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
But is Hongkong so different? Remember the listing rule
waivers given to the likes of Tom.com 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
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.