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And what is being done to prevent future Enrons? A primer on corporate watchdogs, conflicts of interest, and new reforms on the table.
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+ Reforms on the Table + Questions Investors Need to Ask + Boosting the Bubble? | |
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+ The Securities and Exchange Commission + The Financial Accounting Standards Board + The American Institute of Certified Public Accountants | |
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June 20, 2002
The astonishingly rapid failure of Enron -- at one point the nation's seventh largest company -- has led many to ask the question: Where were the watchdogs? The Securities and Exchange Commission (SEC) is charged with overseeing U.S. capital markets and is conducting an investigation into Enron's collapse, as is Congress. Both are re-examining the roles of corporate watchdogs, including corporate boards of directors, auditors, investment banks, credit rating agencies and lawyers. Some critics see the case of Enron as a consummate example of "crony capitalism," in which the ties between the company's executives and its auditors, bankers, and board were so close that no one was keeping score on Enron's aggressive accounting strategies. Others argue that corporate America has a good system of checks and balances and that Enron was a "perfect storm," a unique situation in which all the varied elements of good corporate governance and oversight failed for one reason or another.
Below is a primer on corporate watchdogs and the potential conflicts of interest they face in keeping score on companies like Enron.
Auditors
What is their responsibility?
The job of auditors is to independently examine a company's financial information and to make an assessment of its validity and accuracy. Certification by an auditor signals to the investor that the company's fiscal statements conform to generally accepted accounting principles (GAAP).
The need for auditors was recongized after the 1929 stock market crash, and the Securities Exchange Act of 1934 gave the Securities and Exchange Commission (SEC) the authority to set financial reporting and accounting standards. The SEC has delegated that franchise to the accounting industry, which since 1973 has been overseen by the Financial Accounting Standards Board (FASB), a private-sector organization. FASB is funded by the non-profit Financial Accounting Foundation (FAF), which solicits much of its funding from the accounting industry and its clients.
Potential Conflicts of Interest:
There are several potential conflicts of interest for the accounting industry. On the most basic level, critics assert that although auditing firms are charged with protecting investors' interests, they are paid by the companies that they audit. Critics believe this can make it more difficult for firms to perform tough audits because auditors may be reluctant to criticize management for fear that they will lose the client. The accounting industry maintains that this fear is groundless because an audit firm's reputation is at stake with every audit it performs.
Throughout the 1990s, as revenues from auditing fees declined, accounting firms turned to their consulting practices as a means to generate greater profits. For critics such as former SEC Chairman Arthur Levitt, the fact that auditing firms are now making the bulk of their money performing consulting services for customers including their audit clients is a clear conflict of interest. Levitt and others argue that if an accounting firm is both auditing and consulting for a client, it loses its independence -- accountants may be reluctant to perform a tough audit on the client if they fear losing the revenues from their consulting deal. Another problem is that accounting firms have in the past tied auditors' compensation to their cross-selling of auditing and consulting services to a client. Levitt and others call for the separation of auditing and consulting functions within auditing firms, and for an independent oversight board to govern the industry. The industry originally argued that there was no conflict of interest in the combination of auditing and consulting functions, and bristled at the idea of regulation. As former Andersen CEO Joseph Berardino told FRONTLINE, "I do believe the market is a better place than the government in deciding how the market should be formed." However, in the fallout from the Enron collapse, four out of the Big Five accounting firms embraced at least some separation of auditing and consulting -- only Deloitte & Touche has yet to take a position on the issue.
A second source of conflicts of interest related to auditing is that the industry is largely self-policing. Standards are set by the FASB, which is funded in part by the industry. Although state boards and the SEC have disciplinary authority to investigate accounting fraud, they are often slow-moving because they lack the resources necessary to vigorously pursue many investigations. A Washington Post analysis of disciplinary actions against accountants during the 1990s found that "when things go wrong, accountants face little public accountability." The American Institute of Certified Public Accountants (AICPA), the industry's professional organization with over 330,000 members, has a Professional Ethics Division which is responsible for disciplinary action. However, the Washington Post analysis found that, "Even when the AICPA determined that accountants sanctioned by the SEC had committed violations, it closed the vast majority of ethics cases without disciplinary action or public disclosure."
Another potential conflict of interest for auditors that was evidenced in the collapse of Enron is the "revolving door," or the tendency for auditors take jobs with companies they audit. The halls of Enron were filled with many former Arthur Andersen employees. The SEC has warned that this potential can affect the motivation of auditors, who are hired to be professional skeptics, but may be reluctant to offend a potential employer.
Read about accounting reforms currently on the table.
Boards of Directors
What are their responsibilities?
The ultimate responsibility of corporate management is to maintain the interests of the company's owners -- its shareholders. Much of this rests on the shoulders of the company's board of directors, who are supposed to be the independent guardians of shareholder interests. The board of directors hires company management, and its audit committee signs off on the work of the company's auditors.
Potential Conflicts of Interest:
In recent years, executives' compensation packages have included large grants of stock options -- often worth hundreds of millions of dollars -- making them ever more sensitive to the short-term performance of the company's stock. Granting stock options to executives was intended to give them a greater stake in overall company performance, but as the stock market soared in the 1990s, many companies used the promise of options -- and the potential for enormous short-term gains -- to lure both executives and directors.
