[Senate Hearing 107-376]
[From the U.S. Government Publishing Office]
S. Hrg. 107-376
THE FALL OF ENRON: HOW COULD IT HAVE HAPPENED?
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HEARING
before the
COMMITTEE ON
GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
JANUARY 24, 2002
__________
Printed for the use of the Committee on Governmental Affairs
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COMMITTEE ON GOVERNMENTAL AFFAIRS
JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan FRED THOMPSON, Tennessee
DANIEL K. AKAKA, Hawaii TED STEVENS, Alaska
RICHARD J. DURBIN, Illinois SUSAN M. COLLINS, Maine
ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio
MAX CLELAND, Georgia PETE V. DOMENICI, New Mexico
THOMAS R. CARPER, Delaware THAD COCHRAN, Mississippi
JEAN CARNAHAN, Missouri ROBERT F. BENNETT, Utah
MARK DAYTON, Minnesota JIM BUNNING, Kentucky
Joyce A. Rechtschaffen, Staff Director and Counsel
Cynthia Gooen Lesser, Counsel
David M. Berick, Professional Staff Member
Hannah S. Sistare, Minority Staff Director and Counsel
William M. Outhier, Minority Investigative Counsel
Darla D. Cassell, Chief Clerk
C O N T E N T S
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Opening statement:
Page
Senator Lieberman............................................ 1
Senator Thompson............................................. 4
Senator Levin................................................ 6
Senator Collins.............................................. 9
Senator Durbin............................................... 11
Senator Cochran.............................................. 12
Senator Torricelli........................................... 12
Senator Voinovich............................................ 14
Senator Cleland.............................................. 16
Senator Bennett.............................................. 18
Senator Carper............................................... 19
Senator Bunning.............................................. 20
Senator Carnahan............................................. 21
Senator Dayton............................................... 23
WITNESSES
Thursday, January 24, 2002
Hon. Arthur Levitt, Jr., former Chairman, U.S. Securities and
Exchange Commission............................................ 26
Lynn E. Turner, former Chief Accountant, U.S. Securities and
Exchange Commission............................................ 29
Bruce B. Henning, Director, Regulatory and Market Analysis,
Energy and Environmental Analysis, Inc......................... 54
John H. Langbein, Sterling Professor of Law and Legal History,
Yale Law School................................................ 56
Frank Partnoy, Professor of Law, University of San Diego School
of Law......................................................... 58
Alphabetical List of Witnesses
Henning, Bruce B.:
Testimony.................................................... 54
Prepared statement with attachments.......................... 84
Langbein, John H.:
Testimony.................................................... 56
Prepared statement........................................... 93
Levitt, Hon. Arthur Jr.:
Testimony.................................................... 26
Prepared statement........................................... 75
Partnoy, Frank:
Testimony.................................................... 58
Prepared statement........................................... 103
Turner, Lynn E.:
Testimony.................................................... 29
Prepared statement with an attachment........................ 78
Appendix
Chart entitled ``Market Losses to Investors After Corporate
Restatements'' (submitted by Senator Torricelli)............... 135
Chart entitled ``Corporate Restatements Have Increased
Dramatically in the Last Three Years'' (submitted by Senator
Torricelli).................................................... 136
Chart entitled ``Corporate Overstatements in the Past Decade''
(submitted by Senator Torricelli).............................. 137
Questions for the Record with responses from:
Mr. Levitt................................................... 138
Mr. Langbein................................................. 142
Mr. Partnoy.................................................. 150
THE FALL OF ENRON: HOW COULD IT HAVE HAPPENED?
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THURSDAY, JANUARY 24, 2002
U.S. Senate,
Committee on Governmental Affairs,
Washington, DC.
The Committee met, pursuant to notice, at 10:07 a.m., in
room SH-216, Hart Senate Office Building, Hon. Joseph I.
Lieberman, Chairman of the Committee, presiding.
Present: Senators Lieberman, Thompson, Levin, Collins,
Durbin, Cochran, Torricelli, Cleland, Carper, Carnahan, Dayton,
Voinovich, Bennett, and Bunning.
OPENING STATEMENT OF CHAIRMAN LIEBERMAN
Chairman Lieberman. This hearing will come to order.
Good morning. With this hearing, the Senate Governmental
Affairs Committee begins its investigation of the Enron
scandal, the spectacular rise and fall of an American
corporation and the devastating effects its collapse has had on
its employees and retirees, on its shareholders and customers,
and on the confidence many Americans have in the markets and in
their government.
The basic facts of this story are now well known. Less than
a year and a half ago, Enron was ranked as the seventh largest
corporation in America. The energy trading company was a bright
star on Wall Street, a juggernaut trading at $90 a share at its
height, with revenue over $100 billion. Stock analysts could
not recommend it fast enough, and the company made millionaires
of many loyal employees who invested their life savings in its
stock.
Then last month Enron's bright star collapsed into a black
hole, when it abruptly declared bankruptcy and was exposed as a
house of cards built on greed and deceit. To add insult to
injury, average workers and investors were cheated out of their
life savings, while a small group of executives and insiders
made off with hundreds of millions of dollars from well-timed
stock sell-offs.
Today, the company's stock is worth pennies, and it is no
longer traded on the New York Stock Exchange. Five thousand of
its employees are out of a job, and thousands more are reeling
in the ruin of their retirement dreams. One of the Nation's top
accounting firms, Arthur Andersen, is accused of helping to
conceal Enron's liabilities instead of reporting them. Public
and private employee pension funds from Florida to California
have lost billions of dollars, and at a time when over 60
percent of Americans own stock, in one way or another, the
confidence of the investing public in the stock market has been
shaken.
So this is not just a tempest in a teapot. It is an
unprecedented corporate storm that has already hurt thousands
of people and now leaves dark clouds over America's economy and
American's confidence in their future personal economic
security. This scandal cries out for thorough congressional
investigation to make sure that nothing like this ever happens
again.
Yet, because Enron has made substantial political
contributions to Members of Congress and the Executive Branch,
some have questioned the capacity of any congressional
committee to conduct an independent, thorough investigation of
Enron.
Now I think there are two things we in Congress can do to
overcome that skepticism and rebuild public trust. One is
simply to do a completely independent and demanding
investigation, and that is the intention of this Committee. The
second is to pass campaign finance reform.
As for this Committee, we have a clear duty, under the
rules of the Senate, to investigate, and we will carry out that
duty by conducting an investigation that is independent,
comprehensive, aggressive, fair and nonpartisan. We should
neither jump to conclusions before the facts justify them, nor
hesitate to ask tough questions of those in the public and
private sectors who can produce the facts that we need in order
to get answers, and we will follow the facts wherever they lead
us.
This is a big and complicated investigation. So our
Committee has divided it between the full Committee and our
lead investigative committee. The Permanent Subcommittee on
Investigations, chaired by Senator Levin, with Senator Collins
as Ranking Republican, will investigate the internal
malfeasance of Enron and its auditors, the role of the board of
directors, conflicts of interests, off-shore tax havens and
insider trading.
Here at the full Committee level, we are going to focus on
the external controls and protectors, the Federal agencies and
laws, and ask why, in this case, they could not better protect
the thousands of employees and investors who have suffered from
Enron's untimely and unnatural demise.
As the Senate's chief oversight committee, it is our
responsibility, again, under the Senate rules, to make sure the
Federal Government is as effective as it can be in protecting
the public interest. Because in this case so many have lost so
much, this Committee must ask if the relevant Federal agencies,
the Securities and Exchange Commission, the Labor Department,
the Commodity Futures Trading Commission, and the Federal
Energy Regulatory Commission did everything they could have
done to protect the public and, if not, why not.
At least one of those agencies was formed way back in the
most serious crisis American capitalism has ever faced, the
Great Depression. It and those other watchdog agencies that
have followed it, have been established, I think, to require
the fullest disclosure and fairest play that are necessary to
make our market economy work for the benefit of the many, the
broad middle class and not just the privileged insider few.
Now, in the context of the Enron scandal, people are
asking, and we will ask, whether these agencies need to be
strengthened to perform this critically important function.
Here are some of the questions we are going to ask:
How was Enron allowed to hide its debt and losses in shady
accounting from SEC oversight?
Could the Labor Department have intervened when Enron
barred its employees from selling company stock in their 401(k)
plans and blocked them from salvaging what was left of their
retirement nest eggs?
Could FERC and the CFTC have exercised more oversight to
rein in abuses that might have contributed to Enron's collapse?
We have got to ask, also, if the regulatory agencies need
additional powers to prevent this kind of massive investor rip-
off from occurring again.
We have got to ask, and we will, and Senator Levin's
Subcommittee will, why the private sector checks and balances
that we rely on to keep the markets honest and open, the
auditors, analysts, and independent corporate directors, did
not do their part to make sure that the Enron investors and
employees were getting the true story.
Are the auditors, with their enormous consulting fees, too
beholden to management to protect the shareholders' interests?
Are stock analysts too concerned about protecting the
lucrative business relationships of their firms to be objective
in their assessments of companies?
Are independent directors, with their stock options, and
consulting contracts and corporate perks, truly independent?
Is the system, in sum, so rife with conflicts of interest
that the average American, trusting his or her future to the
stock market, is inadequately informed and, therefore, poorly
protected?
We are going to begin our oversight and investigation
during a series of hearings during the next several weeks on
the most important public policy questions that have emerged
from the Enron scandal. At the same time, we will also issue
written interrogatories to the agencies of the Federal
Government that have had jurisdiction over Enron and to the
White House to determine what they knew and did regarding
Enron's regulation by the four agencies I mentioned earlier
over the last several years.
We also plan to request, by subpoena, that Enron and Arthur
Andersen turn over documents related to their context with the
same Federal agencies and offices. After we have collected that
information and conducted additional interviews, we will report
our findings to the public in hearings to be conducted later
this year.
In the end, I hope that this Committee will have specific
recommendations to make to change the law and regulation,
recommendations that will strengthen the watchdogs, both in and
out of the Federal Government, so, I repeat, nothing like the
Enron scandal ever happens again.
In today's hearing, we are going to set the stage for what
will follow and try to put the Enron story into context by
defining a set of the most important policy issues that have
come into question as a result of Enron's collapse. The sudden,
wholly unanticipated failure of the Nation's seventh largest
corporation, under infuriatingly suspicious circumstances, with
grave consequences for thousands of people, is a clarion call
for all of us in government to make sure we are doing all we
can to protect the integrity of our markets, that in their way
have allowed the growth of the great American middle class, and
the savings and investments of the American people. That is
what our Committee intends to do.
I would like to say just a few words, briefly, to my fellow
Members of the Committee. We are beginning a journey today, one
that will be long, and complicated and often controversial, but
it is a very important journey. It is not a journey that was on
our Committee agenda for this year, but then Enron happened,
and now this Committee, which is uniquely charged with
oversight and investigation by the Senate Rules, has a duty to
act.
Along the way, there will be people outside the Committee
who will try to distract us and divide us. For my part, I
pledge to you that I will do everything possible to make sure
they do not succeed. I want to end this journey together, as we
begin it together today, having found the truth, as best we
could, and proposing reforms that are the best we can.
I am very privileged to have Senator Fred Thompson as the
Ranking Republican on this Committee. We have worked closely
together over the years. I have great respect for Senator
Thompson. I might even say I like him. [Laughter.]
I even, occasionally, enjoy his company.
I would say, in specific regard to this matter, I have
consulted with him, as we have shaped our investigative plan,
and I look forward to working closely with him as the
investigation proceeds.
I am also pleased that Senator Levin, Senator Collins, and
their staffs are working closely together on the work of the
Permanent Subcommittee on Investigations.
Senator Thompson.
OPENING STATEMENT OF SENATOR THOMPSON
Senator Thompson. Thank you, Mr. Chairman.
I believe it is correct to say that this marks the first
day of the first full Senate Committee hearing on the Enron
matter, and it clearly is an appropriate matter for the
Governmental Affairs Committee. How our government agencies and
institutions perform is a vital part of the inquiry that needs
to be made, as Congress works its way to the bottom of this.
Mr. Chairman, I think you have set exactly the right tone,
and I would like to say that I am pleased that you are chairing
these hearings. Having worked closely with you in the past, I
know of no one who has a more proven record of fairness and
objectivity, and I look forward to working with you on this
matter.
I think we really have an opportunity to do some good here,
to examine what went wrong and to consider constructive changes
to the governance of our public capital markets, which appear
to be inadequate to the demands of the 21st Century and the
complex financial transactions that now take place on a daily
basis.
It is true that not every aspect of the Enron matter is
either unusual or especially a cause of great concern. For
instance, to what extent is this simply a case of individual
misconduct or illegal conduct? No system known to man can
prevent unscrupulous and clever individuals from manipulating
the system and even getting away with it for a period of time.
Also, how much of this financial disaster was simply the
results of bad business judgment and legitimate risk taking
that simply did not pan out? This is not the first big company
to go belly up with losses to stockholders and employees, and
when it happens it is not always because of illegal or
unethical conduct.
But while it may be that part of what we are seeing here is
individual misconduct or simple bad business judgment, both of
which our system is very capable of dealing with, and we are in
the process of dealing with it right now, there also seems to
be some systematic failures that are much more troubling.
Our free markets and our public financial system--much as
our government--are dependent upon certain checks and balances.
Some of the unfortunate tendencies of human nature that were of
concern to our Founding Fathers, are just as prevalent in the
corporate world, as they are in the political world. People
entrusted with power need watchdogs and must be required to
operate under public scrutiny. We must ask ourselves where were
the watchdogs here? Where were the auditors, the law firms, the
board of directors, the analysts, and the government agencies?
As an economist recently pointed out, we must especially
look at the role played by auditors. As they said, ``The
capital markets and, indeed, capitalism itself can function
efficiently only if the highest standards of accounting,
disclosure and transparency are observed. In America, well-
policed stock markets, fearsome regulations at the SEC, stern
accounting standards in the form of generally accepted
accounting principles, and the perceived audit skills of the
Big 5 accounting firms have long been seen as crucial to the
biggest, most liquid and most admired capital markets in the
world.''
The most troubling feature of this issue to me is not so
much how these entities or gatekeepers, watchdogs failed in the
Enron matter, as the fact that this may be indicative of
problems with auditors, boards, and gatekeepers in general. For
one thing, we have learned that most of them are up to their
necks in conflicts of interest. One way or another, all of
these people, especially the private entities, have tremendous
financial incentive for the company to make the numbers and to
keep the stock price high.
This, of course, plays right into the hands of the
unscrupulous corporate executive, who is willing to cover up
the financial realities of the corporation through
nondisclosure, taking corporate debt off the books and any
number of things that would raise a question in the mind of an
average high school bookkeeping student.
As is often the case, the real scandal here may be in the
form of not what is illegal, but what is totally permissible.
If the generally accepted accounting principles allow the
bookkeeping shenanigans that have been reported in the press,
then we should all go into the derivative business.
It seems that all too often the name of the corporate game
is to conceal the true financials, while doing the minimum
amount of disclosure to avoid legal exposure. The system is
clearly not designed with the primary interests of the general
public or the investor in mind.
Also, what about the role of the government agencies? What
should they have caught? Do they have an adequate staff? We
have 17,000 public companies in this country. Is the SEC
supposed to keep up with all of them? Is it necessarily just an
after-the-fact proposition? Perhaps it is. Can we put a
government official in every board room in the Nation?
Also, what about those rare instances where the government
catches wrongdoing? Are penalties sufficient to deter this kind
of behavior?
So, while issues such as individual wrongdoing and who made
contacts with the administration are interesting and
titillating, the issue of most long-term importance to our
country has to do with the integrity of our systems.
It is also the area in which we have the most
responsibility as legislators. We must address our legal and
regulatory framework, not as what we thought it was, but as we
now know it to be, and work together toward reforming it.
As I said, I believe we have an opportunity here, Mr.
Chairman, to do some real good on a bipartisan basis, and who
knows, in the process, we may even finally decide that allowing
huge amounts of soft-money contributions to public officials is
not really such a good idea. We may even come to the conclusion
that this practice is always just a scandal waiting to happen,
and we do ourselves and the institution we serve a disservice
by tolerating it.
So, Mr. Chairman, I look forward to working with you and
other Members of this Committee toward a really constructive
set of hearings. Thank you very much.
Chairman Lieberman. Thank you, Senator Thompson. Thanks
very much.
I am now going to give each of the Members of the Committee
an opportunity for an opening statement, which I ask them, as
best as they are able, to keep it close to 5 minutes.
Senator Levin.
OPENING STATEMENT OF SENATOR LEVIN
Senator Levin. Thank you very much, Mr. Chairman and
Senator Thompson, for your statements, which I thought were
really on target.
The Enron debacle has stirred the passions of Americans
nationwide. The deceptions and the accounting gimmicks, the
shredding of documents that have occurred shake the very
foundation of our confidence in corporate America. What a
travesty. Enron's management made out like bandits, while tens
of thousands of average people saw their savings, retirement
funds or jobs go down the drain. People are now concerned that
the marketing of the stock of other U.S. corporations may be no
more than ``pump and dump'' schemes writ large.
Enron's abrupt collapse from corporate star to disgraced
bankrupt is crucial for all of us to understand, because each
and every American's future is tied to the success or failure
of corporate America. Publicly traded companies employ millions
of Americans. They are the key to U.S. international
competitiveness. Over half of all U.S. households are now
investing in American capital markets, placing their hopes for
a college education for their children, quality care for their
parents, and adequate money for their retirement, in the hands
of our publicly traded companies.
I was, frankly, surprised when Treasury Secretary O'Neill
said, ``Companies come and go. Part of the genius of capitalism
is people get to make good decisions or bad decisions, and they
get to pay the consequences or enjoy the fruits of their
decisions.''
Well, Ken Lay and his colleagues at Enron got the fruits.
The employees and stockholders are the ones who suffered the
consequences.
We have laws and regulations designed to ensure that our
publicly traded corporations are managed for the benefit of
stockholders and employees. We require boards of directors to
serve as a check on overreaching and bad judgment by corporate
offices. We require outside auditors to make sure company
accounting practices are accurate and trustworthy. We require
transparent financial reporting so that investors can track
their investments and decide when to buy or sell stock.
Yet, in the case of Enron, we have misleading financial
statements, corporate conflicts of interest, insider profits at
the same time employees were losing their shirts, off-shore
shenanigans, hidden debt, and what I call tax laundering--that
is, taking earnings that are taxable in the United States and
somehow creating off-shore paper entities in the Caribbean or
elsewhere through which to route them and, presto, convert them
to nontaxable earnings.
Enron also avoided hundreds of millions of dollars in taxes
by its use of stock options. Some years ago some of us fought
to require corporations to treat stock options on their
financial statements the same way they treat them on their tax
returns. Corporate executives receive large quantities of stock
options from their companies. When they exercise those options,
the companies can claim a compensation expense on their tax
return, while accounting rules let them omit that same expense
from the corporate earnings statement.
The company can tell Uncle Sam one thing, but its
shareholders or future stock buyers the opposite. That is one
of the means by which Enron avoided paying taxes for 4 out of
the last 5 years, while bragging to investors about
skyrocketing revenues.
Enron is far from unique in that regard, since other
corporations use the same technique. The stock-option loophole
that Enron used makes no sense to me. But when the Financial
Accounting Standards Board or FASB, the entity that decides the
accounting standards, tried to change the rules, audit firms
and major corporations fought the board tooth and nail.
It may be that Enron and Andersen broke laws or it may be
that the principal scandal is what passes for legal conduct in
today's marketplace. Some of our witnesses will be telling us
today that it is not just Enron, that our entire system of
corporate management, auditing, stock analysis, investment
banking needs a top-to-bottom shake-up and major repairs.
Many have been raising flags, shouting warnings for years,
including the witnesses before us today. Arthur Levitt, former
SEC Chairman, for one, carried on an intense and often lonely
battle to curtail the conflicts of interest that are inherent
in the practice of permitting our largest auditors to serve as
both outside auditor and management consultant to the same
company.
Mr. Chairman, I am very fortunate that Senator Collins is
the Ranking Republican on our Permanent Subcommittee on
Investigations. The legislative effort that is needed to turn
this travesty into a positive force, to clean up some long-
festering problems in U.S. corporate governance and accounting
practice will require a sustained effort from all of us.
I know that she, with her history and experience of
chairing hearings in such a distinguished, fair, and thoughtful
way when she was Chair of the Permanent Subcommittee on
Investigations, will help us a great deal to make the best
contribution that we can to that sustained effort which must be
made if we are going to clean up the mess that we, indeed, all
face. Thank you.
[The prepared statement of Senator Levin follows:]
PREPARED STATEMENT OF SENATOR LEVIN
The Enron debacle has stirred the passions of Americans nationwide.
The deceptions and accounting gimmicks and shredding of documents that
occurred shake the very foundation of our confidence in corporate
America. What a travesty. Enron's management made out like bandits
while tens of thousands of average people saw their savings, retirement
funds or jobs go down the drain. People are now concerned that the
marketing of the stock of other U.S. corporations may be no more than
``pump and dump'' schemes writ large.
Enron's abrupt collapse from corporate star to a disgraced bankrupt
is crucial for all of us to understand, because--like it or not--each
and every American's future is tied to the success or failure of
corporate America. Publicly traded companies employ tens of millions of
Americans; they are the key to U.S. international competitiveness. Over
half of all U.S. households are now investing in American capital
markets--placing their hopes for a college education for their
children, quality care for their elderly parents, and adequate money
for their retirement in the hands of our publicly traded companies.
I was surprised when Treasury Secretary Paul O'Neill said,
``Companies come and go. Part of the genius of capitalism is people get
to make good decisions or bad decisions and they get to pay the
consequences or enjoy the fruits of their decisions.'' Well, Ken Lay
and his colleagues got the fruits and haven't yet suffered the
consequences; the employees and stockholders have done that.
We have laws and regulations designed to ensure that our publicly
traded corporations are managed for the benefit of stockholders and
employees. We require Boards of Directors to serve as a check on
overreaching and bad judgment by corporate officers. We require outside
auditors to make sure their accounting practices are accurate and
trustworthy. We require transparent financial reporting so that
investors can track their investments and decide when to buy or sell
stock. We require of our public accountants and corporate directors a
fiduciary responsibility to act in the best interest of the investing
public and the corporation's stockholders, and not in their own
financial interest.
Yet in the case of Enron we have misleading financial statements;
corporate conflicts of interest; insider profits at the same time
employees were losing their shirts; offshore shenanigans; hidden debt,
and what I call tax laundering--that is, taking earnings that are
taxable in the United States and somehow creating offshore paper
entities in the Caribbean through which to route them and voila--
convert them to nontaxable earnings.
Enron also avoided hundreds of millions of dollars in taxes by its
use of stock options. Some years ago some of us fought to require
corporations to treat stock options on their financial statements the
same way they treat them on their tax returns. Corporate executives
receive large quantities of stock options from their companies. When
they exercise those options, the company can claim a compensation
expense on their tax returns, while accounting rules let them omit that
same expense from the corporate earnings statement. The company can
tell Uncle Sam one thing and its shareholders the opposite. That's one
of the means by which Enron avoided paying taxes for four out of the
last five years, while bragging to investors about skyrocketing
revenues. The stock option loophole Enron used makes no sense, but when
the Financial Accounting Standards Board or FASB--the entity that
decides the accounting standards--tried to change the rules, audit
firms and major corporations fought the Board tooth and nail. In the
end, the best FASB could get was a footnote noting the earnings charge
on a company's books. But that stock option footnote--like so many
Enron footnotes--doesn't tell the true financial story of a company.
