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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

(

(II)

SENATE COMMITTEE ON COMMERCE, SCIENCE, AND TRANSPORTATION

ONE HUNDRED SEVENTH CONGRESS

FIRST SESSION

ERNEST F. HOLLINGS, South Carolina, Chairman 

DANIEL K. INOUYE, Hawaii 

JOHN D. ROCKEFELLER IV, West Virginia 

JOHN F. KERRY, Massachusetts 

JOHN B. BREAUX, Louisiana 

BYRON L. DORGAN, North Dakota 

RON WYDEN, Oregon 

MAX CLELAND, Georgia 

BARBARA BOXER, California 

JOHN EDWARDS, North Carolina 

JEAN CARNAHAN, Missouri 

BILL NELSON, Florida 

JOHN MCCAIN, Arizona 

TED STEVENS, Alaska 

CONRAD BURNS, Montana 

TRENT LOTT, Mississippi 

KAY BAILEY HUTCHISON, Texas 

OLYMPIA J. SNOWE, Maine 

SAM BROWNBACK, Kansas 

GORDON SMITH, Oregon 

PETER G. FITZGERALD, Illinois 

JOHN ENSIGN, Nevada 

GEORGE ALLEN, Virginia 

KEVIN D. KAYES, Democratic Staff Director 

MOSES BOYD, Democratic Chief Counsel 

MARK BUSE, Republican Staff Director 

JEANNE BUMPUS, Republican General Counsel 

(III)

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

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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 

2

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. 

3

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. 

4

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 

5

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 

6

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 

7

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. 

8

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-yearold 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 

9

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 longterm 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. 

10

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. 331⁄2 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 

11

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 

12

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. 

13

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 

14

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 

15

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 FORE- MAN, 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 § 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 § 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 

16

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 § 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 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 

17

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. 

18

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. 

19

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? 

20

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 331⁄2 years? 

Mr. PRESTWOOD. Yes, sir. 

Senator MCCAIN. And in those 331⁄2 years you accumulated stock worth $1.3 million? 

Mr. PRESTWOOD. Yes, sir. 

Senator MCCAIN. And how much do you have left now? 

21

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 

22

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.

23

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 

24

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 legisVerDate 0ct 09 2002 13:21 Sep 27, 2005 Jkt 082282 PO 00000 Frm 00028 Fmt 6633 Sfmt 6601 S:\WPSHR\GPO\DOCS\82282.TXT JACK PsN: JACKF
25

late 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? 

26

[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 

27

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 

28

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? 

29

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. 

30

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 

31

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 

32

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 wellknown 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 sysVerDate 0ct 09 2002 13:21 Sep 27, 2005 Jkt 082282 PO 00000 Frm 00036 Fmt 6633 Sfmt 6601 S:\WPSHR\GPO\DOCS\82282.TXT JACK PsN: JACKF
33

tem 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. 

34

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 

35

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 

36

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. 

37

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 

38

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 agenVerDate 0ct 09 2002 13:21 Sep 27, 2005 Jkt 082282 PO 00000 Frm 00042 Fmt 6633 Sfmt 6621 S:\WPSHR\GPO\DOCS\82282.TXT JACK PsN: JACKF
39

cies, 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 dotcom 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.

40

—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 

41

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 tradVerDate 0ct 09 2002 13:21 Sep 27, 2005 Jkt 082282 PO 00000 Frm 00045 Fmt 6633 Sfmt 6601 S:\WPSHR\GPO\DOCS\82282.TXT JACK PsN: JACKF
42

ing. 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;

43

• 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. 

44

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 

45

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 ‘‘proforma’’ financial results, the press tacitly lends credibility to a serious conflict of interest, because public companies should not be making up their own accounting reVerDate 0ct 09 2002 13:21 Sep 27, 2005 Jkt 082282 PO 00000 Frm 00049 Fmt 6633 Sfmt 6621 S:\WPSHR\GPO\DOCS\82282.TXT JACK PsN: JACKF
46

sults 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 sellside 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 business 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 

47

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.

48

The Wall Street Journal’s ‘‘Best on the Street’’ Stock Pickers—‘‘95% of These Top 82 Firms Have Research Conflicts’’

Wall Street Journal Ranking June 26, 2001 Investment Banking Proprietary Trading Money Management Source 

1. Salomon Smith Barney X X X www.salomonsmithbarney.com2. Merrill Lynch X X X www.ml.com3. Morgan Stanley X X X www.morganstanley.com4. Lehman Brothers X X X www.lehman.com5. Goldman Sachs X X X www.gs.com6. A.G. Edwards X X X www.agedwards.com7. Credit Suisse First Boston X X X www.csfb.com8. J.P. Morgan Chase X X X www.jpmorgan.com9. Bear Stearns X X X www.bearstearns.com

10. Banc Of America Sec’s X X X www.bofasecurities.com11. UBS Warburg X X X www.ubswarburg.com12. Deutsche Banc Alex Brown X X X www.deutsche-bank.com13. William Blair X X X www.wmblair.com14. McDonald Investments X X X www.key.com15. SG Cowen Securities X X X www.sgcowen.com16. Prudential Securities NO X X www.prudential.com

