Special Section: The Enron Mythos
No accountability? Missing billions? Meaningless annual reports? Pick any Federal agency you like. WorldCom's $4 billion is less than one sixtieth of the new US $248 billion farm subsidy bill, three-quarters of which goes to a bunch of multimillionaire play-farmers like Ted Turner and David Rockefeller. Take any G8 member. Okay, let's exclude Russia, and Italy, and stick with the semi-respectables. Say what you like about Enron's Ken Lay but he's no Jacques Chirac. In Canada last week, the Liberal Government more or less admitted giving millions of taxpayer dollars to advertising agencies which never made any actual advertisements but instead were grateful enough to give some of the money back - not to the taxpayers, but to the Liberal Party. The great thing about government money laundering is you don't even need to go to the trouble of opening an offshore account in Bermuda. At least, the market is always, eventually, self-correcting. Given the choice between government scrutiny of business or business scrutiny of government, I know what I'd opt for.
July 20, 2002
Let's see. Bill Clinton was a business partner of the owners of a crooked savings and loan whose demise cost taxpayers $60 million or so, and liberals complained bitterly about the fact that his actions were investigated at all. It all happened before he became President, and nobody was hurt (we were assured without investigation), so any inquiry was a sign of "obsession".
Now the same people are demanding investigations of Vice President Cheney. The Washington Post went so far as to denounce President Bush editorially for a routine expression of confidence that his number two would be cleared by the SEC. That was "prejudg[ing] the outcome of an ongoing SEC enforcement action", which would interfere with the ability of the agency's staff to reach a proper conclusion. Needless to say, no liberal ever prejudged guilt or innocence in the Whitewater affair or tried to interfere with its investigation.
One might conclude, then, that Mr. Cheney stands accused of a crime more serious than any that might have been involved in Whitewater. That is certainly the impression that one gets from the news headlines. Here are the dimensions of the potential crime:
In 1998, while Dick Cheney was its CEO, Halliburton Company revised the way in which it accounted for disputed billings on completed construction projects. The change increased reported revenue for 1998 by $89 million. Total revenue for the year was $17,353 billion, meaning that revenue was 51/100ths of one percent higher than it would have been in the absence of a change. Assuming that the full revenue increase flowed through to the bottom line, the impact on fully diluted earnings per share was about 20 cents (13 cents after taxes) on stock that was then trading at about $30 a share. (Data from PR Newswire, Jan. 25, 1999).
Constructing a scandal around numbers like these is a real challenge, but let it not be said that Democrats and the news media cannot rise to the occasion. ABCNews.com can be taken as an example. Its story is, in fact, more balanced and rational than most.
The company's current chief says Cheney, as CEO, knew about the change. . . . The move was approved by the scandal-plagued accounting firm, Arthur Andersen.
Andersen was not "scandal-plagued" in 1998. The implication, though, is that the CEO of a $17 billion company should have personally overridden the judgement of the firm's accountants on a trivial item that the reporter makes a valiant effort to puff into significance.
The added revenue was important: Analysts say it helped Halliburton beat its earnings target by 2 cents a share for the year. Without that accounting change, those same analysts say, the company would have missed that target by 11 cents a share.
Hitting earnings targets was a weirdly overemphasized objective during the last years of the dotcom bubble, but how important could the discrepancy really have been to investors? On a per share basis, Halliburton's 1998 results are shown in the table below.
1998 Results per Share (fully diluted)
Operating income - active business units
Operating income - general corporate
Net interest expense
Income before special charges
Special charges (mostly related to merger with Dresser Industries)
Income before taxes and minority interests
Income tax provision
Minority interest in net income of subsidiaries
An extremely naive investor might, I suppose, have been impressed by the difference between a loss of 3 cents a share and one of 16 cents a share, but most people trying to evaluate the company's future prospects would be more interested in revenue and in net income from the active operations, neither of which looks much difference if reduced by 20 cents a share before taxes.
But investors did not learn about the change until March 2000, 18 months later, when it was disclosed in a footnote buried deep inside the company's 1999 annual report.
Since the change had not material impact on 1998 results, there was no need to disclose it in that year's annual report. Burdening financial statements - already long and recondite enough - with useless data is no favor to users.
Paul Brown, the chairman of the accounting department at New York University's Graduate School of Business, says the average investor would have to look pretty hard to find it. "It literally amounted to two or three additional sentences in one footnote of dozens of footnotes that were attached to a very detailed financial statement," comments Brown.
See what I mean? Professor Brown was doubtless making a neutral observation. The reporter seems to think that there is something sinister about the fact that "the average investor would have to look pretty hard to find it". Or is he advocating less detail in public companies' financials? Which disclosures would he eliminate or downplay in order to give this one more prominence?
Setting aside its impact on investors, was the change of method right or wrong? Early on, the story quotes a lawyer who has brought suit against Halliburton:"Rather than booking actual profit, they started to book speculative profit on contracts that were in dispute, that really hadn't come to fruition yet." This gentleman's qualifications to opine on accounting theory are left unstated, but we later hear from two men who know the subject, Professor Brown and Jack Coffee (simply described as an "expert"; he is a Columbia law professor and well-known securities lawyer). Their views are introduced under the heading "Aggressive Accounting or Fraud?", as if there were no possibility of any less pejorative characterization.
Some accounting experts say it looks like Halliburton went right up to the line but may not have crossed it. [emphasis added]
That is a rather skewed interpretation of what the two professors are quoted as saying. Professor Coffee: "I'm not telling you that this was the proper accounting policy to follow. I'm telling you, rather, that this is within the judgmental realm that falls well short of criminal fraud. [emphasis added]" Professor Brown: "We might have aggressive reporting to the point that possibly it was misleading. But fraud involves overt actions by egregious partners involved in activities. I don't think that is what is in the case here. [emphasis added]" Note that neither expert passes judgement on whether Halliburton's accounting was actually aggressive; they simply entertain that possibility while making the point that it was not fraudulent. The story also quotes, without denying or questioning, the company's statement that the same method of accounting for disputed charges is followed by most engineering and construction companies.
There are solid grounds for booking disputed revenue in the year in which it is earned, regardless of whether final agreement has been reached with the other party. One of the most elementary of generally accepted accounting principles is that both revenue and expense should be recognized as they accrue. Otherwise, earnings are distorted by the vagaries of receipt of the one and payment of the other. (The federal government's own accounting ignores this principle, making possible annual budget manipulations to make deficits look smaller.) The fact that an item is in dispute does not alter when it should be recognized, except to the extent that collection is seriously in doubt. Where a large portion of a company's revenue is from large construction projects and post-completion haggling can drag on for years, it is less distorting to report the best available revenue estimate when the work is finished than to delay recognition to a later period.
The facts indicating that Halliburton (and a fortiori the Vice President) did no wrong are pretty well buried in the middle of the story. The final paragraphs, like the initial ones, ooze suspicion. Quotation in detail is unnecessary, but one statement (by Professor Coffee, whose legal expertise evidently exceeds his historical sense) stands out: "The Bush administration on the issue of corporate governance is about as compromised as the Clinton administration was on marital fidelity." Well, everybody's entitled to his own sense of proportion, but Halliburton is no Paula Jones, much less a Juanita Broaddrick or Monica Lewinsky.
July 15, 2002
[Revised, August 1, 2002] As Congress moved toward enactment of a helter-skelter collection of "reforms", every armchair economist in the country figured out that the real source of corporate skulduggery was, of all the myriad possibilities, stock option accounting. Folks who would be hard pressed to distinguish fixed from variable accounting are absolutely certain that companies should be compelled to use the latter rather than the former for stock option grants. As New York Times puts it, the accounting treatment of options is "the seemingly obscure issue that many governance experts say is behind exorbitant executive pay and has fueled the worst abuses of many of the current scandals."
Procedural maneuvering kept a proposal to mandate variable accounting out of the"corporate reform" legislation, but there will be intense pressure for further action, with proponents claiming that fixed accounting is the root of most evil and defenders of the status quo (who include the President) forecasting disaster if any change is made. The ferocity on both sides will doubtless exceed that of three years ago, when the Financial Standards Accounting Board weighed amending generally accepted accounting principles to require that all option grants be recognized as corporate expenses but was browbeaten (mostly by Congress) into relegating disclosure to financial statement footnotes.
So we may anticipate sound and fury signifying - well, not very much. Expensing options is arguably the theoretically correct treatment, but the case is not unchallengeable. More important, the practical significance is nil, particularly if the expense is calculated in the manner prescribed by FASB. The alternative adopted by most public companies, in which options result in no expense so long as the exercise price is at least equal to the fair market value of the optioned stock on the date of grant, doesn't lead to "exorbitant executive pay", nor is there a scintilla of evidence that it has fueled any abuses, much less the worst ones. The world shaking significance attached to this trivial issue is testimony to the yearning to find simple, secret causes for all great effects. That impulse leads to scientific discovery, but, thoughtlessly applied, it can bring forth unadulterated nonsense.
Let's begin with the theory. (Caveat: I am not an accountant, though I come into close contact with stock option accounting in the course of my professional work. The following discussion probably misses some subtleties and is simplified, though not, I trust, to the point of material inaccuracy.)
Granting stock options (the right to purchase shares of the employer's stock at a predetermined price) is a way to pay employees. Compensation for services is, of course, an expense that has to show up on the employer's profit-and-loss statement. When payment is made in cash, it is easy to figure out how much the expense is and when it should be charged. The use of options makes the time of the expense and its amount more obscure.
The alternatives available can be illustrated by considering a simpler case. Suppose that a company sells stock outright to an employee. It is no surprise that GAAP calls for booking an expense, at the time of sale, equal to the excess of the fair market value of the shares over their purchase price. If the two amounts are equal, the expense is zero. Nothing that happens after the sale affects corporate earnings or is reported anywhere. Should the stock value increase a thousand fold, the public will envy the investment acumen of, say, Bill Gates, but no one will denounce him on account of his stockholder profits as an "overpaid CEO".
Now suppose that the sale has a string attached. If the employee leaves the company before the lapse of a specified period, he must sell the shares back to his employer at their purchase price, thus losing the benefit of any appreciation in their value. Under those circumstances, GAAP reasons, the actual corporate expense is not knowable until the employee either completes the requisite period for unconditional ownership or leaves prematurely and forfeits any interim gains. Until one of those events - vesting or forfeiture - occurs, the employee hasn't really been paid. In the meantime, the company has set aside for his potential benefit stock that could otherwise be used for a variety of purposes, such as compensating other employees, raising cash or making acquisitions. As the stock rises in value, so does the company's opportunity cost. That cost is calculated each year and recognized as an expense. The amount of expense varies over time with the value of the stock; hence, the term "variable accounting". At the moment of vesting, the expense is fully recognized, and later fluctuations in the stock price have no effect on the employer's financial statements.
The typical corporate stock option does not quite fit either pattern. It has an exercise price equal to the fair market value of the stock on the date of grant, is forfeited if the optionee leaves employment within a relatively short period (six months is common) after grant, and can be exercised at any point within a fairly long period thereafter (usually ten to 15 years), with the proviso that it will expire shortly (usually within three to 12 months) after termination of employment.
Three different ways of accounting for option expense have some degree of support:
1. Fixed, intrinsic value accounting. This is the most popular method. Its advocates argue that a garden variety option is property that passes irrevocably to the optionee as soon as it becomes vested and that the theoretically correct way to account for it is to recognize its value as an expense at that time, just as one does when a stock grant becomes vested. The most straightforward way to measure value is to determine how much money the option holder would make if he exercised the option on the measurement date. Where exercise price and fair market value are equal, the potential gain in zero, and that is, according to this view, the expense that ought to be recognized. A minor flaw is that, in most cases, "intrinsic value" is calculated at the date of grant (when it is usually zero) rather than at the date of vesting, but the difference is not too significant when the vesting period is relatively brief.
2. Fixed, fair value accounting. This approach also takes the date of grant as the date of expense recognition but sets the expense equal to the fair market value of the option. An option with zero intrinsic value is worth more than that, because the holder has the hope of gain if the stock value rises. If there were active markets for options similar to those used for compensation purposes, one could look up the value of newly granted options in The Wall Street Journal and record the corresponding expense. Unhappily, there are no useful market data, so values are derived from mathematical formulae, such as the Black-Scholes model. GAAP requires that the expense determined in this manner as of the date of vesting be disclosed either in the financial statement itself or in footnotes.
