Four years after Enron: assessing the financial-market regulatory cleanup.

• Author: Smith, Roy C.

Last year was the tenth anniversary of the beginning of the tech bubble in the stock market that began after the commercialization of the Internet and, through it, the development of a "new economy" led by "dot.coms" and other Internet-enabled companies. These developments drove a tremendous stock-market expansion from 1995 until the end of the 1990s, during which the NASDAQ index increased fivefold.

Early in 2000, however, the air began to leak out of the bubble, and by the end of the year a widespread reduction of approximately 30 percent in the valuation of technology stocks had occurred. This market drop sharply affected other businesses that relied on Internet technology, causing several to fail outright, to slide out of control, or to engage in accounting gimmickry in order to shore up their profits. By December 2001, when Enron, the seventh-largest company in the United States and one of its leading "new economy" concept companies, filed for bankruptcy, the NASDAQ index had fallen 74 percent from its high of less than two years earlier. In 2001, 171 large corporate bankruptcies occurred, involving liabilities of $230 billion, more than twice as many bankruptcies as in 2000, the previous record year. In July 2002, WorldCom, the country's second-largest long-distance telecom company, with $107 billion in assets, filed for bankruptcy after revealing massive accounting fraud. Throughout 2002, bankruptcies continued to occur, involving liabilities of $338 billion, thus establishing a three-year period in which U.S. bankruptcies--the ultimate form of corporate failure--broke all previous records (Altman 2002).

In addition, instances of accounting failures in the form of "restatements" of prior audited financial results because of accounting errors nearly quadrupled to 616 cases in the four-year period 1998-2001 (Wu 2002). Restatements continued to occur in record numbers during 2002 and 2003, when 389 cases were reported (Huron Consulting Group 2003). As a consequence of these failures, there was an explosion of securities-fraud class-action lawsuits seeking damages from all involved officers, directors, and advisers of the companies. In all, 489 such suits were filed in 2001 (of which 312 were related to initial public offerings), and 259 more were filed in 2002, as compared to an average of 194 filings per year during the three years prior to passage of the Private Litigation Reform Act of 1995, a bill designed to limit substantially the number of such class-action lawsuits (Stanford Law School 2006). Many of these lawsuits were the consequence of stock prices that fell rapidly after sudden news of changed financial information.

The financial losses caused by these failures were considerable. Bank-loan write-offs for 2001-2002 were in the tens of billions of dollars. Publicly traded noninvestment-grade bond defaults for 2002 were (at par value) $96.9 billion--the highest amount of such defaults then recorded--representing 12.8 percent of outstanding issues. In 2001, the default rate of these bonds was 9.8 percent, the highest since 1999. On the assumption that the bond defaults will result in recoveries (through bankruptcy or other workout arrangements) equal to the ten-year historical average of about 30 percent, the expected losses from loan write-offs and from bond defaults for the two-year period will be about $100 billion (Altman 2004).

Equity-market losses in 2001-2002 attributable to fears of corporate failures caused by misgovernance were far greater: the S&P 500 peaked at 1,527 in March 2000 and then, reflecting the collapse of the technology bubble, fell steadily to 966 in September 2001, before recovering to nearly 1,200 by the end of the year. Even after clear signs of recovery in the economy and in corporate earnings were evident late in 2001, however, the Enron bankruptcy in December 2001 and other corporate surprises affected the market, and the S&P 500 index reversed direction and fell farther. Unlike the periods following recovery from previous recessions, the stock market continued to sag, with the S&P 500 index reaching a five-year low of 798 on July 23, 2002, down 33 percent for the year (a loss of approximately $4 trillion of market capitalization) and lower by more than 47 percent from its all-time high two and a half years earlier. For many industries suspected of accounting or governance shortcomings (for example, telecom, health care, energy services, and technology), share-price declines were even greater.

These losses were not sustained by the rich alone. In 2002, a survey conducted by the Investment Company Institute and the Securities Industry Association reported that 52.7 percent of American households owned equity investments either directly or in mutual or pension funds (2002, 48). Accordingly, the stock-market losses, the bankruptcies, and the revealed corporate misconduct associated with them became matters of great interest to the public media and to elected officials in Washington and the state capitals.

The corporate failures were publicized as being widespread, which they were indeed in the sense that record numbers of bankruptcies and corporate accounting restatements, involving more than six hundred companies, were reported during a three-year period--a great number of companies to be seen to have failed or acted badly (approximately 8 percent of all listed public companies in the United States). However, most of these failures were not the result of malfeasance or violations of law (officers and directors of fewer than fifty public corporations were involved in criminal charges), but rather of corporate mistakes and mismanagement in an environment of extraordinary risk taking. Of course, the vast majority of U.S. corporations did not fail and were not involved in scandals of any kind.

Inspired by low interest rates and rising stock prices, many companies in the 1990s committed themselves to high-growth strategies that could be sustained only by aggressive corporate actions and, in some cases, by "creative" accounting practices. Accountants at all five of the major auditing firms were cooperative and accommodating in these practices, despite being pledged to play an independent role, because of the consulting and other nonaudit fees they earned from large audit clients. According to a study of more than four thousand proxy statements filed with the Securities and Exchange Commission (SEC) between February and June 2001, nonaudit fees of the Big Five auditors represented two-thirds of total fees billed (Frankel, Johnson, and Nelson 2002). Banks, brokers, asset managers, and other intermediaries, enlarged by a decade of consolidation and deregulation, evolved into aggressive, multiline business platforms with considerable exposure to conflicts of interest, which all too often were resolved in their own favor (Levitt 2002, 130-35). Even the SEC, the regulatory body responsible for financial markets and practices, had quietly sunk into ineffectiveness in the face of powerful resistance in Congress (resulting from lobbying and political contributions by interested parties) to its efforts to improve accounting and other market practices in the 1990s.

Public officials--including regulators, enforcement agencies, and legislatures--began to compete with each other in their common zeal to "clean up" the these perceived corporate excesses and abuses and to "restore confidence" in financial markets. During the four years after Enron's failure, federal and state government officials expended a great deal of energy in pursuit of these objectives.

Cleanup Actions since Enron

Immediately after the Enron bankruptcy, congressional committees began investigations and consideration of legislative action. WorldCom's collapse accelerated these actions. In July 2002, President George W. Bush directed the Justice Department to establish the Corporate Fraud Task Force, which would include a variety of prosecutors, investigators, and technical experts. Within this group, a separate Enron Task Force was also appointed. Henceforth, Congress, the Justice Department, the SEC, and other enforcement agencies began an earnest effort to close in on those thought to be offenders.

* The Justice Department indicted Arthur Andersen, Enron's auditor, for obstructing justice in March 2002. By this time, an Arthur Andersen partner had confessed to inappropriate document shredding, which was alleged to have been the consequence of the firm's policy to destroy evidence that might be incriminating. Justice was also angered by Andersen's accommodating role in the...