After the Fall

The experts weigh in on how to prevent future Enrons.

Hill: I’d like to go back to a couple of points from the perspective of my cyclical thesis. The conflict-of-interest and complexity issues are more than just a cyclical problem. There is a secular trend going on in both of those, and that’s where we need more focus on changing things.

Complexity in…

Hill: The complexity of the transactions. If you were a superb professional analyst and Enron had not done anything illegal, you still couldn’t analyze that company. With the complexity of derivatives and a company that has essentially morphed into a hedge fund, how do you analyze that?

When I raised this issue in December before the House Committee on Financial Services, I was asked, Well, what can you do about it? I said, Maybe it ought to be a different kind of security — where you’ve identified it as a high-risk situation that can’t be analyzed the way a normal company could be, and therefore it’s subject to some different kind of regulation. There would be an understanding that this was a different kind of animal.

Jenkins: It would be sort of a scarlet letter. [Laughter] Of course, we don’t want to say that derivatives are bad per se, because in fact they can be very good for investors if they’re properly used. But we do need to account for them properly. Our standard [SFAS 133], as complex as it is, is complex because it reflects complexity. And I think it does provide new information that we’re just now learning how to deal with in the marketplace.

Griep: I’d like to comment on this point. Fundamental analysis — to the extent that it’s difficult because of complexity to understand the nature and risk of the business as disclosed in the financials — has shifted to focusing on the risk-management function. The more opaque the financials are, the more that fundamental analysis has to focus on the systems in place to control risk.

It’s interesting to look at the energy-trading companies. Many of them have risk-management systems in place, but no two approach the valuations with the same kind of assumptions. No two have the same VAR [value-at-risk] methodology or system in place.

Clapman: If I could just pick up on this point of complexity and conflicts. When Enron was the seventh-largest company in America, how many analysts were saying, “We just can’t understand this company — therefore, we are neutral and have no recommendation on it?” I am concerned that the analysts with the conflicts that have been identified here were affecting the market [on Enron].

Hill: On the eve of the third-quarter report from Enron that started the ball rolling, of the 16 analysts that covered it, 13 had a strong buy or their equivalent terminology, and 3 had a buy. There were no holds, no sells, no strong sells, and nobody with no recommendation.


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