This accounting method, described in FAS 123, is the one adopted by those companies, such as Coca-Cola, that have recently announced their virtuous decisions to recognize option expense. All that is involved is elevating the pertinent number from the footnotes to the main body of the financials. Moreover, that number is not especially informative. Even if one could be confident that it provided an accurate valuation of the options, it does not represent the true opportunity cost to the corporation. No company would ever raise money by selling options with similar characteristics to the investing public. Indeed, it could not do so if it would, because the link between continued employment and the right to exercise the option is one of the instrument's key features.
3. Variable accounting. This method, required by GAAP in some circumstances and the bane of CFO's, has the same theoretical basis as variable accounting for grants of forfeitable stock. As its supporters point out, the ability to exercise compensatory options is ordinarily linked to continued employment, albeit more loosely than in the case of stock subject to a risk of forfeiture. Hence, a variable expense should be recognized until the option either is exercised or expires.
The desirable consequence of either form of fixed accounting, from the company's point of view, is that reported earnings are less volatile and, when the stock price is steadily rising, higher than they would be under variable accounting. In a market that often seems to attach cosmic significance to earnings that come in pennies a share below or above consensus estimates, it is comforting if the numbers to which the press pays most attention are unaffected by a factor that varies recursively with the price of the stock. Comforting but not misleading. The variable numbers can be estimated from available data. That analysts show no interest in digging them out suggests that few perceive them as genuinely important. That may be a misjudgement, but it is the misjudgement of people who make their living by forecasting what the market will do and have more incentive to separate wheat from chaff than do people who make their living by writing laws. (The chairman of the Senate Finance Committee sold all of his equities on the very day of the 1982 market bottom yet still feels qualified to instruct others in how to invest.)
Mandating fixed, fair value, rather than fixed, intrinsic value accounting would be an exercise in triviality. No effort at all is needed to read the footnotes and plug the numbers there disclosed into the compensation expense line of the profit-and-lost statement.
Compulsory variable accounting for options would be a somewhat bigger, but not a big, deal. Minor though the benefit of fixed accounting really is, it does represent some reason to prefer stock options over other methods of compensating executives. With mandated variable accounting, options would lose their current predominance to the extent that it stems from artificial accounting considerations. Would the upshot be more or less of what Congresscritters would label "abuse"?
The accusation made against options is that executives have an incentive to use accounting gimmicks to inflate stock prices artificially in order to enjoy larger gains when they exercise their options. That incentive exists, however, only if the executive contemplates selling his stock shortly after the option exercise. As many dotcom option holders discovered in 2000, there are few worse fates than exercising options when the stock price is abnormally high, then holding the acquired shares as they slide southward.
Corporate executives, particularly those in the uppermost echelons, overwhelming choose to hold rather than sell stock acquired by exercising options. It is hard to find, among companies affected by the current wave of accounting scandals, any noteworthy exceptions. The Worldcom CFO who initiated the recharacterization of expenses as capital expenditures didn't sell a share during the period when he was inflating reported earnings. A few culprits elsewhere sold small portions of their holdings, but nowhere does one see the paradigm of accounting fraud followed by option exercise followed by selling stock and cashing in profits.
If options do not, so far as empirical evidence shows, lead to the alleged abuses, what about other forms of executive compensation? It is easy enough to tie cash compensation to stock price, reported earnings or other measures of performance, but that scarcely seems like the way to discourage accounting tricks. If a CFO stands to receive a bonus if earnings hit a target figure, will he be more or less tempted to be manipulative than if he holds a bunch of stock options?
Perhaps the reformers really want to stop linking pay to performance, so that executives would be hirelings on a fixed salary scale, financially detached from the interests of shareholders. If so, one hopes that they will remember to repeal one of the reforms of just a few years back, by which public companies cannot deduct pay to top officers in excess of $1 million a year unless that compensation is linked to corporate performance.
On the whole, reform of stock option accounting would be a vindication of sound theory, accompanied by a deterioration of real-world practice. Now that I think of it, isn't that the kind of reform that liberals like best?
July 9, 2002
After wavering for a couple of hours, the stock market reacted to President Bush's denunciation of "corporate greed" by tumbling again. Conventional wisdom, as reflected on the on-line edition of the Wall Street Journal, had its spin ready to go: "U.S. stocks skidded Tuesday as President Bush's attempt to bolster investor confidence by calling for tougher criminal penalties for corporate executives convicted of fraud failed to comfort investors." The premise is that investors are disillusioned with big business and want fiercer regulation of the financial markets. If that is really so, they should feel very comfortable these days. No one doubts that the President's proposals are merely the starting point in a bidding war that will lead to much closer government scrutiny of accounting standards, annual reports and corporate governance. It is probable that, by this time next year, GAAP will have given way to accounting rules set by an independent commission dominated by non-accountants, auditors will be expected to delve much more deeply (and more expensively) into the data behind financial statements, boards of public companies will be dominated by outside directors, lawsuits against companies and their accountants will be easier to win, and CEO's will have to worry seriously about going to jail for the mistakes or malfeasances of their underlings.
If the prospect of such reforms has not reinvigorated Wall Street, there are three possible explanations:
The stock market's anemic performance results from factors other than accounting scandals, such as the long delay in the implementation of tax cuts (which prolongs present burdens and creates an incentive to postpone profitable activity to later years), increasing protectionism and worry about the slowing pace of the war on terrorism.
Investors are political naïfs who don't realize that their favored agenda is highly likely to be enacted.
Stock prices are being discounted to reflect the impact of anticipated legal and regulatory changes.
My bets are on number three. Investors crave transparency and accurate balance sheets, but the U.S. has those to a far greater extent than it did fifty, or even twenty, years ago. The current scandals are not like Equity Funding or ZZZZ Best, where fictitious businesses existed only on paper. Instead, Enron, Worldcom, Xerox and almost all of their brethren are instances of real businesses trying to gloss over deteriorating profits - and generally failing in the attempt. In virtually every case, the company's stock fell sharply, declining more rapidly than the market as a whole, before any creative accounting came to light. The downward movement might have been even faster if the facts had been known more definitively, but it is obvious that the public had more than enough information to form accurate judgements about the value of shares.
The marginal improvements in transparency that may issue from the new wave of reforms need to be balanced against the inevitable detriments: Management will become more cautious. Lawyers will gain greater influence over corporate decision making. Outsider-dominated boards will know less about their companies' businesses and be more inclined to reject strategies that carry more than a minimal degree of risk. The impetus will be toward stability rather than growth, keeping out of trouble by shying away from new opportunities.
Maybe there virtues in solid mediocrity, but, if that is the future of the U.S. economy, should we be surprised if the market assigns mediocre values to the companies that will live in it?
June 29, 2002
Although the accounting scandal at Worldcom bears, for reasons that I am about to point out, practically no resemblance to Enron, it has already entered the Enron Mythos. The two names are linked inseparably. Paul Krugman thinks that Worldcom proves that he was right to call Enron's collapse more important than September 11th. On the other end of the political spectrum, Peggy Noonan similarly connects the two companies and assails "corporate greed" in tones reminiscent of Al Gore (who blames this and everything else on George W. Bush). Less frenzied commentators view the two companies as the highest waves in a vast, homogenous ocean of fraud.
In sober truth, though, the accounting deficiencies at Worldcom were strikingly unlike Enron's. Moreover, contrary to the instant hysteria of so many commentators, what happened at Worldcom and how it was exposed speaks well for the status quo in financial reporting and American business culture. Both proved willing and able to detect and punish misconduct, winning in direct competition with the government's watchdogs.
The fraud at Enron was elaborate and well-disguised. Senior executives set up an array of partnerships, ostensibly for the purpose of obtaining debt financing without exposing Enron's assets to liability for repayment, and were handsomely compensated for services to these entities. The company's accountants scrutinized the arrangements intensively and concluded, either because they didn't understand the structures or weren't told all of the facts, that their debts did not have to be reflected on Enron's financial statements. Late last year, it became evident that the accountants had been wrong. Far from being legitimate vehicles for obtaining outside capital, the partnerships were devices for hiding debts and fabricating phantom profits.
Worldcom's improper practices were, next to that, like a Little League team matched against the Diamondbacks. Starting with the first quarter of 2001, the company begain treating about 15 percent of its "line costs" (primarily fees paid to local telephone companies for putting long distance calls through to their local customers) as capital expenditures rather than current operating expenses. Accounts of how many people at the company knew about this change of practice differ sharply, but there was nothing complicated or subtle about it. The issue was Accounting 101: Did the line fees create an asset with a useful life beyond the current period? If they did, it was proper to postpone recognizing them as expenses until the related asset generated income. Otherwise, they had to be expensed as they as were incurred.
Although the details of the line costs have yet to be made public, the company's accountants, when presented with the question of whether they could be capitalized, reportedly regarded the answer as an open-and-shut "don't be ridiculous". The CFO, who made the decision to capitalize, apparently based it on nothing stronger than the observation that 15 percent of line costs had no associated current revenue, from which he inferred that they must be creating revenue in the future. Later he seems to have had doubts, telling the board on May 23rd that he was considering taking a charge against earnings for various items, including line costs. Before he could take the matter further, it erupted and he was fired.
The misclassification was first brought to management's attention by the company's internal audit department in the course of a review ordered last May by the newly hired CEO. One of the reasons for his predecessor's dismissal had been questions about his accounting practices. An internal review was an obvious step, and it found the problem almost immediately. The board's audit committee informed the SEC, which has now sued the company on the strength of the revelation. The agency had initiated its own investigation two months earlier but had not uncovered this or any other instance of wrongdoing.
One of the mysteries of the situation is how Worldcom's outside auditors were able to overlook the malfeasance. To cynics it will be a sufficient explanation that, until May of this year, the audit was in the hands of much-battered Arthur Andersen. Andersen asserts, without contradiction from anybody, that it was never consulted about capitalizing line costs, but routine audit tests should have revealed that something was wrong; that is proven by the ease with which the internal auditors found the problem. Andersen was either very careless, extraordinarily unlucky or fatally distracted by the Enron turmoil that enveloped it at the same time as the 2001 Worldcom audit was in progress. In the item immediately below, I mention the disruption of corporate activities caused by Andersen's decapitation. Perhaps users of Worldcom's financial statements were among the unheralded victims.
What lessons can we draw from this sad tale?
1. First and foremost, despite the fact that Worldcom's reports on 2001 operations were misleading, investors knew that all was not well. The most obvious sign was that free cash flow, a figure unaffected by moving outflows from one part of the profit-and-loss statement to another, had dropped to near zero. By June 25th, when the accounting issue became public knowledge, Worldcom stock was trading at roughly a twentieth of its early 2001 value. As was also the case with Enron, accounting revelations did not send the company's shares into abrupt decline. The decline came first, then the revelations. This phenomenon suggests that the market has enough data from enough sources that false information does not dominate its perceptions. Veiled in one corner, bad news pops up some place else.
2. Whatever may be true of other frauds, this one was not the product of greed, short-term thinking or any of the other familiar scapegoats. The ex-CFO owns 3.2 million shares of Worldcom stock and sold none of them while he was cooking the books. He was not trying to make a quick killing and get out. In fact, the information so far available leaves the impression that he sincerely believed in his questionable theory about what should be capitalized. He has little excuse for not knowing better and none for failing to consult experts before recharacterizing over $3 billion in expenses, but he reaped no profit from his sins.
So what was his motive? The simplest explanation is a human trait that no regulation will eradicate: dislike of admitting mistakes. If 15 percent of Worldcom's payments for access to telephone lines purchased capacity that was not being used, management had misjudged the market for the company's services. The ex-CFO preferred to believe that the excess capacity was being stored up for the future. In retrospect, that was a mistake - but not a mistake necessarily made with fraudulent intent.
We would be well off if greed were the principal cause of corporate malfeasance, because greedy people are deterred by the threat of detection and punishment. Stupid people aren't, since they don't realize that they have done anything wrong. Stupidity cannot be eliminated from the human species - we are all stupid at times - and is hard to prevent. The only palliative is an economic system is decentralized and transparent, in which the impact of stupid actions is readily counteracted.
