[Congressional Record Volume 148, Number 66 (Tuesday, May 21, 2002)]
[Senate]
[Pages S4619-S4621]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]




              FALLOUT FROM ENRON: LESSONS AND CONSEQUENCES

 Mr. HOLLINGS. Mr. President, when I was chairman of the Senate 
Budget Committee I worked closely with Henry Kaufman, who has, in my 
judgment, the most respected opinion on the economy. We can all benefit 
from his views, and I encourage my colleagues to read this speech that 
he gave last month to the Boston Economic Club, entitled ``The Fallout 
from Enron: Lessons and Consequences.''
  I ask that the speech be printed in the Record.
  The speech follows.

 The Fallout From Enron: Lessons and Consequences--An Address by Henry 
 Kaufman, President, Henry Kaufman & Co., Inc. to the Boston Economic 
                          Club, April 3, 2002

       Today I would like to talk about an event that has rocked 
     the financial community: the collapse of the Enron 
     Corporation. Much has been said and written about Enron in 
     recent weeks, but it seems to me that too little attention 
     has been paid to either the underlying issues posed by the 
     demise of the Enron Corporation, or to the likely 
     consequences of this failure for financial markets.
       Not very long ago, Enron was widely heralded in the 
     business and financial community for its spectacular growth, 
     its innovative achievements, and its future potential. All of 
     that changed suddenly and dramatically late last year. Since 
     then, many pundits have pointed the finger of blame at Arthur 
     Andersen. But it would be wrong to conclude that Enron's 
     failure stemmed chiefly from the accounting shortcomings of 
     its outside auditors. To be sure, Andersen probably was 
     derelict in carrying out its responsibilities. No accounting 
     firm should have the kind of intimate and conflicting 
     relationship that Andersen had with Enron. Auditing and 
     concurrent consulting arrangements with clients just don't 
     mix, for they pose very real conflicts of interest that 
     compromise objectivity and independence.
       Even so, I am not convinced that a complete dismantling of 
     Arthur Andersen would serve the larger interests of all 
     stakeholders. To be sure, any senior officers and managers at 
     Andersen found to have compromised sound accounting standards 
     should be fired. But from a social perspective the thousands 
     of Andersen employees who were innocent of high-level 
     misdeeds do not deserve to be displaced.
       The issue here is even more complicated. On the one hand, 
     dismantling Andersen would push forward by a giant step the 
     concentration in the accounting business that already is 
     quite high. On the other hand, no business organization 
     should be considered to be too-big-to-fail. Otherwise, 
     competition, which should be the market equalizer, will be 
     distorted. In addition to these considerations is the fact 
     that focusing on Andersen simply deflects the spotlight away 
     from the misdeeds of Enron itself. It offers Enron's 
     officials and all the others involved in the Enron 
     relationship, from the private sector to people in 
     government, a convenient scapegoat, and increases the 
     likelihood that we will fail to learn important lessons form 
     the energy trader's debacle. That would be very unfortunate.
       The failure of Enron is a drama with many dimensions. It 
     encapsulates a remarkable number of the kind of misbehaviors, 
     shortcomings, and excesses that have plagued business and 
     financial life in the last few decades. Even if we look back 
     over financial crises in the half-century since World War II, 
     it is difficult to find one with as many salient elements as 
     the Enron failure.
       Consider, for example, the volatile decade of the 1970s. 
     The calamities began in 1970, with the staggering collapse of 
     the Penn Central Railroad. The Pennsy was derailed by its 
     excessive short-term borrowing, mainly in the form of 
     commercial paper, supported by weak earnings. Later on, the 
     Hunt brothers succeeded in cornering the silver market, but 
     financed their manipulations with heavy short-term 
     borrowings. Many of their lenders used silver as collateral, 
     which led to a massive sell-off in the silver market when the 
     hunts exhausted their borrowing capacity. Then there were the 
     oil crises of the 1970s, which set off a crippling around of 
     defaults among key Latin American nations that had borrowed 
     heavily from large money market banks. Because these banks 
     had failed to exercise prudent credit judgment, the financial 
     pressure of the oil shocks plunged debtors and creditors 
     alike into serious trouble.
