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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

2

COMMITTEE ON ENERGY AND COMMERCE

W.J. ‘‘BILLY’’ TAUZIN, Louisiana, Chairman

MICHAEL BILIRAKIS, Florida

JOE BARTON, Texas

FRED UPTON, Michigan

CLIFF STEARNS, Florida

PAUL E. GILLMOR, Ohio

JAMES C. GREENWOOD, Pennsylvania

CHRISTOPHER COX, California

NATHAN DEAL, Georgia

STEVE LARGENT, Oklahoma

RICHARD BURR, North Carolina

ED WHITFIELD, Kentucky

GREG GANSKE, Iowa

CHARLIE NORWOOD, Georgia

BARBARA CUBIN, Wyoming

JOHN SHIMKUS, Illinois

HEATHER WILSON, New Mexico

JOHN B. SHADEGG, Arizona

CHARLES ‘‘CHIP’’ PICKERING, Mississippi

VITO FOSSELLA, New York

ROY BLUNT, Missouri

TOM DAVIS, Virginia

ED BRYANT, Tennessee

ROBERT L. EHRLICH, Jr., Maryland

STEVE BUYER, Indiana

GEORGE RADANOVICH, California

CHARLES F. BASS, New Hampshire

JOSEPH R. PITTS, Pennsylvania

MARY BONO, California

GREG WALDEN, Oregon

LEE TERRY, Nebraska

JOHN D. DINGELL, Michigan

HENRY A. WAXMAN, California

EDWARD J. MARKEY, Massachusetts

RALPH M. HALL, Texas

RICK BOUCHER, Virginia

EDOLPHUS TOWNS, New York

FRANK PALLONE, Jr., New Jersey

SHERROD BROWN, Ohio

BART GORDON, Tennessee

PETER DEUTSCH, Florida

BOBBY L. RUSH, Illinois

ANNA G. ESHOO, California

BART STUPAK, Michigan

ELIOT L. ENGEL, New York

TOM SAWYER, Ohio

ALBERT R. WYNN, Maryland

GENE GREEN, Texas

KAREN MCCARTHY, Missouri

TED STRICKLAND, Ohio

DIANA DEGETTE, Colorado

THOMAS M. BARRETT, Wisconsin

BILL LUTHER, Minnesota

LOIS CAPPS, California

MICHAEL F. DOYLE, Pennsylvania

CHRISTOPHER JOHN, Louisiana

JANE HARMAN, California

DAVID V. MARVENTANO, Staff Director

JAMES D. BARNETTE, General Counsel

REID P.F. STUNTZ, Minority Staff Director and Chief Counsel

(II)

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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)

(1)

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.

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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.

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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

4

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-tomarket 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.

5

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.

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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-toshoulder 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 wellbeing 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.

7

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 alVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00022 Fmt 6633 Sfmt 6602 E:\HEARINGS\77986 pfrm09 PsN: 77986
19

lowed 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 selfserving 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

20

was referred to as Kenny Boy. Kenny Boy had unfettered access to

the White House and enormous influence within the administration. He contacted Curt He ́bert, 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. He ́bert 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’’

21

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 welltimed 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 (rightmindedness) 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.

22

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 CommonVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00026 Fmt 6633 Sfmt 6602 E:\HEARINGS\77986 pfrm09 PsN: 77986
23

wealth 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.

24

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

25

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 conVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00029 Fmt 6633 Sfmt 6621 E:\HEARINGS\77986 pfrm09 PsN: 77986
26

vert 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 He ́bert to discuss

issues of policy and to talk about whether the President would retain Mr. He ́bert

as the Chairman of the Commission.

Mr. H ́ bert described these conversations as unusual, noting that he never had

similar conversations with other industry chief executives. In the end, Mr. H ́ bert 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. He ́bert 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.

He ́bert 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.

27

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

28

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

29

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 enVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00033 Fmt 6633 Sfmt 6602 E:\HEARINGS\77986 pfrm09 PsN: 77986
30

ergy 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

31

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

32

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?

