Enron Debacle Shows No Time to Rush on Solutions that may not Work

In spite of all that has been said about the Enron debacle, there are a few things left to be said. We all feel sympathy for the employees of Enron who have lost much of their retirement resources because of the precipitous decline in the market price of Enron’s common stock last year.

However some of the proposed solutions are worse than the disease to be cured. Some have stated that the solution to the Enron-type retirement fund problem is to permit the employees to sell their stock in the market, which, of course, would mean that some other poor suckers would take the losses in-stead of the employees. One person’s profit is another’s loss. It should be apparent that this is not a good answer to the problem.

The only effective and fair solution is to have comprehensive and honest disclosure of the financial condition and operations of each public company, examined and evaluated by disinterested financial analysts and advisers. It is hard to see how analysts affiliated with stock brokerage and investment banking firms ever can be free of a corrupting self-interest. People who want disinterested advice will likely have to pay for it.

Another problem with the Enron situation is that we do not know how much of the losses suffered were real (cash out of hand) verses the decline in the company’s inflated market value. Obviously, some of the losses were real, but some of them were evaporated dreams. Some of the "value" lost was not real in the first place and therefore wasn’t lost.

Enron officers and directors, if they sold their stock into the market while possessing material non-public information about their company, can be sued and forced to cough up their profits from the sale.

Absent the possession of material non-public information, the ability of management to sell stock into the market is dependent on compliance with SEC Rule 144, which requires a holding period for restricted securities and limitations on the volume and method of resale. Unless the shares had been registered with the SEC for resale by Enron for the benefit of its directors and senior management personnel, these individuals would have to hold their shares for two years before re-selling them pursuant to Rule 144.

Is it unfair that some employees could not sell while some members of management could sell? Not necessarily. If the management personnel had held their shares for years and com-plied with Rule 144 (and were not trading with the benefit of material undisclosed information), and the employees had recently received the benefit of a deposit of shares to their account, the fact that employees couldn’t sell would be consistent with the regulatory scheme of the federal securities laws that have worked very well for a long time.

We’ve not been told enough to determine what the legally required holding periods were and who had complied with them and who had not.

It’s hard to quarrel with the basic soundness of the principal of diversity in one’s retirement portfolio, but I’m not sure we should require it by law. I’ve had many friends who were heavily invested in the stock of their respective employers who have benefited enormously from that concentration. It is human nature when a bet backfires to blame the folks you bet on, rather than blaming yourself for having made what proved to be a foolish bet.

On the other hand, I think employees should be free to diversify their retirement accounts when the applicable legal holding periods have been complied with.

We also need to understand that some financial restatements are inevitable, even when the financial statements restated have been carefully and honestly constructed and audited.

There is the illusion that auditing is a precise science, and that there is one, and only one, right number for every line. An audit is not and cannot be a guarantee by the auditors that the statements they have audited are correct so long as the financials must be based in part on predictions of the out-come of future events.

Many accounting decisions are based on estimates of future events. This is true of loan-loss reserves of financial institutions and real estate companies. Any audit committee member of a real estate company who has faced the question of how much its real estate assets are "worth" on a particular day when the fiscal year ends knows how uncertain and intimidating an experience it is to make such a judgment. Subsequent events can prove such earlier decisions made care-fully and in good faith to have been incorrect nonetheless.

For better or worse, the law does not permit excessive conservatism in making such estimates any more than it permits excessive optimism. If a bank is excessively conservative in estimating its loan loss reserves, shareholders who subsequently sell their shares may successfully assert that the company had been undervalued, and that caused them to sell their stock and lose out on its subsequent appreciation.

Or like SunTrust Banks, a company may be required to restate its historical earnings because of allegedly excess conservatism in providing for loan loss reserves. I’ve long thought that the financial markets would be better served by permitting companies and their auditors in appropriate situations to state a range of possible values and to identify the factors that a reader should consider in evaluating the possible outcomes.

There are far more honest and responsible CPA’s than there are dishonest or irresponsible ones, and they, like lawyers, are often required to face down overly aggressive clients at the risk of losing a client. The great emphasis that the media and Congress have placed on consulting as a corrupting influence in the accounting profession is probably misplaced.

All professionals are subject to considerable economic pressures. Some executives threaten to move their accounting or legal work elsewhere if the company’s auditors or lawyers will not acquiesce in what the executive wants to do.

The Andersen partner in charge of the Enron audit would have been under tremendous pressure to preserve the accounting business of Enron for Andersen ($31 million in 2000) whether or not Andersen was providing consulting services as well. Not only would the partner’s compensation and role in the firm be a stake, but so would the jobs for the many other Andersen employees committed to Enron work.

Adding the consulting business to the financial pressures of retaining the auditing business obviously increases the pressure on the particular accountants overseeing this work, but separating out the consulting business won’t eliminate the financial pressures and conflicts.

The conflict is in getting paid for whatever service is rendered. The diversity of income sources provided by consulting gives accounting firms something to fall back on if they have to walk away from some of their audit work. The only real alternative to learning how to live with this pressure is to create a corps of government auditors to do the work, as in the case of national banks.

Such a change would generate its own set of problems and would be fraught with uncertainty. I believe most folks would rather work within the present system than turn the job over to the federal government.

Some of these problems we are seeing are a result of the unfortunate concentration that has developed in the accounting profession over the last 20 years; a concentration that has been acquiesced to by the Justice Department and the Federal Trade Commission.

The government should not com-pound its sins by forcing Andersen out of business, rather than preserving and reforming it as has been proposed by Paul Volcker. We have not been well served by the mergers among the major accounting firms that have left us with the Big Five, and we may be down to the Big Four before long. It’s not far from there to the Big One. Unlike what has occurred in the automotive and airlines industries, major foreign auditing firms do not appear to be on the scene to provide alternatives for American companies.

The concentration of accounting and investment banking has been highly undesirable for lawyers in Atlanta and other cities, and for the companies using their services. Such size and power often leads to arrogance and error. The people running the organizations lose contact with their principal lieutenants, and management loses the capacity to evaluate the independence and integrity of partners they do not know except as numbers on a financial statement. Financial results become the only reality in their relationships.

Rather than forcing Andersen out of business, its remains should be merged with Grant Thornton, BDO Seidman or another smaller firm, or it should be allowed to survive and to be reformed. We need more large and successful international auditing firms, not fewer.

© Daily Report 2002.