Although the company's board of directors is supposed to represent the interests of shareholders, some charge that in recent years they either have been asleep at the wheel or have been seduced by company management. Critics charge that sitting on a corporate board has turned into a lucrative venture, with directors receiving consulting fees, sales contracts, donations to their favorite charities, and other assorted side deals that have the potential to compromise their objectivity and make them beholden to management, rather than the other way around. The critics propose that company boards need to be made up of more independent directors without ties to the company, and that director compensation be restricted solely to directors' fees.
Read about proposed corporate governance reforms.
Investment Banks
What are their responsibilities?
Investment banks are built upon a potential conflict of interest in that they serve two very different and sometimes competing functions. One element of their business is to help a company raise funds through issuing stock or bonds, assisting in mergers and acquisitions, or performing other financial services. Their other function is to provide independent investment advice to investors. For investment banks, the interests of their banking clients -- who want to keep the stock price as high as possible -- differ very much from the interests of investors, who want to buy stocks as cheaply as possible, and often rely on the recommendations of the investment bank's research analysts. Traditionally, banks are supposed to maintain a "Chinese wall" between the banking and analyst divisions to keep potential conflicts of interest at bay.
Potential Conflicts of Interest:
Critics charge that during the 1990s bull market, the "Chinese wall" did not exist and that the analyst and banking divisions were anything but independent. Analysts were under tremendous pressure to stay bullish not only from their banking colleagues, but also from companies whose stock they covered, and even large institutional clients who held large amounts of stock. During the stock market bubble, "sell" ratings made up around 1 percent of analyst recommendations; they currently make up less than 2 percent. In his investigation into whether investment banks fraudulently promoted stocks in which they had an investment banking interest, New York State Attorney General Eliot Spitzer charged that the analysts' compensation was directly tied to how much banking business they brought in or maintained.
On the banking side, critics charge that the investment bankers were seduced by the potential for short-term profits to participate in schemes such as Enron's off-the-books partnerships. Enron's investment banks, including Credit Suisse First Boston, Citigroup and JP Morgan Chase, were involved in designing the structure of these hidden partnerships, and then made money from investment in them. The banks not only made money from their investments in Enron stock -- which continued to be pumped up by analyst "buy ratings" -- but also from underwriting fees.
Read more about analyst conflicts from FRONTLINE's January 2002 report "Dot Con."
Read more about Wall Street reforms.
Credit Rating Agencies
What are their responsibilities?
For almost a century, credit rating agencies (also known as bond rating agencies) have published research and opinions on the creditworthiness of companies, governments, and other entities that issue securities. Their importance has grown dramatically over the past few decades, as the increase in the number of issuers and the globalization of financial markets has caused investors to rely more heavily on credit ratings. Ratings are also critical because they determine the interest rates at which the issuer pays its debt.
Although credit rating agencies are not regulated, since 1975 they have had to meet SEC standards to become accredited as "Nationally Recognized Statistical Ranking Organizations" (NRSROs). The three major credit rating agencies are Standard & Poor's, Moody's Investors Service and Fitch Ratings. Although each agency uses a different grading system, they all indicate whether a firm is "investment grade," meaning it is unlikely to default on its debt, or "junk" status.
Potential Conflicts of Interest:
An potential conflict of interest exists in the way the credit rating agencies are paid. The issuing company that is applying for the rating pays a fee, and the industry has acknowledged that some companies use this to pressure the agencies for a higher rating. However the industry argues that the agencies can and do resist this pressure because their reputations are at stake.
All three major credit rating agencies downgraded Enron's debt to junk status on November 28, 2001, and the company filed for bankruptcy five days later. Critics argue that the agencies were unduly slow to act. The agencies have responded that they rely on information provided to them by the companies themselves, and they wouldn't necessarily know if they have been provided with fraudulent information. Some have suggested that the agencies should act more quickly to warn investors. However others caution that this may cause more harm than good, as a downgrade in credit rating can worsen a company's situation by triggering payments to creditors or forcing large pension and mutual funds, (who are mandated to own only high-rated securities) to sell.
Lawyers
What are their responsibilities?
Companies hire outside law firms to provide them with legal advice. The lawyers have a professional obligation to act in the company's best interest and to maintain client confidentiality.
Potential Conflicts of Interest:
Critics argue that a conflict of interest exists because lawyers, who are paid by the company, may be inclined to overlook or overreach to justify aggressive management actions. In Enron's case, critics have charged that Vinson & Elkins, the company's outside counsel, failed by assisting management to set up and approve Enron's controversial off-the-books partnership structure. The report of Enron's own internal investigation found that "Vinson & Elkins should have brought a stronger, more objective, and more critical voice to the disclosure process." Lawyers argue that they are required to keep client confidentiality, and therefore cannot publicly blow the whistle on a client. In the case of Enron, Vinson & Elkins insists it has done nothing wrong, and that its lawyers made judgment calls based on incomplete information.
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