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Although Howard Schilit wasn't covering the energy industry when Enron was allegedly performing its accounting sleight-of-hand, he was called to testify before the Senate earlier this year as a general expert on tricks of corporate accounting. Excerpts of Schilit's remarks:

Testimony of Howard M. Schilit
President and Founder
Center for Financial Research & Analysis

Prepared remarks

Senator Lieberman and your esteemed colleagues, I am pleased to appear before this Committee to describe my role as an independent financial analyst and some of the important differences between Wall Street (or “sell-side”) research and our independent boutique.

Before proceeding, I want to emphasize that my comments are based solely upon personal observations over the last decade, rather than on an comprehensive study of the Wall Street establishment or other independent research boutiques.

My organization, CFRA, has been writing research reports since 1994, warning institutional investors about companies experiencing operational deterioration or using unusual accounting practices. Our reports are published daily and distributed over our web site http://www.cfraonline.com.

We use a variety of quantitative and qualitative screens to initially select companies for review. Then, a CFRA analyst reviews the financial reports and other public documents to search for any problems. If any are found, we interview the Company management to discuss these issues. If concerns remain, we publish a report on our web site. We make no buy or sell recommendations; rather, we simply discuss the issues of concern.

Our clients are mainly institutional investors who purchase the research on a subscription basis. We are paid a fixed fee based on the number of actual users at a firm, similar to a license fee on software. Subscribers receive an e-mail each morning with a notification of the companies profiled and the reports are posted on our web site each morning at 9:00 A.M. EST.

All CFRA subscribers receive the information in the same way and at the same time. In addition, all subscribers have equal access to discuss issues with our analysts.

CFRA has a variety of strict editorial policies and ethical guidelines that protect clients’ interests and ensure CFRA employees receive no remuneration based on stock price performance of companies they profile. (I have attached our policies and guidelines.)

In short, we have no brokerage, investment banking, or money management operations. We have no conflicts-of-interest. We have one client class (those who make economic decisions based on financial disclosures). And, we have one overarching goal – to help them make the best decisions.

In contrast to our independent research boutique, Wall Street research is fraught with real or potential conflicts-of-interest.

Wall Street brokerage firms have at least two major client groups; they include companies purchasing investment banking services and institutional investors. Typically, a company needing funding will hire a brokerage firm to underwrite securities in a public offering. The brokerage firm receives a fee (generally 6 percent or higher) for this investment banking service. Shortly thereafter, the research analyst at the brokerage firm will begin coverage on this new client with a positive research report. Generally, future reports on this investment banking client will remain positive. Future investment banking fees on stock or bond offerings depend on a close relationship with the corporate client.

If CFRA, or another critic raises concerns to investors, the brokerage firm often publishes a rebuttal to show support for its investment banking client.

This shows the inherent conflict-of-interest; the brokerage firm serves both the underwriting client (the subject of the report), and the investor, who must be informed when problems arise.

The method of payment for research also differs substantially at Wall Street firms. Whereas CFRA receives a cash payment for selling subscriptions, brokerage firms are paid by investors in commission dollars. The trading volume affects the amount, the timeliness of information and the access to speak to research professionals. That is, bigger clients typically get “the first call” from institutional brokers and salesmen, while smaller clients have lesser access.

Moreover, non-institutional investors who generate no commissions often have no (or very limited) access to such research. CFRA, for example, was not permitted to purchase brokerage research from First Call (a distributor of brokerage research) because we generate no commission. They refused our offer to purchase the research for cash.

As result of the conflicts-of-interest and internal policies, Wall Street research has regularly failed to regularly warn investors about problems at companies.

Question-and-answer testimony

There's a lot wrong. ... It absolutely should be expected that the research should be an independent function, should be set up separately, customers should pay a fee for that, and the marketplace decides the value of that research...

Also I did want to comment on "Were there any signs in any of the public filings that there were problems at Enron?" -- a very logical question.

Everybody's saying "They hid from us, they lied to us, they committed a fraud." Did you read the public filings that were published at the SEC?

I spent an hour of my time last night going through every quarterly filing, proxy -- no more than an hour. I have three pages of warnings. Words like "non-cash sales." Words like "$1 billion of related party revenue."

This (stack of reports) was beginning in March of 2000. Every single quarter, there was a little blurb looking at the reported profits. For one quarter, $338 million, and $264 million of that -- a pretty material amount -- represents earnings from unconsolidated affiliates. More than two-thirds of the earnings. And it goes on and on and on.

I'm heartbroken I was not covering this company when I could have done some good. But for any analyst to say there were no warning signs in the public filings -- they could not have read the same public filings that I did.

Just looking at the most basic things that any investor could understand: if a company reports a profit of $1 billion and that same period, the company says we had negative $1.1 billion of cash received from that operation, there's got to be some warning out there. And those numbers come right from the June 2001 quarterly report.

Very often after we have found problems at a company, and the stock gets cut in half and gets cut in half again, and people ask me, "Well, has this played out," I typically tell them, a stock doesn't stop going down because it gets tired. There usually has to be some type of intervention. ... Is there some change in the business dynamic? Perhaps a new chief executive comes in, perhaps they're selling off a money-losing business. But very often...when a stock is in a long-term downdraft, it usually doesn't stop going down because it gets tired. There's usually more problems that will be coming out.

Every time I've seen an analyst go out on a limb and go against the conventional wisdom -- which is you have to be very positive on the companies that you're writing about -- that becomes a very controversial analyst. It could be a very good step if they want to leave the sell-side and go to work for a hedge fund... but if you want to move up the hierarchy in the Wall Street establishment, you don't rock the boat. That's the reason why nobody at those firms will say there's a problem at a company.