```

[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]

 
LESSONS LEARNED FROM ENRON'S COLLAPSE: AUDITING THE ACCOUNTING INDUSTRY
=======================================================================

                                HEARING

                               before the

                    COMMITTEE ON ENERGY AND COMMERCE
                        HOUSE OF REPRESENTATIVES

                      ONE HUNDRED SEVENTH CONGRESS

                             SECOND SESSION
                               __________

                            FEBRUARY 6, 2002
                               __________

                           Serial No. 107-83
                               __________

       Printed for the use of the Committee on Energy and Commerce

 Available via the World Wide Web: http://www.access.gpo.gov/congress/
                                 house
                               __________

                    U.S. GOVERNMENT PRINTING OFFICE
77-986                       WASHINGTON : 2002
____________________________________________________________________________
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                    COMMITTEE ON ENERGY AND COMMERCE

               W.J. ``BILLY'' TAUZIN, Louisiana, Chairman

MICHAEL BILIRAKIS, Florida           JOHN D. DINGELL, Michigan
JOE BARTON, Texas                    HENRY A. WAXMAN, California
FRED UPTON, Michigan                 EDWARD J. MARKEY, Massachusetts
CLIFF STEARNS, Florida               RALPH M. HALL, Texas
PAUL E. GILLMOR, Ohio                RICK BOUCHER, Virginia
JAMES C. GREENWOOD, Pennsylvania     EDOLPHUS TOWNS, New York
CHRISTOPHER COX, California          FRANK PALLONE, Jr., New Jersey
NATHAN DEAL, Georgia                 SHERROD BROWN, Ohio
STEVE LARGENT, Oklahoma              BART GORDON, Tennessee
RICHARD BURR, North Carolina         PETER DEUTSCH, Florida
ED WHITFIELD, Kentucky               BOBBY L. RUSH, Illinois
GREG GANSKE, Iowa                    ANNA G. ESHOO, California
CHARLIE NORWOOD, Georgia             BART STUPAK, Michigan
BARBARA CUBIN, Wyoming               ELIOT L. ENGEL, New York
JOHN SHIMKUS, Illinois               TOM SAWYER, Ohio
HEATHER WILSON, New Mexico           ALBERT R. WYNN, Maryland
JOHN B. SHADEGG, Arizona             GENE GREEN, Texas
CHARLES ``CHIP'' PICKERING,          KAREN McCARTHY, Missouri
Mississippi                          TED STRICKLAND, Ohio
VITO FOSSELLA, New York              DIANA DeGETTE, Colorado
ROY BLUNT, Missouri                  THOMAS M. BARRETT, Wisconsin
TOM DAVIS, Virginia                  BILL LUTHER, Minnesota
ED BRYANT, Tennessee                 LOIS CAPPS, California
ROBERT L. EHRLICH, Jr., Maryland     MICHAEL F. DOYLE, Pennsylvania
STEVE BUYER, Indiana                 CHRISTOPHER JOHN, Louisiana
GEORGE RADANOVICH, California        JANE HARMAN, California
CHARLES F. BASS, New Hampshire
JOSEPH R. PITTS, Pennsylvania
MARY BONO, California
GREG WALDEN, Oregon
LEE TERRY, Nebraska

                  David V. Marventano, Staff Director
                   James D. Barnette, General Counsel
      Reid P.F. Stuntz, Minority Staff Director and Chief Counsel

                                  (ii)

  

                            C O N T E N T S

                               __________
                                                                   Page

Testimony of:
    Chanos, James S., Kynikos Associates, Ltd....................    71
    Dharan, Bala G., Rice University.............................    87
    Lev, Baruch, New York University.............................    96
    Longstreth, Bevis, Debevoise & Plimpton......................   111
    Raber, Roger W., National Association of Corporate Directors.    79
    Sokol, David L., Midamerican Energy Holdings Company.........   122
    Weil, Roman L., University of Chicago........................    82
Material submitted for the record by:
    Chanos, James S., Kynikos Associates, Ltd., letter dated 
      March 8, 2002, enclosing response for the record...........   169
    Tauzin, Hon. W.J. ``Billy'':
        Letter dated February 19, 2002, to Baruch Lev, enclosing 
          questions, and responses to same.......................   165

                                 (iii)

  

LESSONS LEARNED FROM ENRON'S COLLAPSE: AUDITING THE ACCOUNTING INDUSTRY

                              ----------                              

                      WEDNESDAY, FEBRUARY 6, 2002

                          House of Representatives,
                          Committee on Energy and Commerce,
                                                    Washington, DC.
    The committee met, pursuant to notice, at 12:53 p.m., in 
room 345 Cannon House Office Building, Hon. W.J. ``Billy' 
Tauzin (chairman) presiding.
    Members present: Representatives Tauzin, Bilirakis, Barton, 
Stearns, Gillmor, Greenwood, Cox, Deal, Largent, Burr, 
Whitfield, Ganske, Norwood, Shimkus, Shadegg, Pickering, Blunt, 
Davis, Bryant, Ehrlich, Buyer, Radanovich, Bass, Pitts, Walden, 
Terry, Dingell, Waxman, Markey, Hall, Boucher, Towns, Pallone, 
Brown, Gordon, Deutsch, Rush, Eshoo, Stupak, Engel, Sawyer, 
Wynn, Green, McCarthy, DeGette, Barrett, Capps, Doyle, John, 
and Harman.
    Staff present: Jim Barnette, general counsel; David 
Cavicke, majority counsel, Shannon Vildostegui, majority 
counsel; Brian McCullough, majority counsel, Jon Tripp, 
assistant press secretary; Will Carty, legislative clerk, Jill 
Latham, staff assistant; David R. Schooler, minority general 
counsel and deputy staff director; Sue Sheridan, minority 
counsel; Consuela Washington, minority counsel; Candy Butler, 
minority professional staff; Nicole Kenner, minority 
legislative clerk; and Jessica McNiece, minority intern.
    Chairman Tauzin. Let me announce the order of business. We 
will begin opening statements on the full committee hearing 
this morning, but we will suspend and interrupt those opening 
statements as soon as staff informs me that we have a full 
quorum of the committee present to do business. At that point, 
we will introduce a resolution before the full committee with 
the concurrence of the minority, which will authorize the Chair 
with again the concurrence of the minority to issue subpoenas 
in this case as we further need them in our investigation. And 
then we will go back to opening statements and introduce our 
witnesses and finish the hearing.
    The Chair will first recognize himself for an opening 
statement. Today, we're taking the extraordinary step of 
holding a full Energy and Commerce Committee hearing to 
consider some of the most important policy issues that relate 
to Enron's collapse. These issues include corporate governance, 
accounting and governance of the auditing profession and very 
importantly, the health of our energy interest and markets. We 
take this step because of the profoundly troubling things we've 
discovered in the investigation of Enron. Most significantly we 
have learned that first, senior Enron management engaged in 
self-dealing transactions, and second, Enron transacted with 
partnerships controlled by CFO, the Chief Financial Officer, 
Andrew Fastow, his associate, Michael Kopper and others, and 
that Enron appeared to shift the risk of loss on risky 
investments in these partnerships, but in fact, remained fully 
liable for their investments and those risks.
    And third, Enron went ahead and reported fictitious gains 
on these transactions with the LJM and Raptor entities when the 
hedged investments declined in value, and that these gains were 
illusory. The partnerships lacked the economic resources to 
make good on the transactions. The effect of these sham 
transactions was to inflate Enron's publicly reported earnings 
in 1999, 2000 and 2001 significantly by more than $1 billion.
    We have found substantial evidence of illegal activity by 
Enron and its management. And this activity served to deceive 
the public about Enron's financial condition. It artificially 
pumped up Enron's stock price and allowed these same executives 
to enrich themselves with the sales of Enron stock.
    We have also found that Enron's auditor, Andersen, knew or 
should have known or should have discovered the fraudulent 
nature of the Fastow transactions and we have found that 
Enron's financial statements violated numerous existing 
accounting rules. These statements misled investors about 
Enron's financial condition and over-estimated that net income 
by over $1 billion. In the end it turns out that the Enron 
debacle is an old fashioned example of theft by insiders and a 
failure of those responsible for them to prevent that theft. We 
believe this is a huge aberration of corporate behavior in 
America. For example, in one transaction, Fastow and Kopper 
informed the investors in LJM2, a partnership at the center of 
this theft, that the expected rate of return on the transaction 
was 2,503 percent to be realized in just 8 days.
    In each of the so-called Raptor transactions, Fastow 
extracted all of his equity, along with additional fees in the 
tens of millions of dollars before any transactions that 
involved any economic risk took place. In this way, Enron was 
doing business with an entity with only one asset and that was 
Enron's shares that Enron had contributed. This was not a 
hedging transaction. Enron was merely issuing shares and 
calling the issuance earnings. This clearly violated existing 
law and the most basic norms of corporate behavior.
    Enron's Board of Directors, its Finance Committee and its 
Audit Committee failed to exercise due care with respect to 
these transactions and it simply boggles the mind that the 
Chief Financial Officer of a company was allowed to organize 
partnerships and simultaneously take the other side of deals 
with this company. Such an arrangement should never have 
happened and does not ordinarily happen in any corporation that 
I know of in America.
    Additionally, we have learned that the SEC conducted no 
meaningful review of Enron disclosures from 1997 through 2001, 
so before we rush to impose new laws and regulations in the 
wake of the scandal, we want to be sure that we're actually 
enforcing existing law and today, we're going to look at some 
of the broader implications of Enron and what it means for the 
controls and safeguards we have built into our capital raising 
system.
    We'll hear from experts in corporate governance, in 
accounting, in the governance of auditors and we'll hear from 
an energy firm. We'll look at the state of current law and the 
current practice to see if reforms are necessary.
    Now I want to also make some other comments. Next week, 
I've asked the Energy Subcommittee, chaired by Joe Barton to 
suspend action on his energy package, the electricity package, 
until we can thoroughly understand the effect of this Enron 
collapse under the energy markets. And he will conduct a 
hearing next week on that issue.
    I've also asked the chairman of our Commerce, Trade, and 
Consumer Protection Subcommittee, Mr. Stearns to conduct a 
hearing into FASB's Rules, the accounting principles involved 
here and the accounting rules that may need improvement as we 
go forward and learn more from today's hearing and other 
hearings about this important area.
    In short, this hearing today will feed into the hearing 
tomorrow by the Oversight and Investigations Subommittee in 
which we will have the principals whom we are investigating at 
Enron and who may have been responsible for some of this mess 
before us, and into the substantive committees on the Enron 
energy market's effect, as well as the effects on FASB and the 
need for changes in accounting principles or rules or 
governance in this country.
    Today's hearing will give us a chance to look into those 
three areas and to get a clear understanding of what happened 
at Enron, what perhaps ought to be happening in the governance 
of accounting, and what perhaps ought to be happening in terms 
of board memberships and the quality and the capacity of board 
members to serve in America, and finally, the situation in the 
energy markets as a result of the collapse of Enron.
    After the hearing or some time in the middle of the 
hearing, we will conduct the disposition of the resolution 
authorizing subpoenas, and then we will take up our witnesses.
    Let me again, as I've done throughout this process, offer 
my sincere and deep appreciation to the ranking minority member 
of this committee, Mr. Dingell, for his extraordinary 
cooperation and for the fact that this investigation is being 
conducted in such a truly bipartisan fashion. Our joint 
investigators are doing a superb job, not simply for this 
committee, but I think for our country, and again I want to 
thank the ranking member as I recognize him for his opening 
statement.
    Mr. Dingell.
    [The prepared statement of Hon. W.J. ``Billy'' Tauzin 
follows:]
  Prepared Statement of W.J. ``Billy'' Tauzin, Chairman, Committee on 
                          Energy and Commerce
    Today, we are taking the extraordinary step of holding a full 
Energy and Commerce Committee hearing to consider some of the most 
important policy issues raised by Enron's collapse. These issues 
include corporate governance, accounting and governance of the auditing 
profession and the health of our energy markets.
    We take this step, because of the profoundly troubling things we've 
discovered in our investigation of Enron. Most significantly, we've 
learned that:

1. Senior Enron Management engaged in self-dealing transactions.
2. Enron transacted with partnerships controlled by CFO Andrew Fastow, 
        his associate Michael Kopper and others. And that Enron 
        appeared to shift the risk of loss on risky investments to the 
        partnerships, but in fact it remained fully liable for those 
        investments.
3. Enron went ahead and reported fictitious gains on these transactions 
        with the LJM and Raptor entities when the hedged investments 
        declined in value. These gains were illusory; the partnerships 
        lacked the economic resources to make good on the transactions. 
        The effect of these sham transactions was to inflate Enron's 
        publicly reported earnings in 1999, 2000 and 2001 
        significantly--by more than a billion dollars.
    We have found substantial evidence of illegal activity by Enron and 
its management. This activity served to deceive the public about 
Enron's financial condition. It artificially pumped up Enron's stock 
price and allowed these same executives to enrich themselves with sales 
of Enron stock.
    We have also found that Enron's auditor, Andersen, knew or should 
have discovered the fraudulent nature of the Fastow transactions. We 
have found that Enron's financial statements violated numerous existing 
accounting rules. These statements mislead investors about Enron's 
financial condition and overestimated Enron's net income by over $1 
billion.
    In the end, it turns out that the Enron debacle is an old fashion 
example of theft by insiders, and a failure by those responsible for 
them to prevent that theft. For example, in one transaction, Fastow and 
Kopper informed the investors in LJM2--a partnership at the center of 
this theft--that the expected rate of return on the transaction was 
2,503%, to be realized in just eight days.
    In each of the so-called Raptor transactions, Fastow extracted all 
of his equity, along with additional fees in the tens of millions of 
dollars, before any transactions that involved any economic risk took 
place. In this way, Enron was doing business with an entity whose only 
asset was Enron shares that Enron had contributed. This was not a 
hedging transaction; Enron was merely issuing shares and calling the 
issuance earnings.
    This clearly violated existing law and the most basic norms of 
corporate behavior.
    Enron's board of directors, its Finance Committee and Audit 
Committee failed to exercise due care with respect to these 
transactions. It simply boggles the mind that the chief financial 
officer of a company was allowed to organize partnerships and 
simultaneously take the other side of deals with his company. Such an 
arrangement should never have happened.
    Additionally, we have learned that the SEC conducted no meaningful 
review of Enron disclosures from 1997-2001. So before we rush to impose 
new laws and regulations in the wake of this scandal, we will want to 
be sure that we are actually enforcing existing law.
    Today, we are going look at some of the broader implications of 
Enron and what it means for the controls and safeguards we have built 
into our capital-raising system.
    We will hear from experts in corporate governance, accounting, 
governance of auditors and an energy firm. We will look at the state of 
current law and current practice and to see if reforms are necessary.
    In the area of corporate governance, we will examine the proper 
role of a board, and the role of outside directors. We will consider 
what incentives are necessary to get the outside directors to invest 
the time and effort necessary to oversee a company in times of 
difficulty. We will compare that effort to the woeful performance of 
the Enron board.
    In the area of accounting, we will examine existing rules governing 
disclosure of these now notorious Special Purpose Vehicles, the so-
called 3% test, and mark-to-market accounting. We will consider whether 
FASB, which has been considering changes to the rules governing 
accounting for off-balance sheet transactions for the better part of a 
decade, should be encouraged to expedite those changes.
    We will also consider the changes that need to be made in the area 
governance of the accounting profession. We need to restore public 
confidence in the important work performed by the accountants. We also 
need to be certain that adequate regulation of accounting firms is in 
place to encourage them to put investor's interest ahead of getting a 
particular deal done.
    In the vital area of energy policy, we will consider what effect, 
it any, Enron's collapse had on the market for electricity and natural 
gas and its effect on consumers. We will also consider the implications 
for reliability on an ongoing basis and whether prudent regulatory 
changes are called for.
    After this hearing of the full Committee, our bipartisan 
investigation will continue under Subcommittee Chairman Greenwood. 
Importantly, both Subcommittee Chairmen Barton and Stearns will begin a 
more detailed review of the policy implications in these areas and work 
to ensure that there are no future financial calamities of this type.
    I welcome our witnesses, and look forward to their knowledgeable 
testimony.

    Mr. Dingell. Mr. Chairman, I thank you. I commend you for 
this hearing and I join you in the comment you have just made 
about the bipartisan character of this inquiry.
    I commend you for that and I say that we on this side look 
forward to continuing the fine relationship which we have had 
in connection with this investigation. It has been a bipartisan 
investigation and it is something which has been most welcome 
to me and to us over here.
    Mr. Chairman, I want to commend you for scheduling this 
full committee Hearing on the lessons of Enron. A week ago 
today, the Kids Post Page of the Washington Post summed it up 
nicely under the banner headline, ``Greedy Liars, the Enron 
Scandal'', perhaps showing that while figures don't lie, liars 
can figure.
    There was a picture of Enron's CEO, Kay Lay, with the 
caption, ``Did this Man Get Rich . . . '' and a picture of a 
former Enron employee and his wife with the caption, ``. . . 
while These People Got Poor?''
    Then there was a little box at the bottom on the 
accountants with a caption, ``The Watchdog Doesn't Bark.'' In a 
nutshell, these comments accurately sum up what happened here. 
And I join you, Mr. Chairman, in beginning to discuss it.
    Last month, SEC Chairman Harvey Pitt made a profound 
declaration: ``There's nothing rotten in the accounting 
profession.'' This is just plain hooey. There are many honest 
accountants, and there are many fine and honest accounting 
firms. I happen to retain one accountant and accounting firm to 
deal with my affairs and I find them to be completely honest 
and worthy of respect and admiration.
    There are, however, systematic problems with the way the 
profession is governed and compensated, coupled with corrosive 
pressures put on honest auditors to bring in nonaudit business 
at almost any price and to satisfy their clients and employers, 
by coming up with acceptable answers.
    It is almost impossible for many honest people to stand up 
and blow the whistle on management. I held hearings on these 
matters in the late 1980's and early 1990's. The accountants 
said that I was wrong, but now history says they were wrong. 
The accountants promised that they would reform themselves. 
They did not.
    So, Mr. Chairman, we must now do it for them. And in so 
doing we must recognize that this action constitutes protection 
of our entire economic system which functions on facts, truth 
and, most importantly, on the trust of the people.
    Today we start the process of looking broadly at regulatory 
issues. As I said, Mr. Chairman, I welcome this event and I 
commend you for it and I welcome this morning's distinguished 
panel witnesses and I look forward to their testimony and 
guidance.
    I note that amongst others we have before us today a 
witness suggested by the minority, Mr. James Chanos, who 
recently appeared on the cover of Barron's as ``The Guy Who 
Called Enron.'' I ask unanimous consent to include a copy of 
that article in the hearing record.
    Chairman Tauzin. Without objection, so ordered.
    Mr. Dingell. Thank you, Mr. Chairman. Along with a copy of 
Bethany McLean's March 5, 2001, Fortune article entitled, ``Is 
Enron Overpriced?''
    Chairman Tauzin. Without objection, so ordered.
    Mr. Dingell. Apparently, there were red flags waving all 
over Enron's financial statement, if you wanted to see them. 
Was everybody else blind? Why did the accountants not see them 
and if so, why?
    We also have at the minority's request, Mr. Bevis 
Longstreth, who had a distinguished career as an SEC 
Commissioner during the Reagan Administration. He recently 
served 2 years on the O'Malley Panel on Audit Effectiveness 
which reported a number of critical findings and 
recommendations in August 2000 for improving the performance of 
the profession and its governance system.
    All the witnesses are here today because Enron is not 
unique. It is huge. Indeed, the biggest bankruptcy in history, 
but it is not unique. Similar events may well be out there at 
this time, waiting to happen after similar or identical causes 
and reasons.
    The SEC has been reporting in increasingly record numbers 
of financial fraud in cases involving bad accounting. Enron is 
only an exclamation point in a long list of accounting frauds 
that include Waste Management, Sunbeam--and I note that those 
were both matters which were under the trust of, guess who, 
Arthur Andersen--Cendant, Rite Aid, Microstrategy, just to name 
a few. I supported Arthur Levitt's efforts to rein in the abuse 
and I supported FASB's efforts to write tough accounting 
standards. Others saw fit to bully the SEC and FASB on behalf 
of special interests who were opposed to what the regulators 
were trying to do.
    I hope today, Mr. Chairman, that we will all stand 
shoulder-to-shoulder in our resolve to do the right thing by 
the American people and to fix a badly broken system.
    Mr. Chairman, this system smells bad enough for either 
repair or early burial and I suggest that the continued health 
and well-being of our financial system depends upon it.
    Mr. Chairman, I thank you for this recognition and we on 
this side will support the motion on subpoena authority at the 
proper time.
    [The prepared statement of Hon. John D. Dingell follows:]
    Prepared Statement of Hon. John D. Dingell, a Representative in 
                  Congress from the State of Michigan
    Mr. Chairman, I commend you for scheduling this full Committee 
hearing on the lessons of Enron. A week ago today the KidsPost page of 
the Washington Post I think summed it up nicely under the banner 
headline ``Greedy Liars? The Enron Scandal.'' There was a picture of 
Enron CEO Ken Lay with the caption ``Did this man get rich . . .'' and 
a picture of a former Enron employee and his wife with the caption ``. 
. . while these people got poor?'' Then there was a little box at the 
bottom on the accountants with the caption ``The Watchdog Doesn't 
Bark.'' In a nutshell, that pretty accurately sums up what happened 
here, and it's disgusting.
    Last month SEC chairman Harvey Pitt declared: ``There is nothing 
rotten in the accounting profession.'' This is bunk. There are many 
honest accountants--I happen to think that I retain one--and many 
honest accounting firms. But there are systemic problems with the way 
the profession is governed and compensated. Coupled with the corrosive 
pressures put on honest auditors to bring in nonaudit business at 
almost any price, it is almost impossible for honest people to stand up 
and blow the whistle on management. I held hearings on these issues in 
the late '80s and early '90s. The accountants said I was wrong, but we 
now know they were wrong. The accountants promised that they would 
reform themselves. They did not. We will now do it for them.
    Today we start the process of looking broadly at regulatory issues. 
I welcome this morning's distinguished panel of witnesses and I look 
forward to their testimony and guidance. I note that, among others, we 
have before us today a witness suggested by the Minority, Mr. James 
Chanos who appeared on the cover of a recent Barron's issue as ``The 
Guy Who Called Enron.'' I ask unanimous consent to include a copy of 
that article in the hearing record, along with a copy of Bethany 
McLean's March 5, 2001, Fortune article, ``Is Enron Overpriced?'' 
Apparently, there were red flags waving all over Enron's financial 
statements if you wanted to see them. Was everybody else blind? And, if 
so, why?
    We also have, at the Minority's request, Mr. Bevis Longstreth who 
had a distinguished career as an SEC commissioner during the Reagan 
Administration. He recently served two years on the O'Malley Panel on 
Audit Effectiveness which reported a number of critical findings and 
recommendations in August 2000 for improving the performance of the 
profession and its governance system.
    All the witnesses are here today because Enron is not unique. It is 
huge but it is not unique. The SEC has been reporting annually 
increasingly record numbers of financial fraud cases involving bad 
accounting. Enron is the exclamation point in a long list of accounting 
frauds that include Waste Management, Sunbeam, Cendant, Rite Aid, and 
Microstrategy, to name just a few. I supported Arthur Levitt's efforts 
to rein in the abuse, and I supported FASB's efforts to write tough 
accounting standards. Others in the Congress, however, saw fit to bully 
the SEC and FASB on behalf of special interests who were opposed to 
what the regulators were trying to do. I hope today we all stand 
shoulder-to-shoulder in our resolve to do the right thing by the 
American people and fix this badly broken system. The continued health 
and wellbeing of our financial system depends upon it.
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    Chairman Tauzin. I thank my friend for his statement. We 
obviously have a different view of some of that history, but we 
do stand shoulder to shoulder, Mr. Dingell.
    The Chair will now interrupt the opening statements for the 
business meeting of the committee which is the resolution on 
subpoena power.
    [Business meeting.]
    Chairman Tauzin. The Chair will now ask if there are any 
other members who seek recognition first on this side? The 
gentleman from Florida, Mr. Bilirakis, is recognized for 5 
minutes.
    Mr. Bilirakis. Thank you very much, Mr. Chairman. I won't 
take anywhere near that much time. I have no prepared 
statement. I would just merely like to thank you and 
particularly the witnesses for their willingness to come here 
today to give us this broad overview of the implosion, if you 
will, of Enron and what led up to it. I know we're all 
concerned about the lack of confidence and the lack of 
credibility which has suddenly taken place in our minds, 
particularly regarding the accounting industry and the auditing 
industry. Hopefully you gentlemen here today may help us to 
back away from that lack of confidence and credibility so that 
some of the things that we see happening today not only to 
employees, but also in the stock market, will change course.
    I appreciate being here, Mr. Chairman, and again, thank you 
very much.
    Chairman Tauzin. The gentleman yields back his time. Under 
our rules, our members will be recognized for 3 minutes under 
our rules. The Chair asks if there are any members on this side 
seeking recognition. The gentleman from California, the 
gentleman, Mr. Boucher, is recognized for 3 minutes.
    Mr. Boucher. Thank you very much, Mr. Chairman. I want to 
commend you and Ranking Member Dingell for the very thoughtful 
way in which you have handled our committee's investigation 
into the Enron collapse. It is a seismic event. It resulted 
from a total system failure. The safeguards upon which we have 
traditionally relied were inadequate to prevent this collapse 
and to warn that it was coming. Enron's accountants did not 
detect and require reporting of more than $1 billion of 
inflated earnings over a 15-month period as recently revealed 
in the report prepared by the Dean of the University of Texas 
Law School. Banks extended credit without determining the 
corporation's true, financial condition. Stock analysts who 
should have achieved a deeper understanding of the company's 
off the balance sheet liabilities continued to recommend the 
stock.
    Chairman Tauzin. Excuse me, Mr. Boucher. The Chair will ask 
for the cooperation of all the members and guests present. This 
room is cavernous and even small whispers and talk is 
exaggerated here. Let's give the speakers the courtesy of 
listening to them, please.
    Mr. Boucher is recognized to complete his statement.
    Mr. Boucher. Thank you, Mr. Chairman. Stock analysts who 
should have achieved a deeper understanding of the company's 
off the balance sheet liabilities continued to recommend the 
stock as recently as a few months ago. The ERISA law did not 
prevent Enron employees from losing their retirement funds and 
even allowed a freeze on their ability to sell Enron shares in 
their 401(k) accounts while the shares lost value throughout 
the fall and became almost worthless. The corporation's 
directors failed in their duties as representatives of the 
stockholders. They apparently took no actions. They were either 
unaware of the corporation's precarious financial condition or 
complicit in permitting that condition to continue. Either way, 
they failed in their duties. And some company executives who 
had front line responsibility for the financial success of the 
company were making huge profits from the businesses they were 
doing themselves with the company, as the self-serving 
arrangements they created sent Enron on a path to corporate 
collapse.
    This committee's careful investigative work has contributed 
greatly to the public understanding of what went wrong and I 
again commend Chairman Tauzin for his stewardship of that work. 
Many of the events contributing to the failures at Enron are 
within the purview of this committee's legislative 
jurisdiction. Today, we will hear from knowledgeable witnesses 
who will speak to many of these matters from corporate 
governance to the use of derivative financial instruments to 
accounting practices. As we assess the steps that need to be 
taken to assure that other companies do not suffer the same 
fate as Enron.
    I look forward to the examination of those issues and to 
the recommendations of these witnesses and others from whom our 
full committee and various cubcommittees will hear concerning 
appropriate steps for this committee to take.
    Thank you, Mr. Chairman.
    Chairman Tauzin. I thank the gentleman. Further requests 
for opening statements on this side? The gentleman, Mr. Brown 
from Ohio is recognized with 3 minutes for an opening 
statement.
    Mr. Brown. Thank you, Mr. Chairman, for calling this 
hearing and for your dogged investigation of this scandal. We 
all know that Enron was the seventh largest corporation in 
America. We all know that it was the largest energy trading 
company in the world. We all know that the company was a Wall 
Street powerhouse and the darling of the Bush Administration. 
Now we know that Enron is a company predicated on little more 
than greed and deceit. It was no more than a pyramid scheme, a 
company that vastly overstated profits and concealed 
liabilities while using political and financial clout to free 
themselves from accountability, to rig the energy markets in 
their favor, then use their position to ravage consumers, 
investors and employees. Some have called this crony 
capitalism, others Enron conservatism.
    Its fall has had a devastating impact on its employees and 
its retirees, as we know. The Public Pension Fund in my home 
State of Ohio lost $62 million in Enron investments. Florida's 
Public Pension Fund managed by that State's very own Bush 
Administration lost $300 million. One of the Nation's most 
esteemed accounting firms, Arthur Andersen, has also been 
implicated in this scandal.
    We'd be remiss to avoid discussion of Enron's relationship 
with the Bush White House and how that may have influenced the 
Federal response to the company's decline. Before his company's 
spectacular flameout, Ken Lay, the former Chair and CEO of 
Enron, was a close friend of President Bush's, such a close 
friend that he was referred to as Kenny Boy. Kenny Boy had 
unfettered access to the White House and enormous influence 
within the administration. He contacted Curt Hebert, the 
Chairman of the Federal Energy Regulatory Commission and told 
him that if he wanted to keep his job, he would do well to 
bring his thinking into line with Enron's. Mr. Hebert declined. 
He's no longer FERC's Chairman.
    When Vice President Cheney wrote the administration's 
energy plan, he met with Enron officials six separate times. 
He's declined to release information about that.
    While none of us is eager to see a return to the witch hunt 
mentality that surrounded the White Water investigation, we 
should carefully examine the closeness of the relationship 
between the White House and Enron and the impact it's had on 
that company's demise. The President's friends at Fox News and 
elsewhere have assured the American people that because the 
President did not rush to save Enron from failure, that the 
President did nothing wrong.
    But it isn't the administration's lack of action during 
Enron's death throes that concern me most. What concerns me is 
what this administration and its allies on Capitol Hill did 
before Enron's collapse to create a permissive culture, a 
permissive culture for large corporations in America and to 
encourage rapacious behavior at companies like Enron. The Bush 
White House last year called off a Clinton Administration 
initiative to stop money laundering through offshore banks. The 
manipulation of our tax laws through offshore bank accounts and 
partnerships reduced Enron's 5-year tax liability to 
substantially less than zero. In four of the last 5 years Enron 
paid no taxes at all.
    Ironically, on the very same day that we are here 
investigating the spectacular collapse of Enron, we're being 
asked to confirm on the House floor right this minute the 
appropriateness of last year's Bush tax cut plan. Enron and Ken 
Lay were one of the plan's greatest proponents. Instead of 
wasting time affirming a plan that gives billions in tax breaks 
to corporate giants like Enron, $256 million in the tax plan, a 
plan that has, in essence, spent the Nation's surplus, we 
should instead, Mr. Chairman, be worrying--we should worry 
about preventing the collapse of the next Enron.
    I'm hoping that his hearing will be a first step toward 
that goal.
    I thank the chairman.
    [The prepared statement of Hon. Sherrod Brown follows:]
Prepared Statement of Hon. Sherrod Brown, a Representative in Congress 
                         from the State of Ohio
    Good afternoon. Chairman Tauzin, thank you for calling this hearing 
into Enron's collapse, and for your dogged investigation of this 
scandal.
    Less than a year ago, Enron was the seventh largest corporation in 
America and the largest energy trading company in the world. The 
company was a Wall Street powerhouse and a darling of the Bush 
Administration.
    Then a couple of months ago, Enron abruptly declared bankruptcy and 
was exposed as a company predicated on little more than greed and 
deceit.
    Enron was no more than a pyramid scheme--a company that vastly 
overstated profits and concealed liabilities--while using political and 
financial clout to free themselves from accountability, rig the energy 
markets in their favor, and then use their position to ravage consumers 
investors, and employees. This style has been called ``Enron 
conservatism''
    Enron's fall has had a devastating impact on its employees and 
retirees, on its shareholders and customers, and on the confidence many 
Americans have in private equity markets and their government.
    Average workers and investors were cheated out of their life 
savings--while a small group of executives and insiders made off with 
over a billion dollars from well-timed stock sales.
    The public pension fund in my home state of Ohio lost $62 million 
on Enron investments--and Florida's public pension fund--managed by 
that state's very own Bush Administration, lost $306 million.
    One of the nation's most esteemed accounting firms, Arthur 
Andersen, has also been implicated in this scandal--accused of helping 
to conceal its client's deceit.
    Despite internal misgivings about Enron's methods of financial 
reporting, Andersen continued to certify the company's required 
financial disclosures as ``full and accurate.''
    At a time when over 60 percent of Americans own stock, concerns 
about the lack of transparency in financial disclosures--and a lack of 
independence among auditors--has damaged the confidence of the 
investing public.
    The Powers Report, released earlier this week, makes clear that the 
series of complex transactions that brought Enron down were not well-
intentioned deals that went bad. They were deliberate gimmicks created 
to conceal losses and to deceive investors.
    This committee has a responsibility to the American people to 
conduct a comprehensive investigation into the malfeasance of Enron's 
executives, its auditors, and its board of directors.
    And to better protect the thousands of employees and investors who 
have suffered from Enron's untimely and unnatural demise, this 
committee must also ask if the relevant federal agencies did everything 
they could have to protect the public.
    I am confident that we will discharge these responsibilities.
    We would be remiss, however, to avoid discussion of how Enron's 
relationship with the Bush White House may have influenced the federal 
response to the company's decline.
    Before his company's spectacular flame-out, Ken Lay, the former 
Chairman and CEO of Enron was such a close friend of President Bush's 
that the President referred to him as ``Kenny-boy.''
    Kenny-boy had unfettered access to the White House and enormous 
influence within the Administration, and he wielded this influence 
freely.
    At one point last year, Mr. Lay contacted Curt Hebert, the Chairman 
of the Federal Energy Regulatory Commission--the agency that regulated 
much of Enron's business--and told him that if he wanted to keep his 
job he would do well to bring his thinking into line with Enron's.
    Mr. Hebert declined to do so, and is no longer FERC's chairman.
    When Vice-President Cheney ``wrote'' the Administration's energy 
policy, he met with Enron officials six times. Not surprisingly, the 
plan favored the same energy goals that Enron did.
    Since May, the Vice President has refused to turnover the records 
of his meetings with Enron on the grounds that Congress and the GAO 
have no right to this information.
    Vice President Cheney has also said that any similarities between 
Enron's recommendations and the Administration's Energy Plan are just a 
matter of (right-mindedness) like-mindedness.
    In December, columnist Molly Ivins wrote that if Bill Clinton were 
still in the White House--and he were as close to Ken Lay as this 
President is--``we'd have four congressional investigations, three 
special prosecutors, two impeachment inquiries and a partridge in a 
pear tree by now.''
    While none of us is eager to see a return to the witch hunt 
mentality that surrounded the Whitewater investigation, we should 
carefully examine the closeness of the relationship between this White 
House and Enron, and the impact it had on that company's demise.
    The President's friends at Fox News and elsewhere have assured the 
American people that because the President did not rush to save Enron 
from failure that he couldn't have done anything wrong.
    Treasury Secretary Paul O'Neill and Commerce Secretary Don Evans 
have said they were aware of Enron's difficulties before the company 
went bankrupt--and have celebrated their decisions to do nothing on the 
company's behalf.
    Secretary O'Neill even went so far as to say this incident was 
emblematic of ``the genius of capitalism.''
    Tell that to Enron's former employees.
    It isn't the Administration's lack of action during Enron's death 
throes that concern me most.
    What concerns me most is what this Administration and its allies on 
Capitol Hill did before Enron's collapse to create a permissive culture 
for large corporations in America, and to encourage rapacious behavior 
at companies like Enron.
    Last year, the Bush White House called off a Clinton Administration 
initiative to stop money-laundering through offshore banks.
    The manipulation of our tax laws through offshore bank accounts and 
partnerships reduced Enron's five-year tax liability to substantially 
less than zero, and in four of the last five years--Enron paid no taxes 
at all.
    These same activities ultimately led to Enron's implosion, but they 
went unreported by the company's independent auditors--and the 
initiative to prevent this behavior was deemed unnecessary by President 
Bush.
    Ironically--on the very same day that we are here investigating the 
spectacular collapse of Enron we are also being asked to confirm the 
appropriateness of last year's Bush tax cut plan. Enron was one of the 
plan's greatest proponents.
    Instead of wasting time affirming a plan that gives billions in tax 
breaks to corporate giants like Enron--a plan that has helped to 
eliminate the nation's surplus--we should worry about preventing the 
collapse of the next Enron.
    I am hopeful that this hearing will be the first step toward that 
goal.

    Chairman Tauzin. I thank the gentleman. The gentleman's 
time has expired. The Chair would ask if there are other 
members present who want to make a statement. The Chair does 
not see any member present and the Chair will announce that the 
committee will suspend until Mr. Greenwood is in the Chair.
    It's my understanding, Mr. Brown, that we have about 4 
minutes to make this vote, if you have not made it yet.
    So I will patiently wait and see that Mr. Greenwood arrives 
and then I will make the vote.
    Mr. Greenwood [presiding]. The Chair recognizes himself for 
90 minutes for the purpose of an opening statement.
    The captains of American industry in the early 20th century 
were not without serious flaws and yet they also left us a 
remarkable legacy of new ideas, new technologies and in many 
cases enduring enterprises. Simply taking a roll call of some 
of the more illustrious and in some cases notorious of these 
industrialists bears witness to this truth. Henry Ford, John D. 
Rockefeller, Andrew Carnegie, John and Horace Dodge, George 
Westinghouse, Henry Firestone, Thomas Edison, George Eastman 
and Henry Heinz. What they built, they built to last. But in 
many ways, they were also rapacious and grasping men whose 
monopolistic tendencies trampled on the legitimate rights of 
smaller businesses, threatening free enterprise and the birth 
of new technologies.
    The first Republican President of the 20th century, 
Theodore Roosevelt, rightly called them malefactors of great 
wealth. But for all their faults, it was the wealth they 
themselves had created. It is not clear that even this much can 
be said of the authors of the Enron debacle. If they were 
malefactors of wealth, it appears it was largely the wealth of 
many unsuspecting others and in this reckless enterprise they 
were enabled and empowered, if not openly encouraged, by the 
accountants who were supposed to serve as watchdogs, sadly, at 
the time investors failed to notice these watchdogs' peculiar 
behavior. They did not bark.
    Perhaps our witnesses today are familiar with the demand 
that Cuba Gooding, Jr.'s character makes in the movie, Jerry 
MaGuire, ``show me the money.'' Surely this is the question 
Enron's shareholders are asking from the pension fund in my own 
Commonwealth of Pennsylvania, to the President's mother-in-law, 
nearly all those who had invested in this darling of Wall 
Street, got hurt.
    Winston Churchill once observed that some people regard 
private enterprise as if it were a predatory tiger to be shot. 
Others look upon it as a cow that they can milk. Only a handful 
sees it for what it really is, the strong horse that pulls the 
whole cart. How surprised he would have been to discover that 
the system of free enterprise for honest profit which lies at 
the core of our Republic's greatness and success was assaulted 
not by its enemies, but by those who profess the greatest 
allegiance to it. This was perhaps their greatest betrayal.
    For the triumph of free markets and the wealth they create, 
depend on the confidence of the investor, more and more of whom 
are average Americans. In 1960, only 18 percent of American 
households had any investments in the stock market. By 1999, 
that number was nearly 50 percent. And here we get to the heart 
of the matter, for all their vaunted talk of aggressive 
accounting, an oxymoron that would be amusing if it had not led 
to such terrible consequences. Their failure is about so much 
more than money lost or money gained. These were men who in the 
single minded pursuit of personal wealth apparently jettisoned 
any shred of personal morals or business ethics and replaced 
them with the morals of a dealer in a game of Three Card Monte. 
The antidote to this behavior is not difficult to find. In 1913 
in a thoughtful essay on the lessons of history and free 
enterprise, former President Theodore Roosevelt wrote this, 
``First and foremost, we must stand firmly on a basis of good, 
sound ethics. We intend to do what is right for the ample and 
sufficient reason that it is right.'' He then continued with 
these prophetic words. ``If business is hurt by the stern 
exposure of crookedness and the result of efforts to punish the 
crooked man, then business must be hurt, even though good men 
are involved in the hurting.'' In this matter, too, the 
reputations of many who sought to do their best will be 
swallowed up in the bad dealings of the few. Sadly, this too is 
part of the unfolding Enron tragedy.
    The Chair recognizes the gentlelady from California, Ms. 
Eshoo.
    [The prepared statement of Hon. James Greenwood follows:]
 Prepared Statement of Hon. James Greenwood, Chairman, Subcommittee on 
                      Oversight and Investigations
    The captains of American industry in the early 20th century were 
not without serious flaws. And yet they also left us a remarkable 
legacy of new ideas, new technologies and in many cases enduring 
enterprises. Simply taking a roll call of some of the more illustrious, 
and in some cases, notorious, of these industrialists bears witness to 
this truth.
    Henry Ford, John D. Rockefeller, Andrew Carnegie, John and Horace 
Dodge, George Westinghouse, Henry Firestone, Thomas Edison, George 
Eastman, and Henry Heinz . . . what they built, they built to last.
    But, in many ways, they were also rapacious and grasping men, who's 
monopolistic tendencies trampled on the legitimate rights of smaller 
businesses, threatening free enterprise and the birth of new 
technologies.
    The first Republican president of the 20th century, Theodore 
Roosevelt, rightly called them malefactors of great weatlh. But for all 
their faults, it was the wealth they themselves had created.
    It is not clear that even this much can be said of the authors of 
the Enron debacle. If they were malefactors of wealth, it appears it 
was largely the wealth of many unsuspecting others.
    And in this reckless enterprise they were enabled and empowered, if 
not openly encouraged, by the accountants who were there to serve as 
watchdogs. Sadly, at the time, investors failed notice their peculiar 
behavior--they did not bark.
    Perhaps our witnesses today are familiar with the demand that Cuba 
Gooding Jr's character makes in the movie Jerry McGuire. ``Show Me the 
Money''?
    Surely this is the question Enron's shareholders are asking. From 
the pension fund in my own Commonwealth of Pennsylvania to the 
President's mother-in-law, nearly all those who had invested in this 
``darling of Wall Street'' got hurt.
    Winston Churchill once observed that, some people regard, ``private 
enterprise as if it were a predatory tiger to be shot. Others look upon 
it as a cow that they can milk. Only a handful sees it for what it 
really is--the strong horse that pulls the whole cart.''
    How surprised he would have been to discover that the system of 
free enterprise for honest profit--which lies at the core of the 
Republic's greatness and success--was assaulted not by its enemies, but 
by those who professed the greatest allegience to it.
    This was their greatest betrayal.
    For the triumph of free markets and the wealth they create, depend 
on the confidence of the investor . . . more and more of whom are 
average Americans. in 1960, for example only 18% of American households 
had any investment in the stock market. By 1999, that number was nearly 
50%.
    And here we get to the heart of the matter. For all their vaunted 
talk of aggressive accounting, an oximoron that would be amusing if it 
had not led to such terrible consequences, their failure is about so 
much more than money lost or money gained.
    These were men who, in the singleminded pursuit of personal wealth, 
aparently jettisoned any shred of personal morals or business ethics.
    And replaced them with the morals of the dealer in a game of three-
card monte.
    The antitote to this behavior is not difficult to find. In 1913, in 
a thoughtful essay on the lessons of history and free enterprise, 
former President Theodore Roosevelt wrote this: ``First and foremost, 
we must stand firmly on a basis of good sound ethics. We intend to do 
what is right for the ample and sufficient reason that it is right.''
    He then continued with these prophetic words ``If business is hurt 
by the stern exposure of crookedness and the result of efforts to 
punish the crooked man, then business must be hurt, even though good 
men are involved in the hurting . . .''. In this matter too, the 
reputations of many who sought to do their best, will be swallowed up 
in the bad dealings of the few.
    Sadly, this too is part of the unfolding Enron tragedy.

    Ms. Eshoo. Thank you, Mr. Chairman. I appreciate the 
thoughtful comments that you have made since this issue has 
imploded and I have confidence that what you will do as Chair 
of the Oversight and Investigations Subcommittee is going to 
cast more light and help the Congress come to grips with what 
needs to be done relative to Enron, the abuses that are now 
known, and the areas where we need to make reforms.
    As a member of California's Congressional Delegation, I 
have a very special interest in this issue of Enron and what 
went wrong, as do my constituents and as do all Californians. 
As early as November of 2000, the Federal Energy Regulatory 
Commission, FERC, declared that consumers in California had 
been and were paying ``unjust and unreasonable rates'' yet 
nothing substantive was done about it. Some estimate that the 
gouging amounted to hundreds of millions of dollars, perhaps a 
billion. The California's ISO says it was in the ballpark of $9 
billion.
    When the 107th Congress convened in January of 2001, a year 
ago, I introduced bipartisan legislation that allowed the 
Secretary of Energy to control price gouging. In the following 
months, I called for hearings. I called on the Attorney General 
to investigate. I introduced legislation that would have 
imposed cost of service based pricing. I introduced bipartisan 
legislation to provide refunds to consumers. Enron and the rest 
of the industry in opposition said that these calls should go 
unheeded. And the process then became politicized.
    So in this hearing and in other hearings, we're not only 
going to examine what went wrong inside, what did Enron do 
wrong inside and anyone, the professions included, that were 
associated with them, but also I think a worthy area of 
exploration is what they did wrong to others.
    I believe that if the Congress had heeded the call of many 
of us on this very committee, on this issue, that we could have 
cast light on some of the wrongdoing of Enron at the time. 
Californians paid. Other people's pockets were lined. 
Californians paid as did shareholders and Enron's employees. So 
this is tragic not only in the fall of supposedly the seventh 
largest corporation in the country, but what they imposed in 
terms of policy, in terms of their lobbying, in terms of public 
policy and what was left unheeded, including the calls that 
some of us made right here in this Energy and Commerce 
Committee.
    So I look forward to being part of the solution. We know we 
have to have campaign finance reform. We know that we need to 
have reforms relative to the accounting industry. We know that 
we have to have reforms relative to the Securities and Exchange 
Commission, but I also think that it is worthwhile, very 
worthwhile in terms of my constituents and Californians to 
place on the record today that some of us were on to this a 
long time ago. It went unheeded. It's high time that the 
Congress come to grips with it.
    Thank you, Mr. Chairman. And I yield back any balance of my 
time.
    [The prepared statement of Hon. Anna Eshoo follows:]
Prepared Statement of Hon. Anna G. Eshoo, a Representative in Congress 
                      from the State of California
    Thank you, Mr. Chairman.
    As a member of California's Congressional delegation, I have a 
special interest in these hearings. Enron and other energy marketers, 
generators and gas suppliers gouged the people of California and my 
district for more than a year.
    According to Administrative Law Judge Curtis Wagner, consumers in 
California were gouged by ``hundreds of millions of dollars, probably 
more than a billion in aggregate sum'' (Report and Recommendation of 
Chief Judge and Certification of Record, Federal Energy Regulatory 
Commission, July 12, 2001). I think this is a rather conservative 
estimate. According to the California Independent System Operator, the 
sum was closer to $9 billion. One day my constituents may recover a 
portion of these overcharges, but I have my doubts and Enron's collapse 
certainly does not help this effort.
    The fact is that Enron and its business go to the heart of the 
gouging and its collapse.
    What was Enron's business? While all Americans know that Ford and 
GM make cars, I doubt many people could explain what Enron, seventh on 
the Fortune 500, actually did. Enron was an energy company that really 
didn't produce or distribute energy. Instead, it acted as a middleman, 
making deals between producers and users. These were paper transactions 
that added no value to the product it sold. It was corporate alchemy; 
it was like producing gold from straw. Maybe this explains why other 
participants in the electricity market didn't suffer after Enron 
collapsed and why the industry doesn't seem to miss the company today.
    Perhaps Enron's mysterious business explains why some call Enron's 
glass-walled headquarters in Houston ``the Black Box''--a more apt name 
might be Oz. By stretching and breaking complex accounting rules, Enron 
wove a mystical shroud. The mystery of what lay behind that curtain 
made Enron even more appealing to investors, as did its majestic 
profits.
    Many Congressional committees, including this one, have focused on 
Enron's corporate structure and governance and acts of malfeasance that 
allowed Enron to convert debt for profit whenever it wished. However, 
it seems that nobody is asking questions about the transactions between 
Enron and its clients. It seems to me that the same creative minds that 
created Chewco, one of Enron's corporate shells, might also have one or 
two tricks to raise artificially the price of electricity in the West. 
I hope this Committee and other investigators will be looking at these 
activities and transactions.
    Last March I called upon Attorney General Ashcroft to look into the 
pricing practices of Enron and other energy companies operating in the 
West. At that time, massive amounts of electricity were being withheld 
from the market, and wholesale energy costs rose by as much as 1,000%. 
Yet to my knowledge, the Department of Justice did not investigate. As 
the DOJ and Committees conduct a postmortem of Enron, the company's 
day-to-day business operations must be examined. I've called on just 
written to Deputy Attorney General Larry D. Thompson (who has taken 
over the oversight of the Enron investigation following Attorney 
General Ashcroft's recusal) to explore fully this line of inquiry.
    But accounting is only part of the Enron story. While Enron 
exploited the complexity of accounting rules to manufacture profits, it 
also tried to exploit its political connections to create a business 
environment--an environment without rules--in which it could thrive. To 
do this, Enron greased the wheels with millions in campaign 
contributions to both parties. That bought access and arguably more.
    In interviews for the television program Frontline last year, 
former Enron CEO Kenneth Lay acknowledged that he provided the 
Administration with a list of Enron-favored nominees for the Federal 
Energy Regulatory Commission (FERC). He also acknowledged that he and 
Enron executives interviewed potential nominees to judge their 
suitability.
    This was Ken Lay's casting couch, and a candidate's suitability was 
judged by how likely he or she was to agree with Enron's view of how 
the energy market should operate. Several news reports indicate that 
Mr. Lay's top choices for FERC were accepted by the Administration. 
These reports are extremely disturbing.
    Citing potential bias, this Administration broke with a half-
century tradition begun by President Eisenhower when it decided to 
refuse independent advice from the American Bar Association about the 
professional qualifications of potential nominees to the federal bench. 
But, the Administration seemed more than willing to accept the same 
kind of advice from Enron in the selection of the regulators who are 
charged with overseeing the company.
    Mr. Lay was not only lobbying the White House. He attempted to 
influence FERC directly. Mr. Lay himself called then-FERC Chairman 
Curtis Hebert to discuss issues of policy and to talk about whether the 
President would retain Mr. Hebert as the Chairman of the Commission.
    Mr. Hbert described these conversations as unusual, noting that he 
never had similar conversations with other industry chief executives. 
In the end, Mr. Hbert resigned from FERC after Vice President Cheney 
told reporters that Patrick Wood would replace him as Chairman.
    In an interview for Frontline in 2001, Mr. Hebert was told, ``Our 
sources tell us that he [Mr. Lay] offered to talk to the President on 
your behalf if you would go along with what he wanted [open access to 
wholesale and retail markets].'' Mr. Hebert responded, ``I don't think 
there's any doubt he would be a much stronger supporter of mine if I--
were willing to do what he wanted.''
    Perhaps this heavy lobbying didn't amount to anything, but I think 
we're beyond accepting ``trust me'' as an answer when it comes to 
matters involving Enron. The Administration must be more forthcoming 
about its dealings with Mr. Lay and his company.
    Mr. Chairman, the collapse of Enron is a tragedy for the company's 
employees and an embarrassment for the energy and accounting 
industries. It's obvious that Congress must legislate a number of 
reforms. Chief among these are campaign finance reform, pension reform, 
and accounting reform.
    What we should not do is enact legislation that fundamentally 
restructures the electricity market until we have all the answers about 
Enron. California made a huge mistake in hastily adopting a 
restructuring bill in 1996. We should not make a similar mistake in 
Congress.
    Mr. Chairman, thank you, for holding this Committee hearing on 
Enron. I hope that along with today's examinations that you call a 
Committee hearing on the role of Enron in electricity pricing and 
practices.

    Mr. Greenwood. The Chair thanks the gentlelady and 
recognizes the gentleman from Florida, Mr. Stearns for 3 
minutes for an opening statement.
    Mr. Stearns. Thank you, Mr. Chairman, and let me just say 
that--commend you and the staff for all the hard work you're 
doing on the Oversight Committee on which I serve. I ask by 
unanimous consent that my complete opening statement be part of 
the record.
    Mr. Greenwood. Without objection, the gentleman's statement 
will be entered into the record.
    Mr. Stearns. And also, Mr. Chairman, as chairman of my 
Subcommittee on Commerce, Trade, and Consumer Protection, I 
wrote to the Financial Accounting Standards Board shortly after 
this fiasco, this debacle and I asked in that letter that they 
answer some questions and they wrote back to me on December 18, 
2001 and I ask unanimous consent that the reply by the 
Financial Accounting Standards Board President be made part of 
the record.
    Mr. Greenwood. Without objection, that document will be 
entered into the record.
    Mr. Stearns. Mr. Chairman, what we have seen so far is that 
Enron's collapse was a result of a complete failure and 
meltdown of fundamental responsibilities and oversight and 
thereby allowing what appears to be unscrupulous Enron 
executives, the opportunity to reap fortunes on questionable 
transactions, ultimately draining the retirement security of 
thousands of employees and investors. Professor Dharan of Rice 
University appearing before us today, directly states that 
``Enron's collapse may be the biggest case of security fraud.'' 
I believe he may be the first witness before the committee to 
unequivocally state what many have been surmising over the past 
few months, especially with more Enron executives invoking the 
fifth amendment. So perhaps we're just scratching the surface 
here, the complexity is very astounding. We've heard the term 
aggressive accounting. Accounting isn't just math. It also 
means making judgment calls about what the rules allow. 
Aggressive accounting isn't illegal, but it should be when it 
tells investors that red is black and so we hear the term 
aggressive accounting or cutting edge accounting to justify 
Enron's pursuit of these partnerships and Arthur Andersen has 
also used those terms. But I think we need to get beyond the 
rhetoric here and get to what standards are adequate. Is the 
private sector handling enforcement of these standards 
properly? Are these standards in line with economic innovation 
or is the accounting industry lagging behind with new rules?
    In regards to Enron's practices, Paul Brown, Chairman of 
the Accounting Department of New York University, has been 
quoted as saying, ``It's the old adage of a FASB rule, it takes 
4 years to write it, and it takes 4 minutes for an astute 
investment banker to get around it.'' And that is not right. So 
Mr. Chairman, I look forward to the hearing and again, I 
compliment the staff for their developing this hearing and 
others. I yield back.
    Chairman Tauzin. I thank the gentleman. Is there anyone 
from this side? The gentleman from California, Mr. Waxman is 
recognized for 3 minutes.
    Mr. Waxman. Mr. Chairman, thank you for holding this 
hearing and for your efforts to get to the bottom of the Enron 
scandal. Our committee has a proud history of oversight and the 
investigation you and Representative Dingell are leading is in 
keeping with that tradition. A small group of executives have 
robbed thousands of American families of their financial 
security and we are holding these hearings to find out who did 
it and how they did it. But I don't think we can just look at 
Enron and Arthur Andersen and stop there. We also have to look 
at ourselves. When I've said that before, others have accused 
me of playing a partisan blame game that would divert attention 
from other issues. I couldn't disagree more.
    To prevent future Enrons we have to understand how Ken Lay 
and other executives operated in the political system. We need 
to know how they acquired political influence and how they 
asserted the power they accumulated.
    We must, of course, scrutinize Enron and Arthur Andersen. 
We have to scrutinize the regulators and we should scrutinize 
how Enron and Arthur Andersen exploited the political system. 
And even though I believe we must look at both parties, some of 
my Republican colleagues have told me that I'm being partisan. 
Now that we have a Republican President and a Republican House, 
I'm told that it's wrong to raise these issues and in doing so 
will only feed public cynicism. I don't buy that. We can't sit 
here sanctimoniously and browbeat Enron and Arthur Andersen 
executives and question every decision they made if we're not 
willing to give the same scrutiny to ourselves, to the Clinton 
Administration and to the Bush Administration. And if we don't 
examine how the political system broken down, the public will 
see through us and that, in truth, will only deepen cynicism.
    Washington created the regulatory environment that allowed 
Enron executives to steal from thousands of families and Arthur 
Andersen auditors looked the other way and we in the Congress 
need to examine how that happened.