3. The reflexive response to Worldcom, as to Enron, has been to call for stricter accounting rules and closer government supervision. Exactly how would either have helped here? American accounting principles already include detailed guidance on what expenditures should be capitalized. Worldcom violated the clear letter of those rules. As for government supervision, an ongoing SEC inquiry failed to detect the violation. In brief, wrongdoing took place, the private sector discovered it, and the stock market administered condign punishment (in advance of the crime, displaying greater clairvoyance than the imaginary "pre-crime unit" of Minority Report). The government did nothing but trail along behind. It is now occupied in shooting the stragglers. That record does not impress me as a strong argument for greater government activism. Indeed, to the extent that regulation encourages centralizaton and opacity, which is its natural tendency, it aggravates the problem.
June 17, 2002
When prosecutors first unleashed the threat to indict Arthur Andersen - not particular partners or employees but the firm as a whole - for obstruction of justice, I predicted that the charges would go nowhere. I was wrong - but only because the government set the bar so low that its spavined horse of an indictment was able to stumble over it without quite breaking a leg.
The public will carry away from the verdict the impression that the evidence proved Andersen's management guilty of destroying vital information in hopes of thwarting SEC investigation of its Enron audit. What the jury actually concluded was much less: that some "agent" of the firm persuaded someone else to do something with the intention of hindering investigators. According to a post-verdict statement by the foreman, the jurors regarded the government's evidence that Andersen personnel had improperly destroyed Enron-related documents as "superficial and circumstantial". Instead, the basis for the conviction was an in-house counsel's request that her name be left out of a memorandum summarizing a conference call, because she didn't want to increase the risk of having to appear as a witness in any future litigation. That single act was enough to meet the extremely low standard of guilt set by the trial judge. As the Wall Street Journal, whose news coverage can scarcely be described as unfriendly to the prosecution, put it, "What began as an indictment for massive illegal document destruction by the firm's accountants ended with the finding, the four jurors said, of a lone instance of attempted illegal document alteration by a newly hired Andersen lawyer."
Having no special expertise in criminal law, I won't dogmatically assert that the judge was wrong as a legal matter about the degree of proof required to hold a partnership collectively responsible for the acts of its employees. The law has a great many expansive theories that can be deployed on the prosecution's behalf. Prosecutors in turn have an obligation not to use unnecessary or excessive legal force, lest they inflict punishment on defendants who are technically guilty but morally innocent.
In the Andersen case, the prosecutors flagrantly abused their discretion. They knew that a criminal indictment would be tantamount to imposing a death sentence on the firm and chose nonetheless to bring charges that did not involve any high degree of wrongdoing. In short, someone at the Department of Justice reached a conscious decision that Arthur Andersen should be destroyed by executive action, as if it were an accounting Mafia. That decision had massive impact on the innocent. It forced thousands of men and women to seek new jobs, disrupted the activities of hundreds of Andersen clients, fined the firm's partners - 90-plus percent of whom had never spent a minute on the Enron engagement - hundreds of millions of dollars by making their unfunded pensions worthless, diminished competition in the already concentrated accounting profession, and otherwise wreaked far greater havoc than Enron's bankruptcy ever did.
And what were the execution's positive effects? I suppose that audit files will grow fatter, to the delight of plaintiffs' lawyers, who present every sign of disagreement within an audit team as evidence of malfeasance, and the frustration of legitimate investigators, who do not have unlimited time and resources to pore through massive documentation of byways and dead ends. Beyond that, what is there? No guilty parties have been found, so none will be punished, save for the government's star witness David Duncan, who doubtless will receive lenient treatment in return for his cooperation.
Any good that may emerge from United States v. Arthur Andersen LLP will have to await the outcome of Andersen's inevitable appeal. A reversal of the verdict - better than a 50/50 chance, in my judgement - will not save the firm, but, if accompanied by strong animadversions against prosecutorial overkill, it could serve as a useful check on future ventures into the Red Queen justice ("Off with their heads!" - "Sentence first, verdict later!") on display at this trial.
April 20, 2002
The front page of yesterday's New York Times business section carried the above-the-fold headline, "Labor Dept. Questions Enron's Truthfulness". Well, who doesn't these days? But the story beneath the headline tells us less about Enron's truthfulness than the government's misplaced priorities.
First, the story's factual background: After Enron collapsed and its section 401(k) plan attracted a barrage of negative publicity, the Department of Labor's Pension and Welfare Benefits Administration demanded that the company oust the trustees of its retirement plans and turn their management over to an "independent fiduciary". Enron did not resist very strongly, and State Street Bank was chosen as the new overseer, with fees that could go as high as $2.7 million a year. The parties agreed that these payments would come from corporate assets, not from the plans.
Two weeks ago, Bankruptcy Court Judge Arthur Gonzalez scotched that deal by refusing to authorize payment of the new trustee, on the ground that the expense was not necessary to preserve the bankruptcy estate. The government is now livid and blames Enron's attorneys for the court's action. The inspiration for the Times story is a letter to the company from the Solicitor of Labor, in which he declares, "It seems reasonable to conclude that Enron did not merely break its agreement with the government, it embarked on a course two months ago to deceive the government by entering an agreement that it had no intention of honoring."
The basis for this charge is Enron's counsel's failure to give energetic support to the petition to authorize payments to State Street. In fact, counsel openly suggested that this use of funds would violate bankruptcy law, a proposition with which the court concurred.
At first blush, it does seem deceitful for Enron to agree to pay an expense out of its own pocket, then connive at being denied permission to do so, but the first blush is of the wrong color. Enron and the government were not the only interested parties here. Enron is not, in a real sense, a party at all. Being deeply insolvent, it has no money of its own but is merely holding assets that will ultimately be applied to recoup a portion of the losses suffered by its creditors. Those creditors gain no discernible benefit from the expenditure of $2.7 million a year of their money on the cost of an independent pension fiduciary. The bankruptcy judge had a duty to protect their interests, and the bankrupt's attorneys could not honorably hide those interests from him.
Still, even if the lawyers pulled a fast one on the feds (who are hardly babes in the wood in the bankruptcy arena), this incident reveals a strain of irresponsibility in the government's approach to the case. Altering the management of Enron's plans should have been among the lowest of its priorities. Though allegations of fiduciary misconduct have flown thick and fast, it takes no more than a modest acquaintance with pension law to see that the accusations range from doubtful to absurd (as many of the earlier entries on this page have discussed). Unfortunately, the Department of Labor lacked the political mettle to call absurdities by their right names. Instead, it gave in to the cry to "do something". That the something would be done at the expense of Enron's creditors, that is, at the expense of the direct victims of any fraudulent conduct by the company, was ignored.
Assuming that the court does not reverse itself, Labor will now have to choose either to let the current plan fiduciaries remain in place or to acquiesce in compensating State Street from plan assets. The former will be tantamount to admitting that insistence on the appointment of an independent fiduciary served the DoL's interest in favorable publicity rather than the plan participants' interest in good management of their retirement funds; the latter, to sacrificing some of those funds for the sake of avoiding a blot on the Department's reputation. The way that the decision goes will be highly revealing.
Update, 4/22/02: Even before the pixels were dry on the preceding post, the DoL obtained Judge Gonzalez's consent to the transfer of control of Enron's plans to State Street, regardless of where the money to pay the fees comes from. So we now know what the Department regards as most important.
April 3, 2002
Today's Wall Street Journal (the pink-tinged news operation, not the editorial page) rakes Lou Dobbs, host of the CNN show Moneyline, over the coals for bias. At first blush, it's remarkable, particularly in light of liberal defensiveness in the face of Bernard Goldberg's book on the subject, to see liberal newsies suggest that there is such a thing as slanting the news (unless the perpetrator is a "right wing" outlet like the Fox network or The Washington Times). Any sense of astonishment fades quickly, though, when one discovers what sort of "bias" is imputed to Mr. Dobbs: He is, we are told, too friendly toward Arthur Andersen.
Since criticism of Andersen is pervasive these days, there might seem to be more serious causes for alarm than the pro-Andersen perspective of a single TV show, but WSJ reporter Matthew Rose seems to think that he has has hooked a first-rate scandal. In an on-air opinion piece (labeled as such), Mr. Dobbs criticized the Justice Department for indicting Andersen! He has had guests on his show who share that view!! He questioned the factual basis of statements by an anti-Andersen interviewee!!! (The victim, apparently confusing an interview with a valentine, "felt like he 'got hit over the head'"!!!!) Andersen employees have taped Moneyline segments and shown them to their colleagues!!!!!! And - showing the sinister side of all this - Andersen was the exclusive sponsor of a program on which Mr. Dobbs appeared from 1997 to 1999!!!!!!! And Mr. Dobbs once spoke at an Andersen event, for which he may have been paid!!!!!!!! A J-school professor is brought in to suggest that these facts add up to an ethical problem.
Yes, bias is certainly present, but I somehow don't think that Lou Dobbs, CNN and Moneyline are the culprits.
March 28, 2002
As expected, the media are all a-twitter about who was and was not "consulted" in the formulation of the Administration's energy policy proposals. Newly released documents show that task force members held lots of meetings with businessmen and far fewer with environmentalists. To liberals, that "imbalance" proves that the policy is no more than a scheme to destroy the environment for the sake of corporate enrichment. The Administration has defended itself by pointing out that it did talk to some major environmentalist organizations and that others refused to respond to invitations. The critics respond that the meetings should have been earlier and more frequent, excusing refusals to participate on the ground (not wholly consistent with their main line of argument) that the White House had made up its mind anyway, so what was the point of talking to it?
This back-and-forth ignores a key difference between advocacy groups and businesses. Proclaiming their visions of what is best for the country is the raison d'etre of the former. To learn what policies the National Resources Defense Council or the Cato Institute favors and why, one need only read their publications. For a government official trying to formulate legislative and regulatory proposals, meeting think tank representatives face-to-face is largely superfluous.
Businesses, by contrast, are innocently employed in making money. Any public policy positions that they espouse aim at benefiting shareholders and are, in most instances, formulated by public relations hacks cobbling together useful arguments from elsewhere.
Businessmen's intimate knowledge of their industries is useful to policy makers but is not accessible in the same way as think tank expertise. The best way to obtain it is through meetings, preferably meetings that are strictly off the record. A corporate executive who knows that his advice to government officials will be reported in The Wall Street Journal is not likely to stray from the text of his company's press releases. One who is confident that his words will never be attributed can express opinions that diverge from his employer's interests.
The task force's numerous meetings with businessmen and Vice President Cheney's insistence on keeping those contacts private thus make excellent sense. There is no better way to get candid, useful views from people in a position to know which parts of the press releases make real-world sense and which are dictated by self-interest narrowly understood. That point will, of course, be lost on those whose preference is for the government to listen only to left-wing views.
March 26, 2002
A colleague whose employee benefits experience antedates my own reminded me today that, just a few years ago, the great concern of retirement experts was the hyperconservatism of rank-and-file workers' investment choices. During the long bull market that began in 1982, employees who had the opportunity to choose their own investments showed a strong penchant for GIC's, balanced mutual funds, bond funds and other "slow but steady" investment vehicles. As a result, returns on participant-directed accounts in 401(k) plans consistently underperformed the market, and retirement counselors labored to demonstrate that risk is the necessary precondition to reward.
Given the inherent conservatism, if not downright stodginess, of the average worker's "portfolio" - Social Security, augmented in most cases by a defined benefit pension plan and ownership of a home - it is irrational to be equally risk-averse with 401(k) money. Yet now many liberal Democrats, those soi disant "friends of the working man", want to write the GIC mentality into law.
An article in this week's Time (Bill Saporito, "When One Stock Is Enough") succinctly points our why putting all of one's eggs in a single basket is often the best policy:
To understand the potential price of diversification, consider this example: say you started with a 401(k) balance of $100,000 on Jan. 1, 1999, all of it in Enron stock. By Dec. 31, 2000, the value would have shot up to $297,000, a return of almost 200%. A portfolio that consisted instead of 20% Enron stock, 50% in a broad-based equity fund such as the Vanguard 500 Index Fund and 20% in a bond fund like the Vanguard Long-Term Bond Index Fund plus 10% in cash would have yielded $47,035, or a 47% return--most of it provided by Enron. Today that Vanguard 500 fund would be in its third year of negative returns--imagine, being legally coerced toward a loss. Granted, it's a smaller loss than Enron diehards suffered late last year. But for every Enron there's an IBM; for every Lucent, a GE.
Senator Corzine is not, of course, the first fellow to make it to the top and then try to pull the ladder up after him, but most such don't simultaneously mouth pieties about how they are just protecting their buddies below from the dangers of heights.
