Question

What were the legal consequences of the Enron scandal?

Answer 1

Enron was the seventh biggest company in the US. It was valued at nearly $70bn. Suddenly it collapsed in what now appears to be a monstrous accounting fraud. The fact that the fraud seems to have been mostly conducted in accordance with US GAAP does not help either the accountancy profession or Enron's.

Its implications are worth some thought. And it seems inevitable that Enron will bring further changes not only for the profession, but for corporate governance and the securities industry.

The competition authorities, especially those in the EU, will be unhappy that the Big Five have suddenly become the Big Four, but there will not be a lot that they can do about it. Andersen in the US has no foreseeable independent future. This means that Andersen in the rest of the world has no foreseeable independent future either. Big Five firms pitch their services at large multinational companies; that offer lacks credibility without a large presence in the US. Andersen outside the US is therefore forced to find another Big Five firm that it can attach itself to.

Different countries may go in different directions and even within a single country the various parts of the business may go separate ways, but they will all have to find a new home. The competition authorities may want to spend some time investigating matters and assuring themselves that there are no other options, but that is the conclusion at which they will eventually have to arrive.

Independence issues made worse

This will affect the regulatory authorities' attitude to auditors. Events at Enron had already provoked worldwide reviews of the rules relating to auditors' independence. Andersen's downfall will make matters worse. Regulators will be concerned that if the Big Five can suddenly turn into the Big Four without the authorities having a say in the matter, they could equally well, and equally suddenly, turn into the Big Three in precisely the same way. The authorities will be keen to avoid this. If they conclude that Andersen's demise was attributable to a lack of independence, they will be more inclined than they would have been anyway to take a severe line on independence to make sure that nothing similar happens again.

The quandary now facing companies will reinforce this. After Enron, a number of companies in the US and a few in Europe decided to stop commissioning consulting work from their auditors. As Andersen is absorbed within the Big Four, some companies that went to the trouble of ensuring that audit and consultancy services were provided by separate firms will find that they are now provided by the same firm again. The company will be able to reallocatethe work, but the choice of who to give it to will have shrunk from five firms to four. While commercially this will assist competitors from outside the Big Four, it will be another factor making the regulatory authorities think in terms of severe solutions. Instead of getting bogged down in endless debates about which services firms can provide to audit clients, wouldn't it make life a lot simpler, regulators will ask themselves, if they were to ban audit firms from providing any non-audit services?

The key country, as always, is the US. There, Enron/Andersen is a highly political issue. It is being investigated by a handful of Congressional committees, the Securities and Exchange Commission, the Department of Justice, and even the White House, which has produced a list of rather limp-looking recommendations for reform. On top of that, there is the civil litigation, which the plaintiffs would like to see running into billions of dollars. As long as Congress has the initiative, the results are likely to be drastic. All the incentives for these politicians are to produce dramatic solutions, especially as so many of them received contributions from Enron; they are now keen to show how upright they are. If the political head of steam behind this issue continues long enough, we can expect to see something that at least looks tough in terms of reinforcing auditors' independence.

The intense political pressure will fade as other issues capture the headlines. If it fades away before the Congressional investigators can push their own solutions through, then the initiative will pass to the SEC. Harvey Pitt, the SEC's chairman, has a reputation as an eminently sensible man, and while the SEC will have to introduce something that reinforces auditors' independence, its solution should be more rational and more open to debate than whatever the politicians might come up with on their own. But political pressure will remain, and the SEC will have to come up with solutions that also satisfy key figures in Congress. There will be changes and auditors won't like them. Deloitte & Touche's reluctant decision to divest its consultancy was in part a reflection of what it could see coming anyway.

Qualified self-satisfaction

The US accounting rules are also likely to change. There has been a good deal of smugness in the UK that the 'special-purpose entities' that Enron kept off its balance sheet under US rules would have had to be consolidated in the UK. Fortunately, the self-satisfaction has some justification. But it is worth bearing several qualifications in mind:

Some of Enron's off balance sheet liabilities should have been on balance sheet even under US rules (ie, Enron broke the rules).

Even under substance-based rather than form-based standards there are borderline cases. What, with the benefit of hindsight, people may feel should have been on balance sheet may at the time be kept off balance sheet. Form-based systems typically evolve from such failings of substance-based ones.