49

17. ING Barings X X X www.ingbarings.com18. First Union Securities X X X www.firstunionsec.com19. CIBC World Markets X X X www.cibcwm.com20. ABN Amro X X X www.abnamro.com21. Robertson Stephens & Co X X X www.robertsonstephens.com22. Needham & Co X X X www.needhamco.com23. Dain Rauscher Wessels X X X www.dainrauscherwessels.com24. Raymond James X X X www.raymondjames.com25. BMO Nesbitt Burns X X X www.bmonesbittburns.com26. Wit SoundView X X X www.witcapital.com27. Wasserstein Perella X X X www.wassersteinperella.com28. Morgan Keegan X X X www.morgankeegan.com29. SunTrust Equitable Sec’s X X X www.suntrust.com30. Keefe,Bruyette & Woods X X X www.kbw.com31. Ferris, Baker Watts X X X www.fbw.com32. Buckingham Research NO X X New York ph# 212.922.550033. Tucker Anthony X X X www.tucker-anthony.com34. Robinson-Humphrey X X X www.robinsonhumphrey.com

50

The Wall Street Journal’s ‘‘Best on the Street’’ Stock Pickers—‘‘95% of These Top 82 Firms Have Research Conflicts’’—Continued

Wall Street Journal Ranking June 26, 2001 Investment Banking Proprietary Trading Money Management Source 

35. Barrington Research X X X www.brai.com36. D.A. Davidson X X X www.dadco.com37. Stifel Nicolaus X X X www.stifel.com38. Fahnestock X X X www.fahnestock.com39. Midwest Research NO X NO Sarah O’Connor-Compliance40. First Analysis X X X www.firstanalysis.com41. Thomas Weisel Partners X X X www.tweisel.com42. Janney Montgomery Scott X X X www.janneys.com43. First Albany X X X www.fac.com44. Adams, Harkness & Hill X X X www.ahh.com45. Jefferies X X X www.jefco.com46. Ryan Beck X X X www.rbeck.com47. U.S. Bancorp Piper Jaffray X X X www.piperjaffray.com48. Sidoti NO NO X John Zolidis-Sidoti49. BB&T Capital Markets X X X www.bbandt.com50. Pacific Growth Equities X X X www.pacgrow.com

51

51. Hibernia Southcoast Capital X X X www.hibernia.com52. Argus Research NO NO NO www.argusresearch.com53. Davenport & Co, LLC X X X www.davenportllc.com54. Friedman,Billings,Ramsey X X X www.fbr.com55. H.C. Wainwright X X X www.hcwainwright.com56. Gerard Klauer Mattison X X X www.gkm.com57. Robert W. Baird X X X www.rwbaird.com58. Legg Mason X X X www.leggmasoncapmgmt.com59. Brean Murray X X X www.bmur.com60. Griffiths McBurney X X X www.gmponline.com61. Hoak Breedlove Wesneski X X X www.hbwco.com62. LJR Great Lakes Review NO NO NO www.ljr.com63. RBC Dominion Securities X X X www.rbcds.com64. Gruntal X X X www.gruntal.com65. Lazard Asset Mgmt X X X www.lazardnet.com66. Wedbush Morgan Sec’s X X X www.wedbush.com67. Credit Lyonnais X X X www.creditlyonnais.com68. Hilliard Lyons X X X www.hilliard.com

52

The Wall Street Journal’s ‘‘Best on the Street’’ Stock Pickers—‘‘95% of These Top 82 Firms Have Research Conflicts’’—Continued

Wall Street Journal Ranking June 26, 2001 Investment Banking Proprietary Trading Money Management Source 

69. Advest Group X X X www.advest.com70. Sandler O’Neill X X X www.sandleroneill.com71. Stephens Capital Mgmt X X X www.stephens.com72. Fox-Pitt, Kelton X X X www.foxpitt.com73. Miller Johnson X X X www.stockwalk.com74. Josephthal X X X www.josephthal.com75. Simmons X X X www.simmonsco-intl.com76. WR Hambrecht X X X www.wrhambrecht.com77. Frost Securities X X X www.frostsecurities.com78. Johnson Rice X X X New Orleans 504.525.376779. Kaufman Brothers X X X www.kbro.com80. Wells Fargo Van Kasper X X X www.fsvk.com81. Pacific Crest Securities X X X www.pacific-crest.com82. 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. 

