Mr. Chairman and members of the Committee:
I am pleased to be invited here to add my thoughts on Enron to the many outstanding presentations you have already received, including my distinguished friend Chuck Bowsher.
My experience that may be relevant to the questions raised by Enron's disastrous failure include:
· Chairman of an international accounting firm in troubled times;
· Chief Financial Officer of a major international copper producer in troubled times;
· Dean of a major Business School in troubled times;
· Chairman of the FDIC and RTC in very troubled times; and
· Chief Business Commentator on CNBC 10 years in both good and troubled times.
There is no doubt that Enron's failure has created troubled times for the accounting profession and securities markets looking for the causes of failure and its accompanying financial losses, as this committee knows is not a simple task. The changes that are needed to try to avoid such costly events in the future will be numerous and unfortunately complicated.
I believe we still have more to learn about Enron (and related activities), but it seems more clear each day, that Enron failed because it held itself out to be a trading company designed to hedge risk and make profits on trading, when, in fact, it turned out to be a company taking huge risks speculating in many volatile markets, including some that it was pioneering. When the market prices moved against the exposed underlying position, the company failed. Not as has been stated, because of a bank run, but because of huge losses that finally became visible. Enron's hedges proved to be ineffective because they were with Enron's "other pocket" related companies for which Enron was ultimately financially responsible. Further, the profits were reported on a market-to-market basis for future contracts for which there was no real market. Thus profit was dependent on future market prices determined by the company as the largest "market maker" in the field. Using optimistic forecasts, the company was anticipating earning profits based on estimates of future prices, when, in fact, these were not determinable. While accounting rules require market to market, there has to be a market for them to apply.
The free market has now exercised its will and "regulated" Enron, as it always will, but the unrestricted free market is often a brutal and costly regulator. What can be done to avoid or minimize this kind of debacle in the future?
I would suggest examination of three areas in need of some reform:
I. Accounting policy and governance.
II. Corporate governance.
III. Government's regulatory, tax, and supervisory role.
I. Accounting Matters
From what we know at this stage, it seems that the CPA audit reports did not really "fairly present" the position of the company in a way that was understandable by investors, even sophisticated ones. Further, the accounting standards, though possibly technically followed, did not result in information adequate for markets to make decisions. Enron was a very complex large company and thus it was difficult to understand its operation, but the accountants did not make it easier.
Both accounting standards and the firm applying them failed to provide the clear information necessary for free markets to perform effectively.
What to do:
1. The government must provide and control the regulation of public accounting firms. Accountants start with a basic conflict of interest since they are paid by the enterprises they audit. Thus governmental control is necessary to insure compliance with the rules of operation. The alternative is for government itself to audit, which is undesirable (though the government does run the worlds largest "audit firm" (the IRS). Auditing is a highly competitive profession that needs structure for competition with compliance done by government. This government body should be appointed by the SEC Board. Its charge will be to insure that accountants follow the rules of practice as set by the SEC, FASB (or successor). The body should be bipartisan with terms of at least four years.
Many changes will follow from this, including, but not limited to, separating audit from consulting, control of the "swinging door" between audit firm personnel and client accounting positions and possible rotation of auditors. Incidentally, I don't believe that tax return preparation and advice should be a part of the consulting practice separated.
2. Accounting and auditing standards must be set by an independent body financed by independent sources – government tax, user fee, etc. This organization must be protected from undue influence both of a public and private nature much like the FDIC and RTC was during my tenure as chairman. The FASB seems to have performed reasonably well, except where outside pressures forced them to abandon necessary action.
II. Corporate Governance
A. The Board
It is far from clear what the failure of corporate governance was at Enron. The Board relied upon reputable independent CPAs and legal counsel, and on a management perceived to be of the highest reputation. Even their doubtful approval of a conflict of interest regarding related parties transactions were set up with care. The audit committee's independence perhaps is in question, but there are already many independence rules in place on that issue. We must take care not to unfairly burden directors and particularly audit committee members or the result will be to reduce the availability of good directors to serve.
If the directors failed in their fiduciary duties, the courts will hold them accountable. While insurance may cover their liabilities, they cannot be assured of this result if their conduct violates their fiduciary duties. I would suggest only two substantive changes be considered.
First, my experience as a member of boards suggest that allowing one person to be the Board Chairman and CEO concentrates too much power in one place. While this is the way most U.S. boards of directors are organized, it can result in real abuse when the wrong person is CEO.
Second, in this regard, it is important that the independent director (or some of them) constitute the committee to recommend new and retained directors to the board for approval. This suggestion will support board independence on which the governance system is based.
B. The Corporate Offices
Corporate officers performed poorly (to say the least) at Enron, but it is difficult to set performance standards legislatively. At the FDIC, we recommended, and the Congress passed, laws preventing golden parachutes when used shortly before a company failed. This was a difficult law to draft and enforce. Today, the golden parachute is offered in the form of options exercised while the officer knew or should have known the company was in trouble. Today's laws allow reclaiming profits, but this is not punitive. I guess most taxpayers would say, "do something," but don't create more lawsuits so perhaps a penalty is justified.
III. Government Regulation, Supervision and Taxation
In my view, free markets usually work better when government has set the structure for them to perform. That is why we have an SEC, FDIC, Federal Reserve, OCC, EPA, CFTC, Anti Trust Division and many other agencies. Each came into being to remedy a market failure in the past.
A good free market operates like a prizefight, plenty of chance to slug it out, but not below the waist and not with the second's stool. An unrestricted market is like a ballroom brawl where the fight results in wide spread destruction of both people and the place, and the winner may be the dirtiest fighter on the scene.
The trick, of course, is to have the right rules that promote fair competition without stopping the competition.
Enron tells us the structure for unregulated futures markets and derivatives failed and a market structure, while difficult to construct, is needed. Enron was a brawl because no regulators were empowered to deal with a good part of their market behavior. This supervision will be complicated to create, but only slightly more so than other supervision such as commodities futures, banking, anti-trust, etc.
Further, the tax system, which allowed Enron to avoid tax liability while reporting large profits, also must be fixed. The loss of revenue through Enron type activities is growing rapidly. Tax results can be improved by enhancing IRS capabilities, including the use of private sector professionals and better tax laws.
Above all, Enron's markets and activities needed transparency – a job that can only be done appropriately by the government agency – the SEC.
I have not tried, in this short period, to deal with all the many suggested actions in Congressional bills, testimonies, and the administrative proposals. I will be pleased to answer questions where I can on these and other matters.
In summary, there is much to be done by the Congress, to reduce the chances of "another Enron," but it must keep in mind that overreaction can do as much harm as no action at all.
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