It may be that Enron and Andersen broke laws or it may be that the
principal scandal is what passes for legal conduct in today's
marketplace. Some of our witnesses will be telling us today that it's
not just Enron--that our entire system of corporate management--
auditing, stock analysis, investment banking--needs a top-to-bottom
shake-up and major repairs. The Big 5 accounting firms admitted in a
recent petition to the SEC that when it comes to financial disclosure
many ``public companies provide boilerplate or very high-level
disclosures that provide little or no meaningful information.'' And
that's from the accountants themselves--the very group charged with
ensuring that companies issue fair financial statements. What an
indictment that is of our financial disclosure system.
Many in the industry have been raising red flags and shouting
warnings for years. Arthur Levitt, the former SEC Chairman for one,
carried on an intense and often lonely battle to curtail the conflicts
of interest inherent in the practice of permitting our largest auditors
to serve as both outside auditor and management consultant to the same
company. Mr. Levitt knew what he was talking about, but not many wanted
to listen. The question now is whether we've learned the lesson Mr.
Levitt is still trying to teach.
Just about all the various failures in our corporate governance
systems have coalesced in the Enron saga. Hopefully Enron's implosion,
while damaging to so many lives, may serve as the engine for reforms
long overdue. We already have some sense of what needs to be done:
Insisting on greater auditor independence; a stronger Financial
Accounting Standards Board; fairer accounting, including consistent
treatment of stock options; ending the use of offshore tax havens; more
accountable corporate governance; and employee pension protections.
A large number of investigations are ongoing in the Congress and
the Executive Branch, because we have a lot of ground to cover and
different responsibilities to fulfill. The Permanent Subcommittee on
Investigations, which I chair, and on which Senator Susan Collins
serves as the Ranking Member, will be paying particular attention in
the months ahead to the role of the Enron Board of Directors and
officers, the role of Arthur Andersen ,particularly with regard to
Enron's Special Purpose Entities, and Enron's use of offshore entities
and tax havens.
Our hearings in the Permanent Subcommittee on Investigations will
come later in the year, after our analysis of the thousands of
documents that we receive as a result of the 51 subpoenas issued two
weeks ago. I look forward to the hearings in our full committee, which
will examine what federal agencies could have and should have done to
detect or prevent the Enron debacle. The legislative effort needed to
turn this travesty into a positive force to clean up some long-
festering problems in U.S. corporate governance and accounting practice
will require a sustained effort from all of us.
Chairman Lieberman. Thank you, Senator Levin. Senator
Collins.
OPENING STATEMENT OF SENATOR COLLINS
Senator Collins. Thank you, Mr. Chairman.
Mr. Chairman, I want to thank you and Senator Levin for
convening this important investigation into some of the key
issues involved in the Enron bankruptcy, the largest corporate
failure in our Nation's history.
It is my hope that, with the help of our witnesses today,
we can begin to gain a better understanding of how the
financial and regulatory systems utterly failed to protect the
company's shareholders, employees and customers, while top
executives apparently walked away with handsome profits on the
sale of their Enron stock.
A common theme in many of the issues we will examine is
conflicts of interest. Corporate officers, outside accountants,
board members, and security analysts all have duties, both
legal and ethical, to investors, to clients, to employees, to
regulators and to the public. To be more specific, we impose on
corporate managers and financial professionals a fiduciary
obligation to act in the best interest of those who provide the
capital.
A brief review shows just how pervasive the role of the
nongovernmental protector of investor interests is in our
capitalist system. We impose, for example, on auditor, the
obligation to ensure that investors have access to financial
statements that accurately and fairly describe the finances of
the companies in which they invest. We impose on corporate
managers the obligation to act in a fashion that will maximize
the benefits received by the firm's stockholders. We impose on
corporate directors the obligation to safeguard investor
interests by monitoring the conduct of those managers, and we
impose on retail brokerage firms the obligation to give their
clients competent and objective advice about the companies they
follow.
For a system that places such heavy reliance on the
obligation of some private citizens to safeguard the interests
of other private citizens, we are remarkably lenient, perhaps
even lax, in allowing conflicts of interest. The potential for
such conflicts to cause trouble in the accounting arena, in
particular, has attracted considerable attention not just in
the Enron case, but over the past few years, as the number of
companies restating their earnings has increased significantly.
Indeed, Enron is only the latest in a string of well-known
large corporations whose books were blessed by auditors,
despite questionable accounting. Financial data, compiled in
accordance with generally accepted accounting principles,
certified as such by an independent auditor, and fully
disclosed under securities laws, are fundamental to the
integrity of our financial markets.
If a company's financial statements do not accurately
represent its financial health, investors cannot make prudent
decisions on whether or not to purchase its stock. Without the
confidence engendered by fully disclosed financial data, our
vibrant capital markets, which help businesses finance new
plants and create new jobs, and which many Americans rely on
for their children's college tuition and their own retirement,
will be ultimately undermined. The very health of our economy
hinges on the integrity of our financial markets.
A champion of small investors and strong capital markets,
former SEC Chairman Arthur Levitt will be testifying before the
Committee today. Chairman Levitt was very helpful to me when I
held hearings with Senator Levin on penny stock fraud and day
trading. He has long pressed for a prohibition on accounting
firms providing both consulting and auditing services for the
same client, to prevent the kinds of conflict of interest that
contributed to the collapse of Enron.
Although the Enron bankruptcy raises many important issues,
perhaps the most important to the individual investor may be
what it has to teach us about the 401(k) plans relied upon by
so many Americans as a future source of retirement income.
Private pensions governed by ERISA are intended to help
Americans reach the goal of retirement security. Because of the
rapid decline in Enron's stock price, however, thousands of its
employees find themselves in dire straits, having lost nearly
all of their savings from a lifetime of hard work.
Like Enron's employees, many American workers have a
disproportionate share of their employer's stock in the 401(k)
plan. In fact, at some companies, workers have as much as 90
percent of their retirement assets in their employer's stock.
One issue that I am very interested in is whether employees
have access to impartial financial advice, and Senator Jeff
Bingaman and I have introduced legislation to try to achieve
that goal.
Although it is not perfect, it is important to remember
that our systems of accounting and financial regulation are the
best in the world. That makes the Enron case all that much more
troubling because it simply should not have happened. It
represents a colossal failure of virtually every mechanism that
is supposed to provide the checks and balances on which the
integrity of our capital markets depend.
I look forward to working with the Chairman, as well as the
Chairman of the Subcommittee, my distinguished colleague,
Senator Levin, as we proceed with these issues.
Chairman Lieberman. Thank you very much, Senator Collins.
Senator Durbin.
OPENING STATEMENT OF SENATOR DURBIN
Senator Durbin. Thank you very much, Mr. Chairman.
With Biblical certainty, the United States preaches the
gospel of free markets and capitalism to the unconverted around
the world. Third-world nations, former command and control
economies, and socialist governments alike are all exhorted to
let the laws of supply and demand run their course.
As proof of the truth of our message, we can point to our
own experience--a frontier nation which joined democratic
government to a market economy and created the freest, most
stable and prosperous nation in history.
But the American story also includes a chapter where we
came to realize that the rule of law and the guiding hand of
government were critical to a just result in the world of
business.
Theodore Roosevelt was the first President to acknowledge
that the genius of capitalism could also be a triumph of greed
without rule and regulation to save us from our baser
instincts.
Today this Committee joins a chorus of Congressional
critics pecking at the carrion of Enron. When the mightiest
fall, the politically curious scramble over the ruins. What we
know is this: A flawed and fraudulent business concept failed.
But there are other things we also know:
When the corporate insiders at Enron realized the ship was
sinking, they grabbed the lifeboats and left the women and
children, their workers and investors, to drown. When the
accountants and auditors responsible for policing Enron were on
the beat, they were also on the take--a badge in one hand, an
open palm in the other.
When workers and investors were captivated by too-good-to-
be-true profits and fraudulent claims by the corporate bigwigs
in Houston, they made decisions they could not escape. And when
the high-flying corporate executives became political high
rollers, they left a lot of embarrassed people in their wake.
After all of the sound and fury of these investigations,
the bottom-line questions are: Is Congress willing to amend the
law to rein in the greed of the next Enron? Are we willing to
concede that the genius of capitalism can result in ruthless
behavior without our oversight and the protection of law? Can
we save pensioners and investors--who were outsiders believing
in the fairness of the market--from the corporate insiders who
walk away from these colossal business train wrecks with their
pockets full and without a scratch?
Over 100 million Americans who own stock and 42 million who
own 401(k)'s will be watching to see if these hearings and many
others on Capitol Hill are about more than just face time on
the nightly news.
To me, this national debate is about more than a failed
corporate giant. It is about the values of our Nation. Enron is
a big story not just because of its bankruptcy. Sadly,
bankruptcies occur every day. Enron is a big story because it
reminds us of our vulnerability. It reminds us that without the
enforcement of fair and just laws, the average American doesn't
have a fighting chance.
Mr. Chairman, I welcome the opportunity in the coming weeks
and months to transform what we learn into legislation that
will guard against a repeat of this shameful chapter in
American business history. Thank you.
Senator Lieberman. Thank you very much, Senator Durbin.
Senator Cochran.
OPENING STATEMENT OF SENATOR COCHRAN
Senator Cochran. Mr. Chairman, I commend you for having
this hearing to learn the facts surrounding the collapse of the
Enron Corporation. While business failures are common, it is
not at all common to see a company of Enron's size driven to
bankruptcy and virtually unheard of to see it happen as quickly
as it did, that a company like Enron could fail so
precipitously and with such devastating consequences is both
puzzling and troubling.
Particularly devastated are Enron's employees, many of whom
have lost their jobs and nearly all of whom have seen their
pensions and 401(k)'s disappear. While business ventures and
investments in them always entail risk, the government has a
role in assuring that there are safeguards in place to keep
employees and investors from being victimized by inappropriate
practices.
With Enron's failure, we must ask whether such safeguards
were adequate and, if they were adequate, were they improperly
circumvented? We should also find out if any Federal agencies
failed to carry out their responsibilities.
This is a very complex case, and I hope we use these
hearings to learn the facts and understand the complexities so
we can determine what we need to do to help avoid this kind of
unfortunate event in the future.
Senator Lieberman. Thank you, Senator Cochran. Senator
Torricelli.
OPENING STATEMENT OF SENATOR TORRICELLI
Senator Torricelli. I thank you, Mr. Chairman, Mr. Levitt,
and Mr. Turner.
The matter of Enron is going to be addressed in a variety
of forums. Some of these are going to be criminal proceedings
because laws have obviously been violated. Creditors will be in
bankruptcy court for many years seeking redress, and there will
be civil suits in courtrooms across the country involving
thousands of people.
The responsibility of this Committee and this Congress is
somewhat different. Allow the criminal and the civil
proceedings to run their course, but our responsibility is to
set what happened with Enron in some perspective. My hope is
the testimony this morning begins that process. The collapse of
Enron has been an individual tragedy for 5,000 employees and
thousands of investors, people have lost their jobs, many will
lose their homes, their families are in peril, and thousands of
other Americans have lost their retirement savings.
This Committee and this Congress needs to recognize the
impact on an even larger scale. Many of my colleagues have
commented about the uniqueness of the American capital market.
Those comments are well stated today. It is no exercise in
hyperbole to note that we have become the world's largest
economy in large measure because we created confidence in the
world's most transparent equity markets.
The uniqueness of our system is that the individual worker,
the retiree, the family planning their finances, feels that
they stand in an equal position with members of the board,
large firms, and management. All have access to equal
information. They can make individual judgments--good or bad,
we stand together. If that confidence is shaken, it is at
enormous perils, to the financial future of the country.
Senator Lieberman noted that our duty is to ensure that
what happened with Enron must never happen again. Perhaps, but
the simple truth is it is happening all of the time. Enron has
brought a dirty little lie into the light of day. The system of
confidence and transparency in our markets has been steadily
eroding.
Mr. Levitt, the purpose of these opening comments by
Members of the Senate, if they serve any purpose at all, is to
tend to direct testimony, to set a stage where you might
respond. Here is the stage I would like to set. I have three
charts I would like you to see.
Market losses to investors after corporate restatements.\1\
Now every American knows about Enron, their restatements, their
false accounting. What was a $17-billion issue in 1998 has
risen to a $31-billion question in what has become a habit, a
routine of corporate restatements. Some are undoubtedly
required, some are necessitated by changing events, but the
changing culture of corporate reporting to investors is at
least suspicious.
---------------------------------------------------------------------------
\1\ Chart entitled ``Market Losses to Investors After Corporate
Restatements'' appears in the Appendix on page 135.
---------------------------------------------------------------------------
The second chart \2\ will give you an idea as well of what
this means in terms of the number of corporations. It may have
been proper in 1998 that 116 corporations needed to do
restatements. Markets change, situations are altered. But it is
at least suspicious that by the year 2000, 233 needed to do the
same. Is Enron unique?
---------------------------------------------------------------------------
\2\ Chart entitled ``Corporate Restatements Have Increased
Dramatically in the Last Three Years'' appears in the Appendix on page
136.
---------------------------------------------------------------------------
Well, the third chart,\1\ I think, illustrates Enron is not
even the largest of what have become a series of outrageous
corporate overstatements to the tunes of billions of dollars in
recent decades.
---------------------------------------------------------------------------
\1\ Chart entitled ``Corporate Overstatements In the Past Decade''
appears in the Appendix on page 137.
---------------------------------------------------------------------------
Enron is now in bankruptcy, so is Sunbeam, largely,
unrecognized outside of the investor community, Waste
Management being even larger. These companies are not alone.
Mr. Levitt, I hope you will address these questions in your
testimony. We would all prefer that the markets are able to
regulate themselves. We all believe it would be better if
professions could engage in self-management. We are being
reminded that there is a reason for government regulation. Mark
Twain once said that before he takes down a fence, he likes to
ask why somebody put it up.
It is not so long ago you reminded the country and the
Congress the reason for some additional regulations in the
accounting industry. The country may not have listened, the
Congress did not respond. We were wrong. You were right. Now we
need to discover what else it is that we should be doing. Thank
you, Mr. Chairman.
Senator Lieberman. Thank you, Senator Torricelli. Senator
Voinovich.
OPENING STATEMENT OF SENATOR VOINOVICH
Senator Voinovich. Thank you, Mr. Chairman, for holding
this hearing today.
The story of Enron's collapse into bankruptcy has dominated
the headlines nationwide this month and has replaced the war on
terrorism as the most common news story. It was just last month
that we were having hearings on terrorism. Enron is the most
covered news event so far this year.
As such, this Committee, along with at least nine other
congressional committees, the Department of Justice, the
Securities and Exchange Commission, and the Department of Labor
are looking into the causes of the corporation's collapse and
any wrongdoing that may have taken place.
Our Nation's financial market is composed of a multi-
layered system of checks and balances. Within a public company,
the executives are obligated to report honest earnings in their
books. Internal auditors are responsible for publishing fair
and independent reports on the company's financial situation.
Audit committees are responsible for ensuring that the auditors
produce fair and accurate statements.
Outside of a public company, the external auditors are
hired to make sure the company's finances present an accurate
picture of what is going on. Financial analysts scrutinize the
company's financial situation to recommend to investors whether
or not the company is a smart investment. Credit lenders
analyze a company's financial reports to determine the level of
risk associated with lending to the company, and the Securities
and Exchange Commission and other Federal regulators are
responsible for monitoring the financial markets and the public
companies that compose this market.
This system usually works pretty well. Mr. Chairman, in the
case of Enron, the multi-layered system of checks and balances
failed. It calls out for Congress to consider overhauling the
whole system to guarantee that we are not going to have any
more situations like Enron.
The aspect of Enron's collapse that bothers me most,
however, is the dishonesty and disloyalty that appears to have
existed at the top of the corporation, conduct which has dealt
a lethal economic blow to thousands of shareholders and
employees and cast a dark shadow on corporate America. It will
take a long time for people's faith in investing to be
restored.
Our country has the best system of civil and criminal laws
in the world, and if there was any wrongdoing--and I suspect
there was--at Enron, we must utilize that system to the fullest
extent to make an example of executives and warn other public
companies and their executives not to gamble with the life
savings of thousands of American families and the investing
public.
In Ohio alone, the Public Employees Retirement System, of
which I am a member, and the State Teachers Retirement System
estimate their losses as a result of investments in Enron at
approximately $127 million. The State has filed a class action
lawsuit against Enron in coordination with a number of other
States that invest in Enron as a result of the company's
misleading financial statements.
I am equally concerned about the allegations I read in the
paper about Arthur Andersen's failure to do its job. I know a
little bit about this company from my experience with them as
Governor, and it was not very good. I think we should take a
careful look at our accounting system and evaluate it if we
can, under the current system, provide the unbiased assessment
which the public expects and is entitled to. Is a new
independent oversight of the profession needed? At the very
minimum, we must prevent the inherent conflict of interest that
arises when a company hires the same firm to audit its books
and then provide consulting services.
In the midst of headlines about the Enron scandal, there is
some good news, and that is, the condition of our Nation's
energy markets. The biggest corporation in the world collapsed
within a few weeks, and I did not hear about a single blackout
that resulted from that crash, nor have I seen a tremendous
fluctuation in gas prices, as some would have predicted. I
think it says a lot about the country's efforts to deregulate
our energy markets, and I think we need to continue with
deregulation in the smartest way possible.
In closing, I look forward to hearing from our witnesses
today and from our witnesses in the future on what steps the
Federal Government must take to guarantee that there are not
going to be any more Enrons and how should we restore the
public's faith in our financial markets. Thank you, Mr.
Chairman.
Chairman Lieberman. Thank you, Senator Voinovich. Senator
Cleland.
OPENING STATEMENT OF SENATOR CLELAND
Senator Cleland. Thank you very much, Mr. Chairman, Mr.
Levitt, and Mr. Turner. Thank you very much, ladies and
gentlemen.
Let me just say that, before I came to this position in the
Senate, I was Secretary of State in Georgia for some 12 years.
In that State, the Secretary of State is the commissioner of
securities, that is, the State regulator of securities,
primarily responsible for looking after the small investor. I
am fortunate to be served now as my administrative assistant by
Wayne Howell, who was then the assistant commissioner of
securities. So we have been together in this business of
securities regulation or trying to detect fraud and prevent it
for quite a while.
I will say that while I was Secretary of State, we saw
various examples of fraud. We were the first State to put First
Jersey Securities out of business. We were the first State to
come with a major fine against Drexel Burnham Lambert. We were
the first State to really run the penny stock industry out of
our State. So I have been dealing with the question of fraud
and securities malfeasance for quite a while.
I will say that if the allegations here in this case of
Enron are true, it is the worst case of lying, cheating, and
stealing that I have come across in my public life and in 20
years, almost, of dealing with the securities industry.
We, in the Congress, will be hearing volumes of testimony
and evidence related to this collapse, but it really does come
down to this: Enron possibly lied, cheated, and stole from its
own investors and employees. That is the bottom line.
It is interesting that in combat, officers eat last. It is
obvious in the combat in the marketplace, Enron officers ate
first and left the troops to fend for themselves. That is
unconscionable. It is unconscionable in war, it is
unconscionable in peace, and it is unconscionable in our
economy.
We are actually here in this Committee to see if this is
true, if these allegations were indeed the case. We have got
hearings, subpoenas, and so forth. The bottom line is that this
is real. It is real in my State. We have a teacher retirement
system there. We have an employees' retirement system there.
They have already lost $127 million from the Enron collapse.
There are people in my State who worked for Enron. I came
across a family the other day that, through their 401(k)
program that they thought was very solid and sound, they
invested their life savings. The head of that family is now
sacking groceries--in the background himself--and does not
really have a substantial future.
There were really two Enrons: One run for the insiders and
the big boys at the top; the other Enron run for the employees
and the public.
Some interesting facts: If you were an Enron insider, from
the sale of company stock last year, you made $130 million. But
if you were just a shareholder, you took a $63 billion hit.
The average compensation for just a board member of Enron,
$400,000--but the average loss if you were just an investor was
71 percent.
If you were an insider and one of the big boys that ran
that operation, you put together 900 partnerships that were
based offshore, and then Enron itself paid no Federal taxes
last year.
These numbers really paint a tale of two corporations,
basically a corporation that the average citizen and the
average employee could not get a handle on in truth. But there
is Ken Lay giving employees in an online chat in September
these words, when he said about Enron stock it was ``an
incredible bargain.''
Now, basically, the two Enrons had a powerful negative
effect. It is fascinating that over $1 billion has been lost by
retirement funds, pension funds of people like teachers,
firefighters, and other public employees. What an irony. The
very first responders we depend on in case of a terrorist
attack were the first to get hurt by the Enron collapse.
Most pension funds, mutual funds, and institutional
investors held some Enron stock, and when one out of every two
Americans are invested in the market, most small investors in
America now have lost money over the Enron collapse, whether
they know it or not.
A sound investment is based on sound information. Georgia
is a full-disclosure State. One of the things that bothers me
most about the Enron situation is the lack of full disclosure,
the lack of transparency. What kind of information did Enron
investors have? Again, they had assurances from Ken Lay in
September that ``the company is fundamentally sound.'' An
outright lie. They had recommendations from Wall Street's top
investment firms recommending Enron as a strong buy. Wrong. And
they had a stamp of approval from auditor Arthur Andersen
saying that information in Enron's financial statements was
reliable. False and fraudulent.
Of course, we all know what is the situation now. Having
been Secretary of State as I was in charge of professional
boards also, and one of those was the CPA Board in Georgia. I
find it hard to believe that professional people, CPAs, sworn
to do a professional job, would not only be analyzing the books
but cooking the books at the same time. What an American
tragedy.
Mr. Chairman, as I go over these reams of documents, and go
through these hearings, I will try to keep an open mind. But I
am shocked at the revelations already disclosed to the
Committee, not only what were potentially illegal, but also
what were the legal actions taken by the corporations, actions
which were perfectly legal but designed to hide losses, evade
regulators, enrich corporate insiders.
Despite all these accounting irregularities, Enron's most
recent annual report included two statements from its
accounting firm, Arthur Andersen. One stated Andersen's opinion
that Enron's internal accounting system was ``adequate to
provide reasonable assurance as to the reliability of financial
statements.'' A lie. The other stated Enron's financial reports
``present fairly in all material aspects the financial
condition'' of the company. Wrong.
Why would Andersen make these statements? The real question
is: Why not? They were both Enron's accountant and its
strategic business consultant. The fox was truly guarding the
chicken coop, and ultimately the people of America have had to
pay a great price.
Interesting that this is not isolated. Twenty years ago,
consulting fees added up to about one-tenth of the revenues for
major accounting firms. Today, those consulting firms--they
account for about half of the revenues for these consulting
firms.
So the safeguards we thought we had in place have become
little more than window dressing. Our confidence is shaken. But
hopefully this Committee can address this and, through real
legislation and real sunlight on the problem and real
transparency in securities markets, can restore some of the
lost confidence we have all suffered.
Thank you, Mr. Chairman.
Chairman Lieberman. Thank you very much, Senator Cleland.
Senator Bennett.
OPENING STATEMENT OF SENATOR BENNETT
Senator Bennett. Thank you, Mr. Chairman.
