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Oversight Hearing on "Accounting and Investor Protection Issues Raised by Enron and Other Public Companies."

Prepared Statement of Professor Joel Seligman
Dean and Ethan A.H. Shepley University Professor
Washington University School of Law
Tuesday, March 5, 2002 - Dirksen 538

-----Joel Seligman is the author or co-author of 20 books and over 35 articles on legal issues related to securities and corporations, including the 11-volume treatise co-authored with the late Louis Loss, Securities Regulation. He is the co-author of Fundamentals of Securities Regulation and the casebook, Securities Regulation which he co-wrote with John Coffee. His book, The Transformation of Wall Street: A History of the Securities and Exchange Commission and Modern Corporate Finance, is widely regarded as the leading history of the Commission.

  At the University of Arizona College of Law, Seligman was named dean and the Samuel M. Fegtly Professor of Law in 1995. He previously served on the law faculty of the University of Michigan (1986-1995), George Washington University (1983-1986), and Northeastern University (1977-1983). He has served on the Arizona State Bar Board of Governors (1995-1999) and as a consultant to the Federal Trade Commission (1979-1982), U.S. Department of Transportation (1983), and Office of Technology Assessment (1988-1989).

  Since beginning as dean at Washington University School of Law in 1999, Seligman served as Reporter for the National Conference of Commissioners on Uniform State Law which adopted a new Uniform Securities Act in July 2002; in 2000-2001 was Chair of the Securities and Exchange Commission Advisory Committee on Market Information; and has served as a member of the American Institute of Certified Public Accountants Professional Ethics Executive Committee.

  Seligman received his bachelor's degree magna cum laude from the University of California at Los Angeles in 1971 and his law degree cum laude from Harvard University School of Law in 1974.

  Nearly 70 years ago, Supreme Court Justice Harlan Stone memorably observed at the dedication of the University of Michigan Law School Quadrangle:

  I venture to assert that when the history of the financial era which has just drawn to a close comes to be written, most of its mistakes and its major faults will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that 'a man cannot serve two masters.' More than a century ago equity gave a hospitable reception to that principle and the common law was not slow to follow in giving it recognition. No thinking man can believe that an economy built upon a business foundation can permanently endure without some loyalty to that principle. The separation of ownership from management, the development of the corporate structure so as to vest in small groups control over the resources of great numbers of small and uninformed investors, make imperative a fresh and active devotion to that principle if the modern world of business is to perform its proper function. Yet those who serve nominally as trustees, but relieved, by clever legal devices, from the obligation to protect those whose interests they purport to represent, corporate officers and directors who award to themselves huge bonuses from corporate funds without the assent or even the knowledge of their stockholders, reorganization committees created to serve interests of others than those whose securities they control, financial institutions which, in the infinite variety of their operations, consider only last, if at all, the interests of those whose funds they command, suggest how far we have ignored the necessary implications of that principle. The loss and suffering inflicted on individuals, the harm done to a social order founded upon business and dependent upon its integrity are incalculable.(1)

  The same year, 1934, that Justice Stone offered these observations, the Securities and Exchange Commission (SEC) began operations. By 1940 the SEC enforced six federal securities laws.(2)

  In the years since the SEC began operations, the United States securities markets have experienced an almost unimaginable growth and vitality.

  The number of United States stockholders has increased from 1.5 million (or 1.2 percent of the population) in 1929 to 84 million (or 43.6 percent of the adult population) in 1998.(3) As long ago as 1980, 133 million United States citizens indirectly owned shares through such intermediaries as mutual funds or pension plans.(4)

  When the stock market began its collapse in September 1929, the aggregate value of all shares on the New York Stock Exchange (NYSE) was approximately $90 billion.(5) By 2000 NYSE capitalization had grown to nearly $12.4 trillion.(6) Perhaps most remarkably in 2000 over $2.3 trillion in new securities was sold in some 16,481 corporate underwritings and 3,540 private placements.(7)

  Underlying these remarkable numbers was the longest sustained bull market in United States history. Focusing on year-end closing indexes, the Dow Jones Industrial Average rose from 875 in 1981 to 11,497 in 1999, paralleling similar surges in other leading composite indexes.(8) To put this in other terms, between 1981 and 1999, the NYSE stock market capitalization increased nearly 11 fold from $1.1 to $12.3 trillion.(9)

  With this unprecedented success there also appears to have come a lulling of our institutional sensibilities. A widespread belief appears to have evolved in the United States financial community that time honored rules such as those that discourage conflicts of interest are quaint and easily circumvented. Too frequently, in recent years, sharp practitioners in business, investment banking, accounting or law appear to have challenged the fundamental tenets of "full disclosure of material information" or "fair presentation of accounting results." A deterioration in the integrity of our corporate governance and mandatory disclosure systems may well have advanced, not because of a novel strain of human cupidity, but because we had so much success, for so long, that we began to forget why fundamental principles of full disclosure and corporate accountability long were considered essential.

