties have not.
5. Preempting State Litigation. Although securities fraud
litigation in state court became a substantial risk for accountants in
the late 1990's, that risk was effectively ended in 1998 by the passage
of the Uniform Standards Act, which preempted class actions and certain
consolidated actions that assert causes of action, based on either
state law or the common law, that allege a misrepresentation or
omission of a material fact in connection with a purchase or sale of a
security.\8\
---------------------------------------------------------------------------
\8\ Section 28(f) of the Securities Exchange Act of 1934 precludes
any ``covered class action based upon the statutory or common law of
any State or subdivision'' that alleges ``a misrepresentation or
omission of a material fact in connection with the purchase or sale of
a covered security.'' A similar provision is set forth in Section 16(b)
of the Securities Act of 1933. Neither provision preempts an individual
suit, standing alone, but the term ``covered class action'' includes
any ``single lawsuit in which . . . damages are sought on behalf of
more than 50 persons.'' Hence, sizable consolidated actions are also
barred.
---------------------------------------------------------------------------
The bottom line is that, although litigation involving accounting
irregularities remains common, accounting firms themselves are unlikely
to be held liable for more than a nominal percentage of the losses--
except in cases where their behavior has been egregious.
B. Organizational Changes Within the Auditing Profession
Auditing firms have long marketed three general types of services
to their clients: (i) auditing, (ii) tax services, and (iii) management
advisory services. The last category--management advisory services (or
``MAS'')--has expanded dramatically over roughly the last decade in a
manner that has transformed the accounting firm from the traditional
firm of accounting professionals to a multi-disciplinary service
organization. In 1981, MAS accounted for only thirteen percent of the
Big Five's total revenues, but that figure has grown to fifty percent
or more by 2000.\9\ Over the period from 1993 to 1999, the average
annual growth rate for revenues from management advisory and similar
services has been twenty-six percent, while the comparable growth rates
for audit and tax services has been only nine percent and thirteen
percent, respectively.\10\ In short, MAS has been growing at roughly
three times the rate of the traditional audit service. Finally, in
1999, the U.S. revenues for management advisory and similar services
for the Big Five amounted to over $15 billion.\11\
---------------------------------------------------------------------------
\9\ See Securities Act Release No. 33-7919 at p. 18; see also
Securities Act Release No. 33-7870 (June 30, 2000) at Appendix 13,
Tables 1 and 2.
\10\ Id. at p. 18; see also Securities Act Release No. 33-7870 at
Table 1 in Appendix B.
\11\ Id.
---------------------------------------------------------------------------
A more ominous transition involves the relative balance between
audit fees and MAS fees. Not until 1997 did the percentage of audit
clients who paid MAS fees in excess of their audit fees to Big Five
firms exceed 1.5%.\12\ Yet, by 1999, this figure had grown from 1.5% to
4.6%--an over 200% increase in only two years.\13\ Moreover, average
MAS fees received by the Big Five firms came to ten percent of all
revenues in 1999.\14\ Today, for at least some audit clients, the
amount of non-audit revenues paid to their auditor already exceeds
their audit fee. At least in the case of these clients, intransigence
by the audit partner with regard to some ``aggressive'' accounting
treatment proposed by the client could expose the firm to the loss of
much greater non-audit revenues, which the client could presumably
purchase (or threaten to purchase) elsewhere.
---------------------------------------------------------------------------
\12\ See Securities Act Release No. 33-7870 at Table 3 in Appendix
B; see also Securities Act Release No. 33-7919 at p. 19.
\13\ Id.
\14\ Id.
---------------------------------------------------------------------------
The danger lies in where these trends are taking us. Not only are
non-audit revenues received by auditors from their audit clients
beginning to exceed audit fees from the same clients, but the SEC's
noted in its latest Release on auditor independence that some audit
firms may be pursuing a marketing strategy under which the firm ``low-
balls'' the audit fee (even offering to perform it at a loss) ``in
order to gain entry into and build a relationship with a potential
client for the firm's non-audit services.'' \15\ Once auditing becomes
a de facto ``loss leader'' for the multi-services consulting firm,
there is less reason for such a firm to resist questionable accounting
practices. To be sure, some threat of liability to third parties
remains, but in considering resignation, the auditing firm must now
balance the threat of liability against not only the loss of its audit
fees, but also the loss of far larger present and expected future non-
audit revenues from the client. Other things being equal, this implies
that the threat of liability (even if it were undiminished) would less
often be adequate to deter.
---------------------------------------------------------------------------
\15\ Securities Act Release No. 33-7919 at 27.
---------------------------------------------------------------------------
The Enron fact pattern again illustrates this shift in the source
of client revenues. According to press reports, Enron paid more to
Arthur Andersen in consulting fees during its last fiscal year than it
paid in audit fees. In addition, it paid over $50 million in total fees
to Arthur Andersen last year.\16\ Put simply, this is a very different
relationship that the traditional relationship between auditor and
client because historically no single client would have been
financially material to the auditor. Hence, the rational auditor would
not risk its reputation for an audit fee that was small in percentage
terms to its overall earnings. But, as the individual client becomes
material to the auditor, the auditor unfortunately becomes less
independent of its client.
---------------------------------------------------------------------------
\16\ Last year, Enron paid Arthur Andersen $25 million in audit
fees and $27 million for non-audit services. See Jerry Hirsch and
Thomas Mulligan, ``Auditors, Execs Target of Enron Creditors,'' Los
Angeles Times, November 30, 2001 at Part 3-1.
---------------------------------------------------------------------------
C. Implications
In sum, a credible story can be told that auditors today are
subject to less of a legal threat than a decade ago and are,
correspondingly, subject to a greater temptation to defer to management
with regard to questionable accounting policies. Whether this story
truly explains the Enron debacle is, of course, uncertain, and no
suggestion is here made that we yet know whether Enron's auditors did
acquiesce improperly (as opposed to being themselves deceived by
Enron).
But even if this story does fit the instant case, the policy
prescriptions that should follow from it are at least equally
debatable. The PSLRA was an intensely lobbied statute, and there seems
little likelihood that Congress would wish to repeal or seriously
modify its provisions. Even if the SEC's current auditor independence
rules seems inadequate, it also seems unlikely that the SEC will wish
to revisit it only a year after reaching a hard fought compromise with
the industry. Finally, reliance on class action litigation to
discipline auditors may not be the optimal remedy. Prior to the PSLRA,
the very solvency of some auditors was coming into doubt.
What other avenues of reform are then available? Here, a noteworthy
contrast can be drawn between the accounting industry and the broker-
dealer industry. Broker dealers are subject to close supervision and
professional discipline by a self-regulatory body--the National
Association of Securities Dealers (``NASD''). Nothing remotely
comparable exists in the convoluted structure of accounting regulation,
and professional discipline is rarely imposed.
In this light, the most conservative reform might be the creation
of a truly independent, self-regulatory body, modeled after the NASD
and with independent directors that did not come from the industry, to
monitor and enforce self-regulatory rules for the accounting
profession.\17\ Although the industry may not welcome such a
development, it represents far less of an intrusion into their affairs
than would any attempt to expose them to greater antifraud liability.
---------------------------------------------------------------------------
\17\ I have made a detailed proposal along these lines in an
article available on the Social Science Research Network (``SSRN'')
website. See Coffee, ``The Acquiescent Gatekeeper: Reputational
Intermediaries, Auditor Independence, and the Governance of
Accounting'' (May 21, 2001) (SSRN identification number = 270944).
---------------------------------------------------------------------------
Ultimately, the increasing frequency of accounting irregularities
faces the accounting industry with an unpleasant choice: implement a
serious and reliable system of self-regulation and professional
discipline or expect that the courts and/or Congress over time will
return to a system of punitive tort liability.
Sen. Dorgan: Professor Coffee, thank you very much. We
appreciate your testimony. Next we will hear from Bill Mann,
Senior Analyst with The Motley Fool. Mr. Mann, why don't you
proceed?
STATEMENT OF WILLIAM H. MANN, III,
SENIOR ANALYST, THE MOTLEY FOOL
Mr. Mann. Good morning, Mr. Chairman, I wanted to thank
you. I am William Mann from Motley Fool. It's not very often
that someone who purposely calls himself a Fool gets to address
the U.S. Senate. So, I am honored by the invitation. I'm sorry
about the situation about which I am testifying today. I have
listened to the testimonies in the first panel, as you all did,
and my heart bleeds for these people. They are innocent in what
will go down to be one of the largest, most destructive company
failures of all time.
Let me say at the outset, what was missing in the case of
Enron was skepticism. Individual investors, institutional
investors alike, piled millions of investment dollars into the
company. They were mesmerized by its rate of growth and
completely sold on what seemed to be an insurmountable business
advantage. Even though Enron emitted plenty of hints about
impropriety for several years, few people, from Wall Street
analysts to individual investors, stopped to ask the tough
questions. And that's one of the reasons we're here today. I'd
like to discuss some of those hints, the questions, and what I
believe is the mechanism that allowed Enron to fall through the
cracks.
