Enron's fall

Outside editorial

Posted: Tuesday, December 04, 2001

The following editorial appeared in today's Washington Post:

Enron's collapse is by some measures the largest bankruptcy in history, and the list of victims will be long. Shareholders have already seen the value of their stock evaporate. Banks that lent to Enron will lose millions. Most unfairly, employees who now risk joblessness may also lose their retirement security, since many had 401(k) retirement plans invested overwhelmingly in Enron stock. But there might just be a silver lining in Enron's implosion, for it may bring an overdue revolt against conflicts of interest at stockbrokers and audit firms.

Stockbrokers are supposed to analyze companies and advise investors which shares to buy; investors pay for this advice. But the biggest stockbroking outfits are owned by investment banks that also do other types of business: advising companies on mergers, helping them to issue shares or bonds. These advisory businesses create a conflict of interest: In order to cultivate corporations that may hire them, banks are reluctant to allow their stock analysts to issue sell recommendations on their stock. The "Chinese walls" that are supposed to guarantee analysts' objectivity by separating them from other parts of their banks are ineffective, and sometimes nonexistent. In some banks, stock analysts who are supposedly working in investors' interests are also expected to work on corporate advisory projects.

This kind of conflict may explain why many analysts continued to recommend Enron's stock just a few days before the company's bankruptcy. In one unfortunate case, Lehman Brothers rated Enron a "strong buy" as it headed toward disaster. It may or may not be coincidental that Lehman was in line to earn a large fee for advising on the takeover of Enron a takeover that fell through partly as a result of falls in Enron's stock price.

A similar conflict of interest plagues audit firms. Auditors are supposed to serve investors by certifying the accuracy of companies' financial statements. But auditors also earn consulting fees when they advise companies on information technology and other management issues. The desire to win consulting contracts may reduce auditors' appetite for dust-ups with companies whose accounts seem suspicious. Enron's auditor, Arthur Andersen, earned $27 million in consulting fees from the company last year - slightly more than the $25 million it got paid to audit Enron's books. At the same time it failed to challenge Enron's habit of hiding some of its dicier business in partnerships that went unreported on the balance sheet.

The conflicts of interest for stockbrokers and auditors, while similar, demand different remedies. Investors themselves are in a position to correct some of the stockbroker problem: They can ignore advice from analysts at the integrated investment banks, and route their business through smaller independent stockbrokers. But the auditor conflicts need to be fixed by regulators at the Securities and Exchange Commission. The commission's last chairman, Arthur Levitt, took a tough line with the auditors; his successor, Harvey Pitt, has struck a softer tone. With luck, Mr. Pitt will now adopt more of his predecessor's outlook. Without objective auditing, there will be more and more Enrons - and more and more investors, lenders and employees who get unfairly burned.

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