       The 1980s had its share of financial excesses. The decade's 
     economic boom had been fed in large measure by the liberal 
     lending policies of banks--especially savings and loan 
     associations--and by the massive leveraging of many 
     corporations through junk bond financing. These financial 
     splurges later made it initially difficult to jumpstart the 
     economic recovery in the early 1990s.
       As for the 1990s: the serious financial strains in Mexico 
     and in several Asian countries, as well as the recent debt 
     default of Argentina--all remain fresh in our memories. Then, 
     as the decade drew to a close, the financial world was rocked 
     by a financial debacle that threatened the very viability of 
     key money market institutions. I am referring here, of 
     course, to the dramatic fall of Long Term Capital Management 
     in late 1998. Enron's collapse, however, did not pose a 
     systemic risk to the financial system the way LTCM's 
     failure did, although some of Enron's senior managers and 
     creditors have suggested as much during their negotiations 
     with government officials. To their credit, regulators and 
     central bankers did not step in to rescue the faltering 
     energy giant from its own misdeeds.
       Which brings us back to the lessons to be derived from the 
     Enron case. It seems to me that Enron--by bringing together a 
     range of issues and problems that have plagued the U.S. 
     financial system for decades--raises a host of questions that 
     we simply must address:
       How effectively do boards of directors discharge their 
     responsibilities?
       What are the inadequacies of senior managers?
       Are lenders conducting effective due diligence?
       Are sell-side analysts objective in their analysis, or are 
     they compromised?
       Should employees be permitted to invest a high portion of 
     their pensions in the equity of the corporations that employ 
     them?
       Is official oversight adequate?
       Can elected officials be objective in dealing with 
     financial excesses given that they may be conflicted by 
     contributions?
       Should the public accounting firm serve a client a both an 
     auditor and a consultant?
       These vexing questions lie at the heart of the Enron 
     debacle. To a large extent, they point to a fundamental 
     problem that has been festering for some time, namely, the 
     separation of corporate ownership and control. This problem 
     has become more acute in recent decades because of structural 
     changes in finance and investments. But this issue hardly is 
     new. In fact, it is a symptom of advanced industrial 
     capitalism, in which firms become too large to be owned and 
     managed by individuals or even wealthy families.
       One of the most penetrating critiques of the concentration 
     of corporate control appeared back in 1932, when Adolf Berle, 
     a law professor and reformer, and economist Gardiner Means 
     published their landmark book, The Modern Corporation and 
     Private Property. As Berle and Means noted vividly:
       ``It has often been said that the owner of a horse is 
     responsible. If the horse lives he must feed it. If the horse 
     dies he must bury it. No such responsibility attaches to a 
     share of stock. The owner is practically powerless through 
     his own efforts to affect the underlying property. The 
     spiritual values that formerly went with ownership have been 
     separated from it. . . . [T]he responsibility and the 
     substance which have been an integral part of ownership in 
     the past are being transferred to a separate group in whose 
     hands lies control.''
       In the financial markets of the last few decades, this 
     problem has become more acute with the rise of hostile 
     takovers, leveraged buyouts, golden parachutes, green mail, 
     and many other financial innovations that are associated with 
     corporate control. Many corporate raiders have become instant 
     celebrities.
       At the same time, there have been some significant changes 
     in the role that senior managers play within the corporation. 
     In recent years, many are given incentives that encourage 
     them to strive to achieve near-term objectives through a 
     variety of compensation schemes. Rarely is management 
     actually penalized for failing to achieve their objectives. 
     Their cash bonuses may be reduced, but they still are 
     entitled to stock options. If the price of the company's 
     stock is down, many firms in the past lowered the exercise 
     price of the outstanding options. More recently, many 
     corporations simply issue more options at the lower 
     prevailing price level. The gatekeepers for many of the 
     compensation awards are outside consultants who rarely 
     exercise strong control over the compensation process. Very 
     often they merely codify what others are doing in the 
     industry.