March 21, 2002
A minor incident affecting my own employer illustrates how easily eagerness to uncover a "big story" can divert the media from accurate news coverage. Yesterday's Dow Jones news service carried an ominous article about how New York State was overdue in renewing Deloitte & Touche's license to practice there. Quotes from state officials gave the impression that the application had serious deficiencies that might never be resolved, while spokesmen for the firm sounded defensive, bleating about how "paperwork" had been lost as a result of the September 11th attacks. Many readers undoubtedly suspected that they were reading the first page of Arthur Andersen: The Sequel.
What they were really reading was a badly timed fantasy. On the same day, the New York authorities completed their work and issued the license renewal. The lost paperwork "excuse" turned out to be the simple truth.
The moral is that, even in the post-Enron era, smoke sometimes comes from smoke machines.
March 14, 2002
Ironically, Enron Corporation is now more likely to survive, if as a smaller, renamed entity, than is its erstwhile auditor Arthur Andersen. Today saw the twin blows of a groundless federal indictment for obstruction of justice (discussed immediately below; the text of the indictment gives no hint that the prosecution's case is founded on hitherto undisclosed evidence) and the collapse of acquisition talks with two of the Big Five accounting firms. There are rumors of other possible combinations, but their prospects are dubious. Barring brilliant tactical moves that might easily be mistaken for a miracle, the Andersen name and client base will be gone within the year, leaving only an interminable bankruptcy administration to sort through the debris.
Andersen's survival would have been a good thing. The number of firms with the capacity to audit corporate giants has fallen in a little over a decade from eight to, now, four. It was not long ago that the SEC energetically blocked proposed mergers that would have reduced the figure below five. The effort hardly seems to have been worth the bother.
With survival out of the question, Andersen's clients would have been best served by an acquisition, which would have minimized the disruption inherent in an unanticipated change of auditors. The firm's collapse will instead proceed chaotically, doing palpable damage to a yet-fragile economic recovery.
What made an orderly acquisition impracticable was not the looming indictment but the unquantifiable threat of tort litigation. Andersen's fate highlights one of the underemphasized consequences of the litigation explosion, namely, the complete loss of predictability in tort actions. Potential acquirers could not rationally anticipate, and adjust purchase terms to account for, the magnitude of Andersen's potential liability, because the outcome of a given audit liability lawsuit has become impossible to foresee with any degree of confidence. What can be predicted is that, the deeper the defendant's pockets, the higher the amount that a jury is likely to award. Hence, if a Deloitte & Touche or Ernst & Young had purchased Andersen, it would have almost certainly ended up paying far more in Enron-related claims than will be assessed against Andersen solo.
Decades of aggressive tort lawyers, complaisant (or, often, complicit) judges, flummoxed juries and unperceptive legislatures have brought the legal system to the point where it inflicts harm even on non-litigants. Contrary to what the plaintiffs' bar is currently proclaiming, the Andersen case is the most powerful argument for tort reform that has yet come along.
March 11, 2002
In the aftermath of September 11th, civil libertarians worried about the potential for overreaction and abuse by law enforcement agencies. Most of their concerns were overblown or ridiculous, as when the police chief of Portland, Oregon, refused to help the FBI question young men who had recently arrived from the Middle East, but the impulse to worry made sense. Police and prosecutors on the trail of a really big crime often instinctively temper justice with mercy killing.
That instinct is starting to show its fangs in the Enron imbroglio - but the defenders of procedural due process don't seem particularly concerned. Many of them, it is not rash to predict, will soon be whooping it up for the vigilantes.
Today's Wall Street Journal reports that federal prosecutors are threatening to indict Arthur Andersen - not specific wrongdoers but the entire firm - for obstruction of justice. The alleged crime is the destruction of documents related to the Enron audit after the SEC had started its investigation of the company. Andersen does not deny - it was in fact the first to reveal - that document destruction occurred. The actual shredding was carried out by personnel in its Houston office, but the Feds, according to published reports, think that the national firm can be held responsible.
Unless evidence exists that has not been so much as hinted at in the media (and it's hard to believe that data of such spectacular interest has been kept so completely quiet), the "proof" of Andersen's guilt is that an in-house lawyer sent the Houston office this e-mail: "Mike - It might be useful to consider reminding the engagement team of our documentation and retention policy. It will be helpful to make sure that we have complied with the policy. Let me know if you have any questions."
The policy referred to is an entirely legal one, acceptable to the SEC. Yet prosecutors, like much of the media, now construe an instruction to consult it as an official directive to destroy documents in violation of its own terms! That is the self-serving interpretation that the actual document shredders have adopted after the fact. They now claim to have "acted on advice from Andersen's legal counsel". But could any reasonable man infer that advice from the counsel's statements?
Again, there may be other evidence. Perhaps lawyers from HQ followed up with phone calls urging Houston to get on with purging the files of incriminating material, but, again, there are no signs that anything like that happened. Standing alone, the "incriminating" e-mail is ludicrously short of a prima facie case. Nonetheless, Andersen is desperately striving to stave off indictment on a charge on which it would have the certainty of a directed acquittal. The reason for that desperation is, of course, that indictment would destroy the firm, no matter how clear its innocence. The prosecutors are thus in a position to execute justice Red Queen-style: sentence first, verdict later. It takes no gift of prophecy to foresee that they will use this advantage to extract concessions from the firm. The WSJ story suggests that they will ask not only for what is euphemistically called "full cooperation" in cases against Enron and its executives but also "changes in the firm's practices, which regulators could then herald as a model for reform throughout the profession."
Coercing witnesses runs a high risk of producing miscarriages of justice. In ordinary cases, that risk is mitigated by the fact that prosecutors need solid evidence of the witness's own guilt before they can threaten him credibly. In Andersen's case, that hurdle scarcely exists. Formal accusation, supported by a the scintilla of evidence needed to sway a grand jury, is tantamount to conviction.
Using that same leverage for partial imposition of a new regulatory scheme, without any attention to the Administrative Procedures Act, is likewise dubious. The APA was intended to rein in regulators by requiring them to act only after notice, comment and other procedural safeguards. It's doubtful that many people seriously think that plea bargaining is a better rule-making mechanism.
Shouldn't this situation worry anyone who believes in due process of law? If the FBI asks the Portland chief of police to raid the local Andersen office, how, I wonder, will he respond?
March 5, 2002
Empirical evidence has now emerged undermining the widespread belief that audit firms go easy on companies for which they also provide consulting services. The following article is reproduced from the International Accounting Bulletin, 2/14/02:
It may fly in the face of public opinion, but a survey has emerged from the US that contends that the provision of audit and non-audit services by accounting firms to the same company does not impede their independence. The University of Southern California study states that there is "no association between consulting service fees and the auditor's propensity to issue a going concern opinion". [A “going concern opinion” states that there is reason to believe that the client’s ability to continue in business as a going concern is in jeopardy.-ed.] Its findings are deeply ironical, given the current post-Enron brouhaha and the decision by PricewaterhouseCoopers (PwC) and Deloitte Touch Tohmatsu (DTT) to finally jettison their consulting arms (see above).
The survey's authors, Mark DeFond and KR Subramanyam, believe their study demonstrates that the payment of consulting fees to an audit firm has no effect on the incidence of going concern reports, and that "higher audit fees actually increase the propensity of auditors to issue going concern reports". The authors believe that the reputation and litigation damages associated with audit failure are greater for larger clients (such as Enron ), and this encourages auditors to be more conservative in their audit opinions.
"The loss of reputation and litigation costs provide strong incentives for auditors to maintain their independence. Our study provides evidence that these incentives outweigh the economic dependency created by higher fees," said DeFond.
The research contradicts recent pronouncements on the relationship between firms offering audit and consulting services to the same client. After a long battle with the accounting profession, the US Securities and Exchange Commission (SEC) adopted new regulations forcing companies to disclose all fees paid to their outside auditors. The main thrust of the SEC argument is that accounting firms are too dependent financially on clients that purchase both auditing and consulting services to be objective and maintain independence. The level of consulting fees paid by Enron to its auditor Andersen has put the issue very much under the spotlight, once again.
DeFond and Subramanyam looked at 944 financially distressed companies with proxy statements that include audit fee disclosure for the year 2000, including 86 receiving first-time going concern audit reports.
As I have argued before (2/5/02), audit firms that provide a variety of services to their clients are in a better position to deliver bad audit news that those whose relationship depends entirely on the annual audit. DeFond and Subramanyam's study is not, of course, conclusive, but it furnishes evidence in support of that position. The year will come, I suspect, when we will look back on the "separation of auditing and consulting" as the most unfortunate effect of the Enron debacle.
February 27, 2002
Ellen Schultz, the Wall Street Journal's lead writer on pension matters, is either deeply ignorant of her chosen journalistic field or a shameless liar. Today she repeats her prior misleading description of Enron's pension plan, claiming that a 1996 amendment was a prohibited cutback in participants' accrued benefits. The details of the amendment are a matter of public record and are discussed below (1/24/02, 3rd bullet point). What happened was this: Before the amendment, a participant's benefit was the higher of his accrued benefit under the pension plan or the value of his ESOP account. The amendment (implemented over a five-year period) delinked the two plans. Participants were given the right to withdraw or diversify their ESOP accounts, and their pension benefits were adjusted to equal their accrued benefits net of the offset. In simple terms, if someone previously had a pension accrual worth $50,000 and Enron stock in the ESOP worth $40,000, he now had $40,000 of Enron stock (which he could liquidate and reinvest in other assets) and a $10,000 pension benefit.
Miss Schultz claims that this change reduced benefits. She adds supporting quotes from Rep. Lloyd Doggett (D-Tx), a liberal hysteriac on pension issues, and from a lawyer who evidently hasn't looked up the facts (available in a published Department of Labor advisory opinion). The only reason why her assertion has even surface plausibility is that she avoids, as before, disclosing a key point about the amendment: the right to distribution or diversification of ESOP accounts. If employees voluntarily continued to invest in Enron, pension law does not give them any legal claims based on 20/20 hindsight.
Update (2/28/02): Today's Wall Street Journal, in an article bylined by Kathy Chen (Ellen Schultz gets a "contributed to" acknowlegment), quietly adds the facts omitted in the paper's previous, Schultz-bylined accounts of the Enron pension plan. It still contends, most implausibly, that giving employees the option of withdrawing or diversifying the stock investments that had formerly been taken into account in the calculation of their pension benefits "may have been a bottom-line reduction in the value of pensions that employees accrued" and that "some question" exists abouts its legality. One must try to save Miss Schultz's face, I suppose, but Miss Chen is to be commended for doing her own research instead of relying on a colleague's assertions.
A large part of the article reports testimony by David Walker, now Comptroller General but once the head of the Labor Department's Pension and Welfare Benefits Administration, who favors requiring all grandfathered floor/offset ESOP's to delink pension accruals and ESOP accounts. The only practicable way to accomplish that would, ironically, be to phase out the arrangements in exactly the same way that Enron did.
Further update (3/1/02): Ellen Schultz is back today with a solo piece in which she blithely continues her misrepresentation, alleging that, as a result of the phasing out of Enron's floor/offset ESOP arrangement, "the phantom past values of the ESOPs permanently erased some of the pensions that people had earned in earlier years". Let's see. If I owe you $50 and pay you $40, I have "permanently erased" four-fifths of my debt. That is the essence of the conduct that Miss Schultz condemns as illegal. How does a woman so dense manage to avoid drowning in her bathtub?
February 26, 2002
When I wrote the entry immediately below, I took it for granted that I would eventually have to add an update along the lines of "Professor Krugman has now issued a correction, stating that he was confused by the tax form and jumped to an unwarranted conclusion." But the effects of Enroneurosis are more debilitating than I realized. Instead of a correction, the disease-stricken columnist has belligerently reiterated his mistake:
My Feb. 22 column mentioned "line 47" in this year's 1040. What I said was correct, but has been subject to misinterpretation, most of it innocent, some of it deliberate [the Vast Right Wing Conspiracy at work]. Let me say it another way: Most people think that they received both a rebate and a tax cut. But the rebate was only an advance on the tax cut; it must be counted against the refund you would otherwise receive. Hundreds of thousands of early filers have already gotten this wrong. The effect is to give many people a rude shock, which is not what this economy needs.
