TCS Daily


After Enron

By James K. Glassman - June 17, 2002 12:00 AM

After any breakdown of a public institution, politicians feel the urge to "fix" things so it doesn't happen again. Often, however, the cure is worse than the disease. That's the case with the proposed remedies following the collapse of Enron.

Why does Congress need to do anything in the first place? The Enron scandal was primarily a story of executives and auditors deceiving investors about the true state of a business. If it was "greed" that caused the deception, it was greed that uncovered it as well. James Chanos, a money manager who specializes in short-selling (speculating that a stock's price will fall), got wind of Enron's shenanigans, and tipped off a reporter at Fortune. Enron was forced to restate its earnings and acknowledge hidden debts.

Investors reacted with fury, dump-ing Enron stock. The company's worth declined from $30 billion to almost nothing. Before any indictment or government report, the market pronounced Enron guilty and imposed a sentence of capital punishment. Then longtime clients started punishing Arthur Andersen, Enron's auditor. Delta ended its 53-year relationship with the auditor, as did Merck and Freddie Mac. Andersen, and the executives who allowed it to stray, face oblivion.

This is just what we want markets to do: Exact justice quickly and brutally. There are already plenty of laws against fraud to handle corporate executives who lie. Punishments meted out by markets and legal authorities serve as a powerful demonstration to others. The Enron reaction from many corporations, like General Electric, has been to issue even more detailed annual reports. Investors have battered the stocks of any firms they suspect of being dishonest.

Is a further response needed? Just one. If Congress really wants to help investors analyze complex corporations, it should encourage firms to issue dividends. Quarterly payouts are the most accurate manifestation of a company's health; it's hard to monkey with cash. But dividends have been on the decline-mainly because they are taxed twice at high rates, first at the corporate level, and then again when the individual receives them. If Congress ended this double taxation, shareholder dividends would recover, and small investors would regain a powerful tool for separating real successes in business from the impostors.

Congress, however, is focusing on something completely different: what's called "auditor independence." The idea is that there's a terrible conflict of interest when an accounting firm both audits a company's books and provides it with consulting services like designing its financial computer systems.

The Securities & Exchange Commission began looking at this situation back in the 1950s, and several studies have been conducted since then-producing no empirical evidence that the combination of auditors and consultants in the same firm causes distorted audits. None of the studies recommended separating auditing from consulting.

Andersen earned just about the same amount from Enron for auditing as for consulting, and no one has claimed that Andersen fudged one to protect the other. In any case, if auditors could be bribed by giving them non-audit work, wouldn't it be even easier to bribe them by simply paying extra premiums for audit work?

Members of Congress have complained that Enron employees owned too much stock in their own company. They did. A year ago, roughly 60 percent of the assets in the average Enron worker's 401(k) retirement plan consisted of company stock. That's far too many eggs to put in one basket.

Senator Ted Kennedy (D-MA) claimed in a press release that "the main reason why Enron workers lost more than a billion dollars is that they were pressured by Enron executives to put all their 401(k) money in the company." He's wrong. Most Enron employees put nearly all their personal 401(k) contributions into mutual funds; Enron then matched those contributions with free company stock, which quadrupled in value between 1997 to 2000. The result was a lopsided portfolio with too much Enron and not enough diversified mutual funds.

But the solution is not to put hard limits on what 401(k) holders can own;

it is to remind Americans that they are responsible for their own investments. No government can prevent every economic calamity. We can only make sure that markets, free to respond, will crush miscreants and warn other crooks not to follow in their footsteps.

This article first appeared in The American Enterprise magazine.
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