After the Demise of Enron and Parmalat: Lessons on the Approach to Regulation

1
After the Demise of Enron and Parmalat Lessons
on the Approach to Regulation

• The Financial Sector Post-Crisis Challenges and
  Vulnerabilities
• April 27, 2005, Washington, DC
• Robert E. Litan
• Vice President, Research and Policy
• Ewing Marion Kauffman Foundation,
• and Senior Fellow, Brookings Institution

2
Recent Reporting Scandals

• Enron, Worldcom, Tyco, and others
• Enron combination of lawful accounting but bad
  incentives (MV accounting of long-term gas sales
  bonuses tied to sales of plants) and failure to
  disclose guarantees of SPEs (used to borrow
  extensively from banks, proceeds used to buy gas
  from Enron and recognize revenue)
• MCI capitalization of line rentals
• Common themes overstatement of revenues or
  understatement of expenses one contributing
  cause
• Small comfort US is not the only country with
  financial reporting problems France
  (Vivendi/Messier) Italy (Parmalat) Britain
  (Conrad Black, CEO of Hollinger and looting of
  400 million) in each of these countries, as in
  US, CEOs lost their jobs.
• But in Korea CEO of SK (Chey Tae-Won) is back on
  the job after only a 3 month jail sentence (of an
  original 3 yrs) and execs of Daewoo and others
  are still be sought by interpol

3
So Who Was At Fault?

• Corporate managers (excessive stock options
  expensing since required)
• Boards of directors, where were they? Was it lack
  of independence? (Enrons directors were
  nominally independent)
• Where were the accountants? In theory, SEC/state
  regulation, both failed class action lawsuits
  (was 95 law limiting joint and several liability
  at fault? No, no change in lawsuits) Was it
  consulting work? (Incentives to keep audit
  clients anyhow)
• Where were the analysts who were publicly touting
  the stocks but privately disparaging them?

4
US Responses to the Scandals

• Multiple Actors SEC, NY State AG, DOJ, Congress
  (SOX), Exchanges
• To address corporate misconduct CEO
  certification backed by criminal penalties (SOX)
  DOJ lawsuits against CEOs of Worldcom (guilty),
  Enron (trial), lesser officials already have pled
  guilty
• Also, FASB has now required expensing of stock
  options (allowing several valuation methods)
• To address directors Exchanges now require
  majority of directors to be independent head of
  audit committees to be financial experts (SOX)
• A number of CEOs have since been forced out (AIG,
  Fannie Mae, Freddie Mac, Marsh Mac, Boeing,
  Hewlett-Packard)
• Directors of Worldcom settled personally (in
  lawsuit filed by NY State pension fund)
• To address accountants SOC set up the PCAOB and
  largely prohibited accountants from non-audit
  work (hasnt hurt, largely because of 404
  internal audit requirements effective this year)
  DOJ forced AA out of business
• Big corporate complaints about costs/500
  inadequacies reported (but most not material)
• Many class action lawsuits against accounting
  firms still in the pipeline
• To address analysts (NY State AG) Settlement
  requiring 1.4 billion payment to investors and
  requirement that investment banks fund
  independent research (would be better just to
  advise most retail investors of benefits of index
  funds)

5
An Assessment The Benefits

• Tougher board scrutiny of CEOs is welcome, though
  not clear that SOX alone is responsible (also
  class action lawsuits)
• Accounting firms have not fallen apart from
  non-audit firm (though still controversy about
  their tax work), largely because of 404 revenues
• CEOs clearly take accounting issues more
  seriously, so audit committees
• Prosecutions against CEOs and lesser officials
  going much better than initially expected (easier
  to convict when underlings talk)

6
An Assessment The Costs

• Many CEOs complain of greater risk aversion (in
  part due to board independence rules, and
  composition of board directions also more time
  spent on accounting trivia)
• Internal audit costs much higher than once
  thought some say as high as 30 billion (not
  clear if one-time or ongoing SEC has given
  extensions to small firms, rethinking the 404
  process, hearing in mid-April) most of the 500
  404 corrections are minor
• Some companies have gone private some foreign
  companies want off the US exchanges (and the SEC
  is considering ways to make it easier, to the
  complaints of US firms who want off!)
• Accounting firms remain worried about class
  action lawsuit liability, current and potential
  brain drain of senior partners criminal action
  against entire AA (rather than specific offices)
  looks like a big mistake in retrospect
• Major reason for PCAOB was higher salaries for
  greater expertise (but funding mechanism is
  controversial and maybe unconstitutional)

7
Bottom Line

• Too early to tell whether benefits (in terms of
  enhanced market confidence, better corporate
  behavior) have been worth the costs, or
• More important, whether essentially the same
  benefits could have been achieved through
  criminal and civil lawsuits and future
  deterrence without all of the additional
  detailed rules (especially independence/404)
• May be modest trimming of most onerous provisions
  in the future (404 as an example)
• But major overhaul of SOX and exchange listing
  requirements is not likely any time soon (66
  years for Glass-Steagall to be reversed, despite
  Glass reversal in 1935)

8
Application to Emerging Markets

• Dont feel need to copy all that the US has done,
  especially after US finger-pointing in 98
• Other countries dont have our class action
  systems or history and expertise in prosecutions
  of white collar misconduct
• But dont be misled auditing outside the US,
  especially in many emerging markets, tends to be
  weaker than the US (and less oversight)
• Also, greater parts of emerging market economies
  are still largely in private hands, so minority
  shareholders have less protection and growth of
  securities markets is tied to minority
  shareholder protection
• Best advice follow, or try to follow, the new
  audit standards to be developed by the PCAOB
  since most audit firms are now multinational,
  perhaps other countries can ask for and receive
  examination help from the PCAOB of audits in
  their countries (and maybe the World Bank can
  help pay for?)
• Perhaps also technical assistance in prosecutions
  of corporate officials guilty of fraud
• But my advice too soon to copy the rest of the
  US system overhaul SOX, independence
  requirements (not applicable to private
  companies), and class action lawsuits. Perhaps
  best results from beefing up prosecutorial
  efforts against fraud