53

Institutional Investor Magazine’s ‘‘2000 All-America Research Team’’—100% of These Top 16 Firms Have Research Conflicts 

Institutional Investor Magazine Ranking Investment Banking Proprietary Trading Money Management Source 

1) Merrill Lynch X X X www.ml.com2) Morgan Stanley X X X www.morganstanley.com3) Salomon Smith Barney X X X www.salomonsmithbarney.com4) Credit Suisse First Boston X X X www.csfb.com5) Donaldson Lufkin Jenrette X X X www.dlj.com6) Goldman Sachs & Co X X X www.gs.com7) Bear Stearns & Co X X X www.bearstearns.com8) Lehman Brothers X X X www.lehman.com9) PaineWebber X X X www.painewebber.com

10) J.P. Morgan Securities X X X www.jpmorgan.com11) Prudential Securities NO X X www.prudential.com12) Sanford C. Bernstein & Co NO X X www.bernstein.com13) Banc of America Securities X X X www.bofasecurities.com14) Deutsche Banc Alex. Brown X X X www.deutsche-bank.com15) ISI Group NO NO X www.morningstar.com16) 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. 

54

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.’’ SteVerDate 0ct 09 2002 13:21 Sep 27, 2005 Jkt 082282 PO 00000 Frm 00058 Fmt 6633 Sfmt 6621 S:\WPSHR\GPO\DOCS\82282.TXT JACK PsN: JACKF
55

fan 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.

56

McGee, Suzanne. ‘‘After Oracle Misfire, Wall Street’s Research Is Blasted.’’ Wall 

Street Journal, December 11, 1997. www.wsj.com.

Morgenson, Gretchen. ‘‘How Did So Many Get It So Wrong?’’ New York Times, December 31, 2000. www.nytimes.com.

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 

57

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 state- ment at least, the $27 million we were paid in terms of consulting, 

a significant part of that actually was for work that an auditor 

58

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 nonauditrelated 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 reVerDate 0ct 09 2002 13:21 Sep 27, 2005 Jkt 082282 PO 00000 Frm 00062 Fmt 6633 Sfmt 6601 S:\WPSHR\GPO\DOCS\82282.TXT JACK PsN: JACKF
59

gards 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? 

60

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-thebooks 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. 

61

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? 

62

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 responsiVerDate 0ct 09 2002 13:21 Sep 27, 2005 Jkt 082282 PO 00000 Frm 00066 Fmt 6633 Sfmt 6601 S:\WPSHR\GPO\DOCS\82282.TXT JACK PsN: JACKF
63

bility 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 

64

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 busi- ness, 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. 

65

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. 

66

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. 

67

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. 

68

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 

69

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 

70

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. 

71

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). 2See Jonathan Glater, ‘‘Flood of Lawsuits Puts Underwriters in Cross Hairs,’’ New York 

Times, December 2, 2001 at Section 3, p.4. 3See Arthur Levitt, ‘‘The Number Game,’’ Sept. 27, 1999 (‘Speech Given at NYU Center for 

Law and Business). 

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

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 

72

4Many 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). 5The 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). 6See Glater, supra note 2.

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

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: 

‘‘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 

73

7There 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. 8Section 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 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

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

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 

74

9See 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. 12See 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. 15Securities Act Release No. 33–7919 at 27. 16Last year, Enron paid Arthur Andersen $25 million in audit fees and $27 million for nonaudit services. See Jerry Hirsch and Thomas Mulligan, ‘‘Auditors, Execs Target of Enron Creditors,’’ Los Angeles Times, November 30, 2001 at Part 3–1. 

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

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. 

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. 

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. 

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 

75

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). 

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. 

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 

76

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?’’

77

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 

78

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 

79

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 

80

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 sellside 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 comVerDate 0ct 09 2002 13:21 Sep 27, 2005 Jkt 082282 PO 00000 Frm 00084 Fmt 6633 Sfmt 6621 S:\WPSHR\GPO\DOCS\82282.TXT JACK PsN: JACKF
81

pany’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.

82

* The information referred to was not available at the time this hearing went to press. 

Submitted for further consideration: * 

• 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. 

83

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. 

84

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) 

85

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 

86

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. 2What Chinese Wall?, Barr Stephen, CFO, March 1, 2000. 

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

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 

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3Wall Street’s Secret Code Spoils Investors’ Aim, Noelle Knox USA Today, December 21, 2000; 

CFO, ibid. 4Why do Firms Switch Underwriters? Wayne H. Shaw, Kent Womack, Forthcoming, Journal 

of Financial Economics. 

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

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

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 

88

5 ‘‘Is Enron Overpriced?,’’ by Bethany McLean. Fortune, March 5, 2001, Pg. 122 6Testimony of First Call CEO before Joint Hearing of House Subcommittees on Capital Markets and Investigations, December 12, 2001. 7The 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. 8 ‘‘Enron: An Unreported Triumph For Investment Letters.’’ Forbes.com, December 7, 2001. 

9 ‘‘Assessing the Role of the Financiers,’’ by Patrick McGeehan, New York Times, December 

2, 2001, Section 3, page 11. 

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

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

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. 

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

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, 

89

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 

90

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.] 

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APPENDIX

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. 

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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 riskmanagement 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 overVerDate 0ct 09 2002 13:21 Sep 27, 2005 Jkt 082282 PO 00000 Frm 00096 Fmt 6601 Sfmt 6621 S:\WPSHR\GPO\DOCS\82282.TXT JACK PsN: JACKF
93

sight 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 sexysounding 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. 

94

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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