It’s not nice to fool the investing public — energy companies and their auditors are learning as Enron’s collapse continues to spark a tidal wave of investigations, recriminations and falling stock prices. Not only the companies are under attack but also the investment analysts who follow them and even the watchdog Securities and Exchange Commission (SEC) itself is coming under fire for a “failure of leadership,” for abdicating its responsibility to set strict financial reporting standards.
Conflicts of interest, “rampant throughout the U.S. capital markets system, virtually ensure that future Enron- type collapses will occur again unless the internal controls of the system are substantially strengthened,” according to Scott Cleland, CEO of The Precursor Group, an independent research firm based in Washington. Cleland was one of several witnesses testifying last week before the Senate Commerce Committee, Subcommittee on Consumer Affairs, Foreign Commerce and Tourism which is investigating the Enron collapse.
Enron Chairman Ken Lay is expected to testify when the committee resumes hearings Feb. 4. Former CEO Jeff Skilling and CFO Andrew Fastow also will be asked to appear.
“The U.S. capital markets system clearly failed thousands of Enron investors, pension holders, creditors, employees and customers. It is clear that the system will continue to fail investors, until the root cause — rampant conflicts of interest throughout the system — are brought under control,” Cleland said. “All of the watchdogs are being paid for someone else.” Judging from the number of special off-balance sheet entities Enron had set up over the years, the company “should have been caught in 1997, 98, 99 and 2000. The system is supposed to catch these things.”
If the problems had been caught earlier, the company’s stock would have suffered some reversals, but the situation would not have cascaded and Enron would not be in the position it is today. Cleland suggested passage of a sense of the Congress resolution that “Conflicts are not a good idea.” He said auditing firms increasingly are doing both inside and outside auditing work for companies. “They are essentially grading their own papers.”
Cleland also said that most of the research work put out by Wall Street, essentially has been bought and paid for by the companies the research is about. He warned that problems with other companies would surface, threatening the retirement funds of the baby boomers.
Conflict of interest was a key theme throughout the hearing. Of the 17 analysts who regularly covered Enron, all but one had a buy, or a strong buy recommendation in effect as of September, after the CEO had resigned and the stock price had dropped 60%, Bill Mann, senior analyst for the Motley Fool, an online financial reporting service, told the committee.
Even as Enron declared bankruptcy Goldman Sachs and Lehman Brothers, both of which had provided significant banking services to Enron, still were recommending investors hold the stock, he pointed out. Lehman actually was issuing an aggressive buy recommendation. A Lehman employee also was on Enron’s board of directors, Mann said.
While the blame for the company’s failure “clearly lies with Enron senior management,” analysts helped make it possible for them to defraud the public by failing to demand facts and figures from the company. “Enron routinely failed to provide a balance sheet with their earnings announcements. They were a black box. No one, not analysts or individual investors knew what was going on,” Mann said. “There ought to have been pointed questions from analysts.”
But, could these analysts have done any better, given the confusing and contradictory financial information they had to work with? NGI talked with John Gehman, president of Energy Performance Review (EPR), who has been tracking financial information from energy companies for nearly 20 years. He sees the failure of the SEC to set down serious guidelines for companies to report financial information on a “line of business” basis as contributing to the current crisis of confidence.
“It appears you have to have a multi-billion dollar company collapse before anybody starts to get serious about making companies report what they actually do on a day-to-day basis,” Gehman told NGI. The SEC missed its chance when it endorsed the Financial Accounting Standards Board (FASB) rule 131 in 1997, Gehman said. The order loosened accounting standards first installed in 1976 and gave the companies broad leeway in reporting financial results according to the way they manage their businesses, rather than requiring reports according to specified business segments. “This makes it impossible for anyone attempting to track the profitability of a company’s various business activities or to compare it with the results of other companies.”
“The SEC’s decision not to force companies to break out their financial reporting on the basis of business segments was a really dangerous decision.” The lack of clarity in financial reporting “comes back to haunt them when there is a crisis of confidence,” such as the one brought on by Enron’s financial collapse, Gehman continued. “Companies have taken advantage of the loose reporting standards, and now they are suffering from it. You can only have a free competitive market and maintain investor’s confidence if there are strong government reporting guidelines that are enforced,” he added. But most of the companies “just don’t get it.”
It appears the SEC in loosening its reporting standards may have been influenced by the major accounting firms, which in turn, are acting in the interests of their company clients, Gehman said. (President Bush last week announced he intends to nominate two new commissioners of the SEC, one from PricewaterhouseCoopers and the other from Ernst & Young.)
Gehman has been prodding energy companies for a number of years to report on a line of business or business segment basis. More companies recently have been coming around to the idea, but too many “just mix everything up, coal, gas electricity, with all kinds of things thrown in.” EPR attempts to sort out the results and maintains a comparative financial and operating database for companies and industries at www.energyperformancereview.com.
An energy analyst who asked to remain anonymous, told NGI part of the blame for the Enron debacle on the “herd mentality” on Wall Street. “It would have been the end of the career of any analyst who raised questions about Enron while it was a high-flyer, and while all the top analysts were touting it.” He said a number of analysts had questions about Enron’s indecipherable financial reports, but they didn’t dare to be the lone wolf raising them. The fact that there were so many questions just beneath the surface accounts for the energy giant’s swift fall. Once Enron disclosed the partnerships and restated earnings, those with questions “had something to fasten on.”
Meanwhile Cleland and research team have five recommendations for Congress, which he believes would strengthen investor confidence in the capital markets system: (1)official regulatory and industry policy should discourage conflicts of interest that can undermine critical internal controls; (2)auditors should be prohibited from consulting for companies they audit and from conducting “independent” audits of their own internal audits; (3) the overall objectivity of the investment research system should be strengthened so investors get more unbiased research and are more aware of conflicts of interest; (4) analysts should be discouraged from owning a financial stake in the companies they cover; and (5) there should be increased awareness and vigilance of the press to stock manipulation, especially as it applies to “pro-forma” accounting and “Street expectations.”
Â©Copyright 2001 Intelligence Press Inc. Allrights reserved. The preceding news report may not be republishedor redistributed, in whole or in part, in any form, without priorwritten consent of Intelligence Press, Inc.
© 2023 Natural Gas Intelligence. All rights reserved.
ISSN © 2577-9877 | ISSN © 1532-1266 |