[Senate Prints 107-75]
[From the U.S. Government Publishing Office]
107th Congress
2d Session COMMITTEE PRINT S. Prt.
107-75
_______________________________________________________________________
FINANCIAL OVERSIGHT OF ENRON:
THE SEC AND PRIVATE-SECTOR WATCHDOGS
__________
R E P O R T
PREPARED BY THE STAFF
of the
COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE
[GRAPHIC] [TIFF OMITTED] TONGRESS.#13
October 7, 2002
U. S. GOVERNMENT PRINTING OFFICE
82-147 WASHINGTON : 2002
___________________________________________________________________________
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COMMITTEE ON GOVERNMENTAL AFFAIRS
JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan FRED THOMPSON, Tennessee
DANIEL K. AKAKA, Hawaii TED STEVENS, Alaska
RICHARD J. DURBIN, Illinois SUSAN M. COLLINS, Maine
ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio
MAX CLELAND, Georgia THAD COCHRAN, Mississippi
THOMAS R. CARPER, Delaware ROBERT F. BENNETT, Utah
JEAN CARNAHAN, Missouri JIM BUNNING, Kentucky
MARK DAYTON, Minnesota PETER G. FITZGERALD, Illinois
Joyce A. Rechtschaffen, Staff Director and Counsel
Laurie R. Rubenstein, Chief Counsel
Beth M. Grossman, Counsel
Cynthia Gooen Lesser, Counsel
John N. Wanat, Congressional Fellow
Richard A. Hertling, Minority Staff Director
Gary M. Brown, Minority Special Counsel
Darla D. Cassell, Chief Clerk
C O N T E N T S
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Page
INTRODUCTION..................................................... 1
PART ONE: THE SEC AND OTHER WATCHDOGS WITH LEGAL OBLIGATIONS..... 6
I. BACKGROUND.................................................. 7
A. The SEC................................................... 7
1. Mission and Organization................................ 7
2. Review of Public Filings................................ 8
3. Enforcement............................................. 11
B. Private-Sector Gatekeepers................................ 13
1. Boards of Directors..................................... 13
2. Auditors................................................ 16
II. EXPERIENCE WITH ENRON...................................... 20
A. Private-Sector Gatekeepers................................ 21
1. Enron's Auditor......................................... 21
2. Enron's Board of Directors.............................. 22
B. The SEC................................................... 23
1. Review of Enron's Public Filings........................ 24
2. Enron's Shift to Mark-to-Market Accounting.............. 31
3. Exemptions from the Public Utility Holding Company Act.. 36
4. Exemption from the Investment Company Act of 1940....... 43
III. RECOMMENDATIONS........................................... 46
PART TWO: MORE WATCHDOGS--WALL STREET SECURITIES ANALYSTS AND
CREDIT RATING AGENCIES......................................... 52
I. ENRON AND THE WALL STREET ANALYSTS.......................... 53
A. Investment Research Analysts.............................. 54
B. The Wall Street Analysts' Assessments of Enron............ 55
C. GFactors Affecting the Objectivity of Sell-Side Analyst
Recommendations................................................ 62
D. Solutions................................................. 69
II. ENRON AND THE CREDIT RATING AGENCIES....................... 76
A. History and Uses of Credit Ratings........................ 77
B. Efforts to Regulate Credit Rating Agencies................ 80
C. Chronology of Enron's Ratings............................. 84
D. Problems With the Agencies' Analyses and Actions.......... 89
E. Conclusions and Recommendations........................... 98
APPENDIX: Note 16 to Financial Statements, Enron Corp. Form 10-K
for the Year Ended December 31, 2000........................... 100
FINANCIAL OVERSIGHT OF ENRON:
THE SEC AND PRIVATE-SECTOR WATCHDOGS
October 7, 2002
INTRODUCTION
On December 2, 2001, Enron Corp. (together with its
subsidiaries, collectively referred to in this report as
``Enron'') filed for bankruptcy protection, making it--at the
time--the largest company to declare bankruptcy in the nation's
history.\1\ Enron's collapse deprived thousands of employees of
their jobs, severely diminished their retirement savings, and
led to the loss of billions of shareholder dollars. Perhaps
most significantly, the company's failure and the months of
revelations that followed triggered a crisis in investor
confidence in U.S. capital markets. The repercussions of
Enron's collapse continue to be felt today.
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\1\ Since that time, WorldCom has superseded Enron as the largest
corporate bankruptcy. See Simon Romero and Riva D. Atlas, ``WorldCom's
Collapse: The Overview; WorldCom Files for Bankruptcy; Largest U.S.
Case,'' The New York Times, July 22, 2002.
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The misdeeds that led to Enron's demise were, in the first
instance and ultimately, the responsibility of Enron and its
management. Enron, however, functioned within a larger
environment consisting of private and public entities alike
that were supposed to monitor or regulate the company's
activities and public disclosures. In January 2002, Senate
Committee on Governmental Affairs Chairman Joseph I. Lieberman
and Ranking Member Fred Thompson initiated a wide-ranging
review of the actions of the various governmental and private
watchdogs that were supposed to monitor Enron's activities and
help protect the public against these sorts of calamities. The
Chairman and Ranking Member charged the Committee with
examining whether these watchdogs did their jobs correctly and
whether different actions by those watchdogs could have
prevented--or at least detected earlier--the problems that have
come to be associated with Enron.
The Committee took a broad look at a range of entities that
play some role in monitoring the financial activities of
publicly held companies, from the company's Board of Directors
to the accounting firm that audited Enron's books to stock
analysts and credit rating agencies that purported to give the
public accurate and objective information about Enron's
financial health.\2\ The Committee placed a particular focus on
the most important watchdog of all, the Securities and Exchange
Commission (the ``SEC'' or the ``Commission''). Each of these
entities plays a particular role in monitoring our capital
markets. Together, they are supposed to ensure that the markets
operate fairly, with complete, accurate and comprehensible
information available to all investors.
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\2\ The Committee's Permanent Subcommittee on Investigations
(``PSI'') also has been investigating aspects of Enron's collapse, and
has held a series of hearings on the role of Enron's Board of Directors
and the role of financial institutions in Enron's collapse. See The
Role of the Board of Directors in Enron's Collapse, Hearing Before the
Permanent Subcommittee on Investigations, Senate Governmental Affairs
Committee, 107th Cong., S. Hrg. 107-511 (May 7, 2002); The Role of
Financial Institutions in Enron's Collapse, Hearing Before the
Permanent Subcommittee on Investigations, Senate Governmental Affairs
Committee, 107th Cong., S. Hrg. 107-618 (July 23 and 30, 2002) (Printed
Hearing Record Pending). PSI also has issued a report on the role of
the Board of Directors in its collapse. See Report of the Senate
Permanent Subcommittee on Investigations on ``The Role of the Board of
Directors in Enron's Collapse,'' S. Prt. 107-70 (July 8, 2002).
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In looking at the array of purported checks on financial
misbehavior, what Committee staff discovered was deeply
disturbing--not so much because they uncovered malfeasance or
intentional wrongdoing on anyone's part (although that seems to
have been present in some cases as well), but because what
emerged was a story of systemic and arguably catastrophic
failure, a failure of all the watchdogs to properly discharge
their appointed roles. Despite the magnitude of Enron's
implosion and the apparent pervasiveness of its fraudulent
conduct, virtually no one in the multilayered system of
controls devised to protect the public detected Enron's
problems, or, if they did, they did nothing to correct them or
alert investors. Not one of the watchdogs was there to prevent
or warn of the impending disaster: Not Enron's Board of
Directors, which asked few, if any, probing questions of
Enron's management and which authorized various related-party
transactions that facilitated many of Enron's fraudulent
practices; not Enron's auditor, Arthur Andersen, which
certified the apparently fraudulent financial statements; not
the investment banking firms, which structured and sold
securities and other financial products that appear to have
allowed Enron to obfuscate its financial position; not the
attorneys, whose opinions and work were critical to certain
transactions that may have been central to Enron's collapse;
not the Wall Street securities analysts, many of whom continued
to recommend Enron as a ``buy'' up until the bitter end; not
the credit rating agencies, who rated Enron's debt as
investment grade up until 4 days before the company filed for
bankruptcy; and not the SEC, which did not begin to seriously
investigate Enron's practices until after the company's demise
became all but inevitable.
These failings call into question the basic assumptions on
which our financial regulatory framework is built. The SEC,
with its relatively small staff, does not, and is not set up
to, directly perform many of the tasks necessary to root out
corporate fraud. Instead, we have a system in which the public
relies on a partnership of both the SEC and private gatekeepers
in order to keep tabs on the enormous U.S. markets. But this
foundational assumption--that the SEC can depend on private
entities as the first and primary restraint against massive
corporate wrongdoing--proved terribly wrong in the case of
Enron. And the failure of this premise, along with the
insufficiency of the SEC's adjustment for it, raises questions
about whether the SEC is effectively functioning as the lead
market watchdog that it is meant to be.
That the Enron collapse, moreover, has been followed by a
seeming flood of allegations about large-scale financial fraud
at other prominent companies, including WorldCom, Global
Crossing, Tyco, Adelphia, and Rite Aid, precludes any easy
characterization of Enron as simply a ``bad apple'' or the
lapses of the gatekeepers and regulators as isolated breakdowns
in an otherwise sound system. Indeed, even if the malfeasants
are viewed as but rogue corporations, it is precisely the role
of the gatekeepers to spot and protect against such rogues.
That none of them did so suggests that there have been some
basic flaws in our system of market regulation, ones that well
warrant the re-examination that the system is currently
undergoing.
Furthermore, while Enron is now the poster company for all
of the failures of due diligence and objectivity on the part of
the watchdogs, portents of such problems should have been seen
for some time. The SEC, for example, had reason for years to
question the validity of financial statements; restatements of
filings with the SEC skyrocketed from just 3 in 1981 to 270 in
2001.\3\ Former SEC Chairman Arthur Levitt, moreover, in a now
famous speech called the ``Numbers Game,'' was talking about
gaps in the system of gatekeepers more than 3 years before
Enron imploded. In that speech, then-Chairman Levitt expressed
deep concern about ``earnings management''--the manipulation of
accounting in order to meet Wall Street's earnings expectation.
``Too many corporate managers, auditors and analysts are
participating in a game of nods and winks,'' he warned. ``I
fear that we are witnessing an erosion in the quality of
earnings, and therefore, the quality of financial reporting.
Managing may be giving way to manipulation; Integrity may be
losing out to illusion.'' In the conclusion to the speech
Levitt asked this ominous question: ``Today, American markets
enjoy the confidence of the world. How many half-truths, and
how much accounting sleight-of-hand, will it take to tarnish
that faith?'' \4\
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\3\ See Ianthe Jeanne Dugan, ``Depreciated: Did You Hear the One
About the Accountant? It's Not Very Funny,'' The Wall Street Journal,
March 14, 2002; Financial Executives International, ``Quantitative
Measures of the Quality of Financial Reporting,'' June 7, 2001,
available at http://www.fei.org/download/QualFinRep-6-7-2k1.ppt; Huron
Consulting Group, ``A Study of Restatement Matters,'' June 11, 2002,
available at http://www.huronconsultinggroup.com/files/tbl--s6News/
PDF134/50/restatement--study.pdf.
\4\ Arthur Levitt, ``The Numbers Game,'' Remarks at the NYU Center
for Law and Business, September 28, 1998, available at http://
www.sec.gov/news/speech/speecharchive/1998/spch220.txt. See also The
Fall of Enron: How Could It Have Happened, Hearing Before the Senate
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-376 (January
24, 2002) at 26-27 (Statement of the Honorable Arthur Levitt, Jr.,
former SEC Chairman) (``Enron's collapse did not occur in a vacuum. Its
backdrop is an obsessive zeal by too many American companies to project
greater earnings from year to year. When I was at the SEC, I referred
to this as a `culture of gamesmanship'--a gamesmanship that says it is
okay to bend the rules, to tweak the numbers, and let obvious and
important discrepancies slide; a gamesmanship where companies bend to
the desires and pressures of Wall Street analysts rather than to the
reality of the numbers; where analysts more often overlook dubious
accounting practices and too often are selling potentially lucrative
investment banking deals; where auditors are more occupied with selling
other services and making clients happy than detecting potential
problems; and where directors are more concerned about not offending
management than with protecting shareholders.'').
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Sadly, the Enron debacle and those that have followed may
have provided the answer to Levitt's question. The size and
number of these corporate frauds, coupled with the failure of
all of those charged with protecting against such fraud to do
so, appear to have left many investors with doubts about
whether they can rely on any of the financial information in
the marketplace.\5\ And because the proper functioning of U.S.
financial markets rests on the cornerstone principle that all
individuals have access to accurate basic information about the
companies in which they invest, this crisis in investor
confidence is widely seen as contributing significantly to the
current downturn in the stock market and as being a drag on any
economic recovery.\6\
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\5\ In one recent survey, for example, 57 percent of respondents
indicated that they do not trust corporate executives or brokerage
firms to give them honest information, and one third indicated that
they believed that what happened at Enron is typical of what goes on at
most or many companies. John Harwood, ``Americans Distrust Institutions
in Poll,'' The Wall Street Journal, June 13, 2002 (reporting the
results of a Wall Street Journal/NBC News Poll). In another poll, 72
percent of respondents said they thought stockbrokers acting in their
own interest rather than that of their clients was a somewhat or very
widespread practice; 73 percent said they thought financial audits
hiding damaging information about a company was somewhat or very
widespread; and 77 percent said they thought improper, self-serving
actions by top executives were somewhat or very widespread. Gary
Strauss, ``Bush's Call for Reform Draws Mixed Reviews,'' USA Today,
July 10, 2002 (reporting the results of a USA Today/CNN/Gallup Poll;
complete survey results available at http://www.usatoday.com/news/2002-
07-09-poll.htm).
\6\ See, e.g., Steven Pearlstein, ``Corporate Scandals Taking Toll
on Markets,'' The Washington Post, June 26, 2002; Joseph Nocera et al.,
``System Failure,'' Fortune, June 24, 2002. See also David W. Moore,
``Corporate Abuses, 9/11 Attacks Seen as Most Important Causes of
Economic Downturn,'' Gallup News Service, August 5, 2002, available at
http://www.gallup.com/poll/releases/pr020805.asp?Version=p (poll found
that 77 percent of respondents said that greed and corruption among
corporate executives was ``the major reason'' or ``one of the most
important reasons' for the current state of the economy). The lack of
confidence resulting from these scandals has also reportedly led to a
decline in foreign investment in U.S. markets. See Louis Uchitelle,
``Foreign Investors Turning Cautious on Spending in U.S.,'' The New
York Times, August 4, 2002; Philip Coggan, ``Losing Faith,'' Financial
Times (London), June 27, 2002; Pearlstein, above.
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Fortunately, with the recent enactment of the Sarbanes-
Oxley Act of 2002 \7\--which, among other things, strengthens
the oversight of accountants, takes steps to reduce the
conflicts of interests faced by auditors and stock analysts,
and enhances the SEC's enforcement tools--things seem to be
moving in the right direction. There are additional actions,
however, that can and should be taken by the various actors in
our system of market oversight themselves to improve the
information and protection they provide to the public. No one
watchdog--governmental or nongovernmental--alone can restore
the investor confidence that is vital to the continued robust
operation of our markets; all of those entrusted as gatekeepers
will need to take action to ensure the public that fraud will
be uncovered and that financial chicanery will not be
tolerated.
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\7\ Pub. L. No. 107-204.
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This report documents the results of the Committee's review
of the financial oversight of Enron. It is divided into two
parts. Part One discusses Committee staff's findings with
respect to the SEC's oversight of Enron. As discussed below,
the SEC staff failed to review any of Enron's post-1997
financial filings even though the company was undergoing
significant growth and substantially changing the nature of its
business and the SEC itself was aware that other gatekeepers,
such as boards of directors and auditors, were proving
increasingly unreliable. Had SEC staff reviewed these filings,
they would have had an opportunity to uncover some of the
problems with the company's financial practices that appear to
have been signaled in those documents. In addition, the SEC
staff made administrative determinations that allowed Enron to
engage in certain accounting practices and exempted the company
from certain regulatory requirements. Whether or not these
decisions were reasonable at the time, what is particularly
troubling is that the SEC lacked any procedures by which to
monitor the effects of these determinations to see whether they
were being applied appropriately by the company and/or whether
the circumstances that underlay them had changed. The leeway
afforded Enron by these determinations in certain cases appears
in fact to have been abused by the company in ways that
ultimately played a role in Enron's collapse. In short, the
SEC's interactions with Enron reveal the downside to the
Commission's largely reactive approach to market regulation and
should provide an impetus for the Commission to reorient some
of its activities toward more proactive anti-fraud measures.
Unfortunately, although the Commission has stepped up its
enforcement activities post-Enron, it has been less than
proactive in attempting to address fraud at an earlier stage,
before it becomes a corporate calamity.
The report's second part describes the roles of two
additional groups of private sector watchdogs--Wall Street
securities analysts and credit rating agencies--and how each
group failed the market by not ringing the alarm bells about
Enron until it was too late.\8\ Along with other investigations
into securities analysts, Enron exposed a dirty little secret--
apparently known widely among market insiders, but
unfortunately kept from average investors--that Wall Street
analyst recommendations were of questionable reliability. Of 15
analysts at major Wall Street firms who covered Enron, all 15
were recommending that investors buy Enron stock when the news
about the company's financial misdeeds was first revealed.
Three weeks later, after the company had announced an SEC
investigation, its Chief Financial Officer had resigned and it
had announced that it was restating its financial results for
the past 4\1/2\ years due to accounting irregularities, 10 of
those 15 analysts continued to encourage the public to buy
Enron stock. Why, after so much bad news, would these experts
hold to their rosy assessment of this company? It turns out
that Enron, which tapped the capital markets for funds on a
regular basis, had a great deal of investment banking business,
and the Wall Street firms that wanted that business also had
research departments with analysts assessing Enron stock. This
kind of conflict of interest is rife in the industry, and only
now, with the historic passage of the Sarbanes-Oxley Act, is
there a chance that investors may obtain the unvarnished stock
advice that they had thought they were receiving all along.
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\8\ This report focuses on groups about which the Committee has
already conducted hearings. Committee staff, however, is mindful that
there are other groups that can, and in fact, do function as
gatekeepers, particularly in the public securities markets. One of
these groups, securities underwriters, has been the subject of an
extensive investigation and hearings by PSI. It is also Committee
staff's understanding that some firms are being investigated by other
governmental bodies. A second group is attorneys. The role of lawyers
and law firms as gatekeepers should not be overlooked. See Soderquist,
Understanding the Securities Laws, Sec. 1:7 (Practising Law Institute
2002) (discussing the special position of securities lawyers); ``SEC
Enforcement Actions Against Securities Lawyers: New Remedies vs. Old
Policies,'' 22 Del. J. Corp. L. 537 (1997) (same). The Sarbanes-Oxley
Act requires the SEC, within 180 days from the law's enactment, to
promulgate rules regarding lawyers' conduct. Pub. L. No. 107-204
Sec. 307.
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The credit rating agencies, though unhampered by the kind
of conflicts faced by securities analysts at major Wall Street
firms, similarly failed to warn the public of Enron's
precarious situation until a mere 4 days before Enron declared
bankruptcy. Until that time, the rating agencies gave Enron an
``investment grade'' rating, which indicated that Enron was
creditworthy and its bonds were a safe investment. How could
the creditworthiness experts consider a company less than a
week away from bankruptcy to be a solid investment? This is
particularly troubling given that numerous Federal and State
statutes and regulations rely on credit ratings to set the
standard for the kind of investments that funds of public
importance, such as money market funds, State pension funds or
insurance companies, may make. Based on interviews with the
credit rating agencies about their coverage of Enron, Committee
staff concluded that, at least with respect to Enron, the
rating agencies failed to detect Enron's problems--or take
sufficiently seriously the problems they were aware of--until
it was too late because they did not exercise the proper
diligence. They did not ask sufficiently probing questions and,
despite their mission to make long-term credit assessments, did
not sufficiently consider factors affecting the long-term
health of the company, particularly accounting irregularities
and overly complex financing structures. Committee staff
recommends increased oversight for these rating agencies in
order to ensure that the public's trust in these firms is well-
placed.
PART ONE: THE SEC AND OTHER WATCHDOGS WITH LEGAL OBLIGATIONS
Of those entities that participate in our public-private
system of market oversight, a number have legally required
responsibilities to serve an interest broader than their own.
Corporate boards of directors, for example, are responsible to
the corporation's shareholders, while auditors owe duties to
the company's shareholders and creditors and, indeed, to the
investing public. The SEC occupies a unique position in this
system as the public institution responsible for overseeing the
financial markets, and, accordingly, has the most comprehensive
mandate to act in the public interest and protect the interests
of investors.
This Part looks at this set of mandated watchdogs, focusing
in particular on the actions of the SEC.\9\ It starts with an
overview of the role each entity plays in our system of market
oversight. Looking first at the SEC, this Part reviews the
Commission's operations and describes its role in preventing
and combating financial fraud. It then turns to the roles and
responsibilities of the private-sector gatekeepers and
describes the integral part boards of directors and auditors
are supposed to play in protecting against fraud.
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\9\ This Part of the report is based on a Committee investigation
that began with letters from the Committee to the SEC on February 15,
2002 and March 27, 2002, seeking information concerning the
Commission's dealings with Enron from 1992 to the present, as well as
certain additional information about the operations of the agency. The
SEC provided the Committee with written responses to the Committee's
letter request, and over the course of the months that followed,
Committee staff held numerous meetings and telephone calls with staff
from various offices in the SEC and received supplementary documents as
requested. (The SEC staff has been consistently responsive and helpful
to Committee staff throughout this process). The telephone calls, of
various lengths and range, are cited in this report as ``Committee
staff interview with SEC staff''; face-to-face meetings are cited as
``Committee staff meeting with SEC staff.'' In addition, Committee
staff has consulted with numerous outside individuals with relevant
knowledge, including former SEC employees, experts in securities law,
accounting, and public management, consumer and investor advocates,
independent stock analysts and others, and has reviewed documents
produced by Enron in response to the Committee's subpoenas to the
company on February 15, 2002 and March 22, 2002.
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This Part next examines the actions of each of these
players in the case of Enron. It begins with a brief discussion
of what Enron's Board of Directors and its auditor did--or,
more importantly, failed to do--to head off the company's
fraudulent practices. Against this backdrop of failings by the
private-sector gatekeepers, the report turns to the SEC,
describing the Commission's review of Enron's public filings
over the past decade, including its failure to review Enron's
filings in recent years. It then examines some of the SEC's
other regulatory actions with respect to Enron and their
implications, including the SEC's determination in 1992 to
allow an Enron subsidiary to use so-called ``mark-to-market''
accounting to record certain of its transactions, and
exemptions the SEC granted Enron and its affiliates from the
requirements of the Public Utility Holding Company Act of 1935
(``PUHCA'') and the Investment Company Act of 1940 (the
``Investment Company Act'').
Part One of the report concludes by offering
recommendations about how, within our overall system of
oversight, the SEC can improve its ability to protect investors
against future cases of financial fraud and thereby help
restore confidence to the financial marketplace.
I. BACKGROUND
A. The SEC
1. Mission and Organization
In the wake of the 1929 stock market crash, Congress
created the SEC in an effort to restore stability and
confidence to the U.S. capital markets. Then and now, the SEC's
mission has been to protect investors and ensure the integrity
of the securities market. The core principle of the fundamental
Federal securities statutes, the Securities Act of 1933 \10\
(the ``Securities Act'') and the Securities Exchange Act of
1934 \11\ (the ``Exchange Act'') is one of disclosure: That all
investors should have access to basic information about a stock
or other security before investing in it.\12\
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\10\ 15 U.S.C. Sec. 77a et seq.
\11\ 15 U.S.C. Sec. 78 et seq. The Exchange Act established the
SEC.
\12\ See Louis Loss and Joel Seligman, Fundamentals of Securities
Regulation (4th ed. 2001) at 29-31; Joel Seligman, The Transformation
of Wall Street: A History of the Securities and Exchange Commission and
Modern Corporate Finance (Rev. ed. 1995) at 39-40, 561-62.
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The SEC is divided into four ``divisions'' and 18
``offices.'' The four divisions, reflecting the scope of the
Commission's responsibilities, are: (1) the Division of
Corporation Finance, which oversees corporate disclosures
through review of companies' public filings; (2) the Division
of Market Regulation, which regulates major market
participants, including broker-dealers and self-regulatory
organizations, such as NASD (formerly known as the National
Association of Securities Dealers) and the eight stock
exchanges; (3) the Division of Investment Management, which
oversees investment companies, including mutual funds, and
investment advisers, and which administers PUHCA; and (4) the
Division of Enforcement, which investigates possible violations
of U.S. securities laws and brings legal action where
appropriate.\13\ Altogether, the Commission employs
approximately 3,000 people.
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\13\ The SEC's 18 ``offices'' include the Office of the General
Counsel, the Office of the Chief Accountant, the Office of Compliance
Inspections and Examinations (which administers the SEC's examination
and inspection program for broker-dealers, self-regulatory agencies,
investment companies and others), the Office of Investor Education and
Assistance, the Administrative Law Judges, and assorted other
administrative and policy offices. Also, in addition to its
headquarters in Washington, D.C., the SEC has 11 regional offices.
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With respect to fighting financial fraud, the SEC plays
perhaps its most essential roles within the broader public-
private scheme in two areas. First, the SEC establishes
requirements that companies disclose certain information to
investors and works to ensure compliance with those disclosure
requirements by reviewing the public filings companies submit.
In doing so, the SEC both directly discourages shady accounting
practices and, by ensuring that material, comprehensible
information is publicly available, empowers the entire
marketplace--stock analysts and credit raters, individual
shareholders and institutional investors--to evaluate the
information provided. This is particularly true after the SEC
implemented electronic filing and on-line availability of
company filings through its EDGAR (Electronic Data Gathering
And Retrieval) System. Second, when preventive measures fail,
the SEC has the authority to enforce the law and bring legal
action against those who have committed fraud.
2. Review of Public Filings
The SEC's Division of Corporation Finance employs
approximately 330 people, of whom approximately 144 are lawyers
and 107 are accountants; \14\ together, they are charged with
reviewing the public filings of more than 17,000 public
companies in the United States.\15\ The Division's staff is
organized into 11 groups, with each group responsible for
reviewing the filings of a different industry category.\16\
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\14\ Correspondence from SEC staff to Committee staff (August 9,
2002).
\15\ See Letter from Harvey L. Pitt, Chairman, Securities and
Exchange Commission, to Joseph I. Lieberman, Chairman, and Fred
Thompson, Ranking Member, Senate Committee on Governmental Affairs,
dated March 4, 2002 (``SEC Response'') at 4.
\16\ One of these groups is not industry-specific but instead
devoted to the review of small businesses. Until recently, Enron's
filings were reviewed by the natural resources and food companies
group. In February 2001, representatives from Enron's investor
relations department, arguing that Enron was no longer primarily a
natural gas pipelines company, asked that the Corporation Finance
Division reassign Enron to the group that reviews filings from
companies that deal with commodities pools. Corporation Finance
declined to do this, but did reassign Enron to the financial services
group (which reviews filings made by securities and commodities brokers
and dealers), based on the fact that Enron's revenues were at that time
primarily derived from its wholesale trading business. No reviews of
Enron's filings have been conducted since the reassignment was made.
SEC Response at 20-21; Committee staff interview with SEC staff,
Division of Corporation Finance (April 24, 2002).
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The public filings required to be submitted to the
Commission fall largely into two general categories:
Transactional filings and periodic reports. Transactional
filings are those associated with a particular transaction--
e.g., the sale of securities (including initial public
offerings) or a merger. They contain information about the
transactions as well as about the company's financial
condition. Transactional filings are prospective (that is, they
address events that have not yet happened) and often call for
action by Commission staff. A sale of securities, for example,
requires the Division to declare the registration statement
submitted by the company to be effective before the sale can go
forward. Periodic filings include annual reports (Forms 10-K)
and quarterly reports (Forms 10-Q) that set forth a company's
financial condition.\17\ They are historical in nature,
describing the last period's events, and do not require further
Commission action. Transactional filings typically contain or
incorporate the historical information available in periodic
filings.
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\17\ In addition to annual reports and quarterly reports, companies
are required to file so-called ``current reports'' on Form 8-K to
report certain specified events which are material to shareholders so
that this information is made available sooner than the next quarterly
or annual filing.
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The Corporation Finance Division does not have the
resources to review every filing submitted; accordingly, it
employs a screening process to select the filings to be
reviewed fully. This ``screening'' process is distinct from an
actual ``review'' of the filings. Although it involves an
initial examination of the filings, the screening process is
intended only to determine whether a filing merits a further
``review.'' Unlike a ``review,'' it does not involve a
substantive evaluation of the disclosures made in the filing.
The screening process employs a variety of criteria, both
financial and otherwise (including the length of time from last
review), to determine which filings warrant further scrutiny.
These criteria can vary by industry group. The criteria are
kept confidential by the SEC, but are intended to target those
filings that ``most warrant[ ] staff review''--presumably those
most likely to pose the greatest risk to investors.\18\ The
screening process relies heavily on initial, direct staff
examination of the filings, although it incorporates computer-
based financial data as well. As a result of the screening
process, a filing may be selected for one of four levels of
review: A full review (that is to say, a review of the entire
filing), a financial statement review (a review only of the
company's financial statements and Management Discussion and
Analysis (``MD&A'')), \19\ a limited review or ``monitor'' (a
review of a specific item or items in the filing), or no review
at all.
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\18\ SEC Response at 2.
\19\ These financial statements--including balance sheet, income
statement, and statement of cash flows--are accompanied by explanatory
footnotes, which are also reviewed. MD&A (formally, ``Management
Discussion and Analysis of Financial Condition and Results of
Operations'') is a required supplementary analysis of the financial
statements in which the company is required to provide other
information necessary to understand its financial condition. See
generally SEC Regulation S-X, 17 C.F.R. Part 210 (detailing the
requirements for financial statements); SEC Regulation S-K, 17 C.F.R.
Part 229 (detailing other requirements for information contained in SEC
filings, including Form 10-K; MD&A is discussed at 17 C.F.R.
Sec. 229.303).
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All transactional filings go through the screening process
because the Division must take action on them. The Corporation
Finance Division, furthermore, has given priority to initial
public offerings (IPOs) because of the risks to investors
inherent in a company's first sale of stock.\20\ Accordingly,
all IPO filings are reviewed by Corporation Finance Division
staff. Although this may reflect a reasonable risk assessment,
it nonetheless leaves fewer resources to devote to other types
of filings. This became a particular problem in the mid-to-late
1990's, when the number of initial public offerings increased
substantially.\21\ According to SEC staff, the focus on IPO
reviews has meant that even those non-IPO transactional filings
that meet the screening criteria are not necessarily reviewed.
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\20\ According to SEC staff, IPOs, which constitute a company's
first filing with the Commission, often raise a greater number of
disclosure and securities law concerns than other filings; they also
provide an opportunity for staff to correct improper disclosures early,
before they appear in later periodic reports. Correspondence from SEC
staff to Committee staff (August 9, 2002). One former SEC official,
agreeing that the greatest risk of misrepresentations lies with
companies attempting to raise capital, opined that many company
officials had adopted more brazen attitudes in the late 1990's with
respect to IPO filings, deliberately testing the limits of what the SEC
would allow them to do. Interview with Lynn Turner, Director, Center
for Quality Financial Reporting, Colorado State University College of
Business and former SEC Chief Accountant (June 24, 2002).
\21\ The number of IPO filings examined by the SEC peaked at 1,350
in 2000; as recently as 1995, the number was 805. By 2001, the number
decreased to 745. Correspondence from SEC staff to Committee staff
(August 9, 2002); see also U.S. General Accounting Office, ``SEC
Operations: Increased Workload Creates Challenges,'' GAO-02-302, March
2002, at 17.
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As for periodic reports, screening of these is uncertain
and is subject to the time and resources available after
screening and review of transactional filings. In other words,
many periodic reports are not screened at all, even to
determine whether they should be examined further.\22\ The
SEC's stated goal has been to review every company's annual
report at least once every 3 years, but in recent years, it has
fallen far short of this mark. In fiscal year 2001, for
example, the Division completed a full or financial statement
review of only 2,280 of 14,600 Forms 10-K filed, or
approximately 16 percent. Of more than 17,300 public companies,
approximately 9,200, or 53 percent, have not had their Forms
10-K reviewed in the past three years.\23\
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\22\ The SEC does not track the number of periodic reports that go
through the screening process. Committee staff interview with SEC
staff, Division of Corporation Finance (June 25, 2002); Correspondence
from SEC staff to Committee staff (August 9, 2002).
\23\ SEC Response at 4. Following the Enron collapse, the SEC
announced that it will ``monitor'' the Forms 10-K of each of the
country's 500 largest companies (by revenue) each year for selected
disclosure issues and, where problems are identified, will select these
filings for expedited review. ``Program to Monitor Annual Reports of
Fortune 500 Companies,'' SEC News Digest, Issue 2001-245, December 21,
2001. The SEC staff hopes to conduct reviews of approximately half
these filings. As of August 2002, they had screened over 400 of these
filings and issued comments on approximately 100. Committee staff
meeting with SEC staff (June 10, 2002); Committee staff interview with
SEC staff (August 22, 2002). The Sarbanes-Oxley Act now requires the
SEC to review a company's filings at least once every 3 years. Pub. L.
107-204 Sec. 408.
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For those annual reports actually reviewed by the
Corporation Finance Division, the review generally is limited
to the four corners of the document. One SEC staff member
referred to this process as a ``desk audit--'' that is,
information one can get while sitting at one's desk. The review
may thus incorporate information gleaned from news stories and
analyst and industry reports, but the focus is on the filings
themselves.\24\ The primary goal is to ensure that required
disclosures are set forth in the report and that the
disclosures themselves are facially accurate and
comprehensible.\25\ If the staff has questions or concerns
about disclosures that do not comply with the requirements, are
incomplete or are inconsistent with other information in the
filings or that is otherwise available, the company will
receive a comment letter listing the staff's concerns. In some
cases after the initial reply by the company, another round or
rounds of comments may follow. These formal exchanges may be
supplemented by informal conversations between the SEC staff
and the company, its counsel, or its auditor. When a resolution
is reached about the changes to be made, the company may, at
the staff's discretion, be required either to amend an existing
filing or to incorporate the changes in the future filings
submitted by the company.\26\
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\24\ Committee staff interview with SEC staff, Division of
Corporation Finance (April 24, 2002).
\25\ Id.
\26\ Id.
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The review of a company's periodic filings, however, is not
intended to serve as a second audit of the financial statements
or otherwise validate the numbers set forth.\27\ Thus, SEC
reviewers may look at whether a company has clearly explained
its accounting policies (e.g., how it calculates certain
revenue or how it determines in what period it records that
revenue), but they generally will not look at whether those
policies have been applied appropriately in a particularly
instance. Should a company simply lie about the amount of
revenue it got from a particular source or record that revenue
in an earlier period than would be permitted under its stated
policies, a routine SEC review of the company's filings may
well not detect this--and is not designed to.\28\ To look
behind the numbers of all the filings SEC staff reviews is too
resource-intensive; as further explained below, the SEC relies
on auditors to perform this function.\29\ Nonetheless, when the
Corporation Finance Division staff's review of a company's
filings does reveal a troubling item or some indicia of fraud
that the company is unable to explain adequately, Corporation
Finance Division staff may refer it to the Division of
Enforcement for further investigation.\30\
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\27\ Committee staff interview with SEC staff, Division of
Corporation Finance (April 24, 2002); Committee staff meeting with SEC
staff (June 10, 2002).
\28\ SEC staff explained that, among other things, no single
transaction is likely to be material in and of itself to a company's
overall financial condition.
\29\ In the case of a large corporation, even auditors typically do
not look behind each transaction that contributes to the numbers on the
company's financial statements; rather, they review a sample of notable
or representative ones. See American Institute of Certified Public
Accountants Professional Standards, AU Section 350 (Audit Sampling).
Full-scale forensic accounting is generally done only when there is
already evidence that fraud has occurred. See Michael R. Young,
Accounting Irregularities and Financial Fraud (2d ed. 2002) at 102-105
(describing the difference between ordinary audits and forensic
investigations).
\30\ Committee staff interview with SEC staff, Division of
Corporation Finance (April 24, 2002).
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3. Enforcement
Another important way in which the SEC combats financial
fraud is through its Division of Enforcement. The Enforcement
Division's role--investigating and prosecuting fraud under the
securities laws--is essential not only to punish wrongdoers but
also to deter those who might be considering committing similar
misdeeds. Although the Commission cannot on its own bring
criminal prosecutions, it may nonetheless obtain significant
civil sanctions against those found to have violated the
securities laws--and may (and frequently does) refer to the
Department of Justice matters that it believes warrant criminal
charges.\31\
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\31\ See Securities Act Sec. 20(b), 15 U.S.C. Sec. 77t(b); Exchange
Act Sec. 21(d)(1), 15 U.S.C. Sec. 78u(d)(1). For a general discussion
of the relationship between civil and criminal enforcement of the
securities laws, see Thomas C. Newkirk and Ira L. Brandriss, SEC
Division of Enforcement, ``The Advantages of a Dual System: Parallel
Streams of Civil and Criminal Enforcement of the U.S. Securities
Laws,'' Remarks at the 16th International Symposium on Economic Crime,
Jesus College, Cambridge, England, September 19, 1998, available at
http://www.sec.gov/news/speech/speecharchive/1998/spch222.htm.
Many of the securities laws that are civilly enforced by the SEC
also provide that willful violations may be prosecuted criminally. See,
e.g., Securities Act Sec. 24, 77x; Exchange Act Sec. 32, 15 U.S.C.
Sec. 78ff. In addition, the recently enacted Sarbanes-Oxley Act of 2002
establishes the new Federal crime of ``securities fraud'' for the
knowing execution of a scheme to defraud any person in connection with
any security, or to obtain money or property by means of false or
fraudulent pretenses in connection with the purchase or sale of any
security. Pub. L. No. 107-204 Sec. 807 (to be codified at 18 U.S.C.
Sec. 1348). The Sarbanes-Oxley Act also increases the criminal
penalties for violations of the Exchange Act, and for other associated
white-collar crimes, such as mail and wire fraud. See Pub. L. No. 107-
204 Sec. Sec. 901-904, 1106.
---------------------------------------------------------------------------
Potential financial fraud cases, like other cases brought
by the Enforcement Division, are identified for investigation
by a variety of means. Often, Commission staff receives a tip
from an insider at the company warning of a potential fraud.
Other times, there may be something anomalous about a company's
performance or something reported in the news that causes staff
to take a closer look. Sometimes, Corporation Finance staff
will make a referral of a disclosure matter they deem
suspicious (although, by the accounts of staff of both
divisions, these referrals account for a small portion of the
Enforcement Division's cases).\32\ Once there is some reason to
believe that a company has misreported financial information,
the Enforcement Division can conduct an in-depth investigation
of that company's accounting and reporting practices to
determine whether and to what extent there has been financial
fraud. The Commission has the power, and may authorize its
staff, to subpoena documents and witnesses.\33\
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\32\ Committee staff interviews with SEC staff, Division of
Enforcement (May 7, 2002), and Division of Corporation Finance (April
24, 2002).
\33\ Securities Act Sec. 19(b), 15 U.S.C. Sec. 77s(b); Exchange Act
Sec. 21(b), 15 U.S.C. Sec. 78u(b). SEC staff may begin its
investigation by conducting an informal inquiry--that is, opening a so-
called ``matter under inquiry.'' If and when staff seeks to use
compulsory process, it will seek a formal order of investigation from
the Commission. Committee staff interview with SEC staff (July 24,
2002).
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If the Enforcement Division staff's investigation uncovers
violations of the securities laws, the Commission may bring an
enforcement action either in Federal court or through an
administrative proceeding (with a trial before an
administrative law judge, with a right of appeal to the
Commission itself). Depending on whether it is a court or the
Commission imposing the sanctions, the available remedies
differ somewhat, but can include injunctions, \34\ monetary
penalties, \35\ disgorgement of ill-gotten gains, \36\ and bans
on a person serving as an officer or director of a publicly
held company.\37\
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\34\ Securities Act Sec. 20(b), 15 U.S.C. Sec. 77t(b); Exchange Act
Sec. 21(d)(1), 15 U.S.C. Sec. 78u(d)(1) (providing for injunctive
relief in Federal court). The equivalent remedy in an administrative
proceeding is a cease-and-desist order. See Securities Act Sec. 8A, 15
U.S.C. Sec. 77h-1; Exchange Act Sec. 21C, 15 U.S.C. Sec. 78u-3.
\35\ Securities Act Sec. 20(d)(1), 15 U.S.C. Sec. 77t(d)(1);
Exchange Act Sec. 21(d)(3), 15 U.S.C. Sec. 78u(d)(3) (providing for
monetary penalties in a Federal court action). In some, more limited
circumstances, the Commission is also able to impose monetary penalties
in administrative cases. See Exchange Act Sec. 21B, 15 U.S.C. Sec. 78u-
2.
\36\ Disgorgement can be imposed by Federal courts as part of their
inherent equitable powers. See, e.g., SEC v. Materia, 745 F.2d 197,
200-01 (2d. Cir. 1984); SEC v. Texas Gulf Sulphur Co., 446 F.2d 1301,
1307-08 (2d. Cir. 1971). In 1990, Congress gave the Commission the
power to require disgorgement in an administrative proceeding as well.
See Securities Act, Sec. 8A(e), 15 U.S.C. Sec. 77h-1(e); Exchange Act
Sec. 21C(e), 15 U.S.C. Sec. 78u-3(e)
\37\ Securities Act Sec. 20(e), 15 U.S.C. Sec. 77t(e); Exchange Act
Sec. 21(d)(2), 15 U.S.C. Sec. 78u(d)(2) (providing for such bans by a
Federal court). The Sarbanes-Oxley Act now gives the Commission the
power to impose such bans in an administrative proceeding as well. Pub.
L. No. 107-204 Sec. 1105 (to be codified at 15 U.S.C. Sec. Sec. 77h-
1(f) and 78u-3(f)).