It would be a gross exaggeration to suggest that there are no principles in US standards and no detailed rules in UK ones. The difference between the two is a matter of degree. Also, many of the more detailed requirements of UK GAAP are relegated to industry SORPs. Nor should we forget, even if they do, that Americans have an overriding requirement to 'present fairly', which is the equivalent of 'true and fair' in the UK (see Allister Wilson in this issue, p 97). This is likely to be an important point in any criminal prosecutions arising from Enron's accounts.

If Enron pushes US standard-setters more in the direction of substance-based standards, they will not go unwillingly. In 1999, the Financial Accounting Standards Board wanted a standard that would take a substance-based approach to special-purpose entities. It was told by industry and auditors that the proposal was unworkable; they wanted detailed rules. This indicates what the real problem is in the US.

American preparers and auditors have an avoidance mentality when it comes to accounting standards (or, if you prefer, a compliance mentality). They want detailed rules that they can comply with and which they can then find ways around. Changing this will require a cultural revolution.

Enron will at any rate cause Americans to question their strongly-held belief that US standards are the best in the world. This may make them more willing to accept International Accounting Standards. Enron may also help push the International Accounting Standards Board towards a more substance-based approach as it considers the style of its first standards.

It is always difficult - and some would say impossible - to lay down effective rules for corporate governance. The quality of the governance in any particular company depends more on the individuals concerned than on the system they operate under. This is unlikely to stop new rules emerging. Some of the new rules may be aimed at the auditors as much as at the company. Enron is not the only high profile collapse recently where the senior finance team at the company was heavily recruited from the auditors. In other cases, retired audit firm partners have become non-executive directors at the client. There are obvious dangers in these practices and they are likely to be cracked down on.

Audit committees have not always covered themselves with glory lately, and there are widespread worries about the calibre of some of them. This reflects the lack of talent available to fill non-executive posts generally. There are two contrasting views of a non-executive's life. Some think it's easy money; £25,000 a year for very little effort and no real responsibility. At the other extreme are those who regard a nonexecutive's role as onerous and risky and worth far more than the meagre sums on offer. Perhaps too many of the actual occupants of these posts take the former view. It is difficult to see what most former politicians, retired civil servants and practising academics have to offer as nonexecutive directors, but one still finds them on the boards of some major companies - including Enron before its collapse.

Unfortunately, the alternative is not terribly attractive either. Top companies recruiting top executives from other top companies as nonexecutives leads to what looks like a cosy circle of top people endorsing one another's conduct and approving one another's pay rises.

The role of non-executives in the UK will be reviewed by the government once it finds somebody willing to conduct the enquiry. (Sainsbury's Sir Peter Davis turned it down.) Some will hope that the review marks a turning point away from the idealised view of recent years - of the non-executive as panacea for all corporate ills.

Especially in the US, Enron has also helped create a climate of disillusion with investment analysts. This has added to worries that emerged after the dot.com and telecoms boom and bust. The US has far more individual investors than the UK and many of them feel that they've been robbed. What they see is a system that looks horribly-corrupt. The analysts are employed by big investment banks to boost stocks in companies that pay huge fees to the investment bankers.

One or two analysts have emerged who say that they took a sceptical view of Enron's stock but were silenced or even fired by their investment bank employers. And Enron payed these banks hundreds of millions of dollars a year (over $250m in 2000) for, among other things, the off balance sheet finance deals that played such a significant part in its downfall.

Everybody in the US - Congress, the SEC, etc - is on the case, and new rules have already appeared to try to reinforce analysts' independence. Some of the banks themselves have taken steps to reassure investors of the independence of their analysts' advice.

This is not a new problem. Before the analysts were working for investment banks' stockbroking arms, they were working for independent stockbrokers. Stockbrokers want people to buy stocks. The analysts have to be paid for, and unless their work results in more business one way or another, how can their costs be recovered? There is no obvious solution to this one, but further change of some sort seems likely.

Momentous collapse

The politicians themselves may well be changed by Enron. Campaign funding in the US was an issue before its collapse. But the company's widespread generosity and apparent success in influencing regulators and legislators has given it fresh impetus.

Andersen's downfall has been one shocking result of the Enron debacle. The further consequences of Enron will, with luck, be more deliberate, but may be just as dramatic. No single company's collapse since the South Sea Bubble of 1720 has been quite so momentous.