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Lessons from Enron and the Other Corporate Scoundrels: Can it happen over here?

Author: Roger M. Kubarych
September 25, 2002
Council on Foreign Relations

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1. Since April the stock market in the US has taken a beating. Corporate malfeasance is widely cited as the main reason. You can’t trust the numbers anymore. The problem is that other stock markets have done just as badly or even worse, and nobody is complaining that it is all about faulty accounting and greedy CEOs. So there have to be some powerful economic forces at work, as well. But the impact of the corporate scandals in the US is not negligible, either. And it may leave a lasting wound that never quite heals and so is vulnerable to being opened up in the future.

2. I would identify four areas where there have been significant impacts. Each of these areas requires attention, fixing, and continuing scrutiny. They are: corporate governance, Wall St. behavior, the role of professionals who are supposed to provide checks & balances in the private sector, and public policy. So far there has been considerable movement in two of these areas, but much to be done in the other two.

3. Corporate governance: In too many instances there has been a complete failure by members of corporate boards of directors to exercise their prescribed “duty of care”. They were too often servants of a powerful, or at least bullying, CEO, too rarely servants of investors. Members of Audit and Compensation Committees were especially subservient to inside management. But all board members seem to have shown no sense of personal accountability for the misdeeds of the companies which they governed. There was no formal lead director to provide leadership. Too many board members were other CEOs, with much dirty linen of their own to hide. Too many were simply pals of the CEO, without allegiance to any other stakeholder. Fixing this will require many changes. The supervisory board concept, long scorned in the US, needs to be reconsidered. The successful example of FIRREA, which legislated personal accountability for directors of depository institutions, needs to be emulated for all public companies. Some have proposed separate elections for Audit Committee members to enhance their independence from the rest of the board. So far, little or nothing useful has been done voluntarily by corporate America, apart from some brave souls who have decided to expense options. But that just scratches the surface and deals with a symptom, not the disease, which is a lack of incisive questioning of CEO behavior. After all that is the most important thing a board does: choose the CEO and evaluate his/her performance – not just to be a cheering section or public relations image-maker.

4. Financial institutions practices: Booms lead to diminished vigilance, complacency, sloppy thinking, hero worship, and subservience. More so on Wall St. than anywhere else, except perhaps Washington DC. Wall St. analysts are not to be trusted. Maybe once they were, but they have lost that respect. They were mainly the channel for creating buying clubs. They are just the most visible and highly publicized part of a system that has serious flaws. But the institutional investor community has no cause for self-righteousness. They either knew and were willing to play along for the big ride or didn’t know and were either ignorant or lazy. This carelessness aggravated the problem and allowed the securities industry to lose its integrity. Who was criticizing the analysts when 98% were publishing buy recommendations? A few grumpy old men who were ridiculed as has-beens. Naturally the investment banking connections with companies assessed by what should be objective critics created questionable conflicts of interest. Maybe even illegal conflicts, but that has yet to be proved in court. Meanwhile, lenders also failed to do appropriate due diligence. There was poor stress testing, although many patted themselves on the back for their superior risk management systems, which in retrospective were primarily backward-looking and sterile. They certainly didn’t catch many of the huge looming bankruptcies. When an analyst or investor really doesn’t understand how a company makes money, the implication is don’t invest/lend. Rarely were they humble enough to admit they didn’t understand. Plus, when companies say they make money but then don’t pay any taxes, most people would raise a red flag: somebody is being deceived. But too many times such an anomaly was handwaved away. By the way, the old guard predicted what would happen when Glass-Steagall was abolished – the competitive pressures that would emerge as commercial banks strived to get into the lucrative investment banking business and the lowering of standards and forbearance that would result. Naturally those critics were dismissed as out-of-date or out-of-touch. But they were prescient.

5. Checks and balances inadequate. Who are the providers of checks and balances? Outside auditors. Lawyers. Journalists. All those who are professional critics, the people who are supposed to ask the tough questions. Many failed miserably, as now admitted by senior partners of accounting and law firms, and top editors of the business press. One of the lessons from the scandals is that consulting and auditing don’t mix well. But few examples have been given to prove how sordid it had become. Consultants are highly paid. Auditors aren’t. So they aspire to be consultants in their firms. Does that make them more or less eager to raise questions about a device, gimmick, or accounting judgment that their consulting division colleagues have crafted for an important client? By the way, this is a weakness of the human condition, not a deformity in US or English-speaking character. Of course, behind it in the US case is the entire edifice of GAAP accouting, once praised (perhaps a eulogy would have been more appropriate) as one of the bedrock strengths of the US capitalism by a former high US Government official. It may have some virtues, compared to other systems. But it is too complicated and too easily gamed. And too dependent on experts to referee the games. What’s worse is when the partners of the referees are drawing up the plays. What must be done to fix all this? Simplify. And clarify the role of the legal community and the SEC in overseeing the overseers. At least that much will be done because it is now mandated. But a lot more has to be done to stop companies, even basically honest ones, from hiding behind highly legalistic footnotes and arcane explanations that are so ambiguous that even the experts disagree on what they mean. The SEC mandated plain language prospectuses for the mutual funds industry, which deals every day with the average citizen-investor. It can do no less for public financial reporting.

6. Public policy. Congress has been dismal in its performance over the past decade. It probably wouldn’t have done anything after Enron, except for the WorldCom travesty. That scandal couldn’t even be dignified under the category of “complex”. They simply capitalized expenses that freshmen accounting students at the lowliest community college are told is forbidden. Out went the silly argument that Enron was a special case and that most companies are simon pure. But it took an unknown state attorney general in NY by the name of Spitzer to blow the lid on Wall St. corruption. He went after Merrill Lynch, he was ridiculed by many in an organized campaign to impugn his motives and his IQ, and he won. It set the stage for Sarbanes-Oxley, which would have never passed in anything like its present form. Now of course that legislation is being ridiculed for not changing much. What a preposterous notion! If it was so limp, why did the industry virtually fall all over itself trying to stop it? We can review the top ten things S-O will do – and it is plenty. But one of particular importance to European companies is the extra-territorialityof its provisions – that may subject German and some other companies to a nasty dilemma regarding their US Audit Committee requirements and their home country laws and regulations.

7. Market implications. Investors believe, rightly or wrongly, that all participants – companies, their boards, their auditors, their legal counsel, their government regulators – will push for more conservatism in defining and reporting earnings. That means profits forecasts will be scaled back. And that will keep the stock market from mounting a dynamic recovery – or maybe any meaningful recovery at all. In time, stronger corporate governance, more honesty in the numbere, and the return of adequate checks and balances are all investor friendly. Getting there may not be trouble-free, however.

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