We have had a lot of conversation about Enron and Enron
executives, and I won't repeat any of that, but will just add
this reflection:
Had the Enron business plan worked, of course, they would
all be heroes. That is a little like saying had the roulette
wheel come up red instead of black, the investor who put his
money on red would be considered a really smart guy, because
what Enron management was doing was almost as dangerous, if not
as dangerous, as going to Las Vegas and putting their chips on
one number or another as far as the roulette table is
concerned. But they were the management. They were running the
company, and they decide that was the right thing to do.
What distresses me is that nobody who was looking over
their shoulders pointed out that they were gambling in such a
high-risk circumstance.
We have heard about Arthur Andersen. The auditors didn't.
We have heard about the analysts who didn't look as deep as
they should but were anxious to hang on to their relationships.
We haven't heard anything about the outside directors. I have
served on boards of public companies, and I can give examples,
as everyone in the room can, of outside directors who said,
``Wait a minute, we have a fiduciary responsibility as outside
directors to call a halt to this.''
My first experience with a major bankruptcy was when I was
serving in the Nixon Administration on the Penn Central
Railroad, which in its own way was as glittering an example of
corporate success as Enron was, and it ended up going belly up.
The people who called that shot, who blew that whistle, who
raised the specter of bankruptcy were the outside directors. I
remember very clearly when they came to the Nixon
Administration and said there is a serious problem. And I won't
go into the details of what we then dealt with in trying to
ameliorate the failure of the then Nation's largest railroad,
with all of the implications that had for transportation policy
throughout the country. But it was the outside directors who
said we have a fiduciary responsibility to the shareholders to
point out the fact that management is on a very dangerous
course and this railroad is going to go under.
So there is a broader blanket to be thrown out here than
just beating up on the top executives of Enron, and I concur in
the beating up that has gone on. I am not trying to defend
them. But we investors depend on auditors; we depend on the
analysts from the big investment firms; and we depend on the
system of outside directors. I think there is a requirement
that X percentage of the directors be outside directors, not
insiders. And that system has failed us.
I am not sure we can resolve it by passing laws that say
every outside director will henceforth take his duty seriously.
I know some outside directors, potential outside directors who
refused to accept appointments because they said you don't have
adequate insurance for the kind of class action lawsuits if I
take this on.
But this is an opportunity for us to examine all aspects of
the way public companies work in this country and see what we
can do to improve it.
Thank you, Mr. Chairman.
Chairman Lieberman. Thank you, Senator Bennett. Senator
Carper.
OPENING STATEMENT OF SENATOR CARPER
Senator Carper. Thank you, Mr. Chairman. I will not attempt
to match the outrage or the eloquence of my colleagues who have
spoken before me. I would observe that I have never had the
pleasure of hearing Mr. Levitt or Mr. Turner testify. I am
going to get that chance, and I am looking forward to that
opportunity, and I am going to be real brief.
Mr. Chairman, I have a statement I would like to enter for
the record, if I could.
Chairman Lieberman. Without objection, so ordered.
[The prepared statement of Senator Carper follows:]
OPENING PREPARED STATEMENT OF SENATOR CARPER
I know we've all read a lot in recent weeks about Enron's collapse
and I know most of my colleagues and I will have multiple opportunities
to study more closely what happened and what we can do to prevent it
from happening again. The Justice Department and a number of
congressional committees are also looking into this matter. As we go
about our work, however, I believe it is important to recognize that
Enron is not an isolated incident but instead the latest, and certainly
the largest and most high-profile in a series large-scale corporate
accounting mishaps. While not on the same scale, Sunbeam, Waste
Management, Rite Aid, Lucent and Xerox have all had problems similar to
Enron's.
We're not here this morning to hunt down the juicy details about
who at Enron, Arthur Andersen or even the Bush Administration knew what
and what they were doing about it. What we are doing is taking a look
at some of the broader public policy questions raised by this company's
failure.
While the United States still has the best auditing and accounting
standards in the world, and thus the strongest capital markets, Enron
illustrates areas where these standards must be improved. I don't know
yet which is the best course of action but we need to take steps before
we hear about the next Enron to address the independence of auditors
and analysts, the oversight of the accounting profession and the
transparency of corporate disclosures.
In recent years, more and more Americans at all income levels have
put more and more of their retirement savings in the stock market.
Enron's failure raises serious questions about the accuracy of the
information investors have access to when making investment decisions.
Investors have lost millions on their Enron stock, and countless Enron
employees have watched their retirement savings vanish as their company
collapsed in a matter of months. Congress, regulators and the
accounting profession must act now to restore investors' confidence.
Senator Carper. Senator Voinovich, alluded earlier to his
participation in the State of Ohio's pension plan for its
employees when he was governor. My guess is he also nominated
those who served as members of the board of trustees to oversee
that pension plan. I had a similar responsibility as governor
for Delaware for a number of years. I took that responsibility
seriously, as I am sure he did.
There is more to this than the outrage that we feel on
behalf of those Enron employees who have lost their life
savings. There is more to this than the outrage we feel for
those who might be members of the Ohio or Delaware State
employee pension plans who have lost measurably their
retirement savings.
There is a bigger question, and that is the confidence that
the rest of the world, which is looking for places to invest
their money to ensure that we continue to enjoy their
confidence; and as trillions of dollars move throughout the
investment community and many of them end up here, that we
continue to be an attractive environment in which to invest
those funds.
One of the best ways that we can do that, once we have
completed flogged verbally those who have caused this disaster,
is to bear down and stay with this issue when the media maybe
loses attention and to continue to probe and to find the
answers to the questions so that we can ensure that not only
have we just gotten some satisfaction from venting our spleen
at the outrages we have learned of, but we have actually done
something real to ensure that other employees of companies but
also other investors from around the world will continue to
invest in the securities within this country with the kind of
confidence that has enabled us to be the most successful Nation
on Earth.
Thank you, Mr. Chairman.
Chairman Lieberman. Thank you, Senator Carper. That is
certainly our intention, which is to be judged by the ultimate
product of our oversight and investigation.
Senator Bunning.
OPENING STATEMENT OF SENATOR BUNNING
Senator Bunning. Thank you, Mr. Chairman.
Obviously what we have before us today is a mess. There is
no other way to look at it. We have an energy trading company
basically in ruins, thousands of employees with little or no
retirement savings, a major accounting firm under a cloud, and
investors left holding the bag.
We have heard allegations of shredding documents, shady
business deals, and insider trading. Every day it seems a new
revelation comes to light.
As it has been mentioned, in the year 2000, Fortune
magazine listed Enron as the seventh largest corporation in
America. Now the company has filed bankruptcy, the largest
business ever to do so in U.S. history.
Enron's fall was relatively quick, but it seems to come on
the heels of several years of questionable business deals.
Enron's financial transactions are also extremely complicated,
and we are only beginning to understand exactly what happened
to this company.
We are going to be asking who, what, when, where, and why
for a long time. I am confident that Congress and the Federal
agencies will move as quickly as possible to get the answers to
these questions.
This is just the first of, I imagine, many hearings the
Governmental Affairs Committee will hold, and at last count,
there were almost a dozen other congressional committees
digging into this Enron problem. Combine that with the
investigations by the SEC, Justice, Labor, the IRS, and all the
private lawsuits that have been filed, and you have definitely
got a full-blown financial meltdown.
Some people have already started offering ideas about ways
we can prevent this from happening again. While ideas are
always helpful, the last thing we need is a knee-jerk reaction.
Before we charge in the middle of it and start making
changes, we have to understand exactly what happened before we
can seriously propose legislation or regulatory changes. The
story of Enron employees who not only lost their jobs but also
their retirement savings should be a major wake-up call for all
of us to look at the companies that require their employees to
invest their 401(k)'s in their own stocks.
I am looking forward to working with the Committee as we
get to the bottom of this Enron mess and consider the changes
that need to be made.
Thank you, Mr. Chairman.
Chairman Lieberman. Thank you, Senator Bunning. Senator
Carnahan.
OPENING STATEMENT OF SENATOR CARNAHAN
Senator Carnahan. Thank you, Mr. Chairman.
America has the most vibrant and dynamic economy in the
world. The foundation of our economy is our capital markets,
which are robust and resilient. But the success of these
markets depends on the free flow of accurate and reliable
information. Our markets are the envy of the world because of
the confidence that investors have in the private and public
institutions that produce, verify, and analyze this
information.
The collapse of Enron, however, represents a dramatic
failure of these institutions. These failures will have
repercussions for years to come. There were a number of
failings, and let me mention just three.
The first failing was committed by the company executives
who had a legal duty to act in the best interest of the
shareholders. And while I do not want to prejudge the facts in
this case, based on what we now know, it is fair to say that
Enron executives did not make full and candid disclosures of
the company's financial condition until they were forced to do
so.
The next failure came when the accountants who were charged
with auditing the information that Enron presented certified
that it was consistent with the generally accepted accounting
principles. In this instance, the same firm who was auditing
Enron's financial records was also advising Enron on its
business operations and accruing lucrative fees. We do not know
the total effect of this blatant conflict of interest, but we
know that the accountants failed to protect investors.
And, finally, there was the failure of government agencies.
The SEC is charged with regulating the financial activities of
publicly traded companies. They should ensure that the
information provided to investors is accurate.
But with all of these safeguards in place, what went wrong?
Why didn't the alarm bells go off sooner? These multiple
failures have created multiple victims. I feel for the
employees who worked for Enron, those who dedicated themselves
to that company for so long and now find themselves financially
devastated.
And I sympathize with those who invested in Enron. They had
no reason to mistrust the information that Enron published to
the world. The massive debt hidden in partnerships was not
known to them or to the hundreds of analysts and advisors upon
whom they relied.
Public employees in Missouri have suffered large losses.
The Missouri State Employees Retirement System has an
impeccable record of making conservative, prudent investments
of employees' pension funds. Still, the system owned just under
750,000 Enron shares prior to the collapse and lost $8.7
million. Missouri teachers fared even worse. Their retirement
plan lost $22.8 million from investments in Enron.
If these sophisticated investors could not detect that
Enron was in poor financial condition, how could the average
investor, putting aside money for college or for retirement,
how could they have known?
Let me also suggest that the victims are not limited to
those who invested in Enron. Every person who owns stock or a
mutual fund or has a pension will suffer due to the collapse of
Enron. The action of Enron's executives and its accountants
together with the failure of our oversight agencies have eroded
investor confidence in our markets.
Investors never had to consider that a large, reportedly
profitable company might go belly up in a span of months. Now
they do.
Investors never had to question whether a prestigious
accounting firm would certify balance sheets that were grossly
misleading. And now they do.
Investors never had to wonder whether respected, highly
compensated executives were playing a risky shell game with
billions of dollars. But now, thanks to Enron, they do.
This scandal will have an impact on investors' confidence,
stock prices, and access to capital for many years to come. The
task of this Committee and the Congress as a whole is to
identify where the system failed, fix those problems, and begin
to remedy them.
We need a greater transparency and an earlier warning
system. One warning system that a company may be in trouble is
when its executives are selling large amounts of stock. I have
learned, however, that information about insider trading is not
easily accessible. When I directed my staff to request
information from the SEC about sales by Enron executives, they
were told that I would have to file a written request and wait
15 days. The SEC also stated that 95 percent of the reports of
insider trading were not filed electronically. This is
unacceptable in a computer age.
So, today, I will introduce legislation that requires
information about insider sales of publicly traded companies to
be filed electronically on the day of the sale. The bill will
also require the SEC to make this information available to the
public on the Internet.
This single reform could dramatically level the playing
field between insiders and ordinary investors. Never again
would company executives be able to dump large amounts of
company stock without facing immediate scrutiny about the
financial health of their company.
I know my colleagues will be proposing many other new ideas
in the coming days, and I hope these hearings will result in
reforms, for never again should workers and investors be
violated as they have been by an American corporation.
Thank you, Mr. Chairman.
Chairman Lieberman. Thank you, Senator Carnahan. Senator
Dayton.
OPENING STATEMENT OF SENATOR DAYTON
Senator Dayton. Thank you, Mr. Chairman. I want to commend
you for holding this very important hearing. I also want to say
to my colleague, Senator Carnahan, please put me down as a
cosponsor of your bill.
Mr. Chairman, I hope that this and subsequent hearings will
discover and disclose the truth about this financial debacle,
especially the actions of Enron's officers and directors who
caused it and of the auditors at Arthur Andersen who abetted
its concealment. The recent shredding of documents by both
Enron and Andersen personnel shows how much they don't want us
to know about their irresponsible and possibly illegal actions.
This hearing properly focuses on the failures of government
regulation and oversight which permitted or failed to detect
the company's questionable dealings, the mounting losses, and
the resulting financial collapse.
While we must identify those regulatory shortcomings and
propose the necessary remedies, it is very important, I
believe, not to imply that they bear the primary responsibility
for Enron's disastrous collapse. In my view, that blame and
shame belong first and foremost to the Enron officers and
directors who devised, approved, and then concealed these
unwise and unsound financial schemes; and, second, to the
Andersen auditors who abetted them.
These were not a few honest corporate mistakes. They appear
to be a multitude of deliberate actions taken over several
years to maximize profits--nothing wrong with that--but also to
cover up losses, evade taxes, enrich company insiders, and then
deceive employees, stockholders, and regulators.
These corporate misdeeds have caused enormous damage to
thousands of Enron employees. It is heartbreaking to read about
the honorable, hard working Americans who have lost their jobs,
their retirement savings, and their life's security, and who
also were lied to by Enron's top management about the company's
actual condition.
Enron's investors have lost over $80 billion from the
stock's collapse. Like the employees, they didn't know about
the company's concealed dealings, 881 offshore accounts,
successive disasters, and mounting debt. Enron's top executives
certainly knew. They unloaded over $1 billion of their stock
before its collapse.
Someone who should have known about Enron's true financial
condition, and who was responsible for telling everyone else
about it was the supposedly independent auditor, Arthur
Andersen. I know something about auditing from my 4 years as
Minnesota's State Auditor. The auditor exists and is paid for
one essential purpose: To assure everyone else that a company
is reporting its financial condition completely, honestly, and
accurately.
Whatever the complexities of corporate transactions, the
auditor has one simple standard: The truth. Is the client
telling the truth and all of the truth? Everyone else in our
economic system, financial institutions, capital markets,
investors, and other companies, all rely upon the auditor's
ability and integrity. There is mounting evidence that Arthur
Andersen in this instance violated that trust.
In 1997, the auditors reportedly determined that Enron's
stated earnings of $105 million were $51 million too high.
Nevertheless, Andersen agreed to invoke a materiality provision
and signed off on $105 million as Enron's reported earnings.
That is deceitful, dishonest, and wrong. And no one needs an
accounting manual to know it.
Last October, when Enron reported a third-quarter loss of
$618 million, it also disclosed that it had overstated its
profits by nearly $600 million during the prior 5 years.
Enron's CEO also mentioned that the company's value had
declined by $1.2 billion as a result of its deals with certain
partnerships.
Those disclosures precipitated the stock's collapse, and at
the time both Enron and Andersen employees were reportedly
shredding documents.
If time permitted, Mr. Chairman, I would present more
damning evidence. However, I also want to address the
inadequacies in government rules, disclosure requirements, and
oversight which permitted and then failed to detect these
egregious abuses.
I believe that this and subsequent hearings must
investigate the following matters: In 1993, the Chairwoman of
the Commodity Futures Trading Commission, just before her
departure, persuaded that board to exempt energy futures from
its regulation and oversight. Shortly after her departure, that
Chairwoman joined Enron's board of directors.
Then 2 years ago, when Congress was updating these
commodity regulations and oversight responsibilities, Enron
reportedly lobbied aggressively and successfully to keep energy
financial transactions exempted from any government regulation
or oversight. William Rainer, then the Chairman of the
Commodity Futures Trading Commission, testified that he was
``deeply concerned'' about exempting energy trades from
regulation, because those dealers had no one else regulating
them, whereas the dealers in financial derivatives were still
subject to other Federal financial regulation. His warning went
unheeded and proved to be prophetic.
Recently, Charles Bowsher, who served as the Comptroller
General of the United States from 1981 to 1996, observed,
``Money allowed the Enron leadership to come to town. If you
look back over the last 5 years, what they did get was no
oversight.''
In another area, then-Chairman of the Securities and
Exchange Commission, Mr. Levitt, tried repeatedly and
courageously to pass legislation that would prohibit an auditor
from both conducting the annual independent audit and also
providing extensive accounting services. Andersen pocketed $52
million from that dual role in its last reported year. Yet, the
accounting industry has strongly opposed this and other
proposed reforms.
And now the person who led the industry's successful
opposition has been appointed by President Bush to chair the
Securities and Exchange Commission. Addressing an accounting
industry conference, the new chairman lamented that previously
the SEC had not been a ``kinder and gentler place for
accountants,'' but that would change. Henceforth, he told them,
the SEC will have a ``continuing dialogue and partnership with
the accounting profession, and we will do everything in our
power to evidence a new era of respect and cooperation.''
Unfortunately, what is needed now is a new era of higher
standards and stricter accountability for the accounting
industry. Financial relationships which compromise auditors'
independence should be prohibited. Existing peer reviews in
which firms exonerate each other must be replaced with a
strong, independent governing board. That board or another
independent entity must regularly review and update existing
audit standards and the generally accepted accounting
principles which comprise them. And neither the standards nor
the principles nor the enforcement of them should be
adjudicated by Congress.
If these shortcomings are not swiftly remedied, there will
be more Enrons, not in the sense of companies failing, which is
an unpleasant but inescapable feature of capitalism, but in the
sense that these failures are caused by mistakes and misdeeds
previously hidden or misreported. This oversight laxity
benefits a relatively few but well-connected corporate cowboys,
who want to play fast and loose with other people's capital and
the people they pay to lie with them. But it is terribly
harmful to everyone else in this country, the millions of
businessmen and businesswomen, company employees, and investors
whose livelihoods depend upon an honest and reliable economic
system. It is our responsibility to ensure that system.
Thank you, Mr. Chairman.
Chairman Lieberman. Thank you very much, Senator Dayton.
I want to thank all my colleagues on the Committee for
their opening statements. I appreciate them. As Chairman of the
Committee, I am proud of them. I think what is reflected here
is a shared sense of outrage about what happened as we know it
now in the Enron scandal and a shared desire to end this
investigation, whenever we conclude it is ended, with a series
of proposals for reform that will do as best as we can to
ensure that the Enron scandal or anything like it never happens
again.
So I appreciate very much what was said in reflection of
the experience and the insight that is here on the Committee,
and it gives me confidence that the goal that all of us have,
which is to conduct a rigorous, nonpartisan investigation
producing concrete proposals for reform, will be accomplished.
We will go now to our witnesses. Mr. Levitt and Mr. Turner,
thanks very much for your patience as this Committee begins
what I have described as a long journey, an important journey
ahead of us. Arthur Levitt, we couldn't have a better witness
to start this off than yourself. You worked on Wall Street. You
were the chairman of the American Stock Exchange, worked as
chairman of the New York City Economic Development Corporation.
In an unusual chapter of your life, you owned the Roll Call
newspaper here on Capitol Hill, but then most directly and
significantly related to these matters, for 8 years, from 1993
to 2001, you were the Chair of the Securities and Exchange
Commission.
Lynn Turner, a background in education and in business
accounting, served for 3 years as chief accountant of the
Securities and Exchange Commission during the time that Arthur
Levitt was chairman.
I would say, as you have heard these statements, that I
appreciate very much that both of you are here. There are
several investigations of Enron going on. They are fact-
intensive. We have begun one ourselves, and those are going on
both in Congress and in prosecutorial offices around the
country. But it seemed to me that as we started our
investigation, we would benefit greatly from having you two and
the expert witnesses on the panel to follow, if you will, to
take us up to the mountaintop and, based on what we know about
Enron and what happened to it today, help us understand the
facts as we know them, looking backward, but also give us some
guidance as we begin our investigation as to what the most
critical questions are we should ask and perhaps even suggest
to us what you would guess based on your considerable
experience some of the answers to those questions might be.
So, with that, and our thanks, I now welcome the testimony
of Arthur Levitt.
TESTIMONY OF HON. ARTHUR LEVITT, JR.,\1\ FORMER CHAIRMAN, U.S.
SECURITIES AND EXCHANGE COMMISSION
Mr. Levitt. Mr. Chairman, Senator Thompson, and Members of
the Committee, thank you for the invitation to share my
thoughts on the failure of Enron and its implications for our
financial markets.
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\1\ The prepared statement of Mr. Levitt appears in the Appendix on
page 75.
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Today, there is an emerging crisis of systemic confidence
in our markets. What has failed is nothing less than the system
for overseeing our capital markets. I do think we have an
opportunity to repair trust in those on whom investors depend,
and in the process, trust in the numbers that are the backbone
of our markets. But our response must be comprehensive. Healthy
and resilient financial markets depend on the accountability of
every single one of its key actors--managers, auditors,
directors, analysts, lawyers, rating agencies, standard
setters, and regulators.
Enron's collapse did not occur in a vacuum. Its backdrop is
an obsessive zeal by too many American companies to project
greater earnings from year to year. When I was at the SEC, I
referred to this as a ``culture of gamesmanship''--a
gamesmanship that says it is OK to bend the rules, to tweak the
numbers, and let obvious and important discrepancies slide; a
gamesmanship where companies bend to the desires and pressures
of Wall Street analysts rather than to the reality of the
numbers; where analysts more often overlook dubious accounting
practices and too often are selling potentially lucrative
investment banking deals; where auditors are more occupied with
selling other services and making clients happy than detecting
potential problems; and where directors are more concerned
about not offending management than with protecting
shareholders.
Any reforms must recognize the importance of the
gatekeepers in safeguarding the interests of investors and the
fundamental need to preserve and enhance those gatekeepers'
independence. Certainly these steps, or any steps, are not a
panacea, but we have got to begin to reinvigorate the financial
checks and balances that over the years, as a result of nothing
less than a cultural change, has eroded in America.
First, we must better expose Wall Street analysts'
conflicts of interest. For years, we have known that analysts'
compensation is tied to their ability to bring in or support
investment banking deals. In early December, with Enron trading
at 75 cents a share, 12 of the 17 analysts who covered Enron
rated the stock either a hold or a buy.
Two years ago, I asked the New York Stock Exchange and the
National Association of Securities Dealers to require
investment banks and their analysts to disclose clearly all
financial relationships with the companies they rate. That
rulemaking--still not finalized--should go further and mandate
that analysts disclose how their compensation is affected by
their firm's investment banking relationships. And Wall
Street's major firms--not its trade group--need to take
immediate steps to reform how analysts are compensated.
As long as analysts are paid based on banking deals that
they generate or work on, there will always be a cloud over
what they say. Analysts also should not be allowed to trade the
stock of any company for which they have issued a
recommendation in the last 30 days.
Second, company boards, unhappily, fail to confront
management with tough questions. Stock exchanges, as a listing
condition, should require at least a majority of the directors
on company boards to meet a strict definition of independence.
That means no consulting fees, use of corporate aircraft
without reimbursement, support of director-connected
philanthropies, or the kinds of corporate seductions that are
present in all too many board rooms in this country. In Enron's
case, at least three so-called independent board members would
have been disqualified under this test of independence.
Third, many accounting rules need to be updated to better
reflect changing business practices to give investors a better
understanding of the underlying health of companies.
