1 107th Congress "!S. PRT. 2d Session COMMITTEE PRINT 107–75 FINANCIAL OVERSIGHT OF ENRON: THE SEC AND PRIVATE-SECTOR WATCHDOGS R E P O R T PREPARED BY THE STAFF OF THE COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE OCTOBER 7, 2002 U.S. GOVERNMENT PRINTING OFFICE 82–147 PDF WASHINGTON : 2002 For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800 Fax: (202) 512–2250 Mail: Stop SSOP, Washington, DC 20402–0001 VerDate 11-MAY-2000 09:59 Oct 16, 2002 Jkt 000000 PO 00000 Frm 00001 Fmt 5012 Sfmt 5012 82147.TXT SAFFAIRS PsN: SAFFAIRS COMMITTEE ON GOVERNMENTAL AFFAIRS JOSEPH I. LIEBERMAN, Connecticut, Chairman CARL LEVIN, Michigan FRED THOMPSON, Tennessee DANIEL K. AKAKA, Hawaii TED STEVENS, Alaska RICHARD J. DURBIN, Illinois SUSAN M. COLLINS, Maine ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio MAX CLELAND, Georgia THAD COCHRAN, Mississippi THOMAS R. CARPER, Delaware ROBERT F. BENNETT, Utah JEAN CARNAHAN, Missouri JIM BUNNING, Kentucky MARK DAYTON, Minnesota PETER G. FITZGERALD, Illinois JOYCE A. RECHTSCHAFFEN, Staff Director and Counsel LAURIE R. RUBENSTEIN, Chief Counsel BETH M. GROSSMAN, Counsel CYNTHIA GOOEN LESSER, Counsel JOHN N. WANAT, Congressional Fellow RICHARD A. HERTLING, Minority Staff Director GARY M. BROWN, Minority Special Counsel DARLA D. CASSELL, Chief Clerk (II) VerDate 11-MAY-2000 09:59 Oct 16, 2002 Jkt 000000 PO 00000 Frm 00002 Fmt 5904 Sfmt 5904 82147.TXT SAFFAIRS PsN: SAFFAIRS C O N T E N T S Page INTRODUCTION .................................................................................................... 1 PART ONE: THE SEC AND OTHER WATCHDOGS WITH LEGAL OBLIGATIONS ................................................................................................... 6 I. BACKGROUND ................................................................................................ 7 A. The SEC ....................................................................................................... 7 1. Mission and Organization ........................................................................ 7 2. Review of Public Filings ........................................................................... 8 3. Enforcement .............................................................................................. 11 B. Private-Sector Gatekeepers ......................................................................... 13 1. Boards of Directors ................................................................................... 13 2. Auditors ..................................................................................................... 16 II. EXPERIENCE WITH ENRON ...................................................................... 20 A. Private-Sector Gatekeepers ......................................................................... 21 1. Enron’s Auditor ......................................................................................... 21 2. Enron’s Board of Directors ....................................................................... 22 B. The SEC ....................................................................................................... 23 1. Review of Enron’s Public Filings ............................................................. 24 2. Enron’s Shift to Mark-to-Market Accounting ......................................... 31 3. Exemptions from the Public Utility Holding Company Act .................. 36 4. Exemption from the Investment Company Act of 1940 ......................... 43 III. RECOMMENDATIONS ................................................................................ 46 PART TWO: MORE WATCHDOGS—WALL STREET SECURITIES ANALYSTS AND CREDIT RATING AGENCIES ........................................ 52 I. ENRON AND THE WALL STREET ANALYSTS ......................................... 53 A. Investment Research Analysts ................................................................... 54 B. The Wall Street Analysts’ Assessments of Enron ..................................... 55 C. Factors Affecting the Objectivity of Sell-Side Analyst Recommenda- tions .............................................................................................................. 62 D. Solutions ....................................................................................................... 69 II. ENRON AND THE CREDIT RATING AGENCIES ..................................... 76 A. History and Uses of Credit Ratings ........................................................... 77 B. Efforts to Regulate Credit Rating Agencies ............................................... 80 C. Chronology of Enron’s Ratings ................................................................... 