I doubt that many taxpayers thought seriously about whether the rebates were in addition to the initial installment of rate cuts. The facts were certainly publicized well enough, but perhaps Professor Krugman is asserting (contrary to his usual stance) that there wasn't enough tax relief in EGTRRA. If so, will he now call for accelerating this year's rate reductions?
As for the "rude shock": This year's tax tables take the rebate into account and assume that every taxpayer received the full amount to which he was entitled. In some instances, that is not the case. Line 47 allows those who were "shorted" to get the balance of their rebates. It is labeled, "Rate reduction credit. See the worksheet on page 36." Someone who fills out the worksheet correctly (and it isn't particularly challenging) will get a result of zero (the great majority, who have already gotten their rebates) or a number to be entered on line 47 as a reduction to tax liability. (In those rare cases in which the rebate already received was too high, the government doesn't ask for its money back.) Where exactly is the shock, rude or otherwise?
The early filers who have "gotten this wrong" fall into two groups: people who ignored line 47 when they were entitled to a credit and those who ignored the worksheet and wrote in the amount of their rebates. The latter perhaps hoped that they might be entitled to the same rebate twice, but they can't reasonably be shocked to have had that hope disappointed.
Well, I still have my update in hand. Let's see how many more Krugman columns elapse before I have to use it.
February 23, 2002
Though his column in yesterday's New York Times says nothing about Enron, weeks of fretting about the subject have at last taken their toll on what was once a great mind. Paul Krugman, until recently regarded by economists of all ideological stripes as one of the premier thinkers in their field, reveals that he cannot tell positive from negative numbers. To be more specific, he declares to his readers that the "rate reduction credit" on the 2001 federal income tax return means that "most taxpayers . . . will discover that they owe $300 more in taxes than they expected", meaning that last year's tax rebate "is about to be snatched away. The direct monetary impact will be significant; the psychological impact, as taxpayers realize that they've been misled, may be even greater."
Any Times reader who sits down with his Form 1040 and peruses the instructions will discern that Professor Krugman is the one doing the misleading. The rate reduction credit has no effect on the vast majority of taxpayers and will lower the tax liability of the rest. The professor's bout of Enroneurosis has evidently robbed him of the capacity to comprehend English that, while perhaps not simple, ought to be within the grasp of the average Ph.D. (The Treasury Department, apparently concerned that gullible Times readers would trust Professor Krugman implicitly, has issued a press release correcting his misunderstanding.)
The same column shows other symptoms of mental confusion. On taxes, the country's most famous foe of tax cuts now complains that higher taxes (the imaginary "snatching away" of the rebate and state tax increases to deal with budget problems) will slow the economy. That observation does not lead him, however, to urge accelerating federal tax reductions.
Even more alarming than the patient's incoherent analysis is his strange detachment from reality. Could any man in full possession of his faculties and aware of his environment have written the following paragraph less than six months after September 11th?
The only clear force for recovery I see is the administration's military splurge. After all, even useless weapons spending does create jobs, at least for a while. Japan props up its economy by building bridges to nowhere; the Bush administration buys Crusader artillery systems and F-22's.
You tell 'em, professor. It's not as if there were a war going on.
Note: Not to be too harsh on Professor Krugman, his column makes one sensible point: Capital investment by businesses remains weak, and, until it recovers, the broader economy is likely to remain in the doldrums. Indicators of the direction of capital investment have been ambivalent lately. The G7 Group's business investment index, a widely used gauge, stood at -79 for February, up only a bit from the -85 registered late last year. (A zero index corresponds to five percent annual expansion of business investment, -35 to no growth.) Other straws in the wind are more promising. For example, production of business equipment expanded in January after several months of contraction.
It is important to remember, though, that capital investment is highly volatile. In the past, it has expanded or contracted abruptly as companies' perceptions of the economic climate have changed. Therefore, it makes a highly unreliable leading indicator, though columnist Krugman, mired in his loathing for the Bush Administration and his hopes that it will preside over continued recession, cannot bring himself to point that out.
February 20, 2002
Ben Stein, a vastly entertaining writer who knows more than a little about Wall Street, has come up with a thoroughly bad idea for safeguarding stockholders against inept accounting. In a piece for The American Prowler, he urges repeal of the very mild restraints that the Private Securities Litigation Reform Act (passed in 1995 over President Clinton's veto) imposes on class action securities litigation. His theory is that the threat of Bill Lerach-style lawsuits is needed to persuade auditing firms to perform high quality work. The PSLRA made it slightly more difficult for Mr. Lerach to ply his trade in the federal courts, and to that restraint Mr. Stein attributes the failure of Arthur Andersen to prevent numbers cooking at Enron and Global Crossing. (How little has really changed on the legal front is evident from perusal of Overlawyered.com's articles on class action lawsuits, but we'll pretend that the statute had something like the impact that Mr. Stein imagines.)
One can argue about whether audit quality has gone downhill since 1995, but the thesis is more than a little doubtful. Accounting fraud certainly existed in the pre-PSLRA era, undeterred by the Leraches of the world. (Vide, e. g., Leslie M. Brown, Jr., "Lessons to be Learned: ZZZZ Best, Regina and Lincoln Savings". Abraham Briloff's classic Unaccountable Accounting was published way back in 1972.) Mr. Stein in fact undermines his own case by rejoicing in the billions of dollars that class action lawyers extracted from accounting firms before the law was changed. If deterrence had been working, wouldn't the accounting profession have been getting better, and wouldn't plaintiffs' lawyers have seen a steady decline, rather than an explosive increase, in their recoveries?
Litigation could, in theory, play a useful role in policing accountants, but it didn't in the past and doesn't now. In 15 years with a public accounting firm, I have heard many exhortations on behalf of high quality work. Not one of them has suggested that doing a good job will reduce litigation risk. No one makes that suggestion, because, in the current legal environment, it isn't true. At best, litigation has no effect on quality; more often, it is a negative influence.
In real world lawsuits against accounting firms, plaintiffs' lawyers rely on bamboozling ill-informed jurors by showing that the personnel assigned to the audit bumbled around, changed their minds, disagreed with one another and generally did not go about their business in a flawless, well-oiled fashion. Whether they reached the right conclusions in the end is less important than how they got to them. It isn't surprising that trials concentrate on process: Jurors think that they can understand how decisions were reached, even if they have none of the skills and tools needed to evaluate their correctness.
The most important defensive tactic, therefore, is to make the process look smooth and trouble-free - even though a well-conducted audit of a complex financial situation will usually include many false starts, changes of mind, backtrackings to rectify mistakes, and professional disagreements. A poor decision supported by a facade of steady confidence is more defensible in court than a sound one arrived at only after hesitation and doubt.
In the appearances-driven world of Lerachian litigation, being right carries no premium, and lawsuits thus do not encourage potential defendants to take the steps necessary to make sure of being right a larger percentage of the time. What they do encourage is an emphasis on cosmetics, suppression of healthy controversy and a determination to defend initial judgments without regard to later information. Those habits all appear to have been at work on the Enron audit team. They are the product of the efforts of a generation of tort lawyers, whose profitable "protection" of shareholders' interests has done as much as anything to undermine the usefulness of audits.
February 12, 2002
Over the last decade Enron spent roughly $1 million a year on political contributions, not even one one-hundredth of one percent of its peak annual revenues. If one believes the consensus of liberal commentators, that investment was spectacularly profitable, buying the ability to direct U.S. energy policy for the company's benefit. Had it not been for Enron dollars in their campaign kitties, these pundits believe, conservative Republicans would have shunned the breakup of electricity monopolies (which is what the demonized term "deregulation" means), favored stricter environmental controls and generally expressed the same views as liberal Democrats. Al Hunt thinks that President Bush would have extended the term of the liberal, Clinton-appointed chairman of the Federal Energy Regulatory Commission, had Ken Lay not ordered him to substitute an Enron stooge.
On a million bucks a year - probably less than the company spent on Christmas parties and employee picnics - that is a spectacular return. American politicians evidently come dirt cheap, so cheap that one cannot help wondering: Why couldn't environmentalists scrape together, say, $2 million a year to outbid Mr. Lay for the GOP's loyalty? For that matter, New Jersey socialist Jon Corzine spent $65 million to win a Senate seat in 2000. Couldn't he have purchased influence far beyond a freshman Senator's by devoting, say, $5 million a year to "soft money"?
If the market attaches very low prices to allegedly valuable goods, that ought to be cause for suspecting their value. Gold coins offered for their weight in copper most likely aren't real, and political influence that costs next to nothing may be worth about that. No matter how many lists one compiles of governmental actions that Enron liked, the theory that Enron caused those actions through legalized bribery founders on the meagerness of the bribes and the huge number of well-heeled bidders who would undoubtedly have entered a genuine auction and driven up the price of favoritism.
Considerations like these do not enter the thoughts of campaign reformers. "Campaign finance reform" is too narrow a term. The McCain-Feingold and Shays-Meehan bills propose a fundamental reshaping of elections not limited to their financial aspects. "Preventing future Enrons" requires not merely limitations on political contributions but also the curtailment of free speech. The First Amendment may protect pornographers and flag burners, but it is not to be construed as restricting the federal government's authority to regulate who can make public statements about candidates for office, and when and how they can make them. (Vide Kathryn Jean Lopez, "Freedom to Speak".) To add to the oddity, some candid reformers both profess that limitations on political speech are essential and acknowledge that the courts will eviscerate them. Despite the fact that their remedy is concededly futile, they do not abandon it and seek an efficacious one but instead press on, as if a symbolic victory will eradicate concrete evils.
Campaign reform in its McCain-Feingold-Shays-Meehan form is explicable only as an instance of postmodernist legislation. It derives from a "constructed reality", for which the factual world is merely "text" to be deconstructed into whatever the reformers desire. Notions of cause and effect, those instruments of patriarchalist oppression, are cast aside and a liberated new world formed out of images, emotions and subjective "needs".
Postmodernism has long exercised a tremendous influence over higher education. Why shouldn't it extend its sway to other areas? Academics are not exactly like other men, but neither are they Martians. Modes of thought that appeal to them may be attractive to others as well. If Stanley Fish can believe that literature is all about power, John McCain can believe that government is all about money. And is Al Hunt any less rational than Noam Chomsky?
Science fiction writer Neal Stephenson identified a key aspect of contemporary culture in his novel Zodiac: "The ability to think rationally is pretty rare, even in prestigious universities. We're in the TV age now and people think by linking images in their brains." We're starting to see where that kind of "thinking" leads in practice.
February 8, 2002
As a further sign that journalists can think about Enron and retain their rationality, Ramesh Ponnuru calls attention to the fact that only Enron's accounting gimmicks and artificially inflated stock price made it look like the biggest bankruptcy ever ("Explaining Enron"). Enron had far fewer employees and probably less real importance to the economy than KMart, which filed for bankruptcy at almost the same time without attracting a funeral cortège of doomsayers. Stripped of hyperbole, the Enron story is "that an energy company went bankrupt in the middle of a recession and a downdraft in energy prices". It has unsavory elements, but those are being as overtouted as the company's stock was at its peak.
Also weighing in for common sense is Daniel Henninger ("Enron's Decline Tracks the Fall of Good Advice"), who argues that the failures of Enron's executives and accountants reflect the stultification of professional judgement by an ethos of tolerance and proceduralism.
February 7, 2002
In the howling press hysteria about Enron, the rare voices of reason have to struggle to be heard. One of them is Steve Chapman, a moderately conservative columnist for the moderately liberal Chicago Tribune. In "Our Real Protection Against Future Enrons", he makes the obvious but mostly forgotten point that the best deterrent to corporate misconduct is public exposure and financial ruin. Arthur Andersen, for instance, has lost far more money from its guilt-by-association with Enron than it ever reaped in audit and consulting fees. The example is not likely to be lost on the other Big Five accounting firms, which are already altering their business practices to avoid Andersen-like fiascos. Similarly, corporate directors now have a clear warning of what can happen to them personally if they negligently acquiesce in dubious schemes. The lesson will be lost on some - those who are either too stupid or too confidently dishonest to be instructed - but most will take it to heart. What businessman wants to be remembered as the next Kenneth Lay?
An earlier Chapman column ("A Non-Solution to a Non-Scandal") debunked the popular shibboleth that campaign finance reform would have prevented whatever disease afflicted Enron.