---------------------------------------------------------------------------
In recent years, the Commission has brought approximately
500 enforcement cases annually and, of these, approximately 100
have involved financial fraud.\38\ Though financial fraud
matters make up only about 20 percent of the cases, Division of
Enforcement staff estimate that these matters consume half of
the Division's resources, because of their complex and
document-intensive nature.\39\ Not surprisingly, Commission
staff expects the number of financial fraud cases brought to
increase substantially this year.\40\
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\38\ Committee staff interview with Commission staff, Division of
Enforcement (May 7, 2002; see also Securities and Exchange Commission,
2001 Annual Report, at 1, 134, available at http://www.sec.gov/about/
annrep01.shtml.
\39\ Committee staff interview with SEC staff, Division of
Enforcement (May 7, 2002).
\40\ Id.
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Essential as it is, the Enforcement Division's method of
operation has two important (and inherent) limitations. First,
though it may punish wrongdoers and deter others, it generally
comes after the damage has been done and so can do little to
make whole those shareholders and employees who have seen the
value of their holdings substantially diminished as a result of
others' financial fraud.\41\ Second, by its nature, it can only
be undertaken where there is already some reason to believe
that fraud has been committed. Thus, it is impossible to know
how many cases of fraud--cases where no tip has been received
or the fraud has not yet snowballed to the point of inevitable
discovery--are not being found and therefore not being brought
and the wrongdoers not being punished.
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\41\ When feasible, disgorgement proceeds may be used to compensate
victims, see, e.g., SEC v. Levine, 881 F.2d 1165 (2d Cir. 1989); SEC v.
Certain Unknown Purchasers, 817 F.2d 1018 (2d Cir. 1987), and, under
the Sarbanes-Oxley Act, civil penalty amounts now may be added to
disgorgement funds to be used for this purpose, see Pub. L. No. 107-204
Sec. 308. Although such procedures provide important potential remedies
to investors, payments received thereby are highly unlikely to fully
compensate shareholders for their losses.
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B. Private-Sector Gatekeepers
As the discussion above suggests, the SEC plays a key but
nonetheless circumscribed role in addressing financial fraud.
The Commission's reviews of corporate filings, limited as they
are in number and nature, are not (and have not been intended
to be) a reliable mechanism for identifying fraud, and
enforcement actions can only be brought when fraud has already
been identified. The system contemplates that much of the
front-line work for prevention and discovery of financial
misconduct will be done by private-sector gatekeepers--most
importantly, corporations' boards of directors and auditors--a
role implicitly recognized in the legal obligations that govern
the conduct of these groups.\42\
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\42\ There are other private actors that can serve as gatekeepers
as well, such as securities lawyers and investment bankers. See note 8
above.
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1. Boards of Directors
One of the first lines of defense against management
wrongdoing is the company's board of directors. Boards are not
supposed to run a corporation's day-to-day operations--that is
the job of the full-time management--and they are not supposed
to work full-time in their capacity as board members.
Nevertheless, as the elected representatives of the
shareholders, directors are charged with protecting their
interests by setting the direction for the corporation and by
watching over management.\43\ The board should provide
leadership and oversight with an eye toward maximizing
shareholder value. Unfortunately, this is a difficult job for
the board on a part-time basis, as corporations, their
businesses and the transactions they enter into become ever
larger and increasingly complex.
---------------------------------------------------------------------------
\43\ Boards of directors typically are composed of both outside
directors, who are elected by the company's shareholders, and
management directors who sit on the Board by virtue of their position
in the company (such as CEO). Notably, outside directors are not
necessarily ``independent'' directors as that term is generally
understood. For example, the New York Stock Exchange's new rules, which
await SEC approval, define an independent director as one with no
``material'' relationship with the company. See New York Stock Exchange
Listed Company Manual Sec. 303A(2) (proposed). Thus, a director who has
had extensive business dealings with the company but is elected by the
shareholders would be an outside director, but not an independent one.
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The duties and responsibilities of corporate directors are
set mostly by State law, which governs the general structure
and function of corporations. State law is fairly consistent
with respect to the duties of directors. Directors are
fiduciaries owing the two basic duties to the company and its
shareholders: A duty of care and a duty of loyalty.\44\ As the
Delaware Supreme Court, which many courts and commentators view
as a leading authority on corporate law, has stated: ``Duty of
care and duty of loyalty are the traditional hallmarks of a
fiduciary who endeavors to act in the service of a corporation
and its stockholders.'' \45\ The duty of loyalty requires a
director to be independent and objective, and to put the
interests of the corporation before others, including his
own.\46\ The duty of care requires a director to act in good
faith with the diligence that an ordinary prudent person in a
similar position would exercise under similar
circumstances.\47\ Beyond these general duties, the law
generally provides few specific requirements or prohibitions
for directors; they are merely to oversee the corporation
consistent with their fiduciary duties. The SEC, however, has
placed certain specific requirements on directors. One of the
most significant is the directors' responsibility to sign the
company's annual report. This is supposed to signal to
investors that the directors have reviewed and approve of its
contents.
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\44\ Most States, when confronted with a lack of precedent on a
particular matter, follow the corporate law of Delaware, a State in
which many companies have incorporated, and whose law generally is
recognized as the most developed in this area. Enron originally was
incorporated in Delaware; in 1993, it reincorporated in Oregon. Oregon
law, like Delaware law, requires directors to fulfill fiduciary duties
of both care and loyalty. Oregon Revised Statutes Sec. 60.357; Klinicki
v. Lundren, 298 Ore. 662, 667; 695 P.2d 906, 910 (1985). In any event,
Oregon will often look to Delaware precedent on corporations law
issues. See, e.g., Stringer v. Car Data Systems, Inc., 314 Ore. 576,
841 P.2d 1183 (1992).
\45\ Cede & Co. v. Technicolor, 634 A.2d 345, 367 (Del. 1993).
\46\ Guth v. Loft, 23 Del. Ch. 255, 273; 5 A.2d 503, 511 (1939),
aff'd, 19 A.2d 721 (Del. 1941).
\47\ Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).
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Despite their weighty responsibilities, directors in
reality have little personal accountability or oversight. The
SEC can sue directors for violations of the Federal securities
laws (as it can with any person), and if it proves a violation,
can among other things request a Federal court to issue an
injunction barring that person from serving on the board of any
other public company in the future. In addition, the Sarbanes-
Oxley Act permits the SEC to prohibit an individual who has
committed securities fraud from serving as a director on the
boards of public companies without the need to go to Federal
court.\48\ The SEC, however, has no jurisdiction over State law
violations by corporate directors; such violations, generally
breaches of their fiduciary duties, are enforced by private
shareholder lawsuits in State court. Holding directors
personally accountable is not easy. After the Delaware Supreme
Court held directors responsible for grossly negligent conduct
in Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), some States
reacted by enacting ``exculpation statutes.'' \49\ These laws
allow corporations to provide in their charters that directors
are not liable for breaches of the duty of care involving
simple negligence. Furthermore, even when a director might be
held liable for such a breach, or for a breach of the duty of
loyalty, a director may be entitled to indemnification from the
corporation or covered by directors and officers liability
insurance, except in cases of fraud on the corporation by the
director.
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\48\ Pub. L. No. 107-204 Sec. 1105. See also Pub. L. No. 107-204
Sec. 305 (easing the standard for obtaining a Federal court order
barring an individual from serving on a board of directors).
\49\ See, e.g., 8 Del. C. Sec. 102(b)(7) (permitting corporate
charters to excuse directors from liability for any breach of fiduciary
duty except a breach of the duty of loyalty, intentional misconduct or
knowing violations of law, or any transaction from which the director
improperly derived a personal benefit).
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In addition, decisions of the board are presumptively
protected from liability by the doctrine known as the
``business judgment rule,'' unless it can be shown that the
directors breached one or both of their duties.\50\ The initial
burden is on shareholders to prove that the directors did
something wrong in order to convince a court to second-guess
the board's decisionmaking, and to determine that the board did
something that hurt the company. Thus directors, in general,
have little at stake personally if they do not properly
discharge their duties, at least with respect to the duty of
care.
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\50\ See In Re Unitrin, Inc., 651 A.2d 1361, 1373 (Del. 1995).
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Because of the part-time and big-picture nature of their
work, directors by law are entitled to rely on experts in
discharging their duties.\51\ This reliance, however, may not
be blind: The statutes require that the reliance be reasonable
under the circumstances. In addition, directors may delegate
certain functions or responsibilities to a committee of the
board, although such delegation does not relieve the full board
of its fiduciary obligations. One of the most common committees
formed by a board of directors is the audit committee.
Typically, an audit committee focuses on the corporation's
retention of auditors, financial reporting and internal
financial controls.\52\ Audit committees are not required by
SEC regulations, \53\ but they are mandated by listing
requirements for both the New York Stock Exchange (``NYSE'')
and the NASDAQ.\54\ NYSE requires that all the members of the
audit committee be independent of the corporation (that is, not
affiliated with management or a large shareholder), and NASDAQ
requires a majority of the audit committee members to be
independent. By maximizing use of committees and the full
board, directors are supposed to maintain a strong foothold on
what is going on in the company and ensure management's efforts
are serving the needs of the shareholders.
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\51\ See 8 Del. C. Sec. 141(e); Oregon Revised Statutes
Sec. 60.357.
\52\ ``The primary functions of the audit committee generally are
to recommend the appointment of the public accountants and review with
them their report on the financial reports of the corporation; to
review the adequacy of the system of internal controls and of
compliance with material policies and laws, including the corporation's
code of ethics and conduct; and to provide a direct channel of
communication to the board for the public accountants and internal
auditors and, when needed, finance officers, compliance officers, and
general counsel.'' Statement on Corporate Governance, The Business
Roundtable, September 1997.
\53\ Nevertheless, the SEC does require each company, in its annual
proxy statement, to disclose the existence, composition, functions, and
number of annual meetings of its audit committee. 17 C.F.R. Sec. 14a-
101, Item 7, Paragraph (e)(3).
\54\ Subject to SEC approval of their rules, stock exchanges (of
which there are currently eight) are self-regulatory organizations,
allowed to govern the conduct of their members--broker-dealers that
trade or make markets in equities--and the companies that list
securities on those exchanges. Exchange Act Sec. 19(b), 15 U.S.C.
Sec. 78s(b). To those who prefer market solutions, listing requirements
generally are viewed with more favor than SEC regulation because they
come from market participants rather then government. Stock exchanges
can fine, penalize or delist listed companies that do not comply with
their rules; they can fine, penalize or suspend the membership of
members that fail to comply.
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The series of corporate collapses that began with Enron has
caused concern about the independence and vigilance of
corporate boards, and has led to calls for board reform. There
has been some response. On June 6, 2002, the New York Stock
Exchange Corporate Accountability and Listing Standards
Committee published a list of recommendations for changes in
the Exchange's listing requirements to enhance corporate
governance. Many of these address directors in an effort to
tighten their sense of accountability and diligence. Among
them: A majority of directors on boards of listed companies
must be independent directors; boards must convene regular
sessions without management in attendance; the chair of the
audit committee must have financial or accounting expertise;
and audit committees must have sole responsibility for hiring
or firing independent auditors and for approving all non-audit
work by the auditors. The recommendations also attempt to
enhance the independence of independent directors by requiring
that the board affirmatively determine, with respect to each
independent director, that he or she has no material
relationship with the company and that directors fees
constitute the sole compensation received from the company by
any audit committee member. These recommendations were adopted
by the NYSE Board of Directors on August 1, 2002, following a
2-month public comment period. On August 16, 2002, the proposal
and summary of comments was submitted by the NYSE Board to the
SEC for review and approval, which involves an additional
public comment period.\55\ Similar changes have been proposed
for NASDAQ's listing requirements.\56\
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\55\ See ``NYSE Files Changes to Listing Standards with SEC, NYSE-
Approved Measures Aim To Strengthen Corporate Accountability,'' NYSE
Press Release August 16, 2002, available at http://www.nyse.com/pdfs/
corp--gov--pro--b.pdf. The proposed standards filed with the SEC are
available at http://www.nyse.com/report.
\56\ See ``Nasdaq Takes New Actions on Corporate Governance
Reform,'' NASDAQ Press Release, July 25, 2002, available at http://
www.nasdaqnews.com/news/pr2002/ne--section02--141.html; ``Summary of
NASDAQ Corporate Governance Proposals,'' September 13, 2002, available
at http://www.nasdaq.com/about/Corp--Gov--Summary091302.pdf.
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2. Auditors
Beyond the watchdog role boards of directors are supposed
to play, the securities laws add a second layer of oversight:
The independent auditor. As discussed above, our market
regulatory system rests upon the supposition that companies
offering their securities to the public provide broad and
accurate disclosure to investors. In order for the information
to have meaning--and for investors to be able to compare apples
to apples--it must be presented according to a set of uniform
standards. For financial information, those standards are
accounting standards. The accounting standards now applicable
in the U.S. markets are known as Generally Accepted Accounting
Principles (GAAP). In addition, to assure investors that each
company is preparing its financial statements in accordance
with applicable accounting standards, which should result in
statements that provide a fair depiction of the company's
financial position, \57\ companies must have their books
audited by independent certified or public accountants. This
requirement, so basic to the scheme of securities regulation,
was incorporated into the securities laws in the Securities
Act, even before the SEC was created the following year in the
Exchange Act.\58\ During the hearings on the bill that was to
become the Securities Act, several senators suggested that
auditors working for the government, rather than the private
sector, should inspect public company financial statements.
Representatives of the accounting profession and others,
however, urged rejection of that proposal due to the size and
the complexity of the market.\59\ With an ever-expanding and
ever-changing set of industries, this remains the approach. The
SEC relies entirely on private-sector auditors to ensure that
the financial statements of public companies comply with GAAP;
as discussed above, the SEC does not do audits.
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\57\ Although compliance with GAAP is expected to result in a fair
presentation of a company's financial statements, this is not always
the case. See United States v. Simon, 425 F.2d 796 (2nd Cir. 1969)
(despite technical compliance with GAAP, conviction of defendant for
preparing false and misleading financial statements was proper where
the statements did not fairly present financial position of company).
But see SEC v. Arthur Young, 590 F.2d 794 (9th Cir. 1979) and Escott v.
Barchris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968)
(compliance with GAAP is a defense to auditor liability for false
financial statements).
\58\ Exchange Act Sec. 4, 15 U.S.C. Sec. 78d.
\59\ Hearings on S. 875 Before the Senate Committee on Banking and
Currency, 73rd Cong., 1st Sess., at 57-62 (1933).
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Although the SEC has the power to promulgate accounting and
auditing standards, \60\ since its inception the SEC has chosen
to delegate the primary responsibility for these matters to
private bodies. Until 1973, the American Institute of Certified
Public Accountants (AICPA) or its predecessor organization--the
trade association for accountants--set both accounting and
auditing standards. In the late sixties and early seventies,
widespread dissatisfaction developed with AICPA's process for
setting accounting standards; not only was the process slow, it
was handled by professionals from corporations and the
accounting industry only on a part-time basis. This led to the
creation in 1973 of the Financial Accounting Standards Board
(FASB), an independent organization, which was charged by the
SEC to set GAAP. The AICPA and its member firms, however,
continue to have influence in the standard-setting process.
Most of the funding for the FASB comes from the accounting
industry, and members of accounting firms and representatives
from AICPA and other trade groups sit on the board of FASB's
parent organization, which chooses the members of the FASB.
FASB, like its predecessor, has been subject to criticism for
its lack of speed in promulgating standards and for being too
close to the accounting industry.
---------------------------------------------------------------------------
\60\ Securities Act Sec. 19(a), 15 U.S.C. Sec. 77s(a); Exchange Act
Sec. 13(b), 15 U.S.C. Sec. 78m(b).
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The SEC also has allowed the AICPA to set auditing
standards for the industry. This raised doubts almost from
inception. In 1940, the SEC investigated McKesson & Robbins, a
reputable accounting firm that failed to prevent senior
officers of one of its audit clients from embezzling millions,
while overstating inventory and accounts receivable and
reporting profits from a non-existent business. Based on the
findings of that investigation, the AICPA adopted a number of
changes to auditing practices. The reforms essentially
persuaded the SEC to continue allowing the industry to set its
own standards.\61\ Doubts arose again, in the wake of the
collapse of the Penn Central Company, the massive Equity
Funding Corporation fraud, foreign bribery scandals, and other
corporate abuses revealed in the early to mid-1970's.\62\
Senate and House subcommittees initiated investigations into
the perceived failure of accounting firms serving as
independent auditors to detect and to disclose business
reversals or fraudulent conduct of managements of publicly held
corporations. The leaders of this Congressional effort, Senator
Metcalf and Representative Moss, tried to convince the SEC to
take direct control of audit standards.\63\ When the SEC did
not, Moss introduced a bill to establish a self-regulatory
organization in the style of NASD, called the ``National
Organization of SEC Accountancy'' to oversee the accounting
industry.\64\ The legislation was never adopted, and the AICPA,
through the Auditing Standards Board, continues to set audit
standards today. The Board, which has 15 members, promulgates
Statements on Auditing Standards.\65\ In addition, for 25
years, the Auditing Standards Board was overseen by the Public
Oversight Board, a private entity of five members funded by
AICPA, which provided guidance with respect to the audit
process.\66\
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\61\ See Louis Loss and Joel Seligman, Fundamentals of Securities
Regulation (4th ed. 2001) at 178.
\62\ Id.
\63\ Michael S. Luehlfing, ``The Politics of Self-Imposed
Regulations--Has a New Day Dawned?'' Accounting Horizons, June 1995.
\64\ Id.
\65\ See ``The Enron Crisis: The AICPA, The Profession & The Public
Interest,'' available at http://www.aicpa.org/info/regulation02.htm.
\66\ The Public Oversight Board disbanded in March 2002 after SEC
Chairman Pitt announced his intention to form a new body to oversee the
accounting industry.
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In addition to setting its own standards for auditing, the
accounting industry until recently also, for the most part,
disciplined itself. The SEC may bar or suspend from practice
before the Commission any professional--including an
accountant--who has engaged in ``unethical or improper
professional conduct.'' \67\ Beyond that, however, until the
recent passage of the Sarbanes-Oxley Act, accountants were
subject to direct professional discipline only from two places.
First, to the extent accountants are licensed (Certified Public
Accountants--the only accountants who may serve as external
auditors in satisfaction of the securities laws--must be
licensed), they receive their licenses from the State in which
they practice; the applicable State board of accountancy may
fine, suspend or bar a CPA from practice. Second, the AICPA,
through its Professional Ethics Division, investigates
allegations of unethical or wrongful conduct and, if
appropriate, expels or suspends accountants from AICPA
membership. These avenues of professional discipline for
accountants have been criticized--particularly in the wake of
the Enron scandal--as fairly ineffective.\68\ State boards of
accountancy vary in their approaches and do not have sufficient
resources to monitor the professionals in their States.
Meanwhile, the AICPA, as the industry trade association, tends
not to act aggressively, particularly against accountants in
the most established firms. The Sarbanes-Oxley Act, however,
has changed this system by providing for a centralized,
independent disciplinary body for accountants.\69\ The Public
Company Accounting Oversight Board will issue rules
establishing standards for accountants with respect to auditing
practice, ethics, and independence.\70\ The Board will also
monitor accounting firms for compliance with these and other
applicable rules and may investigate and punish violations with
fines, censures or suspensions from the practice of auditing
public companies.\71\
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\67\ SEC Rule of Practice 102(e).
\68\ David S. Hilzenrath, ``Auditors Face Scant Discipline; Review
Process Lacks Resources, Coordination, Will,'' The Washington Post,
December 6, 2001.
\69\ Pub. L. No. 107-204 Sec. Sec. 101-109.
\70\ Pub. L. No. 107-204 Sec. 103(a).
\71\ Pub. L. No. 107-204 Sec. 105.
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One specific issue regarding auditors that has been the
subject of attention in recent years concerns auditors'
responsibility for independence and objectivity in carrying out
audits. In auditing companies, accountants are supposed to
approach the books with a skeptical eye and with allegiance
only to the company and its investors.\72\ For example,
auditors are required to make efforts to detect fraud in their
audits and report what they find to the Board, and if not
appropriately dealt with at that level, to the SEC.\73\
Management and its decisions are supposed to be questioned and
scrutinized. Consulting services, on the other hand, are
provided at the pleasure and direction of management.
Consulting services, which can be anything non-audit related,
such as advice on tax issues, information technology design,
internal audits, or assisting in accounting aspects of
structured finance, are seen by clients as value-added services
(unlike audits, which are just an expensive necessity), and
therefore, they are more lucrative for accounting firms than
auditing. Accordingly, allowing the same firm to audit a
company and provide consulting services for that company might
tempt the firm to work with and please management in the audit
function in order to assure itself further consulting work.
Moreover, to the extent that some of the consulting work may
involve setting up internal audit systems or even helping to
structure transactions, the firm might end up auditing its own
work, perhaps leading it to be either less critical or more
trusting than it should be.
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\72\ ``By certifying the public reports that collectively depict a
corporation's financial status, the independent auditor assumes a
public responsibility transcending any employment relationship with the
client. The independent public accountant performing this special
function owes ultimate allegiance to the corporation's creditors and
stockholders, as well as to the investing public. This `public
watchdog' function demands that the accountant maintain total
independence from the client at all times and requires complete
fidelity to the public trust.'' United States v. Arthur Young & Co.,
465 U.S. 805, 817-818 (1984) (emphasis in original).
\73\ Exchange Act Sec. 10A, 15 U.S.C. Sec. 78j-1. Nevertheless,
according to a recent study, only 41 percent of auditors--as opposed to
71 percent of investors--believe auditors serve as ``public
watchdogs.'' John McEnroe and Stanley Martens, ``Auditors' and
Investors' Perception of the `Expectation Gap,' '' Accounting Horizons,
December 2001. This is the case despite the Supreme Court's clear
pronouncement in the Arthur Young case (see note above).
---------------------------------------------------------------------------
In June 2000, the SEC proposed new rules to enhance auditor
independence, which would have prohibited a firm auditing a
public company from providing much of the consulting work it
was then permitted to provide. The rule was controversial,
however, and faced strong objections from the accounting
profession as well as from Congress. The rule that the SEC
eventually promulgated in November 2000, in addition to setting
new guidelines, required mainly that companies disclose the
amounts they paid the firms that audited them for audit work
and consulting work.\74\ The Sarbanes-Oxley Act, however,
passed in the wake of the Enron scandal, includes auditor
independence provisions that borrow in significant part from
the initial SEC proposal, particularly with respect to the
consulting services that are considered a conflict for auditors
to provide. Under the Act, accounting firms are barred from
providing companies they audit with many non-audit services,
including bookkeeping, financial information systems design and
implementation, appraisals, and investment adviser and
investment banking services. The Sarbanes-Oxley Act also
requires lead audit partners at accounting firms to rotate
every 5 years.\75\
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\74\ Securities Act Release No. 7919, Exchange Act Release No.
43602 (November 21, 2000); 65 Fed. Reg. 76008 (December 5, 2000). In
addition, the rule specifies a limited number of non-audit services
that firms conducting audits may not provide. 17 C.F.R. Sec. 210.2-
01(c)(4).
\75\ Pub. L. No. 107-204 Sec. Sec. 201-209.
---------------------------------------------------------------------------
In sum, the Federal securities and State corporate laws
place at least three tiers of oversight over public companies--
the board of directors, who are supposed to keep tabs on
management inside the company; the independent auditors, who
are supposed to make sure the company is keeping--and
disclosing--its books honestly; and the SEC, which is supposed
to watch over and keep tabs on the whole system and make sure
the other watchdogs are doing their jobs. As the next section
discusses, they all failed--to one degree or another--in the
Enron case.
II. EXPERIENCE WITH ENRON
Before addressing how the watchdogs reacted to Enron's
financial practices, it is worth noting what Enron is alleged
to have done wrong--and therefore what more effective watchdogs
might have discovered. Beginning at least as early as 1997 and
gaining momentum in 1999 and 2000, Enron is alleged to have
engaged in complex and ultimately pervasive accounting fraud
designed to make it look like the company had more revenue and
earnings, less debt, greater operating cash flow, and generally
healthier financial statements than it in fact had.
The various investigations into Enron--including those of
the SEC, Justice Department, and Congress--are still ongoing,
but a number of allegations about Enron's specific practices
have come to light which, if true, are likely to have involved
violations of Federal securities laws. The alleged practices
include: Not fully disclosing the extent and nature of
transactions the company engaged in with so-called ``related
parties''--primarily partnerships operated by Enron's Chief
Financial Officer, Andrew Fastow, and those who worked for him;
\76\ improperly excluding the debt of certain so-called
``special purpose entities'' (SPEs) \77\ from the company's
balance sheet; \78\ treating certain transactions as asset
sales (in order to get poorly performing assets off the
company's books and/or to realize immediate revenue) without
actually transferring the risks of ownership; \79\ executing
transactions that, in reality, were loans disguised as
commodity trades and treating them as trading liabilities
rather than debt and treating the cash received as cash flow
from operations rather than cash flow from financing; \80\
failing to disclose the full extent of contingent liabilities--
i.e., debt that would come due if Enron's stock price and/or
credit rating dropped below a specified level; \81\
misaccounting for a note received in exchange for the company's
stock so that it was considered an asset and increased
shareholder equity instead of (properly) reducing shareholder
equity; \82\ and engaging in transactions that purportedly
hedged the company's risk in certain investments but, not being
true hedges, were designed instead to keep losses from these
investments off Enron's books and left Enron open to
significant financial risk.\83\
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\76\ See ``Report of Investigation by the Special Investigative
Committee of the Board of Directors of Enron Corp.,'' February 1, 2002,
(``Powers Report'') at 178-203.
\77\ Special purpose entities are entities created by a sponsoring
company for a limited purpose, such as to hold a particular asset.
Enron used a number of these entities in the transactions that have
come under scrutiny since its collapse. In some cases, SPEs can be
treated as unconsolidated entities for financial reporting purposes:
That is, their assets and liabilities need not be included (i.e.,
``consolidated'') on the sponsoring company's balance sheet. In order
to qualify for nonconsolidation, an SPE must meet two requirements: (1)
at least 3 percent of the total capital in the SPE must come from an
independent outside equity investor; and (2) the SPE must be under the
control of the outside investor--that is to say, the outside investor
must hold a majority of the SPE's stock. See Powers Report at 36-40.
\78\ See Powers Report at 49-54, 66-67.
\79\ See Powers Report at 134-147; The Role of Financial
Institutions in Enron's Collapse, Hearing Before the Permanent
Subcommittee on Investigations, Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-618 (July 30, 2002) at-- (Printed Hearing
Record Pending) (evidence of Enron's purported sale of interest in
three power barges located in Nigeria to Merrill Lynch).
\80\ The Role of Financial Institutions in Enron's Collapse,
Hearing Before the Permanent Subcommittee on Investigations, Senate
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-618 (July 23,
2002) at-- (Printed Hearing Record Pending) (evidence that Enron used
questionable structured finance transactions to disguise loans as
trading liabilities in order to avoid reporting such financing as
debt).
\81\ See William W. Bratton, ``Enron and the Dark Side of
Shareholder Value,'' 76 Tulane L. Rev. -- (forthcoming May 2002)
(Draft), available at http://papers.ssrn.com/sol3/papers.cfm?abstract--
id=301475, at 43-47, 65-67.
\82\ See Powers Report at 125-26; Bratton, at note 81 above, at 37-
38.
\83\ See Powers Report at 97-118; Bratton, at note 81 above, at 38-
40.
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Not only do these fraudulent practices appear to have been
many and varied, but they also involved substantial--in some
cases staggering--amounts of money. The loans-cum-commodity
trades, for example, alone accounted for an estimated $7-8
billion in allegedly improperly recorded liabilities and cash
flow; \84\ not disclosing contingent liabilities kept the
potential for almost $4 billion in losses out of Enron's
financial statements; \85\ the disclosure of the failure to
consolidate two Enron SPEs (and a related partnership) led to
an approximately $500 million restatement of net income over 4
years; \86\ the improper hedging transactions led to a charge
against earnings of $710 million ($544 million after taxes);
\87\ and the improper accounting of the note-for-stock exchange
resulted in a $1 billion reduction in shareholder equity.\88\
---------------------------------------------------------------------------
\84\ The Role of Financial Institutions in Enron's Collapse,
Hearing Before the Permanent Subcommittee on Investigations, Senate
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-618 (July 23,
2002) at-- (Printed Hearing Record Pending).
\85\ Enron Corp. Form 10-Q for the quarter ended September 30, 2001
(filed November 19, 2001), Part I, Item 2, at 66.
\86\ Enron Corp. Form 8-K (filed November 8, 2001), Section 2, at
3-5. In addition to recording a reduction in net income, the
restatement also resulted in a significant reduction in shareholders'
equity and a significant increase in reported debt. See also Powers
Report at 3.
\87\ Enron Corp. Form 10-Q for the quarter ended September 30, 2001
(filed November 19, 2001), Part I, Item 1, Note 4, at 23; see also
Powers Report at 128.
\88\ Enron Corp. Form 8-K (filed November 8, 2001), Section 3, at
6-7.
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A. Private-Sector Gatekeepers
The private-sector gatekeepers--such as Enron's Board of
Directors and its auditor, Arthur Andersen--were the first
lines of defense against the apparent fraud described
above.\89\ The failure of these parties to discharge their
duties have been delved into more deeply and reported on more
thoroughly elsewhere.\90\ They are recounted here in brief to
give context to the SEC's actions with respect to Enron.
---------------------------------------------------------------------------
\89\ Indeed, other private sector gatekeepers, such as some of the
investment banks with which Enron worked, appear to have actively
participated in some of the transactions described above. In recent
hearings held by PSI, e-mails, memoranda and presentation materials
revealed that financial institutions structured and marketed
transactions apparently used by Enron to disguise loans as energy
trades, characterize loan proceeds as cash flow from operations rather
than cash flow from financing, and generate proceeds from asset sales
that, in fact, were not true asset sales. See The Role of Financial
Institutions in Enron's Collapse, Hearing Before the Permanent
Subcommittee on Investigations, Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-618 (July 23 and 30, 2002) at-- (Printed
Hearing Record Pending) (Hearing Exhibits 102, 158, 201 and 203.)
\90\ See, e.g., Report of the Senate Permanent Subcommittee on
Investigations on ``The Role of the Board of Directors in Enron's
Collapse,'' S. Prt. 107-70 (July 8, 2002).
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1. Enron's Auditor
Audit failures have increasingly occurred over the last
decade--restatements have reached record numbers, at over 270
in 2001--and every major accounting firm has been involved in
at least one significant financial fraud case in the last few
years.\91\ Nevertheless, Enron appears to be the straw that
broke the camel's back in instigating a climate for change in
auditor regulation. Even beyond its conviction for obstruction
of justice in connection with its shredding of documents
related to Enron, Andersen appears to have failed miserably in
its responsibility as Enron's auditor. In its report about
failures at Enron with respect to the related-party
transactions, the special committee of Enron's Board of
Directors concluded that ``Andersen did not fulfill its
professional responsibilities in connection with its audits of
Enron's financial statements, or its obligation to bring to the
attention of Enron's Board (or the Audit and Compliance
Committee) concerns about Enron's internal controls over the
related-party transactions.'' \92\ In addition, Andersen helped
structure many of the transactions Enron used to improve the
appearance of its financial statements but which had no
economic purpose, such as the so-called ``Raptor''
transactions.\93\ Indeed, the Committee's Permanent
Subcommittee on Investigations (``PSI'') concluded as part of
its investigation into Enron's collapse that Andersen was aware
of how problematic these transactions were and warned the Board
of Directors that they represented ``high-risk accounting.''
\94\ Among themselves, Andersen partners involved on the Enron
engagement were even more frank. In its yearly client risk
analysis on Enron, Andersen expressed concern about some of
Enron's business as ``form over substance transactions''; in an
e-mail describing the content of one annual client retention
meeting regarding Enron on February 6, 2001, Andersen
acknowledged ``Enron's dependence on transaction execution to
meet financial objectives,'' and how ``aggressive'' Enron was
in its accounting.\95\
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\91\ Though Andersen has surely had its share of audit failures
with Sunbeam, Waste Management, Enron, and now WorldCom, the other big
four accounting firms can hardly boast spotless records:
PricewaterhouseCoopers audited Microstrategy, Ernst & Young audited
Cendant, KPMG audited Rite-Aid and Xerox, and Deloitte & Touche audited
Adelphia, all of which resulted in significant audit failures.
\92\ Powers Report at 24.
\93\ Powers Report at 24-25. The Raptors were SPEs purportedly set
up to hedge certain of Enron's investments but which were in fact used
to avoid reflecting losses in those investments on Enron's income
statement. Id. at 97.
\94\ Report of the Senate Permanent Subcommittee on Investigations
on ``The Role of the Board of Directors in Enron's Collapse,'' S. Prt.
107-70 (July 8, 2002) at 15-20.
\95\ Id. at 18-19.
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One of the major concerns about Andersen as the auditor of
Enron has been that it did not exhibit sufficient independence
and objectivity in discharging its responsibilities. In 2000,
Andersen earned $52 million in fees from Enron. Less than half
of that amount, $25 million, was for audit work; $27 million
related to consulting services. As discussed above, it is
difficult to comprehend how such large consulting fees could
not have created a serious conflict of interest for Andersen.
But regardless of the cause, the result is clear: Enron's
auditor failed to discharge its role of verifying the accuracy
of Enron's books.
2. Enron's Board of Directors
After the Enron scandal broke, the company's Board of
Directors appointed a special committee of the Board to
investigate the company's transactions with partnerships
controlled by Enron's Chief Financial Officer, Andrew Fastow,
and others who worked with Fastow.\96\ The special committee
concluded that the Board did not act with sufficient diligence
in approving these transactions. Moreover, the special
committee further faulted the board for failing to carefully
monitor the precarious situation once they allowed it to go
forward.\97\ PSI went further, and concluded that the board of
the directors did not take appropriate care to protect
shareholder value from management overreaching in a number of
respects. PSI, based on an extensive investigation involving
over one million documents and numerous interviews, including
interviews of 13 former Enron board members, found that
although the directors argued that management misled and
concealed key facts about the company's activities from them,
the board in fact had substantial amounts of information about
the high-risk accounting and structured finance vehicles used
by Enron. And instead of responding with probing questions to
what corporate governance and accounting experts at a May 7,
2002 hearing before PSI characterized as obvious red flags, the
board simply and unreasonably (in light of the warning signs)
relied on management. Indeed, the board and its committees met
only about five times annually, \98\ and spent under an hour
reviewing even the most complicated transactions.\99\
---------------------------------------------------------------------------
\96\ Powers Report at 1.
\97\ Powers Report at 10.
\98\ Report of the Senate Permanent Subcommittee on Investigations
on ``The Role of the Board of Directors in Enron's Collapse,'' S. Prt.
107-70 (July 8, 2002) at 9.
\99\ Id. at 32.
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Despite their apparent lack of diligence, Enron board
members enjoyed compensation that was among the highest offered
to any corporate directors in the country. Their compensation,
which was paid in cash, stock and stock options, was valued in
2000 at approximately $350,000 per director--more than twice
the national average for a U.S. publicly traded
corporation.\100\ In addition, some of the directors received
other forms of compensation or had other financial ties with
Enron. The expert witnesses at the May 7, 2002 PSI hearing not
surprisingly opined that all of this remuneration may have
compromised the directors' objectivity with respect to
management.\101\
---------------------------------------------------------------------------
\100\ Id. at 11, 56.
\101\ Id. at 56-57.
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B. The SEC
Since Enron's auditors and Board of Directors failed to
ensure the accuracy of the company's public reports, the SEC
was left as the watchdog of last resort for Enron. The
Committee set out to review the SEC's interactions with Enron
and determine what, if anything, the SEC could have done
differently to prevent, or at least detect sooner, the problems
that led to Enron's collapse. Most of Enron's dealings with the
SEC, staff learned, were in connection with the public filings
the company was required to submit to the Commission--its
periodic reports, proxy statements, securities registration
statements, and the like. In fact, before it undertook its
current investigation of Enron's accounting practices, the SEC,
in the past decade, had opened only one other investigation
involving Enron: An informal probe of an affiliated entity on a
relatively minor matter that was subsequently closed without
further action.\102\ The Commission similarly received few
substantive complaints about Enron, none of which appear
relevant to the allegations that later surfaced.\103\
Furthermore, in contrast to its aggressive lobbying of other
agencies and in other forums, Enron appears to have presented
its views to the SEC on a major policy matter only once: In
September 2000, CEO Kenneth Lay sent a letter to then-SEC
Chairman Levitt opposing the Commission's proposed auditor
independence rules.\104\ Enron did, however, on a number of
occasions, successfully seek exemptions from applicable
statutes or other favorable determinations. In at least two
instances, Enron was the first company to present the issue to
the SEC.
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\102\ This was a ``matter under inquiry''--that is to say, an
informal investigation that had not yet risen to the level that the SEC
staff had requested the authority to issue subpoenas--involving the
Enron affiliate Zond Panaero Windsystems concerning its disclosure
regarding the potential for year 2000 problems. The matter was opened
in April 1999 and closed in September 1999, after the company revised
the disclosure. SEC Response at 90; Committee staff interview with SEC
staff (September 6, 2002).
The general partner of Zond Panaero Wind Systems is a subsidiary
of Enron Wind Systems (formerly Zond Systems), which is (through at
least one further layer of ownership) a subsidiary of Enron Corp. In
1997, Enron Wind Systems sold part of its interests in various wind
farms to an entity called RADR, which was allegedly controlled by
former Enron executives Andrew Fastow and Michael Kopper. These
transactions formed part of the basis for the civil and criminal
charges recently brought against Fastow and Kopper. See Complaint, SEC
v. Kopper, Civ. Action No. H-02-3127 (S.D. Tex. August 21, 2002);
Information, United States v. Kopper, Cr. No. H-02-0560 (S.D. Tex.
August 20, 2002); Complaint, SEC v. Fastow, Civ. Action No. H-02-3666
(S.D. Tex. Oct. 2, 2002); Criminal Complaint, United States v. Fastow,
Cr. No. H-02-889-M (S.D. Tex. Oct. 1, 2002). No interest in Zond
Panaero, however, was ever transferred to RADR and the 1999
investigation of Zond Panaero Windsystems is, from all indications,
unrelated to the subsequent charges. For further discussion of Enron's
transfer of its interests in various windfarms, see note below and the
accompanying text.
\103\ See SEC Response at 86-89.
\104\ The letter was treated as a public comment and placed on the
public record. It has subsequently been revealed that the letter was
sent at the urging, and with the assistance, of Enron's auditor, Arthur
Andersen. See, e.g., Alexei Barrionuevo and Jonathan Weil, ``Duncan
Knew Enron Papers Would Be Lost,'' The Wall Street Journal, May 14,
2002 (reporting on testimony by David Duncan, a former Andersen
partner, at the Arthur Andersen obstruction of justice trial that he
and an Andersen lobbyist had enlisted Lay to write such a letter to the
SEC Chairman).
In addition, Enron's lobbying disclosure forms indicate that it
had at least one lobbying contact with the SEC during the first half of
2001. Enron Corp. 2001 Amended Mid-Year Lobbying Report (March 1,
2002). The SEC has no record of such a contact. SEC staff speculated,
however, that Enron's disclosure might refer to an interview with Enron
that was conducted for a Joint Report on Retails Swaps issued in
December 2001 pursuant to the Commodity Futures Modernization Act of
2000 by the SEC, the Board of Governors of the Federal Reserve System,
the Department of the Treasury and the Commodity Futures Trading
Commission. Committee staff interview with SEC staff, Office of General
Counsel (June 7, 2002).
---------------------------------------------------------------------------
Committee staff's investigation points to a number of
problems that need to be addressed. As discussed more fully
below, Enron's case suggests that the SEC's largely passive
interaction with companies (particularly large companies)
likely led it to miss warning signs of corporate misconduct.
Moreover, the Commission's failure to follow up on a change in
Enron's accounting deprived the Commission of an important
opportunity to better scrutinize and therefore sooner discover
Enron's questionable activities. More broadly, the Enron case
suggests that the SEC needs to re-examine the way it operates:
In particular, its assumption that it can rely as fully as it
does on private gatekeepers to play a significant role in
ensuring the flow of honest and accurate information. Without
the ability to rely as extensively on these private watchdogs,
the SEC must find ways to more proactively detect and root out
financial fraud.
1. Review of Enron's Public Filings
In the decade preceding its collapse, Enron submitted
numerous filings to the SEC.\105\ These included annual and
quarterly reports each year, as well as 29 registration
statements for the sale of securities, \106\ and two filings in
connection with proposed mergers.\107\
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\105\ According to the SEC's electronic database of public filings,
EDGAR, Enron submitted in excess of 300 filings to the SEC from January
1994 to the date of its bankruptcy. This total, however, includes a
number of routine filings that would not have ordinarily been subject
to review. In addition, Enron had an ownership interest in 50 other
companies that were required to file separately with the SEC; in half
of these, Enron's interest was 20 percent or greater. Memorandum from
Alan Beller, Director, Division of Corporation Finance to Office of
General Counsel, dated September 12, 2002, under cover of letter from
Peter Kiernan, Deputy Director, Office of Legislative Affairs,
Securities and Exchange Commission to Beth Grossman, Counsel, Committee
on Governmental Affairs, dated September 18, 2002.
\106\ This excludes registration statements that becomes effective
without SEC action, such as registration statements for employee
benefit plans filed on Form S-8.
\107\ SEC Response at 23-66.
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During this period, the SEC's Corporation Finance Division
reviewed four of Enron's annual reports on Form 10-K--those for
the years 1991, 1995, 1996 and 1997.\108\ The latter three
annual reports were reviewed as part of the SEC's consideration
of other transactions pending with the Commission at that time.
This fact--and, according to SEC staff, not any concerns raised
about the filings themselves--accounts for the uneven intervals
between reviews and the fact that reviews were conducted of the
company's 10-Ks 3 years in a row.\109\
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\108\ In addition, SEC staff reviewed Enron's 10-Q for the second
quarter of 1997 in conjunction with its review of the S-4 registration
statement that Enron filed in connection with the merger between Enron
Global Power and Pipelines (a 54 percent owned subsidiary of Enron) and
another, wholly-owned subsidiary of Enron. SEC Response at 11, 31.