    The Enron scandal is a searing indictment of a business 
culture that values stock prices over honesty and integrity and 
it elevates fictional performance over actual productivity. The 
Enron scandal is also an indictment of an accounting profession 
that has lost its way in values, profits and new business 
opportunities over honoring the public trust, and the Enron 
scandal is an indictment of a political system that allowed 
this calamity to happen.
    Arthur Levitt's sensible accounting reform proposals didn't 
die an accidental death. They were a victim of the political 
system and it was that same system that allowed derivatives to 
go unregulated.
    Last year, Enron was the most politically powerful company 
in Washington. Even as its foundation was rotting away, it was 
able to influence energy policy in a number of areas. It's 
leader, Ken Lay was able to screen potential FERC Commissioners 
and lead a successful House effort to retroactively repeal the 
corporate minimum tax which would have brought Enron $254 
million. We owe it to all the victims and their children to 
hold Enron accountable. We owe it to them to hold Arthur 
Andersen responsible, and we owe it to them to hold ourselves 
accountable as well.
    Chairman Tauzin. The Chair thanks the gentleman. Further 
requests for statements on this side? The gentleman, Mr. Ganske 
from Iowa, is recognized for 3 minutes.
    Mr. Ganske. Thank you, Mr. Chairman. I'll be brief. Mr. 
Chairman, I am a Star Wars fan, a story about the triumph of 
good over evil. So I think it was sort of hypocritical when 
Enron subsidiaries had names out of Star Wars like Jedi and 
Chewco. Well, Mr. Chairman, today Mr. Ken Lay is looking like 
Darth Vader and Enron like the Death Star to investors and all 
those company employees who have had their pensions evaporated.
    The auditor should have been the real Jedi, policing evil 
doings. Instead, it appears like they were the bounty hunter, 
Boba Fett, doing the bidding of the evil empire.
    Mr. Chairman, let us use our light sabers to cut to the 
quick of this galactic scandal. May we have the wisdom of Yoda 
to fix whatever accounting and pension laws needs strengthening 
in order to protect the innocent, punish the greedy and prevent 
clone wars in other companies like we've seen in Enron. I yield 
back, Mr. Chairman.
    Chairman Tauzin. May the force be with you.
    I thank the gentleman for his statement. Further requests 
on this side? The gentleman, Mr. Green from Texas, is 
recognized for 3 minutes.
    Mr. Green. Thank you, Mr. Chairman, and I appreciate you 
calling not only this hearing today, but the efforts of the 
full committee and the subcommittee to explore the 
circumstances surrounding the collapse of Enron.
    As the only member of the Commerce Committee from Houston, 
I'm angered by the continuing disclosures of financial 
wrongdoing by the company. Enron was the largest company in 
Houston, employing over 20,000 Houstonians and helped make our 
city the energy capital of the world. Enron's position in our 
community and around the world has been permanently and 
probably irreparably damaged by the shenanigans of a few. Enron 
is now the buzz word for financial funny business. Enron's Ken 
Lay, Jeff Skilling and Andrew Fastow are all household names 
known for this financial funny business. They used Enron like a 
giant Monopoly game to enrich both themselves and their friends 
at the expense of their shareholders and employees and they 
were not able to accomplish this historic meltdown alone. They 
had the help from Arthur Andersen, the New York banking 
community, even their own legal counsel. Together, these 
entities were either blinded by the green of Enron's billions 
or just simply incompetent and allowed Enron to fool everyone.
    So what have we learned about this tragedy? We need 
stronger accounting standards, better corporate financial 
disclosure and more Federal oversight by the Securities and 
Exchange Commission. Congress needs to take a hard look at 
forcing companies to file bankruptcy in the community or the 
State at least where their corporate headquarters reside. Enron 
made a corporate decision to file bankruptcy in New York which 
is a great deal, a long way away from small creditors and 
former employees to be able to address the bankruptcy. Enron 
was allowed to walk through loopholes in the law and conduct 
their illegal business practices. They used business practices 
which should be rarely used and created hundreds of off-the-
book partnerships which enriched a few at the expense of the 
many. These holes need to be patched. Apart from these changes, 
I do want to take a minute and highlight what I believe has 
been one of the positive actions resulting from the collapse, 
probably the only positive action. Houston's remaining energy 
trading companies were able to weather the storm and I want my 
colleagues to understand that Enron is a unique case and not 
the model for the energy community.
    Enron's entire trading business was efficiently absorbed by 
competitors without any interruption of service to their 
consumers. In addition, the demise of Enron has created more 
competition in the sector which will benefit consumers with 
lower energy prices.
    Mr. Chairman, I want to thank you again for your hard work 
on the issue and I'm looking forward to continuing this process 
in the future. The people of Houston, the stockholders and the 
current and former employees deserve a clear answer to what 
happened here and to see that those responsible are held 
accountable and that we pass legislation to prevent these type 
of scams in the future and thank you again. I yield back my 
time.
    [The prepared statement of Hon. Gene Green follows:]
  Prepared Statement of Hon. Gene Green, a Representative in Congress 
                        from the State of Texas
    Mr. Chairman: I want to commend you for calling this important 
hearing today, and I again appreciate the opportunity to participate 
with the Subcommittee.
    I believe today will be our first real chance to receive firsthand 
information about what truly went on at Enron.
    Let me begin by saying that I am pleased Mr. Skilling has decided 
to come forward and give the American people some insight into the 
inner workings of Enron and Enron's off-book partnerships.
    I am truly disappointed that the rest of Enron's ``Masters of the 
Universe'' crowd failed to come forward and instead chose to exercise 
behind the Fifth Amendment.
    While no American can be forced to testify against his or her will, 
I believe failing to provide answers to the Subcommittee is an 
indication that the witnesses are trying to hide and obscure their 
roles in this debacle.
    The Powers Report that this Subcommittee received over the weekend 
outlined a pattern of malfeasance that spread from the Board of 
Directors, through the upper management and finally to the auditors and 
outside legal counsel.
    The Board of Directors, Arthur Andersen, and Vinson & Elkins 
provided the enabling ability to Ken Lay, Jeffrey Skilling, and Andrew 
Fastow to manipulate the financial records of this once great company.
    Along the way, each of these individuals began to see themselves as 
a new Rockefeller or J.P Morgan of the 21st century.
    In reality, the upper management of Enron turned out to be only 
pretenders.
    Their accomplishments were based on smoke and mirrors and their 
accomplishments did not rival those of our country's greatest 
industrialists.
    However, their accomplishments do bare a striking similarity to a 
group of infamous financiers.
    Ken Lay, Jeffrey Skilling and Andrew Fastow are now in the same 
league as Ivan Boesky, Michael Milken, and the true inventor of the 
complicated Rube Goldberg.
    Mr. Chairman, I look forward to hearing from this witness panel, 
and I again want to thank you for allowing me to participate here 
today.

    Chairman Tauzin. I thank my friend. The Chair asks if any 
members on this side--the gentleman, Mr. Shimkus, is recognized 
for 3 minutes.
    Mr. Shimkus. Thank you, Mr. Chairman, and I'll be brief. 
Along with my good friend, Gene Green from Texas, I room with 
Kevin Brady who's also really been involved with this for his 
constituents and he's fighting a good fight and I appreciate 
the lessons he's told me, about his neighbors and the problems 
that they've fallen into.
    As you said in your opening statement, this is old 
fashioned theft by insiders. We need to make sure we have 
things in place to protect our folks. That's why the subpoena 
power is so important and I'm glad we did that as a first order 
of business. I ask unanimous consent that my additional 
comments be submitted in the record and I look forward to the 
hearing and I yield back my time.
    [The prepared statement of Hon. John Shimkus follows:]
 Prepared Statement of Hon. John Shimkus, a Representative in Congress 
                       from the State of Illinois
    Thank you Mr. Chairman for holding this hearing today. I am looking 
forward to hearing from the witnesses on their take of what exactly has 
happened here and what can be done to prevent it from happening again 
in the future.
    This hearing should focus on the accounting problems that occurred 
in the Enron collapse, because that is what falls under the 
jurisdiction of Committee. Congress may need to address possible 
changes in accounting laws and any loopholes that need to be closed 
regarding allowing accountants to also perform auditing functions. I am 
happy to hear that Chairman Tauzin has stated that the Committee will 
be holding future hearings on the Financial Accounting Standards Board.
    Aside from Enron, accounting concerns are being raised about other 
recent bankruptcies, including Kmart and Global Crossing, where 
insiders sold $1.3 billion in stock in the years prior to the 
bankruptcy.
    So much in fact that accounting firms are looking at ways to change 
their business structure. PricewaterhouseCooper and Deloitte & Touche 
both have recently announced that they will spin off their consulting 
businesses.
    The Illinois Department of Regulation has been investigating Arthur 
Andersen since before the Enron collapse over its business practices. 
Andersen was the auditor for Waste Management in 1998, when the company 
admitted that it had overstated its earnings by more than $1.4 billion.
    The Committee also needs to look into the role of the states. 
Accountants are regulated in every state and many state regulators are 
believed to be looking at Andersen. Connecticut, for example, has taken 
steps that officials there say could lead to Andersen being banned from 
doing business in that state. These state investigations are in 
addition to federal probes being conducted by the Justice Department 
and the Securities and Exchange Commission.
    One question that was asked in a hearing yesterday needs to be 
answered. Were Andersen's accountants and consultants involved in the 
complex deal by which Enron bought out its JEDI partnership by creating 
a new one called Chewco--one of the off-balance-sheet deals that 
greatly contributed to Enron's collapse?
    Mr. Chairman, thank you for holding this hearing and I yield back 
the balance of my time.

    Chairman Tauzin. I thank my friend. Members on this side? 
The gentleman from Ohio, Mr. Sawyer, I think has sought 
recognition.
    Mr. Sawyer. Thank you, Mr. Chairman, and thank you for your 
work with our ranking member, Mr. Dingell, to bring this 
opportunity before us today. The collapse of Enron is really 
almost inconceivable in its magnitude and its suddenness. It's 
like a mighty edifice now fallen that seems to have disappeared 
like a column of smoke. It is an extraordinary event. The 
nature and scope of this company's collapse is both multi-
faceted and complex, but in the end, I have the sense that this 
is really a case about disclosure.
    Our Federal securities' laws are there to protect 
shareholders, investors, not officers, not directors, not the 
companies' bottom line and it's designed to work through a 
system, yes, grounded in trust, but based on transparency, 
transparency through disclosure of relevant financial 
information. This framework is designed so that employees, 
shareholders and prospective investors could make sound and 
informed decisions about how they invest their money. In this 
case, where they were dealing with energy derivatives rather 
than securities, we simply didn't have that disclosure. For 
nearly a decade these complex, financial transactions escaped 
regulatory review and were exempt from the same disclosure and 
reporting requirements that their securities counterparts were 
subject to from the beginning. It seems to me that at its base 
that is what we must change.
    Enron's bankruptcy has triggered visceral responses in all 
of us. We're dismayed that this could have happened and more 
importantly, we must ask ourselves if it could happen again.
    In the end, it's our role to ensure that it does not. And 
as tragic as this incident has been for our Nation and 
particularly for the thousands of Enron employees, it does 
raise important public policy questions for us to address. 
That's our job here today and in order to get on with it, I'm 
going to yield back the balance of my time, Mr. Chairman.
    [The prepared statement of Hon. Thomas C. Sawyer follows:]
Prepared Statement of Hon. Tom C. Sawyer, a Representative in Congress 
                         from the State of Ohio
    Good morning Mr. Chairman, Mr. Dingell.
    First, I would like thank you for the opportunity to be here today 
to address an issue of such importance to our nation. Mr. Chairman, I 
am grateful for both your leadership and insight in bringing this issue 
before the Committee.
    The collapse of Enron--only one year ago--the seventh largest 
company in the world, a leader in energy trading and distribution, is 
almost inconceivable to us as we sit here today. It illustrates to all 
of us the vulnerability of American corporations--even the most 
seemingly solid--and the importance of government oversight to ensure 
that employees, shareholders and the American public receive adequate 
information upon which to make their investment decisions.
    To ensure that employees have some degree of protection when it 
comes to their retirement and life savings.
    The nature and scope of this company's collapse is both multi-
faceted and complex. It involves myriad issues such as: the degree of 
regulation the federal government should assume over complex financial 
arrangements, the role that accounting firms play with the corporate 
clients they audit, and the degree to which we oversee 401(k) 
retirement plans.
    In my opinion, this is a case about disclosure. The purpose of our 
federal securities laws, enacted in 1933 and 1934, is to protect 
shareholders--not officers--not directors--and not the company's bottom 
line. Our federal securities laws protect shareholders through a system 
that is based on disclosure--disclosure of all relevant financial 
information that a rational investor would use to assess the status of 
a company. We set up this framework so that employees, shareholders, 
and prospective investors could make sound decisions about how they 
invest their money.
    In this case, where we were dealing with ``energy derivatives'' 
rather than ``securities'', we simply did not have that disclosure. For 
nearly a decade, these complex financial transactions escaped 
regulatory purview and were exempt from the same the disclosure and 
reporting requirements their securities counterparts were subject to 
from the beginning. This is what we must change.
    It is not our role as members of Congress to legislate the nature 
of business transactions or the degree of risk that a company--or its 
investors for that matter--should assume. It is not our role to tell 
employees which funds to invest their retirement dollars or the degree 
of diversification that is necessary. However, we can, as members of 
Congress, set parameters. We can set the framework--so that employee 
pensions and 401(k) plans are protected and investors and employees are 
given clear and accurate information about a company's financial 
performance. It is our role set guidelines for auditors--to ensure that 
they are free from the inherent conflict of interest associated with 
both auditing and consulting for a client at the same time.
    Enron's filing for bankruptcy has triggered visceral responses in 
all of us. We wonder how this could happened--and more importantly, if 
it could happen again. It is our role to ensure that it does not happen 
again. And, as tragic as this incident has been for our nation, and 
particularly for the thousands of Enron employees, it does raise 
important public policy issues for us to address:

 Is it necessary for there to be some federal oversight of 
        ``energy derivatives''? And, if so, who is the most logical 
        body to oversee these transactions?
 What the scope of the auditors' role with their clients? 
        Should accounting firms be restricted from providing 
        information technology and ``other consulting services'' to the 
        clients they audit?
 What amount of stock should own employees own of their 
        company? Should employees be subject to a 10% cap as other 
        federally-insured plans are?
    These are the questions that I hope this Committee can answer and 
address in public policy. These are the answers I seek today in this 
proceeding.
    Thank you, Mr. Chairman for giving us the opportunity to delve into 
these issues and provide some sort of solution for our country.

    Chairman Tauzin. I thank my friend for yielding and for his 
statement. The Chair seeks anyone on this side who seeks 
recognition? The chairman of the Environmental Subcommittee.
    Mr. Gillmor. Thank you very much, Mr. Chairman, and I 
appreciate your affording another opportunity to sort out the 
recent events, as well as focus on possible reforms regarding 
Enron's collapse. As we delve into the destruction of 
documents, listen to the findings of a special investigative 
committee concerning the illegal transactions between Enron and 
partnerships, controlled by its chief financial officer, I 
welcome the witnesses today and look forward to hearing the 
testimony.
    My motivation regarding this issue lies with the well being 
of shareholders and employees and the reckless actions of those 
in corporate management should not come at their expense. In my 
own State of Ohio, the State Teachers Retirement System 
invested $4 million in Enron in late October 2001, and a month 
later it was worth $100,000 leaving the Teachers Pension Fund 
with 2.5 percent of its original investment. Their total loss 
stands at over $55 million and added to the Public Employees 
Retirement System, a loss of $59 million. Ohio's two principal 
employee pension systems were among the Nation's largest 
pension fund losers in Enron stock and while it is a sizable 
loss, fortunately both Ohio pension funds have assured teachers 
and public employees that it will not endanger member benefits.
    However, the illegal transactions of a few at Enron turning 
thousands into millions in a matter of weeks, the same can't be 
said of other State funds of Enron employees and individual 
shareholders. Enron stands as a company comprised of improperly 
structured transactions, faulty accounting, lack of internal 
oversight and an overall attempt to misrepresent the company's 
financial condition. And most importantly, Enron hid its 
behavior from all those who had an interest in it.
    Unfortunately, I think Enron is just an extreme example of 
a change of attitude over the last couple of decades of too 
many corporate managements in large publicly held companies 
where you have an atmosphere of management enrichment, 
regardless of whether the company does well, of management 
enrichment at the expense of the shareholders and at the 
expense of the employees. There has been, I think, a continuing 
breakdown in corporate management responsibility, whether it's 
the way options are turned into a game where management can 
only win, they can't lose, so that they don't have a community 
of interest with the shareholders, whether it's the disguising 
or the failure to disclose corporate charitable contributions 
which may or may not be made for any corporate purpose, so 
there are a number issues here and I look forward to hearing 
the witnesses' viewpoint today and I thank you, Mr. Chairman.
    [The prepared statement of Hon. Paul E. Gillmor follows:]
    Prepared Statement of Hon. Paul E. Gillmor, a Representative in 
                    Congress from the State of Ohio
    Thank you Mr. Chairman, for yet another opportunity to sort out the 
recent events as well as focus on possible reforms regarding Enron's 
collapse. As we have delved into the destruction of documents and 
listened to the findings of a Special Investigative Committee 
concerning the illegal transactions between Enron and partnerships 
controlled by its Chief Financial Officer, I welcome the witnesses 
today and look forward to hearing their testimony.
    As I stated before, my motivation concerning this issue lies with 
the well-being of the shareholders and employees--The reckless actions 
of those in corporate management should never come at their expense.
    In my home state of Ohio, the State Teachers Retirement System 
invested $4 million into Enron stock in late October of 2001. A month 
later it was worth just $100,000, leaving the teachers' pension fund 
with 2.5% of its original investment. Their total loss stands at $55.6 
million. Added to the Public Employees Retirement System's (PERS) loss 
of $58.8 million, Ohio's two principal public employee pension systems 
were among the nation's largest pension fund losers in Enron stock at a 
combined $114.4 million.
    While it can be perceived as a sizable loss, both Ohio pension 
funds assured teachers and public employees that it would not endanger 
the funds' bottom lines or affect member benefits. However, with the 
illegal transactions of a few at Enron, turning thousands into millions 
in a matter of weeks, the same cannot be said by other state funds, 
Enron employees, and individual shareholders.
    In the end, Enron stands as a company comprised of improperly 
structured transactions, faulty accounting, lack of internal oversight, 
and an overall attempt to misrepresent the company's financial 
condition. Most importantly, Enron hid its behavior from all who had an 
interest in them.
    I look forward to hearing the witnesses' viewpoints from their 
respective sectors as well as further congressional oversight regarding 
this issue.

    Chairman Tauzin. I thank my friend for his statement. 
Further members on this side? The gentleman from Texas, first, 
will be recognized, I think for unanimous consent.
    Mr. Green. Mr. Chairman, I ask unanimous consent to put my 
opening statement in the record and for all others to put an 
opening statement in the record.
    Chairman Tauzin. Without objection, the gentleman's 
unanimous consent request is granted. His statement and all the 
members' written statements will be part of the record, and I 
thank the gentleman. Anyone else on this side, first of all, in 
the order of seniority? Mr. Stupak, I believe would be next. 
You are recognized for 3 minutes.
    Mr. Stupak. Thank you, Mr. Chairman, and thanks for once 
again holding his hearing. I greatly appreciate our 
distinguished panel for coming before us today to help to 
explain the many complex and technical issues related to the 
Enron transactions. I look forward to hearing from various 
industry perspectives on how and why this happened as well as 
what can be done to prevent this from happening in the future.
    Mr. Chairman, over the past several weeks, the Oversight 
Investigation Subcommittee has held hearings to explore this 
house of cards that was once the mighty Enron Corporation. We 
have heard from Andersen employees about the shredding of 
documents, the destruction of e-mails that went on in an 
effort, I'm sure, to cover up their whole mess.
    We have heard from Mr. Powers about his Commission's 
findings and the actions of several Enron employees who set up 
the special purpose entities to assist in cooking the financial 
books at Enron. We have heard and read about the totally lax 
oversight of Mr. Lay and Mr. Skilling and other executives on 
the Enron Board of Directors.
    The Board of Directors gave dangerous flexibility to Mr. 
Fastow in allowing him to establish several of these special 
purpose entities. They supposedly put a number of checks and 
balances in place when they waived their conflict of interest 
provisions. But thus far all we have seen of the checks are 
tens of millions of dollars worth going into Mr. Fastow's bank 
accounts. There certainly were no balances in the equation and 
no follow up to make sure the company wasn't being bilked.
    We've learned new terms like aggressive accounting which in 
this case relates in my interpretation into making fat cats of 
Enron richer while sticking it to the shareholder. This 
aggressive accounting, I believe, was the result of a new 
cavalier attitude in corporate America since the passage of the 
Securities Litigation Act of 1995.
    You know, back then in 1995, many of us referred to this as 
the Securities Rip Off Act as I and others fought against this 
bill, because it insulates corporations from legal actions by 
putting up roadblocks, making it difficult for shareholders and 
employees to take action against them.
    Mr. Chairman, this committee and the Powers Report have 
only scratched the surface of a thick veneer on Enron's house 
of cards. We have not had the time or the cooperation from the 
parties involved to get to the root of this cancerous corporate 
greed. We have not looked into allegations of corruption in 
Enron's worldwide holdings, corporations and partnerships. We 
do not know who got bilked overseas who may have been cooking 
the books. We do not know who all the investors were in these 
special purpose entities and what role, if any, they may have 
played in the aiding and abetting the leaders of this 
corporation.
    Mr. Chairman, the top executives and board at Enron have 
allowed the seventh largest corporation in America to collapse. 
In their wake, lies thousands of Enron employees and retirees 
with shattered financial lives while the corporate executives, 
many of whom are still working at Enron today, have lined their 
pockets. It will be difficult, if not impossible for Enron to 
emerge as a credible company from bankruptcy without a 
comprehensive purging of Enron executives and board members who 
were at the helm during this debacle. They must be held 
accountable and I hope the investors in Enron will get 
themselves a true board of directors and new senior management 
team.
    Thank you again, Mr. Chairman, for holding these hearings. 
I look forward to learning from our panel's perspective on the 
Enron transactions. I'm sure they'll provide us additional 
insight that will be useful in questioning many of the key 
players in this Enron scheme at tomorrow's oversight hearing.
    Thank you, Mr. Chairman.
    [The prepared statement of Hon. Bart Stupak follows:]
 Prepared Statement of Hon. Bart Stupak, a Representative in Congress 
                       from the State of Michigan
    Mr. Chairman, thank you for holding this full committee hearing 
today. I greatly appreciate our distinguished panel for coming before 
us today to help explain the many complex and technical issues related 
to the Enron transactions. I look forward to hearing their various 
industry perspectives on how and why this happened as well as what can 
be done to prevent this from happening again in the future.
    Mr. Chairman, over the last several weeks the Oversight and 
Investigations Subcommittee has held hearings to explore this house of 
cards that was once the mighty Enron Corporation. We have heard from 
Andersen employees about the shredding of documents and destruction of 
e-mails that went on in an effort, I'm sure, to cover-up their role in 
this mess. We have heard from Mr. Powers about his Commission's 
findings and the actions of several of Enron's employees to set up 
these Special Purpose Entities to assist in cooking the financial books 
at Enron. We have heard and read about the totally lax oversight by Mr. 
Lay, Mr. Skilling, other executives and Enron's Board of Directors. The 
Board of Directors gave dangerous flexibility to Mr. Fastow in allowing 
him to establish several of these Special Purpose Entities. They 
supposedly put a number of ``checks and balances'' in place when they 
waived their conflict of interest provisions, but thus far all we have 
seen are checks--tens of millions of dollars worth--into Mr. Fastow's 
bank accounts. There certainly were no balances in the equations and no 
follow-up to make sure the company wasn't being bilked.
    We have learned new terms like ``aggressive accounting'' which in 
this case translates in my interpretation into making fat cats in Enron 
richer while sticking it to the shareholders. This aggressive 
accounting I believe is the result of a new cavalier attitude in 
corporate America since the passage of the Securities Litigation Reform 
Act of 1995--or the Securities Rip Off Act as I refer to it--which 
insulats corporations from legal actions by putting up roadblocks--
making it difficult for shareholders and employees to take legal action 
against them.
    Mr. Chairman, this committee and the Powers report have only 
scratched the surface of a thick veneer on Enron's house of cards. We 
have not had the time or the cooperation from parties involved to get 
to the root of this cancerous corporate greed. We have not looked into 
allegations of corruption in Enron's world-wide holdings, corporations, 
and partnerships. We do not know who got bilked overseas or who may 
have been cooking the books. We do not know who all of the investors 
were in the Special Purpose Entities and what role--if any--they may 
have played in aiding and abetting the leaders of this corporate scam.
    Mr. Chairman, the top executives and Board at Enron have allowed 
the 7th largest corporation in America to collapse. In their wake lies 
thousands of Enron employees and retirees with shattered financial 
lives while the corporate executives, many of whom are still working at 
Enron today, have lined their pockets. It will be difficult--if not 
impossible--for Enron to emerge as a credible company from bankruptcy 
without a comprehensive purging of Enron executives and Board members 
who were at the helm during this debacle. They must be held accountable 
and I hope the investors in Enron will get themselves a new TRUE Board 
of Directors and new Senior Management team.
    Thanks you again Mr. Chairman for holding this hearing. I look 
forward to learning our panel's perspective on the Enron transactions. 
I'm sure they will provide us with additional insight that will be 
useful in questioning many of the key players in this scheme at 
tomorrow's Oversight hearing.

    Chairman Tauzin. I thank my friend for his statement and 
for yielding back. The Chair now recognizes the soon to be 
leaving us, in fact, the gentleman from Oklahoma, whom we'll 
sorely miss from my committee and from the Congress, but I know 
he's going on to bigger and bigger things in the great State of 
Oklahoma. The gentleman from Oklahoma, Mr. Largent, is 
recognized for 3 minutes.
    Mr. Largent. Thank you, Mr. Chairman. I want to commend you 
for holding these important hearings this week. The Enron 
debacle is of particular importance to my constituents in 
Tulsa, many of whom are employed by the energy industry. As you 
may have heard from various news reports, the Enron bankruptcy 
is having a ripple effect on many other energy companies, 
specifically Williams Company, one of the largest employers in 
my District realized that $100 million fourth quarter loss due 
to unmet obligations by Enron. Further, Williams' stock prices 
have fallen significantly, due to the fear of many on Wall 
Street that companies who engage in complicated transactions 
cannot be trusted to accurately list their assets and 
liabilities. This is a guilt by association type mentality.
    The purpose of these hearings should be to find out what 
went wrong at Enron and to make sure that it never happens 
again. The backbone of a free market economy rests on the clear 
and transparent display of information that allows investors 
and employees the ability to make accurate decisions on how to 
invest their money. Congress must now take a good look at 
corporate American and our accounting standards to see if we 
can prevent the type of shell games that created the largest 
bankruptcy in American history.
    At the same time, the Department of Justice should 
vigorously prosecute any one and every one who violated the law 
with respect to Enron. It is important to remember though, as 
horrible as the Enron bankruptcy is, for the most part our 
energy markets seem to be weathering the storm. The fact is 
that markets formerly served by Enron are quickly being 
absorbed by other companies without widespread price or supply 
disruption. This is an industry that is far from broken or in 
need of repair.
    I understand that in the coming weeks the committee may 
consider legislation to reform our Nation's electricity 
markets. I am concerned, however, that some of my colleagues 
might want to use the Enron bankruptcy as a means to advance an 
unneeded regulatory barrage on the energy industry. I hope that 
we will resist that temptation and focus on the task at hand. 
Let's not forget that in the end free markets do work.
    Thank you, Mr. Chairman. I yield back.
    [The prepared statement of Hon. Steve Largent follows:]
Prepared Statement of Hon. Steve Largent, a Representative in Congress 
                       from the State of Oklahoma
    Mr. Chairman, I want to commend you for holding these important 
hearings this week. The Enron debacle is of particular importance to my 
constituents in Tulsa, many of whom are employed by the energy 
industry. As you may have heard from various news reports, the Enron 
bankruptcy is having a ripple effect on many other energy companies. 
Specifically, Williams Companies, one of the largest employers in my 
district, realized a $100 million fourth quarter loss due to unmet 
obligations by Enron. Further, Williams stock price has fallen 
significantly due to the fear of many on Wall Street that companies who 
engage in complicated transactions cannot be trusted to accurately list 
their assets and liabilities. This is a guilt by association type 
mentality.
    The purpose of these hearings should be to find out what went wrong 
at Enron and to make sure that it never happens again. The backbone of 
a free market economy rests on the clear and transparent display of 
information that allows investors and employees the ability to make 
accurate decisions on how to invest their money. Congress must now take 
a good look at corporate America and our accounting standards to see if 
we can prevent the type of shell games that created the largest 
bankruptcy in American history. At the same time, the Department of 
Justice should vigorously prosecute anyone and everyone who violated 
the law with respect to Enron.
     It is important to remember though, as horrible as the Enron 
bankruptcy is, for the most part, our energy markets seem to be 
weathering the storm. The fact is that markets formerly served by Enron 
are quickly being absorbed by other companies without widespread price 
or supply disruption. This is an industry that is far from broken or in 
need of repair.
    I understand that in the coming weeks the Committee may consider 
legislation to reform our nations electricity markets. I am concerned, 
however, that some of my colleagues might want to use the Enron 
bankruptcy as a means to advance an unneeded regulatory barrage on the 
energy industry. I hope that we will resist that temptation and focus 
on the task at hand. Lets not forget, in the end, free markets work.

    Chairman Tauzin. I thank the gentleman for his statement 
and ask if there are members on this side, the gentleman from 
New York, Mr. Engel, is recognized for 3 minutes.
    Mr. Engel. Thank you, Mr. Chairman. There's an old saying 
and it goes like this, ``Oh what a tangled web we weave, when 
first we practice to deceive.''
    It's evident to me and to all of us that there's has been a 
concerted effort by the top brass of Enron to create an 
intricate web of lies, so intricate in fact, that it will take 
months and years to discover the whole truth.
    Our ability to learn the truth would be greatly facilitated 
by the assistance of Enron's top brass. Thus, I'm saddened by 
the fact that Mr. Lay has chosen not to testify. I believe that 
Mr. Lay, Mr. Skilling and Mr. Fastow should be doing everything 
they can to help us uncover the truth. Instead, they're doing 
everything they can to cover their own proverbial backsides.
    I'm especially interested in knowing for what purposes Mr. 
Lay used the money he was loaned by Enron. As I understand, Mr. 
Lay had a $4 million line of credit with Enron. I have to 
wonder if he used any of this money to set up any of the 
hundreds of partnerships. These partnerships took on debt for 
Enron, thus making Enron's bottom line look better. This, in 
turn, caused Enron stock to increase in price and finally Mr. 
Lay paid off these loans with Enron stock. A tangled web 
indeed.
    Then we come to the other player in this tragic comedy, 
Arthur Andersen. Arthur Andersen in the terms of addiction was 
an enabler. And as Enron's auditor they enabled Enron to set up 
hundreds of partnerships, enabled Enron to hide debt in the 
hundreds of millions of dollars, enabled Enron's top executives 
to personally profit through this tangled web of deceit, and 
enabled thousands of investors and employees to be misled and 
victimized.
    During the oversight investigation hearings I questioned 
some of the Andersen employees about their code of professional 
conduct. They responded that they did not view their actions as 
violation of the AICPA's code but as, and I quote, ``a gross 
error.''
    I again quote from AICPA's code of professional standards 
that the code ``cannot accommodate deceit or subordination of 
principle.''
    I must beg to differ with Andersen in its assessment of its 
culpability in this matter. Andersen was a party to and did 
accommodate deceit. The Powers report not only states that 
Andersen failed in its role as auditor, but that it directly 
participated in the structuring and accounting of the Raptor 
transactions.
    Luckily for Andersen there is little chance that the AICPA 
will take any action against it. AICPA has failed time and time 
again to properly oversee its members in the industry.
    I have with me two articles from the Washington Post that 
delve into the poor performance of the AICPA. They detail a 
history of lax oversight. In fact, often when an individual was 
cited and fined by the SEC, the AICPA did nothing. For an 
industry that has fought tooth and nail for the power of self-
regulation, this is a shameful track record.
    Mr. Chairman, I ask unanimous consent that the articles be 
added to the official record.
    Chairman Tauzin. Without objection, so ordered.
    Mr. Engel. Already we have a number of proposals to deal 
with some of the aftermath of this failure. I strongly support 
preventing auditing companies from providing consulting 
services at the same time. I believe we must take a serious 
look at how well AICPA, FASB and the SEC enforce ethical 
standards. I think we should make companies disclose at the 
very least all of their partnerships and the debt and assets 
thereof. The Federal Reserve has expressed its concerns about 
SPEs and how they are being used to hide the true nature of so 
many corporations' debt. This is material information that is 
constantly being hidden from the view of the investor and the 
general public.
    Chairman Tauzin. The gentleman's time----
    Mr. Engel. I read in today's paper that the Houston Astros 
baseball team is trying to change the name of Enron Field.
    Chairman Tauzin. The gentleman's time is expiring.
    Mr. Engel. It's no wonder. I thank you, Mr. Chairman, and I 
look forward to these hearings.
    [The prepared statement of Hon. Eliot L. Engel follows:]
Prepared Statement of Hon. Eliot L. Engel, a Representative in Congress 
                       from the State of New York
    Mr. Chairman: There is an old saying ``Oh what a tangled web we 
weave, when first we practice to deceive!''
    It is evident to me that there has been a concerted effort by the 
top brass of Enron to create an intricate web of lies. So intricate, in 
fact, that it will take months, possibly years to discover the whole 
truth.
    Our ability to learn the truth would be greatly facilitated with 
the assistance of Enron's top brass. Thus, I am saddened by the fact 
that Mr. Lay has chosen not to testify. I believe that Mr. Lay, Mr. 
Skilling, and Mr. Fastow should be doing everything they can to help us 
uncover the truth. Instead, they are doing everything they can to cover 
their own proverbial backsides.
    I am especially interested in knowing for what purposes Mr. Lay 
used the money he was loaned by Enron. As I understand, Mr. Lay had a 
$4 million line of credit with Enron. I must wonder if he used any of 
this money to set up any of the hundreds of partnerships. These 
partnerships took on debt for Enron, thus making Enron's bottom line 
look better. This in turn caused Enron stock to increase in price. 
Finally, Mr. Lay paid off these loans with Enron stock.
    A tangled web indeed!!
    Then we come to the other player in this tragic comedy.
    Arthur Andersen.
    In the terms of addiction was an ``enabler.'' Andersen, as Enron's 
auditor:

 enabled Enron to set up hundreds of partnerships
 enabled Enron to hide debt in the hundreds of millions of 
        dollars
 enabled Enron's top executives to personally profit through 
        this tangled web of deceit
 enabled thousands of investors and employees to be misled and 
        victimized
    During the Oversight and Investigations hearing, I questioned some 
of the Andersen employees about their code of professional conduct. 
They responded that they did not view their actions as violation of the 
AICPA's code, but--and I quote-- a gross error!
    I again quote from AICPA's code of professional standards that the 
code ``cannot accommodate deceit or subordination of principle'''
    I must beg to differ with Andersen in its assessment of its 
culpability in this matter. Andersen was a party to and did accommodate 
deceit. The Powers report not only states that Andersen failed in its 
role as auditor, but that it directly participated in the structuring 
and accounting of the Raptor transactions.
    Luckily for Andersen, there is little chance that the AICPA will 
take any action against it. AICPA has failed time and time again to 
properly oversee its members and the industry. I have with me two 
articles from the Washington Post that delve into the poor performance 
of the AICPA. They detail a history of lax oversight. In fact, often 
when an individual was cited and fined by the SEC, the AICPA did 
nothing. For an industry that has fought tooth and nail for the power 
of self regulation, this is a shameful track record.
    Mr. Chairman, I ask unanimous consent that the articles be added to 
the official record.
    Already, we have a number of proposals to deal with some of the 
aftermath of this failure. I strongly support preventing auditing 
companies from providing consulting services at the same time. I 
believe we must take a serious look at how well AICPA, FASB, and the 
SEC enforce ethical standards.
    I think we should make companies disclose at the very least all 
their partnerships and the debt and assets thereof. The Federal Reserve 
has expressed its concerns about SPE's and how they are being used to 
hide the true nature of so many corporations' debt. This is material 
information that is constantly being hidden from the view of the 
investor and general public.
    I thank the Chairman and the Ranking Member and pledge to work with 
them to ensure that such unabashed abuses of accounting never occur 
again.

    Chairman Tauzin. I thank my friend. The gentleman's time 
has expired. Is there further request at this time? The 
gentleman, Mr. Buyer, is recognized from Indiana for 3 minutes.
    Mr. Buyer. Mr. Chairman, thank you also for holding the 
hearings on the Enron collapse. I appreciate your leadership 
and that of Mr. Dingell and Mr. Greenwood. Like others on the 
committee have stated, it is very serious if financial books 
were altered, if investors were intentionally misled, if 
employees were intentionally given false information and 
treated differently than executives. It is appropriate for this 
committee to review all these allegations.
    There are two things that trouble me at this time about the 
Enron collapse. First, how employees were treated. Executives 
were given the opportunity to sell stock when they knew the 
price was tumbling, but used the rules to prevent employees 
from doing the same. This stabs at the most basic ideals of 
fairness. If the rules were utilized to aid and abet this 
unfair treatment of employees, then we need to correct the 
wrong. 401(k)s are an important tool in retirement planning. 
This one instance of abuse should not be used to dismantle 
401(k)s, but to strengthen them and I'm confident that Congress 
will address pension reform.
    The second most troubling item to me at the moment is the 
scandal of culture that has a foundation, an architecture, in 
Washington, DC and how this scandal of Enron feeds into it. 
This is a business scandal, not a political scandal. There are 
those in this town that want to transfer it to the latter, 
rather than the former. It's important for us to put the 
microscope on this so we can understand the marketplace and a 
company and what went wrong.
    This is a matter of a business failure. Despite the 
financial losses to thousands, and I am not minimizing this 
loss, I note that the free market economy, the most successful 
in the world that we've ever seen, lets businesses fail if they 
deserve to fail. We often hail victors of free markets and 
great innovators like Thomas Edison who developed an idea to 
benefit us all, but we must also realize that if the market 
rewards excellence, it also punishes failures. And in the Enron 
case, it was brutal. If Enron engaged in illegal and unethical 
business practices, then that is exactly what should happen in 
the end. There is a failure in the marketplace.
    Some may question whether it is the responsibility of 
government to guarantee success in the marketplace. I submit it 
is not. The responsibility of government is to make sure the 
marketplace is fair, free, open and competitive. If, in fact, 
someone is not operating in that marketplace under those 
standards, we then can bring the microscope in and find out 
what went wrong. And if, in fact, there are rules that need to 
be corrected, that is the responsibility for us to engage. So I 
want to thank you Mr. Chairman and Mr. Dingell, Mr. Greenwood 
and others. I think it's going to take time. It will take some 
patience. What I've learned is follow the facts, it will 
determine where the law should go and for the best result for 
the American society.
    I return my time.
    Chairman Tauzin. I thank the gentleman for his thoughtful 
statement and I ask if there are members on this side who wish 
to be recognized first in order of seniority. The gentleman, 
Mr. Rush, would be in line from Chicago. Mr. Rush? He is 
recognized for 3 minutes.
    Mr. Rush. Thank you, Mr. Chairman, for holding today's----
    Chairman Tauzin. Bobby, would you turn your mike on? Thank 
you.
    Mr. Rush. I want to again thank you, Mr. Chairman, for 
holding this full committee's hearing on the Enron collapse. 
Mr. Chairman, today, I hope today's hearing will allow the 
committee to gain a panoramic view of the Enron debacle so that 
when all is said and done and we in the Congress can make the 
legal and policy changes necessary to prevent this disaster 
from ever occurring again. Today's hearing will be an 
opportunity to hopefully shed light on the various industry-
wide accounting, corporate governance and energy concerns 
raised by the Enron collapse. And while I commend the committee 
for calling witnesses to discuss the roles and responsibilities 
of the executives, auditors and accountants, I fear that we 
have left out an important player in the story of Enron and its 
fall from grace. I feel that the lawyers should be also a focus 
of our deliberations and our investigations.
    In Enron's own limited investigations of its shady business 
practices, Vinson & Elkins confirmed that the procedures for 
monitoring those practices was uniformly overseen, not only by 
accountants and executives, but lawyers as well. The legal 
department at Enron had a role to play. Unfortunately, the 
Vinson & Elkins investigation which was meant to root out 
mismanagement and illegality, seemed to be marked by a cloud 
mismanagement and missed opportunity. In its finding, Vinson & 
Elkins describe the monitoring procedures for its LJM 
transactions as generally adhered to, accounting as creative 
and aggressive and the working conditions as awkward. Even 
though Enron's SPE-related transactions and I quote ``created a 
serious risk of adverse publicity and litigation'', Vinson & 
Elkins nonetheless concluded that there was no need for an 
expanded investigation. In short, while the building was aflame 
and burning down around its client, Vinson & Elkins called for 
business as usual.
    In the written testimony given today by the panelists, by 
one of our panelists, he tells of a corporate climate in which 
aggressive mismanagement, there's the accountant to ``show me 
where it says I can't twist and stretch the rules to show a 
profit.'' Accountants were under the gun. They were dared to 
show management where it said they couldn't bend the rules and 
stretch the rules to accomplish what they wanted to accomplish.
    Certainly this component to the Enron collapse must be part 
of our public debate. What was the lawyers' role in this? The 
outside attorneys and also Enron's own legal department. And 
however, Mr. Chairman, in conclusion, it may be equally as 
important to discuss the importance of sound, legal advice that 
would have guided Enron to a very different place than where it 
is today. Again, where were the lawyers, what were they doing 
and why did they not advise Enron to do differently than they 
did.
    [The prepared statement of Hon. Bobby L. Rush follows:]
Prepared Statement of Hon. Bobby L. Rush, a Representative in Congress 
                       from the State of Illinois
    Mr Chairman: Thank you for holding today's Full Committee hearing 
on the Lessons Learned from Enron's Collapse.
    Today's hearing will allow the Committee to gain a panoramic view 
of the Enron debacle, so that when all is said and done, we in Congress 
can make the law and policy changes necessary to prevent this disaster 
from ever happening again.
    Today's hearing will hopefully shed light on the various, industry 
wide accounting, corporate governance, and energy concerns raised by 
the Enron collapse.
    And while I commend the committee for calling witnesses to discuss 
the roles and responsibilities of the executives, auditors, and 
accountants, I fear that we have left out an important player in the 
story of Enron and its fall from grace . . . The lawyers.
    In Enron's own limited investigation of its shady business 
practices, Vinson and Elkins confirmed that the procedures for 
monitoring those practices was uniformly overseen, not only by 
accountants and officers, but lawyers as well.
    Unfortunately, the very investigation meant to rout out 
mismanagement and illegality, seemed marked by a cloud of mismanagement 
and missed opportunity.In its findings Vinson and Elkins described the 
monitoring procedures for its LJM transactions as:

 generally adhered to,
 The accounting as, creative and aggressive and
 the working conditions as awkward.
    Even though ENRON's SPE related transactions ``created a serious 
risk of adverse publicity and litigation,'' . . . Vinson and Elkin's 
nonetheless concluded that, there was no need for an expanded 
investigation.
    In short, while the store burned down around its client Vinson and 
Elkins called for business as usual.
    In the written testimony given by one of today's panelists, he 
tells of a corporate climate in which aggressive management dares the 
accountant to ``show me where I can't'' bend twist and stretch the 
rules to show a profit. Certainly, this component to the Enron collapse 
must be a part of the public debate. However, it may be equally as 
important to discuss the importance of the sound legal advice that 
would have guided Enron to a very different place than where it is 
today.

    Chairman Tauzin. The gentleman's time is expired. The Chair 
thanks the gentleman for his statement. The Chair recognizes 
the gentleman from Oregon, Mr. Walden, for an opening 
statement.
    Mr. Walden. Thank you very much, Mr. Chairman. Mr. 
Chairman, let me start by quoting some material from Robert 
Vigil, a constituent of mine living in Madras, Oregon, 
testifying in front of the Senate Committee on Commerce, 
Science and Transportation during their hearing on Enron. Mr. 
Vigil is an electrical machinist working as foreman for 
Portland General Electric, PGE. He works at PGE's Pelton Round 
Butte Hydroelectric Project in Central Oregon. He's 47 years 
old and has been employed by PGE for 23 years. Here's what he 
said. ``Enron purchased PGE in 1997 at which time all of the 
PGE stock we had in our accounts automatically converted to 
Enron stock. At first this looked like good news for the 
employees. Enron was riding high and as we saw the company 
officers and supervisors investing in company stock, we felt 
assured that our own investments were solid. As you're probably 
aware by August of 2000 Enron's stock had shot up to all time 
high of $90.56. At that time, my 1800 shares were worth 
$163,000.'' Continuing with Mr. Vigil's comments: ``We were all 
barred from trading our stock during the critical period this 
last fall. It seemed strange to me that as soon as the really 
bad news came out on Enron, we found ourselves unable to move 
out of the stock. Enron suddenly changed account managers and 
our investment accounts were locked down. I've seen that Enron 
says we were only locked out of our accounts for 10 trading 
days, from October 29 through November 12, but as early as 
September 26 my co-workers were finding they could get access 
to their accounts, but they could not conduct any transactions. 
As the truth about Enron started to come to light and as the 
officers at the top cashed out, we, the employees had no choice 
but to ride the stock into the ground.''
    Mr. Chairman, I encourage everyone here to read the 
entirety of Mr. Vigil's statement because it puts a human face 
on what we're talking about today. No longer is the giant 
energy marketing company Enron or the Big Five accounting firm 
Arthur Andersen. We can see how far reaching this collapse is 
from Houston, Texas, the fourth largest city in America to 
Madras, Oregon, population, 5,080.
    We have to get to the bottom of this, Mr. Chairman, and I 
commend you and others in this committee for these hearings. 
Too many workers saw their retirement vanish, too many 
shareholders were misled, too many years of financial 
statements were misleading at best or downright fraudulent at 
worst. Credibility of companies and auditors has been lost. The 
impact on the financial markets and investor confidence has yet 
to be determined and it comes at a critical time of our 
economy.
    What did the top execs at Enron and Arthur Andersen know 
and when did they know it? Particularly troubling is the timing 
of actions of both Enron and Arthur Andersen. Also, were they 
intentionally misleading investors and employees? Why were the 
blackout dates for employees inconsistent? Is it usual to 
destroy documents like Enron and Arthur Andersen did? Were 
there side letters that were made by Enron with its partners in 
relation to risk sharing and structure of those same 
partnerships? Has the FASB failed to issue regulations that may 
have prevented some of this from happening in the first place? 
Has the SEC failed to issue enhanced financial statement 
disclosure requirements describing partnerships? Do the 
disclosures need to be more comprehensible to the reader at 
large? Do auditor independence requirements need to be reviewed 
again in light of the current situation?
    Any time there's a declining business environment, 
transactions inherently become more complicated. Companies like 
Enron and their auditors will continue to find ways to get 
around returns to their investors. The FASB and SEC must 
continue to evolve with these complex transactions. Delay is 
not an option.
    Thank you, Mr. Chairman.
    [The prepared statement of Hon. Greg Walden follows:]
 Prepared Statement of Hon. Greg Walden, a Representative in Congress 
                        from the State of Oregon
    Thank you Mr. Chairman.
    Mr. Chairman, let me start by quoting some material from Robert 
Vigil, a constituent of mine living in Madras, Oregon, testifying in 
front of the Senate Committee on Commerce, Science and Transportation 
during their hearing on Enron. Mr. Vigil is an Electrical Machinist 
Working Foreman for Portland General Electric (``PGE''). He works at 
PGE's Pelton/Round Butte Hydroelectric Project, in Central Oregon. He 
is 47 years old, and has been employed by PGE for 23 years.
    ``Enron purchased PGE in 1997, at which time all of the PGE stock 
we had in our accounts automatically converted to Enron stock. At 
first, this looked like good news for the employees. Enron was riding 
high, and as we saw the company officers and supervisors investing in 
company stock, we felt assured that our own investments were solid. As 
you are probably aware, by August 2000, Enron's stock had shot up to an 
all-time high of $90.56. At that time, my 1800 shares were worth 
$163,000.
    ``. . . we were all barred from trading our stock during a critical 
period this last fall. It seems strange to me that as soon as the 
really bad news came out on Enron, we found ourselves unable to move 
out of the stock. Enron suddenly changed account managers, and our 
investment accounts were `locked down.' I have seen that Enron says we 
were only locked out of our accounts for ten trading days--from October 
29 through November 12. But as early as September 26, my coworkers were 
finding that they could get access to their accounts, but they could 
not conduct any transactions. As the truth about Enron started to come 
to light--and as the officers at the top cashed out--we, the employees, 
had no choice but to ride the stock into the ground.''
    Mr. Chairman, I encourage everyone here to read the entirety of Mr. 
Vigil's statement. It puts a human face on what we are talking about 
today. No longer is it the ``giant energy marketing company Enron'' or 
the ``big five accounting firm Arthur Anderson.'' We can see how far 
reaching this collapse is. From Houston, TX, the fourth largest city in 
America to Madras, OR: population 5,080.
    I intend to get to the bottom of this. Too many workers saw their 
retirement vanish. Too many shareholders were misled. Too many years of 
financial statements were misleading at best, or downright fraudulent 
at worst. The credibility of companies and auditors has been lost. The 
impact on the financial markets and investor confidence is yet to be 
determined and comes at a critical time of our economy.
    What did the top execs at Enron and Arthur Anderson know and when 
did they know it?
    Particularly troubling is the timing of actions by both Enron and 
Arthur Anderson. Also, were they intentionally misleading investors and 
employees? Why were the blackout dates for employees inconsistent? Is 
it usual to destroy documents like Enron and Arthur Anderson did? Were 
there side letters that were made by Enron with its partners in 
relation to risk sharing and structure of those same partnerships? Has 
the FASB failed to issue regulations that may have prevented some of 
this from happening in the first place? Has the SEC failed to issue 
enhanced financial statement disclosure requirements describing 
partnerships? Do the disclosures need to be more comprehendible to the 
reader at large? Do auditor independence requirements need to be 
reviewed again in light of the current situation?
    Anytime there is a declining business environment, transactions 
inherently become much more complicated. Companies like Enron and their 
auditors will continue to find ways to get the most return for their 
investors. The FASB and SEC must continue to evolve with these complex 
transactions. Delay is not an option.
    Thank you for the time Mr. Chairman. I look forward to the question 
session in the hopes that I can provide answers to my constituents.

    Chairman Tauzin. The gentleman's time has expired. The 
Chair thanks the gentleman. The Chair is pleased to welcome and 
recognize the gentleman fresh from his victories in New 
Orleans, took the town by storm, chief sponsor and supporter of 
the Patriots, Mr. Markey.
    Mr. Markey. I thank you, Mr. Chairman, very much, and I now 
realize why 9 of the 36 Super Bowls have been played in New 
Orleans. I think once you're there, you want to go back as 
quickly as you can.
    Chairman Tauzin. Glad you enjoyed it, Mr. Markey.
    Mr. Markey. It was beautiful.
    Chairman Tauzin. It was truly a great Super Bowl and again, 
I think we all owe thanks to the United States securities 
forces for making it such a safe and amazing event for America. 
I think we're all very grateful and quite a game, Mr. Markey, 
congratulations.
    Mr. Markey. For us, it was the expurgation of so many 
ghosts of years gone back, beginning with Bill Buckner, but 
then back so far into time that we can't remember them all and 
all of them now, the cloud has passed. Not unlike what we're 
going to have to do with Enron and Arthur Andersen in terms of 
the cloud that it's placed over the capital markets. For many 
of us the most striking thing about the Enron debacle is that 
the time these transactions were being put together no one ever 
appears to have stepped forward to say you can't do this. No 
one appears to have stepped forward to say that would be wrong. 
No one ever appears to have stepped forward said what you're 
trying to do is unethical and possibly illegal. Instead, every 
single financial professional who was supposedly there to 
protect the public investors, the outside auditors, the 
attorneys, the Wall Street investment banks and the corporate 
insiders, all of them got together and conspired with one 
another on how to structure deals that could evade or flout the 
rules.
    And what about the Wall Street expert securities analysts 
who were supposedly scrutinizing Enron's performance and the 
credit rating agencies or supposedly evaluating the company's 
credit worthiness? Where were these when the shenanigans were 
taking place? The public wants to know how could this happen? 
Where was Enron's Board? Where was its senior management? Where 
were the risk management systems? Where was the outside 
auditors? Where were the lawyers? Where were the regulators? It 
wants to know why it was that so many of the internal and 
external checks and balances that were supposed to protect the 
public failed so catastrophically?
    Traditionally, many have thought of accounting as an 
incredibly dull and arcane subject. The stereotype of the 
accounting profession has been that it is pretty much a bunch 
of nerdy geeks with an inexplicable fascination with obscure 
and abstruse rules and regulations. And let's face, accounting 
is boring. Unless, of course, you wish to engage in financial 
fraud. In which case, accounting is an absolutely fascinating 
subject. Successfully cooking the books is the key to getting 
away with financial fraud and at Enron and at Arthur Andersen, 
new and innovative recipes appear to have been devised.
    This week the Powers Committee Report was released and 
provided us with an exhaustive review of Chewco, Raptor and LJM 
transactions and these transactions' insiders appear to have 
constantly flouted the rules.
    Back in the 1930's Will Rogers said that from what he could 
tell a holding company was where you hide the money when the 
cops show up. Today, for Enron and for possibly many other U.S. 
companies, special purpose entitles are where you hide your 
debts, disguise your nonperforming assets, boost your earnings, 
conceal your losses and avoid paying your taxes. And so I think 
our committee must look at this issue. We are not at--we have 
not found the iceberg yet, Mr. Chairman. We are at the tip of 
the iceberg.
    When accountants want to keep score and play the game at 
the same time, we'd all love to do that if we could get away 
with it. But once you start doing that, you are setting 
yourself up for big problems.
    I thank you for your leadership in conducting these 
hearings.
    Chairman Tauzin. I thank my friend for his statement. And 
the Chair is pleased to recognize the gentleman from Nebraska, 
Mr. Terry, for an opening statement.
    Mr. Terry. Thank you, Mr. Chairman. I want to highlight a 
couple of points and I'll submit the rest of my statement for 
the record. And while the statement is chock full of pithy 
quotes, I sadly have no Star Wars references.
    I do want to point out two things, in the role of Omaha, 
Nebraska in this hearing today. First of all, I welcome a 
friend and constituent, Mr. David Sokol. Mr. Sokol is an expert 
in energy policy since that's his life and I think he's world 
renowned for his knowledge of the industry and we welcome him 
here today to share his expertise with us. So welcome, Mr. 
Sokol.
    The other, sad, part about Omaha is that in the late 1970's 
we enjoyed a great company called Internorth and Internorth had 
arranged a merger with a small Houston company named Enron. 
Well, as it ended up, the small fish gobbled up the big fish. 
Mr. Lay moved to Omaha promising great things for our 
community, all the while secretly plotting its removal from 
Omaha to Houston. Nonetheless, while hundreds of people were 
ripped from their jobs and either forced to move to Houston or 
retire, they did keep a small division in Omaha, their pipeline 
division. We have about 400 employees in Omaha and several of 
those people are friends of mine. And I've heard from several 
people in the Enron Division in Omaha who told me stories about 
how they had hundreds of thousands of dollars built up for them 
from their years of service with Enron in their 401(k) and now 
as they are looking toward retirement, have nothing.
    Now Mr. Chairman, it's said that there are two kinds of 
light. The glow that illuminates and the glare that obscures. 
Obviously, we thought Enron was a company with an illuminating 
glow, but we have found out that they have used that glow to 
obscure their tactics and we're here today to try and uncover 
those tactics.
    Mr. Chairman, I appreciate your outspokeness on behalf of 
the employees in Omaha, Nebraska and in Houston, because I 
think it's our duty today to find those tactics, fill the 
policy void so this can never happen again and make sure that 
the Justice Department vigilantly pursues those who have broken 
the law.
    I yield back the balance of my time.
    [The prepared statement of Hon. Lee Terry follows:]
Prepared Statement of Hon. Lee Terry, a Representative in Congress from 
                         the State of Nebraska
    Thank you Mr. Chairman. Today's hearing will primarily examine the 
lax accounting practices Andersen employed in its auditing of Enron. I 
am pleased, though, that we will also hear testimony regarding the 
status of our energy markets. I think it's worthy to note that although 
the largest energy trading company in America collapsed, energy prices 
have remained fairly stable, and I'm looking forward to the testimony 
of my good friend David Sokol, chairman of MidAmerican.