Because the Financial Accounting Standards Board is funded
and overseen by accounting firms and their clients, its
decisions have become agonizingly slow. This well-meaning group
must defend itself as well from congressional pressure, which
is often applied when powerful constituents hope to undermine a
rule that might hurt their rulings. FASB's funding should be
secured not just through the accounting firms and the
corporations for whom they establish standards, but also a
number of market participants from the stock exchanges, to
banks, and to mutual funds.
The Financial Accounting Foundation, which chooses FASB
members, should be composed entirely of the best qualified
people, the people with the best judgment, not merely those who
neatly represent constituent interests. I have never favored
constituent boards and I think the way this board is structured
really defies the kind of standard setting that is cried out
for in this situation. The FASB should then be able to focus
more on getting the standards right and avoiding delays and
compromises that ill serve investors.
I will turn briefly to probably the most urgent area of
reform. Like no other, the accounting profession has been
handed an invaluable but a fragile franchise. From this Federal
mandate to certify financial statements, the profession has
prospered greatly. But as an edict for the public good, this
franchise is only as valuable as the public service it provides
and as fragile as the public confidence that gives it life.
It is well past time to recognize that the accounting
profession's independence has been compromised. Two years ago
the SEC proposed significant limits on the types of consulting
work an accounting firm could perform for an audit client. An
extraordinary amount of political pressure was brought to bear
on the Commission. We ended up with the best possible solution,
given the realities of the time. I would now urge, as a
minimum, that we go back and reconsider some of the limits
originally proposed, namely, a prohibition on the auditor
designing or installing information technology systems and
performing the internal audit.
Auditors, I believe, should also be barred from consulting
on precisely how to structure transactions, such as the kinds
of special purpose entities that Enron engaged in. This type of
work only serves to help management get around the rules.
I also believe that the audit committees, not company
management, should pre-approve all other consulting contracts
with the audit firm. Such approvals should be granted rarely
and only when the audit committee decides that a consulting
contract is in the shareholders' best interests.
And last, I propose that serious consideration be given to
requiring companies to change their audit firms, not just the
partners, every 5 to 7 years to ensure that fresh and skeptical
eyes are always looking at the numbers.
More than 3 decades ago, Leonard Spacek, a visionary
accounting industry leader, stated that the profession could
not survive as a group, obtain the confidence of the public
unless, as a profession, we have a workable plan of self-
regulation. Yet all along the profession has resisted
meaningful oversight. Rarely, of all the groups that the
Commission oversees, has this group ever spoken of the public
interest.
We need a truly independent oversight body that has the
power not only to set the standards by which audits are
performed, but also to conduct timely investigations that
cannot be deferred for any reason, and the ability to
discipline accountants. All of this needs to be done with
public accountability, not behind closed doors.
To preserve its integrity, this organization cannot be
funded in any way by the accounting profession. The rise of the
baby-boomer generation, changing retirement patterns and
markets that sometimes defied the laws of gravity brought more
and more first-time investors into our markets. These are our
friends. These are our neighbors, whose hopes and aspirations
became inextricably linked to the health, the resiliency of our
markets.
We assault those dreams if company executives sell out our
shareholder faith and if those purporting to be independent are
anything but. Enron, like every other financial failure before
it, proves that investors bear the ultimate cost. It is time to
repair what has been lost.
Thank you.
Chairman Lieberman. Thank you, Mr. Levitt, for an excellent
statement. Mr. Turner.
TESTIMONY OF LYNN E. TURNER,\1\ FORMER CHIEF ACCOUNTANT, U.S.
SECURITIES AND EXCHANGE COMMISSION
Mr. Turner. Mr. Chairman, Senator Thompson, and Members of
the Committee, Enron highlights two issues. The first is that
accounting standards are meaningless unless fully complied with
and enforced through a rigorous, unbiased, and independent
audit. The process needs to be improved so as to yield more
timely and higher quality standards. That is our accounting
standard setting process.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Turner with an attachment appears
in the Appendix on page 78.
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But keep in mind that no matter how quickly information is
reported to the public, or what information is reported, if it
is inaccurate its value is lost. Even worse, bad information
leads to counterproductive decisions.
To the first issue, we know that under the existing rules,
Enron's financial statements should have presented a clearer
picture than when they were first presented to investors. Based
on filings the company made with the Securities and Exchange
Commission in November of last year, there were four instances
of non-compliance with existing rules. Three of these errors
have resulted in Enron restating its financial statements for
improperly recording an approximately $1.2 billion in
additional equity; the company failing to book audit
adjustments, decreasing income by $51 million or 48.6 percent
of the reported net income of $105 million in 1997, as we
already heard from Senator Dayton; and the company failing to
consolidate or include the numbers, including debt, from
partnerships commonly referred to as special purpose entities
in Enron's financial statements.
These special purpose entities, or SPEs, are typically
designed for a specific transaction. SPEs come in various
forms, including partnerships like Enron established,
corporations, or even trusts. SPEs are used for many purposes
such as financing buildings or equipment, raising capital by
transferring receivables, and providing capital to a bank that
has troubled loans that are shifted out at the bank. While SPEs
are sometimes used for legitimate business purposes, they are
also used to hide liabilities away from the unwary investor.
SPEs usually involve at least four parties when they are
set up: The company who sets it up, called the sponsor, in our
case Enron; the SPE itself, as you have read about in the
paper, with names like LJM1, Chewco or Jedi; a lender to the
SPE, who is willing to finance its activities; and an investor
from the outside who will own the SPE. In a nutshell, the
sponsor establishes the SPE which in turn acquires or builds an
asset. The funding is provided by the lender who in turn may
look to the sponsor for some form of support for the loan such
as a guarantee or credit enhancement.
The SPE is owned by an independent investor who puts in, in
the form of equity, at least 3 percent of the amount of capital
needed to acquire the asset. The debt of the lender is then
paid back through lease payments or securitization of the SPE's
assets. There is an expanded discussion of SPEs in my written
statement. I would be happy to respond later to any questions
you might have.
The fourth question raised with respect to the financial
statements of Enron involves the adequacy of the disclosures,
the transactions Enron entered into with related parties such
as SPEs. The description and discussion of these related party
transactions are significantly greater in detail in the
November 2001 filings than had previously been disclosed. One
can only ask if now, why not before?
New accounting rules were not needed to prevent the
restatements of Enron's financial statements or to improve the
quality of some of its disclosures. Compliance with and
enforcement of the accounting rules that have been on the books
for years would have given investors a timely and more
transparent picture of the trouble the company was in. And the
security rules also currently require disclosures that are
intended to give the investor an opportunity to look at the
company ``through the eyes of management.''
While Enron has correctly been described as a business
failure, in the end it was also a failure that the audited
numbers did not report the true economic condition of the
company in an accurate or timely manner to the investors. To
correct this lack of compliance with accounting standards I
urge you to consider the imperative need for an effective,
independent professional oversight body for the accounting
profession that has the following critical elements: It is
conducted by an adequately funded organization. Its members are
drawn from the public and not currently practicing accountants.
It has the ability to effectively and expeditiously investigate
and then effectively and expeditiously discipline those who
failed to follow the rules. It must have the power to establish
auditing and quality control standards that serve the interests
of investors, especially those when these vary from the
interest of the profession. And it inspects the work of
auditors on an ongoing basis to ensure they have made the
investing public, and not the amount of consulting fees they
can generate, their number one priority.
In studying this issue, I would encourage you to consider
various types of regulatory organizations that have already
been established, including the NASDR, the National
Transportation Board and the recently created foundation in the
United Kingdom.
Let me just briefly mention the second issue, which deals
with accounting disclosures. We need to enhance disclosures
regarding events and transactions that, should they occur,
would result in a company being required to make payments to a
third party. We have now seen this type of meltdown, as we have
seen in Long-Term Capital Management, in Enron, and those
disclosures need to be made to prevent that in the future.
In addition, greater disclosure should be required of key
performance indicators that provide investors with the ability
to identify at an early stage trends in the business that may
have predictive ability about what is going on.
Second, as Chairman Levitt has noted, our standard-setting
process for issues such as SPEs has taken longer than it has
taken my children to graduate from high school. If the SEC is
to continue to look to the private sector to set standards,
which I do very strongly support, then the SEC and investors
have the right to expect timely resolution of this and other
important issues. If the FASB were unable to rectify the SPE
issue by the end of 2002, then I would urge the SEC to take
action.
Third, FASB can accomplish its goal of publishing guidance
in a timely fashion only if unimpeded by the constant lobbying
of special interests who seek to slow down its processes with
issues that lack relevance and who too often run to our
government to seek its intervention in order to keep investors
in the dark about the numbers.
Fourth, the FASB's emerging task force is comprised
entirely of representatives of industry and the accounting
profession and lacks representatives from the investing public
and community. Its mission does not mandate standards that
result in the most transparent reporting for investors. In
fact, it has at times seemed to be more intent on
grandfathering poor accounting from the past. This should
change.
And finally, one of the stark realities the FASB has faced
in the past when setting standards is that before the ink
dries, the investment banking community and accountants are
joining forces to find ways to structure transactions, just as
we have seen in the Enron case, to get around new rules. It is
time to get away from this mentality and a good starting point
would be to prohibit auditors from designing and structuring
transactions that result in less rather than more transparency
for investors.
Thank you.
Chairman Lieberman. Thank you, Mr. Turner, for a very
helpful statement. We are going to go around now and have 7
minutes for each Senator to ask you questions.
I wanted to start with a broader baseline question, if I
can, Mr. Levitt, and put it in this context: Congress and, in
fact, State legislatures, etc., all over the country pass laws
which are aimed at encoding our best aspirations for our
behavior, encouraging good behavior and prohibiting and
ultimately punishing bad behavior. Notwithstanding that, human
nature being what it is, people will violate those laws.
So as you look at what we know now about the Enron
collapse, which we now call the Enron scandal, is this one of
those situations where these folks were just going to do what
they did regardless of what the law was? Or is it a situation
where we can now look back and say if the laws had been
different, perhaps--as your opening statement indicated--self-
regulation of professions had been different, if the agencies
had had more authority, we could have prevented the collapse of
Enron? Or we certainly could have prevented some of the damage
that was done to the thousands of employees and investors who
lost their life savings?
I think you understand what I am asking. If the laws and
agencies were better prepared, could we have protected a lot of
the people who were hurt by Enron's collapse?
Mr. Levitt. I have thought about that very question many
times, and I think it is another case of the nail in the shoe
of the horse. Any of the elements around the rating agencies,
the standard setters, the regulators, the board, the analysts,
the auditors, at different points in time could have blown the
whistle, could have turned up what a sham this really was.
But these things, I do not think, happen in a vacuum. The
fact that any one of them might have been able to do it says
something about the confluence of all of them in this unhappy
event, which I believe occurs only when there is a kind of
cultural economic erosion created by a business community that
is highly competitive, certainly a desirable characteristic,
but where some of them begin to push toward the lines, and go
over the line, others cannot afford not to follow. And almost
everybody else is playing catch up.
And when you have an incidence of guile of this magnitude,
playing catch up just is not enough.
Chairman Lieberman. Of course, one of the functions or
effects of law often is to effect the kind of culture that you
have talked about. I think in one sense that comes to mind we
have done that with regard to the environment over the years.
We have changed the ethic out there so that a lot of what used
to pass as business as usual now does not, and it does not
require law everywhere. Potential polluters are cleaning up on
their own. So part of the question is can we change the ethic
that you have described quite correctly by what we do here?
Mr. Levitt. Absolutely, you can change behavior. You can
begin to get lots of those of us in this game to focus on it
differently, to deal with our responsibilities differently.
Right now this event has been a clarion call to America's
boards of directors. Whether they stay with it depends on
whether you can be focused in terms of a direction which will
encompass the elements that led to this background. And they
are very broad.
To focus merely on the auditors I think would be a mistake.
This goes far beyond that.
Chairman Lieberman. I agree. That is one of my hopes for
this investigation and the others that are occurring, that by
trying to tell the story--and obviously we are being assisted
greatly by the media at this point--about what happened with
Enron, we create a fact situation, an exposure, that presumably
will alter the ethic as well. And then it is up to us and the
professional groups that are out there, in terms of self-
regulation, to encapsule that ethic as we go forward.
You talked in your opening statement about the importance
of shoring up the independence and resolve of the gatekeepers
which keep our markets honest--and, of course, I agree with
you--the auditors, the analysts, the corporate directors, and
the folks who set accounting standards.
I want to ask you, as a former Chairman of the SEC, about
what its role is. Because I would guess that most investors,
average investors, assume that it is the Securities and
Exchange Commission that is the watchdog that makes sure that
disasters like Enron do not occur. So I would like to ask you
to give us a baseline here about what the SEC's role is in the
system of gatekeepers guarding the integrity of the markets.
And tell us if you think there is anything that should be done,
particularly in the light of what we know about Enron now, to
alter that role?
Mr. Levitt. The SEC's role is multifaceted. It ultimately,
I believe--and every chairman will view this from a different
perspective. I think the most important constituent that this
government agency has is America's individual investors. Nearly
all of you have commented on confidence in our markets, and
preserving that confidence by protection of the American
investor is the primary goal of the SEC.
It is done in many different areas. The Commission has the
responsibility for maintaining markets where competition is
both fair and fierce. They have the responsibility for
overseeing the standard-setting process which we delegated to
the FASB. We have the responsibility that our regulation is
based not on merit regulation but on full and on fair
disclosure. And in that connection, we monitor thousands of
filings every year. We have the responsibility when the system
fails, when fraud enters into the picture, of bringing
enforcement action.
Those are the multitude of responsibilities. Now I have
learned through years in the private and public sector that to
expect any government agencies to operate so comprehensively
that they can eliminate all fraud and deception simply will not
work. The SEC and investor protection in the United States is
determined by a trilogy of private rights of action, of self
regulation, and of the SEC's enforcement arm. Any one of those
three could not do it alone.
Chairman Lieberman. I believe my time is up. There is a
question that maybe someone else will ask--and perhaps we can
talk about it another time--which is whether there is a larger
role here for the SEC, including as I gather occurs--and I am
not proposing this, I am raising it. I gather it occurs in some
developed economies in Europe, for instance, where there is a
public auditor. There are public employees who audit the books
of publicly held corporations, so that they are obviously
thoroughly independent and do not have any of the conflicts
that we have seen occur here with regard to private auditors. I
am going to hold on that and just leave the question with you.
I will now yield to Senator Thompson.
Senator Thompson. Thank you, Mr. Chairman. And, gentlemen,
thank you for your analysis and suggestions as to what we might
do. It is remarkable the things that are so self-evident that
need to be done have to really hit home to us in the context of
a crisis like this. But now we have the crisis, and perhaps we
can do some things that we should have done a long time ago.
I think you rightfully point out the problem with the
gatekeepers and what seems to be just an inherent conflict of
interest for all of them. I guess a lot of it cannot be
avoided. But we have a situation here where the numbers are so
great, a tremendous amount of dollars with so many people
dependent on the company making the numbers, the analysts
pushing it. And obviously the accountants and the auditors have
a great deal of responsibility.
But I guess even more perplexing to me are these outside
analysts. We criticize Mr. Lay for touting his own stock. I
think the latest was September 26. Then October 16 Enron posted
a loss of $618 million. And then, as you pointed out, Mr.
Levitt, you may be looking at another date, but as late as
October 25, when Enron stock was in free fall, 15 out of 17
analysts tracking the stock still had buy or strong buy
recommendations, despite the fact that analysts for more than a
year were complaining that they could not figure out how Enron
made money. Plus, you had the corporate executives selling
stock. Plus, you had the CEO leaving in August.
What in the world were these analysts looking at when they
made these buy recommendations? Was their desire to be deceived
so great that they refused to look at the facts before them? Or
were the transactions so complicated that they just could not
figure it out and went ahead on hope and expectation that
things would work out in the end? What do you think?
Mr. Levitt. I think that it is a little of all of that. I
used to run a large brokerage firm which had many analysts. And
an analyst, I have found, hates to prove himself wrong. So if
an analyst is recommending a stock at 80 and it goes to 60 and
50, boy, it was a good buy then, it is a better buy now. And
sell-side analysis has become both conflicted--and one of you
mentioned the multitude of conflicts in this whole system. They
clearly have been conflicted, and there is every reason that
they might not want to interfere with an important investment
banking client.
Senator, you said something which struck me as being
critically important as we work through this process over the
course of coming weeks and months. You said that real scandal
is not what is illegal but what is permissible. And certainly,
with respect to analysts and their conflicts which are hidden
from public view, that is one of many examples that responds,
that resonates to that statement of yours.
Senator Thompson. Can an American investor today depend on
Wall Street analysts?
Mr. Levitt. I think Wall Street sell-side analysis has lost
virtually all credibility. So much of the revenues of firms
depend upon investment banking that the importance of the
analyst to acquiring and maintaining an investment banking
relationship becomes a primary concern.
Senator Thompson. And, of course, the average investor
certainly cannot analyze these complex financial statements.
Mr. Levitt. It is difficult.
Senator Thompson. So they are basically left with total
guesswork in the end, it would seem to me.
With regard to the auditors, it looks to me like one could
make the case that the era of self-regulation should be over. I
am not sure what the alternative would be. Obviously, the SEC
would turn into a different organization, in some respects. But
we have these outside entities now supposedly conducting
oversight. I think some try to do a good job. The Financial
Accounting Standards Board, as you say, are very slow on things
such as rules with regard to some of these complex new-type
transactions, special purpose entities, and so forth.
Now, Chairman Pitt and I would appreciate your views for
his recent suggestion for yet another independent entity that
perhaps is financed differently and so forth. What difference
that would make? What do we need to do in that regard? Do we
need to continue to try to develop some kind of pristine entity
out there that can oversee these boards, that will finally get
it right?
And last, what is SEC's role in this? As I understand it,
since the 1930's, the SEC has had the authority to set
standards themselves, if you want to step in, if FASB is that
slow in doing something that important, why does the SEC not
step in?
So two or three or four questions in there for you.
Mr. Levitt. I think the SEC does have the authority to set
standards. I have found several areas of public policy in which
the political process simply does not work. One is closing
military bases and the other is setting accounting standards. I
have just resisted getting the SEC directly involved in that.
In this effort to work toward auditor independence, the
pressure on us was so enormous that if you get to----
Senator Thompson. But if you are getting that kind of
pressure, and with your stature and ability to withstand it and
resist it, think of the pressure that these so-called
independent boards of citizens will be getting.
Mr. Levitt. Well, there is no perfect solution. What I
would suggest, however, is a group similar to the POB, which is
made up of some of the finest citizens in our community----
Senator Thompson. Who just retired en masse, as I
understand.
Mr. Levitt. But who had such an amorphous mandate and
funding by the industry cheerleaders, rather than independent
sources, that they were absolutely impotent. But if you gave a
group of that caliber a firm mandate and the responsibility
that only Congress can give to them to get at documents, to
subpoena them, to get at it not just from the auditors but from
the clients as well, because doing it otherwise is doing half
the job. Give them the mandate, give them the funding.
Will that answer the problem? It is one important link, and
it is one that I believe would begin to reassure the public.
Three years ago if you asked the typical American what he
knows about accountants, they would shrug their shoulders. I
went to my dentist here in Washington about 7 months ago, and
before I began the painful process, the dentist turned to me
and said, Arthur, those accountants are really scalawags, are
they not? Well, when dentists begin to understand what
accountants are, we have got a problem.
Senator Thompson. Maybe even we might, right? Is that what
you are suggesting?
What do you think about Mr. Pitt's recommendation?
Mr. Levitt. I would have to hear more about how the funding
would take place, whether there could be the kind of deferral
that I think has held up processes for years. I would have to
know whether this would be a truly independent group. There are
many more details to be worked out.
Senator Thompson. Mr. Turner, do you have ideas on that?
Mr. Turner. I actually commend Chairman Pitt for heading, I
think, in the right direction and trying to pull that all
together in one organization. I think, as Chairman Levitt said,
it is a step in the right direction, and I think it can work if
we give it the independent funding and we have a real public
board of the nature that you just heard about.
I think probably there are a lot of details to still hear
about that we do not know. From what we have seen, I would say
we probably have advanced the ball out of the end zone and up
to about the 30, and we have probably still got about 70 yards
to go.
Senator Thompson. Thank you, Mr. Chairman.
Chairman Lieberman. A very seasonally appropriate metaphor.
So you have told us what dentists think about accountants. What
do you think accountants think about dentists?
Mr. Turner. My wife is a dentist.
Chairman Lieberman. So you want to recuse yourself. Senator
Levin.
Senator Levin. Thank you, Mr. Chairman.
I would like to press you a little bit further on the Pitt
proposal because it has been severely criticized, it seems to
me. When we have a former U.S. Comptroller General and head of
the GAO who is resigning apparently in protest in a mass
resignation, as I understand, it is intended to be a protest to
this new Pitt proposal because it does not have the features of
independence which you both proclaim are so important. That has
got to resonate a bit with us.
So I would like to press you a little bit further frankly
on that issue. I know there are a lot of details still to be
unveiled, but from what you know of the Pitt proposal, does it
have the characteristics of an independent oversight body that
has the power, in your words, not only to set the standards by
which audits are performed but to conduct timely investigations
that cannot be deferred for any reason, and to discipline
accountants? From what you know, does it meet that standard?
Mr. Levitt. If you had asked me that question a year ago, I
probably would have answered in the affirmative. The
environment today calls for very different remedies, very
different actions. A year ago had you asked me whether I felt a
legislative solution was desirable, I would have said no
because of the unintended consequences. Today I would answer
that in the affirmative.
You have to be, and I do not have to tell you because you
often are in a situation where a crisis erupts right underneath
you. And you have got to come out with an instant response. The
press is at you, the legislature is harassing you. The world at
large is demanding an action. I think in those instances
perhaps the first action is not as thoughtful as it could be.
So I think that we have got to put a lot more teeth into
the proposal than the initial proposal would appear to have
come out.
Senator Levin. You are talking about the initial proposal
of Mr. Pitt?
Mr. Levitt. The initial Pitt proposal I think needs more
teeth. Frankly, I need to see more about how it will be
implemented.
Senator Levin. As you would approach it, which is now
legislatively, as I understand it, that issue of having an
independent board oversee the auditors to make sure that there
are, in fact, teeth, as you put it, who would select the
members of that independent board? What should we look at?
Should it be selected by the SEC? Should we try to set forth
some kind of representation of various kinds of backgrounds and
experiences? Give us some hint. Who, first, would make the
appointment?
Mr. Levitt. Every time I have gone down the road of
selecting boards--and I have done this many times and I worked
out a formula--I have always regretted it. There is no perfect
way of doing it.
I certainly think that the SEC would be in a good position
to start the ball rolling. And I know that Chairman Pitt has
great confidence in the members of the POB. I think the POB
might be a logical starting point for this. I have no doubt
that Chairman Pitt will be in consultation with Mr. Bowsher,
who is recognized for integrity and probity and understanding
of these issues. He has the public's confidence.
Senator Levin. The Federal Accounting Standards Board,
FASB, as you pointed out, has had tremendous pressures placed
upon it and has not moved quickly in terms of the adoption of
accounting standards. For instance, what should be on the
balance sheet, what should be off the balance sheet. This is
not the discipline side, which we have just discussed, but the
standards as to what accountants should go by in making
accounting decisions.
How would you change FASB to give it greater independence,
an independent source of financing, and to represent, for
instance, the investing public which has not been represented
and to overcome other kinds of shortfalls? Should that be
looked at legislatively? How do we go about that?