The Motley Fool's message was not adopted in a vacuum. Our
founding was predicated on the fact that there was no one who
really had an incentive to tell people the truth about money
and their investments. Part of the reason that we began
teaching about the stock market was the amount of poor and
self-interested advice that was being given by brokerages and
their analysts. We believe that price targets and analyst
ratings are, frankly, things that are made with several masters
in mind, none of whom is the individual investor. In a similar
fashion, sell-side stock analysts are generally compensated
based on the overall profitability of their firms, not on the
quality or the accuracy of their analysis. In the end, analysts
have minimal structural incentives to be accurate in their
predictions; rather, their built-in incentive is to be as
favorable to the corporate clients as possible. It's a well-
worn joke that there apparently is no word as infrequently used
in Wall Street as ``sell.''
In the case of Enron, in September there were 17 analysts
who covered the company. Sixteen had a ``buy'' or ``strong
buy,'' one had a ``hold,'' and none had a ``sell'' or a
``strong sell'' rating. This was true after Enron's CEO
suddenly resigned and the stock had already dropped more than
60 percent in the year.
I don't want to blame Wall Street analysts for the Enron
implosion. The blame for the billions of dollars and the
hundreds of thousands investors have lost lies almost entirely
with the senior management of Enron. The problem lies in the
fact that these analysts have much greater incentive to focus
upon the positive of a company than to root out the risks and
the negatives. And, their employers value their ability to
generate investment banking business much more than they do
proper analysis.
I wish as a personal--as an individual investor, that I
could say that I'd sniffed out the trouble at Enron when I did
my analysis in 2000. I was really intrigued by this company. I
really didn't want to miss out on what I thought was a really
pretty spectacular growth story. But what I found in the
company's filings was just plain confusing to me, and there
were a few items that made me extremely uncomfortable. In
particular, Footnote 16 in the Form 10-K, under the heading
``Related Party Transactions,'' where Enron disclosed that it
had entered into a deal with LJM Cayman Corporation stating
that a senior officer in Enron is the managing member of LJM's
general partner.
When James Chanos, a famous short-seller, began asking
questions that needed to be asked about these statements, none
of the analysts followed up. When Enron routinely failed to
provide a balance sheet along with its earning releases for the
company conference calls, none of the analysts voiced much of a
complaint. Or, if they did, it was not reflected in the ratings
of the stock. Enron was a ``black box'' company, where no one,
not the analysts nor any of the institutional or individual
investors was really sure how the company made money.
There is no ``smoking gun'' with Enron. The financials look
great and even now there is no single item that we could look
back and say that's the ``tip-off'' that this ``company was
going to implode.'' However, the more important issue to my
mind is whether or not analysts have any incentive at all to do
the analysis and to ask these tough questions. It strains
credulity to say that, of the 17 analysts who covered Enron,
none of them had any idea that related party transactions could
be used to massage earnings or to hide debt. Enron's business
was complicated enough, its financials convoluted enough, its
disclosures opaque enough, and its sales growth spectacular
enough that there ought to have been some pointed questions
from analysts so that they could provide knowledgeable guidance
to their shareholding clients, which thus begs the question,
``Why weren't there?''
Goldman Sachs analyst David Maccarrone and David Fleischer
issued a report on October 24, 2001, following Enron's
conference call to address investor concerns. One of the quotes
in the report were as follows, ``Lack of Disclosure and
Transparency--A Longstanding Enron Hallmark.'' ``New disclosure
about related party transactions and structured off-balance
sheet transactions occurred some 18 months ago. . . .''
``However, an undercurrent of concern began and questions
remained unanswered. . . .'' ``We do not believe that
management has done anything wrong. . . .'' Despite a lack of
visibility and some pretty important risk factors, Goldman's
analysts continued to keep Enron on its ``recommended list,''
Goldman's highest rating.
At the same time, Lehman Brothers, covering Enron, put out
their own version of the conference call. He called it, ``an
inadequate defense of the balance sheet,'' but then concluded,
``despite the disappointing call we continue to think that the
stock should be bought aggressively at these levels.'' Lehman
Brothers also kept their highest rating on the stock.
I don't think analysts should be taken to task for being
wrong. In an environment where people are expected to take past
and current trends and predict the future, getting things wrong
would be an inevitable reality of the business. As Yogi Berra
once noted, ``It's hard to make predictions, especially about
the future.'' The issue here is that the analysts who were
covering Enron, despite the company's long-standing policy of
withholding key information, and despite knowledge of the fact
that there was an unknown level of debt being hidden from them,
remained nearly uniformly positive on the company until it was
clear the company would collapse.
Both Lehman Brothers and Goldman Sachs have provided
significant investment banking services to Enron. Both provided
financial services or sold or managed Enron commercial paper,
managed a public offering of the stock, all within the last 3
years. Additionally, a Lehman Brothers employee is an Enron
director.
Enron collapsed because its management got caught up
playing in Wall Street's estimates game, promising and
delivering big revenue and profit growth, regardless of the
debt and other balance sheet contortions it took to get there.
Looked at this way, the pursuit of hyper-growth seems to have
caused Enron's executives to take undue risks with shareholder
funds. Maintaining Enron's darling status in the investment
world apparently caused these same men to take the short walk
across the aisle from being aggressive with company assets to
being downright deceptive by hiding information individuals and
institutional investors must have to make good investment
decisions.
At The Motley Fool, our advice to investors is and has
always been to ignore the ``noise'' that comes from Wall
Street, and to treat any specific recommendations for stock
purchase with skepticism. We teach investors to think like
business owners, not renters or passive pushers of paper. It's
our genuine hope that investors seek to buy companies that they
truly understand and would be willing to hold for a lifetime.
If there's one lesson that individual investors must learn from
Enron, it is this: You must buy what you know. Enron's CEO Ken
Lay has admitted that he himself did not fully understand the
inner workings of Enron, and we can assume that he at least had
all the information. Even with full disclosure, Enron would
have been a tough company for the majority of all investors to
understand. The company was unapologetic in its refusal to
provide information about its equity and debt structures for
many years before it actually blew up. My hope is that
investors take the lesson offered by Enron and remain healthy
skeptics in the future.
There's a simple calculus that investors use in valuing a
company. A company is fairly valued by all of its future
profits, discounted for risk. Obviously, the greater the risk
to profits the higher the discount should be; and the less
valuable every expected dollar of future profits would be right
now. Over the last twelve months, 233 companies have had to
restate their earnings. And not surprisingly, none of these
restatements have made the company's operating results look
better. Getting away with falsifying earnings over a long
period of time is difficult. It is much easier to falsify
levels of risk, and this in the end is what Enron, and by
extension its auditors and analysts, have done--by commission
or omission.
We hope to see that the work that has been done by the SEC
and Congress to implement improvements, such as Regulation Fair
Disclosure, will go even further to ensure that individual
investors are protected. Thank you for your attention and I
look forward to the opportunity to answer questions.
[The prepared statement of Mr. Mann follows:]
Prepared Statement of William H. Mann, III, Senior Analyst,
The Motley Fool
Mr. Chairman, Members of the Committee, and esteemed guests:
Good Morning. I am William H. Mann, Senior Analyst for The Motley
Fool. As it is not often that a Fool gets the chance to address the
United States Senate, I am honored by the invitation to speak before
you today about Enron--an situation that will no doubt go down in
history as one of the largest, most destructive company failures of all
time.
The Motley Fool was founded in 1993 with a mission to educate,
amuse and enrich individual investors. Our work is driven by our belief
that average people--you and I--ought to take a more active interest in
our management of money. In order for individual investors to
effectively engage themselves, they need education about how the
financial system works, access to information, and opportunities for
open dialogue. That's what we provide. We teach people the fundamentals
of long-term financial management; we highlight online and offline
information resources for them; and we manage a 24-hour open network of
communication on the topic of money shared by people in more than 100
countries around the globe.
In addition, individual investors need to have trust in the
marketplace. Congress and the SEC have actively supported education
programs and disclosure practices that have helped to strengthen the
confidence that individual investors have in the public markets. One
statistic that should make us all proud is that while in 1990 less than
a quarter of all American households directly owned stocks, today that
number has grown to more than 50%.
Let me say at the outset that what was missing in the case of Enron
was skepticism. Investors--individual and institutional alike--piled
millions of investment dollars into the company, mesmerized by its
growth rates, and completely sold on what seemed to be an
insurmountable business advantage. Even though Enron emitted plenty of
hints of impropriety for several years, few people, from Wall Street
analysts to individual investors stopped to ask tough questions. I'd
like to discuss those hints, the questions, and what I believe is the
mechanism that allowed an Enron to slip through the cracks.
The Motley Fool's message was not adopted in a vacuum. Our founding
was predicated on the fact that there was no one who had an incentive
to tell people the truth about money and their investments. Part of the
reason that we began teaching about the stock market was the amount of
poor and self-interested advice that was being issued by brokerages and
their analysts. To this day, the majority of stockbrokers are
compensated on the number of trades their customers make, not on the
returns they generate for them or on the quality of the advice they
provide. We believe that the price targets and analyst ratings are made
with several masters in mind, none of whom are the individual investor.
In a similar fashion, sell-side stock analysts are generally
compensated based upon the overall profitability of their firms, not
the quality or accuracy of their analysis. In the end, analysts have
minimal structural incentive to be accurate in their predictions;
rather their built-in incentive is to be as favorable to their
corporate clients as possible. It is a well-worn joke that there is no
word as infrequently used on Wall Street as ``sell.''