    When I contemplate the Enron saga I am reminded of a line from 
Shakespeare's Henry The Eighth, ``Thy ambition, Thou scarlet sin, 
robb'd this bewailing land.'' What I'm concerned about are Enron's 
accounting practices: are they the exception to the rule, or are they 
the rule in Corporate America? We've seen the collapse of Enron late 
last year, and last week Global Crossing declared bankruptcy--who's 
next?
    Enron's story is reminiscent of a Shakespearean tragedy: a hugely 
successful company responsible for transforming an entire industry 
engaged in an elaborate scheme of complicated, unprofitable, and 
possibly illegal business partnerships; a politically connected CEO; a 
precipitous financial collapse of immense proportions; and the recent 
tragic death of its former Vice Chairman.
    How could a company so well reputed, employing so many hardworking 
Americans, and with such a prolific stature in Corporate America just 
crumble?
    As we begin to investigate what happened here and why, it's 
important to keep in mind people's motives. My interest is twofold: 
first as a member of this Committee, but more importantly because Enron 
was formed by merging two companies--Houston Natural Gas and 
Internorth--the latter headquartered in my home district of Omaha, 
Nebraska.
    Enron employs more than 20,000 people, or at least did before this 
past Fall. 400 or so of those employees are located in Omaha. They 
joined thousands in trusting Enron's officers to make decisions that 
were good for the firm's employees, retirees, shareholders, and not 
merely to enrich its executives' bank accounts. Until late last year, 
it appeared Enron's expansion knew no boundaries. The company grew to 
titanic proportions, spanning 40 countries, operating 30,000 miles of 
pipeline, holding nearly $50 billion in assets, and taking in revenues 
in excess of $100 billion in 2000 alone. This seemed like a company 
playing out that fabled American dream, and its employees and 
shareholders were reaping the rewards.
    On Sunday, the Special Investigative Committee of Enron's Board of 
Directors released the Powers Report, detailing intricate schemes that 
created assets that never existed, coaxing investors and employees to 
invest in a retirement future that would never be. For those who have 
not read the Powers Report, I'd like to read a brief excerpt of how 
people like Chief Financial Officer Andrew Fastow, Michael Kopper, and 
others made millions.
          ``We were charged with investigating transactions between 
        Enron and partnerships controlled by its Chief Financial 
        Officer, or people who worked in his department. That is what 
        our Report discusses. What we found was appalling.
          ``First, we found that Fastow--and other Enron employees 
        involved in these partnerships--enriched themselves, in the 
        aggregate, by tens of millions of dollars they should never 
        have received. Fastow got at least $30 million, Michael Kopper 
        at least $10 million, two others $1 million each, and still two 
        more accounts we believe were at least in the hundreds of 
        thousands of dollars.
          ``Second, we found that some transactions were improperly 
        structured. If they had been structured correctly, Enron could 
        have kept assets and liabilities--especially debt--off its 
        balance sheet. But Enron did not follow the accounting rules.''
    Now we're here to determine how this charade was allowed to happen. 
Who dropped the ball? A lot of finger pointing has taken place, and yet 
no one has come forward to say, ``I'm responsible. I was the one making 
millions of dollars, all the while knowing that what I was doing was 
illegal, malicious, and a complete breach of public trust.'' I hope our 
witnesses here today can shed some light on what happened in the 
accounting world to have allowed such a corporate calamity to occur.
    It has been said that there are two kinds of light--the glow that 
illuminates, and the glare that obscures. For years, Enron seemed to be 
that illuminating glow. Today, we seek uncover the tactics they used to 
glare their investors and obscure the reality of their condition. If 
the only result of these hearings, though, is placing blame on the 
appropriate parties, we have not fulfilled our duties. We must seek 
solutions to the problems exposed by this unfortunate collapse and 
implement reforms on a bipartisan basis to ensure this does not happen 
again. Therefore, I look forward to this Committee and others in 
Congress exploring further the relationship Enron had with Andersen. It 
may make sense that one firm should never hold the duplicitous roles of 
both auditor and consultant. Congress may need to closely examine the 
possibility of closing this loophole.
    I hope the issue of reporting earnings, and the practice of 
restating earnings, is further explored. We must ensure American 
investors have accurate, transparent, and timely information when 
making their investment decisions. I am also hopeful we make some 
meaningful reforms to how 401(k) plans are administered--not knee-jerk 
reactions, but commonsense, pro-active legislation that creates safe 
plans for both employers and employees. It's unfortunate that these 
reforms are too late for some, but hopefully will benefit future 
American employees and retirees.
    In the 1980's there was a popular movie entitled Wall Street. One 
of the primary characters, Gordon Gecko, while speaking to a group of 
shareholders proclaims the memorable line, ``Greed is Good.'' However, 
it should be remembered that greed is one of the seven deadly sins. And 
unfortunately in Enron's case--it has proved to be prophetic.
    Thank you again, Mr. Chairman, and I look forward to the testimony.

    Chairman Tauzin. I thank my friend. The Chair is pleased 
now to recognize the gentleman from New York, Mr. Towns, for an 
opening statement.
    Mr. Towns. Thank you very much, Mr. Chairman. This is a sad 
day for this committee and the shareholders of Enron and the 
families that were employed by Enron. It is clear that the 
leadership of Enron Corporation did nothing to protect their 
investors, their shareholders or the employees of the company. 
The executives put their own interest ahead of the workers and 
their families and the company's shareholders. Unfortunately, 
they were able to use regulatory loopholes to accomplish this 
deceit. It appears that they also broke a lot of rules and 
laws.
    We look to the leadership of our present Chairman, Billy 
Tauzin from Louisiana in guiding our efforts to plug the 
loopholes and make sure that such an ungodly mess never happens 
again in this country.
    The financial losses resulting from Enron's collusion to 
defraud everyone except a few executives cannot be understated. 
While Enron employees lost some $1.6 billion, let me just 
briefly discuss the impact on some New York institutions. 
Amalgamated Bank of New York shareholders lost an estimated 
around $500 million. J.P. Morgan Chase and CitiGroup could lose 
over $3 billion from loans made to Enron and finally the losses 
of the New York Common Retirement Fund will lose approximately 
$58 million. In the past the SEC had argued that budgeting and 
staffing constraints limited their regulatory capability.
    Mr. Chairman, you probably remember, in the 106th Congress 
I was the first member to propose a fee reduction and pay 
parity bill for the SEC. I'm pleased to say that the President 
recently signed into law the legislation which provides pay 
parity for SEC staff. However, I'm deeply troubled that the 
President's budget for fiscal year 2003 does not provide 
funding for either the pay parity to stem the loss of 
experienced staff or additional resources to hire the staff 
attorneys, staff accountants, economists and examiners 
necessary for safeguarding America's investors. Since we can't 
find the money for the SEC, I cannot understand how all of a 
sudden we can find funds for Chairman Pitts' new oversight 
board. That just bothers me. It is up to us, here in the 
Congress, to ensure that no American investor or employee is 
ever again victimized by the corporate greed practiced by 
Enron.
    I look forward to hearing from our witnesses today about 
how we can strengthen our existing regulatory system. I yield 
back the balance of my time, Mr. Chairman, and thank you for 
holding this hearing.
    Chairman Tauzin. I thank my friend. Let me interrupt to 
explain to our witnesses, it is our practice to do these 
opening statements for several reasons. One is it's the first 
opportunity for all the members of the full committee to make 
comments, even those who do not serve on the Oversight 
Subcommittee that is doing the investigation, and to give their 
observations and their perspectives on this issue. That is 
valuable to the Chair and to the subcommittees who are going to 
have to produce the legislation, hopefully, to repair some of 
the damage that has been done, and as many members have said, 
to see to it that this does not happen again.
    Second, I hope it helps the witnesses in terms of 
understanding either the correct impressions we have or give 
you a chance to correct any misimpressions we have about the 
state of some of these concerns. And so I hope it's helpful to 
both of us.
    Again, I apologize that we've kept you waiting, but this is 
an extraordinarily important part in the way in which our 
committee hears from one another, understands one another's 
perspectives and then prepares for the solution phase of our 
process which is to produce the legislation, hopefully, that 
will repair this damage.
    The Chair now asks if there are members on this side of the 
aisle who seek recognition for an opening statement. Mr. Deal, 
are you prepared at this time? The gentleman from Georgia is 
recognized for 3 minutes.
    Mr. Deal. Thank you, Mr. Chairman, and thanks to the 
distinguished panel. We look forward to your testimony.
    Obviously, there are many points of view that have been and 
will be expressed during the course of this hearing and others 
that will follow. As many of us in the legislative branch have 
always heard, there is an admonition that I think is important 
here and that is that bad facts sometimes make bad law.
    The Enron debacle is bad facts of historic proportions. I 
think our challenge is not to react to bad facts by tempting to 
solve the problem with bad law. Certainly those who have 
violated the existing laws should be prosecuted as those laws 
provide. If there is a requirement that Congress act to provide 
further legislative safeguards that, to me, is the thrust of 
what we need to do and what we need to understand.
    Certainly, the confidence of the American public and others 
in the safeguards and the oversight of the business community 
in its private capacity has been shaken as a result of these 
events. Obviously, I think it would be a mistake for us to 
attempt to pre-empt those by simple governmental action or 
governmental rules and regulations. But I think we need to have 
assurances from the private business community that they will 
take the kind of corrective action that would not make further 
legislative, detailed legislative action necessary, but that 
they as a good part of our overall business community are 
willing to do some of the policing themselves.
    I think those are the challenges that we face. I look 
forward to the testimony of the witnesses.
    Thank you, Mr. Chairman.
    Chairman Tauzin. I thank the gentleman for an opening 
statement. He yields back and the Chair is pleased to 
recognized the gentleman from New Jersey, Mr. Pallone, for an 
opening statement.
    Mr. Pallone. Thank you, Mr. Chairman. I want to say that 
I'm amazed at how many public policy crises are Enron-related. 
I'd just like to list, for example, campaign finance reform, 
energy deregulation, SEC reform, bankruptcy protection and 
pipeline safety measures. And I don't have time to review all 
these, but the first point I'd like to make is aimed directly 
at Enron's political influence. On January 24, USA Today said 
it best. They said ``Enron's aggressive lobbying drove the 
deregulation of markets for energy and other commodities that 
allowed it to escape scrutiny and outdistance its rivals.'' The 
New York Times noted that ``Enron and its executives have been 
President Bush's most generous contributors.'' But we aren't 
hearing much about House Majority Whip Tom DeLay's well-known 
relationship with Enron and his bold, fundraising campaigns 
created in part by his former Chief of Staff, turned Enron 
lobbyist, Ed Buckham.
    A Washington Post article from October 1999 noted that 
``DeLay's fundraising deals are straight forward. A seat at the 
table to plot legislative and political strategy in exchange 
for help in passing the Republican's agenda and financial 
support for GOP candidates.''
    Well, what was Enron's role when this committee drafted 
industry-supported energy restructuring legislation that would 
have provided FERC full authority over all transmission and 
interstate commerce? According to an Energy Daily article 
printed October 21, Enron lawyers argued this very issue before 
the Supreme Court supporting FERC's order opening access to 
transmission and further arguing that it did not go far enough. 
Did Enron work with Mr. DeLay in an attempt to undermine the 
activities of this committee or try to push legislation that 
would remove consumer protections?
    Another point is aimed directly at the SEC and its role in 
corporate disclosure, 401(k) and pension reform. Enron's 
collapse caused New Jersey's Public Worker Pension Fund $60 
million in loss and 20 jobs in my District in Edison, New 
Jersey. It wasn't the largest loss, but it's the proof of the 
impact of Enron's collapse around the country.
    Finally, Mr. Chairman, I'd like to mention the need for 
bankruptcy reform in light of the effects it has on Enron's 
wholly owned subsidiary, San Juan Gas Company's 1996 pipeline 
explosion that killed 33 and injured 80 others. In 1996, Enron 
lobbied in support of the Accountable Pipeline Safety 
Partnership Act. I didn't support this bill with many of my 
colleagues and we called upon President Clinton to veto the 
bill because it gutted pipeline safety laws. Shortly after it 
became law, Enron's San Juan Pipeline exploded and NTSB 
reported this explosion noted that Enron knew that the gas 
company's operations did not comply with pipeline safety 
requirements and recommended industry practices had knowledge 
of failure to meet safety standards on this pipeline since 
1985.
    Today, Enron and its subsidiaries are being held 
accountable for financial loss, wrongful death, personal injury 
and post-traumatic stress disorder caused by this pipeline 
explosion, but according to the January 21 New York Times, 
``Enron's bankruptcy case has frozen settlement negotiations 
and the first scheduled trials for hundreds of victims.'' 
First, this provides us a clear example of why we must 
strengthen pipeline safety laws and further ensure improvements 
and reform in corporate bankruptcy.
    I know there are a lot of other issues, but I just wanted 
to highlight those, Mr. Chairman. Thank you.
    [The prepared statement of Hon. Frank Pallone, Jr. 
follows:]
  Prepared Statement of Hon. Frank Pallone, Jr., a Representative in 
                 Congress from the State of New Jersey
    Mr. Chairman, I want to say that I am amazed at how many public 
policy crises are Enron related.
    ENRON was the Lone Star of Texas, shining blindingly bright. But, 
in truth, each of the Lone Star's points of light was aimed squarely at 
the American public like a weapon. Each point represents significant 
public policy crises that warrant our immediate and thorough attention: 
campaign finance reform, energy deregulation, SEC reform, bankruptcy 
protection and pipeline safety measures.
    The first point of this Lone Star is aimed directly at Enron's 
political influence. On January 24, USA Today said it best, ``Enron's 
aggressive lobbying drove the deregulation of markets for energy and 
other commodities that allowed it to escape scrutiny and outdistance 
its rivals.'' The New York Times noted that Enron and its executives 
have been President Bush's most generous contributors giving more than 
$550,000 to President Bush's various campaigns, the vote recount 
coffers and the inaugural committee. Enron's political connection to 
and relationship with President Bush through Mr. Lay, has been tight.
    But, when asked about his relationship with Mr. Lay, President 
Bush's initial reaction was to fib. In a Texas newspaper, the Dallas 
Morning News, President Bush claimed that Kenneth Lay was ``a supporter 
of Ann Richards'' whom he ``first got to know'' when he decided to 
retain Mr. Lay as the head of the Governor's Business Council. In fact, 
according to a 1994 article published in The Nation, President Bush 
lobbied on behalf of Enron in 1988 when he called Rodolfo Terragno, a 
former Argentine Cabinet Minister and pressured Mr. Terragno to award a 
contract worth hundreds of millions of dollars to Enron. To what extent 
has Enron held onto this level of influence with President Bush and 
been able to influence public policy created by this Administration 
during the past year?
    According to a Businessweek report in December 2000, transition 
scouts were eyeing Ken Lay to serve as Treasury Secretary and just a 
few months later they reported that Ken Lay was a key Bush advisor on 
energy and was named a ``transition adviser'' to the Energy Department.
    But, we also aren't hearing much about House Majority Whip Tom 
DeLay's well-known relationship with Enron and his bold fundraising 
campaigns created in part by his former chief of staff turned Enron 
lobbyist, Ed Buckham. A Washington Post article from October 1999, 
noted that DeLay's fundraising deals are straightforward: a seat at the 
table to plot legislative and political strategy in exchange for help 
in passing the Republicans' agenda and financial support for GOP 
candidates. What was Enron's role when Rep. DeLay attempted to 
undermine the work of this committee last July by drafting industry-
supported energy restructuring legislation that in part would have 
provided FERC full authority over all transmission in interstate 
commerce? According to an Energy Daily article printed October 21, 
Enron lawyers argued this very issue before the Supreme Court--
supporting FERC's order and further arguing that it did not go far 
enough. Was it Enron that instigated the attempt to undermine the 
activities of this committee and push legislation that would remove 
consumer protections?
    This ties in very closely with the Lone Star's second bright point, 
the need to examine energy markets. Did deregulation of the electricity 
market assist Enron in its ability to operate under the radar of 
regulatory oversight? The industry maintains that a deregulated 
electricity market is necessary. However, did deregulation allow 
Enron's executives more flexibility in what Chairman Wood calls, 
``questionable non-core business investments''? To what extent do we 
need to implement more transparency in the electricity trading market?
    I think it is also important to keep in mind the expanding web of 
relationships as well. Last year, Vice President Cheney told Frontline 
that he did not hear from Mr. Lay regarding FERC appointments. However, 
the White House last week admitted that it received a letter signed by 
Mr. Lay that included suggestions for new FERC commissioners. Mr. Lay's 
suggestions included Pat Wood and Nora Brownell, now the FERC Chairman 
and a Commissioner respectively. Is this mere coincidence?
    The third Lone Star point is aimed directly at the SEC and its role 
in overseeing accounting and auditing activities, corporate disclosure, 
401K and pensions. Enron's collapse caused New Jersey's public-worker 
pension fund $60 million in loss and 20 jobs in the Edison, New Jersey 
office--not the largest loss of a state but proof that the impact of 
Enron's collapse was broad. We need to take action to prevent mega-
corporations from undermining the retirement savings of their 
employees. Employees must have accurate information about the pension 
benefits they have earned, including employer stock holdings in their 
plans, and vested employees must have the right to diversity employer 
contributions. Employers should also have to provide clear notice 
before ``locking down'' pension account, and allowed to do so for only 
a limited time. Finally, employees must be able to use the Labor 
Department and the courts to recover losses if their retirement funds 
are misused. We cannot allow such financial losses to fall upon 
misinformed workers again.
    The fourth and fifth points of the this Lone Star's saga are 
related, the need for bankruptcy reform in light of the effects it has 
had on Enron's wholly owned subsidiary San Juan Gas Company's 1996 
pipeline explosion that killed 33 and injured 80 others.
    In 1996, Enron lobbied in support of the Accountable Pipeline 
Safety Partnership Act. I did not support this bill and with many of my 
colleagues and called upon President Clinton to veto this bill--it 
gutted pipeline safety laws. Shortly after it became law, Enron's San 
Juan pipeline exploded. An NTSB report of this explosion noted that 
Enron knew ``that the gas company's operations did not comply with 
pipeline safety requirements and recommended industry practices had 
knowledge of failure to meet safety standards on this pipeline'' since 
1985.
    Today, Enron and its subsidiary are being held accountable for 
financial loss, wrongful death, personal injury and post-traumatic 
stress disorder caused by the pipeline explosion. But, according to a 
January 21 New York Times article, Enron's bankruptcy case has frozen 
settlement negotiations and the first scheduled trials for hundreds of 
victims. First, this provides us a clear example why we must strengthen 
pipeline safety laws to prevent corporate negligence as well as ensure 
that corporate bankruptcy protection does not undermine the ability of 
innocent victims to receive compensation for such loss.
    Thank you.

    Chairman Tauzin. The gentleman yields back his time and the 
Chair will recognize Mr. Cox, if he's ready for his opening 
statement, for 3 minutes.
    Mr. Cox. Thank you, Mr. Chairman. On September 11, the men 
and women who worked at the World Trade Center, Wall Street 
analysts, traders, investment bankers, accountants were heroes. 
We recognize that among the 3,000 souls who perished that day 
were some of our best and brightest, extraordinary individuals 
whose creativity, energy and leadership helped power the 
economic miracle that is our free enterprise system.
    Today, America's men and women of Wall Street are under 
deep suspicion. The problems at Enron, K-Mart and Global 
Crossing and at their accounting firms have deeply damaged the 
credibility of every accountant, every corporate manager, every 
analyst.
    Today, accountancy is in the dock. The essence of the Enron 
fraud is accounting. According to the Powers Report, the 
accounting for Chewco was flatly wrong from its inception. The 
purpose of the many SPEs that Enron created was to keep debt 
and risk hidden from investors, from regulators and from the 
public. The audited financial statements were misleading. The 
only questions that remained are the various levels of 
culpability and the number of people knowingly involved.
    It is my hope that as we explore accounting issues today, 
we can learn not only how to inform remedial legislation, but 
also how to inform better regulation, both by the industry and 
by the Securities and Exchange Commission.
    I hope that we also keep uppermost in mind our 
responsibility to protect the livelihoods of those people who 
are not guilty of any wrong doing and who participate honestly 
every day in the business of America at other places of work, 
in other firms. I hope that we do everything possible to 
restore the confidence of the investing public, of workers and 
their own retirements and of people and their own employers so 
that we can get about the business of America.
    I thank you, Mr. Chairman.
    Chairman Tauzin. The Chair thanks the gentleman whose time 
has expired and the Chair will recognize--who's next? Mr. 
Barrett.
    Mr. Barrett. Thank you, Mr. Chairman.
    Chairman Tauzin. You are recognized for 3 minutes.
    Mr. Barrett. I want to thank you for holding this hearing 
and thank our witnesses for being here today. We should learn 
lessons about the administration of Enron's 401(k) plan today. 
As a result of what may prove to be willful deception, 
thousands of workers lost not only their family supporting job, 
but also their retirement savings. Those families deserve 
answers from this Congress.
    We should learn lessons about the limits of Wall Street's 
securities analysis capabilities. Because of America's 
investment advisor and brokerage houses took Enron at its word, 
America's families and large institutional investors suffered 
untold losses. Wisconsin State employees alone lost over $45 
million in pension fund assets when Enron stocks held by 
Wisconsin Investment Board became virtually worthless. 
Wisconsin employees and participants in other large 
institutional investment plans have worked hard to earn their 
pension benefits. And Mr. Chairman, they deserve answers from 
this Congress.
    We should learn lessons about the effectiveness of the 
accounting and audit system that helps investors and creditors 
to value one business venture against another. Enron's chief 
work product appears to have been a web of dummy corporations 
and mislabeled accounts. With literally thousands such sham 
devices, the company's wrong doing appears to have been as 
inconspicuous as a bulldozer at a tea party. But Arthur 
Andersen signed off on Enron's reports and investors around the 
world took Enron at its word, in part, because Andersen had 
looked over the books.
    Some of Andersen's reactions to allegations concerning its 
role in Enron's failure have been disappointing. In comments 
appearing in the February 3 Washington Post, Andersen spokesman 
Charlie Leonard responded to Enron's internal audit by setting 
Enron's failure to provide information about its money-pit 
partnership Chewco. ``We attempted to speak with them and they 
didn't speak with us'' Mr. Leonard told the Post.
    Now it's been a while since I worked as a Federal bank 
examiner, but as I recall when a responsible auditor does not 
get the information he needs to be satisfied that the numbers 
add up, he refuses to sign off on the audit. He doesn't rubber 
stamp it and then complain after the fact that he hadn't gotten 
all the information.
    To borrow a phrase from President Bush, Enron's math was 
not just fuzzy, it was hairy, wooly, shaggy, downright furry. 
But whether it was willful complicity or just shoddy work, 
Arthur Andersen was the watchdog that never barked.
    We can take lessons from these failures too. The current 
system of auditor accountability based on peer review may no 
longer serve the public interest. I am hopeful that our 
witnesses will help us consider whether an independent, self-
regulatory organization might better safeguard American 
investors.
    We can also take a broader lesson from the Enron debacle 
about the importance of honest and complete information 
disclosure. A capitalist economy, like America's, requires a 
certain basic level of trust between business associates. One 
party must believe that information provided by the other is 
accurate and complete or the system cannot work.
    In this case, this was forgotten. We should learn from 
these failures and assure that America's business transactions 
are more transparent, more accessible and more responsible than 
before.
    Thank you, Mr. Chairman.
    [The prepared statement of Hon. Tom Barrett follows:]
 Prepared Statement of Hon. Tom Barrett, a Representative in Congress 
                      from the State of Wisconsin
    Thank you, Mr. Chairman.
    And I want to thank all of our witnesses for appearing today. I 
expect that we will find your testimony enlightening.
    Mr. Chairman, the focus of today's hearings is certainly an 
appropriate one. We should be looking for lessons from Enron's 
collapse, because there is a lot at stake.
    We should learn lessons about the administration of Enron's 401(k) 
plan. As the result of what may prove to be willful deception, 
thousands of workers lost not only a family-supporting job but also 
their retirement savings. Those families deserve answers from this 
Congress.
    We should learn lessons about the limits of Wall Street's 
securities analysis capabilities. Because America's investment advisors 
and brokerage houses took Enron at its word, American families and 
large institutional investors suffered untold losses. Wisconsin state 
employees alone lost over $45 million in pension fund assets, when 
Enron stocks and bonds held by the Wisconsin Investment Board became 
virtually worthless. Wisconsin employees and participants in other 
large institutional investment plans have worked hard to earn their 
pension benefits, and Mr. Chairman, they deserve answers from this 
Congress.
    We should learn lessons about the effectiveness of the accounting 
and audit system that helps investors and creditors to value one 
business venture against another. Enron's chief work product appears to 
have been a web of dummy corporations and mislabeled accounts. The 
company's wrongdoing appears to have been as inconspicuous as a 
bulldozer at a tea party. But Arthur Andersen signed off on Enron's 
reports, and investors around the world took Enron at its word, in part 
because Anderson had looked over the books.
    Some of Arthur Andersen's reactions to allegations concerning its 
role in Enron's failure have been disappointing, to say the least. In 
comments appearing in the February 3rd Washington Post, Anderson 
spokesman Charlie Leonard responded to Enron's internal audit by citing 
Enron's failure to provide information about its money-pit partnership, 
Chewco. ``We attempted to speak with them, and they didn't speak with 
us,'' Mr. Leonard told the Post.
    Now, it's been a while since I worked as a federal bank examiner. 
But as I recall, when a responsible auditor does not get the 
information he needs to be satisfied that the numbers add up, he 
refuses to sign off on the audit. He doesn't rubber-stamp it, then 
complain after the fact that he hadn't gotten all of the information.
    To borrow a phrase from President Bush, Enron's math was not just 
fuzzy--it was hairy, woolly, shaggy--downright furry. But whether 
because of willful complicity or just shoddy work, Arthur Anderson was 
the watchdog that never barked.We can take lessons from Andersen's 
failures, too. The current system of auditor accountability, based on 
peer reviews, may no longer serve the public interest. I am hopeful 
that our witnesses will help us to consider whether an independent, 
self-regulatory organization might better safeguard American investors.
    We can also take a broader lesson from the Enron debacle, about the 
importance of honest and complete information disclosure. A capitalist 
economy like America's requires a certain basic level of trust between 
business associates. One party must believe that information presented 
by the other party is accurate and complete, or the system cannot work.
    In this case, this was forgotten. We should learn from their 
failures and ensure that America's business transactions are more 
transparent, more accessible, and more responsible than before.

    Chairman Tauzin. I thank the gentleman. The Chair 
recognizes Mr. Blunt of Missouri.
    Mr. Blunt. Enron went down with a bang not a whimper and 
the ripple effects have been felt in communities nationwide. In 
my hometown of Stratford, Missouri--one of the largest 
employers and you don't have to be a very big employer in 
Stratford, Missouri, but one of the largest employers--went out 
of business on Friday because their owner had a contract and a 
loan with Enron. Enron couldn't hold up their end of the 
bargain and now 130 Southwest Missourians are looking for work. 
This is a complicated story with ramifications spilling over 
into many legislative and regulatory areas. It would be easy 
for me and for all of us on this panel to propose a mountain of 
changes to prevent what happened to Enron. Subsequently, what 
happened to businesses like Midwest Products in Stratford from 
ever happening again. That's why I'm so pleased that the Mr. 
Chairman has chosen to hold these hearings so that we, as a 
committee, can find out what new regulations really are 
warranted or whether we're simply creating obstacles to 
solutions in the future.
    Much of this mess may have been attributed to illegal 
business practices or individual misconduct, but we can't, of 
course, legislate scruples. Some of this bankruptcy could be 
the result of bad business decisions and we can't legislate 
good business judgment either. But the true scandal of this 
case may be cutting bookkeeping tricks and promises of 
retirement security that ultimately weren't worth the paper 
they were written on.
    It's clear that we need to shine some light on corporate 
practices and then enforce corporate disclosure requirements. 
SEC regulations and accounting rules already require disclosure 
in situations that are likely to have a material effect on a 
company's financial condition, but in this case, Enron's 
financial disclosures were vague at best or criminal at worst.
    Wall Street continued to overvalue Enron stock based on 
this pattern of misleading reports. If adequate information had 
been available about the true state of Enron's finances, Enron 
employees would have made informed decisions about their 
financial futures. After all, fully 62 percent of their 401(k)s 
consisted of Enron stock and that stock plummeted from over $80 
a share in January 2001 to less than $.80 a share by January 
2002.
    They never had a real chance, based on the reassurances 
they apparently were receiving about the future state of the 
company. I'm co-sponsoring legislation as many on this panel 
are. The legislation I'm working on with Congressman Portman 
and Congressman Carden will be legislation that will help 
workers avoid over-concentration in stock of their own 
companies. Enron's been a case in point for enhanced employee 
control of retirement security. We need to look closely at a 
bill of rights for retirement security.
    Look at all the Enron-related problems that could have been 
avoided had we had this type of regulation already on the 
books.
    I look forward to the committee's investigation of 
corporate disclosures at Enron and at all companies. We need to 
get to the bottom of what changes need to be made and then 
enforce them so that workers aren't left trading years of 
service for empty promises and uncertainty in their retirement 
years.
    [The prepared statement of Hon. Roy Blunt follows:]
Prepared Statement of Hon. Roy Blunt, a Representative in Congress from 
                         the State of Missouri
    Mr. Chairman, I want to thank you for calling these hearings. We 
have an excellent opportunity to use Enron's collapse to effect some 
significant change in the way our nation's businesses do business.
    Enron went down with a ``bang--not a whimper,'' and the ripple 
effects have been felt in communities nationwide. In my hometown of 
Strafford, Missouri, one of our largest employers went out of business 
on Friday because their owner had a contract and a loan with Enron, and 
Enron couldn't hold up their end of the bargain. Now 130 Southwest 
Missourians are looking for work.
    This is a complicated story with ramifications spilling over into 
so many legislative and regulatory areas. It would be easy for me and 
for all of us on this panel, Mr. Chairman, to propose a mountain of 
changes to prevent what happened to Enron--and subsequently to 
businesses like Midwest Products in Strafford--from ever happening 
again. That's why I'm so pleased that you're conducting these 
hearings--so we as a committee can find out which new regulations are 
warranted, or whether we'd simply be creating obstacles to the real 
solutions.
    Much of this mess may be attributable to illegal business practices 
or individual misconduct, and we can't legislate scruples. Some of this 
bankruptcy could be the result of imprudent business decisions.
    And we can't legislate good business judgment either. But the true 
scandal in this case may be that which is perfectly legal--cunning 
bookkeeping tricks and promises of retirement security that ultimately 
weren't worth the paper they were written on.
    It's clear that we need to shine some light on corporate practices 
and enact, and then enforce, corporate disclosure requirements. SEC 
regulations and accounting rules already require disclosure in 
situations that are likely to have a material effect on a company's 
financial condition, but, in this case, Enron's financial disclosures 
were vague at best and criminal at worst. Wall Street continued to 
overvalue Enron stock--based on this pattern of misleading reports.
    If adequate information had been available about the true state of 
Enron's finances, Enron employees could have made informed decisions 
about their financial futures. After all, fully 62 percent of their 
401(k)s consisted of Enron stock, and that stock plummeted from 80 
dollars a share in January 2001 to less than 80 cents a share in 
January 2002. They never even had a chance.
    I signed on yesterday to a bill Congressmen Portman and Cardin have 
introduced to avoid workers' over-concentration in the stock of their 
own companies. Enron has been a case-in-point for enhancedemployee 
control of retirement security. This legislation would provide for new 
diversificationrights, new disclosure requirements and new tax 
incentives for retirement planning and education. It's a bill of rights 
for retirement security.
    Look at all of the Enron-related problems that could have been 
avoided had we had this type of regulation already on the books to 
allow employees to take control of their own financial futures. This 
bill will prohibit companies from forcing employees to invest in 
employer stock. It will grant new diversification rights for 401(k) 
matching contributions in employer stock. The bill will require 
companies to notify employees within 21 days of so-called ``blackout'' 
periods, so they can rearrange their investments if they see fit. And 
it will require companies to make sure employees know about general 
investment principles when they enroll in a retirement plan, so they 
can make knowledgeable decisions about their futures.
    Mr. Chairman, I look forward to the Committee's investigation of 
corporate disclosure--at Enron and in all companies. Let's get to the 
bottom of what changes need to be made and then enforce them, so that 
workers aren't left trading years of service for empty promises and 
uncertainty in their retirement years.
    Thank you, Mr. Chairman.

    Mr. Blunt [presiding]. I recognize Ms. DeGette for an 
opening statement.
    Ms. DeGette. Thank you, Mr. Chairman. I guess I'll 
filibuster until everyone else comes back.
    Mr. Blunt. Then we have Mr. Ehrlich to follow you who has 
to vote as well.
    Ms. DeGette. I have an opening statement which I will 
submit for the record, but I have a few comments I'd like to 
make. I'm privileged to sit on the Oversight and Investigations 
Subcommittee which has been investigating the Enron mess over 
the last few weeks and a few of my observations are as follows: 
when we started this investigation several weeks ago, we were 
told that the entire collapse of the house of cards that was 
Enron was due to just a few bad actors and as we have gotten 
deeper and deeper into this issue, it has become clear to all 
of us that the problems go deep and wide, both in Enron and all 
of its advisors.
    Let me give a few examples. First, Enron's auditors, Arthur 
Andersen. We were told in the Oversight and Investigations 
Subcommittee that one renegade at Arthur Andersen, David 
Duncan, the project manager, on his own decided to simply shred 
documents using an appropriately named company, Shredco. And we 
were told that he just decided this should be done.
    As we went through the hearing it became immediately clear, 
that the shredding was done with the tacit understanding and 
the not-so-tacit advice of Andersen's in-house legal department 
and of Mr. Duncan's supervisors. Mr. Duncan was told to use 
Andersen's regular policy and destroy all backup documentation. 
He was told this, even after Andersen and Enron knew of pending 
litigation.
    Second, the limited partnerships. We've heard much today 
and in the last week about the complex web of limited 
partnerships and other financial entities which were designed 
to boost up Enron's balance sheet while at the same time hiding 
fantastic losses. We were told at first this was just a few 
greedy individuals. But as we sat through the Oversight an 
Investigations Subcommittee hearings this week, it became 
immediately clear that Andersen's senior management and their 
board were either asleep at the switch or worse.
    This is the diagram of the Chewco transaction. You can't 
see it too well from the witness table, but it doesn't make 
much difference because this transaction is so complex it's 
difficult for even fairly well trained lawyers like me to 
understand what was going on. But the bottom line was to shift 
Enron's debt off the books to run it through limited 
partnerships and other entities and in the end to inflate what 
it looked like the bottom line was. There were thousands of 
entities not all structured like this. In fact, many structured 
quite differently than this. This is a diagram of the first 
financial entity put together which I have an interest in since 
it was a Colorado company, Rhythms. As you can see, these two 
are very different transactions. And as we sat there and 
listened to the web of very complicated partnerships and 
accounting slight of hand, I could only help but think of one 
thing, what would a low level Enron employee with all of their 
401(k) retirement plan in stocks make of these? The Enron 
investors relied upon Arthur Andersen, the Board of Directors 
and senior management of Enron to make sure that all of these 
transactions were legitimate and that any conflicts of interest 
were disclosed.
    Finally, the huge personal gains made by Enron employees 
and offices. Again, we were told this was just one or two 
people making a lot of money. As we sat in the Oversight and 
Investigations Subcommittee, we realized many senior level 
employees, several officers were benefiting unbelievably from 
these. Let me just give a couple of examples. People who 
invested a few thousand dollars in the limited partnership and 
received $1 million in compensation 6 months later. People who 
invested a few tens of thousands of dollars and received $30 
million in compensation, just a few months later, all 
undisclosed. It's clear we must know exactly what happened. How 
did Enron senior executives and board members hide these losses 
while getting personal gains like this? What can Congress do? 
And most importantly, perhaps, what can our society do to 
protect the small investors who have lost everything while the 
executives gained.
    [The prepared statement of Hon. Diana DeGette follows:]
Prepared Statement of Hon. Diana DeGette, a Representative in Congress 
                       from the State of Colorado
    Thank you, Mr. Chairman. In the past few weeks all of us have been 
stunned by the revelations surrounding Enron's bankruptcy and the 
involvement of Arthur Anderson. These hearings may help us get to the 
bottom of the matter. The arrogant web of lies and deception must be 
untangled.
    We must restore investor confidence, mandate greater transparency, 
deter other corporations from flimsy fiscal practices, and find just 
recompense for employees who lost their savings.
    Enron was the largest corporate implosion in history. And while 
those charged with fiduciary duty protected their money, loyal 
employees and trusting investors were scammed. The American people have 
lost confidence that Enron will provide the truth. They have learned 
that Arthur Anderson, which functioned as an auditing safeguard, failed 
in its duty. Now, the American people are looking to us for an honest 
accounting. It is our duty to use these hearings to answer the many 
questions at hand.
    We must know exactly what happened. How did Enron's senior 
executives and board members hide such fantastic losses while 
themselves realizing some breathtaking gains? How can shell 
partnerships be created that bury huge losses? How did Enron get away 
with annual reports filled with half-truths, even lies, omitting key 
information and transactions? What kind of corporate mentality creates 
a climate to ignore the law with seeming impunity, especially in an 
organization that in many ways was so visible?
    We know Enron was a hard-charging, rapid-growth company that 
constantly pushed the envelope. The Powers Report detailed a litany of 
problems, compounded by a corporate mentality where executives thought 
that the law was an inconvenience to be over-ridden, not a legitimate 
public demand for honest practices and transparent dealings.
    Arthur Anderson helped Enron, of course. How did a reputable, 
internationally recognized firm like Arthur Anderson fail to provide a 
credible, transparent, honest audit of the company? How did Arthur 
Anderson hope to remain objective and credible when they were receiving 
astronomical consulting fees?
    I am most mindful of the many investors here who have lost their 
money, and the employees who lost their retirement funds. What can 
Congress do to protect these employees and shareholders, many of whom 
have lost their entire retirement savings. We have had two Oversight & 
Investigation hearings which have provided extensive illumination. I 
look forward to learning more today so that we may begin to untangle 
the web which Enron left us.
    Thank you.

    Mr. Blunt. The gentlelady's time has expired. The Chair 
recognizes the gentleman from Maryland, Mr. Ehrlich, for 3 
minutes.
    Mr. Ehrlich. Thank you, Mr. Chairman. I have a sense of 
compassion for our witnesses. I'll give you the Cliff Notes 
version of my opening statement because you all have certainly 
gotten the spirit of the day.
    We all know Enron is the largest corporation in American 
history to file for bankruptcy. In addition to the type of 
investor losses the gentlelady just discussed, there was a 
dramatic and sudden fall in Enron stock prices that stripped 
retirement accounts of many current and retired Enron employees 
whose savings were based on Enron's stock.
    Our committee colleagues from both sides of the aisle 
support this committee's efforts to discover whether or not 
Enron engaged in illegal business practices. We want to 
understand a lot. We want to understand why executives received 
large bonuses and compensations during a period of financial 
decline while other employees were prevented from selling their 
stock. We want to understand how such a large corporation was 
able to hide its debt and collapse without any warning from 
responsible regulatory agencies and auditors.
    Yet additional questions must be answered. Did Enron's use 
of a large number of partnerships contribute to its collapse? 
Was there a complete failure of Federal regulators? Did Federal 
regulators have authority to adequately oversee complex 
commodity trading and financial transactions, the foundation of 
Enron's rapid growth?
    Through your guidance we'll certainly come to some 
conclusions, hopefully, solid conclusions with regard to these 
issues.
    Chairman Tauzin's efforts to promote dependable, affordable 
and environmentally friendly production and distribution of 
energy are well known. Some, and you've heard a sampling here 
today, but not most members of this committee, may try to 
confuse deregulation and the need for sound energy policy with 
illegal and duplicitous actions. I continue to believe that the 
competitive market protected from potential abuse through 
proper oversight and the law remains the foundation for a 
strong economy, the basis for our national security and 
provides the best products and services for our citizens.
    We look forward to what you all have to say and thank you 
for being here. I yield back.
    [The prepared statement of Hon. Robert Ehrlich follows:]
Prepared Statement of Hon. Robert Ehrlich, a Representative in Congress 
                       from the State of Maryland
    Thank you, Mr. Chairman. Mr. Chairman, the failure of any business 
is deeply disappointing. In most cases, employees and their families 
bear the brunt of this failure with many experiencing a profound sense 
of loss, anger, and shame. As the failure ripples through related 
enterprises, rocking businesses and communities--disillusionment and 
loss is left in its wake. Unfortunately, the tempest of a failed 
enterprise is in direct proportion to its size, and, accordingly, I 
applaud your conducting this inquiry of Enron, once our nation's 7th 
largest company.
    On December 2, 2001, energy-giant Enron shocked the energy and 
financial communities by filing for Chapter 11 bankruptcy. Enron is the 
largest corporation in American history to file for bankruptcy. In 
addition to investor losses, the sudden and dramatic fall in Enron's 
stock price has stripped the retirement accounts of many current and 
retired Enron employees, whose savings were largely based on Enron 
stock.
    Mr. Chairman, my colleagues and I support the committee's efforts 
to discover whether or not Enron engaged in illegal business practices. 
We want to understand why executives received large bonuses and 
compensation during Enron's financial decline while other employees 
were prevented from selling their stock. We want to understand how such 
a large corporation was able to hide its debt and collapse without any 
warning from responsible regulatory agencies and auditors. Yet 
additional questions must be answered: Did Enron's use of a large 
number of partnerships contribute to its collapse? Was there a failure 
re the performance of federal regulators? Did federal regulators have 
authority to adequately oversee complex commodity trading and financial 
transactions--the foundation of Enron's rapid growth? Through your 
guidance, these and many other questions will be answered.
    Mr. Chairman, I applaud your efforts to review accounting 
standards, practices, and services and their effects in the Enron 
collapse. If there are flaws in the regulatory system, then the laws 
must be changed to guarantee that a debacle of this magnitude will 
never happen again. I agree with President Bush's State of the Union 
statement that through stricter accounting standards and tougher 
disclosure requirements will make corporate America more accountable to 
employees and shareholders alike. This must be an era of corporate 
responsibility.
    The deliberate destruction of evidence by an employee in an ongoing 
investigation brings its own State and Federal criminal and civil 
penalties, as does failure to comply with SEC regulations and 
directives. Our court system will resolve the many lawsuits seeking 
justice and compensation. Illegal and duplicitous actions should not 
and cannot be tolerated. Further, it is clear that some may attempt to 
use this business scandal that has hurt so many as a tool for petty 
politics and opinion manipulation. We owe those who have worked hard, 
played by the rules, and have lost so much a strong, bipartisan 
investigation, or risk victimizing them a second time.
    Mr. Chairman, your efforts to promote dependable, affordable, and 
environmentally-sound production and distribution of energy are well 
known. Opponents may try to confuse deregulation with illegal and 
duplicitous actions. I continue to believe that the competitive market, 
protected from potential abuse through proper oversight and legal 
protections, remains the foundation for a strong economy, the basis for 
national security, and provides the best products and services to our 
citizens.
    Finally, this committee's investigation into Enron's business 
practices will prevent future business collapses of this nature, 
determine the effectiveness of Federal oversight and regulatory 
agencies, and make clear whether changes to Federal law are necessary 
to protect employees and shareholders. We must and will get to the 
bottom of Enron's failure, and work to ensure it never happens again.
    Thank you Mr. Chairman.

    Chairman Tauzin. I thank the gentleman for his statement. 
The Chair is pleased to recognize the gentlelady, Ms. McCarthy, 
for an opening statement.
    Ms. DeGette, I was not here to recognize you and I did want 
to take a moment to personally thank you for the extraordinary 
work you're doing on the subcommittee and I deeply appreciate 
the attention you've given that work. Thank you.
    Ms. McCarthy is recognized for 3 minutes.
    Ms. McCarthy. I thank you very much, Mr. Chairman. I thank 
you for conducting this hearing. I would like the panelists to 
know that I arrived at 12:15, 2\1/2\ hours ago and so I'm going 
to submit the bulk of my text to the record, but I want to 
thank you for taking the time to be here with us today. I think 
what the committee is about is lessons learned and I'm pleased, 
Mr. Chairman, that that is how you have framed this hearing, 
because while all of us have been consumed by this in the news, 
and our committee staff has done 2 months of investigation and 
they've come up with some very serious determinations for us to 
look to, I look forward to your presentations because I think 
you're going to help us understand that many of the things that 
we feel we might need to fix can be done through regulatory and 
statutory mechanisms already in place, but that we might need 
to revisit some of the ideas that former Chairman Levitt and 
others presented to us over time that might tighten those 
regulatory processes to avoid this in the future.
    I'm particularly interested in hearing your thoughts on how 
corporate boards can reform themselves because I think they can 
go a long way toward finding or being part of the solution to 
this kind of activity so that it doesn't happen anywhere else 
and I think too, Mr. Chairman, that all of us on this committee 
can learn from this experience that we're going to have, how we 
can shape national energy policy that we are working on very 
diligently, to make sure that we in the Congress also are 
working together with the regulatory agencies and existing 
statutory law and the boards to make sure we have sound energy 
policy in the future. So I thank you and I will submit my 
formal remarks for the record.
    Chairman Tauzin. I thank the gentlelady for always very 
thoughtful comments and she yields back. Are there further 
requests for time? I believe we have the vice chairman of the 
full committee, the gentleman from North Carolina, Mr. Burr, 
who has done such an excellent job for our committee for 3 
minutes.
    Mr. Burr. I thank the Chair. I don't want to prolong 
opening statements. I only want to make a comment about the 
work of this committee. This committee has a long history and 
certainly in the 7 years that I have been here to tackle tough 
issues. And even though the Oversight and Investigations 
Subcommittee has been asked to look at numerous things in those 
7 years and prior to that under other leadership, also 
difficult issues, I personally have not been as challenged as I 
think we have been so far with the Enron issue, nor do I think 
we will be any more challenged as we head through this.
    This is clearly like peeling an onion and with every layer 
we see something different. We see something new and in many 
cases we find something even more ugly than we saw in the last 
layer. We owe it to the American people to fulfill our 
commitment of oversight, of understanding, but most 
importantly, of assurance that we have gotten at the cancer 
that exists.
    I'm confident, Mr. Chairman, under your leadership and with 
the commitment of all members, and hopefully, hopefully, with 
the cooperation of more directly involved in this whole issue 
we can get at the truth and move on to the solution much 
faster.
    I yield back.
    Chairman Tauzin. I thank the gentleman for his statement 
and the Chair yields to the gentlelady, Ms. Capps, from 
California for an opening statement.
    Ms. Capps. Thank you, Mr. Chairman. I'm so pleased the 
committee is holding this wide ranging hearing about Enron. 
It's important that we begin now to look into steps Congress, 
the regulatory agencies and corporate players must take to 
protect the public from future Enrons. The distinguished panel 
of witnesses we have here will certainly be helpful in shedding 
light on this scandal and how we might prevent future ones.
    I share the outrage of my colleagues and my constituents 
over this whole affair. The various actions of Enron and 
Andersen executives has been inexcusable, immoral and maybe 
illegal. As we all know, Enron's meltdown has cost thousands of 
the company's employees some or all of their life savings. It 
has burned millions more investors across the country. It has 
highlighted some glaring inadequacies in the accounting 
profession and its ineffective system of oversight that has 
allowed and even encouraged corporate shenanigans. And of 
course, Enron has shown us, once again, the ugly face of greed 
and dishonesty.
    Every day, congressional hearings in the media bring out 
more details about this sordid affair. We know, for example, 
that Enron executives set up thousands of partnerships to help 
the company hide its debts. We know that many of these 
executives made fortunes through these partnerships. We know 
that Arthur Andersen was involved in some or all of this and we 
now know that Enron, once touted as a management innovator, was 
apparently not much more than a sophisticated pyramid scheme.
    But there's a lot we still don't know. For starters, Mr. 
Chairman, we still don't know exactly who approved all these 
complex relationships and what they knew when they did it, who 
were all the partners and how much money they made. We don't 
know how deeply Enron may have been involved in the California 
electricity crisis. These are my constituents. How Enron's 
actions may have exacerbated that situation? We know there's a 
strong connection. We still are paying that price and will be 
paying it for a long time in California.
    Until we know answers to these and many other questions our 
work here will not be complete. So this committee must continue 
its aggressive investigation and I applaud all of the efforts 
into doing that.
    The unanswered questions, however, do not excuse us from 
taking actions immediately. I would hope that we can look into 
the idea of limiting the amount of time an accounting firm can 
do audits for the same company to a set number of years. 
Perhaps that's worth exploring. The attempt of our former SEC 
Chairman Arthur Levitt to stop accounting firms from performing 
auditing and consulting for the same client is now clearly seen 
as something that should be pursued in Congress. Some have 
suggested that the stock exchanges be responsible for hiring 
the accounting firms to audit companies. These ideas should be 
explored and I would like to hear from our witnesses on these 
and other ideas.
    These kinds of changes may be necessary to give investors 
more responsible and accurate accounting of corporate books. I 
think it's important to note, however, that at the bottom of 
all this are not seemingly mundane accounting problems. At the 
bottom appears to be simple greed and dishonesty at the highest 
levels of a corporation. It was Enron executives who were in 
charge when the company was going to say what was happening 
regarding its profits and losses. It was Enron executives that 
chose to stretch and finally break the bounds of propriety. And 
so it must be the goal of this committee to take whatever steps 
are necessary to make sure that the next set of executives in 
Enron or any other of our large corporation or any of our 
business executives think twice before they do the same thing.
    Thank you, Mr. Chairman. I yield back the balance of my 
time.
    [The prepared statement of Hon. Lois Capps follows:]
  Prepared Statement of Hon. Lois Capps, a Representative in Congress 
                      from the State of California
    Thank you, Mr. Chairman.
    I am pleased the Committee is holding this wide ranging hearing 
about Enron.
    It is important that we begin now to look into steps Congress, the 
regulatory agencies and corporate players must take to protect the 
public from future Enrons.
    The distinguished panel of witnesses we have here will certainly be 
helpful in shedding some light on this scandal and how we might prevent 
futures ones.
    I share the outrage of my colleagues and my constituents over this 
whole affair.
    The varoius actions of Enron and Andersen executives has been 
inexcusable, immoral and probably illegal.
    As we all know, Enron's meltdown has cost thousands of the 
company's employees some or all of their life savings.
    It has burned millions more investors across the country who bought 
Enron stock based on false premises.
    It has highlighted some glaring inadequacies in the accounting 
profession and its ineffective system of oversight that has allowed and 
even encouraged corporate shenanigans.
    And, of course, Enron has shown us once again the ugly face of 
greed and dishonesty.
    Every day Congressional hearings and the media bring out more 
details about this sordid affair.
    We know, for example, that Enron executives set up thousands of 
partnerships to help the company hide its debts and artificially boost 
its profits.
    We know that many of these executives made fortunes through these 
partnerships.
    We know that Arthur Andersen was involved in either setting up the 
accounts or approving them or somehow giving some cover to Enron's 
misdeeds.
    And we now know that Enron--once touted as a management innovator--
was apparently not much more than a sophisticated Pyramid scheme.
    But there is an alot we still don't know.
    For starters, Mr. Chairman, we still don't know exactly who 
approved all these complex partnerships and what they knew when they 
did it.
    We don't know who were all the partners in the partnership, how 
they became partners, or how much money they made.
    We don't know how deeply Enron may have been involved in the 
California electricity crisis and how its actions may have exacerbated 
that situation.
    And until we know the answers to these and many other questions, 
our work here won't be complete.
    This Committee must continue its aggressive investigation into 
these questions and many others.
    The unanswered questions do not, however, mean that there are no 
clear actions we should take.
    For example, the former SEC Chairman Arthur Levitt's attempt to 
stop accounting firms from performing auditing and consulting for the 
same client is now clearly seen as correct.
    I think that we should look into the idea of limiting the amount of 
time an accounting firm can do audits for the same company to a set 
numer of years is worth exploring.
    Some have suggested that the stock exchanges be responsible for 
hiring the accounting firms to audit companies.
    That idea might be worth exploring as well and I would like to hear 
from our witnesses on all these ideas.
    These types of changes may be necessary steps to give investors a 
more responsible and accurate accounting of corporate books.
    However, I think it is important to note that at the bottom of all 
this are not just seemingly mundane accounting problems.
    At the bottom of this mess appears to be simple greed and 
dishonesty in the highest levels of a corporation.
    It was Enron executives that were in charge of what the company was 
going to say regarding its profits and losses.
    It was Enron executives that chose to stretch and finally break the 
bounds of propiety.
    I hope that this Committee can take steps to make sure that the 
next set of executives think twice before doing the same thing.
    Thank you, Mr Chairman.

    Chairman Tauzin. The Chair thanks the gentlelady. The Chair 
is now pleased to recognize the gentleman from Arizona, Mr. 
Shadegg, for an opening statement.
    Mr. Shadegg. Thank you, Mr. Chairman. I want to commend you 
for holding this hearing. I'm pleased that our committee is 
going to look into these critically important issues.
    It simply cannot be stated how important this inquiry is to 
our Nation and to its free market system. If people do not have 
confidence in the market place, if they do not have confidence 
in the financial documents which describe the companies in 
which they are asked to invest, then we will not have a 
functioning free market in this country and we will not have 
the capital to move forward as a Nation and to sustain the 
lifestyle we have. So I commend you, Mr. Chairman, for holding 
these hearings.
    I think I want to jump off of the point that Ms. Capps just 
made. There are clearly some things wrong in the system. When I 
listen to the bureaucratese about special purpose entities and 
then you go behind those and you discover that they really are 
off-balance sheet entities which in this instance were used to 
hide debt and create a false impression about the financial 
security of this company, it is clear that we need to take a 
close look at the accounting standards of this country. We need 
to take a close look at the role for the SEC. We need to take a 
close look at the role of FASB and whether or not we're doing 
the right things there. I commend you for bringing in this 
particular panel of witnesses.
    But in our effort to examine this, we need to discern 
between that which was a regulatory failure where we did not 
have bright lines in the rules that govern misconduct and as 
Ms. Capps put it simple greed, because in this instance it 
looks to me fairly clear that there was a great deal of simple 
greed. No one I believe reading the documents and studying what 
happened can fail to recognize that members of the board of 
directors had to know what was going on, officers had to know 
what was going on, they had to know that the public was being 
deceived.
    Now someone should have caught that before now and we 
should make sure that the enforcement mechanisms are there to 
do so, but we should not just enact new regulations to replace 
the regulations that failed the last time and thereby burden 
the economy. This is a critically important inquiry. I commend 
you, Mr. Chairman, for conducting it.
    Chairman Tauzin. I thank the gentleman. Further requests 
for statements? Mr. Doyle is recognized for an opening 
statement.
    Mr. Doyle. Thank you very much, Mr. Chairman, and in 
deference to our panel members I'll submit my entire statement 
for the record.
    Chairman Tauzin. Without objection, so ordered.
    Mr. Doyle. And just state that this member, along with all 
members of this committee and the Nation are not only shocked, 
but outraged by what transpired here and one of the things we 
have to make sure of in this committee is that this can never 
happen again.
    Thank you, Mr. Chairman.
    [The prepared statement of Hon. Mike Doyle follows:]
  Prepared Statement of Hon. Mike Doyle, a Representative in Congress 
                     from the State of Pennsylvania
    Mr. Chairman, thank you for providing today's forum to examine 
issues that demand this Committee's prompt attention; accounting 
standards reform and auditor oversight.
    Malcolm Forbes once said: ``Too many people overvalue what they are 
not, and undervalue what they are.''
    Some of Enron's top leadership knowingly and systematically 
reported an income and financial stability that simply did not exist, 
and thus betrayed consumer trust by portraying a greater value of the 
company than actually existed. To make this matter all the more 
onerous, Enron accountants appear to have exploited loopholes in 
existing law governing the disclosure of relevant material financial 
information to achieve their deception. I am troubled by the 
allegations that top management officials with Enron capitalized on the 
lack of effective and enforceable accounting standards, and thus 
bullied their accountants into misrepresenting numbers to public 
investors to hide the fact management had made terrible business 
decisions.
    The debt incurred by these deals was obscured from investors in 
special purpose entities, and what real income Enron was realizing from 
other SPE deals was being pocketed by a select few at the top. Enron 
officials knew this was occurring, but did nothing to alert the public. 
