The rapidity of Enron's decline is an effective illustration of the vulnerability of a firm whose market value largely rests on capitalized reputation. The physical assets of such a firm comprise a small proportion of its asset base. Trust and reputation can vanish overnight. A factory cannot.
In December 2001, the Enron Corporation and many of its subsidiaries filed for bankruptcy protection. At the time of filing, Enron was the largest bankruptcy in U.S. history, having previously ranked as the seventh largest U.S. corporation in terms of revenue. A string of similar high-profile bankruptcies followed, amid allegations of fraudulent accounting practices and the apparent failure of American securities market regulation (U.S. Senate Committee on Governmental Affairs 2002b).
While the fortunes of these corporations changed rapidly, it was not accidental. The problems that have emerged in recent years are the result of intentional design. The past twenty years have seen the rapid adoption of innovative financial techniques, while a renewed faith in the efficiency and stability of market structures has been used to justify a reduction in funding for capital market agencies. Corporate interests have increasingly influenced the construction and passage of accounting rules and market regulations. Touted as the growth of freely competitive markets, the current drift of economic policy is more clearly caused by the growing influence of narrowly defined corporate interests (Champlin and Knoedler 1999).
For the most part, critics of these trends have been dismissed. Those who do not believe the circular logic of natural efficiency- where the existence of a practice is evidence of its efficiency--argue the recent history of deregulation has produced an increasingly fragile capital structure in industry. Loosened oversight has encouraged the exploration of the boundaries of corporate practice, creating an economy where the manipulation of financial assets has become a more important source of corporate value than the act of production and sale.
Thorstein Veblen's description of the modern corporation provides valuable insight into the tendency toward financial fragility and the role of regulation. He argued the most important asset of the modern corporation was its expected future earning capacity-an intangible and volatile asset whose price was determined by social expectations about the future ( 1978; Raines and Leathers 1996). The nature of this asset benefits the consolidation of market power. Through the mechanism of equity finance and the stock market, the corporation is able to convert expectations of future profitability into contemporary purchasing power, purchasing power that can then be used to realize those expectations or simply to divert income. Consequently, the ability of the corporation to extend its influence and reorganize industry in the future is determined by the social perception of its worth in the present. To incorporate this social characteristic of corporate value, accounting conventions have necessarily evolved. Intangible assets such as goodwill, the growing sophistication of financial instruments and structured finance, and the use of the secondary stock market to define the constantly changing value of the corporation are evidence of Veblen's "credit economy."
Because corporate value is influenced by social perception, the foundations of the corporate economy are fundamentally prone to manipulation. Seeking competitive advantage or personal enrichment, managers may aspire to manipulate the value of the putative earning capacity of some block of capital (Veblen  1978, 155). While Veblen's description of the credit economy focused on particular assets generally conceptualized as goodwill, the growth of modern finance has simply extended the range and number of assets/contracts whose values are subject to a greater degree of future uncertainty and malleability.
As argued in this paper, misguided notions of market efficiency have undermined the regulatory processes necessary to limit fraudulent corporate practice. Changes in the accounting industry, most notably the shift from auditing toward consulting, allow the growing complicity between the interests of management and the guardians of fair reporting. This influence has compromised auditing and regulatory standards. At the same time, changes in the way managers are paid--the growth of stock options--provide new incentive to engage in deceptive accounting practice and manipulate stock price.
This story is not, however, simply about moral hazard, or a few bad agents, but rather about the general evolution of the practices used to define the rights to income derived from the productive assets of corporations, whether through the distribution of profits or capital gains. As a leading innovator in its field, pressing into the gray areas of corporate practice to more aggressively engineer its financial structures, Enron provides a convenient case of best practice in modern industrial evolution. In light of its bankruptcy this may seem unusual, but it should be remembered that the practices which led to its collapse had previously been praised as visionary. Enron was selected by Fortune magazine as "America's Most Innovative Company" for an unprecedented six years from 1996 to 2001, while its chief financial officer Andrew Fastow was selected as a top CFO of the year by CFO magazine in 2001.
Reduction in Regulatory Oversight
According to the Congressional testimony of Washington University Law Professor Joel Seligman, the last decade at the U.S. Securities Exchange Commission (SEC) has been as politically uncertain as the period surrounding its creation seventy years ago (Senate Banking, Housing, and Urban Affairs Committee 2002). During the stock market boom of the 1990s, funding for the agency increased so slowly that the review of each corporation's major securities filings slipped from once every three years to once every seven (Stephen Labaton, "S.E.C. is Suffering from Nonbenign Neglect," New York Times, July 20, 2002). Political attempts to roll back legislation, beginning with the 1994 Republican "Contract with America," were complemented by corporate attempts to circumvent existing regulations (Stephen Labaton, "In Stormy Time, S.E.C. Is Facing Deeper Trouble," New York Times, December 1, 2002). The integrity of accounting practice and stock market analysis was quickly degraded. Arthur Levitt, who served as chairman of the SEC during much of this period, described this new environment as the "culture of gamesmanship" (Senate Committee on Governmental Affairs 2002a).
While regulatory oversight declined, the capital markets and financial industry experienced broad-based deregulation. Gathering influence in the 1970s, competitive forces that had been segregated by depression-era legislation were allowed to develop and undermine existing regulatory structures. After twenty years of neglect, the passage of the Gramm-Leach-Bliley Act in 1999 marked the end of functional specialization in finance and the repeal of the Glass-Steagall separation of investment and commercial banking.
In its response to the new regulatory challenges, the Securities Exchange Commission was frequently met with resistance and circumvention as accounting industry lobbyists attempted to exert influence through Congressional allies. Notable examples include the 1994 fight over the expensing of stock options, the 1998 investigation of auditors independence rule violations, and the 2000 attempt to split auditing and consulting work (David Henry, "Accountants Bristle at SEC's Auditor Review," USA Today, May 11, 2000; Mayer 2002; Levitt 1998; Senate Committee on Governmental Affairs 2002a). Claims that accounting industry regulation was becoming politicized also ran in the opposite direction, blaming Arthur Levitt and the SEC for overstepping its regulatory authority (Miller 2002).
A cavalier attitude about the veracity of financial statements was encouraged in part by increased competition between accounting firms and a reduction in the severity and probability of being convicted for fraudulent accounting practices. The consent decree signed by the American Institute of Certified Public Accountants in the late 1970s required accounting firms to begin competing in terms of auditing fees and advertising (Olson 1999). During the 1980s, as competitive bidding forced down fees, revenues from auditing fell from 70 percent to 30 percent of revenue at the major accounting firms (David Henry, "Accountants Bristle at SEC's Auditor Review," USA Today, May 11, 2000). Consulting work filled much of the void. From 1981 to 2000, the share of revenues coming from consulting services rose from 13 percent to 50 percent at the Big Five firms (Senate Commerce, Science, and Transportation Committee 2001). The profitability of audit work declined to such an extent that some firms offered auditing as a loss leader, a service provided at a loss as a way to secure a longer term and more valuable consulting relationship with a client firm.
While accounting firms came into closer contact with corporate management and their revenues became increasingly dependent on satisfying the interests of management, the Private Securities Litigation Reform Act of 1995 reduced the penalties for accounting and legal fraud. By removing the "aider and abettor" rules, accountants and lawyers could give advice without liability (Weiss 2002). In the event of arbitration, the standard of proof was made more stringent, while the threat of triple damages from the application of the RICO statute was removed (Senate Commerce, Science, and Transportation Committee 2001).
In addition to the degradation of independence caused by the rise in consulting work, the historically American practice of the auditor being hired directly by the audited firm also compromises the independence of...