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[Senate Hearing 107-724]
[From the U.S. Government Publishing Office]

                                                        S. Hrg. 107-724

                   AN OVERVIEW OF THE ENRON COLLAPSE

=======================================================================

                                HEARING

                               before the

                         COMMITTEE ON COMMERCE,
                      SCIENCE, AND TRANSPORTATION
                          UNITED STATES SENATE

                      ONE HUNDRED SEVENTH CONGRESS

                             FIRST SESSION

                               __________

                           DECEMBER 18, 2001

                               __________

    Printed for the use of the Committee on Commerce, Science, and 
                             Transportation

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       SENATE COMMITTEE ON COMMERCE, SCIENCE, AND TRANSPORTATION

                      ONE HUNDRED SEVENTH CONGRESS

                             FIRST SESSION

              ERNEST F. HOLLINGS, South Carolina, Chairman
DANIEL K. INOUYE, Hawaii             JOHN McCAIN, Arizona
JOHN D. ROCKEFELLER IV, West         TED STEVENS, Alaska
    Virginia                         CONRAD BURNS, Montana
JOHN F. KERRY, Massachusetts         TRENT LOTT, Mississippi
JOHN B. BREAUX, Louisiana            KAY BAILEY HUTCHISON, Texas
BYRON L. DORGAN, North Dakota        OLYMPIA J. SNOWE, Maine
RON WYDEN, Oregon                    SAM BROWNBACK, Kansas
MAX CLELAND, Georgia                 GORDON SMITH, Oregon
BARBARA BOXER, California            PETER G. FITZGERALD, Illinois
JOHN EDWARDS, North Carolina         JOHN ENSIGN, Nevada
JEAN CARNAHAN, Missouri              GEORGE ALLEN, Virginia
BILL NELSON, Florida
               Kevin D. Kayes, Democratic Staff Director
                  Moses Boyd, Democratic Chief Counsel
                  Mark Buse, Republican Staff Director
               Jeanne Bumpus, Republican General Counsel

                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on December 18, 2001................................     1
Statement of Senator Boxer.......................................    28
Statement of Senator Burns.......................................     6
Statement of Senator Dorgan......................................     1
Statement of Senator Fitzgerald..................................    25
Statement of Senator Hollings....................................     3
Statement of Senator McCain......................................     3
Statement Senator Nelson.........................................     8
Statement of Senator Wyden.......................................     5
    Article from The Oregonian, dated November 29, 2001, entitled 
      Enron's Rise and Fall July 1985: Houston Natural Gas Merges 
      With InterNorth............................................    22

                               Witnesses

Andrews, C. E., Global Head of Auditing and Business Advisory, 
  Andersen.......................................................    31
    Prepared statement with attachment...........................    33
Cleland, Scott, Chief Executive Officer, the Precursor 
  Group'..............................................    40
    Prepared statement with attachments..........................    42
Coffee, Jr., John C., Adolf A. Berle Professor of Law, Columbia 
  University School of Law and Joseph Flom Visiting Professor of 
  Law, Harvard University Law School.............................    68
    Prepared statement...........................................    71
Eri, Donald, Special Tester (Retired), Portland General Electric.    16
    Prepared statement...........................................    17
Farmer, Janice, Enron (Retired)..................................     6
    Prepared statement...........................................     7
Mann, III, William H., Senior Analyst, The Motley Fool...........    75
    Prepared statement...........................................    78
Pearson, Mary Bain, Enron Shareholder............................     8
    Prepared statement...........................................     9
Prestwood, Charles, Enron (Retired)..............................    10
    Prepared statement...........................................    12
Silvers, Damon A., Associate General Counsel, AFL-CIO............    82
    Prepared statement...........................................    85
Vigil, Robert, Electrical Machinist Working Foreman, Portland 
  General 
  Electric Pelton/Round Butte Hydroelectric Project..............    13
    Prepared statement...........................................    15

                                Appendix

Berman, Steve W., Hagens Berman LLP, prepared statement..........    91
Enron: Let Us Count The Culprits, Business Week, December 17, 
  2001, article..................................................    92
Enron: The Lessons For Investors; Hindsight, shmindsight. There's 
  much to learn when a stock loses $67 billion in value, Money, 
  January, 2002, article.........................................    93

 
                   AN OVERVIEW OF THE ENRON COLLAPSE

                              ----------                              

                       TUESDAY, DECEMBER 18, 2001

                                       U.S. Senate,
        Committee on Commerce, Science, and Transportation,
                                                    Washington, DC.
    The Committee met, pursuant to notice, at 9:30 a.m. in room 

SR-253, Russell Senate Office Building, Hon. Byron L. Dorgan, 
presiding.

          OPENING STATEMENT OF HON. BYRON L. DORGAN, 
                 U.S. SENATOR FROM NORTH DAKOTA

    Senator Dorgan. This hearing will come to order. This is a 
hearing of the full Commerce Committee. I am the Chairman of 
the Subcommittee on Consumer Affairs, Foreign Commerce and 
Tourism. Senator Hollings has asked that I chair the hearing 
today. We will be joined by other colleagues on the Committee 
shortly, but we do want to begin on time. The subject of the 
hearing is the meltdown and bankruptcy of the Enron Corporation 
over the past four months. This raises many serious and 
troubling issues, and we want to, in this hearing, explore some 
of these issues.
    This will be the first of several hearings on this matter. 
Mr. Ken Lay, the Chief Executive Officer of Enron, did not 
accept our invitation to testify at this hearing. However, we 
have been informed this morning that Mr. Lay has committed to 
appear before our Committee and present testimony at a second 
hearing which will be held on February 4.
    We also intend to request at that hearing the attendance of 
Mr. Skilling and Mr. Fastow, former top executives at Enron, 
and others, who can help explain what happened. I spent many 
hours in recent days reading and learning about the events that 
preceded the collapse of one of the world's largest 
corporations.
    Frankly, the more I have learned, the more troubled I have 
become. This is not your average business failure. This is a 
tragedy for many, including workers and investors who, it 
appears to me, have been cheated out of billions of dollars. 
This is about an energy company that morphed itself into a 
trading company involved in hedge funds and derivatives. It 
took on substantial risks, created off-the-books partnerships, 
and in effect cooked the books under the nose of their 
accountants and investors.
    At a time when the executives, board members, and other 
insiders were selling nearly $1 billion in stock in recent 
years and were profiting handsomely, employees and investors 
were set up to take the financial beating. Was this just bad 
luck, incompetence, or greed? Were there some criminal or 
illegal actions, as have been suggested by the accounting firm 
that reviewed Enron's books? Where was the board of directors 
when this was happening? How much did they profit from it? Were 
they brain dead, or just kept in the dark? What about the 
accounting firm? Were they duped? Incompetent? How on earth can 
there be adjustments of billions of dollars? Is it not a 
conflict of interest for the accounting firm to depend on the 
company they are auditing for tens of millions of dollars in 
consulting contracts? Where were the Federal agencies? Did they 
bear some responsibility, those in Congress who derailed 
efforts at Federal regulations for this type of trading 
activity? Did the stock analysts who kept recommending a strong 
buy know what they were doing? Was there a conflict of interest 
there?
    This is a company that operated between the cracks of 
Federal regulations. It created secret, off-the-books 
partnerships with names like Jedi, Chewco, LJM and others, and 
allowed a top executive to take ownership in these 
partnerships, which seems to me to be a clear conflict of 
interest. Who in the company approved these transactions? Who 
are the investors, besides Enron, in these partnerships? How 
much were their investments, and what was their return?
    These are some but not all of the questions the American 
people deserve to have answered, and we intend to search for 
those answers.
    If this were just another business failure, there would be 
no need for congressional hearings, but it is anything but just 
another failure. More than $60 billion in value has been lost 
in just months. Some at the top of the pyramid got rich, many 
at the bottom lost everything. It appears to me to be a 
combination of incompetence, greed, speculation with investors' 
money, and, perhaps, some criminal behavior. Investigations 
will sort out all of that, but the tens of thousands of 
employees and investors in the end will have lost billions of 
dollars.
    It is my hope these hearings and other investigations will 
help us determine whether laws need to be changed. If they do, 
we should change them. They will help us determine whether laws 
have been broken. If they have, those who did so will be held 
accountable.
    I would like to read a quote from Business Week's editorial 
page, which I think goes a long way in summarizing why this 
hearing is so important, and why the work of this Committee is 
necessary. The editorial goes, and I quote, ``Enron Corp.'s 
bankruptcy is a disaster of epic proportions by any measure--
the height from which it fell, the speed with which has 
unraveled, and the pain it has inflicted on investors, 
employees, and creditors. Virtually all checks and balances 
designed to prevent this kind of financial meltdown failed. 
Unless remedied, this could undermine public trust, the capital 
markets, and the nation's entire equity culture.'' That is from 
Business Week, and I certainly agree with those sentiments, and 
that describes the importance of this hearing. It sums up why 
we are here today, and I look forward to hearing from many of 
our witnesses, many of whom traveled some long distance to be 
here.
    Let me call on the Chairman of the full Committee, Senator 
Hollings.
    The Chairman. I yield.
    Senator Dorgan. Let me call on the Ranking Member, Senator 
McCain.

                 STATEMENT OF HON JOHN McCAIN, 
                   U.S. SENATOR FROM ARIZONA

    Senator McCain. I thank the Chairman for convening today's 
hearing to provide us with an overview of the Enron collapse. I 
hope that the witnesses can provide a better understanding of 
the facts leading up to the company's bankruptcy and allow us 
to understand whether U.S. investors and employees may face 
similar situations with other companies.
    The losses experienced by Enron's shareholders, 
particularly those who lost a substantial portion of their life 
savings so close to retirement, is a tragic example of losses 
that appear to be due not to poor investment decisions but to 
misplaced reliance on those entrusted to protect the integrity 
of their investment, the company's executives and independent 
auditors. The purpose of this hearing is to examine how such a 
situation can happen and what, if anything, the federal 
government can and should do to prevent future instances from 
occurring. Whether the law has been violated is not for us to 
decide. Rather, the issue for Congress is whether existing 
controls, if adhered to, are sufficient to protect 
shareholders.
    Thank you, Mr. Chairman. I look forward to today's hearing.
    Senator Dorgan. Senator McCain, thank you. The Chairman of 
the full Committee, Senator Hollings.

             STATEMENT OF HON. ERNEST F. HOLLINGS, 
                U.S. SENATOR FROM SOUTH CAROLINA

    The Chairman. Well, Mr. Chairman, thank you very, very much 
for chairing this hearing for our full Committee.
    I have been engaged full-time in trying to make certain 
that they did not give away the broadband spectrum. We have got 
a Chairman of the Federal Communications Commission that is 
determined to divest ownership in spectrum, and they have got a 
$5 billion kitty for the K Street crowd to make sure it happens 
by December 31, so that has kept me very, very busy.
    Otherwise, they have got the full court press over there on 
the outside with Tauzin-Dingell to make sure they extend 
monopolies rather than engage in competition. That has kept me 
busy, along, of course, with the conference committees that are 
going on right now between the defense appropriations and the 
labor, health and human resources appropriations and then, of 
course, Mr. Chairman, this Committee has jurisdiction over 
terrorism insurance. We got together a bipartisan bill after 
hearings with the Secretary of the Treasury and would've 
otherwise reported it out. It is on the calendar, and then the 
political maneuvering started.
    I was called one morning by the Secretary of Treasury, and 
he and I talked informally. We agreed that we could get at 
least, without all of these differences, a 1-year terrorism 
insurance bill, so everyone would have security here in the 
renewal of policies at the first of the year. Our staff started 
working early the next morning, but the Republican conference 
came in to the working session and pulled all the Members out, 
and we have not heard from them since.
    Trying to get your job done around here is next to 
impossible in these closing days, and by your holding this 
hearing it is quite an eye-opener to this particular Senator. I 
noticed that Money magazine reported that Lay made $66 million 
in selling shares, while Jeff Skilling garnered another $60 
million, and 16 board members had made $164 million in selling 
their shares by June. Money magazine quotes, ``While insider 
sales do not automatically spell trouble for a company . . . 
the selling of Enron was prolific. And the fact that the 
selling persisted even as the stock fell throughout 2001 was a 
`screaming red flag,'. . . If Skilling and Lay believed the 
stock was undervalued--as they repeatedly told investors--then 
why were they cashing in?''
    And then I never had heard, until Enron, of a special 
purpose entity (SPE). In fact, I am determined to put in a bill 
to eliminate that thing. I do not know what it is. Its best 
description by the SEC in the hearing before the House, and I 
quote, ``An SPE is an entity created by a sponsor to carry out 
a specified purpose or activity, such as to consummate a 
specific transaction or series of transactions with a narrowly 
defined purpose. SPEs are commonly used as financing vehicles 
in which assets are sold to a trust or similar entity in 
exchange for cash or other assets funded by debt issued by the 
trust. In many cases SPEs are used in a structured transaction 
or series of transactions to achieve off-balance sheet 
treatment.''
    Well, Enron's board of directors have been accused of 
allowing the board members and officers of the company to run 
these SPE's. Arthur Andersen has been accused of engaging in a 
conflict of interest when it served both as a consultant and an 
accountant. That thing ought to be stopped. Arthur Andersen 
claims they were paid $25 million for its accounting services 
and $27 million for its consulting services. If that is not a 
conflict on its face, I do not know what is.
    Between October 1998 and November 2001, Arthur Andersen 
received over $100 million in accounting and consulting fees, 
including $52 million in 2000 alone, and then you have got 
Salomon Smith Barney. They rated Enron a buy until October 26, 
when it went to neutral, where it remained until, of course, 
they filed for Chapter 11.
    So you can go on and on. There is no doubt about the 
shenanigans that have been going on. I hesitated when you 
mentioned the need for us to hold this hearing in light of the 
jurisdictional concerns regarding this subject. Frankly, by 
asserting the jurisdiction over insurance in this Committee, 
and with the Banking Committee taking over with a reinsurance 
loan guarantee bill, that is a sweetheart deal for the 
insurance companies, I wanted to make sure that our inquiry was 
not interpreted as a response to the Banking Committee 
encroaching on Commerce Committee's jurisdiction. The Consumer 
Subcommittee that you head has a responsibility to investigate 
this matter, and we rightfully are in our rights here in 
holding this hearing, but the truth of the matter is that all 
of these financial deals and these SPEs, are Banking issues 
that are within the Banking Committee's purview. We must work 
together, and support the Banking Committee's efforts to craft 
possible solutions to the problems at hand. Brooksley Born 
suggested tighter regulation of the securities, but not only 
was Enron successful in blocking this action in the Congress, 
but it was able to get Congress to pass legislation exempting 
energy derivatives that are traded without rigid regulations. 
So we might get the members of the Commission up here and hear 
what has been going on here. This is a cancer.
    When you see in Business Week in August of 2000, last year, 
the company was worth $90 billion and today it is worth $1 
billion, that thing has got to stop, and we are all guilty in 
letting it happen.
    I thank you.
    Senator Dorgan. Senator Hollings, thank you very much.
    Senator Wyden.

                 STATEMENT OF HON. RON WYDEN, 
                    U.S. SENATOR FROM OREGON

    Senator Wyden. Thank you, Mr. Chairman, and let me thank 
you for holding this hearing. You have a long record of 
advocating for the consumer and workers and investors, and I 
just appreciate the chance to work with you and especially 
appreciate you including the Oregon witnesses we will hear from 
today.
    Because of what happened at Enron, Mr. Chairman, there are 
Oregon families going to grief counseling rather than holiday 
parties this year. These are Oregonians who lost retirement 
security because its Enron stock plunged like the Titanic. In 
effect, the senior executives on the deck locked the workers in 
the boiler room, preventing them from selling off 401(k) shares 
while they dumped their own.
    What is especially unsettling to me is, there is a law on 
the books right now that was designed to prevent the sort of 
carnage that took place at Enron. I wrote this law. It is 
called the Financial Fraud Detection and Disclosure Act, and it 
stipulates that there would be significantly stiffer 
requirements on accountants to search for fraud at publicly 
held companies like Enron and disclose it when they find it.
    I am going to withhold my judgment on this case until the 
Securities and Exchange Commission and criminal investigators 
have completed their inquiry, but given what is already on the 
record it sure does not look like much was done to detect and 
disclose the very conduct that the Financial Fraud, Detection, 
and Disclosure Act was designed to root out. This law was 
written after more than 30 hearings into the accounting 
profession, hearings chaired by John Dingell, and I intend to 
see to it that this law is complied with.
    For example, the Financial Fraud, Detection, and Disclosure 
Act requires that every single audit include procedures 
designed to detect illegal acts, and that they specifically 
identify related party transactions that are essential to the 
integrity of the financial statements. Here, there were clearly 
related party transactions that had financial hide-and-seek 
written all over them, and yet the auditors failed to have 
procedures in place to identify them.
    When Enron's chief financial officer set out a special 
purpose entity funded primarily with Enron's stock bought at a 
discount while continuing to serve as an officer of Enron, that 
should have set off the warning lights required by the 
Financial Fraud, Detection, and Disclosure statute. Certified 
financial statements are not supposed to be a game of financial 
hide-and-seek, and our review should pay particular attention 
to how it was that Enron transactions big enough to bring down 
this financial house of cards were not big enough to clearly 
and visibly be reported by the auditors.
    Mr. Chairman, I thank you, and again I appreciate all of 
your leadership.
    Senator Dorgan. Senator Wyden, thank you. Senator Burns.

                STATEMENT OF HON. CONRAD BURNS, 
                   U.S. SENATOR FROM MONTANA

    Senator Burns. Mr. Chairman, I am looking forward to 
listening to the witnesses. Thank you.
    Senator Dorgan. Senator Burns, thank you very much.
    I would like to ask the first panel to come forward. I will 
call your name as you come to the table. Ms. Janice Farmer, Ms. 
Mary Bain Pearson, Mr. Charles Prestwood, Mr. Robert Vigil, and 
Mr. Donald Eri, if you would come forward and take seats at the 
table we would appreciate that.
    The Committee thanks you for being here today. We know many 
of you have traveled many miles, and we will benefit from your 
testimony. We will ask Ms. Janice Farmer to go first. Ms. 
Farmer, you are, I understand, accompanied by your daughter. Is 
that correct?
    Ms. Farmer. Yes, that is correct.
    Senator Dorgan. Ms. Farmer, why don't you proceed, and we 
will include the entire statement you have produced for the 
record. You may summarize. Thank you very much.

          STATEMENT OF JANICE FARMER, ENRON (RETIRED)

    Ms. Farmer. Dear Members of the Commerce Committee, thank 
you for inviting me to speak today. Although in some ways it is 
an exciting experience for an average American to be appearing 
before the Senate, I wish the circumstances were such that I 
was not here. My name is Janice Farmer, and I am from Orlando, 
Florida. I spent 16 years in the natural gas industry, starting 
with Florida Gas Transmission Company, which later became a 
part of Enron. I worked in the Right of Way Department and also 
at the training center, where people were trained to handle 
natural gas safely.
    One year ago, I retired from Enron Corporation with nearly 
$700,000 in Enron stock. This was my life savings, my nest egg. 
I am a single woman, and I am proud that I was able to amass 
this amount in the Enron 401(k) plan. I did without many things 
that I would like to have spent money on in order to 
participate in this plan. I thought that I had prudently 
planned for my financial future and that of my children and of 
my grandchildren.
    I was proud to invest in Enron stock. The company 
encouraged me and others to do so, saying that employee 
ownership would help prevent any possible hostile corporate 
takeovers. We were a loyal and hardworking group of employees. 
We lived, ate, slept, and breathed Enron, because we were 
owners of the company. I trusted the management of Enron with 
my life savings.
    Senators I will not mince words here. They betrayed that 
trust. My life savings are gone. I am now left, a year away 
from Social Security, with a $63 a month pension check from 
another company. On top of all of this is the lockdown. By 
October 22, 2001, I was upset and dismayed over the news of 
Enron's financial status. When I saw the stock drop, I called 
to sell and was told that I was locked out, so I had to stand 
by and watch my savings disappear. In the end, I received a 
check for $4,000. That is all that was left.
    I leave it to you and the courts, I guess, to decide if 
locking me and other employees out was a breach of trust by 
those running the plan. I know that many other employees share 
my financial pain, and the sense of betrayal.
    Senators I am not a lawyer, but I understand there is a law 
called ERISA, and that this law imposes some fiduciary 
obligations on those in charge. I cannot help but feel that I 
and thousands of employees like me have been lied to and we 
have been cheated. Instead of being rewarded for my hard work 
and loyalty, I am left with a lawsuit against my employer and 
those responsible. It may be too late for you to help me, but 
it is not too late for you to take some action to help make 
certain that this does not ever happen to anyone else again.
    Thank you very much.
    [The prepared statement of Ms. Farmer follows:]

          Prepared Statement of Janice Farmer, Enron (Retired)
Dear Members of the Commerce Committee,

    Thank you for inviting me to speak today. Although in some ways it 
is an exciting experience for an average American to be appearing 
before the Senate, I wish the circumstances were such that I was not 
here.
    My name is Janice Farmer. I am from Orlando, Florida. I spent 
sixteen years in the natural gas industry starting with Florida Gas 
Transmission, which later became a part of Enron. I worked in the Right 
of Way Department and also at the training center, where people were 
trained to handle natural gas safely.
    One year ago, I retired from the Enron Corporation with nearly 
$700,000 in Enron stock. This was my life savings, my nest egg. I am a 
single woman and am proud that I was able to amass this amount into the 
Enron 401(k) plan. I did without many things I would have liked to have 
spent money on, in order to put money in that plan. I thought that I 
had prudently planned for my financial future and that of my children 
and grandchildren.
    I was proud to invest in Enron stock. The company encouraged me and 
others to do so, saying that employee ownership would help prevent any 
possible hostile corporate takeovers.
    We were a loyal and hard-working group of employees. We lived, ate, 
slept and breathed Enron because we were owners of the company.
    I trusted the management of Enron with my life savings. Senators, I 
won't mince words here. They betrayed that trust. My life savings is 
gone. I am left now a year away from Social Security and am living off 
a $63.00/month pension check from another company.
    On top of all this is the lockdown. By October 22, 2001, I was 
upset and dismayed over the news of Enron's financial status. When I 
saw the stock drop, I called to sell and was told I was locked out. So 
I had to stand by and watch my savings disappear. In the end, I 
received a check for $4,000. That's all that was left. I leave it to 
you and the courts, I guess, to decide if locking me and other 
employees out, was a breach of trust by those running the plan.
    I know that many other employees share my financial pain and sense 
of betrayal.
    Senators, I am not a lawyer, but I understand there is a law called 
ERISA and that this law imposes some fiduciary obligations on those in 
charge. I cannot help but feel that I and thousands of employees like 
me have been lied to and cheated.
    Instead of being rewarded for my hard work and loyalty, I am left 
with a lawsuit against my employer and those responsible. It may be too 
late for you to help me, but it is not too late for you to take some 
action to make certain that this does not happen again.
    Thank you very much.

                STATEMENT OF HON. BILL NELSON, 
                   U.S. SENATOR FROM FLORIDA

    Senator Nelson. Mr. Chairman, I just want to point out that 
the lady is from my home town area of Central Florida, and 
there is a great deal of concern among the retirees that live 
in Florida that are suffering as has been stated here. I will 
get into some specifics later on, but I just want to thank Ms. 
Farmer for being here.
    Ms. Farmer. Thank you. It is an honor to be here.
    Senator Dorgan. Senator Nelson, thank you. Ms. Farmer, 
thank you for your testimony.
    Next, we will hear from Ms. Mary Bain Pearson. Ms. Pearson.

       STATEMENT OF MARY BAIN PEARSON, ENRON SHAREHOLDER

    Ms. Pearson. My name is Mary Bain Pearson. I am a 70-year-
old Latin teacher and tutor. I am a widow of G. P. Pearson, who 
was a Representative in the Texas Legislature from Grimes 
County, Texas.
    I have always tried to handle my business in a logical 
manner, like you conjugate a verb or decline a noun. I am also 
a child of the Depression, when my father was working in a bank 
and the bank failed during the Depression, and he never got 
over that, and for the next 50 years he used to always warn me 
to save something for an emergency or an illness, and not to 
put all my eggs in one basket, and be careful with my money. I 
used to laugh at him and kid him, but you know what, he was 
right.
    After a while, I decided I would invest in Enron stock. 
Now, I do not want you to think I am too naive. I did a lot of 
work investigating it, and learned about its history. Finally, 
I bought 100 shares so I could go to the board meeting, and I 
did go to some board meetings and met some of the members of 
the board, who I held in the highest esteem.
    We had Charles Lemaistre, who I still hold in the highest 
esteem, who is a very wonderful man, and Mrs. Phil Gramm was 
there that day, and I thought she was smart, because she 
already had a job in the economy up here in Washington, and I 
thought she was smart. There were other people on the board in 
Houston that I knew, and I always held them in high esteem, and 
so I thought, well, this must be a good company to invest in, 
so I bought some more stock.
    Many times I would pick up the newspaper and see Ken Lay's 
name in it. He was very generous. He was always at charity 
parties and giving millions of dollars to this and hundreds of 
thousands of dollars to that, and it was a wonderful thing, and 
it made the company look very, very good.
    I am just a pebble in the stream, a little bitty 
shareholder. I did not lose billions. I did not even lose a 
million, but what I did lose seems like a billion to me. In 
fact, what really hurts is, I bought my granddaughter some 
Enron stock, and she is 10 years old, so I feel real bad about 
that.
    I was going to use my Enron stock as my long-term health 
care. I had taken my father's advice and put that aside in case 
of an emergency if I got sick. I had nursed my husband for 7 
years with cancer, day and night, and been happy to do it, but 
after he passed away I did not want that to fall on my 
children's shoulders, so I put this stock aside so that I could 
call on it and use it in case I had a long-term disease.
    Well, I do not know what I am going to do now. I am going 
to have to go home and reevaluate my life and see what I can 
do. I am not a big stockholder, just a little person, but when 
they asked me how I felt about Enron I said, well, at first I 
was in a state of shock for a while. I could not believe that 
it happened so quickly. I asked my accountant if I should not 
sell the stock and he said no, hold onto it. I can hardly wait 
till April 15 when I go to see him.
    [Laughter.]
    Ms. Pearson. And then after that wore out, a veil of 
disappointment fell over me. I was disappointed in the people 
that I put my trust in years ago. 1986 is when I bought my 
first stock. And then after a little time passed on, bitterness 
came into being, and bitterness will eat you alive if you let 
it, but sometimes at night I do feel real bitter over what I 
have lost, because it was a big part of my future, and I do not 
know how I am going to handle the future now. All I can do is 
hope and pray I do not get sick.
    So thank you for letting me pour my heart out to you.
    [The prepared statement of Ms. Pearson follows:]

       Prepared Statement of Mary Bain Pearson, Enron Shareholder
    My name is Mary Bain Pearson. I am 70-years of age. I am the widow 
of G.P. Pearson, formerly a state representative from Grimes County, 
Texas. After my husband passed away, I tried to follow the teachings of 
my husband and my father by setting aside money for the eventual 
downturn in the economy which always seems to occur. I am a child of 
the depression and my father had told me after having worked in a bank 
that failed, that I should set aside my money in safe investments for 
my retirement and for needed medical expenses.
    After attending a board meeting, I was impressed with what the 
leaders of the company had to say and decided to buy more stock for my 
granddaughter. I have been adding to my stock over the years and have 
not sold because my accountant also believed Enron was a good company 
and that I shouldn't sell. I believed what the people at the company 
said, not only in their public statement, but in the annual reports and 
believed in the people who were on the board of directors such as Dr. 
Charles LeMaitre, former Chancellor of the University of Texas and 
Wendy Gramm, wife of U.S. Senator Phil Gramm. I knew some other members 
of the board who resided in Houston and believed them when they 
represented that they were running the company in the best interest of 
the shareholders.
    Many times when I picked up the newspaper Ken Lay was either giving 
money to charities or helping raise money for some worthy purpose. I 
believed he was a good man and kept my money with his company because I 
thought he and the people he had placed in positions of trust in the 
company were honest.
    I am just a pebble in the stream, just a little bitty stockholder, 
but both my granddaughter and I have lost money we had set aside for 
our future and do not know how we will replace those losses. I 
specifically set aside my stock for my long-term health care needs 
because I took care of my ailing husband for seven years before he 
passed away. I was happy to take care of him, but I do not want my 
grown children to have the responsibility to take care of me if 
something should happen to me health wise.
    Thank you for taking the time to listen to me and to consider my 
plight which is not nearly so bad as many of the people who worked for 
Enron for many years and had their life savings disappear.

    Senator Dorgan. Ms. Pearson, thank you very much for being 
here.
    Next, we will hear from Mr. Prestwood.

        STATEMENT OF CHARLES PRESTWOOD, ENRON (RETIRED)

    Mr. Prestwood. Thank you, Mr. Chairman, and all the 
Committee members and other Senators that are here. My name is 
Charles Prestwood, and I have come from Conroe, Texas, which is 
about roughly 50 miles north of Houston, I am 63 years old, and 
I have been with Enron ever since the beginning. I have been 
with the Houston Natural Gas System before that. Internorth and 
Houston Natural Gas, they merged, and that is where Enron was 
formed, and I have been there the whole way, all the way from 
the beginning to the end.
    Senator McCain. How many years is that, Mr. Prestwood?
    Mr. Prestwood. 33\1/2\ years that I was in the gas 
business, in Enron most of that time, and I am a very broke 
person. I lost everything I had.
    I was what I call very loyal. The word loyalty to a 
company, you know, is something that we helped build. We worked 
real hard on building the corporation of Enron to be the number 
1 gas supplier, or the number 1 energy supplier for which we 
achieved that goal, and we were very happy to achieve that 
goal, and then just to see it evaporate right in front of our 
eyes, and I had all my savings, everything in Enron stock. I 
lost $1.3 million, and I hope and pray that it can be 
recovered, or I hope and pray that--my solemn prayer is that no 
other company will ever go through what we did, because Enron 
was a good corporation.
    We made lots of money. We were trained to believe that we 
were number 1 no matter what we did, and we achieved every goal 
we set out to achieve, and everything was just so lovey-dovey, 
you know what I mean, with our financial standing and stuff. In 
other words, I reached the age of retirement at 62. I retired 
October 1 in the year 2000, and I had everything kind of 
financially under control. In other words, I could take my 
retirement. I could take my social security and bridge it with 
a little out of my savings account and live a fairly decent and 
happy life, you know, but all those plans have changed now. In 
other words, it was from rags to riches and back to rags, and 
that is a simple way of explaining it.
    In other words--and the way that the company prospered, the 
bookkeeping and the accountants, and the way they did things 
was way over our heads. We did not know anything about that, us 
retirees in 99 percent of the Enron employees they did not know 
anything was wrong with our company. They had no idea. I had no 
idea that our company was in trouble, that our company was on 
the verge of collapse, but you know, it does not take long.
    And then we get back to the lockdown. The strategy that was 
used there, they called it a coincidence, you know. 
Coincidences happen, you know, and everybody understands that, 
but when we were locked down we could not get to our stock. We 
could not get to our broker to move our stock out because it 
was in the process of being transferred to another company. All 
we could do was just sit there and watch it melt down.
    I still have all my stock, but the most important thing 
about that stock is the ink on it. That is about what it is 
worth, and it is very touching to be in a predicament like 
this, because a lot of people have asked me, Charlie, why in 
the world didn't you get out beforehand?
    I go back to that one simple word of loyalty. Loyalty to a 
corporation, loyalty to something that I helped build, that I 
strived and worked a lifetime to build, and that is the reason 
I did not, and the revenues are simply stunning, of our 
company. In other words, how a company--well, let me just read 
a little quotation here.
    It says, that is how Chief Executive Officer Jeff Skilling 
described Enron's strong financial operating performance in 
2000. Every major business pipelines, wholesale services, 
retail, and broadband turned in strong performances in the year 
that were reflected in record volumes, contract value, and 
profitability. In other words, we reached $101 billion in the 
year 2000. That was our sales, and right now, in other words, 
that was the business that we had done across the Nation and 
across the world, all of the foreign works we have got overseas 
and stuff.
    We had a great year in the year 2000, and now we are down 
to the year of 2001, when our stock started just falling. We 
thought it was just the economy. You know, the economy is bad, 
and so everybody's stock is going down. It did, but then when 
the balance sheet started coming out we still--we thought we 
had the best.
    In other words, if there is a good accountant, we will hire 
him. That was our goal, our motto. We were supposed to have the 
best, and not get things messed up like they did, and back on 
January 26 is another illustration of why the employees and the 
retirees did not sell their stock. It was--I pulled a copy of 
it off of the computer that the estimated value of the Enron 
stock at the close of the year of 2001 would be between $122 
and $126, with an average of $124 to $125, and at the end of 
2002 the value of the Enron stock would be $145 on the average.
    Well, you know, common sense will tell you you do not get 
rid of stock like that. You hang onto it, and try to achieve 
those goals, and another just common sense way I see it, they 
said, well, you could have rolled out of that and rolled it 
into something else, but who wants to get off a winning horse?
    So where does that leave me? I can tell you without pulling 
punches something stinks here, and it really does. There are 
people at Enron who made millions selling Enron stock, 
encouraging the retirees and encouraging the Enron employees to 
just hang on to it, it is going to get better. It will get up 
there and our stock will split again, for which I have been 
very fortunate. I have been very fortunate, but the fact is 
that I have seen two or three stock splits, 2 for 1. The stock 
would come up and split, and it would come back up, and that is 
where I gained mine.
    But in other words, I lost it a whole lot quicker than I 
made it, and I and my coworkers, and I am speaking for the 
Enron employees that are still working for Enron. I am speaking 
for the employees that got discharged here a few days back, and 
all the retirees that are not here. I am honored to be here and 
get to say a few words on our behalf that you all will know the 
actual truth of what actually is happening to us in this good 
old U.S.A., and I hope and pray that there is something that 
can be done about it, and I hope and pray that there are some 
laws that can be set up to where every corporation in the 
United States will be on the same page on keeping books, that 
there will not be any of this thing happening again.
    So I thank all of you for listening, and that is my story.
    [The prepared statement of Mr. Prestwood follows:]

        Prepared Statement of Charles Prestwood, Enron (Retired)
    Thank you, Mr. Chairman, for the opportunity to appear before you 
today.
    My name is Charles Prestwood. I am from Conroe, Texas and I am 63 
years old.
    I built my retirement fund over the course of a long career in the 
natural gas industry, most of which I spent in the field with Houston 
Natural Gas working on pipelines. In the 1990s, when Enron acquired 
HNG, all my retirement investments were automatically converted to 
Enron stock.
    Enron stock was aggressively promoted by executives within the 
company. I continued to receive part of my compensation from Enron in 
company stock and stock options. Enron promoted employee stock 
ownership verbally and through internal publications. Here is a quote 
from an internal publication sent to all employees in early 2001:

        Simply stunning. That's how Chief Executive Officer Jeff 
        Skilling describes Enron's strong financial and operating 
        performance in 2000. Every major business--pipelines, wholesale 
        services, retail and broadband--turned in strong performances 
        for the year that were reflected in record volumes, contract 
        value and profitability. Revenues increased two-and-a-half 
        times, reaching $101 billion. For the first time, Enron's pre-
        tax net income exceeded $1 billion, a 32 percent increase over 
        last year, and shareholders received an 89 percent gain on the 
        stock price. Other significant highlights included:

     Fourth quarter revenues of $40.75 billion, exceeding 
            1999's entire reported revenues of $40 billion;

     25 percent increase in earnings per diluted share to 
            $1.47;

     59 percent increase in marketed energy volumes to 52 
            trillion British thermal unit equivalents per day; and

     Nearly doubling of new retail energy contracts to $16.1 
            billion.

Enron Business met with Jeff to discuss last year's results and his 
outlook for 2001.