Investors took such information in good faith and heavily invested 
pension plans in Enron stock. The results were catastrophic for working 
class Americans, as the value of employee pension plans a worker had 
invested in and counted on for years were wiped out in an instant.
    I am very concerned that our current accounting and auditing 
practices can be manipulated and exploited to hide fraudulent 
activities. This committee must look at ways to improve and strengthen 
our accounting standards to prevent intentional circumvention by 
unscrupulous individuals whose greed overshadows principle. Such 
individuals are compromising the integrity of their professional and 
personal reputations, while ruining the trust of a public that relies 
on information they provide to make investment decisions. If this is 
the best that accounting industry self-regulation can do, then Congress 
has no choice but to step in with real regulation.
    In my view, allowing the same firm on a company payroll to do the 
auditing for that company is a practice that is ripe for exploitation, 
especially when laws prohibiting this exploitation are vague or 
nonexistent. We must empower the Securities and Exchange Commission 
with the proper resources and authority to enforce accounting and 
auditing standards, and I sincerely hope this Committee explores ways 
to reduce or eliminate this conflict of interest in industry practice.
    My colleagues, one of prime directives of this Committee is to 
ensure that American consumers are protected from harmful goods and 
services. Clearly, Enron violated the rights of consumers by reporting 
false or misleading information through the use of ``pro-forma'' 
earnings reports, whereby disclosure laws are skirted through the use 
of creative accounting terms and practices. We must act to reform our 
ability to regulate and enforce disclosure laws so that investors know 
and clearly understand the financial shape of a company before making 
investments.

    Chairman Tauzin. Further requests on this side? Then the 
Chair is pleased to announced to our very patient panel of 
witnesses that he's going to recognize the last member on this 
side of the aisle, Mr. John of Louisiana. We've come full 
circle.
    Mr. John. Thank you, Mr. Chairman. I know that you're very 
happy that I'm giving an opening statement only because I'm the 
last one, right? Thank you, Mr. Chairman.
    I really appreciate the on-going efforts that you and the 
other ranking members of O&I have put together to educate the 
members of this committee, most of which are not accountants 
nor attorneys, and the public about really what went wrong at 
Enron and the steps we can take in Congress to prevent 
employees and investors at other companies from experiencing 
some of the same problems.
    There are many lessons to be learned from Enron's collapse. 
Some are very simple. But some are very complex. The expert 
panel that we have today, that you've assembled on auditing and 
accounting practices will greatly assist us and this committee 
in distinguishing between what transpired at Enron versus what 
takes place in corporate America on a day to day basis. The 
witnesses have made lots of concrete recommendations in your 
testimony, a lot of which have merit and we're going to discuss 
them today. And we'll enact, possibly enact, legislation at the 
end of our investigation.
    I think Enron's collapse revealed a complex, corporate web 
of related party transactions and off-balance partnerships that 
beg the question: ``how could this have happened to a publicly 
traded company?'' The Powers Report of which we had many hours 
of testimony yesterday reveals a company that was plagued with 
flagrant conflicts of interest, as he called them walking 
conflicts of interest through the doors of Enron, lax oversight 
of auditing and reporting processes, a complete disregard for 
their own code of ethics, and collusion among members of senior 
management to distort the true financial picture of the company 
in its public filings.
    Mr. Chairman, I believe the Justice Department will bring 
justice to the individuals that played any role in defrauding 
the millions of investors and for destroying the retirement 
dreams of thousands of employees, some of whom live in my 
District in Louisiana.
    However, I believe that it is the responsibility of this 
committee to determine what role the auditing and accounting 
professions have played in the collapse of Enron. I think that 
is our role. For example, is there enough self-regulation in 
the industry to convince investors that accurate and relevant 
information is being disclosed? Or does Congress need to take 
legislative action to ensure auditor independence?
    I think before we take any legislative action, it's 
important to be sure that we have not learned the wrong lessons 
here. We must make sure that we do not harm consumers or 
investors with our good intentions or the hasty movements of 
this committee.
    I look forward to the testimony with our witnesses here 
today, and I yield back the balance of my time.
    [The prepared statement of Hon. Chris John follows:]
  Prepared Statement of Hon. Chris John, a Representative in Congress 
                      from the State of Louisiana
    Mr. Chairman, I appreciate your ongoing efforts to educate members 
of this committee and the public about what went wrong at Enron and the 
steps we can take in Congress to prevent employees and investors at 
other companies from experiencing the same fate. There are many lessons 
to be learned from Enron's collapse, some simple and others more 
complex. The expert panel you have assembled today on auditing and 
accounting practices will greatly assist the committee in 
distinguishing between what transpired at Enron versus what takes place 
every day in corporate America. The witnesses have made many concrete 
recommendations in their written testimony which merit discussion today 
and possible legislative enactment at the end of our investigation.
    Enron's collapse has revealed a complex corporate web of related-
party transactions and off-balance-sheet partnerships that beg the 
question: how could this happen to a publicly traded company? The 
Powers Report reveals a company that was plagued with flagrant 
conflicts of interest, lax oversight of the auditing and reporting 
process, a complete disregard for their own code of ethics, and 
collusion among members of senior management to distort the true 
financial picture of the company in public filings.
    Mr. Chairman, the Justice Department will determine which Enron 
executives should be put on trial for their roles in defrauding 
millions of investors and for destroying the retirement dreams of 
thousands of employees. However, it is the responsibility of this 
committee to determine what role the auditing and accounting profession 
played in Enron's collapse. For example, is there sufficient self-
regulation in the industry to convince investors that accurate and 
relevant information is being disclosed, or does this Congress need to 
take legislative action to ensure auditor independence?
    However, before we take legislative action, it is important to make 
sure we have not learned the wrong lessons. We must make sure that we 
do not harm consumers, investors or businesses with our good 
intentions. I look forward to the testimony of our panel to ensure we 
stay on the right track.
    Thank you, Mr. Chairman. I yield back the balance of my time.

    Chairman Tauzin. I thank my friend for yielding and I think 
we're through with opening statements. I'm sorry, the chairman 
of the Energy Subcommittee, Mr. Joe Barton of Texas has 
arrived. I wish to recognize him for an opening statement.
    Mr. Barton. For once I timed it right. I got here right at 
the end of the opening statements, so I apologize to our panel 
for having to wade through all of this. I have just a few brief 
comments. I am very glad that we're holding this hearing. I 
think the American public needs to understand if it's possible 
to understand exactly what happened at Enron. I think the 
accounting practices are paramount to that understanding. I 
took six different accounting classes in undergraduate and 
graduate school. And for the first 10 years out of college I 
could understand an annual report about as well as anybody. I 
took a look at the Enron annual report and I can't understand 
it. I spent an hour attempting to really understand what they 
were doing and it's impossible by a layman reading their annual 
report.
    I am very interested to learn how some of these accounting 
practices came to be generally accepted. The mark to market 
accounting seems to me murky at best. How in the world you can 
book a revenue this year for something you may not get for 10 
or 15 years at 100 percent face value is beyond the 
comprehension of the average American. I also would be very 
interested if the panel is allowed, to discuss this practice of 
an audit firm with a consulting arm, both consulting and 
auditing the same firm. It would seem to me that one pretty 
straight forward change would be you could do one or the other, 
but you can't do both.
    So again, Mr. Chairman, I thank you for holding this 
hearing. I have followed very closely the collapse of Enron. 
I'm one of the stockholders that has now got stock that if I 
were to trade it would probably be trading at pennies on the 
dollar, so I want to get to the bottom of this as well as the 
next person and do whatever we need to do as a committee to 
prevent this from happening to future companies and future 
stockholders.
    Chairman Tauzin. I thank the gentleman. I also thank the 
gentleman for agreeing to examine the energy markets next week 
at a hearing. I think we've scheduled it for the 13th or 14th, 
Joe?
    Mr. Barton. The 13th, I think.
    Chairman Tauzin. The 13th, so stand by for that one.
    [Additional statements submitted for the record follow:]
Prepared Statement of Hon. Tom Davis, a Representative in Congress from 
                         the State of Virginia
    Mr. Chairman, I would like to first thank you for calling this 
hearing into the Enron collapse and all of the ramifications it holds 
for our economy and financial paradigm.
    To say the Enron situation is troubling is, of course, an 
understatement. Beyond being another episode of self-enrichment by 
rogue employees and careless oversight by senior officers and board 
members, this case has possible severe implications for our capitalist 
system. This is because the accounting and auditing procedures 
currently in place are now being questioned. As we have heard over the 
past several weeks, if the numbers on the financial reports are 
meaningless, or if there is widespread gimmickry in use to conceal true 
financial status of an enterprise, then we are in deep trouble. If 
investors cannot rely upon the information available to them, then the 
equities markets devolve into little more than games of chance, where 
smoke and mirrors prevail over reason and rational decision-making.
    While it is not the role of Congress to try and convict those 
charged with wrongdoing, it is the duty of Congress to conduct 
effective oversight and strengthen regulation to ensure as little 
chicanery as possible goes on in the marketplace. If, as evidence 
becomes available and as events unfold, it becomes apparent that the 
officers and former officers of the Enron Corporation were guilty of 
gross negligence and/or criminal activity, then it is my personal 
desire to see them prosecuted to the fullest extent of the law. If the 
Powers report is to be believed, it is unfortunately likely that such 
misdeeds and derelictions of duty did, in fact, occur. What is also 
troubling--perhaps more so--is the role the auditors of Arthur 
Anderson, LLP played in this whole affair. Can we believe that simple 
human error is to blame for the basic accounting mistakes attending the 
creation of the Special Purpose Entities created by Mr. Fastow in an 
effort to conceal debts and liabilities of the Enron Corporation? Or 
was something more sinister at play?
    We are now left with the aftermath of this debacle. Recently, 
doubts have been cast regarding the accounting procedures of other 
large and heretofore extremely successful companies. While the 
fluctuations of the stock market should never be used as the basis for 
policy decisions, the underlying investor doubt in financial reporting 
is something to take very seriously. Most unfortunate of all, however, 
are the employees and other innocents who were forced to stay on board 
the SS Enron while the top officials jumped like rats off the sinking 
vessel. While it may be impossible to make their retirement accounts 
whole again, this unseemly episode does give added impetus to thorough 
review of pension laws so that this does not happen to anyone else.
    In summary, there was enough shoddy oversight by all responsible 
parties, enough self-enrichment, enough complicity on the part of 
auditors and senior management, to warrant an exhaustive investigation. 
I look forward to hearing the testimony today and to the ongoing 
efforts of the committee to bring the actions of the Enron board and 
executives to light.
                                 ______
                                 
   Prepared Statement of Hon. George Radanovich, a Representative in 
                 Congress from the State of California
    Mr. Chairman, today's hearing is a very important step in building 
confidence in our U.S. capital markets. Without consumer confidence our 
American market system, based in part on trust, will not operate. While 
trust is a key, we need to fix the system to abide by the principle 
tenant of ``trust but verify.''
    We must uncover all the secret Enron partnerships that were 
designed to enrich top executives and defraud stockholders. The Enron 
Special Investigation Committee report has uncovered secret and 
possible illegal dealings between Enron and partnerships controlled by 
its top executives. We owe a thorough investigation to the people who 
worked all their lives at Enron only to retire with a handful of change 
while top executives made millions.
    Enron's attempt to trade water rights in my home state of 
California through their subsidiary Azurix Inc. is a perfect example of 
Enron's appalling business deals. It is unjust for a company to 
dissolve losses of $326 million in one transaction alone, while 
executives who leave just prior to the downfall receive millions in 
severance pay at the time of their departure. Huge severance payments 
paid out to former executives played a part in Azurix's downfall and 
left many Californians broke and unemployed.
    Due to the Enron failure and the scandalous events surrounding the 
company, the accounting profession has also been tarnished. Arthur 
Anderson has shown that the regulatory model that governs their 
profession is in dire need of reform. The conflict of interest when 
auditors provide other services, especially management consulting 
services, to their audit clients, require changes that are vital to the 
survival of the industry.
    In the end, I hope we collect enough information to determine the 
real purpose behind the creation of these secret Enron partnerships. 
And if their purpose was to have a friendly third party with which 
Enron could engage in various financial transactions in order to 
improve Enron's balance sheet, those involved should be brought to 
justice.
    For the sake of our markets, our investors, and our pension plans 
this problem must be fixed. I thank you Mr. Chairman for holding this 
hearing, and I yield back the balance of my time.
                                 ______
                                 
Prepared Statement of Hon. Joe Pitts, a Representative in Congress from 
                       the State of Pennsylvania
    Thank you Mr. Chairman. Before I begin, I would like to thank you, 
Chairman Tauzin, Chairman Greenwood, the Ranking Members, and your 
staffs for all the hard work you have been doing on behalf of this 
Committee.
    So far, this Committee's investigation of the Enron collapse has 
been very thorough and meticulous, thanks to the careful work and long 
hours put in by your staff.
    Mr. Chairman, like all of us, I am disheartened what happened with 
Enron. It seems that every day reveals new information and evidence 
about this collapse that makes this case even more serious and 
complicated.
    Enron's collapse is not just about corporate mismanagement, 
accounting standards, or regulatory failure, but about thousands of 
American working men and women who lost their jobs and saw their 
pensions shrivel to nothing.
    As we move forward on this investigation, we shouldn't forget 
them--those whose futures have been affected by this mismanagement.
    I am hopeful that this hearing will help us get to the bottom of 
what happened, and obviously, how we can avoid this from happening in 
the future.
    I look forward to hearing from this panel of experts today about 
the transactions behind the company's collapse.
    Specifically, I am interested in learning more about audit 
practices and current standards for Audit Committees and whether these 
standards are adequate to ensure meaningful oversight for shareholders.
    I am also hopeful that the witnesses will discuss the current state 
of corporate disclosure and make recommendations for improvements. 
Unfortunately, in the case of Enron, it seems there was a failure to 
communicate essential information about the real risks facing the 
company to the people who needed it most--the investors.
    As I mentioned before, our final goal in this investigation should 
be to make sure this doesn't happen again, to protect the hard-earned 
pensions of the American people and to restore their trust.
    Mr. Chairman, I believe we should be careful not to rush to 
legislative responses to the Enron bankruptcy. However, I do look 
forward to looking into President Bush's plan and others which address 
federal laws governing worker pensions and 401(k) plans.
    I appreciate the witnesses taking the time to share with us today 
and look forward to hearing their testimony.
    I yield back the balance of my time.
                                 ______
                                 
Prepared Statement of Hon. Mary Bono, a Representative in Congress from 
                        the State of California
    Mr. Chairman: Thank you for holding these hearings.
    Enron created more than 3,000 partnerships, restated nearly $600 
million of profit over four years and went from one of this country's 
top companies to a source of controversy and shame.
    Seeking to look more profitable, the creation of these 3,000 
partnerships allowed Enron to move its debts off its financial 
statements and out of the public eye. In doing so, the company 
allegedly sought to mislead investors and shareholders and betrayed the 
trust and confidence of its very own employees. In fact, Enron 
officials went beyond keeping quiet about the company's financial 
woes--top officials allegedly encouraged further investment by its 
employees when they knew this house of cards would collapse.
    It is unfortunate that Congress must now look at enacting 
safeguards for 401(K) plans not only because a business failed, but 
because of the callousness of the men and women who ran it.
    Another player in this disturbing turn of events is the Arthur 
Andersen firm. Arthur Andersen seemed to either bless these business 
practices of Enron or was oblivious to it. But what makes this 
relationship even more tenuous is the fact that not only was Arthur 
Andersen Enron's auditor, but also its consultant. Arthur Andersen 
collected audit fees of $25 million but earned even more for its 
consulting work.
    Therefore, the role played by auditors in our capital markets 
should also come under scrutiny. The ``Big Five'' have long served as a 
sort of ``Good Housekeeping'' seal of approval for investors in our 
capital markets. High standards of disclosure and transparency are the 
keystones to a healthy and vibrant market. Unfortunately, it has become 
apparent that Congress needs to discuss implementing stricter 
accounting standards and more thorough disclosure requirements.
    But these troubles do not end in the questionable business 
practices of Enron and Arthur Andersen. It is now apparent that 
individuals at both firms decided to shred documents after the Security 
and Exchange Commission launched a formal investigation on October 31, 
2001.
    Mr. Chairman, I look forward to this hearing and ones to come in 
order to understand exactly what went wrong and how Congress can 
address these problems in a responsible and well thought out manner.
                                 ______
                                 
Prepared Statement of Hon. Ralph M. Hall, a Representative in Congress 
                        from the State of Texas
    Mr. Chairman and Members of the Committee--I thank you for holding 
this hearing today on accounting issues and questions that have been 
raised in the wake of the collapse of Enron. Let me state at the outset 
that I fully support the Committee's inquiries and investigations of 
Enron to determine what, if any, laws, rules and regulations have been 
broken or evaded. While it is important that we understand fully what 
happened at Enron so that we may carry out our obligations to make 
whatever changes are needed in law and policy--we should recognize that 
ultimately the courts and the regulatory agencies will deal with what 
happened there.
    The title of this hearing--``Lessons Learned . . .'' is an 
appropriate one that is in keeping with our role. However, I suggest 
that this may be only the first ``Lessons Learned''' hearing. As facts 
continued to be uncovered, obviously there will be a need for more 
hearings of this type by the Full Committee. The witnesses before us 
today have a great deal to teach us based on what they have observed 
thus far, and I trust that we will benefit greatly from their 
observations and experience. Perhaps we ought to have them back six 
months from now and ask them how their views may have changed as the 
Enron saga continues to unfold.
    Analysts are telling us that investors are becoming uneasy about 
the truthfulness and veracity of financial statements issued by major 
corporations. As corporate securities are more widely held now by 
individuals than ever before, it is even more incumbent on us to work 
carefully but fast to find and identify the problems in accounting and 
reporting and take all actions necessary to remedy them in this 
Congress. Some people are frightened about the security of their life's 
savings in 401(k) and similar plans, so we need to work carefully and 
calmly to ascertain the facts and take appropriate action in order to 
calm the markets and those who invest in them.
    In closing, Mr. Chairman, as a member from the oil patch, let me 
urge my colleagues not to tar all other energy companies with the Enron 
brush. There are many, many well-run energy companies that are 
conservatively managed and treat their creditors, employees and 
shareholders fairly. Oil, natural gas, and--yes--electricity markets 
are evolving. But let's be careful that we don't act hastily to undo 
the progress that these markets have made. As problems are uncovered, 
let's correct them, but don't throw out the premise that competitive 
markets are innately bad.
    I yield back the balance of my time.

    Chairman Tauzin. It is now time for us to turn to our 
distinguished panel, again, with my deep appreciation for your 
patience. I hope you have gathered from all the discussions of 
the members how deeply members are concerned to find solutions, 
not just to understand what went wrong in this case, which is 
our first tour of duty, but also then move on and find 
solutions. I want to thank again Mr. Dingell and the minority 
for helping us to assemble this panel who will begin the 
process of telling us what we might want to do in order to fix 
these problems and we start with an understanding of what 
happened at Enron and we move from an understanding of what 
happened at Enron coming from Mr. James Chanos, who was the 
first, I think, of the analysts who actually could see this 
coming. He was recommending a sell while everybody else was 
recommending a buy. And we move on to experts in the accounting 
field, Mr. Robert Raber, who is the President and Chief 
Executive Officer of the National Association of Corporate 
Directors who first talked to us about the role of directors in 
a major corporation. What is their responsibility? What is 
their training? What is their expertise, what might we do to 
enhance the capacity of directors of America's publicly traded 
corporations to do a better job than we see was done at Enron? 
We'll move on to accounting issues and we'll hear from Dr. 
Roman Weil, who is a Ph.D., Professor of Accounting at the 
University of Chicago who will talk to us about general 
accounting issues and we'll move on to special purpose 
vehicles, the SPEs and the market-to-market accounting issues 
that my friend from Texas finds it difficult to follow in an 
annual report. I think all Americans would find difficult to 
follow. We will hear from Dr. Bala Dharan who is a professor in 
the Graduate School of Management at Rice University in Texas. 
We'll also then move to Mr. Baruch Lev who is the Philips 
Bardes Professor of Accounting and Finance at the Department of 
Accounting Taxation and Business Law at the Stern School of 
Business in New York. I'm told that Mr. Lev is an 
extraordinarily gifted individual in this area and who can 
teach us about accounting policy and possible remedies and we 
look forward to your recommendations, Mr. Lev. We'll move then 
to governance of accounting. Many suggestions as to how we 
might oversee the accounting industry, who audits the auditors 
has been the question raised and we're going to get some 
recommendations from another witness recommended by the 
minority, Mr. Bevis Longstreth of New York, who also has some 
expertise in this area and I would be deeply interested in your 
suggestions and observations, Mr. Longstreth. Finally, I want 
to thank David Sokol, Chairman and CEO of MidAmerican Energy 
Holdings Company for coming to give us a perspective on the 
energy markets and the energy business and how it reacted to 
the collapse of Enron and whether or not it worked well as Mr. 
Largent has indicated in working around the financial collapse 
and still delivered electricity and gas to customers across the 
country served by the seventh largest corporation in America as 
it collapsed. So we get a sense of the effect of the Enron 
collapse on the energy markets. Indeed, a distinguished panel. 
We turn to you and we welcome Mr. James Chanos, for your 
testimony, sir.

STATEMENTS OF JAMES S. CHANOS, KYNIKOS ASSOCIATES, LTD.; ROGER 
W. RABER, NATIONAL ASSOCIATION OF CORPORATE DIRECTORS; ROMAN L. 
 WEIL, UNIVERSITY OF CHICAGO; BALA G. DHARAN, RICE UNIVERSITY; 
BARUCH LEV, NEW YORK UNIVERSITY; BEVIS LONGSTRETH, DEBEVOISE & 
   PLIMPTON; AND DAVID L. SOKOL, MIDAMERICAN ENERGY HOLDINGS 
                            COMPANY

    Mr. Chanos. Good afternoon, my name is James Chanos. I 
would like to take this opportunity to thank the House 
Committee on Energy and Commerce for allowing me to offer my 
perspective on this tragic Enron story. I'm the president of 
Kynikos Associates, a New York private investment management 
company that I founded in 1985. Kynikos Associates specializes 
in short selling, an investment technique that profits in 
finding fundamentally overvalued securities that are poised to 
fall in price. Kynikos Associates employs seven investment 
professionals and is considered the largest organization of its 
type in the world, managing over $1 billion for its clients.
    Prior to founding Kynikos Associates, I was a securities 
analyst at Deutsche Bank Capital and Gilford Securities. My 
first job on Wall Street was as an analyst at the investment 
banking firm of Blyth Eastman Paine Webber, a position I took 
in 1980 upon graduating from Yale University with a B.A. in 
Economics and Political Science. Neither I nor any of our 
professionals is an attorney or a certified public accountant, 
and none of us has had any direct dealings with Enron, its 
employees or accountants.
    On behalf of our clients, Kynikos Associates manages a 
portfolio of securities we consider to be overvalued. The 
portfolio is designed to profit if the securities it holds fall 
in value. Kynikos Associates selects portfolio securities by 
conducting a rigorous financial analysis and focusing on 
securities issued by companies that appear to have (1) 
materially overstated its earnings; (2) been victims of a 
flawed business plan; or (3) that engaged in outright fraud. In 
choosing securities for its portfolios, Kynikos Associates also 
relies on the many years of experience that I and my team have 
accumulated in the equity markets.
    My involvement with Enron began normally enough. In October 
of 2000, a friend asked me if I had seen an interesting article 
in The Texas Wall Street Journal, which is a regional edition, 
about accounting practices at large energy trading firms. The 
article, written by Jonathan Weil, pointed out that many of 
these firms, including Enron, employed the so-called ``gain-on-
sale'' accounting method for their long-term energy trades. 
Basically, ``gain-on-sale'' accounting allows a company to 
estimate the future profitability of a trade made today and 
book a profit today based on the present value of those 
estimated future profits.
    Our interest in Enron and other energy trading companies 
was picked because our experience with companies that have used 
this accounting method has been that management's temptation to 
be overly aggressive in making assumptions about the future was 
too great for them to ignore. In effect, ``earnings'' could be 
created out of thin air if management was willing to push the 
envelope by using highly favorable assumptions. However, if 
these future assumptions did not come to pass, previously 
booked ``earnings'' would have to be adjusted downward. If this 
happened, as if often did, companies addicted to the crack 
cocaine of ``gain-on-sale'' accounting would simply do new and 
bigger deals--with a larger immediate ``earnings'' impact--to 
offset those downward revisions. Once a company got on such an 
accounting treadmill, it was hard for it to get off.
    The first Enron document my firm analyzed was its 1999 Form 
10-K filing, which it had filed with the U.S. SEC. What 
immediately struck us was that despite using the ``gain-on-
sale'' model, Enron's return on capital, a widely used measure 
of profitability, was a paltry 7 percent before taxes. That is, 
for every dollar in outside capital that Enron employed, it 
earned about seven cents. This is important for two reasons; 
first, we viewed Enron as a trading company that was akin to an 
``energy hedge fund.'' For this type of firm, a 7 percent 
return on capital seemed abysmally low, particularly given its 
market dominance and accounting methods. Second, it was our 
view that Enron's cost of capital was likely in excess of 7 
percent and probably closer to 9 percent, which meant from an 
economic point of view, that Enron wasn't really earning any 
money at all, despite reporting ``profits'' to its 
shareholders. This mismatch of Enron's cost of capital and its 
return on investment became the cornerstone for our bearish 
view on Enron and we began shorting Enron common stock in 
November of 2000 for our clients.
    We were also troubled by Enron's cryptic disclosure 
regarding various ``related party transactions'' described in 
its 1999 Form 10-K as well as the quarterly Form 10-Qs it filed 
with the SEC in 2000 for its March, June and September 
quarters. We read the footnotes in Enron's financial statements 
about these transactions over and over again, and like 
Representative Barton, we could not decipher what impact they 
had on Enron's overall financial condition. It did seem strange 
to us, however, that Enron had organized these entities for the 
apparent purpose of trading with their parent company, and that 
they were run by an Enron executive. Another disturbing factor 
in our review of Enron's situation was what we perceived to be 
the large amount of insider selling of Enron stock by Enron's 
senior executives. While not damning by itself, such selling in 
conjunction with our other financial concerns added to our 
conviction.
    Finally, we were puzzled by Enron's and its supporters' 
boasts in late 2000 regarding the company's initiative in the 
telecommunications field, particularly in the trading of 
broadband capacity. Enron waxed eloquent about a huge, untapped 
market in such capacity and told analysts that the present 
value of Enron's opportunity in that market could be $20 to $30 
per share of Enron stock. These statements are troubling to us 
because our portfolio already contained a number of short ideas 
in the telecommunications and broadband area based on the 
snowballing glut of capacity that was developing in that 
industry. By late 2000, the stocks of companies in this 
industry had fallen precipitously, yet Enron and its executives 
seemed oblivious to this. Despite the obvious bear market in 
telecommunications capacity, Enron still saw a bull market in 
terms of its own valuation of the same business, an ominous 
portent.
    In January 2001, we began contacting a number of analysts 
at various Wall Street firms with whom we did business and 
invited them to our offices to discuss Enron. Over the next few 
months a number of them accepted our invitation and met with us 
to discuss Enron and its valuation. We were struck by how many 
of them conceded that there was no way to analyze Enron, but 
that investing in Enron was instead a ``trust me'' story. One 
analyst, while admitting that Enron was a ``black box'' 
regarding profits, said that, as long as Enron delivered, who 
was he to argue. It was clear to us that most of these analysts 
were hopelessly conflicted over the investment banking and 
advisory fees that Enron was paying to their firms. We took 
their ``buy'' recommendations, both current and future, with a 
very large gain of salt.
    Something else that caught our attention was a story that 
ran in The New York Times about Enron in early February of 
2001. In light of the California energy crisis, Enron was 
invoking a little-noticed clause in its contract with its 
California retail customers. This clause allowed Enron to 
directly match its retail buyers of power in California with 
the power providers with whom Enron had contracted on its 
customers' behalf. Most of these power providers were in 
bankruptcy now. In effect, Enron was telling a number of very 
prominent California companies and institutions ``This is now 
your problem, not ours.'' This was done despite the fact that 
Enron was paid by its customers a middleman fee precisely so 
that Enron would accept what is called counter-party risk, 
something Enron now backed out of doing. As a result, Enron's 
credibility in the entire energy retail business began to 
crumble simply because the company refused to recognize sure 
losses in California. One of my analysts said at the time, 
``Gee, it's as if Enron can never admit to a losing trade.'' 
Future revelations would prove that remark prophetic.
    It was also in February 2001 that I presented Enron as an 
investment idea at our firm's annual ``Bears in Hibernation'' 
conference. As I recounted Enron's story to the conference 
participants, most of them agreed that the fact pattern and 
numbers presented were very troubling. Most also agreed that 
Enron's stock price left no room for error. Following our 
conference, the short position in Enron reported monthly began 
to move higher.
    In the spring of 2001, we heard reports, confirmed by 
Enron, that a number of senior executives were departing from 
the company. Further, the insider selling of Enron stock 
continued unabated. Finally, our analysis of Enron's 2000 Form 
10-K and March 2001 Form 10-Q filings continued to show low 
returns on capital as well as a number of one-time gains that 
boosted Enron's earnings. These filings also reflected Enron's 
continuing participation in various ``related party 
transactions'' that we found difficult to understand despite 
the more detailed disclosure Enron had provided. These 
observations strengthened our conviction that the market was 
still is over-pricing Enron's stock.
    In the summer of 2001, energy and power prices, 
specifically natural gas and electricity, began to drop. Rumors 
surfaced routinely on Wall Street that Enron had been caught 
``long'' in the power market and that it was moving 
aggressively to reverse its exposure. It is an axiom in 
securities trading that no matter how well ``hedged'' a firm 
claims to be, trading operations always seem to do better in 
bull markets and to struggle in bear markets. We believe that 
the power market had entered a bear phase at just the wrong 
moment for Enron.
    Also in the summer of 2001, stories began circulating in 
the marketplace about Enron's affiliated partnerships and how 
Enron's stock price itself was important to Enron's financial 
well-being. In effect, traders were saying that Enron's 
dropping stock price could create a cash-flow squeeze at the 
company because of certain provisions and agreements that it 
had entered into with affiliated partnerships. These stories 
gained some credibility as Enron disclosed more information 
about these partnerships in its June 2001 Form 10-Q which it 
filed in August of 2001.
    To us, however, the most important story in August of 2001 
was the abrupt resignation of Enron's CEO, Jeff Skilling, for 
``personal reasons.'' In our experience, there is no louder 
alarm bell in a controversial company than the unexplained, 
sudden departure of a chief executive officer no matter what 
``official'' reason is given. Because we viewed Skilling as the 
architect of the present Enron, his abrupt departure was the 
most ominous development yet. Kynikos Associates increased its 
portfolio's short position in Enron shares following this 
disclosure.
    The events affecting Enron that occurred in the fall of 
2001, particularly after October 16, have been recounted 
seemingly everywhere in the financial press. Kynikos Associates 
cannot add much to that discussion, but I have tried to provide 
an overview of what our firm thought were significant 
developments and revelations during the preceding 12 months.
    And while this testimony is mainly about our firm's 
assessment of Enron and the basis for that assessment, we would 
be remiss if we did not share a few observations about what 
happened.
    First and foremost, no one should depend on Wall Street to 
identify and extricate investors from disastrous financial 
situations. There are too many conflicts of interest, all of 
them usually disclosed, but pervasive and important 
nevertheless. In addition, outside auditors are archaeologists, 
not detectives. I can't think of one major financial fraud in 
the United States in the last 10 years that was uncovered by a 
major brokerage house analyst or an outside accounting firm. 
Almost every such fraud ultimately was unmasked by short 
sellers and/or financial journalists.
    In addition, a company's adherence to GAAP, generally 
accepted accounting principles, does not mean that the 
company's earnings and financial position are not overstated. 
GAAP allows too much leeway in the use of estimates, forecasts 
and other inherently unknowable things to portray current 
results. In the hands of dishonest management, a rapidly 
growing subset in my opinion, GAAP can mislead far more than 
they inform. Further, I believe that certain aspects of GAAP, 
particularly accounting for stock options in the United States, 
are basically a fraud themselves. Such obvious accounting scams 
should be ended immediately without any interference by third 
parties.
    While no fan of the plaintiffs bar, I must also point out 
that the so called ``Safe Harbor'' Act of 1995 has probably 
harmed more investors than any other piece of recent 
legislation. The statute, in my opinion, has emboldened 
dishonest managements to lie with impunity, by relieving them 
of concern that those to whom they lie will have legal 
recourse. The statute also seems to have shielded underwriters 
and accountants from the consequences of lax performance of 
their ``watchdog'' duties. Surely, some tightening of this 
legislation must be possible, while retaining the worthy 
objective of preventing obviously frivolous lawsuits.
    Our current system of self-monitored disclosure is first-
rate in my opinion, with one important exception. In this day 
and age of EDGAR, the internet and real-time disclosure, our 
system for disclosing insider stock purchases and sales remains 
antiquated. Insiders buying or selling shares should disclose 
such transactions immediately. And esoteric collars, loan/stock 
repurchase deals and other derivatives that are in the ``gray 
area'' of insider disclosure should be treated for what they 
are, another way to either buy or sell shares. The structure of 
an inside transaction should never hinder its immediate 
disclosure.
    Finally, I want to remind you that despite 200 years of 
``bad press'' on Wall Street, it was those ``unAmerican, 
unpatriotic'' short sellers that did so much to uncover the 
disaster at Enron and at other infamous financial disasters 
during the past decade. While short sellers probably will never 
be popular on Wall Street, they often are the ones wearing the 
white hats when it comes to looking for and identifying the bad 
guys.
    Thank you very much for this opportunity to tell our story.
    [The prepared statement of James S. Chanos follows:]
    Prepared Statement of James S. Chanos, Kynikos Associates, Ltd.
    Good afternoon. My name is James Chanos. I would like to take this 
opportunity to thank the House Committee on Energy and Commerce for 
allowing me to offer my perspective on the tragic Enron story.
    I am the President of Kynikos Associates, a New York private 
investment management company that I founded in 1985. Kynikos 
Associates specializes in short-selling, an investment technique that 
profits in finding fundamentally overvalued securities that are poised 
to fall in price. Kynikos Associates employs seven investment 
professionals and is considered the largest organization of its type in 
the world, managing over $1 billion for its clients.
    Prior to founding Kynikos Associates, I was a securities analyst at 
Deutsche Bank Capital and Gilford Securities. My first job on Wall 
Street was as an analyst at the investment banking firm of Blyth 
Eastman Paine Webber, a position I took in 1980 upon graduating from 
Yale University with a B.A. in Economics and Political Science. Neither 
I nor any of our professionals is an attorney or a certified public 
accountant, and none of us has had any direct dealings with Enron, its 
employees or accountants.
    On behalf of our clients, Kynikos Associates manages a portfolio of 
securities we consider to be overvalued. The portfolio is designed to 
profit if the securities it holds fall in value. Kynikos Associates 
selects portfolio securities by conducting a rigorous financial 
analysis and focusing on securities issued by companies that appear to 
have (1) materially overstated earnings (Enron), (2) been victims of a 
flawed business plan (most internet companies), or (3) been engaged in 
outright fraud. In choosing securities for its portfolios, Kynikos 
Associates also relies on the many years of experience that I and my 
team have accumulated in the equity markets.
    My involvement with Enron began normally enough. In October of 
2000, a friend asked me if I had seen an interesting article in The 
Texas Wall Street Journal (a regional edition) about accounting 
practices at large energy trading firms. The article, written by 
Jonathan Weil, pointed out that many of these firms, including Enron, 
employed the so-called ``gain-on-sale'' accounting method for their 
long-term energy trades. Basically, ``gain-on-sale'' accounting allows 
a company to estimate the future profitability of a trade made today, 
and book a profit today based on the present value of those estimated 
future profits.
    Our interest in Enron and the other energy trading companies was 
piqued because our experience with companies that have used this 
accounting method has been that management's temptation to be overly 
aggressive in making assumptions about the future was too great for 
them to ignore. In effect, ``earnings'' could be created out of thin 
air if management was willing to ``push the envelope'' by using highly 
favorable assumptions. However, if these future assumptions did not 
come to pass, previously booked ``earnings'' would have to be adjusted 
downward. If this happened, as it often did, companies addicted to the 
crack cocaine of ``gain-on-sale'' accounting would simply do new and 
bigger deals (with a larger immediate ``earnings'' impact) to offset 
those downward revisions. Once a company got on such an accounting 
treadmill, it was hard for it to get off.
    The first Enron document my firm analyzed was its 1999 Form 10-K 
filing, which it had filed with the U.S. Securities and Exchange 
Commission. What immediately struck us was that despite using the 
``gain-on-sale'' model, Enron's return on capital, a widely used 
measure of profitability, was a paltry 7% before taxes. That is, for 
every dollar in outside capital that Enron employed, it earned about 
seven cents. This is important for two reasons; first, we viewed Enron 
as a trading company that was akin to an ``energy hedge fund.'' For 
this type of firm a 7% return on capital seemed abysmally low, 
particularly given its market dominance and accounting methods. Second, 
it was our view that Enron's cost of capital was likely in excess of 7% 
and probably closer to 9%, which meant, from an economic cost point-of-
view, that Enron wasn't really earning any money at all, despite 
reporting ``profits'' to its shareholders. This mismatch of Enron's 
cost of capital and its return on investment became the cornerstone for 
our bearish view on Enron and we began shorting Enron common stock in 
November of 2000.
    We were also troubled by Enron's cryptic disclosure regarding 
various ``related party transactions'' described in its 1999 Form 10-K 
as well as the quarterly Form 10-Qs it filed with the SEC in 2000 for 
its March, June and September quarters. We read the footnotes in 
Enron's financial statements about these transactions over and over 
again but could not decipher what impact they had on Enron's overall 
financial condition. It did seem strange to us, however, that Enron had 
organized these entities for the apparent purpose of trading with their 
parent company, and that they were run by an Enron executive. Another 
disturbing factor in our review of Enron's situation was what we 
perceived to be the large amount of insider selling of Enron stock by 
Enron's senior executives. While not damning by itself, such selling in 
conjunction with our other financial concerns added to our conviction.
    Finally, we were puzzled by Enron's and its supporters boasts in 
late 2000 regarding the company's initiatives in the telecommunications 
field, particularly in the trading of broadband capacity. Enron waxed 
eloquent about a huge, untapped market in such capacity and told 
analysts that the present value of Enron's opportunity in that market 
could be $20 to $30 per share of Enron stock. These statements were 
troubling to us because our portfolio already contained a number of 
short ideas in the telecommunications and broadband area based on the 
snowballing glut of capacity that was developing in that industry. By 
late 2000, the stocks of companies in this industry had fallen 
precipitously, yet Enron and its executives seemed oblivious to this! 
Despite the obvious bear market in telecommunications capacity, Enron 
still saw a bull market in terms of its own valuation of the same 
business--an ominous portent.
    In January 2001, we began contacting a number of analysts at 
various Wall Street firms with whom we did business and invited them to 
our offices to discuss Enron. Over the next few months a number of them 
accepted our invitation and met with us to discuss Enron and its 
valuation. We were struck by how many of them conceded that there was 
no way to analyze Enron, but that investing in Enron was instead a 
``trust me'' story. One analyst, while admitting that Enron was a 
``black box'' regarding profits, said that, as long as Enron delivered, 
who was he to argue! It was clear to us that most of these analysts 
were hopelessly conflicted over the investment banking and advisory 
fees that Enron was paying to their firms. We took their ``buy'' 
recommendations, both current and future, with a very large grain of 
salt!
    Something else that caught our attention was a story that ran in 
The New York Times about Enron in early February of 2001. In light of 
the California energy crisis, Enron was invoking a little-noticed 
clause in its contract with its California retail customers. This 
clause allowed Enron to directly match its retail buyers of power in 
California with the power providers with whom Enron had contracted on 
its customers' behalf. Most of these power providers were in 
bankruptcy. In effect, Enron was telling a number of very prominent 
California companies and institutions ``This is now your problem, not 
ours.'' This was done despite the fact that Enron was paid by its 
customers a middleman fee precisely so that Enron would accept what is 
called counter-party risk--something Enron now backed out of doing. As 
a result, Enron's credibility in the entire energy retail business 
began to crumble simply because the company refused to recognize sure 
losses in California. One of my analysts said at the time, ``Gee, it's 
as if Enron can never admit to a losing trade!'' Future revelations 
would prove that remark prophetic.
    It was also in February 2001 that I presented Enron as an 
investment idea at our firm's annual ``Bears In Hibernation'' 
conference. As I recounted Enron's story to the conference 
participants, most of them agreed that the fact pattern and numbers 
presented were very troubling. Most also agreed that Enron's stock 
price left no room for error. Following our conference, the short 
position in Enron (reported monthly) began to move higher.
    In the spring of 2001, we heard reports, confirmed by Enron, that a 
number of senior executives were departing from the company. Further, 
the insider selling of Enron stock continued unabated. Finally, our 
analysis of Enron's 2000 Form 10-K and March 2001 Form 10-Q filings 
continued to show low returns on capital as well as a number of one-
time gains that boosted Enron's earnings. These filings also reflected 
Enron's continuing participation in various ``related party 
transactions'' that we found difficult to understand despite the more 
detailed disclosure Enron had provided. These observations strengthened 
our conviction that the market was mispricing Enron's stock.
    In the summer of 2001, energy and power prices, specifically 
natural gas and electricity, began to drop. Rumors surfaced routinely 
that Enron had been caught ``long'' the power market and that it was 
moving aggressively to reverse its exposure. It is an axiom in 
securities trading that, no matter how well ``hedged'' a firm claims to 
be, trading operations always seem to do better in bull markets and to 
struggle in bear markets. We believed that the power market had entered 
a bear phase at just the wrong moment for Enron.
    Also in the summer of 2001, stories circulated in the marketplace 
about Enron's affiliated partnerships and how Enron's stock price 
itself was important to Enron's financial well-being. In effect, 
traders were saying that Enron's dropping stock price could create a 
cash-flow squeeze at the company because of certain provisions in 
agreements that it had entered into with its affiliated partnerships. 
These stories gained some credibility as Enron disclosed more 
information about these partnerships in its June 2001 Form 10-Q, which 
it filed in August of 2001.
    To us, however, the most important story in August 2001 was the 
abrupt resignation of Enron's CEO, Jeff Skilling, for ``personal 
reasons.'' In our experience, there is no louder alarm bell in a 
controversial company than the unexplained, sudden departure of a chief 
executive officer no matter what ``official'' reason is given. Because 
we viewed Skilling as the architect of the present Enron, his abrupt 
departure was the most ominous development yet. Kynikos Associates 
increased its portfolio's short position in Enron shares following this 
disclosure.
    The events affecting Enron that occurred in the fall of 2001, 
particularly after October 16th, have been recounted seemingly 
everywhere in the financial press. Kynikos Associates cannot add much 
to that discussion, but I have tried to provide an overview of what our 
firm thought were significant developments and revelations during the 
preceding twelve months.
                      some observations post-enron
    While this testimony is mainly about our firm's assessment of Enron 
and the basis for that assessment, we would be remiss if we did not 
share a few observations about what happened.
    First and foremost, no one should depend on Wall Street to identify 
and extricate investors from disastrous financial situations. There are 
too many conflicts of interest, all of them usually disclosed, but 
pervasive and important nevertheless. In addition, outside auditors are 
archeologists, not detectives. I can't think of one major financial 
fraud in the United States in the last ten years that was uncovered by 
a major brokerage house analyst or an outside accounting firm. Almost 
every such fraud ultimately was unmasked by short sellers and/or 
financial journalists.
    In addition, a company's adherence to GAAP (generally accepted 
accounting principles), does not mean that the company's earnings and 
financial position are not overstated. GAAP allows too much leeway in 
the use of estimates, forecasts and other inherently unknowable things 
to portray current results. In the hands of dishonest management (a 
rapidly growing subset in my opinion), GAAP can mislead far more than 
they inform! Further, I believe that certain aspects of GAAP, 
particularly accounting for stock options in the United States, are 
basically a fraud themselves. Such obvious accounting scams should be 
ended immediately without any interference by third parties.
    While no fan of the plaintiffs bar, I also must point out that the 
so called ``Safe Harbor'' Act of 1995 has probably harmed more 
investors than any other piece of recent legislation. That statute, in 
my opinion, has emboldened dishonest managements to lie with impunity, 
by relieving them of concern that those to whom they lie will have 
legal recourse. The statute also seems to have shielded underwriters 
and accountants from the consequences of lax performance of their 
``watchdog'' duties. Surely, some tightening of this legislation must 
be possible, while retaining the worthy objective of preventing 
obviously frivolous lawsuits.
    Our current system of self-monitored disclosure is first-rate, in 
my opinion, with one important exception. In this day and age of EDGAR, 
the internet and real-time disclosure, our system for disclosing 
insider stock purchases and sales remains antiquated. Insiders buying 
or selling shares should disclose such transactions immediately. And 
esoteric collars, loan/stock repurchase deals, etc., that are in the 
``gray area'' of insider disclosure should be treated for what they 
are--another way to either buy or sell shares. The structure of an 
insider transaction should never hinder its immediate disclosure!
    Finally, I want to remind you that, despite two hundred years of 
``bad press'' on Wall Street, it was those ``unAmerican, unpatriotic'' 
short sellers that did so much to uncover the disaster at Enron and at 
other infamous financial disasters during the past decade (Sunbeam, 
Boston Chicken, etc.). While short sellers probably will never be 
popular on Wall Street, they often are the ones wearing the white hats 
when it comes to looking for and identifying the bad guys!
    Thank you very much for this opportunity to tell our story.

    Chairman Tauzin. Thanks for your patience, Mr. Chanos, it's 
interesting testimony. We normally limit our witnesses to 5 
minutes. You can see I'm being rather generous after you've 
waited so long, but I would encourage to try to keep it at 
least within a 10 minute frame if you can.
    We'll now turn to Mr. Roger Raber who is the President of 
the trade association of Boards of Directors, correct, Mr. 
Raber?

                  STATEMENT OF ROGER W. RABER

    Mr. Raber. Good afternoon, Mr. Chairman. I'm honored to be 
here as the President and CEO of the National Association of 
Corporate Directors founded in 1977 to enhance the education 
and development of corporate directors.
    Corporate directors are an important key to the success of 
our free enterprise system. True, some aspects of our corporate 
system such as disclosure do require continuous improvements 
that directors alone cannot accomplished. Directors must work 
with others such as institutional investors and regulators to 
ensure this improvement. But improvements to the system are not 
enough. Good corporate governance requires, above all, the 
presence of independent informed directors who have the courage 
and integrity to ask difficult questions.
    With such directors, any reasonable system can work. 
Without such directors, any system, no matter how excellent can 
and will fail.
    NACD was founded in 1977 as a membership organization for 
corporate directors committed to improving board effectiveness. 
Today, NACD is still the only membership organization of its 
kind in this country. At this time, the NACD has more than 
10,000 active members and participants. These are individuals 
or entire boards who read our publications, attend our seminars 
or receive training in their board rooms. Most of our members 
and participants are directors, but some are board advisors 
such as attorneys and accountants. Many distinguished corporate 
directors add to our knowledge and practice as members of our 
governing board, advisory board and faculty.
    NACD services cover both basic and emerging issues. We 
promote high board standards and create forums for peer 
interaction. We have 12 chapters throughout the country where 
directors meet to learn, discuss and respond to current issues. 
NACD also conducts research on governance trends, tracking over 
100 issue over time and across company sizes and industries.
    Now the board of directors has an important place in the 
corporate systems. Corporations are owned by shareholders. 
Boards are accountable to shareholders and management is 
accountable to the board. Corporations are chartered through 
State corporation laws. Their laws vary by state, but they 
share some common features. One common feature in State 
corporation law is the notion of director, duty of care and 
duty of loyalty. The duty of care says that corporate directors 
must exercise care in their decisions, just as they would do in 
their own decisions process. The duty of loyalty says that 
directors must be loyal to the company, remaining free of any 
conflicts of interest as they vote on particular matters. A 
judicial doctrine called the business judgment rule shields 
directors' decisions from liability as long as the directors 
exercise care and were free of conflicts of interest.
    As companies grow, boards form committees such as an audit 
committee, a compensation committee and a nominating committee. 
They may also form special committees to look at sensitive 
issues. The NACD recommends that these committees be composed 
of qualified independent directors. Our recommendations have 
made a difference. For example, today, part of the result of 
concepts advocated by a member of our board of directors in a 
blue ribbon committee report to the SEC and stock exchanges, 
the boards of publicly listed companies must have an audit 
committee composed entirely of independent directors who are 
financially literate. This is one of the many reforms NACD has 
advocated over the past 25 years.
    But in closing, I would like to explain how directors can 
be a solution to the kinds of problems that allegedly occurred 
at Enron. I believe that there are three keys to board 
effectiveness: independence, information and integrity, 
especially the courage to ask tough questions.
    Independence. NACD commends the SEC and stock exchanges for 
requiring independent audit committees. Meanwhile, independent 
nominating and compensation committees are now on the rise. 
Unless this beneficial trend continues, we anticipate stock 
exchange requirements mandating the independence of these 
committees.
    Information. Directors need to be well informed about 
governance and about the companies and industries they serve. A 
vital source of information is financial statements. Overall, 
the financial statements of U.S. companies do a good job of 
disclosure, keeping up with such new challenges of financial 
reporting, but we want to make sure that oversight groups for 
accounting standards remain free from undue influence by any 
particular constituency.
    On-going education for directors is also important if not 
mandatory. A number of major institutional investors actively 
encourage director education in their portfolio companies.
    Integrity. Last, but not least, there is integrity. 
Directors should have the duty of curiosity to have difficult 
questions such as do these numbers reflect our true 
profitability? What will this policy do for the employees in 
our 401(k) program? Isn't it risky to have our auditors do some 
of our internal auditing work? After Enron, more directors will 
be asking such questions. We will do our part to make sure that 
they do.
    In summary, directors play an important role in the 
governance of corporations. Whatever actions you recommend as a 
committee, I ask you to remember that in the long run corporate 
directors can be an important part in helping your actions 
succeed.
    I thank you for your time.
    [The prepared statement of Roger W. Raber follows:]
   Prepared Statement of Roger W. Raber, President and CEO, National 
                   Association of Corporate Directors
    I am honored to be here today as President and CEO of the National 
Association of Corporate Directors (NACD), a not-for-profit 
professional association founded in 1977 to enhance the education and 
development of corporate boards.
                           summary statement
    In my remarks this afternoon I will cover three main subjects.

 First, I will explain the work and mission of the NACD, 
        especially our longstanding commitment to improving board 
        leadership through director education.
 Second, I will define the role of the corporate board of 
        directors, explaining the duty of care, the duty of loyalty, 
        and the business judgment rule, and showing how the board is 
        accountable to shareholders, and management is accountable to 
        the board.
 Third, I will explain how corporate directors can be a 
        solution to the kinds of problems that contributed to the 
        collapse of Enron.
    My main point in all of this is that corporate directors are an 
important key to success of our free enterprise system. True, some 
aspects of our corporate system--such as disclosure--do require 
continuous improvements that directors alone cannot accomplish. 
Directors must work with others, such as institutional investors and 
regulators, to ensure this improvement. But improvements to the system 
are not enough. Good corporate governance requires above all the 
presence of independent, informed directors who have the courage and 
integrity to ask difficult questions. With such directors, any 
reasonable system can work. Without such directors, any system, no 
matter how excellent, can fail.
                    the mission and work of the nacd
    NACD was founded in 1977 as a membership organization for corporate 
directors committed to improving board effectiveness. Today, NACD is 
still the only membership organization of its kind in the United 
States. At this time, the NACD has more than 10,000 active members and 
participants. These are individuals or entire boards who purchase our 
publications, attend our seminars, and receive training in their 
boardrooms. Most of our members and participants are directors, but 
some are board advisors such as attorneys and accountants. Many 
distinguished corporate directors add to our knowledge and practice as 
members of our governing board, advisory board, and faculty.
    Through our publications, seminars, and services, which cover both 
basic and emerging issues, NACD promotes high board standards and 
creates forums for peer interaction. We have 12 chapters where 
directors meet to learn about, discuss, and respond to current issues. 
Since 1977, our Director's Monthly publication has featured ``best 
practice'' articles by and for corporate directors--over 2,000 articles 
to date. Also, for the past decade, NACD has issued annual ``Blue 
Ribbon Commission'' reports on issues such as director professionalism 
and evaluation, executive and director compensation, and the board's 
role in strategy, among other topics. Furthermore, NACD also conducts 
research on governance trends, tracking over 100 issues steadily over 
time and across company sizes and industries. Finally, our members, 
directors, and officers also communicate with the media, regulators, 
institutional investors, and others where needed to improve 
understanding of board issues.
              the role of the corporate board of directors
    The board of directors has an important place in the corporate 
system. Corporations are owned by shareholders. Boards are accountable 
to shareholders, and managers are accountable to the board. 
Corporations are chartered through state corporation laws. These laws 
vary by state, but they share common features.
    One common feature in state corporation laws is the notion of 
director duty--namely the twin duties of care and loyalty. The duty of 
care says that corporate directors must exercise care in their 
decisions, just as they would in their own decisions. The duty of 
loyalty says that directors must be loyal to the company, remaining 
free of any conflicts of interest as they vote on particular matters. A 
judicial doctrine called the business judgment rule shields directors' 
decisions from liability as long as the directors exercised care and 
were free of conflicts of interest.
    Another common feature in state corporation laws is the notion that 
corporations are ``managed under the direction of a board of 
directors.'' The nature of this direction varies. A small new 
corporation may just have a few key officers, who are all directors and 
owners as well. If a corporation sells stock to the general public, 
however, ownership shifts to non-managers. These non-manager-owners 
need protection. This is the role of state and federal securities laws. 
For example, securities laws require full, timely, and clear disclosure 
of important (``material'') information. Also, securities laws ensure 
that owners have representation on boards, through voting on 
nominations of particular directors.
    As companies grow, boards often grow, and form committees, such as 
an audit committee, a compensation committee, and a nominating 
committee. They also may form special committees to look at sensitive 
issues. The NACD recommends that these committees be composed of 
qualified, independent directors. Our recommendations have made a 
difference. For example, today, partly as the result of concepts 
advocated by a member of our board of directors, in a Blue Ribbon 
Committee report to the Securities and Exchange Commission and stock 
exchanges, the boards of publicly listed companies must have an audit 
committee composed entirely of independent directors who are (or who 
will spend time to become) financially literate. This is only one of 
the many reforms NACD has advocated in the past 25 years.
                lessons learned: directors as a solution
    In closing, I would like to explain how directors can be a solution 
to the kinds of problems that allegedly occurred at Enron. (For a 
detailed response to the specific issues raised in the Enron case, I 
refer the committee to the January 31, 2002, issue of our newsletter, 
DM Extra, which can be viewed on our web site, nacdonline.org. I 
include a copy for the record.)
    In general, I believe that there are three keys to board 
effectiveness: independence, information, and integrity--especially the 
courage to ask the tough questions.
    Independence. NACD commends the SEC and stock exchanges for 
requiring ``independent'' audit committees. Meanwhile, independent 
nominating and compensation committees are now on the rise. Unless this 
beneficial trend continues, we anticipate stock exchange requirements 
mandating the independence of these committees.
    Information. Directors need to be well informed about governance, 
and about the companies and industries they serve. A vital source of 
information is financial statements. Overall, the financial statements 
of U.S. companies do a good job of disclosure, keeping up with new 
challenges of financial reporting, but we want to make sure that 
oversight groups for accounting standards remain free from undue 
influence by any particular constituency. Ongoing education for 
directors is also important. A number of major institutional investors 
actively encourage director education in their portfolio companies. The 
late Jean Head Sisco, in her speech as NACD Director of the Year in 
2000, went so far as to suggest that the stock exchanges require newly 
listed companies to provide evidence of ongoing director education.
    Integrity. Last but not least, there is integrity. Directors should 
have the ``duty of curiosity'' to ask difficult questions, such as, `Do 
these numbers reflect our true profitability?' ``What will this policy 
do for the employees in our 401-k plan?'' ``Isn't it risky to have our 
auditors do some of our internal auditing work?'' After Enron, more 
directors will be asking such questions. We will do our part to make 
sure that they do.
    In summary, directors play an important role in the governance of 
corporations. Whatever actions you recommend as a committee, I ask you 
to remember that in the long run, corporate directors can be an 
important part in helping your actions succeed.
    I thank you for your time.

    Chairman Tauzin. I thank you.
