Hongkong lessons from Enron

SCMP January 29



The Enron affair will go down in history as one of the defining moments of the age. The discomfort of America, and the Bush administration in particular, will doubtless cause some wry smiles in an Asia long accustomed to being lectured on crony capitalism and professional propriety by many of the same names now caught up in this nasty mess. But Enron has lessons for everyone.

How many similar practices are on our doorstep, or already embedded in links between businessmen, politicians and bureaucrats? At the local level for the US it is comparable to the early 1980s Carrian scandal in Hongkong or the Recruit scandal which grew out of and helped burst the late 80s Japanese financial bubble. In all cases the mix of greed, politics and the dishonesty of supposed professionals created a mixture which eventually exploded in the faces of its chemists and left a trail of collateral damage to the community at large.

At the international level the size and linkages of Enron and the influence of the US on global financial markets makes this as important as the events such as the Bankaus Herstatt Bank collapse whose knock on effects rocked global markets in 1974.

There are so many facets to the Enron scandal. One was, as with Recruit, the payoffs (aka campaign contributions) to politicians who enjoyed cosy relationships with its leading executives. These enabled it to gain favors such as the exemption of energy trading, in which it specialized, from the regulations applying to other forms of commodity trading.

But is Hongkong so different? Remember the listing rule waivers given to the likes of when it sought to exploit the internet craze and sell shares to the public at many times the price of those allocated to the (politically connected) insiders. In the US, revelation of undesirable practices is at least viewed as an outrage. To Hongkong's business-friendly government such practices may seem normal.

A similar attitude is apparent in official response of the Environmental Protection Department to recent revelations in this newspaper about purchase of anti-pollution devices for diesels.

Next is the role of the auditors, Arthur Andersen. This reminds me of the role that Price Waterhouse (now Pricewaterhouse Coopers) played in the Carrian affair, not only signing off on fairy tale accounts but also providing its senior partner and two other accountants as senior executives for Carrian. Price Waterhouse used its connections to resist an investigation by the HK Society of Accountants, the profession's self-regulatory body.

The tendency of auditors to be beholden to the boards which appoint them rather than to the shareholders and rule-governed society at large has existed for many years. However the amalgamations which have reduced the number of well known international auditing names has not improved professional standards. Indeed, as those who invested in certain mainland companies which were supposedly audited to international standards discovered to their cost, the big names became well-paid accomplices in deluding outside shareholders about their profitability.

Meanwhile the auditors have also set themselves up as consultants - on management, information technology, recruitment etc. These interests are clearly in conflict with auditing responsibilities and reduce the already small likelihood that they will blow the whistle on corporate mis-governance. In the case of Enron the auditors appear to have been instrumental in setting up the very structures which hid the reality of Enron's finances from public gaze.

Given the scale on which this was done, it is hard to believe that this relationship and the accompanying partnership structures were unique to Enron. Likewise it is hard to believe that at least a few of the banks and investment which provided the loan capital for these partnerships did not know what was up.

The previous head of the US Securities and Exchange Commission, Arthur Levitt, tried hard to tackle conflicts of auditor interest, in particular to disbar firms from auditing companies from whom they had with consultancy business. But he was thwarted by their political clout. Even after Enron, prospects for reform are not bright.

Instead of examining their consciences, the Big Five auditors are reported stepping up their lobbying against tighter regulation. They have a friend in Bush's appointee to the SEC, Harvey Pitt, a lawyer who has specialized in representing the auditing industry. Enron also raises questions about the role of non-executive directors.

This is of particular interest in Hongkong given that Hang Lung's Ronnie Chan, the very patriotic Chinese who is also a US citizen and heads the Asia Society here, was a member of the audit and finance committees of Enron. Mr Chan has not commented but remarks of high profile Templeton Fund guru Mark Mobius sum up the complaisance with which the financial sector seems to view the role of highly paid, well-optioned non-executive directors of Enron. Mr Mobius felt "sorry" for them adding "if Arthur Andersen cannot uncover the kind of thing that was going on the independent directors are in trouble because they have to depend on the auditors".

This is upside down, Mr Mobius. Auditors are supposed to review the actions of board and management. In this case anyway the structures were created with the full knowledge of Andersen. Was the board unaware? This is the very same Mr Mobius, friend of the small investor, who put former Peregrine boss Philip Tose on his investment team weeks after a badly managed, un-transparent Peregrine crashed, causing huge losses to investors.

The Enron affair is not just about politicians, greedy businessmen and conniving auditors. It is also about the absurdly inflated earnings expectations put about by self-serving broker analysts, often spurred on by their investment banking colleagues in the big houses. As the investment bankers make the big money from corporate clients they wish to flatter, it is not surprising that so-called "research" is often biased against the interests of those it is supposed to serve - brokerage clients.

Even independent analysts usually end up following trends rather than forecasting them. The whole brokerage vocabulary of "target prices" and "earnings guidance" gives unjustified influence to financial analysts. So much emphasis is placed on quarterly earnings gains that managements are often pressured into using accounting devices to find ways of putting gains in the profit and loss account and hiding losses in various ways. Where these cannot fit even with flexible Generally Accepted Accounting Principles (GAAP) rules, announcements are made of "pro-forma" and "operational" results which give the good news and bury the red ink. Failure to meet analysts earnings expectations can be fatal for share prices. Managers paid in stock options are especially susceptible to the pressures of the system.

In the case of Enron, what had been a genuinely innovative company, it came to feel necessary to produce absurdly high earnings gains to maintain its status. Hence the off balance sheet accounting through partnerships which allowed debt to be hidden and book "profits" to be generated.

More conservative managers often feel the pressure on their jobs. How many perfectly competent CEOs have been ousted as a result of inflated market expectations after perhaps less than two years to revive a giant company.

It does not help that many of the fund managers who buy stocks on the public's behalf are not only part of the same giant financial institutions. In most cases they are rewarded on the basis of performance and the growth of funds under management. The latter objective has often been met up deluding the public into believing that stock investment will return twice or more its historical average.

As for performance, manager rewards based on five year results would be acceptable, even for those (the majority) investing with a 20-year horizon. But in practice huge rewards are doled out for short term performance. This gives the managers the same vested interests as the brokers and investment banks pushing hot stocks. Buyers and sellers in the stock game ought to be in perpetual conflict.

In practice there are huge mutual interests - even excluding the front running and outright kickback corruption that are common but very seldom prosecuted. No wonder that on a medium term view most fund managers underperform the indices they are paid to beat. The financial services industry has become the tail wagging the whole economy. It is bloated, overpaid, run by people who change jobs at the drop of a hat, are focussed on returns to themselves not even their own companies. Not surprisingly returns on capital are abysmal. But that is a dirty secret the industry does not like to admit. Its greed, its institutionalized lack of ethics has been eloquently described by former insiders. But thus far nothing has changed. The leaders of continue to be lauded, the dubious practices go on.

Being from Texas and about energy, Enron has done things to a degree and in a style which outdoes the fictional "Dallas". But if it is treated as a one-off bizarre event rather than symptom of a more extensive cancer it will lead to no more changes than Recruit did to Japan's business/politics nexus. Japan's failure to learn lessons from Recruit is one cause of its present problems. That should be a lesson to all students of Enron.



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