|September 18, 2002
|Robert F. GRONDINE(President, American Chamber of Commerce in Japan / Partner, White & Case LLP)
|AKAISHI Koichi(Fellow, RIETI)
The debacle of Enron Corp. is quite an interesting case to study for a legal expert but it caused a great deal of trouble to the world. It has long been said in the United States that it is impossible to completely prevent scams by those who intend to defraud. Since 1925, efforts have been made to hunt down fraudulent market manipulations, but stock market scandals continue to occur. The Securities and Exchange Commission was established in the 1930s to reinforce efforts to crack down wrongdoings, but we have been unable to completely eradicate fraudulent acts. The recent Enron case occurred despite the fact that the company had been under the supervision of external professionals. Scandals have been taking place almost regularly all across the world and it seems that Japan is trailing the U.S. by 20 to 30 years.
In the U.S., too, corporate governance of a closed nature used to be predominant. With the emergence of the 401(k)-type defined contribution pension scheme in the 1970s, however, institutional investors have grown influential. Increased volume of investment trusts under their management triggered the change of tide. The 1980s saw a significant rise in the number of independent board directors. Investors' actions activated in the early 1990s when the chief executive officer of General Motors Corp. was ousted. Under the corporate governance listing standards set by the New York Stock Exchange (NYSE), listed companies have been required to have at least two independent board directors. Following the Enron debacle, it is now moving to heighten the hurdle to require majority-independence. Meanwhile, despite the explosive increase in trading volume in the 1980s and 1990s, the number of SEC staffers remains flat. Former U.S. President Bill Clinton attempted to reinforce the SEC function but failed to do so as the Congress rejected to give its approval to the relevant budget proposal. Consequently questions were raised as to whether the SEC, being scarce both in budget and staff, is capable of conducting strict inspections. Today, the SEC functions are being strengthened.
Revelation of Enron Debacle
Enron, founded a small gas pipeline company in 1986 by taking advantage of the deregulatory moves at the time, grew rapidly through mergers and acquisitions. The company continued to ride on the wave of subsequent deregulations to begin trading of gas, electricity and bandwidth from around the mid 1990s. All those years, Enron had been highly evaluated on the market. In 2001, Forbes magazine listed Enron as the 5th largest earner in the U.S. An excessive adherence to maintaining the growth throughout the decade, however, led to the inception of the problem. In the early 1990s, Enron set up a joint fund with California Public Employees' Retirement System (CalPERS). The management of the fund went well in its initial period. When CalPERS cashed out of the fund to invest in a second joint fund with Enron, Enron tried but failed to find a new partner to take over the CalPERS portion of the first fund. Instead of liquidating the fund, however, Enron kept the fund going by concocting a fictive investment entity and kept the fund off its balance sheet. The fund, thus, became an internal investment by Enron rather than by a third party. And this was the beginning of Enron's downfall. From now on, it must be investigated who actually got involved in those investment schemes, whether Arthur Andersen and the management of Enron knew what were going on. These points will be eventually clarified in the course of criminal proceedings. At the moment, Arthur Andersen is insisting that they had no knowledge of this.
There is also the question of possible conflicts of interest in the transactions between Enron and its executive officer as an individual. It has been reported that the chief financial officer of Enron had been making profits through a private partnership. Also, the possibility has been cited that investment banks might have been involved in the scam. Indeed, it is quite strange that no one had read Enron's disclosure materials carefully in an investment case worth hundreds of millions of dollars. In addition to insufficient supervision and risk management, I cannot help wondering just what board directors were doing. Enron had been growing rapidly over a period of 10 years and the board was extremely lenient on Chief Executive Officer Kenneth Lay who was producing "results." Lay said he had no knowledge of wrongdoings but such a remark from a CEO is unacceptable.
Whether an act by an Enron independent director amounts to an insider trading is posing a big problem. For instance, one of Enron's independent directors is a professor at a state university and it is said that the director was unable to say anything critical about Enron which had been making substantial contributions to the university. Many of other independent directors were close to either Enron or Mr. Lay. How to define insider trading is a very difficult question.
As it turned out, Enron's internal control had been quite sloppy. It is said that an employee who authored a memo accusing Mr. Lay languished, wondering whether or not to directly tell Mr. Lay. In the end, Mr. Lay was informed of the problem and attempted to handle the matter internally. He should have appointed a law firm that had no previous engagements with Enron to investigate the case. But he asked the firm with which Enron had long associated. This shows the low level of awareness and the looseness of risk control.
As to the function of external auditors, Enron's relations with its independent auditing firm Andersen were continuing for 10 years with some of former Andersen partners hired by Enron as financial officers. The amount of fees Enron paid to Andersen is said to have totaled $100 million. Within Andersen, some people raised warning voices, criticizing Enron's accounting as being too lax. But those people were relegated by the internal politics and Andersen gradually lost its objective auditing function with the development of collusive relations between the two companies.