        EB: Enron had a great 2000. How did we do it?

        Jeff: Every one of our businesses performed beyond our 
        expectations.

    We believed in the story in this publication and it is typical of 
the type of promotion by Enron executives. I recall when the company 
did particularly well, these types of internal publications would be 
circulated. I also recall attending a breakfast with Mr. Lay where he 
told us not to sell our Enron stock.
    As a result of this type of promotion, I and many others continued 
to invest in Enron up until the bitter end. To me, this is the American 
way, loyalty to your employer.
    I retired from Enron Corp. in October 2000 feeling that after a 
lifetime of hard work, my retirement account with Enron provided 
financial stability. I could no longer keep pace with the physically 
demanding work required in plant operations. I expected that Enron 
stock would support me. I worked hard to make it so. I had $1.3 million 
in savings, all in Enron stock.
    Let me mention the lockdown. The lockdown started, to the best of 
my knowledge on October 17, 2001. At this point, Enron had just 
announced the bad news that shocked us all. Much to our chagrin, we 
were locked out of our accounts. So folks who bought Enron on the 
street could trade, but we could not.
    So where does that leave me? I can tell you, without pulling 
punches, something stinks here. There are people at Enron who made 
millions selling Enron stock, while we, the rank and file, got burned. 
It's that simple. I am left with a tiny fraction of my $1.3 million, or 
about $8,000. It's too late in my life to start over to build up my 
funds.
    I don't know the law, but I know what is right and what is wrong. 
There is something terribly wrong here. I thought someone was supposed 
to be looking out for our interests. I thought that people had to treat 
us honestly and deal fairly with us. In my neck of the woods, what 
happened is not right.
    I am only one of thousands who have been wiped out. I hope you can 
do something about it for me and the many like me.
    I and my co-workers are proud of the industry we helped build, 
including the work we did for Enron and its predecessors. For most 
ordinary workers, Enron's failure taints lifetimes of dedicated work as 
well as striking a devastating blow to our futures.
    Thank you all for listening to me today.

    Senator Dorgan. Mr. Prestwood, thank you very much.
    Next, we will hear from Mr. Vigil. Mr. Vigil, will you 
proceed?

    STATEMENT OF ROBERT VIGIL, ELECTRICAL MACHINIST WORKING 
     FOREMAN, PORTLAND GENERAL ELECTRIC PELTON/ROUND BUTTE 
                     HYDROELECTRIC PROJECT

    Mr. Vigil. Good morning. Thank you for allowing me to be 
here. My name is Bob Vigil. I am an Electrical Machinist 
working for Portland General Electric (PGE). I work at PGE's 
Portland Hydroelectric Plant in Central Oregon. I am 47 years 
old and have been employed by PGE for 23 years.
    I come to you representing hundreds of hardworking PGE 
employees who have been financially devastated by Enron's 
recent stock price collapse and bankruptcy. I am one of 911 
current PGE employees representing the Local 125 International 
Brotherhood of Electrical Workers. In addition to the members 
of our bargaining unit there are 1,870 other employees at PGE.
    Since 1981, all of PGE's employees have participated in a 
401(k) plan which we expected to provide us with a comfortable 
retirement. For every $1 that we individually contribute to the 
plan, up to 6 percent of our income, the company has committed 
to contribute an equal amount in stock.
    Enron purchased PGE in 1997, at which time all of PGE's 
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 sold.
    As you probably are aware, by August 2001 stock had shot up 
to an all-time high of $90.56. At that time, my 1,800 shares 
were worth $163,000. Little did those of us working hard every 
day to help make the company successful know what was going on 
at the top of Enron. We trusted management's glowing reports of 
strong financial growth and opportunity with Enron. Then in 
October 2001, Enron's house of mirrors came crashing down in 
the largest bankruptcy in history.
    There are a few things you need to understand about our 
401(k) plan to understand the impact of Enron's collapse. 
First, we are free to make various kinds of investments with 
our own contributions, but the plan prohibits any employee 
under age 50 from trading the company's contributions. In other 
words, the company puts in its own stock, and until we reach 
age 50 they hold that stock.
    Second, until very recently, even after age 50 we could 
only trade 25 percent of the company's contributions per year.
    Third, I said before that the company is committed to 
contributing stock equal in value to our cash contributions. 
The company's practice, however, has been to purchase blocks of 
stock at the beginning of the year which it then uses to match 
our contributions over the course of the year. In making those 
contributions, Enron uses the cost of the stock when it 
purchased it, not the value when it makes the contributions. In 
good years, this certainly has been advantageous, but over the 
course of the last year our employer has been contributing 
stock worth a fraction of the contribution it is supposed to be 
matching.
    Finally, as all of you well know, 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 10 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 the 
officers at the top cashed out, we, the employees, had no 
choice but to ride the stock into the ground. We were all 
somewhat hopeful that the proposed Dynegy buy-out of Enron 
would at least give us relief from the $5 per share range, but 
when Dynegy pulled out on November 28, 2001, Enron's stock 
dropped below the $1 per share range, where it currently stays.
    Every PGE employee tells a tale about his or her losses. 
All of them are tragic, and most of them are life-changing. All 
of us regarded the 401(k) plan as a way of investing our hard-
earned wages for future security, and we assumed that in 
matching our contributions our employer was giving us something 
of value. It all now appears to have been a cruel illusion. As 
a result, retirees are finding their nest eggs gone. Older 
employees are facing having to work much longer than they had 
intended, and younger workers are being forced to revise their 
financial and career plans.
    To give you an idea of the magnitude of the overall losses, 
a number of my coworkers at PGE have agreed to allow me to give 
their names, ages, years of service with PGE and losses in 
Enron stock. Keep in mind that the losses I am about to list 
represent only the lost stock value since we were locked out of 
our accounts in mid-September:

        Tim Ramsey, age 55, 33 years with PGE, $995,000 loss;
        Roy Rinard, age 53, 22 years with PGE, $472,000 loss;
        Al Kaseweter, age 43, 21 years with PGE, $318,000 loss;
        Joe and Diane Rinard, age 47, 12 years with PGE,
          $300,000-plus loss;
        Dave Covington, age 32, 22 years with PGE, $300,000 
        loss;
        Tom Klein, age 55, 30 years with PGE, $188,000 loss;
        Mike Schlenker, age 41, 10 years with PGE, $177,000 
        loss;
        Patti Klein, age 47, 24 years with PGE, $132,000 loss.

    Just eight employees who have together invested 188 years 
with PGE have together lost $2,882,000. You can imagine how 
this catastrophe has affected us. Now multiply that feeling 
across thousands of our homes.
    Rest assured that our experience represents just the tip of 
the iceberg of the heartache and family devastation caused by 
Enron's collapse. It is estimated that Enron's collapse 
resulted in employee pension plan losses of up to $1 billion. 
If my eight coworkers alone lost $2.8 million that estimate is 
probably low.
    I came from across the country today to urge you to fully 
investigate the circumstances surrounding Enron's collapse. We 
are not looking for a handout. We are looking for solid, 
truthful answers as to what happened here so that we may 
possibly recoup some of this money, maintain our dignity, and 
prevent further theft occurring to others who worked their 
entire lives only to become victims of robbery.
    In addition, the working people in this country need your 
assurances that neither the future solvency of their social 
security benefits nor any greater share of their pension 
benefits will depend on the goodwill of corporate traders.
    Thank you sincerely.
    [The prepared statement of Mr. Vigil follows:]

   Prepared Statement of Robert Vigil, Electrical Machinist Working 
  Foreman, Portland General Electric Pelton/Round Butte Hydroelectric 
                                Project

    Good morning. My name is Robert Vigil. I am an Electrical Machinist 
Working Foreman for Portland General Electric (``PGE''). I work at 
PGE's Pelton/Round Butte Hydroelectric Project, in Central Oregon. I am 
47 years old, and I have been employed by PGE for 23 years.
    I come to you today representing hundreds of hard-working PGE 
employees who have been financially devastated by Enron's recent stock 
price collapse and bankruptcy. I am one of 911 current PGE employees 
represented by Local 125, International Brotherhood of Electrical 
Workers. In addition to the members of our bargaining unit, there are 
some 1870 other employees at PGE. Since 1981, all of PGE's employees 
have participated in a Sec. 401(k) plan, which we expected to provide 
us with a comfortable retirement. For every dollar that we individually 
contribute to the plan, up to 6% of our income, the company is 
committed to contributing an equal value in its stock.
    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.
    Little did those of us working hard every day to help make the 
company successful know what was going on at the top of Enron. We 
trusted management's glowing reports of strong financial growth and 
opportunity with Enron. Then, in October 2001, Enron's house of mirrors 
came crashing down in the largest bankruptcy in history.
    There are a few things you need to understand about our Sec. 401(k) 
plan to understand the impact of Enron's collapse. First, we are free 
to make various kinds of investments with our own contributions, but 
the plan prohibits any employee under age 50 from trading the company's 
contributions. In other words, the company puts in its own stock, and 
until we reach age 50, we hold that stock. Second, until very recently, 
even after age 50, we could only trade 25% of the company's 
contributions per year. Third, I said before that the company is 
committed to contributing stock equal in value to our cash 
contributions. The company's practice, however, has been to purchase 
blocks of stock at the beginning of the year, which it then uses to 
match our contributions over the course of the year. In making those 
contributions, Enron uses the cost of the stock when it purchased it, 
not the value when it makes the contributions. In good years, this 
certainly has been advantageous. But over the course of the last year, 
our employer has been contributing stock worth a fraction of the 
contribution it is supposed to be matching.
    Finally, as you all well know, 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.
    We were all somewhat hopeful that the proposed Dynegy buyout of 
Enron would at least give us relief in the $5-per-share range. But when 
Dynegy pulled out of the deal on November 28, 2001, Enron's stock 
dropped below the $1-per-share range, where it currently stays.
    Every PGE employee has a story to tell about his or her losses. All 
of them are tragic, and most of them are life changing. All of us 
regarded the Sec. 401(k) plan as a way of investing our hard-earned 
wages for future security. And we assumed that, in matching our 
contributions, our employer was giving us something of value. It all 
now appears to have been a cruel illusion. As a result, retirees are 
finding their nest eggs gone; older employees are facing having to work 
much longer than they had intended; and younger workers are being 
forced to revise their financial and career plans.
    To give you an idea of the magnitude of the overall losses, a 
number of my co-workers at PGE have agreed to allow me to give you 
their names, ages, years of service with PGE, and losses in Enron 
stock. Keep in mind that the losses I am about to list represent only 
the lost stock value since we were locked out of our accounts in mid-
September:

        1.  Tim Ramsey, age 55, 33 years with PGE: $995,000 loss.
        2.  Roy Rinard, age 53, 22 years with PGE: $472,000 loss.
        3.  Al Kaseweter, age 43, 21 years with PGE: $318,000 loss.
        4.  Joe and Diane Rinard, age 47, 12 years with PGE: $300,000-
        plus loss.
        5.  Dave Covington, age 32, 22 years with PGE: $300,000 loss.
        6.  Tom Klein, age 55, 30 years with PGE: $188,000 loss.
        7.  Mike Schlenker, age 41, 10 years with PGE: $177,000 loss.
        8.  Patti Klein, age 47, 24 years with PGE: $132,000 loss.

    Just these eight employees--who have together invested 188 years 
with PGE--have together lost $2,882,000.
    You can imagine how this catastrophe has affected us. Now multiply 
that feeling across thousands of other homes. Rest assured that our 
experience represents just a tip of the iceberg of the heartache and 
families' devastation caused by Enron's collapse. It is estimated that 
Enron's collapse resulted in employee pension plan losses of up to $1 
billion. If my eight co-workers alone lost nearly $2.8 million, that 
estimate is probably very low.
    I come from across the country today to urge you to fully 
investigate the circumstances surrounding Enron's collapse. We are not 
looking for a handout. We are looking for solid, truthful answers as to 
what happened here so that we may possibly recoup some of this money, 
maintain our dignity and prevent further theft from occurring to others 
who work their entire lives only to become victims of robbery. In 
addition, the working people in this country need your assurances that 
neither the future solvency of their Social Security benefits nor any 
greater share of their pension benefits will depend on the good will of 
corporate traders.
    Thank you sincerely.

    Senator Dorgan. Mr. Vigil, thank you very much.
    Finally, we will hear from Mr. Eri. Mr. Eri, you may 
proceed.

      STATEMENT OF DONALD ERI, SPECIAL TESTER (RETIRED), 
                   PORTLAND GENERAL ELECTRIC

    Mr. Eri. Good morning. My name is Don Eri. I am 57 years 
old. I retired from Portland General Electric (PGE) in April of 
2001, after 33 years of company service. I joined the company 
in December 1967, and worked my way up the ranks, retiring as a 
Senior Tester. I come to you today representing the thousands 
of PGE retirees who have been financially devastated by Enron's 
recent stock price collapse and bankruptcy.
    Enron purchased PGE in 1997. Because of the sale, the PGE 
stock that my coworkers and I had in our 401(k) accounts 
automatically converted to Enron stock, and from that time to 
the present PGE met its obligation to match employee 
contributions to the 401(k) plan by giving us Enron stock. For 
a time, that looked real good. As you probably are aware, by 
August of 2000, Enron stock had shot up to an all-time high of 
$90.56 a share. Before I retired in April of 2001, I sold all 
but 600 of my Enron shares. I expected the remaining stock to 
provide me with some growth in my retirement and give me a 
cushion to provide for the basics in my later life, such as the 
rapid rise in medical cost.
    How wrong I was. It turns out the people at the top of the 
company seriously misrepresented the financial picture of the 
company's future to those of us who worked to keep the lights 
on for over 700,000 customers. We took pride in what we did. We 
worked in all kinds of adverse weather conditions for days at a 
time without rest to make sure that our Oregonians had light 
and heat when they needed it. Since I had the shear luck of 
getting out of Enron before it collapsed completely, my 
exposure was, as I mentioned, only 600 shares, but Enron's 
smoke and mirrors still cost me over $40,000. Next to the 
stories you have heard from my coworkers, who have lost 
hundreds of thousands of dollars, $40,000 may not sound like 
much to you, but to me it is a significant amount of money that 
I had counted on to help support me through my retirement. 
Moreover, if I had not retired and cashed out in late April I 
probably could not afford to retire now, since far more of my 
pension would have disappeared.
    The money I lost represents past earnings that I invested 
on my own, as well as contributions toward my pension that the 
employer was committed to provide for me. Now it is gone. With 
Enron in bankruptcy, it will be something short of a miracle if 
I ever get any of it back. PGE retirees who had Enron stock are 
hurting. They do not know what the future holds. For some of 
them a substantial portion of their retirement portfolio has 
simply disappeared.
    What they want from our country's leaders are some straight 
answers about what happened at Enron. Then they can make their 
own decisions whether there are any realistic means for trying 
to recover their hard-earned money. We are not looking for 
handouts. We just want to be heard, and help this Committee and 
others to determine the truth so we can get on with our lives.
    Thank you.
    [The prepared statement of Mr. Eri follows:]

      Prepared Statement of Donald Eri, Special Tester (Retired), 
                       Portland General Electric

    Good morning. My name is Donald Eri. I am 57 years old. I retired 
from Portland General Electric--PGE--in April 2001, after 33 years with 
the company. I joined the company in November 1968 and worked my way up 
the ranks, retiring as a Special Tester.
    I come to you today representing the thousands of PGE retirees who 
have been financially devastated by Enron's recent stock price collapse 
and bankruptcy. Enron purchased PGE in 1997. As an immediate result of 
that sale, the PGE stock that my co-workers and I had in our 401(k) 
accounts automatically converted to Enron stock, and from that time to 
the present, PGE met its obligation to match employee contributions to 
the 401(k) plan by giving us Enron stock.
    For a time, this looked like a good deal. As you are probably 
aware, by August 2000, Enron's stock had shot up to an all-time high of 
$90.56 a share. When I retired in April of 2001, I sold all but 500 of 
my Enron shares. I expected the remaining stock to provide me with some 
growth in my retirement and give me a cushion to provide for basics in 
my later life, such as the rapidly-rising medical costs most people can 
no longer afford to insure against.
    How wrong I was.
    It turns out that Enron was really a sham. Here it was, the 10th-
largest company (in revenue) in the United States, a leader in the move 
toward a deregulated energy market. Its top executive, Ken Lay, was a 
personal friend of President George Bush and Vice President Dick 
Cheney. Its directors were prominent people, with valuable political 
and industrial ties. They were all making huge amounts of money, 
apparently off of a highly successful company. We saw our supervisors 
buying up the stock, and encouraged by the smell of success, we used 
our own money in our 401(k) plan to do likewise.
    Despite our employer's enthusiasm for deregulation, those of us who 
have worked in the electric utility industry over the years have always 
had serious misgivings about whether a deregulated industry would be 
able to provide the kind of reliable service that the nation expects 
and that we have taken pride in providing. But we had no idea how 
unregulated the industry actually is--and that our employer's financial 
dealings would completely escape any meaningful regulatory scrutiny.
    It turns out that the people at the top of the company seriously 
misrepresented the financial picture and the company's future to those 
of us who worked to keep the lights on for over 700,000 customers. We 
took pride in what we did. We worked in all kinds of adverse weather 
conditions for days at a time without rest to make sure that Oregonians 
had light and heat when they needed it. And this is how we get paid 
back.
    And they lied to you, and to legislators and regulators around the 
country, painting a picture of an industry that could flourish without 
government intervention.
    Since I had the sheer luck to get out of Enron before it collapsed 
completely, my exposure was, as I mentioned, only 500 shares. But 
Enron's smoke and mirrors still cost me over $40,000. Next to the 
stories you have heard of my co-workers who have lost hundreds of 
thousands of dollars, $40,000 may not sound like much to you. But to 
me, it's a significant amount of the money that I had counted on to 
help support me through my retirement. Moreover, if I had not retired 
and cashed out last April, I probably could not afford to retire now, 
since far more of my pension would have disappeared.
    The money I lost represents past earnings that I invested on my 
own, as well as contributions toward my pension that my employer was 
committed to provide for me. Now it's gone and, with Enron in 
bankruptcy, it will be something short of a miracle if I ever get any 
of it back.
    PGE retirees who had Enron stock are hurting. They don't know what 
the future holds now that, for some of them, a substantial portion of 
their retirement portfolio has simply disappeared. What they want from 
our country's leaders are some straight answers about what happened at 
Enron. Then they can make their own decisions whether there are any 
realistic means for trying to recover their hard-earned money.
    What Enron's current employees want is the same as what employees 
throughout this country want--some assurances that the pensions they 
are promised, and in which they are investing today, will have some 
real value when the time comes for them to retire.
    We are not looking for a handout. We just want to be heard and to 
help this Committee and others determine the truth so that we can get 
on with our lives and--for some of us--retain our dignity.
    Thank you.

    Senator Dorgan. Thank you very much. Let me thank all five 
of you. It is not easy to come to Washington and appear at a 
Senate hearing. You represent, the five of you represent 
thousands and thousands and thousands of employees and 
investors across this country who could be here telling similar 
stories, and you tell your stories on their behalf, and we 
appreciate your willingness to do that.
    Let me just ask one question, then I will call on my 
colleagues. I will show a chart a bit later on that shows the 
substantial amount of stock that was sold by the officers of 
the company, directors of the company, and other insiders, a 
very substantial amount of stock over a period of years, 
especially in recent years, totaling nearly $1 billion.
    Were any of you aware that there was very vigorous activity 
among top officers of the company to sell stock at the time 
they were suggesting to you you ought to buy stock? Was anyone 
on the panel aware of the amount of selling that was going on 
by those who were running the company, the board of directors, 
officers, and others?
    Mr. Vigil. We were aware that there was some activity going 
on. As far as those individuals that are 50 years and less of 
age, it did not make any difference. We could not do anything, 
so we did watch, and we did see the executives dumping a lot of 
stock, but we were bound by the plan. We could not do anything.
    Senator Dorgan. Let me just ask one additional point on 
that matter. I believe it was Ms. Farmer who talked about the 
question of being locked out. Someone said--Mr. Vigil, you said 
that the company is responding by saying that lock-out, with 
respect to the change in plan, administrators really 
effectively only caused about a 10-day problem, and you are 
saying that employees did not have that experience at all. That 
lockout was more prohibitive than that and much more costly 
than that. Can anyone respond to that? The company is saying 
there was just this narrow and short period, because of the 
change in plan administrators, during which the employees were 
not able to sell their stock.
    Mr. Prestwood. Well, Mr. Chairman, I would like to respond 
on that, because down in the Houston Chronicle we got a 
statement last weekend where management was trying to confuse 
some dates or something, but I know exactly the date that I got 
my letter. The letter was written on October 8. The letter was 
mailed on October 10, and from Conroe to Houston it normally 
takes about 2 to 3 days for me to get my mail, and then I would 
have then until October 19, from October 19 through November 19 
it was locked down, so that is the dates that I have.
    Senator Dorgan. So your notification was 30 days during 
which you were locked out of transactions?
    Mr. Prestwood. Yes, it was.
    Senator Dorgan. Senator McCain.
    Senator McCain. Mr. Prestwood, how much money did you lose?
    Mr. Prestwood. Sir, I lost $1,310,000. That--sometimes 
people might think that is not very much money, but to me it 
was my life savings.
    Senator McCain. It depends on what committee you serve.
    [Laughter.]
    Senator McCain. Mr. Prestwood, at any time, did you hear of 
Enron executives selling off blocks of stock.
    Mr. Prestwood. Yes, sir. Yes, sir. I saw it on the 
computer, but they hold us normally a month behind times on the 
channel. In other words, the page that I was pulling mine off 
of, I never thought anything about it, because I had great 
trust in our executives. In other words, I did not think 
anything about it. If I had, that should have been the first 
red flag that went up right there to me, but apparently it 
never dawned on me that it was bail-out time, because who would 
think there is anything wrong with Enron Corporation, the 
largest energy company in the world.
    Senator McCain. Ms. Pearson, you are familiar with Texas 
politics?
    Ms. Pearson. Just a little bit, by marriage.
    Senator McCain. Do you think that the Texas regulators 
should have had something to do with this, or do you think it 
is a federal responsibility?
    Ms. Pearson. Since so many shareholders are from all over 
the country, I would think it would be Federal.
    Senator McCain. Did you have any idea that Enron was in any 
kind of difficulty?
    Ms. Pearson. Why, no, of course not. The prediction was, 
like he said, $100 now and $125 in the next 6 months, so you do 
not think about selling the stock that has that bright outlook. 
No, I had no idea. I am on the perimeter. I am not a member of 
their employees. I am a stockholder, not an employee.
    Senator McCain. But, as you said, you got to know some of 
the board members.
    Ms. Pearson. I did know some of them, yes, I did, but I 
certainly thought if they were in there it was a good company, 
and they were smart enough to run it well, but I was wrong.
    Senator McCain. Mr. Vigil, do you think that the 
stockholders should be reimbursed?
    Mr. Vigil. I believe the employees that counted on the 
Enron executives to maintain and protect something that we 
considered a part of our wage package, there should be some way 
to recoup some of that, yes. I do not know how the entirety of 
all the stockholders can ever be repaid, but I think for the 
employees there should be something done, and I think 
legislation should be enacted to help that.
    Senator McCain. I thank you.
    Yes, Ms. Farmer.
    Ms. Farmer. May I respond to the first question that was 
asked? As far as the lockdown goes, I did not get the 
notification from Enron that they were changing administrators 
and that there would be a lockdown, and so I was totally 
unaware of that. When I called the new administrator I was 
transferred to their phone number in order to sell my stock on 
October 22. That is when I found out that there was a lockout 
of the employee's stock plan, savings plan, and when I pled 
with the person I was speaking to, the main response that I got 
was, yes, the timing is very unfortunate, and that was 
basically the main response, and I cannot even begin to 
describe to you how devastating that was to find out on that 
telephone call that I could not do anything with my stock.
    Enron had made all employees responsible for their own 
retirement in mid-1990. They no longer wanted to be responsible 
for paying a monthly pension check after their employees 
retired. Therefore, when they made us responsible for our own 
retirement, at the most crucial time they denied access to our 
own money, and that is so wrong.
    Senator McCain. Mr. Prestwood, let me get this straight. 
You worked for 33\1/2\ years?
    Mr. Prestwood. Yes, sir.
    Senator McCain. And in those 33\1/2\ years you accumulated 
stock worth $1.3 million?
    Mr. Prestwood. Yes, sir.
    Senator McCain. And how much do you have left now?
    Mr. Prestwood. Well, for whatever it is per share. I 
started out, I had about 16,500 shares. I have not figured it 
up. Whatever the market closed yesterday. It would be roughly 
$20,000 or less, zero you might say.
    Senator McCain. I Thank you. Thank you, Mr. Chairman.
    Senator Dorgan. Senator McCain, thank you.
    I would like to just show a chart that describes part of 
what you were asking about, if I might.
    This chart, if I could just hold it up, shows--and this is 
from November of last year to November of this year. This bar 
shows insider and restricted shareholder transactions, and it 
is very interesting that based on your testimony, management 
was counseling you all that the future was going to be quite 
wonderful and you need to hold onto your Enron stock, but at 
the same time, it is interesting that those who really knew 
from the inside moved their stock right at the top of the price 
range. It looks like there was an interesting paradox here 
about what they were doing with what they knew and what they 
were telling you.
    This somehow cannot be an accident, that the officers and 
directors found the exact top of the price range to sell stock, 
while at the same time as you say in your testimony Mr. 
Prestwood, that assurances to employees are describing a simply 
stunning future and financial performance and that you ought to 
hang onto the Enron stock. I think it relates to the questions 
you asked, Senator McCain, and I think that is a fascinating 
chart.
    Senator Hollings.
    The Chairman. Thank you, Mr. Chairman, and I certainly 
thank this panel, because it has been the most important 
appearance we have had before this Committee this year. I say 
that not just casually.
    Mr. Prestwood, you have really emphasized the need for 
Federal Government oversight. I have to listen to this nonsense 
of deregulation as proposed by people like Enron's leadership 
team who ran the company into the ground. You have got a whole 
coterie of people that comes up here to the Congress wanting to 
get rid of the Federal Government, as if the Government is the 
enemy. They claim the Government is not the solution, the 
Government is the problem. They succeeded in deregulating the 
oversight of energy derivatives, and we can all see where that 
has led.
    You get the best of the best, Arthur Andersen, Salomon 
Brothers and all of these highly credentialed financial 
entities working with special purpose entities that you and I 
do not know anything about, but we put all of those things in 
the law because some people in government are persuaded to 
deregulate and remove protections that are there for a reason. 
They are there to protect loyal employees like you all. I have 
been here for 50 years, since the late forties, working on 
economically and industrially developing my little State, and I 
know all about the balanced budget, transportation and the 
market and tax system and everything else of that kind, but the 
one thing that businesses come to South Carolina for is that 
loyalty that you mentioned, loyalty to the employer.
    We have a BMW plant in South Carolina with about 4,000 
employees. They come from within 50 miles, a majority of them, 
of that particular plant. They produce a quality car better 
than what they produce in Munich, Germany, where they have been 
making cars for years on end, but that employee loyalty, that 
is the thing. We need Government up here to protect the loyalty 
of you folks, because you all cannot tell what is going on. You 
all are working hard, a day's work for a day's dollar, as we 
say, and Enron's losses just emphasize that some businesses use 
all these little gimmicks and you have just got to watch how 
these things put everyday folks in peril. They say deregulate, 
deregulate, deregulate, and here we are, the finest working 
group in the world gone in a year's time from $90 billion to $1 
billion and everybody is broke.
    So your testimony here has been the best. We do not need 
any more hearings, but we are going to have some more hearings. 
We are going to find out from Lay and Skilling and all these 
other fellows exactly what went on, and follow it right down to 
affix individual responsibility as best we can, but overall, 
you have emphasized our particular need, which I have to 
constantly emphasize at every one of these endeavors up here, 
the necessity for regulation.
    There is no question that we have the Federal 
Communications Commission to regulate, not to give away, or the 
Federal Trade Commission to protect consumers, or the 
Securities and Exchange Commission to protect the employees and 
these 401(k) plans and everything else of that kind, and I hope 
they will transmit your particular testimony time and again on 
C-SPAN so the public will understand the necessity of all these 
regulations.
    They say get rid of the Government. They say the Government 
is not the solution, that the Government is the problem. Well, 
we have found what happens when Government does not deal with a 
problem, because we are not following through with regulations 
on the books. Thank you very much.
    Senator Dorgan. Senator Hollings, thank you very much.
    Senator Wyden.
    Senator Wyden. Thank you, Mr. Chairman. First, I so 
appreciate your coming. There is additional evidence that the 
lockdown period where you all could not sell your shares and 
your 401(k)s worked exactly how you all described it, and Mr. 
Chairman, I will just ask unanimous consent to put into the 
record an article from the newspaper, the Oregonian, that 
indicates that the plan was frozen, as the workers suggested, 
from October 17 until November 14, and that the stock price 
dropped almost $24 per share during that period.
    Senator Dorgan. Without objection.
    [The information referred to follows:]

                   Enron's Rise and Fall July 1985: 
               Houston Natural Gas Merges With InterNorth

                    The Oregonian, November 29, 2001

                            (Copyright 2001)

July 1985: Houston Natural Gas merges with InterNorth, a 
natural gas company based in Omaha, Neb., to form Enron, a 
natural gas pipeline company.

1989: Enron begins trading natural gas commodities, later 
becoming North America's largest natural gas merchant.

June 1994: Enron North America begins to trade electricity. 
Enron goes on to become the largest U.S. electricity marketer.

July 1996: Enron announces a deal to buy Portland General 
Electric for $3.23 billion in stock and assumed debt.

March 1998: FirstPoint Communications, a division of Portland 
General Electric, becomes Enron Communications.

April 1999: Enron agrees to pay $100 million over 30 years to 
name new Houston ballpark.

November 1999: Enron launches EnronOnline, the first global 
commodity trading site.

January 2000: Enron Communications becomes Enron Broadband 
Services, a bandwidth-trading subsidiary.

December 2000: Enron announces that President and Chief 
Operating Officer Jeffrey Skilling will take over as chief 
executive in February. Kenneth Lay will remain as chairman. 
Shares hit 52-week high of $84.87 on Dec. 28.

July 13: Enron announces it will close its 100-employee Enron 
Broadband office in Portland, then plans subsidiary's shutdown 
by Oct. 1.

August: Skilling resigns; Lay becomes CEO again.

Oct. 16: Enron reports a $638 million third-quarter loss and 
discloses a $1.2 billion decline in shareholder equity, partly 
related to partnerships run by Chief Financial Officer Andrew 
Fastow, who is later ousted.

Oct. 17: Enron's 401(k) plan is frozen so that the company can 
change plan administrators. Employees can't sell their 
holdings, including Enron stock.

Oct. 22: Enron acknowledges Securities and Exchange Commission 
inquiry into a possible conflict of interest related to Enron's 
partnership dealings.

Nov. 6: Enron's stock price drops below $10 a share after 
reports that the company was seeking additional financing.

Nov. 8: Enron files documents revising financial statements for 
past five years to account for $586 million in losses.

Nov. 9: Dynegy announces an agreement to buy its much larger 
rival Enron for more than $8 billion in stock.

Nov. 14: Enron announces it is trying to raise an additional 
$500 million to $1 billion. Enron 401(k) also reopens to 
transactions; Enron stock is $23.86 a share lower than on Oct. 
17.

Nov. 21: Enron reaches critical agreement to extend $690 
million debt payment.

Nov. 28: Dynegy drops deal. Enron shares end at 61 cents.

    Senator Wyden. You all have made the point. The fact of the 
matter is that Enron was just sinking like the TITANIC, and you 
have got the top officers up on the deck selling shares and all 
of you are locked in the boiler room not able to get rid of the 
stock. I really appreciate Mr. Vigil making the point as well 
about the company barring the employees from selling in a 
number of instances where they could have provided for their 
future.
    A question I wanted to ask all of you is that with respect 
to 401(k)s, it is sort of Investing 101 that you diversify, 
that you have a variety of stocks in your portfolio. In fact, 
there are fiduciary standards that you have a diversified 
portfolio. Did Enron ever, at any point, take the workers aside 
and say, you know, you have really got to look at your 401(k) 
in terms of putting your eggs in a lot of different places, 
rather than just all going through Enron.
    Mr. Vigil, I see you nodding your head.
    Mr. Vigil. To the best of my knowledge, nobody from Enron 
ever suggested that we diversify. In terms of the Enron stock, 
that was being awarded to us on the matching contribution.
    There is one little comment I would like to make here. 
Those of us who were participating in the 401(k), we were 
putting as much as 10 to 15 percent of our own money into that 
401(k), and it was diversified in another separate portfolio, 
or various portfolios, but what has been lost in this whole 
discussion is that those portfolios lost money also, because 
the people in Vanguard, Windsor II, and other places, they were 
also buying Enron stock, and so there is more to the losses 
here than just the 401(k) plan in terms of the company 
contributions.
    Senator Wyden. Ms. Farmer, did you ever get the word that 
you ought to have a diversified portfolio?
    Ms. Farmer. No, sir, never.
    Senator Wyden. Well, we are going to look into that some 
more, because as I say there is supposed to be a spread in 
terms of investments in a 401(k), and that is just Investing 
101. There are fiduciary standards with respect to these plans, 
and I have real questions about whether they were complied 
with.
    A question for the PGE folks, and as you all know, this is 
a bittersweet holiday for a lot of Oregonians. When PGE was 
taken over by Enron your stock was automatically converted to 
Enron stock, but obviously this is going to be a very different 
company. Certainly Enron is much more aggressive, experimenting 
with all of these financial derivatives. You do not just have a 
basic utility stock any longer. Were all of you at PGE given 
any warning or notification that when that change was made it 
would change the nature of your 401(k) holdings, and in 
particular that they would become more risky?
    Mr. Eri. Not to my knowledge. The first that I realized 
that my 401(k) needed to be adjusted was when I got ready to 
retire in April, prior to April, when I went out and summoned 
some financial advisors to look at my portfolio, and at that 
time that is when they told me that I had way too much Enron 
stock in my portfolio, and I needed to have that diversified 
more than what it was.
    Senator Wyden. One last question for you, Mr. Vigil. Did 
the company provide any justification for forcing employees to 
hold onto company-contributed Enron stock until age 50?
    Mr. Vigil. None. Nobody under age 50 understood why we 
could not roll that stock over. There was no justification ever 
given.
    Senator Wyden. Well, I want you to know I am also going to 
look into whether this is another example of the double 
standard at Enron, because its senior management did not have 
that rule applied to it and the workers did. That would be more 
evidence that there was one set of rules for folks like 
yourselves, who did a lot of the heavy lifting, and another set 
of rules for folks at the top. I appreciate your coming before 
the Committee today.
    I have real questions about whether the laws on the books 
like the one I wrote on financial fraud are being complied 
with, so we are going to stay at this, and stay at it until we 
get to the bottom of it.
    Thank you, Mr. Chairman.
    Senator Dorgan. Senator Wyden, thank you.
    Senator Burns.
    Senator Burns. I have no questions for this panel. I think 
what we have to do now is to find out the roots of the problem, 
and it sounds like to me, with the work that Senator Wyden has 
done, and a lot of other work that has been done, but it is 
hard to legislate or pass laws that deal with conscience, and 
responsibility. Just like, Mr. Prestwood, your loyalty to the 
company should have been matched by the loyalty of the 
management of the employees, and that is a hard thing to 
legislate, as you well know, but it points out, I think, we 
have to find out what went wrong and when it went wrong, to 
prevent it from here on.
    The recovery, of course, may be a more difficult thing, and 
we are certainly aware of your circumstances, and so I think 
what we have to do in the Senate is to find out what happened, 
and when did they know it, and if their loyalty to the 
employees was matched by the loyalty of the employees to the 
company. That is what we have to find out.
    So I am looking forward to the next panel, and to those 
people who were a little bit closer to the fire, so to speak, 
and find out what really happened, because it is a devastating 
thing, and I thank the Chairman.
    Senator Dorgan. Senator Burns, thank you.
    Senator Fitzgerald.