\109\ Committee staff interview with SEC, Division of Corporation
Finance (April 24, 2002). In addition to the annual reports, since
1992, the SEC conducted full reviews of two of Enron's proxy statements
(in 1993 and 1994), and the Forms S-4 submitted in connection with two
mergers--Enron's acquisition of Portland General Electric (filed in
1996) and the merger of two of its subsidiaries (filed in 1997). Only
two of Enron's registration statements for the sale of securities were
subject to a full review; both of these reviews took place in 1992 (in
addition, the registration statement for an Enron subsidiary's
proposed--and ultimately abandoned--IPO was reviewed in 1998). None of
Enron's registration statements after 1992--the last of which was filed
on June 1, 2001--has received a full or financial statement review,
although seven have been monitored for specific issues. See SEC
Response at 23-66.
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There appears to be little remarkable about the SEC's
reviews of these filings. SEC staff conducted a full review of
Enron's 1991 annual report--that is, a review of the entire
filing. The staff issued an initial comment letter and two
follow-up letters in the fall of 1992 that raised a number of
concerns about the report, ranging from a request for
additional information about potential liability for pollution
clean-up to concerns about its discussion of net cash flows.
Enron responded to each of the comment letters and ultimately
amended its 10-K to conform to the SEC's comments.\110\
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\110\ SEC staff had agreed to permit Enron to forego amending its
10-K and instead to conform its future filings to certain of the
comments. After the issuance of comment letters, however, Enron decided
to spin-off one of its subsidiaries, Enron Oil Trading and
Transportation Company, and amended its 10-K to reflect the spin-off as
well as ``substantially all'' of the SEC's comments. SEC Response at
13-14.
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The reviews of the 1995 and 1996 annual reports, both also
described by SEC staff as full reviews, were undertaken in
conjunction with the Commission's review of transactional
filings associated with Enron's acquisition of Portland General
Corp.\111\ Although the filing concerning the acquisition--a
so-called ``merger proxy''--received 44 separate comments from
SEC staff (all of which appear to have been ultimately
resolved), \112\ the annual reports led to fewer questions. In
response to its review of the 1995 annual report, the SEC staff
issued a letter to Enron with two comments, both relating to
details of Enron's defined benefit plan; \113\ the review of
the 1996 10-K, which took only 3 days, resulted in no comments
at all.\114\
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\111\ SEC Response at 35. In connection with the acquisition, Enron
filed a registration statement on Form S-4 confidentially with the
Commission on August 14, 1996. The registration statement was declared
effective on October 10, 1996. Subsequently, on May 16, 1997, Enron
filed an amendment to the Form S-4. Enron's 1995 10-K was reviewed in
connection with the review of the original registration statement. Its
1996 10-K was reviewed in connection with the review of the post-
effective amendment. See Correspondence from SEC staff to Committee
staff (August 9, 2002).
\112\ SEC Response at 35-38.
\113\ SEC Response at 12-33.
\114\ SEC Response at 11-12. The post-effective amendment to the
merger proxy that was reviewed at the same time also generated no
comments. Correspondence from SEC staff to Committee staff (August 9,
2002).
---------------------------------------------------------------------------
SEC staff's review of Enron's 1997 Form 10-K was a
financial review--that is, it looked only at the financial
statements, notes and MD&A--and it was undertaken in connection
with the SEC's consideration of a proposed initial public
offering by two Enron affiliates.\115\ SEC staff also reviewed
Enron's two Forms 10-Q that were filed during the pendency of
this review. The review of the 1997 Form 10-K raised 15
comments, covering an array of subjects. Two of the comments
focused on Enron's description of market risk for its trading
business, a particular focus of SEC's reviews at the time, as
the Commission had recently changed its rules to require
greater disclosure on this topic.\116\ Another addressed
whether certain oil and gas exploration costs were properly
classified as a cost associated with investing cash flows
rather than operating cash flows.\117\ Even in hindsight,
however, these comments address little that is directly
relevant to the fraudulent practices that have since been
revealed.\118\ After further communications between Commission
staff and Enron, the company eventually agreed to address the
SEC's concerns in its future filings; the review was completed
in February 1999.\119\
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\115\ SEC Response at 5, 10. The affiliates were Enron
International Corp. CPO LP and its wholly owned subsidiary Enron
International Corp. CPO, Inc. (collectively, ECPO). The proposed IPO
was ultimately abandoned by Enron in a decision the company attributed
to changed market circumstances. SEC Response at 60-61.
\116\ See Regulation S-K, Item 305, 17 C.F.R Sec. 229.305.
\117\ Letter from H. Roger Schwall, Assistant Director, Division of
Corporation Finance, SEC, to Robert G. Gay, Enron International CPO,
L.P., dated September 16, 1998; see also Letter from H. Roger Schwall
to Rex R. Rogers, Vice President and Associate General Counsel, Enron
Corp., dated January 26, 1999 (following up on cash flow issue).
\118\ As noted, the review of the 1997 10-K was done in connection
with a review of the proposed IPO by the Enron affiliate ECPO; the 1997
10-K of another Enron subsidiary, Enron Oil & Gas Company, was also
reviewed as part of this process. SEC Response at 60. Commission staff
responded to the ECPO filing with 103 comments and the Enron Oil & Gas
filing with 20 comments (Enron never addressed the former because, as
noted above, the IPO was ultimately abandoned). See Letter from H.
Roger Schwall, Assistant Director, Division of Corporation Finance,
SEC, to Robert G. Gay, Enron International CPO, L.P., dated September
16, 1998. Although a handful of the SEC staff's comments on the ECPO
registration statement relate broadly to themes that would later appear
with Enron's collapse--including nonconsolidation of affiliated
entities and conflicts of interest--those themes manifested themselves
in the ECPO filing in ways largely unrelated to their later appearance
in Enron's dubious accounting. Thus, for example, the conflicts of
interest that are the subject of SEC staff comments in the ECPO filing
have to do with the possibility that, in offering certain business
opportunities, Enron might be required to give preference to a certain
other Enron affiliate over ECPO--troubling, perhaps, but not the sort
of related-party transactions involving the enrichment of Enron
insiders that have been the focus of much of the subsequent Enron
revelations about conflicts of interest.
\119\ SEC staff issued its comment letter to Enron on September 16,
1998. Enron had not responded to this letter by January 12, 1999, when
it filed a registration statement for the sale of securities on Form S-
3. SEC staff indicated that the Form S-3 would not become effective
until the comments raised were satisfactorily resolved. Enron then
responded by letter dated January 14, 1999. After a subsequent exchange
of correspondence, SEC staff concluded its review. SEC Response at 10.
---------------------------------------------------------------------------
None of Enron's subsequently filed Forms 10-K (i.e., those
from 1998, 1999 and 2000) were reviewed by SEC staff. The SEC
has indicated that, in response to concerns raised in the press
about Enron's accounting for derivatives and Enron's general
lack of clarity in its reporting, it flagged Enron's next
scheduled annual report--its 2001 Form 10-K--for review.\120\
This annual report was due to be filed April 1, 2002; because
of Enron's collapse, it was never submitted.
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\120\ SEC Response at 18. The 2001 10-K, the SEC notes, would have
been the first annual filing to reflect a new accounting pronouncement
on audited derivative disclosures (FASB Statement No. 133, Accounting
for Derivative Instruments and Hedging Activities).
---------------------------------------------------------------------------
As discussed in the earlier section on the SEC's methods of
operations, the SEC's lack of scrutiny of Enron's financial
statements was not in and of itself unusual. Nevertheless, the
Commission's experience in reviewing (or not reviewing) Enron's
periodic filings raises four distinct sets of concerns, each of
which calls into question the wisdom of the SEC's previously
existing practice of not regularly examining large companies'
annual reports.
First, the fact that the SEC did not review Enron's post-
1997 financial statements--and indeed reviewed relatively few
companies' annual reports at all during this time period--is
troubling in part because of the backdrop against which these
cutbacks in reviews took place. By the late 1990's, the
vulnerabilities in the private portion of the public-private
system of checks on financial malfeasance were becoming quite
apparent. In fact, as noted above, the SEC was well aware of
the burgeoning breakdown, signaled by such trends as the
increasing number of financial restatements filed with the
Commission. Indeed, in 1998, the SEC's Chairman had warned of
the declining quality of financial reporting and voiced his
belief that ``almost everyone in the financial community''--
management, analysts, boards of directors, auditors--``shares
responsibility for fostering a climate'' in which this was
so.\121\ Specific concerns about the potential conflicts faced
by auditors, moreover, had led the SEC to propose significantly
tightening the rules on auditor independence. Faced with
increasing indications of the inadequacy of the private
watchdogs, the SEC took some modest measures, such as the
creation of an ``earnings management task force'' that was set
up to pull out and review those companies' public filings that
had certain indicia of active ``earnings management.'' \122\
For the most part, however, the Commission's processes remained
unchanged just when additional efforts from government
regulators--the other half of the public-private system of
oversight--were most needed.
---------------------------------------------------------------------------
\121\ Levitt, ``The Numbers Game,'' at note 4 above.
\122\ Committee staff interview with SEC staff, Division of
Corporation Finance (June 25, 2002).
---------------------------------------------------------------------------
Second, even within the existing review system, better
screening perhaps should have led SEC staff to select Enron's
later Forms 10-K for further review. Securities law experts
with whom Committee staff spoke suggested a couple of factors
that should have at least triggered the SEC's interest in these
reports, including Enron's astonishingly rapid growth, among
the fastest of U.S. companies, and the significant change in
the nature of its business (from energy to trading)--facts
available from both press reports and the filings
themselves.\123\ The sheer number of Enron-related entities--
Enron's 2000 Form 10-K lists over 50 pages of affiliates, many
of which were not consolidated onto Enron's balance sheets--
perhaps also should have raised suspicions, if only because it
suggests the possibility that the information in the company's
public filings and consolidated on its financial statements did
not reflect the full scope of its business dealings.\124\
Notwithstanding these facts, the SEC's selective review process
did not identify Enron's later annual reports, including its
2000 report, as worthy of review. One reason for this was that,
under the Commission's priority system, Enron was not ``due''
to have its annual report reviewed until 2002. As noted, the
SEC's goal was to review a company's 10-K once every 3 years.
The SEC staff calculates this 3-year period from the time the
last review was completed. Thus, the SEC's review of Enron's
1997 Form 10-K having been finished in February 1999 (along
with a review of the intervening 10-Qs), no further review was
called for before Enron's bankruptcy in December 2001. Even
apart from this timing, however, the SEC staff confirmed that
Enron's 2000 Form 10-K would not have been flagged for review
under their remaining screening criteria.\125\
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\123\ Committee staff interview with James D. Cox, Brainerd Currie
Professor of Law, Duke University (June 13, 2002); Committee staff
interview with Joel Seligman, Dean and Ethan A. H. Shepley University
Professor, Washington University School of Law (June 3, 2001).
\124\ See Enron 2000 Form 10-K, Exhibit 21. Notably, the extent of
Enron's off-balance sheet entities (and the concomitant complexity of
Enron's filings) led at least one large institutional investor to
eschew investments in Enron in its actively managed portfolio as early
as 1998. Committee staff interview with Scott Budde, Director, Equity
Portfolio Analytics, TIAA-CREF (July 26, 2002).
\125\ This is confirmed by the handling of Enron's transactional
filings. Over the last few years, Enron submitted several registration
statements for the sale of securities to the Commission, none of which
were selected for full or financial reviews, despite the fact that all
necessarily went through the screening process. Because the screening
criteria for transactional filings are similar to (in fact, more
inclusive than) those for periodic filings but do not include any time-
from-last review factor, it follows (as SEC staff explained to
Committee staff) that if these transactional filings were not selected
for review, it is likely that neither would the Forms 10-K that were
filed close in time to them. Committee staff interview with SEC staff,
Division of Corporation Finance (June 25, 2002).
Late in the process, Commission staff did identify Enron as a
company warranting further scrutiny, with the Corporation Finance
Division determining in August 2001 that press reports about Enron's
accounting merited checking out Enron's filings the following year. SEC
Response at 18. At approximately the same time, staff in the SEC's Fort
Worth office opened an informal investigation (a so-called ``matter
under inquiry'') into Enron in the wake of these press reports as well
as the sudden resignation of Enron's CEO, Jeffrey Skilling; as part of
that investigation, Fort Worth staff took an initial look at Enron's
filings, including its most recently filed annual report, the 2000 Form
10-K. Committee staff interview with SEC staff, Division of Enforcement
(May 7, 2002), and Office of Legislative Affairs (July 24, 2002). See
also Alexei Barrionuevo and Jonathan Weil, ``Partner Warned Arthur
Andersen on Enron Audit,'' The Wall Street Journal, May 9, 2002
(reporting on the testimony of Spencer Barasch, Associate District
Administrator of the SEC's Forth Worth office, concerning the
initiation of the SEC's Enron investigation, at the obstruction of
justice trial of Arthur Andersen); Tom Fowler, ``Enron's Woes Become
Focus of Andersen Trial,'' Houston Chronicle, May 9, 2002 (same).
---------------------------------------------------------------------------
Third, the fact that the SEC did not review Enron's later
filings, particularly its 2000 Form 10-K, is of concern
because, had it done so, there are a number of items that are
likely to have led to questions by Commission staff and,
perhaps, to the discovery of at least some of Enron's wrongful
practices. The most notable of these, of course, is the now
notorious footnote 16, which appeared in Enron's 2000 Form 10-
K--and, in somewhat different form in its 1999 Form 10-K as
well.\126\ Footnote 16, which addresses ``related party
transactions'' and runs for seven paragraphs in Enron's 2000
Form 10-K, raises several issues.\127\ There was the inherent
potential for conflicts of interests in such transactions; for
this reason, every person whom Committee staff consulted
(including SEC staff) agreed that such transactions are often a
sign of trouble and generally merit further inquiry. In
addition, footnote 16 makes oblique reference to a number of
transactions that are themselves troubling--or would be if
their details could be understood.\128\ Among these are the use
of SPEs for purported hedging activities (which, as noted
above, turned out not to be legitimate hedges at all) \129\ and
the funding of these SPEs with Enron stock in exchange for a
note receivable (the misaccounting for which led, as noted, to
a $1 billion reduction in shareholder equity). There is also a
particularly inscrutable reference to the sale of ``dark
fiber,'' which, read with the benefit of subsequently disclosed
information, turns out to involve the sale of an asset related
to Enron's broadband business to a Fastow-controlled SPE at an
inflated price.\130\
---------------------------------------------------------------------------
\126\ See Enron Corp. Annual Report on Form 10-K for fiscal year
ended December 31, 2000 (filed April 2, 2001), Item 14, Note 16
(``Enron 2000 Form 10-K''); Enron Corp. Form 10-K for fiscal year ended
December 31, 1999 (filed March 30, 2000), Item 14, Note 16. In the 2000
10-K, footnote 16 references a long list of transactions with an
unidentified ``related party'' (apparently LJM2, controlled by Enron
CFO Andrew Fastow). Footnote 16 in the 1999 10-K discusses a more
limited set of transactions, but identifies the related party entities
involved (although not the individuals who control them): LJM and LJM2
(both controlled by Fastow, identified only as ``a senior officer of
Enron''), JEDI (whose limited partner, Chewco, was controlled by
Michael Kopper, who reported to Fastow, and who is identified as an
``officer of Enron''), and Whitewing, one of Enron's unconsolidated
equity affiliates.
\127\ See Appendix for the full text of footnote 16 as it appeared
in Enron's 2000 Form 10-K.
\128\ Footnote 16 is so lacking in significant information that it
does not even name the related party involved in these transactions.
One needs to closely read Enron's 2000 proxy statement to learn that
the Enron ``senior officer'' referred to is its former CFO, Andrew
Fastow. See Enron Corp. Definitive Proxy Statement (Schedule 14A)
(filed March 27, 2001), at 29 (``Certain Transactions'').
\129\ Among other things, footnote 16 states that, in connection
with the hedging activity, Enron owed the SPEs ``premiums'' of $36
million (no reason is given, but it turns out, as explained in the
Powers Report, to be essentially a payment to Fastow). It goes on to
say that ``Enron recognized revenues of approximately $500 million
related to the subsequent change in the market value of these
derivatives, which offset market value changes in certain merchant
investments and price risk management activities,'' although it does
not specify how the SPE would cover the $500 million loss exposure
(with Enron's own stock, as it turns out). See Bratton, at note above,
at 40.
\130\ The relevant passage reads in full: ``In 2000, Enron sold a
portion of its dark fiber inventory to the Related Party in exchange
for $30 million cash and a $70 million note receivable that was
subsequently repaid. Enron recognized gross margin of $67 million on
the sale.'' Enron apparently was able to sell the ``related party'' an
asset worth $33 million for $100 million--a deal, it turns out, the
related party was willing to enter into because Enron had promised to
make the investors in the SPE whole if the asset declined in value.
(``Dark fiber'' refers to the right to transmit data over fiber-optic
cables that are not yet ready to transmit internet data, but would
possibly be so in the future--an asset difficult to value). See The
Fall of Enron: How Could It Have Happened, Hearing Before the Senate
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-376 (January
24, 2002) at 115 (Statement of Frank Partnoy, Professor, University of
San Diego School of Law).
---------------------------------------------------------------------------
Beyond footnote 16, experts whom Committee staff consulted
identified several other items in Enron's 2000 Form 10-K that
might cause a reviewer to take a closer look. These include, in
footnote 9, a list of unconsolidated equity affiliates in which
Enron's interest was at or near 50 percent--just below the
threshold for having to consolidate these entities on Enron's
balance sheet.\131\ This fact, coupled with indications that
Enron was providing substantial amounts of money to these
entities, raises questions about the independence of these
entities and, by extension, the purposes for which they were
being used.\132\ Also noted was a reference in the MD&A to the
contingent liabilities that ultimately were disclosed more
fully by Enron in November 2001.\133\ The relevant passage
states ``Enron is a party to certain financial contracts which
contain provisions for early settlement in the event of a
significant market price decline in which Enron's common stock
falls below certain levels (prices ranging from $28.20 to
$55.00 per share) or if the credit ratings for Enron's
unsecured, senior long-term debt obligations fall below
investment grade,'' \134\ but offers no indication of the
magnitude of these liabilities--a whopping $4 billion. Finally,
as one of the Committee's witnesses testified, there was
another ``flashing red light'' in the 2000 Form 10-K, a
notation by Enron in its discussion of risk management, that it
had recently ``refined'' its value at risk model (a
sophisticated and complex way of estimating its exposure in its
trading operations) ``to more closely correlate with the
valuation methodologies used for merchant activities'' \135\--a
``refinement'' that raises troubling concerns that the previous
model may have come up with unacceptable high risk values.\136\
None of these items (and this list is not intended to be
exhaustive), in and of itself, is necessarily an indication of
fraud, but each might well lead a reviewer to probe further
into Enron's complexities. By not reviewing Enron's last three
Forms 10-K--or any of its recent registration statements, which
incorporated much of this information--the SEC missed potential
opportunities to identify serious problems before the house of
cards fell.\137\
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\131\ Enron 2000 Form 10-K, Item 14, Note 9. ``Unconsolidated
equity affiliates'' refers to companies in which Enron owned at least
some, but not more than 50 percent, of the company's stock. If Enron
had over a 50 percent interest in a company, the assets and liabilities
of the company would have to be included on Enron's own balance sheet--
i.e., ``consolidated.'' By maintaining an interest at 50 percent or
below, Enron (though perhaps owning a sufficient share to effectively
control these companies), was able to avoid including such information
on its financial statements. According to at least one expert, having a
large number of such entities, with little disclosure about them in
Enron's public filings, at least raises the possibility that Enron was
deliberately structuring them so as to keep certain information off its
own financial statements. Committee staff interview with April Klein,
Associate Professor of Accounting, New York University Leonard N. Stern
School of Business (June 26, 2002).
\132\ See Bratton, note 81 above, at 46 (noting, for example, that
of Enron's $23.4 billion of assets reported on its balance sheet, $5.3
billion, or 22.6 percent, represented investments in these
unconsolidated equity affiliates); Committee staff interview with April
Klein (June 26, 2002) (observing that Enron appeared to be loaning a
substantial portion of its income to these entities and that it had
recognized significant revenues from its transactions with these
entities); Enron 2000 Form 10-K, Item 14, Note 9.
\133\ See Enron Corp. Form 10-Q for quarter ended September 30,
2001 (filed November 19, 2001), Part I, Item 2, at 66; Committee staff
interview with William W. Bratton, Samuel Tyler Research Professor of
Law, George Washington University Law School (June 19, 2002).
\134\ Enron 2000 Form 10-K, Item 7, Capitalization.
\135\ Enron 2000 Form 10-K, Item 7A, Value at Risk, note (c) to
table. A value at risk model is one of three ways by which the SEC
permits companies to disclose their market risk. Committee staff
interview with SEC staff, Division of Corporation Finance (April 24,
2002); see SEC Regulation S-K, Item 305, 17 C.F.R. Sec. 229.305.
\136\ The Fall of Enron: How Could It Have Happened, Hearing Before
the Senate Governmental Affairs Committee, 107th Cong., S. Hrg. 107-376
(January 24, 2002) at 127. (Statement of Frank Partnoy, Professor,
University of San Diego School of Law).
\137\ This is not to suggest that merely by reviewing Enron's 2000
10-K, the SEC might have averted Enron's collapse. Enron's 2000 10-K
was filed on April 2, 2001. Allowing the SEC staff time to initiate and
conduct a review in accordance with its ordinary timetables, it is
unlikely that any revelations its review brought about would have come
early enough to do more than hasten Enron's demise. Nonetheless, more
routine reviews of Enron's filings over a course of years would likely
have put the SEC in a better position to identify and address budding
problems.
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The final concern highlighted by the SEC's review of
Enron's public filings is the constrained nature of those
reviews and their limited power to detect serious wrongdoing.
For example, we now know from Enron's announced restatements
and the Powers Report that although the most egregious
practices appear to have occurred from 1999 on, Enron's
financial statements back to at least 1997 contained
inaccurate, and likely fraudulent, information.\138\ Yet the
SEC's review of the 1997 Form 10-K did not--indeed, given that
such reviews are not intended to re-audit the company's
numbers, could not be expected to--identify such problems,
which included the initial, improper structuring of certain
unconsolidated SPEs. One accounting expert with whom Committee
staff spoke described Enron's 1997 Form 10-K as ``murky'' but
found no facial indicia of fraud in the filing, which mentioned
neither related-party transactions nor SPEs.\139\ Even in
Enron's 2000 Form 10-K, which contained some warning signs
about some of the wrongful practices, much of the fraud was
hidden--in off-balance sheet entities or inflated valuations--
in ways that could not be detected by a mere review of the
filing. To uncover such fraud requires a considerably more in-
depth audit than the SEC has thus far been equipped or oriented
to do.
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\138\ One recent report suggests that Enron's use of SPEs to
improperly keep debt off the company's balance sheet may have begun as
far back as the early 1990's. See John R. Emshwiller, ``Enron May Have
Started Earlier On Its Off-Balance-Sheet Deals,'' The Wall Street
Journal, September 30, 2002.
\139\ Committee staff interview with April Klein, Associate
Professor of Accounting, New York University Leonard N. Stern School of
Business (June 26, 2002). It is possible that if the SEC had diligently
insisted on the clarification of all instances of murkiness in Enron's
disclosures, it may have affected Enron's future practices, even if it
did not uncover fraud. It can be argued that, if Enron and its auditor
had believed that the SEC would insist on full, clear disclosures in
its financial statement, it would have been deterred from engaging in
the worst of its practices, the details of which it would have been
loath to disclose. Moreover, the murkiness of Enron's filings itself--
which only became worse with time--should likely have been a signal to
the SEC that further inquiry was necessary.
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2. Enron's Shift to Mark-to-Market Accounting
By letter dated June 11, 1991, Enron notified the SEC's
Office of Chief Accountant of its intent to use ``mark-to-
market'' accounting to record the natural gas trades of its
newly formed subsidiary, Enron Gas Services (EGS).\140\ Using
mark-to-market accounting meant that when EGS entered into a
natural gas contract, \141\ it would book the present value of
all future profits from that contract at the time the contract
was signed, in contrast to traditional accounting methods that
would have required that the company spread out the recognition
of revenue over the life of the contract. Any changes in the
value of the contract once it had been recorded on EGS's
books--and the contracts were required to be revalued
quarterly--would, under mark-to-market principles, be reflected
as subsequent increases or decreases in revenue on the
company's income statement.\142\ EGS's accounting, moreover,
would carry over onto Enron's consolidated balance sheet.
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\140\ Enron Gas Services, which engaged primarily in gas trading
activities (including gas derivatives), later became Enron Capital and
Trade Resources Corp., which in turn became Enron North America. At the
time this request was made, EGS's CEO was Jeffrey Skilling.
\141\ Only some of EGS's contracts involved the actual, physical
delivery of natural gas; the rest involved derivatives and other
financial instruments sold as a means of purported price risk
management.
\142\ Alternatively, gains and losses may be recorded in a separate
account on the balance sheet rather than reported on the income
statement, thus having no immediate effect on reported revenue or
profits. This is a more conservative treatment, and according to
experts with whom Committee staff spoke, a more appropriate one when a
contract's value is not easily susceptible to objective measure.
Committee staff interview with April Klein, Associate Professor of
Accounting, New York University Leonard N. Stern School of Business
(June 26, 2002); Committee staff interview with Bala G. Dharan, J.
Howard Creekmore Professor of Management, Graduate School of
Management, Rice University (August 1, 2002); see also Lessons Learned
From Enron's Collapse: Auditing the Accounting Industry, Hearing Before
the House of Representatives Energy and Commerce Committee, 107th
Cong., Hrg. No. 107-83 (February 6, 2002) at 95 (Statement of Bala G.
Dharan).
---------------------------------------------------------------------------
Enron sought a so-called ``no-objection'' letter from SEC
staff. Such a letter would tell Enron that SEC staff would not
object to Enron's proposed change in accounting. At the time
Enron requested the no-objection letter, it was unusual for
pipeline companies or others outside the financial industry to
use mark-to-market accounting. Enron, however, argued that EGS
was essentially a commodity trading business and that mark-to-
market accounting was common in such businesses. In its request
to the SEC, moreover, Enron included a letter from Arthur
Andersen to the effect that such accounting was the preferable
method to use in these circumstances. Enron also included a
letter from Ernst & Young indicating that the treatment was
consistent with GAAP.\143\
---------------------------------------------------------------------------
\143\ Letter from Jack I. Tompkins, Senior Vice President and Chief
Financial Officer, Enron Corp. and George W. Posey, Vice President
Finance and Accounting, Enron Gas Services to George H. Diacont, Acting
Chief Accountant, Office of the Chief Accountant, Securities and
Exchange Commission, and Robert Bayless, Associate Director (Chief
Accountant), Division of Corporation Finance, Securities and Exchange
Commission, dated June 11, 1991 (letters from Arthur Andersen and Ernst
& Young attached as Exhibits I and II, respectively).
---------------------------------------------------------------------------
Over the course of the next several months, at least eight
letters, as well as additional phone calls, were exchanged
between SEC staff and Enron, and Enron representatives
(including Jeffrey Skilling) met with SEC staff twice. Staff in
the Office of Chief Accountant posed a number of questions,
including how comparable businesses did their accounting, how
mark-to-market results would be calculated, and how such
accounting would interact with the accounting of Enron's non-
trading subsidiaries.\144\ In addition, at one point, SEC staff
apparently suggested that Enron consider supplemental
disclosure of mark-to-market results (that is, in addition to
its traditional accounting) until it got a better sense of the
reliability of the supporting measurements. Enron resisted,
asserting that the mark-to-market earnings would be calculated
based on ``known spreads and balanced positions'' and that the
reliability of the measurements would not be ``significantly
dependent on subjective elements.'' \145\
---------------------------------------------------------------------------
\144\ See SEC Response at 76-81.
\145\ Letter from Jack I. Tompkins, Senior Vice President and Chief
Financial Officer, Enron Corp. and George W. Posey, Vice President
Finance and Accounting, Enron Gas Services, to John W. Albert,
Associate Chief Accountant, Office of the Chief Accountant, Securities
and Exchange Commission, dated July 29, 1991.
---------------------------------------------------------------------------
Ultimately, the Office of Chief Accountant sent the
requested no-objection letter to Enron on January 30, 1992,
indicating that it would not object to the proposed change in
accounting method beginning in the first quarter of fiscal year
1992.\146\ By letter dated February 11, 1992, Enron replied
that ``upon further review,'' it had decided that the ``most
appropriate period for adoption of mark-to-market accounting''
was the beginning of 1991--a year earlier than the SEC had
approved--and represented that the impact on 1991 earnings was
not material.\147\ Apparently, the SEC did not respond further
to this correspondence and Enron went ahead and reported EGS's
1991 financial information using the mark-to-market
method.\148\
---------------------------------------------------------------------------
\146\ Letter from Walter P. Schuetze, Chief Accountant, Securities
and Exchange Commission, to Jack I. Tompkins, Senior Vice President and
Chief Financial Officer, Enron Corp., dated January 30, 1992.
\147\ Letter from Jack I. Tompkins, Senior Vice President and Chief
Financial Officer, Enron Corp., to Walter P. Schuetze, Chief
Accountant, Securities and Exchange Commission, dated February 11,
1992.
\148\ According to one press account, Enron's representation that
its use of mark-to-market accounting for its 1991 financial statements
would not have a material impact on earnings was false. The account
quotes unnamed former Enron employees as saying that Enron signed two
large natural gas supply contracts in the latter half of 1991 and used
mark-to-market accounting for those contracts to significantly boost
Enron's revenues for the last two quarters of the year. This enabled
Enron to show increased earnings over the same periods in the previous
year. Barbara Shook, ``Enron Missteps Began In 1991; Aggressive
Accounting Blamed,'' Natural Gas Week, January 28, 2002. See also
``Origin of Questionable Enron Accounts,'' World Gas Intelligence,
January 18, 2002.
---------------------------------------------------------------------------
At the time EGS changed its accounting methods, the switch
to mark-to-market accounting was unusual and was seen by many
as an aggressive move.\149\ Mark-to-market accounting has since
become common in the energy trading industry.\150\ In fact, the
experts with whom Committee staff spoke did not raise any
general objections to the use of mark-to-market accounting and
suggested that, at least as a theoretical matter, mark-to-
market accounting was often a preferable method of accounting,
because, applied correctly, it can enable investors to see more
accurately the current value of a company's assets.\151\
---------------------------------------------------------------------------
\149\ See, e.g., Toni Mack, ``Hidden Risks,'' Forbes, May 24, 1993
(warning that if something major happened to impair the value of the
contracts that Enron was marking to market, the company could be forced
to book losses, and that by accelerating income, Enron would have to
keep doing more and more deals to show the same or rising income);
Harry Hurt III, ``Power Players,'' Fortune, August 5, 1996 (citing
former employees as suggesting that mark-to-market accounting
``simultaneously inflates current earnings and creates a `feeding
frenzy' as executives scramble to make new deals to prop up future
profits.'').
\150\ Committee staff interview with Bala G. Dharan (August 1,
2002); see FASB Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities (June 1998).
\151\ See, e.g., Committee staff interview with Lynn Turner (June
24, 2002); Committee staff interview with Bala G. Dharan (August 1,
2002); see also Lessons Learned From Enron's Collapse: Auditing the
Accounting Industry, Hearing Before the House of Representatives Energy
and Commerce Committee, 107th Cong., Hrg. No. 107-83 (February 6, 2002)
at 95 (Statement of Bala G. Dharan). This contrasts with historical
cost accounting, a more traditional accounting method in which assets
are recorded at their original cost without subsequent adjustments. SEC
staff explained to Committee staff that awareness of the problems that
arose from historical cost accounting in the Savings and Loan crisis of
the late 1980's had, in fact, contributed to their decision to permit
Enron to use mark-to-market accounting. The savings and loans, pursuant
to historical cost accounting principles, had kept on their books at
their original cost investments that thereafter declined substantially
in value, thereby effectively shielding from the public the true state
of their finances (under mark-to market accounting, these investments
would have had to be revalued quarterly and the changes in value
recorded on the company's financial statements). This practice had
resulted in substantial criticism. Committee staff interview with SEC
staff, Office of Chief Accountant (April 22, 2002).
---------------------------------------------------------------------------
Mark-to-market accounting, however, is not without its
problems--some significant. Most importantly, it was
questionable whether Enron could accurately value these
contracts at the time of signing. For short-term, standard form
contracts, there is often a public market, such as the New York
Mercantile Exchange, that can provide the necessary values. For
longer-term or more complex trading contracts, there would
likely not be market quotes available on which to base the
values. Instead, Enron would use complex models to estimate the
value of these contracts, making assumptions about an
assortment of variables that could range from future gas prices
to the pace of energy deregulation to trends in interest
rates.\152\ The assumptions underlying these models were, in
the best case, necessarily subjective and, in the worst,
subject to deliberate manipulation.
---------------------------------------------------------------------------
\152\ See Floyd Norris and Kurt Eichenwald, ``Fuzzy Rules of
Accounting and Enron,'' The New York Times, January 30, 2002; Committee
staff interview with Bala G. Dharan (August 1, 2002).
---------------------------------------------------------------------------
The evidence suggests that Enron, at a minimum,
overestimated and very possibly manipulated the values of the
energy contracts it marked to market. Enron's misuse of mark-
to-market accounting has been most widely reported in
connection with the activities of Enron Energy Services (EES),
the company's retail energy subsidiary (Enron ultimately used
mark-to-market accounting at subsidiaries beyond EGS). One
former employee with whom Committee staff spoke described the
arcane models and aggressive assumptions--often, according to
this employee, different even from those employed by Enron's
own Wholesale Services division--that were used to value the
highly complex, long-term energy contracts that EES was
marketing to major commercial customers.\153\ The incentives to
be optimistic about the assumptions underlying the model,
moreover, were present not only for Enron's executives,
concerned about the next quarter's revenue numbers, but also
for lower level employees whose bonuses were based on the full
marked-to-market value of the deals they completed.\154\ As the
deals came to maturity, however, the assumptions underlying the
valuations in many cases proved incorrect and the contracts had
to be revalued. By Spring 2001, Enron apparently would have had
to report significant losses from these deals, had it not
merged the commodity risk activities of EES with those of
Enron's Wholesale Services group, effectively hiding these
losses amid that group's substantially larger revenues and
allowing the remaining part of EES to appear profitable.\155\
---------------------------------------------------------------------------
\153\ Committee staff interview with Margaret Ceconi (February 1,
2002). One press account lists a number of specific practices cited by
former EES employees that were used to inflate the present value of EES
contracts, including routinely underestimating commodities prices in
the later years of a contract, quoting prices from highly illiquid
markets that Enron dominated, and projecting unjustifiably high
efficiency savings. Joshua Chafin, Stephen Fidler and Andrew Hill,
``Enron: Virtual Company, Virtual Profits,'' Financial Times (London),
February 4, 2002. Another press account describes similar practices at
Enron North America, a subsidiary that engaged in wholesale energy
trading, where a former manager on the trade desk alleged that the
price curves (the expected direction of prices in the future) on which
the deals were valued were set unreasonably high and then were moved
even higher, often at the end of a quarter, in order to generate
reported income. Michael Brick, ``What Was the Heart of Enron Keeps
Shrinking,'' The New York Times, April 6, 2002. Enron Vice President of
Corporate Development Sherron Watkins' now famous letter to Ken Lay
warning of various improper accounting practices (primarily
transactions related to the so-called Raptor SPEs) also mentions
possible ``valuation issues'' in connection with EES's mark-to-market
positions. Letter from Sherron Watkins to Kenneth Lay (August 2001),
reprinted in The Financial Collapse of Enron, Hearing before the
Subcommittee on Oversight and Investigations, House of Representatives
Committee on Energy and Commerce, 107th Cong., Hrg. No. 107-89
(February 14, 2002) at 119.
\154\ Committee staff interview with Margaret Ceconi (February 1,
2002); see also Laura Goldberg and Tom Fowler, ``The Myth of Enron,''
Houston Chronicle, January 27, 2002.
\155\ Id. Notably, after filing for bankruptcy, Enron sought and
received permission to abandon 700 EES contracts as ``burdensome to the
estate.'' Motion of Enron Energy Services Operations, Inc., Enron
Energy Services, Inc. and Enron Energy Marketing Corp. Pursuant to
Section 365(a) of the Bankruptcy Code for Order Authorizing Debtors to
Reject Certain Executory Contracts, In re Enron Corp., Case No. 01-
16034 (AJG) (Bankr. S.D.N.Y., December 21, 2001); Order Authorizing
Rejection of Certain Executory Contracts, In re Enron Corp., Case No.
01-16034 (AJG) (Bankr. S.D.N.Y., January 4, 2002); see ``Business Folly
As Well As Financial Fraud,'' Gas Processors Report, February 11, 2002.
Ceconi was sufficiently concerned about the transfer of EES
losses to another subsidiary that she contacted the SEC to inquire if
the accounting was permissible, e-mailing her question to the SEC's
Office of Investor Education and Assistance in July 2001. In response,
she received a phone call from a Commission employee. In neither her e-
mail nor her telephone conversation, however, did Ceconi reveal the
company at issue. Only after the SEC's current investigation was
underway and had been publicly announced, did Ceconi sent another e-
mail which expressly referred to Enron. Committee staff interview with
Margaret Ceconi (February 1, 2002); SEC Response at 86.
---------------------------------------------------------------------------
In permitting Enron to switch to mark-to-market accounting,
SEC staff appeared to anticipate some of the problems that
could arise when a company was allowed to estimate the present
value of a long-term contract. Indeed, in its no-objection
letter, the Office of the Chief Accountant explicitly
conditioned its acceptance of Enron's change in accounting
methods on the company's representations that it would value
such contracts objectively.\156\ Once the conditions were set
forth, however, the SEC itself had no procedures to ensure that
the company complied with these conditions. The Division of
Corporation Finance staff would have seen the Chief
Accountant's no-objection determination if and when they
reviewed Enron's filings, but the complex and detailed work of
determining whether Enron was employing appropriate valuation
models and that trading contracts were marked to market fairly
would have been left to Enron's auditors. The SEC, by all
indications, did not seek to ascertain whether the auditors in
fact had validated the models used by the company.\157\
---------------------------------------------------------------------------
\156\ Specifically, the Office of the Chief Accountant noted, among
other things, Enron's representations that:
LMarket values will be based on market prices to the extent such
prices are available. Where derived values are used because market
prices are not available, those values will be derived using a
valuation model that uses objective data, such as actual bid and asked
prices from transactions in the marketplace, to develop a value;
and that
LAllocation of the physical risk and price risk components (price
risk being the element of the contract subject to mark-to-market
measurement) is objectively verifiable by the independent auditors.
Letter from Walter P. Schuetze, Chief Accountant, Securities and
Exchange Commission, to Jack I. Tompkins, Senior Vice President and
Chief Financial Officer, Enron Corp., dated January 30, 1992.
\157\ The actual validation of the models used by Enron does appear
to be a task that is best left in the first instance to the auditors;
the large accounting firms typically have the expertise to design and
evaluate such models. See Committee staff interview with Lynn Turner
(June 24, 2002). Nonetheless, the SEC has an important role to play in
assuring that such validation is taking place and, where appropriate,
requiring documentation of how the models work. See Committee staff
interview with Bala G. Dharan (August 1, 2002).
---------------------------------------------------------------------------
Even without any investigation into particular contracts or
computer models, however, Enron's public filings suggest both
the magnitude and the subjectivity of the company's mark-to-
market valuations--something the SEC staff might well have
noticed had they reviewed the filings and done so with an eye
toward this issue. For the year 2000, Enron's unrealized
trading gains--that is, the profits it expected to earn in
future years--constituted over half the company's $1.41 billion
originally reported pre-tax profit.\158\ Of the basis for the
company's mark-to-market valuations, the Forms 10-K that Enron
filed with the SEC for the years 1997 onward state that ``[t]he
market prices used to value these transactions reflect
management's best estimate considering various factors
including closing exchange and over-the-counter quotations,
time value and volatility factors underlying the commitments.''
\159\ Despite the opacity of this explanation as well as the
relative size of the valuations at issue, and despite its
initial concerns, the SEC did not attempt to look more closely
at Enron's mark-to-market accounting methods, or at any point
even seek to require Enron to amend this disclosure to go
beyond the unhelpful information that this was management's
``best estimate'' and clarify for investors any of the key
assumptions it was relying on in valuing the transactions for
its financial statements.\160\ The SEC's failure to follow up
on its initial accounting determination (and the concerns
accompanying it) meant another lost opportunity to identify
(and potentially mitigate) some of the accounting abuses
perpetrated by Enron.
---------------------------------------------------------------------------
\158\ Jonathan Weil, ``After Enron `Mark to Market' Accounting Gets
Scrutiny,'' The Wall Street Journal, December 4, 2001. Enron's public
financial statements do not separate out the precise amount of these
unrealized gains, but a line item in its cash flow statement--
``additions and unrealized gains'' equal to almost $1.3 billion (though
it may also include unrealized gains from other activities as well)--
suggests the magnitude. See Enron Corp. 2000 Form 10-K, Item 14,
Consolidated Statement of Cash Flows; Committee staff interview with
Bala G. Dharan (August 2000). Weil had first pointed out this issue a
year earlier, noting that, without the inclusions of these unrealized,
noncash gains, Enron would have in fact lost money in the second
quarter of 2000. See Jonathan Weil, ``Energy Traders Cite Gains, But
Some Math is Missing,'' The Wall Street Journal (Texas ed.), September
20, 2000.
\159\ Enron 2000 Form 10-K, Item 14, Note 1, Accounting for Price
Risk Management; Enron 1999 Form 10-K, Item 14, Note 1, Accounting for
Price Risk Management; Enron 1998 Form 10-K, Item 14, Note 1,
Accounting for Price Risk Management; Enron 1997 Form 10-K, Item 14,
Note 1, Accounting for Price Risk Management. Equally unhelpful is
Enron's caveat that ``Judgment is necessarily required in interpreting
market data and the use of different market assumptions or estimation
methodologies may affect the fair value amounts.'' Enron 2000 Form 10-
K, Item 14, Note 3.
\160\ Subsequently, the SEC has issued a statement urging companies
to consider including additional disclosures in its financial
statements concerning commodity contracts accounted for at fair value,
but for which there is a lack of market price quotations. Commission
Statement About Management's Discussion and Analysis of Financial
Condition and Results of Operations, Release Nos. 33-8056, 34-45321, 67
Fed. Reg. 3746 (January 25, 2002).