Lessons to Learn
Judgment on the independence of board directors used to depend primarily on whether "family relations" exist or not. This measurement, however, has been deemed insufficient and it has been mandated to check the independence of respective board directors even when they are not family members. Board members should be renewed from time to time so as to prevent the same members to serve too long and objectivity must be given due consideration in doing so. Someone who joined a company board as a total outside would develop close relations with the company after serving as its board director for 10 years. Also, there has been a growing awareness that the presence of board directors would be meaningless if they are appointed by the chief executive officer. As to the specific case of Enron, the next focal point is how liabilities for damage will be settled. The very fact that Enron's chief financial officer had been allowed to make improper investments shows the company's failure to fulfill its accountability and whether or not the CFO will be personally held liable for the damages will become a point of disputes. There is also a question whether or not to allow former Enron directors and executives to collect liability insurance if they were found to have violated law. There is no guarantee that they did not. They would be found guilty in a criminal trial and held liable for damage in a civil court case.
As a means to strictly condemn Enron executives, court procedures are proceeding first on litigations against Andersen. But it is hard to understand why no internal punishment has been internally imposed within the Enron headquarters. Enron's financial statements themselves were not in violation of the accounting standards but it is questionable whether auditors are able to keep their independence when they get too close to their clients. In this regard, a new watchdog organization should be established to supervise the accounting industry. And those who use corporate financial statements should recognize that the accounting principles provide them with no scientific answer and they must make their own judgment based on the information written there. Rating agencies offer various rankings but there are both pros and cons about such rankings.
Under the light of the accounting principles, how should we consider the conflicts of interests concerning consulting services by auditing firms? Some people say that listed companies should be prohibited from using the same accounting firm for consulting services and auditing. There are four major accounting firms in the United States and they are called "Final Four" rather than "Big Four." In reality, it would be difficult to mandate listed companies to use different accounting firms for consulting and auditing services. Can we expect the emergence of new accounting firm sometime in the near future? Upon receiving a guilty verdict, Andersen lost its license across the 50 states and the firm disappeared in a matter of a year or so. Even if it was found not guilty, I think that the fate of Andersen was determined the moment it was indicted.
Impact on American Society
Markets are in need of greater transparency and there have been mounting calls that thorough disclosure of corporate risks and accounting policies should be ensured. Many people urge for raising the amount of fines in case of violation and stiffening penalties for violators, for instance, holding corporate executives and board directors liable for damages. The NYSE provides a two-year grace period for companies to abide with its rule that a majority of a company's director must be independent. Other measures being urged include promoting the disclosure of risk analysis and the greater transparency and reduction in amounts of remunerations.
Relations with Japan
Having its own house in such a disorder, some Japanese people say that the U.S. should stop preaching Japan. But markets are demanding greater transparency and there is no accepting an argument that Japan's corporate governance can stay as it is. Unless Japan seriously tackles this issue, it would be looked upon with scorn on the global market.
Questions and Answers
A: Has the U.S. learned any lessons from the Enron incident? The number of independent directors was increased and regulations were toughened, but those measures failed to function properly. I wonder whether the reinforcement of those measures can deter the recurrence of scandals.
Grondine: I do not have an immediate answer as to what other measures we should take. But if we are to act promptly, we should reinforce the existing laws. There are a series of questions, for instance, what to do with penalty, fines and imprisonment as well as how to prove complicated frauds. Today we are living in the era of Internet and infested with the "CNN syndrome" that urge us to analyze things instantaneously. But creating a new model takes more time. Yet, in reality, we cannot afford to take too much time as markets move quickly.
B: Up until recently, Japanese corporate managers have embraced American-style corporate governance that emphasizes return on equity, but there seems to be a certain backlash after the Enron and WorldCom incidents. For which direction do you think the global trend of corporate management will shift? I believe that the SEC has much to blame. Why didn't the SEC fail to detect Enron's wrongdoings?
Grondine: Up until now, insider trading has been narrowly defined. Even if certain transactions are deemed as problematic under the insider trading provision of corporate law, not securities exchange law, there has been an ample room for corporate officers and executives to engage in such transactions as long as they obtain an approval of the board. The judicial circle is partly blamable for this. But regulations need to be improved always. When we have new regulations we will have a new system.
C: NYSE is moving to increase the number of independent directors. But is remuneration worth $40,000 or so enough for them to make enough commitment. Wouldn't it be better to increase the amount of remuneration and make them spend enough time so that they understand more about the internal situation of a company for which they serve as an independent director?
Grondine: Independent directors' responsibility has been increasing. There are some companies in which the function of independent directors is working properly. A major difference between the U.S. and Japan is that in the U.S. we appreciate diversity and independent directors are views in the positive light as an "eye of a society." For instance, in the incident of Snow Brand Milk Products Co., they were all internal members and had the same way of viewing things. I believe this kind of situation, coupled with the sense of fraternity, has led to conservatism. Japanese corporate governance should find its new direction through trials and errors. For instance, Toyota Motor Corp.'s internal control has been very efficient. If internal directors, not independent directors, are in charge of matters important to corporate governance, they can explain this to the market. Corporate auditors are often ridiculed as being like appendix. But if internal audit is functioning properly, they should explain this to the market. Things do not improve because they do not explain. Because the Japanese Commercial Code was revised amid the Enron scandal, Japanese companies may find an excuse for postponing their decision. But if the reform of Japanese corporate governance is delayed because of this, it would be no good for Japan.
*This summary was compiled by RIETI Editorial staff.