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enron - what's the fix? by hedrick smith

June 20, 2002

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+ Introduction
A synopsis of FRONTLINE's "Bigger Than Enron."

The conviction of Arthur Andersen for document shredding gives the Bush Administration an early, if shaky, legal success in its investigation of the Enron scandal. But that does not yet address the central problem plaguing the financial markets -- Enron's playing fast and loose with its books, which gave vent to a cloud of public distrust that now hangs over America's financial markets.

To restore that trust, the first test for the Bush Administration is how aggressively it prosecutes the president's political friends at Enron -- and also, perhaps, at Arthur Andersen -- for their deceptive corporate accounting. Cynicism about the markets will persist until the public sees some high corporate officials go to jail -- not just at Enron, but elsewhere -- for putting out false financial reports. And merely prosecuting secondary figures won't be enough.

The need for reform is indisputable. After all, Enron was just the climax of an epidemic of questionable accounting and corporate ethics in the 1990s. And week by week the litany of scandal continues to grow: Global Crossing, Xerox, Tyco, Adelphia Communications, coming on the heels of Cendant, Rite Aid, Lucent, Microstrategies, Travelers, Informix, Conseco, and an avalanche of others.

Strong SEC action is needed. Harvey Pitt, President Bush's SEC chairman, has proposed a new public oversight board to monitor the quality of corporate audits -- which is something of an irony given that Pitt has spent the past decade as one of the lead attorneys for the accounting industry, helping them fight government controls and oversight. Pitt's proposal, while better than what he talked about last January, still falls short.

What's more, the SEC itself can only impose civil penalties; it cannot bring criminal charges. And so far SEC fines and even hundreds of millions of dollars in stockholder settlements have not been a sufficient deterrent to corporate financial wrongdoing, given the continuing growth of the corporate financial scandal list. Last year, for example, the SEC reprimanded and fined Arthur Andersen $7 million for what the SEC called a six-year cover-up of "massive fraud motivated by greed" at Waste Management. Andersen promised never to do it again. But Andersen was already in trouble at Enron, and there was no visible effect on its conduct.

Andersen seems to have taken its punishment over Waste Management "not much more seriously than you or I might take getting a ticket for going 35 in a 25-mile-an-hour zone," comments Richard Breeden, SEC Chairman under President Bush from 1989-93. "They just didn't use that as the wake-up call to say my God, how did this happen in our firm and we need to make changes to never let this happen again."

Accounting firms seem to take these fines and stockholder lawsuits as a cost of doing business. They are not effective deterrents to future bad behavior. To fix the Niagara of deceptive financial practices in corporate America requires much tougher action -- sending some top executives to jail, as was done to Ivan Boesky and Michael Milken for insider trading in the 1980s.

"We certainly have seen in the securities markets the clear lesson that when people stand to make millions and millions of dollars from breaking the law, that the risk of simply getting a civil judgment is not enough to deter the conduct -- the upside is too big and the downside isn't big enough," observes Mr. Breeden. "On the other hand, people understand and fear going to jail. People have to understand that if you knowingly allow millions of people to be cheated, you can end up in jail."

Ironically, better criminal enforcement is the easy part -- and the part for which the Bush Administration has shown a preference so far. The hard part is finding better ways to prevent failed audits and dishonest books -- and on that score both the Bush Administration and the Congress have failed to produce reforms sufficient to prevent more Enrons, Tycos, and Global Crossings in the future.

The dimensions of the problem are sweeping, and sweeping reforms are needed. During the 1990s, more than 700 companies -- and their auditors -- had to admit that the financial reports they gave the public were seriously flawed, if not bogus, and no one knows how many more undiscovered cases there still are. The number of corporate financial restatements leapt from 3 in 1981 to 156 in 2000 -- and every single one of the big accounting firms was implicated.

All those bad books cost investors a fortune -- "losses probably coming close to $200 billion," according to Lynn Turner, former chief accountant of the Securities and Exchange Commission. "It is real, real damage to the country." Financially, those are far bigger losses that what the country suffered on 9/11.

What is most disturbing is that all but a small fraction of this flawed accounting was legal. The accounting rules, set primarily by the accounting profession itself, are so loose and so easily evaded or manipulated by what corporate America calls "creative accounting" that it is possible to abide by the rules and still put out financial reports that mislead investors.