       For their part, equity investors rarely are involved in the 
     affairs of a corporation. Indeed, portfolio practices today 
     have a short-term fuse. Portfolio performance is measured 
     over very short-term horizons--monthly, quarterly, or at most 
     yearly. Underperformance is penalized very quickly. Today, 
     day trades and portfolio shifts based on the price momentum 
     of the stock are commonplace. Institutional investors now

[[Page S4620]]

     hold a majority of outstanding stocks, but they rarely want 
     to be involved in their portfolio companies. Instead, a novel 
     but powerful alliance often exists between the highest bidder 
     in a corporate takeover and many of its institutional 
     shareholders. Thus, stockholders are largely temporarily 
     holders of a certificate that legally is called ``equity.''
       This is clearly demonstrated by the huge increase in the 
     turnover of the stocks listed on the New York Stock Exchange. 
     As shown in the accompanying Figure 1, the turnover of these 
     stocks has escalated sharply over the last forty years--from 
     an average of 20% from 1960 to 1980, to 75% times in the 
     1990s, with last year's average reaching 94%. Only a few 
     large investors, such as Warren Buffett, truly are involved 
     as stockholders. In today's financial marketplace, they are a 
     rare breed.
       Because corporate control typically rests in the hands of 
     senior managers, they and directors assume responsibilities 
     that are difficult to fill in the current structure of the 
     marketplace. Let me try to explain what I mean here by 
     referring to the management of large financial institutions, 
     where I spent a good part of my career. And much of what I 
     have to say in this regard is applicable to the problems of 
     Enron.
       I first realized the enormity of the challenge of managing 
     large financial institutions when I joined Salomon's board 
     following our merger with Phibro in 1981. The outside members 
     of the board brought diverse business backgrounds to the 
     table. With the exception of Maurice ``Hank'' Greenberg, none 
     had strong first-hand experience in a major financial 
     institution. How, then, could they possibly understand, among 
     other things: the magnitude of risk taking at Salomon, the 
     dynamics of the matched book of securities lending, the true 
     extent to which the firm was leveraging its capital, the 
     credit risk in a large heterogeneous book of assets, the 
     effectiveness of operating management in enforcing trading 
     disciplines, or the amount of capital that was allocated to 
     the various activities of the firm and the rates of return on 
     this capital on a risk-adjusted basis? Compounding the 
     problem, the formal reports prepared for the board were 
     neither comprehensive enough nor detailed enough to educate 
     the outside directors about the diversity and complexity of 
     our operations.
       Today, this problem is magnified as firms extend their 
     global reach and their portfolio of activities. In recent 
     years, quite a few major U.S. financial institutions have 
     become truly international in scope. They underwrite, trade 
     currencies, stocks, and bonds, and manage the portfolios and 
     securities of industrial corporations and emerging nations. 
     Some of the largest institutions contain in their holding 
     company structures not only banks but also mutual funds, 
     insurance companies, securities firms, finance companies, and 
     real estate affiliates.
       The outside directors on the boards of such firms are at a 
     major disadvantage when trying to assess the institution's 
     performance. They must rely heavily on the veracity and 
     competency of senior managers, who in turn are responsible 
     for overseeing a dazzling array of intricate risks undertaken 
     by specialized, lower-level personnel working throughout the 
     firm's wide-flung units. Indeed the senior managers of large 
     institutions are beholden to the veracity of middle managers, 
     who themselves are highly motivated to take risks through a 
     variety of profit compensation formulas. It is easy for gaps 
     in management control to open up between these two groups.
       Unfortunately, the accounting profession has been of little 
     help to outside board members. Few audit reports truly 
     reflect a firm's range of risk taking. Reports on assets and 
     liabilities would be far more meaningful if they were shown 
     in gross terms instead of net figures. The off-balance-sheet 
     activities most often cited in footnotes should be integrated 
     into reports to reveal the total flow of activities and 
     liabilities. Unfortunately, when the FASB proposes 
     conservative accounting rules, operating managers generally 
     oppose them. This is because such rules tend to reduce stated 
     profits and encourage conservative lending and investing 
     policies, thus infringing on the stated profits. But managers 
     should recognize that such rules, over the long run, will 
     strengthen their institution's credit quality.