An April 1999 speech from U.S. Securities & Exchange Commission
Chairman Arthur Levitt cited a study that found sell recommendations
account for just 1.4 percent of all analysts' recommendations, compared
to 68% of all recommendations being buys. In the case of Enron, in
September there were 17 analysts who covered Enron, and of them, 16 had
a ``buy'' or ``strong buy'' rating, one had a ``hold,'' and none had a
``sell'' or a ``strong sell''. This was true after Enron's CEO, Jeff
Skilling, suddenly resigned, and the company's stock had already lost
some 60% of its value from its high of the year.
I do not wish to blame the Wall Street analysts for the Enron
implosion. The blame for the billions of dollars that hundreds of
thousands of investors lost lies almost entirely upon the senior
management of Enron. But Enron was playing a game that is utterly
corruptible in ways that are not transparent to retail investors, and
the playing field is dominated by Wall Street firms, their analysts
serving as the public face. I submit that every single gross mis-
pricing in equities over the last decade has come with analysts
cheering it on the way up and maintaining silence as it dropped. I use
the word corruptible because, for all of the exhortations of The Motley
Fool that investors ignore analyst ratings, there can be no question
that people remain deeply influenced by them. The problem lies in the
fact that analysts have a much greater incentive to focus upon the
positive of a company than to root out the risks and the negatives, and
their employers value their ability to generate investment-banking
income much more than they do proper analysis.
I wish that I could say that I had sniffed out trouble at Enron
when I did my analysis in 2000. I was really intrigued by the company,
and did not want to miss out on what already was a spectacular growth
story. But what I found was just confusing, and there were a few items
that made me uncomfortable. In particular, Footnote 16 in their 2000
Form 10-K, under the heading ``Related Party Transactions,'' where
Enron disclosed that it had entered into a deal with LJM Cayman
Corporation, stating that ``A senior officer of Enron is the managing
member of LJM's general partner.'' Under Generally Accepted Accounting
Practices, disclosing a related party transaction is properly done in
this fashion. However, related party transactions are also a method
that companies use to ``groom'' their financials, so I would generally
insist upon a high level of disclosure for the risks and benefits to
shareholders that such a transaction would provide. Related party
transactions are ideal vehicles for companies to hide risk, to get
debts off of the balance sheet by using Special Purpose Entities
(SPE's).
In Enron's case, the disclosures were minimal. When James Chanos, a
famous short-seller, began asking questions that needed to be asked
about these statements, no analysts followed up. When Enron routinely
failed to provide a balance sheet along with its earnings releases for
company conference calls, none of the analysts voiced much complaint,
or if they did, it was not reflected in their ratings of the stock.
Enron was a ``black box'' company, where no one, not the analysts nor
any of the institutional or individual investors was really sure how
the company made money.
There is no ``smoking gun'' with Enron. The financials looked
great, so even now there is no single item that one can look at and
say, ``that was the tip-off,'' or ``there is the sign that the company
was going to implode.'' However, the more important issue is whether or
not analysts have any incentive at all to do the analysis and to ask
the tough questions. It strains credulity to say that, of the 17
analysts who covered Enron, that none of them had any idea that Related
Party Transactions could be used to massage earnings or to hide debt.
Enron's business was complicated enough, its financials convoluted
enough, its disclosures opaque enough, and its sales growth spectacular
enough that there ought to have been some pointed questions from
analysts so that they could provide knowledgeable guidance to their
shareholding clients. Which thus begs the question, ``Why weren't
there?''
Goldman Sachs analysts David Maccarrone and David Fleischer issued
a report on October 24, 2001, following Enron's conference call to
address investor concerns. Some of the quotes in the report are as
follow ``Lack of Disclosure and Transparency--A Longstanding Enron
Hallmark.'' ``New disclosure about related party transactions and
structured off-balance sheet transactions occurred some 18 months ago .
. .'' ``However, an undercurrent of concern began and grew as questions
remained unanswered . . .'' ``We do not believe that management has
done anything wrong . . .'' Despite a lack of visibility into some
pretty important risk factors at Enron, Goldman's analysts continued to
keep Enron on its ``recommended list,'' Goldman's highest rating.
At the same time, the Lehman Brothers analyst covering Enron put
out his own version of the conference call. He called it ``an
inadequate defense of the balance sheet,'' but then concluded ``despite
the disappointing call we continue to think the stock should be bought
aggressively at these levels''. Lehman Brothers also kept their highest
rating on the stock.
I do not believe that analysts should be taken to task for being
wrong. In an environment where people are expected to take past and
current trends and predict the future, getting things wrong would be an
inevitable reality of the business. As Yogi Berra once noted, ``It's
hard to make predictions, especially about the future.'' The issue here
is that the analysts who covered Enron, despite the company's long
standing policy of withholding key information, and despite knowledge
of the fact that there was an unknown level of debt being hidden from
them in off-balance sheet SPE's remained nearly uniformly positive on
the company until it was clear the company would collapse.
Both Lehman Brothers and Goldman Sachs have provided significant
investment banking services to Enron. In the case of Goldman Sachs, the
company provided financial services, sold or managed the sale of Enron
commercial paper, and managed a public offering of its stock, all
within the last three years. Lehman Brothers, for its part, also
managed a public offering in Enron stock, plus a Lehman employee is an
Enron director.
These investment banking activities comprise a much larger
component of Lehman Brothers and Goldman Sachs revenues and profits
than do their retail brokering activities. Story after story in the
media have shown that these analysts are having their compensation much
more closely tied to the ability of their banks to provide these
investment banking deals. Morgan Stanley analyst Mary Meeker, for
example, had an ``outperform'' rating on all of the Internet stocks in
December 2000, though they were down by an average of 83% from their
highs of the year. The vast majority of these companies had received
investment banking services from Morgan Stanley.
JP Morgan's head of equity research, Peter Houghton, sent a memo to
the bank's equity analysts in March of this year stating that the
analysts were required to consult both the company concerned and
Morgan's investment banker before publishing research that regarded one
of Morgan's corporate clients.
This environment ought to call into question the integrity of
analyst research. The Enron collapse is neither the first nor the most
expensive loss of shareholder capital that came while analysts
maintained cheery ratings on a company. It's only by virtue of the fact
that the loss on Enron shares has approached 100% for shareholders that
made it the most noteworthy.
Lucent's struggles, although less apocalyptic so far, reinforces my
point about sell-side analysts' failings. In January 2000, Lucent
Technologies had a market capitalization well in excess of $240
billion. It was, by a significant margin, the most widely held stock in
America. You only needed to understand one simple principle of
financial analysis to see that trouble was coming for Lucent--namely,
that growth in inventory and accounts receivable should be no faster
than growth in sales. For four consecutive quarters in 1999, both
receivables and inventories at Lucent were growing at double, triple,
even four times sales. And yet, of the 38 analysts who covered Lucent
in January 2000, 32 had ``buy'' or ``Strong buy'' ratings on the stock,
6 had ``hold,'' and none had a ``sell'' rating. Many of these analysts
are employed by investment banks that had generated significant
revenues from Lucent's acquisition and debt placement activities. Not
one pointed out that the company's receivables or inventories were
skyrocketing. Lucent's weak balance sheet has nearly bankrupted the
company. This year it has laid off more than 60,000 employees, and in
the last 22 months more than $200 billion of market cap has been
erased.
Prior to January 2000, Lucent had never failed to meet Wall
Street's estimates. It would seem that this fact, not the convolutions
that Lucent needed to meet these estimates, was what was valued on Wall
Street. Those convolutions have conspired to nearly destroy the keeper
of Bell Laboratories, one of the treasures of American ingenuity.
Enron collapsed because its management got caught up in playing
Wall Street's estimates game, promising and delivering big revenue and
profit growth, regardless of the debt and other balance sheet
contortions it took to get there. Individual investors lost money, in
part, because analysts had limited incentives to look at the company's
financials with critical eyes. Management withheld key information from
shareholders, and then, even after the troubles came to light last
month, refused to answer questions about the nature of its deals with
partnerships that were controlled by Enron executives. Looked at in
this way, the pursuit of hypergrowth seems to have caused Enron
executives to take undue risks with shareholder funds. Maintaining
Enron's (and its managers') darling status in the investment world
apparently caused these same men to take that short walk across the
aisle from being aggressive with company assets to being downright
deceptive by hiding information individual and institutional
shareholders must have to make good investment decisions.
Enron's management walked the fine line between keeping analysts
happy and providing good information to their shareholders for years.
Then Enron's management apparently made the conscious choice to place
the appearance of high-profits, high-growth and low-risk--things held
dear by Wall Street--over proper disclosure of risks and realities to
their shareholders.
At The Motley Fool, our advice to investors is and has always been
to ignore the ``noise'' that comes from Wall Street, and to treat any
specific recommendations for stock purchase with skepticism. Meaning
that things such as one-year price targets, which are the language of
sell-side analysts, ought to be of no interest to an individual
investor. We teach investors to think like business owners, not renters
or passive pushers of paper. It is our genuine hope that investors seek
to buy companies that they truly understand and would be willing to own
for a lifetime. If there is one lesson that individual investors must
learn from Enron, that is: Buy What You Know. Enron's CEO Ken Lay has
admitted that he himself did not fully understand the inner workings of
Enron, and we can assume that he at least had all of the information.