* * * *
Today's Wall Street Journal carries another Francis/Schultz op-ed piece disguised as a news article, continuing their complaints about executive compensation at Enron (Theo Francis & Ellen Schultz, "Enron Executives Protected Pensions with Partnerships"). The story looks at split-dollar life insurance arrangements for top executives and has the merit of being less tendentious and distorted than the previous piece by the same writers. (Vide 1/24/02 infra.) It concedes, as its predecessor did not, that the bulk of the executives' nonqualified deferred compensation is unprotected in bankruptcy and will never be paid. That still leaves life insurance policies purchased for them with company funds. The bankruptcy court cannot reach the cash values of those policies, because the company doesn't own them.
Unfortunately, the article's headline and much of its body give the wrong idea about why the policies are outside the bankruptcy estate. The fact that a policy is owned by a partnership or trust has no bankruptcy significance. What is important is that Enron's only connection to the policies was as a lender. It paid a portion of the policy premiums and was promised repayment when the executive died or withdrew cash from the policy. What made the program attractive was that, under IRS rules that have been in place for nearly 40 years, these de facto loans could be interest-free without tax consequences to the employee. (Normally - though this is a fairly new rule - employees are taxed on imputed interest on no-interest or below-interest loans from their employer.) The ability to borrow money at a highly preferential rate is of course beneficial, but it is not the same as "protecting" deferred compensation. The deferred compensation element was the expectation that Enron would forgo collecting the principal of the loans, an expectation that its bankruptcy renders hopeless.
No one pretends that the tax treatment of split-dollar insurance is anything other than an anomaly. As the article notes, the IRS last year proposed sweeping changes, from which it recently "backed off". Left unmentioned is that the 2001 proposal would have affected many policies retroactively and was withdrawn largely for that reason. The IRS has announced that it will promulgate essentially the same rules prospectively through regulations.
Is it too much to ask that the Francis/Schultz duo include all of the pertinent facts in their "news" instead of cherry-picking the ones that suit their anti-business bias?
February 5, 2002
On one point the conventional wisdom about Enron, from Left to Right, is unanimous: The scandal proves that a company's auditors should not also provide it with consulting services. Major corporations have scrambled to announce that they will no longer let their audit firms bid on consulting projects, while Congressmen and commentators call on the Securities and Exchange Commission to affirmatively outlaw service in dual capacities. After token resistance, the Big Five accounting firms seem prepared to go along. It's a safe bet that, by the end of the year, all of them will have spun off their consulting practices.
This is one of those cases in which the herd is stampeding is exactly the wrong direction. No one has presented a scintilla of evidence that Arthur Andersen's consulting personnel influenced, or so much as knew anything about, audit decisions. Nor, despite many claims over the years by proponents of separation, has any such evidence ever been found in any other dubious audit. Arthur Levitt, former chairman of the SEC and a long-time crusader on the subject, conceded late in his term of office that there was no prospect of finding a "smoking gun" (though that was just what the SEC staff had promised and failed to produce on numerous occasions). Instead, he fell back on his experience on corporate audit committees, which, he said, had shown him the hold that management has over auditors. (Vide this interview published 11/2/00.) He neglected to furnish what would no doubt have been fascinating details of how he himself had been involved in exercising this power to intimidate auditors into cooking the books. As with campaign finance reform, the whole world is corrupt, except for the angelically pure reformers.
If one pays any attention to facts, the Andersen/Enron "gun" has about as much smoke as an American Cancer Society fund raiser. The relationship between Andersen's audit and consulting practices was notoriously hostile for years before the two unamicably divorced in 2000. If separating auditing and consulting improved the quality of audit work, Andersen should have been a shining example for the profession.
There is, in fact, no reason to expect a firm narrowly focused on auditing to do a better job than one with a broad range of skills. Diversification is a good idea in professional activities as well as investing. As pointed out in a previous item (so I'll simply repeat myself), "An Andersen that did nothing for Enron but perform its annual audit would have only one way to please management: by being agreeable on accounting issues. An Andersen that does a lot of things for the company can be pleasing in other ways. It can earn points with tax planning or software development or actuarial valuations and store them up against the day when it has to say 'no' on an accounting question. Anyone with real experience at a Big Five firm knows that saying 'no' is not a rare occurrence and that one reason why it isn't traumatic is that the firm's relationship with the typical client is not built just on the annual audit." One highly likely possibility in the Enron debacle (though I have no inside information) is that Andersen's internal tensions made the various functions more rivals than colleagues, so that the auditors did indeed feel that their relationship with the client rested solely on "creative" solutions to the company's accounting conundrums.
A further danger in separation is that audit firms' expertise in areas outside accounting will wither away, leaving them less well-equipped to analyze complex transactions (and thus less able to thread to the end of future Enron-like mazes). In my own practice with a Big Five firm (not as an auditor), I field frequent questions from audit staff about how pension plans and other employee benefit arrangements are structured. If the auditors had to figure out the answers on their own, they would be less likely to find the right answers and more easily led astray by the attorneys and consultants employed by clients.
If we were trying to have more Enrons, more Global Crossings, more Waste Managements, even - heaven forfend! - an occasional Equity Funding and ZZZZ Best, forcing the leading audit firms to become intellectually narrower and more dependent on a single line of business would be a good starting point. It looks like that's where we're starting.
February 2, 2002
The Bush Administration has cleverly responded to media alarmism about §401(k) plans by putting forward a set of harmless "solutions" to the imaginary "problems" revealed by the Enron debacle. Business interests will doubtless raise objections, as a tactical move to exert a counter-pull to liberal proposals that really would cause harm, but no one can credibly assert that the package will undermine retirement savings or unduly complicate plan administration.
The drawback to this sort of cleverness is that it may be too clever by half. It leaves the public with the impression that §401(k) plans have been working badly; in particular, that "blackout periods" and investments in employer stock harm plan participants. Both are, in fact, designed to serve the interests of participants. Only shamefully inaccurate reporting has tainted them with the stigma of corporate corruption.
Blackout periods, during which participants cannot modify their investment elections, are a necessary feature of changing plan recordkeepers. Keeping track of exactly who owns what in a large plan is not a simple matter, and anyone who has much contact with plan administration knows that errors are common. Someday software and data entry will approach perfection and mistakes will dwindle to minor proportions, but that day is not yet here. I have seen plans with differences of several million dollars between what participants were supposed to have in their accounts and what the plan actually had on hand. The discrepancies were not the result of any misconduct. The plans had all of their money but, due mostly to the accumulation of small errors (frequently just a few cents per transaction) over many years, did not know to whom it all belonged.
The purpose of a blackout is to make sure that the new recordkeeper begins with an accurate slate, one on which the sum of each participant's separate investment accounts equals his total account balance and the sum of all of the account balances equals the total assets of the plan. If that is not done, discrepancies will emerge and, because the old recordkeeper's data are no longer available, will be insoluble. Typically, it takes two to four weeks to complete a thorough reconciliation, though the periods have happily been getting shorter.
The media have become excited about blackouts (many news accounts use the more sinister sounding "lockdown"), because the Enron plan changed recordkeepers in October 2001 and had a blackout period lasting 11 trading days. During that time, the company released unfavorable earnings news and the price of its stock fell by about four dollars a share. Plan participants were prevented from selling instantly on the bad news, but it was not exactly the first bad news that Enron had ever had. In the year before the blackout, its stock had fallen from $90 to $15 a share. Those who wanted to get out in late October can blame the blackout for only a minuscule fraction of their losses.
In more normal cases, blackouts have no effect at all. Plan participants ought not to be in-and-out market timers, and the impact of timing on accounts that will not be liquidated for decades in minimal. We should keep in mind, too, that the possibility of switching investments every day is a new development. Until fairly recently, most plans allowed investment changes only once a quarter, because their recordkeepers couldn't handle more frequent activity. Now recordkeepers' capabilities have improved, but their systems remain imperfect. Blackout periods are a consequence of that imperfection, not a nefarious conspiracy to force employees to lose money.
The Administration's proposal for "improving" blackouts has two elements. One involves fiddling with ERISA's fiduciary standards in ways that haven't been defined yet but are virtually certain to have no real-world significance. The other is an amendment to the securities laws to bar executives from selling personally owned employer stock during plan blackouts. Since there are already numerous periods during which, in order to comply with insider trading prohibitions, high-level employees cannot trade in their company's stock, this additional restriction will be no more than a minor nuisance. Perhaps it will encourage dovetailing blackouts with quarterly earnings reports. (Public corporations typically prohibit insiders from trading during the days before earnings are announced.) How that will help ordinary participants is a mystery to me, but it won't do them much harm.
The controversy about retirement plan investments in employer stock has more philosophical content. The idea of giving employees a stake in the success (or failure) of their employer has a long history in America. The very first successful corporate retirement plan, established by Sears Roebuck & Co., held only Sears stock until the 1950's and made many rank-and-file workers at least moderately rich. Pension legislation has consistently favored investment in employer stock by individual account plans, where gains and losses inure to participants, though it is now limited in defined benefit pension plans, where gains benefit only the employer and losses may have to be absorbed by the government's pension insurance program.
"Employee ownership" has a liberal ring to it, and it has been promoted by many liberals. Senator Russell Long, chairman of the Senate Finance Committee for many years (and very far from a conservative, though he hailed from Louisiana), was an ardent champion. But liberals of the harder-line left have never liked it. Aligning the interests of the capitalist and the working classes will, they fear, erode ideological clarity. This hostility pops up now and again. For instance, the Clinton Labor Department floated an arcane interpretation of overtime pay rules that would have greatly increased the cost of granting stock options to lower level employees. (Congress reversed that action by a nearly unanimous vote.)
Enron, by illustrating the sad truth that stock can go down as well as up, has given leftish legislators like Senators Corzine and Boxer an opening to call for limiting the ability of workers to acquire employer stock. The Bush Administration has not embraced that position, offering only a modest expansion of the right of participants to diversify employer stock that had been contributed to their accounts. Democrats have already denounced that proposal as inadequate, and the official Democratic line apparently will be that workers will be adequately protected only if the government tells them how to invest their retirement funds.
A look at the facts of Enron's plan is instructive. The only part of anyone's account that was mandatorily invested in employer stock was matching contributions, which could equal, at most, three percent of pay and, according to a CNN report, represented only 11 percent of the Enron stock held in the plan. That was the extent to which employees were forced to link their financial fortunes to Enron's. The reason why Enron stock was so large a portion of plan assets was that participants chose to buy it, in preference to 30 or so other investment options. (Requiring participants to invest their own contributions in employer stock is, incidentally, prohibited by current law, with some rarely occurring exceptions.)
After the fact, we can see that buying Enron was a mistake, one that lots of people who did not work for the company also made. On the other hand, it was a great investment for those who diversified before the collapse, and the stock of most other companies has performed well. Just last week the left-wing cartoonist Herbert Block died and left behind a $50 million fortune, almost all of it in stock of his employer, the Washington Post. His case is spectacular but far from unique.
The argument for taking away from the next generation of workers opportunities that were available to the last is the principle of diversification. That is a valid principle but is misapplied here. Accounts in §401(k) plans are not the only retirement savings that American workers have. Virtually all are covered by Social Security. Most who are over age 40 own their homes. Most who work for large companies are covered by pension plans. Those are all (with the occasional exception of home ownership) conservative holdings. Adding a block of employer stock to that mix is consistent with sound investment principles, giving the possibility of large gains without exposing too large a share of the overall portfolio to the risk of loss.
The Administration has had the wisdom to look at what happened to the Enron plan and conclude that nothing needs to be done, but it hasn't had the courage to say so. Instead, it has come out in favor of doing very little. It will be unfortunate if its timidity about speaking the truth gives aid and comfort to those who want to do far too much.
January 24, 2002
Having complained below about Time's scandalous manufacturing of evidence in l'affaire Enron, I feel an obligation to call attention to the similarly deplorable burying of evidence by the Wall Street Journal's news staff. An article in yesterday's paper, "Enron Executives' Benefits Kept on Growing As Retirement Plans of Employees Were Cut", by Ellen E. Schultz and Theo Francis, purports to contrast steady improvements in benefits for the higher-ups with unfavorable changes to the plans that cover rank-and-file employees. The theme is dear to the heart of Ellen Schultz, who for years has been editorializing on the news pages against what she sees as the unfair state of American pension law. She usually gets her facts wrong, and this story is no shining exception.
