Multinational Monitor: What is the auditors accountability
in the Enron case?
John Coffee: That is the most significant question in
the Enron case. It will always happen that some managements
will overstate their income, or understate their liabilities,
or otherwise engage in earnings management. The question is
not why they do it. The question is why the gatekeepers have
failed to detect it.
This looks like a case where both the auditors and the other
gatekeepers had plenty of warning that they were entering
very treacherous waters. Both the auditors and the securities
analysts failed the shareholders of Enron.
The auditors did not withdraw their certificate until just
about a month before the company failed, when they belatedly
decided that three years of earnings had to be restated. And
of the 20 or so securities analysts following Enron, up until
the date of bankruptcy, only one at the last minute put a
sell recommendation on the stock.
MM: Isnt that generally the case now, that the
securities analysts say, Buy, buy, buy?
Coffee: It is generally the case, but it is the product
of conflict of interests.
Analysts today are chiefly compensated based on a transactional
basis. Their earnings come from the investment banking side
of the business. The investment banking firm pays analysts
because they are useful in helping the investment banking
firm attract and retain clients for underwritings.
Part of the underwriters marketing pitch may be an implicit
promise that their star analyst will bless the
company and put a strong buy recommendation on its stock.
Once you create a competitive process where one investment
bank firm can obtain a client from another, so that the investment
banking firm with the top analysts can steal clients, then
you create a world in which the analysts are very highly paid,
but paid in terms of the their ability to please the management
of companies, and cause those companies to switch investment
Thats not a world that we used to see. Twenty years
ago, analysts were paid by the buy side of the
business, namely, the brokerage side. Today, the source of
funding comes not from the buy side, but from the investment
banking side, which is trying to sell deals. That makes the
analyst much more subservient to the corporate management
over which he is supposed to watchdog.
You are not going to be a very effective watchdog, if the
person you are supposed to watch feeds you.
MM: On the auditing side, the key gatekeeper was Arthur
Andersen. What was their conflict?
Coffee: Arthur Andersen is characteristic of the big five
accounting firms. They are not that different. I dont
want to suggest that this is a firm that is grossly different
from or worse than the other big five accounting firms. All
of them now receive income both from auditing and from management
advisory services. In the case of Arthur Andersen, during
the last year that they represented Enron, they received something
like $27 million for auditing services, and more than that,
$28 million for management advisory services, which often
involves software consulting and other high growth income.
If you are looking at Enron as a client from
a standpoint of a chief executive of the auditor, or that
of the local branch chief of Arthur Andersen down in the Houston
office what you see is a client that is producing
fairly staid, straight line revenues for auditing and also
very high growth revenues for management consulting services.
You may have seen that grow from a few million dollars to
$28 million this year. And you may anticipate the prospect
in the future that this could grow to $100 million or more.
Management consulting services is a very high growth market,
whereas auditing is a fairly limited market, that doesnt
have much growth potential. There are only so many large companies
you can service. The auditing income doesnt change much
year to year.
In that kind of world, you may see much more profit potential
in trying to develop your advisory relationships with the
company than as serving it as an auditor. To maximize the
income in that relationship, you have to be extremely friendly.
And you have an incentive at least in many cases to be willing
to subordinate your responsibility as an auditor to your desire
to market your consulting services. Thats the conflict
that bothered the SEC when the SEC put out a fairly tough
proposal to regulate the independence of auditors.
That came out early in 2000. Under federal securities laws,
the auditor has to be independent of the client to provide
the annual auditing of the firm necessary to be both listed
on an exchange and to file its 10Ks and 10Qs with the SEC
to continue as a publicly held company.
To be an independent auditor, the SEC said, you should not
have other relationships with the company that would give
you this basic conflict of interest, this desire to subordinate
the auditing role to other business relationships.
Let me explain in simpler terms. The classic auditor of 20
or 30 years ago was a firm that might have had 1,000 clients,
each of them paying between one tenth of one percent to one
percent of the firms overall revenues. In that world,
where you had many clients, each paying a small annual revenue
flow, there was very little incentive to compromise your own
auditing judgment, to subordinate what you thought was the
necessary standards required by generally accepted accounting
principles, to what the company wanted.
You had very little incentive, because at most you were going
to gain on the profit side the continuation of that one tenth
of one percent to 1 percent of your revenues each year. Whereas,
if you made a mistake, or if you acquiesced in improper accounting,
it could blow up in your face and damage your reputation,
which was far more valuable to you than the prospective income
from that client.
Today, the client is a much more lucrative asset, capable
of providing much more income. And the auditing relationship
is not nearly as important.
Indeed, auditors today, in their own professional journals,
often view the auditing role as a kind of portal of entry
through which they gain the attention of senior management,
such as the treasurer, the comptroller and the chief financial
officer. Through them, the auditors try to market more lucrative
services, such as software consulting, management advice and
so on. In that kind of world, you are inherently subject to
a greater conflict of interest.
In the Old World, an auditor had to be irrational to risk
its reputational capital, its personal prestige, simply to
appease a client that was responsible for only less than one
percent of its revenue.