---------------------------------------------------------------------------
3. Exemptions from the Public Utility Holding Company Act
The Public Utility Holding Company Act of 1935 \161\ was
passed to protect consumers and investors against abuses by the
holding companies that then controlled a substantial portion of
the country's gas and electric utilities. In the 1920's, many
of these companies had developed complex, multistate pyramid
structures that masked unsound financial practices, adversely
affected the underlying utilities and their ratepayers, and
made the companies less susceptible to State regulation.\162\
In response, PUHCA imposes a number of restrictions on public
utility holding companies, defined as companies which directly
or indirectly own 10 percent or more of a gas or electric
public utility.\163\ These provisions require, among other
things, that each registered holding company be limited to a
single ``integrated public utility system'' that is
geographically confined and physically interconnected; \164\
prohibit the ownership of nonutility businesses unless those
businesses are ``reasonably incidental, or economically
necessary or appropriate'' to the operations of the integrated
public utility system; \165\ restrict transactions between
holding company affiliates; \166\ and require SEC review of a
holding company's issuance of securities \167\ or acquisition
of securities or utility assets of another holding or public
utility company.\168\ The SEC is charged with administering
PUHCA, \169\ and companies that come within the definition of a
public utility holding company must register with the SEC or
apply for an exemption under the Act. As of March 4, 2002,
there were 29 registered holding companies in the United States
and 124 exempt holding companies.\170\
---------------------------------------------------------------------------
\161\ 15 U.S.C. Sec. 79a et seq.
\162\ See 15 U.S.C. Sec. 79a(b) (setting out factual basis for
legislation).
\163\ 15 U.S.C. Sec. 79b(a)(7).
\164\ 15 U.S.C. Sec. 79k(b)(1).
\165\ Id.
\166\ 15 U.S.C. Sec. Sec. 79l and 79m.
\167\ 15 U.S.C. Sec. Sec. 79f and 79g.
\168\ 15 U.S.C. Sec. 79i and 79j.
\169\ For the last 20 years, the SEC has advocated the repeal of
PUHCA and the transfer of related responsibilities to the Federal
Energy Regulatory Commission. See, e.g., Effects of Subtitle B of S.
1766 to the Public Utility Holding Company Act, Hearing Before the
Subcommittee on Securities, Senate Committee on Banking, Housing, and
Urban Affairs 107th Cong., S. Hrg. 107-521 (February 6, 2002) at 7-16
(Statement of the Honorable Isaac C. Hunt, Jr., SEC Commissioner);
Public Utility Holding Company Act Amendments, Hearing Before the
Subcommittee on Securities, Senate Committee on Banking, Housing, and
Urban Affairs, 97th Cong., S. Hrg. 97-62 (June 8, 1982) at 359-421
(Statement of SEC).
\170\ SEC Response at 95 and n. 2. Of those companies that are
public utility holdings companies but are exempt from registration, the
majority have claimed an exemption because they are intrastate holding
companies or because they are predominantly utility companies
themselves and operate in a single State or States contiguous to that
State. SEC Response at 95-96. In numerous other instances, companies
have successfully sought determinations from the Commission or its
staff that they did not come within the definition of a public utility
holding company. SEC Response at 97, 108-16.
---------------------------------------------------------------------------
Enron appears to have been aggressive in its efforts to
ensure that the company would not be brought within the
strictures of PUHCA. In the last 10 years, Enron and/or its
subsidiaries on six occasions successfully either asserted that
they were entitled to an exemption under the Act or sought
determinations from SEC staff that the activities they intended
to engage in would not bring them within the definition of a
``public utility holding company.'' \171\ In addition, on five
other occasions, Enron sought exemptions from the Commission or
no-action letters from SEC staff, but no Commission or staff
determination was reached because either Enron withdrew the
request, the issue became moot, or the request is still
pending.\172\ Questions have been raised publicly about two of
these PUHCA determinations, \173\ and a third matter that is
still pending poses some additional concerns. We will address
each of these three matters in turn.\174\
---------------------------------------------------------------------------
\171\ None of these required action by the Commission itself. On
five of these occasions, Enron was issued a no-action letter by SEC
staff. In the remaining case (involving Enron's Portland General
Electric subsidiary, discussed below), the exemption was self-
executing--that is, Enron was able to claim the exemption by filing a
form; in the absence of an objection by SEC staff, the exemption was
effective.
\172\ SEC Response at 131, 133-34. In a further PUHCA matter, Enron
sought and received permission to include consolidating balance sheets
for only its first-tier subsidiaries on the exemption form (Form U-3A-
2) it filed in connection with its claim for an intrastate exemption
related to its Portland General Electric subsidiary. Id. at 131.
\173\ See, e.g., Michael Schroeder, ``Accounting for Enron: SEC
Feels Heat Over Exemptions to Enron,'' The Wall Street Journal, January
21, 2002.
\174\ The remaining four no-action requests that were granted were
as follows:
L (1) a 1992 request concerning the sale and distribution of
compressed natural gas for use in compressed natural gas vehicles. A
no-action letter was sought on the grounds that this was not the type
of activity contemplated by PUHCA and also that the cars constituted
``portable containers'' equivalent to the portable cylinders of
compressed natural gas that the SEC had exempted from PUHCA in other
cases.
L (2) a 1993 request concerning an Enron affiliate that provided
certain operation and maintenance services to an electric power plant
in the Philippines. Enron sought a no-action letter based on PUHCA's
exemption for foreign utility companies under section 33(a)(1) of
PUHCA, 15 U.S.C. Sec. 79z-5b(a)(1).
L (3) a 1997 request by Enron Capital & Trade (the successor to
Enron Gas Services) for a no-action letter in connection with retail
energy activities (including hooking up individual consumers to the
power grid and supplying electricity meters) that they believed might
be beyond the scope of an earlier no-action letter given to EGS for
Enron Power Marketing, Inc.'s power marketing activities, discussed
below.
L (4) a 1999 request by Enron Federal Solutions for a no-action
letter related to its proposal to own and operate electric, gas, water,
and wastewater distribution systems at Fort Hamilton Military Base in
Brooklyn. Enron asserted that an entity dedicated exclusively to
provide services to the Federal Government was not the type of company
PUHCA was intended to regulate.
SEC staff characterized all but the last of these as routine.
---------------------------------------------------------------------------
The first of these involved a request, in 1993, by Enron
Power Marketing, Inc. (EPMI), a wholly owned subsidiary of
Enron Gas Services, which was, in turn, a wholly owned
subsidiary of Enron Corp. EPMI asked the SEC for a ``no-action
letter''--that is, staff assurances that it would not recommend
enforcement action--in connection with EPMI's power marketing
activities. Although EPMI did not itself generate or transmit
electricity, it proposed to engage in transactions such as
purchasing and then reselling electricity. At issue was whether
these activities made EPMI an ``electric utility company''
under Section 2(a)(3) of PUHCA. If so, Enron, as the parent of
EPMI, would be considered a public utility holding company and
subject to the restrictions of the Act.
Enron first contacted the SEC about this issue on October
19, 1993.\175\ At the time, Enron was one of a number of
companies inquiring whether power marketing would subject them
to the registration and other requirements of PUHCA.\176\ After
speaking informally with the SEC staff and soliciting their
advice as to how to proceed, Enron submitted for staff review a
draft application for a declaratory order from the Commission
that power marketers were not ``utilities'' under the Act.\177\
For reasons that remain unclear, Enron did not proceed with
this application. Instead, it chose to request a no-action
letter from the SEC staff on this issue and subsequently
submitted draft and then final versions of such a no-action
request in December 1993.\178\ Enron was the first power
marketer to request an exemption from PUHCA on these grounds.
Without commenting on the issues raised, the SEC issued the no-
action letter on January 5, 1994; \179\ since that time, 20
other companies have received similar no-action letters.\180\
---------------------------------------------------------------------------
\175\ Enron contacted the SEC through its attorney, who sought
advice from SEC staff at that point without revealing the client's
name. Memorandum to Files from T.C. Havens, Reid & Priest, dated
October 19, 1993 (Enron document numbers EC2 000032904-EC2 000032907).
\176\ Committee staff interview with SEC staff, Division of
Investment Management (July 2, 2002).
\177\ Application Pursuant to Section 2(a)(3)(A) of the Public
Utility Holding Company Act of 1935, as Amended, for an Order Declaring
Enron Power Marketing, Inc. Not to be an Electric Utility, dated
November 30, 1993 (Draft) (Enron document numbers EC2 000032908-EC2
000032928).
\178\ Letter from William T. Baker, Jr., Reid & Priest, to Kevin
An, Office of Public Utility Regulation, Securities and Exchange
Commission, dated December 22, 1993 (Enron document numbers EC2
000032929-EC2 000032952) (enclosing draft no-action request); Letter
from William T. Baker, Jr., Counsel for Enron Power Marketing, Inc.,
Reid & Priest, to William C. Weeden, Associate Director, Office of
Public Utility Regulation, Division of Investment Management,
Securities and Exchange Commission, dated December 28, 1993, available
at 1994 SEC No-Act. LEXIS 42 (request for no-action determination).
\179\ Enron Power Marketing, Inc., Ref. No. 94-1-OPUR, Response of
the Office of Public Utility Regulation, Division of Investment
Management, from S. Kevin An, Staff Attorney, dated January 5, 1994,
available at 1994 SEC No-Act. LEXIS 42.
\180\ SEC Response at 94. Subsequently, the Commission promulgated
a rule permitting registered holding companies to engage in power
marketing activities that implicitly recognizes that power marketing is
a nonutility activity. See 17 C.F.R. Sec. 250.58.
---------------------------------------------------------------------------
Section 2(a)(3) of PUHCA defines an ``electric utility
company'' as ``any company which owns or operates facilities
used for the generation, transmission, or distribution of
electric energy for sale.'' \181\ As EPMI represented that it
did not own generating plants, transmission lines or electric
distribution systems, the resolution of this issue turned on
whether the contracts, books, and records associated with the
proposed power marketing activity constituted ``facilities''
for the generation, transmission, or distribution of
electricity under the statute.\182\
---------------------------------------------------------------------------
\181\ 15 U.S.C. Sec. 79b(a)(3).
\182\ As is their practice, SEC staff noted in their no-action
letter that it did not purport to express any legal conclusion on the
questions presented. Nonetheless, SEC staff now notes that ``it would
be logical to conclude'' that the staff did not regard Enron's
contracts and associated books and records to be ``facilities'' as
defined in the Act and consequently concluded that power marketers were
not ``electric utilities'' within the meaning of the Act. SEC Response
at 94.
---------------------------------------------------------------------------
Interestingly, some years before, the Federal Energy
Regulatory Commission (FERC) had been faced with a similar
question about the definition of ``facilities' under the
Federal Power Act (FPA), \183\ a companion statute to PUHCA
that is administered by FERC. In that case, FERC held that a
power marketer's contracts, books, etc. were facilities under
the FPA and that those who bought and resold electricity were
subject to FERC's jurisdiction under the Act as utilities, even
if they did not own traditional transmission facilities.\184\
---------------------------------------------------------------------------
\183\ 16 U.S.C. Sec. 791a et seq.
\184\ Citizens Energy Corporation, 35 F.E.R.C. 61,198 (1986)
(reasoning that, among other things, a contrary decision would have
left FERC ``without any other party over whom to assert authority with
respect to what are clearly wholesale sales . . . in interstate
commerce''); see 16 U.S.C. Sec. 824(b) (providing that FERC ``shall
have jurisdiction over all facilities for such transmission or sale of
electric energy'').
---------------------------------------------------------------------------
At the time of its no-action request, Enron argued, and the
SEC has since explained in its response to the Committee, that
a contrary ruling would have effectively prohibited companies
from creating power marketing subsidiaries as it would be
virtually impossible for such companies to then comply with
PUHCA's requirement for an integrated system operating in a
single geographic area, because ``power marketing by its nature
tends to be a nationwide activity that does not rely on
specific, in-place assets.'' \185\ Power marketers could thus
presumably exist only as free-standing companies, not as
subsidiaries of holding companies. In addition, both Enron and
the SEC have pointed to the different statutory purposes
underlying PUHCA and the FPA and have further argued that
precisely because FERC had asserted jurisdiction over power
marketers, there was no danger that excluding such activities
from PUHCA's requirements would leave them unregulated.\186\
Although it is possible to disagree with the SEC staff's
reasoning, it does not appear to Committee staff that the
conclusion they reached was insupportable.
---------------------------------------------------------------------------
\185\ SEC Response at 94; see also Enron request for no-action
determination, note 178 above.
\186\ Committee staff interview with SEC staff, Division of
Investment Management (July 2, 2002); Enron request for no-action
determination, note 178 above.
---------------------------------------------------------------------------
The second issue that has received a fair amount of public
attention is Enron's claim under PUHCA Rule 2 of an exemption
from PUHCA as an intrastate holding company when it acquired
Portland General Electric (PGE) in 1997. Rule 2 implements
Section 3(a)(1) of PUHCA, which provides that the SEC is to
exempt a holding company if it and each of its subsidiary
public utility companies ``are predominantly intrastate in
character and carry on their business substantially in a single
State in which such holding company and every such subsidiary
company thereof are organized.'' \187\ The SEC has interpreted
this provision to mean that when a holding company and each of
its public utilities (as that term is defined in the statute)
are located in one State, the holding company is exempt from
PUHCA. A company that meets this requirement is not required to
formally apply for an exemption or request a no-action letter.
Rather, it need only file a form claiming the exemption; the
exemption is effective unless the Commission notifies the
company that it has questions.
---------------------------------------------------------------------------
\187\ 15 U.S.C. Sec. 79c(a)(1).
---------------------------------------------------------------------------
When Enron acquired PGE, it re-incorporated in Oregon (it
had previously been a Delaware corporation). As PGE, too, was
incorporated in Oregon and was the only Enron subsidiary that
was considered a ``public utility,'' Enron was clearly eligible
for this exemption under governing SEC interpretation. Although
some have raised questions about the SEC's interpretation of
the intrastate provisions of Section 3(a)(1) \188\--and other
interpretations are clearly possible and perhaps more
intuitive--the Commission's approach, first set forth in 1937,
\189\ is well-established and the Commission's response to
Enron's application was consistent with this precedent.
---------------------------------------------------------------------------
\188\ See, e.g., Effects of Subtitle B of S. 1766 to the Public
Utility Holding Company Act, Hearing Before the Senate Committee on
Energy and Natural Resources, 107th Cong., S. Hrg. 107-521 (February 6,
2002) at 41-62 (Statement of Scott Hempling, Attorney at Law). Hempling
argues that Enron does not meet the literal requirements of the section
3(a)(1) exemption because its business operations are not
``predominantly intrastate in character'' and its worldwide business is
not carried on ``substantially in a single State.'' Alternatively, he
suggests that SEC should have found Enron's exemption to be
``detrimental to the public interest'' under section (3)(a) of the Act,
15 U.S.C. Sec. 79c(a).
\189\ See In the Matter of Southeastern Indiana Corp., 2 SEC 156
(1937) (holding that as long as the public utility business of a
holding company's subsidiaries was confined to one State, the company
could engage in non-utility activities in other States without losing
its PUHCA exemption).
---------------------------------------------------------------------------
Had the SEC in these cases not found Enron exempt from
PUHCA, and the stringent requirements of PUHCA in fact been
applied to Enron, it would theoretically have had a substantial
effect on Enron's operations. Enron, for example, presumably
would not have been able to own and operate a power marketing
company, or to own other businesses that were not ``reasonably
incidental, or economically necessary or appropriate to the
operations'' of its public utility company, and it may have
been subject to greater restrictions in issuing securities or
engage in transactions among its affiliates. Indeed, had Enron
otherwise failed to take action to remove itself from PUHCA
jurisdiction, it could potentially have been subject to SEC
efforts to simplify its structure. For this reason, however, it
is also reasonable to expect that Enron, had the SEC made
different determinations, would have gone to some lengths to
restructure its business to avoid coming within PUHCA's
restrictions.
In the remaining PUHCA matter, Enron filed an application
with the SEC on April 14, 2000, for an exemption under section
3(a)(3) or, in the alternative, section 3(a)(5) of PUHCA. These
provisions specify that the Commission may exempt from the
requirements of PUHCA a company that is only ``incidentally'' a
public utility holding company and is primarily engaged in
other businesses \190\ or a company that ``derives no material
part of its income'' from companies the principal business of
which is that of a public utility company.\191\ From an SEC
perspective, this request was unnecessary--as described above,
Enron was already exempt from PUHCA under section 3(a)(1), the
intrastate exemption provision. Nonetheless, Enron sought this
exemption because doing so provided it with certain benefits
before FERC.
---------------------------------------------------------------------------
\190\ 15 U.S.C. Sec. 79c(a)(3).
\191\ 15 U.S.C. Sec. 79c(a)(5).
---------------------------------------------------------------------------
Specifically, at about the same time that it was applying
for this PUHCA exemption, Enron was in the process of
repurchasing its interest in certain windfarms from, among
others, an entity (RADR) allegedly controlled by Enron
executives Andrew Fastow and Michael Kopper, to which Enron had
sold a 50 percent interest in these windfarms in 1997. Under
the Public Utilities Regulatory Policies Act of 1978 (PURPA),
administered by FERC, and its associated implementing
regulations, the windfarms were potentially ``qualifying
facilities'' (QFs) that were eligible for certain economic
benefits--but only if they were no more than 50 percent owned
by a public utility or its holding company.\192\ Because Enron
owned a public utility (PGE), if it owned more than a 50
percent interest in the windfarms--which it proposed to do by
buying out RADR's and others' interests--they would ordinarily
not be eligible for QF status.\193\
---------------------------------------------------------------------------
\192\ See 16 U.S.C. Sec. 796(18)(b); 18 C.F.R. Sec. 292.206(b).
\193\ The desire to preserve the projects' QF status is apparently
what led Enron initially to sell a 50 percent interest in the windfarms
to RADR when it acquired PGE in 1997. The sale and repurchase of these
interests and certain associated financial transactions (which is
alleged to have resulted in significant payments to Fastow, Kopper, and
others) formed part of the basis for the civil and criminal charges
recently brought against Fastow and Kopper. See Complaint, SEC v.
Kopper, Civ. Action No. H-02-3127 (S.D. Tex. August. 21, 2002);
Information, United States v. Kopper, Cr. No. H-02-0560 (S.D. Tex.
August 20, 2002); Complaint, SEC v. Fastow, Civ. Action No. H-02-3666
(S.D. Tex. Oct. 2, 2002); Criminal Complaint, United States v. Fastow,
Cr. No. H-02-889-M (S.D. Tex. Oct. 1, 2002).
---------------------------------------------------------------------------
What guaranteed these projects QF status, however, were
FERC regulations that provided for an exception to the QF
ownership rules when a company is exempt ``by rule or order''
under section 3(a)(3) or 3(a)(5) of PUHCA.\194\ FERC's
practice, moreover, was to treat a company's ``good faith''
application to the SEC for an exemption under these sections of
PUHCA--unless and until it was denied by the SEC--to be
sufficient to qualify for this PURPA exception.\195\ Thus,
merely by having an application pending with the SEC for a
3(a)(3) or 3(a)(5) exemption under PUHCA, Enron was able to
preserve its windfarms' beneficial QF status.\196\
---------------------------------------------------------------------------
\194\ 18 C.F.R. Sec. 292.206(c)(1).
\195\ See Doswell Limited Partnership and Diamond Energy, Inc., 56
F.E.R.C. 61,170 (1997).
\196\ See, e.g., Notice of Self-Recertification of Qualifying
Facility Status for Small Power Production Facility, August 3, 2000,
Zond Windsystems Holding Co., FERC Docket No. QF87-365 (notifying FERC
that Enron, through its Zond subsidiary, had repurchased a 100 percent
interest in a wind energy facility and that it had made a good faith
application to the SEC for a PUHCA exemption). When no affected utility
company raises objection, FERC accepts such self-recertifications
without review. Committee staff meeting with FERC staff (September 6,
2002).
---------------------------------------------------------------------------
In its application to the SEC for the 3(a)(3) or 3(a)(5)
PUHCA exemption and in its related communications with SEC
staff, Enron made clear that its purpose was to get out from
under FERC's QF ownership rules.\197\ Enron noted that it had
contracted to sell PGE and, if it did so, it would no longer be
a ``public utility holding company,'' and, accordingly, this
would render the FERC QF issue moot. Enron strongly suggested
that it had no interest in the SEC ruling on the exemption
application before the sale of PGE was either completed or
abandoned.\198\ If the PGE sale went through, Enron, no longer
in need of the PUHCA exemption, would withdraw its application;
if not, it could pursue its request for an exemption at that
time. In the interim, the pending application served to
maintain the QF status of the windfarms and to enable Enron to
acquire or develop new QFs.\199\
---------------------------------------------------------------------------
\197\ Enron Corp. Form U-1, Application under the Public Utility
Holding Company Act, SEC File No. 70-9661 (April 14, 2000); Letter from
Joanne C. Rutkowski, LeBoeuf, Lamb, Greene & MacRae to Catherine A.
Fisher, Assistant Director, Office of Public Utility Regulation,
Division of Investment Management, Securities and Exchange Commission,
dated April 13, 2000; see also Committee staff interview with SEC
staff, Division of Investment Management (September 3, 2002).
\198\ Id. In a 2001 presentation to SEC staff, Enron asserted that
``the SEC and Enron agreed to delay pursuing a formal order on the
Application pending the PGE sale.'' Enron Corp., ``Alternative PUHCA
Exemption for QF Relief-SEC Staff Presentation,'' July 27, 2001. SEC
staff denied that there was such an agreement, but stated that it was
nonetheless their priority to complete the regulatory review of the PGE
sale before turning their attention to Enron's exemption application.
Committee staff interview with SEC staff, Division of Investment
Management (September 3, 2002).
\199\ In its application to the SEC, Enron emphasizes its desire to
bid to acquire additional QF assets and asserts that, without the
exemption, it had been unable to do so. Enron Corp. Form U-1,
Application under the Public Utility Holding Company Act, SEC File No.
70-9661 (April 14, 2000), at 8-9. FERC records evidence at least one
case in which Enron has relied on its exemption application to the SEC
in order to first obtain QF status for a wind power facility, rather
than simply maintaining the existing QF status of such a facility. See
Green Power Partners I LLC, FERC Docket No. QF00-96-000 (Notice of
Self-Certification of Qualifying Facility Status for Small Power
Production Facility, filed September 29, 2000).
---------------------------------------------------------------------------
To this date, the SEC has not ruled on Enron's request for
this exemption. Since Enron's initial application--which was
amended in response to SEC staff's comments in August 2000--a
number of relevant events, however, have transpired. To begin
with, on April 26, 2001, Enron and Sierra Pacific terminated
their agreement for the sale of PGE. Thereafter, on July 24,
2001, Enron submitted a further amended draft application,
along with a letter setting forth Enron's request that the
Commission now act on the application and issue an exemption
order. A few days later, Enron met with SEC staff to discuss
its revised application. After submitting this revised
application, Enron then entered into another agreement to sell
PGE, this time to Northwest Natural Gas Co. Announced on
October 8, 2001, this agreement also eventually was terminated,
on May 16, 2002. Finally, on March 26, 2002, Southern
California Edison Co., which has long-term contracts with
several Enron QF projects (and which is therefore paying higher
rates than would be required if the projects were not
considered QFs), filed a motion to intervene and opposition to
Enron's application for an exemption. Southern California
Edison argues, among other things, that Enron's collapse and
resulting precipitous decline in revenue means that (whatever
was the case previously) the income the company receives from
PGE now constitutes a highly substantial portion of Enron's
total income and so cannot be said to be nonmaterial or merely
incidental as required by sections 3(a)(3) and 3(a)(5) of
PUHCA.\200\ Enron filed a response to Southern California
Edison's motion on April 30, 2002, asserting that its exemption
request was, and continues to be, in good faith and asking that
any hearing on the exemption be deferred further until after
the company's bankruptcy reorganization plan is adopted.\201\
---------------------------------------------------------------------------
\200\ Motion to Intervene and Opposition of Southern California
Edison Company, March 26, 2002, Enron Corp., SEC File No. 70-09661.
\201\ Memorandum of Law in Response to Motion to Intervene and
Opposition of Southern California Edison Company, April 30, 2002, Enron
Corp., SEC File No. 70-09661.
---------------------------------------------------------------------------
Throughout the substantial changes that have occurred at
Enron since the company's request for this PUHCA exemption was
filed in April 2000--the collapse of one proposed deal to sell
PGE, the entry into another such proposed deal and its
termination, not to mention the bankruptcy of the whole
company--Enron's exemption application has remained pending at
the SEC and, as a result, the QF status of certain of its
projects has remained intact, regardless of whether that status
is actually merited. At no point has the SEC ruled on the
application or, apparently, even asked that it be withdrawn in
light of changes in circumstances. Perhaps more troubling is
the fact that neither FERC nor the SEC has questioned whether
the application was, or continues to be, in good faith, as FERC
requires for it to serve as a basis for an exemption from the
ordinary QF ownership requirements.\202\ Thus, although the
circumstances that Enron now finds itself in are radically
different than when it first sought the exemption nearly 2\1/2\
years ago, and Commission staff are aware that Enron continues
to rely on the application in its FERC matters, the SEC has
allowed the application to remain open throughout this period.
---------------------------------------------------------------------------
\202\ Staff of each agency, in fact, disclaimed responsibility for
doing so. The SEC, for its part, observed that the decision to rely on
a good faith application was FERC's and suggested that it was up to
FERC to determine if the application met that agency's standards for
good faith. Committee staff interview with SEC Staff, Division of
Investment Management (September 3, 2002). FERC, for its part, argued
that the application was made to the SEC and that an attempt by FERC to
determine whether such an application was in good faith before the SEC
had a chance to rule on it would be preemptively second guessing in
advance its sister agency's decision. Committee staff meeting with FERC
staff (September 6, 2002). According to staff at both agencies, they
did not discuss between the two agencies the pending application.
---------------------------------------------------------------------------
Had the SEC reviewed Enron's application earlier, it would
not necessarily (or even likely) have led to the SEC's earlier
discovery of the accounting misdeeds that lay behind the sale
and repurchase of some of its windfarms.\203\ The SEC's failure
to take any action on Enron's application, however, may mean
that Enron has been able to collect more money than the company
is legitimately entitled to from ratepayers of utilities that
purchased their electricity from Enron QFs. Moreover, the lack
of coordination between the SEC and FERC permitted Enron to
take full advantage of the gaps and overlaps in the agencies'
jurisdiction and may have prevented the SEC from learning about
the full context of the QF transactions.
---------------------------------------------------------------------------
\203\ See note 193 above. In contrast to FERC, with which Enron
filed a request for recertification of the QF status of its windfarms
in 1997 that described the sale transaction between Enron and RADR, see
Request for Recertification of Qualifying Facility Status for Small
Power Production Facility, May 14, 1997, Zond Windsystems Holding Co.,
FERC Docket No. QF87-365-003, the SEC became involved in this matter
only when the PUHCA exemption application was filed in 2000 in
anticipation of that interest being repurchased. The exemption
application submitted to the SEC did not address the windfarms'
ownership issues.
---------------------------------------------------------------------------
4. Exemption from the Investment Company Act of 1940
On May 15, 1996, Enron and two of its subsidiaries, Enron
Oil & Gas Company and Enron Global Power & Pipelines, L.L.C.,
filed with the SEC an application for an exemption from the
Investment Company Act of 1940.\204\ The Investment Company Act
governs companies, such as mutual funds, that engage primarily
in investing, reinvesting and trading in securities. It
requires these companies to comply with certain disclosure
requirements and places certain limits on the companies'
investment activities and affiliate transactions; it also
provides for a particular corporate structure.
---------------------------------------------------------------------------
\204\ 15 U.S.C. Sec. 80a-1 et seq. Enron subsequently added a third
subsidiary, Enron International, Inc., to the application.
---------------------------------------------------------------------------
At the time of the application, Enron's growing investments
in foreign infrastructure projects threatened to bring it
within the scope of the Act. Enron and its affiliates were
engaged in developing numerous power plants, gas transmission
lines and other infrastructure projects throughout the
developing world and typically did so through the establishment
of SPEs created specifically to operate these projects. For
what Enron described as legitimate tax, liability and
governance reasons--including the fact that certain countries
prohibited foreign control of corporations in their
jurisdictions--Enron generally did not own a majority interest
in these entities. The Investment Company Act applies to a
company that owns investment securities having a value
exceeding 40 percent of the company's total assets. Securities
of a subsidiary that is majority owned by the company are
excluded from the definition of ``investment securities'' and
do not count toward the 40 percent limit. Because the entities
that operated the foreign infrastructure projects, however,
were not majority owned by Enron or its affiliates, they would
ordinarily be considered ``investment securities,'' and,
consequently, Enron and/or its affiliates, as their foreign
infrastructure ventures expanded, would potentially be
considered investment companies subject to the Act.
Enron initially sought an exemption from the Investment
Company Act from Congress as part of what became the National
Securities Markets Improvement Act of 1996, \205\ but was
unsuccessful.\206\ Nonetheless, in its report on the bill, the
House Committee on Energy and Commerce devoted three paragraphs
to addressing this issue and appeared to urge the SEC to grant
the exemption administratively. Specifically, the House Report
noted that ``the Committee supports appropriate administrative
action by the [SEC] to prevent the Investment Company Act from
having unintended and adverse consequences to U.S. companies in
the business of developing or acquiring and operating foreign
infrastructure projects''; that ``the activities of U.S.
companies involved in foreign infrastructure projects are not
the sort of activities the Investment Company Act was designed
to regulate''; and that, when exemptive relief was a
requirement for investments in these projects, ``the Committee
expects the [SEC] to take administrative action
expeditiously.'' \207\ Although the SEC staff appears to have
opposed the grant of a broad statutory exemption--they believed
that a generally applicable exemption might lead to
unpredictable results, that it might suggest that the
Commission did not have the authority to grant such an
exemption itself, and that it was better to proceed on a case-
by-case basis--they did not object to Enron seeking similar
relief through the SEC's own administrative procedures.\208\
---------------------------------------------------------------------------
\205\ Pub. L. No. 104-290.
\206\ See Committee staff interview with SEC staff, Division of
Investment Management (July 2, 2002); Committee staff interview with
Barry Barbash, Attorney, Shearman & Sterling, and former Director of
the Division of Investment Management, SEC (August 1, 2002); Committee
staff interview with Craig Tyle, General Counsel, Investment Company
Institute (June 24, 2002).
\207\ H. Rept. No. 104-622, at 19 (June 17, 1996). The conference
report, which included only a brief discussion beyond the final text of
the bill itself, did not address this issue. See H. Rept. 104-864
(September 28, 1996).
\208\ Committee staff interviews with SEC staff, Division of
Investment Management (July 2, 2002), Barry Barbash (August 1, 2002),
and Craig Tyle (June 24, 2002).
---------------------------------------------------------------------------
Thus, as its next step, Enron filed its application with
the SEC to obtain an exemption administratively.\209\ Under
section 6(c) of the Investment Company Act, the SEC has broad
power to exempt a company from the provisions of the Act if the
exemption is deemed to be in the public interest and consistent
with investor protection and the purposes of the Act.\210\
Staff in the Commission's Division of Investment Management met
with Enron concerning its request for an exemption \211\ and
provided written comments on the application.\212\ Enron
subsequently submitted three amended applications.\213\ A
notice summarizing the penultimate version of the application
was published in the Federal Register on February 24, 1997;
\214\ no comments on the application were received.\215\ On
March 13, 1997, the Division of Investment Management, acting
under delegated authority from the Commission, issued an order
granting the application for exemption.\216\
---------------------------------------------------------------------------
\209\ Application for an Order of the Securities and Exchange
Commission Pursuant to Section 6(c) of the Investment Company Act of
1940 Exempting Applicants from All of the Provisions of the Act, May
15, 1996, In re Enron Corp., et al., SEC File No. 812-10150.
\210\ 15 U.S.C. Sec. 80a-6(c).
\211\ SEC Response at 21.
\212\ Letters from David W. Grim, Staff Attorney, Division of
Investment Management, SEC to Robert Baird, Esq., Vinson & Elkins LLP,
dated Sept. 17, 1996 and January 21, 1997.
\213\ These were filed with the SEC on October 22, 1996, February
12, 1997, and February 21, 1997, respectively.
\214\ 62 Fed. Reg. 8279. (The application was publicly released on
February 14, 1997, but did not appear in the Federal Register until 10
days later).
\215\ SEC Response at 119.
\216\ In re Enron Corp., et al., Investment Company Act of 1940
Release No. 22560, 1997 SEC Lexis 571.
---------------------------------------------------------------------------
Experts with whom Committee staff spoke disagreed about
whether the exemption was appropriate.\217\ Some suggested that
investments in overseas ventures that Enron did not legally
control posed substantial risks to shareholders of the sort
that the Investment Company Act was specifically designed to
protect against. Others argued that Enron was clearly an
operating company, not a passive investor of the sort at which
the Act was directed, and that the risks posed were associated
with these operations. SEC staff, in addition to agreeing with
the latter argument, also noted that because Enron's foreign
infrastructure projects took the form of joint ventures, which
are not considered investment securities, it was possible that
Enron did not need the exemption at all.\218\ The SEC further
reported that similar exemptions were granted to companies
engaged in foreign infrastructure projects both before and
after it granted an exemption to Enron.\219\
---------------------------------------------------------------------------
\217\ See, e.g., Committee staff interview with Mark Sargent, Dean,
Villanova University School of Law (July 29, 2002) (expressing concerns
about the SEC decision to grant the exemption); Committee staff
interview with Tamar Frankel, Professor, Boston University School of
Law (July 29, 2002) (supporting the decision to grant the exemption).
\218\ See SEC Response at 117-118 n. 25; Committee staff interview
with SEC staff, Division of Investment Management (July 2, 2002);
Committee staff interview with Barry Barbash (August 1, 2002).
According to Barbash, Enron indicated that it sought a formal exemption
because it felt that a private legal opinion that it was not an
investment company given the joint venture nature of its projects would
not provide it with sufficient certainty.
\219\ See SEC response at 119, n. 28. Some of these exemptions were
granted not under section 6(c) of the Investment Company Act but rather
under section 3(b)(2), which allows for an exemption where a company is
engaged in a business other than that of an investment company. 15
U.S.C. Sec. 80a-3(b)(2).
---------------------------------------------------------------------------
Everyone with whom staff spoke about this issue, however,
agreed that Enron, as an operating company (in contrast to a
classic investment company, such as a mutual fund), could not
have functioned within the strict constraints of the Investment
Company Act. Nevertheless, as with PUHCA, even had Enron's
application for an exemption been rebuffed, it is likely that
Enron would have in some fashion restructured its operations to
remain outside the Act's restrictions.\220\
---------------------------------------------------------------------------
\220\ It can be argued, however, that if Enron had to restructure
its operations through increasing its formal control over these foreign
infrastructure projects (assuming it could have done so), this in and
of itself may have decreased risk for the company's shareholders.
---------------------------------------------------------------------------
Of more concern, therefore, than the initial grant of the
exemption itself--which was not clearly erroneous and had some
Congressional support--was the SEC's lack of any means to
monitor the continued appropriateness of the exemption. The
exemption grant was expressly conditioned on Enron not
``hold[ing] itself out as being engaged in the business of
investing, reinvesting or trading in securities'' and on the
foreign infrastructure projects not ``differ[ing] materially
from that described in . . . [the] Application.'' \221\ It is
unclear whether Enron violated these conditions. At minimum,
however, as Enron's business evolved in the late 1990's and it
became less of an energy company and more of a trading
enterprise--dealing increasingly in derivatives, for example,
rather than tangible items--it arguably came closer to being an
``investment company'' as envisioned by the Act.\222\ The SEC,
however, had not incorporated any conditions into the exemption
it granted that would have required Enron to demonstrate in the
future that it still merited an exemption, and the SEC staff
did not routinely follow up on their own. As a result, the
changing nature of Enron's business and its relationship with
its foreign infrastructure projects--a number of which have
ultimately been linked to problems for Enron and its
shareholders \223\--were left unexamined by the Commission.
---------------------------------------------------------------------------
\221\ See In re Enron Corp., et al., Investment Company Act of 1940
Release No. 22560, 1997 SEC Lexis 571; Third Amended and Restated
Application for an Order of the Securities and Exchange Commission
Pursuant to Section 6(c) of the Investment Company Act of 1940
Exempting Applicants from All of the Provisions of the Act, February
21, 1997, In Re Enron Corp., et al., SEC File No. 812-10150, at 31.
\222\ See Committee staff interview with Tamar Frankel (July 29,
2002).
\223\ Some of these projects have garnered attention as having had
substantial financial difficulties and/or having been used by Enron in
dubious ways to enhance its financial statements. See, e.g., Powers
Report at 135-138 (detailing Enron's sale to, and subsequent repurchase
from, the Fastow-controlled LJM1 partnership of an interest in an
entity building a power plant in Cuiaba, Brazil, enabling Enron to
avoid consolidating the entity on its balance sheet and to record as
income projected proceeds from a gas supply contract Enron had with the
project--as well as providing LJM1 with a substantial, and seemingly
unjustified, return on its investment); Rebecca Smith and Kathryn
Kranhold, ``Enron Knew Foreign Portfolio Had Lost Value,'' The Wall
Street Journal, May 6, 2002 (reporting that Enron's portfolio of
foreign assets had lost as much as half of its value); Saitha Rai,
``New Doubts on Enron's India Investment,'' The New York Times,
November 21, 2001 (reporting on the history of problems at Enron's $2.9
billion Dabhol power plant); ``Enron Spanned the Globe With High-Risk
Projects; Deals Lost Money but Helped Hide Troubles,'' The Washington
Post, February 16, 2002.
---------------------------------------------------------------------------
III. RECOMMENDATIONS
Since the first Federal securities laws were passed in
response to the 1929 stock market crash, oversight of the
securities markets has been entrusted to a combination of
public and private entities. In crafting the Securities Act of
1933, Congress expressly rejected the idea of direct government
audits of companies' books. Reasoning that private sector
controls would allow for a more efficient and flexible system
of checks on wrongful conduct, our system of regulation relies
in the first instance on boards of directors and private,
independent auditors, responsible to shareholders and the
public, respectively.
In the case of Enron--and the corporate collapses that have
since followed--we have witnessed a fundamental breakdown in
this system. Apparently, the SEC cannot rely on company
auditors and boards of directors to assume the lion's share of
responsibility for ensuring honest public disclosure of company
finances, as assumed by the securities laws. Thus, although our
investigation found no willful malfeasance by the Commission
with respect to Enron, Committee staff has concluded that the
Commission's largely hands-off approach to the company--
combined with the failure of the auditors and board of
directors to do their jobs--allowed inaccurate and incomplete
information to flood the market, leading to significant
financial losses for thousands of Enron employees and an even
greater number of investors. Unfortunately, through the 1990's,
the SEC had reason to question whether auditors and boards of
directors were playing their appointed roles in the system--
and, indeed, did question it--yet the Commission did little to
adjust its own role to fill the gap. The failure of the SEC's
approach became all too evident in its limited interactions
with Enron--its lack of review of company financial statements
that would have raised questions, for example, and its failure
to monitor the effects of Enron's permitted shift to mark-to-
market accounting.
Accordingly, for our public-private method of oversight to
continue to work effectively, significant improvements will
need to be made. Tightening up the controls on the private
gatekeepers is a key first step, and this effort is already
underway. The recently enacted Sarbanes-Oxley Act provides,
among other things, for an independent board, subject to SEC
oversight, to oversee the practices of auditors, \224\
prohibits auditors from engaging in much of the consulting work
for their audit clients causing potential conflicts of
interest, \225\ and places additional obligations on corporate
officers and directors.\226\ Others are taking action in this
area as well: The New York Stock Exchange, for example,
recently announced additional listing requirements designed to
force boards of directors to more effectively oversee the
accounting practices of their companies.
---------------------------------------------------------------------------
\224\ Pub. L. No. 107-204 Sec. Sec. 101-109.
\225\ Id. at Sec. Sec. 201-209.
\226\ Id. at Sec. Sec. 301-308.
---------------------------------------------------------------------------
Beyond imposing stricter standards on the private players,
however, it is also critically important that the SEC enhance
its effectiveness.\227\ The SEC needs not only to find ways of
improving its performance in its traditional roles of ensuring
compliance with disclosure requirements and enforcing the laws
against those who commit fraud, but also to work directly to
uncover fraud, serving as a backstop when other parts of the
system fail. The public rightly expects that the SEC will be
there to ensure our capital markets are operating fairly.
---------------------------------------------------------------------------
\227\ On March 20, 2002, following GAO's call for the agency to
engage in better strategic planning, the SEC announced that, with the
help of an outside consulting firm, it was undertaking an ambitious, 4-
month long study to examine ``the Commission's operations, efficiency,
productivity, and resources.'' ``Pitt Announces Special Study of SEC
Operations, Resources,'' SEC Press Release, March 20, 2002, available
at http://www.sec.gov/news/press/2002-42.txt. The study was to be
completed in August, with a report expected this fall. We commend the
SEC for this self-examination, and look forward to its results.
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Some of the necessary improvements at the SEC will require
additional resources, as has already been contemplated in the
Sarbanes-Oxley Act. More central, however, is the need for the
Commission, in some measure, to reconceptualize its role as a
more proactive force in protecting the marketplace against
financial fraud. Based on our investigation, we believe, more
specifically, that it is important the SEC take the following
actions to more effectively protect investors and help restore
public confidence in the markets:
Review More Filings and Review Them More Wisely and
Efficiently. While most types of fraud cannot be detected
simply through an examination of a company's periodic filings,
a greater number of reviews (particularly of the right filings)
nonetheless increases the chances of uncovering information
that may lead to the discovery of wrongdoing. The increased
likelihood that a company's filings will be reviewed can also
deter certain misleading reporting practices. In large measure,
this is a resource question--300 people are simply not enough
to review a meaningful portion of the filings the SEC receives.
Indeed, the relatively stable size of the SEC's workforce in
the face of increasingly large and complex markets has been
well-documented, including in a recent General Accounting
Office study, \228\ and additional resources--such as have been
authorized in the Sarbanes-Oxley Act \229\--will undoubtedly
have to be part of any solution.
