Enron: Could It Happen Again?

As the Enron story gradually begins to fade from the news, one has to wonder if such an economic debacle could happen again. As a result of Enron, WorldCom and other corporate scandals, there are now former top executives from several major corporations who, since they probably won’t live long enough to serve out their time, have been given what amounts to a life sentence.

Will such severe sentences serve as a deterrent to future malefactors? Probably not. Human nature being what it is, there no doubt will be situations in the future that will mirror the Enron fiasco, despite the passage of Sarbanes-Oxley (SOX) in 2002.

The Board of Directors Is the Sentinel

A corporate board of directors is the major protection against a recurrence of an Enron-type catastrophe. SOX has given the board and the company officers this responsibility. Now, board members would be foolish if they were to succumb to the temptation of supporting their executive friends over their duty to the stockholders.

Listen to Ted di Stefano (6:58 minutes)

We are all aware that it is quite human to agree with our friends, and the fact is, a friend or good acquaintance who is an officer of a corporation is often the person who makes recommendations for appointments to a board.

I have personally seen friendships fractured when a board member refused to go along with a wrong-headed policy of an executive friend, even though the board member was justified in his position.

The driving factor, in my opinion, is who gets to appoint a new member of a board. The answer usually is the management of a corporation.

Do you think that management would be inclined to appoint someone known for his/her fierce independence? Perhaps, but not always. I know of some companies who search vigorously for independent board members. Others simply rely on their network of business friends.

Signs of Trouble

I have been asked by clients, what is the first telltale sign that a company is trying to “cook the books?”

My answer is watch whether the company is auditor shopping. There have been many instances where management doesn’t like the results of an audit, argues with the auditors, then switches accounting firms. This is a sure sign of trouble.

Another sign is frequent changes in the membership of the board of directors. Boards should be relatively stable, without constant changes in membership. Continuity aids in the monitoring of the company and gives board members a good perspective as to past actions and happenings.

When the composition of a board changes frequently, there is usually trouble afoot. Either management isn’t satisfied with the board’s deliberations, or the board members are afraid that future service on the board will expose them to unacceptable legal liability.

SOX Helps Prevention

How can SOX prevent future Enrons? The main way is through the empowerment that it gives the audit committee and how it defines membership eligibility on this committee.

First of all, SOX gives the audit committee quite specific responsibilities such as the integrity of a company’s financial statements, legal and regulatory compliance, and the vetting of independent auditors. These three SOX requisites for the audit committee give it quite a bit of clout.

Also, SOX wants a minimum of three people as audit committee members, all of whom must be “independent.” That is, they cannot be members of the management team. These members must also be “financially literate” with at least one member who is a “financial expert” as defined by SOX.

Though there have been many complaints about SOX, it is really conceptually quite sound. Just recently, the SEC made some moves to lessen the severity of SOX, especially for smaller corporations. Consequently, I believe that the SOX detractors will be diminishing.

SOX has done a great deal to reduce the possibility of another Enron. However, the fact remains that, human nature being what it is, there will be future financial scandals, but probably with far less impact than the Enron scandal.

Avoiding Another Enron

Who else can help us avoid another Enron? The answer is rather clear: management, board members, stockholder groups and regulatory agencies. Management responsibilities are rather obvious. The same can be said for board members.

What about the responsibilities of stockholders? They obviously have the most to lose and should be ever vigilant. The greatest burden goes to the institutional investors who are the watchdogs of funds belonging to a wide range of people such as public employees, and retirees.

One of the most prominent of institutional investors that have taken an extremely proactive role in watching over the funds of its members is the California Public Employees’ Retirement System, otherwise known as CALPERS. They have been wonderful guardians of the public’s money. As one can see, stockholder involvement is a must if we are to avoid future Enrons.

But, what about the regulators, the government? Certainly they play a prominent role. Their main task, as I see it, is to make the regulations strong enough to protect stockholders, but yet not so severe that they are limiting the competitiveness and profitability of business.

Although I am an optimist by nature, I don’t think we’ll ever see the day that corporate governance is scandal-free. There will always be people in high positions who have too much ambition, power or ego. Although I believe there will always be corporate scandals, I doubt that we’ll witness another Enron in the near future.

Good luck!

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at [email protected].

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