Mr. Levitt. I believe that the FASB must be--the structure
of it which is, their members are chosen by a constituent board
made up of the securities industry, the accounting profession,
a whole group of people not known necessarily for competence,
although they are headed by a very effective leader, but known
because of whom they represent. So I think the way the board is
chosen should be reconsidered.
The fact that the board is funded by the very firms for
whom they set standards, who often come back to them and say if
you are going to set this standard we are going to cut off your
funding. That is wrong. We have got to change their funding.
But ultimately, I think the SEC must get a little bit more
involved in terms of being ready themselves to create a
standard in the event that FASB is too slow to do their job. It
is not something that I think is a comfortable position for the
Commission to be in, but I see no other way around it.
Senator Levin. As you know, Mr. Levitt, I proposed a bill
about 10 years ago which would have required stock options be
treated the same way in company tax returns and in their
earnings statements. Now they are allowed to treat them
differently, not show them as an expense in their earnings
statements, and therefore give a very different impression, a
much more positive impression of the company in terms of its
earnings and profits, at the same time taking a tax deduction
in their tax returns.
What is your reaction to that? Should we change that? Treat
them one way or the other, but to treat them consistently? So
that when executives get these huge amounts of stock options--
which resulted, in part, by the way, in Enron being able to
show itself as being highly profitable--that they have got to
then reflect it on the books the same way they reflect it on
their income tax returns so that investors and stockholders
understand that those options are a cost to the company?
Mr. Levitt. I believe that clearly options have great value
or we would not have seen the lobbying effort that we saw when
this issue came up. During my first 4 months at the Commission,
I had a policy of seeing anyone that wanted to see me. I spent
nearly half my time talking to the business community that
objected to that treatment, partially correctly because at that
point the board was unable to establish a way of creating a
value for those options.
I look back upon that period now and say that my greatest
mistake was not pushing FASB harder to do that. Right now we
have the International Accounting Standards Board ready to go
down that road where international standard setters are doing
that very thing. So I would be, in general, supportive of your
recommendation, and I regret that I was not more aggressive in
that area when I was at the Commission.
Senator Levin. Thank you. Thank you for your service, as
well.
Just in closing, I will point out that in the October 1999
issue of the magazine that is put out by the chief financial
officers, the so-called CFO Magazine, they handed out awards
for the finest in finance. One of their winners was the chief
financial officer of Enron, Arthur Fastow, who was applauded
for developing ``remarkably innovative financing'' techniques.
[Laughter.]
That is what we are investigating right now, but there is a
lot of work to be done in terms of both setting independent
standards and making sure that the accountants themselves are
held accountable to those standards. That is going to require a
lot of action on our part and I think your support for that
kind of legislative action here today is really critical.
Thank you.
Chairman Lieberman. Thank you, Senator Levin. Senator
Collins.
Senator Collins. Thank you, Mr. Chairman. Mr. Levitt, it is
nice to see you once again and to hear your testimony.
I have a particular concern for the small investor who
relied on a strong buy recommendation from a sell-side analyst,
who relied on a system that let the investor down totally, and
then bought Enron stock for a retirement savings or for any
other purpose. In that regard, I want to go back to the issue
that Senator Thompson raised about the conflicts of interest
that affect the analysts.
We allow retail brokerage firms to earn enormous sums of
money underwriting the securities of companies about which they
are expected to give objective and disinterested advice to
their clients. That seems to me to be an inherent conflict of
interest.
When you look at Enron's case, if you look at the
recommendations of the sell-side analysts, most of them stayed
with a buy or a strong buy recommendation. By contrast,
however, the independent analysts were telling their
subscribers through the fall to dump their Enron stock.
I think it is very significant that the two brokerage
houses that did downgrade Enron were those that had fewer ties
to Enron or its potential merger partner. By contrast, the firm
that advised Dynergy in merger negotiations, which stood to
make a large sum of money had the merger gone through, rated
Enron a strong buy throughout the fall. So it seems to me that
the whole system is just rife with conflicts of interest that
make it very difficult for the small investor to rely on the
advice of the analysts.
Now you have mentioned that you think we need greater
disclosure. Is something beyond the disclosure of business
relationships needed?
Mr. Levitt. I would be very reluctant to go beyond that.
The tensions that exist in our society between legitimate
business interests and what is a conflict, I find is best
resolved by embarrassment and humiliation rather than by
rulemaking and legislation, unless it becomes so pernicious and
so obscure that it cannot come to the public's attention.
The analysts' problem is, I think, on the margin of what
went wrong at Enron. I think it is an important problem. I
think there are, because it goes way beyond Enron, and I think
the way to deal with it would be to disclose much more clearly
when they have a conflict and see to it that they cannot trade
in the stock that they are recommending for a longer period of
time. I think it is unfortunate that the self-regulating
organizations have not yet gotten to this. It has been 2 years
since we talked to them about it. I think that is the way to
deal with them.
They are not, in my judgment, really at the core of this.
The core of this, we are talking about boards, we are talking
about auditors and how they are supervised. We are talking
about regulators and standard setters and how they work
together.
Senator Collins. Let me move to one of the core issues that
you just mentioned and ask you and Mr. Turner your opinion. Mr.
Turner, you mentioned briefly in your statement that in 1997
Andersen wanted Enron to make a change that would have reduced
Enron's annual income from I think it was $105 million to $54
million. Despite Enron's refusal to make that change, Andersen
nevertheless approved and certified its financial statements.
Yet, later on, that $51 million was part of the $591 million
adjustment that Enron made last November. Had Andersen held its
ground we might not have gone down the road that has led us to
these hearings today.
I asked the CFO of a large non-profit entity in Maine how
this could have happened. And his response to me was: ``Oh,
that is easy. Whenever we get an audit finding that we do not
like, we sit down with our auditors and we negotiate what the
findings are going to be.''
I must say I was surprised to learn this and his assumption
that this is very common. Should not the auditor be reporting
to the audit committee and not to the managers of the entity,
whether it is a for-profit corporation or a non-profit group?
Mr. Turner. Senator, I could not agree with you more, and I
have been out there as an audit partner on hundreds of these
audits myself, and I think your observation is right on point.
A couple of years ago there was a very prestigious panel of
businessmen that came out and said we really need to create a
system where the auditor does, in fact, report to the audit
committee directly. I think if we can get it to where it is the
audit committee who turns around and engages the auditor, if it
is the audit committee who turns around and pre-approves any
consulting contracts so that they can find whether or not these
really do benefit the shareholders, I think that would be a
tremendous help.
At the Commission we have seen time and time again,
including some of the cases that were cited on Mr. Torricelli's
board, where the auditors actually identified the issue. It was
not that they were bamboozled by the management team. They saw
it and they knew it was there and yet continued to issue the
report.
I think they are out there. They are humans. They also know
they are trying to get the consulting. They are trying to serve
two masters. They are trying to serve a management team. I have
been a CFO. They are trying to impress you because they want
the next contract and they know what it takes to get that.
At the same time, they have to serve the investors. That is
a tough job. There is a lot of good people in the industry that
do a good job, but we put them in one of the most difficult
jobs you could be in. I would encourage people to look at tying
this more into the audit committee than the management team.
Senator Collins. Thank you. Mr. Levitt, would you like to
add anything to that response?
Mr. Levitt. No.
Senator Collins. Thank you, Mr. Chairman.
Chairman Lieberman. Thank you very much, Senator Collins.
Senator Cleland.
Senator Cleland. Thank you very much.
Mr. Turner, maybe I am missing something here. There is a
lot of this that is just unbelievable to me. Back in my life as
Secretary of State, I not only was the commissioner of
securities but, as I said, handled the professional licensing
boards. These boards were made up of professionals. They had a
staff, they had investigators.
And in the case of the accountancy board in Georgia, it is
a very strong board made up of wonderful professionals, all
CPAs. And they administered the CPA exam, I mean certified
public accountant.
What I am hearing here is that somehow, some way the public
interests of accountancy in America has gone by the wayside
here. I cannot believe a lot of what I am hearing, not just in
terms of Enron but in this sense that there is so much conflict
of interest, how in the world do you get a clear audit now? And
that the public is actually dependent on that in its investment
decisions.
I think we have just slipped a long way from the public
entity, the public interest here. But there are a lot of good
people, the CPAs around America. You would think that
somewhere, some way, some certified public accountant that was
licensed by the State, that was accountable in a professional
way to the public for their license, and they are all licensed,
would stand up and say this is ridiculous. This violates
everything I learned on the first day I went to accountancy
school.
I mean, it is hard for me to believe, for instance, that
the average small business person in my State would be treated,
as Enron was treated, by their auditors and accountants. For
instance, it has been alleged that Enron overstated $1.2
billion in shareholder's equity since 1997, including listing
$172 million as an asset instead of a reduction for the year.
Now, Joseph Berardino, CEO of Arthur Andersen, has stated
that this transaction ``fell below the scope'' of their audit.
Do you not think any average American who has been subjected to
an audit in this country would have a hard time understanding
how $172 million escaped the notice of an auditor?
Mr. Turner. That is what my dentist tells me. The answer is
yes. And in fact, while the chairman and I were at the SEC, we
put out some guidelines that said when people are doing these
type of things and they are intentional, it did not matter
whether it was $100 billion or $1 million. For a CPA to be
intentionally cooking the books like this, and for the auditor
to pass on it when they know it is an intentional-type error,
and in the $1.2 billion, that is quite simply Accounting 101.
That is black and white, there is no gray to it. I cannot
comprehend that.
The rule that we put in place back in August 1999 would
clearly say that something like this you just can not do.
Mr. Levitt. Senator Cleland, I would have to call to your
attention, as you go through the airport at National or in
Atlanta, just look at the signs on the walls that the
accounting firms put up. They call themselves multi-
disciplinary professional firms. If this was your first day on
Earth walking through those airports, and you were asked what
these people did, the last thing in the world you would say is
they had their roots in public auditing.
Senator Cleland. Yes, I agree. Good point.
By the way, Mr. Levitt, I appreciate your public service. I
have been in hearings where you have testified over the last
few years, and we appreciate all you have brought to the table
with your public service. Thank you for your testimony today.
Mr. Turner, one more point here. One of the things I am
learning here, and it is hard for me again to believe that just
the average person or the investor or small business person in
my State would think OK, you have things that are on the books
and then whoops, you have things that are off the books. And it
is OK to have things off the books. They are called special
purpose entities.
Do you think the SEC rules should require disclosure of all
special purpose entities in order to allow credit rating
agencies and analysts the information to provide sound advice
to their clients?
Mr. Turner. First of all, as a former business executive, I
think those financial statements should, without a doubt,
provide clear transparency with what is going on with the
business. And if I am going to go out and finance something and
I am going to have the obligation to pay it, whether I do it in
an SPE or not, that should be on my financial statements.
Otherwise, quite frankly, I am just lying to my investors, and
I think that is a shame.
So I do think the rules need to be quickly changed here to
bring all of these back onto the balance sheet. Let us make the
balance sheets look like the business actually looks like. And
to the extent we need additional disclosure so that someone can
read this and understand it, which I clearly do not think the
average investor could in these cases, yes, we need to enhance
those disclosures.
Senator Cleland. I hate to say it, but it sounds like we
are having a hard time finding out what ``is'' is.
Steve Shepherd, the editor-in-chief of Business Week
Magazine has stated, ``Enron was really a systemic failure of
all the checks and balances we have on corporate governance.''
That is kind of scary. Basically the editor of Business
Week Magazine says this is just kind of a failure of the
system. There are a lot of corporations out there. Are we
looking at more Enrons, Mr. Levitt? Do we have such a systemic
failure going on here that there are not checks and balances
any more out there?
Mr. Levitt. I am not certain as to the presence or extent
of fraud in the Enron case, so I cannot say whether that is a
factor. And I certainly have no reason to believe that there is
that kind of potential fraud in other companies.
I can say, however, that with respect to managing the
numbers, to massaging the numbers, to deceiving the public, in
effect, by talking about pro forma numbers, earnings after
certain charges, I think that is prevalent throughout the
system. And I think the restatements that we are about to see,
that Senator Torricelli mentioned in his chart, that the
frequency of these restatements which have cost America's
investors billions and billions of dollars is a phenomena that
will be on the business pages for the foreseeable future.
So that Enron's problems, apart from fraud, are problems
that exist, in my judgment, in many other American companies,
some of them really great companies whose competitive zeal has
moved them to embrace some of the kind of obfuscation that I
think represents a systemic problem.
Senator Cleland. Thank you very much for that very strong
testimony. Thank you very much, Mr. Turner.
Mr. Chairman, I would like to ask unanimous consent for my
opening statement to be put in the record.
Chairman Lieberman. Without objection, so ordered.
[The prepared statement of Senator Cleland follows:]
OPENING PREPARED STATEMENT OF SENATOR CLELAND
Introduction
I was Georgia's Secretary of State for more than thirteen years and
in my role as the Georgia Commissioner of Securities, I was charged
with administering the provisions of the Georgia Securities Act
including the registration of securities issuers, the licensing of
broker-dealers, stockbrokers and investment advisers. I was also
responsible for the disciplining of the professionals involved in the
offer and sale of securities to Georgia residents. During my tenure I
insisted on a vigorous enforcement program utilizing administrative,
civil and criminal sanctions that were available to me under the law. I
am concerned that the regulatory agencies have relaxed their monitoring
and oversight functions without an increase in a focus on strong
enforcement of our securities laws. A strong regulatory enforcement
program and an expedited criminal prosecution of persons willfully
engaging in fraud and deceits in our markets will provide a major
deterrent against financially related misconduct.
The securities markets are, and must continue to be, an integral
part of our nation's economy. Unfortunately, the successes experienced
in recent years have led to what appears to be an alarming increase in
instances of major fraud and abuse. These markets exist as a result of
the public confidence that we have demonstrated in the industry's
integrity. Billions of dollars change hands every day on the markets as
a result of a telephone call, head nod or a hand shake. Should this
integrity be replaced with an era of mistrust, this confidence would
quickly erode and the markets would suffer. The public confidence and
trust has emanated, in part, from the confidence our citizens have in
the regulatory system that has been in place for over sixty years.
The market collapse and meltdown of Enron Corporation (``Enron'')
has raised serious doubts and concerns over corporate and regulatory
oversight of the securities markets, even for major corporations whose
securities are listed on national exchanges.
I am extremely upset and concerned that Enron was able to conceal
financial practices that were not detected by our financial regulatory
systems, our credit reporting agencies and financial analysts. As a
result, Georgia's retirement systems suffered a loss of about
$127,000,000 over the three year period preceding the bankruptcy filing
by Enron. Thanks to the diligent work of our Georgia's analysts and
investment officers, I was pleased to learn that this loss only
resulted in a 2/10 of 1% decline in investment earnings over that
period and that they were still able to report a 10.1% return on
investment for this period. However, many individuals in Georgia and
around the country suffered real economic hardship.
Based on my review of documents and news reports, I am appalled at
the alleged conduct of certain Enron executives. In my statement today
I will outline some of the major problems that have come to light as a
result of corporate conduct and serious financial irregularities
engaged in by these officials.
Enron Corporation
In July, 1985 Kenneth Lay (``Lay'') was appointed chairman and
chief executive officer after Enron was formed from the merger of
Houston Natural Gas and InterNorth, a natural gas pipeline company. In
December of 1996 Jeffrey K. Skilling (``Skilling'') became Enron's
president and chief operating officer. Kenneth Lay remained as Chairman
of the Board.
Enron conducted business as a pipeline company and grew to be a
dominant force controlling major pipelines throughout the United
States. During the 1990's Enron ventured into the trading of oil, gas
and electricity. It was instrumental in the development of an energy
trading system utilizing a relative new breed of financial instruments
that allowed them to manage their risk such that they became the
dominant energy trader in the United States. This quick success let
Enron to move away from the traditional energy business into other
emerging markets involving telecommunications, broadband and other
Internet related businesses.
Enron maintained its headquarters in Houston, Texas. Its securities
were listed on the New York Stock Exchange and it was required to file
reports with the United States Securities and Exchange Commission
(``SEC'') pursuant to the federal securities laws. In August, 2000
Enron was ranked by Fortune magazine as the seventh largest company in
the United States based on market capitalization. At that time its
common stock was trading in the $90 range, having increased 1,700%
since its first shares were issued in the 1980's.
On October 16, 2001 Enron reports its first quarterly loss in over
4 years after taking charges of $1 billion on poorly performing
businesses and a $1.2 billion charge against shareholder' equity
relating to dealings with ``off-balance'' sheet entities. This
disclosure resulted in the announcement of an SEC inquiry.
The Bankruptcy Filing
In June 2001, after questions arose about the validity of Enron's
stock valuation, the company's top executives were apparently engaged
in a systematic effort to sell off many of their shares resulting in an
estimated $1.1 billion return to these executives. CEO Skilling
announced his resignation in August and Kenneth Lay resumed the
position of chief executive officer.
On October 22, 2001 Enron reported a third quarter loss of $618
million and the SEC announced an inquiry into its operations. On
November 8, the company amended and restated its financial reports back
to 1997 showing that profits had been overstated by $586 million. As a
result of its financial practices, credit reporting agencies, financial
analysts and the investing public lost confidence in the company
resulting in a total collapse of its business operations and its share
value.
Sophisticated financial engineering, risky corporate ventures,
overstatements of asset value and understatement of liabilities forced
Enron into bankruptcy on December 2, 2001 in a New York bankruptcy
court. This represents the largest bankruptcy filing in U.S. history.
At the time of the petition, the assets of the company were estimated
to be about $50 billion and its liabilities approximately $40 billion.
Energy Trading
Enron engaged in a successful and sophisticated financial trading
system involving the trading of energy contracts including oil, gas and
electricity. By the development of a state of the art trading
environment, Enron was able to engage in massive bilateral trading
contracts that were outside the overview of the SEC or the United
States Commodities Futures Trading Commission (``CFTC''). The CFTC
overview of such contracts was excluded or exempted as the result of a
recent amendment to the federal commodities futures trading law, even
though these contracts are similar to other futures contracts regulated
by the CFTC.
This type trading is risky but apparently necessary in order to
provide an open market in these commodities. For example, by engaging
in appropriate risk management techniques a supplier can assure a
future market for its products and a user can assure the availability
of the product at an established price. In order to track supply and
demand it is necessary to have state of the art hardware and software
and the personnel resources trained in such trading environments.
Even though energy futures contract trading is a risky business,
the meltdown of Enron was accelerated as a result of action by credit
reporting agencies that downgraded them from investment grade to junk
status. An energy trading entity will not be able to remain in the
market once they have lost financial integrity and confidence by their
trading partners. The disclosure of their serious financial problems,
the lost value in their shares, the off-balance sheet financial
engineering and the decline in the broadband telecommunications
business, all came to light much in the manner of the weather systems
in the movie ``The Perfect Storm''.
Enron's Questionable Corporate, Auditing and Financial Practices
LThe use of off-balance sheet transactions involving entities
that were formed by, and controlled by, Enron or its executives, that
were created without complying with Rule 140 of Financial Accounting
Standards Board. It has been reported that certain of these entities
were created by Enron executives borrowing funds from Enron's bankers
using Enron compensating balances and its shares as guarantees.
LEnron failed to disclose the formation of these entities
resulting in the failure to disclose material financial transaction and
the understatement of corporate liabilities. This resulted in continued
positive ratings by credit rating agencies and financial analysts.
LThe use of mark to market evaluation reports of certain Enron
assets by these entities resulted in false and significant valuations
of Enron's assets.
LOn October 17, 2001 Enron apparently decides to change plan
administrators for its employee's 401(k) plan resulting in significant
restrictions being placed on Enron's employees ability to dispose of
their Enron shares. Enron later issued press releases stating that the
lock-down period was from October 29 through November 12, 2001. This
lock-down was eventually lifted on or about November 19, 2001 after
Enron shares declined approximately 71% to $9.06 per share.
LThe downgrading by major credit agencies of Enron's bonds to
``junk'' status on November 28, 2001.
LEnron's filing and disclosure of materially false financial
statements that were relied on by the markets, credit reporting
agencies and financial analysts.
LThe financial practices engaged in by Enron may have resulted
in its executive employing a device, scheme, or artifice to defraud
market investors and engaging in acts, practices, or a course of
business that operates or would operate as a fraud or deceit upon a
purchaser or holder of Enron securities.
LThe financial practices engaged in by Enron resulted in
omissions to state material facts necessary in order to make the
statements made, in the light of the circumstances under which they are
made, not misleading.
LEnron executives sold approximately $1.1 billion of their
shares on the market. As an example, on August 14, 2001, Skillings,
Enron's president and chief executive officer, resigns citing a decline
of share price and personal reasons after selling shares for an
aggregate value of approximately $17.5 million. The sale and
distribution of Enron shares by its executive officers may constitute
the offer or sale of securities by means of insider information not
available to the investing public. The questions that must be answered
regarding these transactions include what information the executive
knew, or should have known regarding the questionable financial
transactions engaged in by Enron and when did such information become
known to each of them.
LThe compensation and profits paid to Enron employees engaged
in the off-balance sheet entities.
LThe use of market appraisals from affiliated, off-balance
sheet entities that resulted in inflated mark to market asset values.
LThe use of over-valued and misleading broadband and
telecommunications assets to maintain its bond rating status.
LThe failure of the Arthur Andersen auditing team to explore
and report on the questionable financial transactions and accounting
practices.
LThe destruction of audit records and documents by employees
of Arthur Andersen.
LThe payment of significant compensation, reported to be $55
million to 500 executives, on the eve of the bankruptcy filing.
LPossible conflicts of interest charges involving Enron, its
accountants and consultants and an investment advisor's employee being
a member of the Enron board.
LThe untimely and questionable selection of a new plan
administrator that resulted in Enron employees being unable to dispose
of their Enron shares for an extended period of time when the Enron
shares were declining in value as a result of newly reported material
changes to Enron's financial condition.
LThe use of plan restrictions limiting the ability of
employees to dispose of their company match shares prior to age 50.
LThe SEC oversight and reviews of the filings of public
companies.
LThe changes in the Commodities Futures Trading Act that
exempted or excluded energy trading futures from CFTC oversight.
LThe Enron campaign contributions further reveals the flaws in
our system of financing the campaigns of candidates for the Congress,
the President, and other federal officeholders.
The Rising Tide of Securities Fraud
Top securities watchdogs in the United States have constantly
warned investors that the explosion in the stock market has brought
with it a sharp rise in securities sales fraud and stock price
manipulation. The past year or so have proved them to be correct. At a
town meeting in Los Angeles, Former SEC Chairman Levitt cautioned that
investors are ``more vulnerable than ever to fraud.'' This concern
continues to be echoed by others who point to a disturbing rise in the
level of securities fraud and allegations.
What is unusual about the increasing evidence of wrongdoing in the
stock market is that shady practices usually go unnoticed in the heady
days of a strong bull market. As in the Enron matter, the misconduct is
normally uncovered only after a sharp market drop. This has many in the
regulatory community wary about what they will be facing if we continue
to see other Enron type market collapses.
The challenge to government and industry self-regulators in keeping
up with the job of policing a marketplace that is undergoing explosive
growth was graphically illustrated several years ago in Forbes Magazine
(``Swindlers' Paradise''). Forbes writer Gretchen Morgenson cautioned
that ``greed makes people careless'' but that investors ``shouldn't
count on the cops to protect them.'' In this regard you must also
include the financial market regulators.