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\228\ U.S. General Accounting Office, ``SEC Operations: Increased
Workload Creates Challenges,'' GAO-02-302, March 2002.
\229\ Pub. L. No. 107-204 Sec. 601. Such additional resources have
not yet been appropriated, however.
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The Sarbanes-Oxley Act now requires that the SEC review
companies' periodic reports at least once every 3 years.\230\
This is an important start, but regular reviews will not
necessarily be enough. Rather, the Commission's challenge is to
find better ways to identify those filings that need attention
or that present higher risk to investors The SEC currently
attempts to do this through its selective review criteria, as
well as through certain ad hoc measures. Such measures include
the creation in the late 1990's of an earnings management task
force to identify and review those filings that had indicia of
the sort of earnings management that former Chairman Levitt was
publicly inveighing against at the time, as well as the
Commission's recent decision to review the annual reports of
the Nation's 500 largest companies. Though well-intentioned,
there is little evidence that this relatively informal system
has been particularly successful, and more sophisticated means
of risk analysis appear to be needed.
---------------------------------------------------------------------------
\230\ Pub. L. No. 107-204 Sec. 408(c).
---------------------------------------------------------------------------
A number of those with whom Committee staff spoke
emphasized the importance of technology in this process.\231\
Computer systems that can rapidly sift through large amounts of
corporate data can be a valuable tool for SEC staff, enabling
them to make more effective use of the available data and
freeing staff up for less mundane tasks. Such systems, it was
reported to us, are used by both auditing firms to spot
problems with clients' financial reports and certain equity
analysts seeking to identify vulnerable stocks.\232\ The SEC
currently employs what appears to be a basic version of such
software in conjunction with its manual screening; it is in the
process of upgrading to a more sophisticated system that will
enable it to access a greater range of data and sort through it
more easily and effectively.\233\ While such technology will
not eliminate the difficult task of identifying and continually
revising the criteria for high-risk filings--nor the basic need
to have capable, well-trained staff to review filings \234\--
used wisely, it can potentially facilitate this selection
process.
---------------------------------------------------------------------------
\231\ See Committee staff interviews with Lynn Turner (June 24,
2002), Arthur Levitt (June 7, 2002), and David Martin, Attorney,
Covington & Burling and former Director of the Division of Corporation
Finance, SEC (June 25, 2002).
\232\ Id. See also Committee staff interview with Mark Roberts,
Director of Research and Principal, Off Wall Street Consulting Group,
Inc. (June 6, 2002). Roberts explained that it was through his firm's
computer screening process that he was initially able to identify Enron
as a company with potential problems.
\233\ Committee staff interview with SEC staff, Division of
Corporation Finance (June 25, 2002).
\234\ The former SEC officials who raised the issue of technology
in their interviews with Committee staff each also noted the importance
of hiring high quality professionals and providing them with good
training. See Committee staff interviews with Lynn Turner (June 24,
2002), Arthur Levitt (June 7, 2002), and David Martin (June 25, 2002).
Though it is beyond the scope of this report, a discussion of employee
turnover and other human capital challenges faced by the SEC can be
found in U.S. General Accounting Office, ``Securities and Exchange
Commission: Human Capital Challenges Require Management Attention,''
GAO-01-947, September 2001.
---------------------------------------------------------------------------
Look for Fraud. One of the reasons the SEC did not uncover
much of the fraud that has been the subject of recent scandals
is that it does little to proactively look for it. The public
filing review process, as discussed above, is designed almost
exclusively to assure compliance with disclosure requirements,
not to catch wrongdoing. On the other hand, the enforcement
process, though it can allow investigators to dig deeply to
unearth the details of corporate malfeasance, does not come
into play until there is already significant evidence of
illegality and, generally, after much of the harm has been
done. If the SEC is to play a role in finding and rooting out
financial fraud--as we believe it should--it will need to make
this an explicit goal and develop new processes to support it.
Random or targeted audits, in the manner of the IRS, though
requiring significant resources, are one possibility that can
be applied more broadly for uncovering not only fraud in
particular cases, but also identifying emerging trends in how
fraud is being carried out.\235\ The SEC has taken a more
proactive approach in other areas, such as internet fraud,
where it has established a group specifically dedicated to
finding fraud on the web, and it subjects broker-dealers to
periodic inspections. Whether any of these models can be
applied to cases of complex financial fraud, or whether there
is a new, more appropriate model that can be developed is
something that the SEC, in light of the recent vulnerabilities
displayed by other parts of the system, will need to explore.
Though uncovering fraud will appropriately remain, in the first
instance, the province of auditors, the SEC must play a
meaningful part in fraud detection if it wishes to fulfill its
role of ensuring the integrity of the markets.
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\235\ The Sarbanes-Oxley Act provides for the new accounting
oversight board to conduct inspections of the auditors' work, which
also may prove of assistance to the SEC in addressing issues of fraud
control. See Pub. L. No. 107-204 Sec. 104.
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Follow Up To Ensure That Commission Mandates Are Met. When
SEC staff raises an issue of concern, there appears often to be
inadequate follow-up procedures to ensure that the concern is
addressed. With respect to the SEC's decision to permit Enron
to switch to mark-to-market accounting, we saw that the
conditions imposed by Commission staff--that Enron rely on
market prices where available and other objective data where
not--were in fact the right ones and, had they been followed,
the abuses associated with the valuation of Enron's energy
contracts might not have occurred. Yet, the SEC staff, having
issued its decision and set forth the conditions, apparently
never had any intention of checking to see if they were
complied with; indeed, they had no mechanism for doing so.
Rather, having informed Enron of the conditions, the SEC staff
simply assumed that the company would abide by them. Similarly,
after imposing conditions on Enron's exemption from the
Investment Company Act, SEC staff never attempted to ascertain
whether these conditions continued to be met or whether the
exemption continued to be appropriate--and did not see it as
their role to do so.\236\
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\236\ In implementing follow-up procedures, moreover, the SEC needs
to ensure that there is coordination between its various offices. An
initial policy decision may be made by one division (the Office of
Chief Accountant and the Division of Investment Management,
respectively, in the examples above), while later monitoring of the
company is conducted by another (generally, the Division of Corporation
Finance).
---------------------------------------------------------------------------
The lack of follow through--either as a result of lack of
resources or lack of priority--is apparent on a broader level
as well. Thus, for example, in an effort to help get accurate
information to investors in an era of earnings management and
aggressive accounting practices, the Commission, both before
and after the collapse of Enron, has proposed a variety of new
disclosure requirements, or augmented existing requirements,
including identification of critical accounting policies, \237\
increased disclosure about off-balance sheet entities, the
valuation of mark-to-market transactions and effects of
transactions with related parties, \238\ and additional items
or events to be reported on, and accelerated filing of, Form 8-
K (a so-called ``current report'').\239\ Such enhanced
disclosure requirements, if followed, may well provide
additional and needed clarity for investors. Given the
relatively small number of filings that are currently reviewed,
however, the SEC staff is not in a position to ensure that
these disclosure obligations are met. Merely issuing increasing
numbers of edicts for disclosure without reviewing those
disclosures or otherwise ensuring that the new requirements are
complied with is unlikely to prove effective. As recent events
amply demonstrate, the SEC cannot simply assume that all
companies will comply with the letter and spirit of the law.
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\237\ Disclosure in Management's Discussion and Analysis About the
Application of Critical Accounting Policies, 67 Fed. Reg. 35620 (May
20, 2002); Cautionary Advice Regarding Disclosure About Critical
Accounting Policies, Securities Act Release No. 8040, Exchange Act
Release No. 45149 (December 12, 2001), 66 Fed. Reg. 65013 (December 17,
2001).
\238\ Commission Statement About Management's Discussion and
Analysis of Financial Condition and Results of Operations, Securities
Act Release No. 8056, Exchange Act Release No. 45321 (January 22,
2002), 67 Fed. Reg. 3746 (January 25, 2002).
\239\ Additional Form 8-K Disclosure Requirements and Acceleration
of Filing Date, 67 Fed. Reg. 42914 (June 25, 2002).
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Supplement Aggressive Enforcement With Other, More
Proactive Measures. Since the collapse of Enron, the SEC has
announced a number of high-profile enforcement actions.\240\
The SEC Chairman, moreover, has frequently stated his
commitment to aggressively pursue wrongdoers, and has
emphasized that SEC staff will pursue a policy of ``real time
enforcement''--that is, cases will be brought quickly,
particularly when violations of law are ongoing.\241\ Committee
staff strongly supports these efforts to hold those who violate
the securities laws accountable, and believes that the prompt
punishment of wrongdoers is important not only in and of itself
but also to deter future fraud.
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\240\ See, e.g., ``SEC Charges Adelphia and Rigas Family with
Massive Financial Fraud,'' SEC Press Release, July 24, 2002, available
at http://www.sec.gov/news/press/2002-110.htm; ``SEC Announces Fraud
Charges Against Former Rite Aid Senior Management,'' SEC Press Release,
June 21, 2002, available at http://www.sec.gov/news/press/2002-92.htm;
``Waste Management Found and Five Other Former Top Officers Sued for
Massive Fraud,'' SEC Press Release, March 26, 2002, available at http:/
/www.sec.gov/news/press/2002-44.txt. In conjunction with the Department
of Justice, the SEC is also, of course, conducting a far-reaching
investigation into the Enron collapse, and has thus far brought charges
in one case. See ``SEC Charges a Former High-Ranking Enron Official
With Fraud,'' SEC Press Release, August 21, 2002, available at http://
www.sec.gov/news/press/2002-126.htm.
\241\ See, e.g., Harvey L. Pitt, Remarks Before the National Press
Club (July 19, 2002), available at http://www.sec.gov/news/speech/
spch577.htm; Harvey L. Pitt, Speech at the Fall Meeting of the ABA's
Committee on Federal Regulation of Securities (November 16, 2001),
available at http://www.sec.gov/news/speech/spch524.htm; Harvey Pitt,
Remark at the PLI 33rd Annual Institute on Securities Regulation
(November 8, 2001), available at http://www.sec.gov/news/speech/
520.htm; Hearings Before the Subcommittee on Commerce, Justice, State,
and the Judiciary, Senate Committee on Appropriations, 107th Cong., S.
Hrg. 107--- (March 7, 2002) at-- (Printed Hearing Record Pending)
(Statement of the Honorable Harvey L. Pitt, SEC Chairman), available at
http://www.sec.gov/news/testimony/030702tshlp.htm.
---------------------------------------------------------------------------
We note, however, that large-scale financial frauds are
perhaps the cases least amenable to real time enforcement. The
complexities of such cases require a great deal of resources
and the time to do a close review of the usually large number
of pertinent documents. Trying to shortcut this process may
well lead investigators to overlook the most deeply hidden
practices.\242\ The Enron case itself demonstrates the array of
complexities that a financial fraud case can present; even
after months of intensive scrutiny, there continue to be fresh
revelations about Enron's fraudulent practices.
---------------------------------------------------------------------------
\242\ In cases of large-scale financial fraud, it may be easy to
miss significant portions of the wrongdoing without a comprehensive
review. In its recent investigation of accounting fraud at Xerox Corp,
for example, the SEC had uncovered approximately $3 billion in
improperly booked revenue at the time it settled the case in April
2002; 2\1/2\ months later, Xerox revealed in a restatement that, in
fact, over $6 billion in revenue had been improperly accounted for. See
Kathleen Day, ``Xerox Restates 5 Years of Revenue; 97-01 Figures Were
Off by $6.4 Billion,'' The Washington Post, June 29, 2002; Claudia H.
Deutsch, ``Xerox Revises Revenue Data, Tripling Error First Reported,''
The New York Times, June 29, 2002. See also Michael Schroeder and Greg
Ip, ``Imperfect Guardian: SEC Faces Hurdles Beyond Low Budget in
Stopping Fraud,'' The Wall Street Journal, July 19, 2002 (noting
problems that may arise from attempting to bring cases too quickly).
---------------------------------------------------------------------------
The SEC's current emphasis on enforcement, moreover, needs
to be accompanied by equally strong action on proactive
measures related to prevention and detection. Enforcement alone
cannot prevent shareholders from unfairly losing their money,
and it can only address the cases where wrongful practices have
already come to light. Moreover, an overemphasis on enforcement
presupposes that the problems the markets face now are
primarily due to individual bad actors. For these reasons, an
approach that combines enforcement with other, more systemic
remedies is necessary to fully restore public trust in the
market and our system of oversight.
Coordinate Better With Other Agencies. In administering
PUHCA, the SEC's responsibilities interact substantially with
those of FERC under the Federal Power Act, PURPA and other
statutes relating to public utilities and public utility
holding companies. Thus, it is essential that the SEC and FERC
coordinate their activities in these areas. Effective
coordination between agencies helps ensure consistency in
policy determinations and prevents companies from exploiting
the lack of oversight in areas where neither agency may have
taken full responsibility--as Enron did in using its PUHCA
exemption application to the SEC to obtain regulatory benefits
from FERC under PURPA.
Better communication between agencies can also enable each
agency to more fully understand the context surrounding the
companies and transactions that they are overseeing. Had the
SEC staff consulted with FERC staff about Enron's 2000
application for a PUHCA exemption, they might have learned
important additional information about some of the ultimate
objects of that application, the windfarms, and the ownership
transactions surrounding them--information that Enron had
provided to FERC, but not to the SEC. Such knowledge may have
informed the SEC's evaluation of Enron's application and,
perhaps, other matters as well. More generally, improved
coordination could provide each agency with the benefit of
additional, complementary expertise in their regulatory and
oversight efforts, with FERC lending its broader energy and
utility industry knowledge to the SEC, and the SEC bringing its
experience in market oversight to FERC, an agency responsible
for overseeing an increasingly deregulated and market-based
energy system.
Determine Why the SEC Did Not Act on Enron's PUHCA
Application and Ensure That Such Oversights Do Not Happen
Again. Under both Federal securities law \243\ and FERC
practice, companies may obtain immediate benefits by filing a
``good faith'' application for a PUHCA exemption with the SEC.
Thus, the Commission's failure to act promptly on requests for
PUHCA exemptions can provide significant, and potentially
unwarranted, regulatory and economic benefits to companies that
submit such applications. The handling of Enron's exemption
application described above raises troubling questions about
the Commission's treatment of such applications. The Commission
should thoroughly investigate the handling of this exemption
request to determine (1) whether it represents a pattern of
delay that has provided unwarranted benefits to, or been abused
by, applicants; and (2) whether, in this specific instance,
Commission staff agreed to Enron's request to hold this matter
in abeyance in order to facilitate Enron's regulatory goals
before FERC. If either is found to be true, it would be very
disturbing, and the SEC should take immediate action to correct
the problem. Moreover, the Commission should ensure that a
consistent practice of prompt review is in place to avoid any
similar results in the future.
---------------------------------------------------------------------------
\243\ See 15 U.S.C. Sec. 79c(c) (providing that the filing of
application for a PUHCA exemption in good faith ``shall exempt the
applicant from any obligation, duty, or liability imposed in this
chapter upon the applicant as a holding company until the Commission
has acted upon such application''; the subsection also provides that
the Commission must grant, deny or otherwise dispose of the application
``within a reasonable time'' after receipt).
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PART TWO: MORE WATCHDOGS--WALL STREET SECURITIES ANALYSTS AND CREDIT
RATING AGENCIES
As discussed in Part I of this report, the story of Enron
and the financial watchdogs was one of catastrophic failure--
one in which all of those overseeing the company and providing
information to the markets about the company's finances for a
variety of reasons failed to get accurate information to
investors. As this Part of the report explains, that oversight
failure was not limited to entities with legal obligations to
watch over the company in the name of the investing public,
such as the SEC or the company's board of directors and
auditors. Two other groups that provided information to the
markets about Enron also failed to accurately report on the
company's condition, again to the detriment of the investing
public.
These groups--Wall Street securities analysts and credit
rating agencies--hold themselves out as unbiased and accurate
assessors of various companies' financial conditions, a view
shared, at least until recently, by large parts of the
investing public. Yet, as with the entities discussed in Part
I, Enron revealed both groups to be not nearly so reliable as
the general public perceived them to be. Instead, Enron's case
proved Wall Street analysts to be far less focused on
accurately assessing a company's stock performance than on
other factors related to their own employers' businesses and
the credit rating agencies to be far less diligent and
attentive to fulfilling their functions than they should have
been.
This Part examines the stories of Enron and the analysts
and the credit raters, explores how and why entities whose
mission is to accurately assess a company's financial health
failed so completely to do so, and offers some suggestions for
improving the system and ensuring that these entities do better
what they say they are doing.\244\
---------------------------------------------------------------------------
\244\ In contrast to the Committee staff's review of the SEC's
interactions with Enron, Committee staff did not conduct an in-depth
investigation of the sell-side analysts or the credit rating agencies.
This section of the Report is instead intended as a broad summary of
their story, based on the Committee's February 27, 2002 and March 20,
2002 hearings and staff interviews leading up to them, as well as other
public sources.
---------------------------------------------------------------------------
I. ENRON AND THE WALL STREET ANALYSTS
In his testimony before the Governmental Affairs Committee
in a January 24, 2002 hearing, Arthur Levitt declared, ``I
think Wall Street sell-side analysis has lost virtually all
credibility.'' \245\ This is significant, because, according to
the testimony of Frank Torres of Consumers Union in the
Committee's February 27, 2002 hearing, ``The Watchdogs Didn't
Bark: Enron and the Wall Street Analysts,'' small investors
``rely on the expertise of [Wall Street] analysts to digest raw
data, to talk to insiders, to put together the recommendations.
Analysts' research is likely to be the most detailed
information some investors have.'' \246\ And investors relied
on the recommendations they got: The PBS news magazine Now With
Bill Moyers profiled three Jupiter, Florida women who had
formed an investment club about their loss of thousands of
dollars they invested in technology stocks. One, Fraeda Kopman,
said: ``I think that we put a lot of emphasis on the work that
the analysts were doing for the various brokerage firms.
Especially the big ones. Because we believed in them. I guess
we were very naive. And we thought that that information was
correct. They were the ones that were visiting the companies.
So obviously, they would know a lot more than I would know by
just reading about a company.'' \247\
---------------------------------------------------------------------------
\245\ The Fall of Enron: How Could It Have Happened, Hearing Before
the Senate Governmental Affairs Committee, 107th Cong., S. Hrg. 107-376
(January 24, 2002) at 34.
\246\ The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 56.
\247\ Transcript, Now With Bill Moyers, May 31, 2002, available at
http://www.pbs.org/now/transcript/transcript120--full.html.
---------------------------------------------------------------------------
Until the Enron story broke and questions started being
asked in the mainstream media about why analysts were
recommending the stock until just before the company collapsed,
the average American investor probably did not know that
analysts' recommendations were often more euphemism than
dependable investment advice. Furthermore, until April 2002,
when, after a year-long investigation, New York Attorney
General Eliot Spitzer released e-mails sent by analysts within
Merrill Lynch calling a stock they were recommending ``a piece
of junk'' and worse, many Americans did not suspect that the
recommendations might be influenced more by the amount of the
investment banking revenue that company could provide than by
the quality of the company.
Nearly all of the Wall Street analysts who covered Enron
recommended Enron as a stock to buy--meaning that they were
telling investors that the stock was undervalued--well into the
fall of 2001, even as Enron's hidden partnerships were
revealed, the SEC initiated its investigation, and Enron
restated its financials going back more than 4 years. Most
troublesome, though, is that during the period well prior to
Enron's collapse, analysts recommended the stock to investors
even though at least some of those same analysts admittedly did
not understand how Enron, which was generally recognized as a
``black box,'' made its money. Many of these analysts worked
for banks that derived large investment banking fees from Enron
deals, invested in Enron's off-balance-sheet partnerships, and/
or had significant credit exposure to Enron.
This section of the report gives an overview of the so-
called sell-side analysts who covered Enron. It first describes
the role such analysts are supposed to play, then describes the
assessments of Enron by analysts who covered the company prior
to its bankruptcy. Following that, the report outlines factors
affecting the objectivity of sell-side analyst recommendations,
and then suggests some solutions that can be implemented by the
SEC to implement the mandates of the historic Sarbanes-Oxley
Act and to enhance the independence and therefore the integrity
of Wall Street stock recommendations.
A. Investment Research Analysts
There are three types of analysts who evaluate stocks:
Sell-side analysts, buy-side analysts, and independent
analysts.\248\ Sell-side analysts work for broker-dealers that
offer brokerage services, usually to both institutional and
retail clients. Buy-side analysts work for institutional money
managers, including mutual funds or hedge funds, counseling
them on what securities to buy or sell. Some independent
analysts work for a broker-dealer that does not offer any
client services, such as investment banking services, but which
instead makes commissions from the sale of securities through a
third-party brokerage. Other independent analysts sell their
research through a retainer or subscription agreement to
clients, usually institutional money managers who can afford
their large fees.
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\248\ See generally ``Analyzing Analyst Recommendations,'' SEC
Online Publication For Investors, http://www.sec.gov/investor/pubs/
analysts.htm. This report's description of analysts and their business
is derived from this publication.
---------------------------------------------------------------------------
There is no consistent template for all analysts to follow,
but sell-side analysts generally publish periodic reports on
each company they cover. A report will contain an assessment of
the company's business itself, where the company fits into the
overall trends in its industry, and any current or possible
future good points or problems. The report will probably have a
recommendation on the stock, a variation of either buy, sell,
or hold, with each firm using its own variations on these
terms. For some firms, ``buy'' is their highest rating; for
others, it is their third-tier ranking for a stock. Research
reports may also provide a target stock price, which represents
what the analyst believes the stock is worth based on his or
her analysis of the company. Sometimes analysts set earnings
estimates for companies, usually in the form of earnings per
share, prior to the companies announcing their earnings. Sell-
side analyst reports, while much more widely disseminated than
other analyst reports, are not freely available to the public
at large, at least not in their entirety. Such reports are
generally available only to firm clients, either through
brokers or through the firm's website; some firms also sell
their research reports through other brokerages or services,
where investors may pay a fee to have access to them. Beyond
firm clients and paying customers, the average investor's
access to an analyst's research in written form is generally
limited to the recommendation, the earnings per share estimate,
and the target price, which are widely published on the
internet or are discussed in financial journals or on cable
networks like CNN Financial News Network, which regularly
interview analysts about trends and stocks.
As a part of their analysis, sell-side analysts--who
generally cover a number of companies within one industry
sector--will compile information about that industry and follow
closely the developments of the corporations they follow. They
participate in regular conference calls with and even attend
on-site presentations by the companies they cover. They get to
know the management of these companies. Outside of a company's
officers, directors and auditors, the analysts who regularly
cover a company are among the foremost experts on the
operations of that company. Indeed, the SEC has recognized that
securities analysts are important to efficient operation of the
securities markets.\249\ This is why the information they
provide to the market can be so valuable and why analysts can
serve as real market watchdogs. In an ideal world, their
expertise and close scrutiny of corporate disclosures and
financial statements should position them to notice where
problems may be afoot and to challenge a company on the issues
management would prefer to avoid.
---------------------------------------------------------------------------
\249\ See Regulation Analyst Certification, SEC Release Nos. 33-
8119; 34-46301; File No. S7-30-02 (July 25, 2002); 67 Fed. Reg. 51510
(proposed August 8, 2002) (``[t]he Commission has stated that analysts,
who `ferret out and analyze information,' play an important role in the
securities markets'').
---------------------------------------------------------------------------
B. The Wall Street Analysts' Assessments of Enron
The analysts who covered Enron, as a group, maintained an
optimistic outlook on that company's prospects, even as the
stock slid over the course of 2001. After reaching a high of
$90.75 in August 2000, the stock's high in 2001--$84--occurred
on the first trading day of the year; by the end of September,
the stock closed at about $25, after a fairly consistent fall
throughout the year. Nevertheless, Enron analysts retained
their bullish stance: Of 15 sell-side analysts who covered
Enron, \250\ 13 had a buy or strong buy on August 7, 2001; on
October 17, 2001, the day after the company announced a $1
billion charge to earnings and the day that The Wall Street
Journal broke the story of Enron's financial shenanigans
involving related-party transactions with partnerships headed
by Enron's own chief financial officer, 15 out of 15 of the
major analysts who covered Enron had a strong buy or buy rating
on the stock.\251\
---------------------------------------------------------------------------
\250\ This list, provided by Thomson Financial, does not purport to
include all the firms that covered Enron, but does include the largest.
The 15 are: A.G. Edwards, Banc of America Securities, Bernstein, CIBC,
Citigroup Salomon Smith Barney, Credit Suisse First Boston, FAC Equity,
Fulcrum Partners, Goldman Sachs, J.P. Morgan Chase, Lehman Brothers,
Merrill Lynch, Prudential, Sanders Morris, and UBS Warburg.
\251\ See The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 127 (Chart entitled
``Enron Stock Recommendation By Broker, August 7, 2001 through December
7, 2001,'' derived from information provided by Thomson Financial).
---------------------------------------------------------------------------
Strong Wall Street analyst support continued as the
problems at Enron became increasingly apparent: On October 24,
2001, Chief Financial Officer Andrew Fastow resigned, and 12 of
15 securities analysts retained a buy or strong buy rating on
the stock.\252\ On October 31, when Enron announced that the
SEC had opened up a formal investigation into the allegations
in The Wall Street Journal report, 10 analysts kept a buy or
strong buy rating on the stock, even as the stock price had
slid to $13.90, practically a third of where it had been at the
beginning of that month.\253\ On November 8, when Enron filed
with the SEC a document indicating its intention to restate its
financial statements going back more than 4 years due to shoddy
accounting, disclosing that it would take a charge to earnings
of approximately $500 million--about 20 percent of earnings
during that period--these 10 analysts did not budge from their
buy or strong buy ratings on Enron's stock, which by then had
gone down to $8.41.\254\
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\252\ Id.
\253\ Id.
\254\ Id.
---------------------------------------------------------------------------
On November 9, 2001, Enron announced a planned merger with
Dynegy, and many hoped despite the company's burgeoning
accounting problems that this merger could save the company.
Over the next 3 weeks, it became apparent that the merger was
not going to go through. On November 28, 2001, Enron's credit
rating was reduced from investment grade to junk, and the
merger with Dynegy was called off. Still, that same day, four
analysts retained a buy or strong buy rating on Enron's
stock.\255\ On December 2, Enron declared bankruptcy. As of
that date, only two analysts rated Enron as a sell. Seven firms
rated Enron as a hold, and one still rated Enron a buy.\256\
---------------------------------------------------------------------------
\255\ Id.
\256\ Id.
---------------------------------------------------------------------------
In the Committee's February 27, 2002 hearing, four of the
Wall Street analysts who had recommended Enron stock as a
strong buy well into the fall of 2001 were invited to explain
the basis for their belief in Enron's stock despite its
consistent downward movement throughout 2001: Richard Gross of
Lehman Brothers, Anatol Feygin of J.P. Morgan Chase, Curt
Launer of Credit Suisse First Boston, and Raymond Niles of
Citigroup Salomon Smith Barney.
As late as October 24, 2001, Richard Gross of Lehman
Brothers rated Enron stock as a strong buy, Lehman's highest
rating, which is supposed to mean that the stock will
outperform the market by 15 percent over the next year.\257\ On
October 16, 2001, after Chairman and CEO Ken Lay announced that
Enron was taking a $1.2 billion charge to shareholder equity,
Gross apparently remained unconcerned. He was quoted as saying:
``The end of the world is not at hand. . . . We think investors
should rustle up a little courage and aggressively buy the
stock.'' \258\ In his last report on Enron, dated October 24,
2001, Gross acknowledged growing concerns about Enron as its
liquidity was waning and the scandal was mounting, but he
maintained his strong buy rating on the stock.\259\ Gross kept
his strong buy rating on Enron until he dropped coverage of it
on December 7; according to Gross, he could not reconsider his
recommendation as of late October because Lehman was advising
Dynegy on its proposed merger with Enron, and he had been
brought in to assist the Lehman investment bankers in their
work.\260\
---------------------------------------------------------------------------
\257\ Information provided by Thomson Financial.
\258\ Ben White, ``Analysts Faulted For Forecasts,'' The Washington
Post, January 11, 2002.
\259\ Lehman Brothers Research Report on Enron Corp., October 24,
2001.
\260\ Committee staff interview with Richard Gross, February 13,
2002. When an analyst assists the investment banking department in a
transaction, the details of which are not yet public, that analyst,
because of his or her exposure to this confidential information, cannot
publicly speak about that company either until the transaction becomes
public or until the transaction is abandoned. Referring to the so-
called ``Chinese'' or ethical wall that exists between the research
division and the investment banking division of a firm--which is
generally set up to prevent such information from leaking to analysts,
who might disclose it publicly before the company intends it--analysts
are said to be ``brought over the wall'' when they assist in
confidential investment banking transactions.
---------------------------------------------------------------------------
Anatol Feygin of J.P. Morgan maintained a buy
recommendation--J.P. Morgan's highest rating--on Enron until
October 24, 2001, when Andrew Fastow resigned as Enron's Chief
Financial Officer amid the growing scandal. At that point,
Feygin downgraded Enron to a long-term buy, \261\ which by J.P.
Morgan's definition meant that he expected the stock to
maintain its value or grow by 10 percent over the next
year.\262\ In that report, Feygin indicated that ``the
appearance of impropriety'' had caused ``damage'' to Enron's
stock price, and that he agreed that ``investors are justified
in their reservations to buy'' the stock at that point.\263\
Nevertheless, the next day, Feygin wrote in a report that ``we
continue to have full faith in the propriety of Fastow's
involvement with the controversial off-balance sheet financing
vehicles. . . .'' \264\ Feygin retained the long-term buy
rating on Enron until J.P. Morgan dropped coverage of Enron on
November 29, 2001, \265\ the day after the proposed merger with
Dynegy fell apart.
---------------------------------------------------------------------------
\261\ J.P. Morgan Research Report on Enron Corp., October 24, 2001.
\262\ Information provided by Thomson Financial.
\263\ J.P. Morgan Research Report on Enron Corp., October 24, 2001.
\264\ J.P. Morgan Research Report on Enron Corp., October 25, 2001.
\265\ The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 127.
---------------------------------------------------------------------------
Until October 26, 2001, by which time Enron's stock price
had fallen to a closing price of $15.40, Raymond Niles of
Citigroup Salomon Smith Barney recommended Enron stock as a
buy, his firm's highest rating.\266\ At that time, he
downgraded it two levels to neutral, \267\ which indicated,
under Salomon Smith Barney's definition, that the stock price
should stay steady over the following 12 months.\268\ The day
prior to the downgrade, Niles expressed confidence that Enron
would survive and prosper once the scandal died down: ``We are
long term believers in the Merchant Energy story [Enron's
trading business] and Enron.'' He added that the likelihood
that ``lingering uncertainty over financial practices may begin
to impair Enron's commercial operations'' was low with a
``probability [of] 10 percent-15 percent.'' \269\ When he
downgraded his rating to neutral, Niles reaffirmed that he
``continue[d] to think [Enron's growth] is the most likely
outcome,'' although he acknowledged ``a now higher probability
`worst case' outcome.'' \270\ Although he retained the neutral
rating, in his November 14, 2001 report, Niles expressed an
expectation that Enron's stock price would go up due to the
merger.\271\ Even after Enron declared bankruptcy, Salomon
Smith Barney maintained its ``hold'' rating on Enron.\272\
---------------------------------------------------------------------------
\266\ Id.
\267\ Id.
\268\ Information provided by Thomson Financial.
\269\ Salomon Smith Barney Research Report on Enron Corp., October
25, 2001.
\270\ Salomon Smith Barney Research Report on Enron Corp., October
26, 2001.
\271\ Salomon Smith Barney Research Report on Enron Corp., November
14, 2001.
\272\ The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 127.
---------------------------------------------------------------------------
Curt Launer of Credit Suisse First Boston (``CSFB'') rated
Enron a strong buy, CSFB's highest rating, until November 29,
2001.\273\ On September 10, 2001, Launer concluded, based on
his ``analysis, discussions with management and reviews of
recent filings'' that ``there is no truth'' to the speculation
in the market that Enron might have to restate earnings from
prior quarters due to misplaced investments.\274\ Despite the
fact that it appears that management may have misled him on
this point--Enron did have to restate earnings--Launer
continued to believe in the company. In his October 19 report,
Launer wrote that ``the so-called LJM Partnerships were fully
disclosed in Enron's financial statements and were subject to
appropriate scrutiny by Enron's board, outside auditors and
outside legal counsel. . . . Considering the disclosures made
and the appropriateness of the accounting treatment . . . we
anticipate that the negative sentiment surrounding these issues
will dissipate over time.'' \275\ In his October 29 report,
Launer reiterated his confidence that no restatement would be
required (although one did come just over 1 week later);
moreover, despite the fact that Enron had just drawn down $3
billion in credit (exhausting its available credit lines),
Launer stated that he viewed Enron's ``credit ratings and
balance sheet issues as unlikely to worsen materially.'' \276\
On November 29, Launer downgraded Enron to a hold.\277\ At that
point, the proposed merger had fallen through and Enron's stock
price had fallen to a close of 36 cents.
---------------------------------------------------------------------------
\273\ Id.
\274\ Credit Suisse First Boston Natural Gas & Power Research
Report, September 10, 2001.
\275\ Credit Suisse First Boston Research Report on Enron Corp.,
October 19, 2001.
\276\ Credit Suisse First Boston Natural Gas & Power Research
Report, October 29, 2001.
\277\ Credit Suisse First Boston Research Report on Enron Corp.,
November 29, 2001.
---------------------------------------------------------------------------
Despite the sell-side analysts' enthusiastic
recommendations of Enron's stock throughout 2001, other
observers correctly questioned whether Enron was a good
investment. In the March 5, 2001 edition of Fortune, reporter
Bethany McLean asked the question, ``Is Enron Overpriced?'' As
she presciently noted, ``It's in a bunch of complex businesses.
Its financial statements are nearly impenetrable. So why is
Enron trading at such a huge multiple [of earnings per
share]?'' \278\ In her story, analysts joked about Enron's
opaque financial statements; even analysts from credit rating
agencies Standard & Poor's and Fitch said they could not figure
out Enron's numbers. McLean warned that ``the inability to get
behind the numbers combined with ever higher expectations for
the company may increase the chance of a nasty surprise.'' She
quoted the J.P. Morgan equity strategist Chris Wolfe, Goldman
Sachs analyst David Fleischer, and Bear Stearns analyst Robert
Winters--all of whom believed in Enron--admitting that they
could not piece together how Enron made its money.
---------------------------------------------------------------------------
\278\ Bethany McLean, ``Is Enron Overpriced?'' Fortune, March 5,
2001.
---------------------------------------------------------------------------
The problem was that all along, even though Enron
consistently beat earnings estimates by analysts by at least a
penny per share, Enron simply was not providing answers to the
questions about where its profits were coming from. As McLean
reported in March 2001, Enron was giving two responses to
concerns about its lack of transparency: (1) Enron's business
is complicated and it would not take the time to explain it;
and (2) how Enron made its money was ``proprietary information,
like Coca-Cola's secret formula.'' \279\ Despite this lack of
transparency--Enron's now infamous ``black box'' quality--and
despite the company's falling stock price, analysts continued
to recommend the company as a buy or strong buy. Particularly
ironic was the comment of Carol Coale, an analyst at
Prudential, after she was the first Wall Street analyst to
downgrade Enron to a sell on October 24, 2001: ``The bottom
line is, it's really difficult to recommend an investment when
management does not disclose the facts.'' \280\
---------------------------------------------------------------------------
\279\ Id.
\280\ Alex Berenson and Richard A. Oppel, Jr., ``Once Mighty Enron
Strains Under Scrutiny,'' The New York Times, October 28, 2001.
---------------------------------------------------------------------------
Some independent analysts also questioned Enron's value
well prior to its demise. A Forbes.com study found that, in
contrast to sell-side analysts, six of eight independent
investment newsletters were recommending that Enron stock be
sold prior to November 2001--three as early as March or April
2001.\281\ In a May 6, 2001 research report--nearly seven
months before Enron's bankruptcy--the Off Wall Street
Consulting Group, an independent research firm based in
Cambridge, Massachusetts, suggested that Enron's stock was
worth less than half of its then $60 price.\282\ Off Wall
Street pointed out that Enron's profit margins were declining
and would likely continue to decline because, although the
revenues from its trading operation--its most profitable
division--were increasing, that division's actual profits were
shrinking due to growing liquidity and less volatility in the
energy markets.\283\ Low return on capital was also a bad sign
to Off Wall Street that Enron was not getting the benefit it
should from its assets and investments.\284\ Off Wall Street
also expressed concern about Enron's heavy reliance on related-
party transactions--including the fact that one of the entities
with which Enron was trading was headed by CFO Andrew Fastow
and the fact that sales to a related party of dark fiber
(optical cable not in use) improved earnings in the previous
quarter by 4 cents per share, allowing Enron to exceed earnings
expectations.\285\ Off Wall Street believed--correctly, it
turned out--that Enron was resorting to the related-party
transactions--transactions with entities controlled by Enron
insiders or subsidiaries--to improve earnings appearance, and
resorted to them more and more as profits became more
elusive.\286\ On August 15, 2001, Off Wall Street issued
another report on Enron, noting that Enron was selling off
assets and booking the payments as income to improve the
appearance of profitability in its trading division in the
second quarter; meanwhile, Enron was refusing to reveal how
much profit it was booking from the sales, so analysts were
unable to determine how much of its profits were recurring
(from their business, a sign of health), as opposed to non-
recurring (from one-time deals, booster-shots to
earnings).\287\
---------------------------------------------------------------------------
\281\ ``Enron: An Unreported Triumph For Investment Letters,''
Forbes.com, December 7, 2001, available at http://www.forbes.com/2001/
12/07/1207newsletterwatch.html.
\282\ Off Wall Street Consulting Group, Inc., Research Report
Regarding Enron, May 6, 2001 at 1. In that report, Off Wall Street
valued Enron, which was at the time trading at nearly $60 per share, at
$30 per share and recommended that its clients sell the stock at the
then-current levels.
\283\ Id. at 3.
\284\ Id. at 7.
\285\ Id. at 10-11.
\286\ Id. at 11, 13.
\287\ Off Wall Street Consulting Group, Inc., Research Report
Regarding Enron, August 15, 2001.
---------------------------------------------------------------------------
An even earlier skeptic of Enron was James Chanos,
President of Kynikos Associates, a New York investment firm.
Chanos began to research Enron after reading a piece in the
Texas regional edition of The Wall Street Journal on September
20, 2000, entitled ``Energy Traders Cite Gains But Math Is
Missing,'' \288\ questioning whether Enron's profits, which
were largely non-cash, were inflated by accounting tricks.\289\
Chanos, like Off Wall Street, was concerned about low return on
capital, large and frequent insider stock sales, and the
general opacity of the company's financial statements. Chanos
began shorting Enron's stock--a bet that its price would go
down--in November 2000. (Although Enron's stock price actually
stayed fairly stable at the $70 to $80 range from November
through February 2001, in March 2001, Chanos' bets started
paying off--the stock price started to decline steadily).
---------------------------------------------------------------------------
\288\ See note 46 above and accompanying text.
\289\ Scott Sherman, ``Enron: Uncovering the Uncovered Story,''
Columbia Journalism Review, March/April 2002.
---------------------------------------------------------------------------
There were other market participants who were doubtful of
Enron's prospects--after all, its stock price was falling
throughout 2001. Howard Schilit, President of the independent
research firm Center for Financial Research and Analysis,
testified at the Committee's February 27 hearing that there
were a number of red flags that would have been revealed by a
mere perusal of the financial statements. Although Dr. Schilit
did not cover Enron prior to its collapse, he testified that he
reviewed the financial statements of the company for 1 hour on
the evening prior to his testimony and took down ``three pages
of warnings'' that there were problems at Enron, ``words like
`non-cash sales,' words like `$1 billion of related party
revenue.' '' \290\ Dr. Schilit told the Committee that ``for
any analyst to say there were no warning signs in the public
filings, they could not have read the same public filings that
I did.'' \291\
---------------------------------------------------------------------------
\290\ The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 40.
\291\ Id. It should be noted that stock analysts, in contrast to
government regulators such as the SEC, are not necessarily looking just
for fraud in a company's public filings, but also for signs that a
company's stock is overvalued. Therefore, what should be ``red flags''
to an analyst looking at whether a company has problems may or may not
also be indicia of fraud. See Committee staff interview with Scott
Budde, Director, Equity Portfolio Analytics, TIAA-CREF (July 26, 2002).
---------------------------------------------------------------------------
Despite these red flags, nearly all the sell-side analysts
who covered Enron were bullish on the stock. The analysts who
testified at the Committee's February 27 hearing insisted that
their conclusions about Enron were based on what they saw as
positive performance by the company over the course of
years.\292\ They cited Enron's increasing revenue, its
``strong'' business model, and its impressive ``bench'' of
capable managers.\293\ The analysts maintained that their
support for Enron was reasonable given the information that was
publicly available and the information they had been given by
the company itself.\294\ In short, they argued that they had
been misled, just like everyone else. Although prospects for
the company may have dimmed by early November 2001, as more
questions arose about Enron's related-party transactions, its
Chief Financial Officer resigned and Enron announced it was
restating its financial statements going back more than 4
years, the analysts said that they believed that the
prospective merger with Dynegy, made public on November 8, was
a positive development that they thought would have averted the
company's collapse.\295\ They also cited instances of what they
believed to be affirmative misrepresentations by the company to
dupe them into seeing Enron in a more positive light. For
example, Curt Launer of CSFB testified that in January 1998, he
along with 100 other analysts visited Enron to view the new
trading floor of Enron Energy Services, Enron's retail
business. Impressed at the time, Launer since learned from news
reports that the trading floor had apparently been entirely
staged.\296\ (Enron executives, including former CEO Jeffrey
Skilling, deny this.) As Launer of CSFB put it, ``[H]indsight
allows a view that I as an analyst never had. I based my views
and ratings on the information that was available every step of
the way.'' \297\
---------------------------------------------------------------------------
\292\ The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 25, 26, 69, 84.
\293\ Id. at 26, 69.
\294\ Id. at 22, 38, 78-79, 85.
\295\ Id. at 70-71.
\296\ Id. at 19.