  No recent case better illustrates this deterioration than Enron. Enron was an extraordinarily fast growing provider, primarily of natural gas, electricity, and communication products and services,(10) whose total assets quadrupled between 1996 and 2000 from $16.137 to $65.503 billion.(11) Its 2000 Form 10-K annual report filed with the SEC was a consistently upbeat review of its many claimed successes, only unusual because of Exhibit 21 to the certified financial statements which was a 49 page list of subsidiaries. In 2001 Enron was seventh on the Fortune 500 list, with revenues in 2000 of $100.8 billion.(12)

  Then, abruptly, essentially without warning, Enron melted down. A November 8, 2001 Form 8-K stunningly stated: "Enron intends to restate its financial statements for the years ended December 31, 1999 through 2000 and the quarters ended March 31 and June 30, 2001. As a result the previously-issued financial statements for those periods and the audit reports covering the year-end financial statements for 1992 to 2000 should not be relied upon."(13)

  This Committee, I know, is already familiar with the Enron Special Investigative Committee Report [Powers Report], chaired by University of Texas Law School Dean William Powers. Let me not here revisit its fact finding. I would like, however, to augment one type of fact finding made by the Special Investigative Committee.

  The Powers Report was critical of required public disclosure of the LJM partnerships which it characterized as systematically inadequate:(14)

  In Note 16 to the Enron Corp. 2000 Form 10-K, related party transactions are described in these terms:

  In 2000 and 1999, Enron entered into transactions with limited partnerships (the Related Party) whose general partner's managing member is a senior officer of Enron. The limited partners of the Related Party are unrelated to Enron. Management believes that the terms of the transactions with the Related Party were reasonable compared to those which could have been negotiated with unrelated third parties.

  In 2000, Enron entered into transactions with the Related Party to hedge certain merchant investments and other assets. As part of the transactions, Enron (i) contributed to newly-formed entities (the Entities) assets valued at approximately $1.2 billion, including $150 million in Enron notes payable, 3.7 million restricted shares of outstanding Enron common stock and the right to receive up to 18.0 million shares of outstanding Enron common stock in March 2003 (subject to certain conditions) and (ii) transferred to the Entities assets valued at approximately $309 million, including a $50 million note payable and an investment in an entity that indirectly holds warrants convertible into common stock of an Enron equity method investee. In return, Enron received economic interests in the Entities, $309 million in notes receivable, of which $259 million is recorded at Enron's carryover basis of zero, and a special distribution from the Entities in the form of $1.2 billion in notes receivable, subject to changes in the principal for amounts payable by Enron in connection with the execution of additional derivative instruments. Cash in these Entities of $172.6 million is invested in Enron demand notes. In addition, Enron paid $123 million to purchase share-settled options from the Entities on 21.7 million shares of Enron common stock. The Entities paid Enron $10.7 million to terminate the share-settled options on 14.5 million shares of Enron common stock outstanding. In late 2000, Enron entered into share-settled collar arrangements with the Entities on 15.4 million shares of Enron common stock. Such arrangements will be accounted for as equity transactions when settled.

  The first paragraph is an exercise in obfuscation. What transactions? How much money is involved? What risk is there to Enron? Who is the senior officer of Enron? How much is he or she paid? Who are the limited partners? What basis is there for management's belief that the terms of these transactions "were reasonable compared to those which could have been negotiated with unrelated parties?"

  The second paragraph is more detailed but equally confusing. Why did Enron enter into these transactions? Who is the Related Party? What risk does Enron bear?(15)

  There were other significant public disclosure issues that the Powers Report did not address in the same detail as it did related party transactions. The Report, for example, noted that the LJM2 entities had approximately 50 limited partners, "including American Home Assurance Co., Arkansas Teachers Retirement System, the MacArthur Foundation, and entities affiliated with Merrill Lynch, J.P. Morgan, Citicorp, First Union, Deutsche Bank, G.E. Capital, and Dresdner Kleinworth Benson."(16) Newspaper accounts have raised the quite troublesome possibility that at least some of these limited partners had been shown different financial statements than were publically disclosed.(17)

  The Enron debacle has raised fundamental policy and regulatory questions, notably including the following in corporate and securities law:

  (1) Perhaps most significant is the empirical question: Was Enron an isolated, but serious, breakdown or are the problems exposed there more widespread? By early February 2002 newspapers were reporting a market wide dampening of stock prices because of uncertainty whether the accounting, auditing, and corporate governance problems at Enron would prove widespread.(18) One article reported: "Last year, a study by Financial Executives International, a trade group for corporate executives, found that public companies had revised their financial results 464 times between 1998 and 2000, nearly as many restatements as in the 20 previous years combined, and the problem probably worsened last year."(19)

  Nonetheless, the hard empirical work to gauge the magnitude of dysfunction either at Enron or generally is far from complete. The more we learn about incidence, types of dysfunction, and the causes of dysfunction, the more intelligently we can consider remedies. We are still very far away from a comprehensive analysis of Enron. Systematic review of other company's SEC filings can reveal similar patterns of dysfunction, but not all, particularly , if like Enron, a key problem is unreported off balance sheet transactions.

