The twister hits
Jan 17th 2002, Economist

Nothing about Enron's demise was surprising; nor is what must be done

WITH each fresh turn in the Enron tale, one conclusion gets plainer. America's biggest bankruptcy was not a result merely of commercial misfortune or personal crookedness. The collapse was possible only because of flaws in the way that American capitalism has worked over the past decade. These flaws were widely known, and much discussed. But as America's economy and stockmarket boomed, few had an interest in fixing them. Presumably that will now change.

America's love affair with equities played a part in Enron's failure. The pay of senior executives and board members hangs on the performance of a company's shares—their reward for good performance aligned their interests with those of shareholders, supposedly. In practice, the alignment of interests is imperfect.

Equity-related pay schemes tempt managers to seek to boost the share price in the short term, giving them the chance to cash out their stakes, to the detriment of the company and its shareholders in the long run. Enron's managers made wide use of “special purpose entities” (SPEs), vehicles that shifted losses and debts off the company's balance sheet. The company's directors should have asked tough questions about the practice, but they did not. After all, a lot of personal wealth was at stake, for Enron's creative accounting suggested to investors that the company was more profitable and less leveraged than it really was. That kept Enron's share price up. The interests of “insiders” were thus at odds with those of outside shareholders. If managers and directors were not allowed swiftly to sell the shares they were given, then interests would be better aligned. Last year, executives sold stacks of shares even as Enron got into trouble.

Employees at lower levels fared less well. Many lost chunks of their 401(k) retirement funds, which were invested in Enron shares: an absurd risk for supposedly prudential savings schemes. Congress may now legislate to cap the proportion of a 401(k) plan that may be invested in an employer's shares.

In theory, many safeguards should stop managers boosting their share price through the use of dodgy financial numbers. Enron's audit committee appeared better qualified than most. It boasted a professor of accounting and an economist-turned-financial regulator. But several committee members faced financial conflicts of interest, generated only in part by Enron's donations to charities to which they were connected. Full disclosure of the financial interests of non-executives might help. But Robert Monks, a long-time activist for better governance, doubts that audit committees will ever attain enough of the independence of mind needed to watch over boardroom colleagues.

The rating agencies have also been criticised for failing to raise the alarm. They can demand additional financial information to rate companies' debt, but they did not probe deeply enough into the SPEs used by Enron. Leo O'Neill, head of Standard & Poor's, one such agency, asks what can you do “if you don't know what you don't know?” One answer is to read the footnotes to Enron's accounts more carefully: these mentioned, but glossed over, the SPEs. In a more justified defence of the agencies, Mr O'Neill argues that they “were never part of the euphoria surrounding Enron.” Even before the crisis hit, Standard & Poor's rated Enron barely at investment grade.

Analysts at investment banks were even worse at asking tough questions—advising clients to buy shares in Enron until the moment the firm went bust. The conflicts of interest common during the dotcom bubble appeared here too. Wall Street profited handsomely over the years from serving Enron and the trading markets it created. Investment banks did good business setting up SPEs for companies.

That Enron's collapse came so suddenly and as a surprise to all but a few insiders was due largely to the opacity of its accounts, and in particular of its use of these off-balance-sheet entities, which were notionally separate and independent. Last November, Enron announced that it would restate its annual financial statements from 1997 to 2000, resulting in a cut in cumulative profits of nearly $600m and an increase in debts of $630m. The reason, it said, was that it should have added in three off-balance-sheet entities.

Called to account

It seemed curious that Enron's auditors had not spotted this earlier: these are not trivial sums of money. In August last year an Enron employee, Sherron Watkins, wrote to her boss, Kenneth Lay, expressing her concern that “we will implode in a wave of accounting scandals.” If Ms Watkins, whose field was “corporate development”, could see the writing on the wall, surely Enron's auditors, Andersen, should have been able to read it? Ms Watkins also passed on her concerns to Andersen. The firm told lawyers hired by Mr Lay to look into Ms Watkins' claims that, although the accounting practices were “creative and aggressive”, they were not “inappropriate from a technical standpoint”.

Joseph Berardino, Andersen's chief executive, admitted to Congress last month that his firm made an “error of judgment” over one of the off-balance-sheet vehicles. But most of the restatement, he said, came from a bigger SPE, called Chewco (after Chewbacca: one Enron quirk was to name these outfits after “Star Wars” characters in the hope, perhaps, that the force might save them when gravity reasserted itself). Mr Berardino insisted that Enron had withheld information about Chewco that would have led Andersen to insist on its consolidation into the balance sheet.