\297\ Id.
---------------------------------------------------------------------------
Nevertheless, Chanos, the independent research firm Off
Wall Street, and those investment newsletters counseling their
readers to sell Enron in Spring 2001 came to their conclusions
about Enron based on the same public information that the sell-
side analysts relied on; one might wonder why these Wall Street
analysts, who made their careers following the energy sector
and companies like Enron, missed what Off Wall Street, Chanos,
and the investment newsletters saw. This is particularly the
case given that at least some of these analysts knew of Off
Wall Street's and Chanos' reasoning about Enron and yet still
remained firm that Enron was a strong buy. In a May 9, 2001
report by The Street.com on the May 6, 2001 Off Wall Street
research report advising clients to sell Enron stock, the
reporter shared the research report on Enron with an unnamed
Wall Street analyst bullish on Enron. That Wall Street analyst
expressed his view that Off Wall Street misunderstood the
energy markets, but agreed that Enron's heavy use of related-
party transactions was troubling, remarking, ``Why are they
doing this? It's just inappropriate.'' \298\ At the Committee's
February 27 hearing, Curt Launer of CSFB testified that he had
``made it a practice throughout [his] career not to use other
research reports written by anybody,'' but acknowledged that he
was aware of the points made by Off Wall Street about Enron,
which had been brought to his attention by institutional
investors. Launer felt that the Off Wall Street objections to
Enron ``were relatively easy to answer analytically through our
own work,'' and accordingly he dismissed them.\299\
---------------------------------------------------------------------------
\298\ Peter Eavis, ``Why One Firm Thinks Enron Is Running Out of
Gas,'' TheStreet.com, May 9, 2001, available at http://
www.thestreet.com/comment/detox/1422781.html.
\299\ The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 27.
---------------------------------------------------------------------------
Launer and Niles similarly dismissed Chanos' work in early
2001. Chanos testified before the House Energy and Commerce
Committee on February 6, 2002 that he met sometime early in
2001 with the analysts covering Enron from CSFB and Salomon
Smith Barney, and he questioned them about their unwavering
support for the company in the face of the red flags that led
Chanos to sell the stock short. Chanos testified: ``[T]hey saw
some troubling signs. They saw some of the same troubling signs
we saw. . . . A year ago management had very glib answers for
why certain things looked troubling and why one shouldn't be
bothered by them. Basically that's what we heard from the sell-
side analysts. They sort of shrugged their shoulders. . . .
[O]ne analyst said, `Look, this is a ``trust me'' story.' ''
\300\ Launer and Niles confirmed at the Committee's February
27, 2002 hearing that they each met with Chanos and had this
conversation. However, in their testimony before the Committee,
neither indicated that they had had concerns about ``troubling
signs'' in early 2001, and neither suggested that their view on
Enron was based on ``a trust me story.'' Rather, they testified
that they formed their opinions of Enron based on what they
believed was the strong ``core business'' of the company.\301\
---------------------------------------------------------------------------
\300\ Developments Relating to Enron Corp., Hearing Before the
House of Representatives Energy and Commerce Committee, 107th Cong.,
Hrg. No. 107-83 (February 6, 2002) at 133.
\301\ The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 22.
---------------------------------------------------------------------------
The investigation by the New York Attorney General
involving internet stock analysts at Merrill Lynch, the results
of which were first announced in April 2002, offers an inside
look into other cases where analysts have produced rosy reviews
of overvalued stocks, even when they privately doubted them.
New York Attorney General Eliot Spitzer conducted a 10-month
investigation into the recommendations by the internet analysts
at Merrill Lynch from 1999 through 2001.\302\ He found that
although they were wholeheartedly endorsing stocks of companies
like InfoSpace, Excite@Home, GoTo.com, and Lifeminders, all
with long-term ratings of ``buy'' and short term ratings of, at
worst, ``neutral,'' the Merrill research analysts were
internally saying that these equities were a ``piece of junk''
(InfoSpace), ``piece of sh-t'' (Lifeminders), ``nothing
interesting about the company except banking fees'' for Merrill
(GoTo.com) and ``such a piece of crap'' (Excite@Home).\303\
Based on these findings, Spitzer brought an injunctive
proceeding against Merrill in New York State Supreme Court
under the Martin Act, a provision of New York law that
prohibits any fraud or deception relating to securities while
engaged in the purchase, sale, or distribution of, or in making
investment advice regarding, those securities in New York. In
May 2002, Merrill settled with Spitzer, agreeing, among other
things, to reform its research department practices and to pay
penalties of $100 million.\304\
---------------------------------------------------------------------------
\302\ Affidavit in Support of Application for an Order Pursuant to
General Business Law Section 354, by Eric Dinallo, April 8, 2002,
Spitzer v. Merrill Lynch, et al., New York Supreme Court, County of New
York, Index No. 02-401522 (``Dinallo Affidavit'') at 2-3.
\303\ Id. at 13.
\304\ ``Spitzer, Merrill Lynch Reach Unprecedented Agreement to
Reform Investment Practices,'' Press Release, Office of New York State
Attorney General Eliot Spitzer, May 21, 2002.
---------------------------------------------------------------------------
C. Factors Affecting the Objectivity of Sell-Side Analyst
Recommendations
Overly rosy stock recommendations by sell-side analysts
were not unique to Enron. Instead, Wall Street analysts have
long exhibited a clear bias towards rating stocks a ``buy.''
Charles Hill, Director of Research at Thomson Financial/First
Call, testified at the Committee's February 27, 2002 hearing
that, in 2001, about two-thirds of sell-side analysts'
recommendations were ``buys,'' about one-third were ``holds,''
and less than 2 percent were sell recommendations.\305\ If
taken at their word, this would mean that analysts believe that
less than two of every 100 companies will experience a fall in
stock price in the coming months; the rest would either stay
constant or go up. This seems unlikely and especially
questionable given that over the past 2 years, as sell-side
analysts' recommendations have remained basically consistent,
the S&P 500 index has fallen from over 1,500 to the lows we are
seeing now. One explanation for this optimism--and the optimism
of the Enron analysts--is that the context in which sell-side
analysts work has built-in conflicts and pressures that
discourage sell recommendations and encourage buy
recommendations.
---------------------------------------------------------------------------
\305\ The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 109. From March
2002 to May 2002, there was an increase in the proportion in sell
recommendations, according to Thomson Financial, to 2.5 percent; this
was largely due to the poor performance of the market in general,
although it was also due to Morgan Stanley's revision of its rating
system, which resulted in 22 percent of its ratings being in the lowest
category--underweight, which is the equivalent of a sell
recommendation. See Kathleen Pender, ``Less Bull on Wall Street? What
The Settlement With Merrill Lynch Means For Investment Research,'' San
Francisco Chronicle, May 23, 2002.
---------------------------------------------------------------------------
As David Becker, former General Counsel of the SEC, said in
a speech last year: ``Let's be plain: broker-dealers employ
analysts because they help sell securities. There's nothing
nefarious or dishonorable in that; but no one should be under
any illusion that brokers employ analysts simply as a public
service.'' \306\ This ability to help sell securities affects
the business of the analysts' employers on a number of fronts.
Most significantly, analysts' recommendations can affect their
firms' investment banking relationships in either a positive or
negative way. Even though analysts and investment bankers are
supposed to be separated by a so-called ``Chinese'' or ethical
wall, this wall is not per se mandated by rule or law, and to
the extent that it does exist at Wall Street firms, it exists
mainly to protect non-public material information learned by
bankers in the course of deals from being given to the
analysts, who might be tempted to use it in making their
assessments, which might violate insider trading laws.\307\
Therefore the wall is mainly set up--if it exists at all--to
protect the bankers and the companies, not the independence of
the analysts. For example, many investment banks invested in
the partnerships run by Enron CFO Andrew Fastow while the
analysts working for those firms were recommending Enron stock;
the firms could not share information about the fact or
operation of these partnerships with the analysts due to
confidentiality agreements. Columbia University Law School
Professor John Coffee called this an example of ``the Chinese
wall working to injure public investors, rather than benefit
them.'' \308\ Moreover, despite this wall, analysts are still
influenced by investment banking considerations.\309\
---------------------------------------------------------------------------
\306\ David Becker, ``Analyzing Analysts,'' Remarks Before the
Committee on Federal Regulation of Securities of the American Bar
Association, August 7, 2001, available at http://www.sec.gov/news/
speech/spch510.htm.
\307\ See Marc I. Steinberg and John Fletcher, ``Compliance
Programs For Insider Trading,'' 47 SMU L. Rev. 1783, 1804 (July-August
1994).
\308\ Kurt Eichenwald, ``Investors Lured to Enron Deals By Inside
Data,'' The New York Times, January 25, 2002.
\309\ In addition to the evidence uncovered by the New York
Attorney General in his Merrill investigation, see, e.g., Roni Michaely
and Kent L. Womack, ``Conflict of Interest and the Credibility of
Underwriter Analyst Recommendations,'' Review of Financial Studies,
vol. 12, no. 4, 653-686 (1999) at 683 (finding that analysts were less
accurate and more optimistic in recommendations regarding client
companies after initial public offerings than analysts from firms that
were not involved in IPO).
---------------------------------------------------------------------------
Most broker-dealers who offer investment banking services
make much if not most of their profits from these services,
which include such things as underwriting securities offerings
or advising on mergers, acquisitions, or sales of businesses.
Because fees from these services can be quite high, banks
compete fiercely for these deals. Companies--particularly
companies like Enron that have a lot of investment banking
business \310\--are unlikely to choose as their business
partner a bank whose analyst is criticizing their stock, and
banks are unlikely to appreciate analysts who issue
recommendations that hamper their ability to obtain lucrative
deals. For example, as the Senate Permanent Subcommittee on
Investigations recently showed in its July 30, 2002 hearing,
``The Role of the Financial Institutions in Enron's Collapse,''
a memorandum from investment bankers at Merrill Lynch to its
President indicated that Enron was pressuring Merrill Lynch to
improve its rating in 1998, by threatening to withhold
investment banking business. Soon thereafter, the analyst
responsible for reporting on and rating Enron left Merrill, and
was replaced by another analyst who immediately changed Enron's
rating to a buy.\311\
---------------------------------------------------------------------------
\310\ According to information provided to the Committee by Thomson
Financial, Enron did about 30 securities offerings in 2000-2001.
\311\ The Role of Financial Institutions in Enron's Collapse,
Hearing Before the Permanent Subcommittee on Investigations, Senate
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-618 (July 30,
2002) at-- (Printed Hearing Record Pending) (Statement of Subcommittee
Chairman Carl Levin), available at http://www.senate.gov/?gov--affairs/
073002levin.htm.
---------------------------------------------------------------------------
In the New York Attorney General's investigation of
Merrill, the evidence indicates that Merrill used its research
department to sell its investment banking services to
companies, essentially promising that positive ratings from the
influential Henry Blodget, Merrill's lead internet analyst,
would be used to convince investors to invest in those
companies, increasing their stock price. One e-mail from a
banker to an analyst at Merrill made clear their strategy: ``We
should aggressively link coverage with banking--that is what we
did with [a prior client] (Henry [Blodget] was involved) . . .
if you are very bullish . . . we can probably get by on a
`handshake.' '' \312\ Indeed, Blodget estimated that his group
would spend at least 50 percent of their time on investment
banking matters. In one e-mail, Blodget essentially conceded
that the main driver behind his group's ratings was investment
banking concerns; frustrated about negotiations with the
investment banking group about a rating for one particular
company, Blodget threatened to ``just start calling the stocks
(stocks not companies), including [the one at issue], like we
see them, no matter what the ancillary business consequences
are.'' \313\
---------------------------------------------------------------------------
\312\ Dinallo Affidavit, note 302 above, at 15.
\313\ Id. at 19.
---------------------------------------------------------------------------
Indeed, given the importance of investment banking fees to
the firms, and the effect ratings can have on client
relationships, it should not be surprising that many analysts
have, as a matter of practice, shared their research with the
companies they cover prior to issuing the reports. The SEC
found in a survey conducted last year that six out of nine
investment banks studied had analysts give companies, as well
as the investment bankers at the analyst's firm who work with
those companies, advance notice of any pending change in their
recommendation status.\314\ In March 2001, a memo from the head
of European equities research at J.P. Morgan Chase was leaked
to the press, which set forth this policy with the additional
requirement that the analyst incorporate any change requested
by the company unless he or she can make an argument why the
change should not be made, calling it ``a communication
process,'' not an ``approval process.'' \315\ Anatol Feygin,
the J.P. Morgan Chase analyst who testified at the Committee's
February 27, 2002 hearing said that the rules reflected in the
March 2001 memo did not apply for U.S. research analysts at
J.P. Morgan. Nevertheless, a J.P. Morgan Chase Vice President
in the United States commented to the press that providing
advance notice to companies of a change in their rating was
standard operating procedure on Wall Street.\316\ At Merrill,
despite a policy that analysts were not to disclose proposed
investment ratings to company management, the internet group
analysts did so freely; Henry Blodget, the head of the internet
analyst group, claimed not to even know of this policy.\317\ In
one case, the company management agreed to a particular rating
from Merrill only so long as its main competitor was downgraded
to a similar rating. That company was accommodated.\318\
---------------------------------------------------------------------------
\314\ Analyzing the Analysts, Hearing Before the Subcommittee on
Capital Markets, Insurance, and Government-Sponsored Enterprises, House
of Representatives Committee on Financial Services, Hrg. No. 107-25
(July 31, 2001) at 231-33 (Statement of the Honorable Laura Unger,
former Acting Chairman of the SEC).
\315\ ``JP Morgan Reins in Analysts,'' The Times (London), March
21, 2001.
\316\ Kathleen Pender, ``Sell Ratings Were Few As Market Tanked,''
San Francisco Chronicle, March 28, 2001.
\317\ Dinallo Affidavit, note 302 above, at 22.
\318\ Id.
---------------------------------------------------------------------------
The analysts who covered Enron and who testified at the
Committee's February 27 hearing denied that their coverage was
in any way affected or influenced by their firm's investment
banking ties or other exposure to Enron, even though all of the
banks they worked for had significant relationships with
Enron.\319\ Enron entered into a large number of investment
banking transactions, it actively used financial products, and
in general it had a lot of business to give banks.\320\ Other
deals, including structured finance and trading, earned banks
additional fees. For example, J.P. Morgan's Mahonia Limited
entered into natural gas trades with Enron, which may have
earned the bank as much as $100 million.\321\ These
transactions, and similar transactions with an entity set up by
Citigroup, appear to have been structured so that Enron could
obtain financing that would appear on its financial statements
as trading liabilities rather than debt, with the proceeds
treated as cash flow from operations rather than cash flow from
financing.\322\
---------------------------------------------------------------------------
\319\ The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 26.
\320\ Beth Piskora and Erica Copulsky, ``Don't Take Stock in Buy
Boosters--Wall Street Firms Cash in While Rating Losers High,'' New
York Post, February 4, 2002.
\321\ Jathon Sapsford and Anita Raghavan, ``Trading Charges:
Lawsuit Spotlights J.P. Morgan Ties to Enron Debacle,'' The Wall Street
Journal, January 25, 2002.
\322\ See The Role of Financial Institutions in Enron's Collapse,
Hearing Before the Permanent Subcommittee on Investigations, Senate
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-618 (July 23,
2002) at-- (Printed Hearing Record Pending) (Statement of Robert Roach,
Counsel and Chief Investigator, Permanent Subcommittee on
Investigations), available at http://www.senate.gov/?gov--affairs/
072302roach.pdf.
---------------------------------------------------------------------------
Moreover, banks that invested in Enron's related-party
partnerships or that underwrote offerings by certain SPEs knew
that the entities were backed by Enron stock; it was clearly in
the banks' interest to ensure that the stock price stayed up.
Enron CFO Andrew Fastow may have sent a letter to banks,
telling them that their profits from the partnerships were tied
directly to the price of the stock.\323\ Investment bank
investors in the partnerships reportedly included Merrill Lynch
at $22 million, Wachovia at $25 million, Credit Suisse First
Boston at $15 million, Lehman Brothers at $10 million, and
Citigroup at $10 million, among others.\324\ During hearings
before the House Energy and Commerce Committee, witnesses
including Enron Vice President Sherron Watkins testified that
banks had been pressured to invest in the partnerships by
Andrew Fastow.\325\
---------------------------------------------------------------------------
\323\ ``Wall Street Investment Banks Facing Lawsuits For Sharing
Responsibility For Huge Losses Caused by Enron's Collapse,'' NBC News,
February 22, 2002. According to this report, however, it was unclear
whether banks had actually received the letter; the copy of the letter
NBC obtained was unsigned.
\324\ Charles Gasparino and Randall Smith, ``Merrill Executives
Invested Their Money In Enron Partnership That the Firm Sold,'' The
Wall Street Journal, January 30, 2002.
\325\ See Financial Collapse of Enron Corp., Hearing Before the
Subcommittee on Oversight and Investigations, House of Representatives
Energy and Commerce Committee, 107th Cong., Hrg. No. 107-89 (February
14, 2002), at 54 (Statement of Enron Vice President Sherron Watkins)
(``Mr. Fastow was almost somewhat threatening; that if you didn't
invest in LJM, Enron would not use you as a banker or an investment
banker again. That he was threatening the institutions, that, to get
Enron business, they should invest in LJM''); see also Kurt Eichenwald,
``Enticements Are Cited By Bankers in Enron Case,'' The New York Times,
February 21, 2002 (bankers confirming that pressure tactics took
place).
---------------------------------------------------------------------------
Another way analysts can affect their firms' bottom line
with their recommendations is if those firms' mutual funds or
institutional investor clients hold large positions in a stock;
a sell-side analyst's positive recommendation can drive the
price of that stock higher, improving those portfolios'
performance.\326\ In Attorney General Spitzer's investigation,
for example, an e-mail regarding the Merrill analysts'
continued support for one company even as its stock price
tumbled indicated that a reason for its good ratings were that
that company was ``very important to [Merrill] from a banking
perspective, in addition to our institutional franchise. . .
.'' \327\ In the February 27 Committee hearing, the Enron
analysts testified that they, unlike the Merrill analysts, were
not aware of the positions of their firms.\328\
---------------------------------------------------------------------------
\326\ Kent L. Womack and Leslie Boni, ``Wall Street's Credibility
Problem: Misaligned Incentives and Dubious Fixes?,'' The Brookings-
Wharton Papers in Financial Services (2002), at 19.
\327\ Dinallo Affidavit, note 302 above, at 35 (emphasis added.).
\328\ The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 41-42.
---------------------------------------------------------------------------
Another factor that could influence analysts' behavior is
the effect a poor rating for a stock might have on their
compensation.\329\ Although every firm compensates its analysts
differently, the general rule of thumb on Wall Street is that
compensation is mostly--perhaps more than 75 percent--comprised
of a bonus, and this bonus, for some of the better paid
analysts, can often be in the six-figure range.\330\ Despite
their impressive salaries, the analysts' research itself does
not generate any income for the bank; thus a bank's evaluation
of the value an analyst brings to the firm will be based on
other things. The specific structure of bonuses will differ,
but at the very least, analysts' bonuses are tied to the
success of the firm in general--the better a bank does in a
given year, the higher the bonuses. The analysts who testified
at the February 27 hearing said that their bonuses were
dependent in this regard on the overall profitability of their
firms.\331\ Given that ``buy'' recommendations contribute to
more business for firms--particularly with respect to potential
investment banking clients--while negative ratings of companies
contribute to less, analysts on that count alone have incentive
to be positive about the companies they cover.
---------------------------------------------------------------------------
\329\ Analyzing the Analysts, Hearing Before the Subcommittee on
Capital Markets, Insurance, and Government-Sponsored Enterprises, House
of Representatives Committee on Financial Services, Hrg. No. 107-25
(July 31, 2001) at 230 (Statement of the Honorable Laura Unger, former
Acting Chairman of the SEC).
\330\ Committee staff interview with Richard Gross, February 13,
2002; also confirmed by information provided by Thomson Financial.
\331\ The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 47.
---------------------------------------------------------------------------
In an interview prior to the February 27 hearing, Richard
Gross of Lehman Brothers gave Committee staff a more specific
description of the factors on which his bonus was based than he
provided at the hearing. Gross said that his bonus was
determined by a number of factors, including the volume of
commissions earned by the brokerage from stock sales in the
industry he covers and the assistance he has provided to the
investment bankers in helping them evaluate or formulate deals
or strategy.\332\ Compensation based on specific deals is now
prohibited by the new NASD and NYSE rules, though analysts are
commonly compensated based on overall assistance to investment
banking, which, for all intents and purposes, amounts to the
same thing.\333\
---------------------------------------------------------------------------
\332\ Committee staff interview with Richard Gross, February 13,
2002; see also Michaely and Womack, note 309 above, at 660.
\333\ See Melvyn Teo, ``Strategic Interactions Between Sell-side
Analysts and the Firms They Cover,'' Working Paper, December 2000,
available at http://papers.ssrn.com/sol3/papers.cfm?abstract--
id=258028, at 5 (``it is common for a significant portion of a research
analyst's compensation to be determined by the analyst's `helpfulness'
to the corporate finance department'').
---------------------------------------------------------------------------
Attorney General Spitzer's investigation determined that
the Merrill analysts' compensation was based, at least in part,
on assistance to investment banking, perhaps in a way much like
Gross was describing. In a Fall 2000 survey relating to
compensation sent by the head of the Merrill research
department, analysts were asked to provide details about their
contributions to investment banking, including about
``involvement in [each] transaction, paying particular
attention to the degree your research coverage played a role in
origination, execution and follow-up.'' \334\ Merrill analyst
Blodget, in his response to this request, indicated that his
group had been involved in all aspects of 52 transactions,
amounting to $115 million in business for Merrill. According to
Blodget's description, those efforts included pitching the
client, marketing the offering and initiating follow-on
coverage. After providing this information, Blodget's minimum
cash bonus increased from $3 million to $12 million.\335\
---------------------------------------------------------------------------
\334\ Dinallo Affidavit, note 302 above, at 20.
\335\ Id. at 21.
---------------------------------------------------------------------------
Annual compensation itself is not the only reason for
analysts to maintain a positive outlook on companies; optimism
also brings better job prospects. A recent study by economists
Harrison Hong of Stanford University and Jeffrey Kubik of
Syracuse University found that analysts are much more likely to
be promoted if their recommendations are optimistic, and
optimism is rewarded more in that regard than accuracy.\336\
Conversely, analysts who offer negative ratings can experience
pressure to improve their outlook on companies they cover. As
Professor John Coffee testified before the Senate Banking
Committee, ``In self reporting studies, securities analysts
report that they are frequently pressured to make positive buy
recommendations, or at least to temper negative opinions. . . .
According to one survey, 61 percent of all analysts have
experienced retaliation--threats of dismissal, salary
reduction, etc.--as a result of negative research reports.
Clearly, negative research reports (and ratings reductions) are
hazardous to an analyst's career.'' \337\
---------------------------------------------------------------------------
\336\ Paul Taylor, ``Bullish Analysts More Likely to Be Promoted,''
Financial Times (London), February 1, 2002.
\337\ See Accounting and Investor Protection Issues Raised by Enron
and Other Public Companies, Hearing Before the Senate Committee on
Banking, Housing and Urban Affairs, 107th Cong., 107--- (March 5, 2002)
at-- (Printed Hearing Record Pending) (Statement of Columbia University
Law School Professor John Coffee), available at http://
banking.senate.gov/02--03hrg/030502/coffee.htm.
---------------------------------------------------------------------------
Finally, analysts may feel pressure from the companies they
cover to offer positive recommendations. As Thomas Bowman,
President and Chief Executive Officer of the Association of
Investment Management and Research, testified at the
Committee's February 27 hearing:
L[S]trong pressure to prepare ``positive'' reports and
make ``buy'' recommendations comes directly from
corporate issuers who retaliate in both subtle, and not
so subtle, ways against analysts they perceive as
``negative'' or who don't ``understand'' their company.
Issuers complain to Wall Street firms' management about
``negative'' or uncooperative analysts. They are also
known to bring lawsuits against firms--and analysts
personally--for negative coverage. But the more
insidious retaliation is to ``blackball'' analysts by
not taking their questions on conference calls or not
returning their individual calls to investor relations
or other company management. This puts the ``negative''
analyst at a distinct disadvantage relative to their
competitors, increases the amount of uncertainty an
analyst must live with in doing valuation and making a
recommendation, and disadvantages the firm's clients
who pay for that research. Such actions create a
climate of fear that does not foster independence and
objectivity. Analysts walk a tightrope when dealing
with company managements. A false step may cost them an
important source of information to their decision-
making process and ultimately can cost them their
jobs.\338\
---------------------------------------------------------------------------
\338\ The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 105-106. Accord
Analyzing the Analysts, Hearing Before the Subcommittee on Capital
Markets, Insurance, and Government-Sponsored Enterprises, House of
Representatives Committee on Financial Services, Hrg. No. 107-25 (July
31, 2001) at 240 (Statement of the Honorable Laura Unger, former Acting
Chairman of the SEC) (``The management of companies an analyst follows
may pressure him/her to issue favorable reports and recommendations.
Less than favorable recommendations may not be well received by
management and issuers may threaten to cut off an analyst's access to
its management if the analyst issues a negative report on the company.
This could cause the analyst to issue a more favorable report than his/
her analysis would suggest.'').
In order to do their jobs, analysts must have regular,
meaningful contact with the companies they cover. Having a good
relationship with those companies means that their phone calls
will be returned and their questions will be answered. Although
companies cannot refuse to share material information with
certain analysts while sharing it with others--Regulation F-D,
promulgated by the SEC in 2000, prohibits companies from
selectively disclosing material information to any person or
group \339\--companies can give favored analysts certain non-
material tidbits, while shutting disfavored analysts out.
Nevertheless, the analysts who testified at the February 27
hearing denied that Enron in any way influenced their
recommendations.\340\
---------------------------------------------------------------------------
\339\ 17 C.F.R. Sec. 243.100.
\340\ The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 26.
---------------------------------------------------------------------------
D. Solutions
Like the SEC, Arthur Andersen, and Enron's Board of
Directors, the analysts covering Enron failed to do what the
market expected of them. The analysts failed to provide
accurate and unbiased analyses of Enron and the value of its
stock. The unreliable nature of the analysts' recommendations
may well have been an open secret on Wall Street. However, it
was largely unknown to individual investors like the Jupiter,
Florida women profiled on Now with Bill Moyers who relied on
Henry Blodget's research, probably unaware of these clear,
inherent conflicts faced by research analysts until the Enron
implosion and Attorney General Spitzer's investigation. They
most likely thought that these analysts were providing their
unvarnished opinions, based on years of expertise and study.
Even if some analysts thought they were providing honest
assessments, they were most likely affected in some respect by
the business pressures of the firm, the companies they covered,
and the potential that their own compensation could suffer. How
else to explain these analysts' near universal bullishness on
virtually all stocks in the face of market realities telling
them their advice statistically just could not be right? \341\
Whatever the cause, Enron demonstrated without doubt that there
was a problem.
---------------------------------------------------------------------------
\341\ As the S&P 500 index fell, analysts' recommendations stayed
constant overall on the S&P 500 companies. According to Thomson
Financial, in the 2 years from January 2000 through January 2002, as
the S&P fell from a high of 1,500 to approximately 1,100, the
``consensus recommendation'' on those 500 companies--the average
rating--remained at a buy, and fell only slightly in July 2001. See The
Watchdogs Didn't Bark: Enron and the Wall Street Analysts, Hearing
Before the Senate Governmental Affairs Committee, 107th Cong., S. Hrg.
107-385 (February 27, 2002) at 128 (chart entitled ``S&P 500 Price
Index Versus S&P 500 Consensus Recommendation'').
---------------------------------------------------------------------------
So the challenge we face now is how to address this
situation, to ensure that those who hold themselves out as
giving unbiased, expert advice are in fact doing so. There is
no easy or complete solution.
Most sell-side analysts work for broker-dealers, which are
regulated by the SEC, and are member firms of self-regulatory
organizations (SROs) like NASD (formerly the National
Association of Securities Dealers) and the New York Stock
Exchange (NYSE). The SEC has delegated rulemaking and
enforcement authority to these SROs under section 13 of the
Securities Exchange Act of 1934, pursuant to which the SROs
oversee broker-dealer activity. Until recently, analysts were
not subject to any specific regulation much beyond the general
anti-fraud provisions of the securities laws and NASD
requirements regarding broker-dealer advertisements that all
representations be fair, balanced and not misleading. Recently,
however, the landscape of regulation for analysts changed
significantly. On May 10, 2002, the SEC approved proposed rule
changes by NASD and NYSE to address analyst conflicts of
interests.\342\ Further, the Sarbanes-Oxley Act, which was
signed by the President on July 30, 2002, set new standards for
analyst conduct and conflict disclosures and required the SEC
or the SROs to issue additional rules, which will hopefully
close the expectation gap for investors in analyst
recommendations.\343\ The NASD/NYSE rules, \344\ now in place,
are:
---------------------------------------------------------------------------
\342\ Exchange Act Release No. 45908 (May 10, 2002), 67 Fed. Reg.
34968 (May 16, 2002). In addition to these rules, private associations
to which analysts or their firms may belong have guidelines. Some
analysts are Chartered Financial Analysts (CFAs), a designation
indicating that they have at least 3 years of experience and have
passed 3 day-long exams. The Association for Investment Management and
Research (AIMR) administers these exams and awards the CFA. Many
analysts are CFAs, though very few sell-side analysts are. AIMR expects
all CFAs to follow their Code of Ethics and Standards of Professional
Conduct, which among other things requires that analysts ``use
reasonable care and exercise independent professional judgment,'' and
``exercise diligence and thoroughness in making investment
recommendations . . . [and] [h]ave a reasonable and adequate basis,
supported by appropriate research and investigation, for such
recommendations.'' The Securities Industry Association (SIA), the
industry trade group covering all securities broker-dealers, has also
issued a set of ``best practices'' for research.
\343\ Pub. L. No.107-204 Sec. 501.
\344\ The new rules can be found as NASD Rule 2711 and amendments
to NYSE Rules 351 and 472.
---------------------------------------------------------------------------
Reducing Pressure/Influence on Analyst Recommendations
LNo Control by Investment Banking Department.
Research analysts may not be subject to the supervision or
control of the investment banking division of the bank. To the
extent that analysts communicate with investment bankers
regarding research reports, such communication must be only for
verification of accuracy or review of potential conflicts of
interest that should be disclosed and must be monitored by the
legal department.
LCompanies May Not Review Ratings In Advance.
Companies may review research reports about them in advance of
their release only to check for accuracy, and may not review in
advance the rating or the price target.
LAnalyst Compensation. Analyst compensation may not
be tied to specific investment banking transactions. To the
extent that analysts are compensated based on investment
banking revenues at all, it must be disclosed in research
reports.
LNo Quid Pro Quos. No firm may directly or
indirectly offer a favorable rating or price target or threaten
an unfavorable rating or price target in exchange for business.
Disclosures of Conflicts
LDisclosure of Company Relationship With Firm.
Research reports, or analysts in public appearances (if they
know or have reason to know), must disclose if the analyst's
firm or its affiliates received compensation from the subject
company within the last 12 months, or expect to receive
compensation in the 3 months following the report.
LDisclosure of Firm's or Analyst's Ownership of
Company Stock. An analyst must disclose, in reports or public
appearances, if the analyst, or the analyst's firm, has a
financial interest in the subject company.
Limits on Trading/Ownership
LQuiet Periods. A firm may not issue a research
report on a company for 40 days following its IPO or 10 days
following a secondary offering if the firm acted as a manager
or co-manager of the offering, unless significant events
warrant a report.
LBlackout Period for Analysts' Trading Before and
After Report, Change in Rating or Price Target. Analysts may
not trade in the stock of a company on which they issue a
report or change their rating or price target for the 30 days
prior, and 5 days after, such report or change. (There are some
limited exceptions to this rule.)
LNo Trading Against Recommendations. An analyst may
not trade against the analyst's own recommendations.
LNo Pre-IPO Shares. No analyst or member of the
analyst's household may receive pre-IPO securities of a company
in the industry sector he/she covers.
Clarifying Ratings
LRatings Must be Defined and Firms Must Show How
They Rated All the Companies They Cover, and Within Those
Categories, How Many Were Investment Banking Clients. Research
reports must clearly define rating systems (e.g., ``strong
buy'' means the stock will go up by 10 percent in the next
year) and must show the distribution of the firms'
recommendations for all the companies they cover across three
categories--buy, hold, or sell--and within those categories,
how many were investment banking clients (e.g., of all
recommendations, 75 percent were buys, 90 percent of which were
investment banking clients; 20 percent were holds, 2 percent of
which were investment banking clients; and 5 percent were
sells, 0 percent of which were investment banking clients).
LTrack Record Chart. A firm must include in all
research reports a price chart that maps the price of the
subject stock over time and indicates points at which the
analyst assigned a rating and/or price target, enabling
investors to compare recommendations over time with actual
stock performance. The chart would not have to extend back
further than 3 years.
The Sarbanes-Oxley Act has gone further in addressing the
issue of analyst independence and disclosure.\345\ That Act
amended the Securities Exchange Act of 1934 to require the SEC,
or the SROs under the direction of the SEC, to promulgate rules
to enhance analyst independence and to require disclosures
regarding conflict of interest. The Act requires the SEC, or
the SROs, to issue rules to achieve the following goals:
---------------------------------------------------------------------------
\345\ Pub. L. No.107-204 Sec. 501.
---------------------------------------------------------------------------
Enhancing Independence
LSeparation of Research and Investment Banking.
Structural and institutional safeguards must be established to
ensure that analysts are partitioned from the review, pressure,
or oversight by investment banking, activities that might
potentially bias analysts' judgment.
LRestrict Pre-Approval of Reports. Pre-publication
clearance or approval of research reports by non-research
department staff at the analyst's firm, such as investment
bankers, must be restricted.
LLimit Supervision/Evaluation of Analysts to
Research Department. Supervision of analysts, or evaluations of
analysts related to compensation, must be limited to non-
investment banking personnel.
LNo Retaliation for Unfavorable Rating. Retaliation
against an analyst for an unfavorable rating of an issuer,
which may negatively affect the firm's investment banking
relationship with that issuer, is prohibited.
LQuiet Periods. The SEC or the SROs must establish
certain time periods during which firms involved in a public
offering of securities for an issuer may not issue research
reports on that issuer.
Disclosure
LInvestment of Analyst in Covered Issuer. The SEC or
the SROs must adopt rules requiring analysts to disclose in
reports or in appearances if they have investments in the
companies covered in those reports or appearances.
LCompensation Received by Analyst or Firm. The SEC
or the SROs must adopt rules requiring analysts to disclose any
compensation received from rated companies, with exceptions
permitted to prevent disclosure of material non-public
information, consistent with the public interest and investor
protection.
LClient Relationship. The SEC or the SROs must adopt
rules requiring firms to disclose whether an issuer that is the
subject of their research reports is also a client, and must
disclose the types of services provided.
LAnalyst Compensation. The SEC or the SROs must
adopt rules requiring analysts to disclose whether they have
received compensation from the issuer related to any research
reports, or whether they have received compensation based on
investment banking revenues.
The NASD/NYSE rules are a step in the right direction--
prior to their existence there were no rules directly
addressing these issues at all. The Sarbanes-Oxley Act,
however, has provided the guiding principles that should govern
SEC action going forward. The Sarbanes-Oxley Act's requirement
that the separation between the investment banking and research
departments be shored up is particularly important. If the SEC
or the SROs work aggressively with the firms to find a workable
solution to fulfill the mandate of Sarbanes-Oxley, it will
provide meaningful protection to the independence and
objectivity of research, which should assist in restoring
market confidence in analyst recommendations.
In order to meet the goals set by the Sarbanes-Oxley Act
both to enhance the independence of analysts and provide useful
disclosure, the SEC clearly needs to go further than the
current NASD/NYSE rules. For instance, the NASD/NYSE rules
prohibit analyst compensation from being tied only to specific
investment banking transactions. Even at Merrill Lynch, with
its alleged abuses, compensation seems to have been decided on
overall contribution to the investment banking department, not
individual deals. Indeed, even basing analyst compensation on
overall profitability--particularly when investment banking
makes up a significant portion of a firm's revenue--allows
analysts to be compensated informally based on the work they do
to prop up the investment banking side of their firms. Thus,
there is an incentive to help smooth the investment banking
relationship. Disclosure of any compensation analysts receive
based even generally on investment banking revenue, required by
the NASD/NYSE rules and the Sarbanes-Oxley Act, is an important
tool for savvy investors, but disclosure is not sufficient to
achieve the separation of investment banking from research
envisioned by Sarbanes-Oxley.
Similarly, the NASD/NYSE ``quid pro quo'' rule, prohibiting
firms from offering positive ratings in exchange for business,
whether directly or indirectly, arguably misses the mark;
companies already public are likely to work with banks that
favor their stock and companies going public are likely to seek
a firm that is likely to be favorable. The Sarbanes-Oxley Act's
prohibition on retaliation by firms against analysts who issue
negative ratings will be helpful to minimize the effect of this
phenomenon on analysts. To give this provision full effect,
however, the SEC should try to address the ``carrot'' as well
as the ``stick'' approach by firms in encouraging undue
optimism among their analysts. Given that studies, cited above,
have shown that analysts are promoted more often for optimism
than accuracy, the SEC or the SROs should work with firms to
ensure that analysts are rewarded for getting it right for
investors, not for their rosy outlooks.
In addition, the NASD/NYSE rule prohibiting firms from
sharing investment ratings with subject companies in advance of
releasing the research report does not go far enough. Analysts
are still permitted, and may be required by their firms, to
share the text of the report with the covered company,
supposedly to ensure accuracy. Reading the text of the report
will certainly give companies an indication of the ratings
conclusion. In order to help relieve analysts of the strong
pressure they face from the companies they cover, there should
be a rule prohibiting sharing the full text of the reports,
allowing analysts to provide only so much as is necessary to
fact-check their work.
Finally, it would be very helpful if the disclosures
required by the NASD/NYSE rules, particularly those regarding
the firm's rating track record, would be available more widely
than just on the research reports themselves. Many investors
who are not brokerage clients of a large firm obtain
information about analyst ratings from other sources, including
financial websites and cable financial news shows. These
investors will not benefit from these disclosures if they only
appear on the face of the research reports.
In addition to the NASD/NYSE rules and just before the
enactment of the Sarbanes-Oxley Act, the SEC proposed
Regulation A-C, which would require that analysts personally
certify that their reports accurately reflect their own views
and whether they have been or expect to be compensated
specifically for any individual rating.\346\ The first part of
this rule may, as securities attorney Sam Scott Miller said,
``focus people's attention''--particularly analysts,
hopefully--on the issue of analyst independence and the
importance of being honest.\347\ However, it does not appear to
do much more than that; if the rating is issued under the
analyst's name, it is reasonable to assume that the rating
represents his or her opinion, and NASD rules already prohibit
issuing reports that are contrary to the beliefs of the analyst
who writes them.\348\ The second part of the rule merely
certifies that the analyst has followed the law: If an analyst
is compensated for a rating, the Sarbanes-Oxley Act requires
that such compensation must be disclosed.
---------------------------------------------------------------------------
\346\ SEC Release Nos. 33-8119; 34-46301; File No. S7-30-02 (July
25, 2002); 67 Fed. Reg. 51510-51516 (August 8, 2002).
\347\ Michael Schroeder, ``SEC Moves on New Rule,'' The Wall Street
Journal, July 23, 2002.
\348\ See NASD Notice to Members 02-39 (May 2002) (``If a member
issues a report or a research analyst renders an opinion that is
inconsistent with the analyst's actual views regarding a subject
company, NASD considers such action to constitute a fraudulent act and
conduct inconsistent with just and equitable principles of trade.'').
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In order to further enhance analyst independence and
disclosure of analyst and firm conflicts to meet the goals set
by the Sarbanes-Oxley Act, the Committee staff has the
following recommendations for the SEC:
LSeparate analysts from investment banking's
influence. Probably the most basic conflict in this system is
that the compensation an analyst receives if he or she works
for a firm that does a significant amount of investment banking
work will be derived largely from investment banking; to the
extent that negative ratings can affect their compensation,
analysts will be loath to issue them. This compromises their
objectivity, a problem the SEC should address, and indeed is
required to address under the Sarbanes-Oxley Act. Recent
reports indicate that the SEC is considering proposing a rule
requiring complete separation of investment banking and
research departments at firms, perhaps by mandating that they
operate through entirely separate, though affiliated
entities.\349\ If these reports are accurate, the SEC is moving
in precisely the right direction.\350\ In addition, in order to
further strengthen the objectivity of stock recommendations,
the system of compensation and reward for analysts should be
structured to offer them incentives to issue their best rather
than their most flattering assessments of companies. One
possible path may lie in performance-based compensation, which
would reward accuracy over optimism. At the Committee's
February 27, 2002 hearing, Charles Hill of Thomson Financial/
First Call endorsed the system used when he was a Wall Street
analyst, in which large customers would give feedback to the
firms to indicate which analysts' research they relied on.\351\
Merrill Lynch apparently has instituted such a system as part
of its settlement with the New York Attorney General. The SEC
or the SROs should ensure that all other Wall Street firms
follow suit.
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\349\ Susan Pulliam and Randall Smith, ``SEC's Pitt Seeks Split of
Banking, Analyst Areas,'' The Wall Street Journal, September 26, 2002.
\350\ Concerns have been expressed, however, about whether the
research divisions will remain economically viable without being a part
of the same entity through which investment banking revenue flows,
given that many Wall Street firms derive so much of their profits from
investment banking activities. Many average investors depend on sell-
side analysis to assist them in making their investment decisions
because most can ill-afford much more expensive independent research.
Therefore, the SEC must be careful to craft a rule that does not have
the unintended result of cutting off access to this relatively
affordable information.
\351\ The Watchdogs Didn't Bark: Enron and the Wall Street
Analysts, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 59.
LFirms should not be permitted to share research
reports with the subject companies at all prior to their
release. If analysts know they might have to show their reports
to companies in advance of release, analysts will feel pressure
to soft-pedal their language and their ratings. Firms that rely
on good relationships with these companies have no incentive to
protect the analysts if they do not have to. There is no need
for analysts to show companies their reports in order to fact-
check them. Fact-checking can be achieved by asking targeted
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questions about specific matters that need verification.