            STATEMENT OF HON. PETER G. FITZGERALD, 
                   U.S. SENATOR FROM ILLINOIS

    Senator Fitzgerald. Thank you, Mr. Chairman, and I 
appreciate your convening this hearing. I think it is a very 
important hearing. I have a question for all of you, both as 
employees who held shares in Enron, and also Ms. Pearson, as an 
outside shareholder.
    To what extent were you relying on what financial analysts 
were saying about Enron stock? I ask you that because my 
understanding is that in the case of Enron, in September of 
this year, when things were going south, you had 17 analysts 
covering Enron, and of them, 16 had a ``buy'' or ``strong buy'' 
rating on the stock, one had a ``hold'', and none had a 
``sell'' or a ``strong sell.''
    In April 1999 the head of the Securities and Exchange 
Commission, Arthur Levitt, gave a speech that cited a study 
that found sell recommendations account for just 1.4 percent of 
all analyst recommendations, compared to 68 percent of all 
recommendations being buys, and I have to tell the panelist 
from The Motley Fool who is up next that I am borrowing this 
from some of his testimony, reading ahead, but I think it is 
very good testimony.
    Clearly, you have analysts out there hyping stocks. The 
analysts work for some investment bank that meanwhile is 
providing investment banking services to the corporation--in 
this case, Enron. Does that, or did this play a role in your 
decisions to hold the stock until you could not sell it and it 
was locked down?
    Ms. Farmer. Absolutely.
    Senator Fitzgerald. Were you all following those ``buy'' 
recommendations and so forth?
    Ms. Farmer. Yes.
    Senator Fitzgerald. Did any of you think that you needed to 
take those ``buy'' recommendations with a grain of salt, or did 
you think of those recommendations as objective, nonbiased 
opinions?
    Ms. Farmer. Objective, nonbiased opinions, and I relied 
upon them as a guidance.
    Senator Fitzgerald. Does anybody say they did not rely on 
them?
    [No response.]
    Senator Fitzgerald. Well, it seems to me those analysts' 
recommendations are an issue that we want to get into.
    Ms. Pearson. If you cannot rely on them, who can you rely 
on? They are supposed to be smarter than we are.
    Senator Fitzgerald. That is a good point. They are supposed 
to know more than all the rest of us on this, and they were all 
recommending ``buy'' or ``strong buy'', only one ``hold'', even 
after Jeff Skilling, the Enron CEO, suddenly resigned and the 
company stock had already lost 60 percent of its value from the 
high of the year, and we, of course, saw the same thing with 
the Internet stocks in some cases, too.
    Well, thank you all very much. I appreciate your being 
here, and let us hope that out of your misfortune, we can 
create better controls and better laws to protect others from 
having to experience the same financial fate. I know that is 
not much of a consolation here, but that may be the most we can 
do, and so we thank you for your contribution.
    Ms. Pearson. Can I say one thing? As a sort of a funny side 
point, one of the directors under question was building a new 
house on a very valuable piece of property in a very valuable 
part of Houston, and he built it about halfway, and I am 
talking about a $4 million house, and it has stopped work. 
There is no more being done on that house, and that gives me 
great satisfaction.
    [Laughter.]
    Senator Burns. What about the carpenters that were working 
on that house?
    Ms. Pearson. I just hope they did not own any Enron stock.
    [Laughter.]
    Senator Dorgan. Ms. Pearson, one has to take satisfaction 
where one finds it. We appreciate your answer.
    Senator Nelson.
    Senator Nelson. Thank you, Mr. Chairman. All of you have 
been absolutely riveting in your testimony. Ms. Farmer, it 
hurts when it comes close to home; that you would lose nearly 
all of your nest egg of over $700,000 in your 401(k). 
Unfortunately, we have got a lot of folks like you in our State 
that are retirees that were relying on the same thing. I am 
curious, tell us a little bit more about when you got wind that 
the management had changed, and then you called the pension 
plan because you had received no written communication.
    Ms. Farmer. They had made a statement there that they were 
going to, I believe on October 16 that they were going to have 
to restate their earnings for the last several years, and at 
that time the stock had dropped to a point to where I no longer 
felt like I could maintain, and I was going to sell and keep 
what I had, even though I had already lost about 50 percent of 
my retirement fund, and that is when I called. On October 22 
was the first point in time I could get through, and that is 
when I learned that there was a lockdown.
    Senator Nelson. Did they say how long the lockdown had been 
in place?
    Ms. Farmer. They said it had started on October 17 and 
would go through November 20, and if I may, at this point I 
would like to mention that on November 20, with the 
Thanksgiving holidays, the phones at the Plan Administrator 
were very busy, because I am sure there were a lot of other 
people trying to get through. I could not sell my stock until 
Monday, November 26, and therefore lost even more money, 
because the stock had dropped even lower.
    Senator Nelson. When you had called on October 22, it looks 
like the stock was somewhere about the mid-twenties, and it was 
precipitously dropping every day.
    Ms. Farmer. Yes, sir.
    Senator Nelson. You said that they told you October 17 that 
the lockdown occurred, and Mr. Prestwood had testified that he 
knew that the letter was written October 8 but not mailed until 
October 10, and therefore if you figure 3 or 4 days for mail to 
be delivered, that is bumping right up against October 17, the 
very day that you said that they said the lockdown is in 
effect. That does not give a participant in a 401(k) retirement 
plan much time.
    Ms. Farmer. Personally, in my opinion, I do not think that 
is coincidence.
    Senator Nelson. That is interesting. Well, we are going to 
investigate that.
    Ms. Farmer. Thank you very much.
    Senator Nelson. What did any of the managers tell you 
concerning the reason for not allowing you to sell? In other 
words, the reasons for the lockdown? What did they say to you?
    Ms. Farmer. I did not hear from the managers. As I said, I 
did not get the notification that there was going to be a 
lockdown, but when I spoke to the new administrators of the 401 
savings plan they were told that it was strictly for a change 
in plan administrators, that it was going to take approximately 
30 days in order to complete that change, and that I would have 
to wait till the end of that period before I could transfer or 
sell any of my stock.
    Senator Nelson. Did you have any knowledge as to who had 
made that decision there was going to be a 30-day lockdown?
    Ms. Farmer. No, sir.
    Senator Nelson. Were there any kind of internal company 
newsletters to retirees like yourself that would give any 
indication as to the financial condition of the company and of 
the retirement savings plan?
    Ms. Farmer. No, sir.
    Senator Nelson. Well, Mr. Chairman, it is just very clear 
we have got a lot to investigate here. Mrs. Farmer started with 
the Florida Gas Corporation. It is headquartered in my old 
congressional district of Winterpark, Florida when I went to 
Congress in 1978. It was a good company. It had a gas pipeline 
that came all the way from Texas right down the spine of 
Florida to supply all the natural gas, and she started to work 
for that--what year did you start?
    Ms. Farmer. In 1981. I began with Florida Gas Transmission 
Company.
    Senator Nelson. Was Mr. Lay at Florida Gas when you 
started?
    Ms. Farmer. I do not believe he was. I believe Mr. Lay came 
with Florida Gas in the mid-eighties, maybe 1983, some thing of 
that nature, and then beginning in 1985 was when several 
pipeline companies merged throughout the United States and 
Enron was formed, and the home office was moved for Florida Gas 
Transmission from the Winterpark, Florida location to Houston.
    Senator Nelson. Well, in my opinion, each one of these 
participants at our witness table today is very heroic. Here is 
a lady from my home area, she worked hard, she played by the 
rules, she saved, she believed in the company, and now she has 
lost everything for her retirement years. I am looking forward 
to finding out what this investigation is going to reveal, Mr. 
Chairman.
    Thank you.
    Senator Dorgan. Senator Nelson, thank you.
    Senator Boxer.

                STATEMENT OF HON. BARBARA BOXER 
                  U.S. SENATOR FROM CALIFORNIA

    Senator Boxer. Thank you very much, Mr. Chairman. I want to 
thank you and Senator McCain for having this hearing. I think 
it is important that we listen and we learn, and we come out 
with a plan that is well-thought-out. Let me say this is an 
incredible panel. I would like to take Ms. Pearson home with 
me.
    Ms. Pearson. That could be arranged.
    [Laughter.]
    Ms. Pearson. Do you have any Enron stock?
    Senator Boxer. That is another story for another day. We 
will talk, but here is the point. These people have been 
deeply, deeply, deeply hurt, their dreams shattered, and they 
are here helping us, and I want to thank you so much.
    In my former life, way back many years ago, I was a 
stockbroker, and I saw many smiles and many tears and went 
through a lot of ups and downs. The stock market in those days 
was a little easier. There were only 12 million shares traded 
per day back then, and I never saw anything like this. I never 
saw anything with the depth of this.
    Unfortunately, in my State, we had a couple of things that 
were really the precursor to this. I want to see if my 
colleagues remember the Color Tile failure where a company went 
broke--some of you are nodding in the audience--and they forced 
their employees to buy the company through their 401(k) plan, 
so when the company went broke they had nothing. They had real 
estate in the company which was gone, so they had nothing.
    And then we had Carter Hawley Hale, which was a giant 
retailer that had emporium stores. The same thing happened. No 
one could believe this happened, the same thing, so as Senator 
Wyden alluded, my other colleagues and I who worked in this 
area, wrote a law that I think could come into play here, and I 
want to tell you about it and tell you what I have done.
    Sad to say, and I apologize, it was watered down. I could 
not fight. I mean, I had to fight so hard to get what little I 
got, but the law that passed in 1997 says that an employer--and 
I want you to follow this--cannot force an employee to buy 
company stock with the employee's contribution. Now, I know you 
were not forced. They did not force you that I know, because I 
have checked it. You did it of your own free will. However, I 
believe that when the plan was locked down, in essence you were 
forced to keep that company stock. Is there anyone on the panel 
that would disagree with that? In other words, you wanted out, 
some of you called, so my view is that they violated that law.
    Now what is the punishment for that in the law? The 
punishment for that is that the tax advantages that Enron got 
could well be taken away from them in retrospect, putting the 
IRS at the front of the line to collect some of this money and 
hopefully, if we work together, maybe we can direct some of 
that money back to the employees.
    Now, we are looking at how much that would be, but I want 
to tell you something. As I checked into this, when an employer 
makes a contribution in stock to a plan they get a 100-percent 
tax deduction, based on the value of the stock at the time, so 
they took big, big write-offs, and they said that they were a 
good actor, they were in good faith. Well, they were in good 
faith until the lockdown, so we have written to the IRS, and I 
am hoping to get some of my colleagues to work with me to see 
if there is some hook here where we can get the employees more 
to the front of the line to get some of this back.
    Whether we have a shot, I am not sure. I feel that it is 
true what Senator Burns said, you cannot legislate a conscience 
or good character, or fairness in people. I mean, let us take a 
look at this insider stuff. Kenneth Lay, Enron's Chairman, sold 
1.8 million shares for $101 million. All this happened in a 
period of a couple of years. Jeffrey Skilling--this is all 
public information--former chief executive, sold 1 million 
shares for $66 million, so when you asked, Mr. Prestwood, $1 
million, I think $1 million is a lot of money, but it pales 
compared to these people. $268 million for Lou Pai, and this 
goes on, and you probably know these names. I do not. I am not 
familiar with them.
    Here is the thing. I think we need to do more. First, we 
have to make sure that laws such as Senator Wyden's law and my 
law and other pension laws are definitely followed here, and if 
not, we have to come down hard and see what we can do to 
recover some of these loss streams.
    But Senator Corzine and I are introducing legislation which 
I am very excited about, and in my remaining time I will tell 
you the principles. It would limit to 20 percent the investment 
an employee can have in an individual account, or individual 
retirement plan. I mean, it is all the eggs in one basket. We 
always know it is not right, but when we are sort of tempted 
into it, and I think this would be a good thing.
    Second, and this speaks to something that Mr. Vigil pointed 
out, it would limit to only 90 days the time an employer could 
force an employee to hold a matching employer stock 
contribution. In other words, why should you have to wait till 
you are 50? You are a grown person. If this is the way they are 
helping you, and they are making stock contributions, that is 
great, but why should you have to sit tight when the market 
starts to change?
    Third, we would change the tax deduction to 50 percent if 
they made the contribution in stock. If they made the 
contribution in cash, they could get 100 percent. Those are the 
main points I want to make, and they are as a result of what 
you have been telling us about your experience.
    So Mr. Chairman, again my deepest thanks for your 
leadership, and I thank the panel.
    Senator Dorgan. Senator Boxer, thanks very much. This panel 
has been extraordinary. As all of us know, public companies' 
financial statements are supposed to be transparent and public. 
We now know that in the case of Enron's secret off-the-books 
partnerships they were neither transparent nor public. As a 
result of that, as I indicated in my opening statement, it 
appears to me that we have what some in my home town they would 
say, ``cooked books'' here, and those that cooked the books 
made off with a fair amount of money. I wanted to, in respect 
to Senator Boxer's comments, display a chart that shows the 
sale of stock by some of the key people at Enron from 1998 to 
the present. I have, I think, 25 pages of this information.
    But one individual, Kenneth Lay, sold $101 million; Mr. 
Rice, $72 million; Mr. Skilling, $66 million; Mr. Horton, $45 
million; and Mr. Fastow, $30 million. I might just again show 
this chart, because I think it is important. This shows the 
value of the stock, and the green line is when the insiders 
were selling the stock, and so those folks that I just 
described making money off the sale of stock actually managed 
to find the top stock price for the largest block of sales.
    They knew something, but they were telling the employees: 
hang onto your stock, this company is going to get bigger and 
better and stronger, and tomorrow is going to be better for 
you. At the same time, they were selling their own stock. I 
think that raises all of the questions that have been described 
by my colleagues.
    Senator Boxer. Would you yield for just a very quick point? 
This is so discouraging and depressing, and what adds to it is, 
you had these big companies which have been mentioned before, 
and the auditors. It is one thing for a stock analyst to be fed 
a bunch of baloney. We have seen that happen. It is another 
thing for people who are paid to tell the truth and to be 
honest, these big accounting firms that we rely on, that in my 
day the first thing you look at when you make a recommendation 
for a stock, what do these people say, they are the honest 
ones, but their eyes were glazed over from these big contracts 
they were getting from Enron. It is a whole other area.
    Senator Dorgan. Senator Boxer, we will have the auditors 
next.
    Mr. Prestwood from Texas, you are familiar with Bob Wills 
and his Texas Playboys and their rather famous refrain, 
``Little bee sucks the blossom, but the big bee gets the honey. 
Little guy picks the cotton, but the big guy gets the money.'' 
We understand those things happen in life all too often, but 
there is much more at work with respect to this, so we intend 
to pursue this as long as it takes to get to the bottom of it.
    Again, thank you for spending the time to be with us.
    Ms. Farmer, one final comment?
    Ms. Farmer. Yes, I would like to have one final comment, 
please. I was fortunate enough to have my daughter accompany me 
here to Washington, D.C. to appear before this Committee. My 
family, my son Jeffrey Farmer, he serves with the U.S. Marine 
Corps, and he sends his thanks to you also for any help that 
you can give us in this concern, and we do appreciate and I am 
honored to have had the opportunity to appear here, and I thank 
you from the bottom of my heart.
    Senator Dorgan. Well, Ms. Farmer, you thank your son for 
his service to our nation in this important time, and thanks to 
all of you for being at the table today. You are welcome to 
stay for the rest of the hearing.
    We would now like to call the next panel, and I indicated 
that Mr. Kenneth Lay was invited. He will not appear today, but 
his representatives told me this morning that Mr. Lay will be 
available for a second hearing scheduled for February 4. We 
will also ask Mr. Skilling and Mr. Fastow to be present, along 
with others.
    The global head of auditing for Arthur Andersen, Mr. C. E. 
Andrews is with us, and I am going to ask, because of the time 
problem, Mr. Scott Cleland, Chief Executive Officer, Precursor 
Group,' to join the second panel.
    Following the second panel, we will have three individuals 
on the third panel testify as well, but if we could ask Mr. 
Andrews to please come forward, and Mr. Scott Cleland, if you 
are here, would you please come forward and take a seat at the 
table. My understanding is Mr. Cleland has a travel issue, and 
so we want to move him up to the second panel.
    Mr. Andrews, thank you very much for joining us today. You 
have heard a generous amount of discussion today about a range 
of questions that are asked about auditors, analysts' records, 
secret partnerships, et cetera. We appreciate the fact that 
your company went to a hearing in the U.S. House upon request 
and have now appeared at a hearing in the U.S. Senate.
    I understand that, given what has happened, it is not 
pleasant to respond to these requests, but this Committee very 
much appreciates your company's willingness to come when asked 
and provide testimony. Why don't you proceed. Your entire 
statement will be made a part of the permanent record, and you 
may summarize.

    STATEMENT OF C. E. ANDREWS, GLOBAL HEAD OF AUDITING AND 
                  BUSINESS ADVISORY, ANDERSEN

    Mr. Andrews. Chairman Dorgan, Chairman Hollings, Senator 
Fitzgerald, Senator McCain, and members of the Committee, good 
morning. Thank you for inviting me to appear before you. I am 
the Managing Partner of Anderson's global audit practice. I am 
here because faith in our firm and in the integrity of the 
capital market system has been shaken. What happened at Enron 
is a tragedy on many levels. We are very aware of the impact 
this has had on investors and the pain that this business 
failure has caused for employees and others, as you have heard 
very poignantly this morning.
    Many questions need to be answered. Some involve accounting 
and auditing. I will do my best to address these. I ask you 
keep in mind the auditing and accounting issues are very 
complex and part of a bigger picture. None of us yet know all 
the facts. Today's hearing is an important step in enlightening 
all of us. If there is one thing you take away from my 
testimony, I hope it is this. The public's confidence is of 
paramount importance. Andersen will not shrink from its 
responsibilities. If our firm has made errors in judgment, we 
will acknowledge them. We will take the actions needed to 
restore confidence.
    In my written testimony, I have addressed two issues that 
go to the heart of concerns about our role as Enron's auditor. 
Did we do our job? Did we act with integrity?
    To aid the Committee in its inquiry I have provided 
detailed answers to these questions in my written statement, 
but let me touch on some key points. On the accounting issues, 
Enron has said it will restate its financial statements back to 
1997 as a result of issues with two special purpose entities or 
SPE's. These are sophisticated financing vehicles used by many 
companies. They are well-known to the investment community. On 
the larger of these, which was responsible for 80 percent of 
the SPE-related restatement, it appears that important 
information was not revealed to our team. We and the board's 
special committee are looking into why.
    As required by section 10A we have notified the audit 
committee of possible illegal acts within the company. We have 
not concluded that any illegal acts occurred. On the smaller of 
the SPE's, which were responsible for 20 percent of the SPE 
restatement, we now believe, based upon a second look, that our 
team made an error in judgment, an honest error, but an error 
nonetheless, but I do believe that we did a professional job 
overall and that this error did not cause Enron's collapse.
    There have also been questions about the sufficiency of 
Enron's disclosures. It is true that Enron did not disclose 
every transaction or contingency. It was not required to. 
Accounting rules also do not require a company to disclose 
remote contingencies such as the sudden rapid decline we 
witnessed in Enron's stock price and credit ratings.
    Finally, let me spend a minute on fees. We were paid $52 
million by Enron last year, including $25 million for our 
audit. There is the perception that the remaining $27 million 
was for traditional management consulting work such as 
installation of computer systems. In fact, the bulk of that $27 
million was for audit-related work, tax work, and work that can 
only be done by auditors. $13.3 million was for consulting work 
done by Arthur Andersen.
    Some may assert that even $13 million of consulting work is 
too much, that it weakens the backbone of the auditor. There is 
a fundamental issue here. Whether it is consulting work or 
audit work, the reality is that auditors are paid by their 
clients. For our system to work, you and the investing public 
must have confidence that the fees we are paid, regardless of 
the nature of that work, will not weaken our resolve to do what 
is right and in the best interests of investors.
    I do not believe the fees we received compromised our 
independence. Some will disagree, and we have to deal with the 
reality of that perception. I am very aware that our firm must 
restore the public's trust. I do not have all the answers 
today, but I can assure you that we are carefully assessing 
this issue and will take the steps necessary to reassure you 
and the public that our backbone is firm and our judgment is 
clear.
    Andersen will have to change to restore the public's 
confidence, and we are working hard to identify the changes we 
need to make. The accounting profession will also have to 
reform itself. Our system of regulation and discipline will 
have to improve, and others will have to do things differently 
as well, companies, boards, audit committees, analysts, 
investment bankers, credit analysts and others.
    I believe we can work together to give investors more 
meaningful, relevant, and timely information. Our firm will do 
its part. Thank you.
    [The prepared statement of Mr. Andrews follows:]

    Prepared Statement of C. E. Andrews, Global Head of Auditing and
                      Business Advisory, Andersen

    Chairman Dorgan, Senator Fitzgerald, Chairman Hollings, Senator 
McCain, Members of the Committee.
    I am the managing partner for Andersen's global audit practice. I 
am here today because faith in our firm and in the integrity of the 
capital market system has been shaken. There is some explaining to do.
    What happened at Enron is a tragedy on many levels. We are acutely 
aware of the impact this has had on investors. We also recognize the 
pain this business failure has caused for Enron's employees and others.
    Many questions about Enron's failure need to be answered, and some 
involve accounting and auditing matters. I will do my best today to 
address those.
    I ask that you keep in mind that the relevant auditing and 
accounting issues are extraordinarily complex and part of a much bigger 
picture. None of us here yet knows all the facts. Today's hearing is an 
important step in enlightening all of us. I am certain that together we 
will get to the facts.
    If there is one thing you take away from my testimony, I hope it is 
this: The public's confidence is of paramount importance. Andersen will 
not shrink from its responsibilities. If our firm has made errors in 
judgment, we will acknowledge them. We will take the actions needed to 
restore confidence.
    Today, I would like to address two issues that go to the heart of 
concerns about our role as Enron's auditor.
    First, did we do our job? I want to explain what we knew and when 
we knew it on several key issues, keeping in mind that our own review--
like yours--is still under way.
    Second, did we act with integrity? I want to discuss the $52 
million in fees we received and respond to concerns that have been 
raised.
    I also would like to cover what I believe are some of the lessons 
we can already learn from Enron--for our firm, for the accounting 
profession, and for all participants in the financial reporting system. 
My firm has publicly discussed many of these already.
    Let me start by telling you what we know about three particular 
accounting and reporting issues:

   the restatements caused by the consolidation of two Special 
        Purpose Entities, known as SPEs, and the recording of 
        previously ``passed'' adjustments as a required byproduct of 
        the restatement;

   a $1.2 billion reclassification in the presentation of 
        shareholders' equity during 2001--of which $172 million was 
        misclassified in the audited 2000 financial statement, and;

   the company's disclosures about its off-balance-sheet 
        transactions and related financial activities.

    I want to emphasize that my remarks are based on the information 
that is currently available. We have made our best efforts to be 
complete and accurate in describing what we know. But our review, like 
the work of the SEC, this Committee, Enron's board, and others, is not 
yet complete. It is always possible that new information could be 
developed that would change current understanding of events or uncover 
new events.
Consolidation of Special Purpose Entities
    Let me begin with the Special Purpose Entities. SPEs are financing 
vehicles that permit companies, like Enron, to, among other things, 
access capital or to increase leverage without adding debt to their 
balance sheet. Wall Street has helped companies raise billions of 
dollars with these structured financings, which are well known to 
analysts and sophisticated investors.
    Two SPEs were involved in Enron's recent restatement announcement. 
On one, the smaller of them, we made a professional judgment about the 
appropriate accounting treatment that turned out to be wrong. On the 
one with the larger impact, it would appear that our audit team was not 
provided critical information. We are trying to determine what happened 
and why.
    Let's begin with the larger SPE, an entity called Chewco. What 
happened with Chewco accounted for about 80 percent of the SPE-related 
restatement.
    In 1993, Enron and the California Public Employees Retirement 
System (Calpers) formed a 50/50 partnership they called Joint Energy 
Development Investments Limited, or JEDI for short. Among other 
factors, the fact that Enron did not control more than 50 percent of 
JEDI meant that that partnership's financial statements could not be 
consolidated with Enron's financial statements under the accounting 
rules. In 1997, Chewco bought out Calpers' interest in JEDI. Enron 
sponsored Chewco's creation as an SPE and had investments in Chewco.
    The rules behind what happened are complex, but can be boiled down 
to this. The accounting rules dictate, among other things, that 
unrelated parties must have residual equity equal to at least 3 percent 
of the fair value of an SPE's assets in order for the SPE to qualify 
for non-consolidation. However, there is no prohibition against company 
employees also being involved as investors, provided that various tests 
were met, including the 3 percent test.
    In 1997, we performed audit procedures on the Chewco transaction. 
The information provided to our auditors showed that approximately 
$11.4 million in Chewco had come from a large international financial 
institution unrelated to Enron. That equity met the 3 percent residual 
equity test. However, we recently learned that Enron had arranged a 
separate agreement with that institution under which cash collateral 
was provided for half of the residual equity.
    What happened?
    Very significantly, at the time of our 1997 procedures, the company 
did not reveal that it had this agreement with the financial 
institution. With this separate agreement, the bank had only one-half 
of the necessary equity at risk. As a result, Chewco's financial 
statements since 1997 were required to be consolidated with JEDI's 
which, in a domino effect, then had to be consolidated in Enron's 
financial statements. We identified the impact of this separate 
agreement on Enron's financial statements in the course of examining a 
number of documents provided to us by Enron management and the Board's 
special committee in November 2001. Kenneth Lay and Richard Causey have 
told us that they were not aware of this separate agreement until its 
discovery in November 2001 and we do not know of any contrary facts.
    It is not clear why the relevant information was not provided to us 
in 1997. We and the Board's special committee are still looking into 
that.
    We have notified Enron's audit committee of possible illegal acts 
within the company, as required under Section 10A of the Securities and 
Exchange Act. Because the special committee is investigating all of 
these matters, Section 10A does not require us to take any additional 
action until the special committee finishes its work and the Board acts 
upon any recommendations. We have not concluded that any illegal acts 
occurred.
    Now, about the second SPE structure; specifically, a subsidiary of 
the entity known as LJM1. This transaction was responsible for about 20 
percent--or $100 million--of Enron's recent SPE-related restatement.
    In retrospect, we believe LJM1's subsidiary should have been 
consolidated. I am here today to tell you candidly that this was the 
result of an error in judgment. Essentially, this is what happened:
    After our initial review of LJM1 in 1999, Enron decided to create a 
subsidiary within LJM1, informally referred to as Swap Sub. As a result 
of this change, the 3 percent test for residual equity had to be met 
not only by LJM1, but also by LJM1's subsidiary, Swap Sub.
    In evaluating the 3 percent residual equity level required to 
qualify for non-consolidation, there were some complex issues 
concerning the valuation of various assets and liabilities. When we 
reviewed this transaction again in October 2001, we determined that our 
team's initial judgment that the 3 percent test was met was in error. 
We promptly told Enron to correct it.
    We are still looking into the facts. But given what we know now, 
this appears to have been the result of a reasonable effort, made in 
good faith. I do believe that we did a professional job overall and 
that this error did not cause Enron's collapse.
Adjustments previously not made to Enron's 1997 financial statement
    As a result of the restatement for the SPEs, Enron was required to 
address proposed adjustments to its financial statements that were not 
made during the periods subject to restatement. Questions have been 
raised about certain of these ``passed adjustments.'' Let me address 
that issue next.
    As part of the audit process, the auditor proposes adjustments to 
the company's financial statements based on its interpretation of 
Generally Accepted Accounting Principles (GAAP). A company's decision 
to decline to make proposed adjustments does not mean that there has 
been an intentional effort to misstate. If the auditor believes that 
the company's actions result in either an intentional error or a 
material misstatement, it may not sign the audit opinion.
    Often, there is a timing issue to consider. These adjustments 
typically are proposed by the auditor at the conclusion of the audit 
work--usually one or two months after the close of the year-end. Some 
companies, like Enron, choose to book those adjustments in the year 
after the auditor identifies them, when they are immaterial.
    Questions have been raised about $51 million in adjustments not 
made in 1997 when Enron reported net income totaling $105 million. Some 
have asked how adjustments representing almost half of reported net 
income could have been deemed to be immaterial.
    Auditing standards and SEC guidance say both qualitative and 
quantitative factors need to be considered in determining whether 
something is material. The Supreme Court has described this approach as 
the ``total mix'' of information that auditors must consider.
    In 1997, Enron had taken large nonrecurring charges. When the 
company decided to pass these proposed adjustments, our audit team had 
to determine whether the company's decision had a material impact on 
the financial statements. The question was whether the team should only 
use reported income of $105 million, or should it also consider 
adjusted earnings before items that affect comparability--what 
accountants call ``normalized'' income?
    We looked at ``the total mix'' and, in our judgment, on a 
quantitative basis, the passed adjustments were deemed not to be 
material, amounting to less than 8 percent of normalized earnings. 
Normalized income was deemed appropriate in light of the fact that the 
company had reported net income of $584 million one year earlier, in 
1996, $520 million in 1995 and $453 million in 1994.
    It is also important to remind you that the restatement analysis 
presented in Enron's recent 8-K filing was not audited. When Enron's 
audited restatement is issued, the $51 million in adjustments presented 
in 1997 will be reduced for the effect of adjustments proposed in 1996, 
which were recorded in 1997.
Reclassification of $1.2 billion of shareholders' equity
    Now let me turn to the issue of shareholders' equity. Shareholders' 
equity was incorrectly presented on Enron's balance sheet last year and 
in two unaudited quarters this year.
    Auditors do not test every transaction and they are not expected 
to. To do so would be impractical and would be prohibitively expensive. 
EnronOnline alone handled over 500,000 transactions last year.
    Auditing standards require an audit scope sufficient to provide 
reasonable--not absolute--assurance that any material errors will be 
identified. This testing is based on a cost-effective and proven 
technique known as sampling. If appropriate accounting is found in a 
properly chosen sample, this generally provides reasonable assurance 
that the accounting for the whole population of transactions has been 
done in accordance with GAAP and is free of material misstatement.
    Shareholders' equity was initially overstated last year for a 
transaction with a balance sheet effect of $172 million. This amount 
was recorded as an asset, but should have been presented as a reduction 
in shareholders' equity. We recognize that this is a large number in 
absolute terms, but our work as auditors requires us to put such 
numbers into their proper context. That amount, $172 million, was less 
than one third of one percent of Enron's total assets and approximately 
1.5 percent of shareholders' equity of $11.5 billion. It was a very 
small item relative to total assets and equity and had no impact on 
earnings or cash flow. Accordingly, the transaction fell below the 
scope of our audit.
    In the first quarter of this year, Enron accounted for several more 
transactions in a similar way, increasing the size of the incorrect 
presentation of shareholders' equity by about $828 million.
    The quarterly financial statements of public companies are not 
subject to an audit, and we did not conduct an audit of Enron's 
quarterly reports. Consistent with the applicable standards, our work 
primarily was a limited review of the company's unaudited financial 
statements.
    In the third quarter, Enron closed out the transactions that 
included the $172 million and the $828 million equity amounts, and we 
and Enron reviewed the associated accounting. This review included 
third-quarter impacts on the profit and loss statement and on the 
balance sheet. This is when the erroneous presentation of shareholders' 
equity came into focus. (The remaining $200 million of this adjustment 
in equity was the result of transactions that occurred during the third 
quarter of 2001.)
    We had discussed the proper accounting treatment for other 
transactions affecting equity with Enron's accounting staff, and 
therefore, the scope of our work on the year 2000 audit and this year's 
quarterly reviews did not anticipate this sort of error. When we 
informed the company of the error, the company made the necessary 
changes in its financial statements.
Questions about disclosure
    Questions have been raised about the sufficiency of Enron's 
disclosures, especially about unconsolidated entities. I ask you to 
keep in mind that the company disclosed in its financial statements 
that it was using a number of unconsolidated structured financing 
vehicles. Unconsolidated means, by definition, that the assets and 
liabilities of these entities were not recorded in Enron's financial 
statements. However, in certain circumstances, footnote disclosures are 
required.
    With that disclaimer, let me offer one man's view of what investors 
were told. Enron had hundreds of structured finance transactions. Some 
were simple; others, very complex. The company did not disclose the 
details of every transaction, which is acceptable under GAAP, but it 
did disclose those involving related parties and unconsolidated equity 
affiliates.

   JEDI and other entities are listed in footnote nine of 
        Enron's 2000 annual report.

   LJM1 and LJM2, involving the company's former CFO, both were 
        described in the 1999 and 2000 annual reports and described 
        more fully in its annual proxy statements.

   Enron's unaudited quarterly financial statements also 
        disclosed transactions with LJM1 and LJM2.