  The first and most urgent need in the wake of Enron is not solutions, but facts.
(2) Will the type of problem illustrated by Enron prove self-correcting, at least for the foreseeable future? Already there appear to be underway SEC, Justice Department, and private investigations or litigation. The SEC has begun a series of regulatory initiatives, including proposed changes in corporate disclosure rules, that, among other points, significantly broaden the list of significant events that require current disclosure on Form 8-K.(20)

  Inevitably, without further legislative or regulatory action, it is reasonable to anticipate enhanced board review of transactions, more detailed and more precise disclosure in SEC filings, more demanding internal accounting controls and outside audits, and more skeptical investment analyst reports.

  It is too early to judge whether voluntary steps will suffice. We need both to better understand the problems involved and what voluntary steps will occur. There will be other steps from the self-regulatory organizations such as the NYSE that also need to be taken into account.(21)

  A caveat is in order here. Voluntary steps often work well when there is a mood of crisis or a fear of legislation or regulation. There is a different type of uncertainty regarding whether voluntary steps will endure after a crisis mood has abated.

  (3) If structural or standard reform does prove necessary, there appears to be broad support for focusing on accounting standard setting and auditing regulation. In mid-January 2002 SEC Chairman Harvey Pitt proposed a new industry organization that will oversee auditor discipline.(22) In response, the Public Oversight Board, shortly later, voted to disband because of concern it was being "shunted aside."(23) Regardless of the fate of the POB the time seems ripe for a systematic review of accounting standard setting by the FASB, auditing oversight by the POB and other private and state agencies, and accountant independence.(24)

  The need for significant reform of the accounting profession has been particularly stressed in recent Congressional hearings.(25)

  It is worth disaggregating several specific issues.

  The off balance sheet transactions that Enron employed were made in accordance with generally accepted accounting standards. This has appropriately focused attention on the quality of the existing accounting standard setting organization, the Financial Accounting Standards Board (FASB). Long before Enron, the political and financial weaknesses of the FASB were much discussed. As former SEC Chairman David Ruder has stated:

  Despite its attempts to seek the views of the business community, the FASB faces difficulty in obtaining financing from business, which often objects to FASB standards that affect business interests. The FASB is financed through sales of its work product and through contributions by accounting firms and businesses. When businesses do not like the FASB's standards or its process for creating then, they sometimes withdraw financial support, or fail to provide it in the first place. The FASB continually faces difficulties in financing its operations. The accounting profession is supportive, but generally speaking business is not. Institutional investors and investment bankers, who benefit greatly from financial statement disclosures, contribute little to the FAF, creating a classic free rider problem.

  I believe the solution to the financial pressures on the FASB would be to provide a system of financing . . . FASB should be financed by payments by preparers and users of financial statements. If a voluntary system cannot be established, Congress should enact legislation creating financing for the FASB.(26)

  Paul A. Volcker, now Chair of the International Accounting Standards Committee Foundation, similarly has testified:

. . . [P]roblems, building over a period of years, have now exploded into a sense of crisis. That crisis is exemplified by the Enron collapse. But Enron is not the only symptom. We have had too many restatements of earnings, too many doubts about "pro forma" earnings, too many sudden charges of billions of dollars to "good will", too many perceived auditing failures accompanying bankruptcies to make us at all comfortable. To the contrary, it has become clear that some fundamental changes and reforms will be required to provide assurance that our financial reporting will be accurate, transparent, and meaningful.(27)

  Congress or the SEC should systematically review the process and substance of accounting standard setting. It is urgently necessary to restore and strengthen the fundamental premise that financial statements will provide a "fair presentation" of an entity's financial position. This both involves addressing specific disclosure items such as off balance sheet transactions, stock options, and derivatives and strengthening the independence of accounting standard setting.

  The key here, as elsewhere, is money. You can not expect a government agency or private entity to be truly independent without an assured source of funds. Congress should explore means to legislate a user or accounting firm fee system that will provide such independence.

  Enveloping generally accepted accounting principles is the SEC mandatory disclosure system. The mandatory disclosure system deserves to be under sharp question. How could financial reporting practices sufficient to bankrupt the seventh largest industrial firm in the country so long go undisclosed? Is this simply an isolated instance of bad disclosure practices or is Enron suggestive of more systematic failure?

  The SEC has begun to grapple with the latter, more disturbing possibility. In December 2001 the Commission issued a cautionary Release on "pro forma" financial information,(28) rapidly followed by a similar statement regarding the selection and disclosure of critical accounting policies and practices,(29) and in January 2002 by a consequential and broad new interpretation of the pivotal management discussion and analysis disclosure item.(30)

  More needs to be done. The Commission and Congress should carefully review whether SEC oversight of the generally accepted accounting principles and the context of its mandatory disclosure system has unacceptably deteriorated.