       What often is missing for new directors is an intensive 
     orientation program. Large financial institutions are very 
     complex. As I noted earlier, they engage in a wide range of 
     activities--traditional banking, underwriting and trading of 
     securities, insurance, risk arbitrage, financial derivatives 
     from the simple to the complex, and domestic and foreign 
     transactions. The new directors should be given a detailed 
     analysis of the institution's accounting procedures. They 
     should be educated about exactly the kind of activities that 
     Enron directors failed to appreciate: (1) transactions with 
     affiliated companies, (2) transfer of assets/debts to 
     special-purpose entities in order to achieve ``off balance 
     sheet'' treatment; (3) related-party and insider 
     transactions; (4) aggressive use of restructuring changes and 
     acquisition reserves; and (5) aggressive derivative trading 
     and use of exotic derivatives; and (6) aggressive revenue 
     recognition policies.
       Directors of financial institutions also should be 
     familiarized with their institution's quantitative risk 
     analysis techniques. Indeed, the risk analysis group should 
     be independent of the trading and underwriting department. It 
     should be well compensated and have reporting 
     responsibilities to the chief executive, to the chief 
     operating officer, and to the board of directors itself. As 
     part of the orientation process, new directors should be 
     required to meet with members of the official supervisory 
     agencies such as the Federal Reserve, the Comptroller of the 
     Currency, and the Securities and Exchange Commission, all 
     whom should explain what these agencies require from the 
     institution. Legal counsel should also meet with new 
     directors to explain their responsibilities and liabilities 
     from a legal perspective.
       But this kind of orientation process alone is not enough to 
     achieve effective board oversight. Board meetings should be 
     allotted more time. Directors should be given more detailed 
     information than highly sanitized and summarized financial 
     information. Board expertise in accounting, quantitative risk 
     analysis, and information technology will become more and 
     more essential in our complex world of finance.
       To be sure, the primary task of boards is to define 
     strategy and set policy, to represent the interests of the 
     shareholders and creditors, not to operate the institution. 
     But unless boards devote enough time to handle their 
     responsibilities, the financial industry will suffer even 
     more upheavals, forcing government to step in to clean up 
     messes--and, increasingly, to regulate and control.
       I want to turn now to the question, ``Can sell-side 
     research be objective?'' As many of you here know, when I was 
     at Salomon I managed for many years a large research group 
     that grew to more than 450 professionals by the time I 
     left in 1988. In formulating my own forecasts over those 
     many years, I was never urged to modify my views to 
     confirm with the immediate underwriting or trading 
     activities of the firm, and I know of no researcher in my 
     department who was coerced to change his analytical 
     conclusion.
       To be sure, there were occasional complaints from trading 
     and underwriting desks because of one or another view I 
     expressed publicly (usually in written form); but as head of 
     research, I was in a unique position to fend off any 
     criticism. I was a senior partner and a member of the firm's 
     Executive Committee, where no member ever asked that research 
     accommodate the underwriting or trading activity.
       In recent decades, however, the objectivity of sell-side 
     research has been compromised more and more. One obvious 
     result is that it is hard to find negative reports these 
     days. Few, for instance, warned of the speculative bubble in 
     the high tech industry. Many analysts wrote glowingly about 
     companies with no earnings, high cash burn rates, and shares 
     selling at high prices relative to sales volume and distant 
     profit prospects. In place of rigorous analyses of firms and 
     industries, one usually saw reports that parroted the views 
     of corporate management and that of historical evaluation 
     norms.
       And the scope of the problem is vast. Public attention is 
     most focused on the role that sell-side analysts play in 
     attracting new issues of securities. But very few, if any, 
     seem concerned about the potential for the sell-side 
     institution to front-run trading positions on the basis of 
     soon-to-be-released research reports. The fact is, traders 
     typically have many opportunities in their conversations with 
     equity analysts to ferret out a change in the analyst's view 
     or to learn of the timing of upcoming press releases.