    In footnote 11 to the 2000 annual report, Enron also disclosed 
under the heading ``Derivative Instruments'' that it had derivative 
instruments on 12 million shares of its common stock with JEDI and 22.5 
million with related parties.
    Some people say we should have required the company to make more 
disclosures about contingencies, such as accelerated debt payments, 
associated with a possible decline in the value of Enron's stock or 
changes in the company's credit rating. The Company did disclose this 
possible risk in its Management's Discussion and Analysis, or MD&A, 
section of its annual report.
    I ask you to keep in mind that the company's shares were coming off 
near record levels when we completed our audit for 2000. No one could 
have anticipated the sudden, rapid decline we witnessed in this stock 
and its credit ratings, and accounting rules don't require a company to 
disclose remote contingencies.
    That said, we continue to believe investors would be better served 
if our accounting rules were changed to reflect the risks and rewards 
of transactions such as SPEs, not just who controls them. Putting more 
of the assets and liabilities that are at risk on the balance sheet 
would do more than additional disclosure ever could. We have advocated 
changes in these accounting rules since 1982.
    I offer an additional observation about Enron's disclosures. Press 
reports indicate that some who analyzed the company's public 
disclosures came to the conclusion that perceptions about the company--
and thus the market's valuation of Enron--were not supported by what 
was in the company's public filings.
Fees paid to Andersen
    Some are questioning whether the size of our fees, $52 million, and 
the fact that we were paid $27 million for services other than the 
Enron audit, may have compromised our independence. I understand that 
the size of fees might raise questions, and I think our profession must 
be sensitive to that perception.
    With that in mind, it would be helpful for the Committee to have a 
deeper understanding of the nature of the work we did for Enron, and 
how the fees for that work were reported.
    As a starting point, Enron was a big, complex company. Enron had 
$100 billion in sales last year. It operated 25,000 miles of interstate 
pipeline and an 18,000-mile global fiber optic network. Enron did 
business in many countries. Its EnronOnline trading system was the 
world's largest web-based eCommerce system and handled more than half a 
million transactions last year--for 1,200 products. Enron was the 
seventh largest company on the Fortune 500.
    This was not a simple company. It was not a simple company to 
audit. In addition to its operations and trading, Enron, as we know, 
engaged in sophisticated financial transactions--hundreds of them. 
Assets worldwide totaled $65 billion, both before and after Enron 
adjusted for the restatements
    Given this complexity, it should not surprise anyone that the fees 
paid to our firm for Enron's audit were substantial. The $25 million 
fee for Enron's audit last year is comparable to the amounts that 
General Electric and Citigroup, two sophisticated financial services 
providers, paid for their audits. It is slightly more than the audit 
fees paid by two others--JPMorgan Chase and Merrill Lynch.
    Additional questions have recently arisen about whether Andersen 
served as Enron's internal auditor.
    Enron has engaged Andersen to issue two separate reports: (1) a 
report on Enron's financial statements, and (2) a report on 
management's assertions about the reliability of Enron's system of 
internal control. Andersen is Enron's external auditor in preparing 
both types of reports. This second report is not required by federal 
law but has long been recognized--by the GAO, among others--as a best 
practice for large, complex companies like Enron. The standards for 
issuing such reports on internal controls, which are a type of attest 
work, are covered in the auditing literature. The fees associated with 
our report on Enron's system of internal control were part of our 
engagement as Enron's external auditor. These fees were properly 
reported as ``audit'' fees in Enron's proxy statement since Andersen 
performed the work as part of a single integrated audit.
    From 1994-1998, Enron outsourced parts of its internal audit 
function to Andersen. That arrangement ended in 1998. Enron then began 
to add to its existing internal audit function under the umbrella of 
Enron Assurance Services (EAS). Enron's Risk Assessment and Control 
group also performs internal audit-type work.
    From time to time after 1998, we were asked by Enron to perform 
certain consulting projects related to prospective changes to the 
control system. The fees for these projects in 2000 were disclosed as 
``non-audit'' fees in Enron's proxy statement.
    It is important to understand that internal auditing is not the 
same as bookkeeping. Internal auditors do not prepare a company's 
financial statements; those statements are prepared by the company--at 
Enron, by the accounting and financial reporting function led by the 
company's Chief Accounting Officer. An internal auditor does some of 
the same activities that an external auditor does, such as testing the 
company's system of internal control to assess whether it provides 
``reasonable assurance'' that the company is accurately recording 
transactions on its books. Internal auditors can also perform 
additional functions such as operational auditing and reviews of 
prospective changes to the control system.
    Next, I would like to address questions about our fees for non-
audit services. Because of the way the fee categories for new proxy 
statement disclosures on auditor fees were defined, many services 
traditionally provided by auditors--and in many cases only provided by 
auditors--now are classified as ``Other.'' Regrettably, without 
knowledge of the underlying facts, this leads some to believe that such 
fees are for ``consulting'' services. That is incorrect.
    In fact, $2.4 million of the $27 million in ``other'' fees reported 
by Enron last year related to work we did on registration statements 
and comfort letters. This is work only a company's audit firm can do.
    Another $3.5 million was for tax work, which has never been 
mentioned as a conflict with audit work. Audit firms almost always do 
tax work for clients.
    Another $3.2 million of the ``other'' fees related to a review of 
the controls associated with a new accounting system--a service highly 
relevant to the auditor's understanding of the company's financial 
reporting system. Another Big Five firm installed that financial 
accounting system--for about $30 million. The scope and amount of this 
work, which is a type of work sometimes performed by a company's 
internal auditors, complied with the AICPA professional standards and 
the SEC rules governing internal audit outsourcing which take effect 
next August.
    Finally, $4 million of the fees listed as having been paid to 
Andersen were, in fact, paid to Andersen Consulting, now known as 
Accenture. As most of you know, our firms formally separated last 
August and had been operating as independent businesses for some time. 
Nevertheless, the rules said Enron had to report any fees it paid to 
Andersen Consulting as having been paid to its audit firm.
    If you take all these factors into account, the total fees that our 
firm received from Enron last year amounted to $47.5 million. And of 
this, about $34.2 million, or 72 percent, was audit-related and tax 
work. Total fees for other services paid to our firm amounted to $13.3 
million. This was for several projects, none of which was for systems 
implementation or for more than $3 million.
    Some may still assert that even $13 million of consulting work is 
too much--that it weakens the backbone of the auditor. There is a 
fundamental issue here. Whether it's consulting work or audit work, the 
reality is that auditors are paid by their clients. For our system to 
work, you and the investing public must have confidence that the fees 
we are paid, regardless of the nature of our work, will not weaken our 
willingness to do what is right and in the best interest of the 
investors as represented by the audit committee and the board.
    I do not believe the fees we received compromised our independence. 
Obviously, some will disagree. And I have to deal with the reality of 
that perception. I am acutely aware that our firm must restore the 
public's trust. I do not have all the answers today. But I can assure 
you that we are carefully assessing this issue and will take the steps 
necessary to reassure you and the public that our backbone is firm and 
our judgment is clear.
Lessons for the Future
    When a calamity happens, it is absolutely appropriate to ask what 
everyone involved could have done to prevent it. By asking the other 
witnesses and me to testify today, the Committee is working hard, in 
good faith, to understand the issues involved and to help prevent a 
recurrence with another company.
    I believe that there is a crisis of confidence in my profession. 
This is deeply troubling to me, as I believe it is a concern for all of 
the profession's leaders and, indeed, all of our professionals. Real 
change will be required to regain the public's trust.
    Andersen will have to change, and we are working hard to identify 
the changes that we should make.
    The accounting profession will have to reform itself. Our system of 
regulation and discipline will have to be improved. Our CEO discussed 
some of the issues that the profession faces in an op-ed in the Wall 
Street Journal, which is attached to my testimony.
    Other participants in the financial reporting system will have to 
do things differently as well--companies, boards, audit committees, 
analysts, investment bankers, credit analysts, and others.
    We all must work together to give investors more meaningful, 
relevant and timely, information.
    But our work starts with our firm. We are committed to making the 
changes needed to restore confidence.
    A day does not go by without new information being made available, 
and I would observe that all of us here today--and many others who are 
not here--have a responsibility to seek out and evaluate the facts and 
take needed action. My firm will continue to do our part. I hope that 
my participation today has been helpful to your efforts.
    Thank you.

                                                         Attachment

                         Enron: A Wake-Up Call
                            By Joe Berardino
               The Wall Street Journal, December 4, 2001
              (Copyright 2001, Dow Jones & Company, Inc.)

    A year ago, Enron was one of the world's most admired companies, 
with a market capitalization of $80 billion. Today, it's in bankruptcy.
    Sophisticated institutions were the primary buyers of Enron stock. 
But the collapse of Enron is not simply a financial story of interest 
to major institutions and the news media. Behind every mutual or 
pension fund are retirees living on nest eggs, parents putting kids 
through college, and others depending on our capital markets and the 
system of checks and balances that makes them work.
    My firm is Enron's auditor. We take seriously our responsibilities 
as participants in this capital-markets system; in particular, our role 
as auditors of year-end financial statements presented by management. 
We invest hundreds of millions of dollars each year to improve our 
audit capabilities, train our people and enhance quality.
    When a client fails, we study what happened, from top to bottom, to 
learn important lessons and do better. We are doing that with Enron. We 
are cooperating fully with investigations into Enron. If we have made 
mistakes, we will acknowledge them. If we need to make changes, we 
will. We are very clear about our responsibilities. What we do is 
important. So is getting it right.
    Enron has admitted that it made some bad investments, was over-
leveraged, and authorized dealings that undermined the confidence of 
investors, credit-rating agencies, and trading counter-parties. Enron's 
trading business and its revenue streams collapsed, leading to 
bankruptcy.
    If lessons are to be learned from Enron, a range of broader issues 
need to be addressed. Among them:

--Rethinking some of our accounting standards. Like the tax code, our 
accounting rules and literature have grown in volume and complexity as 
we have attempted to turn an art into a science. In the process, we 
have fostered a technical, legalistic mindset that is sometimes more 
concerned with the form rather than the substance of what is reported.
    Enron provides a good example of how such orthodoxy can make it 
harder for investors to appreciate what's going on in a business. Like 
many companies today, Enron used sophisticated financing vehicles known 
as Special Purpose Entities (SPEs) and other off-balance-sheet 
structures. Such vehicles permit companies, like Enron, to increase 
leverage without having to report debt on their balance sheet. Wall 
Street has helped companies raise billions with these structured 
financings, which are well known to analysts and investors.
    As the rules stand today, sponsoring companies can keep the assets 
and liabilities of SPEs off their consolidated financial statements, 
even though they retain a majority of the related risks and rewards. 
Basing the accounting rules on a risk/reward concept would give 
investors more information about the consolidated entity's financial 
position by having more of the assets and liabilities that are at risk 
on the balance sheet; certainly more information than disclosure alone 
could ever provide. The profession has been debating how to account for 
SPEs for many years. It's time to rethink the rules.

--Modernizing our broken financial-reporting model. Enron's collapse, 
like the dot-com meltdown, is a reminder that our financial-reporting 
model--with its emphasis on historical information and a single 
earnings-per-share number--is out of date and unresponsive to today's 
new business models, complex financial structures, and associated 
business risks.
    Enron disclosed reams of information, including an eight-page 
Management's Discussion & Analysis and 16 pages of footnotes in its 
2000 annual report. Some analysts studied these, sold short and made 
profits. But other sophisticated analysts and fund managers have said 
that, although they were confused, they bought and lost money.
    We need to fix this problem. We can't long maintain trust in our 
capital markets with a financial-reporting system that delivers volumes 
of complex information about what happened in the past, but leaves some 
investors with limited understanding of what's happening at the present 
and what is likely to occur in the future.
    The current financial-reporting system was created in the 1930s for 
the industrial age. That was a time when assets were tangible and 
investors were sophisticated and few. There were no derivatives. No 
structured off-balance-sheet financings. No instant stock quotes or 
mutual funds. No First Call estimates. And no Lou Dobbs or CNBC.
    We need to move quickly but carefully to a more dynamic and richer 
reporting model. Disclosures need to be continuous, not periodic, to 
reflect today's 24/7 capital markets. We need to provide several 
streams of relevant information. We need to expand the number of key 
performance indicators, beyond earnings per share, to present the 
information investors really need to understand a company's business 
model and its business risks, financial structure and operating 
performance.

--Reforming our patchwork regulatory environment. An alphabet soup of 
institutions--from the AICPA (American Institute of Certified Public 
Accountants) to the SEC and the ASB (Auditing Standards Board), EITF 
(Emerging Issues Task Force) and FASB (Financial Accounting Standards 
Board) to the POB (Public Oversight Board)--all have important roles in 
our profession's regulatory framework. They are all made up of smart, 
diligent, well-intentioned people. But the system is not keeping up 
with the issues raised by today's complex financial issues. Standard-
setting is too slow. Responsibility for administering discipline is too 
diffuse and punishment is not sufficiently certain to promote 
confidence in the profession.
    All of us must focus on ways to improve the system. Agencies need 
more resources and experts. Processes need to be redesigned. The 
accounting profession needs to acknowledge concerns about our system of 
discipline and peer review, and address them. Some criticisms are off 
the mark, but some are well deserved. For our part, we intend to work 
constructively with the SEC, Congress, the accounting profession and 
others to make the changes needed to put these concerns to rest.

--Improving accountability across our capital system. Unfortunately, we 
have witnessed much of this before. Two years ago, scores of New 
Economy companies soared to irrational values then collapsed in dust as 
investors came to question their business models and prospects. The 
dot-com bubble cost investors trillions. It's time to get serious about 
the lessons it taught us.
    In particular, we need to consider the responsibilities and 
accountability of all players in the system as we review what happened 
at Enron and the broader issues it raises. Millions of individuals now 
depend in large measure on the integrity and stability of our capital 
markets for personal wealth and security.
    Of course, investors look to management, directors and accountants. 
But they also count on investment bankers to structure financial deals 
in the best interest of the company and its shareholders. They trust 
analysts who recommend stocks and fund managers who buy on their behalf 
to do their homework--and walk away from companies they don't 
understand. They count on bankers and credit agencies to dig deep. For 
our system to work in today's complex economy, these checks and 
balances must function properly.
    Enron reminds us that the system can and must be improved. We are 
prepared to do our part.
    Mr. Berardino is managing partner and CEO of Andersen.

    Senator Dorgan. Mr. Andrews, thank you very much.
    Mr. Cleland, you represent--you are the Chief Executive 
Officer of The Precursor Group.' We appreciate your 
willingness to participate today. Why don't you proceed.

   STATEMENT OF SCOTT CLELAND, CHIEF EXECUTIVE OFFICER, THE 
                  PRECURSOR GROUP'

    Mr. Cleland. Thank you for the honor to testify and 
allowing me to go early. I am Scott Cleland, founder and CEO of 
the Precursor Group'. We are an independent broker-
dealer. We provide investment research to institutional 
investors. We do no investment banking, no proprietary trading. 
We do not manage money, and none of our analysts are allowed to 
own individual stocks.
    Before entering the investment business, I worked for the 
U.S. Government and gained experience in improving internal 
controls at the U.S. Treasury Department and the U.S. Office of 
Management and Budget.
    My message to you is very simple today. There are more 
Enrons out there ready to blow up and devastate more investors, 
but you will know now about it because the system of internal 
controls, the early warning systems, are so rampantly affected 
by conflicts of interest, and it does not need to be that way. 
Government and industry, if they would just officially 
discourage the conflicts of interest, I think a lot of the 
problem could be addressed.
    If the system worked as designed, essentially we would not 
have had the first panel. We would have had a couple of years 
ago a stock that was battered, but we would not have had a 
devastating meltdown with a frighteningly swift collapse. That 
was because this thing had been going on for 3 or 4 years and 
none of the watch-dogs spotted it.
    The stakes are really high here. As baby boomers are 
nearing retirement age, the Nation is increasingly depending 
upon 401(k)'s and other types of market instruments to 
supplement social security, so now more than ever we need to 
restore the integrity of the markets.
    The problem is obvious. Just like an ounce of prevention is 
worth a pound of cure, unsanitary conditions breed disease. 
Conflicts of interest now plague the system. Government and 
industry have not been vigilant enough to keep the system 
clean, because almost all of the watch-dogs supposedly watching 
the system are not paid by investors, they are paid by somebody 
else.
    But what is this plague of conflicts of interest? Let me 
briefly run through eight that are glaring. Companies routinely 
now pay consulting fees to audit companies that are supposed to 
keep the company honest. In Government, that would be a 
violation of public trust.
    2. Auditors are increasingly doing the company's inside 
audit work and also doing their independent outside work. That 
is like grading your own papers or hearing your own appeal.
    3. Through the investment banking back-door, company 
interests effectively pay for most of the research that is 
produced in the United States. The problem is, the average 
American does not get the joke that most all of the research 
they are reading is paid for by investment banking, by the 
companies.
    4. It is common for analysts to have a financial stake in 
the companies they are covering. That is just like essentially 
allowing athletes to bet on the outcome of the game that they 
are playing in.
    5. Most payments for investment research is routinely 
commingled in the process with more profitable investment 
banking and proprietary trading. The problem with this is that 
it effectively means most research analysts work for the 
companies and do not work for investors.
    6. Credit agencies may have conflicts of interest.
    7. Analysts seeking investment banking tend to be more 
tolerant of pro forma accounting, and the conflict there is 
essentially the system is allowing companies to make up their 
own accounting to describe their own financial performance that 
no one then can compare objectively with other companies.
    8. Surprise, surprise, companies routinely beat the 
expectations of a consensus of research analysts that are 
seeking their investment banking business.
    Common sense suggests that conflicts of interest breed 
trouble. I believe the focus of congressional and regulatory 
oversight should be on how to improve the current system, how 
to prevent future Enrons from happening, so I have five simple 
common-sense recommendations.
    1. Officially discourage conflicts of interest. Make it 
U.S. policy to discourage financial conflicts of interest, and 
definitely do not economically reward conflicts of interest in 
the law or in regulation.
    2. I think it is pretty simple. Prohibit auditors from 
consulting for companies they audit, and from reviewing their 
own work, doing the independent review of their own internal 
review.
    3. You really need to strengthen the objectivity of the 
overall investment research system. Discourage the bundling of 
banking, trading, and research, because the commingled nature 
of commissions when there is not a transparent and official 
separate accounting for each type of business, essentially what 
it means is that the more profitable parts of banking and 
trading are rewarded, and it discourages research objectivity.
    One idea you have heard many times is the trading they 
suggest, we need to get best execution for investors, best 
execution of trading. I suggest there should be some evidence 
or some emphasis getting best research execution for investors.
    My last recommendation is there needs to be increased 
awareness among the press and among the Government to stock 
manipulation. Two instances. When the press headlines or gives 
prominence in a story to pro forma accounting financial 
results, the press is lending credibility to a serious conflict 
of interest, because they are allowing public companies to make 
up their own accounting so that they cannot be compared or 
judged relative to other people.
    The second thing is, the press lends credibility to another 
conflict of interest by being allowed to be spun, and playing 
along with the companies in the street in their quarterly 
expectations game that inflates stock prices.
    So I thank you very much for allowing me to testify to 
avert future Enrons. It is very simple. Make the official U.S. 
policy to discourage conflicts of interest where necessary.
    Thank you, Mr. Chairman.
    [The prepared statement of Mr. Cleland follows:]

   Prepared Statement of Scott Cleland, Chief Executive Officer, The 
                      Precursor Group'

``Conflicts of Interest Are Eroding the Market's Integrity and the 
        Market's System of Internal Controls: Enron Is Not Unique, But 
        Part of a Growing Pattern of Missed Warning Signs''
I. Introduction
    Mr. Chairman, thank you for the honor of testifying before your 
Subcommittee and for the Subcommittee's interest in the perspective of 
an independent investment research broker-dealer.
    My testimony includes:

   An explanation of the Precursor Group' 
        perspective;

   Our assessment of why the system was surprised by Enron's 
        demise; and

   Our recommendations help prevent future Enrons from 
        happening again.
II. Precursor Group' Perspective
    I am Scott Cleland, founder and CEO of the Precursor 
Group', an independent research broker-dealer, which 
provides investment research to institutional investors. A year and a 
half ago, my partner, Bill Whyman, and I founded the Precursor 
Group' very intentionally as an independent firm in order to 
better serve our investor clients' interests and not to serve 
companies' interests or investment banking interests. We see a real 
market opportunity for pure investment research uncompromised by 
company conflicts of interest. We also have learned that the investment 
research marketplace is thirsting for trust; and our business is trying 
to quench a part of that thirst.
    Our business is simple. We work for institutional investors; they 
pay us research commissions on their trading to the extent that we help 
improve their investment performance.

   If our research helps investors identify opportunities or 
        avoid pitfalls, we get paid in trading commissions.

   If our research does not help investors, we do not get paid.

   We have a market-driven, merit-based business model.

    We are unusual in that we are a pure research firm in a business 
dominated by integrated full-service brokerage firms that bundle 
investment banking, trading and research. We are exclusively an 
investors' broker-dealer, akin to a buyer's broker in real estate. We 
are not the traditional sellers' or company broker-dealer, which tries 
to represent both companies' and investors' interests.
    We have done our best to align our financial interests with 
investors' interests. We are very serious about avoiding conflicts of 
interest, actual and perceived, so we:

   Do no investment banking for companies;

   Do not manage money or own a stake in any companies;

   Do not allow Precursor Group' researchers to 
        trade individual stocks--as a condition of employment (which 
        exceeds NASD rules); and

   Do not trade securities for proprietary gain.

   We get paid through agency trading commissions, which is the 
        primary payment mechanism that institutional investors use to 
        pay for investment research.

   Our contracted-out agency trading is not a conflict of 
        interest because:

     We do not act as an agent and never as a principal that 
            has capital at risk--so our contracted-out agents execute 
            stocks for others at their request, but we never actually 
            own a stock of a company.

     Our clients have complete freedom to choose which of our 
            four contracted-out trading clearing firms they want to 
            use.

     Our institutional investor clients completely control 
            whether and how we get paid with their shareholder or 
            pension fund resources.

     This arrangement eliminates any financial conflict.

    We are a pure research firm because we do not believe one firm can 
well serve different masters at the same time: investors and companies. 
We strongly believe true independence yields better research.
III. The Problem: Conflicts of Interest Erode the Integrity of Markets
(a) Systemic Conflicts of Interest
    The U.S. capital markets system is playing with fire--effectively 
ignoring rampant conflicts of interest--and investors are getting 
burned. The U.S. capital markets system clearly failed thousands of 
Enron investors, pension holders, creditors, employees and customers. I 
believe it is clear that the system will continue to fail investors, 
until the root cause--rampant conflicts of interest throughout the 
system--are brought under control.
    Hopefully Congress and regulators will hear the Enron collapse and 
the tech bubble bursting as wake up calls, alerting us that the 
market's system of internal controls have broken down and are no longer 
effective. The system's internal controls are supposed to warn 
investors, auditors and regulators of financial problems, before they 
get out of hand and become an Enron.
    Conflicts of interest abound where they should not:

   Companies routinely pay consulting fees to the audit 
        companies that are supposed to keep the company honest.

   Auditors are increasingly doing the companies' inside audit 
        work and the outside review of it--essentially grading their 
        own papers or hearing their own appeal.

   Through the investment banking backdoor, companies 
        effectively pay for most of the research departments, providing 
        research on their company, of most all of the prominent 
        brokerage firms that offer research to most Americans.

   It is common for analysts to have a financial interest in 
        the companies they are expected to cover objectively.

   Credit agencies may have an indirect financial interest in 
        the companies that they rate.

   Most payments for investment research is routinely 
        commingled with more profitable and dominant banking and 
        proprietary-trading commissions, effectively subordinating 
        research for investors to the promotion of company interests.

   Analysts seeking investment banking are more susceptible to 
        company pressure to emphasize the company's preferred pro-forma 
        financial reporting.

   And companies routinely ``beat the expectations'' of a 
        consensus of research analysts that seek their banking 
        business.

    Systemic conflicts of interest are more pervasive and corrosive 
than either Congress, regulators, investors or the press appreciate. 
Conflicts of interest are eroding the integrity and resilience of our 
capital markets, because they undermine the objectivity, integrity and 
accountability of the ``watch dogs'' and the early warning systems that 
markets depend on to prevent Enron-type situations from escalating to 
disasters.
    Congress and regulators should be very concerned because the 
breathtakingly swift collapse of Enron is no isolated incident that can 
be dismissed as unique, brushed under the rug and ignored. During the 
last two years, the bursting of the dot.com and tech bubble produced 
dozens of mini-Enron shareholder disasters (such as Excite@Home this 
past month) that cost investors hundreds of billions of dollars, while 
the capital markets routinely either ignored or missed the signals of 
their demise. Unless the integrity of the financial checks and balances 
in the system are restored, the Enrons and dot.com collapses will 
happen again and again.
    Millions of trusting American investors have lost big in the 
markets in recent years in part because the system has become so 
conflict-ridden that the system no longer effectively serves investor 
interests but primarily serves company interests. It appears that the 
oversight mood has now shifted to an ``investor beware'' attitude from 
an ``investor protection'' attitude. An investor protection system 
keeps investors adequately informed; identifies problems early; 
protects investors from misrepresentation and fraud; and ensures 
fairness in information dissemination.
    As the Baby Boomers age, our Nation increasingly will depend on 
market vulnerable 401(k)s and company pension plans to supplement 
Social Security and adequately fund Americans' retirement. Now more 
than ever, we need the internal controls capital markets rely on--
auditors, research analysts, and boards of directors--to function with 
integrity to ensure the protection of investors' financial security.
(b) A Pattern of Conflicts
    The system failed investors at multiple levels because conflicts of 
interest have spread like a disease throughout the system of checks and 
balances, and undermined independent voices and public watchdogs.

   Auditors: The integrity and functioning of the entire 
        capital markets system depends on investors trusting publicly 
        reported numbers. However, auditors now routinely work as 
        consultants to the companies they are supposed to be 
        objectively auditing for investors. This is analogous to 
        expecting a judge to always be fair when judging someone who 
        directly pays half of his or her salary.

   Investment Banks' Research Analysts: Research analysts of 
        all types are supposed to be objective, have an expert 
        understanding of the companies and identify material problems 
        early. However, it is now the norm that equity and debt 
        analysts' pay comes primarily from companies, not investors, 
        through investment banking and proprietary trading. About 95% 
        of the firms in the Wall Street Journal's ``Best of the 
        Street'' research rankings have investment banking conflicts of 
        interest. Conflicts of interest are pervasive on the Street. 
        (See attached survey.) Analysts also routinely have another 
        conflict in that they often have financial stakes in the 
        companies they are covering. (This is analogous to the 
        prohibited practice of an athlete betting on the outcome of the 
        game they are playing in.)

   Role of the Press: The press exacerbates the corrosive 
        effect of rampant conflicts of interest by tacitly and 
        unwittingly condoning them. The press routinely headlines 
        ``pro-forma'' or ``spin'' numbers that can't be relatively 
        compared to anything else, rather than headlining Generally 
        Accepted Accounting Principles or GAAP results that are readily 
        compared to every other investment. In essence, regulators and 
        the press are allowing companies to define their own success, 
        and run from an accountable benchmark.
    Further, the press routinely plays along with the Street's 
        ``expectations game,'' where the spin ignores actual 
        performance and redirects focus to how the company still 
        exceeded the ``consensus expectations'' of like-minded company 
        cheerleaders. The expectations game tends to decouple a 
        company's stock performance from its actual financial 
        performance.

    Ask the average American if it is wise to:

   Tempt auditors' objectivity by letting auditors moonlight 
        for those they audit;

   Have companies pay for most of the investment research done 
        on them; and

   Enable publicly-traded companies to make up their own 
        accounting and decide what liabilities they have to disclose to 
        investors.
    Common sense suggests that conflicts of interest breed trouble. 
Other systems that depend on the public trust discourage conflicts of 
interest more strongly as the first line of defense against serious 
problems. Government policymakers must avoid conflicts of interest and 
our judicial system has very strict conflict of interest rules. The 
most obvious way to prevent more Americans from being financially 
devastated by Enron-like fiascos is to strengthen and improve the 
integrity of the early warning signals and the structural checks and 
balances in the system. Just like an ounce of prevention is worth a 
pound of cure, unsanitary conditions breed disease.
IV. Recommendations: Emphasize Trust--Discourage Conflicts of Interest
    I believe that the focus of Congressional and regulatory oversight 
should be on how to improve the current system and prevent more Enrons 
from happening in the future. I recommend some common sense changes 
that can strengthen the integrity and functioning of U.S. capital 
markets, and protect the financial retirement security of all investing 
Americans.

(a) Officially discourage conflicts of interest.
    Wherever possible, policies should encourage alignment of financial 
service provider interests with investor interests, or at a minimum, 
make it much more transparent when a person or an entity is not working 
primarily for investor interests. Investors must be better informed of 
the extent of the conflicts of interest. The Senate could pass a Sense 
of the Senate Resolution reaffirming the importance of protecting the 
integrity of capital markets by discouraging financial conflicts 
whenever possible.
    I don't believe it is wise, necessary or practical to prohibit all 
conflicts of interest, but it sure is necessary to make it U.S. policy 
to discourage financial conflicts of interest and not create economic 
incentives that reward these conflicts through laws, regulations, 
structure or oversight processes.
    Self-regulatory organizations can be effective, if combined with 
the strong discouragement of conflicts of interest in order to build 
checks and balances that can actually work as designed. Self-regulation 
combined with condoned conflicts of interest equals a recipe for more 
Enrons.

(b) Prohibit auditors from consulting for companies they audit and from 
        conducting independent audits of their own internal audits.
    Even better, encourage auditors to be only auditors. The public 
trust in the accuracy of public financial reporting is so critical it 
is not even worth the perception of a conflict of interest. Judges and 
U.S. government employees cannot moonlight for those that they have a 
public trust to police. Would it be a good idea for IRS divisions to do 
paid tax consulting for the companies they audit on the side? Mixing 
auditing and consulting is such a blatantly bad idea, it is amazing 
that it is officially tolerated. Moreover, auditors are increasingly 
conducting the outsourced internal audit function of the company, 
essentially acting as contract employees while also being responsible 
to investors for the outside audit to assure investors that all is well 
financially. The government is allowing organizations to essentially 
grade their own papers or handle their own appeals. There are probably 
no more corrosive and counter-productive conflicts of interest in the 
U.S. capital markets than these. The system is just asking for more 
Enrons to happen, because it appears that it is no longer in some 
auditor's primary interest to protect investors from fraud and 
misrepresentation.

(c) Strengthen the overall objectivity of the investment research 
        system.
    Discourage the bundling of banking, trading and research. The 
commingled nature of commissions without transparent and official 
separate accounting among trading, research and banking services has 
the practical effect of rewarding conflicts of interest and 
discouraging research objectivity. Investment funds go to great 
lengths, including third party evaluations and industry self-
regulation, to get best trading execution for investors. Yet, there is 
surprisingly little systematic effort to get ``best research 
execution'' for investors. This could be encouraged through disclosure 
of what percent of trading commissions are spent on conflicted vs. non-
conflicted research.

(d) Discourage analysts owning a financial stake in companies they 
        cover.
    Industry standards should be fostered and enforced so that analysts 
that present themselves to the investing public as ``objective research 
analysts'' should not have a financial interest in the company they are 
covering. Many in the industry condone the practice of analysts having 
``skin in the game'' so they think like investors themselves. This is 
analogous to saying it is a good idea to condone athletes betting on 
the outcome of the games they play in. The extent to which analyst 
compensation is linked to investment banking should also be examined.

(e) Increase awareness and vigilance of the press to stock 
        manipulation.
    When the press headlines or gives prominence in a story to a 
company's ``pro-forma'' financial results, the press tacitly lends 
credibility to a serious conflict of interest, because public companies 
should not be making up their own accounting results or creating a 
public perception of their financial performance that can't be compared 
or checked objectively. The whole rationale behind GAAP is to create a 
transparent market, instilling investor confidence that reported 
earnings are actually earnings. Pro-forma reporting at its best is 
``spin'' or partial truth; at its worst, it is misrepresentation. Pro-
forma reporting has become more commonplace because the press has so 
frequently played along.
    The press also perpetuates and lends credibility to conflicts of 
interest by being ``spun'' and playing along with the companies and the 
``Street'' in the quarterly ``expectations game.'' The companies and 
their potential investment banking firms have an interest in the stock 
going up regardless of whether the financial performance warrants it. 
The quarterly ``expectations game'' is one of the subtlest 
manifestations of conflicts of interest. By headlining or leading a 
financial story with how a company ``beat expectations,'' the press 
lends objective credibility to the company sell-side cheerleading corps 
that has a strong financial interest in the stock going up. The press 
can limit the impact of this conflict of interest through an editorial 
policy of reporting ``expectations'' after actual earnings results are 
reported or by putting sell-side expectations in context with the 
consensus expectations of independent analysts.

V. Conclusion
    To avert future Enron-type disasters and protect public confidence 
in the integrity and resilience of U.S. capital markets, Congress and 
regulators need a policy to reemphasize integrity and trust in U.S. 
capital markets. Congress can take a big step in that direction by 
officially discouraging conflicts of interest within the system of 
watchdog groups, auditors, analysts, and independent board members, 
which the system depends on to protect investors. Conflicts of interest 
are becoming so common and pervasive that they are becoming the norm 
not the exception. Sadly, this could mean that investor disasters like 
Enron could increasingly become the norm as well.
    Thank you again Mr. Chairman for the honor and opportunity to 
testify on this important matter.
                                                        Attachments
Precursor Group' Survey Shows Conflicted Investment Research 
                       is Systemic and Pervasive
                             July 30, 2001

Washington, D.C.--A new survey by The Precursor Group', a 
Washington-based independent investment research firm, shows that 
almost all of the top investment research firms in the country have 
multiple structural conflicts of interest that undermine research 
credibility and investor confidence. In recent weeks, two top firms, 
have announced new policies that restrict their analysts from owning 
stock in the companies they cover. While analyst ownership of companies 
they cover is the most obvious conflict, the deeper, more important 
conflicts are investment banking and proprietary trading, according to 
Precursor.
    ``The problem of conflicted investment research is more systemic 
and pervasive than most investors appreciate,'' said Scott Cleland, 
chief executive officer of Precursor, an independent research firm 
based in Washington. ``Almost all of the top investment research firms 
have structural financial conflicts of interest that undermine research 
objectivity. At least 95% of The Wall Street Journal's top 2001 stock 
picking firms and 100% of Institutional Investor magazine's 2000 All-
America Research firms have multiple conflicts of interest.''
Survey of Research Conflicts:
    Precursor's survey (attached) of top investment research firms 
shows that almost all have structural financial conflicts of interest 
that create actual and perceived research conflicts and undermine 
research objectivity: either through investment banking representation 
of companies or through direct ownership of a company through 
proprietary trading and money management.

   Ninety-five percent of the 82 firms ranked by The Wall 
        Street Journal 
        (June 26, 2001) as the ``Best Stock Pickers on the Street'' 
        have line of busi-
        ness research conflicts: investment banking, proprietary 
        trading and money management (http://interactive.wsj.com/
        public/resources/documents/best2001-firms.htm).

   And 100% of Institutional Investor's 2000 top investment 
        research firms have line of business research conflicts: 
        investment banking, proprietary trading and money management 
        (http://www.iimagazine.com/activecontent/report.asp?rt=
        leaders&teamid=1&iyear=2000).

   The survey builds upon the two of the most-widely respected 
        and followed rankings of investment research quality. Each of 
        these well-respected business publications publishes their 
        rankings of investment research firms every year. Additional 
        details can be obtained at the source/website address for each 
        firm included in the survey results.

    Precursor conducted the survey after Cleland testified before the 
House Subcommittee on Capital Markets. The Congressional Subcommittee's 
interest in part was prompted by the deterioration in the capital 
markets over the last year. Many people questioned how U.S. companies 
could plummet without more warning from investment research analysts 
who are charged with watching market trends and making investment 
decisions for their clients.
    ``How could American shareholders and pension plan beneficiaries 
lose four trillion dollars in the NASDAQ when only 1% of analysts' 
recommendations were `sell'?'' Cleland asked. ``One seldom-heard 
explanation is that the entire brokerage system is structurally skewed 
to put company interests before investor interests.''
    In addition, Cleland pointed out that almost all of the largest and 
best known brokerage firms that most Americans rely on for their 
investment research have structural business conflicts of interest 
which discourage the production of research that could have a negative 
investment outlook for a company.
    ``More specifically, if a brokerage firm is either in the 
investment banking business or owns stocks through proprietary trading 
or money management, that firm has a financial interest in companies' 
stocks going up, not down,'' Cleland added.
    Precursor conceived of the survey to measure conflicts of interest 
among investment research firms when it became obvious that conflicted 
research was more pervasive throughout the industry than most people 
realize.
    ``The real issue here is that the conflicted research problem is 
systemic,'' Cleland said. ``The primary and most profitable purpose of 
the brokerage industry is to raise capital and provide liquidity for 
companies. So the structure, economics, compensation, and regulation of 
the industry reinforce and perpetuate the purpose of selling companies 
to investors. In a bull market there may be better alignment of 
interests between companies and investors; in a bear market there is 
often a stark divergence of financial interests between companies and 
investors,'' he concluded.
    The Precursor Group' is an employee-owned and -
controlled, independent research Broker-Dealer, which does no 
investment banking, money management, proprietary trading or stock 
picking. Precursor research' analysts, as a condition of 
employment, may not trade individual stocks; independent third parties 
must manage any Precursor analyst's personal portfolio. Precursor 
products and services are designed for use by institutional investors 
and are also used by senior decision-makers from government, industry 
and other professional organizations.
    The Precursor Group' is a Broker-Dealer registered with 
the Securities and Exchange Commission (SEC) and is a member of the 
National Association of Securities Dealers (NASD) and the Securities 
Investor Protection Corporation (SIPC). ``Precursor Group,'' 
``Precursor Research,'' ``Precursor Watch,'' ``Investment Precursors,'' 
and ``Helping Investors Anticipate Change'' are registered trademarks.

