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The Enron Crusade: Don't Hold Your Breath

Peter Eavis

The fireball of outrage that is engulfing Enron's (ENRNQ Quote - Cramer on ENRNQ - Stock Picks) accountants is sucking oxygen from the debate about how to clean up companies' books.

Some of the proposed changes -- like the ones outlined Thursday by Securities and Exchange Commission chief Harvey Pitt -- are long overdue. But we'd be foolish to expect a rapid improvement, since the roots of the problem run very deep.

Rules can only do so much; far-reaching cultural change is much more important. Corporate executives and auditors must regain their conscience. Investors need to wisen up. And economic policymakers like the Fed should dedicate themselves to preventing the financial conditions that enable billions of dollars to be thrown at companies like Enron. Alas, only some of this can be legislated into existence. Much of it can't -- and, thus, will never happen.

In short: Expect more Enrons. Depressing? Yes. But let's not kid ourselves that a brave new squeaky-clean market will emerge from this mess. Such mindless Utopianism will only lose you money.

What Happened

This isn't to absolve the accountants. After Enron executives, they're most at fault. The revelation that Andersen destroyed many documents, perhaps even after an SEC inquiry had begun, shows that the firm was in a mode of self-preservation that bordered on suicidal.

But even before the shredding news came out, Andersen's chief, widely portrayed as a decent man trying his best to salvage his firm's reputation, appeared to be ducking the real issues.

In testimony to the House Committee on Financial Services, Andersen CEO Joseph Berardino said: "Andersen will not hide from its responsibilities." But in the rest of his testimony he did his best to throw up a smokescreen. To see why, we need to delve a little into Enron's dealings.

In the first quarter of 2001, Enron erroneously added $828 million to its equity, as the result of shady deals with a partnership called LJM2 that was headed by Enron's chief financial officer at the time, Andrew Fastow. Commenting on the first-quarter addition, Berardino said "quarterly financial statements of public companies are not subject to an audit, and we did not conduct an audit of Enron's quarterly reports." However, it was in a review of third-quarter financials, also unaudited, that Andersen decided that the equity additions were erroneous.

The most likely explanation for this volte face is that after Enron's stock started sliding and accounting murmurs began, Andersen realized that it had better do its reviews properly. Berardino also argues that an incorrect addition of $172 million to equity in 2000 "had no impact on earnings." But the $172 million contribution stemmed from a deal to protect Enron against the drop in the value of certain telecommunications and power assets. Without the deal, the declines in the asset values would almost certainly have reduced 2000 earnings, perhaps by as much as $500 million.

Just as important, Berardino hasn't explained why his firm never required Enron to improve the explanation in its financials of these key dealings with LJM2. Enron's explanatory text was almost impossible to follow, even to the most skilled market players. "It was gobbledygook. They could have made it much clearer," says James Chanos, of Kynikos Associates, a hedge fund that sells stock short. "It appears they stuck to the letter of the law, but not to the spirit."

But at least one senior Enron employee sure knew how to describe what was going on in plain English. In a now infamous warning letter about LJM2 dealings and other matters sent in August to CEO Ken Lay, a senior Enron employee, Sherron Watkins, wrote: "It sure looks to the layman on the street that we are hiding losses in a related company and will compensate the company with Enron stock in the future."

Sea Change

In this climate, it's no surprise that the SEC, the stock market cop, has decided to throw its weight behind reforms. The proposal to have more nonaccountants on an industry oversight body will do some good. But many wanted the SEC to go further and stop the Big Five from doing consulting work for companies they were also auditing, a move that the former SEC Chairman Arthur Levitt had proposed. Faced with furious opposition from the accounting trade, Levitt ended up compromising and backing off a full ban.

Harvey Pitt, the new chairman, doesn't favor this measure. And the accountants still seem against it. The American Institute of Certified Public Accountants, the auditors' trade body, hasn't shown any indication that it's moving towards Levitt's position after the Enron crisis. An AICPA spokesman didn't respond to a request for comment.

Granted, it's never good when the government moves to restructure an entire industry. But the auditors, with Levitt off their back, made little or no effort to reform and police themselves.

Come Off It

Yes, a consulting ban would bring some unintended consequences. But fears of these are being overdone. One concern is that the audit business will become poorly paid, a ghetto of sub par bean-counters. But this shouldn't happen in a big way, since Levitt wasn't asking for a blanket ban on consulting work. Accountants could pick up the customers that had to be dropped by others. Also, this theory places far too much emphasis on remuneration. Analysts working for ratings agencies like Moody's get below-market compensation -- and yet provide some of the most objective and thorough company analysis in the market. It's a question of will. Auditors got much less consulting income 20 years ago and that didn't stop them from doing a better job.

One threat that might jolt the auditors out of complacency is if Andersen is sunk by damages it pays out to settle shareholder and other lawsuits. But it'd be foolish to rely on this just yet. First, there is no sound estimate of how much Andersen might have to pay out. And outsiders have no idea of how much insurance an accountant like Andersen has. The big accounting firms have a pool, to which each contributes, to help cover losses. But the size of this pool, and each member's deductible, are among the best kept secrets in the industry. Explains Arthur Bowman, of the Bowman Accounting Report: "These are not the sort of numbers the accountants want the plaintiff's bar to know."

If the auditors can't be relied upon, why not let market players have better insight into companies' books? Pitt said this week that the SEC is going to introduce measures to improve corporate disclosure. The short-sellers have excelled recently in uncovering one set of dodgy books after another. "Fuller disclosure would be valuable," says David Rocker, who runs the Rocker Partners short-selling hedge fund. "While the majority would continue to be very casual in its analysis, the diligent would use it and proper research would get disseminated."

The Real Problem

But the real problem here is that most people don't even want extra information. Audits could be first-rate and disclosure doubled, but investors of all stripes would still chase the same overvalued companies that clutter the stock market.

Even in this recession, the S&P 500 and Nasdaq indices trade at bubble valuations. Think about it: This says hard numbers don't matter. It means that investments rest almost solely on faith, as was always the case at Enron.

These stratospheric valuations persist only because investors believe that the earnings growth will return to the prodigious rates of the late '90s. The Enron debacle showed that brokerage and mutual fund analysts do almost no independent thinking. Analyst sell recommendations make up a tiny percentage of the total. A something-for-nothing attitude has eaten away at management ethics, for which we can blame stock options.

How can this culture be tackled? Short-seller Chanos thinks criminal prosecution could help shake the investment world back to its senses. Arrests of prominent Wall Street insider traders in the '80s certainly helped cleanse the market of that pernicious practice. The same could happen if the law enforcement authorities come down hard on anyone implicated in accounting scandals. "We need to see the people involved being led out in handcuffs," says Chanos.

And there is a financial root to all this. Without a speculative boom, and a corporate credit binge, Enron could never have carried out its alchemy. For that, we have to blame the Federal Reserve under Alan Greenspan. Of course, the cops shouldn't be arresting Greenspan for a lax monetary policy, but nor should we forget that market fraud always goes up in speculative booms. In his masterpiece The Great Depression, the British economist Lionel Robbins wrote: "The big frauds almost all have been perpetrated on a rising market." As Alexander Pope wrote:

"Blest paper credit. Last and best supply
To lend corruption lighter wings to fly."