  The Commission also needs to seriously and patiently review whether we today have the right construct of disclosure requirements, proceeding item by item, and whether changes in timing and delivery of data would be appropriate given evolving changes in technology and international securities trading.

  At its core Enron involved an audit failure. The outside auditor both appeared to operate with significant conflicts of interest and to have been too beholden to a highly aggressive corporate management.

  Several aspects of the Enron audit failure deserve particular attention.

  First, the Public Oversight Board, primarily responsible for overseeing SEC auditors, has been much criticized. Former SEC Chairman Harold Williams, for example, recently stated:

  The Public Oversight Board was created by the profession during my chairmanship as an effort at self-regulation. We expressed concern at the time whether the peer review process administered by the profession would be adequate. But, as believers in the principle of self-regulation, we concluded that the Board should have the opportunity to prove itself. In my opinion, the events over the intervening years have demonstrated that it does not meet the needs and is not adequate. Under the peer review system adopted in 1977, the firms periodically review each other. To my knowledge, there has never been a negative review of a major firm. However, the peer review is not permitted to examine any audits that are subject to litigation. The reviews focus on the adequacy of quality control procedures and do not examine the audits of companies to see if the peer would have arrived at a different conclusion. Peer review has proved itself insufficient. Particularly as the Big Eight has become only the Big Five, peer review in its present form becomes too incestuous. A system needs to be established which is independent of the accounting profession, transparent and able to serve both effective quality control and disciplinary functions.

  Further, the Board is not adequately funded and is beholden for its funding to the very people it is supposed to oversee. I suggest that the SEC consider a requirement that a percentage of the audit fees of public companies be assessed to pay for independent oversight, whether it is the Public Oversight Board or a successor body, so that its funding is assured.(31)

  Former SEC Chairman David Ruder would go further and replace the POB with "a new body which will be separate from the AICPA and whose board will be composed entirely of public members who have no connection to the accounting profession."(32)

  I believe at this time a new auditing self-regulatory organization is necessary. It should replace not just the POB, but a byzantine structure of accounting disciplinary bodies which generally have lacked adequate and assured financial support; clear and undivided responsibility for discipline; and an effective system of SEC oversight.

  The success of such a new SRO will be in careful attention to detail. I would recommend:

  , A legal structure similar to that in Sections 15A and 19 of the Securities Exchange Act which apply to the securities associations and other securities industry self-regulatory organizations and addresses such topics as purposes, powers and discipline.(33)

  , A clear scope provision articulating which auditors should be subject to the new SRO and a mandate that they be subject to the SRO.

  , A privilege from discovery of investigative files to facilitate auditing discipline during the pendency of other government or private litigation.

  , Crucially the new SRO should be permitted, subject to SEC oversight, to adopt new auditing standards that can evolve over time. These rules would be limited by SEC rulemaking and, of course, Congressional legislation.

  , As with the accounting standard setting body a pivotal decision involves funding. To effectively operate over time any new auditing SRO must have an assured source of funding. The most logical basis of such funding may prove to be a Congressionally mandated fee on covered auditing firms.

  , The new SRO will need to draw on the expertise of the accounting profession to ensure technical proficiency. A supervisory board with a minority of industry representatives and a majority of public representatives may prove to be an appropriate balance. The chair of such a board, however, should be a public member.

  , I believe the most significant issue may prove to be who conducts periodic examinations and inspections. To paraphrase the classical adage: Who will audit the auditors? I would urge serious consideration be devoted to replacing peer review with a professional examination staff in the new SRO. Peer review has been, to some degree, unfairly maligned. But even at its best it involves competitors reviewing competitors. The temptation to go easy on the firm you review lest it be too critical of you is an unavoidable one. While the inspection processes of the New York Stock Exchange and the NASD Reg are not panaceas, then suggest a workable improvement.

  , Finally it may prove particularly wise to statutorily replicate ?5(b)(4)(E) of the Securities Exchange Act which can impose liability on a broker-dealer who has "failed reasonably to supervise." Particularly in firms with as many offices as the leading auditing firms, a clearly delineated supervision standard strikes me as vital to effective law compliance.

  Second, a separate, not mutually exclusive approach, would be to require mandatory rotation of auditors at specific intervals such as five or seven years.(34)

  Third, particular attention has been devoted to the wisdom of separating accounting firm audit services from consulting. One early result of Enron has been an acceleration of this process by voluntary means in the Big Five accounting firms.(35) Congress or the SEC should consider whether a statute or regulation should require such separation and, if so, how best to define which consulting services and which accounting firms should be subject to the new law or rule.

  Fourth, a key SEC reform of the 1970s, the Board of Directors audit committee, has also been sharply criticized for its ineffectuality. Former SEC Chairman Roderick Hills, during whose term in 1977, the New York Stock Exchange adopted the requirement of the independent audit committee was both detailed in his delineation of shortcomings and in his proposed solutions:

  , Audit committees may consist of people who satisfy the objective criteria of independence, but their election to the board is too often the whim of the CEO, who decides each year who will sit on the audit committee and who will chair it.

