What We Can Learn from Enron

There is no doubt that Enron’s failure has created troubled times for the accounting profession and securities markets seeking to pin down the causes of its failure and accompanying financial losses. The changes that are needed to avoid such costly events in the future will be numerous and, unfortunately, complicated.

While we still have more to learn about Enron, it seems clearer each day that Enron failed because it held itself out to be a trading company designed to hedge risk and make profits on trading when, in fact, it turned out to be a company taking huge risks speculating in many volatile markets, including some that it was pioneering. When the market prices moved against the exposed underlying position, the company failed. Enron’s hedges proved to be ineffective because they were embedded in Enron’s “other pocket”u00e2u20ac”related companies for which Enron itself was financially responsible.

Now the free market has exercised its will and “regulated” Enron, but the unrestricted free market is a brutal and costly regulator. What can be done to avoid or minimize this kind of debacle in the future? I have suggestions in three areas:

Accountingu00e2u20ac”I believe the government must provide and control the regulation of public accounting firms. Accountants start with a basic conflict of interest since they are paid by the enterprises they audit. Thus, governmental control is necessary to ensure compliance with the rules of operation. The alternative is for government itself to audit, which is undesirable. Many changes will follow from this, including separating audit from consulting, control of the “swinging door” between audit firm personnel and client accounting positions, and possible rotation of auditors.

Corporate governanceu00e2u20ac”It is far from clear exactly how corporate governance failed at Enron. The board relied upon reputable independent CPAs and legal counsel and on a management perceived to be of the highest reputation. The audit committee’s independence is, perhaps, in question, but there are already many independence rules in place on that issue. We must take care not to unfairly burden directors, and particularly audit committee members, or the result will be to reduce the availability of good directors to serve. I would suggest only two substantive changes be considered.

First, I believe that allowing one person to be both the board chairman and CEO concentrates too much power in one place. Second, it is important that independent directors constitute the committee to recommend new and retained directors to the board for approval. This suggestion will support board independence on which the governance system is based.

Corporate officers also performed poorly at Enron, but it is difficult to regulate performance standards or enforce them legislatively. At the FDIC, we recommended, and the Congress passed, laws preventing the use of golden parachutes just prior to a company failure. Today, the golden parachute is sometimes offered in the form of options exercised while the officer knew or should have known the company was in trouble. And while current laws allow the reclaiming of profits, this alone is not punitive. It remains to be seen whether the creation of a penalty is the best deterrent.

Government regulation, supervision, and taxationu00e2u20ac”Free markets usually work better when the government has set the structure for them to perform.

A good free market operates like a prizefightu00e2u20ac”plenty of chance to slug it out, but not below the belt. An unrestricted market is like a ballroom brawl where the fight results in widespread destruction of both people and the place, and the winner may be the dirtiest fighter on the scene. The trick, of course, is to have the right rules that promote fair competition without stopping it altogether.

Enron has taught us that unregulated futures markets and derivatives can fail and that a market structure, while difficult to engineer, is needed. Enron was a brawl, because no regulators were empowered to deal with a good part of its market behavior.

Above all, Enron’s markets and activities needed transparencyu00e2u20ac”a job that can only be done appropriately by one government agencyu00e2u20ac”the SEC.

In the end, there is much to be done by Congress to reduce the chances of “another Enron,” but we must keep in mind that overreaction can do as much harm as no action at all.