. |
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 banking firms.
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 the past.
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 of Congress?
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 conflicted.
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 originally proposed.
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 more defenses.
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 detected.
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 billion judgment.
|
|