  , Audit committees too often seek only to reduce the cost of the audit rather than to seek ways to improve its quality. They do not play a sufficient role in determining what the fair fee should be.

  , Audit committees seldom ask the auditor if there is a better, fairer, way to present the company's financial position.

  , Audit committees seldom play a role in selecting a new audit firm or in approving a change in the partner in charge of the audit. They may well endorse an engagement or the appointment of a new team, but they are not seen as material to the selection process.

  , Audit committees seldom establish themselves as the party in charge of the audit. . . .
Congress may wish . . . To require that:

  , Corporations of a certain size with publicly traded stock have an effective, independent audit committee in order to avoid a finding that there is a material weakness in the corporation's internal controls;

  , Corporations of a certain size have an independent nominating committee with the authority to secure new directors and appoint all members of the audit committee;

  , Audit committees be solely responsible for the retention of accounting firms and be responsible for the fees paid them.(36)

  I believe former Chairman Hills proposals should be seriously considered.
(4) A separate principal culprit at Enron was a dysfunctional corporate management, broadly potentially including senior executives, the board, board committees, internal accounting systems, the outside auditor, and both internal and outside legal counsel.(37) The genius of United States corporate law, if genius there be, is its redundant systems of corporate accountability. The Board is intended to monitor the principal executives. Outside accountants and outside legal counsel are supposed to buttress this accountability system as are a series of legal devices, most notably including board and executive potential liability for false and misleading filings with the SEC and state corporate law negligence liability.

  The overlapping accountability systems can individually fail. What made Enron unusual is that they all appeared to fail simultaneously.

  I am skeptical that similar simultaneous dysfunction will prove widespread.

  I am also mindful that poorly designed new regulatory solutions could stultify the type of product innovation and risktaking that has been consequential to the recent growth of the United States economy.

  I am also aware that corporate governance has largely been addressed by state corporate law.

  At the federal level, I anticipate that reforms related to the dysfunction in Enron management will be indirect, based on the more effective use of the mandatory disclosure system and litigation, rather than direct such as proposals for the SEC to audit each registered firm or select directors. Among other proposals that should be thoughtfully reviewed will be:

  First, increasing the size of the SEC staff to increase the number of filings reviewed and enforcement investigations conducted.(38)

  Second, considering whether to strengthen private enforcement of the federal securities laws by reviewing whether the Private Securities Litigation Reform Act of 1995 has deterred or needlessly delayed meritorious lawsuits.(39)

  Third, considering whether it would be wiser to permit private aiding and abetting actions against attorneys and auditors and reverse through legislation the 1994 United States Supreme Court decision in Central Bank,(40) which held that such actions could not be implied from the key federal securities law fraud remedy, Securities Exchange Act Rule 10b-5.(41)

  (5) One step removed from Enron, but strongly suggested by its failure are serious questions of the integrity of investment analysts. As former SEC Chairman Arthur Levitt, Jr. emphatically testified in February 2002:

. . . For years, we've known that analysts' compensation is tied to their ability to bring in or support investment banking deals. In early December, with Enron trading at 75 cents a share, 12 of the 17 analysts who covered Enron, rated the stock either a hold or buy.

  Two years ago, I asked the New York Stock Exchange and the National Association of Securities Dealers to require investment banks and their analysts to disclose clearly all financial relationships with the companies they rate. Last week, we finally saw a response from the self-regulators. But it's not enough. Wall Street's major firms - not its trade group - need to take immediate steps to reform how analysts are compensated. As long as analysts are paid based on banking deals they generate or work on, there will always be a cloud over what they say.(42)

  Congress should broadly investigate whether investment banks have adequately maintained "Chinese walls" between retail brokerage and underwriting and whether, more fundamentally, securities firms that underwrite should be separated from retail brokerage.(43) These are not new questions(44) but they have been revived by Enron.

  I am skeptical that separation here will prove wise. But, to put the matter bluntly, the quality of investment advice has raised fundamental questions.

  An alternative approach worth considering would be a new form of adviser liability for recommendations without a reasonable basis. Increased SEC inspection cycles to review the basis of adviser recommendations is also now in order.


  There will be other proposals, both within the framework of corporate and securities law and without, no doubt, that should receive serious consideration. At its core Enron was a triumph of aggressive and financial chicanery over time honored concepts such as "fair presentation" of financial information and "full disclosure" of material information.

  After thoughtful and diligent investigation, I anticipate at least one inevitable result. Our traditional commitment to avoiding or fully disclosing conflicts of interest will be systematically reinvigorated.


