Don’t Let Enron’s Directors Off the Hook
By GORDON BAVA
The search is on for the Enron villains.
A rich and powerful chairman, his kleptomaniacal lieutenants, and compliant advisors who sanctioned impenetrable and misleading financial statements. Among this cast of rogues, however, the biggest failures are the board and its audit committee. As we anticipate the shower of new laws that will rain upon us in the post-Enron era, we must keep in mind that character, good judgment and common sense traits we expect of our corporate stewards cannot be legislated.
As required by law, members of Enron’s Board signed the annual report that included audited financial statements. These signatures are intended to assure investors that they have received the information essential for a proper understanding of the company’s business and financial performance. In the case of Enron, however, the board’s special investigative committee found that these signatures were meaningless.
Tougher rules not the answer
This spectacular failure has damaged the faith in corporate governance as well as the general trust the world has in the U.S. securities markets. The causes of the Enron collapse will be debated, and tougher rules will be adopted in a well-intentioned effort to prevent similar failures in the future. While some enhanced legal requirements may be appropriate, they will not insure that investors will receive reliable financial information they need to make decisions. In fact, they may detract from this goal.
Board members already must oversee complex accounting, securities, tax and legal systems. If additional burdens are imposed, as they most certainly will be, and the risk of liability becomes too great, it will be impossible for all but our largest corporations to attract and retain experienced, qualified and independent board members.
It is also possible for management to be in technical compliance with specific requirements, yet miss the target of the requirements. Measured by conventional standards, the Enron board did what it was supposed to do. Just as we cannot legislate good parenting, the qualities for successful corporate stewardship cannot be implemented by elaborate codes of conduct.
It is, and must be, the responsibility of the thousands of honest and well-intentioned board members across the country to improve their effectiveness and restore investor confidence. They should focus on a few basic principles rooted in common sense.
Board oversight must be an ongoing process. The board’s involvement should not be limited to the annual report. Its oversight must be a continuous, preventative process, not just an annual event or emergency response.
Audit committees must be skeptical. Boards should approach managers and auditors with an attitude of healthy skepticism. This requires probing questions and documented due diligence. The thoroughness of board inquiries in venture backed corporations is far more intense than the more passive exchanges in many public corporations. Boards of large public corporations could learn from their venture capital brethren.
Scrutiny of audit committees
For openers, financial sorcery cannot be tolerated. Technical accounting alchemy that turns expenses into income, and makes liabilities disappear into a web of special purpose entities and derivative securities will be tolerated no longer. Neither should they be in the boardroom.
Audit committees should have their own independent counsel and advisors. Enron’s outside auditors and regular outside legal counsel did not blow the whistle on the off-balance sheet partnerships within the corporate chain of command. How could they? They recommended them. And just as some large institutional investors retain experts to review published financial statements to eliminate accounting gimmicks from corporate earnings, audit committees should receive the same independent advice.
And boards must enforce independence. While the major auditing firms have started steps to limit their ability to provide consulting or internal audit services to their audit clients, boards can enact restrictions immediately on such dual representation. Disney has already done so. In addition, boards should re-think revolving door practices where outside auditors are a primary source for company recruits. Finally, boards should consider rotating independent auditors on a regular basis to receive the benefit of a fresh perspective.
Had Enron’s audit committee applied these simple principles investors would not be poorer by $60 billion, thousands of employees would still be employed, and fewer laws would be needed for corporate governance.
Gordon Bava is chairman of Manatt, Phelps & Phillips.