Make no mistake about who it is that suffers at the hand of
securities fraud. It is retirees living on fixed incomes, families
struggling to make ends meet and save a little for their children's
education, teachers, factory workers, bankers, and others; it is, in
short, the everyday man and woman who works so hard for every dime they
earn.
The Enron matter, while considerably larger, compares to the losses
suffered by the 8,000 shareholders who collectively lost more than $300
million in the Comparator fiasco. Records reveal that although there
were a smattering of well-to-do investors among the group, for the most
part the investors were common folk: Retirees, school teachers,
engineers, police officers, small-business owners, and maintenance
workers.
Poignant letters from victims of the recent Towers Financial Ponzi
scheme--a scheme which defrauded investors of $460 million--demonstrate
the personal hardship and financial ruin that follows in the wake of a
securities fraud:
L ``This was almost all of [my mother's] retirement money. She
has now obtained a part-time job with Burger King restaurant to
supplement her Social Security income. . . .''
L ``I am a 69-year-old woman who has been a teacher in the
public schools . . . for most of my adult life. I invested
almost all of my life savings, $112,000. . . . Mr. Hoffenberg
has taken away what would have been a nice retirement income
for me. So, as a result, I have returned to teaching and will
probably have do so as long as I am able.''
L ``My husband and I were just married when we invested our
$12,500 with Towers, which was the first and only investment we
have ever made . . . In the last two years we have been
heartbroken . . . to learn that invitro fertilization is our
only hope for having a child. The $12,500 would have covered .
. . two full attempts at having a child. At this point, we have
no child and no hope of having the money it would take to try.
. .''
Each day, equally devastating cases are brought to the attention of
securities regulators, law enforcement officers, and attorneys
representing the interests of defrauded investors. Financial fraud is a
serious and growing problem that must be addressed by the United States
Congress.
The Private Securities Litigation Reform Act (PSLRA)
As Georgia's Secretary of State for more than twelve years, I dealt
with securities regulation on a daily basis. It was my role to regulate
the offer and sale of securities to Georgia residents and to license,
regulate, and discipline issuers of securities, underwriters, broker-
dealers and stockbrokers. However, the monitoring and oversight of
major corporate entities such as Enron was primarily the task of the
SEC and the private bar.
Georgia has long recognized the right of private investors to seek
remedies against those persons selling fraudulent investment products.
I have supported an investor's right to seek redress through mediation,
arbitration and civil litigation. While we should work to streamline
the registration and reporting process, I vigorously opposed, and will
continued to oppose, any changes in the federal regulations that impair
the ability of the SEC and state governments to protect its investors
and for the right of investors to use state courts to redress their
losses.
I am not yet convinced that the PSLRA will provide sufficient
protection to defrauded investors. If the courts ultimately interpret
the PSLRA in a way that makes recoveries under federal law too
difficult, state remedies will be the only means for defrauded
investors to redress their injuries.
The Enron collapse may provide the opportunity to determine whether
the changes resulting from PLSRA will streamline procedure without
having a detrimental impact on the right of individual investors
ability to recover losses from fraudulent transactions.
Conclusions
It is my firm belief that the United States Senate must fully
explore the Enron financial collapse in order to present for debate and
consideration changes in our financial and market regulatory programs
that will deter the use of illegal and improper financial engineering
practices to conceal losses and overstate assets resulting in a market
confidence that is bound to collapse.
In this regard I think the United States Senate should carefully
consider the following areas:
LA thorough examination of the facts and circumstances
surrounding the rise and fall of Enron with a focus on determining
Lwho knew what regarding the improper financial practices and
other material matters relating to the value of Enron shares;
Lwhen these facts were known to them; and
Lwhether or not such executive officers or others, knew or
should have known about such facts.
LA regulatory program for accountants, credit reporting rating
analysts, and financial analyst that will provide for competency
standards, training, conflict standards, and a strong penalty for
violations of established standards and fraudulent practices.
LA review of accounting standards used in reporting ``off-
balance'' sheet transaction.
LA thorough review of the destruction of records by Arthur
Andersen employees to determine the destruction time table and whether
or not such records were destroyed after notice of subpoenas or in
clear anticipation of them.
LA determination about when off-balance sheet transactions
should be disclosed to the SEC, credit reporting rating agencies and
financial analysts.
LAn overview and examination of current SEC overview and
monitoring programs of entities offering their shares to the public
that will be traded on the national markets.
LAn overview of the role of the self-regulatory organizations
that are currently in place to assist the SEC and state regulators in
their oversight responsibilities, as well as a major emphasis on
investor education and awareness.
LA review of the PSLRA and the current arbitration
requirements, to determine if the recent amendments are adequate to
offer access to the state and federal courts for recovery in the case
of fraudulent activities.
LA review of the disposition of share requirements and
restrictions that are placed, or should be placed, on senior executive
officers of major corporations.
LA review of the 401(k) retirement programs to determine what
restrictions, if any, should be placed on employee's shares by:
Lregulatory authorities, such as limiting the % ownership of
company shares in their plan or by a requirement that an
employee's shares received in any manner must contain no
trading restrictions;
Lthe retirement plan; and
Lby unofficial employer coercion or representatives.
LWhile the energy trading industry appears to have survived
the Enron collapse, I think it is appropriate to review energy trading
practices involving risk management practices, bilateral futures
trading contracts and other sophisticated financial investment tools in
order to determine whether or not the public interest requires CFTC or
other federal oversight of such trading practices and transactions.
LWhile I have not heard credible evidence of improper
political influence or actions, I feel that we need a thorough review
of the political contributions made by Enron and its senior officers to
candidates from either political party to determine what, if any,
improper influence may have existed as a result of such campaign
contributions. The public reaction to such political contributions
should be sufficient for the Congress to reform our campaign financing
laws.
Chairman Lieberman. Senator Bennett.
Senator Bennett. Thank you, Mr. Chairman.
I am having all kinds of reactions to all of this, some of
it coming from my Senate activities, and some of it going back
to my business experience. I have never run a company as big as
Enron, and it may be that there is a dividing line somewhere in
terms of size.
Just picking a number of issues in the time I have, your
suggestion that there be a prohibition of consulting activity
in the part of auditors. In the company I ran, the auditor was
enough of a partner in understanding what we had and where we
were, it was PriceWaterhouse at the time, that I wanted to go
to him to get his advice on certain things I was doing and have
him say no, wait a minute, you cannot do that. No, that would
not be a good idea. This is the better way to structure that.
Instead of incurring the extra expense of going to somebody
else and then taking the time to have the somebody else
familiarize himself with our company as well as PriceWaterhouse
was.
It would have been an extra cost that, in terms of the
services to the company, would not have been a value. Now I was
not creating any SPEs and so I can have sympathy with the idea
that if you are going to create this separate set of
transactions you ought to have an independent group do that and
then have your auditor look over the shoulder. I have no
problem with that.
But with the generic sense that we have heard in the past
that says if you are in auditing you should not be in
consulting, and there should be a clear bright line and total
separation, out of my own experience I have a little trouble
with that because I think it does represent, for small and
medium-sized firms like the one I ran, an unnecessary expense.
I would like you to comment on that.
And then while we are doing that, make another comment in
the same area, Chairman Levitt, about your suggestion that
every 5 to 7 years you change audit firms. I was involved in
changing an audit firm and, quite frankly, it had nothing to do
with we want fresh and skeptical eyes. What happened is that
the partner that we were depending on got transferred. He got
promoted. And we looked at the kind of service we were getting
out of the audit firm and the new people that were put into the
Salt Lake office, and we said we do not think these folks are
competent anymore.
Now it was the same Big 5 name on the door, but it was a
different partner and a different set of folks come to see us.
And we had a lot invested in the old partner and we were
delighted he got promoted, glad to see him move on up. But we
said we have got to get better service and more competence out
of our auditor. And so we switched from one Big 5 firm to the
other.
So these are two related issues that I have raised here,
about the capacity of an accounting firm to add value to a
client firm simply by virtue of the amount of expertise that
they bring to the table and the amount of experience that they
have with the firm.
Mr. Levitt. I started with, I think all of us do, with the
assumption that the accounting industry essentially is a
private industry but with a public responsibility. And I am
certain that you can take the position that a business person
develops a relationship with his auditor that is comfortable
and trusting.
Senator Bennett. And synergistic, helpful to the
stockholders.
Mr. Levitt. In many instances, it is helpful to the
stockholders.
During our debate on this issue, as we imposed relatively
modest change in this area and backed away from a change that I
think is terribly important, which is to remove IT from the
consulting services that can be performed for the audit client,
two arguments were raised in opposition. One argument that was
raised was, and we had public hearings on this and the heads of
the firms testified to this and I attended hearings of the
Banking Committee and the Energy Committee and I was confronted
with the same issues on the part of members who said Arthur,
this is a question of perception. That is all, it is just
perception.
And second, where is the smoking gun?
Senator Bennett. I asked that question.
Mr. Levitt. As you know, we had a briefing and members of
the Banking Committee attended that briefing. We went over the
details of cases that were about to be brought.
Well, I do not think the question about the smoking gun is
being asked any longer. There is an exploding gun and there are
smoking guns yet to explode.
With respect to perception, I think it matters enormously
in terms of investor confidence, which is the basis of our
markets. Now if you tell me, Senator, that PriceWaterhouse had
the unique ability to provide a certain kind of consulting
service, I would suggest to you that there are only four other
firms today. Two of them have gone out of the business totally.
There is someone else out there who could provide that service
at no greater cost, in my judgment.
I think the question, we could debate it at great length,
about the relative value of perception to the relatively modest
disruption to the company. But I can tell you, having been on
audit committees and serving on a number of boards, that more
and more independent directors are taking the position that it
is wrong to hire a firm for consulting services that is the
auditor for that firm. That it looks bad, it feels bad, and it
smells bad. And if that is the case, whatever modest costs
might be involved, I think, is a small price to pay for
restoring public confidence.
Right now we are in a crisis of public confidence.
Senator Bennett. Thank you.
Chairman Lieberman. Thank you very much, Senator Bennett.
Senator Dayton.
Senator Dayton. Thank you, Mr. Chairman. This degree of
separation between us gives me a perspective on the expanse
between a freshman Senator and a Committee Chairman.
Chairman Lieberman. I feel very close to you, Mark.
Senator Dayton. I am not even sure we are in the same time
zone.
I want to thank both of you for your very, very
distinguished service and for all you have tried to accomplish.
I have to ask first: Do you feel completely or absolutely,
totally vindicated by the events, which, unfortunately have
transpired?
Mr. Levitt. No, I think this is work in process. I think
that what this Committee does is so important. I know that
there are philosophic differences among all of us in terms of
how far to go. I am a great believer in our markets and how
they work. I have been a major beneficiary of that.
But my conviction about public confidence and a system that
has seen a cultural erosion suggests to me that you must be
focused in terms of the few demonstrations that you give that
you care about this issue and setting it right. And there is no
rule or regulation that is going to do it in and of itself. It
is going to require continual attention by an SEC that has the
resources to do the job, and by the legislative process which
will see to it that they are on target.
Mr. Turner. Senator Dayton, I think Senator Lieberman
absolutely had it right when he said you are beginning a long
journey. And Senator Thompson had it absolutely on the nail
when he said this is a systemic problem. It is pointed out,
probably no better than the charts that Mr. Torricelli had, and
I think Senator Carnahan highlighted one of many things that it
is going to take to fix this systemic problem.
This is not an issue of vindication. This is an issue of
the fact that I would hope that you will be strong, you will
aim high. Someone made the comment let us take you to the
mountaintop. I think when you get to that mountaintop you are
going to find out there is about 5,000 green eyeshades on the
other side coming over the top of the hill.
So you have got a big battle ahead of you. I would just
urge you to stick to your guns, stay the course, and let us
make this problem fix. The investors over the last half dozen
or so years have lost close now to $200 billion. When you talk
about the cost to a company, and I have been in the same
position that Senator Bennett has in selecting auditors myself,
when you start thinking about the cost to investors in this
Nation at $200 billion, and what that does to our market, and
the fact that that market is our crown jewel that no other
country has, and it fuels this economy. We can no longer sit
back and say are you vindicated or not. That is not the issue.
The issue here is sticking with it, staying the course, and
getting this fixed for the American public once and for all.
Senator Dayton. Could each of you depart from your
testimony and just give us, give the American people, a
scorecard. What are the essential reforms, one, two, three,
four, or more, that Congress must enact, in your view, so that
people can have reasonable confidence in the integrity and
truthfulness of these reporting systems?
Mr. Levitt. I believe that the creation of an oversight
body for the accounting profession with the appropriate powers
to do the job of setting auditing standards and having
disciplinary ability and subpoena ability and the ability to
examine clients as well as accountants is something that I am
now persuaded can only be done by legislation.
I believe that other issues, such as the standard setting
process, I would hope that could be addressed outside of a
legislative framework but with strong legislative persuasion.
I believe, with respect to the analysts, that is something
that can be handled by the New York Stock Exchange and the
NASD.
I think the issue of seeing to it that all corporate boards
have a majority of independent directors is something that the
Stock Exchange and the NASD can deal with effectively, again
with appropriate persuasion.
And I think there are marginal issues such as a 2-year
cooling off period for employees of firms being able to join
clients of the firms, and the question of changing auditors
periodically.
I think these do not require a legislative fix, in my
judgment.
Mr. Turner. I agree with the Chairman. I think that we need
to create legislatively an honest to goodness oversight body
under the supervision of the SEC. I do not believe the SEC, in
itself, I do not think I would put it there. I agree with
Chairman Pitt in trying to do something out there with active
oversight by the SEC, though.
I think the need to move forward by the stock exchanges on
the analysts issues and disclosures will help a tremendous
amount.
I actually think the business community, too, needs to pay
a key role here. A couple of years ago, on some of the
corporate board and governance issues, there was an outstanding
panel chaired by a couple of very distinguished businessmen and
the former Deputy Secretary of State, John Whitehead, and Ira
Milstein, head of Wilde Gottschalk. And they came up with some
phenomenal recommendations that then the Commission and the
stock exchanges and the profession acted on.
And I would hope that we will see some leadership again
from the business community and that they will play a role
here, that it does not need to all be done by Congress, it does
not all need to be done by the SEC. But to the extent that
these things do not get fixed, then I think it would be
appropriate, given how you have had thousands of lives
impacted, hurt, I went into a classroom the other day----
Senator Dayton. I have to squeeze in one more question.
Help me to assess and evaluate this shredding of documents
by auditors and accountants. My experience with them is that
they are very thorough and factually oriented people. That is
their profession. And shredding documents goes against that
training; it may violate their professional standards; it may
be illegal.
For them to shred documents despite those inhibitions, says
to me that there must be a huge amount of compelling and
damaging information that they just do not want revealed.
Mr. Levitt. I do not know exactly what the extent of that
may be, but shredding documents obviously is a red flag to
anybody in an enforcement capacity and is a criminal offense.
Senator Dayton. Thank you, Mr. Chairman.
Chairman Lieberman. Thank you, Senator Dayton. Senator
Voinovich.
Senator Voinovich. Thank you. Most of the questions that I
had have already been answered, but in this room I suspect that
we have representatives of analysts, brokers, mutual fund
managers, auditors, financial consultants, you name it.
Mr. Levitt. Lawyers.
Senator Voinovich. Lawyers. The question that I have is do
you think they get it? What advice would you have to all of the
people that are part of this financial market system that we
have in this country, as to what they ought to be doing right
now?
You are saying that we are going to have people on one side
and the other, but what would your candid advice be to some of
those people that are in this room today about the attitude
they ought to take toward this hearing and the ones that we are
going to be having and the new changes that you think need to
be made to restore people's faith in this system. Because if it
is not restored, I believe it is going to have irreparable
damage to our financial markets, which have been the mainstay
of this country for years and years, and frankly, impact on
their respective pocketbooks.
So I will give you a free shot at advice to all of those
that are here in the room and maybe those that are watching on
television.
Mr. Levitt. What a great question. I think that all of
those parties, and I would throw in rating agencies as well to
that package of people who are impacted by this. I would say to
them all of us are in this together. And if there is a systemic
problem, and I think there clearly is, while it may hit company
A today, it is going to hit B, C and D very shortly.
No amount of rulemaking or legislation will ultimately
change human behavior except at the margins. And that those
people who are parties to all of this themselves must consider
their behavior and their attitude toward the public interest,
recognizing the importance of the capital of the profitmaking
motive in a capitalistic society.
But we have to have a system that is trustworthy, and that
begins with participants who are trustworthy. And too many
elements of this system are not trustworthy today. Too many
elements have failed us because of self-dealing and self
interest.
And to recognize that right now we are in a crisis mode,
but this will be responded to. But if we do not learn a lesson
from this, which is an enduring lesson, we will be back here.
And we will be back here in ways where the primacy of America's
capital markets will no longer be assured because too many
other areas of the world are dealing with issues in different
ways. And if you lose trust, you lose everything.
So we are all in this together.
Senator Voinovich. Mr. Turner.
Mr. Turner. I do not think I could say it any better than
what the chairman said, and I think it starts with each and
every one of us. I grew up in the State that Senator Bennett is
from and had a set of wonderful parents fortunately. And I
think they made it clear to me the difference between what is
right and what is wrong. And when I sit in there at the seat,
as the CFO, even though the heat gets turned up at times, and
you know it can get hot, you know if you are in the kitchen you
have to make it work.
And I think it starts with all of us. It cannot be done by
just the auditors. There has been a lot of focus on Andersen.
It is not just Andersen. It starts with the management team.
Directors and everyone has to contribute here. And it has to be
an effort of people. It cannot just be Congress. It has to be
everyone working on this.
Senator Voinovich. Thank you.
Chairman Lieberman. Thanks, Senator Voinovich. That was a
very important exchange and it does, in my opinion, go to the
heart of what this is all about, this inquiry. As others have
said before, and you have said, there has been a remarkable
democratization of capitalism in our time with average people
having the opportunity in this country to buy a piece of the
rock through 401(k)'s, through mutual funds, through stock
options, in fact.
And there is, as you said now, a crisis of confidence. I
will tell you what the question is that I get most asked, and I
am going to ask you this and then I am going to thank you for
your testimony and go on to the second panel.
People have been shaken by the Enron story in this sense.
The question they ask me is do you think my 401(k) is OK? The
reason for that is we have now heard of tales of boards of
directors that are not truly independent, of analysts who
recommend stocks without understanding the books of the
companies they are recommending, of auditors who have conflicts
of interest, of regulatory bodies that--for one reason or
another that we will get into as this investigation goes on--
were not there to be the watchdogs that presumably they were
supposed to be.
So how would you answer that question if people asked you?
Is my 401(k) OK, or am I going to run the risk of having it
tank the way Enron did?
Mr. Levitt. I would not give them a blanket reassurance
that their 401(k) is necessarily OK. I think one of the
greatest needs we have in America, and it is a mission the SEC
has undertaken in recent years, is to educate investors. The
problem with the 401(k), and I know this will be the subject of
extended discussion in the future, is that very often
participants really do not understand what is going on in that
401(k) and companies do not have the ability to legally explain
to them what is going on.
The 401(k) is kind of a stepchild of ERISA and I think
there should be some thought of giving some kind of legislative
certainty to the 401(k). I personally believe that there should
be a prohibition on the amount of a company's stock that an
employee can invest in. Not the employer, because that is all
voluntary and I would not want to discourage that.
But I think employees get caught up in the hype of the
company and feel that if they are not putting the maximum in
somehow or another management will look at them as being less
than loyal employees. And that is wrong. The attitude of
skepticism that is so important just does not exist there.
No, I would not want to panic people who have participated
in this very important program, but I would say that we cannot
take it for granted and there have to be changes and we are
looking into that and we are going to make changes and help
investors become wiser investors.
Chairman Lieberman. That is exactly what I hope will result
from our deliberations and our investigations here. Senator
Thompson.
Senator Thompson. Just a comment. I think what Mr. Levitt
said is very important, that it is not all a matter of
skullduggery. You cannot guarantee the safety of a 401(k), for
example, if the business involved is making bad business
decisions. Sometimes when everybody is obeying the law and
doing the best they can, in the stock market people lose money.
Mr. Levitt. Yes, and always will.
Senator Thompson. And we will never be able to, and never
should try, to institute a system where people speculating in
the stock market, either directly or indirectly, are guaranteed
that there will not be any losses. I think it is important for
the American public to understand that they have a
responsibility to keep up with what is going on with their own
company and the stocks that they invest in.
Mr. Levitt. They need to trust the numbers.
Senator Thompson. That is assuming that everybody else is
doing their job. The gatekeepers are doing their job, and you
can take a look at that and make your decision. But there is an
awful lot of people who lose money in the stock market where
people are not violating the law. They lose money the old
fashioned way.
Chairman Lieberman. I agree with what you have said, and,
of course, I know we also all agree that the disclosure and
transparency is critically important here to make the market
function. Somebody said long ago that market capitalism is by
far the best means ever devised by humans, not only to create
economic growth, but to expand those who are enjoying the
benefits of it.
But market capitalism has inherently no conscience. That is
why we set up gatekeepers and watchdogs. The gatekeepers were
not keeping the gate here, the watchdogs were not watching; and
average people got unnaturally taken advantage of.
We can go on a long time. We will probably ask you back at
the end of these deliberations as we shape the recommendations
we want to make. In the meantime, I thank you both very much
for your previous public service and frankly, for the public
service you are doing today, even though you are out of public
service. Have a good day.
I will call the second panel now. Bruce Henning, Director
of Regulatory and Market Analysis for Energy and Environmental
Analysis, Incorporated. John Langbein, a Sterling Professor of
Law at Yale Law School. And Frank Partnoy, Professor of Law at
the University of San Diego School of Law.
I thank you all for being here and for your patience. We
look forward to your testimony now.
This panel will give us a kind of focus briefing on some of
the specific areas of concern that the Enron episodes raise in
your minds. Just as the previous panel, hopefully they will
help us understand what we know now, but also to guide us as we
go forward in our investigation.
Mr. Henning, thanks for being here.
TESTIMONY OF BRUCE B. HENNING,\1\ DIRECTOR, REGULATORY AND
MARKET ANALYSIS, ENERGY AND ENVIRONMENTAL ANALYSIS, INC.
Mr. Henning. Thank you, Senator. My name is Bruce Henning
and I am Director of Regulatory and Market Analysis at Energy
and Environmental Analysis.
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\1\ The prepared statement of Mr. Henning with attachments appears
in the Appendix on page 84.
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For the past 24 years, I have been an analyst in natural
gas, electricity, and energy markets, and I am here today to
discuss the behavior of natural gas and electricity markets in
the wake of the Enron bankruptcy.
Enron has been an important player in energy markets. Enron
was the largest marketer of natural gas and electricity in the
United States, operating in both the wholesale and retail
energy markets. Enron owns and operates interstate gas pipeline
systems and has interests in electric generation in more than a
dozen States.
The Enron failure caused some disruptions in natural gas
and electricity markets but these were relatively minor. Given
the scope of Enron's activities, the absence of significant
disruption in energy markets is a credit to the markets and to
its people. Throughout the collapse of Enron supplies of gas
and electricity have continued to be delivered to the
consumers. The reliability of the energy delivery system has
not been compromised.
Moreover, gas and electricity prices that the retail
customers have seen have not been significantly affected.
Enron's retail gas customers have been able to migrate to other
suppliers at prices that are substantially below what they were
a year ago today.