The article describes various nonqualified retirement programs for Enron executives. "Enron will pay Mr. Lay a pension estimated at $475,042 a year for life." "Enron also has a kind of executive 401(k) plan, established in the 1980's, which guarantees executives in the plan minimum returns of 12%." "Enron set up an[other] executive savings plan that lets participating executives contribute 25% of their salaries and 100% of their cash bonuses each year. The participants were guaranteed a 9% return on [sic] the first two years of the plan. . . ." Left unmentioned, though surely pertinent now, is the fact that Enron's bankruptcy made all of these arrangements worthless. The executives have only the rights of unsecured general creditors in bankruptcy, meaning that they will almost certainly receive zero cents on the dollar. Those who chose to forgo salary and cash bonuses in hand do not have a guaranteed 9 or 12 percent return on their money. They have a 100 percent loss.
Also singled out is the company's split-dollar life insurance program for executives. We are told that Enron agreed to pay $1.25 million in premiums on a $12 million policy for Mr. Lay. Not much detail is provided, but the arrangement looks like garden variety equity split-dollar with collateral assignment. Enron paid premiums on a universal life or similar policy with a cash value that builds up over time. A portion of the premiums paid for term insurance equal to the difference between the policy's face value and its cash reserve. Mr. Lay was taxed on those premiums, leaving him in the same economic position as if he had bought term insurance himself with after-tax funds. The remaining premiums were not taxed, but they will have to be repaid to the company (or to its bankruptcy estate) when Mr. Lay dies or if he withdraws cash from the policy during his lifetime. (Enron probably agreed to waive repayment, but that promise is now unenforceable.) The only benefit that Mr. Lay or his beneficiaries will receive at company expense is the growth in value of the cash reserve. That isn't nothing, but it is much less spectacular than the article would lead one to believe.
On the workers' side of the ledger, how were benefits cut? The article's Exhibit A is a change in the company's pension plan that was implemented in 1996. The details are slightly complicated but not incomprehensible - except, it appears, to the WSJ writers, who leave out crucial facts. In 1987 Enron established what is called an "ESOP floor/offset plan". The arrangement juxtaposed two plans, a traditional defined benefit pension plan and an employee stock ownership plan (which, as the name suggests, invests primarily in employer stock). Benefits under the two plans were integrated. When a participant retired, his pension benefit was offset by the actuarial equivalent of the value of his ESOP account. The concept is that participants have the upside potential of the ESOP but are protected from downside risk by the pension plan. (The article suggests no motive for setting up this arrangement other than to reduce the employer's pension expense.)
At about the time when Enron was establishing its plan, the Pension Benefit Guaranty Corporation (of which I was an official at the time) began to worry about ESOP floor/offets. During periods when employer stock was rising in value, little or nothing would have to be contributed to the pension plan. If the stock then fell abruptly and the employer went bankrupt, the plan would be left with large unfunded liabilities, much of which would then become the financial responsibility of the PBGC. To protect the PBGC's insurance funds (then impressively in the red), Congress barred new ESOP floor/offset plans. Existing plans, such as Enron's, were allowed to continue under a grandfather clause.
In 1994 Enron decided to phase out the offset, converting the pension plan and the ESOP into stand-alone plans. The phase-out took place over five years, from 1996 through 2000. Each year, one-fifth of each particpant's account balance ceased to act as an offset. Corollarily, his pension benefit was reduced by the actuarial value of that fifth. Suppose, for example, that a participant had an accrued benefit of $1,000 month (assuming commencement at age 65) as of the beginning of 1996 and an ESOP account holding employer stock worth $60,000. The plan's actuary would compute how large a benefit one-fifth of that balance ($12,000) could purchase at age 65. The amount varies with age and actuarial assumptions, but, for a 55-year-old, it would be about $200 per month. The ESOP would then remove $12,000 worth of stock from the offset account into a separate account for the same participant, and the individual's accrued pension benefit would be reduced to $800 a month.
The article describes that part of the process without much clarity but not too inaccurately. It then goes on, however, to imply that, since Enron stock is now worthless, participants have inevitably suffered losses. What is left out is what happened to the stock after it was taken out of the offset accounts. According to publicly available information on which the authors purport to have relied (Department of Labor ERISA Advisory Opinion 94-42A (12/9/94)), participants were given the options of (i) leaving the former offset in the ESOP (where it would no longer offset their remaining pension benefits), (ii) receiving it as an immediate distribution (eligible for tax-free rollover into an individual retirement account) or (iii) transferring it to the company's section 401(k) plan, where they could reinvest it in a wide range of investment alternatives. Anyone who so desired thus could take the value of his ESOP offset account and invest it in a diversified portfolio. Even with last year's stock market decline, those who did that are almost certainly better off today than they would have been if the plan had continued unchanged and their only entitlement at this point were to benefits under the pension plan. The article discloses none of these facts.
As a minor addendum to this point, the article states that "Enron sought - and received - permission from the Labor Department to change the plan in this fashion".I suppose that this "permission" from the DoL will soon start appearing on lists of government favors to Enron, so it should be noted that Enron did not ask for, or need, government "permission" for any of the changes to the plans. It requested a nonbinding DoL opinion on whether those changes would adversely affect the grandfathering of its ESOP during the phase-out period and whether the ESOP would be free of the restrictions on floor/offset plans once it ceased to be used as an offset. Those were not difficult questions and were answered routinely by civil servants.
In conjunction with the elimination of the floor/offset arrangement, Enron prospectively switched from a "traditional" pension formula to a "cash balance" formula. Cash balance plans are Miss Schultz's King Charles' Head, and the article flatly states that "the pension going forward, [starting] in 1996, was reduced". It does not mention that the company identified the group of participants whose rate of future benefit accrual was likely to be lower under the new formula and grandfathered them under the old one. That fact, too, is in the Advisory Opinion.
Finally, the article refers to the now notorious "lockdown", a period during which participants in the Enron 401(k) plan were unable to change investments due to a transition between recordkeepers. "At the same time that employees were locked into much of the Enron stock in their 401(k) plans, executives last year sold shares valued at about $128 million." In a prime example of the WSJ's split personality, today's editorial page disposes of the notion that the lockdown had much impact on the rank-and-file:
Enron notified employees of the coming lockdown several times -- first by mail and then by four separate e-mails. Enron shares were still trading in the $30 range at this time, when workers had ample opportunity to sell. The lockdown itself started Oct. 26 and ended Nov. 13, so workers were locked out for only 11 stock-trading days. And during that time Enron's stock fell from $15.40 to $9.30, a rather small decline for a stock that had already lost almost 70% of its value during 2001. [Note: Other news accounts state that the decline was smaller, from $13.88 to $9.98.]
Many things went wrong at Enron, but the company's retirement plans were not part of the problem and should not be used as a pretext for new governmental restrictions. Unhappily, we will undoubtedly see much more pseudo-reportage of this kind during the coming months.
January 22, 2002
The lull in the war (except for comical claims that the U.S. is mistreating al-Qaeda prisoners by taking their photographs and forcing them to endure "searing" 85 degree temperatures) accounts for this sudden concentration on the Enron quasi-scandal ("quasi" because it acts like a scandal without having much in the way of scandalous activities). The manner in which most politicians and pundits have been discussing this affair leads one to think that they have deep contempt for the intellect of the American public. No one can seriously think that President Bush is much beholden to a company that provided about one-half of one percent of his campaign funds (partially offset by donations to his political opponents) or that his Administration has done anything substantial on Enron's behalf. The Vice President's repetition (to the leader of the opposition party) of longstanding U.S. complaints about India's handling of a contractual dispute with the company is a pretty unimpressive payoff, less than a feather in the balance against the President's rejection of the Kyoto Treaty, from whose mere apparition on the horizon Enron hoped to gain access to a vast new market in environmental rights. The constant talk about scandal is mostly a cloud of guilt by association; repeat "Bush" and "Enron" in the same sentence often enough, liberals hope, and stupid Americanos will get the two mixed up.
Amidst the smoke and noise, a few right-wing columnists and bloggers have uncovered a micro-counterscandal involving liberal economist and New York Times commentator Paul Krugman. Professor Krugman has been as ferocious as anyone in proclaiming that Enron's troubles unveil the evils of the Bush regime's "Crony Capitalism, USA" (title of one of his recent hyperventilations). It turns out, ironically, that the professor himself used to serve on an Enron "advisory committee", for which he received $50,000 in compensation. He insists that he did absolutely nothing to earn that money, that the position was a mere sinecure, which sounds plausible enough - except for one incongruity. In May 1999 Professor Krugman penned an article for Fortune that reads like a valentine to Enron, praising it for its role in the vanguard of "a combination of deregulation that lets new competitors enter [the energy market] and 'common carrier' regulation that prevents middlemen from playing favorites, making freewheeling markets possible." (For a fuller discussion and references, vide Mark Steyn, "Enrongate and the Pious Professor".)
That sounds very different from recent Krugman screeds about Enron. If one applied to him, as some bloggers are eager to do, the standards that he applies to George W. Bush & Co., his actions would look thoroughly suspicious. Though Professor Krugman is not a poor man, it's likely that $50,000 is a considerably larger portion of his net worth than Enron's contributions were of Mr. Bush's campaign funds. What's more, he had unfettered use of that money, while Enron's benefactions to the Bush campaign did not increase by a nickel the disposable wealth of the Bush household. In real terms, then, Enron paid Paul Krugman more than it paid George W. Bush, and it arguably got something in return: a nice puff piece from an eminent economist burnishing both its overall business strategy and its method of carrying it out. The professor's leftist credentials made that endorsement shinier and more valuable than accolades from, say, conservatives Larry Kudlow and Bill Kristol (who also received money for services or non-services to Enron and who, I'm sure, said the same sort of positive things about it that Professor Krugman did).
Talk about an open-and-shut instance of a red-handed payoff! It's unsurprising that media liberals say nothing. Nonetheless, despite the circumstantial evidence, the notion that Enron bribed Professor Krugman is preposterous. The scandal lies not in what he wrote two-plus years ago but in his reversal of front now.
Professor Krugman is, after all, no socialist bonehead. Among professional economists, he is highly regarded, by conservatives as well as liberals. What he wrote in 1999 was no strange aberration but a straightforward explanation of how the world economy has changed. As he put it then, "It's sort of like the difference between your father's bank, which took money from its regular depositors and lent it out to its regular customers, and Goldman Sachs." That sentiment may sound odd in the mouth of a liberal, but it was unsurprising in the mouth of a liberal economist. Economic analysis begins with how the world is, not how one would like it to be. The fact that a limited form of deregulation was working well did not convince Professor Krugman that all of his political principles were wrong; it just furnished a new datum about the world to which those principles had to be applied. In those days, however, a Democrat was in the White House.
Today, Professor Krugman has abandoned economic analysis and taken up the sword of a partisan foot soldier. He now derides those who didn't follow the model of "your father's bank". He does not, it should be noted, contend that his former analysis has been disproven by events. For an economist of his caliber to claim that a single bankruptcy refutes the benefits of "freewheeling markets" would be like a mathematician's denouncing calculus.
What seems to have happened here is that the professor's politics have overridden his economics. It is so vital, he believes, to undermine a Republican President that economic reasoning must be tossed aside in the interests of victory. In the end, the temptation to twist truth in hopes of winning over public opinion has proven more potent than any bribe. Succumbing to that temptation may be less immoral than swallowing a bribe, but it is intellectually a far graver crime.
Letter of Comment from Jeff Hauser (1/23/02)
January 18, 2002
To the mens naturaliter socialistica, everything that happens is a reason to expand the powers of government. September 11th proved that America needs Bigger Government. Now, well before the facts have emerged from the journalistic fog bank, the same lesson is being enthusiastically drawn from the Enron debacle. So let's pause for a moment to observe that Enron operated in a heavily regulated industry. What additional regulations would have prevented the (probable though not yet proven) fraud that enabled its management to cover up the true corporate financial picture (most likely even from themselves) until collapse was certain and recovery impossible?