    The Chair is now pleased to recognize Dr. Roman Weil, Ph.D. 
from Chicago School of Business for his testimony.
    Dr. Weil?

                   STATEMENT OF ROMAN L. WEIL

    Mr. Weil. Thank you, Mr. Chairman. I have been privileged 
to receive a fine education and I'm privileged to be a member 
of the Graduate School of Business at the University of Chicago 
Faculty for 35 years or so and it's a privilege to be here 
today. I thank you very much.
    Chairman Tauzin. Thank you, sir.
    Mr. Weil. This is not a place I can tell for subtlety. I am 
going to give you my broad brush view of what I think and I'll 
be glad to meet with your staff later to talk about the 
subtleties because there are a lot of subtle issues here.
    I have some testimony that's been distributed here and some 
of my co-authors who have looked at this in the last day or so 
say I left some things out, so I brought a new version with me 
today and I'll tell you what Congress has done well as well as 
the accounting profession and what the SEC has done wrong as 
well. So if you have the February 3 version, you don't have the 
places with Congress in it. There's a February 5 version with 
Congress.
    Chairman Tauzin. Did you shred the last copy?
    Mr. Weil. It's been turned over to your staff and if they 
shred it, they're following standard document retention 
policies, but I don't know.
    What can I do here today in this unsubtle forum? Let me 
tell you what I think the basic problem is in accounting. I'm 
not here as an expert on the details of what Enron did or what 
the auditing firm did. I don't know. But I do know, I believe, 
what the underlying cause of getting us to where we've been is 
and I think I know something to do about it. I agree a lot with 
what Mr. Raber's done. I teach directors' college at the 
University of Chicago where we ask directors to come to school 
for a day or two and learn how to do their jobs better.
    It is okay for Enron to bet the farm and lose. We don't 
want to regulate within wide ranges what businesses do and 
their business models. If they want to gamble and lose that's 
okay. But we'd like to know, as shareholders, as outside 
investors, as regulators when such bets are being undertaken 
and what are the consequences of the outcomes. Now I think the 
problem that we get here is a result of a process that started 
about 1940 and got a boost in 1980 and the direction in which 
accounting reports. When we first got the message from the 
Securities and Exchange Commission back in the late 1930's to 
begin regulating accounting, there were two paths that could 
have been taken. The path not taken would be the path based on 
axioms, principles the way we did it in geometry in high 
school, the 12 Euclidian axioms. Here's what you can derive 
from it. Accounting could have said here's what an asset is. My 
students know what an asset is. Here's what an revenue is. My 
students know what a revenue is, and derive the fundamental 
accounting principles from those. Instead, we didn't do it that 
way. We said we've got these myriad accounting problems, let's 
write rules to deal with specific problems.
    Now the first page of my testimony I've given you an 
example. It's got nothing to do with Enron, but is the 
quintessence of what this problem is all about. Let's look at 
this. It's only two paragraphs long.
    Imagine an asset, for the moment think of rights to use a 
patent on a drug that defeats anthrax. Purchased by a dozen 
different companies for a total of $500 million. Now suppose 
that the Congress passes laws saying that any other company who 
so chooses can use that patent to produce the anthrax defeating 
drug, free of royalty to the owners. What do you suppose the 
accountants for the firms who had purchased those patents for 
$500 million would do? They would write off the assets to zero, 
recognizing a collective loss of $500 million before taxes on 
their income statements. Would you suppose that accountants 
would need to look into their GAAP rule books to find out if 
that write down were necessary. Well, I wouldn't think it was 
necessary. What do you think? It seems obvious to me. If they 
did look and couldn't find such guidance, do you think they'd 
write off the assets anyway, recognizing the attendant losses? 
Well, of course.
    What has this got to do with the current situation? A lot. 
Back in 1980, events paralleling those of the story I've just 
told you actually occurred. The Congress passed deregulating 
legislation liberalizing the granting of trucking rights, 
effectively giving any truck the right to carry any commodity 
from one place to another. Prior to that deregulating 
legislation, Congress acting through the Interstate Commerce 
Commission had limited those rights. People bought them in the 
marketplace, traded them, had them on their balance sheet.
    When Congress effectively destroyed the value of those 
rights by allowing any trucker the right to carry the goods 
previously protected by the monopoly rights, what did the 
accountants of the trucking firms do? They wrote off the value 
of those rights on the balance sheet, recognizing a loss. Do 
you suppose trucking firm accountants needed a rule to tell 
them to do that? You've got an asset. It's gone. Write it off.
    But the Financial Accounting Standards Board felt compelled 
to pass such a rule. It was a statement of Financial Accounting 
Standards No. 44, passed in 1980 saying just that. That was an 
important step along the road to where we are today. We are 
getting evermore specific rules to deal with evermore specific 
transactions. And it leads managements to say there are these 
rule books out there. It's now this thick. Let me see where 
there's a transaction that's not covered in the rule book. And 
I'll invent one. I'll make one up. You can be sure that however 
smart we accountants are, the investment bankers who make 30 to 
40 times as much as we do each year, they're smarter, they're 
nimbler. As fast as we can write rules, they can get around it.
    And so the investment banker and the manager will devise a 
new transaction and devise the accounting for it and say to the 
accountant show me where it says I can't? If you can't show me 
where this is forbidden, I'm going to do it and the auditor has 
found that management has got a lot of power in this, the power 
to go elsewhere with the business. The auditor goes to the 
accounting rulemakers and says give me a rule, give me a rule 
to forbid this and so we get some rules.
    But the rules don't come fast enough to deal with the 
transactions. I think it would be a mistake to ever think we 
could get there. I do not believe that you want to pass laws 
that lead to legislation attempting to govern the details of 
accounting because the investment bankers are smarter than you 
are. Smarter than I am. They're going to figure it out.
    Now the SEC has had a hand in this. The SEC says we've got 
this big rule book. If you want to do something, you show me 
where it says you can and now accountants are afraid to do a 
transaction without going to the SEC, without getting 
preclearance for some transaction. We're bogged down in rule 
books.
    No speaker ever angered the audience by talking too short 
of time on the appointed subject. I'll stop now, but I have 
more stories for you, if you have time.
    [The prepared statement of Roman L. Weil follows:]
   Prepared Statement of Roman L. Weil, Graduate School of Business, 
                         University of Chicago
    Enron bet the farm and lost. It's OK to gamble, but shareholders 
should know about the size and risk of bets undertaken as well as how 
the nature of bets changes over time. Why didn't the accounting for 
Enron's activities do a better job of alerting shareholders to the 
risks and changes in them?
                          fundamental problem
    Imagine an asset (for the moment think of rights to use a patent on 
a drug that defeats anthrax) purchased by a dozen different companies 
for a total of $500 million. Now, suppose that the Congress passes laws 
saying that any other company who so chooses can use that patent to 
produce the anthrax-defeating drug free of royalty to the owners.
    What do you suppose the accountants for the firms that had 
purchased those patents for $500 million would do? They would write off 
the assets to zero, recognizing a collective loss of $500 million, 
before taxes, on their income statements. Would you suppose that 
accountants would need to look into their
    GAAP rule books to find out if that write-off were necessary? (Not 
necessary, wouldn't you think--it's obvious.) If they did look and 
couldn't find such guidance, do you think they'd write off the assets 
anyway, recognizing the attendant losses? (Of course.)
    What has this to do with the state of accounting reflected in the 
current Enron/Andersen shambles? A lot.
    In 1980, events paralleling those of the imaginary two paragraphs 
happened: Congress passed de-regulating legislation liberalizing the 
granting of trucking rights, effectively giving any trucker the right 
to carry any commodity between any two points. Prior to that de-
regulating legislation, Congress, acting through the Interstate 
Commerce Commission, had limited those rights. The issued rights traded 
in the market place and, once purchased by a trucking firm, appeared on 
the firm's balance sheet at cost. When Congress effectively destroyed 
the value of those rights by allowing any trucker the right to carry 
the goods previously protected by monopoly rights, what did the 
accountants at trucking firms do? They wrote off the value of the 
trucking rights on the balance sheet, recognizing an amount of loss 
equal to their then-current book value.
    Did the trucking company accountants need a specific accounting 
rule telling them to write off those trucking right assets? You 
wouldn't think so, would you? But the Financial Accounting Standards 
Board (FASB) felt compelled to pass a rule (Statement of Financial 
Accounting Standards No. 44, 1980) saying just that. Accounting rule 
makers took a first step on the road to the Enron accounting debacle.
    Since the early 1980's, an aggressive company's management engages 
in a transaction not covered by specific accounting rules, accounts for 
it as it chooses, and challenges the auditor by arguing, ``Show me 
where it says I can't.'' The auditor used to be able to appeal to first 
principles of accounting. Such principles suggest, for example, that 
post-deregulation trucking rights are no longer assets. Now, the 
aggressive management can say, ``Detailed accounting rules cover so 
many transactions and none of them covers the current issue, so we can 
devise accounting of our own choosing.'' And they do.
    Accounting rule making has become increasingly detailed as auditors 
plead with standard setters for specific rules to provide backbone: 
``Dear FASB or EITF [Emerging Issues Task Force, created by the SEC and 
the FASB], Give us a rule for this new transaction.''
    So, Enron transfers assets, reporting current profit and 
debt,1 then challenges its auditor to ``Show me where it 
says I can't.'' The auditor can't. The auditor considers nixing the 
profit recognition but simultaneously considers the consequences of 
saying, ``No'' to aggressive management: ``We might lose this client.''
---------------------------------------------------------------------------
    \1\ In addition, Enron appears to have promised to give Enron 
shares to the purchaser if the transferred assets later turn into 
losers. If this were true and the auditor knew about the additional 
contingency, I suspect the auditor would have not allowed Enron's 
accounting. I am less confident of these next two: it appears that 
Enron may have strong-armed the auditors into avoiding the equity 
method of accounting for investments and into questionably treating 
some of its derivative transactions as hedges.
---------------------------------------------------------------------------
    The near-majority of the rule-setting FASB comes from high-powered 
audit practice. These members bring to the Board a mindset that the 
accounting profession needs, and wants, specific guidance for specific 
transactions. Three of them can meet privately and can effectively, if 
not formally, guide, perhaps even set, the agenda for the Board. A 
minority of the Board has spent careers dealing with fundamental 
theory. This minority, with more faith in the conceptual basis for 
accounting, appears to prefer to derive broadly applicable rules from 
first principles of accounting, which the FASB developed in the early 
1980s in its conceptual framework. The majority, the members from 
auditing practice, less interested in deriving rules from conceptual 
principles, appears to win most of the battles.
    The emphasis on specific rules for specific issues gets more 
pronounced over time. I concede that these specific rules for specific 
issues leads to more uniform reporting of the covered transactions--all 
else equal, a good thing. That uniformity comes at the cost: practicing 
accountants have less need for informed intelligence and judgment. I 
concede that part of the pressure on standard setters for specific 
rules for specific transactions comes from the current litigation 
environment. Auditors, in a rational pursuit of a full purse, want 
unambiguous rules to stand behind when, inevitably, the trial lawyers 
sue them for accountant judgments and estimates, made in good faith, 
that turn out to miss the target.
    That some good results from specific rules for specific 
transactions doesn't make such rules a good idea. These rules have a 
cost: ``Show me where it says I can't,'' demands management. ``Give me 
more rules for these new transactions,'' pleads the auditor, ``so I can 
combat aggressive management.'' This cycle continues: the increasing 
number of specific rules for specific transactions strengthens 
aggressive management's belief that if a rule doesn't prohibit it, then 
it's allowed. This, in turn, increases the auditor's dependence on 
specific rules.
                              what to do?
    I want accountants to rely on fundamental, first principles in 
choosing accounting methods and estimates. I want accountants not to 
hide behind the absence of a specific rule. Whatever the detailed rules 
accountants write, smart managers can construct transactions the rules 
don't cover.
    You might now think about the parallels of the above with our tax 
collection system, where principles alone cannot suffice. The 
principle: tax income. The principle requires 40,000 pages of tax code, 
regulations, and court decisions to implement. Can financial accounting 
be different? I think yes. The tax collector and the taxpayer play a 
zero-sum game--what one pays, the other gets. Financial accounting 
doesn't have that property and in addition has the auditor to interpret 
the rule book.
    What else, besides more spine in the auditor, do we need to reduce 
the likelihood of more accounting debacles?
Reduce Conflict of Interests
    In recent weeks, we hear about reducing conflicts of interest--two 
recent ones: reduce the opportunities of the auditor to do consulting 
and forbid the auditor from going to work for the audited company.
    The basic conflict occurs because the audited pays the auditor and, 
in practice, selects the auditor. In my opinion, everything else has 
lesser effect.
Auditor Term Limits
    First, let's mandate auditor rotation--term limits for auditors. 
Seven years ought to do it, maybe five. Let the auditor know that, no 
matter what, another auditor will take over the job in a few years and 
will have the incentive to expose a predecessor's 
carelessness.2 Mandatory auditor term limits have a cost--
audit costs might triple. Not just the actual audit bills, but the 
costs the audited company incurs to show the new auditor where the 
inventory records lie in the second file drawer of the cabinet two to 
the left of the green door in the third room on the right of the 
outside corridor.
---------------------------------------------------------------------------
    \2\ Talk about professional peer review. This will be real peer 
review, not the pap we get now.
---------------------------------------------------------------------------
    I imagine that known term limits will induce the Audit Committee to 
begin the search for the subsequent auditor 18 months or so before the 
engagement will start and will be able to bring that new auditor into 
on-board, learn-from-observation mode early in the process. Those who 
argue against mandatory auditor rotation adduce large transition costs. 
Suddenly changing auditors does cause surprise costs that anticipated, 
orderly transitions will reduce.
Prod the Audit Committee
    Then, we need audit committees to exercise the power the SEC has 
given them. Thirty years ago, Rod Hills, then Chairman of the SEC, 
conceived the powerful modern audit committee. He has written that the 
audit committee's most important job is to make the independent, 
attesting auditor believe that the auditor's retention depends solely 
on the decision of the audit committee. Most often, it doesn't work 
that way.
    Most audit committees consist of independent, smart, but 
financially illiterate, members, with rarely more than one financial 
expert.3 (If you don't believe me, look at the accounting 
qualifications of the audit committee of any large company you follow. 
Then, look at how seldom the large corporations change auditors.) Audit 
Committees usually depend on management to recommend the independent 
auditor and changes in the auditor. The auditor learns to take its 
guidance from management, not from the audit committee. The SEC has 
provided power to the audit committee; now, it can help empower the 
audit committee by mandating auditor term limits and having the audit 
committee report on its independent search to find the replacement and 
its independent contacts with the auditor after engagement.
---------------------------------------------------------------------------
    \3\ How do I know they are often illiterate? Because I teach them 
in Directors' College classes where I start with pop quizzes.
---------------------------------------------------------------------------
    Some of my colleagues doubt that the country has enough 
independent, knowledgeable people to staff corporate America's audit 
committees and ask them to do the job Rod Hill set for 
them.4
---------------------------------------------------------------------------
    \4\ At this point, I have three suggestions, all blatantly self-
serving. In earlier drafts of this testimony, I failed to flag these as 
tongue-in-cheek and my friends called me to task for that. Let's 
consider increasing the pay differential between audit committee board 
members and the others. Let's encourage potential audit committee 
members to attend Directors' College at the University of Chicago. 
Let's educate audit committee members to demand of management a budget 
to hire its own accounting consultants, such as professors from the 
University of Chicago, to teach the accounting issues for the company's 
operations and financial structure.
---------------------------------------------------------------------------
Consulting Conflicts
    Management typically views audits as adding no value, purchased 
merely because regulation requires them. Hence, management typically 
wants the most cost/effective job it can get to satisfy the 
regulations. This doesn't mean the cheapest audit. Capital markets will 
guide a company in the S&P 500 not to hire me to do its audit, but to 
hire one of the Big Five, because the resulting savings in the cost of 
funds more than offsets the higher invoice cost. Once that firm decides 
it needs a Big Five auditor, its Chief Financial Officer will prefer to 
spend less, not more, for the service. The audit committee worries less 
about a smaller audit bill.
    The audit committee could say, ``We're going to pay top dollar for 
a high quality audit.'' To the auditor it could say, ``Make a decent 
profit on the audit; don't count on consulting fees to make up for thin 
margins on the audit.'' This will drive up the cost of both the audit 
and the consulting services, because the outside consultant will not 
have the head start in understanding the client's specifics that the 
auditor has. Management will not like this. The audit committee, 
charged to be concerned primarily with the audit, should be unconcerned 
about the higher cost of consulting fees. When did you last hear of an 
audit committee asking for a higher-priced audit?
    Does this require a regulation forbidding the auditor from 
consulting? No, we already have regulations empowering the audit 
committee to act, independent of management. Now, we need the audit 
committee to act.
    In the current environment, it's heresy to suggest that we need not 
to forbid auditors from also providing consulting services. Despite 
this pressure, I suggest to the Committee that mandatory auditor 
rotation, with auditors chosen and beholden to the audit committee, 
will solve the conflict of interest problem.
    Another advantage to term limits for auditors is the ease of 
specifying and enforcing the rule. All proposals to divorce auditing 
from consulting contemplate exceptions. For example, the auditor can be 
the most cost-effective preparer of income tax returns. I, and others, 
see no need to waste resources by having firms different from the 
auditor do the tax return. Where to draw the line? Let's don't mandate 
one, but let the audit committee decide. I can imagine that the auditor 
will prefer shorter terms to longer because the sooner the audit is 
done, the sooner it can undertake consulting engagements.

    Chairman Tauzin. I think I would have enjoyed your classes, 
Professor. Thank you very much.
    The next witness is Dr. Bala Dharan who is Professor of the 
Graduate School of Management at Rice University in Texas. By 
the way, my neighbor at law school was Daria Dharan, same 
spelling. We welcome you, sir, and you're going to speak to us 
about the special purpose vehicles and the market-to-market 
accounting, all these new developments. We welcome your 
testimony.

                  STATEMENT OF BALA G. DHARAN

    Mr. Dharan. Thank you, Mr. Chairman, and members of the 
committee for inviting me to present my analysis of the 
accounting issues that you just mentioned that led to Enron's 
downfall. I am very honored to be given this opportunity. Thank 
you again.
    I am a professor of accounting at Rice University. I've 
also taught at Harvard Business School and University of 
California, Berkeley and along with Roman Weil, I'm also a 
Ph.D. from Carnegie Mellon, so I think we should mention those.
    Given the limited time that you have given us for the oral 
testimony, even though I have a big temptation to give a long 
lecture, which we all do, as you know, I'm going to really 
restrict myself and give mainly the summary of my findings.
    My written testimony which has been submitted to the 
committee contains extensive discussions of both special 
purpose entities as well as mark-to-market accounting.
    Chairman Tauzin. Could you move the mike a little closer, 
Dr. Dharan? Thank you, sir.
    Mr. Dharan. The Enron debacle will rank as one of the 
largest securities fraud cases in history. Evidence to date 
points to signs of accounting fraud involving false valuation 
of assets, misleading disclosures and bogus transactions to 
generate income. This failure is a result of an unparalleled 
breakdown at every level of the usual system of checks that 
investors, lenders and employees rely on.
    Let me start with broken or missing belief systems and 
boundary systems that companies need to have to govern the 
behavior of their senior management. Weak corporate governance 
by board of directors and its audit committee, and compromised 
independence in the attestation of financial statements by 
external auditors. As per your request in my testimony I'll 
focus mainly on the accounting issues on the Enron use of 
special purpose entities and mark-to-market accounting.
    My analysis of the Enron debacle shows that while Enron's 
fall might have been initiated by a flawed and failed business 
strategy which many people have pointed out, it was ultimately 
precipitated by the company's pervasive and sustained use of 
aggressive accounting tactics to generate misleading 
disclosures intended to hide bad business decisions from the 
shareholders. As Dr. Weil pointed out, it's okay to bet the 
farm and lose it, but it's not okay to mislead the investors 
about what you are trying to do.
    Enron's corporate strategy itself was flawed. Let's focus 
on that for a second to see how they elected the accounting 
problems. The strategy was to be an assetless company that 
would buy and sell risk positions. This strategy when you 
really think about it is virtually devoid of any boundary 
systems that tell you what not to do. Essentially, the 
management, the senior management gave its managers a blank 
order to just do it, to do any deal origination that generated 
a desired rate of return. And as Mr. Chanos pointed out, even 
those returns were not adequate. This flawed business strategy 
led to colossal investment mistakes in virtually every new area 
that the company tried to enter. However, again, it's important 
to remember that while bad business strategy can contribute to 
a company's fall, it's often a company's desperate attempt to 
use accounting tricks to hide bad business decisions that seals 
its fate.
    Confronted with normal business problems, a corporation can 
generally use the right decisions to extricate itself out of 
those problems. But when a firm loses their trust and 
confidence of the investing public because of discoveries of 
accounting wrongdoings, the net result on the stock prices is 
mostly devastating and long lasting. This is what happened in 
the case of Enron.
    Let me start with the loss of investor faith and just give 
an example of that to really illustrate this point. They had 
their quarterly earnings release on October 16, 2001. This 
release claimed a pro forma profit while the company was 
actually losing money. Bad news to the tune of $1 billion was 
conveniently labeled as nonrecurring. As earnings releases go, 
this one must rank as one of the most misleading. Accounting 
research suggests that the adoption of this pro forma earnings 
reporting is often a company's desperate response to hide 
underlying business problems. To prevent future Enrons from 
hiding under similar pro forma reporting, we need to ensure 
that the misleading pro forma disclosures are halted all 
together.
    The Securities and Exchange Commission should recognize all 
pro forma disclosures for what they really are, a charade. The 
SEC, the New York Stock Exchange and the NASDAQ should adopt 
new rules restricting the format and the use of pro forma 
reporting. The use of terms such as one time or nonrecurring 
about past events, in earnings communications, in place certain 
promises about the--to the investors about future performance 
of the company and therefore should not be allowed to be used 
in earnings communications, except in rare cases.
    Enron's internal report released on February 1, 2002 makes 
clear that Enron used dozens of transactions with special 
purpose entities. While not all SPEs are bad, in Enron's case, 
special purpose entities are mainly used in the last 5 years to 
achieve dubious accounting goals, rather than genuine business 
purpose. The accounting effects can be summarized in the 
following four categories: (1) hiding of debt from the balance 
sheet; (2) hiding of poor-performing assets with some of your 
members mentioned also; (3) earnings management which is 
reporting gains and losses when desired; and (4) quick 
execution of transactions at desired prices. For example, Enron 
used its own senior managers as part of special purpose 
entities so that they could execute those transactions whenever 
they desired at short notice.
    To prevent the continued use of SPEs, the accounting 
profession and the SEC need to act quickly to enact several 
changes in the existing set of accounting rules. The Financial 
Accounting Standards Board needs to accelerate its current 
project on consolidation accounting and in particular fix the 
consolidation rule for special purpose entities. The current 
rules which includes the infamous 3 percent rule for 
consolidation needs to be abandoned in favor of rules that 
emphasize economic control, rather than specific numbers that 
can be easily violated. Economic control should be assumed, 
unless management can prove otherwise.
    In the U.S. financial assets are reported under a method 
that we call mark-to-market accounting. The values are reported 
at current prices rather than historical costs. Normally, mark-
to-market accounting works, but we also use mark-to-market 
accounting not just for assets that have readily determinable 
market prices, but also for assets such as financial 
derivatives that don't have traded market values. The bottom 
line when you allow mark-to-market accounting for financial 
contracts is that the mark-to-market accounting rule 
essentially allowed, in the case of Enron for example, to pick 
its own market value estimates and report them as gains to 
shareholders, estimates that were supposed to be checked by 
external auditors, but are hard to verify for anyone outside 
the firm.
    The mark-to-market methodology is theoretically sound, but 
it needs to be modified in the light of what we have learned 
from the use of mark-to-market accounting by Enron. Traditional 
revenue recognition rules anchored in conservatism principle 
should be extended to recognition of gains and losses from 
mark-to-market accounting. As several of your members pointed 
out, it really is very hard to understand how we could report 
gains from transactions that are going to happen 20, 30 years 
from now.
    Mr. Chairman, the Enron meltdown is the result of massive 
failure of corporate control and governance, out of focus 
mainly on the accounting issues, and in particular on the 
possible changes we need to make and the lessons we can take.
    I'll be glad to answer questions from you and the committee 
members and elaborate on my analysis. Once again, thank you for 
giving me the opportunity.
    [The prepared statement of Bala G. Dharan follows:]
     Prepared Statement of Bala G. Dharan, PhD, CPA, Professor of 
                      Accounting, Rice University
    Mr. Chairman and members of the Committee, I want to thank you for 
inviting me to present my analysis of the accounting issues that led to 
Enron's downfall. I am honored to be given this opportunity.
    I am Bala Dharan, professor of accounting at the Jesse H. Jones 
Graduate School of Management, Rice University, Houston. I received my 
PhD in accounting from Carnegie Mellon University, Pittsburgh. I have 
been an accounting professor at Rice University since 1982. In 
addition, I have taught accounting as a professor at Northwestern 
University's Kellogg School of Management, and as visiting professor at 
the Haas School of Business at University of California, Berkeley, and 
the Harvard Business School. I am also a Certified Public Accountant 
and a Registered Investment Advisor in the state of Texas. I have 
published several articles in research journals on the use of financial 
accounting disclosures by investors.
    The Enron debacle will rank as one of the largest securities fraud 
cases in history. Evidence to date points to signs of accounting fraud 
involving false valuation of assets, misleading disclosures and bogus 
transactions to generate income. I have had several invitations to 
speak on Enron's accounting issues over the last few months. In my 
talks and lectures, I am asked two questions most frequently: One, how 
could this tragedy have happened while the company's management, board 
of directors and outside auditors were supposedly watching over for 
employees and investors? Two, what can we learn from this debacle so 
that we can avoid future Enrons? Undoubtedly the first question will be 
the focus of the many investigations currently under way, including 
your Committee's efforts. In my testimony, I will focus on what we can 
learn from the accounting issues related to Enron's use of mark-to-
market (MTM) accounting and special purpose entities (SPEs). These two 
issues are very closely related, especially as they were practiced by 
Enron. In addition, I will address the related accounting issue of pro-
forma disclosures, and also how Enron's failed business strategy 
contributed to the accounting errors. I hope other invited panelists 
addressing before this Committee will talk about the critical roles 
played by Enron's management, board, auditors, lawyers, consultants, 
financial analysts, and investment bankers in Enron's fall. I conclude 
with recommendations for regulatory changes and improvements in the 
accounting and auditing rules governing special purpose entities, mark-
to-market accounting, and financial disclosures in general.
                       1. loss of investor trust
    My analysis of the Enron debacle shows that Enron's fall was 
initiated by a flawed and failed corporate strategy, which led to an 
astounding number of bad business decisions. But unlike other normal 
corporate failures, Enron's fall was ultimately precipitated by the 
company's pervasive and sustained use of aggressive accounting tactics 
to generate misleading disclosures intended to hide the bad business 
decisions from shareholders. The failure of Enron points to an 
unparalleled breakdown at every level of the usual system of checks 
that investors, lenders and employees rely on--broken or missing belief 
systems and boundary systems to govern the behavior of senior 
management, weak corporate governance by board of directors and its 
audit committee, and compromised independence in the attestation of 
financial statements by external auditor.
    Enron started its transformation from a pipeline company to a 
``risk intermediation'' company in the 1980s. It adopted a corporate 
strategy of an ``asset-less'' company, or a ``frictionless company with 
no assets.'' The company's Chief Financial Officer said in a 1999 
interview to a management magazine (which awarded him ``CFO Excellence 
Award for Capital Structure Management'') that the top management 
transformed Enron into ``one engaged in the intermediation of both 
commodity and capital risk positions. Essentially, we would buy and 
sell risk positions.'' What this description of the company implies is 
that unlike any other major company in the US, Enron's corporate 
strategy was virtually devoid of any boundary system that defined the 
perimeter of what is an acceptable and unacceptable investment idea for 
managers to pursue. Since any business investment basically involves 
some risk position, this strategy is not really a strategy at all but 
an invitation to do anything one pleases. Enron's top management 
essentially gave its managers a blank order to ``just do it'', to do 
any ``deal origination'' that generated a desired return. ``Deals'' in 
such unrelated areas as weather derivatives, water services, metals 
trading, broadband supply and power plant could all be justified and 
approved by managers under this concept of an asset-less risk 
intermediation company. The company even briefly changed its tagline in 
a company banner from ``the world's leading energy company'' (which 
implies some boundary system for investments) to ``the world's leading 
company.'' It is no wonder that this flawed business strategy led to 
colossal investment mistakes in virtually every new area that the 
company tried to enter.
    While bad business strategy and bad investment decisions can and do 
contribute to a company's fall, it is a company's desperate attempt to 
use accounting tricks to hide bad decisions that often seals its fate. 
My analysis of cases of major stock price declines shows that when news 
of an unanticipated business problem, such as a new product competition 
or obsolescence of technology, is released to the market, the company's 
stock price does take a hit, but it often recovers over time if the 
company takes appropriate and timely management actions. However, when 
a company loses the trust and confidence of the investing public 
because of discoveries of accounting wrongdoings, the net result on the 
company's stock price and competitive position is mostly devastating 
and long-lasting. This is because accounting reports are the principal 
means by which investors evaluate the company's past performance and 
future prospects, and a loss of trust effectively turns away investor 
interest in the company.
    My analysis also suggests that it is not possible to recover from a 
loss of investor confidence by some quick management actions. Before 
re-admitting the company to their investment portfolios, investors 
would demand and seek evidence that the accounting numbers are again 
reliable, and this process of rebuilding of trust often takes place 
through several quarters of reliable financial disclosures. If the 
company's finances are not fundamentally sound to begin with, then it 
is quite likely that the company would not survive this long trust-
recovery phase intact. This is exactly what happened in the case of 
Enron. Burdened with dozens of failing investments and assets hidden in 
special purpose entities whose very existence and financing often 
depended on high stock price of Enron's shares, the company quickly 
entered a death-spiral when investors questioned its accounting 
practices and pushed its share price down to pennies.
                      2. use of pro-forma earnings
    Enron's loss of investor faith started with the company's 2001 
third quarter earnings release on October 16, 2001. As earnings 
releases go, this one must rank as one of the most misleading. The news 
release said in an underlined and capitalized headline, ``Enron Reports 
Recurring Third Quarter Earnings of $0.43 per diluted shares.'' The 
headline went on to reaffirm ``recurring earnings'' for the following 
year, 2002, of $2.15 per share, a projected increase of 19% from 2001. 
But an investor had to dig deep into the news release to know that 
Enron actually lost $618 million that quarter, for a loss of ($0.84) 
per share. A net loss of $618 million loss was converted to a 
``recurring net income'' of $393 million by conveniently labeling and 
excluding $1.01 billion of expenses and losses as ``non-recurring''.
    The practice of labeling certain earnings items as non-recurring or 
``one-time'' has unfortunately become widespread in the US, and has 
corrupted corporate disclosure environment to the detriment of 
investors and the public. Companies ranging from General Motors to 
Cisco mention some form of pro-forma earnings in their earnings 
disclosures. Of course, there is nothing ``one-time'' or ``non-
recurring'' about the $1.01 billion of expenses and losses that Enron 
chose to label as such in its 2001 third quarter earnings release. In 
other words, neither accountants nor managers could assure that what 
they call non-recurring would not recur.
    My ongoing research also shows that the adoption of pro-forma 
earnings reporting is often a company's desperate response to hide 
underlying business problems from its investors. As an example, Enron 
did not always use pro-forma earnings in its news releases. Its 
earnings release as late July 24, 2000, for 2000 second quarter, did 
not contain any reference to recurring earnings. In its 2000 third 
quarter earnings release on October 17, 2000, Enron started using the 
recurring earnings in the body of the news release. We know from the 
Enron board's internal report dated February 1, 2002, that this was 
also the time when the senior management started worrying about the 
declining value of many of their merchant investments. By the following 
quarter, recurring earnings had been elevated by Enron to news 
headline.
    Not all companies, of course, use pro-forma earnings or use them in 
blatantly misleading way. Companies like Microsoft do report their 
earnings without having to resort to misleading pro-forma disclosures. 
However, we need to ensure that misleading pro-forma disclosures are 
halted altogether. In a recent speech, the chairman of the Securities 
and Exchange Commission has warned companies that pro-forma earnings 
would be monitored by the SEC for misleading disclosures. However, this 
does not go far enough. The SEC should recognize all pro-forma 
disclosures for what they really are--a charade. They may differ from 
one another in the degree of deception, but the intent of all pro-forma 
earnings is the same--to direct investor attention away from net income 
measured using generally accepted accounting principles, i.e., GAAP 
earnings.
    Enron's 2001 third quarter earnings press release on October 16, 
2001, contained another major shortcoming--lack of information about 
its balance sheet and cash flows. While the company's press release 
provided information on net income, the company failed to provide a 
balance sheet. This is inexplicable--we teach in Accounting 101 that 
the income statement and the balance sheet are interrelated 
(``articulated'') statements. This essentially means that we cannot 
really prepare one without preparing the other. Not surprisingly, 
almost every major company's earnings release contains the balance 
sheet along with its income statement. Financially responsible 
companies would also provide a cash flow statement. Analysts and 
investors puzzled with Enron's lack of balance sheet disclosure had to 
wait until after the markets closed on October 16, 2001, when the 
senior management disclosed in response to a question during the 
earnings conference call that it had taken a $1.2 billion charge 
against its shareholders' equity (a balance sheet item), including what 
was described as a $1 billion correction of an accounting error. The 
experience suggests that along with reforms on pro-forma earnings 
usage, we should mandate a fuller, more complete presentation of 
financial statements in the earnings news releases so that investors 
can truly be in a position to interpret the quality and usefulness of 
the reported earnings numbers.
                  3. special purpose entity accounting
3.1. Business Purpose of SPEs
    Enron's internal report released on February 1, 2002, makes clear 
that Enron used dozens of transactions with special purpose entities 
(SPEs) effectively controlled by the company to hide bad investments. 
These transactions were also used to report over $1 billion of false 
income. Many of these transactions were timed (or worse, illegally 
back-dated) just near end of quarters, so that the income can be booked 
just in time and in amounts needed, to meet investor expectations. 
However, SPEs were not originally created as mere tools of accounting 
manipulation. Surprisingly, the SPE industry did start with some good 
business purpose. Before discussing the accounting issues related to 
Special Purpose Entity (SPE) accounting, it would be useful to have a 
brief description of what these entities are and how they arose.
    The origin of SPEs can be traced to the way large international 
projects were (and are) financed. Let's say a company wants to build a 
gas pipeline in Central Asia and needs to raise $1 billion. It may find 
that potential investors of the pipeline would want their risk and 
reward exposure limited to the pipeline, and not be subjected to the 
overall risks and rewards associated with the sponsoring company. In 
addition, the investors would want the pipeline to be a self-supported, 
independent entity with no fear that the sponsoring company would take 
it over or sell it. The investors are able to achieve these objectives 
by putting the pipeline into a special purpose entity that is limited 
by its charter to those permitted activities only. Thus a common 
historical use of SPE was to design it as a joint venture between a 
sponsoring company and a group of outside investors. The SPE would be 
limited by charter to certain permitted activities only--hence the 
name. Such an SPE is often described as brain-dead or at least on auto-
pilot. Cash flows from the SPE's operations of the project are to be 
used to pay its investors.
    In the US, the use of SPEs spread during the 1970s and 1980s to 
financial services industry. In the early 1980s, SPEs were used by the 
financial services firms to ``securitize'' (market as securities) 
assets that are otherwise generally illiquid and non-marketable, such 
as groups of mortgages or credit card receivables. Because they provide 
liquidity to certain assets and facilitate a more complete market for 
risk sharing, many SPEs can and do indeed serve a useful social 
purpose.
3.2 Accounting Purposes of SPEs
    These examples illustrate that SPEs can be motivated by a genuine 
business purpose, such as risk sharing among investors and isolation of 
project risk from company risk. But as we have seen from the Enron 
debacle, SPEs can also be motivated by a specific accounting goal, such 
as off-balance sheet financing. The desired accounting effects are made 
possible because of the fact that SPEs are not consolidated with the 
parent if they satisfy certain conditions. The accounting effects 
sought by the use of SPEs can be summarized into the following types:
    1. Hiding of Debt (Off-Balance Sheet Financing). The company tries 
to shift liabilities and associated assets to an SPE. The main purpose 
of forming the SPE in this case is to let the SPE borrow funds and not 
show the debt in the books of the sponsoring entity. The so-called 
``synthetic leases'' are examples of this type of SPEs. In the 1980s 
SPEs became a popular way to execute synthetic lease transactions, in 
which a company desiring the use of a building or airplanes tries to 
structure the purchase or use in such a way that it does not result in 
a financial liability on the balance sheet. Though Enron's earlier use 
of SPEs may have been motivated by this objective, the key SPEs formed 
by Enron since 1997, such as Chewco, LJM1 and LJM2, were intended more 
for the other accounting objectives described below.
    2. Hiding of Poor-Performing Assets. This objective has a major 
factor in several SPE transactions of Enron. For example, Enron 
transferred poor-performing investments such as Rhythms NetConnections 
to SPEs, so that any subsequent declines in the value of these assets 
would not have to be recognized by Enron. In 2000 and 2001 alone, Enron 
was able to hide as much as $1 billion of losses from poor-performing 
merchant investments by these types of SPE transactions.
    3. Earnings Management--Reporting Gains and Losses When Desired. 
This accounting objective has also been a fundamental motivation for 
several of the complicated transactions arranged by Enron with SPEs 
with names such as Braveheart, LJM1 and Chewco. For example, Enron was 
able to transfer a long-term business contract--an agreement with 
Blockbuster Video to deliver movies on demand, to an SPE and report a 
``gain'' of $111 million.
    4. Quick execution of Related Party Transactions at desired prices. 
Enron's use of SPEs such as LJM1 and LJM2, controlled by its own senior 
managers, was specifically intended to do related party transactions 
quickly and when desired, at prices not negotiated at arms length but 
arrived at between parties who had clear conflicts of interest. For 
example, the above Blockbuster deal was arranged at the very end of 
December 2000, just in time so that about $53 million of the ``gain'' 
could be included in the 2000 financial report. (The rest of the gain, 
$58 million, was reported in 2001 first quarter.) The purpose of this 
and several similar transactions by Enron seems to have been to use 
these transactions with SPEs controlled by its own senior executives to 
essentially create at short notice any amount of desired income, to 
meet investor expectations.
    There are three sets of accounting rules that permit the above 
financial statement effects of SPEs. One deals with balance sheet 
consolidation--whether or not SPEs such as synthetic leases should be 
consolidated or reported separately from the sponsoring entity. The 
second deals with sales recognition--when should the transfer of assets 
to an SPE be reported as a sale. The third deals with related party 
transactions--whether transfers of assets to related parties can be 
reported as revenue. Of these, the accounting problem that needs 
immediate fixing is the one dealing with consolidation of SPEs. This is 
addressed next. With respect to sales recognition rules and related 
party transaction rules, the problem may lie more with Enron's 
questionable accounting and corresponding auditor errors, rather than 
the rules themselves. However, Enron's revenue recognition from SPE 
transactions often depended on the so-called mark-to-market accounting 
rules which gave Enron the ability to assign arbitrary values to its 
energy and other business contracts. These rules do have certain 
problems that need fixing, and this issue is addressed in section 4.
3.3. Consolidation of SPEs
    Despite their potential for economic and business benefits, the use 
of SPEs has always raised the question of whether the sponsoring 
company has some other accounting motivations, such as hiding of debt, 
hiding of poor-performing assets, or earnings management. Additionally, 
the explosive growth in the use of SPEs led to debates among managers, 
auditors and accounting standards-setters as to whether and when SPEs 
should be consolidated. This is because the intended accounting effects 
of SPEs can only be achieved if the SPEs are reported as unconsolidated 
entities separate from the sponsoring entity. In other words, the 
sponsoring company needs to somehow keep its ownership in the SPE low 
enough so that it does not have to consolidate the SPE.
    Thus consolidation rules for SPEs have been controversial and have 
been hotly contested between companies and accounting standards-setters 
from the very beginning. In the US, the involvement of the Financial 
Accounting Standards Board (FASB), the accounting standards-setting 
agency, in SPE accounting effectively started from 1977 when it issued 
lease capitalization rules to control the use of off-balance sheet 
financing with leases. Corporate management intent on skirting around 
the new lease capitalization rule appeared to have led to the rapid 
development of SPEs to do the so-called ``synthetic leases''. In the 
first of several accounting rules directed at SPEs, in 1984 the 
Emerging Issues Task Force (EITF) of the FASB issued EITF No. 84-15, 
``Grantor Trusts Consolidation.'' However, given the rapid growth of 
SPEs and their ever-widening range of applications, standards-setters 
were always a step or two behind and were being reactive rather than 
proactive in developing accounting rules to govern their proper use.
    The question of whether a sponsoring company should consolidate an 
SPE took a definitive turn in 1990 when the EITF, with the implicit 
concurrence of the SEC, issued a guidance called EITF 90-15. This 
guidance allowed the acceptance of the infamous ``3 percent rule'', 
i.e., an SPE need not be consolidated if at least 3 percent of its 
equity is owned by outside equity holders who bear ownership risk. 
Subsequently, the FASB formalized the above SPE accounting rule with 
Statement No. 125, and more recently Statement No. 140, issued in 
September 2000.
    An analysis of the development of the 3 percent rule suggests that 
the rule was an ad-hoc reaction to a specific issue faced by the FASB's 
Emerging Issues Task Force and was intended as a short-term band-aid, 
but has somehow been elevated to a permanent fix. More importantly, the 
rule, in many ways, was a major departure from the normal consolidation 
rules used for other subsidiaries and entities. In the US, we generally 
require full consolidation if a company owns (directly or indirectly) 
50 percent or more of an entity. Thus the 3 percent rule is a major 
loosening of the normal consolidation rule. The motivation for this 
seems to have been that the SPEs were restricted in their activities by 
charter and thus the parent company could claim lack of control. The 
parent company only had to show that some other investors did indeed 
join the SPE venture with a significant exposure (signified by the 3 
percent rule) in order to make the SPE economically real and thus take 
it off the books.
    Clearly the accounting for SPE consolidation needs to be fixed, 
starting with the abandonment of the 3 percent rule and its replacement 
with a more strictly defined ``economic control'' criterion. The need 
to fix consolidation rules has also been amply recognized by the FASB, 
which has been working for several years on a comprehensive 
``consolidation'' project. However, the Enron debacle should give our 
standards-setters the needed push to rapidly complete this critical 
project and issue new rules for the proper consolidation of SPEs whose 
assets or management are effectively controlled by the sponsoring 
company. The rules should emphasize economic control rather than rely 
on some legal definition of ownership or on an arbitrary percentage 
ownership. Economic control should be assumed unless management can 
prove lack of control.
          4. mark-to-market accounting and earnings management
    In the US, financial assets, such as marketable securities, 
derivatives and financial contracts, are required to be reported on the 
balance sheet at their current market values, rather than their 
original acquisition cost. This is known as mark-to-market (MTM) 
accounting. MTM also requires changes in the market values for certain 
financial assets to be reported in the income statement, and in other 
cases in the shareholders' equity as a component of ``Accumulated Other 
Comprehensive Income'' (OCI), a new line item that was required for all 
public companies by FASB Statement No. 130 from 1997.
    MTM was implemented in FASB Statement No. 115, issued in 1993, for 
financial assets that have readily determinable market values, such as 
stocks and traded futures and options. In 1996, FASB Statement No. 133 
extended MTM to all financial derivatives, even those that do not have 
traded market values. For some derivatives, a company may have to use 
complex mathematical formulas to estimate a market value. Depending on 
the complexity of the financial contract, the proprietary formulas used 
by companies for market value estimation may depend on several dozen 
assumptions about interest rate, customers, costs, and prices, and 
require several hours of computing time. This means that it is hard, if 
not impossible, to verify or audit the resulting estimated market 
value. Of course, a consequence of this lack of verifiability is that 
MTM accounting can potentially provide ample opportunities for 
management to create and manage earnings. Thus MTM accounting 
represents the classic accounting struggle of weighing the trade-off 
between relevance and reliability--in this case the relevance of the 
market value data against the reliability of the data. In the end, the 
accounting standards-setters took the position that the increased 
benefit from reporting the market value information on the balance 
sheet justified the cost of decreased reliability of income statement 
and the earnings number.
    It will be useful to consider an example of how Enron recognized 
with MTM accounting, in order to understand how MTM can be easily 
manipulated by a company to manage earnings, especially with respect to 
financial contracts that do not have a ready market. Assume that Enron 
signed a contract with the city of Chicago to deliver electricity to 
several office buildings of the city government over the next twenty 
years, at fixed or pre-determined prices. The advantage to the city of 
Chicago from this ``price risk management'' activity is that it fixes 
its purchase price of electricity and allows the city government to 
budget and forecast future outlays for electricity without having to 
worry about price fluctuations in gas or electricity markets.
    Enron sought and obtained exemptions from regulators to allow it 
report these types of long-term supply contracts as ``merchant 
investments'' rather than regulated contracts, and obtained permission 
from accounting standards-setters to value them using MTM accounting. 
Without MTM, Enron would be required to recognize no revenue at the 
time the contract is signed and report revenues and related costs only 
in future years for actual amounts of electricity supplied in each 
year. However, MTM accounting permits Enron to estimate the net present 
value of all future estimated revenues and costs from the contract and 
report this net amount as income in the year in which the supply 
contract is signed. The idea for such an accounting treatment seems to 
be based on the notion that the financial contract could have been sold 
to someone else immediately at the estimated market value, and hence 
investors would benefit from knowing this amount in the balance sheet 
and correspondingly in the income statement. Enron used similar MTM 
procedures to not only value merchant investments on its books but also 
to determine the selling price, and hence gain on sale, for investments 
it transferred to the various SPEs it controlled.
    A major problem with using MTM accounting for private contracts 
such as the one described above is that the valuation requires Enron to 
forecast or assume values for several dozen variables and for several 
years into the future. For example, the revenue forecasts may depend on 
assumptions about the exact timing of energy deregulation in various 
local markets, as well as 20 years of forecasts for demand for 
electricity, actions of other competitors, price elasticity, cost of 
gas, interest rates, and so on.
    While there are strong conceptual reasons to support MTM 
accounting, the Enron crisis points to at least some need to revisit 
and revise the current accounting rules for reporting transactions and 
assets that rely on MTM values. In particular, MTM rules should be 
modified to require that all gains calculated using MTM method for 
assets and contracts that do not have a ready market value should be 
reported only in ``Other Comprehensive Income'' in the balance sheet, 
rather than the income statement, until the company can meet some high 
``confidence level'' about the realization of revenue for cash flows 
that are projected into future years. Normal revenue recognition rules 
do require that revenue should be recognized after service is 
performed, and moreover that revenue should be ``realized or 
realizable'', meaning that cash flow collection should be likely. In 
the absence of satisfying this condition, revenue rules (such as those 
explained in SEC Staff Accounting Bulletin 101) normally compel a 
company to wait until service is performed and cash collection 
probabilities are higher. Extending this logic to MTM accounting would 
protect the investing public from unverifiable and unauditable claims 
of gains being reported in the income statement.
                           5. recommendations
    The Enron Meltdown is a result of massive failure of corporate 
control and governance, and failures at several levels of outside 
checks and balances that investors and the public rely on, including an 
independent external audit. In my testimony, I have focused on the 
accounting issues, and in particular on the possible changes we need to 
make in these areas in order to prevent future Enrons. My 
recommendations are summarized below.

1. The SEC, the New York Stock Exchange (NYSE) and the Nasdaq should 
        adopt new rules severely restricting the format and use of pro-
        forma earnings reporting. All earnings communications by 
        companies should emphasize earnings as computed by Generally 
        Acceptable Accounting Standards. Any additional information 
        provided by the company to highlight special or unusual items 
        in the earnings number should be given in such a way that the 
        GAAP income is still clearly the focus of the earnings 
        disclosure.
2. Companies should be reminded by regulators and auditors that the use 
        of terms such as ``one-time'' or ``non-recurring'' about past 
        events in earnings communications implies certain promises to 
        investors about future performance, and therefore should not be 
        used except in rare cases.
3. Companies should present a complete set of financial statements, 
        including a balance sheet and a cash flow statement, in all 
        their earnings communications to the general public, in order 
        to permit investors evaluate the quality of the reported 
        earnings numbers.
4. The FASB needs to accelerate its current project on consolidation 
        accounting, and in particular, fix the consolidation rules in 
        the accounting for Special Purpose Entities to prevent its 
        continued abuse by corporations for earnings management. The 
        current consolidation rules, including the ``3 percent'' rule 
        for SPEs need to be abandoned and replaced with an ``economic 
        control'' rule. The new rules need to emphasize economic 
        control rather than rely on some legal definition of ownership 
        or on an arbitrary percentage ownership. Economic control 
        should be assumed unless management can prove lack of control. 
        Similar rules should be extended to lease accounting.
5. The FASB and the SEC need to consider requiring new disclosures on 
        transactions between a company and its unconsolidated entities, 
        including SPEs. In particular, more detailed footnote 
        disclosures on the sale or transfer of assets to unconsolidated 
        entities, recognition of income from such transfers, and the 
        valuation of transferred assets should be required.
6. The mark-to-market accounting methodology, while theoretically 
        sound, needs to be modified in the light of what we have 
        learned from the Enron meltdown. Traditional revenue 
        recognition rules, such as the realization principle, should be 
        extended to the recognition of gains and losses from MTM 
        accounting. Forecasted cash flows beyond two or three years 
        should be presumed to have a low level of confidence of 
        collectibility. Gains resulting from present values of such 
        cash flows should be recorded in the Accumulated Other 
        Comprehensive Income in the balance sheet, rather than the 
        income statement, until the confidence level increases to 
        satisfy the usual realization criterion of collectibility.

    Chairman Tauzin. Thank you, Dr. Dharan.
    Now we turn to someone whom I'm told by the staff if they 
did have a Nobel Prize for accounting, would be a recipient of 
the Nobel Prize. In fact, Dr. Lev, the staff affectionately 
called you the Britney Spears of accounting.
    We welcome your testimony, sir.

                    STATEMENT OF BARUCH LEV

    Mr. Lev. Thank you very much, Chairman. I'm deeply grateful 
to be here. I was asked to speak about reforming accounting 
auditing systems. I would like to state at the outset that my 
ideas, concepts, suggestions that are included in my written 
testimony were not shaped by Enron or Arthur Andersen. They 
were shaped by more than 25 years of experience, observations 
and extensive reach. Enron basically provides with, I think, a 
great opportunity to do a much needed over due, overhaul of the 
system.
    I draw your attention to my testimony, the first two pages 
provide diagrams of what I see as the problem. The second one 
what I see as the solution, followed by 9 pages of elaborations 
and then followed a quiz.
    Starting with the problem, the first diagram, there is a 
nexus there of three elements. I'm almost tempted to borrow a 
phrase and call it an ``evil axis'' here and we have financial 
reports, we have auditing and we have enforcement and I 
characterize those financial reports by too narrow auditing, 
it's too cozy and enforcement is too little, too late and too 
opaque. Let me say a word about each of the three.
    Financial reports, I'm sure that the gentleman that took 
six accounting courses will agree with me, accounting is very 
good at recording or portraying simple transactions like sales, 
purchases, borrowing. Accounting is terrible in reporting more 
complex things that are not regular transactions like 
unexecuted obligations, for example, promises that Enron gave 
to the special entities to cover losses if there will be 
losses. All those things are to a large extent not reported, 
not recorded in accounting.
    Accounting does not portray the myriad network of 
alliances, joint ventures, partnerships that corporations have, 
most of them for legitimate, good economic reasons, but they 
are not portrayed in accounting. Accounting is terrible in 
portraying intangible assets like patents, like brands, like 
human resources. Intangible assets now count for more than 80 
percent on average of the values of companies and accounting is 
completely useless in portraying the risk that the company is 
exposed to, so we are speaking here about a really outmoded, to 
a large extent, useless information system.
    If I turn to auditing, you heard a lot about auditing. It's 
basically an ``all-in-the-family'' affair. You heard about the 
consulting and the revolving door and everything. Let me just 
add one nugget here. Even the auditing standards which are 
called generally accepted accounting standards, the rules that 
auditors follow and on which they rely in their report are 
basically set by their own trade association, by the American 
Institute of Certified Public Accountants.
    Enforcement, as I said before, too low, too slow. Let me 
just quote form the Journal, it was the Journal yesterday to 
speak about Global Crossing and they say the SEC tries to 
determine whether accounting rules were violated. The decision 
whether to bring a case can take at least 1 or 2 years. We are 
speaking about the company that went bankrupt last week.
    If I turn to the solution which is the next exhibit that 
you have, speaking about financial reporting, we have to move 
from the very narrow, as it is called financial reporting, to 
the exclusion of everything else to a very broad, comprehensive 
disclosure, to open a net which will capture and report 
alliances and joint ventures and partnerships and all 
obligations and intangible assets and will portray the risk 
position or exposure of the company. This is a tall order. It's 
not an easy thing to do, but it can be done.
    When I turn to auditing, given my time limitation you heard 
a lot about auditing. Let me just mention a couple of things. 
It's not a secret that auditors for all practical purposes are 
selected, chosen and reappointed by managers. We all know about 
the board and the audit committee of the board, but board 
members are also for all practical purposes chosen and selected 
by managers. We have to break this link, this dependency of 
auditors on managers and the only way I see that this can be 
done is that auditors will be chosen, once in 5 years, by 
shareholders. What a novel idea. Those that have to receive the 
information are choosing the auditors and not the auditees.
    Now I hear from people that it's not practical and a 
condescending thing that shareholders don't know and they 
cannot choose auditors. This is, excuse me, this is nonsense. 
We have a very solid process which is called a contest, a proxy 
contest which is used quite frequently to select, to change 
board compositions, to change management, to change policies 
and this can be used to select auditors, once in 5 years. Next 
month shareholders of two giant companies, Hewlett Packard and 
Compaq will vote on the largest acquisition ever in the high 
tech sector. If they know how to do that, they will now how to 
select auditors.
    This will open the audit markets to competition. There will 
be bids every 5 years. New teams will come with expertise, 
something like auditors with expertise in energy trading, 
something like that and if they won't perform, they'll be 
thrown out. In this case, it will break this dependence between 
managers and auditors.
    The second element that was not discussed, at least 
extensively is the audit report. The audit report is a 
meaningless piece of paper with just one sentence and lots of 
hedging and pushing, transferring the information to other 
parties like the financial reports, the responsibility of 
managers and we follow auditing standards and accounting 
standards and so on and so on. We have to discard this report 
for an open-ended report in which auditors will tell, sometimes 
at length, to shareholders what is going on in the company. I 
read that Mr. Berardino, the CEO of Arthur Andersen yesterday 
even came close to these suggestions when he said the current 
past/fail system, this qualified/nonqualified lets companies 
get away with barely adequate accounting. I will say it gets 
away with much less than that and he provides some kind of 
suggestions for a rating.
    Last thing I would say is about enforcement. I am for the 
ideas that were raised by several people including Lynn Turner 
of setting up, and it's the only body that I think has to be 
set up, an investigatory body that will be mandated to 
investigate and quickly, relatively quickly release results 
with respect to failures and failures are not just Enron. 
Failures, for example, are large restatements of earnings that 
are now numbering in the hundreds per year.
    All I can add to this is perhaps a novel idea about 
funding. I don't want the funding for this body to come from 
accounting firms which again will create dependence, all from 
corporations. I calculated that if you'll charge every 100 
shares traded one penny, just one penny which is really a 
minuscule charge, you'll raise more than $70 million which 
probably will be sufficient to fund such a body. The budget of 
the National Transportation Board has year was $57 million. I'm 
coming to a close.
    I agree with the first speaker here that we have to change 
completely the rules of disclosing insider trading. This is 
incredibly important information to shareholders what insiders 
do. Currently, you have to report to the SEC on the tenth day 
or no later than the tenth day of the following month which 
means a lag of 20 to 25 days. This is intolerable. This has to 
be reported no later than the following day after the trade.
    In closing, I think we have a great opportunity here. I 
think we have really a moment of grace to initiate change 
because what we are dealing with here is not just Enron and 
Arthur Andersen. The problems afflict hundreds, to varying 
degree, hundreds if not thousands of corporations in the United 
States. You will soon hear from the awesome forces of the 
vested interest of the status quo that the changes that will be 
proposed can't be done, they're too radical and they really are 
not needed. They are wrong and I hope you rise to the occasion.