84 D. Problems With the Agencies’ Analyses and Actions ................................. 89 E. Conclusions and Recommendations ........................................................... 98 APPENDIX: Note 16 to Financial Statements, Enron Corp. Form 10–K for the Year Ended December 31, 2000 ............................................. 100 (III) VerDate 11-MAY-2000 09:59 Oct 16, 2002 Jkt 000000 PO 00000 Frm 00003 Fmt 5904 Sfmt 5904 82147.TXT SAFFAIRS PsN: SAFFAIRS VerDate 11-MAY-2000 09:59 Oct 16, 2002 Jkt 000000 PO 00000 Frm 00004 Fmt 5904 Sfmt 5904 82147.TXT SAFFAIRS PsN: SAFFAIRS FINANCIAL OVERSIGHT OF ENRON: THE SEC AND PRIVATE-SECTOR WATCHDOGS OCTOBER 7, 2002 INTRODUCTION On December 2, 2001, Enron Corp. (together with its subsidi- aries, collectively referred to in this report as ‘‘Enron’’) filed for bankruptcy protection, making it—at the time—the largest com- pany to declare bankruptcy in the nation’s history.1 Enron’s col- lapse deprived thousands of employees of their jobs, severely dimin- ished their retirement savings, and led to the loss of billions of shareholder dollars. Perhaps most significantly, the company’s fail- ure and the months of revelations that followed triggered a crisis in investor confidence in U.S. capital markets. The repercussions of Enron’s collapse continue to be felt today. The misdeeds that led to Enron’s demise were, in the first in- stance and ultimately, the responsibility of Enron and its manage- ment. Enron, however, functioned within a larger environment con- sisting of private and public entities alike that were supposed to monitor or regulate the company’s activities and public disclosures. In January 2002, Senate Committee on Governmental Affairs Chairman Joseph I. Lieberman and Ranking Member Fred Thomp- son initiated a wide-ranging review of the actions of the various governmental and private watchdogs that were supposed to mon- itor Enron’s activities and help protect the public against these sorts of calamities. The Chairman and Ranking Member charged the Committee with examining whether these watchdogs did their jobs correctly and whether different actions by those watchdogs could have prevented—or at least detected earlier—the problems that have come to be associated with Enron. The Committee took a broad look at a range of entities that play some role in monitoring the financial activities of publicly held companies, from the company’s Board of Directors to the account- ing firm that audited Enron’s books to stock analysts and credit rating agencies that purported to give the public accurate and ob- jective information about Enron’s financial health.2 The Committee 1 Since that time, WorldCom has superseded Enron as the largest corporate bankruptcy. See Simon Romero and Riva D. Atlas, ‘‘WorldCom’s Collapse: The Overview; WorldCom Files for Bankruptcy; Largest U.S. Case,’’ The New York Times, July 22, 2002. 2 The Committee’s Permanent Subcommittee on Investigations (‘‘PSI’’) also has been inves- tigating aspects of Enron’s collapse, and has held a series of hearings on the role of Enron’s Board of Directors and the role of financial institutions in Enron’s collapse. See The Role of the Board of Directors in Enron’s Collapse, Hearing Before the Permanent Subcommittee on Inves- tigations, Senate Governmental Affairs Committee, 107th Cong., S. Hrg. 107–511 (May 7, 2002); The Role of Financial Institutions in Enron’s Collapse, Hearing Before the Permanent Sub- committee on Investigations, Senate Governmental Affairs Committee, 107th Cong., S. Hrg. 107–618 (July 23 and 30, 2002) (Printed Hearing Record Pending). PSI also has issued a report on the role of the Board of Directors in its collapse. See Report of the Senate Permanent Sub- Continued (1) VerDate 11-MAY-2000 09:59 Oct 16, 2002 Jkt 000000 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 82147.TXT SAFFAIRS PsN: SAFFAIRS 2 placed a particular focus on the most important watchdog of all, the Securities and Exchange Commission (the ‘‘SEC’’ or the ‘‘Com- mission’’). Each of these entities plays a particular role in moni- toring our capital markets. Together, they are supposed to ensure that the markets operate fairly, with complete, accurate and com- prehensible information available to all investors. In looking at the array of purported checks on financial mis- behavior, what Committee staff discovered was deeply disturbing— not so much because they uncovered malfeasance or intentional wrongdoing on anyone’s part (although that seems to have been present in some cases as well), but because what emerged was a story of systemic and arguably catastrophic failure, a failure of all the watchdogs to properly discharge their appointed roles. Despite the magnitude of Enron’s implosion and the apparent pervasive-