       I believe that these problems facing the sell-side analyst 
     can at best be mitigated. To begin with, my experience 
     strongly suggests that the head of research should be a 
     member of senior management. This would establish his 
     authority to deal with research issues at the highest level. 
     Of course, I agree with the suggestion that the relationship 
     of the sell-side institution with the company being analyzed 
     should be stated in the report in bold letters. But it would 
     also be helpful if the analyst stated the performance of the 
     company and the price movement of the stock since the last 
     report, and drew explicit conclusions.
       The logical solution to this conflict is for sell-side 
     institutions to provide no research reports to clients. 
     Research would serve only an in-house function by providing 
     analyses that would help the institution assess the merits of 
     the securities it is underwriting and trading. Institutional 
     investors and independent research firms would then fill the 
     gap. This method presumably would lower the cost of research 
     at sell-side firms, which in turn would lower trading and 
     underwriting costs and offset a healthy portion of the 
     increased research costs on the buy side.
       Let me also comment briefly on another matter raised by the 
     Enron debacle. Should employees be required to limit their 
     employee retirement investments in the stock of their 
     company? Considering the losses suffered by the Enron 
     employees, the tendency is to respond positively. There is, 
     however, no simple quantitative rule that will be an 
     equitable solution for all employees. They possess vast 
     differences in ages, compensations, personal 
     responsibilities, health, and person net worth. What 
     government regulation can do justice to all of these factors? 
     The alternative solution is for the employer to provide 
     investment counseling where these characteristics are 
     reviewed and discussed before the employee decides on the 
     size of the investment to be made in the shares of the 
     corporation.
       While many of the consequences of the Enron's demise 
     already are manifest in the market, it seems to me that the 
     most important one is really unpredictable. This is

[[Page S4621]]

     whether more ``Enrons'' will surface in the near future. If 
     they do, market participants will pull away from equity 
     markets and high yield bonds, because new doubts will be 
     raised about the quality of earnings and the accuracy of 
     other reported financial information.
       But already we can see other repercussions from Enron's 
     fall quite clearly. In the securities industry, merger 
     activity has slowed and--by the standards of recent years--
     will remain at a low volume for the foreseeable future. No 
     conglomerate that is on the brink of going below a credit 
     rating of ``below investment trade'' will be able to gain 
     ready access to funds for sometime to come. And while initial 
     public offerings of stock are trickling into the market 
     again, I think we have seen the end of the kind of huge 
     speculative offerings that have been fairly common in recent 
     years. Meanwhile, financial institutions, with lower near-
     term profit margins, will be encouraged to shed more 
     overhead. Research analysts will be particularly vulnerable 
     if institutions cannot use them to help market new issues and 
     trading positions.
       For business corporations, financing costs are rising. This 
     began last year when corporations issued a huge volume of 
     bonds and reduced short-term debt, mainly outstanding 
     commercial paper. In doing so, they paid off lower-cost debt 
     and increased higher-cost debt. The financial problems of 
     Enron and of a handful of other companies late last year has 
     inspired commercial paper investors to become more 
     discerning, thereby forcing corporate issuers to activate 
     bank lines or new bond issuance to pay off maturing paper. 
     The paper market is now virtually closed to all issuers below 
     the top credit rating.
       The liquidation of outstanding commercial paper held by 
     nonfinancial corporations has taken place on an unprecedented 
     scale (see Figure 2). Since 2000, it has declined by $175 
     billion, or a remarkable 49%. This trend has reduced 
     commercial paper to levels that were outstanding in 1997. 
     Moreover, this $175 billion shift in borrowing probably has 
     boosted corporate financing costs by anywhere from $6 billion 
     to $8 billion. Financing costs probably also will rise, as 
     banks raise their fees for back-up lines of credit, although 
     these lines have an uncertain value. On the one hand, they do 
     provide liquidity for the corporate issuer of paper when 
     investors want their money. On the other hand, the runoff of 
     paper tends to accelerate when market participants become 
     aware of the utilization of the bank line.