    Thank you very much.
    [The prepared statement of Baruch Lev follows:]
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    Chairman Tauzin. Thank you very much, Mr. Lev. Excellent 
testimony.
    We turn now to Mr. Bevis Longstreth and Mr. Bevis 
Longstreth is with the firm, this is a tough pronunciation, 
Debevoise & Plimpton, right, in New York.
    Mr. Longstreth.

                 STATEMENT OF BEVIS LONGSTRETH

    Mr. Longstreth. I pronounce it Bevis.
    Chairman Tauzin. I'm sorry.
    Mr. Longstreth. That's okay.
    Chairman Tauzin. And you will give us some idea about your 
thoughts on the governance of accounting and auditing.
    Mr. Longstreth. Yes. I'm going to cover some material that 
my colleague to the right covered. Let me give you a little 
background about my qualifications to be here. I have spent 
most of my professional life at Debevoise & Plimpton, a New 
York law firm, which I retired from about 8 years ago. I served 
as an SEC Commissioner for 3 years, 1981 to 1984.
    Chairman Tauzin. That was during the Reagan Administration, 
correct?
    Mr. Longstreth. It was. I was appointed twice by President 
Reagan and being a registered Democrat, I felt that I could 
serve both sides of the aisle.
    Chairman Tauzin. And serve there with distinction.
    Mr. Longstreth. Recently, I was a member of the panel on 
Auditors----
    Chairman Tauzin. Sir, Mr. Dingell, wanted to add that you 
served there with great distinction as well.
    Mr. Dingell. I just observe that you served there with 
distinction.
    Mr. Longstreth. Thank you. I recently served on the Panel 
on Audit Effectiveness which published a report in 2000 which 
vanished from sight as did the panel. The panel was appointed 
by the POB, the Public Oversight Board, the group that recently 
resigned en masse as a result of some suggestions coming out of 
the SEC.
    For 5 years after I retired, I taught a course on the 
regulation of financial intermediaries at Columbia Law School 
and presently I'm the chair of an audit committee of a large 
public company. So those are the qualifications that bring me 
here to talk to you.
    What I want to say starts really with the leading role in 
capital formation that is served by the audit and just to get a 
definition down, the audit is, as you all know, the critically 
important process by which a public company's financial 
condition is vouched for by a firm of certified public 
accountants as being worthy of the investing public's trust. 
And a fundamental importance to the audit function is an iron 
clad assurance that the auditor is independent of the client, 
both in fact, and in appearance.
    Now I'm going to invite you to consider two notorious 
fictions that for years leaders of the auditing profession have 
staunchly maintained and thereby have deflected efforts over 
the years at any serious reform.
    The first fiction is the claim that payment by an audit 
client to its auditor for consulting another nonaudit services 
no matter how large, will never impair independence, that is, 
it will never have an adverse effect on the quality of the 
audit or be seen to have such an effect in the eyes of the 
investing public. Because of the rule that the SEC wrote a 
couple of years ago requiring separate disclosure of audit and 
nonaudit fees paid to its auditor, the public has recently 
discovered how important nonaudit fees have become to an 
auditor's bottom line. On average in the year 2001, nonaudit 
services represented an astounding 73 percent of total fees 
paid to auditors by their audit clients.
    It just defies common sense to claim that large payments 
for nonaudit services which management could easily purchase or 
threaten to purchase from service providers other than its 
auditor do not function as a powerful inducement to gain the 
auditor's cooperation on how the numbers are presented.
    One of the Big Five in explaining to its clients these SEC 
new rules that were published a couple of years ago, carried 
the fiction I'm describing to a breathtaking extreme. In the 
published and widely distributed pamphlet on the rule, sent to 
all its clients, and presumably prospective clients, the firm 
wrote that the size of nonaudit fees paid by a single company 
are relevant to the question of independence only if those fees 
reach 15 percent of that auditor's total revenues from all 
sources. Now in 2001, the smallest of the Big Five had total 
revenues of over $9 billion. In other words, using the 15 
percent rule threshold of concern, a Big Five firm was claiming 
that a single client could pay annually at least $1.35 billion 
to that audit firm before the audit committee of the firm, of 
the company, the SEC or anyone else need trouble himself over 
independence. In a practical sense, the statement was ``there's 
no limit at all.''
    Audit account partners are expected by their firms to 
establish close relationships with the managements they serve. 
They are expected to cross market to management as full a range 
of services as they can and they are compensated by their firms 
on how much revenue they produce from these audit clients. 
Their stake in maximizing revenue from these clients through 
cross marketing of nonaudit services is as natural and 
compelling as any financial reward could be. To claim these 
incentives have no adverse impact on independence is a fiction, 
pure and simple.
    The second fiction that I wish to address is the 
profession's threefold claim: (1) that it has the ability and 
motivation to regulate itself voluntarily; (2) that it has done 
so effectively over the past several decades; and (3) that 
there is no need for a legislatively empowered regulatory body 
led by persons independent of the profession and who are 
charged to regulate the profession and post discipline where 
it's warranted.
    In fact, the profession's voluntary scheme of self-
regulation is an oxymoron. It is a bewildering maze of 
overlapping committees, panels and boards, piled one on top of 
the other that collectively has failed in protecting the 
investing public.
    Even with the best intentions, these voluntary arrangements 
would be incapable of achieving anything close to effective 
self-regulation. The list of defects is long, but among them is 
(1) lack of public representation; (2) lack of transparency; 
(3) lack of assured funding; (4) lack of any credible system 
for imposing discipline, and overall, a lack of any 
accountability.
    Enron makes it perfectly clear that these two fictions can 
no longer be permitted to carry this once proud profession away 
from its core responsibilities to the investing public and 
those are responsibilities that are under our Nation's 
licensing laws at the State level and the securities laws at 
the Federal level, are reserved exclusively for this profession 
to discharge. Any enterprise that has market exclusivity is a 
blessing, but the blessings have to come with some burdens that 
would flow from essentially a monopoly.
    To address the conflicts of interest that are masked by 
these two fictions, reform is necessary and I'm not a great 
believer in writing law to solve every ill. In fact, I'm a 
great believer that that's a mistake. But I am convinced that 
legislative reform and nothing short of legislative reform will 
meet this need because the profession has been enormously 
effective in overwhelming efforts at reform by the SEC and 
others. Indeed, its lobbying largesse has been so abundant here 
on Capitol Hill that protective legislative voices have 
repeatedly over the decades been raised whenever the SEC has 
tried to effect serious reforms.
    Now, on the back of the Enron disgrace, with public 
investors, small and large, suffering deeply their losses, this 
Congress has a wide open window of opportunity to do something 
of lasting and immense value to the Nation and that something 
is actually quite something. Only two reforms in my judgment 
are needed. First, an effective rule preventing an auditor from 
rendering nonaudit services to its audit clients. I describe 
such a rule at page 18 to 19 of my written testimony. Second, 
an effective legislatively empowered system of self-regulation 
and I describe that and the essential elements of it at pages 
31 to 35.
    One final point if I may be permitted. In the wake of the 
Great Depression with the failure of an immense number of banks 
and the loss, huge losses to depositors, the Congress 
recognized that the public's confidence in the Nation's banking 
system had been badly shaken. Through hearings before this 
House and the Senate it became clear to the Congress that the 
public's earnings, when deposited in banks, simply had to be 
safe and the public had to believe their deposits were safe. 
And to meet this goal, of course, as you all know, the Congress 
created the FDIC and the system of deposit insurance which has 
stood the test of time down to today.
    Since 1933, the public's earnings have gradually migrated 
from the banking system to the capital markets, from bank 
deposits to money market, mutual funds and increasingly to 
equities. With this shift in how the public saves its earnings 
must come a shift by lawmakers in fashioning the kinds of 
protections these public investors need. The Congress should 
not, of course, create a safety net to protect public investors 
in equities against any loss. To do that would be to do more 
harm to our system of capital formation than good. But the 
Congress should act to ensure that the system by which our 
corporations present their financial condition to the public is 
worthy of trust. The auditors, often referred to as 
gatekeepers, are simply the last line of defense against 
management's inclination to fudge the numbers and in recent 
years with increasing and disturbing frequency to present false 
and misleading numbers.
    Legislative action is needed now because with the growing 
number of audit failures in recent years, culminating with 
Enron, I hope culminating with Enron, the public's confidence 
has again been badly shaken, just as in the Great Depression. 
However, this time the loss of confidence is by the public in 
its capacity as investors, not depositors, and its loss of 
confidence is directed at the reliability of financial data 
certified by auditors.
    I hope that the Enron hearings will convince the Congress 
that the public's confidence in the auditing system should be 
restored by prompt and forceful legislative intervention, just 
as the public's confidence in the banking system was restored 
by forceful congressional action in 1933. The two reforms I've 
summarized will do the job. My written testimony develops the 
case for each in some detail. I thank you for your attention 
and the opportunity to be here and I'm happy to answer any 
questions you may have.
    [The prepared statement of Bevis Longstreth follows:]
                 Prepared Statement of Bevis Longstreth
    My name is Bevis Longstreth. I am a retired partner of the New York 
law firm, Debevoise & Plimpton, where I spent the bulk of my 
professional career. From 1981 to 1984, I served as a Commissioner of 
the SEC, a post to which I was appointed twice by President Reagan. 
Recently, I served as a member of the Panel on Audit Effectiveness, 
which released its final Report and Recommendations in August, 2000. 
For five years following retirement from law practice, I taught a 
course on the regulation of financial institutions at the Columbia Law 
School.
    I welcome this opportunity to address the Committee on the subject 
of reforming the audit profession. I am here because my professional 
experience and background give me some basis for contributing to your 
treatment of this urgent need for reform. I represent only myself, but 
in so doing, I hope to offer opinions that will resonate with other 
public investors in our nation's securities markets.
    I want to speak about the audit profession, a once proud profession 
now greatly in need of reform.
    My thesis is simple. The profession needs reform in two major 
respects:

1. An effective rule preventing the delivery of non-audit services to 
        audit clients; and
2. An effective system of self-regulation.
    Despite the SEC's adoption of Rule 2-01, the threat to an auditor's 
independence from performing non-audit services allowed by the Rule 
remains palpable.
    Despite the enlarged charter of the Public Oversight Board, until 
recently the most promising vehicle for improving self regulation, an 
effective system of self-regulation for the profession does not exist 
and can not be achieved without legislative reform. No greater proof of 
this fact could be found than the POB's unanimous vote on January 20, 
2002 to terminate its existence in reaction to the efforts of the 
profession's trade association and the CEOs of the Big Five, in private 
meetings with the new Chairman of the SEC, to circumvent the POB by 
proposing still another voluntary oversight entity.
    While the reforms I advocate offer no guarantee against audit 
failures, they should sharply reduce their size and number, without 
impairing the ability of audit firms to prosper. Indeed, I believe 
that, without these reforms, the profession, which has been its own 
worst enemy, will continue to abuse its public trust, spiraling 
downwards until legislation denies it the exclusive economic franchise 
on which its success was built from the beginnings of the securities 
laws in 1933 and 1934.
        the need for an exclusionary rule for non-audit services
    Arthur Levitt, with strong assistance from Lynn Turner, his Chief 
Accountant, showed boldness in their efforts to achieve a lasting 
solution to the vexing problem of independence. In the SEC's Proposing 
Release, they invited comment on a simple rule excluding an auditor 
from providing non-audit services to audit clients. To many people away 
from the narrow corridor extending from the financial capital of the 
world that is still New York City to the separated powers of government 
in Washington, the idea that boldness, and even personal courage, would 
be required for a governmental powerhouse such as the SEC to propose 
such an obvious, and widely supported, rule is strange. Yet, I am 
positive that it took both boldness and courage to issue the Proposing 
Release. That's because, by so doing, the SEC knowingly unleashed an 
unprecedented attack from those it was seeking to regulate, as it was 
charged by Congress to do, for the protection of the investing public 
and otherwise in the public interest. The ensuing battle, and it was 
clearly a battle, pitted a legally created monopoly, dominated by five 
global accounting firms, against the SEC. Three of the five, 
representing solely their private business interests, rejected any 
meaningful restrictions on the free play of those interests. Despite 
the profession's multi-pronged assault, the SEC, acting upon the need 
for greater independence, a need long recognized by virtually every 
group that's considered the issue (and there have been many), went 
ahead with its proposals, inviting comment and conducting four days of 
public hearing.
    There were almost 3000 comment letters. One hundred witnesses 
testified for about 35 hours. The battle raged far beyond the 
frontlines at 450 5th Street N.W. Given the sharpness of the debate, 
and the transparency of the private vs. the public interest, there was 
more at stake in the outcome than just the independence of auditors. 
The independence of the SEC, itself, was being challenged as the 
accounting firms did all they could, on Capitol Hill and throughout the 
business and legal communities, to bring political pressure to bear 
against a proposal, the exclusionary rule, that could not be defeated 
by argument on the merits. At an informal meeting during the pendency 
of the rule proposal, involving representatives of the SEC and the POB, 
I was told by a veteran Washington insider that there wasn't a 
significant law firm in DC that hadn't been lined up by the profession 
to assist in its battle.
    In the tumult of the moment, many leaders of the accounting 
profession--and here I must say I am not including leadership of the 
POB--forgot their profession's origins as one granted exclusive rights, 
and reciprocal duties, to perform a vital public service. Although 
affected by the public interest as much as, or more than, any public 
utility, these leaders were demanding freedom from serious oversight or 
constraint. From my vantage point as a member of the Panel on Audit 
Effectiveness who had a career of experience working closely with 
literally hundreds of responsible public accountants, I became 
increasingly convinced that the leadership of the profession was 
seriously, perhaps disastrously, disserving a worthy profession.
    A rule on independence was adopted on November 21, 2000, shortly 
before Arthur Levitt's term expired. The adopting release was 212 pages 
long. It was meticulously detailed. In that detail a careful reader can 
discern the parry and thrust of the battle that raged over each 
principle sought by the SEC and every word and sentence by which each 
surviving principle was to be expressed. I'm sure if Lynn Turner bared 
his back and shoulders, we would find more wounds than we could count, 
inflicted by a profession in the hands of hostile and short-sighted 
people.
    The release acknowledges in several places that, in the SEC's view, 
the final rule struck a reasonable balance among the commenters' 
differing views. The release also claims the rule achieves the SEC's 
important public policy goals. I wish these statements were true. But, 
it is my firm opinion they are not. There is a large gap between the 
sound policy goals sought by the SEC and the actual accomplishments 
that can realistically be anticipated by the rule. When the smoke had 
cleared, it was apparent to this observer that the profession had won 
the battle. Importantly, however, it was just one battle in a war the 
outcome of which, when it comes, sooner or later, will be different.
    About the rule, let me be clear. I am not saying that, on balance, 
we would be better off without the rule. It is useful, despite its 
breath-taking complexity, which has proven very costly for the best 
intentioned issuers. I speak here as Co-Chair of the Audit Committee of 
a large public company that is continually struggling to understand the 
rules and assure that both it and its auditor are in compliance.
    The rule is not even ``half a loaf;'' nonetheless, it is a step in 
the right direction. I say that for three reasons. First, because it 
was a bold and honorable battle hard fought by the SEC. In future 
battles this effort will count for a lot, despite the many compromises. 
Second, because the policy goals elaborated in both releases, and 
supported by abundant testimony and comment, provide a compelling 
foundation for carrying the battle forward in the halls of Congress, 
where, it has become clear, the fight must now be taken. And third, 
because the disclosure requirement is proving of particular use in 
focusing public attention, not to mention the attention of audit 
committees, on the amazing growth in non-audit fees paid to their 
auditors.
    In thinking of the disclosure requirement, it is important to 
remember that the SEC in 1978, based on what it then saw as a growing 
amount of non-audit services being performed for audit clients, adopted 
a very similar disclosure rule, ARS 250, which was swiftly repealed in 
1982 as the consequence of massive pressure from a profession that was 
beginning to be adversely impacted by disclosure. Since then, as we now 
know, non-audit services have increased exponentially.
    So, what's wrong with the rule? I want only to address one big 
problem. Here's what I'm talking about. The SEC adduced strong and 
abundant evidence in the rule-making process, as summarized in 
III(c)(2)(a) of the Adopting Release, that providing to one's audit 
client non-audit services of any kind or kinds, if large enough in 
terms of fees paid, may impair independence. Despite this powerful 
predicate for rule-making, the rule adopted fails absolutely to address 
this concern.
    The SEC describes the rule as implementing a ``two-pronged'' 
approach:

1. Requiring separate disclosure of audit fees, financial information-
        related service fees and other non-audit fees.
2. Prohibiting nine specific non-audit services believed by the SEC to 
        be, by their very nature, incompatible with independence.
    Economic incentives derived from non-audit work, no matter what 
their magnitude, were not defined as being, by their very nature, 
incompatible with independence. In failing to address this matter, the 
SEC ignored a mountain of persuasive argument.
    It defies common sense to claim that large payments for non-audit 
services, which management could easily pay to service providers other 
than its auditor, do not function successfully in many cases as an 
inducement to gain the auditor's cooperation on matters of financial 
presentation.
    Audit account partners are expected by their firms to establish 
close relationships with the managements they serve. They are expected 
to cross-market to management as full a range of non-audit services as 
possible. And, they are compensated by their firms on the basis, among 
others, of how much revenue they produce from their audit clients. 
Their stake in maximizing revenue from these clients through cross-
marketing of non-audit services is as natural and compelling as any 
financial reward could be. To claim these incentives have no adverse 
impact on both the fact and appearance of independence is a fiction, 
pure and simple.
    To be fair, I should point out that the rule contains a general 
standard, 2.01(b), that declares an accountant not independent if, in 
fact, or in the opinion of a fully informed, hypothetical ``reasonable 
investor,'' the accountant is not capable of exercising objective and 
impartial judgment. Absent a ``smoking gun,'' this ``capability'' test 
would seem to create a virtually insurmountable hurdle for the SEC.
    The disclosure requirements of the rule, which enjoy the truth-
eliciting feature of proxy rule sanctions for misstatements, have 
already illuminated the seriousness of the economic incentive problem. 
On average, for every dollar of audit fee paid, clients paid their 
auditors $2.69 in fees for non-audit services. In other words, non-
audit fees represent, on average, 73% of total fees paid to auditors. 
This percentage is astoundingly large, even when one discounts it for 
lumping together audit-related services such as work on financials in 
registration statements. Of course, this is just the average. As The 
Washington Post reported in a June 13, 2001 editorial: ``KPMG charged 
Motorola $39 million for auditing and $623 million for other services. 
Ernst & Young billed Sprint Corp. $2.5 million for auditing and $63.8 
million for other services.''
    If Rule 2-01 with all of its promise and detail, allows non-audit 
service fees, as a percentage of total fees, to represent even a 
fraction of the 73% average that we now know prevailed on the eve of 
the rule's adoption, the rule must be counted a failure. Given the 
compromises reached in defining the ``terrible nine'' services that may 
not be provided, I am afraid the percentage will not be substantially 
lessened by these so-called ``bright line'' exclusions. Of course, 
there remains the often powerful effects of disclosure on corporate 
behavior and, in this case, on the behavior of the audit committees.
    Disclosure might encourage the growth of ``best practices,'' as 
exemplified by TIAA/CREF, for example, which denies its auditor any 
non-audit business. Over some period of years, the rule's disclosure 
could cause a growing number of audit committees to back away from 
using their auditors for any significant amounts of non-audit work.
    But I wouldn't bet on it. I fear Rule 2-01 will turn out to be the 
Maginot Line for Independence, crisscrossed with trenches, barbed wire 
and gun emplacements, all pointing in one direction only, capable at 
will of being thoroughly outflanked.
    One indication of the rule's effectiveness can be found in the way 
the Big Five presented it to their audit clients. I have been exposed 
to only one sample, which I suspect may be illustrative of what others 
did. Overall the message of this firm's booklet on the rule, provided 
to audit committees and the managements of its audit clients, is that 
the rule changes almost nothing. In the sweep of its misleading 
characterization of what the SEC was seeking to accomplish, it leaves 
an informed reader amazed at the firm's audacity. I want you to hear 
only one statement taken from this document. It appears twice with only 
slight variations. Here's one version:
    ``The real issue for audit committees is the nature of the work 
performed, not its cost. The rules do not indicate that fees of any 
magnitude alone impair independence. Nor did the SEC cite specific 
ratios of audit to non-audit fees as being ``good'' or ``bad.''
    ``Historically, the size of non-audit fees paid to an audit firm 
has been relevant to SEC independence considerations only to the extent 
that the total fees earned from one client represent a disproportionate 
percentage of the audit firm's total revenues. SEC guidance on this 
point has established 15 percent of an audit firm's total fees as a 
threshold of concern.''
    In 2001, the smallest of the Big Five's total revenues was reported 
in The New York Times to have been more than $9 billion. Using the 15% 
``threshold of concern,'' a client could pay its Big Five auditor at 
least $1.35 billion dollars per year in non-audit fees before the audit 
committee or anyone else need trouble itself over independence. In 
practical terms, there was no limit.
    How any professional firm, let alone a closely regulated firm of 
auditors, could so blatantly, so laughably, so absurdly, deceive its 
audit clients in this way defies common sense. For me the only 
plausible answer is that it's a reflection of the contempt that a 
victor sometimes directs against the vanquished.
    The Big Five surely know that the 15% ``threshold'' came out of a 
1994 no-action position taken by the Office of the Chief Accountant to 
address non-audit fees proposed to be paid to a very small auditor to 
allow that auditor to take on as a client its first SEC registrant. 
They know as well that this ruling was limited to its special facts and 
contained no suggestion of being an authoritative statement with regard 
to independence generally.
    The basic problem with non-audit fees, which exists regardless of 
their magnitude but grows more serious as the fees grow larger, is 
conflict of interest. This conflict derives from the fact that, in 
performing both audit and non-audit services, the audit firm is serving 
two different sets of clients:

1. management, in the case of non-audit services, which typically are 
        commissioned by, and performed for, management, and
2. the audit committee, in the case of audit services, which now are by 
        rule commissioned by the audit committee and performed for that 
        committee, the shareholders and all those who rely on the 
        audited financials and the firm's opinion in deciding whether 
        to invest.
    The audit firm is a fiduciary in respect to each of these two very 
distinct client groups, duty-bound to serve each with undivided 
loyalty. It is obvious, and a matter of common experience, that in 
serving these different clients the firm will be regularly subject to 
conflicts of interest. These conflicts tear at the heart of 
independence. What is independence? It is the absolute freedom to 
exercise undivided loyalty to the audit committee and the investing 
public. When other loyalties tug for recognition, and especially when 
they come from those in a position to enlarge or shrink one's book of 
business, on which depends one's partnership share, the freedom 
necessary to meet one's professional responsibilities as an auditor is 
curtailed, and sometimes eliminated altogether.
    Paul Volcker, in testimony on the rule, given in New York City on 
September 13, 2000, made the same point:
    ``The extent to which the conflict has in practice actually 
distorted auditing practice is contested. And surely, instances of 
overt and flagrant violations of auditing standards in return for 
contractual favors--an auditing capital offense so to speak--must be 
rare. But more insidious, hard-to-pin down, not clearly articulated or 
even consciously realized, influences on audit practices are another 
matter.''
    To highlight the size of the hole in the rule, consider that, in 
addressing disqualifying financial and business relationships between 
an accountant and its audit client, the rule declares in absolute terms 
that an audit firm lacks independence if there exists (a) any 
investment in the client, however small, by the firm or personnel 
involved in the audit, or (b) any direct business relationship with 
that client, however insignificant. Explicitly excluded from the term 
``business relationships,'' is the provision of non-audit services by 
the audit firm to its audit clients. Thus, one faces the absurdity of a 
rule that is absolute in banning financial and business relationships 
that are utterly inconsequential while appearing to permit any level of 
non-audit fees to be paid to the audit firm.
    My point is not to suggest that the finely textured concerns of the 
SEC over the independence-impairing effects of various financial and 
business relationships are misplaced. They reflect legitimate, albeit 
immeasurable, concerns. But the important point is that they pale in 
significance when compared to the potential for impairment that comes 
from the financial and business stake that an audit firm, despite the 
rule, is still free to develop in an audit client through provision of 
a very wide variety of permitted non-audit services.
    This brings me to argue for a simple exclusionary rule covering 
virtually all non-audit services, in place of the deeply complex, 
existing rule that I hope, by now, to have convinced you is 
ineffective.
    This rule would define the category of services to be barred as 
including everything other than the work involved in performing an 
audit and other work that is integral to the function of the audit. In 
general, the touchstone for deciding whether a service other than the 
straight-forward audit itself should be excluded from non-audit 
services is whether the service is rendered principally to the client's 
audit committee, acting on behalf of investors, to facilitate, or 
improve the quality of, the audit and the financial reporting process 
rather than being rendered principally to provide assistance to 
management in the performance of its duties.
    This exclusionary rule could include a carefully circumscribed 
exception to permit certain types of non-audit services to be rendered 
by the audit firm to its client where special circumstances justify so 
doing. Use of such an exception should require at least the following:

(a) Before any such service is rendered, a finding by the client's 
        audit committee that special circumstances make it obvious that 
        the best interests of the company and its shareholders will be 
        served by retaining its audit firm to render such service and 
        that no other vendor of such service can serve those interests 
        as well.
(b) Forthwith upon the making of such finding by the audit committee, 
        submission of a written copy thereof to the SEC and the SRO 
        having jurisdiction over the profession.
(c) In the company's next proxy statement for election of directors, 
        disclosure of such finding by the audit committee and the 
        amount paid and expected to be paid to the auditor for such 
        service.
    The rule would be refined, administered and enforced by the 
legislatively empowered SRO that is the subject of my second 
recommendation for reform (discussed below).
    The fundamental argument for exclusion is the avoidance of 
conflicts of interest. Beyond that, however, there are a number of 
other points to be made. I summarize them below:

1. Given the conflict of interest, it is not realistic to expect the 
        firm, itself, to decide convincingly on its own independence. 
        Given its self-interest in the outcome, the credibility of this 
        process is highly suspect.
2. Nor is it feasible to expect independence to be assured by approval 
        of the audit committee. It is impossible for that committee to 
        identify when the problem exists. To challenge the auditor's 
        judgment on the matter is to challenge its integrity, something 
        audit committees are most unlikely to do. Independence is a 
        state of mind, necessary to maintain the skepticism and 
        objectivity that long have been the hallmarks of the accounting 
        profession. Being subjective and invisible, independence is not 
        something an audit committee can apply any known litmus test to 
        determine.
3. No one has suggested that the audit committee can be a substitute 
        for clear rules where the problem of conflicts is most serious. 
        Thus, for example, there is no suggestion that the audit 
        committee be accorded discretion to assess independence despite 
        the existence of financial or business interests between the 
        audit firm and its client. Stock or other financial interests 
        in one's audit client, for example, have long been viewed as 
        creating too clear a conflict of interest to become the subject 
        of discretion, even if exercised by an audit committee composed 
        only of outside directors. The need for an exclusionary rule is 
        rooted in the same ground: prospective revenues from the 
        provision of non-audit services, extending into the future, 
        create precisely the kind of financial stake that produces a 
        conflict of interest capable of impairing independence.
4. An exclusionary rule is easy to administer. It does not preclude an 
        audit firm from engaging directly or through affiliates in non-
        audit services of any kind. All business entities other than 
        its audit clients are available for business. Since the rule 
        would apply to all audit firms, for each audit client put out 
        of bounds for non-audit services, many more clients of other 
        audit firms become available.
5. An exclusionary rule should correct the current system of 
        compensation, which was found by the Panel on Audit 
        Effectiveness to fail in giving adequate weight to performing 
        the audit function with high levels of skill and 
        professionalism. This situation adversely affects audit 
        effectiveness. Success in cross-marketing an audit firm's 
        consulting services is a significant factor in the compensation 
        system. The skills that make one successful in marketing non-
        audit services to management are not generally consistent with 
        the professional demands on an auditor to be persistently 
        skeptical, cautious and questioning in regard to management's 
        financial representa-tions. As long as the marketing of non-
        audit services by auditors to their audit clients is 
        encouraged, expected and rewarded, there will exist a tension 
        counterproductive to audit excellence. An exclusionary rule 
        would eliminate both this tension and its harmful effects.
6. An exclusionary rule would be effective in rewarding those audit 
        firms most sensitive to the independence issue and most 
        scrupulous in seeking to avoid a real problem or even the 
        appearance of a problem. Exhortation and even disclosure, by 
        itself, often encourage those willing to sail close to the 
        line, or even cross over it. This result has the real and 
        perverse impact of hurting the competitive position of the most 
        sensitive and scrupulous audit firms, and in time encourages 
        even those firms to drop their guard, and exploit the laxness 
        in standards as well.
7. Independence is given important meaning in many analogous situations 
        where potential conflicts, while not always certain to impair 
        independence, nonetheless are prohibited in the interest of 
        avoiding the problem entirely. For example, the Blue Ribbon 
        Committee on Improving the Effectiveness of Corporate Audit 
        Committees determined that, for a director to be independent 
        for purposes of meeting the membership requirements of the 
        audit committee, he or she must not accept compensation from 
        the corporation for any service other than service as a 
        director and committee member. The Blue Ribbon Committee noted 
        that ``. . . common sense dictates that a director without any 
        financial, family or other material personal ties to management 
        is more likely to be able to evaluate objectively the propriety 
        of management's accounting, internal control and reporting 
        practices.'' The common sense parallel to the auditor is both 
        exact and compelling. Compensation for any service other than 
        the audit would impair the auditor's independence.
8. An exclusionary rule is a low cost premium on an important insurance 
        policy for the whole profession, against governmental 
        intervention to deny audit firms the right to do any non-audit 
        work. In the Panel report we wrote, as of August 31, 2000, that 
        ``an exclusionary rule would go far toward eliminating the 
        possibility of a major audit failure being linked to the 
        influence of non-audit service business on the audit firm's 
        diligence and skepticism, an event that would provide a basis, 
        and possibly the momentum, for some radical solution like a 
        total ban.'' Enron could turn out to be the failure we were 
        imagining.
  the need for a legislatively empowered self-regulatory organization
    The present form of self-regulation of the auditing profession 
reminds one of military music, military intelligence or even, some 
might argue, corporate governance--a classic oxymoron. Having looked 
closely at the system of governance within the auditing profession, I'm 
not prepared to be quite so simplistic. But, having studied the matter, 
I am quite certain that the governance of this vitally important 
profession is in an entirely unsatisfac-tory state. Moreover, this is 
no trivial matter.
    Overview of Governance. Today, governance is exercised from three 
sources:

1. State boards of accountancy, which have licensing powers.
2. The SEC, which exercises potentially broad powers over those who 
        audit reporting issuers.
3. Private organizations of the profession, of which there are at least 
        seven important ones.
    The profession claims that, through its various organizations, 
effective self-regulation is achieved. Having looked closely at this 
claim, I believe it to be false. The organizations are characterized by 
complexity and ineffectiveness in matters of central importance to any 
effective system of self-regulation.
    Among the short-comings of the present system are the following:

1. Lack of any public representation.
2. Lack of unified leadership over the seven organizations.
3. Lack of transparency.
4. Fuzzy and often over-lapping areas of responsibility.
5. Conflict between self-interest (as in the American Institute of 
        Certified Public Accountants (AICPA), which is a trade 
        organization parading as an SRO) and protection of the public 
        interest.
6. Lack of any credible system for imposing discipline.
7. Lack of assured financing.
8. Overall, a total lack of accountability to anyone.
    Given its importance, a further word on discipline. Here's all 
there is. The Quality Control Inquiry Committee of the SEC Practice 
Section of the AICPA (QCIC) is charged with investigating alleged audit 
failures involving SEC clients arising from litigation or regulatory 
investigations. However, it is only looking to see if there are 
deficiencies in the firm's system of quality control. It is not 
involved in assessing guilt, innocence or liability of the firm or any 
individual. And its report is only prospective in its impact.
    The Professional Ethics Executive Committee of the AICPA (PEEC) is 
charged with such responsibility for discipline as exists. It is 
supposed to pick up cases from the QCIC. However, out of alleged 
``fairness,'' at the firm's request, the PEEC will automatically defer 
investigation until any litigation or regulatory proceeding has been 
completed, often many years later. This system results in long delays 
in investigation and, as a practical matter, renders the disciplinary 
function a nullity in almost all instances.
    It was the Panel's hope to recast the POB as the central overseer 
of self-regulation, with power and responsibility to effect changes 
necessary to make self-regulation effective. With a new and energetic 
chairman in Chuck Bowsher, this idea seemed achievable. As conceived by 
the Panel, the POB would have had these new elements:

1. Public members, independent of both the profession and the SEC, 
        would constitute a majority of the board.
2. ``Strings attached'' funding would be provided by the profession in 
        amounts sufficient to carry out the POB's mission.
3. Absolute control over the nature of its work and the budget 
        necessary to carry out that work.
4. Power to oversee all of the profession's governance organizations.
5. Power of approval over appointments to the various organizations and 
        over hiring, compensation, evaluation and promotion decisions 
        by AICPA in respect of employees of key organizations.
6. Term limits for board members.
7. Nominating committee for selection of board members, composed of 
        representatives of public and private institutions especially 
        concerned with the quality of auditing and financial reporting.
8. Advisory council, composed similarly to the nominating committee, 
        responsible for annually reviewing the work agenda for the POB.
    The new charter for the POB was the result of heavy negotiation 
among the Big Five, the AICPA and the SEC. It fell short of the Panel's 
recommendations in several important respects:

1. No POB approval over membership of governance organizations. 
        Concurrence rights over Chairs.
2. No oversight over PEEC's standard setting activities.
3. No nominating committee or transparency for POB board membership.
4. No oversight of staff of key governance organizations.
5. No power to change POB charter.
    The POB believed it could work around its charter limitations by 
the threat of going public with disagreements. A whistle-blower 
technique. At the time I thought this a slim possibility. Making the 
POB the central, responsible and empowered regulator of the profession, 
which was the Panel's goal and similarly the goal of the SEC under 
Chairman Levitt, was powerfully and effectively resisted by the AICPA. 
Again, the battle was waged. Again, the AICPA and the big firms 
asserted their immense power on behalf of unchecked self-interest. And 
again, the profession's leaders came out on top.
    However well intentioned Chuck Bowsher and his board might have 
been, and I know they were well intentioned, there was no way they 
could have achieved effective self-regulation of this profession under 
the POB's charter as negotiated in 2000. Even if they had gotten all 
that the Panel advocated, it wouldn't have worked. The reason is quite 
simple. Like many other businesses, the profession, and particularly 
its current leaders, apart from the POB, don't want self-regulation. 
They want the shield of apparent self-regulation. But not anything 
close to the real thing.
    Now, as you know, the POB members have all resigned in protest over 
the actions taken by the Big Five CEOs and the AICPA, in cooperation 
with the new SEC Chairman and in complete disregard of the Panel's 
recommendations and the modest efforts taken so recently to strengthen 
the POB. The five members of the POB did, indeed, become whistle-
blowers, having no other choice even in the face of a palpable crisis 
to the profession.
    Whatever the explanation for the profession's nearly suicidal 
attempt to evade the POB, which was the only plausible entity capable 
of some self-regulation, and whatever the SEC Chairman's motives in 
lending support to this effort, it will not stand scrutiny. On the back 
of Enron, real reform will come at the legislative level. It must 
emerge from the lawmakers on Capitol Hill not only because the SEC 
appears unwilling to lead. In regard to an SRO, only legislation can 
arm an SRO with the necessary powers to do the job. A review of the 
essential elements common to all the existing SROs will explain why 
this is so. Here they are:

1. Creation by legislation or by governmental agency pursuant to 
        legislation, with clear powers to write rules and conduct 
        enforcement and disciplinary proceedings.
2. Supervision by government agency, including registration with that 
        agency to operate as an SRO, agency approval of all rules 
        adopted by the SRO and agency power to adopt rules for the SRO.
3. Power in the supervising agency to sanction the SRO for failure to 
        perform its responsibilities, as, for example, failure to 
        comply with its self-governance rules or to enforce the rules 
        it imposes on those it has the chartered duty to regulate.
4. Requirement that all participants in the profession or industry 
        being regulated (e.g., brokers and dealers) become subject to 
        the SRO's jurisdiction and powers.
    It will be instructive to examine further the workings of the 
NASD's SRO, whose most important public duty is that of policing the 
rules of financial responsibility, professional conduct and technical 
proficiency. In carrying out this charge, the SRO is given essentially 
the same range of sanctions available to the SEC, which must be applied 
by the SRO in cases where a broker-dealer or its employees have 
violated the securities laws or SEC-enacted rules or the rules of the 
SRO. Of particular importance in achieving wide-spread compliance with 
the rules of professional conduct is the power of both the SEC and the 
SRO to discipline either or both the supervisory personnel and the firm 
for a failure to supervise employees who misbehave. To avoid sanction 
the firm must have in place procedures to deter and detect rule 
violations and a system for the effective implementa-tion of those 
procedures. It is hard to exaggerate the importance of this ``duty to 
supervise'' in respect of its prophylactic effects.
    To facilitate speedy investigation by the SRO of alleged 
violations, and speedy judgment and imposition of sanctions where 
warranted, the SRO has one critically important tool that it uses to 
gain the cooperation of those it regulates, even those who are targets 
of an investigation. Its rules require each of its registered firms and 
individuals to turn over all requested documents and other information, 
and to appear and testify, in connection with an SRO investigation. 
Failure to cooperate in this way can result in expulsion from the 
industry. Courts have held the Fifth Amendment privilege against self-
incrimination inapplicable to sanctions imposed by an SRO. Thus, as a 
practical matter, those regulated by the SRO, including the target of 
an investigation, must cooperate or lose their right to be in the 
industry.
    As a result of being vested with law enforcement powers in 
combination with close supervision from a governmental agency, an SRO 
is widely believed to possess three significant protections that 
typically are only enjoyed by governmental agencies in the exercise of 
enforcement powers. They are:

1. Immunity from suit.
2. Privilege from discovery of investigative files. It is important to 
        note here that this privilege is generally understood to 
        operate only during the investigation. This limitation holds 
        for the SEC too.
3. Protection from antitrust violation for group boycott or other 
        activity violative of antitrust principles.
    These protections proceed from the fact, as reflected in 
Congressional committee reports, that an SRO is delegated law 
enforcement powers subject to supervision by the governmental agency 
from whence those powers came. Effectiveness compels the delegation of 
these protections as well.
    From the foregoing brief summary of the common elements of an SRO, 
it can be seen that a private organization such as the POB, voluntarily 
organized by the accounting profession to self-regulate itself, cannot 
do the job, no matter how well-intentioned its leaders might be.
    To reiterate: the SROs are effective because they are accountable 
to a governmental agency and derive from their relationship with that 
agency immunity from suit and important protections against discovery 
and antitrust laws, while at the same time preserving their private 
status enough to avoid the Fifth Amendment's protections for those it 
regulates.
    The inescapable conclusion from this analysis is that, unless and 
until a real, legislatively supported SRO is put in place to regulate 
the accounting profession, little, if any, progress toward an effective 
disciplinary system for accountants practicing before the SEC can be 
made outside the SEC itself.

    Chairman Tauzin. Thank you very much, Mr. Longstreth.
    Our final witness who will testify on the issues of the 
energy markets themselves and the effect of the Enron collapse 
on those markets and he is Mr. David Sokol, Chairman and CEO of 
MidAmerican Energy Holdings Company of Des Moines, Iowa.
    Mr. Sokol.

                  STATEMENT OF DAVID L. SOKOL

    Thank you, Mr. Chairman. I am for the record a registered 
professional engineer and then an accountant. MidAmerican 
Energy Holdings is a privately held company with about $13 
billion in assets and our largest investor and roughly 75 
percent investor is Berkshire Hathaway.
    Mr. Chairman, the Enron disaster is inexcusable and your 
efforts to fully explore it is essential to restoring the 
credibility in the U.S. capital market system. I believe what 
you'll find is arrogance, greed, accounting fraud and poor 
governance.
    As a chairman, president and CEO of a public company for 
the last 16 years, I have seen on balance how well and how 
terrific the U.S. capital markets are, but I've also been 
witness to how badly people can misuse them. Some people ask 
the question why--or someone once said why do people rob a bank 
and someone answered because that's where the money is. And the 
capital markets are where the money is today and they're what 
Enron took advantage of.
    But I think we have to be honest as we look back and say 
that the past 8 years have been a period not only of irrational 
exuberance by investors in the market, but also of irrational 
expectations by stock analysts and of poor performance by 
auditors, rating agencies and management of companies. That 
irrational exuberance throughout that period has created a 
loosening in the quality of our reporting systems and a 
loosening in management's attention its obligations.
    Accounting, as I was taught it, was to reveal information 
on a fair and consistent basis for investors to make informed 
decisions. Accounting today is about concealing information. 
It's about keeping debt off balance sheets. It's about hiding 
obligations called contingent obligations. That's a severe 
twist to what accounting is supposed to be for America's 
corporations and we have to fix it.
    I would offer to you having turned in a corporation to the 
SEC for breaking the rules, that one way you help solve this 
problem in addition to many of the ideas given by this panel is 
to enforce the rules against senior executives and against 
auditing firms.
    I watched a chief executive officer and a CFO get a slap on 
the wrist by causing a very large U.S. corporation to go into 
bankruptcy with over 6 years of accounting fraud and 
manipulation of earnings. The investors lost their money, 
employees lost their jobs, but senior executives often don't go 
to jail and don't pay significant restitution and that needs to 
change. We don't tell youngsters when they rob a convenience 
store that if they give half the money back we'll let them go, 
but that has been how we've treated executives when they steal 
in the public markets.
    And auditing firms have to be held liable for not doing 
their job. Any CEO today will tell you that we spend more time 
negotiating the audit engagement letter than we do spending 
times with the senior management of auditing firms about what 
they're actually going to do. And that auditing letter spends 
very little time saying what the auditor is going to do to 
audit the company. It spends a lot of time expressing what 
they're not going to be liable for. And we need to change those 
activities.
    Directly in regard to the energy markets, I think it's most 
enlightening to notice that through the Enron debacle, a 
catastrophe of giant proportions in any measure, the energy 
markets have continued to function. Electricity has flowed, 
natural gas has flowed, the lights have stayed on and most 
importantly, consumer prices have not been affected by the 
Enron wholesale--the Enron debacle in the wholesale market. It 
is, and I think it's fair, that people have asked questions 
about whether or not Enron may have attempted to manipulate 
wholesale markets in certain regions of the country. I don't 
know if that occurred. If it did, again, it's another law 
they've broken and they should be punished, but it's important 
to recognize that some have estimated that Enron managed 25 
percent or trade 25 percent of the U.S. electrical and gas 
wholesale industry, and there's not a single period you can 
find from September through December of last year where those 
markets were dislocated even while Enron went bankrupt. So it's 
a real tribute to the energy markets.
    Another, I think, misnomer that's been raised is that 
somehow Enron purportedly was trying to skirt the Public 
Utility Holding Company Act and perhaps create an Insull-like 
utility of the 1930's and that's just not the case. In fact, 
Enron is not about the energy markets. It's about fraud, 
corruption and poor governance. The Public Utility Holding 
Company Act in many ways is actually today, if anything, 
harming Portland General Electric which was the only electric 
utility subsidiary Enron had and the reason it's harming it is 
because Enron has been trying to sell it for 2\1/2\ years. We 
wanted to buy it 2 years ago and we can't because Berkshire 
Hathaway, even though they're a AAA-rated company, cannot make 
another investment in the U.S. utilities sector because of 
PUHCA. What that's requiring Enron today to do is to sell 
Portland General Electric to Northwest Natural Gas, a company 
roughly one third its size, in Portland, Oregon, and they're 
having to leverage up using junk bonds to buy the utility from 
Enron. The chairman of the Oregon Public Utility Commission 
testified this morning in front of the Senate that Enron's 
bankruptcy has caused no strain and no cost to consumers of 
Portland General Electric, but that, in fact, PUHCA is today 
making it more difficult for them to actually get another owner 
in place of that utility. The energy markets continue to work 
fine. We would mention that perhaps in the wholesale energy 
markets that those markets should be overseen perhaps by the 
CFTC going forward, but again it's important to recognize that 
Enron didn't collapse because it was in the wholesale trading 
market. It collapsed because of accounting fraud and 
manipulation of earnings.
    Last, we feel it's important to mention that this issue is 
very much a bipartisan issue. It's about the trust and the 
confidence in the United States capital markets. The integrity 
of our capital markets underpin the great economy of the United 
States and it's not about campaign reform. That may be 
necessary. But this issue with Enron and the follow-on effects 
of now the tightening, the proper tightening of accounting and 
oversight, do draw to the credibility of our markets and we 
must protect them and I think it's a very important function 
for both Congress and us and industry to make sure that we 
don't undermine those capital markets.
    Thank you.
    [The prepared statement of David L. Sokol follows:]
  Prepared Statement of David L. Sokol, Chairman and CEO, MidAmerican 
                        Energy Holdings Company
    Thank you, Mr. Chairman. MidAmerican Energy Holdings Company is a 
diversified, international energy company headquartered in Des Moines, 
Iowa with approximately $13 billion in assets. Our largest investor is 
Berkshire Hathaway, one of the only AAA-rated companies in the United 
States.
    The company consists of four major subsidiaries: CE Generation 
(CalEnergy) a global energy company that specializes in renewable 
energy development in California, New York, Texas and the West, as well 
as the Philippines; MidAmerican Energy Company, an electric and gas 
utility serving the states of Iowa, Illinois, South Dakota and a small 
part of Nebraska; Northern Electric, an electric and gas utility in the 
United Kingdom; and HomeServices.com, a residential real estate company 
operating throughout the country.
    I would like to commend you for your persistence in working with 
Energy and Air Quality Subcommittee Chairman Barton to push for energy 
legislation, including electricity modernization provisions. We cannot 
pass a national energy plan for the new century while leaving in place 
a regulatory system that was already outdated at the end of the last. 
Your bill, H.R. 3406, does not seek to do everything, but it does 
critical things that only Congress can do, and it will result in a 
modernized electric infrastructure that will benefit consumers while 
providing for fair competition.
    As the American economy begins to recover, demands on our electric 
system will increase once again, and if we have not moved forward with 
the critical elements of market modernization, consumers may once again 
pay the price for an outdated system. At the same time, we should 
recognize that the pending recovery is tenuous and take steps to 
encourage the markets and American consumers that there is bipartisan 
support for positive, pro-investment initiatives.
    My testimony this morning will focus on the Enron scandal's impact 
on energy policy issues, specifically the relationship, if any, between 
Enron's activities and the Public Utility Holding Company Act of 1935, 
or PUHCA, including issues of consumer protection, barriers to 
investment and market entry, and appropriate forums for regulatory 
oversight.
    These three issues are unavoidably linked. Ten years ago, Congress 
passed the Energy Policy Act of 1992 in order to create open, 
competitive wholesale electricity markets so that investors, not 
consumers, would bear the risks associated with capital-intensive, 
electric generation investment. That is when PUHCA changed from being 
primarily a nuisance for companies to a burden for consumers.
    By keeping investment dollars out of the industry and perpetuating 
market fragmentation, PUHCA contributed to the failure of our electric 
infrastructure to keep pace with the demands of the growing competitive 
wholesale market. MidAmerican's largest investor, Warren Buffett, has 
publicly announced his intention to invest as much as $15 billion in 
the industry once PUHCA is repealed. However, PUHCA's barriers to entry 
prevent him from making these investments, particularly in transmission 
and distribution assets.
    Last year, I testified in both the Senate and the House as to how 
PUHCA blocked MidAmerican from making major investments in the 
California utilities that could have helped stabilize their financial 
positions during the early part of the energy crisis. PUHCA's ownership 
limitations and physical integration requirements stood in the way.
    PUHCA is also complicating attempts by the company to make a major 
expansion of our geothermal development in the Imperial Valley in 
Southern California. While we have begun a smaller project, we cannot 
undertake any expansion that would require us to build significant new 
transmission facilities to bring this power to the grid without 
potentially running afoul of PUHCA.
    Some have claimed in recent contacts to the SEC that one cannot 
invest in a regulated utility asset and also make good non-utility 
investments. No law can make a good investor or a bad investor. Nor 
should any law determine that a person who invests in one industry 
should not be able to invest in another provided there are no conflicts 
of interest. And I can tell you about one investor who has done pretty 
well in both arenas. His name is Warren Buffett, and his record speaks 
for itself.
    PUHCA and those who support its predetermined limitations on who 
can invest in this industry take a shortsighted approach. The way to 
protect consumers is not to maintain a Chinese wall around investment 
in this industry it is to maintain effective separation of the 
financing and rate structures of regulated utilities and their assets 
and any affiliated operations.
    There has not been much good news in energy markets in recent 
months, and even conservatively managed traditional utilities are 
feeling financial pressure. This will make it harder than ever for the 
industry to raise capital and build new infrastructure. And, as 
consumers in California and the West experienced in recent years, 
market failure is the ultimate anti-consumer result.
    PUHCA is not and never was designed to be primarily a consumer 
protection statute. The overwhelming focus of the law is on preventing 
corporate malfeasance that harms investors. By eliminating financial 
abuses, Congress certainly expected that consumers would benefit, but 
PUHCA does not address rates, and the implementing agency, the SEC, has 
no rate setting function or expertise.
    Simply put, if the issue is protecting consumers from unfair rates, 
FERC and the states have developed the expertise over almost seventy 
years to perform these functions. The SEC has absolutely no rate-
setting function and has emphasized this fact on many occasions before 
Congress.
    On the issue of cross-subsidies, the appropriate protection against 
cross-subsidization is the books and records access provided in the 
bill. Using my own company as an example, if the state of Iowa had 
concerns that MidAmerican Energy was inflating rates in our retail 
electric or gas tariffs to support a competitive business in some other 
state, under the bill, state regulators would have an explicit right in 
federal court to gain access to the books and records of any affiliated 
business in any other state that had conducted business with the 
utility.
    At the same time, the Committee should be wary of attempts to make 
FERC some type of super-regulator of retail rates in all fifty states 
in the name of stronger protections against cross-subsidization. FERC's 
expertise is wholesale rates. State commissions are closest to the 
details of retail rate-setting and capital structure decisions. 
Muddying the water on this fairly clear distinction would be a recipe 
for disaster. We've already seen during the California crisis the 
debilitating impact that finger-pointing between Washington and the 
states can have on effective regulation. We should not go down that 
road.
    The only rate-related provision of PUHCA relates to ``at cost''' 
pricing. While the law seeks to ensure that utilities and their 
affiliates do not engage in inter-affiliate pricing schemes to inflate 
consumer costs, the ``at cost'' requirement in the PUHCA law actually 
limits the ability of state and federal regulators to require 
registered holding companies to price some goods and services at the 
lower of ``at cost'' or market rates.
    Much of this ground has been well-covered in recent years. That is 
why the PUHCA provisions included in this bill have been part of 
virtually every electricity modernization bill introduced in the last 
several Congresses, have enjoyed the support of the last four 
Administrations and the regulatory agencies that enforce the laws, and 
passed the Senate Banking Committee last year by a 19-1 vote.
    What has changed then?
    We are here this morning because a few long-time opponents of 
updating the PUHCA law have made new claims arising from the Enron 
collapse. It's worth noting that one of these advocates stated last 
December that he could support the electricity provisions of this bill 
in its present form. But, I suppose that Enron fell, and opportunity 
knocked.
    There are really two stories before this Committee today. The first 
is the story of what actually happened to energy markets as a result of 
the Enron collapse. These events should reassure the Committee that you 
should move forward with this legislation.
    The second story is the one spun by those who have long opposed 
market modernization measures. It poses a series of events that did not 
happen and attempts to force supporters of PUHCA legislation to prove 
that these events could not have happened. Taken to its logical 
conclusion, this ``expand PUHCA'' agenda would require Congress, FERC 
and the states to unravel more than a decade's efforts to create open, 
vibrant and transparent energy markets.
    The reason why this is so is instructive. Virtually every element 
of modern competitive electricity markets exists either as an explicit 
statutory exemption from PUHCA or as a result of regulatory 
determinations that gave flexible interpretations to PUHCA.
    A ``fundamentalist'' view of PUHCA, that every electric or gas 
company that sells on the grid should be registered, would result in 
complete market concentration, elimination of the marketing industry 
and gutting of the EWG exemption since almost all EWGs rely on either 
an affiliated marketing company or independent marketers to sell 
competitive electricity.
let's start with the first story. what happened to energy markets as a 
                     result of the enron collapse?
    Energy markets responded to the Enron collapse with little, if any, 
disruption. The lights stayed on, natural gas flowed, and consumer 
prices did not rise. This is true not only for the markets generally, 
but also for wholesale and retail customers of Enron's subsidiary, 
Portland General Electric.
    In December, all four FERC Commissioners testified before your 
Energy and Air Quality Subcommittee that electric and gas markets had 
responded to the Enron collapse with remarkable resiliency. Chairman 
Wood repeated that assessment before the Senate last week, along with 
independent market analysts, market participants and a representative 
of the state regulators.
    In fact, the situation of the customers of Enron's retail electric 
and gas pipeline subsidiaries proves the argument that PUHCA 
legislation supporters have been making for almost twenty years, which 
is that aggressive, effective state and federal regulation are the true 
keys to consumer protection, not a statute that deals primarily with 
details of corporate structure.
    It's hard to imagine a company collapsing more swiftly or more 
completely than Enron, yet the customers of Portland General have been 
unaffected by the bankruptcy, because its PGE's assets and operations 
have both regulatory and contractual safeguards. This is the result of 
effective state and federal rate regulation and the ability of state 
commissions to oversee issues of utility financing and cost recovery. 
This is where real consumer protection occurs in electric and gas 
markets.
    In December, I met with members and staff on both sides of the 
aisle of this Committee and shared my view that if there was any part 
of Enron's energy assets that had the potential for abuse, it was that 
company's domination of the ``mark-to-market'' exchange.
    The allegations that Enron may have manipulated forward markets are 
troubling, and I encourage the Committee to pursue these further.
    However, I am not aware of any way these issues could be linked to 
PUHCA. For those who argue that this shows that the Enron collapse did 
impact energy markets, I would respond that, if these allegations are 
proven true, it appears to have affected them in a positive direction 
for consumers.
        let's now look at the second story, what did not happen.
1. Enron was not working to build a multi-state Insull-like utility 
        empire.
    To the contrary, it was looking to sell Portland General. In fact, 
Enron probably would not even have been in the regulated utility 
business at the time of its collapse if PUHCA had not hampered its 
efforts to exit that business.
    Why? PUHCA artificially and materially limits the number of 
potential buyers of any utility to those utilities who can meet the 
law's physical integration provisions, which requires that two utility 
systems must be capable of interconnection to be legally combined under 
PUHCA. This is one of the core problems of PUHCA. It serves as a 
barrier to entry and investment and results in market concentration.
2. Enron did not lobby for PUHCA repeal.
    It was a leading opponent of stand-alone PUHCA legislation and 
testified before Congress that it would only support PUHCA repeal as a 
trade-off for concessions it wanted.
    Enron's overall policy position with regard to traditional 
utilities can perhaps best be described as disqualify and dominate: 
Work to keep asset-backed utilities out of emerging energy markets, 
then dominate those markets.
    The Committee should also be aware that in its most recent 
congressional testimony on electricity policy, Enron opposed enhanced 
access to books and records, provisions that we have long favored.
    On July 22, 1999, Enron's Executive Vice President Steven J. Kean 
testified before the House Energy and Power Subcommittee, ``we have 
concerns that H.R. 2363 creates unneeded regulatory oversight of 
affiliated companies that have no need for additional regulation of 
their books and records.''
    Supporters of PUHCA modernization and reform want more competitors 
in the marketplace, not fewer, and support giving federal and state 
regulators more tools to protect consumers.
3. Enron did not receive special exemptions from PUHCA.
    Enron received two PUHCA exemptions from the SEC. Both were clear 
cases under the law.
    The first was a statutory exemption provided to more than 50 other 
holding companies whose utility operations are primarily located in a 
single state.
    The second exemption concerned the question of whether a power 
marketer should be considered a ``public utility'' under PUHCA. PUHCA 
defines an ``integrated public-utility system'' as, ``a system 
consisting of one or more units of generating plants and/or 
transmission lines and/or distributing facilities, whose utility 
assets, whether owned by one or more electric utility companies, are 
physically interconnected or capable of interconnection.''
