Bear Left!

The Deeper Lessons of Enron
Tim Francis-Wright

The demise of Enron has lessons for the American government, but the most important lessons are not the most obvious ones. Enron is not the first company to overstate its earnings as if by habit. It is not the first company to enrich its executives while impoverishing its workers. It is not the first company to build strong and secretive ties to a presidential administration.

Its decline and fall, however, exemplify the failures of some of the vital cogs in the American political and economic systems. The compensation of executives at Enron, as at many publicly-traded companies, insulated top executives from the vicissitudes of the stock market, but left most employees unprotected. Outside accountants who were responsible for certifying Enron's financial statements were both complacent and incompetent. Government regulators were never able to decipher the problems with Enron's finances until the stock market did. The tax system allowed Enron to hide income in offshore shell companies. Finally, Enron's board of directors did little to question the company's dubious business dealings, let alone stop them. These aspects of the Enron debacle are interrelated because much of American politics nowadays is the politics of letting corporations do what they want.

The immediate lesson of the demise of Enron is the tragedy of Enron employees who put the bulk of their retirement savings into Enron stock, stock that they could not sell until they reached 50 years old. The story is similar to something out of Euripides or Sophocles: protagonist engages in hubris (here, putting all retirement money in company stock); angers the gods by doing so (here, the gods are the gods of the market); and pays the price (here, losing job and losing retirement funds). In a Greek tragedy, however, the tragic protagonists would be Kenneth Lay and his peers. In the Enron debacle, the top executives had already made millions of dollars by selling Enron shares purchased with cheap stock options. (Limits on contributions to retirement plans allow 401(k) plans to be very important to rank-and-file workers but not to top executives.)

The deeper lesson about the lost retirement funds is the very common way that Enron used to compensate its top executives. As an excellent article in Fortune magazine explained last year, companies can treat stock options in particularly perverse ways. When employees exercise stock options, a company can deduct as a business expense the value of those options over the stock price at the time. But, for purposes of its financial statements, those options do not affect profits whatsoever, even though similar options in the real world of a stock exchange cost real money. The federal tax code provides even more incentive for companies to grant stock options in lieu of salary. Section 162(m) of the Internal Revenue Code prohibits companies from taking tax deductions on any compensation to a person of over $1,000,000 unless that compensation is based on performance goals.

The rules involving tax returns and financial statements provide ample incentives for corporations to grant stock options to their top employees. The Internal Revenue Code rewarded them for doing so. The rules for reporting earnings on financial statements (and to the stock markets) rewarded them for doing so. Calculations by Fortune magazine show that many corporations, including Enron, had options represent over 10% of their outstanding shares. For many companies, including the cost of options in their book income would seriously affect their reported earnings. Stock options can generate the same effect to investors as the classic Ponzi scheme. In the original variety, an underhanded stock promoter would promise huge returns to investors, pay off a few early investors with later investors' money, then vanish with the profits. In the modern-day variety, executives (who are greedy but not necessarily shady) use stock options to generate huge profits from a rapidly rising stock price, leaving suckers who bought and held their shares holding worthless paper. The trick for executives is to exercise their options and sell at the right time. There are a lot of dot-com executives who never enjoyed their theoretical millions because their options, once lucrative, proved to be worthless.

But if Enron were just the hugest of the fallen darlings of the new economy, its demise would not have the ramifications that it does. One of the most important lessons of the demise of Enron is that the whole system to protect investors against fraud and abuse fell apart.

At many accounting firms, the goals of the auditors who report on the financial health of clients and the consulants who provide services to clients can be at loggerheads. At Arthur Andersen, this conflict was more public than most: the original consulting partners broke away from the auditing partners in 1997 and now run a separate business called Accenture. But like the other four national accounting firms—Ernst and Young, KPMG, PriceWaterhouseCoopers, and Deloitte and Touche—Andersen has a growing consulting business of its own. With respect to Enron, one of its larger clients, this consulting included performing much of Enron's internal accounting. The Andersen auditors were essentially vouching for the accuracy of the work of the Anderson consultants.

The five national accounting firms proved themselves in 2000 to be major political players. The Center for Responsive Politics has a revealing set of data. Counting both money from corporate political action committees and from employees, these five firms were all in the top twenty companies in donations to the Bush-Cheney campaign. Certified Public Accountants are not known for their leftist political views, so it is not surprising that these firms were important donors. But the firms were also wary of Democratic efforts to regulate the consulting services that accounting firms could offer their auditing clients. They were so conerned that they ceased being important donors and became vital to the Bush-Cheney campaign.

Accounting rules are sometimes bizarre, and the accounting profession has done little to improve them. For example, Enron was the seventh-largest corporation by revenue in America in 2000, according to the annual Fortune 500 listing. That ranking reflected just over $100 billion of revenue, and put it between Citigroup, a huge bank and insurance company, and IBM, a huge computer company. As the New York Times reported on Sunday, this figure counted as revenue the dollar value of all of the energy trades that Enron reported. Counting just the commissions would put its revenue at $6.3 billion. The commensurate ranking in the Fortune 500 would have been 287th, between Automatic Data Processing, a payroll company, and Campbell Soup Company. The bizarre world of accounting made Enron look much bigger and much more vital to the economy than it really was.

