FACULTY OPINION: How will Enron change the rules for the game?

Dan Alger

Last week I started commenting on the Enron mess. Congressional hearings and the journalistic feeding frenzy over the outrageous behavior of Enron and Andersen execs continue. But are these just bad guys that existing laws can appropriately deal with, or does their behavior reveal significant flaws in our laws? Last week I considered whether Enron’s money gave it undue influence. While important facts are still unknown, it seems its cash had little impact on broad high-level decisions, but it may have tilted narrower, lower-level decisions. Leveling this playing field would be important. Unfortunately, the political response, the push for campaign finance reform, would have no impact whatsoever on this.

This week I have three questions left to address: Do current pension rules adequately protect pension holders? Do current governance rules concerning the Boards of Directors provide an appropriate safeguard for potential management abuses? Do current accounting standards and practices provide all available, verifiable information that could help any potential shareholder to properly evaluate each company?

Enron shares made up an overwhelming percentage of many Enron employees’ pension assets. No law or regulation forced this; they each individually chose it. While we don’t now need a nanny telling us how we must invest our money, even with this disaster to their savings, maybe if independent financial advice had been made more easily available, these people would have chosen differently. Also, current rules on “blackout periods,” when stocks held in pension accounts cannot be sold, even though executives making these decisions can sell theirs, appear twisted. These are relatively minor, but still useful changes.

Aggravating this problem further were executives touting the stock at the same time they apparently knew it was in trouble. Outrageous behavior. But this doesn’t seem to need s new law. Under current law, each exec has a “fiduciary responsibility” to the shareholders, including the employee-shareholders. A failure subjects them to substantial penalties to cover damages due to their actions. We’ll know how this works out after several years in the courtroom.

The next question involves a primary check on possible management abuses, the Board of Directors. The Board is supposed to look over the shoulders of management and make sure managers are working in the shareholders’ interest. They failed here. Like in many companies, management has too much influence within the Board for the Board to act forcefully and independently. Stronger standards would be appropriate here, but I don’t expect much change, partly because jurisdiction is largely not at the federal, but at the state level.

I think the biggest story concerning Enron involves accounting. Some behavior appears illegal, like the shredding of documents, but even legal behavior here should never have happened. The primary job of the external accountant is to provide a strong, independent check on the company’s books, so that shareholders can rely on these books to appropriately value the company. The outside accountants exist only to assure the stockholders that managers are indeed working in the shareholders’ interests. They failed. Badly.

Expect new rules on the structure of the accountant’s companies. New rules are likely that won’t let this “cop” for the shareholders also work for the company it’s to investigate. You don’t want a company trying to increase the profits of a client with strategic advice, consulting on information technology, keeping the books, and then later play the role of financial cop. Will he blow the whistle if other revenue is at stake? (Actually, even if the firm only played the role of the cop, would it blow the whistle if it might lose 20 years of auditing revenue?)

These new structural rules alone would change the accounting world substantially, but the accounting rules themselves are also under the microscope. To a large extent now, the choice of appropriate accounting rules is up to the industry itself. Expect the SEC to make more choices now when important decisions on gray areas arise, and expect them to insist more forcefully on adopting their choices.

Many of these problems largely work themselves out privately. Companies need a good reputation with investors on providing good information or the investors will go elsewhere. Many clients are now insisting on the structural split before an accountant will gain their business; in response, the accounting firms are separating these businesses (though not completely). But government should codify these changes to prevent backsliding.

These changes involving accounting may seem like small potatoes and appear incredibly boring, but the difference between good information to value companies and poor information that creates greater risk of surprises adds up to hundreds of billions of dollars of extra value for U.S. companies. All right, you can still find it boring.