In the New World, that client is the source of so much income,
that the temptation is so much greater.
MM: Why the change?
Coffee: Its very profitable and the risks in this
practice declined over recent years. Inherently, as an auditor,
you have your foot in the door with the auditing client, and
its much easier to sell once you have your foot in the door.
Also, at the same time, there was a decline in the risk of
liability. Auditors face lesser legal risk because of a Supreme
Court decision, Central Bank of Denver, that abolished aiding
and abetting liability. And they face lesser risk because
of the Private Securities Litigation Reform Act (PSLRA), which,
through its pleading rules, made it much harder to even state
a cause of action against an auditor.
And ultimately auditors face less liability because that same
statute (PSLRA) substituted proportionate liability for joint
and several liability. That means that even if an auditor
were found liable for securities fraud, in most cases, it
would only be liable for a relatively small proportion of
the total judgment 10 to 20 percent on average.
All of those factors coalesce to mean that auditors dont
have to fear the risk of liability as much as they did in
Next, couple the legal side with the marketing side. It is
now possible to sell much more lucrative services to the audit
client than you could ever sell as simply its auditor in the
past. Audit revenues are essentially limited
they grow at a modest rate per year. Whereas software consulting
revenues are not only more lucrative, but they can increase
at a hyperbolic rate as the company becomes more and more
dependent upon the auditing firm as its source of software.
So, in the world of auditing, the benefits of acquiescence
have gone up, and the potential legal liabilities, or costs,
have gone down. And that produces a world in which the auditor
is rationally more likely to acquiesce to what the client
wants to do than it would in the past when the costs were
higher and the potential benefits were lower.
MM: Chairman Levitt had effective control of the SEC.
Why didnt he just impose his rule, barring provision
of consulting services to the audit client, over the objections
Coffee: He would have lost his budget. There was incredible
pressure placed on the SEC by both houses of Congress.
The chairmen of both of the Congressional committees to which
the SEC reports expressed their strong displeasure with Chairman
Levitts proposed, fairly tough audit independence rule.
Chairman Levitt was essentially told that he was going to
lose his budget if he pushed it.
MM: Is this Enron specific, or systemic?
Coffee: The industry wants to contain the scandal and
limit it to being about bad actors at Enron. There may well
have been bad actors at Enron.
Im not sure that we can yet fully apportion the blame
or state from afar who should be indicted, and who shouldnt
be, or who should be sued and who shouldnt be.
Still, the public policy issue is broader than Enron. The
reasons that gatekeepers become acquiescent and lax are structural.
They dont just involve individual moral failures, although
there may have been that element too.
The circumstances that caused Arthur Andersen to fail at Enron
may have also caused it to fail, as the auditors for Sunbeam
and Waste Management, two other egregious cases in which they
were involved recently. And it is not a unique position involving
Arthur Andersen. Im not in a position to say that they
are better or worse than Ernst & Young or Pricewaterhouse
or Deloitte and Touche.
All of these firms are approaching the point where they are
going to be highly conflicted in the future and they are going
to have much reduced incentives to in effect call a halt to
gray or dubious practices by their audit clients.
They instead are in a position where, if there is any way
to say that these practices comply with an accounting principle,
they have a strong incentive to do that.
Over the last three years, an Arthur Andersen study found,
the number of earnings restatements by reporting companies
has risen by 47 percent. Between 1998 and 2000, the numbers
go from 158 to 233. That is a 47 percent rise over three years.
Restatements generally suggest that the accountants have made
an error. Now, on an individual case, I cant tell you
whether that error was the product of simply an honest difference
of opinion or an honest mistake, but on an aggregate basis,
I have to say that that much of an increase in failures by
auditors or the company to file their results in accordance
with generally accepted accounting principles looks to me
like a statistically important trend.
While I cant talk about individual cases easily, I can
say that on an aggregate basis, it seems to me like the simplest
explanation for why auditors are making more and more mistakes
is that they are more and more conflicted.
Errors will occur. But errors occur most when you have a conflict
of interest one that gives you an overriding
desire to be cooperative with management. Auditors down deep
are not simply supposed to be cooperative with management.
They are supposed to protect the interests of investors.
MM: So, what should be done?
Coffee: While we should certainly investigate this individual
case, and dispense justice, we have to expand our range of
vision beyond dealing with the Enron management, and recognize
that the gatekeepers of corporate governance are increasingly
The simplest things to do are to have a much more effective
auditor independence rule that at some point would not consider
an auditor to be independent of management if it had extensive
business dealings with that management such as
by serving as a consultant on a host of non-audit issues.
Reasonable persons can disagree over how to define that rule.
But the rule that the SEC settled under pressure for last
year was too weak. It was a pale imitation of what had been
MM: On the question of private litigation, what are
the chances that these companies will be held liable by the
class action bar?
Coffee: Enron clearly could be forced to settle for a
high number because you are in a very weak position once you
have restated three years or more of earnings and claimed
$500 million in earnings that you now acknowledge you never
earned. There clearly were mistakes. I think it would be difficult
for Enron to escape liability if it could still be sued.
But Enron is essentially immune from securities litigation.