The magnitude of the recent restatement of Enron's recent earnings makes clear that Andersen was doing a lousy job of accurately reporting Enron's financial condition. But Enron was not the only company to have serious flaws in its financial statements. According to TheStreet.com, 464 companies restated earnings in 1998 to 2000, more than did so in the previous 10 years. (Under accounting rules, financial statements only require restatement is there are material errors in them, so any restatement is an admission of a fundamental error of some sort.)

The Securities and Exchange Commission is supposed to review financial statements and other corporate reports to make sure that investors and the general public are receiving the proper information about public companies. But the political will in Washington has been insufficient to give the SEC enough staff to perform reviews more often than once every three years: that frequency is often too optimistic in practice.

Accounting firms are supposed to certify that the financial statements that they issue conform in all material aspects to the rules of financial statement reporting. Andersen issued such certifications to all of Enron's recent audits. But these certifications too often mean very little. Enron managed to move billions of dollars of debt off of its balance sheets even though it lacked the authority to do so, and Andersen certified that Enron's treatment was substantially correct. The footnotes to Enron's 2000 annual report take up 16 pages of agate type. Deep within the footnotes are hints of the transactions that proved to be Enron's downfall. A truly independent auditing firm would have refused to make such transactions as opaque as they were to investors and analysts. But the cost of doing so would have been very real to Andersen. Losing the Enron account would have meant the loss of over $50 million of annual revenue. Keeping the Enron account, however, meant risking much more in the hopes that neither the SEC nor intrepid reporters nor disgruntled employees would ever question the truthfulness of the financial statements. This lack of independence and this conflict between doing well and doing right is not unique to Enron and Andersen. It applies, to some extent, to all of the major accounting frism and to many otf their largest clients.

Intertwined in the scandal of Enron's financial statements is the treatment of Enron's activities for income tax purposes. As the New York Times recently reported, Enron had hundreds of entities in countries and territories with little or no corporate income taxes, especially in the Cayman Islands, where Enron did little or no actual business. The net result was that Enron paid no income taxes in 1996, and in 1998 through 2000. The major accounting firms are perennial promoters of the sort of tax shelters that rely on subsidiaries in foreign tax havens. It took the belated investigations by the SEC and Congress for the IRS to take real notice. As Business Week reported earlier this month, however, that the IRS is investigating a number of aspects of Enron's recent tax returns, including whether Enron improperly treated some money as debt in its tax returns but as capital on its financial statements.

Another lesson of the collapse and bankruptcy were the sorry actions of Enron's board of directors. Its ultimate responsibility was to protect owners of Enron stock against what management might do, and it quite utterly failed. If the board were ignorant of management's actions because it had been misled, then perhaps it would be guilty of negligence. The New York Times revealed, however, that Enron's board of directors was intimately involved in the financial transactions that ultimately led to its bankruptcy. The board even waived the Enron code of ethics to allow the chief financial officer to profit personally from transactions with the company that took debt off of the company's books. It therefore shares with management the blame for the downfall of the company.

It is easy for directors of large corporations to forget the interests of shareholders, never mind the employees or the general public, and to keep only in mind the needs of management. While many shareholders care about the fundamental strengths of a company and think of investments in the long run, the value of a top corporate job depends on the stock options that it entails. To a large extent, these options depend on short term performance. And if short term performance is good, then life is good not only for the corporate executives, but also for the directors who are paid, in part, with company stock.

Is the fall of Enron a political scandal? Enron was particularly well connected politically. Both Texas senators have close ties to Enron. The wife of Phil Gramm is on the Enron Board of Directors. The husband of Kay Bailey Hutchinson in a partner in Enron's law firm. It is not clear, however, that the Bush administration has done anything illegal. Despite a number of contacts by Enron to all sorts of cabinet members, President Bush and his cabinet did nothing to protect Enron or its management from any sort of political or financial fallout. The fall of Enron is not a political scandal.

But the rise of Enron should be a political scandal. During the Bush administration, Enron officials had numerous meetings with Vice President Dick Cheney to discuss the nation's energy policy. The Bush administration has fought hard to keep the substance of those meetings secret. But well before George Bush took office, Enron got what Enron wanted. During the first Bush administration, Enron received waivers from regulation by the Federal Energy Regulatory Commission. (Enron later appointed the head of that commission, Wendy Gramm, to its Board of Directors.) Under the Clinton administration, those waivers were made part of federal law. For years, Enron has been a major donor to both the Democratic and Republican parties. Its largesse to the Bush campaign has overshadowed its beneficence to representatives and senators of both parties. In that respect, Enron has lots of company.

The rise and fall of Enron is a political scandal because corporations now dominate many aspects of politics. The access Enron enjoyed was disproportionate even to the size of its contributions (see here) but what it got was only the bigger and better version of the myriad favors done in Washington for corporations. The provisions of the tax code reward all sorts of machinations by corporations and their top executives. Even when lack of oversight threatened not just the working class but the managing and investing classes, neither party put its full weight behind reining corporate abuses. Deregulation and love of the market are hallmarks not just of the Republican party but for a large segment of the national Democratic party as well.

There is some hope for some good from the demise of Enron. The leadership of the House of Representatives has kept campaign finance reform legislation from coming up for debate. Proponents, chiefly but not exclusively Democrats, need 218 members to agree to force debate, and have 216 members on their side. If just two more representatives realize that political influence was part of the reason for Enron's fall, then something positive can emerge from the morass.