Even with full disclosure, Enron would have been a tough company for
the majority of all investors to understand. The company was
unapologetic in its refusal to provide information about its equity and
debt structures for years before it actually blew up. My hope is that
investors take the lesson offered by Enron and remain healthy skeptics
in the future: when a company fails to treat shareholders as co-owners,
one should assume that those components which are hidden from view do
not contain good news.
Conclusion
There is a simple calculus that investors use in valuing a company.
A company is fairly valued by all of its future profits discounted for
risk. Obviously, the greater the risk to profits, the higher the
discount should be, and less valuable every expected dollar of future
profits would be right now. Over the last 12 months 233 public
companies have had to restate their earnings, and not surprisingly,
none of these restatements have made the companies' operating results
look better. Getting away with falsifying earnings over a long period
of time is difficult. It is much easier to falsify levels of risk and
this, in the end, is what Enron, and by extension, its auditors and the
analysts have done, by commission or by omission.
Individual investors have seen great strides in the level of
protection afforded in the U.S. stock markets over the last decade.
Information technology and the Internet went a long way toward making
public documents, including SEC filings, available at an instant to the
vast majority of shareholders. Regulatory improvements such as
Regulation Fair Disclosure have gone even further to ensure that
companies provide fair and equal access to information vital for people
to make investing decisions. We hope to see that work continued and
support all efforts to increase financial education in America.
In a pari-mutuel environment such as a stock market, where every
decision to buy, sell, or do nothing has a small effect on every other
participant in the market, there is little chance that anyone will be
able to provide absolute protection from bad information, whether
intentionally or accidentally disseminated. However, the markets are
built on trust, and there is a reason far beyond the power of American
commerce that causes more than 48% of the world's equity capital to be
represented here: investors the world wide know that their financial
interests are better protected in the U.S.'s relatively transparent
markets than in any other country on earth. It is in our best interest
to ensure that we eradicate corruption and keep our markets strong.
Thank you for your attention. I appreciate the opportunity to
address the Committee, and I would be happy to answer any questions.
Submitted for further consideration: *
---------------------------------------------------------------------------
* The information referred to was not available at the time this
hearing went to press.
---------------------------------------------------------------------------
10/24/2001 Goldman Sachs Research Report
10/24/2001 Lehman Bros. Research Report
3/21/2001 ``JP Morgan Reins in Analysts,'' The Times,
London.
11/30/2001 ``Enron as Icarus,'' by William Mann.
1/13/2000 ``Lessons From Lucent,'' by Matt Richey, Tom
Gardner and William Mann.
Comments from Individual Investors in Enron, submitted by
members of The Motley Fool Community.
Sen. Dorgan: Mr. Mann, thank you very much. And now we will
hear from Mr. Silvers. Mr. Silvers is Associate General Counsel
of the AFL-CIO. Mr. Silvers, welcome.
STATEMENT OF DAMON A. SILVERS,
ASSOCIATE GENERAL COUNSEL, AFL-CIO
Mr. Silvers. Thank you Chairman Dorgan, and thank you
particularly for the opportunity to appear here today with
Enron employee investors. It is truly an honor to share this
podium with them. The labor movement today is trying to do
everything we can possibly do to get the people who you saw
this morning their money back. I'm afraid that is a long shot,
frankly, but we are trying to do everything we can, and, also
to prevent another Enron.
We began this effort in early November when the AFL-CIO
wrote to Enron's board and frankly begged them to act, to get
responsible and respected people on the board and to make full
disclosure before it was too late. The letters we sent are
attached to our testimony, but tragically they were, frankly,
ignored. Since then, worker benefit funds have sued Enron, its
board and Arthur Andersen. Union members have sued the trustees
of the 401(k) plan. The AFL-CIO has followed Professor Coffee's
advice and asked the Securities and Exchange Commission to
issue rules embodying the strong proposals that Arthur Levitt
carried forward unsuccessfully last year and, in addition, to
issue rules ensuring that corporate boards will be genuinely
independent.
Finally, the AFL-CIO, together with worker funds, is right
now engaging in a dialog with Wall Street money managers about
the effect of their conflicts of interest on worker funds and
their losses in Enron. My written testimony contains a detailed
review of the behavior of Enron's sell-side analysts over the
last year, as well as a general discussion of the problems of
the conflicts of interest that surrounds sell-side investment
analysts. We've heard a bit about this from other witnesses.
The conclusion of our review is quite simple. No sell-side
analysts whose firm was underwriting, advising or lending to
Enron or Dynegy ever recommended that its clients sell their
Enron stock, not even on the day Enron filed for Chapter 11.
Analysts without those conflicts, and in particular
independent investment news letters, were bearish on Enron
starting last spring. Some people, it seems, don't like to put
money in black boxes. In our opinion, conflicted analysts
irrational exuberance over Enron was a substantial contributor
to this catastrophe, but really not the only one or the root of
the problem.
The root of the problem lies here. At various times in the
last several years Enron's executives faced a fateful choice.
They could have done what the law required and reported
disappointing results on various transactions and lines of
business. This would have been to do what many executives do
every day, and frankly suffer some pain for doing. Instead,
Enron's executives chose a different path, the path of using
complex subsidiary structures to hide liabilities and
exaggerate revenues, and apparently, to also funnel company
assets to themselves.
This choice to hide bad news is at the heart of what went
wrong with Enron. From the moment that choice was made, the
people who you heard from today, who were not in on those
decision, began paying more for Enron securities than they
should have. Credit rating agencies and energy market
participants began to participate in deals whose risk they were
being misled as to the full nature of that risk.
Of course, many of the very insiders involved in designing
and approving this financial trickery were getting multi-
million dollar management fees from those same partnerships.
And, at the same time as the Chairman has reminded us today,
Enron executives were selling close to a billion dollars in
their own holdings in Enron common stock at the inflated prices
that appear to have been maintained by their false financial
reporting. If our capital markets were functioning properly,
the fact that some Enron executives wanted to hide the true
state of Enron's finances from the financial markets should not
have automatically resulted in a massive, persistent inflation
of the companies stock price and credit rating, and the
subsequent complete collapse of the firm when the truth became
know.
If the system were working, an audit committee of the board
of directors, an outside independent audit firm, vigilant Wall
Street analysts, and institutional money managers all would
have stood between the desire of Enron managers to artificially
maintain a high stock price, and the victims--the individual
investors, the pension funds, and Enron employees--that ended
up paying that high price--that they were frankly suckered into
paying. But, as we have learned, the audit committee directors
were not really independent, and they appear to have let the
managers do whatever they wanted with the firm's books. You've
heard from the outside directors today--the outside auditors
today. In some ways I think they speak for themselves, but I
will point out that the obviously signed off on an audit with
inadequate or inaccurate information as its basis, and allowed
liabilities to be wrongfully excluded from Enron's books.
Today's testimony from Andersen raises some very clear
questions, and obvious questions. And they are: what did they
do for the $27 million that first they said was internal audit
and then they said wasn't internal audit? What was it? Second,
why did they not tear apart these transactions when they were
brought transactions that were with insiders and that involved
these complex structures that it seemed that no one understood?
Finally, as I note, the buy-side analysts for their part appear
to have forgotten that the word sell is part of the English
language, and we've heard a lot about that from the prior
witness.
And finally, oddly enough, the money manager alliance
capital that bought the most Enron stock over the last 6
months--like Lehman Brothers--shares a director with Enron. As
a result of these sorts of pervasive conflicts of interests our
capital markets, I think this hearing and the hearing in the
House last week have shown, are very treacherous places for the
unwary consumer. Enron is only the most recent and most
dramatic example of this unfortunate fact.
This is, in part, why the labor movement strongly believes
that America's working families retirement security should rest
on three legs: on Social Security, a defined benefit pension
plan, and personal savings. Only one of these legs should be
directly at risk in the markets. I think you frankly heard
testimony on that proposition, far more eloquently than
anything I could say, earlier this morning from people who only
had two legs.
Some companies might have been able to withstand--I'm
sorry--Enron's executives appear to have intentionally misled
investors. But, they were only able to do so because the entire
system of private sector investor protections failed. Now the
question is how will the public sector respond? The government
owes the investing public, and particularly Enron employees and
retirees, answers and justice. In particular, the government
owes Enron employees and retirees answers that can only be
obtained by using the full investigative powers of the Federal
Government.
For starters, this Subcommittee and the Congress as a
whole, might want to get these questions answered: Who were all
of the investors in Enron's limited partnerships and SPEs? Why
was it that Enron executives felt confident that they could
hide material financial data from the public over a period of
years free from regulatory scrutiny? What role did Enron
directors play in the creation of the partnerships and SPEs and
the decisions not to disclose critical information about their
purposes, ownership, management and finances?
What role, and I mean this in detail because obviously
there was a cursory exchange about this this morning, what role
did Arthur Andersen play in the entire life of the SPEs and
partnerships? Who were those SPEs and partnerships own audit
firms, if they had them? Was Andersen aware of them when they
were first set up? These questions deserve, I think, full
exploration.