1. 48 Harv. L. Rev. 1, 8 (1934)

2. There are now seven federal securities law: The Securities Act of 1933, 15 U.S.C. 77a; the Securities Exchange Act of 1934, 15 U.S.C.78a; the Public Utility Holding Company Act of 1935, 15 U.S.C. 79; the Trust Indenture Act of 1939, 15 U.S.C. 77aaa; the Investment Company Act of 1940, 15 U.S.C.80a-1; the Investment Advisers Act of 1940, 15 U.S.C. 80b-1; and the Securities Investor Protection Act of 1970, 15 U.S.C. 8aaa. For general description, see 1 Louis Loss & Joel Seligman, Securities Regulation 224-273 (3d ed. Rev. 1998).

3. Cf. Joel Seligman, The Obsolescence of Wall Street: A Contextual Approach to the Evolving Structure of Federal Securities Regulation, 93 Mich. L. Rev. 649, 654 (1995); N.Y. Stock Exch., Fact Book, 55-56 (2000).

4. Seligman, supra n.3, at 658.

5. Joel Seligman, The Transformation of Wall Street 1 (rev. ed. 1995).

6. Securities Indus. Assoc., 2001 Securities Industry Fact Book at 48.

7. Id. At 12.

8. Id. At 54.

9. Id. At 48.

10. Enron Corp. Form 10-K Item 1 - Business General.

11. Id., Item 6 - Selected Financial Data.

12. Fortune, Apr. 16, 2001 at F-1.

13. Item 5, Enron Corp. Form 8-K (Nov. 8, 2001)

14. [T]hese disclosures were obtuse, did not communicate the essence of the transactions completely or clearly, and failed to convey the substance of what was going on between Enron and the partnerships. The disclosures also did not communicate the nature or extent of Fastow's financial interest in the LJM partnerships. This was the result of an effort to avoid disclosing Fastow's financial interest and to downplay the significance of the related-party transactions and, in some respects, to disguise their substance and import. The disclosures also asserted that the related-party transactions were reasonable compared to transactions with third parties, apparently without any factual basis. The process by which the relevant disclosures were crafted was influential substantially by Enron Global Finance (Fastow's group). There was an absence of forceful and effective oversight by Senior Enron Management and in-house counsel, and objective and critical professional advice by outside counsel at Vinson & Elkins, or auditors at Andersen.
Id. At 17.

15. The Powers Report concluded:

Overall, Enron failed to disclose facts that were important for an understanding of the substance of the transactions. The Company did disclose that there were large transactions with entities in which the CFO had an interest. Enron did not, however, set forth the CFO's actual or likely economic benefits from these transactions and, most importantly, never clearly disclosed the purposes behind these transactions or the complete financial statement effects of these complex arrangements. The disclosures also asserted without adequate foundation, in effect, that the arrangements were comparable to arm's-length transactions. We believe that the responsibility for these inadequate disclosures is shared by Enron Management, the Audit and Compliance Committee of the Board, Enron's in-house counsel, Vinson & Elkins, and Andersen.

Id. At 178.

16. Id. At 73.

17. A Fog Over Enron, and the Legal Landscape, N.Y. Times, January 27, 2002. Cf. McGeehan, Enron's Deals Were Marketed to Companies by Wall Street, N.Y. Times, Feb. 14, 2002 at C1.

18. Berenson, The Biggest Casualty of Enron's Collapse of Confidence, N.Y. Times Feb. 10, 2002 at ? At 1.

19. Ibid.

20. SEC to Propose New Corporate Disclosure Rules, Press Rel. 2002-22 (February 13, 2002). This Press Release explained in part:

The Commission believes that markets and investors need more timely access to a greater range of important information concerning public companies than what is required by the existing reporting system. Accordingly, the Commission intends to expand the types of information that companies must report on Form 8-K. Some of the items that the Commission is evaluating for inclusion in these reports include:

, Changes in rating agency decisions and other rating agency contacts;

, Transactions in the company's securities, including derivative securities, with executive officers and directors;

, Defaults and other events that could trigger acceleration of direct or contingent obligations;

, Transactions that result in material direct or contingent obligations not included in a prospectus filed by the company with the Commission;

, Offerings of equity securities not included in a prospectus filed by the company with the Commission;

, Waivers of corporate ethics and conduct rules for officers, directors and other key employees;

, Material modifications to rights of security holders;

, Departure of the company's CEO, CFO, COO or president (or persons in equivalent positions);

, Notices that reliance on a prior audit is no longer permissible, or that the auditor will not consent to use of its report in a Securities Act filing;

, Definitive agreement that is material to the company . . .;

, Any loss or gain of a material customer or contract;

, Any material write-offs, restructurings or impairments;

, Any material change in accounting policy or estimate;

, Covement or de-listing of the company's securities from one quotation system or exchange to another; and

, Any material events, including the beginning and end of lock-out periods, regarding the company's employee benefit, retirement and stock ownership plans.

Given the significance of current disclosure of these events to participants in the secondary markets, the Commission intends to propose that companies file reports of these events no later than the second business day following their occurrence. The Commission also is considering whether some of these events require filing by the opening of business on the day after the occurrence of the event.