Most damaging for Andersen was its admission last week that employees had disposed of a large but undetermined number of Enron-related documents. Later reports that they had done so after receiving clearance in a memo from an Andersen lawyer led Senator Joseph Lieberman, chairman of a Senate committee investigating Enron, to warn the folks at Andersen that they could be “on the other end of an indictment before this is over.” Andersen has since published the offending memo, an innocuous-looking referral to Andersen's existing policy on the retention of documents. But on January 15th, it said that a partner whom it has now sacked called an urgent meeting to organise the effort to dispose of documents after learning that Enron had received a request for information from the Securities and Exchange Commission (SEC).

Andersen, the smallest of the “big five” accounting firms, is now in deep trouble. Conceivably, Enron-related lawsuits could bankrupt it, by finding the firm liable for billions of dollars in losses. Its indemnity insurance, which it refuses to discuss, is unlikely to run to enough to cover it—and it might anyway be voided, if the firm were found guilty of criminal behaviour.

Andersen is the result of a split between the old Andersen Consulting and Arthur Andersen, a once-respected firm whose employees' solid sense of their corporate identity earned them the moniker of “androids”. This is not the first time it has found itself in trouble. Last year the SEC fined the firm $7m for approving the accounts of another Texas company, Waste Management, even though its accounting methods seemed designed to mislead investors. It also had to pay $110m to settle a lawsuit over auditing work it did for Sunbeam, a Florida consumer-products company that filed for bankruptcy.

Still, Andersen is not the only offender. This week, the SEC rebuked another of the “big five” firms, KPMG, for investing in a fund whose accounts it audited. In 2000, another giant, PricewaterhouseCoopers, was found guilty of no fewer than 8,000 violations of SEC rules covering employee shareholdings in audit clients. The infractions were minor. But they raised a question: if accountants cannot follow rules separating their financial interests from their clients, how can they be trusted to insulate their firms' corporate interests?

Conflicts of interest have become sharper as the accounting firms have transformed themselves into huge “professional-services firms”, offering clients everything from advice on information-technology systems, to legal help, tax planning and recruitment services. Andersen had revenues last year of more than $9 billion, with 85,000 employees in 84 countries. Enron was an important client. But of the $52m in fees Andersen earned from it, more than half, $27m, derived not from auditing its books, but from providing other services. It must surely be time to implement the ban on doing non-audit work for audit clients that was sought by Arthur Levitt, who stepped down as chairman of the SEC in early 2001. As Mr Levitt recalls, Andersen fiercely opposed the ban, arguing that there was no evidence that it was needed. There is now.

Mr Berardino, Andersen's boss, pins much of the blame for Enron's demise on accounting standards that “have fostered a technical, legalistic mindset that is sometimes more concerned with the form rather than the substance of what is reported.” Yet that is partly down to the accounting firms, points out Lynn Turner, head of Colorado State University's Centre for Quality Financial Reporting and a former chief accountant at the SEC. In a recent speech, he cited numerous occasions on which the “big five” had frustrated attempts to improve accounting standards, including beefing up the Financial Accounting Standards Board (FASB). The FASB can at times show that it lacks force: in the 1990s it backed off from a rule to treat stock options as an expense, in the face of heavy lobbying.

America's accounting standards become ever less meaningful, says Baruch Lev of New York University's Stern School of Business. They fail to reflect a blurring of corporate boundaries caused by the proliferation of joint ventures, outsourcing, and so on. Nor do they fully report the emergence of new sorts of assets (such as intangible assets) and liabilities (off-balance-sheet financing, derivative contracts, etc). This creates an environment in which firms can too easily manipulate their figures: facilitating what Mr Levitt says is a move towards “indecipherable” earnings.

“The profession of auditing and accounting is in crisis,” says Paul Volcker, a former chairman of the Federal Reserve who is now head of the International Accounting Standards Committee Foundation. “It is hard to make meaningful change when there is a sense that things are going reasonably well. There is a silver lining in Enron. We do now have a sense of crisis.” Fingers crossed. 


  1. What is the problem with equity-related pay schemes, according to the article?  How would you fix the problems?
  2. Does it make sense for employees to invest their retirement money in their own company's stock?  Why or why not?
  3. Is the defense of Mr. O'Neill of S&P valid?  Why or why not?
  4. What conflicts of interest did Arthur Andersen have in its dealings with Enron?  How would you ensure that such conflicts of interests don't occur?