The collapse of the Enron Corporation is the exclamation point at the end of the late-1990s stock market boom. Enron embodied all the buzzwords. It was high tech, it was asset-light (if only we knew how light!) and it had “skin in the game” for every game under the sun. Oh, and it was all a mirage.
Which brings us to a fundamental point that was overlooked in the go-go years and still is, to a considerable extent: Businesses exist to make money for their owners. No matter what other constituencies we honor, when investors evaluate a business, the bottom line has to be the bottom line.
Aside from being a spectacular financial train wreck, Enron is remarkable for pointing out the many ways in which publicly owned companies have lost sight of the basic mission of business. This is not just a story about self-serving corporate insiders and ineffective auditors. Enron is about bad policies and practices in the way we manage our public companies, in the way we tax them and in the way we measure and report their results.
The United States would not be a superpower without highly efficient capital markets to allocate our resources. Enron is far from the first scandal to illustrate shortcomings in our financial system. In the past, from the trust abuses of the early 1900s to the insider trading cases of the ’80s, this country has made necessary adjustments and repairs, and, for the most part, our policy choices have withstood the test of time. This process is getting under way again.
Enron can ultimately do us a lot of good if it leads to substantial, constructive change.
I think there is a very good chance this will happen. I know I will not see all the changes I want, and I probably will see some that I don’t, but on balance I expect the process to be healthy. Here is what I hope to see in the wake of the Enron debacle.
Corporate Governance
Corporations are owned by shareholders. Managers, even today’s celebrity CEOs, are hired hands who are there to make money for the owners. Boards of directors are elected by shareholders to represent the owners’ interests, not the managers’ interests. Whenever we have gotten away from these principles, we have suffered a financial coup d’etat that usually ends badly for the owners.
Enron ran roughshod over these principles. It treated shareholders like mushrooms, keeping them in the dark and feeding them, well, fertilizer. The most important reform that can come from Enron would be drastically to change the way business is conducted in the boardrooms and executive suites of public companies. My proposals:
- Greatly increased financial disclosure. This would include reporting the financial condition and results of ostensibly independent entities whose financial condition is material to the public company. The governing principle should be that owners are entitled to know everything worth knowing about the financial results of their company. Management has no right to treat the financial deals it has concluded as though they were trade secrets, confidential business strategies or pending transactions.
- Give shareholders new powers to nominate directors who are independent of management. Current practices give managers too much say over who gets on the ballot, which in most situations is tantamount to election. Federal law may need to pre-empt state rules on this and a host of other corporate governance issues to establish high-quality and consistent practices. I tend to dislike federal pre-emption, but the national and global nature of the securities markets demands this in the case of companies that tap those markets.
- Require companies to publish their ethics and conflict-of-interest policies and to disclose waivers granted to highly placed executives. That the board allowed the chief financial officer and others to negotiate against the company for their own benefit is, to me, the most shocking news to emerge from the Enron saga. Mandatory disclosure of such self-dealing might alone have been enough to block the questionable partnership transactions, without which Enron probably would not be in bankruptcy court today.
- Require senior corporate officers to meet strict fiduciary standards to the absentee owners of public companies. We have moved way too close to the point where executives are likely to ask what the company can do for them, rather than the reverse. Treating corporate managers as fiduciaries would, among other things, require them to justify the fairness of their compensation.
- Prohibit executives of a public company from buying or selling stock from or to the corporation, or using stock to satisfy loans from the corporation. Let those executives go to the public markets just as shareholders do, and disclose their activities promptly. This would have avoided the outrage of having former Enron Chairman Kenneth Lay selling tens of millions of dollars in stock to the company at the same time he urged employees to buy.
- Require senior executive compensation to be set by a board committee consisting solely of directors who are truly independent. This means the directors not only cannot be employees of the corporation, but they should have little or no direct business dealing with the corporation, including gifts by the corporation or its officers to nonprofits that employ the directors.
- Prohibit directors from receiving grants of stock options. It’s great if a director wants to have an equity stake in the company she serves, but she can get it by buying stock just like public investors. Granting options to directors treats them as employees who need some sort of incentive to maximize shareholder value, which already is a director’s duty, and also can induce the director to go along with schemes that are intended to boost the stock price in the short term without regard to the long-term health of the business
Accounting and Disclosure
Enron is an accounting scandal of the first order. Much has been made of the compliance, if not outright complicity, of its auditors from Andersen, and the conflicts and pressures those auditors may have felt in dealing with a company that generated $25 million in annual audit fees and another $27 million in other consulting.
