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The Enron Crusade: Don't Hold Your Breath

Politicians and regulators have good intentions but are ultimately hamstrung. It's the culture that must change.

The fireball of outrage that is engulfing



accountants is sucking oxygen from the debate about how to clean up companies' books.

Some of the proposed changes -- like the ones

outlined Thursday by

Securities and Exchange Commission

chief Harvey Pitt -- are long overdue. But we'd be foolish to expect a rapid improvement, since the roots of the problem run very deep.

Rules can only do so much; far-reaching cultural change is much more important. Corporate executives and auditors must regain their conscience. Investors need to wisen up. And economic policymakers like the


should dedicate themselves to preventing the financial conditions that enable billions of dollars to be thrown at companies like Enron. Alas, only some of this can be legislated into existence. Much of it can't -- and, thus, will never happen.

In short: Expect more Enrons. Depressing? Yes. But let's not kid ourselves that a brave new squeaky-clean market will emerge from this mess. Such mindless Utopianism will only lose you money.

What Happened

This isn't to absolve the accountants. After Enron executives, they're most at fault. The revelation that Andersen destroyed many documents,perhaps even after an SEC inquiry had begun, shows that the firm was in a mode of self-preservation that bordered on suicidal.

But even before the shredding news came out, Andersen's chief,widely portrayed as a decent man trying his best to salvage his firm'sreputation, appeared to be ducking the real issues.

In testimony to the House Committee on FinancialServices, Andersen CEO Joseph Berardino said:"Andersen will not hide from its responsibilities."But in the rest of his testimony he did his best tothrow up a smokescreen. To see why, we need to delve alittle into Enron's dealings.

In the first quarter of 2001, Enron erroneouslyadded $828 million to its equity, as the result ofshady deals with a partnership called LJM2 that washeaded by Enron's chief financial officer at the time,Andrew Fastow. Commenting on the first-quarteraddition, Berardino said "quarterly financialstatements of public companies are not subject to anaudit, and we did not conduct an audit of Enron'squarterly reports." However, it was in a review ofthird-quarter financials, also unaudited, thatAndersen decided that the equity additions wereerroneous.

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The most likely explanation for this


is that after Enron's stock started slidingand accounting murmurs began, Andersen realized thatit had better do its reviews properly. Berardino alsoargues that an incorrect addition of $172 million toequity in 2000 "had no impact on earnings." But the$172 million contribution stemmed from a deal toprotect Enron against the drop in the value of certaintelecommunications and power assets. Without the deal,the declines in the asset values would almostcertainly have reduced 2000 earnings, perhaps by asmuch as $500 million.

Just as important, Berardino hasn't explained whyhis firm never required Enron to improve theexplanation in its financials of these key dealingswith LJM2. Enron's explanatory text was almostimpossible to follow, even to the most skilled marketplayers. "It was gobbledygook. They could have made itmuch clearer," says James Chanos, of KynikosAssociates, a hedge fund that sells stock short. "Itappears they stuck to the letter of the law, but notto the spirit."

But at least one senior Enron employee sure knewhow to describe what was going on in plainEnglish. In a now infamous warning letter about LJM2dealings and other matters sent in August to CEO KenLay, a senior Enron employee, Sherron Watkins, wrote:"It sure looks to the layman on the street that we arehiding losses in a related company and will compensatethe company with Enron stock in the future."

Sea Change

In this climate, it's no surprise that the SEC,the stock market cop, has decided to throw its weightbehind reforms. The proposal to have morenonaccountants on an industry oversight body will dosome good. But many wanted the SEC to go further and stopthe Big Five from doing consulting work for companiesthey were also auditing, a move that the former SECChairman Arthur Levitt had proposed. Faced withfurious opposition from the accounting trade, Levittended up compromising and backing off a full ban.

Harvey Pitt, the new chairman, doesn't favor thismeasure. And the accountants still seem against it.The American Institute of Certified PublicAccountants, the auditors' trade body, hasn't shownany indication that it's moving towards Levitt'sposition after the Enron crisis. An AICPA spokesmandidn't respond to a request for comment.

Granted, it's never good when the government moves to restructure an entire industry. But the auditors, with Levitt off their back, madelittle or no effort to reform and police themselves.

Come Off It

Yes, a consulting ban would bring some unintendedconsequences. But fears of these are being overdone.One concern is that the audit business will becomepoorly paid, a ghetto of sub par bean-counters. Butthis shouldn't happen in a big way, since Levittwasn't asking for a blanket ban on consulting work.Accountants could pick up the customers that had to bedropped by others. Also, this theory places far toomuch emphasis on remuneration. Analysts working forratings agencies like Moody's get below-marketcompensation -- and yet provide some of the mostobjective and thorough company analysis in the market.It's a question of will. Auditors got much lessconsulting income 20 years ago and that didn't stopthem from doing a better job.

One threat that might jolt the auditors out ofcomplacency is if Andersen is sunk by damages it paysout to settle shareholder and other lawsuits. Butit'd be foolish to rely on this just yet. First, thereis no sound estimate of how much Andersen might haveto pay out. And outsiders have no idea of how muchinsurance an accountant like Andersen has. The bigaccounting firms have a pool, to which eachcontributes, to help cover losses. But the size ofthis pool, and each member's deductible, are among thebest kept secrets in the industry. Explains ArthurBowman, of the

Bowman Accounting Report

: "Theseare not the sort of numbers the accountants want theplaintiff's bar to know."

If the auditors can't be relied upon, why not letmarket players have better insight into companies'books? Pitt said this week that the SEC is going to introduce measures toimprove corporate disclosure. The short-sellers haveexcelled recently in uncovering one set of dodgy booksafter another. "Fuller disclosure would be valuable,"says David Rocker, who runs the Rocker Partnersshort-selling hedge fund. "While the majority wouldcontinue to be very casual in its analysis, thediligent would use it and proper research would getdisseminated."

The Real Problem

But the real problem here is that most people don'teven want extra information. Audits could befirst-rate and disclosure doubled, but investors ofall stripes would still chase the same overvaluedcompanies that clutter the stock market.

Even in this recession, the

S&P 500



indices trade at bubble valuations. Think about it:This says hard numbers don't matter. It means thatinvestments rest almost solely on faith, as was alwaysthe case at Enron.

These stratospheric valuations persist onlybecause investors believe that the earnings growthwill return to the prodigious rates of the late '90s.The Enron debacle showed that brokerage and mutualfund analysts do almost no independent thinking.Analyst sell recommendations make up a tiny percentageof the total. A something-for-nothing attitude haseaten away at management ethics, for which we canblame stock options.

How can this culture be tackled? Short-sellerChanos thinks criminal prosecution could help shakethe investment world back to its senses. Arrests ofprominent Wall Street insider traders in the '80scertainly helped cleanse the market of that perniciouspractice. The same could happen if the law enforcement authorities comedown hard on anyone implicated in accounting scandals. "We need to see the people involved being led out in handcuffs," says Chanos.

And there is a financial root to all this.Without a speculative boom, and a corporate creditbinge, Enron could never have carried out its alchemy.For that, we have to blame the Federal Reserve underAlan Greenspan. Of course, the cops shouldn't bearresting Greenspan for a lax monetary policy, but norshould we forget that market fraud always goes up inspeculative booms. In his masterpiece

The GreatDepression

, the British economist Lionel Robbinswrote: "The big frauds almost all have beenperpetrated on a rising market." As Alexander Popewrote:

"Blest paper credit. Last and best supply
To lend corruption lighter wings to fly."

Know any companies that the market may be misvaluing? Detox would like to hear about them. Please send all feedback to

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.