                  The Wall Street Journal's ``Best on the Street'' Stock Pickers--``95% of These Top 82 Firms Have Research Conflicts''
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                      Investment          Proprietary
            Wall Street Journal Ranking June 26, 2001                   Banking             Trading        Money  Management            Source
--------------------------------------------------------------------------------------------------------------------------------------------------------
 1. Salomon Smith Barney                                                          X                   X                   X   www.salomonsmithbarney.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 2. Merrill Lynch                                                                 X                   X                   X   www.ml.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 3. Morgan Stanley                                                                X                   X                   X   www.morganstanley.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 4. Lehman Brothers                                                               X                   X                   X   www.lehman.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 5. Goldman Sachs                                                                 X                   X                   X   www.gs.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 6. A.G. Edwards                                                                  X                   X                   X   www.agedwards.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 7. Credit Suisse First Boston                                                    X                   X                   X   www.csfb.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 8. J.P. Morgan Chase                                                             X                   X                   X   www.jpmorgan.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 9. Bear Stearns                                                                  X                   X                   X   www.bearstearns.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
10. Banc Of America Sec's                                                         X                   X                   X   www.bofasecurities.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
11. UBS Warburg                                                                   X                   X                   X   www.ubswarburg.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
12. Deutsche Banc Alex Brown                                                      X                   X                   X   www.deutsche-bank.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
13. William Blair                                                                 X                   X                   X   www.wmblair.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
14. McDonald Investments                                                          X                   X                   X   www.key.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
15. SG Cowen Securities                                                           X                   X                   X   www.sgcowen.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
16. Prudential Securities                                                        NO                   X                   X   www.prudential.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
17. ING Barings                                                                   X                   X                   X   www.ingbarings.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
18. First Union Securities                                                        X                   X                   X   www.firstunionsec.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
19. CIBC World Markets                                                            X                   X                   X   www.cibcwm.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
20. ABN Amro                                                                      X                   X                   X   www.abnamro.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
21. Robertson Stephens & Co                                                       X                   X                   X   www.robertsonstephens.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
22. Needham & Co                                                                  X                   X                   X   www.needhamco.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
23. Dain Rauscher Wessels                                                         X                   X                   X   www.dainrauscherwessels.co
                                                                                                                               m
--------------------------------------------------------------------------------------------------------------------------------------------------------
24. Raymond James                                                                 X                   X                   X   www.raymondjames.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
25. BMO Nesbitt Burns                                                             X                   X                   X   www.bmonesbittburns.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
26. Wit SoundView                                                                 X                   X                   X   www.witcapital.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
27. Wasserstein Perella                                                           X                   X                   X   www.wassersteinperella.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
28. Morgan Keegan                                                                 X                   X                   X   www.morgankeegan.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
29. SunTrust Equitable Sec's                                                      X                   X                   X   www.suntrust.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
30. Keefe,Bruyette & Woods                                                        X                   X                   X   www.kbw.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
31. Ferris, Baker Watts                                                           X                   X                   X   www.fbw.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
32. Buckingham Research                                                          NO                   X                   X   New York ph# 212.922.5500
--------------------------------------------------------------------------------------------------------------------------------------------------------
33. Tucker Anthony                                                                X                   X                   X   www.tucker-anthony.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
34. Robinson-Humphrey                                                             X                   X                   X   www.robinsonhumphrey.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
35. Barrington Research                                                           X                   X                   X   www.brai.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
36. D.A. Davidson                                                                 X                   X                   X   www.dadco.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
37. Stifel Nicolaus                                                               X                   X                   X   www.stifel.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
38. Fahnestock                                                                    X                   X                   X   www.fahnestock.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
39. Midwest Research                                                             NO                   X                  NO   Sarah O'Connor-Compliance
--------------------------------------------------------------------------------------------------------------------------------------------------------
40. First Analysis                                                                X                   X                   X   www.firstanalysis.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
41. Thomas Weisel Partners                                                        X                   X                   X   www.tweisel.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
42. Janney Montgomery Scott                                                       X                   X                   X   www.janneys.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
43. First Albany                                                                  X                   X                   X   www.fac.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
44. Adams, Harkness & Hill                                                        X                   X                   X   www.ahh.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
45. Jefferies                                                                     X                   X                   X   www.jefco.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
46. Ryan Beck                                                                     X                   X                   X   www.rbeck.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
47. U.S. Bancorp Piper Jaffray                                                    X                   X                   X   www.piperjaffray.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
48. Sidoti                                                                       NO                  NO                   X   John Zolidis-Sidoti
--------------------------------------------------------------------------------------------------------------------------------------------------------
49. BB&T Capital Markets                                                          X                   X                   X   www.bbandt.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
50. Pacific Growth Equities                                                       X                   X                   X   www.pacgrow.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
51. Hibernia Southcoast Capital                                                   X                   X                   X   www.hibernia.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
52. Argus Research                                                               NO                  NO                  NO   www.argusresearch.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
53. Davenport & Co, LLC                                                           X                   X                   X   www.davenportllc.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
54. Friedman,Billings,Ramsey                                                      X                   X                   X   www.fbr.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
55. H.C. Wainwright                                                               X                   X                   X   www.hcwainwright.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
56. Gerard Klauer Mattison                                                        X                   X                   X   www.gkm.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
57. Robert W. Baird                                                               X                   X                   X   www.rwbaird.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
58. Legg Mason                                                                    X                   X                   X   www.leggmasoncapmgmt.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
59. Brean Murray                                                                  X                   X                   X   www.bmur.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
60. Griffiths McBurney                                                            X                   X                   X   www.gmponline.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
61. Hoak Breedlove Wesneski                                                       X                   X                   X   www.hbwco.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
62. LJR Great Lakes Review                                                       NO                  NO                  NO   www.ljr.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
63. RBC Dominion Securities                                                       X                   X                   X   www.rbcds.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
64. Gruntal                                                                       X                   X                   X   www.gruntal.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
65. Lazard Asset Mgmt                                                             X                   X                   X   www.lazardnet.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
66. Wedbush Morgan Sec's                                                          X                   X                   X   www.wedbush.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
67. Credit Lyonnais                                                               X                   X                   X   www.creditlyonnais.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
68. Hilliard Lyons                                                                X                   X                   X   www.hilliard.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
69. Advest Group                                                                  X                   X                   X   www.advest.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
70. Sandler O'Neill                                                               X                   X                   X   www.sandleroneill.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
71. Stephens Capital Mgmt                                                         X                   X                   X   www.stephens.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
72. Fox-Pitt, Kelton                                                              X                   X                   X   www.foxpitt.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
73. Miller Johnson                                                                X                   X                   X   www.stockwalk.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
74. Josephthal                                                                    X                   X                   X   www.josephthal.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
75. Simmons                                                                       X                   X                   X   www.simmonsco-intl.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
76. WR Hambrecht                                                                  X                   X                   X   www.wrhambrecht.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
77. Frost Securities                                                              X                   X                   X   www.frostsecurities.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
78. Johnson Rice                                                                  X                   X                   X   New Orleans 504.525.3767
--------------------------------------------------------------------------------------------------------------------------------------------------------
79. Kaufman Brothers                                                              X                   X                   X   www.kbro.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
80. Wells Fargo Van Kasper                                                        X                   X                   X   www.fsvk.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
81. Pacific Crest Securities                                                      X                   X                   X   www.pacific-crest.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
82. Southwest Securities                                                          X                   X                   X   www.swst.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
    Totals                                                                76/82=93%           79/82=96%           79/82=96%
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: The Precursor Group, July 30, 2001.

                Institutional Investor Magazine's ``2000 All-America Research Team''--100% of These Top 16 Firms Have Research Conflicts
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                          Proprietary
             Institutional Investor Magazine Ranking              Investment Banking        Trading        Money Management             Source
--------------------------------------------------------------------------------------------------------------------------------------------------------
 1) Merrill Lynch                                                                 X                   X                   X   www.ml.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 2) Morgan Stanley                                                                X                   X                   X   www.morganstanley.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 3) Salomon Smith Barney                                                          X                   X                   X   www.salomonsmithbarney.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 4) Credit Suisse First Boston                                                    X                   X                   X   www.csfb.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 5) Donaldson Lufkin Jenrette                                                     X                   X                   X   www.dlj.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 6) Goldman Sachs & Co                                                            X                   X                   X   www.gs.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 7) Bear Stearns & Co                                                             X                   X                   X   www.bearstearns.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 8) Lehman Brothers                                                               X                   X                   X   www.lehman.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
 9) PaineWebber                                                                   X                   X                   X   www.painewebber.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
10) J.P. Morgan Securities                                                        X                   X                   X   www.jpmorgan.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
11) Prudential Securities                                                        NO                   X                   X   www.prudential.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
12) Sanford C. Bernstein & Co                                                    NO                   X                   X   www.bernstein.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
13) Banc of America Securities                                                    X                   X                   X   www.bofasecurities.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
14) Deutsche Banc Alex. Brown                                                     X                   X                   X   www.deutsche-bank.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
15) ISI Group                                                                    NO                  NO                   X   www.morningstar.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
16) Robertson Stephens                                                            X                   X                   X   www.robertsonstephens.com
--------------------------------------------------------------------------------------------------------------------------------------------------------
    Totals                                                                13/16=81%           15/16=94%          16/16=100%
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: The Precursor Group, July 26, 2001.

              White Paper: What Ails Investment Research?
                 Precursor Group', May 2001
Introduction
    Why is there so much market volatility? Why are investors so often 
surprised by companies? In large part because the ``sell-side'' 
investment research system is so biased toward the company view. The 
Wall Street firms that produce most ``investment research'' are rife 
with potential financial conflicts of interest. There is precious 
little quality, independent investment research that serves as a source 
of new ideas or as a check and balance on the ``Street/Company'' spin.
What Ails Investment Research?
Bundled Services: Most investment research is not sold separately, but 
as part of a bundle of services including access to investment banking 
and trading liquidity. As part of a financial bundle, research 
functions largely as advertising for other more profitable lines of 
business--banking and proprietary trading. Without separate pricing, 
low quality research is concealed in the bundle of services. 
Consequently, there is little accountability or measure of research 
value in the marketplace, and little incentive to improve the quality 
and objectivity of research. This suggests the current research system 
simply does not value research much.

Conflicts of Interest: Investment research is compromised by financial 
dependence on other lines of business with very different masters than 
investors. Investment banking and proprietary trading heavily subsidize 
Wall Street research, creating both real and perceived financial 
conflicts of interest. Since a research analyst's compensation is often 
largely driven by investment banking deals, there exists a stark 
conflict between the analyst's responsibility to investors and 
responsibility to the firm's corporate finance clients. The evidence of 
this conflict of interest is powerful: according to First Call, of the 
28,000 U.S. stock recommendations, only 1% are ``sells.'' This suggests 
it is not in the interest of most investment research to warn investors 
in advance of problems.

Expedient to Depend on Company Information: Companies are the easiest 
source of information, and are also highly sophisticated in managing 
their investment ``story'' through investor-public relations and 
lobbying firms. Because original research is difficult, time-consuming, 
costly and risky, it is simply easier to adopt the company's world view 
and version of the facts. Securities & Exchange Commission (SEC) fair 
disclosure regulations also give companies wide latitude to manage 
information flow tightly--as long as they are equally stingy to all 
parties. This suggests the investment research system implicitly 
reenforces the incorrect assumption that companies know all, see all 
and share all.

Rehash Rather than Research: Since an underlying purpose of most 
investment research is to sell companies to investors, Wall Street 
markets the positive and does not fully research the negative. The 
large conflict between company and investor interests tends to produce 
a superficial rehash of public company information or benign commentary 
on industry developments. The result is a Wall Street system focusing 
more on ``re'' than ``search''--more backward-looking reporting and 
reformating, and not much forward-looking searching for what is new and 
original in the market, the core value of research to investors. This 
suggests most investment research has become an echo chamber for the 
company line.
                               Conclusion

    Former SEC Chairman, Arthur Levitt calls the problem with 
investment research a ``web of dysfunctional relationships.'' The 
result of a dysfunctional research system is biased and poor investment 
research. This increases market volatility and surprises that blindside 
investors, skews the market toward investment banking at the expense of 
investor interests, and doesn't fully help investors anticipate change, 
capture opportunities and avoid risk.
Quotes from the Industry & Academics
Bundled Services
``Research analysts have become integral members of the investment 
banking units . . . [t]heir compensation is tied importantly to the fee 
revenue that they generate for the investment-banking unit.'' Samuel 
Hayes, professor emeritus at Harvard Business School, June 20, 2000, 
Wall Street Journal.

``Research analysts have become either touts for their firm's corporate 
finance departments or the distribution system for the party line of 
the companies they follow.'' Stefan D. Abrams, Chief Investment Officer 
for Asset Allocation, Trust Company of the West, December 31, 2000, New 
York Times.

``[Y]ou can't get paid for research anymore, because the commissions 
have been whittled down; you have to look elsewhere for money. . . . 
Today, it's investment banking--looking for deals to do.'' Chuck Hill, 
Research Director, First Call Thompson Financial, August 14, 2000, 
Interactive Week.
Conflicts of Interest
``I see . . . a web of dysfunctional relationships--where . . . the 
analyst attempts to walk the tightrope of fairly assessing a company's 
performance without upsetting his firm's investment banking 
relationships.'' Arthur Levitt, Former SEC Chairman, April 6, 2000, 
Remarks at the Economic Club of Washington.

``Analysts must bring in deals, and there is an inherent conflict of 
interest. . . . Quality becomes a function of the deal calendar. It's 
only natural that the credibility of sell-side research falls as 
banking steps up.'' Andrew Barth, U.S. Research Director, Capital 
Guardian Trust Co., October 1, 2000, Institutional Investor.

``[A]nalysts affiliated with the lead underwriter of an offering tend 
to issue more optimistic growth forecasts than unaffiliated analysts. . 
. . [T]he magnitude of the affiliated analysts' growth forecasts is 
positively related to fee basis paid to lead underwriters.'' Patricia 
Dechow & Richard Sloan, University of Michigan; and Amy Hutton, Harvard 
Business School, June 1999, Research Paper: ``The Relation Between 
Analysts' Forecasts of Long-Term Earnings Growth and Stock Performance 
Following Equity Offerings.''

``[T]he way an analyst can get fired is to damage an existing 
investment banking relationship with a company or sour a future 
investment banking relationship.'' Mitch Zacks, Vice President of Zacks 
Investment Research, December 31, 2000, New York Times.
Expedient to Depend on Company Information
``They (analysts) get spoon-fed the information by investor relations 
officers and they have a very strong tendency to put a positive swing 
or twist on everything. . . . And like sheep they follow.'' Hugh 
Johnson, Chief Investment Officer, First Albany Corporation, September 
24, 2000, Reuters.

With the SEC Fair Disclosure regulations, ``nobody's going to have the 
inside dope. Analysts now will distinguish themselves more on 
scholarship and analytical ability rather than connections and 
relationships.'' Ted Pincus, CEO, Financial Relations Board, October 1, 
2000, Institutional Investor.
Rehash Rather Than Research
``[W]e find there's a lack of initiative; they rarely really 
aggressively question what the company is telling them. What we get 
instead of research is reporting.'' Gary Langbaum, Fund Manager, Kemper 
Total Return Fund, December 11, 1997, Wall Street Journal.

``Our findings . . . [suggest] that analysts mostly react to changes in 
market values rather than cause them.'' Eli Amir, Tel Aviv University; 
Baruch Lev, New York University and Theodore Sougiannis, University of 
Illinois, September 2000, Research Paper: ``What Value Analysts?''
References
Periodicals
Editorial Comment. ``Shoot All The Analysts.'' Financial Times, March 
    19, 2001. www.ft.com.
Fuerbringer, Jonathan. ``When Being Wrong Won't Hurt: Economists' Ideas 
    Are Valued More Than Their Forecasts.'' New York Times, October 15, 
    1999. www.nytimes.com.
Guglielmo, Connie, Cantwell, Rebecca, and Mulqueen, John. ``Special 
    Report: Analyze This.'' Interactive Week, August 14, 2000. 
    www.zdnet.com.
Hill, Miriam. ``Even Research Comes With Spin.'' The Philadelphia 
    Inquirer, August 1, 2000. www.phillynews.com.
Kawamoto, Dawn, and Kanellos, Michael. ``Stock Analysts Roll With The 
    Punches.'' CNET News, January 18, 2000. www.cnet.com.
Levitt, Arthur. Remarks at the Economic Club of Washington, April 6, 
    2000. www.sec.gov.
Maremont, Mark. ``As Wall Street Seeks Pre-IPO Investments, Conflicts 
    May Arise.'' Wall Street Journal, July 24, 2000. www.wsj.com.
McGee, Suzanne. ``After Oracle Misfire, Wall Street's Research Is 
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Morgenson, Gretchen. ``How Did So Many Get It So Wrong?'' New York 
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Pulliam, Susan. ``Goldman Raises Eyebrows With E-Commerce List.'' Wall 
    Street Journal, June 20,2000. www.wsj.com.
Roberts, Kristin. ``Wall Street Analysts Miss The Ball.'' Reuters, 
    September 24, 2000. www.reuters.com.
Rynecki, David. ``The Price Of Being Right.'' Fortune, February 5, 
    2001. www.fortune.com.
Sargent, Carolyn and Kenney, Jane. ``The 2000 All-American Research 
    Team.'' Institutional Investor, October 1, 2000. 
    www.iimagazine.com.
Vickers, Marcia. ``The Fall of the Net Analyst.'' Business Week, 
    December 11, 2000. www.businessweek.com.
Academic Research
Amir, Eli (Tel Aviv University), Lev, Baruch (New York University), and 
    Sougiannis, Theodore(University of Illinois). Research Paper: 
    ``What Value Analysts?'' September 2000.
Dechow, Patricia, Sloan, Richard (University of Michigan), and Hutton, 
    Amy (Harvard Business School). Research Paper: ``The Relation 
    Between Analysts' Forecasts Of Long-Term Earnings Growth and Stock 
    Performance Following Equity Offerings.'' June 1999.
Michaely, Roni (Cornell University & Tel-Aviv University), and Kent 
    Womack (Dartmouth College). Research Paper: ``Conflict of Interest 
    and the Credibility of Underwriter Analyst Recommendations.'' 
    February 1999.

    Senator Dorgan. Mr. Cleland, thank you very much.
    Mr. Andrews, when you indicated that there were some 
mistakes in judgment, might I ask about Jedi? That partnership 
kept Enron debt off its books, but Enron was improperly at risk 
for its own Jedi stake. And the Chewco SPE had the same 
problems, where it was used to hold Enron's debts off Enron's 
books, but there were improprieties in its ownership. Is that 
what you are referring to when you talk about mistake in 
judgment by the accounting firm, by your firm?
    Mr. Andrews. Senator, the Chewco investment is actually the 
one that I referred to that is the subject of the 10A 
reporting. That was actually an illegal act. The other SPE is 
the one that was a mistake in judgment, the smaller of the two 
that accounted for 20 percent of the restatement, and 
essentially what occurred there is that dated back till 1997, 
the information that our team reviewed in 1997 concluded that 
it met the requirements of the SPE's, which not to get 
technical on it, but if you have 3 percent, if an outsider has 
3 percent and control you are allowed to, in fact required for 
that entity to be off your books. We believed it met that test. 
The company believed it met that test when it was set up.
    Subsequent information, actually in October of this year, 
was that it was revealed that we made an error in judgment. It 
was not information that was withheld from us, but it was an 
error in judgment. When we realized that error, we pointed it 
out to the company and the company made that correction.
    Senator Dorgan. How big was that correction?
    Mr. Andrews. That correction was 20 percent of the 
restatement amount. I do not have the exact dollar amount, but 
it was 20 percent of the restatement amount.
    Senator Dorgan. Let me ask, should it raise a red flag for 
an auditor if a firm is setting up a special purpose entity 
such as Jedi and Chewco? When a firm is setting up special 
purpose entities for transactions in its own firm's stock, 
should that raise a red flag for auditors?
    Mr. Andrews. Senator, special purpose entities are 
structured in accordance with the accounting rules. Generally 
accepted accounting principles are, in fact, what provide the 
guidance for those entities themselves, and you have to comply 
with the structure of those rules. Obviously, those are rules 
that the profession has that demand compliance.
    Senator Dorgan. But you are answering a question I did not 
ask. I am asking whether an auditor should see some areas of 
concern if a firm is setting up a special purpose entity for 
transactions in its own stock.
    Mr. Andrews. Well, the company----
    Senator Dorgan. I am asking for your judgment.
    Mr. Andrews. The company should report it in accordance 
with those rules, and it is our responsibility as auditors to 
review that.
    Senator Dorgan. Should it raise a red flag for the auditor 
if the chief financial officer of a company is personally 
involved in complex financial transactions in their own firm? 
This was the case with Mr. Fastow, who had a personal stake, as 
I understand it, in the success of these SPEs and was 
compensated in that manner. Should that concern an auditor, and 
did it concern Andersen?
    Mr. Andrews. Senator, as it pertains to related party 
transactions, again the accounting and disclosure rules 
required that related party transactions be reviewed and 
disclosed, where they would be material to the financial 
statement. In this case, that related party transaction was 
disclosed in the footnotes to the Enron financial statement.
    Senator Dorgan. Do you have those footnotes with you?
    Mr. Andrews. Mr. Chairman, I do not.
    Senator Dorgan. The reason I ask is, I have read some of 
those footnotes, and I think it would have been impossible for 
even the most experienced analyst to understand what those 
footnotes meant, and that is of concern.
    Did Arthur Andersen in any way participate in structuring 
or designing any of these special purpose enterprises for 
limited partnerships that were the subject of the restatements 
of earnings?
    Mr. Andrews. Mr. Chairman, we performed our work as 
auditors. We did not design or structure the transactions.
    Senator Dorgan. Let me ask a question raised by Mr. 
Cleland. I raised it in my opening statement. An accounting 
firm that is reviewing the books in a fair manner for a company 
and then represents that review to investors and others, if 
that company is also under contract for other consulting 
services--let us say they are paid $25 million for auditing 
services and have a $27 million consulting contract. Is that 
not an inherent conflict of interest?
    Mr. Andrews. Mr. Chairman, we believe we are independent of 
Enron and we accept the responsibility and the importance of 
maintaining our independence and integrity. The rules related 
to what an auditor can do and cannot do are subject to 
regulation, and we conform and abide by those.
    As I said, mentioned in some of my testimony, my opening 
statement at least, the $27 million we were paid in terms of 
consulting, a significant part of that actually was for work 
that an auditor really must do or has to do. For example, we 
performed the work related to Enron's registration statements, 
corporate letters, the tax work, things of that nature that 
really an auditor has to do the disclosure as to what goes into 
which pot, if you will.
    As to what is called an audit fee versus a nonaudit fee is 
subject to the regulation of the proxy disclosures that the SEC 
passed last year, and many audit-related services actually go 
in the nonaudit-related category in that disclosure.
    Senator Dorgan. Mr. Cleland, did I get any of my questions 
just answered?
    Mr. Cleland. It goes back to if it is tolerated, if it 
abides by the letter of the regulation, then it is not 
necessarily a violation of public trust. I think there is a 
question of the letter of the law and the spirit of the law, 
and what I am urging is, we need to get back to the spirit of 
the integrity of markets and investor confidence in the system, 
and that goes beyond the letter of the law.
    Senator Dorgan. Senator McCain.
    Senator McCain. Following up on Senator Dorgan's comments, 
Mr. Andrews, do you believe that being paid for consulting as 
well as auditing creates the appearance of conflict of 
interest?
    Mr. Andrews. Senator, again we believe we were independent 
in terms of the appearance of conflict of interest, as I said, 
and I believe it is important for us to have the public trust 
and if public trust is shaken by the confidence of that it is 
our responsibility to restore that.
    Senator McCain. Do you believe it creates an appearance of 
a conflict of interest?
    Mr. Andrews. Many people have stated that it creates an 
appearance of conflict of interest.
    Senator McCain. Mr. Cleland, after reading your full 
statement that was submitted for the record, which is a very 
powerful statement, the next time I watch Lou Dobbs as a guest, 
or someone on MSNBC or CNBC or Bloomburg, some so-called expert 
that is recommending I purchase a stock, is it very likely that 
that person has some financial interest in the stock they are 
recommending?
    Mr. Cleland. You betcha, and the reason why I think we were 
asked to testify is we are a telecom tech research firm, and 
this happened in the telecom tech. This is deja vu. I mean, if 
you look in Fortune Magazine this week, there is a little thing 
that said, dot-com death watch, and there are 591 dot-coms that 
died, so Enron is a spectacular, huge hit, but this has been 
happening for the last year, hundreds of times.
    Senator McCain. And it may even be likely at the IPO stage 
these individuals made a whole lot of money?
    Mr. Cleland. A ton of money.
    Senator McCain. That was the history of the stock. It would 
go way up, and they had the initial purchases. Again, speaking 
of the press, perhaps those guests who sound so convincing, and 
are handsome men and women, very bright (smarter than anybody I 
know), do you think that before they make these great 
recommendations, including their overall confidence in the 
future of the stock market (starting some 6 months ago), that 
they should at least reveal any conflict of interest so that 
the viewer with regards to television, or their radio or print 
audience as well, would know?
    Mr. Cleland. Certainly there should be greater disclosure, 
but disclosure has kind of been viewed as the cure, and it 
papers over the problem. The problem is, when people call them 
research analysts, the connotation that the average American 
has when they hear research, they think objective, they think 
scientific, they think analytic, and they think conflict-free. 
That is the connotation we are taught when we are in school of 
what the definition of research is. That is not what investment 
research is today.
    Senator McCain. Do you believe that any auditing 
corporation who receives consulting money, as well as auditing 
money, creates an appearance of conflict of interest?
    Mr. Cleland. Without question, it creates an appearance of 
conflict, and from my years in the Government, at the Treasury 
Department, the Office of Management and Budget, the State 
Department--and you all know in the public eye the appearance 
can be as damaging as the actual conflict, so that is why in 
the Government policy the people that have the public trust, 
you are supposed to avoid even the appearance of conflicts of 
interest.
    Senator McCain. Let us talk about SPEs for a second, Mr. 
Andrews. Clearly, you say there was one illegal act and one, 
``error in judgment.'' Why would your people not detect 
something like this? As I understand it, it was a fairly large 
amount of money--about $172 million, I believe. How do you miss 
something like that?
    Mr. Andrews. Senator, an audit, of course--well, first of 
all, Enron is a large, complex company that had over 3,000 
subsidiaries. It was at one point seventh on the Fortune 100 
list, so a large complex company, and an audit, of course, is 
performed on a sample of transactions to provide reasonable 
assurance that the financial statements are not materially 
misstated, so an audit does not look at every transaction.
    In the case of Enron, they had a number of special purpose 
entities, and the two that you mentioned, or two of those were 
called into question. On one of those, the smaller of them, 
when our team reviewed the information originally they did not 
detect an element of that that would have required that entity 
to fail that SPE test. It was an honest mistake in judgment. 
When we found out about it subsequently we brought it to the 
company's attention and they corrected that error.
    The second one, which is the one you refer to as an illegal 
act, actually information came to us, actually in early 
November. We do not know if an illegal act has been performed, 
but information came to us that would have required the 
accounting for that item to be different than it was originally 
done. Originally it was not recorded on the books, and it needs 
to be consolidated with the entity.
    We do not know why we did not have that information. That 
was referred under 10A to the audit committee of the company, 
and it is currently under investigation.
    Senator McCain. How many SPEs did they have?
    Mr. Andrews. I do not have the exact number, but there were 
several hundred.
    Senator McCain. Were there several hundred SPEs?
    Mr. Cleland--and Mr. Andrews, I understand you are the 
messenger here today, and I appreciate you coming forward to 
testify and help us understand this situation. I thank you for 
being here today.
    Mr. Cleland.
    Mr. Cleland. Just as a comment on that, the thing that I 
think all of us should be just stunned and amazed at is, this 
was a problem that should have been caught in 1997, in 1998, in 
1999, and in 2000. That is what a system of internal controls 
is supposed to be about.
    Mistakes are made, but we have a system that they cannot 
cascade hopefully more than 1 year, and when something cascades 
for 4 years on top of each other you have an Enron, and 
hopefully that is what you are gleaning from all of this, is 
that the system that is supposed to catch these things and fix 
them so they maybe Enron got a stock battering, but all these 
people on the first panel did not need to be here. They might 
have had a lower nest egg, but they would have still had a nest 
egg.
    Senator McCain. Efforts to reform the system of controls 
have been stymied in several areas of government. Do you have 
any comment about that?
    Mr. Cleland. Well, I think that--you know that the legal 
process--you all know better than anybody that if you try and 
do it through legislation, there are all sorts of ways that it 
can get stopped. I have simple suggestion. The U.S. Senate 
should do a resolution that says, we stand up for the integrity 
of the investment system. We think conflicts of interest are 
not a good idea.
    You ought to suggest to your House colleagues to do that, 
and I will bet it is 100-0 and 435-0, and all of a sudden you 
get a sense of the Congress real loud and clear that says yes, 
integrity of the public markets is a good idea, and yes, 
conflicts of interest tempt people in ways we should not tempt 
them.
    Why do I make sure that none of our research analysts may 
own an individual stock? I do not want to tempt them. Human 
nature is something in this. Now, why is Wall Street the way it 
is? They have been tempted with not millions, we are talking 
tens of millions, hundreds of millions of dollars. You are 
tempted with that amount of money and there are all sorts of 
reasons why you would look the other way.
    Senator Dorgan. I am going to call on Senator Wyden, but I 
want to follow up just for one moment on the point Senator 
McCain made. Just to focus on one piece of this: Mr. Fastow, as 
I understand it, received $30 million in management fees for 
these off-the-books partnerships, and we do not know what the 
ownership stake was, but the $30 million was just for 
management fees.
    Now, this was an officer of the company making a 
substantial amount of money in management fees and perhaps an 
ownership stake. When questioned about who were the other 
investors in these partnerships, the answer is: they are 
private. So among the answers we are requesting is, let us 
allow some sunshine to come in here and find out who owned 
these SPEs. How did they profit? When did they profit? How much 
did they profit? That is what we are trying to get to, and I 
think that is what Senator McCain was alluding to as well.
    I would just ask Mr. Cleland the same question I asked of 
Mr. Andrews. I do not think I got an answer, but do you think 
it is an inherent conflict of interest for a CFO of a company 
to have an ownership stake in these off-the-books partnerships 
and be paid commissions for running them and so forth?
    Mr. Cleland. Yes. That is a no-brainer. It is an 
unbelievable conflict of interest, because one thing is public 
and the other is private, and so there is no accountability. 
That is why it is a conflict.
    Senator Dorgan. Senator Wyden.
    Senator Wyden. I participated in more than thirty hearings 
regarding the accounting profession as a member of the House. 
Those hearings were chaired by John Dingell, and after the 
hearings I wrote a law with Mr. Dingell's assistance that was 
designed to prevent this kind of problem. Everything about what 
we did was designed to do what Mr. Cleland talked about which 
was to set off those early warning lights. I'm going to take 
you through that statute and have you tell me what your company 
was doing to, in effect, comply with the law. I'm just going to 
go through it step by step.
    The first part of the law says that every single audit has 
to have procedures in place to detect illegal acts. What did 
you have in place and, in particular, did you revise those 
procedures as more and more evidence came to light, suggesting 
that there was a problem there?
    Mr. Andrews. Senator, as you know I'm not the individual 
that actually managed the individual Enron engagement, so I 
don't have all the details of what we did on the audit. But our 
audits on this engagement were performed in accordance with the 
professional standards. I think our people did the appropriate 
work, which includes, within that scope, the appropriate 
consideration of establishing your audit scope to take into 
account the responsibility for illegal acts.
    Senator Wyden. But did you change it over time? I mean, my 
knowledge at this point is that it would be one thing to have a 
set of procedures at the beginning, but as Mr. Cleland said, 
then all this evidence starts flowing in. You've got a law on 
the books that would suggest to me that the procedures should 
have changed over time. Did they?
    Mr. Andrews. Senator, I do not know how our procedures 
changed over time but I do want to make, point out one thing 
that if my testimony in any way was misleading, is we, at this 
point, have one item that came to our attention in November 
that we have reported to the audit committee under 10A, as 
required. We do not know if that was an illegal act or not. So 
at this point in time we do not know if we have any illegal 
acts at the company.
    Senator Wyden. Let's continue to go through the law. The 
second part of the law goes right to the heart of what all of 
my colleagues are talking about. These related party 
transactions are just a breeding ground for financial hide and 
seek and conflicts of interest. The current law says that there 
have to be procedures to identify related party transactions 
that are material to the financial statements. What procedures 
did you have so as to again identify those related party 
transactions early on as Mr. Cleland is talking about?
    Mr. Andrews. Senator again, our audit procedures 
incorporated the audit steps, if you will, to identify related 
parties and to discuss related parties and to see that related 
party transactions, that the company disclose those related 
party transactions in accordance with generally accepted 
accounting principles. The responsibility for related party 
transactions, first to identify them and to disclose them, is 
foremost the company's and it's our responsibilities as 
auditors to do appropriate auditing procedures related to that. 
Again, a related party transaction is not wrong as long as it's 
accounted for, approved properly and disclosed.
    Senator Wyden. Well, again, it just seems to me that at 
this point there is just the vaguest, most skimpy information 
out there about these partnerships and if you look at section 
two of this law that John Dingell and I wrote, it sure looks to 
me like there wasn't a whole lot of disclosure of those related 
party transactions.
    Now the third part of the law says that when illegal acts 
occur or may have occurred, you're supposed to bring it to the 
attention of the authorities. You've described bringing it to 
the attention of the authorities years after the warning lights 
should have gone off. Years after the warning lights should 
have gone off. Why did that happen?
    Mr. Andrews. Senator, the particular transaction that 
you're referencing, again if I have in any way been unclear on 
that, that was a transaction that was entered into a few years 
ago in which we did not have, the company did not provide us 
with all the information to reach the right conclusion on that 
transaction. It was actually November, early November of 2001 
that upon a request for additional information that the special 
committee of Enron's board had, we got a package of information 
that contained information we did not previously receive when 
that transaction was recorded. When we got that information, it 
was, it was crystal clear to us that the accounting for that 
transaction had been incorrect and within twenty-four hours we 
took that information to the audit committee and asked that the 
company appropriately investigate it and report those findings 
back to us so that we could consider then our responsibilities 
beyond that.
    Senator Wyden. Well again, it just looks to me that the 
firm moved after all the horses were out of the barn, and we 
wrote a law that was designed to have the firm move years and 
years earlier. Now let me, because time is short, ask you about 
just a couple of other matters.
    It's my understanding that Andersen served not only as 
Enron's in-house auditor, but also as the outside auditor as 
well. So in effect, it looks to me like Andersen is auditing 
its own work. Do you think that's appropriate for an internal 
in-house auditor to also serve as the outside person?
    Mr. Andrews. Senator, in the case of Enron we did not audit 
our own work and we certainly concur that we should not audit 
our own work. What we did at Enron, actually our services that 
are referred to as internal audit services, are actually part 
of the external audit fee that, part of the $25 million. We 
rendered two reports on Enron. One is a financial statement 
audit, if you will, the opinion on the financials, and the 
second is a report on internal controls, which many have 
advocated. That's actually, that responsibility is codified 
under the AICPA guidelines, so that's an external audit 
activity. The only internal audit activity we did in 2000 
really related to a request that Enron asked us to review a 
system, the controls around the system, that another big five 
firm had actually installed.
    Now prior to 2000, in the 1994 to 1998 period, we did 
perform internal audit services for Enron. But beginning in 
1998 they rebuilt their internal audit department and since 
that time what we have done is really render those two reports, 
which are external audit activities and occasionally, when they 
would request it, we would do additional services. But we do 
not, we do not audit our own work.
    I certainly concur with your statement that it's 
inappropriate for an external auditor to audit its own work.
    Senator Wyden. This is eye-glazing stuff, you know, Mr. 
Andrews. I mean, I sat through thirty accounting hearings and I 
saw just how this is sort of like prolonged root canal work. 
But I will tell you, at the end of the day, people get hurt 
when auditing firms take years to do what that law, which went 
into effect several years before all of this went on, could 
have brought to light.
    Now let me ask you about a couple of other matters. In 
testimony before the House the CEO of Andersen said it wasn't 
clear why relevant information about one of the big special 
partnerships was not provided to you. Under the Financial Fraud 
Disclosure Act who bears the responsibility for obtaining the 
relevant information?
    Mr. Andrews. Well Senator, as an auditor we expect all 
relevant information to be provided to us. In the case of these 
transactions we believe that it's quite clear what relevant 
information would be appropriate for us to review as well as 
for the company to review. In this case, we don't know why, as 
he stated in his testimony, as I did today, we do not know why 
we did not have a component of that relevant information. 
Again, when it came to our attention, we reacted instantly to 
take the appropriate actions under, under 10A.
    Senator Wyden. But again, under the law, shouldn't you have 
been bearing down to get that relevant information? I mean, 
what I am struck by is that, and I am sure we're going to run a 
lawyer's full employment program and argue about this for some 
time, there may have been a technical compliance here, but all 
of this seems to me to be maneuvering that is different than 
what the Congress intended when we passed that law. When we 
passed that law it said you had to have all the relevant 
financial information. I don't know how you certified the 
accuracy of their books for years and years. How could you have 
certified the accuracy of their books when you couldn't get the 
information?
    Mr. Andrews. Well Senator, obviously we do not know what we 
do not know. We did not realize in this particular case, in 
this one transaction, we did not realize that we did not have 
the information. Again, an audit looks at a sample of 
transactions, does not audit every transaction, and it is our 
professional responsibility to do that. And when we obtained 
the information, we reacted to it as required under 10A.
    Senator Wyden. The point really is that the law changed, 
Mr. Andrews. The law changed when we passed the law to detect 
and disclose financial fraud on the books. But you all are 
acting like very little has changed. When you say we did not 
know what we did not know, the whole point was when you saw 
suspicious activity you were supposed to set off the red 
warning lights. The watchdogs were supposed to wake up from 
their slumber and get it to the attention of the proper 
authorities and it just seems to me, in this case, years were 
taken before that was done. I thank you Mr. Chairman.
    Senator Dorgan. Senator Wyden, thank you very much. You are 
raising questions about an area that is critically important. 
In fact, the number of restatements of earnings, very 
substantial restatements of earnings, in this country today 
ought to cause alarm here in Congress and across the country. I 
do not understand how, what can happen after the fact is for 
the best minds in the country could say: oh, we made, we made a 
mistake of $100 million or a half a billion dollars. It's 
happening all too often and maybe is the subject of another 
hearing at another time. Senator Fitzgerald.
    Senator Fitzgerald. Thank you, Mr. Chairman. Mr. Cleland, I 
wanted to thank you for your testimony. I thought it was superb 
and I would like to work with you implementing some of your 
recommendations.
    Mr. Cleland. Thank you Senator.
    Senator Fitzgerald. And thank you for being here today. And 
Mr. Andrews, I want to compliment your firm for having the 
courage to come before our Committee and take your lumps. I 
think you are being very forthright here in doing so. I would 
have to say too that it really appears to me that your 
restatement of the earnings seems to have caused Enron 
ultimately to go into collapse, because once the earnings got 
restated then people--creditors--really started questioning the 
company and then it evolved into a liquidity crisis where they 
couldn't get more credit and they couldn't keep going forward 
without filing bankruptcy, and I think actually, your forcing 
them to restate their earnings brought this whole thing to 
light ultimately.
    Now you did earn a lot of fees from Enron but I guess I 
would want to ask, what are the overall fees that Arthur 
Andersen earns in a year and what percentage would $52 million 
that Enron paid you last year, what percentage of your total 
revenues for the firm would that be?
    Mr. Andrews. Well, our firm is approximately a $10 billion 
business, so $52 million into $10 billion would be the relative 
size of that.
    Senator Fitzgerald. It wouldn't seem that it is really a 
sizable fraction of your overall revenues and so, I guess it 
would be hard for me to put all the blame on your firm because 
it is hard for me to believe that your firm, because of that 
$52 million, would have been compelled to cover up things in 
Enron's financial statements and risk your whole firm.
    Mr. Andrews. I think, Senator, I think that's an excellent 
point. I'd like to comment on that and also one comment on the 
restatement if I could.
    We are confident we are independent of Enron and I think 
the illustration that you just cited is an example of why I 
think the public should be confident that we are as well. But 
we are independent and our team performed professionally.
    As it pertains to the restatement, I want to make sure I 
clarify actually what took place there. We of course audited 
Enron. The last audit we actually did was December 31, 2000. It 
was subsequent to the third quarter of 2001, of course, which 
we have not audited, that Enron concluded it would restate its 
prior year statements.
    We really, at this point, have not audited the restatements 
and, in fact, we have withdrawn our opinion on the prior 
restatements. So it's really Enron's restatement, and actually, 
that occurred in early November, 2001 and really was not part 
of the October 10Q at that point. It was filed actually in 
November, 2001 but we have not audited those restatements.
    Senator Fitzgerald. I guess I have a question in my own 
mind, Mr. Cleland. Say that all of these SPE transactions had 
been properly disclosed since 1997 through the future. I guess 
all these analysts out there, my suspicion is, would still have 
had buy recommendations on the stock. When you look at the 
annual report of Enron and see pages and pages and pages of 
their subsidiary corporations, 3,000 of them, and then they 
have I don't know how many of these SPEs, you have an 
impenetrable financial statement, that only maybe a handful of 
people in the country with Ph.Ds in accounting would even have 
the slightest possibility of understanding.
    And whenever you see stuff like this, at least in my own 
mind, growing up as I did in a banking family, my father was a 
small town community banker, if he ever saw something, somebody 
came into him with a deal he could not understand, he said bye-
bye. He stayed away from anything that he could not understand.
    Well, I think the fact of the matter is that you had 
bankers that were lending to Enron, we have some big banks, 
Citibank, JPMorgan Chase or, I have got to be careful, I am not 
sure. I know Citibank was involved with over $500 million in 
unsecured debt here. I wonder how many of the people at 
Citibank even understood these financial statements. You had 
analysts all over the country pumping the stock, and I do not 
know that greater disclosure somewhere in the bowels of these 
10K or 10Q's would have made any difference.
    Mr. Cleland. You're exactly right. See, the problem isn't 
whether it's disclosed, it's that you want some part of the 
system to be totally aligned with investor interests. So 
essentially, they are paid and have the responsibility and earn 
an income for finding these things, and right now, we did a 
survey earlier in the year where 95 percent of the Wall Street 
Journal's top research firms had investment banking conflicts 
of interest.
    So all the brand names that everybody comes to understand 
have these conflicts of interest. So, and also they all say 
well, everybody does it, so how can it be wrong? Well, it's 
only when you look at it in totality and you realize that 
virtually all the research is done from a company perspective, 
no one's checking their work. No one is assuming that there 
might be something wrong. And no one is paid by the system to 
assume something's wrong. We're a small firm. We're focused on 
that. We're aligned totally with investor interests and in a 
telecom text base, we do spot these things.
    Senator Fitzgerald. Well, do you think we should require 
analysts be separate from the investment banks or how would 
they get paid? Who would pay for the services?
    Mr. Cleland. I think, you know, I am not a pro-regulatory 
guy in this. I think what you need to do is fix the system 
which is commingled. If you put banking, trading and research 
chits all in the same till, the one that has the most profits 
and the one that generates the most, they rule the house.
    And so, a very simple thing you all could do, and this is 
not very regulatory, is what we're suggesting is say trading 
should be trading. That's what best execution is all about in 
our system and banking, we have all sorts of banking rules that 
say the banking commissions need to be a certain way. We have 
very little that says we want to encourage research to be 
research, because until you allow research to be paid for just 
research, you're not going to have very much of it, because if 
it's commingled, the bankers go, no, no, no, we don't want that 
kind of research because that research might make a stock go 
down. That is not in our interest.
    And so, the best research execution would be a good idea. 
If you want to have a disclosure, you could also have a 
disclosure where public companies would have to say what type 
of research are they using? Maybe not specifically, but in 
general. Are they buying conflicted research or they're buying 
independent research.
    Senator Fitzgerald. And you also believe, and this is my 
final question, you also believe that auditors should not be 
able to provide consulting services for their auditing clients?
    Mr. Cleland. I think that auditing is such a public trust, 
just like working for the government is such a public trust, 
that there needs to be a higher standard and auditors ought to 
be auditors, just like tax examiners should be tax examiners. 
We wouldn't want IRS guys moonlighting on the side. We don't 
want a judge moonlighting on the side for somebody they might 
be judging. I think it's common sense. It begs problems if you 
have conflicts of interest.
    Senator Fitzgerald. Now, Mr. Andrews you don't agree with 
that and generally the big accounting firms don't agree with 
that, is that correct?
    Mr. Andrews. Well, that is correct. I mean, there are rules 
that guide what we can do and what we can't do, and we 
certainly are very responsive to abiding by those rules. I will 
say that, as I've said in my statement, we're very open. We 
think we have a responsibility, the profession has a 
responsibility, Andersen has a responsibility to restore public 
trust. So we recognize that reform is needed in both the 
regulatory process and the disciplinary process and we're open-
minded as to what that reform could be.
    I think we have to look at it in its total context and if 
it does two things I think we would be receptive to considering 
any changes. Those two things are: Does it in fact build and 
restore public trust and does it improve the quality of audits? 
And if we can achieve those two objectives, we certainly are 
open to consideration of a variety of alternatives, but we do 
believe they should be looked at in the total context.
    In the Enron situation, we did not have a conflict of 
interest, we were independent and I believe our team did its 
professional job.
    Senator Fitzgerald. Thank you.
    Senator Dorgan. The Senate will begin two votes at 12 
o'clock. Those votes will last a period of time, so that means 
we have about another half an hour here before we are going to 
have to go and vote. I very much want to hear the other three 
witnesses and Senator Wyden has a brief question prior to 
asking the other witnesses to come forward.
    Senator Wyden. Just one question. It sort of sums it up for 
me, Mr. Andrews. Enron's board was allowing all of these 
partnerships and all of these exotic financial entities that 
were basically keeping the debt off Enron's books. That's what 
it did, kept the debt off Enron's books. What was Arthur 
Andersen doing during this whole period? This went on for 
years. Again, it goes right to the question of why there 
weren't any warning lights blaring?
    Mr. Andrews. Well, Senator I think it runs to the basic 
issue of, you know, why do entities like SPEs, why are there 
rules within generally accepted accounting principles that 
allow, not only allow, but require compliance as to where an 
investment is or isn't. Is it on the books or is it off the 
books? Is the debt on the books or off the books?
    Those rules are the rules that exist within generally 
accepted accounting principles. Neither the company nor 
ourselves have the luxury of deciding which of the rules we 
will follow. Those rules are there and I think your point is, 
all right, as I listen to it, is that those rules are unclear 
and un-complex and perhaps don't result in the disclosure that 
you would like to see.
    Senator Dorgan. Mr. Andrews, time will tell whether those 
rules were bent or broken. I find it hard to believe that 
somehow it's operating within the rules to have a CFO of a 
company be involved in off-the-books partnerships with a 
financial stake in them, making $30 million a year on 
commissions. I think that is a preposterous situation. It's 
full of conflict, and I think a lot of folks in this country 
get hurt. They lose their life savings as a result of it and 
Senator Wyden's inquiring, as I think most of America would 
inquire about, where were the watchdogs and where were the 
auditors?
    Your appearance is appreciated. Some have chosen not to 
appear. Your company has. We appreciate that. We, as I have 
indicated, will have another hearing on February 4th. Mr. Lay, 
we are told, will be available to testify at that hearing. We 
will ask Mr. Skilling and Mr. Fastow to be present as well.
    Mr. Cleland, we would like to be in further touch with you.
    Mr. Cleland. Thank you.
    Senator Dorgan. I appreciate your testimony. I think it is 
very valuable to us, and we will excuse both of you and ask the 
three final witnesses to come forward.
    We are asking Mr. John Coffee, Adolf Berle Professor of Law 
at Colombia University to come forward, Mr. Bill Mann, Senior 
Analyst of The Motley Fool, and Mr. Damon Silvers, Associate 
General Counsel of the AFL-CIO.
    Let me say that I appreciate your patience and your 
willingness to be with us during this period. If you will come 
forward. I want to get your testimony before we break in order 
to vote, because that will take a block of time and I think you 
have waited some lengthy period of time already this morning.
    Mr. Coffee, you are a Professor at the Columbia School of 
Law.
    Mr. Coffee. Actually this semester I'm a Professor at 
Harvard Law School. I just want to make the dean happy by 
indicating that I'm a visiting professor there this semester.
    Senator Dorgan. I see. So you're not exactly disavowing 
Columbia, you're simply giving credit to Harvard.
    Mr. Coffee. I'll go back to Columbia in January. I'm very 
loyal to Columbia.
    Senator Dorgan. Both schools have now profited from this 
public disclosure.
    [Laughter.]
    Senator Dorgan. We appreciate you being with us, Mr. Coffee 
and why don't you proceed.