LIn addition to prohibiting retaliation for negative
ratings, firms should be prohibited from incentivizing positive
ratings. The Sarbanes-Oxley Act's prohibition on retaliation
for negative ratings is an extremely important step towards
protecting the integrity of research. In issuing rules to
effect this prohibition, the SEC or the SROs should consider
whether it might be equally useful to prohibit rewards for
optimism over accuracy. A rule in this vein would further the
spirit of the ban on retaliation, and would minimize another
source of pressure faced by analysts to make their ratings
rosier than they might otherwise do: Studies showing that
optimistic research nets promotions more often than accurate
research on Wall Street.\352\ Perhaps such an effort could be
achieved in concert with the establishment of a performance and
accuracy based compensation system for analysts.
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\352\ Paul Taylor, ``Bullish Analysts More Likely to Be Promoted,''
Financial Times (London), February 1, 2002.
LDisclosures should be made more widely available.
While the NASD/NYSE rules requiring firms to indicate their
overall ratings distribution and their track record with
respect to the companies covered (ratings and target stock
prices compared to actual performance) are a significant step
in providing investors with information to assess the value of
those firms' ratings, many investors obtain ratings information
from places other than research reports, which are generally
available only to clients of the firms that produce them or
through other brokerage houses those firms may partner with.
These disclosures should be made publicly available, either on
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the firms' websites or on the NASD or NYSE websites.
LWhen firms drop coverage of a company without first
downgrading it to the equivalent of a sell, they should be
required to publish a release indicating why they are dropping
coverage. This was a part of the settlement agreement between
the New York State Attorney General and Merrill Lynch; many
firms--including Merrill--will drop coverage of a company
rather than issuing a sell rating. This is a common practice;
the firms of three of the four analysts who testified at the
Committee's February 27 hearing did this with Enron. The
problem with this practice is that unlike a downgrade, which
comes along with an explanation, it does not provide a
sufficient indication to investors of the problems with the
company that brought about the analyst's change of heart. In
the case of Enron, most investors were aware of the troubles
with the company at the time the firms' dropped coverage: The
earliest was J.P. Morgan Chase's drop on November 29, 2001, the
day after the Dynegy merger fell through, when rampant news
reports were predicting the company's imminent bankruptcy. But
where investors have purchased stock in companies that are not
in the center of the media spotlight based on analyst
recommendations to buy, they should be alerted by those very
same analysts that there are problems sufficient to lead their
firms to abandon coverage.
II. ENRON AND THE CREDIT RATING AGENCIES
Like the analysts, another outside watchdog failed the
public with respect to Enron: The credit rating agencies. These
companies do what their name implies: Rate the creditworthiness
of entities, such as public companies, and the debt they issue,
so that those wishing to extend credit--by buying bonds, for
example--can better understand the risk that they may not see a
return on that investment. Ratings have taken on great
significance in the market, with investors trusting that a good
credit rating reflects the results of a careful, unbiased and
accurate assessment by the credit rating agencies of the rated
company. But as with so many other market players, Enron caused
this legendary reliability to be called into question. It was
not until just 4 days before Enron declared bankruptcy that the
three major credit rating agencies lowered their ratings of the
company to below the mark of a safe investment, the investment
grade rating. And as with other market participants, like
securities analysts, auditors, and corporate directors, the
example of Enron shows that rating agency reform is needed if
the actual performance of these organizations is to live up to
public expectations.
This section of the report will provide a brief description
of credit ratings, their use and history, and will describe how
the credit rating agencies made their assessments of Enron, and
where they failed. Finally, it will outline the current
regulatory environment in which credit rating agencies operate,
and make recommendations for how improvements can be achieved
to restore market confidence in the operation of these firms.
A. History and Uses of Credit Ratings
John Moody, the founder of what is now Moody's Investors
Service (``Moody's''), is generally credited with devising
credit ratings for public debt issues at the beginning of the
20th Century. At that time, the United States had the largest
corporate bond market in the world, comprised mostly of
railroad bond issues. Investors, however, had few sources
beyond bankers and the financial press for information about
the quality of those bonds. Moody's credit ratings, first
published in 1909, met that need. It was followed by Poor's in
1916, Standard in 1922, and Fitch in 1924. (Standard and Poor's
merged in 1941 to become Standard & Poor's (``S&P'').) \353\
Moody's--now the largest of the three--offers ratings on over
$30 trillion of debt and 4,300 corporations.\354\
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\353\ See Richard Cantor & Frank Packer, ``The Credit Rating
Industry,'' Federal Reserve Bank of New York Quarterly Review, Summer/
Fall 1994 at 2. Although other credit rating agencies have existed and
still exist in the United States, many, such as Duff & Phelps and
Thomson BankWatch, have each merged into one of the main three:
Moody's, S&P, and Fitch. See Lawrence J. White, ``Bond Raters Troika,''
U.S. Banker, May 2002.
\354\ See ``Introduction to Moody's,'' http://www.moodys.com.
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Credit ratings, which are expressed in a letter grade,
provide an assessment of creditworthiness, or the likelihood
that debt will be repaid.\355\ Generally, companies will
receive a long-term ``issuer'' rating, which is intended to
measure the entity's ability to meet its ``senior'' financial
obligations: Obligations that have not been ``subordinated'' to
other obligations by law or by agreement.\356\ Each of the
letter grades may be modified with a plus or a minus,
indicating relative standing within the categories. S&P and
Fitch use the same ratings system.\357\ Their first four
categories, AAA, AA, A, and BBB, are considered ``investment
grade,'' or of good or better credit quality, AAA+ representing
the highest credit quality, BBB- representing the lowest
investment grade credit quality. BBB generally indicates that
economic conditions may weaken the capacity of the issuer to
meet its obligations, but overall, the issuer has adequate
ability to meet its commitments in a timely manner. Lower
ratings--BB, B, CCC, CC, C, and D--indicate that a company is
of ``speculative grade.'' The BB and B ratings indicate that
company is able currently to meet its financial commitments,
but has significant vulnerability to adverse conditions; lower
ratings indicate a current vulnerability and significant
likelihood of some default. Bonds given a ``speculative''
rating are sometimes referred to as ``junk'' bonds.
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\355\ See Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 82 (``Standard & Poor's
Understanding Credit Ratings,'' January 2002, attached to the Statement
of Ronald Barone); ``Fitch Ratings Definitions: Issuer Financial
Strength Ratings,'' http://www.fitchratings.com.
\356\ The issuer ratings described here are just one type of rating
offered by the credit rating agencies; they also offer short-term
ratings (which are most often used to determine issuers'
creditworthiness relating to commercial paper), ratings for individual
debt offerings, or even ratings of countries' creditworthiness. This
report focuses on Enron's long-term issuer ratings, so for simplicity,
the other ratings systems are not described here.
\357\ See generally ``Standard & Poor's Understanding Credit
Ratings,'' and ``Fitch Ratings Definitions,'' note 355 above.
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Moody's uses a slight variation on the S&P/Fitch approach:
Investment grade is reflected by Aaa, Aa, A, or Baa, with Aaa
being the most creditworthy, and Baa being the lowest
investment grade rating.\358\ Moody's ``speculative'' or
``junk'' ratings are Ba, B, Caa, Ca, and C. Moody's does not
use pluses or minuses as modifiers; instead it uses numbers: 1
being equivalent to a plus, 2 as consistent with no modifier,
and 3 being the same as a minus. In addition to issuing letter-
grade ratings, if the agency is about to lower or raise a
rating, S&P may put out a ``CreditWatch'' with a negative
(likely to downgrade) or positive (likely to increase)
outlook.\359\ Fitch has a similar ``ratings watch,'' and
Moody's puts companies ``on review'' for an upgrade or
downgrade.\360\
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\358\ See ``Ratings Definitions: Issuer Ratings,'' http://
www.moodys.com.
\359\ ``Standard & Poor's Understanding Credit Ratings,'' note 355
above, at 2-3.
\360\ ``Fitch Ratings Definitions: Issuer Financial Strength
Ratings,'' note 355 above.
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When John Moody first initiated the credit rating system,
credit ratings simply provided guidance for investors.\361\
According to the credit rating agencies, this remains the
primary driver of ratings: As S&P explains on its website, its
``recognition as a rating agency ultimately depends on
investors' willingness to accept its judgment.'' If history is
a guide, credit rating agencies generally get it right: Bonds
rated AAA have a less than 1 percent default rate over 10 years
or more, \362\ and S&P has found that there is almost an 88
percent likelihood that companies with ratings of A or above
will still have that rating 1 year later.\363\ On the other
hand, bonds rated BB (below investment grade) have an
approximately 20 percent default rate over 15 years, while
bonds with a B rating have a 35 percent rate of default and
bonds with a CCC rating have a 55 percent default rate over
that same period.\364\
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\361\ See David C. Gates, ``Rating Agencies and the SEC Asleep at
the Switch? Complying With the Basel Capital Accord,'' Risk Management
Association Journal, October 1, 2001, at 3.
\362\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 63-64; ``Moody's Rating System in
Brief,'' provided under cover of letter from John J. Goggins, Esq.,
Senior Vice President and General Counsel, Moody's Corporation, to
Cynthia Lesser, Counsel, Senate Governmental Affairs Committee, dated
March 6, 2002.
\363\ Leo Brand and Reza Bahar, ``Corporate Defaults: Will Things
Get Worse Before They Get Better,'' S&P CreditWeek, January 31, 2001,
at 15, 27.
\364\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 64.
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Nevertheless, since the days of John Moody, the uses of
credit ratings have evolved. Ratings are currently used more as
benchmarks for market participants than as a source of
information for investors. Approximately 95 percent of
corporate bonds are held by institutional investors, \365\
which have their own in-house analysts to assess the value of
the bonds in which they invest.\366\ To the extent that
sophisticated private parties use credit ratings for their own
purposes, they tend to use them in agreements, such as merger
or loan agreements, as conditions or triggers for certain
rights or obligations.\367\ A contract might, for example,
specify that if a company's rating from S&P or Fitch falls
below a specified grade, payments may be accelerated or
additional obligations (such as increased interest rates or
escrows) may be imposed on the company.\368\
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\365\ See The Status of ``Corporate Trades I,'' Hearing Before the
Subcommittee on Securities, Senate Banking, Housing and Urban Affairs
Committee, 106th Cong., S. Hrg. 106-537 (May 26, 1999) at 22 (Statement
of Nelson D. Civello, Chairman, Bond Market Association).
\366\ Even though the State statutes and regulations limiting the
investments allowed to be held by State pension funds to bonds with a
certain level of investment grade rating are intended as sufficient
protection from too many defaulting bonds, State pension funds are
looking for additional ``credit-rating tools'' beyond the ratings of
the three credit agencies to assess the risk associated with potential
investments in the wake of WorldCom and Enron. See, e.g., ``State
Pension Funds Hit But Not Crippled By Enron, WorldCom,'' Associated
Press, June 29, 2002.
\367\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 142 (Statement of Jonathan Macey,
Professor, Cornell University Law School).
\368\ For example, Enron in one instance used S&P ratings in a debt
covenant, otherwise known as a ratings trigger. The trigger was
included in an agreement intended to provide additional credit backing
to an affiliated limited partnership. When Enron's S&P rating fell to a
BBB- on November 9 (the triggering event in the covenant), the
partnership was entitled to accelerate payment of a $690 million note
from Enron to November 27, 2001. Enron Corp. Form 10-Q for Quarter
Ended September 30, 2001 (filed November 19, 2001) at 70. Enron also
had ratings triggers in agreements backing two related trusts, the
Marlin and the Osprey trusts. Those covenants required Enron to repay
$2.4 billion for Osprey and $915 million for Marlin if Enron's stock
price fell below a certain level and its credit rating by any of the
three rating agencies fell below investment grade (below BBB- or Baa3).
Enron Corp. Form 10-Q for Quarter Ended September 30, 2001 (filed
November 19, 2001) at 69.
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Government agencies have found additional uses for credit
ratings. In the 1930's, the Federal Reserve began using credit
ratings on bonds to assess the safety of the portfolio
investments of member banks.\369\ In 1931, the Comptroller of
the Currency adopted credit ratings as measures of quality for
the national banks' bond accounts, first allowing non-
investment grade bonds as long as banks discounted their value,
taking into account their riskiness, then later prohibiting
national banks from investing in non-investment grade bonds
altogether.\370\ State laws and regulations soon adopted
similar standards for State banks, pension funds, and insurance
companies, and additional Federal regulation followed.\371\
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\369\ Frank Partnoy, ``The Siskel and Ebert of Financial Markets:
Two Thumbs Down For the Credit Rating Agencies,'' 77 Wash. U. L.Q. 619
(1999), at 687.
\370\ Id. at 688.
\371\ Id. at 688-89.
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In 1975, the SEC, by rule, significantly enhanced the
importance of credit ratings. In 1970, Penn Central Railroad
defaulted on its bonds, leading to unexpected and significant
losses for investment firms. The bonds, like many others in the
market at the time, had not been rated by any of the credit
rating agencies. Due to a general concern about corporate
creditworthiness at the time, the SEC adopted new net capital
requirements, or asset requirements, for broker-dealers, firms
that trade securities in the market, either for themselves
(dealers) or on behalf of others (brokers).\372\ These
requirements assure investors that their broker-dealers have
sufficient assets to back up the funds that investors entrust
them with. Informally called the ``haircut'' rule, Rule 15c3-1
requires broker-dealers to take a larger discount on below-
investment grade bonds--a ``haircut''--when calculating their
assets for the purposes of the net capital requirements than
for investment grade corporate bonds. This rule specified that
the ratings come from a ``nationally recognized statistical
ratings organization,'' or NRSRO.\373\ The term was not
defined, but it caught on.
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\372\ See Adoption of Amendments to Rule 15c3-1 and Adoption of
Alternative Net Capital Requirements for Certain Brokers and Dealers,
Release No. 11497 (June 26, 1975) 40 Fed. Reg. 29795 (July 16, 1975).
See also Gates, note 361 above, at 4-5 (describing Penn Central
collapse and aftermath); Andrew Fight, The Ratings Game, Wiley & Sons
Ltd (2001), at 6 (same).
\373\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 132 (Statement of the Honorable
Isaac Hunt, SEC Commissioner).
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The Federal Reserve and the SEC are not alone in giving
legal significance to the ratings of NRSROs. Currently, at
least eight Federal statutes and 47 Federal regulations, along
with over 100 State laws and regulations, reference NRSRO
ratings as a benchmark. On the Federal level, they are related
primarily to banks and commodities or securities regulation,
but a few relate to education (qualifications for schools to
participate in a financial assistance program under Title IV of
the Higher Education Act), \374\ to transportation (highway
projects must be rated investment grade by an NRSRO to obtain
funding under program), \375\ and telecommunications
(requirements for approval of loan guarantees from the Federal
Government).\376\ On the State level, most of the State
statutes and regulations referring to NRSRO ratings--which
number over 100--relate to permissible investments by insurance
companies and State funds, banking and State securities laws
and regulations. Because so many regulations affecting
institutional investors incorporate NRSRO ratings, issuers must
seek out ratings from one of the NRSROs--Moody's, S&P, or
Fitch--in order to ensure that they have full access to the
capital markets with respect to their debt instruments.
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\374\ 20 U.S.C. Sec. 1087-2.
\375\ 23 U.S.C. Sec. Sec. 181, 182 .
\376\ 47 U.S.C. Sec. 1103.
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B. Efforts to Regulate Credit Rating Agencies
Although the NRSRO designation has never been formally
defined in statute or regulation, the SEC, as the agency that
coined the term, has taken on the task of granting requests
from rating firms for NRSRO status.\377\ Upon request, the
staff of the Division of Market Regulation provide a ``no-
action'' letter to the firm granting the status.\378\ Since the
inception of the designation, the SEC has granted NRSRO status
to seven companies, including the three that remain today; the
other four merged with Fitch.\379\
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\377\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 133 (Statement of the Honorable
Isaac Hunt, SEC Commissioner).
\378\ See Capital Requirements for Brokers or Dealers Under the
Securities Exchange Act of 1934, Release No. 39457, 62 Fed. Reg. 68018
(December 17, 1994) at 68019 (describing the current process for
determining whether an entity is an NRSRO).
\379\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 133-34 (Statement of the Honorable
Isaac Hunt, SEC Commissioner). Then SEC Commissioner Isaac Hunt
recently indicated that the SEC may be planning to grant the
designation to additional credit rating agencies; he was quoted as
saying that ``we may have more than three by the end of the year.''
Alyne Van Duhn, ``Big Three Learn Lessons From Enron: Ratings
Agencies,'' Financial Times (London), May 27, 2002. There are a few
agencies that have been trying to achieve the designation for some
time. John Labate and Jenny Wiggins, ``Ratings Agencies Live in Hope of
Gaining That Elusive Rise in Status,'' Financial Times (London), May
21, 2002.
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Though it has not received that much attention, the
informal designation process and the small oligopoly it has
created have been somewhat controversial. Throughout the
1990's, Congressman John Dingell wrote a number of letters to
the SEC calling for increased competition in the industry and a
setting of national standards for NRSROs.\380\ The Justice
Department initiated and subsequently closed an investigation
of the credit rating agencies in 1996 to determine if they were
engaging in anti-competitive practices.\381\ In addition, in
the mid-1990's, a school district in Colorado sued Moody's
after it issued unsolicited, and according to the school
district, inappropriately low ratings of a bond issue after the
school district had chosen to retain a different credit rating
company. Following Moody's rating, the school district alleged
that it had to reprice the bonds at a cost of over
$750,000.\382\ The school district lost the suit.
---------------------------------------------------------------------------
\380\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 135 (Statement of the Honorable
Isaac Hunt, SEC Commissioner).
\381\ The antitrust investigation was closed in 1999. Kenneth
Gilpin, ``Justice Dept. Inquiry on Moody's Is Over, With No Charges
Filed,'' The New York Times, March 13, 1999.
\382\ Jefferson County Sch. Dist. v. Moody's Investors Service, 988
F. Supp. 1341 (D. Colo. 1997), aff'd, 175 F.3d 848 (10th Cir. 1999).
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Recognizing that concerns existed and that the public was
increasingly relying on NRSROs, the SEC in 1994 asked for
public comment on the SEC's role in the use of the NRSRO
designation.\383\ The Commission received 25 comment letters in
response, encouraging it to adopt a formalized process for
giving the designation. As a result, the SEC proposed a rule in
1997, seeking to define the term ``NRSRO'' and provide for a
process both for granting the status and removing it, including
an appellate process before an Administrative Law Judge.\384\
The proposed rule set forth the criteria the staff had been
relying on: Namely, whether the applicant's ratings were
nationally recognized, and whether the applicant was
independent, sufficiently staffed, had systematic procedures
designed to produce credible and accurate ratings, and had
internal procedures to protect against the misuse of inside
information. The rule would have required NRSROs to register as
investment advisers under the Investment Advisers Act of 1940,
\385\ and would have required NRSROs to inform the SEC of any
significant organizational changes. The rule would have
officially given the SEC power to withdraw the NRSRO
designation if a credit rating agency failed to maintain the
required criteria. The 16 commenters on the proposed rule
criticized it. Although the rule would have done no more than
to codify the status quo--for example, the NRSROs have all
voluntarily registered as investment advisers, although they
maintain they are not required to--the credit rating agencies
nonetheless opposed the rule because they oppose any formal
regulation of their business.\386\ The Justice Department
criticized the rule for perpetuating the current anti-
competitive environment of credit rating agencies.\387\ The
proposed rule was never finalized.
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\383\ Nationally Recognized Statistical Ratings Organizations,
Release No. 34616, 59 Fed. Reg. 46314 (September 7, 1994).
\384\ See Capital Requirements for Brokers or Dealers Under the
Securities Exchange Act of 1934, Release No. 39457, 62 Fed. Reg. 68018
(December 30, 1997).
\385\ The Investment Advisers Act prohibits fraud, imposes
fiduciary duties on advisers with respect to their advice, requires
advisers to maintain certain books and records, and allows the SEC to
examine advisers to determine compliance with the Act. See generally 15
U.S.C. 80b-1 et seq.
\386\ See, e.g., Comments of Moody's Investors Service in the
Matter of File No. S7-33-97, Release No. 39457, Capital Requirements
for Brokers or Dealers Under the Securities Exchange Act of 1934, dated
March 2, 1998.
\387\ Comments of the United States Department of Justice in the
Matter of File No. S7-33-97, Proposed Amendments to Rule 15c3-1 Under
the Securities Exchange Act of 1934, dated March 6, 1998.
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Even though NRSROs are not subject to any formal process
for designation, monitoring or removal, they do receive special
treatment in securities regulation. First, they are given
special access to companies. SEC Regulation F-D prohibits
issuers from making selective disclosure of material
information in order to ensure that all investors have access
to significant corporate news at the same time.\388\ The rule
was prompted by concern that some favored analysts and market
participants received information first, while the rest of the
market had to wait to find out. Credit rating agencies,
however, are expressly exempted from Regulation F-D.\389\ The
analysts from Moody's, S&P or Fitch can have private
conversations with company management that no other analyst can
have, and the credit rating analysts can see financial
information that no other analyst could see without the company
disclosing it publicly. Moreover, NRSROs are officially
shielded from liability for all but fraud under the securities
laws. SEC Rule 436, promulgated under the Securities Act,
expressly shields NRSROs from liability under Section 11 of the
Securities Act in connection with an offering of
securities.\390\ This means that NRSROs are not held even to a
negligence standard of care for their work.\391\
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\388\ 17 C.F.R. Sec. 243.100.
\389\ 17 C.F.R. Sec. 243.100(b)(2)(iii). Moody's and S&P supported
this exemption. See Comments of Standard & Poor's in the Matter of File
No. S7-31-99, Release Nos. 33-7787, 34-42259, IC-24209, Regarding
Selective Disclosure and Insider Trading, April 17, 2000; Comments of
Moody's Investors Service in the Matter of File No. S7-31-99, Release
Nos. 33-7787, 34-42259, IC-24209, Regarding Proposed Rule: Selective
Disclosure and Insider Trading, April 27, 2000.
\390\ 17 C.F.R. Sec. 230.436(g)(2). Interestingly, the SEC makes
clear in the adopting release for this rule that this rule only applies
to NRSROs; to the extent that companies wish to disclose the ratings of
non-NRSROs in their filings, those credit rating agencies are required
to file consents as attachments to the registration statements
(rendering them subject to liability under section 11 of the Securities
Act of 1933). See 47 Fed. Reg. 11380, 11392 n. 55 (March 16, 1982).
\391\ NRSROs argue that they would not be subject to liability
under a negligence standard in any event because their ratings
constitute opinions protected by the First Amendment. This has been
accepted by at least one court. See, e.g., County of Orange v. McGraw
Hill, 245 B.R. 151 (C.D. Cal. 1999) (where county alleged S&P had
negligently issued defective ratings of municipal bonds, court held
that in order to prove S&P liable for botched ratings, county had to
show actual malice, the standard for protected speech).
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The NRSRO designation has had a significant beneficial
effect on the profitability of credit rating agencies. Until
the late 1960's, the rating agencies made their money by
publishing their ratings and selling them to investors.\392\
This ceased to be profitable due to the increasing use of
improved information sharing technology--basically the
photocopying machine--by users of the ratings.\393\ Starting
around 1970, the rating agencies began to charge issuers of
debt instruments for ratings.\394\ That is the system that
exists today. With a credit rating effectively required by law
for so many purposes, issuers in most instances seek the
ratings out of necessity. Credit rating agencies generally
charge companies per transaction--for a simple transaction,
typically 2 or 3 basis points (.02 or .03 percent of the total
amount of the deal), or somewhat more for a complex one.\395\
If an issuer is extremely active in the markets, agencies also
accept an annual fee.\396\ Some critics suggest that this
arrangement causes a conflict of interest, \397\ although it is
unclear how great an impact any such conflict has, given that
issuers have no choice but to obtain a rating from one of the
limited number of firms offering the service. In other words,
the credit rating agencies probably do not feel pressure to
please issuers to get their business.\398\
---------------------------------------------------------------------------
\392\ Bethany McLean, ``The Geeks Who Rule the World,'' Fortune,
December 24, 2001.
\393\ Lawrence J. White, ``The Credit Rating Industry: An
Organizational Analysis,'' February 2001 (Working Draft) at 13,
available at http://papers.ssrn.com/sol3/papers.cfm?abstract--
id=267083.
\394\ Bethany McLean, ``The Geeks Who Rule the World,'' Fortune,
December 24, 2001.
\395\ Partnoy, note 369 above, at 653.
\396\ Committee staff interviews with Moody's (March 8, 2002), S&P
(March 6, 2002), and Fitch (March 5, 2002), described at note 404
below.
\397\ The SEC solicited comments on this practice in its 1997
proposed rule. See also Fight, note 372 above, at 227 (noting ``the
obvious potential conflict of interest just from the fact that the
rating company is taking ratings fees from the companies it rates'');
Dave Lindorff, ``Judging the Judges: Are the Top Rating Agencies Too
Slow to Downgrade?'' Investment Dealers Digest, August 13, 2001 (taking
fees from issuers is `` `a built-in conflict,' says credit rating
agency Egan-Jones' Managing Director Bruce Jones, previously a senior
analyst at Moody's. `[Moody's] charges issuers for their ratings, and
yet their public posture is to turn double cartwheels to insist that
their constituency is the investor.' '')
\398\ The credit rating agencies, in rare cases, also provide
ratings even when they do not get paid. Although Moody's informed
Committee staff in an interview that it only does this now for high-
yield junk bonds in the United States, S&P and Fitch told Committee
staff in interviews that they provide unsolicited ratings as they see
fit.
---------------------------------------------------------------------------
This enviable market position appears to provide strong
profitability: Rating agencies can benefit from active capital
markets without having to risk any of their own capital. Though
S&P is a division of McGraw-Hill (and therefore its individual
profitability is not publicly available), and Fitch is a
subsidiary of a private corporation, Moody's was recently spun
off as its own publicly-held company by Dun & Bradstreet and
publicly reports its earnings. Moody's--which is an S&P 500
company and has a market capitalization of approximately $7.7
billion \399\--had record results in 2001. Its revenue was $797
million, an increase of a full 32 percent from 2000. Its
operating income was $399 million, 38 percent higher than 2000.
Its profits were $212 million in 2001, 34 percent more than
2000.\400\ Ratings generate approximately 85 percent of Moody's
revenues.\401\
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\399\ Calculated based on closing price of $49.69 on September 10,
2002.
\400\ ``Moody's Corporation Reports Record Results for Fourth
Quarter and Full Year 2001,'' Moody's Corporation Press Release,
February 4, 2002; see also Moody's Corporation Annual Report on Form
10-K for year ended December 31, 2001 (filed March 22, 2002), at Item
7, pp. 15-16.
\401\ Moody's Corporation Annual Report on Form 10-K for year ended
December 31, 2001, at Item 7, p. 16.
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Although they do not consult with one another on ratings,
the rating agencies generally appear to approach the business
of rating issuers in a very similar way.\402\ They will assign
each company to one primary analyst (that analyst will cover a
number of companies, perhaps between 10 and 30), who typically
works with a junior analyst. Analysts work in groups divided by
industry sector; the analysts covering the companies within
that sector are overseen by a managing drector in charge of
that sector. When a company has been rated before and is being
monitored by the rating agencies, analysts will review the
company's periodic SEC filings and other public information
relevant to the company, including press reports or industry
information. The analysts will periodically meet and speak to
the company's management and visit the company's facilities.
The focus of the rating agencies' analysis is the company's
ability to generate cash in comparison to the company's
liabilities; the extent to which the former easily covers the
latter will be a significant determinant of the rating. In
analyzing a company's prospects for paying its obligations, in
addition to reviewing the company's own historical performance
and industry trends, the credit raters will generally request
additional, non-public information. Although the credit raters
stress that they rely primarily on public information, they
will also ask to review the company's projections of future
cash flows and will generally seek a breakdown of cash flows by
company segment, to see how each of its businesses have done
and how the company believes they will do in the future.
According to Moody's, that ``segmentation information'' is
fundamental to assessing a company's creditworthiness. The
credit raters will also generally ask for full disclosure of
all significant liabilities of the company, including those
``off-balance sheet.'' \403\
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\402\ The following description of the credit raters' methodology
was derived from telephonic Committee staff interviews with officials
from Moody's (March 8, 2002), S&P (March 6, 11, 13, 2002), and Fitch
(March 5, 2002), described at note 404 below.
\403\ Committee staff interviews with Fitch (March 5, 2002),
Moody's (March 8, 2002) and S&P (March 11 and 13, 2002), described at
note 404 below.
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To determine a rating, analysts will convene a credit
committee. The committee will consist of anywhere from 4 to 12
people, including the analysts working on the company, their
managing director, and other analysts, management, or staff
with useful expertise. The analyst will make a recommendation,
and the committee will vote. The deliberations of a credit
committee, and the identities of the participants, are kept
confidential. The rating is usually made public through a press
release. Companies are generally notified of their ratings in
advance of the publication if there is a change or if it is a
new rating to allow the issuer to respond if it believes that
the rating does not accurately reflect its creditworthiness--
S&P refers to this process as an ``appeal.'' Such an
``appeal,'' if the company requests it, is conducted within a
day or two of the ratings announcement. S&P has indicated that
it is rare that it will change a rating. With a company that
has been rated and is being monitored, a committee will be
convened periodically, perhaps once a year or once every 18
months, to reaffirm or change the rating. Prior to a ratings
change, a company may be put on a ``watch'' or ``review.'' An
analyst may initiate a ``watch'' or ``review'' without a
meeting of the credit committee.
C. Chronology of Enron's Ratings
Given the significant and market-wide impact of credit
ratings, one would expect the rating agencies to perform a
careful and searching inquiry into companies they rate. They
have access enjoyed by no other corporate watchers--companies
can and do share non-public material information with them
without disclosing it to the public at large--and with their
ability to downgrade a company's credit ratings, the rating
agencies can essentially restrict a company's access to the
capital markets. Indeed, one must question whether so many
State and Federal laws, as well as private contracts, would
vest such authority in the ratings of these agencies if anyone
suspected that the credit raters were not using their power and
access to obtain the best information possible.
Unfortunately, at least in Enron's case, the credit rating
agencies did not perform as expected. Based on a number of
interviews conducted by Committee staff with officials from
Moody's, S&P, and Fitch, \404\ Committee staff has concluded
the agencies did not perform a thorough analysis of Enron's
public filings; did not pay appropriate attention to
allegations of financial fraud; and repeatedly took company
officials at their word, without asking probing, specific
questions--despite indications that the company had misled the
rating agencies in the past.
---------------------------------------------------------------------------
\404\ Staff interviewed officials from each of the agencies in
preparation for the March 20 Committee hearing. On March 5, 2002,
Committee staff interviewed Fitch General Counsel Charles Brown, Glenn
Grabelski, Fitch Managing Director, and Ralph Pellecchia, the senior
analyst on the Enron credit for Fitch. On March 6, Committee staff
interviewed S&P officials, including Leo O'Neill, President of S&P,
Executive Vice President Vickie Tillman, and Counsel for Regulatory
Affairs Rita Bolger. On March 8, Committee staff interviewed Moody's
officials, including Moody's President Ray McDaniel, Pamela Stumpp,
Chief Credit Officer, and John Diaz and Stephen Moore. Moore was the
primary analyst on the Enron credit for Moody's, but his work was
closely overseen by Diaz, Managing Director for the Power and Energy
Group. Diaz had been the Moody's analyst following Enron prior to
Moore, and thus he maintained watch on the company after he was
promoted to managing director. On March 11, Committee staff conducted a
second interview with S&P officials, including Ronald Barone, Managing
Director for the Utilities, Energy & Project Finance Group. On March
13, Committee staff conducted a third interview with S&P officials,
including Todd Shipman, an S&P analyst. Shipman was the primary analyst
on Enron for S&P, but his work was also closely overseen by Barone, as
Barone had also followed Enron when he was an analyst.
---------------------------------------------------------------------------
As of late March 2000, the three agencies gave Enron the
same rating: Moody's \405\ gave it a Baa1, and S&P \406\ and
Fitch \407\ both rated Enron as BBB+, indicating an upper level
within the category of good credit quality.\408\ Retaining this
investment grade rating, and even improving it, was vital to
Enron because its ability to operate and grow its trading
business as well as to access the capital markets for its
liquidity needs were absolutely dependent upon the stability
that the rating provided. In fact, the company consistently
lobbied for a higher rating.\409\ Nevertheless, given the
volatility inherent in an industry that was in the process of
deregulation, and given that Enron was a company that took a
number of risks, the rating agencies did not consider a higher
rating appropriate.\410\
---------------------------------------------------------------------------
\405\ Paul Chivers, ``Empowering Enron,'' Euromoney Institutional
Investor, June 1, 2000.
\406\ ``Standard & Poor's Affirms Enron Ratings Re Cogen
Technologies Acquisition,'' PR Newswire, November 3, 1998.
\407\ ``Fitch IBCA Affirms Enron Corp. at BBB+,'' Business Wire,
November 8, 1999.
\408\ See ``Standard & Poor's Understanding Credit Ratings,'' note
355 above; ``Fitch Ratings Definitions,'' note 355 above; ``Ratings
Definitions: Issuer Ratings,'' http://www.moodys.com, note 358 above.
\409\ See, e.g., Rating the Raters: Enron and the Credit Rating
Agencies, Hearing Before the Senate Governmental Affairs Committee,
107th Cong., S. Hrg. 107-471 (March 20, 2002) at 65-66, 122.
\410\ As S&P's Barone pointed out in his written testimony, the
rating agencies, in consideration of these factors, added back ``debt-
like burdens'' into the numbers it used to calculate Enron's rating.
Barone stated that ``over the years Standard & Poor's `put back' onto
Enron's balance sheet off-balance sheet amounts of between $2 billion
and $4 billion in debt-like obligations for purposes of our ratings
analysis.'' Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 66-67.
---------------------------------------------------------------------------
In early October 2001, Enron's assistant treasurer, Tim
DeSpain, called Moody's and S&P to tell them that Enron would
soon announce: (1) a $1 billion writedown on after-tax income
due to bad investments, and (2) a $1.2 billion reduction in
shareholder's equity, which DeSpain described only as an
accounting adjustment. Moody's analysts were surprised because
they had been assured by Enron just weeks before, after CEO
Skilling's resignation on August 14, 2001, that a writedown was
not imminent. Both Moody's and S&P were concerned about the
effect of the large writedown on Enron's financial strength,
but neither appeared significantly concerned about the equity
reduction.\411\ Based on information provided to Committee
staff, it does not appear that they made any effort to obtain a
cogent explanation for why the reduction was taking place or
how such a significant accounting error could have occurred.
---------------------------------------------------------------------------
\411\ Committee staff interviews with Moody's (March 8, 2002) and
S&P (March 11 and 13, 2002), described at note 404 above. In his
testimony at the March 20 hearing, Moody's Diaz said that Moody's was
``questioning and scratching our heads about the type of accounting
that they were using for that charge and how did that $1.2 billion of
equity actually come about.'' However, he said that Moody's was ``not
satisfied with [Enron's] explanations'' for the actions. Nevertheless,
he testified that Moody's ``discussions [with Enron] during that time
were concentrated on understanding the liquidity position of the
company and how that was impacting the trading business.'' Rating the
Raters: Enron and the Credit Rating Agencies, Hearing Before the Senate
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-471 (March 20,
2002) at 13.
---------------------------------------------------------------------------
On or about October 12, Ken Lay, who had resumed his
position as Enron CEO following Jeffrey Skilling's resignation
in August, called both S&P and Moody's after hearing that the
credit raters were considering a downgrade. Lay tried to
reassure the agencies that Enron would shore up its balance
sheet, selling off assets as necessary to create additional
reserves to cover obligations.\412\ Neither Moody's nor S&P
questioned Lay about the enormous equity adjustment.
---------------------------------------------------------------------------
\412\ Committee staff interviews with Moody's (March 8, 2002) and
S&P (March 11 and 13, 2002), described at note 404 above.
---------------------------------------------------------------------------
On October 16, Enron made the earnings announcement about
which it had advised Moody's and S&P nearly 2 weeks earlier. On
October 17, The Wall Street Journal broke the story about
partnerships run by Enron CFO Andrew Fastow being used to hide
Enron losses and debt.\413\ On October 22, Enron revealed that
the SEC was investigating the allegations in the report. Two
days later, on October 24, Fastow resigned. Although all the
analysts said that they asked Enron officials about the
allegations in The Wall Street Journal story, they never
received--or appear really to have pressed for--a clear
explanation from Enron officials, who, according to the
analysts, simply denied knowledge of the details.\414\ In fact,
the credit analysts were not focused on Enron's questionable
transactions or accounting, despite the possible serious
wrongdoing these practices indicated. Despite their stated goal
of assessing long-term corporate strength, the raters focused
almost exclusively on the cash position of the company, a
short-term consideration. It was only when Enron informed the
credit rating firms that it was going to draw down on and
exhaust its lines of credit--indicating it was in a cash crisis
and that it was having difficulty placing its commercial
paper--that the raters acted.\415\
---------------------------------------------------------------------------
\413\ John Emshwiller and Rebecca Smith, ``Enron Jolt: Investments,
Assets Generate Big Loss; Part of Charge Tied to 2 Partnerships
Interests Wall Street,'' The Wall Street Journal, October 17, 2001.
\414\ Committee staff interviews with Moody's (March 8, 2002) and
S&P (March 11 and 13, 2002), described at note 404 above.
\415\ Committee staff interviews with Fitch (March 5, 2002),
Moody's (March 8, 2002) and S&P (March 11 and 13, 2002), described at
note 404 above.
---------------------------------------------------------------------------
On October 25, S&P changed Enron's ratings outlook to
negative (though it kept Enron at BBB+).\416\ Fitch, having
digested the news from the earnings announcement and concerned
about the drawdown on credit, also placed Enron on watch for a
downgrade.\417\ On October 29, Moody's downgraded Enron one
notch to Baa2 (still investment grade) and kept it on review
for another downgrade.\418\ According to its press release,
Moody's main concern was Enron's shrinking access to liquidity
and the reduction in equity: Neither the SEC investigation nor
the underlying allegations about possible financial fraud were
mentioned.\419\ That same day, S&P's primary Enron analyst,
Todd Shipman, appeared on CNN Financial News Network. Even
though S&P had placed Enron on CreditWatch negative, Shipman
said, ``Enron's ability to retain something like the rating
they're at today''--meaning an investment grade rating--``is
excellent in the long term.'' \420\ When asked about the off-
balance sheet partnerships, Shipman remarked that S&P was
``confident that there's not any long term implications to that
situation and that's something that's really in the past.''
\421\ As he appears to have gotten no information from Enron
about the allegations of questionable transactions and
accounting, it is unclear what basis Shipman had for those
remarks.\422\
---------------------------------------------------------------------------
\416\ ``Ratings on Enron Corp. Affirmed; Outlook to Negative,'' S&P
Press Release, October 25, 2001.
\417\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 11 (Testimony of Ralph Pellecchia).
\418\ ``Moody's Downgrades Enron Corp. Long-Term Debt Ratings
(Senior Unsecured to Baa2) and Keeps Them Under Review For Downgrade,''
Moody's Press Release, October 29, 2001.
\419\ Id.
\420\ Interview of Todd Shipman, S&P, by Deborah Marchini (CNNFN
Street Sweep, October 29, 2001), available on Lexis/Nexis, Transcript
#102915cb.l06.
\421\ Id.
\422\ Barone testified at the March 20 hearing that Enron officials
had told him that ``they would be surprised if they found anything
further,'' but conceded that he had told Committee staff that Enron
officials had said that ``they didn't know what else was out there.''
Rating the Raters: Enron and the Credit Rating Agencies, Hearing Before
the Senate Governmental Affairs Committee, 107th Cong., S. Hrg. 107-471
(March 20, 2002) at 14.
---------------------------------------------------------------------------
Despite Shipman's public comments of confidence in Enron,
on November 1, S&P downgraded Enron to BBB (two notches above
junk), and placed it on negative CreditWatch, although in its
press release, S&P indicated its belief that Enron was
sufficiently liquid to get through ``the current period of
uncertainty.'' \423\ On November 2, the very next day, in a
public conference call set up by S&P to answer questions about
Enron, \424\ Shipman, this time along with Ronald Barone, his
supervisor and S&P Managing Director, again commented on S&P's
``confidence'' that there would be no more revelations about
off-balance sheet partnerships at Enron. Barone said, ``We have
a great deal of confidence there are no more surprises to
come.'' Shipman added, ``We're confident we capture or are
privy to the obligations that Enron has.'' Barone finished, ``I
think it's gonna take a little bit more time before everybody
can get fully comfortable that there's not something else
lurking out there. But at this point, we feel very confident
that that's unlikely.'' \425\
---------------------------------------------------------------------------
\423\ ``Enron Corp.'s Rating Lowered, Placed on CreditWatch
Negative,'' S&P Press Release, November 1, 2001.
\424\ This conference call was open to the public; anyone who
wanted to listen in or ask questions could call into a number provided
by S&P.
\425\ Transcript of S&P Teleconference re: Enron, dated November 2,
2001, provided to the Committee under cover of letter from Floyd
Abrams, Esq. to Cynthia Gooen Lesser, Counsel, Senate Governmental
Affairs Committee, dated March 19, 2002.
---------------------------------------------------------------------------
On November 5, Fitch issued a two-notch downgrade on Enron
to BBB- (just one level above junk).\426\ In its release
regarding the downgrade, Fitch mentioned the SEC investigation
as ``an additional uncertainty,'' and cited as a concern ``an
erosion in investor confidence'' but expressed the belief that
``Enron should be able to manage through this challenging
environment, ultimately recognizing the values of the company's
core businesses,'' which Fitch said have ``generated strong,
predictable performance.'' Fitch expressed this confidence in
Enron's ``strong performance'' despite the reports about its
questionable transactions, which may have been used to make the
company's performance seem better than it was.
---------------------------------------------------------------------------
\426\ ``Fitch Downgrades Enron to `BBB-'; Maintains Rtg Watch
Negative,'' Business Wire, November 5, 2001.