Under the regulatory oversight of the Federal Energy
Regulatory Commission, natural gas has evolved into a highly
competitive commodity market. Competitive wholesale electricity
markets are less mature than their gas counterparts but
significant progress has been made. Examination of the
wholesale prices since September indicates that gas and
electricity markets have behaved reasonably well during a
period in which the largest market participant was in turmoil.
The Enron bankruptcy impacted market participants in a
number of ways. When Enron Online, Enron's electronic trading
platform, went dark the market lost an important source of
price information as well as a low cost transaction method of
trading. Fortunately, there were other sources of price
information and other, albeit much smaller, electronic trading
platforms. Within weeks most participants had largely adjusted
to the loss of Enron Online.
The financial exposure to companies involved in
transactions with Enron is a much more complicated issue. As a
general matter, energy companies work to limit the size of
their exposure to any individual company, even a company as
large as Enron. As Enron came under increasing pressure, many
participants began to reduce their exposure. Even so, these
exposures remained large, but they are manageable for most of
the companies and should not interfere with the physical
delivery of energy to consumers.
Beyond that, Enron had entered into a number of longer term
contracts with buyers and sellers of gas and electricity. The
status of these contracts is unclear and will be determined
through the bankruptcy proceeding. It is possible that parties
will find themselves back in the marketplace, even though they
had thought that they had hedged their stream of future
production or their future energy needs.
The loss of Enron has created an opportunity for other
companies to capture market share. However, the ability of
these companies to act aggressively in pursuit of market share
has been tempered with the need to ensure that these companies
remain financially strong.
The equity prices and bond ratings of a lot of energy
companies have come under pressure in recent weeks. As a
result, these companies have begun to take actions to
strengthen their balance sheets and to restore lenders'
confidence. As part of these actions, companies are reducing
their capital budgets and cancelling or delaying power plant
project constructions or delaying their commitments to new gas
pipeline expansions.
However, the cancellation of power plant projects does not
necessarily foretell an impending electricity shortage. In our
opinion, there was significantly more generation capacity
proposed than was going to be needed for the next 5 years. We
felt like many of these generation projects would be delayed or
cancelled even without the Enron bankruptcy.
That being said, the decline in the bond ratings and equity
prices for many companies will increase the cost of capital for
many of the needed infrastructure projects. This increase will
have an effect on the energy markets for a number of years and
if confidence is not restored in the relatively near future,
the fallout from the Enron bankruptcy could be much more
troublesome.
The events surrounding the Enron bankruptcy have been
tragic for thousands of Enron employees and investors and raise
a number of serious questions regarding the corporate
accounting and disclosure of corporate information. All of us
who work in energy have seen individuals who have been hurt and
I know the pain involved for those people. But from the
relatively narrow perspective of energy markets, the events
show an ability to respond to a major disruption without the
interruption of delivery to energy consumers and without
significant energy price increases.
The electricity markets forged by Federal and State
regulators, and in accordance with Federal and State laws,
performed well in the face of an event that had never been
seriously contemplated.
I would like to thank the Committee and the Chairman for
the opportunity to express my views, and I would be happy to
answer any questions I can.
Chairman Lieberman. Thanks, Mr. Henning. That was very
interesting. I have some questions that I will ask when we get
to that point.
Professor Langbein, thanks for being here.
TESTIMONY OF JOHN H. LANGBEIN,\1\ STERLING PROFESSOR OF LAW AND
LEGAL HISTORY, YALE LAW SCHOOL
Mr. Langbein. Thank you. Mr. Chairman, Members of the
Committee, I have been asked to talk with you about the pension
consequences of the Enron bankruptcy.
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\1\ The prepared statement of Mr. Langbein appears in the Appendix
on page 93.
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The bad news is that there are millions of other American
workers at risk of suffering similar losses in their 401(k)
pension plans and in other types of defined contribution
pension plans. Worse still, it does not take Enron-style
corporate wrongdoing to cause such losses. Businesses fail all
the time, for many reasons. Competition produces failures as
well as successes. The bankruptcy of Kmart, currently in the
news this week, illustrates that point. If Kmart had had
pension arrangements which were of the character of Enron's,
full of employer stock, the Kmart employees would have been as
devastated as were the Enron employees.
In other words, if Enron had been a bunch of angels, the
problem would be the same. It is the bankruptcy that causes the
loss. The cause of the bankruptcy, which is very important for
some of your other purposes, is not what we are focusing on
when we talk about the pension problem.
The good news is that we know exactly what the problem is
and how to fix it. Indeed, the particularly good news is that
Congress already fixed it almost 30 years in the original
enacting process that produced ERISA. Congress fixed it by
imposing a diversification requirement on pension plan
investments for defined benefit plans.
Unfortunately, in 1974 when ERISA was enacted, in the early
1970's when ERISA was working its way through Congress, defined
contribution plans of the 401(k) sort and others, defined
contribution plans were not important. They were regarded
basically as supplementary plans, extra savings for fat cats.
They were not important parts of the pension process.
For very complicated, fascinating reasons, some of them
troublesome, we have had across the last 20 years or so a major
revolution in the way in which the private pension system is
structured. The defined benefit system has matured. It is not
growing. Almost all the growth in the pension system today, in
the private pension system, is in the form of defined
contribution plans, and they have many advantages.
In my prepared testimony I have mentioned a couple of the
most obvious: The tremendous transparency that people
understand what is in an account when it is an individual
account; it is mine; I get the numbers. That encourages more
pension saving. There are other major advantages to defined
contribution plans. It is not all a one-way story of danger.
But the big danger, the big difference associated with a
defined contribution pension plan is that instead of the
employer bearing the investment risk, it is the employee. It is
just in these plans, where the employer has now shifted the
risk to the employee, that we now have practices that the
employers do not follow and would not be allowed to follow by
ERISA; namely, concentrating everything in employer stock. That
is exactly what we do not allow in the defined benefit plans
where the employers bear the risk. But in the defined
contribution plan where the employee bears the risk, we let the
employer stuff employer stock into these plans.
There is just universal consensus in financial circles that
concentrating all of your assets in the stock of any company,
no matter what it is, is stupid. It is dangerous. We have a
technical term for it in the financial literature. It is called
uncompensated risk, bearing uncompensated risk. I do not want
to go into the details of that. Delighted to take questions on
it. But the key point is, nobody who knows anything about how
to run a pension plan would ever do this.
Yet we allow it to be done over in these 401(k) plans, and
even worse in something called ESOP's, employee stock ownership
plans. That is where the big congressional failure has
occurred. It is the failure to bring over into this new world
of employee-operated investment decisions the same basic norms
that we are used to over in the world of defined benefit plans.
Chairman Lieberman. I do not want to show preference to a
Yale law professor, but if you are in the middle of making
another argument, do not be deterred by the red light for a few
moments.
Mr. Langbein. Thanks so much. I think I probably ought to
stand down, but let me just conclude this by saying, I have
more detail in my prepared remarks. I have, in particular, the
further suggestion that if Congress is not able to make the big
fix which is needed, which is to get proper diversification
standards over from the defined benefit world where you
solved--remember, nobody is in here telling you about their
losses. You solved it. You did a wonderful job.
If you cannot fix it over in the defined contribution world
in the way that I think you should, which is to go ahead and
impose diversification, there is another alternative which I
call the Surgeon General cigarette pack solution, which is to
require the summary plan descriptions in defined contribution
plans to warn employees about the dangers of employer stock so
that they value it properly, and also exercise their own option
to move away from it in the part of those plans that they
control.
Let me just conclude, Senator, by saying that I can predict
to you, with absolute certainty, that you will see many more
pension catastrophes just like Enron, a similar sort of
magnitude. We have already had them in the past: Color Tile,
many others--until the basic rules get changed to stop allowing
employers to stuff all this employer stock in these pension
plans. And to move us toward a system in which the same
diversification rules that are followed elsewhere in the
financial community get imposed on defined contribution plans.
Thank you.
Chairman Lieberman. Thanks, Professor. That was very
helpful and in its way riveting, because of the warning at the
end. I will come back to you with some questions.
Professor Partnoy.
TESTIMONY OF FRANK PARTNOY,\1\ PROFESSOR OF LAW, UNIVERSITY OF
SAN DIEGO SCHOOL OF LAW
Mr. Partnoy. I want to thank Senators Lieberman and
Thompson and the Committee for inviting me to testify. We have
heard a great deal today and in previous months about various
aspects of Enron's problems. I am here today to talk to you
about what I regard as an even bigger problem: That is Enron's
involvement in the unregulated derivatives market.
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\1\ The prepared statement of Mr. Partnoy appears in the Appendix
on page 103.
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Please let me make three brief points. First, Enron was
primarily a derivatives trading firm, not an energy firm.
Chairman Lieberman. Take a minute to explain what that
means.
Mr. Partnoy. Enron was involved in various aspects of
derivatives markets, including what we call the over-the-
counter derivatives markets which are, at $95 trillion, 90
percent of the derivatives markets. So derivatives are
basically financial instruments whose value is linked to some
other instrument or index. Enron was involved not in the
exchange traded derivatives, which constitute about 10 percent
of the markets and are regulated already. Those are not at
issue here. Enron was involved in the over-the-counter markets,
which are the bulk of derivatives trading right now.
Chairman Lieberman. Are not regulated?
Mr. Partnoy. Which are not regulated. It may surprise
investors to learn that Enron was in fact a speculative trading
house chock full of these derivative instruments. The best way
to see that is just to look at this building, look at Enron's
building. Executive offices overlook the crown jewel of Enron's
empire which is essentially a cavernous derivatives trading
pit.
Chairman Lieberman. Like a trading exchange?
Mr. Partnoy. Just like a trading exchange, except that it
is not regulated.
In fact Enron has been compared today and previously to
Long-Term Capital Management. Long-Term Capital Management, as
you know, is a hedge fund that collapsed, lost billions of
dollars, and was rescued in a private bailout engineered by the
New York Federal Reserve. There are some similarities, but what
I am here to tell you today is that Enron makes Long-Term
Capital Management look like a lemonade stand.
Enron made more money from derivatives in 2000 than Long-
Term Capital made in its entire life. Enron lost 20 times more
capital than Long-Term. Enron had 100 times more employees. It
had public investors, and no one bailed out Enron.
I have told you a little bit about what these derivatives
are. Enron's derivatives ranged from natural gas prices and
interest rates, to dot-com stocks, and rights to fiber-optic
bandwidth. As I have mentioned, let me repeat, these markets
are largely unregulated markets. That is point No. 1.
Point No. 1, Enron shows we cannot trust derivatives
disclosure more generally. Derivatives were the key to Enron's
abuse of these special purpose entities we have talked about
today. Enron's list of these entities, just the list is 60
single-spaced pages long. Many companies have similar lists,
and their disclosure is now suspect. If we cannot trust Enron,
can we trust General Electric, or IBM, or Coca-Cola.
Special purpose entities are very common and can be used
for good or for ill. Unfortunately, Enron used them for ill. It
hid spectacular losses on technology stocks, it hid billions in
debts, it inflated the value of speculative assets. Many of
these trades did not involve energy at all.
Just let me give you one example. Enron bought a technology
stock called Rhythms Net Communications that skyrocketed during
1999. Enron sold that stock to one of these entities and
recognized a gain of several hundred million dollars. Then
Enron used a sham transaction with the entity, including--and
this is the key--a $1 billion derivatives trade to avoid
recognizing losses as the stock plummeted the next year. This
was true even though Enron retained the economic risk of its
investment in that stock.
The important point here is that Enron, like many
companies, manipulated its numbers to meet analysts quarterly
estimates.
Chairman Lieberman. What is the source of your information
on the story you have just told us?
Mr. Partnoy. The troubling part about this is that much of
the source of this information is from Enron's financial
statements. If you look at Enron's financial statements you get
a sense of how broad its involvement in derivatives is. The
specific information about this company and some of the others
that I allude to in my written testimony come from the more
recent 10Q. If you just look at the difference in size--I will
show you--just in thickness. This is the most recent 10Q Enron
filed. This is where some of the information comes from.
Chairman Lieberman. With the SEC.
Mr. Partnoy. With the SEC. This is after information had
already come out. But much of the information, and one of the
troubling things about this, is alluded to in the documents and
the gatekeepers failed to uncover some of that information.
Chairman Lieberman. That was the point of my question. They
had some of this information that you just relied on but did
not either understand it or did not bother to report it to the
investing public.
Mr. Partnoy. That is exactly right. That, Senator, leads to
my third point, which is that the gatekeepers failed to tell
investors that Enron was so risky. Enron's officers and
directors, of course, are to blame. But we should look
carefully at the gatekeepers as well. Too much focus on Enron's
officers misses the mark.
If I could just finish this thought.
Chairman Lieberman. Go right ahead.
Mr. Partnoy. Enron's officers clearly knew that there was
some derivatives use going on within the firm. Enron even
distributed a derivatives training manual to new employees. But
gatekeepers also had information. Gatekeepers include
accounting firms, law firms, securities firms, and very
importantly, credit rating agencies. They are supposed to
monitor even conflicted managers. Gatekeepers, of course,
should and will be held liable when appropriate. In Enron's
case the accountants, as we know, already are at risk and
others may or may not be.
My point here is that credit rating agencies in particular
have great market power. They have been given market power by
the law, and they are largely undisciplined by the threat of
liability, and that should change.
In closing, ultimately Congress must decide whether after
10 years of steady deregulation the post-Enron over-the-counter
unregulated derivatives markets should remain in this
regulatory black hole, exempt from the rule that covers most
investment contracts. The basic message I would like to leave
with you is that I believe it is time to shine some much-needed
light on these unregulated derivatives markets.
Chairman Lieberman. Thanks very much. Again, the three of
you have been very helpful and I thank you, Professor Partnoy,
and others, for what looks to me to be the fresh work that you
have done in the testimony that you have presented to us,
particularly in analyzing the Enron situation.
Professor Langbein, I was thinking as you were talking, I
once said to somebody about 10 years out of law school that I
was ready to go to law school then because I thought I would
understand better my professors. I think you helped teach me a
lot today.
Mr. Langbein. We have an LLM program if you would like to
come back.
Chairman Lieberman. It is beginning to look pretty good
actually. [Laughter.]
The question I wanted to ask you is about your main point
which is that through ERISA Congress regulated so-called
defined benefit, normal pension plans, but as the 401(k)'s
defined contribution programs came along and expanded, millions
of people now having their dreams of future security resting on
them, we did not have similar protections.
The one you have talked about is diversification. If you
had your druthers, if you were King, what is the rule that you
would promulgate with regard to defined contribution 401(k)'s?
Mr. Langbein. It would take some technical drafting but I
would basically insist that the same diversification standards
apply to 401(k)'s as apply to ordinary pension plans.
Chairman Lieberman. Just for the record, tell us--and I
understand you cannot cover every nuance, but in basic terms
what are they? In other words, some of the proposals that
colleagues here have made is that there should not be more than
20 percent, for instance, of a company's stock in a 401(k) of
its employee. Is that an appropriate number?
Mr. Langbein. That is roughly 20 percent more than I
believe we ought to have. In other words, in a defined benefit
plan today we have only trivial amounts of employer stock. That
is the right answer. The single most important thing for
workers to understand is that employer stock is the single
worst investment you can possibly have.
Chairman Lieberman. Why?
Mr. Langbein. The reason is that the worker is already
horribly underdiversified vis-a-vis the risks of that firm
because he is what we call human capital. His employment
relationship has him already deeply exposed to the risks of
that firm. What ordinary finance theory tells you is, the last
thing in the world you should do is to take the little sliver
of diversifiable capital, your finance capital, namely your
pension savings, take the one bit that you have that you can
invest elsewhere and tie it back up with the employer. That is
the fundamental fallacy of employer stock plans. They are a
fundamentally bad idea.
Chairman Lieberman. So if you had your druthers you would
pretty much prohibit employers from putting its own stock in a
401(k)?
Mr. Langbein. I would not say it just that way. There are
circumstances in which trace amounts show up. For example, you
do not want General Motors in its pension plan not to be able
to buy the S&P 500 type funds which have some General Motors
stock in it. We get the result that we are talking about,
basically no employer stock, without saying so, under existing
ERISA rules for defined benefit plans by imposing a prudence
requirement and then allowing that to sort itself out. No
investor can prudently invest heavily in employer stock.
Chairman Lieberman. Let me go on to another subject.
Mr. Langbein. Senator, may I just say one other thing? Your
question was about the 20 percent proposal in the Boxer-Corzine
bill.
Chairman Lieberman. Yes.
Mr. Langbein. Look, it is a lot better than nothing. If you
have got to compromise, compromise. There are a lot of
political pressures out there, there are a lot of reasons why
employers and their pals want to stuff employer stock down
pension plans.
Chairman Lieberman. You do not have to compromise so I
appreciate hearing exactly what----
Mr. Langbein. That is exactly right. I am just a
schoolteacher. I can go home and leave you to have to cut the
compromises. And if you have got to compromise, that is an
awful lot better than we have got now.
Chairman Lieberman. Incidentally, I do want to note for the
record, as you know--and I have been reading this in the
media--some of the great companies in America have 401(k)'s in
which they have got 60, 70 percent of their stock. That alarms
me as I hear your testimony.
Mr. Langbein. Senator, as of 2 years ago Enron was one of
the great companies in America.
Chairman Lieberman. There you go; exactly.
Mr. Langbein. That should tell you what the danger is.
Chairman Lieberman. Good point. Anything else besides the
diversification requirement that you would say we might do by
law to protect people's investments in their 401(k)'s? If you
want to think about it and submit later testimony, that is OK.
Mr. Langbein. I think the main--99 percent of what has gone
wrong here is having large quantities of any stock, especially
employer stock, in these plans. If there is one piece of advice
I could give your constituents it is, to the extent that you
have discretion over your own employee contributions in these
plans, resist the pressure to show your loyalty to the firm by
investing back in the stock of your employer. Your loyalty
should be shown by what a good employee you are, but not by
concentrating investment risk back in employer stock.
Chairman Lieberman. Let me ask one other question related
to this. One of the parts of the Enron story that infuriates
all of us is the question of the period of time during which
the Enron employees were locked into their 401(k)'s. The stock
price is falling. We now know from public records that the
executives are selling their stock, cutting their losses,
making a lot of money, and the employees cannot get out. They
say this was because of a transition in plan administrators.
I want to ask you whether as a matter of law, technology
being what it is now, in terms of transition of plan
administrators we should prohibit lockdowns of that kind to
make sure that employees always have mobility as the market
moves, and their company moves or other companies move, to sell
their stock?
Mr. Langbein. Senator, I think the answer is that the law
is in place to deal with this. The basic way in which we handle
these details of plan administration is to impose a
requirement, which you have done, and done on defined
contributions as well as defined benefit plans, that they be
administered by people who are fiduciaries. Then we impose
fiduciary duties in Section 404 of ERISA, including one of
prudent administration.
The question of whether or not Enron should have been
changing plan administrators in a period in which its stock
price was under great pressure is, in my view, a very serious
one and one which I think is likely to raise fiduciary
liability on them for having done so.
Chairman Lieberman. You think they may be subject to
lawsuits by their employees----
Mr. Langbein. Those lawsuits are pending right now.
Chairman Lieberman. Do those suits include this element?
Mr. Langbein. Yes, the lockdown period is the subject of
plaintiff's litigation ongoing right now.
The precise question you have asked is, how long the period
ought to be. In the case of the Enron plan there was, I think
11 trading days involved, some such thing. I do not think
Congress should attempt to micromanage this. I think the proper
standard is the one which we have under fiduciary law, which is
that which is reasonable in the light of all the circumstances,
bearing in mind the fiduciary duty to maximize the best
interest of the employees under Section 404(a)(1)(A) of ERISA.
You have got this right already in the law.
That is not where your efforts ought to go. Your efforts
ought to go on the diversification problem.
Chairman Lieberman. Thanks. My time is up. Senator
Thompson.
Senator Thompson. Thank you, Mr. Chairman.
Mr. Partnoy, educate me a little bit further with regard to
the use of derivatives. I take it derivatives are neither
inherently good or evil, that they can be used for speculative
purposes, they can be used as insurance policies to hedge. It
seems that, as you pointed out, Enron used derivatives in deals
with its own special purpose entities that it set up, and by
trading with what looks like pretty much itself in many cases,
it was able to hide debts and losses and to make sales to these
special purpose entities at inflated prices and book the
profits. So apparently that is the way they were using them for
their purposes.
Then you look at the regulatory structure, and as you
pointed out, some derivatives are regulated and some are not.
Apparently this has been the subject of a good deal of debate
over the years and we have come up with a situation where
energy derivatives, for example, are exempted, financial
derivatives are exempted from regulation under the CFTC.
The working group on financial markets under the previous
administration recommended in 1997 that these exempt
derivatives be exempt, as I understand it, for reasons that
they were deep markets. Unlike the agriculture field, for
example, there was likely price manipulation, and there were
big, deep markets in these areas and so forth. So a lot of good
people apparently thought that a lot of these things should be
unregulated.
So tell me what--and I am not trying to make a point here.
I am really curious as to, when we talk about regulation what
is it exactly that would be regulated with regard to the
derivative markets, if they were regulated? I mean, they would
have to go through an exchange and file certain reports, I
guess. But what does it actually mean?
More importantly, what would it mean to the Enron case?
What part of what they did, which in large part seems to me to
be a failure to properly disclose more than the inherent
activity itself perhaps, which may have been legal and proper.
What part of what they did that gave us bad results could have
been avoided, in your opinion, had there been regulation of
these derivatives?
Mr. Partnoy. Senator, I think you have the story absolutely
right; derivatives can be used for ill or for good, and there
are perfectly valid reasons to say we should have some
derivatives traded on an exchange, and some derivatives traded
in some other venue. But I think you have isolated the key
point, and that is disclosure.
Whatever these investments and instruments were--and it
turns out that what they were is quite troubling--they should
have been disclosed. We easily could require that they be
disclosed. There should not be an argument that just because
these are something different that they can be left off the
financial statements.
Senator Thompson. Would regulation as such, in and of
itself, bring about that disclosure? Or is it a disclosure
issue and not necessarily a regulation issue?
Mr. Partnoy. There is a separate matter which is, why is it
that we are treating these sorts of financial contracts
differently than other investments? What is the rationale for
that? In some derivatives there is a very good rationale.
Interest rate swaps, for example. There is a very deep market,
trillions and trillions of dollars with sophisticated actors.
There are not problems of somebody ripping off somebody else.
There are not problems of public investors losing money. That
actually is the vast majority of the over-the-counter
derivatives market.
But there is a decent chunk of the over-the-counter
derivatives market that has problems. I think a lot of those
problems could be corrected by recognizing the fact that these
are investment contracts just like anything else, and
recognizing that they should be disclosed.
Senator Thompson. But I still do not understand what
unpleasantries we could have avoided in this case had these
derivative markets been regulated.
Mr. Partnoy. I would draw your attention to footnote 16 of
Enron's 2000 annual report.
Senator Thompson. I am very familiar with it.
Mr. Partnoy. If you can tell me what is going on----
Senator Thompson. Just kidding.
Mr. Partnoy. You should take a look at it. It is about a
page long and it would be very well worth your time. It is
chock full of derivatives transactions of all sorts. You
literally cannot tell who the derivative transactions are
between, what they are. If we had clear disclosure about those
transactions then the Enron situation might not have happened.
Senator Thompson. Couldn't we have disclosure without
regulation?