       STATEMENT OF JOHN C. COFFEE, JR., ADOLF A. BERLE 
PROFESSOR OF LAW, COLUMBIA UNIVERSITY SCHOOL OF LAW AND JOSEPH 
 FLOM VISITING PROFESSOR OF LAW, HARVARD UNIVERSITY LAW SCHOOL

    Mr. Coffee. Well, when a debacle like Enron occurs, the 
critical question for Congress and for regulators is to ask, as 
you have been beginning to ask, where were the gatekeepers? 
Where were the watchdogs? By gatekeepers I mean the independent 
professionals whose job it is in American corporate governance 
to analyze, verify and examine the financial statements and the 
financial transactions that the company is engaged in. That's 
both the auditors, the audit committee, the securities analysts 
and the bond rating agencies.
    Here all failed, and all failed fairly abysmally. This is a 
pathological symptom. Now I do not want to overstate, I do not 
purport to know whether Enron's auditors were complicit in 
securities fraud. I think no one can tell at this stage, 
there's not enough information and frankly I would be quite 
surprised if we have a case of outright fraud. But I do know 
that this is a case in which all the earmarks and symptoms are 
present of a gatekeeper who was too conflicted to be an 
effective watchdog on whom investors can confidently rely.
    Arthur Andersen just told you they made an error in 
judgment and I'm not accusing them of more than that, but I 
will say that there are more errors of judgment made when 
you're subject to serious conflicts of interest. 
Rationalizations are much easier, particularly in the very gray 
world of accounting principles, which are seldom black and 
white and which always give enormous amounts of discretion to 
the professional gatekeeper.
    We heard earlier that $50 million was not that big for 
Arthur Andersen. But I should remind you that auditing firms 
are a lot like law firms, Partners are compensated on what I'll 
call an eat what you kill basis, and for the Houston office of 
Arthur Andersen this was a very, very big client. In fact, it's 
much more than a $50 million client because within the 
profession of auditing today, the growth is not on the auditing 
side, the growth is on the management advisory services side.
    In their own literature, their own professional journals 
tell them over and over again that auditing is a portal of 
entry, a way to get inside the client and then market the much 
more lucrative consulting services. So an Enron is really a 
potential market of $100 or $200 million to a firm that's 
auditing it, because they're looking at what the future growth 
was if Enron had remained solvent, and that does create a 
serious conflict problem.
    Most importantly, this case is not unique. Accounting 
irregularities are now alleged in the majority of securities 
class actions that are filed each year. The old days of stock 
drops and missed projections, they're gone. They can't be sued 
anymore because the Private Securities Litigation Reform Act 
has basically closed down that type of litigation. Enron is 
really no different than Cendent, Sunbeam, HBOCMcKesson, 
Livent, Mercury Finance, Waste Management, Rite Aid. All of 
these were large corporations with real assets that managed 
either to conceal shortfall in earnings for several years, or 
to postpone cost recognition for several years. Enron is simply 
the decimal point moved two times to the right but the same 
underlining fact pattern. In Yogi Berra's phrase, it's deja vu 
all over again.
    Now the best evidence of this is ironically a study by 
Arthur Andersen, which I think you may have been referring to 
earlier. Arthur Andersen has reported this year that the number 
of accounting restatements by publicly held companies has gone 
up sharply over the last 3 years, and this is not anecdotal 
data, this is significant data. In 1998 there were 158 
accounting restatements of earnings by publicly held companies. 
That's a lot. But last year that number was up to 233. That's 
over a 2-year period. It's a 47 percent rise. Something is 
going on behind that. What is happening? I want to offer two 
generalizations, and I'll be brief on both of these. First of 
all, the legal threat that auditors and accountants face for 
securities fraud liability has sharply decreased over recent 
years for a variety of reasons. It's partly the Private 
Securities Litigation Reform Act. It's partly the preemption of 
state litigation, and it's even more the Supreme Court's 
elimination of aiding and abetting liability, because that's 
traditionally what accountants were sued on--aiding and 
abetting liability, and that was abolished by the Supreme Court 
in a judicial decision.
    Now, I'm not suggesting that the answer here is simply to 
maximize the legal threat. I think there can be too much 
liability as well as too little liability. But, the pendulum 
has swung sharply, to the point today that auditors are very 
uninviting targets. They do get sued, but the cases against 
them usually are dismissed or they settle for fairly small 
damages, except frankly, in these highly publicized cases--like 
Enron may prove to be. That's trend one.
    Trend two is the incentive to acquiesce and to defer to 
management has increased as the accounting profession has 
transformed itself from old-fashioned staid auditors into 
complex, diversified, management advisory conglomerates, which 
view, again, auditing as basically a point of entry, a 
mechanism by which you can maximize cross selling and by which 
you can use auditing as a kind of loss leader to market more 
lucrative services. Very briefly, what can be done? I won't 
take you through a detailed legal analysis, but I would suggest 
there are two things that you should focus on.
    One is the current auditor independence rule is inadequate. 
How do I know that? Last year the SEC proposed a much, much 
tougher rule that would have largely prohibited auditing firms 
from marketing non-audited services to their audit client. The 
SEC thought that was the right rule. The SEC got a fire-storm 
of resistance and the SEC, under and aggressive and bold 
chairman, who I great respect, was unable to get that rule 
through. And he got, frankly, great resistance from Congress 
and others.
    I think the time has come to recognize that Chairman Levitt 
may have been right. There has been, as he publicly said, a 
decline in the quality of financial reporting, and that it is 
partly attributable to both the game of earnings management, 
which is fairly pervasive, and the conflicts of interests as 
auditors have transformed themselves into diversified, 
financial conglomerates.
    I think we should go back and re-examine that rule. And, 
that's an SEC rule, which is much easier to change than trying 
to go back and pass legislation or, God forbid, re-examine the 
Private Securities Litigation Reform Act, which was probably 
the most controversial legislation that I've seen over the last 
10 years. That's something that's manageable.
    The other thing that I think can be done and should be done 
is a serious system of industry self-regulation. Let me focus 
on a basic contrast. I want to contrast the broker-dealer 
industry and the auditing profession. Both involve firms that 
specialize in human capital and professional services, broker-
dealer advice or auditing.
    Broker-dealers are regulated by the National Association of 
Securities Dealers, the NASD, a self-regulatory body subject to 
some SEC oversight. That body is tough, independent, and since 
it was reformed in the mid-1990's, I think a very effective 
agency that is not a captive agency.
    Last week, they and the SEC imposed over a $100 million 
dollar fine on Credit Suisse First Boston. That's not the ear-
mark of a captive agency. They impose thousands of penalties on 
broker-dealers every year, literally thousands. And, they 
impose penalties that are not trivial.
    In contrast, on the accounting side, we have the AICPA and 
a byzantine, convoluted system of regulation. But, the one 
thing it does not do is ever impose discipline. None of the 
regulatory agencies, the AICPA, the Public Oversight Board, or 
any other agency of that sort, is empowered to impose 
discipline. That's delegated down to the states where very 
little happens. Enron is not a local problem. It's a problem on 
a national level and we need a national, self-regulatory body.
    Ultimately, the choice for the accounting profession is 
between developing on their own, with Congressional assistance 
and Congressional insistence on strong, independent directors--
so this wouldn't be a captive agency--a powerful, self-
regulatory agency that can impose real discipline, modeled 
after the NASD which does work. Or, the alternative is that 
over time in our common law system the courts will begin to 
change the common law and impose much more punitive liability 
through the tort system. That will take a long time. It won't 
benefit any of the investors that were here today who are going 
to receive nothing, frankly. But, the choice for the industry 
is serious self-discipline or expect that over time the tort 
system will gradually change the rules and we'll have 
discipline through the class action.
    Of the two, I would say that intelligent self-regulation 
would be the far more sensible, far shrewder answer, if the 
industry, pushed by Congress, were to pursue that. Thank you.
    [The prepared statement of Mr. Coffee follows:]

Prepared Statement of John C. Coffee, Jr., Adolf A. Berle Professor of 
    Law, Columbia University School of Law and Joseph Flom Visiting 
            Professor of Law, Harvard University Law School
              The Enron Debacle and Gatekeeper Liability:
                Why Would the Gatekeepers Remain Silent?

    The sudden and unexpected bankruptcy of Enron has generated 
understandable concerns about our system of corporate governance--and, 
in particular, about the integrity of financial reporting systems. 
Although publicly held companies in the United States are subject to 
uniquely high disclosure obligations, the Enron example shows that the 
much vaunted transparency of the American securities markets can 
sometimes prove illusory and that sometimes very material information 
can be concealed behind opaque accounting.
    When this happens, the inevitable question arises: Why didn't the 
gatekeepers stop them? By ``gatekeepers,'' I mean the independent 
professionals who verify and analyze the disclosures of publicly held 
companies. These include the corporation's outside auditors, the 
securities analysts that follow its stock, and the bond rating agencies 
that review its bonds. Because these professionals have considerable 
reputational capital, which can be damaged by involvement in a 
corporate fiasco, because they face the prospect of legal liability for 
securities fraud, and because they have much less incentive to lie or 
acquiesce in fraud than do the corporate insiders, gatekeepers are the 
primary safeguards on whom investors rely to assure that accurate and 
meaningful disclosures reach the market. Yet, in the Enron case, all 
these protective mechanisms failed: the accountants certified financial 
statements that overstated Enron's financial results by over $500 
million; the security analysts continued to recommend Enron's stock (in 
some cases with a ``strong buy'' recommendation) right up to virtually 
the moment of Enron's bankruptcy filing, and the credit rating agencies 
did not detect that Enron's off-balance sheet financing hid very high 
leverage.
    Who is to blame? It would be premature at this point to even 
attempt to attribute responsibility. Possibly, Enron's auditors were 
deceived, and possibly they may have been lax and acquiescent. One 
simply cannot conclude from the outside on the evidence now available. 
What can be said, however, is that the Enron case does not stand alone. 
In particular, cases involving accounting irregularities have 
proliferated over just the last several years. Some of these cases have 
made it to the front of the business page and the nightly T.V. news: 
Cendant, Sunbeam, HBOCMcKesson, Livent, Mercury Finance, Waste 
Management, and Rite Aid.\1\ Some of these cases have resulted in 
criminal prosecutions and convictions, others in SEC enforcements 
proceedings, and all in large settlements of private class actions. The 
increase in accounting irregularities is not simply an anecdotal 
impression. A study by Arthur Andersen has found that the number of 
restatements of earnings by publicly held companies has risen steadily 
and dramatically over the past four years from 158 in 1998 to 233 in 
2000--or, a 47% increase over this brief period.\2\
---------------------------------------------------------------------------
    \1\ A fuller list of recent ``accounting irregularity'' cases can 
be found in Michael Young, ACCOUNTING IRREGULARITIES AND FINANCIAL 
FRAUD: A Corporate Governance Guide (2000).
    \2\ See Jonathan Glater, ``Flood of Lawsuits Puts Underwriters in 
Cross Hairs,'' New York Times, December 2, 2001 at Section 3, p.4.
---------------------------------------------------------------------------
    That corporate insiders will sometimes commit fraud and suppress 
adverse information is not terribly surprising. After all, they benefit 
from it. That securities fraud escapes the attention of the 
professional gatekeepers may be more surprising--and alarming. Yet, 
former SEC Chairman Arthur Levitt concluded in a famous 1998 speech 
that there had been ``an erosion in the quality of earnings and 
therefore the quality of financial reporting.'' \3\ Specifically, 
Chairman Levitt focused on a variety of what he termed ``accounting 
gimmicks'' that enabled companies to exploit the flexibility of 
accounting rules to obscure actual financial results and risks. Since 
the time of that 1998 speech, a small library of academic and empirical 
studies of the phenomenon of ``earnings management'' have been 
published, most of which confirm that earnings management is 
pervasive.\4\ During his tenure, Chairman Levitt made accounting reform 
a major priority, and, the SEC formulated a series of new accounting 
rules and interpretations during the late 1990's, to restrict earnings 
management; it also established a ``blue ribbon panel'' to improve 
audit committee performance and persuaded both the NYSE and Nasdaq to 
adopt its recommendations. Finally, in a bruising battle with the 
accounting profession, the SEC revised its critical rule on ``auditor 
independence.'' All of these measures were to varying degrees 
controversial, and the last--the SEC's proposed auditor independence 
rule--proved to be politically unobtainable, as the Commission was 
forced to accept a considerably weaker compromise that left auditors 
free to engage in most forms of consulting work for audit clients.\5\
---------------------------------------------------------------------------
    \3\ See Arthur Levitt, ``The Number Game,'' Sept. 27, 1999 (`Speech 
Given at NYU Center for Law and Business).
    \4\ Many of these studies are available on the SSRN Electronic 
Network. See, e.g., Mark Nelson, John Elliott and Robin Tarpley, 
``Where Do Companies Attempt Earnings Management, and When Do Auditors 
Prevent It?'' (SSRN no. id= 248129, October 22, 2000).
    \5\ The final Commission rule is set forth in Securities Act 
Release 33-7919 (November 21, 2000). An earlier and tougher rule was 
proposed in Securities Act Release No. 33-7870 (June 30, 2000).
---------------------------------------------------------------------------
    Nonetheless, the Enron episode and the general increase in 
accounting restatements suggests that the SEC may not be winning its 
war against accounting irregularities. What could explain this apparent 
decline in the quality of financial reporting? A good case can be made 
that both (1) the legal threat confronting the auditor has been sharply 
reduced over recent years by a series of recent judicial and 
legislative developments, and (2) the incentives for the auditor in 
acquiesce in questionable accounting practices have grown, as the 
nature of the industry has changed. I do not suggest that this 
hypothesis has been proven beyond a reasonable doubt or that it fully 
explains the Enron debacle, but I do suggest that Congress should be 
aware of these developments and not view Enron as an exceptional case. 
Enron is different only in that it is larger. Otherwise, it is in Yogi 
Berra's immortal words ``deja vue all over again.'' Both the diminished 
threat facing auditors and their increased incentive to acquiesce are 
briefly reviewed below.

A. The Diminished Legal Threat
    Auditors have long been subject to suit under Rule 10b-5 when they 
certify that the financial results reported by an audit client comply 
with generally accepted accounting principles (``GAAP''). Indeed, 
auditors are named as defendants, in the majority of securities class 
action lawsuits filed in recent years.\6\ To prevail in such a suit, 
however, the plaintiffs must demonstrate not only that a materially 
false statement was made by the auditor, but that the auditor acted 
with the requisite ``scienter''--that is, a mental state embracing both 
an intent to defraud or a reckless indifference to the truth or 
accuracy of the statement made. The term ``scienter'' is defined 
somewhat differently in different federal circuits, but the prevailing 
definition defines scienter as:
---------------------------------------------------------------------------
    \6\ See Glater, supra note 2.

        ``A highly unreasonable omission, involving not merely simple, 
        or even inexcusable negligence, but an extreme departure from 
        the standards of ordinary care, and which presents a danger of 
        misleading buyers that is either known to the defendant or so 
        obvious that the actor must have been aware of it.'' Sunstrand 
---------------------------------------------------------------------------
        Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1987).

The scienter requirements has long been a primary defense for 
accountants in securities fraud litigation, who can escape liability if 
they can convince the fact finder that they were merely negligent (even 
if grossly so). But the protection of this defense has been recently 
and greatly enhance by the following more recent developments:
    1. The Enhanced Pleading Requirements of the Private Securities 
Litigation Reform Act of 1995 (the ``PSLRA''). Under Section 21D(b)(2) 
of the Securities Exchange Act of 1934, which added by the PSLRA, a 
complaint in a securities fraud case must:

        ``state with particularity facts giving rise to a strong 
        inference that the defendant acted with the required state of 
        mind.''

In a Rule 10b-5 suit, this requires the plaintiff to plead with 
particularly facts giving rise to a ``strong inference of fraud'' on 
the part of the specific defendant. This pleading must be made at the 
outset of the litigation before the plaintiff has obtained any 
discovery. In practice, this provision is far more protective of 
auditors than of other defendants. For example, in the Enron case, 
plaintiffs can plead that the corporate officers at Enron withheld 
material information in order to permit them to sell their large stock 
holdings before the Enron market price collapsed. Evidence of such 
insider sales may (if they are large enough in percentage terms) 
satisfy the plaintiff's obligation to plead with particularity facts 
giving rise to the requisite ``strong inference of fraud'' on the part 
of Enron's insiders. But the same pleading cannot be made with respect 
to the auditors, who by definition do not own stock in an audit client. 
Although auditors may have been subject to conflicts of interest or may 
have been pressured into accepting improper accounting presentations, 
these facts will rarely be evident at the outset of the case. Hence, 
the auditor benefits far more from this pleading requirements than do 
other defendants, because the case against it must be dismissed if such 
facts cannot be plead prior to discovery.
    2. Proportionate Liability. Section 21D(f) of the Securities 
Exchange Act of 1934, which was also added by the PSLRA, substituted 
proportionate liability for joint and several liability as the normal 
standard of damages in securities litigation. This change works 
particularly to the advantage of auditors, who, even if culpable, are 
usually much less so than members of management. As a practical matter, 
an accounting firm now knows that, so long as its actual knowledge of 
the fraud is not proven, its maximum exposure to damages has shrunk 
from joint and several liability for 100% of the losses to a likely 
much lower percentage, probably below 25%.\7\
---------------------------------------------------------------------------
    \7\ There are two major exceptions to this generalization: (1) the 
auditor is subject to ``joint and several'' liability if it made a 
knowingly false statement, and (2) to the extent that a judgment 
against another co-defendant is uncollectible, the auditor may be 
required to pick-up a portion of that unsatisfied liability (up to 50% 
of its original liability). This last point has special relevance in 
the instant case, because Enron is insolvent and cannot be held liable.
---------------------------------------------------------------------------
    3. Eliminating RICO Liability for Securities Fraud. The PSLRA also 
ended the use of the private civil RICO statute as a means of seeking 
treble damages in securities fraud cases. Where once a RICO claim was a 
standard feature in securities class actions, because it increased the 
potential damages by a factor of three, the PSLRA denied plaintiffs the 
ability to assert a RICO claim in any case that could have been pled as 
a securities fraud claim in connection with the purchase or sale of a 
security.
    4. Aiding and Abetting Liability. Even prior to the PSLRA, the 
Supreme Court's decision in Central Bank of Denver, N.A. v. First 
Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), eliminated 
liability for aiding and abetting a securities law violation as a 
potential cause of action that an auditor could face in private 
litigation. This theory of liability had been the preferred weapon of 
the plaintiffs' bar in Rule 10b-5 litigation against accountants, 
because typically auditors aid the issuer in the preparation of its 
financial statements (particularly its quarterly statements). Although 
the SEC has regained the right to sue for some ``aiding and abetting'' 
violations pursuant to the PSLRA, private parties have not.
    5. Preempting State Litigation. Although securities fraud 
litigation in state court became a substantial risk for accountants in 
the late 1990's, that risk was effectively ended in 1998 by the passage 
of the Uniform Standards Act, which preempted class actions and certain 
consolidated actions that assert causes of action, based on either 
state law or the common law, that allege a misrepresentation or 
omission of a material fact in connection with a purchase or sale of a 
security.\8\
---------------------------------------------------------------------------
    \8\ Section 28(f) of the Securities Exchange Act of 1934 precludes 
any ``covered class action based upon the statutory or common law of 
any State or subdivision'' that alleges ``a misrepresentation or 
omission of a material fact in connection with the purchase or sale of 
a covered security.'' A similar provision is set forth in Section 16(b) 
of the Securities Act of 1933. Neither provision preempts an individual 
suit, standing alone, but the term ``covered class action'' includes 
any ``single lawsuit in which . . . damages are sought on behalf of 
more than 50 persons.'' Hence, sizable consolidated actions are also 
barred.
---------------------------------------------------------------------------
    The bottom line is that, although litigation involving accounting 
irregularities remains common, accounting firms themselves are unlikely 
to be held liable for more than a nominal percentage of the losses--
except in cases where their behavior has been egregious.
B. Organizational Changes Within the Auditing Profession
    Auditing firms have long marketed three general types of services 
to their clients: (i) auditing, (ii) tax services, and (iii) management 
advisory services. The last category--management advisory services (or 
``MAS'')--has expanded dramatically over roughly the last decade in a 
manner that has transformed the accounting firm from the traditional 
firm of accounting professionals to a multi-disciplinary service 
organization. In 1981, MAS accounted for only thirteen percent of the 
Big Five's total revenues, but that figure has grown to fifty percent 
or more by 2000.\9\ Over the period from 1993 to 1999, the average 
annual growth rate for revenues from management advisory and similar 
services has been twenty-six percent, while the comparable growth rates 
for audit and tax services has been only nine percent and thirteen 
percent, respectively.\10\ In short, MAS has been growing at roughly 
three times the rate of the traditional audit service. Finally, in 
1999, the U.S. revenues for management advisory and similar services 
for the Big Five amounted to over $15 billion.\11\
---------------------------------------------------------------------------
    \9\ See Securities Act Release No. 33-7919 at p. 18; see also 
Securities Act Release No. 33-7870 (June 30, 2000) at Appendix 13, 
Tables 1 and 2.
    \10\ Id. at p. 18; see also Securities Act Release No. 33-7870 at 
Table 1 in Appendix B.
    \11\ Id.
---------------------------------------------------------------------------
    A more ominous transition involves the relative balance between 
audit fees and MAS fees. Not until 1997 did the percentage of audit 
clients who paid MAS fees in excess of their audit fees to Big Five 
firms exceed 1.5%.\12\ Yet, by 1999, this figure had grown from 1.5% to 
4.6%--an over 200% increase in only two years.\13\ Moreover, average 
MAS fees received by the Big Five firms came to ten percent of all 
revenues in 1999.\14\ Today, for at least some audit clients, the 
amount of non-audit revenues paid to their auditor already exceeds 
their audit fee. At least in the case of these clients, intransigence 
by the audit partner with regard to some ``aggressive'' accounting 
treatment proposed by the client could expose the firm to the loss of 
much greater non-audit revenues, which the client could presumably 
purchase (or threaten to purchase) elsewhere.
---------------------------------------------------------------------------
    \12\ See Securities Act Release No. 33-7870 at Table 3 in Appendix 
B; see also Securities Act Release No. 33-7919 at p. 19.
    \13\ Id.
    \14\ Id.
---------------------------------------------------------------------------
    The danger lies in where these trends are taking us. Not only are 
non-audit revenues received by auditors from their audit clients 
beginning to exceed audit fees from the same clients, but the SEC's 
noted in its latest Release on auditor independence that some audit 
firms may be pursuing a marketing strategy under which the firm ``low-
balls'' the audit fee (even offering to perform it at a loss) ``in 
order to gain entry into and build a relationship with a potential 
client for the firm's non-audit services.'' \15\ Once auditing becomes 
a de facto ``loss leader'' for the multi-services consulting firm, 
there is less reason for such a firm to resist questionable accounting 
practices. To be sure, some threat of liability to third parties 
remains, but in considering resignation, the auditing firm must now 
balance the threat of liability against not only the loss of its audit 
fees, but also the loss of far larger present and expected future non-
audit revenues from the client. Other things being equal, this implies 
that the threat of liability (even if it were undiminished) would less 
often be adequate to deter.
---------------------------------------------------------------------------
    \15\ Securities Act Release No. 33-7919 at 27.
---------------------------------------------------------------------------
    The Enron fact pattern again illustrates this shift in the source 
of client revenues. According to press reports, Enron paid more to 
Arthur Andersen in consulting fees during its last fiscal year than it 
paid in audit fees. In addition, it paid over $50 million in total fees 
to Arthur Andersen last year.\16\ Put simply, this is a very different 
relationship that the traditional relationship between auditor and 
client because historically no single client would have been 
financially material to the auditor. Hence, the rational auditor would 
not risk its reputation for an audit fee that was small in percentage 
terms to its overall earnings. But, as the individual client becomes 
material to the auditor, the auditor unfortunately becomes less 
independent of its client.
---------------------------------------------------------------------------
    \16\ Last year, Enron paid Arthur Andersen $25 million in audit 
fees and $27 million for non-audit services. See Jerry Hirsch and 
Thomas Mulligan, ``Auditors, Execs Target of Enron Creditors,'' Los 
Angeles Times, November 30, 2001 at Part 3-1.
---------------------------------------------------------------------------
C. Implications
    In sum, a credible story can be told that auditors today are 
subject to less of a legal threat than a decade ago and are, 
correspondingly, subject to a greater temptation to defer to management 
with regard to questionable accounting policies. Whether this story 
truly explains the Enron debacle is, of course, uncertain, and no 
suggestion is here made that we yet know whether Enron's auditors did 
acquiesce improperly (as opposed to being themselves deceived by 
Enron).
    But even if this story does fit the instant case, the policy 
prescriptions that should follow from it are at least equally 
debatable. The PSLRA was an intensely lobbied statute, and there seems 
little likelihood that Congress would wish to repeal or seriously 
modify its provisions. Even if the SEC's current auditor independence 
rules seems inadequate, it also seems unlikely that the SEC will wish 
to revisit it only a year after reaching a hard fought compromise with 
the industry. Finally, reliance on class action litigation to 
discipline auditors may not be the optimal remedy. Prior to the PSLRA, 
the very solvency of some auditors was coming into doubt.
    What other avenues of reform are then available? Here, a noteworthy 
contrast can be drawn between the accounting industry and the broker-
dealer industry. Broker dealers are subject to close supervision and 
professional discipline by a self-regulatory body--the National 
Association of Securities Dealers (``NASD''). Nothing remotely 
comparable exists in the convoluted structure of accounting regulation, 
and professional discipline is rarely imposed.
    In this light, the most conservative reform might be the creation 
of a truly independent, self-regulatory body, modeled after the NASD 
and with independent directors that did not come from the industry, to 
monitor and enforce self-regulatory rules for the accounting 
profession.\17\ Although the industry may not welcome such a 
development, it represents far less of an intrusion into their affairs 
than would any attempt to expose them to greater antifraud liability.
---------------------------------------------------------------------------
    \17\ I have made a detailed proposal along these lines in an 
article available on the Social Science Research Network (``SSRN'') 
website. See Coffee, ``The Acquiescent Gatekeeper: Reputational 
Intermediaries, Auditor Independence, and the Governance of 
Accounting'' (May 21, 2001) (SSRN identification number = 270944).
---------------------------------------------------------------------------
    Ultimately, the increasing frequency of accounting irregularities 
faces the accounting industry with an unpleasant choice: implement a 
serious and reliable system of self-regulation and professional 
discipline or expect that the courts and/or Congress over time will 
return to a system of punitive tort liability.