---------------------------------------------------------------------------
In the meantime, on or around November 5, Moody's and S&P
were informed by Enron about the upcoming announcement of a
merger with Dynegy.\427\ Fitch was also notified of the merger
plans in advance. All the credit raters said that they retained
Enron's credit rating at above investment grade through
November 28 solely because of the proposed merger.\428\ On
November 9, Fitch essentially improved Enron's credit outlook
by putting it on an ``evolving'' ratings watch, rather than a
negative one, due to the good prospects from the merger. In its
November 9 release, Moody's downgraded Enron to Baa3 (one notch
above junk) due to shrinking investor confidence, but indicated
that it would view ``a substantial near term injection of
equity capital as a stabilizing event,'' an implicit reference
to the merger.\429\ S&P also downgraded Enron to BBB- (one
notch above junk), with a negative watch on November 9, with
its investment grade rating at this point due entirely to the
merger.\430\ Despite the fact that Enron had just 1 day before,
on November 8, announced a restatement for the past 4\1/2\
years, with a charge to earnings of approximately $500
million--about 20 percent of earnings during that period--none
of the credit rating agencies showed concern about the
possibility of financial fraud and the damage that such
illegalities could cause Enron and its merger partner.\431\
---------------------------------------------------------------------------
\427\ It was in connection with the discussions about the merger
that Moody's received telephone calls about Enron's credit rating,
mostly from Enron's bankers. According to a description of these calls
provided to Committee staff by Moody's attorneys on March 19, 2002,
after receiving a copy of the merger term sheet on November 8, 2001,
Moody's was concerned that the merger terms too easily allowed
Citigroup and J.P. Morgan Chase, the banks financing the merger, and
Dynegy, Enron's prospective acquirer, to drop the deal. Moody's told
Enron that it was seriously considering downgrading Enron below
investment grade as a result of this uncertainty. After that, the CEO
of Moody's, John Rutherfurd, received a number of telephone calls.
Former Treasury Secretary Robert Rubin, Chairman of Citigroup's
Executive Committee, and Michael Carpenter, CEO of Citigroup Salomon
Smith Barney, conference called Rutherfurd, who was in his car on his
cellphone at the time. Before the call got started, Rubin apparently
was dropped from the call; he and Rutherfurd did not speak again on the
matter. Carpenter told Rutherfurd that he was concerned about the
possible Enron downgrade; Rutherfurd replied that he did not get
involved with ratings matters, and told Carpenter he would have Debra
Perry, a senior managing director and executive officer of Moody's,
call him. Rutherfurd called Perry, who called Carpenter, and set up a
meeting with her and James Lee, another Citigroup official, and William
Harrison, CEO of J.P. Morgan Chase. (Harrison left a message for
Rutherfurd also, but they never spoke.) In Perry's meeting with
Harrison and Lee, Lee mentioned that William McDonough of the Federal
Reserve might call, but neither he, nor any other government official
ever did. (Richard Grasso, CEO of the New York Stock Exchange, left a
message for Rutherfurd that day, but by the time Rutherfurd called him
back, the issue had been resolved and they never discussed Enron.)
Ultimately, Lee and Harrison agreed to change the terms of the merger
to accommodate Moody's concerns; Dynegy agreed to similar changes.
Neither S&P nor Fitch received such calls, according to their testimony
at the Committee's March 20 hearing. Rating the Raters: Enron and the
Credit Rating Agencies, Hearing Before the Senate Governmental Affairs
Committee, 107th Cong., S. Hrg. 107-471 (March 20, 2002) at 28.
\428\ Committee staff interviews with Fitch (March 5, 2002),
Moody's (March 8, 2002) and S&P (March 11 and 13, 2002), described at
note 404 above.
\429\ ``Moody's Downgrades Enron Corp. Long-Term Debt Ratings And
Keeps Them Under Review For Downgrade,'' Moody's Press Release,
November 9, 2001.
\430\ ``Dynegy Ratings Placed on Watch Negative; Enron Rating
Lowered to BBB-,'' S&P Press Release, November 9, 2001.
\431\ To the extent that the credit rating agencies expressed
concerns in this regard, they were limited to concerns about
counterparty and investor confidence as a result of the allegations--a
short-term concern--not about the inherent, long-term damage that
serious fraud could inflict on a corporation. See, e.g., Rating the
Raters: Enron and the Credit Rating Agencies, Hearing Before the Senate
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-471 (March 20,
2002) at 11, 13.
---------------------------------------------------------------------------
On November 19, Enron filed its Form 10-Q, which reported
its third quarter results. For the first time, to the surprise
of all the credit rating agencies, Enron disclosed that the
November 9 S&P downgrade to BBB- had triggered a demand
obligation for $690 million.\432\ Although the credit rating
agencies were aware of other such agreements backing other
special purpose entities associated with Enron, they did not
know about this one. According to what the credit analysts told
Committee staff in interviews, the analysts had never
specifically asked Enron if other triggers dependent on credit
ratings existed.\433\ Enron officials told S&P that current
Enron management had not even known about the $690 million
obligation; it was a surprise to them when the trustee for the
affected entity had exercised the trigger.\434\ S&P not only
failed to ask if there were other ``surprises'' regarding
credit triggers or other obligations, but the S&P analysts
appear to have also been unconcerned about the fact that Enron
management itself appeared to lack knowledge about a major
company commitment.\435\ On November 20, the day after this
disclosure, S&P reaffirmed its investment grade rating with a
negative watch. S&P said that it believed Enron could deal with
the $690 million obligation (without mentioning the fact that
Enron had failed to disclose a significant financial obligation
and that S&P believed the obligation was a surprise even to
management at Enron).\436\
---------------------------------------------------------------------------
\432\ Enron Corp. Form 10-Q for Quarter Ended September 30, 2001,
filed November 19, 2001, at 10, 33. News reports have indicated that
the $690 million obligation was associated with an entity called
Whitewing. See, e.g., Peter Behr, ``Enron Raised Funds in Private
Offering; Shareholders in Dark, Documents Show,'' The Washington Post,
January 22, 2002. Whitewing was an Enron-affiliated entity that the
credit rating agencies were well aware of; they had rated debt
offerings that were associated with Whitewing. Indeed, the other
obligations Enron had with ratings triggers that the rating agencies
knew about were related to Whitewing. The credit rating agencies told
Committee staff that their understanding was that the $690 million
obligation was associated with a partnership called Rawhide that the
credit raters were unaware of prior to the Form 10-Q filing.
\433\ Committee staff interviews with Fitch (March 5, 2002),
Moody's (March 8, 2002) and S&P (March 11 and 13, 2002), described at
note 404 above.
\434\ Committee staff interviews with S&P (March 11 and 13, 2002),
described at note 404 above.
\435\ Id.
\436\ ``Enron Corp.'s Ratings Still Watch Negative,'' S&P Press
Release, November 20, 2001.
---------------------------------------------------------------------------
Over the next few days, however, the credit rating agencies
heard about a renegotiated deal for the proposed merger, and
the likelihood of the merger seemed more and more remote.
Finally, on November 28, after hearing that the terms had been
revised to give Dynegy additional ways to terminate the
transaction, and without additional cash from the banks
involved, the rating agencies decided to give up on Enron.\437\
On November 28, all three agencies downgraded Enron to below
investment grade: Moody's downgraded Enron to B2 (5 notches
below the previous rating), \438\ S&P downgraded Enron to B- (6
notches below previous rating), \439\ and Fitch lowered Enron
to CC (more than 8 notches below previous rating).\440\
Currently, Fitch and S&P rate Enron as a D and Moody's rates
Enron as a Ca.
---------------------------------------------------------------------------
\437\ Committee staff interviews with Fitch (March 5, 2002),
Moody's (March 8, 2002) and S&P (March 11 and 13, 2002), described at
note 404 above.
\438\ ``Moody's Downgrades Enron Corp.'s Long-Term Debt Ratings
(Senior Unsecured to B2); Commercial Paper Confirmed at Not Prime;
Ratings Remain Under Review For A Downgrade,'' Moody's Press Release,
November 28, 2001.
\439\ ``Enron Rating Cut to `B-'; Doubt Cast on Dynegy Merger,''
S&P Press Release, November 28, 2001.
\440\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 12.
---------------------------------------------------------------------------
D. Problems With the Agencies' Analyses and Actions
While the credit rating agencies did not completely ignore
problems at Enron when those problems became very apparent,
their monitoring and review of the company's finances fell far
below the careful efforts one would have expected from
organizations whose ratings hold so much importance. Instead,
based on what the credit rating analysts told Committee staff
in interviews and the analysts' testimony at the Committee's
hearing on March 20, 2002, entitled ``Rating the Raters: Enron
and the Credit Rating Agencies,'' it appears that the credit
raters took Enron at their word and failed to probe more
deeply. Moreover, in general, the ratings analysts appear to
have taken too narrow a focus in determining what Enron's
problems were: They focused on short-term problems, like cash
flow or counterparty confidence, rather than deep-rooted
problems, such as questionable transactions or suspect
accounting. In short, based on the credit rating agency
analysts' testimony at the March 20 hearing, and what they told
Committee staff in interviews, the Committee staff has
concluded that the credit rating agencies' approach to Enron
fell short of what the public had a right to expect, having
placed its trust in these firms to assess corporate
creditworthiness for the purposes of Federal and State
standards. It is difficult not to wonder whether lack of
accountability--the agencies' practical immunity to lawsuits
and non-existent regulatory oversight--is a major problem.
Insufficient Review of Company Materials. When asked if he
thought the credit rating agencies had done a good job, former
SEC Chief Accountant Lynn Turner testified that his own initial
review of Enron's financial statements ``raised more questions
than they answered,'' and that anyone doing a similar review
should have been given pause by their opacity.\441\ One of the
more glaring concerns Committee staff developed based on their
interviews of the credit rating agencies was that the analysts
who worked on Enron appear to have been less than thorough in
their review of Enron's filings, even though they said that
they rely primarily on public filings for information in
determining credit ratings. Enron's disclosure in its 2000 Form
10-K filing about related-party transactions--footnote 16--
where information about the company's questionable deals with
partnerships and special purpose entities run by Enron insiders
should have been disclosed, was very difficult to understand.
When Committee staff asked the analysts if they understood the
disclosures in footnote 16, Moody's and Fitch told staff they
did not understand precisely what those disclosures referred
to, but were only concerned about the impact these transactions
had on cash flow, which they believed had been disclosed
elsewhere. The analysts from Moody's and Fitch told Committee
staff that they were not concerned about the details of the
transactions themselves, despite that the fact that those
details might have indicated a problem--that Enron was gaining
significant income from deals with partnerships run by its own
CFO--and led them to wonder whether fraud was afoot. The S&P
analysts told Committee staff that they simply assumed that the
opaque disclosures regarding related-party transactions in the
2000 Form 10-K referred to the off-balance sheet entities of
which they were aware (because S&P rated some of these in
connection with debt offerings). According to their remarks to
Committee staff, the S&P analysts did nothing to confirm their
understanding.
---------------------------------------------------------------------------
\441\ The Role of Financial Institutions in Enron's Collapse,
Hearing Before the Permanent Subcommittee on Investigations, Senate
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-618 (July 23,
2002) at-- (Printed Hearing Record Pending) (Testimony of Lynn Turner,
former Chief Accountant of the SEC).
---------------------------------------------------------------------------
In fact, the S&P analysts could have checked their
understanding of this disclosure, to some extent, by reviewing
Enron's proxy statement, which is required to contain
additional information about related-party transactions. (Proxy
statements also have other relevant information not found in
other filings, such as disclosures about certain insider
sales.) The analysts from S&P said that they did not read
Enron's proxy statements.\442\ In fact, they told Committee
staff that they did not even know how the information they
could find in a proxy statement in this regard might differ
from that found in the 10-K. If the S&P analysts had read
Enron's 2001 proxy statement, they may have learned that their
assumption about Enron's 2001 Form 10-K disclosure was
incorrect. The proxy contains a more explicit description of
the related-party transactions than is contained in the 10-K;
for instance, the proxy statement specifically states that the
company had engaged in numerous transactions with an entity
called LJM2 (not the Whitewing, Osprey, and Marlin entities
with which the S&P analysts said that they were familiar) and
indicates that Enron Chief Financial Officer Andrew Fastow was
the general partner of that entity.\443\
---------------------------------------------------------------------------
\442\ Committee staff interviews with S&P (March 11 and 13, 2002),
described at note 404 above. It is worth noting that proxy statements
are incorporated by reference in Forms 10-K; a thorough review of any
10-K would have to include a review of the proxy statement as well.
\443\ Enron Corp. Definitive Proxy Statement (Schedule 14A) (filed
March 27, 2001) at 26.
---------------------------------------------------------------------------
Short Term v. Long Term Focus. The agencies told Committee
staff that their ratings reflect an analysis of long-term
creditworthiness. In the case of Enron, however, the credit
raters, according to their remarks to Committee staff in
interviews, failed to do simple things one would expect from
someone conducting a long-term evaluation of a company's
financial health. For example, based on the information
gathered by Committee staff, it appears that the credit
analysts did not look for fundamental problems at the company
by scrutinizing the financial statements or assessing the
aggressiveness of Enron's accounting methods. When asked by
Committee staff whether they considered as a qualitative factor
in their analysis whether the company was engaging in
aggressive accounting, the agencies indicated that they rely on
the auditors' work. This was consistent with their testimony at
the hearing.\444\ In the Committee staff interviews, the credit
rating analysts resisted staff's suggestion that a company's
accounting methods should be part of their analysis, because
even when financial statements comply with Generally Accepted
Accounting Principles (GAAP), they nevertheless may not present
all the information an investor would want to know, or all the
information a credit rater would want to know. This is
troubling, because the fact that a company may be using the
flexibility of GAAP to hide problems should be a consideration,
particularly if the credit raters take a long-term view.
---------------------------------------------------------------------------
\444\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 29.
---------------------------------------------------------------------------
Moreover, despite their stated effort to take a long-term
approach to ratings, the credit rating agencies appear to have
focused primarily on short-term issues with Enron, like access
to cash in the near term, counterparty confidence, or whether
the Dynegy merger would succeed, even as there continued to be
revelations about Enron's questionable use of off-balance sheet
entities run by its CFO. For example, when Enron's $690 million
obligation was disclosed for the first time--to the surprise of
everyone, including, S&P believed, company management--S&P
analysts told Committee staff that they did not ask if there
were other potential triggers (nor did any of the other credit
rating agencies), nor did they appear to register much concern
about Enron management's expressed lack of knowledge. Indeed,
although the credit analysts told Committee staff that they
asked Enron officials about The Wall Street Journal
allegations, they acknowledged that they did not press for a
detailed answer when none was forthcoming, even after an SEC
investigation was announced. Both Moody's and S&P stressed to
Committee staff that the revelations in The Wall Street Journal
were just allegations, and the analysts were not inclined to
render judgment until all the facts were in.\445\ In interviews
with Committee staff, the credit analysts seemed unwilling to
distinguish between rendering judgment and asking probing
questions--and demanding answers.
---------------------------------------------------------------------------
\445\ Committee staff interviews with Moody's (March 8, 2002) and
S&P (March 11 and 13, 2002), described at note 404 above.
---------------------------------------------------------------------------
Lack of Inquisitiveness. Leo O'Neill, S&P's President, said
in a staff interview that fixed income analysts ask ``green-
eyeshade questions,'' referring to the green eyeshades auditors
were noted for wearing in earlier times, and the tough, probing
queries for which they were then known.\446\ Credit rating
analysts should take a similar approach--they, like fixed
income analysts, assess the ability of the company to repay
debt (fixed income analysts focus on bonds, as opposed to
equity analysts, who focus on stocks). Based on their testimony
at the March 20 hearing and their remarks to Committee staff in
interviews, however, Committee staff concluded that the credit
rating agency analysts did not take this skeptical approach.
Not only did they apparently fail to scrutinize Enron's public
filings (indeed, they failed even to read all the major
filings), the credit analysts in general appear to have taken
the company officials at their word, simply assuming that they
were telling the truth. As Ronald Barone of S&P testified at
the March 20 hearing, ``we do rely on what senior management
tells us. It is in their best interest to tell us and be
forthright and not convey a different message, because if we
convey a message to the market that is different that what the
market perceives over the long term, then the credibility of
Standard & Poor's and then ultimately the credibility of the
company is at risk. . . . And so it is in their best interest
to tell us the truth, and we rely on that.'' \447\ Senator
Thompson called this reasoning ``a chicken-and-egg deal,''
pointing out that corporate executives might instead view it in
their best interests ``to minimize bad news and stretch the
truth.'' \448\
---------------------------------------------------------------------------
\446\ Committee staff interview with S&P (March 6, 2002), described
at note 404 above.
\447\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 15.
\448\ Id.
---------------------------------------------------------------------------
In addition, from what the credit analysts told Committee
staff, they did not pursue what even they admitted was
fundamental information, despite the fact that the credit
raters publicly acknowledged that Enron was a complex company.
In a March 2001 article about Enron's opaque financial
statements, in response to the question of how Enron makes its
money, S&P's Todd Shipman, the analyst working under Ronald
Barone, was quoted as saying, ``If you figure it out, let me
know,'' and Fitch's Ralph Pellecchia joked, ``Do you have a
year?'' \449\ The point of this article was that Enron was
generally understood by Wall Street to be a ``black box,''
difficult to understand and loath to answer too many questions
about ambiguities. While Pellecchia explained at the
Committee's March 20 hearing that his response was merely a
``glib answer,'' he acknowledged that the ``spirit of the
answer was Enron's a big company, a complex company. . . .''
\450\ In other words, these analysts well understood that
getting a clear picture of Enron's financial situation was not
a simple matter. Yet, they apparently failed to use the
necessary rigor--the ``green-eyeshade'' approach--to ensure
that their analysis of such a company was sound.
---------------------------------------------------------------------------
\449\ Bethany McLean, ``Is Enron Overpriced?,'' Fortune, March 5,
2001.
\450\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 23.
---------------------------------------------------------------------------
As early as May 2001, the independent research firm Off
Wall Street Consulting Group called Enron a bad bet. Off Wall
Street's analysis showed that Enron's trading operation--its
most profitable venture--was starting to turn weaker profits as
the market it helped open up became more liquid and prices less
volatile.\451\ Enron did not, in its public filings, indicate
how much money its trading business made as distinct from the
rest of its ``Wholesale Division,'' which contained other
investments and businesses. Accordingly, there was no way to
tell how its trading business was really doing. When the credit
rating agencies asked for this information--information which
Moody's Chief Credit Officer Pamela Stumpp told Committee staff
was ``fundamental'' to a credit analysis \452\--Enron,
according to the credit analysts, told them that it did not
have that kind of detail. Enron's response appears to be either
not credible or a sign of a company in trouble. A company must
know how each of its businesses is performing in order to
monitor it. Nevertheless, even though the credit rating
agencies were allowed to ask for and receive this information
under their exemption from SEC Regulation F-D (their special
access to material information not shared with the rest of the
market), and even though they knew that Enron was very
concerned about its credit rating, the credit rating agencies
acknowledge that they did not push for the information.
According to what the credit analysts told Committee staff,
they simply accepted Enron's refusal.
---------------------------------------------------------------------------
\451\ Off Wall Street Consulting Group, Research Report Regarding
Enron Corp., May 6, 2001 at 3.
\452\ Committee staff interview with Moody's (March 8, 2002),
described at note 404 above.
---------------------------------------------------------------------------
In interviews with Committee staff, all the agencies
acknowledged that they could withdraw a rating for failure to
provide sufficient information. In the March 20 hearing, for
example, S&P's Barone said that ``if we knew . . . then what we
know now, we would have withdrawn Enron's rating for failure to
disclose proper information.'' \453\ Nevertheless, the agencies
told Committee staff in interviews that in response to Enron's
refusal to provide important information--like information
about the trading operation--they did not even raise the
possibility of withdrawing the rating, a suggestion which, if
made, might have convinced Enron to send the agencies the
information requested.\454\
---------------------------------------------------------------------------
\453\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 29.
\454\ Committee staff interviews with Fitch (March 5, 2002),
Moody's (March 8, 2002) and S&P (March 11 and 13, 2002), described at
note 404 above.
---------------------------------------------------------------------------
Similarly, and as noted above, based on what they told
Committee staff, when S&P analysts read the related-party
transactions disclosure in Enron's 2000 Form 10-K, they
assumed, without asking, that the entire footnote referred to
the Osprey and Marlin transactions. It is unclear whether the
disclosure's text is entirely consistent with this assumption,
but the analysts appear to have done nothing to verify their
beliefs. Moreover, according to what the S&P analysts said to
Committee staff in interviews, The Wall Street Journal article
did not lead them to question their assumptions. To the extent
that any of the analysts asked about the allegations in The
Wall Street Journal, they accepted the answer from the company
that a special committee would investigate, without questioning
whether the problems were so deep that they might permanently
scar Enron's future. In short, as Glenn Reynolds, Chief
Executive Officer of independent credit research firm
CreditSights, Inc., stated in his testimony before the
Committee at the March 20 hearing, ``As we look back at the
performance of the rating agencies in the case of Enron, we are
hard pressed to recall a situation where the rating agencies
held so much sway over a company and had such commanding
leverage to extract information, and yet were so ineffective at
doing so.'' \455\
---------------------------------------------------------------------------
\455\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 157 (Statement of Glenn Reynolds,
Chief Executive Officer, CreditSights, Inc.).
---------------------------------------------------------------------------
At the Committee's March 20 hearing, the credit rating
analysts--in particular Ronald Barone of S&P--stressed over and
over again that they were simply duped by Enron management, and
there was nothing they could do. When Chairman Lieberman asked
the analysts whether in retrospect, they felt they should have
asked more questions of Enron, Barone responded, ``Senator, we
rely on the audited financial statements. . . . We are not
forensic accountants, if that is the question, and we don't
have subpoena power. . . .'' \456\ Barone attached to his
written testimony what he referred to as the ``kitchen sink''
documents, which were presentations made by Enron to the credit
raters, in October 1999 and in January 2000, to convince the
agencies to improve Enron's credit rating.\457\ Barone pointed
out in his testimony that, in fact, Enron did not reveal all of
its obligations in this presentation; one example he gave was
that Enron did not disclose that it had billions of dollars in
derivative transactions that were, in substance though not in
form, loans.\458\ Committee staff asked Barone and Shipman in
interviews prior to the hearing whether they had ever asked
about Enron's portfolio of derivatives, or whether, knowing
that Enron was engaging in some rather complex transactions,
they had ever consulted with a derivatives expert at S&P to get
a more specific sense of the obligations Enron could be facing
in connection with its derivative transactions. While they
could not remember if they ever consulted with such an expert,
both Barone and Shipman acknowledged that they had never
specifically asked Enron to detail derivative transactions that
could have loan-like characteristics.\459\ Similarly, Barone
stated in his testimony that S&P was misled by Enron's failure
to provide information about the LJM partnerships.\460\
However, if he or Shipman had reviewed Enron's proxy statement,
they would have discovered these entities, and could have
inquired about them. Barone summed up his attitude about S&P's
responsibility with respect to Enron when he made the following
statement in response to a question by Senator Bunning at the
March 20 hearing: ``Senator, this was not a ratings problem.
This was a fraud problem.'' \461\
---------------------------------------------------------------------------
\456\ Id. at 29.
\457\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 87-115.
\458\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 70. On July 23, 2002, PSI held a
hearing on these transactions, with witnesses from the credit rating
agencies as well as from Citigroup and J.P. Morgan, the banks that had
facilitated the deals. The Role of Financial Institutions in Enron's
Collapse, Hearing Before the Permanent Subcommittee on Investigations,
Senate Governmental Affairs Committee, 107th Cong., S. Hrg. 107-618
(July 23, 2002) at-- (Printed Hearing Record Pending).
\459\ Committee staff interviews with S&P (March 11 and 13, 2002),
described at note 404 above.
\460\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 72.
\461\ Id. at 25.
---------------------------------------------------------------------------
Moody's took a more measured approach at the March 20
hearing. Diaz of Moody's had the following exchange in response
to a question by Senator Thompson about the related-party
transaction disclosures in Enron's 2000 10-K (which appeared in
footnote 16 to the financial statements in that filing):
LDIAZ: ``I think in looking at footnote 16, clearly what
needs to be done in those situations is try to get behind it
and try to understand a lot more of what's there. You know,
looking in hindsight at how that impacted the ultimate
confidence in the company, it's pretty clear that there were--
and from my point of view, we certainly look at a situation
where we could have dug more into and tried to get behind
that.''
LSENATOR THOMPSON: ``It would be fair to say that if you
ran across this same situation again, you would delve into it
deeper?''
LDIAZ: ``Yes sir.'' \462\
---------------------------------------------------------------------------
\462\ Id. at 16.
In addition, in his written testimony, Diaz stated that
``[g]oing forward, we are enhancing the ratings process by
putting increased focus in several areas,'' including
``corporate governance and how aggressive or conservative are
accounting practices'' at the companies Moody's is rating.\463\
---------------------------------------------------------------------------
\463\ Id. at 128.
---------------------------------------------------------------------------
Lack of Accountability. The credit rating agencies are
aware of how much their decisions can affect the fortunes of
the companies they rate (and therefore the fortunes of the
companies' investors). Nevertheless, based on the testimony of
the credit analysts at the March 20 hearing and the remarks of
the analysts in interviews with Committee staff, Committee
staff concluded that the credit analysts do not view themselves
as accountable for their actions. For example, the remarks of
S&P analysts Ronald Barone and Todd Shipman in late October and
early November about their ``confidence'' that there would be
no more surprises from Enron do not appear to be based on
anything more than assumption. In his testimony at the
Committee's March 20 hearing, Barone said that he gained the
confidence from a conversation with Enron management, but
conceded after specific questioning that management had told
him that they did not know whether other entities or special
purpose entities existed, and a special committee had just
begun an investigation.\464\ The credit rating agencies
acknowledged in interviews with Committee staff that others in
the market believe the agencies have access to more information
about companies than any other outsiders due to their market
power (their ability to downgrade) and their exemption from SEC
Regulation F-D. Despite this public expectation about their
superior level of knowledge, S&P, for example, could not cite
to Committee staff any policies to ensure that its analysts
conducted themselves responsibly in media appearances, or in
making public statements similar to those Shipman and Barone
made on CNN and in the S&P conference call (which was reported
in the press \465\).
---------------------------------------------------------------------------
\464\ Id. at 14.
\465\ Tom Fowler, ``S&P: `No More Surprises For Enron,' '' Houston
Chronicle, November 3, 2001.
---------------------------------------------------------------------------
When asked by Committee staff about accountability
concerns, the rating agencies had two responses. First, they
said that their concern for their reputation keeps them on
their toes: As S&P's Barone stated in his testimony: ``Standard
& Poor's recognition as a rating agency ultimately depends on
the credibility of its opinions with investors, importantly,
but also with bankers, financial intermediaries, and securities
traders.'' \466\ The second response, which the raters stated a
number of times in interviews with Committee staff, was that
their ratings were just opinions, protected by the First
Amendment.\467\ Fitch's general counsel referred to the letter
grades given by the credit rating agency as ``the world's
shortest editorial.'' \468\ The credit rating agencies seem to
be trying to walk a fine line between maintaining enormous
market power through both official and unofficial uses of their
ratings, and insisting that their ratings are purely their
``opinion,'' and therefore pure speech under a First Amendment
analysis. First Amendment-protected opinions about matters of
public concern can give rise to liability only when, to the
extent they convey facts, they convey them with actual
knowledge of or reckless disregard for their accuracy.\469\
This standard poses such a high barrier that it virtually
insulates the speaker from liability.
---------------------------------------------------------------------------
\466\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 60.
\467\ S&P arranged a meeting for Committee staff with Floyd Abrams,
its First Amendment counsel, who also prepared a memorandum for staff
laying out the basis for S&P's First Amendment argument.
\468\ Committee staff interview with Fitch (March 5, 2002),
described at note 404 above.
\469\ Milkovich v. Lorain Journal Co., 497 U.S. 1, 20-21 (1990)
(``where a statement of `opinion' on a matter of public concern
reasonably implies false and defamatory facts regarding public figures
or officials, [plaintiff] must show that such statements were made with
knowledge of their false implications or with reckless disregard of
their truth'').
---------------------------------------------------------------------------
Indeed, courts have extended First Amendment protections to
credit ratings, shielding the agencies from liability.\470\
Courts have even refused to require that credit rating agencies
produce records in connection with their work, citing the
``journalist's'' privilege.\471\ However, the fact that the
market seems to value the agencies' ratings mostly as a
certification (investment grade vs. non-investment grade) or as
a benchmark (the ratings triggers in agreements) and not as
information, \472\ and the fact that the law, in hundreds of
statutes and regulations, also uses their work that way, seems
to indicate that their ratings are not the equivalent of
editorials in The New York Times. The fact that the rating
agencies have received First Amendment protection for their
work should not preclude greater accountability.
---------------------------------------------------------------------------
\470\ See, e.g., County of Orange v. McGraw Hill Cos., Inc., 245
B.R. 151, 156 n. 4 (C.D. Cal. 1999) (``Standard & Poor's ratings are
speech and, absent special circumstances, are protected by the First
Amendment. In reaching this ruling, the Court assumed any First
Amendment protected speech, as a matter of public concern, would
receive the heightened protection of the actual malice standard'');
Jefferson County Sch. Dist. v. Moody's Investors Service, 175 F.3d 848
(10th Cir. 1999) (applying the Milkovich standard to a claim that the
Moody's rating of the school district's bonds was an injurious
falsehood).
\471\ See, e.g., In re Pan Am Corp., 161 B.R. 577, 581-583
(S.D.N.Y. 1993) (quashing subpoena to S&P for records of communications
with Delta Air Lines based on qualified journalist's privilege because
``S&P functions as a journalist when gathering information in
connection with its ratings process'').
\472\ See Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 143 (Statement of Jonathan Macey,
Professor, Cornell University Law School) (``Academic studies tend to
show that information in credit ratings is of marginal value at best
because the information contained in the ratings had already been
incorporated into share prices. One well-known study showed that the
ratings provided by rating agencies lagged the information contained in
securities prices by a full year.'').
---------------------------------------------------------------------------
The rating agencies, however, have escaped regulation thus
far. In his testimony at the March 20 hearing, then SEC
Commissioner Isaac Hunt stated that all three of the current
NRSROs were registered with the SEC under the Investment
Advisers Act of 1940, \473\ which prohibits fraud, imposes
fiduciary duties on advisers with respect to their advice,
requires that advisers maintain certain books and records, and
allows the SEC to examine all registered advisers to assure
compliance with the Act. According to Commissioner Hunt's
testimony, the Act would therefore require that NRSROs have an
adequate basis for their ratings.\474\ Commissioner Hunt
testified in addition that the SEC does examine NRSROs, as with
other investment advisers, approximately every 5 years. In the
course of those examinations, the SEC reviews the books,
records, and the operation of the agencies. The legal
application of the Investment Advisers Act to the credit rating
agencies, however, is in doubt. As part of the designation, the
agencies agreed to voluntarily register, but they insist that
they are not covered by the Act and that any information they
provide the SEC is given strictly on a voluntary basis, not
pursuant to the requirements of the Act. The Act, in defining
investment advisers, contains an exception for publishers,
\475\ and the credit rating agencies would argue that they fit
under that exception.\476\ To the extent that they are
correct--and the case law on this point is very favorable to
them--none of the requirements of the Investment Advisers Act
would apply to them.\477\ In any event, the SEC has never taken
enforcement action against the rating agencies based on their
ratings, whether under the Investment Advisers Act or
otherwise.
---------------------------------------------------------------------------
\473\ 15 U.S.C. 80b-1 et seq.
\474\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 136.
\475\ 15 U.S.C. Sec. 80b-2(a)(11)(D) (exempting any publisher of
``any bona fide newspaper, news magazine or business or financial
publication of general and regular circulation'' from coverage of the
Act).
\476\ They rely on Lowe v. Securities and Exchange Comm'n, 472 U.S.
181 (1985), which held that the publisher exception, in concert with
the legislative history of the Act, indicates that meaning of
``investment adviser'' cannot include those who do not provide
personalized advice directly to clients. The Court held: ``As long as
the communications between petitioners and their subscribers remain
entirely impersonal and do not develop into the kind of fiduciary,
person-to-person relationships that were discussed at length in the
legislative history of the Act and that are characteristic of
investment adviser-client relationships, we believe the publications
are, at least presumptively, within the exclusion and thus not subject
to registration under the Act.'' 472 U.S. at 210.
\477\ It is the position of the ratings agencies that they have
been providing information to the SEC over the years voluntarily, not
pursuant to an examination requirement.
---------------------------------------------------------------------------
E. Conclusions and Recommendations
Although the credit rating agencies' ratings are generally
right, when they are wrong, the consequences can be serious. In
the case of Enron, their poor performance, along with the
failures of all the other market watchdogs, has had a market-
wide effect, leading investors to wonder whether they can count
on the information upon which they may have previously relied
in making their investment decisions. It may well be the case
that most companies, particularly those with balance sheets
strong enough to have an investment grade rating, are providing
the investing public with a fairly accurate picture of their
financial state, with disclosures that are full and fair enough
to provide the credit rating agencies with the information they
need to perform their analysis. We have learned, however, that
when company officials are not honest, and their auditors are
too entrenched or conflicted to call management out on
problems, investors need someone to raise a red flag. Credit
raters, with their special access, strong market power, and
lack of conflicts, are in the perfect position to do this.
The problem is that the credit rating agencies have no
incentive to catch the few wrongdoers, no matter how huge the
consequences to the market. Duke Law School Professor Steven
Schwarcz argued in his testimony at the Committee's March 20
hearing that reputational concerns are sufficient incentive for
the credit rating agencies to be diligent in their work, and he
cited their strong track record as proof.\478\ Assuming that
most companies are honest, however, credit rating agencies will
be correct in most cases without having to go much beyond the
face of financial statements. Their limited liability and their
entrenched position of power means that they do not have to go
to additional lengths in order to expose the outlier
corporations that are not being truthful.
---------------------------------------------------------------------------
\478\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 170.
---------------------------------------------------------------------------
Under the current system, credit rating agencies arguably
act in many respects like government agencies. In the March 20
hearing, Chairman Lieberman likened the role of the rating
agencies to the Food and Drug Administration: The FDA does not
``let a drug go out on the market . . . until [it has] gone
over all sorts of investigations to guarantee it is safe, and
then doctors prescribe the drug, people use it in reliance on
that. To some extent, we have asked [the credit rating
agencies] to play . . . a similar role with regard to
corporations.'' \479\ As with drug companies and FDA approval,
corporations wishing to issue debt need ratings in most
instances. But unlike FDA, which is accountable to Congress,
the raters answer to no authority. In addition, unlike a
government agency, they profit from every transaction they
rate, thereby reaping the benefits of the capital markets
without risking any capital.
---------------------------------------------------------------------------
\479\ Id. at 30.
---------------------------------------------------------------------------
Some have suggested replacing credit ratings required in
regulation and statute with a market indicator, \480\ but no
market indicators appear to be sufficiently reliable.\481\
There have also been suggestions that the credit rating
agencies be subject to additional liability for their
actions.\482\ Other suggestions have been that government
agencies--particularly the SEC--exercise additional oversight
over the credit rating agencies' procedures and actions to
ensure diligence and thoroughness.\483\ In fact, at the March
20 hearing, then SEC Commissioner Hunt testified that the SEC
planned to ``engage in a thorough examination, which may
include hearings, to ascertain facts, conditions, practices and
other matters relating to the role of rating agencies in the
U.S. securities markets. . . . We believe it is an appropriate
time and in the public interest to re-examine the role of
rating agencies in the U.S. securities markets.'' \484\ In
addition, the Sarbanes-Oxley Act requires the SEC to conduct a
study into the role and function of credit rating agencies in
the securities market, including a consideration of any
impediments to their accurate appraisal of the financial
resources or risks of the issuers of securities that the
agencies rate.\485\
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\480\ Partnoy, note 369 above, at 705.
\481\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 144-45 (Statement of Jonathan
Macey, Professor, Cornell University Law School).
\482\ Partnoy, note 369 above, at 710-11; see also Comments of the
Investment Company Institute in the Matter of File No. S7-33-977,
Proposed Definition of Nationally Recognized Statistical Ratings
Organization, dated March 2, 1998 (``ICI NRSRO Comments'') (suggesting
that the Rule 436 exemption afforded NRSROs from liability under
Section 11 of the Securities Act of 1933 be removed). The problem with
this suggestion, of course, is that to the extent that credit ratings
are constitutionally protected by the First Amendment, there is no way
to impose additional liability in the courts beyond the applicable
actual malice standard short of a constitutional amendment.
\483\ See Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 146 (Statement of Jonathan Macey,
Professor, Cornell University Law School); ICI NRSRO Comments, at note
482 above.
\484\ Rating the Raters: Enron and the Credit Rating Agencies,
Hearing Before the Senate Governmental Affairs Committee, 107th Cong.,
S. Hrg. 107-471 (March 20, 2002) at 137.
\485\ Pub. L. No. 107-204 Sec. 702.
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The SEC has not finished this process, but Committee staff
recommends that the SEC, in consultation with other agencies
that use the NRSRO designation in their regulations--
particularly banking agencies--set conditions on the NRSRO
designation through additional regulation. Those conditions
should include imposing a set of standards and considerations
that the rating agencies must use in deriving their ratings,
such as accounting issues. In addition, the SEC should also
require a level of training for analysts working for credit
rating agencies, including training as to the information
contained in the periodic filings with the SEC and other
government agencies that oversee companies in the particular
sector each analyst is assigned to as well as training in basic
forensic accounting. The SEC should monitor the compliance with
these requirements, and in the event of a future corporate
meltdown such as Enron, the SEC should investigate to ensure
that the ratings were derived in accordance with those
standards. If the public and the government is to rely on the
ratings of these agencies, and give them legal force, then it
must ensure that they are the product of diligent and effective
analysis. Meaningful SEC oversight is the best way to ensure
such an outcome.
APPENDIX: Note 16 to Financial Statements, Enron Corp. Form 10-K for
the Year Ended December 31, 2000
16 RELATED PARTY TRANSACTIONS
In 2000 and 1999, Enron entered into transactions with
limited partnerships (the Related Party) whose general
partner's managing member is a senior officer of Enron. The
limited partners of the Related Party are unrelated to Enron.
Management believes that the terms of the transactions with the
Related Party were reasonable compared to those which could
have been negotiated with unrelated third parties.
In 2000, Enron entered into transactions with the Related
Party to hedge certain merchant investments and other assets.
As part of the transactions, Enron (i) contributed to newly-
formed entities (the Entities) assets valued at approximately
$1.2 billion, including $150 million in Enron notes payable,
3.7 million restricted shares of outstanding Enron common stock
and the right to receive up to 18.0 million shares of
outstanding Enron common stock in March 2003 (subject to
certain conditions) and (ii) transferred to the Entities assets
valued at approximately $309 million, including a $50 million
note payable and an investment in an entity that indirectly
holds warrants convertible into common stock of an Enron equity
method investee. In return, Enron received economic interests
in the Entities, $309 million in notes receivable, of which
$259 million is recorded at Enron's carryover basis of zero,
and a special distribution from the Entities in the form of
$1.2 billion in notes receivable, subject to changes in the
principal for amounts payable by Enron in connection with the
execution of additional derivative instruments. Cash in these
Entities of $172.6 million is invested in Enron demand notes.
In addition, Enron paid $123 million to purchase share-settled
options from the Entities on 21.7 million shares of Enron
common stock. The Entities paid Enron $10.7 million to
terminate the share-settled options on 14.6 million shares of
Enron common stock outstanding. In late 2000, Enron entered
into share-settled collar arrangements with the Entities on
15.4 million shares of Enron common stock. Such arrangements
will be accounted for as equity transactions when settled.
In 2000, Enron entered into derivative transactions with
the Entities with a combined notional amount of approximately
$2.1 billion to hedge certain merchant investments and other
assets. Enron's notes receivable balance was reduced by $36
million as a result of premiums owed on derivative
transactions. Enron recognized revenues of approximately $500
million related to the subsequent change in the market value of
these derivatives, which offset market value changes of certain
merchant investments and price risk management activities. In
addition, Enron recognized $44.5 million and $14.1 million of
interest income and interest expense, respectively, on the
notes receivable from and payable to the Entities.
In 1999, Enron entered into a series of transactions
involving a third party and the Related Party. The effect of
the transactions was (i) Enron and the third party amended
certain forward contracts to purchase shares of Enron common
stock, resulting in Enron having forward contracts to purchase
Enron common shares at the market price on that day, (ii) the
Related Party received 6.8 million shares of Enron common stock
subject to certain restrictions, and (iii) Enron received a
note receivable, which was repaid in December 1999, and certain
financial instruments hedging an investment held by Enron.
Enron recorded the assets received and equity issued at
estimated fair value. In connection with the transactions, the
Related Party agreed that the senior officer of Enron would
have no pecuniary interest in such Enron common shares and
would be restricted from voting on matters related to such
shares. In 2000, Enron and the Related Party entered into an
agreement to terminate certain financial instruments that had
been entered into during 1999. In connection with this
agreement, Enron received approximately 3.1 million shares of
Enron common stock held by the Related Party. A put option,
which was originally entered into in the first quarter of 2000
and gave the Related Party the right to sell shares of Enron
common stock to Enron at a strike price of $71.31 per share,
was terminated under this agreement. In return, Enron paid
approximately $26.8 million to the Related Party.
In 2000, Enron sold a portion of its dark fiber inventory
to the Related Party in exchange for $30 million cash and a $70
million note receivable that was subsequently repaid. Enron
recognized gross margin of $67 million on the sale.
In 2000, the Related Party acquired, through
securitizations, approximately $35 million of merchant
investments from Enron. In addition, Enron and the Related
Party formed partnerships in which Enron contributed cash and
assets and the Related Party contributed $17.5 million in cash.
Subsequently, Enron sold a portion of its interests in the
partnerships through securitizations. See Note 3. Also, Enron
contributed a put option to a trust in which the Related Party
and Whitewing hold equity and debt interests. At December 31,
2000, the fair value of the put option was a $36 million loss
to Enron.
In 1999, the Related Party acquired approximately $371
million, merchant assets and investments and other assets from
Enron. Enron recognized pre-tax gains of approximately $16
million related to these transactions. The Related Party also
entered into an agreement to acquire Enron's interests in an
unconsolidated equity affiliate for approximately $34 million.
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