I do not think much will be accomplished if auditors are prohibited from providing consulting services to their clients, with just a few exceptions. External auditors should not provide internal audit services, because it puts them in a position of reviewing their own internal audit work. Most large accounting firms have acknowledged this principle in the wake of the Enron failure. Auditors also should not design or maintain financial information systems, for the same reason.
The real problem with the “independent” auditor of a client such as Enron is that he is not in a position to walk away from an aggressive client. Enron’s lead audit partner could not have kept his job if he had lost that engagement over an accounting dispute, unless the client had proposed something that was clearly illegal. That economic reality always will be present when companies are able to hire, retain and fire their auditors at will.
I see two choices: Have the Securities and Exchange Commission hire auditors, which probably is a political non-starter, or require public companies to rotate both the individuals and the firms that audit them every few years. Andersen’s attitude may well have been different if it had known that it was soon going to lose the client as a result of rotation and be second-guessed by a new team of accountants, regardless of how accommodating the Andersen auditors were.
Ultimately, corporate financial reporting works much like our tax system. It relies on the general honesty and compliance of most participants, backed up by the possibility of enforcement and sanction by a government agency — in this case, the SEC rather than the Internal Revenue Service.
The SEC should be given additional power to prescribe accounting rules for public companies, and more staff to enforce those rules and review the reports companies file with it.
Changing Tax Rules
Our corporate income tax really is a tax imposed on shareholders for the privilege of owning public companies. Non-public businesses easily can be organized in forms that are not subject to the corporate income tax, such as partnerships, limited liability companies, or S corporations.
If I make a dollar of profit in my privately held business, I may pay a top federal tax rate of 38.6 percent and then keep the remaining 61.4 cents to spend or invest as I choose. If a publicly held corporation makes that same dollar of profit, it may incur a tax rate of 35 percent, pay the resulting 65 cents to its shareholders as a dividend, and watch them pay a top rate of 38.6 percent on the dividend. The shareholders in this case can spend only about 40 cents as they wish.
The disparity in how businesses are taxed is skewing commerce and investment all over the economic landscape. Faced with the prospect of double taxation, investors avoid companies that pay substantial cash dividends even though the point of investing is eventually to receive cash back from the investment. Rather than receiving dividends, investors hope to take their money out of their investments in the form of long-term capital gains, which are taxed at rates as low as 18 percent for high-income taxpayers.
But problems abound with this approach. The ability to pay dividends is the ultimate test of the quality of a company’s earnings. Accounting subterfuge aimed at pumping up a stock price is not likely to work as well or as long if a company is expected to distribute a decent portion of its earnings to the owners.
At the other extreme stand companies such as Microsoft. An unambiguous success at making gobs of money, the software giant is practically bursting with cash. This treasure makes an appealing target for antitrust and other regulators, and invites company management, sooner or later, to make unwise investments. When investors buy Microsoft stock today, how do they expect the company’s economic success ultimately to move from the corporate treasury to them? Is someone going to liquidate Microsoft?
Ideally, we would get over the fantasy that corporations pay, or don’t pay, taxes, and just repeal the corporate income tax. Corporations are legal fictions that neither know nor care about taxes. Corporate taxes are borne by human beings who own corporate stock. The tax system should not care whether business owners make their money as proprietors, partners or shareholders. Repealing the corporate income tax need not and should not amount to an aggregate tax cut. We can change the individual tax system to tax people who own businesses — all businesses, not just publicly held ones — at whatever rate seems appropriate at the time.
I do not expect the corporate tax to go away any time soon. Failing that, two useful alternatives would be to give shareholders a credit for taxes paid at the corporate level — a system known as “integration” that is widely practiced abroad — and to tax dividends and capital gains at an identical rate, which is what we did for a few years following the 1986 tax reform. By avoiding the distortions of double and unequal taxation of corporate earnings, we could get investors to demand that their companies show them the money they are making, rather than merely telling them about it.