What were the full terms of the arrangements between Enron,
Dynegy, JPMorgan Chase, Citigroup and Lehman Brothers? What
were the incentives and conflicts that were pushing those
analyst recommendations that waxed so positive in November as
these people's money was disappearing? Why did Enron go ahead
with changing its 401(k) advisor, apparently on October 17th,
when Enron itself was controlling the release of the critical
information here that opened the gates--the loss of $1.2
billion in equity on October 17th. October 17th is not a
coincidental date. It is a critical date. Actually, the 16th
was the release of that information, the 17th was the release
of the SEC investigation.
And finally, and perhaps most sort of mysteriously, why did
Jeffrey Skilling resign? Understanding the answers to these
questions, frankly, is not enough though. Congress and the
regulators must act, act to protect the investing public and
act to protect 401(k) participants from these kinds of
conflicts of interest. The AFL-CIO is ready to work with this
Committee to both find out what happened at Enron and see that
it does not happen again. Thank you.
[The prepared statement of Mr. Silvers follows:]
Prepared Statement of Damon A. Silvers, Associate General Counsel,
AFL-CIO
Good morning, Mr. Chairman, my name is Damon Silvers, and I am an
Associate General Counsel of the American Federation of Labor and
Congress of Industrial Organizations. The AFL-CIO believes today's
hearing on Enron Corporation and the marketing of its stock is a vital
contribution to the efforts to both bring to light the causes of
Enron's collapse and protect the public and our economy against future
events of this kind.
Directly and indirectly, America's working families are the
ultimate customers in our securities markets. Defined benefit pension
funds that provide benefits to the AFL-CIO's 13 million members have
approximately $5 trillion in assets. These plans include thousands of
pension plans sponsored by AFL-CIO member unions, public employee
pension plans, and single employer pension plans subject to collective
bargaining. Since the passage of ERISA in the 1970's, these funds have
increasingly invested in equities. 401(k) and other defined
contribution plans, employee stock ownership plans, and union members'
personal savings account for further extensive investments in equity
markets by America's union members.
Enron's collapse devastated some workers' retirement security. You
have heard from some of those workers today and their words speak for
themselves. But the collapse of Enron also took money out of the
retirement savings of practically every worker in America fortunate
enough to have retirement savings.
Most pension funds and institutional investors held some Enron
stock. Many of the most popular mutual funds held Enron stock. If any
person in this room has an S&P 500 index fund in your 401(k) or your
mutual fund portfolio, you lost money in Enron--probably about half a
percent of your total assets in that fund. And this is if you invested
in index funds--in a strategy that is designed to cheaply mitigate the
risks of investing in any single company.
This was by and large money that was going to fund pension benefits
for working families--for the public employees we are counting on to
protect us during this period of national crisis, for the iron workers
who are as we speak clearing the rubble at Ground Zero, for the
firefighters who today, as on September 11, stand ready to give their
lives to save ours. Because of the way that our retirement system has
become increasingly interwoven with the capital markets, practically
every American fortunate enough to be able to save for retirement in
any form was hurt by the collapse of Enron.
Indexed investing is very attractive to both institutions and
individual investors. Indexed investing essentially means you buy the
whole market, and do not make judgments about whether any given stock
is underpriced at any given moment. Indexed investing entails very low
fees and guarantees substantial diversification. But it does assume
that the market prices for securities are roughly reflective of the
real values of those securities in light of the information known at
any given time. The indexed investor is very vulnerable to fraud
perpetrated on the markets, because the indexed investor is essentially
a price taker. Because of the popularity of indexed investing among
institutional investors, when a company artificially inflates its stock
price by withholding information from the markets or putting out false
information, the victims are not only the unsophisticated individual
investors, but some of the largest and most sophisticated funds in the
country, investing on behalf of hundreds of thousands of individual
investors.
Some have suggested that it is too early to know whether anyone is
to blame for the collapse of Enron. While no one has as of today been
literally indicted, the AFL-CIO believes that a number of responsible
parties have emerged. These parties include the senior management of
Enron, the board of directors, Arthur Andersen, the outside auditor,
the sell-side analyst community, and perhaps some money managers. These
people and organizations made up the web of parties with obligations to
Enron, its investors, and the public at large. These are the people and
institutions that failed to ensure that Enron's assets were used to
benefit the company and that the investing public had the information
necessary to make fully informed decisions about whether to invest in
Enron and if so at what price.
The Subcommittee has asked me to focus today on how consumers
purchasing Enron's securities were misled. The AFL-CIO has done
considerable analysis of the behavior of Enron's officers and
directors. I have attached to this testimony letters we and the
Amalgamated Bank, a large manager of worker pension funds, sent to
Enron's board in early November laying out the details of some of the
transactions that led to Enron's collapse and explaining the
undisclosed conflicts of interest that in our view crippled Enron's
board.
The AFL-CIO also has been a longtime supporter of efforts
undertaken by Arthur Levitt when he was chairman of the Securities and
Exchange Commission to rein in conflicts of interest affecting auditor
independence. Pension funds affiliated with the building trades unions
have for several years submitted shareholder proposals seeking to
ensure companies they invest in hire truly independent auditors. Last
week we submitted a rulemaking petition to Harvey Pitt, Arthur Levitt's
successor at the SEC, asking him to act to end the types of conflicts
of interest that appear to have compromised Arthur Andersen's ability
to carry out its duties as Enron's public auditor. That petition is
also attached.
But in the remainder of this testimony I intend to focus on the
analysts' role in the collapse of Enron. Let me begin by summarizing
briefly what sell-side analysts do. Sell-side analysts work for full-
service investment houses. By full-service I mean that these firms
underwrite securities, they make markets in securities, they give
investment banking advice to companies, they manage money on behalf of
clients, and often they trade on their own accounts in the securities
markets. Since the rise of integrated mega-financial service firms
after the repeal of Glass-Steagall, these firms also make bank loans to
companies.
One of the services these full-service firms provide to their
clients who trade securities through their brokers is access to
research reports written by their research analysts. These analysts are
called ``sell-side analysts'' because their firms do a substantial
business selling securities to their clients, and fundamentally the
research is paid for by the brokerage fees generated by the firm's
sales and trading activity. The research itself is not sold. This
business model means that sell-side analysts are eager to share their
work with investors generally, through their reports, and through
appearances on television, radio and the Internet. As a result, sell-
side analysts shape investor opinions out of proportion to their
numbers.
Sell-side analysis is widely available to market participants, both
directly through the brokerage houses and through services like First
Call and Investext. While firms try and keep the most up to date
reports available only to clients, relatively recent sell-side analyst
reports are widely available at a relatively reasonable price.
Few union members or other individual investors are in a position
to master the raw data that informs the financial markets, and even
fewer have routine access to insiders in the companies they invest in.
Most union members, and the trustees of their pension funds, for that
matter, rely on a variety of professionals for their information about
the equity markets. Sell-side analyst reports are likely to be the most
detailed, critically analytical information the typical small investor
has to consult in making investment decisions. For that reason,
America's working families have an enormous stake in the honesty of the
investment information they receive from the analyst community.
Analysts are investment advisors subject to the Investment Advisors
Act of 1940. Under the Act, analysts have a fiduciary duty to their
clients. They are not mere marketers, serving the needs of their firms'
underwriting business. They owe a duty of loyalty and of care to the
investors they advise.
Unfortunately, in recent years the structure of the securities
industry has shifted in ways that appear to have compromised sell-side
analysts. There is substantial statistical evidence that analysts'
decisions whether or not to recommend that investors buy a stock are
influenced by whether their firm is an underwriter for the issuer. That
is the conclusion of a 1999 study by Roni Michaely of Cornell
University as well as a 1997 study by Hsiou-wei Lin of National Taiwan
University and Maureen McNichols of Stanford Business School.\1\ CFO
Magazine reported last year that analysts who work for full-service
investment banks have 6% higher earnings forecasts and close to 25%
more buy recommendations than analysts at firms without such ties.\2\
---------------------------------------------------------------------------
\1\ Conflict of Interest and Creditability of Underwriter Analyst
Recommendations. Michaely, Roni and K Wolmak Review of Financial
Studies 1999 vol 12 no 4 653-686; Underwriting Relationships and
Analyst Earning Forecasts and Investment Recommendations. Lin, Hsiou-
Wei and McNichols, Maureen. Journal of Accounting and Economics vol 25
(1) pp 101-127 1997.
\2\ What Chinese Wall?, Barr Stephen, CFO, March 1, 2000.
---------------------------------------------------------------------------
In some ways what we find more persuasive than the statistics are
the comments of analysts in the financial press. In the last few
months, analysts have been quoted by name saying such things as ``a
hold doesn't mean it's ok to hold the stock'' and ``the day you put a
sell on a stock is the day you become a pariah.'' \3\
---------------------------------------------------------------------------
\3\ Wall Street's Secret Code Spoils Investors' Aim, Noelle Knox
USA Today, December 21, 2000; CFO, ibid.
---------------------------------------------------------------------------
It should not be surprising that this is true given that issuers
pick underwriting firms based on their ability to bring effective
positive analyst coverage to their businesses. This is the conclusion
of a soon to be published paper on why firms switch analysts by Laurie
Krigman of the University of Arizona, Wayne Shaw of Southern Methodist
University and Kent Womack of the Tuck School Business at Dartmouth
College.\4\
---------------------------------------------------------------------------
\4\ Why do Firms Switch Underwriters? Wayne H. Shaw, Kent Womack,
Forthcoming, Journal of Financial Economics.