       While creditors generally will increase their alertness to 
     corporate credit quality as a result of Enron, credit rating 
     agencies surely will intensify the scope of their work and 
     the speed of their responsiveness to changing corporate 
     credit conditions. Already, we hear of the likely issuance of 
     corporate liquidity ratings by the ratings agencies. This 
     closer scrutiny will occur on top of another year in which 
     more corporate credit ratings will be lowered rather than 
     raised.
       Yet another likely outcome from the Enron Episode is 
     improved accounting standards. This will lower reported 
     corporate profits in the short term, but the more 
     conservative profit data will enhance investor confidence in 
     the long run. Let us also hope that there may be an effort to 
     put some of the off-balance-sheet financing onto the balance 
     sheet. If so, the corporate debt data that I spoke about 
     earlier will look worse--but again, the long-term effect for 
     investors will be positive.
       Incidentally, two other costs not related to financing 
     costs are likely to rise as a consequence of Enron's 
     travails. These are audit fees and the cost of liability 
     insurance for directors and officers.
       Of course, all of these costs could be more than offset 
     through a sharp increase in corporate profits. I suspect that 
     this is unlikely. Business does not have pricing power. 
     Excess capacity is high here and around the world. 
     Unfortunately, Enron unraveled at a time when the general 
     financial condition of nonfinancial corporations was probably 
     the worst--for the end of a recession and the start of a new 
     economic recovery--for the entire post-World War II period. 
     From 1995 to 2001, the equity position (retained earnings 
     plus new issuance or minus retirement of stock) of non-
     financial corporations has contracted by $423 billion, while 
     net debt has increased by $2.3 trillion in the same period. 
     Indeed, this exceeded the debt-leveraging binge in the 1984-
     90 period when net equity contracted by $457 billion and debt 
     rose by $1.3 trillion. Due to time constraint, the chart 
     can't be printed in the Record. (See table.)
       The combination of the cyclically weak financial position 
     of corporations, moderate profit recovery, and closer 
     scrutiny of corporate activity by management, auditors, 
     creditors, rating agencies, and officially supervisory 
     agencies will--in the near term--inhibit corporate activity, 
     especially capital expenditures. Thus, once the current 
     inventory restocking ends a few months from now, the economic 
     recovery will moderate significantly.
       In short, there are likely to be some difficult adjustments 
     in the near-term horizon, several of them a direct result of 
     Enron's wayward ways. But all would be a modest price to pay 
     for a return to more reasonable and responsible conduct in 
     business and financial markets.

                     FIGURE 3.--NET CHANGE IN EQUITY BOOK VALUE AND IN DEBT U.S. NONFARM NONFINANCIAL CORPORATE BUSINESS, 1982-2001
                                                                [In billions of dollars]
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                              1982-83         1984-90         1991-94         1995-99          2000            2001
--------------------------------------------------------------------------------------------------------------------------------------------------------
Pre-Tax Profits.........................................         $291.4        $1,446.1        $1,163.5        $2,303.8          $502.2          $379.3
                                                         ===============================================================================================
Less:
    Taxes...............................................          105.6           606.7           409.0           768.4           186.0           141.8
    Dividends...........................................          116.9           589.3           565.0         1,074.8           267.3           302.7
Plus:
    IVA.................................................          (19.1)          (66.3)          (14.5)            8.8           (12.4)            4.4
    Net New Equity......................................           21.9          (640.7)           21.7          (652.7)         (159.7)          (55.7)
                                                         -----------------------------------------------------------------------------------------------
Net Change In Equity....................................           71.7           456.9           196.7          (183.3)         (123.2)         (116.5)
                                                         ===============================================================================================
Net Increase In Debt....................................          186.1         1,274.1           129.9         1,547.6           429.1           267.9
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: Federal Reserve Board, Flow of Funds.



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