Post-Enron, Congress Must Reassure Investors

After Enron, the accounting and securities industries are in the same uncomfortable position as the airlines after Sept. 11.

To reassure fliers wary of the skies after the terrorist hijackings, the airline industry had to accept a long list of federal safety regulations it had long grounded. Likewise, to lure back investors fearful of more Enron-like accounting scandals, the investment industries may now have to accept new federal investor protections they have long blocked. That makes this a good time to think boldly about reforming not only the accounting process, but the safeguards built into the basic governing structure of public corporations.

It’s important for Congress to act quickly, before the Enron outrage fades and the special interests now lying low reassert themselves. Accounting is a good place to start. Enron Corp. has revealed a breakdown at every level, from standard-setting and regulation to the individual accounting firms flyspecking the books in an audit.

The problem starts with the obscure Financial Accounting Standards Board, which writes the rules companies follow in reporting their financial results. Dominated by the accounting industry and whipsawed by political pressures, the board has proved incapable of establishing standards that produce revealing financial reports. At times the board has become incapable of producing any decision at all; with powerful companies resistant to true disclosure, the board has spent 20 years debating the rules governing the sort of off-books subsidiaries central to the Enron scandal. Like Penelope at her loom in the “Odyssey,” the point of the exercise increasingly appears to be the delay itself.

“FASB seems to be incapable of crafting rules that ensure that the economic reality of corporate performance gets disclosed in the face of opposition from the management of those corporations, their auditors, and the politicians they have contributed money to,” says Damon Silvers, associate general counsel at the AFL-CIO.

As Silvers suggests, Congress can be part of the problem; the only time legislators usually pay attention to FASB is to lobby against proposals that powerful interests don’t like (such as the board’s failed attempt a few years ago to require that companies list stock options for executives as an expense on their balance sheets). But Congress could become part of the solution. Sens. Christopher J. Dodd (D-Conn.) and Jon Corzine (D-N.J.) are drafting legislation that would reduce the board’s dependence on industry financing and impose time limits on its decision-making. Even if that bill doesn’t pass, it could become a lever to force overdue changes at the board.

The next breakdown has been in the industry’s self-regulatory organizations that are supposed to oversee and discipline auditors. Harvey Pitt, the former accounting industry lawyer whom President Bush named to chair the Securities and Exchange Commission, has proposed replacing the anemic system of industry self-policing with a still-amorphous new oversight panel that would include representatives from inside and outside the accounting business. Investor advocates want to maximize the new body’s independence from the accounting firms and its power to investigate and sanction. Given Pitt’s long-standing skepticism of federal regulation, it probably will take sustained pressure to ensure any meaningful change.

In 2000, an accounting industry-generated uprising in Congress forced Arthur Levitt, President Clinton’s chairman of the SEC, to drop a proposal to bar accounting firms from consulting for the companies they also audit. It’s a measure of the changed environment that all of the Big Five accounting firms now are voluntarily pledging to construct more walls between auditing and consulting.

Congress may seek to strengthen their resolve by writing those prohibitions into law. But watchdog groups say it’s a mistake to think that barring auditors from consulting will ensure their independence. The problem is more fundamental, says Sarah Teslik, executive director of the Council of Institutional Investors, a coalition of 250 pension funds controlling nearly $2 trillion in assets. “As long as management hires the auditors, they will be conflicted,” she says. “You can talk all you want about self-regulation and public oversight, but as long as your bread is buttered by the people who want you to bless their books, you are going to bless their books.”

Rep. Richard H. Baker (R-La.), chairman of the House Financial Services subcommittee on capital markets, is floating the most intriguing and imaginative response to that dilemma. Baker is asking whether it would be feasible to shift responsibility for hiring and paying auditors from individual companies to the stock exchanges (which could fund the cost with fees on their members). As Baker noted last week, such a shift “would change the culture on Wall Street and across America.” It’s an idea well worth exploring.

But any combination of accounting reforms will only address part of the challenge. The first line of defense against management misconduct has to be a company’s board of directors. Too few now play that role.

One way to strengthen oversight would be to fortify the independence of corporate boards. In a reform package last week, the Council of Institutional Investors proposed that publicly traded companies be required to fill a majority of their boards with directors independent from management. The council also urged that the SEC toughen the standard of what constitutes an independent director to eliminate subtle conflicts, such as contributions from company management to charities tied to board members. An extensive AFL-CIO investigation last month found that four of the eight ostensibly independent Enron board members had ties to management that current SEC rules did not require them to reveal.

Beyond these structural and regulatory changes, the best way to ensure more vigilant corporate boards may be the power of example. Providing jail time, and not just fines, for any Enron executives or board members who are found to have broken the law could focus the attention of corporate boards in a way that reams of new regulations may not. “It is,” Teslik says, “probably the single easiest, cheapest reform that could occur to make corporate boards do their job.”

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Ronald Brownstein’s column appears every Monday. See current and past Brownstein columns on The Times’ Web site at: http://arstechnica.netblogpro.com/brownstein.