Right and Wrong Lessons from Enron
|March 10, 2004||Posted by Fred Foldvary under Archive, Progress Report, The Progress Report|
Right and Wrong Lessons from Enron
by Fred E. Foldvary, Senior Editor
People will learn lessons from the collapse of the Enron energy company and the value of its stock shares. Some of these will be the wrong lessons.
Critics of markets will exclaim that the Enron debacle shows how “capitalism” is defective. But they won’t tell you what “capitalism” means. If you ask them, they can’t tell you, because they don’t really know. It’s typical of economics screed that the writers don’t define the key terms.
Statists, those advocating government interference with markets, will proclaim that the Enron problem shows that the government should increase the regulation of corporations and financial markets. But “regulation” is also a vague, weaselly word. Regulation can be market-helping, as in prohibiting fraud, or market-hurting, such as controlling prices.
What needs to be done is to strengthen laws, enforcement, and penalties regarding fraud. Fraud is a type of theft, and theft is a violation of market rules.
Let’s start with the accounting firms that are supposed to audit corporations. The purpose of such audits is to ensure that the company has truthfully and fully accounted for its operations. That implies that the auditor should be impartial, and therefore not have any financial interest in the company being audited.
That was not the case with Enron. The auditing firm was also engaged in consulting for Enron. In my judgment, that constituted a conflict of interest. If the auditor reported accounting problems, that might reduce its consulting income. Some might argue that the government should prohibit auditing firms from also doing consulting work for the firm it audits. I argue for a somewhat less interventionist policy.
There should be a general “Law of the Market” that all statements made by firms are truthful unless the charter of the company clearly and explicitly states that it might lie, in which case that policy also needs to be stated on all product labels. The Law of the Market would also require corporations to have impartial audits with firms having no financial interest in the company or any links other than the auditing, unless it is clearly and explicitly stated in the charter that it might have other business with the auditing firm, or that it might not be audited at all.
If the company’s charter states that it may be audited with firms that also have other financial interests in the firm, then all shareholders are warned that the audits might be suspect, and that the accounting reports – the balance sheet and income statements – might be misleading. The value of the shares will then be discounted to reflect this.
The Law of the Market should also specify that the accounting reports of a company fully show all assets and liabilities of the firm at current market prices, unless its charter states otherwise. Enron was able to hide liabilities in partnerships, which were not fully disclosed. A firm’s business includes its membership in partnerships, and if a firm wishes to hide part of its balance sheet in partnerships, this policy should be clearly stated in its charter, for all to see. Then shareholders are warned, and the value of the stock will be lower to reflect this.
Likewise when the executives or board members of a corporation make public statements about the prospects of the company, the Law of the Market should require these to be honest, unless the charter lets the company lie. If the charter does not state that the chiefs may commit deception, they should be legally required to tell the truth, to the best of their knowledge.
It is tragic that many Enron employees put much of their retirement funds in the stock of the company. One of the basic principles of personal finance is that your portfolio, your various financial assets, should be diversified. “Don’t put all your eggs in one basket” is age-old advice we learn from grandma.
This should be a financial lesson for everybody. Companies can fail. We don’t know what is going on inside a company. It can look good on the outside but be crumbling on the inside. A general rule for investing is not to put more than 5% of your assets in the stock of any one company. In my opinion, most folks should have most of their retirement assets in mutual funds and not in individual companies.
The Enron problem was not a fault of the market, but one of violating the rules of the market. There will always be those who try to defraud others. That is why we need laws against theft and fraud. The Enron debacle is the fault of government for not having a clear Law of the Market so that the auditing conflicts would have been illegal unless the company charter had stated that it would engage in such practices, which would have warned everybody.
Once again, government, not the market, failed.
Copyright 2002 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieval system, without giving full credit to Fred Foldvary and The Progress Report.
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