    The claim that the ``no action'' letter Enron received for Enron 
Power Marketing Inc. constituted a special exemption for Enron that 
ultimately allowed the company to escape regulatory scrutiny is the 
entire basis for the claim before the Committee today. However, for the 
SEC to have found otherwise would have required it to find that the 
assets of marketers--office equipment, paper contracts, and computer 
data--are ``facilities'' of public utilities comparable to generating 
plants and transmission lines.
    This raises the interesting question of how these types of 
``facilities'' could meet PUHCA's ``physical integration'' requirement. 
Obviously, they could not, and no other decision by the SEC seems 
supportable under either the facts or the clear definition in the law.
    More importantly, had the SEC decided otherwise, the entire power 
marketing industry would probably not have developed.
    It's hard to think of any single decision that would have had a 
more negative impact on consumers and competitive wholesale markets.
4. What about the other exemption mentioned in the January 23, 2002 New 
        York Times article?
    This exemption, to the Investment Company Act of 1940--not PUHCA--
is the exemption that some have claimed allowed Enron to engage is some 
activities that played a significant role in the company's collapse.
    This appears to raise some genuine issues--but these issues have 
nothing to do with PUHCA, and attempts to use the Investment Company 
Act exemption as a way to derail electricity modernization are clearly 
opportunistic.
5. But couldn't the Enron collapse have been prevented had Enron 
        somehow been subjected to PUHCA?
    Since it's clear Enron should not have been considered a registered 
holding company, this could only be true to the extent that Congress 
would apply PUHCA-like financial regulations to every other publicly-
traded company, energy or non-energy. There is nothing unique about the 
energy industry concerning Enron's financial activities.
    If, as has been reported, a company is willing to risk violating 
the '33 and '34 Securities Acts, shred congressionally requested 
documents, engage in highly questionable accounting practices, 
knowingly mislead investors, and ultimately drive itself into 
bankruptcy, why would we believe that PUHCA would somehow protect its 
shareholders.
    Congress can and should conduct a thorough review of all the 
accounting, bookkeeping, pension and corporate governance issues raised 
by this scandal. In some cases, laws and regulations may need to be 
strengthened. But these changes should be applied to all publicly-
traded companies, not to a small subset of companies in one industry. 
At the same time, it may be appropriate to address oversight of energy 
futures trading.
    FERC Chairman Wood is moving aggressively to bring the wholesale 
electric energy market to an end-state of transparency and vibrant 
competition. Some are concerned that he is moving too quickly; others 
may believe he is moving too slowly. Few would disagree with his goal 
of achieving that end-state or the benefits that consumers will gain 
when we get there.
    In his testimony before the Senate Energy and Natural Resources 
Committee last week, he said, ``If Congress' policy goal is to promote 
wholesale energy competition and new infrastructure construction, then 
reform of the Public Utility Holding Company Act of 1935 (PUHCA), 
supplemented with increased access by the Commission to the books and 
state regulators to certain books and records, will help energy 
consumers. Energy markets have changed dramatically since enactment of 
PUHCA, and competition, where it exists, is often a more effective 
constraint on energy prices. In the 65 years since PUHCA was enacted, 
much greater state and federal regulation of utilities and greater 
competition have diminished any contribution PUHCA may make toward 
protecting the interests of utility consumers.''
    This is not just the view of Chairman Wood, but also all the 
members of the Commission, and all his predecessors in the last decade. 
They have understood that this market will never achieve the depth, 
transparency and level of competition we all seek if PUHCA's barriers 
to entry and investment remain in place. The reasons why you must 
eliminate the anti-competitive and anti-consumer aspects of PUHCA are 
simple:
    PUHCA's arbitrary limitations hurt consumers. Just last month, The 
D.C. Circuit Court of Appeals remanded the SEC's approval of a large 
utility merger that would provide consumers and the companies involved 
more than $2 billion in savings, based solely on concerns related to 
PUHCA's single region and physical integration requirements.
    While some have claimed that this decision represented some form of 
victory for consumer interests, I disagree. Quoting from the ruling, 
the Court wrote, ``According to Petitioners, the Commission erred in 
accepting (the two companies') projections that the proposed merger 
would produce approximately $2.1 billion in cost savings. We disagree. 
We owe considerable deference to the Commission's assertion that it 
`reviewed the assumptions and methodologies that underlie' the 
projections and found them `reasonable and consistent with . . . 
precedent.' Moreover, Petitioners point to no evidence or expert 
testimony supporting their assertion that the companies' calculations 
were flawed.''
    The law's ownership restrictions keep capital out of one of this 
country's most critical industries at a time when needs in the 
transmission sector alone will require tens of billions of dollars in 
new investment. As I mentioned before, Mr. Buffett has publicly stated 
his intent to invest as much as $15 billion in the industry if PUHCA is 
repealed.
    The law's counterproductive requirements of interconnection and 
geographic proximity foster regional concentration, directly counter to 
50 years of antitrust law. As I mentioned during testimony in the House 
last year, one of the ironies of PUHCA is that the only other utility 
that MidAmerican could purchase without running afoul of the Act are 
the utility assets of the only other investor-owned utility in the 
state.
    As representatives of FERC have testified on numerous occasions, 
PUHCA hinders their ability to establish large, multi-state regional 
transmission organizations.
    PUHCA also provides foreign companies which are not restricted by 
the physical integration standard an advantage on their ``first bite'' 
entry into the U.S. market and, at the same time, sends overseas 
American dollars that could be invested here. In view of the series of 
negative events that have buffeted this sector beginning with the 
crisis in California and the West, the overall economic downturn and 
the negative financial impact of the Enron collapse on much of the 
sector, I believe we could see a substantial increase in this trend in 
the next several years.
    Congress cannot fix PUHCA by tinkering around its edges. The SEC 
concluded in 1995 that PUHCA had accomplished its goals by 1952, fifty 
years ago. It is time to repeal this law's antiquated and arbitrary 
physical integration requirement and ownership limitations. At the same 
time, you can replace PUHCA with enhanced books and records authority 
and the other consumer protection measures that are contained in H.R. 
3406 and move the country forward toward a competitive, pro-consumer 
market.

    Chairman Tauzin. Thank you very much, Mr. Sokol.
    Now it's our function at this point to allow members a 
round of questions and the Chair recognizes himself very 
briefly.
    Let me say first of all, Mr. Chanos, I hope someone gets 
into the question of why it is that you could see insider 
selling of stock. You could see all these problems when the 
accountants couldn't see it and the SEC was not seeing it in 
their oversight function of looking at the Enron disclosures. I 
won't have time to get into that, but I hope someone will get 
into that. I think they will.
    And Mr. Raber, I would love to get into a lot of questions 
with you about how it is that you can expect any member of a 
board of directors, outside board of directors who comes on and 
is paid $250,000 to $350,000 to serve on that board of 
directors to truly be a tough questioner, a tough insider, sort 
of the whistle blower that we saw in Ms. Watkins, for example, 
an employee who saw everything going wrong and tried to bring 
it to senior management attention at Enron. How is that 
possible when it might jeopardize their position on the board? 
I believe that will come up in some questions too, so you might 
get ready for that.
    What I want to focus on, however, is the substance of the 
questions of how we somehow fix the failure of disclosure of 
relevant information to investors that might have encouraged 
investors to make different decisions about Enron, rather than 
seeing its stock inflated with this unreal value for so long 
that it caused such a problem to so many people. In that 
regard, I had a discussion this morning, very much in the line, 
Professor Weil, of your comments that on whether or not we 
ought to have rules, specific rules, a whole cast of them as 
complicated as the IRS rules are today for the accounting 
profession, or whether they ought to be principles, generally, 
that the accounting profession follows, whether, for example, 
that 3 percent rule is a good rule or we ought to just have a 
principle that you ought to look to see who really controls the 
outside entity, who is really in charge of it as opposed to 
these very specific rules that say whether or not it fits the 
categories that allow you to hide debt into that entity or to 
make up income as we see in this case.
    Here's a question I want you all to think about and answer 
for me. We have been debating the question of whether or not we 
should separate the consulting function from the audit 
function. That came up several years ago. It certainly is 
before us again today. What the SEC Chairman did several years 
ago was to require disclosure as you pointed out, Mr. 
Longstreth of the amount of monies being paid, for one function 
as opposed to the other, as an indicator of whether the 
possibilities of something going wrong might be to the short 
sellers or anyone else who might say well, there's too cozy a 
relationship between the consultant function, too much money in 
there to trust those numbers, trust that audit in the end. But 
the recommendation is now much stronger to separate those two 
functions. Some of the accounting firms are voluntarily saying 
they're going to get rid of one of those functions or separate 
those functions. Disney, I think, announced today they wouldn't 
hire the same auditors today to do both the auditing function 
and the consulting function any more. I suspect other 
corporations are going to make similar conclusions.
    But here's the question, if we move toward general 
principles rather than a whole host of specific rules by which 
the accountants try to give us accurate information, and even 
if Mr. Lev, we take your recommendations and broaden that 
disclosure to include intangibles and all the other much more, 
if you will, filled net of information, and then we leave it to 
that consulting function, that on-going sort of advice to the 
company about how to structure its special purpose entities and 
its partnership, everything else it does, only to have some 
third entity come in and judge later on whether they did it 
right, do we open the door to two very subjective conclusions? 
On the one hand the first set of accountants counseling with 
the company under general principles that we think you can do 
this, so go ahead and do it, and then someone entirely 
different coming in and saying no, man, they gave you terrible 
advice, our subjective interpretation of those general 
principles says you can't do that. Now you have to go back in 
and restate your earnings and declare debt that you didn't 
declare before and is that going to create confusion for the 
investing community, the investment community? Is that going to 
do more harm than good is what I'm asking? Second, if we did 
move to that kind of a frame and we may be moving to that sort 
of a frame, will it create friction if, in fact, as you point 
out, Mr. Longstreth, the counseling part of this, the 
consulting part it is where the real money is and it seems to 
be, 73, 75 percent of where the money is. If I'm hired as the 
auditor and you've been hired as the consulting firm, isn't it 
in my interest then to make you look as bad as I can in the 
hopes that they'll fire you and hire me to the new set of 
counselors? Is that going to create that sort of a friction 
that is going to lead to more confusion and more contradictory 
statements to the American investors? I don't know. Give me 
some thoughts on that real quickly. That's what troubled us 
throughout this period of discussion and frankly, that's why we 
urged Arthur Levitt to have public hearings where corporations 
could come in and accountants can come in and we can have a 
full discussion of that. Perhaps it's time to have that now. 
Let's start, any one of you.
    Dr. Weil?
    Mr. Weil. Consulting comes in a wide variety of cloaks. One 
of the things we're trying to do is to conserve society's 
resources. There is nobody better able to prepare a 
corporation's tax return than its accountant. If you say to the 
accountant, the auditor can't do the tax return, we're going to 
waste resources.
    A company decides they want to do just in time inventory 
system. Nobody's better able to help them design it than 
someone who knows where the inventory records are kept in the 
green filing cabinet next to the door. We will waste society's 
resources if we absolutely forbid that.
    There's some place to draw a line. I think the heavy hand 
of legislation is not the right way to draw the line. I 
disagree with Mr. Longstreth. I think Mr. Raber has got the 
right idea which is we need independent audit committees making 
the decisions of their companies who should be the auditor, how 
quickly we should rotate them out and I think we should 
consider mandatory audit rotation. That's the kind of 
legislative or regulated thing that you can do, and we can talk 
about hiring the way Baruch Lev says, the new audit committee 
via vote, but we can have overlapping terms so the new person 
is learning as the old person is winding up. But if the audit 
committee is independent and feels the responsibility that we 
want the audit committee to have and haven't had, they can make 
a reasoned judgment about when it makes sense to hire the 
auditor. The most important thing is to have the auditor 
believe that his retention, her retention as auditor is a 
function of the audit committee's judgment, not the CFO's 
judgment.
    Chairman Tauzin. Yes, I'd like you to reply, Mr. 
Longstreth. If anyone else wants to make a brief comment, then 
I've got to move on.
    Mr. Longstreth. Well, I think just to pick up on the last 
comment, I think the critical analysis of consulting on the one 
hand and the audit function on the other is to realize that 
when an audit is performed, the client for the auditor are 
really the shareholders and the investing public. The surrogate 
for that body is the audit committee and so the audit 
committee, acting as a surrogate for the shareholders is the 
client of the auditor.
    When the nonaudit services are undertaken, they are 
undertaken for a different client, management. Management 
retains the auditor to perform this range of services. And 
maybe lots of times you can serve both those clients and not 
get into trouble, but not always.
    Chairman Tauzin. Not always.
    Mr. Longstreth. And it's a dangerous situation. I think 
that in coming to what can be legislated and what can't be or 
shouldn't be, obviously Congress can't legislate generally 
accepted accounting principles.
    Chairman Tauzin. That's correct.
    Mr. Longstreth. And they shouldn't regulate or try to write 
laws for auditing principles, but there is a need for a clean 
break between the audit function and the consulting function.
    Chairman Tauzin. But I wanted to know what unintended 
consequences might result when we do it.
    Dr. Lev, I want to give you a chance and Dr. Dharan and 
then I've got to move, please.
    Dr. Lev.
    Mr. Lev. Mr. Chairman, let me say something about rules, 
you mentioned it. I don't think anybody has in mind getting rid 
of all the rules. It's just impossible, but the current system 
that we have now in accounting is really completely crazy. You 
mentioned the IRS. It's much more complicated than IRS. I 
brought you an example of the accounting rules in the United 
States for just one item which is leasing, perhaps even not the 
most important, there are 452 pages and they also add a CD ROM 
to it. This is a system run amok. There is no doubt about this. 
There's no doubt that we can do with much less. The UK is doing 
with much less rule, more flexible, more general system, 
financial markets operating well, but let me give you an 
example. We are speaking in abstract terms. Let me give you 
just one simple example, but an important one. The whole issue 
of consolidation.
    Chairman Tauzin. Yes.
    Mr. Lev. Which relates to the networking activity of 
software companies. I mean pharmaceutical companies like Merck, 
like Pfizer have hundreds of R&D marketing alliances, joint 
ventures, most of them for very good reasons. Accounting is 
bogged down with how to consolidate and if to consolidate these 
things with all kinds of absurd rules like if you have more 
than 50 percent, then it should be consolidated so they do it 
with 49.9 percent. If you have control, no one knows what is 
control. You can have a simple rule which says you have to 
consolidate everything based on proportion consolidation which 
means that if you have a share of 10 percent in an alliance and 
joint venture, you take 10 percent of the asset and the 
liabilities and the profits of the alliance, period. In this 
case and everything will be consolidated in this case. This can 
be done.
    Let me say a word about consulting and then I'm not going 
to be very popular here. I'm, like my colleagues here, from the 
point of view of an educator. It's not a secret that it's not 
very exciting to work for accounting firms.
    Chairman Tauzin. That's right.
    Mr. Lev. And it's extremely difficult to get young, 
talented, capable, venturesome, intellectually curious people 
to work for accounting firms. We don't want to make accounting 
firms even less attractive than they are now by putting all 
kinds of restrictions and other things. Consulting is an 
opportunity for an accounting firm--and they say it and in many 
cases they even do it--to tell young people, our graduates, 
telling them you know you start, you work 2 years in auditing, 
we'll switch you to consulting work, and switch you back. We 
have to be sensible here. I think and that's a suggestion that 
I put in my testimony, if we kept consulting no more than 25 to 
30 percent, let's say, the total of consulting fee, no, we can 
argue about it, maybe 15 to 20 percent, it will--they'll have 
something. It will not create significant independence problems 
in this case, but you don't want to really, as I said before, 
make auditing firms incredibly unattractive. We won't have the 
quality of work that we need.
    Chairman Tauzin. My time has grossly expired. So let me 
just move in. We'll get into some more of this as we move 
along. Let me recognize the ranking minority, Mr. Dingell, for 
a round.
    Mr. Dingell. This has probably harmed investors more than 
any other piece of legislation. I take it you're advising the 
Congress to revisit the law and the assumptions about corporate 
professional behavior that underlies the Act, is that correct?
    Mr. Chanos. I think that's accurate, Congressman. Just 
preceding remarks about auditors and the focus here. I would 
point out in the financial crime that is Enron, the auditors 
were driving the getaway car, but I don't think they were 
committing the crime.
    I would point your attention to a Business Week article in 
the summer of 1998 in which they held a conference for Chief 
Financial Officers and they asked slightly under 200 of these 
Chief Financial Officers of major corporations anonymously, if 
they had been ever asked to knowingly misrepresent financial 
results and if they did so.
    Fifty-five percent answered yes, they had been asked to 
misrepresent financial results, but declined to do so; 12 
percent answered yes, and they had done so; and 33 percent said 
they had not been asked to do so and therefore hadn't done so. 
Two-thirds of these corporate CFOs had been asked to 
misrepresent financial results in this survey. Well, by whom 
are they being asked? It's corporate management. My view on 
accountants is they're generally very cautious and even when 
something controversial comes up before a company and the way a 
transaction can be accounted for, almost every accountant I've 
ever dealt with will present you with a palette of options and 
say here is the most conservative, here is the most aggressive. 
In the most controversial situations that happens and yet it is 
management teams that generally impose their will in these 
situations and whether the accountants go along because of the 
consulting or not is beyond my area of expertise.
    The Safe Harbor Act, I think, has only made these things 
worse. In my practice of listing the conference calls, I've 
seen a noticeable uptake since 1996 of companies that were 
saying everything was fine in response to questions about the 
current outlook, of things that they might know about and then 
shortly thereafter news came out from the corporations that 
turned out for that not to be the case. I think that the Safe 
Harbor Act did a lot of admirable things, I really do on behalf 
of frivolous lawsuits and other things. There's got to be some 
middle ground here that I think could be reached to protect 
investors.
    Mr. Dingell. Thank you. Now you stated that you invited a 
number of Wall Street analysts that followed Enron to discuss 
the warning signs that you and the Wall Street Journal, Texas 
edition, identified. Who are these analysts and which financial 
institutions did they represent?
    Mr. Chanos. The sell side analysts represented a number of 
Wall Street firms, most of the largest ones. These were firms 
such as Goldman Sachs Solomon Smith Barney, C.S. First Boston, 
I believe, who represented the main force of these analysts and 
they were all bullish on the company and generally remained so 
throughout 2001.
    Mr. Dingell. Now did these investment banks invest in any 
of Enron's partnerships?
    Mr. Chanos. I'm not an expert on this, Congressman. I think 
there's been some reports in the press as to whether or not 
they were investors.
    Mr. Dingell. They are not barred from being investors in 
Enron's partnerships, are they?
    Mr. Chanos. To my knowledge, no.
    Mr. Dingell. Did any of these investment banks have buy 
recommendations on Enron stock?
    Mr. Chanos. They all had buy recommendations on Enron 
stock.
    Mr. Dingell. Even after your presentation?
    Mr. Chanos. Yes.
    Mr. Dingell. What was their reaction to your presentation?
    Mr. Chanos. These analysts were not stupid people. As I 
mentioned in my testimony, they saw some troubling signs. They 
saw some of the same troubling signs we saw. It was, with the 
benefit of hindsight, I mean some of these things look very 
clear now, but a year ago management had very glib answers for 
why certain things looked troubling and why one shouldn't be 
bothered by them. Basically, that's what we heard from the sell 
side analysts. They sort of shrugged their shoulders. As I 
mentioned in my testimony, one analyst said look, this is a 
trust me story. One analyst even went further and said he 
thought that Enron was hiding reserves that they were 
understating their earnings which we found a little bit 
remarkable, but that's what he said. So I think that we take 
these sell side analysts with a grain of salt from our side of 
the table. We've seen too many of them just ignore obvious 
financial discrepancies or problems or funny accounting. 
They're just hopelessly conflicted because of the fees that 
their firms get on the investment banking side and then I think 
a lot of investment professionals, maybe not retail investors, 
feel the same way.
    Mr. Dingell. Now in Mr. Longstreth's testimony with which I 
happen to agree in large part, he says unless and until a real 
legislative supported SRO is put in place to regulate the 
accounting profession, little, if any progress toward effective 
disciplinary systems for accountants practicing before the SEC 
can be made outside the SEC itself. Starting with you, Mr. 
Chanos and then going down the table, do you agree with this 
just--and I apologize to this gentleman, but I have very 
limited time and I'm not going to be able to ask many 
questions. Do you agree or disagree with this statement, 
starting with Mr. Chanos?
    Chairman Tauzin. The gentleman's time is expiring, so if 
you'd all take a turn at answering.
    Mr. Dingell. Just give a yes or no response, if you please, 
sir?
    Mr. Raber. Yes.
    Mr. Weil. I don't have an expert opinion on that subject.
    Mr. Lev. I'm not sure about the statement. Can you rephrase 
the statement?
    Chairman Tauzin. Will you restate the question?
    Mr. Dingell. Yes, the question, in Mr. Longstreth's 
testimony with which I happen to agree, it says that unless and 
until a real legislatively supported SRO is put in place to 
regulate the accounting profession, little, if any progress 
toward an effective disciplinary system for accountants, 
practicing before the SEC can be made outside the SEC itself. 
Do you agree with that, sir?
    Mr. Lev. I don't think we need significant more regulation 
on accounting, no.
    Mr. Dingell. And I know, Mr. Longstreth, you agree with it. 
The next gentleman, if you please?
    Mr. Sokol. As an engineer, I'm probably not qualified to 
comment on it.
    Mr. Dingell. Gentlemen, Mr. Chairman, with your leave, this 
has been a very fine panel. Gentlemen, you have my 
congratulations and appreciation. Thank you.
    Chairman Tauzin. Thank you very much, Mr. Dingell. The 
Chair now recognizes the chairman of our Health Subcommittee 
from Florida, Mr. Bilirakis.
    Mr. Bilirakis. Yes, and we're talking about a very 
unhealthy part of our society here, are we not?
    Mr. Raber, very quickly, I commend and respect your support 
of the corporate director community. You made the comment that 
they play a leading role in the governance of corporations. I'm 
not going to ask you a question in that regard, sir, because of 
time limitations, but I would say it has been pointed out here 
that due to the fees that have been given, in theory you're 
right, they should play a leading role. In practice, frankly, 
it's been my limited experience that they don't because certain 
people are chosen to be directors. It's an honor to be a 
director. There's money and other things of that nature 
involved, and you pretty well go right on down the line. If I 
have time maybe I'll ask you to respond to that.
    But in the meantime let me get to Mr. Chanos. Sir, in the 
poll to which you referred, of the approximately two thirds of 
the auditors who indicated that they were requested by CEOs or 
by management to come out with false statements or false 
information, how many of those would you say received 
substantial nonauditing fees?
    Mr. Chanos. It was not auditors. It was chief financial 
officers who were asked that question. These were actual 
members of corporate management.
    Mr. Bilirakis. But we don't have any similar information 
regarding auditors?
    Mr. Chanos. Not to my knowledge. This was a Business Week 
poll, again in 1998, following their summit of CFOs, so they 
might have that, but I don't.
    Mr. Bilirakis. It sure would be interesting to know the 
answer to that question and how many of them actually receive 
substantial nonauditing fees. I suppose a logical, reasonable 
person would assume that if you have received substantial 
nonauditing fees, you're probably going to be more likely to be 
cooperative. So it would be interesting to know that.
    Mr. Dingell already asked the question that I had planned 
to ask you on the Safe Harbor. I wonder if you could, for the 
benefit of the committee and for the benefit of the people who 
are tuning in, take an illustration of how safe market has hurt 
investors and has hurt employees as is the case here.
    Can you give us an illustration? Tell us briefly about the 
Act. How does it protect these people who do something wrong?
    Mr. Chanos. Well, we have disclaimers that are given by 
corporate managements before they make presentations publicly 
or in publicly open conference calls discussing earnings and 
outlook and the disclaimer basically holds, tells investors 
that they're about to make forward looking statements and can 
therefore be shielded under the Act, my interpretation of the 
Act from any legal liability when making such forward looking 
statements.
    Chairman Tauzin. Would the gentleman yield a second?
    Mr. Bilirakis. Yes, of course.
    Chairman Tauzin. I wanted to correct something on the 
record. Mr. Chanos, you said something like everything is okay, 
is covered by this, it's Safe Harbor, if the company says 
everything is okay. That's a current statement, not a forward 
looking statement not covered by the Safe Harbor, is that 
correct?
    Mr. Chanos. Well, forward looking statement would be in 
response to the current outlook. Often managements talk about 
earnings guidance and they would say we are okay with current 
earnings guidance.
    Chairman Tauzin. But we were very specific in the 
legislation, if the gentleman will continue to yield, I will 
make time for him. The legislation says only that forward 
looking statements, that is, projections can only be safe 
harbored if they are forward looking, No. 1, not statements of 
current condition and second, if they contain statements of all 
the elements that might make the forward looking projection 
wrong if those elements are present. Isn't that correct?
    Mr. Chanos. Again, I'm not an attorney, Congressman, but 
that sounds correct to me.
    Chairman Tauzin. I thank the gentleman for yielding. Please 
proceed, sir.
    Mr. Chanos. Well, the game that I see being played on Wall 
Street regarding safeguard, current guidance and forward 
looking statements often has to do with managements discussing 
the period that they are in currently. Now that would be an 
earnings that would be reported in the future for the period 
they are in and for the fiscal year that they are in, which is 
also by definition in the future. My problem is is that we have 
a situation where people who often want to ask questions of 
management in this area about these forward looking statements 
and what colors their input to make such forward looking 
statements are often excluded from these conference calls. They 
may listen, but they may not ask. And again, I don't think 
that's in the spirit of the Safe Harbor Act and what people 
were trying to do to protect investors.
    We've also seen a number of cases where managements have 
reversed themselves rather abruptly following conferences or 
conference calls to discuss earnings and accounting issues. And 
again, it's hard for me from my vantage point on Wall Street to 
believe that they didn't know days before revealing bad news 
publicly when speaking to Wall Street analysts and investors 
that they might not have known at that point.
    Again, I think a lot of what this Act did was admirable 
regarding frivolous lawsuits which I'm not fan of. I think 
there's a middle ground somewhere.
    Mr. Bilirakis. Well, all of you have made recommendations 
to us in your written statements. When I conduct our hearings I 
always ask the witnesses to furnish to us in writing 
recommendations, the changes that they would suggest to us, and 
I'm sure Mr. Tauzin is going to do the same thing. I would be 
very much interested in your recommendations regarding the Safe 
Harbor Act.
    Mr. Raber, just very quickly, forgive me for picking on 
you. Time won't allow me to go into it, but I would like to see 
that, in fact, your confidence in the corporate director is 
something that we can really live with and all have the same 
confidence in. You might want to furnish us, and I certainly 
would love to see them, some ideas that you might have and what 
we can or should do, if, in fact, we should address it 
legislatively, so that we might have a higher level of 
confidence. Frankly, I don't have that much confidence. I know 
I was selected years ago to be a director of a bank, and it was 
a piddling amount, a couple hundred dollars for meetings or 
something like that. But I was selected because I was probably 
going to go along with any of the things that the management 
wanted to go along with, as well as some of the prestige.
    Mr. Raber. Congressman, more and more directors are sitting 
on fewer boards. It's quickly disappearing where directors are 
sitting are 8, 9, 10 boards. What's happening is that when a 
director looks at a particular company where the person is 
being nominated to sit on that board, the more astute director 
will say I know it's well beyond the number of board meetings, 
committee meetings. It's going to be phone calls and e-mails 
back and forth and you see more and more companies they say 
well my expectation is 200 hours or 250 hours, so there's a 
realization, it's a commitment beyond the board meetings and 
the committee meetings and it's also a sense, ``Do I know 
enough about this industry and this company?'' That's key these 
days. And third is disclosure.
    Mr. Bilirakis. My time is up, but I still think, with all 
due respect, that you're talking more theory than you are 
realism and I wish I were wrong.
    Chairman Tauzin. Thank you, gentlemen. His time is expired. 
I wanted to point out to Mr. Chanos for the record that Arthur 
Levitt endorsed legislation on security litigation reform. He 
supported the Safe Harbor positions as they were written in the 
bill, as we negotiated with him and others in that language. 
Now if they can be improved, we'd love to hear from you and 
others how we might improve them.
    Let me make that a general request, by the way, because I 
threw a question at you that I'm not sure you all had a chance 
to think about an answer. We will give you specific questions 
like that, all of you, Dr. Weil, Dr. Dharan, if you might 
respond in writing, we'd deeply appreciate it as we go forward.
    The gentleman from New York, Mr. Engel is recognized for a 
round of questions.
    Mr. Engel. Thank you, Mr. Chairman.
    Chairman Tauzin. Am I missing seniority? Is Mr. Sawyer--I 
think I'm correct, Mr. Engel is next, yes.
    Mr. Engel. I'll sit and listen to his questions also. Thank 
you, Mr. Chairman.
    Mr. Chanos, you stated in your testimony and I'm going to 
quote you, ``certain aspects of GAAP, particularly accounting 
for stock options in the United States are basically a fraud 
themselves.'' And then you refer to them as ``accounting 
scams'' later on your testimony. That's a pretty strong 
statement and I'd like you to please elaborate on it and why 
you say that and what Congress can do or should be doing to 
change the situation.
    Mr. Chanos. Mr. Sokol has as his investor Warren Buffet who 
said it far better than I ever could about stock option 
accounting and I'm paraphrasing, but if stock options aren't 
compensation, what are they? If compensation isn't an expense, 
what is it? And if expenses shouldn't go into the calculation 
of profit and loss, what should? And again, I'm paraphrasing 
from the master, Mr. Buffet, but I agree with that whole 
heartedly.
    Stock options increasingly have skewed the risk/reward for 
corporate managements in the United States today to basically 
heads I win, tails, the shareholders lose, so we talk about the 
rise in agency risk in investing in the United States. It used 
to be that you were in the same boat with your corporate 
management. They were shareholders as well, they were stewards 
of your capital. They served at the board of directors' 
pleasure. And now it seems as if the agency risk that's risen 
is how can we enrich ourselves if the opportunity presents 
itself without harming our earnings per share and therefore our 
stock price?
    Well, one way to do it is innovative compensation schemes 
using stock options because as you know, stock options are not 
calculated, the present value of stock options are not 
calculated as an expense in the profit and loss statement of 
U.S. corporations. No matter how lavish they are, no matter how 
enormous the grants might be, they are contained in the 
footnote to the financial statements as to what their value 
would be under reasonable assumptions in terms of their 
valuation and people can look through that and find out what 
that number is. We do it automatically to figure out what the 
real profitability of a company is if they expense their stock 
options, but it's just simply not run through the P&L 
statement. We see no reason why they shouldn't be. It's an 
expense. It is compensation. And corporations are allowed a tax 
deduction when the options are exercised by their executives. 
Now it's not revenue neutral because the executives pay tax 
when they exercise, but from an accounting point of view and 
I'd be very curious to see what the accounting experts on my 
left have to say, there is no reason that some attempt to value 
these options at market prices should not be an expense item 
when they're granted.
    Mr. Engel. I see Dr. Weil would like to comment.
    Mr. Weil. Thank you. The fault is your predecessors. The 
Financial Accounting Standards Board wrestled with this problem 
in the early 1990's and had a rule that would do just what Mr. 
Chanos wants. It wasn't the best measurement technique, but it 
allowed some good measurement techniques and the lobbying was 
so intense from your constituents that you, your predecessors 
came to the FASB and said you can't pass that rule.
    The Chairman of the SEC at that time told the FASB to back 
off. He later admitted that was a mistake. This is the time, 
the first worst in my opinion, interference with accounting 
standards from Congress. All you have to do is go back to the 
rule that was about to be passed in 1994 and get it going 
again. That was a good rule and I don't think there's going to 
be a single accountant, accounting theorist who is going to 
disagree with that. We had it and you took it away from us, 
your predecessors.
    Mr. Engel. Thank you. Mr. Raber, have you read the Powers 
Report?
    Mr. Raber. I'm sorry?
    Mr. Engel. The Powers Report?
    Mr. Raber. Yes, I read the Powers Report.
    Mr. Engel. In your opinion, did the Board do its job in 
overseeing the financial situation of Enron?
    Mr. Raber. I think that the Board did not fulfill its 
oversight obligations completely and I think they should have 
asked more probing questions.
    Mr. Engel. In the report it states that the Board approved, 
the Enron board approved Mr. Fastow's waiver from the corporate 
code of conduct and allowed him to serve as a general partner 
in partnerships that participated in significant financial 
transactions with Enron. Is it common for a board to allow an 
officer of a company to be the manager of another?
    Mr. Raber. This to me, is unconscionable for that to happen 
and that gets back to disclosure and some of the conflict of 
interest that I talked about in my testimony and I'm sure 
people here would have other comments as well.
    Mr. Engel. Mr. Longstreth, as I mentioned in my opening 
statement, Andersen does not believe that it violated the 
AICPA's code of professional standards, but instead they say 
they committed a gross error. Do you agree with this?
    Mr. Longstreth. Well, I don't think I know what standard 
they think they did not violate, so I really can't answer that 
question. They've admitted to a gross error.
    Mr. Engel. Do you think that AICPA is monitoring, policing 
its members properly, or do you think they failed in that 
regard?
    Mr. Longstreth. No, I said in my testimony, they are a 
trade association and a lobbying vehicle for the profession and 
to put, to charge them with writing and enforcing standards of 
professional conduct is really expecting too much of an 
organization that is chiefly designed to advance the bottom 
line of the industry.
    Mr. Engel. Well, then should the government play a greater 
role in overseeing the industry?
    Mr. Longstreth. What is needed is an adequately empowered 
self-regulatory body in my judgment. You should understand that 
the SEC has powers to discipline the accountants, but it's 
never been a high priority for the SEC, so I think one needs 
something comparable to the NASD. The reason the NASD works, it 
hasn't worked perfectly over the years, but it's working better 
recently, the reason it works is it has subpoena power, it has 
disciplinary power. It has rulemaking power and it has the 
power to tell every one in the industry when something happens, 
turn over your documents, all your documents, come, appear, 
testify. You have no fifth amendment rights and if you don't, 
you're out of the industry. We bar you forever. That power is 
essential for an SRO to function effectively.
    Chairman Tauzin. The gentleman's time has expired and the 
Chair recognizes the gentleman from Texas, Mr. Barton.
    Mr. Barton. I thank the chairman. Just to let the record 
show, my graduate degree is in management from Purdue in the 
1970's, but I have a son who has got a graduate degree in 
business from Stanford in the 1990's, so about 1\1/2\ or 1 year 
ago, I kept reading all these stories that Enron had found a 
new way to make money and it was the new way and I couldn't 
understand it, but I asked my son to evaluate it because he was 
working for a company that did venture capital analysis for a 
group in Texas and he routinely had to review deals and he came 
back to me after about a week and said don't touch it. I said 
what do you mean don't touch it? Everybody on Wall Street is 
for it. He said they don't have any assets. I don't understand 
what they're doing, but sooner or later they're going to head 
south and they're going to head south in a big way. So my 
degree was 20 years old and I couldn't understand it, but my 
son's degree is a little more recent and I was going to put 
some money into Enron and my son told me not to. Eventually, I 
did, anyway. As it headed south, I figured it can't go any 
lower and of course, every time I bought it, it immediately 
went lower, so anyway, that's that.
    I lost everything, but fortunately for me everything for me 
is not a lot so that's a good deal.
    I want to try to put this in some sort of perspective 
because never has a more important subject been presented in a 
more boring fashion and we really need to kind of understand 
this. So I'm going to use the analogy of me as an entity and 
the old economy and the new economy. The old economy, I'm 
Congressman Barton and I have an annual salary after taxes of 
about $100,000 a year and I get that about $8,000 a month and 
out of that I pay my household expenses and I try to save some 
money and I have some assets, a savings account and a stock--
some thrift savings that we can join in. But I know every month 
how much money is coming in and I know every month how much 
money is going out. Now most of the money that's going out is 
to my kids. I have a son who is now running for Congress, 
fortunately, I'm limited to a $1,000 that I can give him, so 
I've got a limit on that, a mandatory, Federal limit. I have a 
daughter to who is about to be married. There is no limit on 
that.
    And I have another daughter who is in college and in a 
sorority who wants to study overseas next year and there's no 
limit to that. Okay? So that's my outgo.
    So in the old economy I know how much money is coming in 
and I know how much money is going out and where it's going and 
I have to balance the books at least once a month, unless I go 
to my banker in which case I can balance once a year, but I'm 
tired of that. So I decide to develop TexasCon.com and I like 
these new accounting rules that generally accepted, which means 
if you can get away with it, do it. So I decide to go to 
somebody and create a special entity, an SPE and I look around 
and I see that former Congressman Livingston is making lots of 
money and former Congressman Brewster and McCurdy and a lot of 
our colleagues are making a lot of money. So I go out and say 
if you'll put up 3 percent net equity and where that number 
comes from I don't know, but we can go and say 5 years from now 
I'm going to be making $1 million a year. So if you'll put up 3 
percent of that which is what, $150,000, I guess, then I can 
create a special purpose entity and I can book that as revenue 
right now and then my children's outgo, I want to limit 
liability so I create an SPE for each of them, you know, and so 
I can take those liabilities off my balance sheet and all of a 
sudden stodgy old Congressman Barton who has got an income of 
about $8,000 a month, an outgo of about $8,500 a month, all of 
a sudden I've got this mark-to-market of this revenue stream in 
my special purpose entity of $5 million and I can book right 
now, even though I haven't got it, and I can take that to the 
bank and borrow money and I don't have any problems, as long as 
nobody calls me on it. And as long as I can sell my stock on 
the market and make my accounting and my annual report so 
confusing that nobody understands it.
    Chairman Tauzin. Will the gentleman yield before you ask 
the question Mr. Barton. Yes, I'm going to ask a question. I've 
set it up now. I'm about to ask the question.
    Chairman Tauzin. Go ahead and ask it.
    Mr. Barton. My question of you guys is which is better, the 
old way where I'm stodgy and everybody understands it, or the 
new way where I'm very unstodgy and I'm very hip and it's all a 
mirage?
    Mr. Sokol, you're a straight shooter, which way do you 
prefer?
    Mr. Sokol. The old way.
    Mr. Barton. The old way. Mr. Longstreth?
    Mr. Longstreth. Yes, I'm convinced by your rhetoric.
    Mr. Barton. Okay, how about Mr. Lev?
    Mr. Longstreth. I like the old way.
    Mr. Barton. Does anybody like the new way?
    Mr. Lev. I like the new way.
    Mr. Barton. Which way? Mr. Lev likes the new way. Why do 
you like the new way?
    Mr. Lev. Let me first say that you really put some life 
into the discussion of accounting and----
    Mr. Barton. It's hard to do, but----
    Mr. Lev. I commend you for this. I commend you for this, 
but there is a new economy and the new economy is a place in 
which there are many assets which are not old assets. If you 
ask yourself what are the assets of Merck or Pfizer, these are 
not old assets, these are not buildings or lab equipment. It's 
patents and minds of people.
    Mr. Barton. Well, there's always been minds of people, 
there's always been ideas. Now Dr. Weil, he said that his 
students understood what a revenue is. I think I understand 
what a revenue is. It's something that comes in, somebody pays 
me money.
    Mr. Weil. I think you're confused. You think you know what 
a receipt is and you have no idea what a revenue is, but a 
revenue isn't necessarily a receipt.
    Baruch here, Professor Lev, is getting to the right thing. 
Your old economy is easy to account for because it's cash-flow, 
it's cash in, cash out. There are enormous numbers of assets 
like the patents of the drug companies where you spend the 
money today, but you don't know for a year, or two or three, 
whether there's going to be cash inflow and between now you 
spend the money and later you might get it. We've got 
uncertainty.
    Mr. Barton. Well, I'll go with you, if you have a patent 
you have a certain monopoly or a royalty right because of that 
patent, but you don't necessarily have a revenue because you 
have the patent, isn't that correct?
    Mr. Lev. You can always license a patent.
    Mr. Barton. But somebody has to buy it. Somebody has to pay 
you money.
    Mr. Lev. Yes, in the future.
    Mr. Barton. I have three real questions here, everybody 
else has had 10 minutes. Now you're not going to hold me----
    Chairman Tauzin. You made 3 percent of $1 million at 
$150,000, I think that was pretty innovative. So I'll give you 
a couple of minutes.
    Mr. Barton. Here are my questions, the first one is to Dr. 
Dharan who gave quite a bit of testimony about mark-to-market. 
What if we just prohibit mark-to-market?
    Mr. Dharan. I don't think that's a good idea at all. 
Again----
    Mr. Barton. Okay, you just say no.
    Mr. Dharan. I say no.
    Mr. Barton. What about instead of having an independent 
audit committee like one of the gentlemen said, what if we just 
eliminate the whole idea of an independent audit committee but 
say it has to be internal and you're liable for it?
    The companies have to do the audits, but they're liable for 
the audits instead of going through this outside independent 
audit firm who's really not liable and it's based on generally 
accepted accounting principles which have been stretched like 
rubber bands for the last 20 years, why not just say you've got 
do a real audit internally and you are liable for it. What's 
wrong with that idea?
    Mr. Raber. You have to have, at least from our perspective, 
you should have an independent external auditor that has no 
problems with some of the independence issues that--you're 
looking at it objectively. You're bringing in the best people 
insofar as skills and experience and that independent judgment, 
independent from management, independent from the internal 
auditor, that person needs to take a look and make an objective 
assessment insofar as the audit.
    Mr. Longstreth. The laws we have today would make the 
company liable if they put out false statements, so we've got 
that. I think the point is we've felt it necessary to have an 
independent verifying process.
    Mr. Barton. But you're really not independent because some 
of these companies are so big you can't say no to them.
    Chairman Tauzin. The gentleman's time has expired.
    Mr. Barton. The auditor of Enron could not say no to Enron.
    Chairman Tauzin. All right, Joe, got to move on. The Chair 
recognizes the gentleman from Ohio, Mr. Sawyer, for questions.
    Mr. Sawyer. Thank you very much, Mr. Chairman. I've got a 
couple questions of corporate governance I'd like to pose. In 
the Enron case, we had both an independent board and a common 
law fiduciary duty imposed on that board. Do we need to have a 
statutory fiduciary responsibility on investment retirement 
plan administrators, similar to that which we have in ERISA?
    Mr. Raber. That's part of the responsibility of the audit 
committee is do what needs to be done to make sure the pension 
plans are being dealt with appropriately, so you--that's part 
of the risk audit of an audit committee, so I don't know if 
that answers your question, but that's part of the due 
diligence you do there is similar to what you do in other areas 
of risk in the company.
    Mr. Sawyer. In Federal pension plans, fiduciaries have a 
responsibility, I quote ``to diversify the investments of the 
plan so as to minimize the risk of large losses.'' Do we need a 
similar kind of standard for 401(k) administrators?
    Mr. Raber. I'd rather look to some of the accountants here 
that may be able to give a judgment on that insofar as that is 
concerned.
    Mr. Sawyer. Anybody?
    Mr. Weil. Well, here we go. Your predecessor did that one 
to us too, back in the 1970's when you started with employee 
stock ownership plans, employee stock ownership trusts, you 
sort of forced the investments in your own company's stock. We 
need diversification. You don't want to put all your eggs in 
one basket. It's been a well-understood principle of financial 
economists for decades and anything you can do to help the 
shareholder diversify retirement funds is a good idea. I'm not 
sure what the details needs to be, but the nondiversification 
started with your predecessor's rules. Let's fix them.
    Mr. Sawyer. Mr. Sokol, I was really interested in the last 
page of your written testimony where you talked at some length 
about a topic that is--I bored my colleagues to death with over 
the last several years and that's the problems of capital 
formation around truly modern regionally built markets 
supported by a modern transmission system. And you talk about 
PUHCA and how it can't be fixed by tinkering around the edges, 
that it's 50 years out of date. I have some appreciation for 
that. However, you don't talk in your testimony about elements 
from PUHCA that need to be retained or transposed into other 
settings in order to continue to preserve the protections that 
they provide. Could you elaborate on that for me.
    Mr. Sokol. Yes, it's a very good point, Congressman. PUHCA 
was established in 1935, known as the 1935 Act to deal with two 
sets of issues, a set of issues that are gone that the SEC has 
said since the 1950's are gone and then a set of issues that 
continue today which are consumer protections which I think 
that's what you're speaking to. We strongly endorse and I think 
the industry strongly endorse, although Enron opposed that. 
When PUHCA is reformed, similar to Senate Bill 1766 currently 
in front of the Senate, that the books and records for State 
regulators, Federal regulators have to be enhanced for all not 
only monopoly utilities, wires or pipes, but any affiliates of 
those, so that any affiliate abuses or other transactions can 
be properly monitored. We strongly agree with that because 
really--and Enron is a good example of this. The consumers, a 
problem with General Electric, which was owned by Enron, an 
intrastate-exempt utility holding company, were protected by 
the State of Oregon, the Public Utility Commission of the State 
of Oregon and they did an excellent job, as almost every State 
today does. It fences a utility within its State so that other 
corporate activities cannot affect that activity. And that's 
the situation. The reality is there's well in excess of 5,000 
State regulators, professional regulators in the United States. 
There's 22 employees of the SEC that oversee PUHCA. And so we 
really strongly endorse both the consumer protections and 
enhanced protections be moved both to the FERC and to the State 
regulatory bodies.
    Mr. Sawyer. Thank you very much.
    Chairman Tauzin. Does the gentleman yield back the balance 
of this time? The Chair recognizes Mr. Stearns of Florida.
    Mr. Stearns. Thank you, Mr. Chairman. One of the purposes 
of this hearing is not just to go into some of the details as 
my good colleague from Texas talked about so that it just gets 
so boring that no one can follow it, but we're trying, as 
Members of Congress, to give confidence to the investor so that 
the investor has full disclosure and can understand what he or 
she is purchasing. And so the whole purpose is somehow to come 
out of this Enron not necessarily with huge reregulation, but 
to come out with some kind of platform in which we can say to 
America, these Enrons won't continue. One of the gentleman here 
has mentioned that the special purpose entities has been going 
on for at least 5 years and I suspect other corporations are 
using this and I suspect there will be a lot of people 
including the people at the table here that would argue that 
it's acceptable to use that if it's done in a proper way and we 
don't have a conflict of interest. But I would like to get at 
the heart of the problem which is the American people are 
saying, ``What confidence will I have that when I go to invest 
in any corporation today, there's not similar type of chicanery 
or hiding smoke and mirrors of the debt and the revenue is 
inflated?''
    Now Dr. Weil, you're teaching MBAs at the University of 
Chicago, Graduate School of Business. I could simply say to you 
when you have a graduate from your MBA school, shouldn't he or 
she be able to discern that Enron's books were bad? And I think 
I would just ask you just plainly and I probably also should 
ask this to Mr. Dharan at the Graduate School of Management at 
Rice University. I mean these MBA graduates should be able to 
understand this. Could they today pick up the Enron P&L 
statement and understand it? Just give me a brief answer, the 
two of you.
    Mr. Weil. My co-author Clyde Stickney who is a Professor at 
Dartmouth College, we've written a book for 30 years on this, 
spent over a week dealing with the Enron financial statements 
to write a case that he can use to teach the students. Mr. 
Stickney is a pro and it's taken 40 man hours to get to the 
bottom of things and he's not 100 percent to the bottom because 
there's not full disclosure, but an MBA graduate is not going 
to be able to do it.
    Mr. Stearns. So the Tucker School of Management, Dartmouth, 
one of the premiere guys could not understand it after weeks, 
okay?
    Mr. Dharan. Congressman, I agree with it totally and I 
think the problem has to do with the way Enron reported the 
numbers, not it's accounting itself. It was very misleading.
    Mr. Stearns. Okay, so your MBA graduates couldn't 
understand it either. Okay, so then the average person couldn't 
understand it. So this goes to the main question of this 
hearing, could FASB, the Financial Accounting Standards Board, 
could they by themselves provide enough rules to clean this up 
and put it in place without Congress doing anything?
    Mr. Weil. I believe, yes, they could.
    Mr. Stearns. Yes, they could.
    Mr. Weil. Here is the rule that they proposed in 1999 that 
was essentially all but passed, that would have solved the 
problem and it was put aside for various----
    Mr. Stearns. Is that the majority of the consensus? Let me 
just go down the line, if you would, from left to right. Could 
FASB on itself clean up this through accounting rules without 
Congress. Just yes or no.
    Mr. Chanos. Yes.
    Mr. Raber. Not sure.
    Mr. Stearns. Dr. Weil, you say yes?
    Mr. Weil. Yes.
    Mr. Dharan. I would say no, but if I could take a second to 
explain why.
    Mr. Stearns. I just want a no or yes. The chairman is going 
to be ruthless with me here. Yes or no?
    Chairman Tauzin. I'm not going to be ruthless with my 
fellow Texan.
    I'll give him all the time he wants.
    Mr. Stearns. Is that a yes then?
    Mr. Dharan. If I want to say no, I need to have a minute or 
2 to explain why.
    Mr. Stearns. Okay, I have a follow-up question, so let me 
just go down to the rest of the fellows, yes? Yes or no.
    Mr. Longstreth. No.
    Mr. Sokol. No.
    Mr. Stearns. Okay, this comes down to the next great 
concern we have is that the Chairman of the Securities and 
Exchange Commission has come out and has indicated that we're 
going to have to go ahead and have an accounting industry 
oversight board and I think Mr. Dingell mentioned on this that 
he asked you this question already, but I judge from what you 
say is we cannot expect FASB to do this by themselves. There's 
some mixed reaction here. So what is the American public 
supposed to do with the Financial Accounting Standards Board 
cannot come up with a solution and provide enough disclosure 
and your MBA, as it presently exist, cannot even understand 
those reports and the man at Dartmouth spent weeks and he 
couldn't understand it. So what are we supposed to do? And I 
just would close, Mr. Chairman, by just asking them again to 
answer this question that Mr. Pitt from the Securities and 
Exchange Commission said, should there be a congressionally 
mandated self-regulatory organization, an SRO like the National 
Association of Security Dealers for accountants to give 
government direct oversight of the accounting industry and just 
yes or no?
    Mr. Chanos. No.
    Mr. Raber. There should be an oversight and it should be 
strengthened. I'm not so sure what it should be though, whether 
it should be the regulator or some sort of a public oversight 
board.
    Mr. Stearns. Dr. Weil?
    Mr. Weil. I think there's a better way, but I don't have 
time to tell you about it now.
    Mr. Stearns. Okay.
    Mr. Dharan. I think there should be an oversight board. 
Again, I'm not very sure about the specifics of SRO that was 
proposed.
    Mr. Lev. We are really mixing two things here and we are 
making disservice to the subject by having to answer yes or no.
    Mr. Stearns. In all deference to you, in my job I have to 
simplify things day in and day out. I do 800 to 900 votes a 
day. I could sit and talk about each vote for 3 hours.
    Mr. Lev. I respect it, but you started speaking of 
accounting rulemaking, the FASB, and then you switch to the SEC 
chair who spoke about oversight of the auditing profession.
    Mr. Stearns. Right.
    Mr. Lev. These are two entirely different things.
    Mr. Stearns. Okay, I'll take your word for it, yes, okay, 
and your answer should there be this congressionally mandated 
self-regulatory organization over the accounting industry?
    Mr. Lev. Yes.
    Mr. Stearns. And last?
    Mr. Sokol. I think it misses the bulk of the point.
    Mr. Stearns. Okay. Mr. Chairman, I think that if any one of 
the members would like to send a letter to outline more 
specifically how they feel about it, we'd be more than happy 
to, but I only have 5 minutes and as I say I have to 
scintillate all this down, so at least the American public can 
have a better appreciation for what we're talking about.
    Thank you, Mr. Chairman, for your indulgence.
    Chairman Tauzin. Thank you. It is a serious subject. I 
would, before we go to Mr. Greenwood, like to Dr. Dharan and 
Mr. Lev, it is a serious subject, all joking aside, if you want 
to elaborate a little on Mr. Stearns. He didn't use as much 
time as the other members.
    Mr. Stearns. Mr. Chairman, if I still have time, I would 
certainly offer them----
    Chairman Tauzin. I'll give them a time to elaborate. We 
need a full hearing record and this is an important subject.
    Mr. Dharan. Thank you, Congressman. I think the question 
was, ``Could the FASB in and of itself clean up the reporting 
and disclosure rules?'' and the answer is no, because the FASB, 
as was pointed out, only sets the accounting rules. It does not 
enforce them. And we really need a combination of both good 
accounting rules and good enforcement. The reliability of 
accounting numbers comes from the enforcement system, not from 
the accounting rules themselves, so that's why it really is 
important to have a support function that really does the best 
job of enforcement. That's really why FASB by itself cannot do 
this.
    Mr. Stearns. So enforcement is the key in your mind?
    Mr. Dharan. Enforcement is the key, along with good rules. 
Enforcement cannot make up for bad rules. And good rules cannot 
make up for lack of enforcement.
    Mr. Stearns. And FASB couldn't provide the enforcement?
    Mr. Dharan. FASB has absolutely no power of any kind to do 
enforcement. It's just a private group. It sets accounting 
standards, but it does not enforce them.
    Mr. Stearns. Okay. Mr. Lev, you are certainly welcome.
    Mr. Lev. Let me just say about the FASB, the rulemaking 
body for accounting. A group of good people basically moving in 
the right direction, but too slow, too timid, they are now 
working about 10 years on consolidation and still we don't have 
really good rules in this case. In my opinion they need, maybe 
not new regulations, they need some kind of a push or a shove 
by the SEC or someone to get the act together. Regarding the 
oversight of the auditing profession, I don't think we need any 
oversight in this case. I think that if we get--we in 
competition, in the auditing industry, along the line that I 
mentioned before, that auditors will be chosen by shareholders 
for a 5-year period, then you don't need any oversight. They'll 
act and if they don't act, they'll be kicked out like any other 
service providers. We don't need another regulatory body.
    Mr. Stearns. How do you get enforcement then?
    Mr. Lev. On what?
    Mr. Stearns. When you said they need a push or a shove, is 
that an enforcement mechanism or is that just a house 
resolution from Congress?
    Mr. Lev. I'm not even sure if--I'm not a lawyer, I'm not 
sure if a resolution is needed, but the little I know about 
laws, the SEC, according to the 1933 and 1934 laws was in 
charge and still is in charge of setting accounting standards. 
They delegated it to the FASB and from time to time they have 
to provide an oversight whether the job is done well, in the 
right pace, the right direction, the right speed and I think 
they should do it.
    Mr. Stearns. Thank you, Mr. Chairman.
    Chairman Tauzin. Thank you. The gentleman from 
Pennsylvania, Mr. Greenwood, is recognized for 5 minutes.
    Mr. Greenwood. Thank you, Mr. Chairman, and thanks to all 
of the panel members for a very long day.
    I'd like to address a question to those who have the 
expertise in accounting and I want to think about board members 
and particularly the board members who are on the audit 
committee. Now I haven't--I was just talking to the staff to 
try to get a sense of the magnitude of the compensation that 
the board members at Enron were getting. My understanding was 
it was pretty nice. I've heard numbers of $400,000, in this 
vicinity. When you look at the cash that they're given, you 
look at the stock they're given, you look at the stock options 
that they're given and then they fly them around first class 
and put them in fancy hotels and all this stuff, and it's been 
my experience and I don't know a whole lot about this, but it's 
been my experience that board members are not necessarily 
chosen by companies because of their great expertise in the 
business that the company is engaged in. They're picked because 
they've got some political juice or they've got some stature or 
wisdom, but they don't necessarily know about all of the 
intricacies of the business that the company is in.
    Now when you're getting this kind of compensation and you 
know that you serve fundamentally, I think one of you said 
earlier at the behest of the CEO, you very likely don't want to 
rock any boats because you can go. You can go pretty easily.
    One question I have is should giving the board members 
stock and stock options, is that a good idea because it's a way 
of saying so the governance that you provide to this 
corporation will affect the value of your stock and so this is 
an inducement for you to really care about the value of the 
stock, or does it, in fact, create a conflict, certainly if I 
were on the board of directors of Enron and I had a lot of 
stock in Enron or stock options in Enron and I knew that my 
being deadly honest about the audit, that that might cause the 
stock to drop, I might be in the same, put me in the same boat 
as some of the management team that had stock and didn't want 
to see its value drop. What do you think about that specific 
question? Should board members--is it a good idea for board 
members to be compensated with stock and stock options?
    Mr. Raber. If I could comment on that since we track it 
with public companies and we firmly believe and recommend that 
40, 50, 60 percent of your compensation should be in equity, 
the rest in cash. They are looking at that you're paid in 
equity, you get the chance to feel the pain or the gain that 
the shareholders feel. We want to pay you in cash to a certain 
extent, so you take the long run, the long look at things, 
rather than maybe the incentive would be if we were paid 
entirely in stock, we have more of a short term perspective. 