Mr. Partnoy. If somehow magically companies were to say,
and some hopefully will, we will tell you all of our
derivatives contracts--this relates to accounting actually.
This relates to the accounting issue. Because if we had strong
accounting standards and strong auditors they would say, hey,
just because these are derivatives contracts does not mean you
can push them off over into this off-balance sheet transaction
and not list them.
So I think that it is possible you could accomplish what
you want through more rigorous disclosure requirements that
apply to derivatives.
Senator Thompson. Mr. Henning, do you have an opinion on
this?
Mr. Henning. Yes, I do, Senator. Appreciate it.
One of the things to recognize is that derivatives, and
basically the financial contracts, are very important in energy
markets, in addition to the fact that the energy markets are
quite liquid, and the data shows that we did not see great
deviations in the prices as a result of that. It is very
important to be able to trade in a whole variety of locations.
Natural gas is exchange traded at the Henry Hub in
Louisiana. But in order to move natural gas around the pipeline
system and in order to be useful to hedge on the behalf of
consumers you have to be able to deal with trades that are
happening at lots of other places around the pipeline system.
This happens in the over-the-counter market.
Over this last summer there has been a big emphasis within
the State regulatory commissions to look at ways to use hedging
strategies in order to try to insulate customers from those
kind of movements.
Senator Thompson. So what? Are you making the case for
these derivatives not to be regulated?
Mr. Henning. I am making the case that they are very
important. I am making the case that the regulated entity in
terms of their involvement should not be forced into any
additional disclosure that an unregulated entity is involved
in, and that fundamental issue in my opinion is a broad
accounting issue in terms of the disclosure of information and
the way we get that disclosure out into the marketplace.
Senator Thompson. I am not sure I know any more than when I
started, Mr. Chairman, but we will revisit the issue.
Chairman Lieberman. I think maybe you and I both should go
back to that LLM program.
Senator Thompson. Thanks.
Chairman Lieberman. Thanks, Senator Thompson.
I have some good news to report that my staff just informed
me of. This is how terrible events sometimes produce in their
wake also good results and reaction, which is that--you will be
happy to hear this, Fred--that they have just obtained the
218th signature in the House on the discharge petition for
campaign finance reform.
Senator Levin. Bravo.
Chairman Lieberman. Bravo is right. So that bill will go to
the House floor, and hopefully it can match up with the
campaign finance reform bill that passed the Senate last year
and we can at least close the loophole in the law through which
the large unregulated, unlimited soft money contributions are
made.
This goes back to something said before, I believe by
Senator Thompson, about this matter, which was, sometimes the
most scandalous behavior is legal. There is some scandalous
behavior I think in Enron that is illegal. But in the campaign
finance laws the most scandalous behavior is the legal end run
of soft money. So anyway, good news.
Senator Levin.
Senator Levin. Thank you. That is good news indeed. I want
to go back to footnote 16. I have not read it either, but you
say that it does disclose something there, and that if certain
people had really been on the ball perhaps they would have
forced a greater disclosure. Auditors never should have agreed
to it to begin with, but if analysts had been on the ball
perhaps they would have asked questions about that disclosure
because it was so obfuscating and unclear. Is that right?
Mr. Partnoy. That is exactly right. I would not have
recommended that anybody buy this based on that footnote. It is
really only a page. Just take a look at it. Would you have
recommended Enron stock if you read that footnote? I do not
think anyone would have.
Senator Levin. So what we are talking about here then is
not just disclosure, you are talking about disclosure which
meets certain standards of clarity. Is that why you want this
to be regulated, because a regulator could force clearer
disclosure standards? Is that the purpose of the regulation
that you are proposing?
Mr. Partnoy. Sure. Clearly, uniformity is important. If we
just have people off making disclosures on their own we may not
be able to understand or compare. One of the points of
disclosure is to be able to compare companies, so that we can
look at Company A and Company B and say, OK, they have this
many derivatives and they have this many derivatives, so we
should buy this one instead. We want it to be comparable.
Senator Levin. Other than disclosure, which is what
regulation could require in greater clarity, is there any
specific action in the creation of these entities, in all of
the havens, the offshore entities that were created as well as
the special purpose entities, 800 or 900 entities that were
created, are there any specific actions of Enron that a
regulatory body in your judgment would have prohibited, other
than the disclosure issue?
Mr. Partnoy. Some of these derivatives transactions with
the special purpose entities are very troubling and the
question would be, if they were put in the context of a
securities regulation, a standard investment contract, what
would a securities regulator say about that? What would the SEC
say about that? I think they would have problems with these
transactions. They are very troubling.
Senator Levin. Who, in your judgment, should regulate this
over-the-counter derivatives market? Is it the SEC or the CFTC?
Who would you recommend for that?
Mr. Partnoy. That has been a very difficult question for 20
years. As you know, I am sure, there was a turf battle between
the SEC and the CFTC over some of these issues, and I do not
have a lot of good answers. I would be happy to think carefully
about it. I think the important point, and it sounds like the
message has gotten through, is that these are unregulated
markets and maybe that is not such a good idea.
Senator Levin. I think that message has probably come
through, but we have to take the next step. If they are going
to be regulated, who would do the regulation? I think we need
the advice of folks on that as well. Mr. Chairman, I would ask
that perhaps this be supplied for the record, if you would just
allow that to happen. That goes for any of our other witnesses,
by the way.
On the question of the 401(k)'s, you made a reference,
Professor, to ESOP's.
Mr. Langbein. Yes.
Senator Levin. I am someone who has supported ESOP's. I
remember Russell Long here talking about the importance of
employee ownership, and we wanted people to have a stake in the
enterprise because they would really feel then a keen interest
in the quality of their work, and a number of other positive
things. But ESOP's were viewed around here as something which
would help those who worked to become owners of the enterprise.
So your comment was somewhat disparaging, I think, about
ESOP's, if I heard it right. But I would like to hear your--
please testify about ESOP's.
Mr. Langbein. You have just repeated the standard theology
of ESOP's, which is that they are wonderful things that help
workers own their own firms, and therefore, cause them to
identify with capitalism.
Senator Levin. Could I just interrupt for one second? First
of all, these are employee stock ownership plans, for anyone
out there who does not know what an ESOP is. I should have said
that. But, second, would you distinguish in your answer between
stock which is owned now by an employee and stock that goes
into a retirement fund; is there any distinction in that
regard?
Mr. Langbein. Yes. Let me take that one first. The most
troubling part of the 401(k) phenomenon, and to some extent the
ESOP phenomenon is that these concentrations of employer stock
are coming in the form of a displacement of conventional
pension plans. Russell Long and the other people who gave us
ESOP's did not foresee or want that. It was always thought that
ESOP's--that is, back in the days when they came into ERISA in
1974--would be supplementary plans and that they would not have
the effect that they have had in all too many companies of
becoming really the substitute for a private pension plan.
A very simple solution--simple to enunciate, difficult to
draft, but it is doable--would be to insist that no firm run an
ESOP without first having run an adequate private pension plan,
a non-ESOP type plan.
Now, with respect to the question, what is wrong with these
plans, with ESOP's and with large concentration of employer
stock, it is the point I made earlier, which is that the
employee already has his future tied up with the firm. Remember
that these ESOP's and 401(k)'s are, in an important way, public
plans as well as private. They are privately created, but they
would not exist in practical significance in their present
extent, they would not exist but for the tax subsidy that is
inherent in them.
These are all what we call tax-qualified plans. There is a
huge tax deduction for this employer stock, and there is the
advantage of tax deferrals across the years which works out to
be--I think it is the second largest so-called tax expenditure
item in the tax expenditure budget. These are hugely
subsidized. They are there for public purposes.
The idea that somebody should come along and be able to
relabel his own company's effort to get the employees to
identify with it, whatever good that does for the company, to
relabel that a pension plan entitled to have this massive
Federal tax subsidy is a very peculiar notion.
Senator Levin. My time is up. I think that I agree with
what you say for the most part, but I am not sure that I would
label this totally as employers stuffing stock into a plan,
because I think there is a real legitimate public policy
purpose in having people own a piece of the enterprise. I think
that there is an added incentive there to make the enterprise
successful that people might not realize to the same extent
through simply being an hourly paid worker.
Mr. Langbein. I agree with that completely, but I would say
to you--I used to be in Chicago and at one point there was a
proposal to build some power plant or something out in the
lake, and the opposition group put together some bumper strips.
When I was in Chicago all the guys had these bumper strips, and
the bumper strips said, ``Don't do it in the lake.'' My
suggestion for the bumper strip here is, ``Don't do it in the
pension plan.''
If you want people to have employer stock and you want to
make it advantageous, we do that right now with discount stock
purchase plans and so on, but they are not tax-qualified
pension plans. What is wrong with the present structure is that
we allow employers to get tax deductions and tax subsidies of
other sorts for putting massive quantities of employer stock in
things that employees are relying on as pension plans.
Senator Levin. I think that is a very important
distinction. So that you are not talking about employee stock
ownership that does not have those tax benefits and are not
part of pension plans, but only the ones that are. I think that
is a huge important distinction.
Mr. Langbein. Yes, and I will go further. For high level
executives, I think it is particularly important that they be
exposed, they be at risk with the company.
Chairman Lieberman. Thanks. Very interesting. Senator
Bennett.
Senator Bennett. Thank you. I could engage in this
conversation some more, but within the limited time let me
switch to the issue of derivatives, because this has come up
before. We were on the Banking Committee when the Orange County
failure occurred and the headlines said, it was because they
traded in derivatives. As we dug into it we found that the
failure occurred because they made stupid decisions. As Alan
Greenspan said to us, the use of derivatives simply made the
effect of those decisions more efficient. If the man had made
intelligent decisions, the use of derivatives would have been a
wise thing because there would be greater efficiency in getting
this.
What it boiled down to is he was making the wrong bet on
interest rates. When the interest rates moved against, because
he had always been right in the past, he doubled down on his
bet, and he used derivatives to do it. Then he destroyed the
entire pension plan of Orange County employees, and taxes had
to go up in Orange County for decades after.
In a sense, is that not what we have here, where the
executives of Enron, filled with the hubris of their success
said, we are so smart that everything we bet on is going to
come up roses, so we will go bet on bandwidth, we will go bet
on dot-coms, we will go invest. And we have figured out this
nifty way to do it with somebody else's money and all we have
to do is guarantee it with our own stock. And since our own
stock is going to be going up perpetually forever, that is no
risk. And it is too hard to explain to somebody so we will put
it in a footnote that nobody can figure out. And everything is
going to be wonderful.
It turned out that they were as stupid as the controller of
the Orange County pension plan and it all collapsed on them,
and then they started shredding documents. But is that a
correct description of what happened? If it is, then let's talk
about the sunshine that we put on, or the spotlight that we
shine on the derivatives trading. Instead of starting with the
spotlight, let's go down to a base understanding of what
happened. Am I correct in my description of what happened?
Mr. Partnoy. Yes. Let's start with the facts. You are
largely correct. The paradox of Enron is that the company
actually made huge amounts of money from its derivative
trading, even in the last year. Where it lost its money is on
all of these other bets, many of which you have mentioned:
Fiber optics--they have been covered in the media extensively.
But at its core it actually made a lot of money trading
derivatives.
One of the problems that I have been trying to think about
is what should be disclosed about that trading operation? Maybe
Enron actually could have been a viable entity as a derivatives
trading shop. But the problem is, investors did not know that.
When you looked at Enron's financial statements it did not say,
hey, we are a derivatives trading firm. It said, hey, we have
all these other businesses going on, and by the way, it looks
like we are making a lot of money over time.
The reality is, the only thing Enron was making money on
was trading its derivatives, and trading derivatives was making
up for all the losses in all of these other bad bets that you
just described.
Senator Bennett. Losses in what was perceived by the
investment community as being its core business?
Mr. Partnoy. That is correct.
Senator Bennett. So we come back to the old adage, where is
the best place to hide a leaf? The answer is, in plain sight on
the floor of the forest surrounded by all of the other leaves.
I have had to produce 10Ks and 10Qs in my life and I know how
impenetrable they are.
Maybe the issue we should be focusing on with the
accounting firm is how to write plain English sentences. Maybe
the summary of the 10K or the 10Q should be: This is what is
happening in the core business. This is what is happening in
the areas we are experimenting with. This is where we are
taking a risk, in bold print right up front rather than the
arcane language of an accountant that drives you--and then the
lawyers. By the time those two groups get through with the
English language it becomes almost impossible for somebody who
is not trained in both to understand what they are saying.
Maybe the focus should be--General Grant. There is an
anecdote. General Grant had as one of his closest staff a
fellow who was not very bright. People would say to him, why do
you have that dummy on your staff. He said, because I read my
general orders to him first, and if he can understand them,
then I know the commanders in the field will not misunderstand
them. Maybe we ought to have a house dummy somewhere at these
accounting firms that has to sift through this language and
say, yes, it is now clear.
Obviously, we cannot pass legislation to that----
[Laughter.]
Mr. Partnoy. There is a plain English requirement and
financial statements have gotten a lot clearer. But I went
through Enron's financial statements, and my written testimony
is 32 pages, and it is as clear as I could make it. And if you
gave it to an average investor it would be quite daunting, I
think.
Part of the problem is that these things really are very
complicated and we have problems with the rules. So the rules,
even if this was clearly described, an investor would say, this
is crazy, do you mean to tell me the accounting does not match
up at all with economic reality? But that is what the rules
say, all of these complicated rules basically allow managers to
have accounting statements that do not match up with economic
reality.
Even if that had been clear to investors I still think you
would have this problem because within the clarity there still
are things that can be moved off the balance sheet. In other
words, say nothing; it is not on the balance sheet. And say
nothing cannot be made any clearer, right? So improving
clarity, I think, is a very important goal but will not solve
the entire problem because many of these, the problematic
transactions, are because of these rules.
As Senator Thompson mentioned before, one of the problems
is a lot of these accounting issues are arguably quite legal.
If they are, even if they are clearly described they still
would lead to these problems.
Senator Bennett. My own problem with this process, a word
that I never learned until I got to the stage in my career
where I was dealing with 10Ks and 10Qs, was materiality. What
is material? We would have towering arguments as to what was
material. Basically what that comes down to is, we do not think
this is important to disclose.
We have just found out that you have done something really
horrible, but we have put a dollar figure on it and the dollar
figure compared to the total value of the enterprise says that
it falls below the statistical level of materiality. So we say,
the fact that you have just raped your secretary and stolen
goods off of the company, etc., when we add up all of the
dollars connected with that activity we say that is not
material, so we are not going to disclose that. Whereas,
somebody that was looking at you as a responsible executive
would say, that is a very material fact.
So I guess what I am saying here is that we ought to
examine what we think people really need to know rather than
the legal structure that is currently there that says, if you
comply with this and this and this you are within the law, even
though you are ignoring all of the rest of this, that we just
say, it is not material.
Mr. Partnoy. Senator, I think you are right. The problem,
of course, is that what is really material, if it is bad, the
managers do not want to tell shareholders because that will
cause the stock price to go down. So the question for
regulation has to be, how do we create incentives that will
either force managers to give up that information, or to have
gatekeepers who will effectively look at the managers and force
the managers to give up that information?
But I think you are absolutely right, there are all sorts
of information that investors would think would be very
important that is not reflected in that information. That is
why, quite frankly, we have seen stocks going down in price
recently, because investors are worried that there could be
other disclosures that accountants said, this was not material,
but it is still there and it is not reflected in the financial
statements.
Senator Bennett. Thank you.
Chairman Lieberman. Very interesting. I could not agree
with you more about the clarity of the reporting. Because part
of what happened, because these are inherently complicated, is
that the people we rely on to translate the complicated
verbiage, the analysts, etc., failed as well.
Incidentally, Senator Levin wanted me to clarify that when
you used the term house dummy you were not referring to his
brother. [Laughter.]
Senator Levin. That was just a private joke. You just
ruined a 66-year-old relationship.
Senator Bennett. I have no comment, Mr. Chairman.
Chairman Lieberman. A quick question and then Senator
Thompson has a final question. This panel is too interesting.
Professor Partnoy, do you have any idea of what the dollar
value annually is of the over-the-counter unregulated trading
in derivatives?
Mr. Partnoy. It is estimated at $95.2 trillion. That is
trillion with a ``T.'' The estimate is almost certainly an
understatement. The over-the-counter derivative transactions
that Enron privately would enter into, for example, with some
of these special purpose entities, would not be included in
that statistic. So we are talking about a number that is seven
times the regulated exchanges. We are talking about a number
that is significantly larger than the U.S. stock market, for
example.
Chairman Lieberman. That is what I was going to ask you.
When you said regulated exchanges, regulated sales, you are
talking about derivative sales it is seven times greater than?
Mr. Partnoy. Exactly, the regulated U.S. options----
Chairman Lieberman. Can you compare it to--what is the
annual volume of sales on the New York Stock Exchange?
Mr. Partnoy. The total market capitalization fluctuates a
lot but we are talking $15 trillion, $20 trillion, in that
ballpark.
Chairman Lieberman. So unregulated derivatives trading is
that much larger every year?
Mr. Partnoy. Yes, this is in notional terms. The amount at
risk we are talking about in those contracts--even the people
from the financial services firms, the lobbyists will come and
say, no, that figure is wrong. It is the amount that is at
risk. But we are still talking about trillions and trillions of
dollars that are at risk.
Chairman Lieberman. That is astounding.
Mr. Partnoy. And in the U.S. stock market it is basically
the same story.
Chairman Lieberman. We will come back in a separate hearing
to the question of whether that should be regulated or not. On
that question, my final question, I will begin with you, Mr.
Henning--Professor Partnoy, if you want to add anything, I
welcome it--which is the whole question of deregulation of
energy markets; not derivatives trading.
Last summer we had these rolling power blackouts in
California and price spikes all around the country. Now we have
got Enron, the largest energy trader, which that trading was
obviously growing in part, some of it, all because of the
deregulation of energy, electricity, for instance, markets. So
obviously some critics of deregulation point to these events as
evidence that deregulation should be reversed. I wanted to ask
you what you think the lessons are for the way in which--from
Enron, and perhaps the California experience--for the way in
which energy markets should be regulated?
Mr. Henning. Senator, I think the movement towards
competitive commodity markets for energy have benefited
consumers. I think that if you look back at the history of
natural gas and you look at the--even with last year's high
natural gases, in real terms natural gas prices were lower than
they were back in 1983. So it has moved to the benefit of
consumers. It, in fact, prevented the need for the same kinds
of situations that you had back in 1976 and 1977 where you
literally had to close schools in the State of Ohio because
there was not any natural gas to heat them that winter.
So the lesson learned from deregulation was that you have
to set up, and you have to set it up in a strong market. The
FERC has been involved in doing that, and the one thing that, I
guess, I believe is somewhat of a misnomer is energy is still
highly regulated. The structures of the markets are being
determined for electricity in regional transmission
organizations. That is work in progress, but the FERC is doing
a good job with that.
The market monitoring that the FERC is doing is going
forward. So from that perspective, yes, you had events, driven
largely by inadequate infrastructure and a confluence of
weather events and so forth that affected the California
market, as well as perhaps a poor original market design in the
State of California. But by in large, the marketplace has wound
up working.
The regulation has continued, and I guess I would just
finish in saying that the FERC is doing its job in oversight
for these energy markets. The question was asked earlier about
where derivatives should be looked at, should it be CFTC or the
SEC? I am not qualified to say, but the one thing I would say
is, have the FERC continue to do what it is doing in energy
markets and not have them impose additional things exclusively
on the regulated entities there.
Chairman Lieberman. I appreciate the answer. It is helpful.
This Committee got into the crisis in California last year. I
must say, there we felt that FERC was not doing its job.
Ultimately, it did come in and create some regulation on the
prices that were being charged by producers and wholesalers to
people in California.
Dr. Partnoy, do you want to add anything?
Mr. Partnoy. Could I just add one brief point to this
because I think you have hit on something very important.
Chairman Lieberman. The basic question is, should we go
back and urge the other State legislators around the country to
go back and take a second look at deregulation--deregulating
the energy markets?
Mr. Partnoy. I think you have hit on a very important point
and it is part of what Senator Bennett and I were talking
about, which is how did Enron's derivatives operation make all
this money? In your dealing with, when you are trading with
people who are less sophisticated than you are it is a better
business. You are going to make more money in those kinds of
markets.
That is one of the reasons--and Senator Thompson raised--
why should we have regulation here? One reason might be, when
you have parties who are dealing with substantially less
sophisticated entities--and the securities markets generally
they have claims, and rightfully so, to make the markets more
efficient. In the derivatives markets those claims are much
more difficult to make. How is it that Enron was making
billions of dollars a year trading? It had an advantage in
trading those markets.
Chairman Lieberman. OK, very helpful. Senator Thompson.
Senator Thompson. Thank you, Mr. Chairman. It seems to me
that Mr. Henning's earlier point is the valid one here, and
that is that it is real proof that free markets do work and
have worked. There has been no price spike and no lack of
product or anything like that, at least not for these reasons.
But Mr. Partnoy, you mentioned another entity here kind of
in passing that I think is very important. The credit rating
companies, bond rating companies which presumably have access
to detailed company financial data, as recently as October both
Standard & Poor's and Moody's gave solid ratings for Enron's
debt. I do not see the conflict of interest with them that we
have been talking about with these other gatekeepers and so
forth. How do you, any of you, how do you account for that?
Mr. Partnoy. They are paid directly by the issuers, first
of all, and we do not know exactly how much they are paid.
Senator Thompson. So there is a conflict issue there?
Mr. Partnoy. There is an issue. The principal problem with
credit rating agencies--and thank you so much for bringing up
this question because I think it is critical to this story--is
that credit rating agencies essentially have a legislative
monopoly. Congress and the SEC and many regulators have given
credit rating agencies a monopoly lock on their business. There
is no one else who can enter and there are hundreds of legal
rules that depend substantively on what rating you get. That is
why they have so much power, from these legal rules.
If we got rid of those legal rules and made credit ratings
a competitive business, we would not have these issues where it
is dramatic if you get downgraded below BBB. Why is that? Why
does it matter if Standard & Poor's, this private agency,
downgrades you below BBB? Because you are toast in financial
markets if you are below BBB. It is much more expensive to
borrow. It is more expensive for people to hold your debt.
So that is where--there are two pieces to this. One is
credit rating agencies make money. Moody's has a market
capitalization of about $5 billion. It is a huge and very
valuable franchise.
The second point is, the reason they have that franchise is
that we, I think quite lazily, adopted legal rules that defer
judgments about investments to these credit rating agencies.
Senator Thompson. Are these legislative enactments that we
have passed or are they regulations coming out of the SEC or
other----
Mr. Partnoy. They are regulations pursuant to various
statutes that Congress has passed. It has been going on for
almost 30 years. I would be happy to give you hundreds and
hundreds of pages on this. I have been writing about this
problem with credit rating agencies for many years and I think
it is central to why Enron collapsed, especially at the end.
Senator Thompson. We will follow up on that. Thank you very
much.
Chairman Lieberman. Thank you. Senator Levin tells me that
I asked the question he had in mind; not about his brother, but
about the value of the over-the-counter unregulated derivatives
markets.
The three of you have been a superb panel. I appreciate
very much the time you took in preparing your testimony and in
being with us. Thank everybody who participated today. I think
we are off to a good substantive start with a lot of work yet
to do.
The hearing is adjourned.
[Whereupon, at 2:05 p.m., the Committee was adjourned.]
A P P E N D I X
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