---------------------------------------------------------------------------
In addition, the data cited by CFO Magazine suggests several quite
disturbing things. First is that it is not just existing relationships
that are affecting analyst recommendations, but also the prospect of
future business. The result is a systematic positive bias affecting
recommendations across the board. Second, the response from the
securities industry that analyst involvement in underwriting helps
ensure that the firms only do quality deals at the right price is
simply inadequate to explain the distortion in the data affecting all
recommendations.
But these conflicts are exacerbated by the ways in which analysts
are used and compensated. It has become a common practice for analysts
to accompany teams from the corporate finance department on
underwriting road shows, and most importantly, analyst compensation has
become tied at many firms to analysts' effectiveness at drawing
underwriting business.
In addition, the consolidation of the financial services industry,
and in particular the repeal of Glass-Steagall, has created a wide
array of further potential conflicts. Issuers are in a position to
withhold business from the firms of critical analysts across a wide
array of markets, including commercial loans and commercial banking
services, pension fund and treasury money management, and insurance
contracts. This leverage is particularly powerful when the issuer is
itself a financial services company. For example, CFO Magazine reported
last year that the troubled financial services giant First Union cut
off all bond trading business with Bear Stearns in response to negative
comments by their analyst, and Bear Stearns ordered the analyst to be
more positive.
At the same time, issuer executive compensation has been linked to
issuer stock price, often in ways that give incentives to executives to
manipulate short term movements in stock prices. The result is that
issuer executives have tremendous personal incentives to use the
resources of their companies to pressure analysts into issuing
conflicted reports.
The rise in the importance of proprietary trading at major firms
also creates further possible conflicts of interest for analysts. A
version of this problem has always existed when firms' trading
operations and market making operations lead to a buildup of inventory
in particular issuers' securities. However, the addition of firms
investing significant capital in proprietary trading creates a risk of
senior executives aware of the positions taken in proprietary trading
encouraging research departments to prop up demand for certain
securities.
Finally, among the most lucrative business areas for full-service
firms is providing investment banking advice to companies going through
large mergers and acquisitions. Such deals are typically dependent on
shareholder approval or effectively dependent on the price of the
stocks of the companies involved remaining within a certain range.
These circumstances can give a full-service firm that is advising a
participant in a deal a substantial interest in trying to encourage
investors to behave in ways that support the transaction closing.
There has been some good news though in the effort to protect
analyst independence. Much of the literature in the 1990's on
securities analysts' behavior noted the ability of issuers to reward
and punish analysts by providing and withholding information. This
power meant that analysts who were doing their best to be loyal to
their customers could not provide customers with the timely information
that is the minimum requirement of the job without tilting their
recommendations so as to ensure they weren't on the losing end of the
business of selective disclosure.
Earlier this year the SEC promulgated Regulation FD barring
selective disclosure. In doing so the Commission recognized selective
disclosure not only harmed those not privy to the selective disclosure,
it gave issuers power that resulted in warping the behavior of those
who were the recipients of the selectively disclosed information. The
adoption of Regulation FD marked an important step toward restoring
analysts' independence. However, Harvey Pitt has at various times
suggested he is not an enthusiastic supporter of this rule. Regulation
FD is an important step toward restoring analyst independence and
deserves Congress' continuing support.
The story of the collapse of Enron illustrates the consequences of
these conflicts of interest on the larger market environment. Enron was
throughout the late '90's a high-flying stock, trading at up to 70
times earnings. Even though its earnings growth as shown in pre-
restatement numbers was around 5% per year from 1998 to 2000, Enron's
stock price quadrupled over the same period.
During the spring and summer of 2001, Enron's stock price was
falling, apparently due to the normal reasons stock prices fall--
deteriorating conditions in certain of Enron's markets, and trouble
with certain large projects. However, in addition, some journalists
were raising concerns that Enron was both opaque and overvalued.\5\
---------------------------------------------------------------------------
\5\ ``Is Enron Overpriced?,'' by Bethany McLean. Fortune, March 5,
2001, Pg. 122
---------------------------------------------------------------------------
What is noteworthy about this is that during this period Enron
executives were engaged in extensive selling of Enron shares. At the
same time Enron's CFO was telling the press ``We don't want anyone to
know what's on those books. We don't want to tell anyone where we're
making money.'' During this period, according to First Call, which
surveys sell-side analyst reports, there was clearly insufficient
transparency to Enron's financial disclosures to allow an analyst to be
able to give an opinion as to whether the company's stock was a good
investment.\6\ Nonetheless, as one might expect from the general data
we have surveyed, out of 11 sell-side firms tracked by Briefing.Com
there were no downgrades of Enron from May 11, 1999 until August 15,
2001.\7\
---------------------------------------------------------------------------
\6\Testimony of First Call CEO before Joint Hearing of House
Subcommittees on Capital Markets and Investigations, December 12, 2001.
\7\ The data that follows regarding shifts in ratings by sell-side
firms comes from Briefing.com, ``Analyst History for Enron Corp.,''
http://biz.yahoo.com/c/e/ene.html.
---------------------------------------------------------------------------
Compare this record to the independent investment newsletters
surveyed by Forbes Magazine.\8\ Of the eight Forbes looked at, six were
advising their subscribers to sell Enron, four before May 1st, and two
in October. One of the eight advised subscribers to sell until the
price hit $9, then went to a buy, and only one of the eight maintained
a consistent buy during the period of Enron's collapse.
---------------------------------------------------------------------------
\8\ ``Enron: An Unreported Triumph For Investment Letters.''
Forbes.com, December 7, 2001.
---------------------------------------------------------------------------
On August 15, following the sudden resignation of Enron's CEO
Jeffrey Skilling, Merrill Lynch's analyst, downgraded Enron from Near
Term Buy/Long Term Buy to NT Neutral/Long Term Accumulate. This may
sound like a modest downgrade. But compare it to the firms that were
underwriters for Enron. The earliest downgrade among this group appears
to be JPMorgan Chase, which went from Buy to Long-Term Buy on October
24, 2001. Strangely enough though, JPMorgan Chase appears never to have
downgraded Enron below a Long-Term Buy in the weeks that followed. In
fact of the twenty seven firms we could find that covered Enron, the
only sell-side firm that actually downgraded Enron to a Sell was
Prudential, which downgraded Enron twice in the week that followed the
announcement of the $1.2 billion charge to earnings on October. These
results of our research parallels a Forbes Magazine study that looked
at 13 sell-side firms and found as of the end of October, two weeks
after the initial announcements of the charge to equity and the SEC
investigation, only one firm recommended Sell, one firm recommended
Hold, and the remaining eleven still had various forms of buy
recommendations.
In late October and November, as Enron attempted to sell itself to
Dynegy, key firms with an interest in the transaction maintained what
appeared to be positive ratings. JPMorgan Chase and Citigroup were
Enron's advisors and stood to earn large fees. These fee arrangements
have not been disclosed but are likely to have been in excess of $50
million per firm. Citigroup lent Enron more than $500 million, monies
in part that came from federally insured commercial bank deposits.
Citigroup's analyst at Salomon-Smith Barney maintained a Neutral-
Speculative rating. JPMorgan Chase lent Enron $400 million, while its
analyst rated the stock a Long-Term Buy all the way through November.
Lehman Brothers, the advisor to Dynegy on the Enron purchase, also
stood to earn a similarly large fee if the deal closed. Lehman kept a
Strong Buy rating on Enron throughout the fall.\9\
---------------------------------------------------------------------------
\9\ ``Assessing the Role of the Financiers,'' by Patrick McGeehan,
New York Times, December 2, 2001, Section 3, page 11.
---------------------------------------------------------------------------
What can be concluded from this record. First, though Enron's
financials included somewhat cryptic references to the partnership
structures Enron's management used to hide liabilities and pass
interests in company assets to executives, no analyst appears to have
paid any attention to these items until they became widely known in
October. Second, with one notable exception in Merrill Lynch, no
analyst took action based on Skilling's resignation. Finally, with the
exception of Prudential, no analyst thought it worthwhile to actually
recommend their clients sell the stock. Interestingly, neither
Prudential nor Merrill Lynch were underwriters for Enron or had any
part in advising or lending money to either Enron or Dynegy.
One can observe in the analysts' treatment of Enron many of the
problems critics of analyst conflicts pointed to before the Enron
debacle. These include the linkage between analyst behavior and the
investment banking, and now commercial banking, interests of their
firms; the use of codes by analysts, where Long-Term Buy may mean Sell,
and Hold certainly means Sell; the reliance on company projections and
the failure to either look deeply into company financials or to consult
outside sources. Taken together, these conflicts seem to have converted
the analysts from providers of analysis with a fiduciary duty to their
investor clients to simple salesmen for their firms' investment banking
clients. And when the investment banking client is defrauding the
investor client, too often the analyst, like the auditor, becomes a
part of the fraud.