33

• 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:]

34

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

35

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

36

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 coverup 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

37

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

38

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.

39

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

40

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

41

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

42

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 comVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00046 Fmt 6633 Sfmt 6602 E:\HEARINGS\77986 pfrm09 PsN: 77986
43

pany 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:]

44

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.

45

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.

46

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.’’

47

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 kneejerk 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.

48

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

49

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

50

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 wellknown 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:]

51

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 wellknown 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 megacorporations 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

52

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.

53

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

54

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 rubberstamp 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

55

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 overconcentration 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:]

56

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

57

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 dolVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00061 Fmt 6633 Sfmt 6602 E:\HEARINGS\77986 pfrm09 PsN: 77986
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lars 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.

59

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

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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, 21⁄2 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

61

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,

62

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.

63

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 forVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00067 Fmt 6633 Sfmt 6602 E:\HEARINGS\77986 pfrm09 PsN: 77986
64

ward 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

65

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 selfregulation 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

66

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.

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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 fullVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00071 Fmt 6633 Sfmt 6621 E:\HEARINGS\77986 pfrm09 PsN: 77986
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est 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.

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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.

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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

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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.

72

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-

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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 oppor- tunity 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 enVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00077 Fmt 6633 Sfmt 6602 E:\HEARINGS\77986 pfrm09 PsN: 77986
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tire 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

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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:]

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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 shortselling, 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

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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.

78

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?

79

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 conVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00083 Fmt 6633 Sfmt 6602 E:\HEARINGS\77986 pfrm09 PsN: 77986
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cepts 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.

81

• 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.

82

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?

83

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

84

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?

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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.

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 pat- ents 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.’’ 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

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2Talk about professional peer review. This will be real peer review, not the pap we get now.

3 How do I know they are often illiterate? Because I teach them in Directors’ College classes

where I start with pop quizzes.

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.

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

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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.

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.

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

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 higherpriced 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.

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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 markto-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,

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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 accountVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00093 Fmt 6633 Sfmt 6602 E:\HEARINGS\77986 pfrm09 PsN: 77986
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ing 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-tomarket (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 acVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00094 Fmt 6633 Sfmt 6621 E:\HEARINGS\77986 pfrm09 PsN: 77986
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counting 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

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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 proforma 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

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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 longterm 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.

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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 offbalance 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 standardssetters 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-tomarket (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.

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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.

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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.

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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

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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,

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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

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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

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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 increasVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00117 Fmt 6633 Sfmt 6602 E:\HEARINGS\77986 pfrm09 PsN: 77986
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ing 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

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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

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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, nonaudit 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 readVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00120 Fmt 6633 Sfmt 6621 E:\HEARINGS\77986 pfrm09 PsN: 77986
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er 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 nonaudit 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, deVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00121 Fmt 6633 Sfmt 6621 E:\HEARINGS\77986 pfrm09 PsN: 77986
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spite 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 nonaudit 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 nonaudit 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

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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.

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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 whatVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00124 Fmt 6633 Sfmt 6621 E:\HEARINGS\77986 pfrm09 PsN: 77986
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ever 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.

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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

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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 21⁄2 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

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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

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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

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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.’’

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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,

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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, proconsumer 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

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$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 ongoing 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

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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.

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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

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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

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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

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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 manVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00138 Fmt 6633 Sfmt 6602 E:\HEARINGS\77986 pfrm09 PsN: 77986
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agement 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.

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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.

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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

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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.

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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 11⁄2 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

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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.

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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?

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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

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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

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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.

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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

146

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.

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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.

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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.

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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.

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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?

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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 socalled 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.

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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.

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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,

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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

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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 selldown 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

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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.

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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-tomarket 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.

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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——

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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

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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 genVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00164 Fmt 6633 Sfmt 6602 E:\HEARINGS\77986 pfrm09 PsN: 77986
161

erally 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

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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

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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

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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 inVerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00168 Fmt 6633 Sfmt 6602 E:\HEARINGS\77986 pfrm09 PsN: 77986
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terpreting 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.

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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,

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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

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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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