Campaign finance reform is the panacea of Al Hunt, the Wall Street Journal's town crier of the Loony Left. It is, of course, his panacea for everything else, too. I wouldn't be surprised to see him aver that the McCain-Feingold Bill will cure AIDS. Others have taken up the same cry, proclaiming the syllogism: Enron made lots of political contributions. Enron is evil. Therefore. . . . In the postmodern world, that passes for logic. What is lacking is any sign that the beneficiaries of Enron's largess relaxed any regulations for its benefit. Mr. Hunt brings forward two implausible pieces of evidence. First, the Commodity Futures Trading Commission, chaired by Senator Phil Gramm's wife, was more laissez faire than under her predecessors, and Enron, a heavy player in commodities, contributed to the Senator's campaigns. True but of no significance. None of Enron's risks in commodities or derivatives would have been headed off by anybody's CFTC, because that body's mission is not to protect giant corporations from themselves (just as the SEC doesn't care if you sell unregistered stock to Bill Gates). Second, Congress barred the SEC from imposing stringent restrictions on the ability of auditors to offer non-audit services to their clients. Mr. Hunt attributes that action to the influence of Big Five campaign contributions, but, even if he is right, adoption of the SEC's proposals would not have made detection of fraud more likely (for reasons discussed below).
Deregulation of the energy market, a cause that Enron aggressively promoted, has also come under fire. Yet there is nothing about buying and selling power that causes the merchant to cook his books, and it appears that Enron ran up its biggest losses from activities that no regulator could or would have prohibited: It entered too many new fields that it knew too little about, and it engaged in heavily leveraged arbitrage without hedging its risks adequately. (Vide Tappen Soper, "The Real Story"; Victor A. Canto, "How Enron Failed".) No one has yet figured out a way to make bad business strategy illegal, much less replace it with government-mandated wisdom.
Enron's auditors have already admitted to having made mistakes. Most notably, they failed to discover that outside investments in several of Enron's partnerships (used to keep debt and losses off the corporate financial statements) were not bona fide, meaning that the partnerships' assets, liabilities, income and expense should have been rolled into Enron's. There may have been further, worse blunders (and there also may be mitigating circumstances that don't fit the story and thus are buried by investigators and the media). The pertinent question here is whether tighter regulation could have kept blunders from happening. A widespread, unexamined assumption is that of course it could have. Whether that assumption is true depends on why the blunders occurred and how much could have been done to foresee and prevent them.
The simple, Ockham's Razor explanation of bad auditing is that the auditors weren't skillful enough to deal with a deliberately complexified financial structure that was designed to avoid transparency. Can the government improve their skills? The SEC already requires the major audit firms to under triennial peer reviews, in which other firms scrutinize the quality of their audit procedures. Chairman Harvey Pitt has just proposed turning the review task over to government employees. It's hard to see what incentive the government has to be tougher on audit firms than their competitors are, but, whatever the merits of the idea, its implementation would not have affected the quality of the Enron audits. There is little doubt that those audits were procedurally sound. The audit team discovered potential issues and sought guidance from higher levels. The problem was that, when decisions had to be made, they were the wrong ones. Ultimately, the decision makers had to evaluate the available information and decide whether it indicated that Enron's financial statements were materially misleading in some respect, and no set of procedures could ensure that they would decide correctly.
Many critics prefer to blame poor audit work on factors more sinister than incompetence. They accuse the auditors of bowing to pressure from management out of fear of losing a profitable account. A particular ground for adverse comment is the large amount of non-audit consulting work that audit firms nowadays typically perform for clients, which is portrayed as creating conflicts of interest. Under its last chairman, the SEC made a strenuous effort to force the accounting profession's Big Five to limit themselves to providing either audit or consulting services, but not both, to any individual client. Al Hunt, at least, believes that Enron's auditors would have done a better job if they hadn't had colleagues providing advice to the company on taxes, human resources, information technology, etc.
A look at the facts of the Enron situation shows the astonishing folly of that belief. Arthur Andersen, Enron's audit firm, received $52 million last year for services to the company, divided about equally (there are disputes about what goes where) between audit and non-audit work. While that is a lot of money, it represented only about one-half of one percent of Andersen's total revenue ($8.4 billion worldwide) - not a very compelling reason to risk one's professional reputation and massive lawsuits. Nonetheless, let us assume that keeping Enron as a client was very important to Andersen and, a bit cynically, that "pleasing top management" was the principal requisite for achieving that goal. Did the diversification of Andersen's services make it more or less likely that it would acquiesce in management's dubious accounting techniques?
An Andersen that did nothing for Enron but perform its annual audit would have only one way to please management: by being agreeable on accounting issues. An Andersen that does a lot of things for the company can be pleasing in other ways. It can earn points with tax planning or software development or actuarial valuations and store them up against the day when it has to say "no" on an accounting question. Anyone with real experience at a Big Five firm knows that saying no is not a rare occurrence and that one reason why it isn't traumatic is that the firm's relationship with the typical client is not built just on the annual audit. (As readers can learn elsewhere on this site, I am employed by one of the Big Five, though I'm not an auditor. If anyone wishes to discount all that I say as loyalty to the "party line", I doubt that I can reason with him.) In this particular case, Andersen did not say no - at least, not often or loudly enough - but restrictions on providing diversified services would have heightened, rather than reduced, the costs and risks of exercising independent judgement.
Enron's troubles reflect badly on its management and on those who were supposed to make sure that investors received accurate data intelligibly presented. They do not reflect any failure of the government to do sufficient regulating, and no new regulations that have been proffered so far would have made the situation any better. Many would have made it worse.
January 15, 2002
At last what looks like a genuine Enron scandal has come to light. But it won't be the lead story on any newscasts, because it doesn't involve the Bush Administration, the Enron executive clique or even (except perhaps as victims) the auditors at Arthur Andersen. The apparent villains are reporters and Congressional staffers, who have been caught in transparent malfeasance.
Last Sunday, Time carried the sensational report that an "October 12 memo" from an Andersen in-house lawyer "directed workers to destroy all audit material, except for the most basic 'work papers'". The accounting firm had already revealed that employees had destroyed Enron-related materials in apparent violation of firm policies. "But," intoned Time, "it did not reveal that the destruction orders came in the Oct. 12 memo".
Other media picked up and trumpeted this revelation as an established fact. Senator Joe Lieberman, his countenance awash in schadenfreude, opined that Andersen might be destroyed along with Enron. There was much speculation about how many of the firm's lawyers would be going to jail.
Yesterday Andersen released the text of the "memo". (Vide its press release, dated 1/14/02.) The document consists of an e-mail addressed to the risk management partner in the Houston office and reads, in full: "Mike - It might be useful to consider reminding the engagement team of our documentation and retention policy. It will be helpful to make sure that we have complied with the policy. Let me know if you have any questions." The recipient forwarded this message to the lead audit partner with the laconic note, "More help".
No doubt a hostile reader could infer that the subtext of this instruction was "destroy all audit material, except for the most basic 'work papers'", but it certainly does not say that on its face, and Andersen's documentation policy does not call for destroying everything "except for the most basic 'work papers'". All of the information essential to supporting the firm's audit conclusions is required to be retained. Drafts and other superseded materials are to be discarded unless they are "source documents for supporting our work" or have been subpoenaed. Andersen's policy is no different from any other accounting firm's and is not at all controversial. There are plenty of innocent, nay admirable, reasons to remind auditors working on a troubled client that they are supposed to follow it. Nor is it obvious how an exhortation to comply with the policy could be read as a coded directive to violate it.
If Time had disclosed the actual text of the e-mail, it would have had no real basis for implicating Andersen higher-ups in the document destruction and not much of a story. To create a story, it suppressed the text and substituted its own heavily tendentious paraphrase. Alternatively, its Congressional staff sources lied about the contents of the document and the magazine lazily took them at their word. In either case, this is a dishonest performance worthy of al-Jezeera. It's likely that Enron's troubles will lead to the lopping off of many heads. Several at Time should be the first to roll.
Letter of Comment from Kevin McGilly (1/16/02)
Update, January 21, 2001: Today's Wall Street Journal (the generally liberal news side, not the conservative editorial page) carries another slippery story about the document destruction. It avers that a "second Andersen executive" has told Congressional investigators that the October 12th e-mail prompted the mass shredding, thus "bolstering the account of a fired Arthur Andersen LLP auditor". Left unmentioned (albeit deducible by a reader with sufficient information from other sources) is that this new witness, the now-suspended risk management partner at Andersen's Houston office, is in serious jeopardy if, as Andersen asserts, documents were destroyed in violation of the firm's policies. The crucial e-mail itself is not quoted, and Andersen's document retention policy is described only as "call[ing] for the disposal of nonessential papers", which is far from its only element. The story also glides over the chronological relationship between the receipt of the e-mail and the commencement of the destruction. We are told that the latter happened "after" the former, but not that (according to Andersen's so-far-unchallenged account) the interval between the two events was 11 days - hardly suggesting a response to an "unprecedented" order from headquarters.
Even without the e-mail text and a clear chronology, the story casts severe doubt on the disciplined executives' claim that they were following instructions. It states that the in-house lawyer who sent the e-mail was a member of an "extended review team" that talked to members of the Houston office (apparently including the risk management partner, though this point, too, is left obscure) several times a week. There is no suggestion that anyone in Houston asked her about her allegedly unprecedented reminder of firm policy or sought clarification, nor is she said to have done anything to reiterate her "orders" during the nearly two-week period when they were not being carried out. By contrast, when the SEC issued a subpoena for records relating to Enron on November 9th, she sent voicemail and e-mail messages to the lead audit partner and to other personnel working on the account, and her unequivocal instruction not to dispose of any documents was, according to the story, carried out immediately. A more than reasonable inference from these two sequences of events is that no orders - certainly not orders to destroy documents - were given on October 12th. But that wouldn't be a very exciting story.
January 11, 2002
Now and then a political issue arises to which I, as a pension lawyer, can speak with a claim to expertise. Jon Corzine, the billionaire socialist Senator from New Jersey, decries the fact that a large portion of the assets of Enron's section 401(k) plan are invested in now-worthless Enron stock and has introduced legislation that would further limit plan investments in employer securities. (401(k) plans that mandatorily invest participants' contributions in employer stock are already barred from placing more than 10 percent of their assets in securities of, or real estate leased by, the plan sponsor and its affiliates, a prohibition that also applies to pension plans.)
If the proposed restrictions existed now, many Enron workers would have lost much less in their employer's crash. One recent retiree, for instance, held Enron stock worth over $1 million in his 401(k) account. Upon retirement, he could have diversified his holdings, but he chose to keep all of his eggs in the Enron basket. His account is now worth less than $20,000.
At first sight, the Corzine bill would have been salvation for this this fellow, but further thought makes the situation less clearcut. Had his account been invested primarily in non-Enron securities, it would have been worth much less than $1 million when he retired. How much less is pure speculation, but Enron, until its collapse, far outperformed market indices and mutual funds. The concentration in Enron gave this employee the opportunity to retire with a larger nest egg than most workers at most companies, an opportunity that he could have used to reinvest in a conservative, diversified portfolio (the advice that he undoubtedly received from any expert whom he consulted). That he missed his opportunity is sad, but the best remedy may not be to take the opportunity away from others.
Senator Corzine may, of course, think that protecting workers against inordinate risk is worth of price of depriving them of the prospect of inordinate reward. If one agrees with that bias, the Corzine bill is nonetheless a cure for a nonexistent disease. Section 401(k) plans are not the only source of workers' retirement income and are the major source only for those whose 401(k) investments have done spectacularly well. Far more important are Social Security (which replaces 60 percent or more of the average American's preretirement income, even if it doesn't do much for high earners), home ownership and employer-funded pension plans. If one looks at the typical worker's overall investment strategy, it is conservative to the point of stodginess, and there is much to be said for a fairly high degree of risk in his 401(k) account.
Senator Corzine, having made his fortune in the stock market, is surely aware of these considerations. That he pays no attention to them probably owes much to his alignment with the current leadership of organized labor. The AFL-CIO is now, for the first time in its history, run by European-style ideologues who see labor and management as natural enemies. To their way of thinking, giving workers an ownership interest in their employers is subversive of labor solidarity and class consciousness. The evil in the Enron case was not so much that employees lost money but that they were given a chance to make it in the wrong way.
U.S. pension law has traditionally taken the opposite view: that employee ownership should be encouraged. Employer stock receives mildly favorable treatment compared to other investments, and corporations have incentives to establish "employee stock ownership plans" that invest primarily in their own stock. (For example, dividends paid to a company's ESOP are deductible if certain conditions - liberalized by this year's tax law - are met.) This policy has not made every single worker better off, but it has been beneficial overall. If we reverse it in order to protect employees against risk, we most likely will protect them against wealth too.