The root of the problem, in the eyes of former chairmen of the Securities and Exchange Commission such as Republican Roderick Hills and Democrat Arthur Levitt is a conflict of interest between tough auditing and protecting rich consulting contracts with corporate clients, something the accounting industry vehemently denies.

"You might call it creeping corruption," Mr. Hills explains. "If you are the audit partner in charge of a large account, you need to keep that account. And if you're not protected by the outside audit committee on that board, you will yield on the margin to something management wants you to do that in your heart you think you shouldn't do."

As a veteran of many corporate boards, Mr. Hills has participated in board firings of nine CEOs. "In each case," he reveals, "the auditors -- after we asked the CEO to leave -- told us of problems that were in these [financial] statements that they had not brought to the attention of the board because management didn't want them to."

When the Enron scandal was breaking last winter, the accounting industry was full of public talk about cleaning up its own act. In response to charges of conflict of interest, some firms said they would voluntarily ease off on some, though not all, of the consulting work they did for audit clients. But when Joseph Berardino, former CEO of Andersen Worldwide, proposed to reform Andersen as an audit-only firm as a model for the industry, accounting's surviving Big Four walked away from the idea.

In short, serious reform is going to have to be pushed by either Congress or the Bush Administration. In the spring, the House of Representatives passed a bill that does little to plug the legal loopholes or materially strengthen oversight. The Public Accountability Board that Bush SEC Chairman Harvey Pitt proposes would have six public members and three accountants. Its teeth, says Mr. Pitt -- who spent a decade or more serving as a lawyer for the accounting industry -- would be the power to replace poor auditors and discipline corrupt ones and to banish any firm that refuses to cooperate with a PAB investigation. But his proposal initially leaves the setting of auditing standards in the hands of the accounting industry, a process that has served corporate clients more than investors. And it stretches the imagination that a private sector PAB would actually put one of accounting's Big Four out of business for non-cooperation, when they have gotten away with defying the more powerful SEC in the past.

More effective reforms have been pushed by Sen. Paul Sarbanes (D-Md.), Chairman of the Senate Banking Committee, whose legislation would try to re-establish auditor independence by forcing changes in the way the accounting industry does business.

The Sarbanes bill, passed by his committee on June 18, would reduce auditor conflicts of interest by imposing limits on the consulting work that accounting firms can do for corporate audit clients and by requiring companies to rotate their auditors every five years. These are steps that Chairman Pitt publicly rejects and has reportedly been working privately to defeat on Capitol Hill.

Where the Sarbanes proposals falls down is in creating a public oversight board of five members, two from the accounting profession, leaving that body vulnerable to domination by the industry it is charged with regulating. And even with such compromises, the Sarbanes proposal faces the danger of being watered down further on the Senate floor and, if it passes, being gutted in conference with the House.

In short, the momentum for reform so visible in the midst of public outrage over the Enron scandal in January has largely evaporated. Reform is now bogged down in the inside politics of Capitol Hill, mostly out of public view and couched in legislative complexity that leaves millions of disillusioned investors shut out of the debate.

With the markets still depressed by public distrust, the Bush Administration could make some political hay out of the Enron debacle by aggressively pursuing criminal prosecutions of corporate executives, not only at Enron but elsewhere, and by moving forcefully to restore auditor independence by curbing the hand-in-glove collaboration of accounting firms and their corporate audit clients. But that cuts against the grain of what the Administration has said publicly.

What investors need is a political champion who will make honest accounting a high profile political issue, as Sen. John McCain (R-Ariz.) did with campaign finance reform. Otherwise, brace yourselves for more Enrons.


Hedrick Smith, correspondent for FRONTLINE's "Bigger Than Enron," is an award-winning documentary filmmaker, author, and journalist. For 26 years, he was a correspondent for The New York Times, serving in Moscow, Cairo, Saigon, Paris, and the American South, as well as in Washington, D.C., where he was the Times bureau chief and chief correspondent from 1976 to 1988. He shared a 1971 Pulitzer Prize for his work on the Pentagon Papers and won another in 1974 for his reporting from Russia and Eastern Europe. He is the author of several books, including The Russians, The Power Game: How Washington Works, The New Russians, and Rethinking America. Over the past 12 years, he has produced 14 PBS documentary programs and mini-series.

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