    Sen. Dorgan: Professor Coffee, thank you very much. We 
appreciate your testimony. Next we will hear from Bill Mann, 
Senior Analyst with The Motley Fool. Mr. Mann, why don't you 
proceed?

              STATEMENT OF WILLIAM H. MANN, III, 
                SENIOR ANALYST, THE MOTLEY FOOL

    Mr. Mann. Good morning, Mr. Chairman, I wanted to thank 
you. I am William Mann from Motley Fool. It's not very often 
that someone who purposely calls himself a Fool gets to address 
the U.S. Senate. So, I am honored by the invitation. I'm sorry 
about the situation about which I am testifying today. I have 
listened to the testimonies in the first panel, as you all did, 
and my heart bleeds for these people. They are innocent in what 
will go down to be one of the largest, most destructive company 
failures of all time.
    Let me say at the outset, what was missing in the case of 
Enron was skepticism. Individual investors, institutional 
investors alike, piled millions of investment dollars into the 
company. They were mesmerized by its rate of growth and 
completely sold on what seemed to be an insurmountable business 
advantage. Even though Enron emitted plenty of hints about 
impropriety for several years, few people, from Wall Street 
analysts to individual investors, stopped to ask the tough 
questions. And that's one of the reasons we're here today. I'd 
like to discuss some of those hints, the questions, and what I 
believe is the mechanism that allowed Enron to fall through the 
cracks.
    The Motley Fool's message was not adopted in a vacuum. Our 
founding was predicated on the fact that there was no one who 
really had an incentive to tell people the truth about money 
and their investments. Part of the reason that we began 
teaching about the stock market was the amount of poor and 
self-interested advice that was being given by brokerages and 
their analysts. We believe that price targets and analyst 
ratings are, frankly, things that are made with several masters 
in mind, none of whom is the individual investor. In a similar 
fashion, sell-side stock analysts are generally compensated 
based on the overall profitability of their firms, not on the 
quality or the accuracy of their analysis. In the end, analysts 
have minimal structural incentives to be accurate in their 
predictions; rather, their built-in incentive is to be as 
favorable to the corporate clients as possible. It's a well-
worn joke that there apparently is no word as infrequently used 
in Wall Street as ``sell.''
    In the case of Enron, in September there were 17 analysts 
who covered the company. Sixteen had a ``buy'' or ``strong 
buy,'' one had a ``hold,'' and none had a ``sell'' or a 
``strong sell'' rating. This was true after Enron's CEO 
suddenly resigned and the stock had already dropped more than 
60 percent in the year.
    I don't want to blame Wall Street analysts for the Enron 
implosion. The blame for the billions of dollars and the 
hundreds of thousands investors have lost lies almost entirely 
with the senior management of Enron. The problem lies in the 
fact that these analysts have much greater incentive to focus 
upon the positive of a company than to root out the risks and 
the negatives. And, their employers value their ability to 
generate investment banking business much more than they do 
proper analysis.
    I wish as a personal--as an individual investor, that I 
could say that I'd sniffed out the trouble at Enron when I did 
my analysis in 2000. I was really intrigued by this company. I 
really didn't want to miss out on what I thought was a really 
pretty spectacular growth story. But what I found in the 
company's filings was just plain confusing to me, and there 
were a few items that made me extremely uncomfortable. In 
particular, Footnote 16 in the Form 10-K, under the heading 
``Related Party Transactions,'' where Enron disclosed that it 
had entered into a deal with LJM Cayman Corporation stating 
that a senior officer in Enron is the managing member of LJM's 
general partner.
    When James Chanos, a famous short-seller, began asking 
questions that needed to be asked about these statements, none 
of the analysts followed up. When Enron routinely failed to 
provide a balance sheet along with its earning releases for the 
company conference calls, none of the analysts voiced much of a 
complaint. Or, if they did, it was not reflected in the ratings 
of the stock. Enron was a ``black box'' company, where no one, 
not the analysts nor any of the institutional or individual 
investors was really sure how the company made money.
    There is no ``smoking gun'' with Enron. The financials look 
great and even now there is no single item that we could look 
back and say that's the ``tip-off'' that this ``company was 
going to implode.'' However, the more important issue to my 
mind is whether or not analysts have any incentive at all to do 
the analysis and to ask these tough questions. It strains 
credulity to say that, of the 17 analysts who covered Enron, 
none of them had any idea that related party transactions could 
be used to massage earnings or to hide debt. Enron's business 
was complicated enough, its financials convoluted enough, its 
disclosures opaque enough, and its sales growth spectacular 
enough that there ought to have been some pointed questions 
from analysts so that they could provide knowledgeable guidance 
to their shareholding clients, which thus begs the question, 
``Why weren't there?''
    Goldman Sachs analyst David Maccarrone and David Fleischer 
issued a report on October 24, 2001, following Enron's 
conference call to address investor concerns. One of the quotes 
in the report were as follows, ``Lack of Disclosure and 
Transparency--A Longstanding Enron Hallmark.'' ``New disclosure 
about related party transactions and structured off-balance 
sheet transactions occurred some 18 months ago. . . .'' 
``However, an undercurrent of concern began and questions 
remained unanswered. . . .'' ``We do not believe that 
management has done anything wrong. . . .'' Despite a lack of 
visibility and some pretty important risk factors, Goldman's 
analysts continued to keep Enron on its ``recommended list,'' 
Goldman's highest rating.
    At the same time, Lehman Brothers, covering Enron, put out 
their own version of the conference call. He called it, ``an 
inadequate defense of the balance sheet,'' but then concluded, 
``despite the disappointing call we continue to think that the 
stock should be bought aggressively at these levels.'' Lehman 
Brothers also kept their highest rating on the stock.
    I don't think analysts should be taken to task for being 
wrong. In an environment where people are expected to take past 
and current trends and predict the future, getting things wrong 
would be an inevitable reality of the business. As Yogi Berra 
once noted, ``It's hard to make predictions, especially about 
the future.'' The issue here is that the analysts who were 
covering Enron, despite the company's long-standing policy of 
withholding key information, and despite knowledge of the fact 
that there was an unknown level of debt being hidden from them, 
remained nearly uniformly positive on the company until it was 
clear the company would collapse.
    Both Lehman Brothers and Goldman Sachs have provided 
significant investment banking services to Enron. Both provided 
financial services or sold or managed Enron commercial paper, 
managed a public offering of the stock, all within the last 3 
years. Additionally, a Lehman Brothers employee is an Enron 
director.
    Enron collapsed because its management got caught up 
playing in Wall Street's estimates game, promising and 
delivering big revenue and profit growth, regardless of the 
debt and other balance sheet contortions it took to get there. 
Looked at this way, the pursuit of hyper-growth seems to have 
caused Enron's executives to take undue risks with shareholder 
funds. Maintaining Enron's darling status in the investment 
world apparently caused these same men to take the short walk 
across the aisle from being aggressive with company assets to 
being downright deceptive by hiding information individuals and 
institutional investors must have to make good investment 
decisions.
    At The Motley Fool, our advice to investors is and has 
always been to ignore the ``noise'' that comes from Wall 
Street, and to treat any specific recommendations for stock 
purchase with skepticism. We teach investors to think like 
business owners, not renters or passive pushers of paper. It's 
our genuine hope that investors seek to buy companies that they 
truly understand and would be willing to hold for a lifetime. 
If there's one lesson that individual investors must learn from 
Enron, it is this: You must buy what you know. Enron's CEO Ken 
Lay has admitted that he himself did not fully understand the 
inner workings of Enron, and we can assume that he at least had 
all the information. Even with full disclosure, Enron would 
have been a tough company for the majority of all investors to 
understand. The company was unapologetic in its refusal to 
provide information about its equity and debt structures for 
many years before it actually blew up. My hope is that 
investors take the lesson offered by Enron and remain healthy 
skeptics in the future.
    There's a simple calculus that investors use in valuing a 
company. A company is fairly valued by all of its future 
profits, discounted for risk. Obviously, the greater the risk 
to profits the higher the discount should be; and the less 
valuable every expected dollar of future profits would be right 
now. Over the last twelve months, 233 companies have had to 
restate their earnings. And not surprisingly, none of these 
restatements have made the company's operating results look 
better. Getting away with falsifying earnings over a long 
period of time is difficult. It is much easier to falsify 
levels of risk, and this in the end is what Enron, and by 
extension its auditors and analysts, have done--by commission 
or omission.
    We hope to see that the work that has been done by the SEC 
and Congress to implement improvements, such as Regulation Fair 
Disclosure, will go even further to ensure that individual 
investors are protected. Thank you for your attention and I 
look forward to the opportunity to answer questions.
    [The prepared statement of Mr. Mann follows:]

      Prepared Statement of William H. Mann, III, Senior Analyst, 
                            The Motley Fool

Mr. Chairman, Members of the Committee, and esteemed guests:

    Good Morning. I am William H. Mann, Senior Analyst for The Motley 
Fool. As it is not often that a Fool gets the chance to address the 
United States Senate, I am honored by the invitation to speak before 
you today about Enron--an situation that will no doubt go down in 
history as one of the largest, most destructive company failures of all 
time.
    The Motley Fool was founded in 1993 with a mission to educate, 
amuse and enrich individual investors. Our work is driven by our belief 
that average people--you and I--ought to take a more active interest in 
our management of money. In order for individual investors to 
effectively engage themselves, they need education about how the 
financial system works, access to information, and opportunities for 
open dialogue. That's what we provide. We teach people the fundamentals 
of long-term financial management; we highlight online and offline 
information resources for them; and we manage a 24-hour open network of 
communication on the topic of money shared by people in more than 100 
countries around the globe.
    In addition, individual investors need to have trust in the 
marketplace. Congress and the SEC have actively supported education 
programs and disclosure practices that have helped to strengthen the 
confidence that individual investors have in the public markets. One 
statistic that should make us all proud is that while in 1990 less than 
a quarter of all American households directly owned stocks, today that 
number has grown to more than 50%.
    Let me say at the outset that what was missing in the case of Enron 
was skepticism. Investors--individual and institutional alike--piled 
millions of investment dollars into the company, mesmerized by its 
growth rates, and completely sold on what seemed to be an 
insurmountable business advantage. Even though Enron emitted plenty of 
hints of impropriety for several years, few people, from Wall Street 
analysts to individual investors stopped to ask tough questions. I'd 
like to discuss those hints, the questions, and what I believe is the 
mechanism that allowed an Enron to slip through the cracks.
    The Motley Fool's message was not adopted in a vacuum. Our founding 
was predicated on the fact that there was no one who had an incentive 
to tell people the truth about money and their investments. Part of the 
reason that we began teaching about the stock market was the amount of 
poor and self-interested advice that was being issued by brokerages and 
their analysts. To this day, the majority of stockbrokers are 
compensated on the number of trades their customers make, not on the 
returns they generate for them or on the quality of the advice they 
provide. We believe that the price targets and analyst ratings are made 
with several masters in mind, none of whom are the individual investor. 
In a similar fashion, sell-side stock analysts are generally 
compensated based upon the overall profitability of their firms, not 
the quality or accuracy of their analysis. In the end, analysts have 
minimal structural incentive to be accurate in their predictions; 
rather their built-in incentive is to be as favorable to their 
corporate clients as possible. It is a well-worn joke that there is no 
word as infrequently used on Wall Street as ``sell.''
    An April 1999 speech from U.S. Securities & Exchange Commission 
Chairman Arthur Levitt cited a study that found sell recommendations 
account for just 1.4 percent of all analysts' recommendations, compared 
to 68% of all recommendations being buys. In the case of Enron, in 
September there were 17 analysts who covered Enron, and of them, 16 had 
a ``buy'' or ``strong buy'' rating, one had a ``hold,'' and none had a 
``sell'' or a ``strong sell''. This was true after Enron's CEO, Jeff 
Skilling, suddenly resigned, and the company's stock had already lost 
some 60% of its value from its high of the year.
    I do not wish to blame the Wall Street analysts for the Enron 
implosion. The blame for the billions of dollars that hundreds of 
thousands of investors lost lies almost entirely upon the senior 
management of Enron. But Enron was playing a game that is utterly 
corruptible in ways that are not transparent to retail investors, and 
the playing field is dominated by Wall Street firms, their analysts 
serving as the public face. I submit that every single gross mis-
pricing in equities over the last decade has come with analysts 
cheering it on the way up and maintaining silence as it dropped. I use 
the word corruptible because, for all of the exhortations of The Motley 
Fool that investors ignore analyst ratings, there can be no question 
that people remain deeply influenced by them. The problem lies in the 
fact that analysts have a much greater incentive to focus upon the 
positive of a company than to root out the risks and the negatives, and 
their employers value their ability to generate investment-banking 
income much more than they do proper analysis.
    I wish that I could say that I had sniffed out trouble at Enron 
when I did my analysis in 2000. I was really intrigued by the company, 
and did not want to miss out on what already was a spectacular growth 
story. But what I found was just confusing, and there were a few items 
that made me uncomfortable. In particular, Footnote 16 in their 2000 
Form 10-K, under the heading ``Related Party Transactions,'' where 
Enron disclosed that it had entered into a deal with LJM Cayman 
Corporation, stating that ``A senior officer of Enron is the managing 
member of LJM's general partner.'' Under Generally Accepted Accounting 
Practices, disclosing a related party transaction is properly done in 
this fashion. However, related party transactions are also a method 
that companies use to ``groom'' their financials, so I would generally 
insist upon a high level of disclosure for the risks and benefits to 
shareholders that such a transaction would provide. Related party 
transactions are ideal vehicles for companies to hide risk, to get 
debts off of the balance sheet by using Special Purpose Entities 
(SPE's).
    In Enron's case, the disclosures were minimal. When James Chanos, a 
famous short-seller, began asking questions that needed to be asked 
about these statements, no analysts followed up. When Enron routinely 
failed to provide a balance sheet along with its earnings releases for 
company conference calls, none of the analysts voiced much complaint, 
or if they did, it was not reflected in their ratings of the stock. 
Enron was a ``black box'' company, where no one, not the analysts nor 
any of the institutional or individual investors was really sure how 
the company made money.
    There is no ``smoking gun'' with Enron. The financials looked 
great, so even now there is no single item that one can look at and 
say, ``that was the tip-off,'' or ``there is the sign that the company 
was going to implode.'' However, the more important issue is whether or 
not analysts have any incentive at all to do the analysis and to ask 
the tough questions. It strains credulity to say that, of the 17 
analysts who covered Enron, that none of them had any idea that Related 
Party Transactions could be used to massage earnings or to hide debt. 
Enron's business was complicated enough, its financials convoluted 
enough, its disclosures opaque enough, and its sales growth spectacular 
enough that there ought to have been some pointed questions from 
analysts so that they could provide knowledgeable guidance to their 
shareholding clients. Which thus begs the question, ``Why weren't 
there?''
    Goldman Sachs analysts David Maccarrone and David Fleischer issued 
a report on October 24, 2001, following Enron's conference call to 
address investor concerns. Some of the quotes in the report are as 
follow ``Lack of Disclosure and Transparency--A Longstanding Enron 
Hallmark.'' ``New disclosure about related party transactions and 
structured off-balance sheet transactions occurred some 18 months ago . 
. .'' ``However, an undercurrent of concern began and grew as questions 
remained unanswered . . .'' ``We do not believe that management has 
done anything wrong . . .'' Despite a lack of visibility into some 
pretty important risk factors at Enron, Goldman's analysts continued to 
keep Enron on its ``recommended list,'' Goldman's highest rating.
    At the same time, the Lehman Brothers analyst covering Enron put 
out his own version of the conference call. He called it ``an 
inadequate defense of the balance sheet,'' but then concluded ``despite 
the disappointing call we continue to think the stock should be bought 
aggressively at these levels''. Lehman Brothers also kept their highest 
rating on the stock.
    I do not believe that analysts should be taken to task for being 
wrong. In an environment where people are expected to take past and 
current trends and predict the future, getting things wrong would be an 
inevitable reality of the business. As Yogi Berra once noted, ``It's 
hard to make predictions, especially about the future.'' The issue here 
is that the analysts who covered Enron, despite the company's long 
standing policy of withholding key information, and despite knowledge 
of the fact that there was an unknown level of debt being hidden from 
them in off-balance sheet SPE's remained nearly uniformly positive on 
the company until it was clear the company would collapse.
    Both Lehman Brothers and Goldman Sachs have provided significant 
investment banking services to Enron. In the case of Goldman Sachs, the 
company provided financial services, sold or managed the sale of Enron 
commercial paper, and managed a public offering of its stock, all 
within the last three years. Lehman Brothers, for its part, also 
managed a public offering in Enron stock, plus a Lehman employee is an 
Enron director.
    These investment banking activities comprise a much larger 
component of Lehman Brothers and Goldman Sachs revenues and profits 
than do their retail brokering activities. Story after story in the 
media have shown that these analysts are having their compensation much 
more closely tied to the ability of their banks to provide these 
investment banking deals. Morgan Stanley analyst Mary Meeker, for 
example, had an ``outperform'' rating on all of the Internet stocks in 
December 2000, though they were down by an average of 83% from their 
highs of the year. The vast majority of these companies had received 
investment banking services from Morgan Stanley.
    JP Morgan's head of equity research, Peter Houghton, sent a memo to 
the bank's equity analysts in March of this year stating that the 
analysts were required to consult both the company concerned and 
Morgan's investment banker before publishing research that regarded one 
of Morgan's corporate clients.
    This environment ought to call into question the integrity of 
analyst research. The Enron collapse is neither the first nor the most 
expensive loss of shareholder capital that came while analysts 
maintained cheery ratings on a company. It's only by virtue of the fact 
that the loss on Enron shares has approached 100% for shareholders that 
made it the most noteworthy.
    Lucent's struggles, although less apocalyptic so far, reinforces my 
point about sell-side analysts' failings. In January 2000, Lucent 
Technologies had a market capitalization well in excess of $240 
billion. It was, by a significant margin, the most widely held stock in 
America. You only needed to understand one simple principle of 
financial analysis to see that trouble was coming for Lucent--namely, 
that growth in inventory and accounts receivable should be no faster 
than growth in sales. For four consecutive quarters in 1999, both 
receivables and inventories at Lucent were growing at double, triple, 
even four times sales. And yet, of the 38 analysts who covered Lucent 
in January 2000, 32 had ``buy'' or ``Strong buy'' ratings on the stock, 
6 had ``hold,'' and none had a ``sell'' rating. Many of these analysts 
are employed by investment banks that had generated significant 
revenues from Lucent's acquisition and debt placement activities. Not 
one pointed out that the company's receivables or inventories were 
skyrocketing. Lucent's weak balance sheet has nearly bankrupted the 
company. This year it has laid off more than 60,000 employees, and in 
the last 22 months more than $200 billion of market cap has been 
erased.
    Prior to January 2000, Lucent had never failed to meet Wall 
Street's estimates. It would seem that this fact, not the convolutions 
that Lucent needed to meet these estimates, was what was valued on Wall 
Street. Those convolutions have conspired to nearly destroy the keeper 
of Bell Laboratories, one of the treasures of American ingenuity.
    Enron collapsed because its management got caught up in playing 
Wall Street's estimates game, promising and delivering big revenue and 
profit growth, regardless of the debt and other balance sheet 
contortions it took to get there. Individual investors lost money, in 
part, because analysts had limited incentives to look at the company's 
financials with critical eyes. Management withheld key information from 
shareholders, and then, even after the troubles came to light last 
month, refused to answer questions about the nature of its deals with 
partnerships that were controlled by Enron executives. Looked at in 
this way, the pursuit of hypergrowth seems to have caused Enron 
executives to take undue risks with shareholder funds. Maintaining 
Enron's (and its managers') darling status in the investment world 
apparently caused these same men to take that short walk across the 
aisle from being aggressive with company assets to being downright 
deceptive by hiding information individual and institutional 
shareholders must have to make good investment decisions.
    Enron's management walked the fine line between keeping analysts 
happy and providing good information to their shareholders for years. 
Then Enron's management apparently made the conscious choice to place 
the appearance of high-profits, high-growth and low-risk--things held 
dear by Wall Street--over proper disclosure of risks and realities to 
their shareholders.
    At The Motley Fool, our advice to investors is and has always been 
to ignore the ``noise'' that comes from Wall Street, and to treat any 
specific recommendations for stock purchase with skepticism. Meaning 
that things such as one-year price targets, which are the language of 
sell-side analysts, ought to be of no interest to an individual 
investor. We teach investors to think like business owners, not renters 
or passive pushers of paper. It is our genuine hope that investors seek 
to buy companies that they truly understand and would be willing to own 
for a lifetime. If there is one lesson that individual investors must 
learn from Enron, that is: Buy What You Know. Enron's CEO Ken Lay has 
admitted that he himself did not fully understand the inner workings of 
Enron, and we can assume that he at least had all of the information. 
Even with full disclosure, Enron would have been a tough company for 
the majority of all investors to understand. The company was 
unapologetic in its refusal to provide information about its equity and 
debt structures for years before it actually blew up. My hope is that 
investors take the lesson offered by Enron and remain healthy skeptics 
in the future: when a company fails to treat shareholders as co-owners, 
one should assume that those components which are hidden from view do 
not contain good news.
Conclusion
    There is a simple calculus that investors use in valuing a company. 
A company is fairly valued by all of its future profits discounted for 
risk. Obviously, the greater the risk to profits, the higher the 
discount should be, and less valuable every expected dollar of future 
profits would be right now. Over the last 12 months 233 public 
companies have had to restate their earnings, and not surprisingly, 
none of these restatements have made the companies' operating results 
look better. Getting away with falsifying earnings over a long period 
of time is difficult. It is much easier to falsify levels of risk and 
this, in the end, is what Enron, and by extension, its auditors and the 
analysts have done, by commission or by omission.
    Individual investors have seen great strides in the level of 
protection afforded in the U.S. stock markets over the last decade. 
Information technology and the Internet went a long way toward making 
public documents, including SEC filings, available at an instant to the 
vast majority of shareholders. Regulatory improvements such as 
Regulation Fair Disclosure have gone even further to ensure that 
companies provide fair and equal access to information vital for people 
to make investing decisions. We hope to see that work continued and 
support all efforts to increase financial education in America.
    In a pari-mutuel environment such as a stock market, where every 
decision to buy, sell, or do nothing has a small effect on every other 
participant in the market, there is little chance that anyone will be 
able to provide absolute protection from bad information, whether 
intentionally or accidentally disseminated. However, the markets are 
built on trust, and there is a reason far beyond the power of American 
commerce that causes more than 48% of the world's equity capital to be 
represented here: investors the world wide know that their financial 
interests are better protected in the U.S.'s relatively transparent 
markets than in any other country on earth. It is in our best interest 
to ensure that we eradicate corruption and keep our markets strong.
    Thank you for your attention. I appreciate the opportunity to 
address the Committee, and I would be happy to answer any questions.
Submitted for further consideration: *
---------------------------------------------------------------------------
    * The information referred to was not available at the time this 
hearing went to press.
---------------------------------------------------------------------------
   10/24/2001 Goldman Sachs Research Report
   10/24/2001 Lehman Bros. Research Report
   3/21/2001 ``JP Morgan Reins in Analysts,'' The Times, 
        London.
   11/30/2001 ``Enron as Icarus,'' by William Mann.
   1/13/2000 ``Lessons From Lucent,'' by Matt Richey, Tom 
        Gardner and William Mann.
   Comments from Individual Investors in Enron, submitted by 
        members of The Motley Fool Community.

    Sen. Dorgan: Mr. Mann, thank you very much. And now we will 
hear from Mr. Silvers. Mr. Silvers is Associate General Counsel 
of the AFL-CIO. Mr. Silvers, welcome.

                STATEMENT OF DAMON A. SILVERS, 
               ASSOCIATE GENERAL COUNSEL, AFL-CIO

    Mr. Silvers. Thank you Chairman Dorgan, and thank you 
particularly for the opportunity to appear here today with 
Enron employee investors. It is truly an honor to share this 
podium with them. The labor movement today is trying to do 
everything we can possibly do to get the people who you saw 
this morning their money back. I'm afraid that is a long shot, 
frankly, but we are trying to do everything we can, and, also 
to prevent another Enron.
    We began this effort in early November when the AFL-CIO 
wrote to Enron's board and frankly begged them to act, to get 
responsible and respected people on the board and to make full 
disclosure before it was too late. The letters we sent are 
attached to our testimony, but tragically they were, frankly, 
ignored. Since then, worker benefit funds have sued Enron, its 
board and Arthur Andersen. Union members have sued the trustees 
of the 401(k) plan. The AFL-CIO has followed Professor Coffee's 
advice and asked the Securities and Exchange Commission to 
issue rules embodying the strong proposals that Arthur Levitt 
carried forward unsuccessfully last year and, in addition, to 
issue rules ensuring that corporate boards will be genuinely 
independent.
    Finally, the AFL-CIO, together with worker funds, is right 
now engaging in a dialog with Wall Street money managers about 
the effect of their conflicts of interest on worker funds and 
their losses in Enron. My written testimony contains a detailed 
review of the behavior of Enron's sell-side analysts over the 
last year, as well as a general discussion of the problems of 
the conflicts of interest that surrounds sell-side investment 
analysts. We've heard a bit about this from other witnesses. 
The conclusion of our review is quite simple. No sell-side 
analysts whose firm was underwriting, advising or lending to 
Enron or Dynegy ever recommended that its clients sell their 
Enron stock, not even on the day Enron filed for Chapter 11.
    Analysts without those conflicts, and in particular 
independent investment news letters, were bearish on Enron 
starting last spring. Some people, it seems, don't like to put 
money in black boxes. In our opinion, conflicted analysts 
irrational exuberance over Enron was a substantial contributor 
to this catastrophe, but really not the only one or the root of 
the problem.
    The root of the problem lies here. At various times in the 
last several years Enron's executives faced a fateful choice. 
They could have done what the law required and reported 
disappointing results on various transactions and lines of 
business. This would have been to do what many executives do 
every day, and frankly suffer some pain for doing. Instead, 
Enron's executives chose a different path, the path of using 
complex subsidiary structures to hide liabilities and 
exaggerate revenues, and apparently, to also funnel company 
assets to themselves.
    This choice to hide bad news is at the heart of what went 
wrong with Enron. From the moment that choice was made, the 
people who you heard from today, who were not in on those 
decision, began paying more for Enron securities than they 
should have. Credit rating agencies and energy market 
participants began to participate in deals whose risk they were 
being misled as to the full nature of that risk.
    Of course, many of the very insiders involved in designing 
and approving this financial trickery were getting multi-
million dollar management fees from those same partnerships. 
And, at the same time as the Chairman has reminded us today, 
Enron executives were selling close to a billion dollars in 
their own holdings in Enron common stock at the inflated prices 
that appear to have been maintained by their false financial 
reporting. If our capital markets were functioning properly, 
the fact that some Enron executives wanted to hide the true 
state of Enron's finances from the financial markets should not 
have automatically resulted in a massive, persistent inflation 
of the companies stock price and credit rating, and the 
subsequent complete collapse of the firm when the truth became 
know.
    If the system were working, an audit committee of the board 
of directors, an outside independent audit firm, vigilant Wall 
Street analysts, and institutional money managers all would 
have stood between the desire of Enron managers to artificially 
maintain a high stock price, and the victims--the individual 
investors, the pension funds, and Enron employees--that ended 
up paying that high price--that they were frankly suckered into 
paying. But, as we have learned, the audit committee directors 
were not really independent, and they appear to have let the 
managers do whatever they wanted with the firm's books. You've 
heard from the outside directors today--the outside auditors 
today. In some ways I think they speak for themselves, but I 
will point out that the obviously signed off on an audit with 
inadequate or inaccurate information as its basis, and allowed 
liabilities to be wrongfully excluded from Enron's books.
    Today's testimony from Andersen raises some very clear 
questions, and obvious questions. And they are: what did they 
do for the $27 million that first they said was internal audit 
and then they said wasn't internal audit? What was it? Second, 
why did they not tear apart these transactions when they were 
brought transactions that were with insiders and that involved 
these complex structures that it seemed that no one understood? 
Finally, as I note, the buy-side analysts for their part appear 
to have forgotten that the word sell is part of the English 
language, and we've heard a lot about that from the prior 
witness.
    And finally, oddly enough, the money manager alliance 
capital that bought the most Enron stock over the last 6 
months--like Lehman Brothers--shares a director with Enron. As 
a result of these sorts of pervasive conflicts of interests our 
capital markets, I think this hearing and the hearing in the 
House last week have shown, are very treacherous places for the 
unwary consumer. Enron is only the most recent and most 
dramatic example of this unfortunate fact.
    This is, in part, why the labor movement strongly believes 
that America's working families retirement security should rest 
on three legs: on Social Security, a defined benefit pension 
plan, and personal savings. Only one of these legs should be 
directly at risk in the markets. I think you frankly heard 
testimony on that proposition, far more eloquently than 
anything I could say, earlier this morning from people who only 
had two legs.
    Some companies might have been able to withstand--I'm 
sorry--Enron's executives appear to have intentionally misled 
investors. But, they were only able to do so because the entire 
system of private sector investor protections failed. Now the 
question is how will the public sector respond? The government 
owes the investing public, and particularly Enron employees and 
retirees, answers and justice. In particular, the government 
owes Enron employees and retirees answers that can only be 
obtained by using the full investigative powers of the Federal 
Government.
    For starters, this Subcommittee and the Congress as a 
whole, might want to get these questions answered: Who were all 
of the investors in Enron's limited partnerships and SPEs? Why 
was it that Enron executives felt confident that they could 
hide material financial data from the public over a period of 
years free from regulatory scrutiny? What role did Enron 
directors play in the creation of the partnerships and SPEs and 
the decisions not to disclose critical information about their 
purposes, ownership, management and finances?
    What role, and I mean this in detail because obviously 
there was a cursory exchange about this this morning, what role 
did Arthur Andersen play in the entire life of the SPEs and 
partnerships? Who were those SPEs and partnerships own audit 
firms, if they had them? Was Andersen aware of them when they 
were first set up? These questions deserve, I think, full 
exploration.
    What were the full terms of the arrangements between Enron, 
Dynegy, JPMorgan Chase, Citigroup and Lehman Brothers? What 
were the incentives and conflicts that were pushing those 
analyst recommendations that waxed so positive in November as 
these people's money was disappearing? Why did Enron go ahead 
with changing its 401(k) advisor, apparently on October 17th, 
when Enron itself was controlling the release of the critical 
information here that opened the gates--the loss of $1.2 
billion in equity on October 17th. October 17th is not a 
coincidental date. It is a critical date. Actually, the 16th 
was the release of that information, the 17th was the release 
of the SEC investigation.
    And finally, and perhaps most sort of mysteriously, why did 
Jeffrey Skilling resign? Understanding the answers to these 
questions, frankly, is not enough though. Congress and the 
regulators must act, act to protect the investing public and 
act to protect 401(k) participants from these kinds of 
conflicts of interest. The AFL-CIO is ready to work with this 
Committee to both find out what happened at Enron and see that 
it does not happen again. Thank you.
    [The prepared statement of Mr. Silvers follows:]

  Prepared Statement of Damon A. Silvers, Associate General Counsel, 
                                AFL-CIO