21. See, e.g., SEC Review of Corporate Governance, Conduct Rules, SEC Press Rel. 2002-23 (February 13, 2002).

22. See Schroeder, SEC Proposes Accounting Disciplinary Body, Wall St. J., Jan. 17, 2002 at C1; Pitt Elaborates on Proposal for New Board to Govern Accountants, Asks for Dialogue, 34 Sec. Reg. & L. Rep. (BNA) 153 (2002).

23. In Protest, POB Votes to Disband; Panel to Consider SEC Chief's Urging Reversal, 34 Sec. Reg. & L. Rep. (BNA) 154 (2002).

24. See, e.g., Former SEC Chairman Levitt Renews Call for Additional Restrictions on Auditing Firms, 34 id. 155; Accounting Debacles Spark Calls for Change: Here 's the Rundown, Wall St. J., Feb. 6, 2002 at C1; Leonhardt, How Will Washington Read the Signs? N.Y. Times, Feb. 10, 2002 at ? At 1.

25. Former SEC Chairman Roderick M. Hills, for example, testified on February 12, 2002 to the Senate Committee on Banking, Housing & Urban Affairs:

. . . The system itself needs a major overhaul. The head of NYU's Accounting Department, Paul Brown, put it well:

"It's the old adage of a F.A.S.B. rule. It takes four years to write it, and it takes four minutes for an astute investment banker to get around it."

Second, it is increasingly clear that the accounting profession is not able consistently to resist management pressures to permit incomplete or misleading financial statements, and the profession has serious problems in recruiting and keeping the highly qualified professionals that are needed.

Third, the audit committees of too many boards are not exercising the authority given to them or the responsibility expected of them. . . .

The financial papers produced dutifully each year by publicly traded companies have become a commodity. Companies produce them largely because they are required to do so. Few CEO's regard this work product as having any intrinsic value. Accounting firms compete for business more on price than on the quality of their personnel or procedures.

If a company does take an interest in the structure of its balance sheet and profit and loss statement, it is far more likely to be caused by a desire to be innovative in how they report their profits than in the quality of the auditor's work. They hire bankers and consultants to design corporate structures that will give them a stronger looking balance sheet and, perhaps, keep the profits and losses of related companies off of their financial papers.

Senate Comm. On Banking, Housing & Urban Affairs, Hearing on "Accounting and Investor Protection Issues Raised in Enron and Other Public Companies," Feb. 12, 2002 (Testimony of Roderick M. Hills) at 1-2.

26. Senate Comm., supra n. 25 (Testimony of David S. Ruder) at 5-6.

After the bankruptcy of Enron in December 2001, SEC Chairman Harvey Pitt published How to Prevent Future Enrons, Wall St. J., Dec. 11, 2001 at A18, which stated in part:

, Private-sector standard setting that responds expeditiously, concisely and clearly to current and immediate needs. A lengthy agenda that achieves its goals too slowly, or not at all, like good intentions, paves a road to the wrong locale.

, An effective and transparent system of self-regulation for the accounting profession, subject to our rigorous, but non-duplicative, oversight. As the major accounting firm CEOs and the American Institute of Certified Public Accountants recently proposed, the profession, in common with us, must provide assurances of comprehensive and effective self-regulation, including monitoring adherence to professional and ethical standards, and meaningfully disciplining firms or individuals falling short of those standards. Such a system has costs, but those who benefit from the system should help absorb them.

See also Pitt Renews Call for Modernization of Disclosure, Regulatory Processes, 33 Sec. Reg. & L. Rep. (BNA) 1630 (2001).

27. Senate Comm., supra n. 25 (Testimony of Paul A. Volcker Feb. 14, 2002) at 1.

28. Sec. Act Rel. 8039, 76 SEC Dock. 896 (2001).

29. Sec. Act Rel. 8040, 76 SEC Dock. 983 (2001).

30. Sec. Act Rel. 8056, ___ SEC Dock. ____ (2002).

This Commission statement delineated additional disclosure that should occur concerning (1) off balance sheet arrangements, (2) commodity contracts, including those indexed to measures of weather, commodity prices, or quoted prices of service capacity, such as energy and bandwidth capacity contracts; and (3) related party transactions. The Commission statement was premised on the assumption that Item 303(a) of Regulation S-K already requires disclosure of "known trends" or "known uncertainties" that could result in a registrant's liquidity or capital resources increasing or decreasing in a material way.

31. Senate Comm., supra n. 25 (Testimony of Harold M. Williams) at 3.

32. Senate Comm., supra n. 25 (Testimony of Ruder) at 4. Ruder explains in ibid:

The POB has functioned well in the past, and there is much to learn from its organization and operations. However, although the POB's powers have been strengthened, it does not have sufficient budget to allow it to function effectively. It does not have the power to force accounting firms to provide the documents necessary to complete investigations, nor does it have the power to promise that documents received will be protected against discovery in private litigation. It is forced to rely upon the accounting profession itself to engage in enforcement activities. Most important, its connection to the AICPA creates an appearance of control by that body.