The filing of a petition in bankruptcy stays all pending litigation
against the company.
So, Enron wont be sued. Even if it were sued and found
liable, the tort judgment would come last in bankruptcy
it would come below every other claim.
MM: What about Arthur Andersen?
Coffee: Arthur Andersen and the directors of Enron can
be sued. They are not quite as inviting a target, because
they dont have quite as deep a pocket and they have
Still, they have deep enough pockets. So we will see major
litigation against Arthur Andersen. From the evidence we know,
this is the kind of case that could produce a very large settlement.
MM: Even with the weakened state of the tort law against
auditors that you mentioned earlier?
Coffee: In cases that really do look egregious, auditors
have been held liable or at least have settled prior
to going to trial. Ernst & Young settled for something
like $300 million in the Cendant case. That was a case where
some of the officials of Cendant and one Ernst & Young
employee were indicted. Once you have cases that are that
egregious, you can get over the pleading hurdle.
Also, the proportionate liability provisions say that you
can get the full judgment, not just the proportionate share,
if you can prove that the auditors had actual knowledge of
the material omission or the material misrepresentation.
And certainly there is that possibility in this case. And
that is what the plaintiffs are going to seek to prove. But
they will have a much easier time pursuing management, which
will have some insurance, and will each be potentially able
to contribute $50 million or so to a settlement. But it still
is difficult to sue the auditors, unless you can prove at
the outset of the case enough information to raise a strong
inference of fraud.
And whether or not they can meet that standard with regard
to the auditors, is still an open question.
MM: Enron created partnerships that moved debt off the
books. Whats your understanding of what happened?
Coffee: Many companies try to use off-balance sheet financing
so that they dont have to show liabilities on their
balance sheet so that they look less leveraged
and thus are able to sell their bonds or get bank debt at
a lower interest rate. The more leveraged you are, the higher
your risk and the higher the interest rates you must pay because
the interest rates will reflect the risk of the enterprise.
Companies do try to hide liabilities.
They often do it through mechanisms such as lease financing.
And accounting rules, to some extent, combat this by sometimes
requiring long-term charges to be capitalized.
Thus, if you have a long-term financing lease, you will have
to show it on your balance sheet, not simply as in this years
payment, but rather as the capitalized value of that lease
over the 40 years that it exists. That will put a lump sum
on the balance sheet.
Enron was ingenious about trying to find ways to exploit the
ambiguities and the limitations of those rules. They in particular
tried to treat the partnerships as independent entities, even
though they might have liability for it.
In some cases, they were looking to an accounting rule that
says if you own 95 percent of an entity, but
some other independent organization or company owns the other
5 percent then you can treat that entity as independent
of you. And its liabilities do not have to be capitalized
on your balance sheet.
Now that is a rule that may be excessive as it is. But Enron
exploited that by finding third parties that would buy a 5
percent equity interest in some of its affiliates, thereby
allowing the liabilities of those affiliates to be kept off
the balance sheets.
The one instance in which Arthur Andersen has admitted an
error was their failure to detect one of these entities that
allegedly owned a 5 percent share of an Enron affiliate and
was actually being guaranteed by Enron so that it didnt
have its own equity at risk. That would require capitalization
of that liability on the Enron balance sheet if it had been
We are in this context about to witness the familiar dispute
that often occurs in these cases in which the auditors say
about the client: They lied to us, they deceived us.
Im not in a position to know the facts here. Thats
for the courts and the SEC to determine. Nonetheless, this
was a rule that was probably too weak to begin with.
I dont think it is in the interest of investors to allow
a company to set up a partnership which issues large obligations
and claims that it doesnt have to be capitalized on
the companys balance sheet simply because 5.1 percent
of the affiliate is owned by someone else. It would be much
more sensible to capitalize 95 percent of that obligation
on the parents balance sheet.
But thats a problem with the accounting rules themselves.
And there is also the problem of whether Arthur Andersen was
overlooking some fairly clear warning signals.
After all, Enron had something like 3,500 subsidiaries. In
my 30 years in corporate law, I have never heard of another
company that had 3,500 subsidiaries. That was a structure
that was so extraordinarily complicated as to be suspicious
in and of itself.
MM: When the investigators and regulators are sitting
down to determine whether to bring criminal charges in this
kind of case, in terms of bringing justice to the victims,
does a criminal charge help or hinder?
Coffee: Bringing a criminal case does change the balance
of advantage in the private litigation.
In Cendant, criminal charges were brought and the private
plaintiffs ultimately obtained a $3.1 billion recovery in
the securities class action. That stands as the all-time record.
In general, the private plaintiffs feel that if the government
indicts management, that puts management in the position where
they cannot really defend the case.
The managers are less interested in the private case than
whether or not they will go to prison.
In terms of whether or not this will pay off all of the employees
who have lost their life savings, I dont think there
is any way that the management of Enron, even if their entire
assets were somehow located and seized, would be able to cover
even 40 percent of the total losses.
MM: What about the auditors?
Coffee: Remember, the auditors are a personal services
firm. We are talking about theoretical market losses of over
$30 billion. There is no auditing firm that could pay a $3