These are safeguards. But the practice is between 40 to 60 
percent is in stock if you look at all public institutions, 
with the larger institutions similarly paying more in stock. 
Now we're also encouraging, again this is part of a principal 
of good corporate governance that when you come on the board 
it's a good idea to purchase outright stock and some companies 
do that. I know when I first got on my board back in 1980, I 
had to make a purchase of X amount of stock and again there, if 
the governance principle is you represent the shareholders, you 
should feel the pain that the shareholders feel.
    I also find, because we do a lot of education of directors, 
this area is the area we spend the most time is on audit 
committees and what I wanted to say before, getting behind the 
numbers. There's no doubt you're seeing a lot more focus on 
audit committee quality and independence by audit committees. 
You're also seeing a lot more focus on enhancing their 
financial competencies. So we're seeing a lot more focus on 
tackling those issues, realizing longer days, longer hours----
    Mr. Greenwood. What about the observation that had the 
audit committee at Enron forced the issue and pushed these off-
book numbers back on book that the stock might have dropped as 
a result of that.
    Mr. Raber. I've got to tell you that the impact of Enron, 
among other things, is to look at those off balance sheet 
transactions, not that they haven't been in the past, again, a 
lot of the people that belong to my organization are more 
enlightened and more engaged in good governance practices, but 
there's no doubt the implication of off balance sheet 
transactions is going to take a heightened interest among audit 
committees.
    Chairman Tauzin. Would the gentleman yield?
    Mr. Greenwood. The gentleman will yield.
    Chairman Tauzin. I'd just like an explanation of the public 
good of allowing off budget entities in this new market 
economy. Why allow that if it hides the real value of the 
company?
    Mr. Raber. I agree with you. To get back to your question 
before about the old and the new and if you can't understand it 
and say you're an MBA, you have a certain amount of financial 
sophistication and you have a finance background and you're 
sitting on a board or an audit committee and you can't 
understand it, that means you can't govern it and something has 
to change.
    Chairman Tauzin. Well, Enron was pretty up front to the 
analytical community that the purpose of these SPEs was to 
provide a hedge against volatility both on the upside of the 
asset and the downside--they were pretty up front that that's 
why they were creating the entity. So that wasn't a secret and 
that wasn't buried in a footnote. Now how they funded them and 
the equity they put in was confusing, but the purpose was to 
protect the parent company balance sheet which would seem to me 
to be contrary to general accepted accounting principles that 
you want transparency and understandability.
    Is the gentleman through with his questions?
    Mr. Greenwood. I'm through questioning, but I would like 
anyone who wanted to respond to my question to respond.
    Mr. Longstreth. I'd like to respond to the, if I could 
respond to the question you put, Congressman Greenwood, about 
options for directors.
    I think that they're not a particularly good idea. I think 
the idea of having directors paid in whole or in significant 
part as my colleague here has suggested ought to be done is a 
very good idea because it aligns the director with the 
shareholder and he pays for it in effect through the director's 
fee. But options is it's a heads I win proposition. And in 
England, options for directors are prohibited.
    Mr. Weil. There's a tradeoff here where economists, if you 
own an ownership interest, you go down with the ship. You have 
interest in going forward and the company doing well. If you 
have too much of your wealth in it, you're going to be tempted 
to hide bad news to protect your own wealth. There is some 
place in there where you want to draw a line, but it's probably 
not at zero. Whether the compensation should be in options and 
shares, we can equilibrate that and make them equivalent. 
That's not an important distinction in my mind, but it is a 
good idea for the director to care about the health of the 
company. It is not a good idea for the director's entire wealth 
to be at stake on the good of the company. It's a tradeoff. 
It's a most simple answer.
    Mr. Dharan. I just have a small comment to add. We have the 
concept of independent directors and we always think of that 
concept in terms of whether the director is part of management 
or is the director coming from outside the company. I think we 
should also start thinking in terms of the independence of the 
director with respect to the stocks that he or she holds in the 
company, so the director that's holding a huge amount of stock 
that is a percentage of his or her wealth very significant, 
then at that point to call the director independent is really 
very difficult to convince in terms of the downside risk he or 
she faces in exposing problems. So I think your point is 
excellent. I think we really should think about what portion of 
the wealth should be held in the director's portfolio of the 
company.
    Chairman Tauzin. The gentleman from Iowa is recognized. 
We're going by seniority, just to let Mr. Shadegg know. Mr. 
Ganske has got seniority on Mr. Shadegg. I was told to do that.
    Mr. Ganske. Thank you, Mr. Chairman. I think the--I've 
enjoyed the panel a lot and there are a lot of strong 
personalities on this panel. I think it gives lie to the old 
saying that you become an accountant if you lack the charisma 
of an undertaker. But then maybe we have some accountant 
teachers here on this Board as well.
    You know, I'm thinking about a gentleman who lives on the 
western edge of my District. His name is Warren Buffet, just 
across the river from Council Bluffs and for a long time while 
that high tech economy was rolling along, Mr. Buffet was kind 
of viewed as being a stodgy guy because he said you know, I 
just can't figure out how to evaluate those companies and what 
a true evaluation. And we've talked a lot today about some of 
the problems with accounting in terms of determining what the 
actual worth is of some of those intellectual property ideas 
that maybe yeah, aren't realizing any gains.
    I don't know that we'll get into that in terms of Congress 
looking at the rules. There very well may be criminal 
prosecutions that arise out of this. The Justice Department is 
looking at this. I share the feelings of some of the members on 
this committee who have expressed frustration, for instance, 
that the person who robs a convenience store gets put in jail 
and isn't given the option of staying out of jail if he returns 
half of what he stole. And I appreciate Mr. Sokol's comments on 
this issue. We really, the Nation's attention will be 
spotlighted on this, on the Justice Department probe.
    We're sort of looking at what can we do right now to try to 
shore up investor confidence because just looking at all sorts 
of things that are going on Wall Street in terms of Global 
Crossings, Tyco, bankruptcies, all up and down, and people 
worrying whether, you know, their investments in particular 
stocks haven't been reported accurately and that there's all 
sorts of offshore entities going on. I think Congress does need 
to do something like that. Several years ago I was sympathetic 
to Arthur Levitt's proposal to somehow or other deal with the 
potential, at least the potential conflict of interest between 
entities that are doing the accounting and those that are 
getting high fees for consultation. I guess I'm reading that 
the Big Five now, if they haven't already, they're spinning off 
their consulting services.
    You know, when I ran my medical practice, I was running a 
small business and I had a professional manager that helped me. 
He was an accountant, kept my books, also did my tax prep. You 
know, but that's a whole lot different entity. I wasn't a 
publicly traded company. People weren't investing in my 
business. And I do think that we need to go back, look at the 
FASB rules. We need to go back and look at possibly 
strengthening and going back to Mr. Levitt's original 
proposition. I am not so worried about accounting firms being 
able to or businesses being able to get the type of 
consultation because you know, look, you hire one firm to do 
your accounting and you get another firm to do your, of some 
type to do your consultation. The specter was that maybe they 
would be at odds with each other. Maybe they would badmouth the 
other. I think you could also wonder whether they would be in 
collusion with each other, since there may not be that many 
large entities. I think the competition would be helpful and 
would help restore some confidence in these companies that 
we're dealing with.
    I guess I don't have any particular questions right now, 
except I do want to thank you for the indulgence, patience that 
you've shown when all of us up here in Congress, up here on the 
bench had our long statements. It's been a long day for you. I 
look forward to going over in more detail the suggestions that 
you submitted in your writings. Thank you very much.
    Chairman Tauzin. We're going by order of seniority which 
would give Mr. Deutsch the opportunity before Mr. Stupak, 
although Mr. Stupak appeared before Mr. Deutsch. So Mr. Stupak 
will be recognized.
    Mr. Stupak. Well, thank you, Mr. Chairman, and thank you, 
Mr. Deutsch.
    Mr. Chanos, I did have a chance to read the article in 
Barron's there and on the last page of that article that was on 
our desk here it said that your correct prediction of Enron's 
demise, it is reported that you suspected more will be 
discovered. Specifically, the article says that you suspected 
other Enron partnerships were used and I'm going to quote now 
``to boost Enron profits by acting as a dumping ground for 
losing trades, bad long-term investments and busted Enron 
investment banking deals.'' The article also says that you 
think ``once Enron's long-term energy trades are properly 
marked to the market, other profits will simply melt away.''
    Can you give us just a little bit more of what's the basis 
for your concluding this in this article?
    Mr. Chanos. Well, again nothing other than a pattern that 
we saw which leads us to believe that if Enron was going to 
great lengths to basically hide losses in its merchant banking 
and other areas through the use of SPEs, it seemed to--and I 
read the report that the company put out, just a simple 
violation of accounting rules, well, why wouldn't they also 
gain in the great, gray morass of the mark-to-market or gain on 
sale area that we discussed a little earlier, be perhaps a 
little bit too aggressive.
    One note I point to there is in the now infamous or famous 
Watkins memorandum that came out. She referred the use of 
partnerships to--and again, I'm going from memory here, but to 
act as a repository for EESMTM positions was, I believe, the 
line she used and we took that to mean Enron Energy Services 
mark-to-market positions. So that's one internal person who 
seems to also believe that may indeed have happened.
    Mr. Stupak. Well, let me ask you this, I mentioned the 1995 
so-called Security Reform Litigation Act, one that I strongly 
disagree with and when you talk about safe harbors for forward-
looking statements that Congress enacted as part of that so-
called reform in 1995, in what ways does that provision prevent 
investors such as yourself from really obtaining accurate 
information about a company's current and future prospects, how 
are corporate insiders using this provision to avoid meeting 
their duty of public disclosure responsibilities?
    Mr. Chanos. How does this prevent us from getting 
information?
    Mr. Stupak. Right.
    Mr. Chanos. I don't know how it prevents us from getting 
information, Congressman. I think the problem I have with it is 
on the back end of it. What happens when the system fails and 
when you're providing some sort of umbrella against litigation 
for the watchdogs for these kinds of things and for managements 
that knowingly try to deceive their shareholders. That's the 
problem I have with it. I'm going to still be able to do my 
job. We're going to go through the footnotes and we're going to 
ask questions and we're going to do everything we possibly can 
on behalf of our investors which I have fiduciary 
responsibility to, but my concern is more to other investors 
who don't have the resources we do or the experience we do and 
have been wronged where there's this asymmetric risk/reward for 
corporate managements as we've talked about. If I give back 
half, will you let me go free? I just don't think at the end of 
the day that's fair.
    Mr. Stupak. With these forward-looking statements, the 1995 
reform, sort of use your words, ``provides an umbrella of 
protection'' and in fact, I think 1995 reform goes so far as 
saying even misleading statements in a forward looking 
statement is not actionable after 1995. Is that correct?
    Mr. Chanos. That's my understanding.
    Mr. Stupak. I know of others and I've prepared some 
legislation that would restore the joint and severable 
liability for accountants that also provide consulting services 
to the same clients and eliminate the current Catch-22 
situation which plaintiffs can't get discovery against the 
accountants needed to pursue claims against them and restore 
liability for aiding and abetting securities fraud.
    Would you support these types of reform or restoration of 
the action that we had before this 1995 reform went in?
    Mr. Chanos. I'd like to see some middle ground. I would not 
like to see wholesale abolishment of that act because I do 
think it accomplished some very good things on one end about 
frivolous lawsuits that are filed and were filed prior to the 
act.
    I don't want to comment on the specifics of the joint and 
severable question because I'm not an expert there. I just 
think that to fall back to what I've said, there's got to be a 
middle ground here to protect corporations and protect the 
managements from making honest statements about what they know 
about and not be sued and not be found liable and yet punish 
those that use this as a way to defraud investors of the 
marketplace. It's got to be better than all or nothing.
    Mr. Stupak. When this whole thing shakes out, this whole 
Enron, whether Enron aided and abetted Arthur Andersen or 
Arthur Andersen aided and abetted Enron, under the 1995 reform, 
again, that umbrella gives them protection that they did not 
have before which help leads to this cavalier attitude that we 
see at least in Enron and hopefully not in other corporations, 
but possibly in other corporations too, according to your 
article in Barron's. Is that a true statement?
    Mr. Chanos. I think it's an accurate interpretation. I 
would agree with it.
    Mr. Stupak. Professor Dharan, some of the infamous Enron 
partnerships apparently ran afoul of accounting standards which 
used a so-called special purpose entities, the SPEs, to have at 
least 3 percent outside equity. Now to me, that doesn't make a 
lot of sense to have a 3 percent equity. That was not what it 
was set up for. Before in accounting standards you always had 
to have at least 50 percent before it triggered an accounting 
standard. Would you be in favor of repealing this 3 percent 
rule?
    Mr. Dharan. Yes, I would be. The 3 percent rule as I 
indicate in my written testimony really came about in a very ad 
hoc accidental way. There was not really a whole lot of 
discussion. It came about not even in the primary rulemaking 
group, the FASB, but one of its emerging issues task force 
group. I think in hindsight, it was pushed by the industry 
group that benefited most from it, rather than any kind of a 
good accounting analysis, so I would certainly support 
repealing that.
    Chairman Tauzin. Would the gentleman yield on that?
    Mr. Stupak. Yes, I would, Mr. Chairman.
    Chairman Tauzin. What industry groups benefited from such a 
low equity requirement?
    Mr. Dharan. I think definitely the companies that were 
sponsoring them needed to have a very low threshold. They don't 
have to report those partnerships and the industry groups that 
would have supported them would be the liars in the accounting 
firms that are supporting the companies to form those special--
--
    Chairman Tauzin. So would you agree that the people that 
pushed the rule were people that just wanted to have a leverage 
transaction and not necessarily really have a true partnership?
    Mr. Dharan. I think so. I mean definitely that's my 
judgment, looking at the history of the 3 percent rule.
    Mr. Stupak. This 3 percent rule, just so the record is 
clear was really developed by the Financial Accounting 
Standards Board, is that correct? And that gives advice to the 
SEC. It wasn't something Congress created.
    Mr. Dharan. That's correct. It was created by a group of 
the FASB called the Emerging Issues Task Force.
    Mr. Stupak. When you do a statement, a corporate statement 
profit/loss, is it your impression all profit/all loss which 
can be attributable to a company should be listed, even if 
there's these partnerships? How would you list it?
    Mr. Dharan. I think the answer if I control the 
partnership, I should also report the gains and losses from the 
partnership, but also we need to look at the collectability, 
and what's the quality of these numbers? Do we have any 
confidence that we are going to get the gains or are these 
gains completely self-estimating numbers that cannot be 
verified? If the gains are fairly reliable and there's a high 
degree of probability that I can get the money, then it makes 
sense for the company to report those gains. Currently, we 
don't have that system in place.
    Mr. Stupak. And in this case, these SPEs, because Enron 
pledged its stock to secure the loans and everything else, they 
had basically control of these and they should have put their 
profits/loss there for----
    Mr. Dharan. I think so.
    Mr. Stupak. I guess it goes back to what Mr. Raber says. I 
guess it's independence information and integrity and until we 
get that, we're going to continue to have problems like Enron.
    Chairman Tauzin. The gentleman's time has expired. I thank 
the gentleman and the Chair recognizes the gentleman from 
Arizona, Mr. Shadegg for a round of questions.
    Mr. Shadegg. Thank you, Mr. Chairman. Gentlemen, let me 
start by saying I've spent now 3 days in Enron hearings. I 
began Tuesday afternoon, where we heard testimony from the head 
of SEC and we also heard Dean Powers' Report. I then spent 
hours yesterday with the head of Arthur Andersen and I want to 
tell you by far and away this has been in terms of solving the 
problem, that is, giving us help and guidance in what we should 
do going forward, the most useful panel.
    I also want to say that I strongly concur with Mr. Sokol 
and Mr. Barton in contending that this is incredibly important. 
I believe, indeed, the economy of the Nation and damage to the 
economy of the world depends upon how this issue gets resolved. 
If we do not have clear and understandable rules, if people 
cannot rely on our markets as honest and fair, then we are in 
serious trouble in a world economy. And so I do think this is--
Joe said he'd never seen a more important subject dealt with in 
a more boring way. I do, in fact, think it's the most important 
subject that I've heard while we've been here. I'm not certain 
that it's the most boring way. I am convinced that it's the 
most confusing way because you are all competing with each 
other and giving different answers to the questions that we 
have and I'm trying to get to some bottom lines and I don't 
know if I'll have time to get to all of them.
    First, some of the things in here are incredibly confusing 
to me and Joe's simple analogy of the old economy and the new 
economy, I'm really old economy, like Joe Barton, only instead 
of $8,000 income and $8,500 outgo in my family, it's about 
$8,000 income a month and $9,000 a month out. So my family and 
I are struggling to get to where Joe and his family are.
    Chairman Tauzin. You need one of those special purpose 
entities.
    Mr. Shadegg. Well, I'm going there. When I began my study 
of this topic and read special purpose entities and then I 
realized they were off balance sheet entities, as I said in my 
opening statement, I thought well, gee, Shirley and I need to 
create an off balance sheet entity. We'll put all our debt over 
there, then we can qualify to buy to move to a much larger 
mortgage to build the house we'd like to build. And really, my 
initial reaction was why in the world should there be any off 
balance entities? Why shouldn't all balance sheets be 
completely consolidated. I've now come to the conclusion that 
that's a too simplistic approach and that indeed there might be 
circumstances under which you need a special purpose or off 
balance sheet entity. But I am troubled by this. It seems to me 
on the one hand if you don't set bright rules and you instead 
use judgment which is the argument that I believe Dr. Dharan 
you made for saying you shouldn't have a 3 percent rule, 
obviously, too arbitrary; you need a judgmental rule about 
control. The problem that I have with that is that when you 
listened yesterday to the head of Arthur Andersen and you 
realized that--and he made the same argument--we should use 
judgment as to whether these really should be off balance 
sheet. The problem is that the money involved, the amount of 
money that the accounting firm gets to make this judgment call 
of whether it's a bonafide or not a bonafide off balance sheet 
entity, makes it I think, quite frankly impossible for those 
individuals to be expected to make a fair call. So that gives 
me serious trouble.
    And then we get down into the next step of detail, let's 
talk about FASB. FASB was involved in setting the 3 percent 
rule and I think I completely agree with one thing here trying 
to distill it. It seems to me that FASB is not, as I think 
several of you have said, doing its job. It is not up to speed. 
It is not performing its task quickly enough or aggressively 
enough. Is there anybody here that disagrees with that?
    Okay, good, we got a--Mr. Sokol?
    Mr. Sokol. Congressman, just can I make a statement to 
that? The accounting issues are complicated in some ways but 
rather simple. The real issue is the misuse of accounting 
principles to deceive investors and to deceive a balance sheet.
    Mr. Shadegg. Okay, I agree with you there. There is misuse 
and there is fraud and somebody ought to catch that and 
somebody needs to supervise and we're going to get just a 
minute to SEC's enforcement of the FASB rules, but I think I 
just got agreement on everybody that the FASB rules aren't up 
to speed, the 3 percent rule was ad hoc, it's out of date. I 
think somebody mentioned that they're working on a 
consolidation rule. I'm having real trouble with how anybody 
can have any faith in this market if there isn't a clear set of 
rules on what has to be consolidated on your financial 
statement and what doesn't. And so again, I think FASB needs to 
be kicked and moved forward and that seems to me that's one of 
the things that comes out of this process and I assumed 
everybody agreed.
    Okay, second, Mr. Longstreth, you said SEC has enforcement 
powers and I think it does have enforcement powers, but I think 
everybody agrees that SEC is not aggressively enough enforcing, 
using its enforcement power. That would certainly be your 
position, would it not?
    Mr. Longstreth. Yes, it is my position. Over the years, 
they have not used those powers as effectively and as 
aggressively as they should have.
    Mr. Shadegg. So as a group, is there anybody on the panel 
that disagrees with that and says no, SEC has been adequately 
aggressive in its use of its enforcement powers? Nobody 
disagrees with that.
    One of the things I worry about and lose sleep over is that 
we can--somebody said here already we screwed up a couple of 
things in Congress by interfering in these things. We have no 
direct control over FASB. The question is should we get 
involved--should government take over FASB? I don't think so. 
We have some control over SEC, but it is an independent entity 
and we have some authority to help encouraging it to use its 
oversight power. But I am most intrigued, Mr. Chanos, by the 
point you made and that is in all of time or maybe you just 
said in the last 10 years, you don't know of a single instance 
where an inside auditor or any regulatory entity discovered at 
the initial stage fraud or one of these problems and you said 
it's always been discovered by either the press or short 
sellers. And I'm fascinated by that because that basically says 
look, the market is the answer here and the market will solve 
these problems and I see that happening. I mean the sell-down 
that occurred the day before yesterday shows a little bit of 
that right now. And I guess I'd like you to expand on how we 
can use that, not to create more regulation, but is there some 
way that we can rely on short sellers? Is there--should the SEC 
have a rule that says if there's a certain level of short 
selling that should trigger an investigation? How do we take 
advantage of the market scrutiny that short sellers are 
performing to catch this kind of problem?
    Chairman Tauzin. The gentleman's time is expiring, but 
please answer the question.
    Mr. Chanos. I'm not so sure how you would do that. I made 
the point that Wall Street analysts and accountants were not 
the--I can't find any instance where they were uncovering these 
things. I don't know. It's--I think that the free market does 
work. I'm a free market person myself. I think that there was 
an editorial in the Journal today, Wall Street Journal today 
about short selling in the free market, that I would commend 
you all to read. I think it does provide an admirable function, 
watchdog in its own free market way by pointing these kinds of 
things out, but having said that, I think that I'm also in 
favor of full and free disclosure so that any investor not just 
people with our resources and expertise can go in and look at 
the financial statements and make informed decisions and I just 
feel that we're still falling short there.
    Mr. Shadegg. Well, we're clearly falling short there and I 
completely agree and I think consolidation of balance sheets is 
a huge part of that. I think abuse of special purpose entities 
is a huge part of that.
    Mr. Chairman, I don't have any other questions, but 
everybody else took a great deal of time. I do have one request 
of each of you. As I said, I think in terms of what we do as a 
Congress going forward and how not to overregulate, but how to 
try to solve some of these problems is extremely important.
    I'd like to make a request of you. I'd like each of you to 
submit to me and to the committee a list of the three or four 
specific things you believe Congress should do in response to 
what has occurred here and the one or two things you think 
Congress absolutely should not do. For example, everybody I 
think on this topic so far has said well, we ought to separate 
auditing and consulting. And yet here today I heard some 
intelligent discussion of how doing that arbitrarily may not be 
a prudent idea. So if you could just each take the time to give 
us three or four suggestions of what you think we ought to do 
and one or two suggestions if you have them of what we 
absolutely should not do, would cause a problem, I would 
greatly appreciate it.
    Chairman Tauzin. And I'm particularly interested when you 
do that, Dr. Lev, that you identify for us your projection, 
your forward looking statements on consequences, if you will, 
if you could do that.
    Mr. Shadegg. Thank you, Mr. Chairman.
    Chairman Tauzin. If you want to make some comments----
    Mr. Sokol. Congressman, if I could make a comment about the 
notion that no internal auditors and no internal managements 
have ever uncovered fraud within their company and turned them 
forward other than the press and short sellers. That's 
nonsense. I think that's an offense to the best capitalist 
system in America. In our own company last year, we found an 
accounts payable person in a title business, had embezzled $1.7 
million and it was found internally, it was dealt with. She's 
being prosecuted and a good portion of the money has been 
recovered. That goes on every day. The internal audit function 
of a corporation is essential and to say that it has never 
functioned properly is wrong.
    Enron is a graphic example of the misuse of the system and 
I think there again people need to be punished, but it would be 
imprudent for me to sit here and say that there's no function 
for an internal audit organization----
    Mr. Shadegg. Well, by no means did I intend to imply nor do 
I think that Mr. Chanos said there's no----
    Mr. Chanos. That's not what I said. My statement said that 
there hasn't been one major financial fraud in the United 
States in the last 10 years that was uncovered by a major 
brokerage house analyst or an outside accounting firm.
    Chairman Tauzin. I've got to move on, but I should tell you 
all that in our investigation we discovered that Arthur 
Andersen did discover problems and unfortunately perhaps didn't 
report it, timely or properly, but they did uncover the fact 
that the first Chewco had not been capitalized correctly and 
therefore they had to restate the earnings. I think this came 
from the accounting firm at some point.
    Mr. Shadegg. My only point was as a foundation I think 
short sellers are something we ought to also be looking to.
    Chairman Tauzin. I thank the gentleman. The Chair 
recognizes the gentleman from Florida, Mr. Deutsch. While I do 
that, I want you all to know that the Subcommittee on Oversight 
and Investigations meets tomorrow with all the principals at 
Enron invited, some of whom will take the fifth, some of whom 
will testify and Jim Greenwood, the chairman of that 
subcommittee, and his ranking member, Mr. Deutsch, have done a 
fabulous job of bringing these facts to the attention of the 
committee and I wanted to commend him for his excellent work 
with Mr. Greenwood.
    Mr. Deutsch?
    Mr. Deutsch. Thank you, Mr. Chairman, and again, I 
apologize for not being here the entire day, but having sat 
through an entire day yesterday I'm looking forward an entire 
day tomorrow. My staff has been here and I've read some of the 
testimony. I want to focus on two very specific questions and 
just in a general way, this is an issue, this is my twentieth 
year as an elected official, my tenth year in Congress. As a 
policy issue, I have been sort of fascinated in many ways, but 
one is just the public's just absolute fascination, intense 
interest in this and that's one of the reasons why we're driven 
to some extent by not just issues, but really what our 
constituents want us to look at. I think part of that is in the 
real world people just see this as an incredible injustice 
what's occurred and that really at the end of the day we don't 
know how many, but probably thousands of people who lost their 
retirement savings and are in terrible situations and people 
can relate to that. I guess what I want to specifically focus 
in on is that in the accounting profession, my understanding is 
that when the accountant signs off on the audit, they say that 
it fairly represents what is going on in the company. That's my 
understanding what they're actually signing. And I think by 
anyone's normal definition, that that was not, the books did 
not fairly represent what was going on in Enron. And I'm not 
convinced at this point that that Andersen violated the law or 
violated accounting rules in terms of what they did, but I 
think what they did by any normal definition is that it did not 
fairly represent what was going on.
    And I guess what I'd like to focus on is maybe there's 
another way of looking at that. If, in fact, audits fairly 
represented what was going on, then Enron wouldn't have 
happened and obviously our concern is how many other Enrons are 
there out there because if people are living on the edge and 
gaming the system as obviously occurred here, I mean if you 
can, if any of you could try to elaborate on that, that in the 
existing rules, it should not have happened by normal 
definitions, but obviously it did.
    Dr. Chanos, you're nodding, so I welcome your comments.
    Mr. Dharan. I could probably spend a second on that. The 
existing rules do a fairly good job insofar as some problem 
areas that I have pointed out earlier such as the extensive use 
of mark-to-market accounting for items that really should not 
have been applied to, and also the use of special purpose 
entities.
    Mr. Deutsch. I guess what I'm saying though that general 
statement of fairly represent, that is something that Andersen 
signed. They said that it fairly represents and how by any 
normal definition it obviously didn't.
    Mr. Dharan. I agree. I think they said two things and 
typically this has been argued in courts quite a bit and again, 
I'm not a lawyer, but there are two phrases that auditors use. 
One is ``fairly.'' And then very next couple of words later 
they say ``in conformity with generally accepted accounting 
principles.''
    Mr. Deutsch. Right.
    Mr. Dharan. And surprisingly, Congressman, there is no in 
between clause like ``and'' or ``or'' or ``except for'' so when 
they say ``fairly'' and ``in conformity with generally accepted 
accounting principles'' there's no real ``and'' there. So they 
hang on to that accepted accounting principles. The investor, 
the public, you are absolutely right, should be looking at the 
word ``fairly'' in a different way, but I don't think my 
understanding is that's not the way the courts look at it.
    Mr. Deutsch. I guess what I'm struggling with is that's 
really what the expectation is. That's what the system working 
is that there's transparency, that it is fair. And obviously, 
the big concern, the big policy issue that we're looking at is 
if we lose investor confidence, the system that exists which is 
by far the greatest economic system ever created and brings us 
such positive things as a society, is challenged. It is being 
challenged today and we're challenging it. That is really what 
we're trying to get. And I don't know--I mean our job is to 
legislate and try to figure out how to get to that point, but 
it goes back to that's what people want. They want that 
transparency. The accounting firms are saying that it fairly 
represents and yet, it's not occurring.
    Did anyone else want to comment I mean just about that?
    Mr. Lev. I can make a comment on that. I mentioned it 
before in my testimony. This report I have here an example of 
the uniform report. It's filled with hedging. It starts by 
saying ``this financial statement is the responsibility of 
management'', hedging No. 1. Hedging No. 2, ``we conducted our 
audits in accordance with auditing standards generally accepted 
in the United States'' which means someone else directed us to 
do what we do. And third one is what Professor Dharan 
mentioned, ``represents fairly in conformity with accounting 
principles generally accepted in the United States.'' This, in 
my opinion, is not an informative report and it definitely has 
to be replaced by an open ended report which will provide 
information, which auditors will tell you what they found, what 
they didn't find, what's their opinion on their internal 
controls in the company, what's their opinion on the corporate 
governance. Questions, something very important, questions that 
they put to management and were not answered; suggestions that 
they made that were not implemented. This has to go out. And 
then people will have some degree of comfort that you 
Congressmen are looking for.
    Mr. Deutsch. In terms of suggestions, so obviously that 
changes dramatically the way the public accounting system is 
set up today?
    Mr. Lev. Yes.
    Mr. Deutsch. Is that specifically, I mean recommendations 
that you will be providing us or that we're looking at at this 
point? I mean----
    Mr. Lev. I already provided it. I wrote about it and I 
strongly believe in this. This is not a statement that is worth 
much.
    Mr. Deutsch. The one final question that I wanted to at 
least offer the opportunity for you is again this sort of 
common sense uses and it's on the security side in terms of 
fraud. I mean as we--in the hindsight that we have now, I mean 
we look at what Enron did, I mean at so many different levels, 
that by any common usage would be fraud. And again, it 
ultimately might be determined either through prosecution, 
through SEC work, of actual criminal fraud.
    But I guess the question is and I'm reminded, the thing 
that I keep coming back to personally, as I'm looking at what 
happened with Enron is a scene in the Godfather movie where the 
attorney, Tom Hanks, comes to the Godfather and the Godfather 
says to him I want you to always remember you can steal a lot 
more with a briefcase than a gun. And when I look at this whole 
episode of Enron, I mean we can add up how much they stole, but 
it looks like they stole maybe as much as $4 billion, I mean 
which is an incredible amount of money and obviously, I can't 
think of a violent crime with a gun where anyone could conceive 
of stealing that much money. And it was at that level in terms 
of what they were doing day by day. And that, a very creative, 
very, very bright people, but really almost evil people because 
every dollar they were stealing, they were stealing from 
someone else. It wasn't a value added business. We've gone 
through enough stuff at this point that it really was not 
value--I mean there's lots of people in America, thank God, who 
have made billions of dollars, who have come up with some great 
ideas and some investors or maybe even some shortsellers who 
have been able to figure out the market through work of their 
own, but in this case, I think we know enough now that 
basically the money was stolen from other people Go ahead.
    Mr. Raber. It's interesting and talking to some of our 
directors who are reacting to Enron, there's an consensus that 
many times throughout their life as a corporate director 
something didn't smell right, something bothered them. And 
we're starting to see more and I don't know enough about Enron 
to know what happened, but I suspect that those board meetings 
and committee meetings there were some board members who felt 
something is wrong here. Now what's happening insofar as 
corporate directors, they're going to be a lot more aggressive 
in asking questions. And I also see, to go back to your comment 
about audit committees. Audit committees want more than just a 
testing, that this has been done appropriately, this particular 
audit. They want it raised to quality and independence. As a 
result of that, we're trying to provide guidance to them about 
red flags, questions to ask and I have to say that's the 
courage and integrity I talked about in my testimony is that 
were there times during Enron board meetings and audit 
committee meetings there was a sense that something was wrong 
here. And go back to some of the fraudulent areas, we know that 
outside board members, if they sense something is wrong, that's 
where they refer to a special committee. Let's take it the next 
step. It doesn't mean that there is something fraudulent, but 
when something like that starts bothering you, even though you 
may not have a sophistication in financial areas, you should 
have enough to know this does not ring right.
    Chairman Tauzin. The gentleman's time has expired. And I 
might point out that we'll have tomorrow at our O&I hearing, 
individuals who worked for Enron who did smell something wrong 
and tried to do something about it. Stay tuned.
    The gentleman, Mr. Shimkus, is recognized, for 5 minutes.
    Mr. Shimkus. Thank you, Mr. Chairman, and I appreciate you 
putting in a long day. Obviously, we are all very disheartened 
and frustrated, but I want to talk about--I only have one 
question and it kind of refers to the man on the street, the 
individual who given clear and concise information can then 
make decisions and be held accountable for the success of those 
decisions or the failure of those decisions. When it's 
disassociated through false information that's what's brought 
us here today. Folks are--they had made the personal decision 
of putting money in a gold mine, then they would say oh, I made 
a stupid decision, but someone was managing this for them.
    So I have a question for the folks who are addressing 
questions on the accounting issues, Mr. Weil, Mr. Dharan and 
Mr. Lev and Mr. Longstreth. And it deals with this whole issue 
of pro forma disclosures and are they really useful? Are they 
abused? I mean we understand spin here in Washington. The 
question is are pro forma statements used more for spin or are 
they used, or are they really an important accounting vehicle 
to let the individual consumer know what's going on and then if 
you would just try to answer that and give me your--and then if 
anyone else wants to jump in, but that's how I'm going to use 
my time----
    Chairman Tauzin. Would the gentleman yield?
    Mr. Shimkus. Yes.
    Chairman Tauzin. The gentleman is talking about the 
statement by Enron, for example, that the billion dollars was a 
nonrecurring problem, was that spin, did that help anybody? 
What's the story on that?
    Mr. Weil. Let me work on this and it dovetails with the 
previous gentleman's questions. We used to have a free market 
in accounting. There were no regulations. Companies went out 
voluntarily and hired accountants to do a report and we got 
pro's statements of what was going on which is what Professor 
Lev would like to see us have now. I don't see how to legislate 
people using judgment. You invite them to do it.
    Pro forma earnings have that characteristic. They're not 
governed, they're not regulated. Some people find them useful. 
Some think they're silly. My colleague professors who studied 
these things scientifically are not persuaded of the 
information merit therein, but I don't see that they do any 
harm because you're alert of what it is. It's the company spin. 
I think you've got the right adjective and I don't see anything 
wrong with it. People get to do what they want to do and the 
analysts get to decide what makes sense.
    Mr. Shimkus. Just go down the table then, Mr. Dharan?
    Mr. Dharan. I happen to disagree with that entirely, 
unfortunately. I think the problem with pro forma earnings is 
that we have a whole system we are trying to fix here which is 
the generally accepted accounting principles. We want companies 
to be able to properly calculate earnings and report it and we 
want investors to be able to understand it, but as soon as we 
allow companies to report in addition to their pro forma 
earnings, the entire focus shifts to pro forma. So the entire, 
the effort that we are all trying to do to strengthen the 
system is completely taken away. It gets diluted. And there's 
no reason to talk about lack of regulation for pro forma 
earnings because these earnings releases should be looked at by 
auditors, should be looked at by lawyers. These are numbers 
that are being communicated to investors and they should be 
regulated just like 10(k)s and 10(q)s because in the old days 
you got the 10(q) in the mail and you read it and you decided. 
Today, you look at the press release, you look at the internet 
and the analysts look at it, the market reacts instantly. And 
if you don't regulate this, we are simply ignoring the reality 
that information is going out through these numbers more than 
the 10(q)s.
    Mr. Shimkus. Mr. Lev?
    Mr. Lev. I don't have very strong feelings about pro forma. 
I tend to agree with Roman Weil that I definitely don't think 
they should be banned. As long as you get earnings or some kind 
of regulated earnings, I don't' see any problem when managers 
are saying that they think that there is another measure which 
reflects better. They don't believe them. They don't look at 
this measure. They don't use this measure. I don't think this 
is a major problem here.
    Mr. Longstreth. I think it's a problem of you can lead a 
horse to water, but you can't make him drink. The earnings, 
according to GAAP are filed by the corporations. They're 
available to the analysts. The analysts call in the first call 
or IBIS and give their estimates. The problem is that the 
analysts have not bothered to look much at the earnings 
according to GAAP. They prefer to take the advice from 
management of what operating profits are going to be with very 
substantial freedom on the part of management to define that 
the way they want to define it. Then they pass it on to first 
call and it gets cooked into the system and everyone says well, 
the companies--the S&P 500 is going to grow at a certain rate. 
The Wall Street Journal did kind of an expose comparing the P/E 
ratios based on earnings as reported according to GAAP compared 
to operating profits that were reported and cooked into the 
first call estimates and it was a spread of something like 23 
times earnings for the--on the basis of the operating profits 
and about 40 times earnings on the basis of the filed earnings. 
So I don't know, I think the private sector has got to get a 
little more realistic in using the data. I don't think there's 
anything to do there with rulemaking.
    Mr. Shimkus. And Mr. Chairman, I yield back my time, thank 
you very much.
    Chairman Tauzin. I thank the gentleman. The Chair 
recognizes the gentleman from Texas, Mr. Green, for a round of 
questions.
    We're coming to the end of this long afternoon and evening 
and I want to thank you again for your patience, gentlemen.
    Mr. Green.
    Mr. Green. Dr. Weil, and frankly for everyone who has 
experience in accounting, I've reviewed your testimony and I 
have a question that's come up. Are you conceptually familiar 
with the practice used by some law firms in our country to shop 
around opinions, for example, that they find new loopholes or 
what they think are loopholes in the tax law and that allows 
companies to lessen their tax burden so they'll shop that 
opinion around?
    Is that something you're familiar with?
    Mr. Weil. We have a phrase, ``opinion shopping'' in 
accounting, but the SEC went after that a decade or two ago and 
it's a lot less problem than you might think because if you go 
opinion shopping and decide to get rid of this auditor and pick 
that one, you've got to send a letter explaining why you fired 
the first one.
    Mr. Green. Well, let me--I've met with a former Arthur 
Andersen employee who worked in the Houston office and he told 
me that Andersen had a similar practice, they pitched for new 
business development. I was told that the Houston office of 
Arthur Andersen had something called the book of ideas and this 
book was described as containing accounting suggestions that 
while technically in compliance with Financial Accounting 
Standards Board, was actually a manual for aggressive 
accounting and like my other colleague from Texas I was a 
business major and I think I took 12 or 18 hours in accounting 
as an undergraduate. But I was wondering if this is a type of 
material commonly compiled by our Big Five accounting firms to 
encourage aggressive accounting?
    Mr. Weil. I don't know and it would be dangerous to 
speculate about that one.
    Mr. Green. Someone never has heard of something similar 
that maybe a firm, and again, I had up until Enron, I had 
probably the highest respect for Arthur Andersen.
    Mr. Dharan. I have never heard of this before, but it does 
sound like it is pushing aggressive accounting in some way, if 
it is true.
    Mr. Green. Mr. Chairman, this information wasn't available 
when our subcommittee had the Arthur Andersen folks, but I 
would sure like to subpoena their records or maybe we can make 
that available, that former staff member to our committee.
    Chairman Tauzin. If the gentleman will yield. Will you make 
the information available to our investigators and we'll chase 
it down for you, obviously, we are going to have, as you know, 
a FASB hearing and it might be appropriate to have that 
information available for that hearing.
    Mr. Green. Okay, thank you, Mr. Chairman. Mr. Chairman, I 
have no other questions. It's been a long day for our witnesses 
and I thank them for their time.
    Chairman Tauzin. I thank the gentleman and for the last 
round of questions, I'm pleased to recognize my friend from 
Nebraska, Mr. Terry.
    Mr. Terry. Thank you. You should be glad to know we go by 
order of seniority and I have the least which means I'm the 
last.
    Mr. Sokol, you haven't participated much, mostly because 
you offer an expertise in energy market and business practices, 
but you stated something in your testimony that has gnawed at 
me, even before you came here today. You said that Enron trades 
25 percent of the natural gas, but yet you testified there were 
no effects on the market, including especially to consumers. 
Why? What went right in the market specifically that protected 
the market, protected the consumers. You would think that an 
entity that controls 25 percent of the trading market of 
natural gas that there would be catastrophic effects. Certainly 
we heard news reports that Kenneth Lay was projecting that 
there would be catastrophic effects if someone didn't ride to 
the rescue.
    Mr. Sokol. Well, first, Congressman, both natural gas and 
electricity was estimated at about 25 percent market share in 
Enron's trading activities. I think the important point first 
is that they didn't control it. They traded it. They did not 
control the flow. They controlled the trading or they were 
participants in that amount of trading.
    What really occurred and what has shown itself to be, 
frankly, I think surprising to all of us is the incredible 
depth of the energy trading markets. Basically, within a 24-
hour period when it was pretty clear that Enron on-line was 
going to be going off-line, the rest of the marketplace picked 
up all those trades. What it really tells and actually it's 
probably a point that Mr. Chanos would recognize as well, that 
Enron really wasn't making very much money in those trades 
because if they were, there would have been a significant 
dislocation for at least a short period of time as all those 
trades shifted to other people that wouldn't make them. The 
reality was many of us believe they were kind of a trader of 
last resort almost, just to have the volume because literally 
when you're talking about billions of dollars of trading and 
the market doesn't move a fraction of a percent when the 
largest trader goes under, that can't happen if they're a large 
market maker and so it's--I think it is a tribute to the depth 
of the wholesale trading markets that are out there and 
frankly, I don't think we're likely to see anyone else even 
approach that level of involvement in the market now because 
it's recognized that it's not necessary.
    Mr. Terry. Interesting. One other aspect that you touched 
on, but not as much as I expected, is PUHCA. One of the issues 
that I want to ask you about today is one I've heard about from 
some of my colleagues, especially, that Enron's failure 
symbolizes why we shouldn't move forward with deregulation. 
Within that deregulation genre, I've heard specifically PUHCA 
and frankly, I don't understand any connection here to PUHCA in 
Enron's failure. I want you to expand on whether you feel that 
there's a connection. And second, there have also been 
accusations that Enron has received exemptions from PUHCA and 
other regulatory requirements that have led to its demise.
    Do you have an opinion on whether or not there's a causal 
link?
    Mr. Sokol. I have a tough time staying in your timeframe. 
First, in the testimony I think I do hit those points, but 
there really is no relation to PUHCA. In fact, I would make two 
points to the chairman about what you're doing here. One is 
that energy modernization regulation has to continue forward. 
The Senate is moving forward, hopefully House 3406 will move 
forward because the Enron problem cannot stop us from crossing 
the street. We're about halfway across it from 1992 when the 
wholesale markets were opened and we need to modernize the 
regulation for natural gas and electricity. That needs to 
proceed.
    What you're doing in regard to Enron is hugely important, 
but I think important that these gentleman are making. There is 
no simple fix to what happened to Enron. Enron, to me, taking 
into account the criminality is the culmination of the excesses 
of the 1990's. Now again, with criminality. It's not to say by 
any means even a significant portion of corporations are doing 
what they were doing. But it does, I think, cause all of us 
including Congress to take pause and say can we do better? 
These gentlemen who have much more expertise, obviously, in the 
accounting side have numerous ideas. I mean proportional 
accounting. Why should executives be allowed to sell stock and 
report it 30 days later? Compensation accounting for options. 
There are serious abuses out there and they need to be fixed, 
but there's no single answer and I think holding hearings, 
asking expert testimony and ideas is the only way you get to 
fix the problems and move forward, but we would certainly urge 
you in the energy industry not to slow down with energy 
regulation modification because it's essential to keep that 
part of our economy moving forward.
    Mr. Terry. Thank you. That's all, Mr. Chairman.
    Chairman Tauzin. If the gentleman, Mr. Terry, will yield?
    Mr. Terry. Yes, I yield.
    Chairman Tauzin. I think it's important to point out that 
the work that has been done by the subcommittee by Mr. Joe 
Barton's subcommittee on the energy markets, particularly the 
work he's done in helping to ensure transmission facilities are 
adequate and that there's adequate supplies in the marketplace 
for it to function is going to go on and what's interesting 
about the product he's got is that it doesn't contain the Enron 
recommendations. It's very different from what Enron asked for 
and wanted, but it is essential, Mr. Sokol, that you were here 
today and it's essential that Joe have this hearing this week, 
that we can literally elaborate on the Enron effect on those 
markets. Get a clear picture of them so that Mr. Barton's 
subcommittee has that as a background to its work, as it 
continues its work toward making sure those markets are sound 
and we don't have California-like problems in the rest of the 
country. We're not going to stop that work. We simply want to 
make sure with this Enron situation that they're not at loose 
ends that need to be covered in that legislation as well.
    I thank the gentleman for yielding. The gentleman is 
complete, then I thank the gentleman for his time.
    Let me conclude, first of all, just you and I, let me make 
the point that 4 years ago if you had told me that we could 
have 40 members of my committee attend so serious a session to 
listen to a bunch of accounting professors talk to them about 
these esoteric kinds of issues and that four cameras would be 
here to cover this, I would have laughed. In fact, years ago, 
several years ago when we talked about having public hearings 
on the issue of separating the auditing functions and 
accounting functions and there was not any takers, nobody was 
willing to come to those public hearings and debate them and 
discuss them.
    The Enron situation has caused us all now to take this much 
more seriously and to take your advice seriously. The record 
will stay open for 30 days. Several members have indicated 
they'd like you to respond in writing to some specific requests 
for information. I have raised the question. I have not gotten 
an answer to yet and I would love for you to respond to it. 
That specific question is whether or not if we go to general 
principles as opposed to specific rules do you have a problem 
with two different accounting firms interpreting them so 
differently that it causes friction and confusion rather than 
clarity for American investors? I'd love you to think about 
that and come back to us with some description.
    Most importantly, when you do write recommendations to us, 
1, 2, 3, 4 things we ought to do legislatively which is where 
we're going to try to get to as rapidly as we can, I'm most 
interested in you thinking through the unintended consequences 
of changes we make. One of the things I have cautioned the 
subcommittees who will be working on these issues is that if we 
make too drastic a change in the way in which this is reported 
and the way in which accountants have to classify income and 
debt and the way companies have to report them, that we might 
have some unintended consequences of making it appear as though 
companies who have legitimately used devices like special 
purpose entities and other alliances and partnerships, we may 
make them look like they were doing something wrong when they 
were not and therefore undermine integrity and confidence in 
the marketplace. Those are serious kinds of concerns for me. I 
hope you will think about those, give us some advice, for 
example, as to transition, moving from this current way in 
which we interpret an audit report, what's included in it. How 
do we transition into a different kind of system? How do we 
move from that forum, Professor Lev, you said is worthless to 
one that's much more worthy of informing people and do it in a 
fashion that doesn't shake the world of investment in the 
meantime. Those are serious concerns I have for our committee 
as we move forward. You have been extraordinarily patient. I 
thank you for that. This has been, believe it or not an 
extraordinarily interesting session for me and I know for many 
members and I thank you for that.
    The hearing stands adjourned.
    [Whereupon, at 6:28 p.m., the committee was adjourned.]
    [Additional material submitted for the record follows:]

                      U.S. House of Representatives
                           Committee on Energy and Commerce
                                                  February 19, 2002
Mr. Baruch Lev
Philips Bardes Professor of Accounting and Finance
Vincent C. Ross Institute of Accounting Research
Stern School of Business, NYU
40 West Fourth Street, Suite 312, Tisch Hall
New York, NY 10012
    Dear Mr. Lev: Thank you for appearing before the Committee on 
Energy and Commerce to present testimony on Accounting Issues.
    Congressional hearings are used to build a record to assist with 
the Committee's legislative initiatives. I would greatly appreciate the 
benefit of your expertise in responding to some follow-up questions 
surrounding issues raised at the hearing. So that your answers may be 
included in the hearing record, please respond in writing to the 
attached questions by March 4, 2002.
    1. Your testimony regarding corporate disclosure points out that 
the system only reflects past transactions. The Chairman of the SEC, 
Mr. Pitt, recently spoke about supplementing disclosure with ``current 
disclosure'' of significant information as it arises? Please comment on 
the Chairman's proposal.
    2. You testified that the reporting of unexecuted obligations is 
deficient. What are the reasons for the deficiency in disclosure and 
how would you remedy the deficiency?
    3. You stated that our current system of accounting is geared for 
an industrial era based economy of tangible assets and that it largely 
ignores or misrepresents the value of intangible assets. Please discuss 
the consequences of the current system and recommendations for 
improvements.
    4. You testified that the current disclosure of specific risk 
exposure is insufficient. How would more accurate information or 
disclosure benefit investors? How do you balance necessary disclosure 
with a company's desire to keep secret its stragetic information?
    5. The number of earnings restatements each year is in the 
hundreds. Is this a recent phenomenon? Why is it occurring and what can 
be done to curb errors that cause restatements?
    6. You suggest mandatory auditor rotations every five years. What 
are the costs and benefits of such a system? Please compare them to the 
costs and benefits of the current system.
    7. You suggest restricting audit firms to performing consulting on 
a limited basis--25-30% of audit fees. Do you believe it is necessary 
to limit the consulting to specific types of services? If so, which 
services should definitely be excluded? Which should definitely be 
included?
    8. Under a regime that forecloses an auditor from performing 
consulting work for an audit client, will there be perverse incentives 
for the auditing firm to provide a poor opinion of the consulting 
firm's work in the hope of replacing its own auditing contract with the 
client's more lucrative consulting contract?
            Sincerely,
                                      W.J. ``Billy'' Tauzin
                                                           Chairman

                                New York University
                        Leonard N. Stern School of Business
                                                      March 4, 2002
Representative W.J. ``Billy'' Tauzin, Chairman
Committee on Energy and Commerce
U.S. House of Representatives
Washington, D.C. 20515-6115

Re: Response to your questions (from February 20, 2002), concerning my 
testimony before your committee (February 6, 2002).

    Dear Chairman Tauzin: The order of my answers follows your 
questions.
    1. Concerning SEC Chairman Pitt's comments about ``current 
disclosures.'' In general, the more current and timely the disclosure 
to capital markets, the more efficient and fair will these markets be. 
So, I definitely encourage quick and unbiased (e.g., not only good 
news) disclosure of business events.
    This, however, differs from my testimony about a major limitation 
of the accounting and financial reporting systems--the reflection of 
past transactions only (with few exceptions). Thus, for example, 
``unexecuted obligations,'' such as loss guarantees to special purpose 
entities, or provisions for future availability of raw materials and 
other inputs (known as ``take-or-pay contracts,'' or ``throughput 
arrangements''), create obligations which are not reflected as 
liabilities in the financial reports. (Unexecuted obligations arise 
from agreements related to future transactions).
    In my testimony, I strongly urged accounting standard-setters (SEC, 
FASB) to expand the scope of financial reports to include most 
unexecuted obligations. This can be done effectively and expeditiously 
in my opinion.
    2. Response include in (1), above.
    3. The issue of intangible (intellectual) assets, which are by and 
large not reflected in financial reports, is broad and obviously beyond 
the confines of this response. It is, however, thoroughly presented and 
analyzed in my recent book--Intangibles: Management, Measurement, and 
Reporting (Brookings Institution Press, 2001).
    For the record I will note that various estimates indicate that 
intangible assets (e.g., discoveries, patents, brands, unique 
organizational designs and processes, etc.) currently constitute 60-75 
percent of corporate value, on average.
    The socially harmful consequences of the failure to account 
properly for those assets (which are mostly expensed immediately by the 
accounting system), and disclose their attributes are numerous and very 
consequential. They include: using intangibles (e.g., in-process R&D) 
for widespread manipulation of financial information, excessive gains 
to corporate insiders from trading the stock of their companies, high 
volatility of stock prices, and not the least--excessive cost of 
capital to intangibles-intensive companies, hindering innovation and 
growth. (Elaboration on these social harms can be found in my book, 
referenced in (1), above, Chapter 4.)
    The accounting and financial reporting systems can, and should be 
significantly modified--for example GAAP rules for asset recognition--
to reflect vital information about investments in intangible assets and 
their consequences. At the minimum, corporations should be required to 
routinely disclose information on their investment in key intangibles--
brands, human resources, information technology, major business 
processes, and breakdown of R&D--and the consequences of such 
investments. Investors should be able to assess the desirability and 
productivity of such investments.
    4. Concerning risk exposure. The SEC required in the early 1990s 
some disclosure by corporations of risk exposure. This was a step in 
the right direction, but a very modest step which was not pursued 
vigorously.
    A system of ``stress tests'' should be developed, to reflect the 
consequences of foreseeable events on the company's operations and 
economic condition. Thus, for example, a globalized corporation exposed 
to foreign exchange fluctuations of the Euro or the Yen (relative to 
the U.S. dollar), should be required to provide information on the 
consequences of expected changes in the value of these currencies. For 
example, the consequences of changes of plus/minus 2%, 5%, 10%, 
relative to the exchange rates at the end of the year. Similarly, a 
company exposed to interest rate fluctuations, should report the 
results of ``stress tests,'' reflecting the consequences (gains/losses, 
changes in assets/liabilities) of expected changes in interest rates of 
0.25,0.5,1.0 percents.
    Similar risk-related information is currently requires from 
financial institutions. I favor expansion of such requirements to 
include non-financial enterprises.
    Concerning your questions about secrecy of strategic information, I 
sincerely doubt that results of stress tests will harm the competitive 
position of the corporation. To the contrary, I believe that a 
requirement to publicly report risk exposure will focus the attention 
of mangers and board members on a vital aspect of operations (i.e., 
risk) currently neglected in many corporations, as a result of the 
failure of the accounting system to reflect risk.
    5. You are perfectly right that the number of earnings restatements 
has mushroomed in recent years. New York University Ph.D. candidate, 
Ms. Min Wu, documented a sharp increase in restatements during 1998-
2001 (see attached graph from her dissertation).
    The major reasons for the increase in restatements in the late 
1990s are: the rise in uncertainty/volatility of the business 
environment in the late 199s, and the pressure from Wall Street to meet 
or beat the earnings forecast of financial analysts (the ``earnings 
game''). These reasons led many executives to ``manage'' their volatile 
earnings toward meeting the forecasts. Ultimately, however, reality 
catches up with such managers, leading to restatements, and in extreme 
cases to bankruptcies.
    Restatements of earnings are just a symptom of the futile but 
pervasive ``earnings game'' played by managers and analysts to the 
detriment of investors and the economy. Fundamentally, the earnings 
game, with its focus on short-term profits and a superficial concept of 
companies' operations (undue focus on accounting earnings), should 
stop. This is not an easy task, but expansion of the disclosure of 
relevant information--a central theme of my testimony--should lessen 
the adverse impact of the earnings game.
    6. Regarding auditors' rotation. I suggest not only a rotation of 
auditors, but mainly their selection and reappointment by shareholders 
every five years. (See my testimony). If shareholders are satisfied 
with the performance of auditors, they will reappoint them. So, 
auditors will not necessarily be changed every five years. What will 
happen every five years is a serious examination of auditors' 
performance, and an opportunity for competitor auditors to publicly bid 
for the audit engagement.
    While I have no reliable cost estimates for the proposed system, I 
doubt whether it will result in a significant cost increase. I am 
familiar with the argument that there are some ``learning'' advantages 
from repeating the audit over several years, but I am not familiar with 
any estimates of the magnitude (cost savings) of such learning. The 
benefits of my proposal in increased auditor diligence, knowing that 
their performance will be seriously evaluated every few years, and in 
the occasional dismissal of negligent auditors, will in my opinion far 
outweigh the additional costs, if any.
    7. Regarding consulting activities. I believe that if revenues from 
non-audit activities will be limited to a reasonable fraction of audit 
fees (I suggest 25-30 percent), then there will be no need to specify 
which services should be excluded--a difficult task at best.
    8. You ask: ``. . . will there be perverse incentives for the 
auditing firm to provide a poor opinion of the consulting firm's work . 
. . ?'' I doubt it. In general, auditors don't opine on managerial 
issues (e.g., effectiveness of operations, quality of the product, 
etc.), only on the faithful representation of financial reports. Most 
consulting engagements, in contrast, deal with management issues (e.g., 
improving information technology, streamlining human resource 
practices, etc.). Accordingly, I don't see a significant opportunity 
for auditors to criticize consulting engagements by other firms.
Concluding Comment
    The above responses are by necessity brief and hopefully concise. I 
will be happy to elaborate, in person, on any issue of concern to your 
legislative activities (within my range of expertise, of course).
            My best wishes,
                                                         Baruch Lev
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