33. 6 Louis Loss & Joel Seligman, Securities Regulation 2692-2723, 2787-2830 (3d ed. 1990).

34. Former SEC Chairman Harold Williams has advocated this approach:

I would urge the Commission to consider a requirement that a public company retain its auditor for a fixed term with no right to terminate. This could be for five years or perhaps the Biblical seven. After that fixed term, the corporation would be required to change auditors. As a consequence of such a requirement, the auditor would be assured of the assignment and, therefore, would not be threatened with the loss of the client and could exercise truly independent judgment. Under such a system the client would lose its ability to threaten to change auditors if in its judgment the assigned audit team was inadequate. It would also reduce the client's ability to negotiate on fees, and almost certainly the audit would cost more. The required rotation of auditors would also involve the inefficiency of the learning curve for the new auditor. I view all of these potential costs acceptable if it reinforces the auditor's independence and makes the work more comprehensive. The client could be given a right to appeal to a reconstituted independent oversight organization if it believes that it is not well served by its auditor and needs some relief.

Senate Comm., supra n. 56 (Testimony of Williams) at 2.

35. Former Chairman David Ruder thoughtfully explained:

One of the substantial worries regarding the Andersen audit of Enron has been that Andersen not only audited Enron, but also was paid approximately the same amount for non-audit services. It has been reported that in the year 2000 Andersen was paid audit fees of approximately $25 million and non-audit fees of approximately $27 million. Comparisons of the amounts of audit fees to non-audit fees for a range of companies and auditors have revealed ratios of non-audit to audit fees ranging as high as nine to one. The expressed general concern is that an audit cannot be objective if the auditor is receiving substantial non-audit fees.

The accounting profession seems to have recognized that management consulting services, which involve accounting firms in helping management make business decisions, should not be performed for an audit client. Three of the Big Five accounting firms (Andersen, Ernst & Young, and KPMG) have now separated their management consulting units from their audit units by contractual splits and spinoffs, and a fourth (PricewaterhouseCoopers) has announced its intention to split off its management consulting unit in a public offering. (Wall Street Journal, p3, January 31, 2002) The fifth firm should also do so, or at least refrain from offering management consulting services to audit clients.

Senate Comm., supra n. 25 (Testimony of Ruder) at 2.

36. Senate Comm., supra n. 25 (Testimony of Hills) at 5, 8.

37. As Former SEC Chairman David Ruder testified:

The primary fault in the Enron failure seems to be poor management . From all accounts it appears that Enron became overly aggressive in its efforts to dominate the energy trading markets, engaged in highly leveraged off balance sheet financing, engaged in extremely aggressive accounting, overstated its earnings, failed to disclose the true nature of its corporate and financial structure, and eventually lost the confidence of its creditors and trading counter parties. Enron management appears to be primarily to blame. . . .

. . . The Enron problems represent a failure in corporate governance. One striking aspect of this failure is Enron's apparent lack of respect for the accounting system that underlies financial reporting. Enron seems to have purposely attempted to avoid disclosure of its true finances. Instead it should have utilized the accounting system as a means of assisting it to make sound management decisions and as a source of information helping it to provide the securities markets with a truthful statement of financial condition.

Senate Comm., supra n. 25 (Testimony of Ruder) at 6-7.

Similarly Former Chairman Hills observed:

Finally, it must be said on this point that unless one has been subjected to a serious corporate meltdown, you cannot possibly appreciate the enormous discretion that management has under GAAP to present its financial position. By changing depreciation schedules, by using different estimates or by adopting different strategies or assumptions, a company can make enormous changes in its annual income. Management too often makes these "top-level" adjustments without adequate disclosure to the public about how much their current earnings depend on such adjustments. A corporate meltdown in which I was involved three years ago was caused by top-level adjustments that accounted for 40% of the company's total income and led to a corporate admission that billions of dollars of income had been improperly reported.

Senate Comm., supra n. 25 (Testimony of Hills) at 3.

38. Cf. Norris, Will SEC's Needs Be Met? Not by Bush, N.Y. Times, Feb. 8, 2002 at C1.

39. See 10 Louis Loss & Joel Seligman, Securities Regulation 4636-4669 (3d ed. Rev. 1996).

40. Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994).

41. 9 Louis Loss & Joel Seligman, Securities Regulation 4479-4488 (3d ed. 1992 & 2001 Ann. Supp.).

42. Senate Comm., supra n. 56 (Testimony of Arthur Levitt, Jr.) at 2.

43. Wayne, Congress's Scrutiny Shifts to Wall Street and Its Enron Role, N.Y. Times, Feb. 19, 2002 at A1.

44. See, e.g., 6 Louis Loss & Joel Seligman, Securities Regulation 2977-2980 (3d ed. 1990). (Proposed segregation of brokerage and underwriting in 1930s), Louis Loss & Joel Seligman, Securities Regulation 3618-3631 (3d ed. 1991) (Chinese Wall).