    Good morning, Mr. Chairman, my name is Damon Silvers, and I am an 
Associate General Counsel of the American Federation of Labor and 
Congress of Industrial Organizations. The AFL-CIO believes today's 
hearing on Enron Corporation and the marketing of its stock is a vital 
contribution to the efforts to both bring to light the causes of 
Enron's collapse and protect the public and our economy against future 
events of this kind.
    Directly and indirectly, America's working families are the 
ultimate customers in our securities markets. Defined benefit pension 
funds that provide benefits to the AFL-CIO's 13 million members have 
approximately $5 trillion in assets. These plans include thousands of 
pension plans sponsored by AFL-CIO member unions, public employee 
pension plans, and single employer pension plans subject to collective 
bargaining. Since the passage of ERISA in the 1970's, these funds have 
increasingly invested in equities. 401(k) and other defined 
contribution plans, employee stock ownership plans, and union members' 
personal savings account for further extensive investments in equity 
markets by America's union members.
    Enron's collapse devastated some workers' retirement security. You 
have heard from some of those workers today and their words speak for 
themselves. But the collapse of Enron also took money out of the 
retirement savings of practically every worker in America fortunate 
enough to have retirement savings.
    Most pension funds and institutional investors held some Enron 
stock. Many of the most popular mutual funds held Enron stock. If any 
person in this room has an S&P 500 index fund in your 401(k) or your 
mutual fund portfolio, you lost money in Enron--probably about half a 
percent of your total assets in that fund. And this is if you invested 
in index funds--in a strategy that is designed to cheaply mitigate the 
risks of investing in any single company.
    This was by and large money that was going to fund pension benefits 
for working families--for the public employees we are counting on to 
protect us during this period of national crisis, for the iron workers 
who are as we speak clearing the rubble at Ground Zero, for the 
firefighters who today, as on September 11, stand ready to give their 
lives to save ours. Because of the way that our retirement system has 
become increasingly interwoven with the capital markets, practically 
every American fortunate enough to be able to save for retirement in 
any form was hurt by the collapse of Enron.
    Indexed investing is very attractive to both institutions and 
individual investors. Indexed investing essentially means you buy the 
whole market, and do not make judgments about whether any given stock 
is underpriced at any given moment. Indexed investing entails very low 
fees and guarantees substantial diversification. But it does assume 
that the market prices for securities are roughly reflective of the 
real values of those securities in light of the information known at 
any given time. The indexed investor is very vulnerable to fraud 
perpetrated on the markets, because the indexed investor is essentially 
a price taker. Because of the popularity of indexed investing among 
institutional investors, when a company artificially inflates its stock 
price by withholding information from the markets or putting out false 
information, the victims are not only the unsophisticated individual 
investors, but some of the largest and most sophisticated funds in the 
country, investing on behalf of hundreds of thousands of individual 
investors.
    Some have suggested that it is too early to know whether anyone is 
to blame for the collapse of Enron. While no one has as of today been 
literally indicted, the AFL-CIO believes that a number of responsible 
parties have emerged. These parties include the senior management of 
Enron, the board of directors, Arthur Andersen, the outside auditor, 
the sell-side analyst community, and perhaps some money managers. These 
people and organizations made up the web of parties with obligations to 
Enron, its investors, and the public at large. These are the people and 
institutions that failed to ensure that Enron's assets were used to 
benefit the company and that the investing public had the information 
necessary to make fully informed decisions about whether to invest in 
Enron and if so at what price.
    The Subcommittee has asked me to focus today on how consumers 
purchasing Enron's securities were misled. The AFL-CIO has done 
considerable analysis of the behavior of Enron's officers and 
directors. I have attached to this testimony letters we and the 
Amalgamated Bank, a large manager of worker pension funds, sent to 
Enron's board in early November laying out the details of some of the 
transactions that led to Enron's collapse and explaining the 
undisclosed conflicts of interest that in our view crippled Enron's 
board.
    The AFL-CIO also has been a longtime supporter of efforts 
undertaken by Arthur Levitt when he was chairman of the Securities and 
Exchange Commission to rein in conflicts of interest affecting auditor 
independence. Pension funds affiliated with the building trades unions 
have for several years submitted shareholder proposals seeking to 
ensure companies they invest in hire truly independent auditors. Last 
week we submitted a rulemaking petition to Harvey Pitt, Arthur Levitt's 
successor at the SEC, asking him to act to end the types of conflicts 
of interest that appear to have compromised Arthur Andersen's ability 
to carry out its duties as Enron's public auditor. That petition is 
also attached.
    But in the remainder of this testimony I intend to focus on the 
analysts' role in the collapse of Enron. Let me begin by summarizing 
briefly what sell-side analysts do. Sell-side analysts work for full-
service investment houses. By full-service I mean that these firms 
underwrite securities, they make markets in securities, they give 
investment banking advice to companies, they manage money on behalf of 
clients, and often they trade on their own accounts in the securities 
markets. Since the rise of integrated mega-financial service firms 
after the repeal of Glass-Steagall, these firms also make bank loans to 
companies.
    One of the services these full-service firms provide to their 
clients who trade securities through their brokers is access to 
research reports written by their research analysts. These analysts are 
called ``sell-side analysts'' because their firms do a substantial 
business selling securities to their clients, and fundamentally the 
research is paid for by the brokerage fees generated by the firm's 
sales and trading activity. The research itself is not sold. This 
business model means that sell-side analysts are eager to share their 
work with investors generally, through their reports, and through 
appearances on television, radio and the Internet. As a result, sell-
side analysts shape investor opinions out of proportion to their 
numbers.
    Sell-side analysis is widely available to market participants, both 
directly through the brokerage houses and through services like First 
Call and Investext. While firms try and keep the most up to date 
reports available only to clients, relatively recent sell-side analyst 
reports are widely available at a relatively reasonable price.
    Few union members or other individual investors are in a position 
to master the raw data that informs the financial markets, and even 
fewer have routine access to insiders in the companies they invest in. 
Most union members, and the trustees of their pension funds, for that 
matter, rely on a variety of professionals for their information about 
the equity markets. Sell-side analyst reports are likely to be the most 
detailed, critically analytical information the typical small investor 
has to consult in making investment decisions. For that reason, 
America's working families have an enormous stake in the honesty of the 
investment information they receive from the analyst community.
    Analysts are investment advisors subject to the Investment Advisors 
Act of 1940. Under the Act, analysts have a fiduciary duty to their 
clients. They are not mere marketers, serving the needs of their firms' 
underwriting business. They owe a duty of loyalty and of care to the 
investors they advise.
    Unfortunately, in recent years the structure of the securities 
industry has shifted in ways that appear to have compromised sell-side 
analysts. There is substantial statistical evidence that analysts' 
decisions whether or not to recommend that investors buy a stock are 
influenced by whether their firm is an underwriter for the issuer. That 
is the conclusion of a 1999 study by Roni Michaely of Cornell 
University as well as a 1997 study by Hsiou-wei Lin of National Taiwan 
University and Maureen McNichols of Stanford Business School.\1\ CFO 
Magazine reported last year that analysts who work for full-service 
investment banks have 6% higher earnings forecasts and close to 25% 
more buy recommendations than analysts at firms without such ties.\2\ 
---------------------------------------------------------------------------
    \1\ Conflict of Interest and Creditability of Underwriter Analyst 
Recommendations. Michaely, Roni and K Wolmak Review of Financial 
Studies 1999 vol 12 no 4 653-686; Underwriting Relationships and 
Analyst Earning Forecasts and Investment Recommendations. Lin, Hsiou-
Wei and McNichols, Maureen. Journal of Accounting and Economics vol 25 
(1) pp 101-127 1997.
    \2\ What Chinese Wall?, Barr Stephen, CFO, March 1, 2000.
---------------------------------------------------------------------------
    In some ways what we find more persuasive than the statistics are 
the comments of analysts in the financial press. In the last few 
months, analysts have been quoted by name saying such things as ``a 
hold doesn't mean it's ok to hold the stock'' and ``the day you put a 
sell on a stock is the day you become a pariah.'' \3\
---------------------------------------------------------------------------
    \3\ Wall Street's Secret Code Spoils Investors' Aim, Noelle Knox 
USA Today, December 21, 2000; CFO, ibid.
---------------------------------------------------------------------------
    It should not be surprising that this is true given that issuers 
pick underwriting firms based on their ability to bring effective 
positive analyst coverage to their businesses. This is the conclusion 
of a soon to be published paper on why firms switch analysts by Laurie 
Krigman of the University of Arizona, Wayne Shaw of Southern Methodist 
University and Kent Womack of the Tuck School Business at Dartmouth 
College.\4\
---------------------------------------------------------------------------
    \4\ Why do Firms Switch Underwriters? Wayne H. Shaw, Kent Womack, 
Forthcoming, Journal of Financial Economics.
---------------------------------------------------------------------------
    In addition, the data cited by CFO Magazine suggests several quite 
disturbing things. First is that it is not just existing relationships 
that are affecting analyst recommendations, but also the prospect of 
future business. The result is a systematic positive bias affecting 
recommendations across the board. Second, the response from the 
securities industry that analyst involvement in underwriting helps 
ensure that the firms only do quality deals at the right price is 
simply inadequate to explain the distortion in the data affecting all 
recommendations.
    But these conflicts are exacerbated by the ways in which analysts 
are used and compensated. It has become a common practice for analysts 
to accompany teams from the corporate finance department on 
underwriting road shows, and most importantly, analyst compensation has 
become tied at many firms to analysts' effectiveness at drawing 
underwriting business.
    In addition, the consolidation of the financial services industry, 
and in particular the repeal of Glass-Steagall, has created a wide 
array of further potential conflicts. Issuers are in a position to 
withhold business from the firms of critical analysts across a wide 
array of markets, including commercial loans and commercial banking 
services, pension fund and treasury money management, and insurance 
contracts. This leverage is particularly powerful when the issuer is 
itself a financial services company. For example, CFO Magazine reported 
last year that the troubled financial services giant First Union cut 
off all bond trading business with Bear Stearns in response to negative 
comments by their analyst, and Bear Stearns ordered the analyst to be 
more positive.
    At the same time, issuer executive compensation has been linked to 
issuer stock price, often in ways that give incentives to executives to 
manipulate short term movements in stock prices. The result is that 
issuer executives have tremendous personal incentives to use the 
resources of their companies to pressure analysts into issuing 
conflicted reports.
    The rise in the importance of proprietary trading at major firms 
also creates further possible conflicts of interest for analysts. A 
version of this problem has always existed when firms' trading 
operations and market making operations lead to a buildup of inventory 
in particular issuers' securities. However, the addition of firms 
investing significant capital in proprietary trading creates a risk of 
senior executives aware of the positions taken in proprietary trading 
encouraging research departments to prop up demand for certain 
securities.
    Finally, among the most lucrative business areas for full-service 
firms is providing investment banking advice to companies going through 
large mergers and acquisitions. Such deals are typically dependent on 
shareholder approval or effectively dependent on the price of the 
stocks of the companies involved remaining within a certain range. 
These circumstances can give a full-service firm that is advising a 
participant in a deal a substantial interest in trying to encourage 
investors to behave in ways that support the transaction closing.
    There has been some good news though in the effort to protect 
analyst independence. Much of the literature in the 1990's on 
securities analysts' behavior noted the ability of issuers to reward 
and punish analysts by providing and withholding information. This 
power meant that analysts who were doing their best to be loyal to 
their customers could not provide customers with the timely information 
that is the minimum requirement of the job without tilting their 
recommendations so as to ensure they weren't on the losing end of the 
business of selective disclosure.
    Earlier this year the SEC promulgated Regulation FD barring 
selective disclosure. In doing so the Commission recognized selective 
disclosure not only harmed those not privy to the selective disclosure, 
it gave issuers power that resulted in warping the behavior of those 
who were the recipients of the selectively disclosed information. The 
adoption of Regulation FD marked an important step toward restoring 
analysts' independence. However, Harvey Pitt has at various times 
suggested he is not an enthusiastic supporter of this rule. Regulation 
FD is an important step toward restoring analyst independence and 
deserves Congress' continuing support.
    The story of the collapse of Enron illustrates the consequences of 
these conflicts of interest on the larger market environment. Enron was 
throughout the late '90's a high-flying stock, trading at up to 70 
times earnings. Even though its earnings growth as shown in pre-
restatement numbers was around 5% per year from 1998 to 2000, Enron's 
stock price quadrupled over the same period.
    During the spring and summer of 2001, Enron's stock price was 
falling, apparently due to the normal reasons stock prices fall--
deteriorating conditions in certain of Enron's markets, and trouble 
with certain large projects. However, in addition, some journalists 
were raising concerns that Enron was both opaque and overvalued.\5\
---------------------------------------------------------------------------
    \5\ ``Is Enron Overpriced?,'' by Bethany McLean. Fortune, March 5, 
2001, Pg. 122
---------------------------------------------------------------------------
    What is noteworthy about this is that during this period Enron 
executives were engaged in extensive selling of Enron shares. At the 
same time Enron's CFO was telling the press ``We don't want anyone to 
know what's on those books. We don't want to tell anyone where we're 
making money.'' During this period, according to First Call, which 
surveys sell-side analyst reports, there was clearly insufficient 
transparency to Enron's financial disclosures to allow an analyst to be 
able to give an opinion as to whether the company's stock was a good 
investment.\6\ Nonetheless, as one might expect from the general data 
we have surveyed, out of 11 sell-side firms tracked by Briefing.Com 
there were no downgrades of Enron from May 11, 1999 until August 15, 
2001.\7\
---------------------------------------------------------------------------
    \6\Testimony of First Call CEO before Joint Hearing of House 
Subcommittees on Capital Markets and Investigations, December 12, 2001.
    \7\ The data that follows regarding shifts in ratings by sell-side 
firms comes from Briefing.com, ``Analyst History for Enron Corp.,'' 
http://biz.yahoo.com/c/e/ene.html.
---------------------------------------------------------------------------
    Compare this record to the independent investment newsletters 
surveyed by Forbes Magazine.\8\ Of the eight Forbes looked at, six were 
advising their subscribers to sell Enron, four before May 1st, and two 
in October. One of the eight advised subscribers to sell until the 
price hit $9, then went to a buy, and only one of the eight maintained 
a consistent buy during the period of Enron's collapse.
---------------------------------------------------------------------------
    \8\ ``Enron: An Unreported Triumph For Investment Letters.'' 
Forbes.com, December 7, 2001.
---------------------------------------------------------------------------
    On August 15, following the sudden resignation of Enron's CEO 
Jeffrey Skilling, Merrill Lynch's analyst, downgraded Enron from Near 
Term Buy/Long Term Buy to NT Neutral/Long Term Accumulate. This may 
sound like a modest downgrade. But compare it to the firms that were 
underwriters for Enron. The earliest downgrade among this group appears 
to be JPMorgan Chase, which went from Buy to Long-Term Buy on October 
24, 2001. Strangely enough though, JPMorgan Chase appears never to have 
downgraded Enron below a Long-Term Buy in the weeks that followed. In 
fact of the twenty seven firms we could find that covered Enron, the 
only sell-side firm that actually downgraded Enron to a Sell was 
Prudential, which downgraded Enron twice in the week that followed the 
announcement of the $1.2 billion charge to earnings on October. These 
results of our research parallels a Forbes Magazine study that looked 
at 13 sell-side firms and found as of the end of October, two weeks 
after the initial announcements of the charge to equity and the SEC 
investigation, only one firm recommended Sell, one firm recommended 
Hold, and the remaining eleven still had various forms of buy 
recommendations.
    In late October and November, as Enron attempted to sell itself to 
Dynegy, key firms with an interest in the transaction maintained what 
appeared to be positive ratings. JPMorgan Chase and Citigroup were 
Enron's advisors and stood to earn large fees. These fee arrangements 
have not been disclosed but are likely to have been in excess of $50 
million per firm. Citigroup lent Enron more than $500 million, monies 
in part that came from federally insured commercial bank deposits. 
Citigroup's analyst at Salomon-Smith Barney maintained a Neutral-
Speculative rating. JPMorgan Chase lent Enron $400 million, while its 
analyst rated the stock a Long-Term Buy all the way through November. 
Lehman Brothers, the advisor to Dynegy on the Enron purchase, also 
stood to earn a similarly large fee if the deal closed. Lehman kept a 
Strong Buy rating on Enron throughout the fall.\9\
---------------------------------------------------------------------------
    \9\ ``Assessing the Role of the Financiers,'' by Patrick McGeehan, 
New York Times, December 2, 2001, Section 3, page 11.
---------------------------------------------------------------------------
    What can be concluded from this record. First, though Enron's 
financials included somewhat cryptic references to the partnership 
structures Enron's management used to hide liabilities and pass 
interests in company assets to executives, no analyst appears to have 
paid any attention to these items until they became widely known in 
October. Second, with one notable exception in Merrill Lynch, no 
analyst took action based on Skilling's resignation. Finally, with the 
exception of Prudential, no analyst thought it worthwhile to actually 
recommend their clients sell the stock. Interestingly, neither 
Prudential nor Merrill Lynch were underwriters for Enron or had any 
part in advising or lending money to either Enron or Dynegy.
    One can observe in the analysts' treatment of Enron many of the 
problems critics of analyst conflicts pointed to before the Enron 
debacle. These include the linkage between analyst behavior and the 
investment banking, and now commercial banking, interests of their 
firms; the use of codes by analysts, where Long-Term Buy may mean Sell, 
and Hold certainly means Sell; the reliance on company projections and 
the failure to either look deeply into company financials or to consult 
outside sources. Taken together, these conflicts seem to have converted 
the analysts from providers of analysis with a fiduciary duty to their 
investor clients to simple salesmen for their firms' investment banking 
clients. And when the investment banking client is defrauding the 
investor client, too often the analyst, like the auditor, becomes a 
part of the fraud.
    The AFL-CIO believes strongly that Congress, the regulatory 
agencies, and the self-regulatory agencies need to act in a coordinated 
fashion to protect the independence of analysts. In particular, we 
believe that what used to be called the Chinese Wall between research 
and investment banking in full service houses needs to be rebuilt. The 
AFL-CIO has submitted shareholder proposals to several full-service 
financial services companies seeking to have those firms make such 
changes on their own. However, we believe that short-term competitive 
pressures are likely to lead to the continued violation of analysts' 
fiduciary duties unless regulatory action is taken.
    Currently, as a result of pervasive conflicts of interest, our 
capital markets are treacherous places for the unwary. Enron is only 
the most recent and most dramatic example of this unfortunate fact. 
This is in part why the labor movement strongly believes that America's 
working families need retirement security that rests on three legs--
Social Security, a defined benefit pension plan and personal savings, 
only one of which should be directly at risk in the capital markets.
    In conclusion, the AFL-CIO believes that systematic problems with 
the ways in which information flows to and in the capital markets 
contributed to both Enron's collapse and the severity of the impact of 
its collapse. While analyst conflicts were not the cause of the 
collapse of Enron, they contributed to a climate in which Enron's 
shares were artificially inflated and in which the conduct of 
management at Enron remained hidden long after it could have been 
brought to light. Finally, it appears that these conflicts contributed 
to a false optimism about the success of the Dynegy deal, an optimism 
that allowed Enron executives to continue to withhold vital information 
from the markets about Enron's liabilities and demands on its cash 
until the final collapse of the Dynegy deal.
    We commend this Subcommittee for opening the Senate's formal 
inquiry into these matters. We urge both this Subcommittee and all 
involved: in Congress, the SEC, the Department of Labor, and the 
Justice Department to continue to investigate both the actions of 
particular individuals and firms and the larger structural arrangements 
that led to the collapse of Enron and the loss of so many peoples' 
savings. On behalf of the AFL-CIO, we look forward to continuing to 
work with the Subcommittee on this vital matter. Thank you.

    Senator Dorgan. Mr. Silvers, thank you very much. There is 
a vote occurring in the Senate. I believe there's 5 minutes 
remaining, so I regret that we're going to have to cut this 
short. I would like to submit questions on behalf of the 
Committee to the witnesses. Let me make just a couple of 
comments.
    First of all, the testimony you have presented is really 
excellent. As I indicated to you earlier, we are going to hold 
other hearings and I think your testimony sets the stage for 
the important questions. The first panel today described the 
heartbreak of losses that people have experienced. I recall the 
word loyalty described by one of the witnesses. People who were 
loyal to their company, who did the right thing, worked hard 
all their lives, saved, were thrifty, only to lose their life 
savings.
    That's part of what motivates us to get to the bottom of 
this, who profited and who lost? And, what are the lessons to 
be learned from this? At the next hearing, Mr. Lay will be with 
us. We will ask Mr. Skilling, Mr. Fastow, and others to appear 
as well. But I think in the end, if this is viewed somehow by 
people as just another failure or just another scandal, then we 
will have missed the point.
    It seems to me there are numerous conflicts with respect to 
company executives, boards of directors, auditors, and stock 
analysts. Some in Congress spent a lot of time trying to derail 
the legislation that would have plugged some of these holes. 
There just is so much that is in conflict. Yet, if one studies 
all those conflicts, how can the problems not be apparent to 
everyone? We have allowed a big auditing firm to get millions 
and millions of dollars from a company they are auditing and 
then contract with them to perform other services. It's alright 
for an investment bank to be giving their analysts the rein to 
tell the American public about a stock in which they have a 
significant financial interest and which they would never 
willingly, I assume, report bad news.
    So, there is so much here that we need to consider and 
investigate, and we will do that. This Committee is going to 
request substantial information. We will request information 
about who the investors are in the partnerships that have been 
off the books and who profited from them. I have been in touch 
with the company's attorneys and they indicate that they want 
to provide that information. They're the ones who indicated 
they will ask Mr. Lay to testify and he has agreed to do that.
    So, I think the logical point from this hearing is as we 
move forward we want to get information. But in the end, we 
also want to understand what do we do with respect to changes 
in regulation and changes in law that will prevent this from 
happening again. Those are the important considerations for us 
and the testimony of the three of you will be very helpful to 
this Committee.
    I thank you very much for testifying. This Committee is 
adjourned.
    [Whereupon, the Committee was adjourned at 12:30 p.m.]

                            A P P E N D I X

        Prepared Statement of Steve W. Berman, Hagens Berman LLP
Mr. Chairman,

    I am a partner of the law firm of Hagens Berman, and my office is 
in Seattle, Washington. We represent hundreds of Enron employees.
    Two of my clients, Janice Farmer and Charles Prestwood, have agreed 
to appear before the Senate Commerce Committee in connection with its 
investigation of the plight of Enron employees in the aftermath of 
Enron's decline and eventual bankruptcy.
    I am not submitting this testimony to argue the facts or law, but 
simply to alert this Committee to the fact that my two clients are just 
the tip of the iceberg. Since we began representing Enron employees, we 
have fielded over 3,000 inquiries. I have three lawyers and two 
investigators working nearly full time to handle inquiries. I have been 
representing victims of financial fraud for twenty years. I cannot 
recall circumstances that have resulted in such financial devastation.
    My primary purpose is to provide just a few examples of the impact 
of this crisis on the lives and futures of Enron employees in 
submitting this testimony:

   A Wisconsin woman with Stage IV breast cancer, unable to 
        work, acquired her Enron ESOP stock as a divorce settlement 
        after a 10 year battle with her former husband describes 
        watching in horror as her account dropped from $ 250,000 to 
        virtually nothing during the company's lockdown of employee 
        investment accounts. The stock was her most valuable asset and 
        her hope for future cancer treatments, income, and her 
        children's college educations.

   A 54-year-old lineman with Portland General Electric, a 
        subsidiary of Enron, suffers from significant health problems 
        (arthritis and sarcoidosis, a lung ailment) and was looking 
        forward to retirement in 4 or 5 years. He maximized his 401(k) 
        contribution year after year. The bulk of his investment was in 
        Enron stock, both because it was swapped into his account from 
        the PGE stock he had owned for most of his career and because 
        the Company continually promoted Enron stock as safe and 
        secure. He watched helplessly as the Enron stock - and his 
        retirement plan - were wiped out during the Company's lockdown 
        of the retirement plan. His plans to retire by age 59 are 
        shattered as he begins to rebuild the assets he lost.

   An Oregon couple in their late 50's who both had retirement 
        accounts with Enron stood by helplessly during the company's 
        lockdown of their accounts as their financial stability and 
        dreams for retirement were destroyed by the drop in Enron 
        stock. The couple now faces selling property which has been in 
        the husband's family for more than a century to support 
        themselves.

   A retired oil and gas worker in California watched his 
        financial future crumble as his $ 1 million savings plan with 
        Enron disintegrated into nothing. Unable to return to work in 
        the oil and gas industry, the financial consequences have 
        forced him to take work making garbage bags twelve hours a day 
        to support himself.

    We appreciate you and the other Committee members taking the time 
to hear Ms. Farmer's and Mr. Prestwood's stories and to investigate the 
drastic impact of Enron Corporation's acts on the lives and financial 
futures of its employees. Please let us know if we can provide 
additional information.
                                 ______
                                 
                    Enron: Let Us Count The Culprits
                    Business Week, December 17, 2001
           (Copyright 2001, The McGraw-Hill Companies, Inc.)

    Enron Corp.'s bankruptcy is a disaster of epic proportions by any 
measure--the height from which it fell, the speed with which it has 
unraveled, and the pain it has inflicted on investors, employees, and 
creditors. Virtually all the checks and balances designed to prevent 
this kind of financial meltdown failed. Unless remedied, this could 
undermine public trust, the capital markets, and the nation's entire 
equity culture. Even now, no one really knows what liabilities are 
buried inside dozens of partnerships or the role ex-CEO Jeffrey 
Skilling played in creating a byzantine system of off-balance-sheet 
operations. A culture of secrecy and a remarkable lack of transparency 
prevented any realistic assessment of the company's financial risk. 
Nothing less than an overhaul of the auditing profession is now 
required to police accounting standards. Wall Street, mutual funds, and 
the business press would also do well to rethink why each, in its own 
way, celebrated what is now revealed to be an arrogant, duplicitous 
company managed in a dangerous manner (page 30).
    What is increasingly clear is that Skilling, a former McKinsey & 
Co. consultant and Harvard Business School grad, tried to craft Enron 
as a new kind of virtual trading giant, operating outside the scrutiny 
of investors and regulators. Enron's numerous partnerships were 
shrouded in secrecy, tucked away off the balance sheet. They were used 
to shift debt and assets off the books while inflating earnings. The 
chief financial officer ran and partly owned two partnerships, a clear 
conflict of interest. Enron leveraged itself without a reality check by 
any outsider. ASLEEP. Hardly anyone inside the company was urging 
caution, certainly not chairman Ken Lay. The independent auditing 
committee on the board of directors was clearly asleep. Given Enron's 
arcane financial engineering, the committee probably relied on Arthur 
Andersen, the auditor, for information. But Andersen didn't blow any 
whistles. No surprise there. It made more money selling consulting 
services to Enron last year than it did auditing the company. 
Criticizing Enron's books might have jeopardized consulting work. 
Similar conflicts of interest stopped Wall Street analysts from pulling 
the plug on Enron. Even as Enron slid toward bankruptcy, ``buy'' 
recommendations were being issued by analysts whose firms were doing 
investment-banking business with the company, or were hoping to.
    Did anyone really know what was going on inside Enron? The rating 
agencies, Moody's Investor Service and Standard & Poor's, presumably 
had better access than average investors, but neither downgraded 
Enron's credit rating to below investment grade until the bitter end. 
The rating agencies argue that had they downgraded Enron sooner, they 
would have simply pushed the company into bankruptcy earlier. Here's a 
flash: So what? Moody's and S&P have one basic job--assessing risk for 
investors. If they couldn't penetrate Enron's complex financial 
engineering, the rating agencies should have said so.
    The business press, including BusinessWeek, did no better. It 
celebrated Skilling's vision of Enron as a virtual company that could 
securitize anything and trade it anywhere. The press blithely accepted 
Enron as the epitome of a new, post-deregulation corporate model when 
it should have been much more aggressive in probing the company's 
opaque partnerships, off balance sheet maneuvers, and soaring leverage. 
TRAGIC. Enron's fall is made all the more tragic because of the pain 
inflicted on its thousands of employees. Not only are many losing their 
jobs, but some 12,000 are also losing most of their retirement savings. 
In perhaps its most egregious risk-management error, employees mostly 
held Enron stock in their 401(k)s, yet the company prevented them from 
selling until they reached the age of 54. People could only watch as 
the stock plummeted from $89 to a dollar. Diversification, particularly 
in retirement accounts, is the cardinal rule in managing risk. Enron 
broke that rule, as have other companies.
    Enron's tale is a clarifying event. It reveals key weaknesses in 
the financial system that must be corrected as the U.S. moves forward 
in the 21st century. If America is to have an equity culture in which 
individuals invest in stocks and provide the capital for fast economic 
growth, the market must be able to correctly value companies. This 
requires making financial data readily available and easily 
comprehensible.
    To restore public confidence, several steps should be taken. After 
accounting disasters at MicroStrategy, Cendant, Lucent, Cisco, and 
Waste Management, it is clear that self-regulation is not working. 
Conflicts of interest within auditing firms remain widespread. 
Investors can ignore analysts on TV who work for investment firms. But 
someone has to play the role of the honest watchdog. Unless the Big 
Five auditing firms clean up their act, they will wind up with a 
federally chartered oversight body. It is equally clear that current 
standard accounting rules aren't sufficient. Loopholes allowed Enron to 
fool everyone, making a mockery of public disclosure.
    Regulators should also insist that corporations give their 
employees choice in their 401(k)s. Some 30% of assets held in 1.5 
million 401(k) plans are in the stock of the company sponsoring the 
plan. This lack of diversification puts too many people at risk.
    In the end, the Enron story is about a secretive corporate culture 
that failed in its primary business mission: to manage risk. Had the 
Federal Reserve and other central banks not flooded the global economy 
with liquidity in recent months, Enron's collapse could have posed a 
deep threat to the financial markets. It's past time to fix the system.
                                 ______
                                 
                   Enron: The Lessons For Investors;
 Hindsight, shmindsight. There's much to learn when a stock loses $67 
                           billion in value.
            Byline: Lisa Gibbs, Jeff Nash and Nick Pachetti
                          Money, January, 2002
                      (Copyright 2002, Time Inc.)

    It seems hard to believe now, but Enron (ENE) used to be the envy 
of corporate America. In less than a decade, the Houston company 
transformed itself from stodgy gas-pipeline operation to natural gas 
and electricity trading powerhouse. Dazzled by sizzling earnings 
growth, giddy investors bid up Enron's shares 312% in two years to a 
high of $90.75 in 2000. Then someone turned out the lights. Beset by 
marketplace woes and management mishaps, the stock already had tumbled 
53% when chief executive Jeffrey Skilling stunned investors by 
resigning last August. After that, the bad news came at hyperspeed: 
$1.2 billion in shareholder equity zapped by risky hedging deals, a 
Securities and Exchange Commission probe, a last-chance merger with 
rival Dynegy called off and, finally, a bankruptcy filing. By the end 
of November, the stock had plummeted to 26[cents], obliterating $67 
billion in market cap--a shocking fall for a company that just last 
year occupied the No. 7 spot on the Fortune 500.
    Perhaps most incredible, however, about the Enron debacle is how 
long investors hung on to the belief that everything would turn out 
fine. As recently as MONEY's October issue, our Ultimate Investment 
Club's Abby Joseph Cohen of Goldman Sachs was calling Enron a ``good 
value.'' If pros like Cohen got it wrong, how could the average 
investor have discerned the disaster in time? Sure, hindsight is 
marvelous. But along Enron's fast track to penny stock, there were red 
flags for informed shareholders that all was not as it seemed.
    Out-of-control valuation. In 2000, investors levitated Enron's 
stock to a lofty price/earnings ratio of 69 times that year's earnings 
on the belief that forays into sexy-sounding online energy trading and 
broadband businesses could sustain supercharged earnings growth. 
Skilling was telling Wall Street that Enron's broadband biz alone 
deserved $37 a share, and investors seemed to buy it, despite the fact 
that the unit was unproved and unprofitable. His outlandish valuation 
of broadband drew an early ``hold'' rating from analyst Andre Meade of 
Commerzbank Securities in March 2000. ``An energy company trading at 
the multiple Enron was,'' Meade explains today, ``should have been 
cause for eyebrows to be raised.''
    The lesson? Pay attention to the P/E even after you buy a stock. 
Whenever the valuation starts to climb, you should stop and question 
whether the company can sustain the sales and earnings growth expected 
of it.
    Insider selling. In 2000, then CEO Kenneth Lay netted $66.3 million 
from exercising stock options and selling the shares, while Skilling 
scored $60.7 million, roughly double the amounts the year before. By 
the end of June 2001, 16 members of Enron's top management had sold 
$164 million in shares, reports Thomson Financial Network. While 
insider sales don't automatically spell trouble for a company--
executives often have valid reasons for raising cash--the selling at 
Enron was prolific. And the fact that selling persisted even as the 
stock fell throughout 2001 was a ``screaming red flag,'' says Thomson 
analyst Paul Elliott. If Skilling and Lay believed the stock was 
undervalued--as they repeatedly told investors--then why were they 
cashing in? Executive stock trades are easy for ordinary investors to 
follow: The Wall Street Journal regularly publishes insider trading 
tables, and websites such as Yahoo Finance (finance.yahoo.com) list 
insider trades for each stock.
    Obfuscations. Enron's trading business is extremely complex, and 
analysts admit they didn't always understand what Enron was doing. That 
said, the company seemed to go out of its way to obfuscate. ``I've 
never seen such complicated disclosures,'' says Michael Heim, an A.G. 
Edwards energy analyst. ``It was hard to follow the movement of 
money.''
    When pushed to reveal more, management was often tight-lipped and 
unprofessional. During one famous conference call last April, Skilling 
called an analyst an ``asshole'' for complaining about the company's 
failure to provide a balance sheet with its earnings announcement. 
Prudential Securities' Carol Coale points to rumors in late September 
of an SEC investigation. ``When I asked Enron about an investigation, 
they said there was no investigation,'' says Coale. Once it was 
revealed that the SEC was conducting an inquiry, she says Enron 
returned to her with a feeble excuse: ``They said, `Well, you didn't 
ask about an inquiry.'''
    The typical investor isn't privy to such conversations, although 
more and more company conference calls are in fact being opened to the 
general public. But the larger point (famously stated by Warren 
Buffett) is this: If you don't understand what a company does, don't 
invest in it. There's a corollary to that too: If management refuses to 
fill in holes and keeps investors in the dark, run.
    Fishy filings. Investors who read Enron's quarterly SEC filing in 
the summer of 1999 would have noticed a new entry under the heading 
``Related Party Transactions.'' The item noted that Enron was doing 
business with a private partnership whose general partner was led by a 
``senior officer of Enron.'' A proxy filed in May 2000 revealed that 
the senior officer was Enron CFO Andrew Fastow, and that not one but 
two partnerships existed.
    Possible conflicts of interest--is the CFO looking out for Enron or 
himself?--should have turned heads. But even professional money 
managers like those at Janus, enthralled by Enron's opportunities, 
overlooked the partnerships as the funds built up their stakes. As late 
as Sept. 28, with Enron at $27.25, Janus owned 41.3 million shares, 
which it has since dumped.
    To be fair, Enron revealed little about the partnerships and their 
function--to divert from Enron's balance sheet the debt from new 
acquisitions--as well as the extent to which the companies were in bed 
together. Besides, back then the stock was going gangbusters and 
earnings looked great; the partnerships seemed like small potatoes. 
Even the stock's few critics weren't paying much attention. Recalls 
Meade of Commerzbank: ``It was difficult to see that there were 
significant liabilities associated with this.''
    Attitudes began changing after Enron filed its first quarterly 
report of 2001, which said it was entering into complicated and risky 
derivatives transactions that involved an $827 million loan to one of 
the partnerships. Whoa, some analysts said. ``You started to see in the 
footnotes some pretty large sums of money,'' says Tara Gately, energy 
analyst for Loomis Sayles funds. ``It raised questions, and there were 
really no good answers.''
    Yes, this is complicated stuff and, yes, there wasn't enough 
information, but you don't have to be a big-deal financial analyst to 
know that the CFO in a side business is smelly stuff.
    Executive departures. When the chief executive--someone who spent a 
decade moving up the ladder and building the company's core energy-
trading business--flees after just six months at the helm, you've got a 
problem. Skilling, 47 at the time, called it a ``purely personal'' 
decision. ``That was the worst excuse I've ever heard,'' scoffs John 
Hammerschmidt, a fund manager at Turner Investments. If top management 
resigns for unclear reasons, consider selling. Hammerschmidt didn't 
even hesitate in this case: ``As soon as I heard that, I dumped my 
shares.''
    One red flag does not necessarily a disaster make. More often it's 
a succession of little somethings that ultimately tells you: It could 
get real ugly here. The trick is to put aside your enthusiasm for a 
stock. That's probably the hardest thing for any investor to do. But as 
Enron's meltdown shows, the homework isn't over once you buy the stock.

                                  
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