The AFL-CIO believes strongly that Congress, the regulatory
agencies, and the self-regulatory agencies need to act in a coordinated
fashion to protect the independence of analysts. In particular, we
believe that what used to be called the Chinese Wall between research
and investment banking in full service houses needs to be rebuilt. The
AFL-CIO has submitted shareholder proposals to several full-service
financial services companies seeking to have those firms make such
changes on their own. However, we believe that short-term competitive
pressures are likely to lead to the continued violation of analysts'
fiduciary duties unless regulatory action is taken.
Currently, as a result of pervasive conflicts of interest, our
capital markets are treacherous places for the unwary. Enron is only
the most recent and most dramatic example of this unfortunate fact.
This is in part why the labor movement strongly believes that America's
working families need retirement security that rests on three legs--
Social Security, a defined benefit pension plan and personal savings,
only one of which should be directly at risk in the capital markets.
In conclusion, the AFL-CIO believes that systematic problems with
the ways in which information flows to and in the capital markets
contributed to both Enron's collapse and the severity of the impact of
its collapse. While analyst conflicts were not the cause of the
collapse of Enron, they contributed to a climate in which Enron's
shares were artificially inflated and in which the conduct of
management at Enron remained hidden long after it could have been
brought to light. Finally, it appears that these conflicts contributed
to a false optimism about the success of the Dynegy deal, an optimism
that allowed Enron executives to continue to withhold vital information
from the markets about Enron's liabilities and demands on its cash
until the final collapse of the Dynegy deal.
We commend this Subcommittee for opening the Senate's formal
inquiry into these matters. We urge both this Subcommittee and all
involved: in Congress, the SEC, the Department of Labor, and the
Justice Department to continue to investigate both the actions of
particular individuals and firms and the larger structural arrangements
that led to the collapse of Enron and the loss of so many peoples'
savings. On behalf of the AFL-CIO, we look forward to continuing to
work with the Subcommittee on this vital matter. Thank you.
Senator Dorgan. Mr. Silvers, thank you very much. There is
a vote occurring in the Senate. I believe there's 5 minutes
remaining, so I regret that we're going to have to cut this
short. I would like to submit questions on behalf of the
Committee to the witnesses. Let me make just a couple of
comments.
First of all, the testimony you have presented is really
excellent. As I indicated to you earlier, we are going to hold
other hearings and I think your testimony sets the stage for
the important questions. The first panel today described the
heartbreak of losses that people have experienced. I recall the
word loyalty described by one of the witnesses. People who were
loyal to their company, who did the right thing, worked hard
all their lives, saved, were thrifty, only to lose their life
savings.
That's part of what motivates us to get to the bottom of
this, who profited and who lost? And, what are the lessons to
be learned from this? At the next hearing, Mr. Lay will be with
us. We will ask Mr. Skilling, Mr. Fastow, and others to appear
as well. But I think in the end, if this is viewed somehow by
people as just another failure or just another scandal, then we
will have missed the point.
It seems to me there are numerous conflicts with respect to
company executives, boards of directors, auditors, and stock
analysts. Some in Congress spent a lot of time trying to derail
the legislation that would have plugged some of these holes.
There just is so much that is in conflict. Yet, if one studies
all those conflicts, how can the problems not be apparent to
everyone? We have allowed a big auditing firm to get millions
and millions of dollars from a company they are auditing and
then contract with them to perform other services. It's alright
for an investment bank to be giving their analysts the rein to
tell the American public about a stock in which they have a
significant financial interest and which they would never
willingly, I assume, report bad news.
So, there is so much here that we need to consider and
investigate, and we will do that. This Committee is going to
request substantial information. We will request information
about who the investors are in the partnerships that have been
off the books and who profited from them. I have been in touch
with the company's attorneys and they indicate that they want
to provide that information. They're the ones who indicated
they will ask Mr. Lay to testify and he has agreed to do that.
So, I think the logical point from this hearing is as we
move forward we want to get information. But in the end, we
also want to understand what do we do with respect to changes
in regulation and changes in law that will prevent this from
happening again. Those are the important considerations for us
and the testimony of the three of you will be very helpful to
this Committee.
I thank you very much for testifying. This Committee is
adjourned.
[Whereupon, the Committee was adjourned at 12:30 p.m.]
A P P E N D I X
Prepared Statement of Steve W. Berman, Hagens Berman LLP
Mr. Chairman,
I am a partner of the law firm of Hagens Berman, and my office is
in Seattle, Washington. We represent hundreds of Enron employees.
Two of my clients, Janice Farmer and Charles Prestwood, have agreed
to appear before the Senate Commerce Committee in connection with its
investigation of the plight of Enron employees in the aftermath of
Enron's decline and eventual bankruptcy.
I am not submitting this testimony to argue the facts or law, but
simply to alert this Committee to the fact that my two clients are just
the tip of the iceberg. Since we began representing Enron employees, we
have fielded over 3,000 inquiries. I have three lawyers and two
investigators working nearly full time to handle inquiries. I have been
representing victims of financial fraud for twenty years. I cannot
recall circumstances that have resulted in such financial devastation.
My primary purpose is to provide just a few examples of the impact
of this crisis on the lives and futures of Enron employees in
submitting this testimony:
A Wisconsin woman with Stage IV breast cancer, unable to
work, acquired her Enron ESOP stock as a divorce settlement
after a 10 year battle with her former husband describes
watching in horror as her account dropped from $ 250,000 to
virtually nothing during the company's lockdown of employee
investment accounts. The stock was her most valuable asset and
her hope for future cancer treatments, income, and her
children's college educations.
A 54-year-old lineman with Portland General Electric, a
subsidiary of Enron, suffers from significant health problems
(arthritis and sarcoidosis, a lung ailment) and was looking
forward to retirement in 4 or 5 years. He maximized his 401(k)
contribution year after year. The bulk of his investment was in
Enron stock, both because it was swapped into his account from
the PGE stock he had owned for most of his career and because
the Company continually promoted Enron stock as safe and
secure. He watched helplessly as the Enron stock - and his
retirement plan - were wiped out during the Company's lockdown
of the retirement plan. His plans to retire by age 59 are
shattered as he begins to rebuild the assets he lost.
An Oregon couple in their late 50's who both had retirement
accounts with Enron stood by helplessly during the company's
lockdown of their accounts as their financial stability and
dreams for retirement were destroyed by the drop in Enron
stock. The couple now faces selling property which has been in
the husband's family for more than a century to support
themselves.
A retired oil and gas worker in California watched his
financial future crumble as his $ 1 million savings plan with
Enron disintegrated into nothing. Unable to return to work in
the oil and gas industry, the financial consequences have
forced him to take work making garbage bags twelve hours a day
to support himself.
We appreciate you and the other Committee members taking the time
to hear Ms. Farmer's and Mr. Prestwood's stories and to investigate the
drastic impact of Enron Corporation's acts on the lives and financial
futures of its employees. Please let us know if we can provide
additional information.
______
Enron: Let Us Count The Culprits
Business Week, December 17, 2001
(Copyright 2001, The McGraw-Hill Companies, Inc.)
Enron Corp.'s bankruptcy is a disaster of epic proportions by any
measure--the height from which it fell, the speed with which it has
unraveled, and the pain it has inflicted on investors, employees, and
creditors. Virtually all the checks and balances designed to prevent
this kind of financial meltdown failed. Unless remedied, this could
undermine public trust, the capital markets, and the nation's entire
equity culture. Even now, no one really knows what liabilities are
buried inside dozens of partnerships or the role ex-CEO Jeffrey
Skilling played in creating a byzantine system of off-balance-sheet
operations. A culture of secrecy and a remarkable lack of transparency
prevented any realistic assessment of the company's financial risk.
Nothing less than an overhaul of the auditing profession is now
required to police accounting standards. Wall Street, mutual funds, and
the business press would also do well to rethink why each, in its own
way, celebrated what is now revealed to be an arrogant, duplicitous
company managed in a dangerous manner (page 30).
What is increasingly clear is that Skilling, a former McKinsey &
Co. consultant and Harvard Business School grad, tried to craft Enron
as a new kind of virtual trading giant, operating outside the scrutiny
of investors and regulators. Enron's numerous partnerships were
shrouded in secrecy, tucked away off the balance sheet. They were used
to shift debt and assets off the books while inflating earnings. The
chief financial officer ran and partly owned two partnerships, a clear
conflict of interest. Enron leveraged itself without a reality check by
any outsider. ASLEEP. Hardly anyone inside the company was urging
caution, certainly not chairman Ken Lay. The independent auditing
committee on the board of directors was clearly asleep. Given Enron's
arcane financial engineering, the committee probably relied on Arthur
Andersen, the auditor, for information. But Andersen didn't blow any
whistles. No surprise there. It made more money selling consulting
services to Enron last year than it did auditing the company.
Criticizing Enron's books might have jeopardized consulting work.
Similar conflicts of interest stopped Wall Street analysts from pulling
the plug on Enron. Even as Enron slid toward bankruptcy, ``buy''
recommendations were being issued by analysts whose firms were doing
investment-banking business with the company, or were hoping to.
Did anyone really know what was going on inside Enron? The rating
agencies, Moody's Investor Service and Standard & Poor's, presumably
had better access than average investors, but neither downgraded
Enron's credit rating to below investment grade until the bitter end.
The rating agencies argue that had they downgraded Enron sooner, they
would have simply pushed the company into bankruptcy earlier. Here's a
flash: So what? Moody's and S&P have one basic job--assessing risk for
investors. If they couldn't penetrate Enron's complex financial
engineering, the rating agencies should have said so.
The business press, including BusinessWeek, did no better. It
celebrated Skilling's vision of Enron as a virtual company that could
securitize anything and trade it anywhere. The press blithely accepted
Enron as the epitome of a new, post-deregulation corporate model when
it should have been much more aggressive in probing the company's
opaque partnerships, off balance sheet maneuvers, and soaring leverage.
TRAGIC. Enron's fall is made all the more tragic because of the pain
inflicted on its thousands of employees. Not only are many losing their
jobs, but some 12,000 are also losing most of their retirement savings.
In perhaps its most egregious risk-management error, employees mostly
held Enron stock in their 401(k)s, yet the company prevented them from
selling until they reached the age of 54. People could only watch as
the stock plummeted from $89 to a dollar. Diversification, particularly
in retirement accounts, is the cardinal rule in managing risk. Enron
broke that rule, as have other companies.
Enron's tale is a clarifying event. It reveals key weaknesses in
the financial system that must be corrected as the U.S. moves forward
in the 21st century. If America is to have an equity culture in which
individuals invest in stocks and provide the capital for fast economic
growth, the market must be able to correctly value companies. This
requires making financial data readily available and easily
comprehensible.
To restore public confidence, several steps should be taken. After
accounting disasters at MicroStrategy, Cendant, Lucent, Cisco, and
Waste Management, it is clear that self-regulation is not working.
Conflicts of interest within auditing firms remain widespread.
Investors can ignore analysts on TV who work for investment firms. But
someone has to play the role of the honest watchdog. Unless the Big
Five auditing firms clean up their act, they will wind up with a
federally chartered oversight body. It is equally clear that current
standard accounting rules aren't sufficient. Loopholes allowed Enron to
fool everyone, making a mockery of public disclosure.
Regulators should also insist that corporations give their
employees choice in their 401(k)s. Some 30% of assets held in 1.5
million 401(k) plans are in the stock of the company sponsoring the
plan. This lack of diversification puts too many people at risk.
In the end, the Enron story is about a secretive corporate culture
that failed in its primary business mission: to manage risk. Had the
Federal Reserve and other central banks not flooded the global economy
with liquidity in recent months, Enron's collapse could have posed a
deep threat to the financial markets. It's past time to fix the system.
______
Enron: The Lessons For Investors;
Hindsight, shmindsight. There's much to learn when a stock loses $67
billion in value.
Byline: Lisa Gibbs, Jeff Nash and Nick Pachetti
Money, January, 2002
(Copyright 2002, Time Inc.)
It seems hard to believe now, but Enron (ENE) used to be the envy
of corporate America. In less than a decade, the Houston company
transformed itself from stodgy gas-pipeline operation to natural gas
and electricity trading powerhouse. Dazzled by sizzling earnings
growth, giddy investors bid up Enron's shares 312% in two years to a
high of $90.75 in 2000. Then someone turned out the lights. Beset by
marketplace woes and management mishaps, the stock already had tumbled
53% when chief executive Jeffrey Skilling stunned investors by
resigning last August. After that, the bad news came at hyperspeed:
$1.2 billion in shareholder equity zapped by risky hedging deals, a
Securities and Exchange Commission probe, a last-chance merger with
rival Dynegy called off and, finally, a bankruptcy filing. By the end
of November, the stock had plummeted to 26[cents], obliterating $67
billion in market cap--a shocking fall for a company that just last
year occupied the No. 7 spot on the Fortune 500.
Perhaps most incredible, however, about the Enron debacle is how
long investors hung on to the belief that everything would turn out
fine. As recently as MONEY's October issue, our Ultimate Investment
Club's Abby Joseph Cohen of Goldman Sachs was calling Enron a ``good
value.'' If pros like Cohen got it wrong, how could the average
investor have discerned the disaster in time? Sure, hindsight is
marvelous. But along Enron's fast track to penny stock, there were red
flags for informed shareholders that all was not as it seemed.
Out-of-control valuation. In 2000, investors levitated Enron's
stock to a lofty price/earnings ratio of 69 times that year's earnings
on the belief that forays into sexy-sounding online energy trading and
broadband businesses could sustain supercharged earnings growth.
Skilling was telling Wall Street that Enron's broadband biz alone
deserved $37 a share, and investors seemed to buy it, despite the fact
that the unit was unproved and unprofitable. His outlandish valuation
of broadband drew an early ``hold'' rating from analyst Andre Meade of
Commerzbank Securities in March 2000. ``An energy company trading at
the multiple Enron was,'' Meade explains today, ``should have been
cause for eyebrows to be raised.''
The lesson? Pay attention to the P/E even after you buy a stock.
Whenever the valuation starts to climb, you should stop and question
whether the company can sustain the sales and earnings growth expected
of it.
Insider selling. In 2000, then CEO Kenneth Lay netted $66.3 million
from exercising stock options and selling the shares, while Skilling
scored $60.7 million, roughly double the amounts the year before. By
the end of June 2001, 16 members of Enron's top management had sold
$164 million in shares, reports Thomson Financial Network. While
insider sales don't automatically spell trouble for a company--
executives often have valid reasons for raising cash--the selling at
Enron was prolific. And the fact that selling persisted even as the
stock fell throughout 2001 was a ``screaming red flag,'' says Thomson
analyst Paul Elliott. If Skilling and Lay believed the stock was
undervalued--as they repeatedly told investors--then why were they
cashing in? Executive stock trades are easy for ordinary investors to
follow: The Wall Street Journal regularly publishes insider trading
tables, and websites such as Yahoo Finance (finance.yahoo.com) list
insider trades for each stock.
Obfuscations. Enron's trading business is extremely complex, and
analysts admit they didn't always understand what Enron was doing. That
said, the company seemed to go out of its way to obfuscate. ``I've
never seen such complicated disclosures,'' says Michael Heim, an A.G.
Edwards energy analyst. ``It was hard to follow the movement of
money.''
When pushed to reveal more, management was often tight-lipped and
unprofessional. During one famous conference call last April, Skilling
called an analyst an ``asshole'' for complaining about the company's
failure to provide a balance sheet with its earnings announcement.
Prudential Securities' Carol Coale points to rumors in late September
of an SEC investigation. ``When I asked Enron about an investigation,
they said there was no investigation,'' says Coale. Once it was
revealed that the SEC was conducting an inquiry, she says Enron
returned to her with a feeble excuse: ``They said, `Well, you didn't
ask about an inquiry.'''
The typical investor isn't privy to such conversations, although
more and more company conference calls are in fact being opened to the
general public. But the larger point (famously stated by Warren
Buffett) is this: If you don't understand what a company does, don't
invest in it. There's a corollary to that too: If management refuses to
fill in holes and keeps investors in the dark, run.
Fishy filings. Investors who read Enron's quarterly SEC filing in
the summer of 1999 would have noticed a new entry under the heading
``Related Party Transactions.'' The item noted that Enron was doing
business with a private partnership whose general partner was led by a
``senior officer of Enron.'' A proxy filed in May 2000 revealed that
the senior officer was Enron CFO Andrew Fastow, and that not one but
two partnerships existed.
Possible conflicts of interest--is the CFO looking out for Enron or
himself?--should have turned heads. But even professional money
managers like those at Janus, enthralled by Enron's opportunities,
overlooked the partnerships as the funds built up their stakes. As late
as Sept. 28, with Enron at $27.25, Janus owned 41.3 million shares,
which it has since dumped.
To be fair, Enron revealed little about the partnerships and their
function--to divert from Enron's balance sheet the debt from new
acquisitions--as well as the extent to which the companies were in bed
together. Besides, back then the stock was going gangbusters and
earnings looked great; the partnerships seemed like small potatoes.
Even the stock's few critics weren't paying much attention. Recalls
Meade of Commerzbank: ``It was difficult to see that there were
significant liabilities associated with this.''
Attitudes began changing after Enron filed its first quarterly
report of 2001, which said it was entering into complicated and risky
derivatives transactions that involved an $827 million loan to one of
the partnerships. Whoa, some analysts said. ``You started to see in the
footnotes some pretty large sums of money,'' says Tara Gately, energy
analyst for Loomis Sayles funds. ``It raised questions, and there were
really no good answers.''
Yes, this is complicated stuff and, yes, there wasn't enough
information, but you don't have to be a big-deal financial analyst to
know that the CFO in a side business is smelly stuff.
Executive departures. When the chief executive--someone who spent a
decade moving up the ladder and building the company's core energy-
trading business--flees after just six months at the helm, you've got a
problem. Skilling, 47 at the time, called it a ``purely personal''
decision. ``That was the worst excuse I've ever heard,'' scoffs John
Hammerschmidt, a fund manager at Turner Investments. If top management
resigns for unclear reasons, consider selling. Hammerschmidt didn't
even hesitate in this case: ``As soon as I heard that, I dumped my
shares.''
One red flag does not necessarily a disaster make. More often it's
a succession of little somethings that ultimately tells you: It could
get real ugly here. The trick is to put aside your enthusiasm for a
stock. That's probably the hardest thing for any investor to do. But as
Enron's meltdown shows, the homework isn't over once you buy the stock.