[Senate Hearing 107-1140]
[From the U.S. Government Printing Office]
S. Hrg. 107-1140
EXAMINING ENRON: THE CONSUMER IMPACT OF ENRON'S INFLUENCE ON STATE
PENSION FUNDS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON CONSUMER AFFAIRS, FOREIGN COMMERCE AND TOURISM
OF THE
COMMITTEE ON COMMERCE,
SCIENCE, AND TRANSPORTATION
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
MAY 16, 2002
__________
Printed for the use of the Committee on Commerce, Science, and
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SENATE COMMITTEE ON COMMERCE, SCIENCE, AND TRANSPORTATION
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
ERNEST F. HOLLINGS, South Carolina, Chairman
DANIEL K. INOUYE, Hawaii JOHN McCAIN, Arizona
JOHN D. ROCKEFELLER IV, West TED STEVENS, Alaska
Virginia CONRAD BURNS, Montana
JOHN F. KERRY, Massachusetts TRENT LOTT, Mississippi
JOHN B. BREAUX, Louisiana KAY BAILEY HUTCHISON, Texas
BYRON L. DORGAN, North Dakota OLYMPIA J. SNOWE, Maine
RON WYDEN, Oregon SAM BROWNBACK, Kansas
MAX CLELAND, Georgia GORDON SMITH, Oregon
BARBARA BOXER, California PETER G. FITZGERALD, Illinois
JOHN EDWARDS, North Carolina JOHN ENSIGN, Nevada
JEAN CARNAHAN, Missouri GEORGE ALLEN, Virginia
BILL NELSON, Florida
Kevin D. Kayes, Democratic Staff Director
Moses Boyd, Democratic Chief Counsel
Jeanne Bumpus, Republican Staff Director and General Counsel
------
SUBCOMMITTEE ON CONSUMER AFFAIRS, FOREIGN COMMERCE
AND TOURISM
BYRON L. DORGAN, North Dakota, Chairman
JOHN D. ROCKEFELLER IV, West PETER G. FITZGERALD, Illinois
Virginia CONRAD BURNS, Montana
RON WYDEN, Oregon SAM BROWNBACK, Kansas
BARBARA BOXER, California GORDON SMITH, Oregon
JOHN EDWARDS, North Carolina JOHN ENSIGN, Nevada
JEAN CARNAHAN, Missouri GEORGE ALLEN, Virginia
BILL NELSON, Florida
C O N T E N T S
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Page
Hearing held on May 16, 2002..................................... 1
Statement of Senator Dorgan...................................... 1
Statement of Senator Nelson...................................... 2
Witnesses
Calvert, Bruce W., Chairman and CEO, Alliance Capital Management. 7
Prepared statement........................................... 10
Glassman, James K., Resident Fellow, American Enterprise
Institute...................................................... 21
Prepared statement........................................... 24
Harrison, Alfred, Vice Chairman, Alliance Capital Management..... 13
Prepared statement........................................... 15
Herndon, Tom, Executive Director, Florida State Board of
Administration; Accompanied by C. Coleman Stipanovich, Deputy
Executive Director, Florida State Board of Administration; and
Trent Webster, Portfolio Manager, Florida State Board of
Administration................................................. 3
Prepared statement........................................... 6
Musuraca, Michael, Assistant Director, Department of Research and
Negotiations, District Council 37, American Federation of
State, County, and Municipal Employees (AFSCME)................ 59
Prepared statement........................................... 61
Plunkett, Travis, Legislative Director, Consumer Federation of
America........................................................ 64
Prepared statement........................................... 66
Teslik, Sarah Ball, Executive Director, Council of Institutional
Investors, prepared statement.................................. 55
EXAMINING ENRON: THE CONSUMER IMPACT OF ENRON'S INFLUENCE ON STATE
PENSION FUNDS
----------
THURSDAY, MAY 16, 2002,
U.S. Senate,
Subcommittee on Consumer Affairs, Foreign Commerce
and Tourism,
Committee on Commerce, Science, and Transportation,
Washington, DC.
The Subcommittee met, pursuant to notice, at 2:30 p.m. in
room SR-253, Russell Senate Office Building, Hon. Byron L.
Dorgan, Chairman of the Subcommittee, presiding.
OPENING STATEMENT OF HON. BYRON L. DORGAN,
U.S. SENATOR FROM NORTH DAKOTA
Senator Dorgan. This hearing will come to order. I'll be
joined momentarily by my colleagues, Senator Nelson--I believe
Senator Boxer will join us as well. But in light of the hour, I
want to proceed.
I will necessarily have to absent myself for a leadership
meeting, at which time Senator Nelson will take the chair, in
about 40 minutes, but--Senator Nelson has just joined us, as
you see.
This hearing is a continuation of a number of hearings that
we have been holding discussing issues that surround the Enron
Corporation. This hearing is at the request of my colleague
from Florida, Senator Nelson, who, quite properly, wants an
explanation about how the pension fund of Florida lost some
$329 million in Enron's stock issues, more than any other
public pension fund in the country, I understand.
This is a long and tortured subject. We began hearings
dealing with Enron matters in--last December, I believe it was,
and we'll continue to hold some hearings into June. One of the
issues that has arisen is the purchase of Enron stock, even as
the Enron stock was collapsing, and the cost of those purchases
to the Florida pension fund and other pension funds around the
country, but the largest purchase, I think, and the biggest
loss was to the Florida public employee's pension fund.
Let me say that I don't have any preconceived notions or
judgments about today's hearings. We're trying to understand
and learn from the hearings. And I agree with my colleagues
that Florida's public employees deserve to try to get some
answers, and my hope is that this hearing will shed some light
on some of these vexing and troubling issues.
Let me call on my colleague, Senator Nelson.
STATEMENT OF HON. BILL NELSON,
U.S. SENATOR FROM FLORIDA
Senator Nelson. Mr. Chairman, what we would like to
accomplish here as we have responsibility for crafting
legislation to try to protect the public for the future, and
here we have--the public has been harmed in the course of this
whole saga, because public servants in investing their funds in
a public retirement fund, those funds having severely
diminished under conditions that we're going to explore. In
Florida's case, taxpayers were not harmed because the Florida
retirement system was, in fact, fully funded. But it was only a
few years ago that the retirement fund was not fully funded,
and, had the same circumstances occurred, the losses would be
being borne by taxpayers not by the pensioners of the state of
Florida. So that adds another dimension that is considerably
important for us as we are examining what is the legislative
solution to this.
So what we want to do is to get to the bottom of this and
to prevent it from happening again by virtue of coming forth
with legislation that would make it a lot less likely that this
kind of scenario would occur again.
Thank you, Mr. Chairman.
Senator Dorgan. Senator Nelson, thank you. And the long-
term goal, of course, is for us to evaluate what we're learning
form this scandal. And, yes, the Enron matter is a scandal
involving, in my judgment, substantial dishonesty and grand
theft, in some cases.
Yesterday, for 4 hours, we heard of price fixing in
California, which I expect will be the subject of a substantial
criminal investigation. It appears to be not just the Enron
Corporation, but they were neck deep in it. And so this issue
has many tentacles, one of which deals with the losses to
pension funds. And the question is: How do we legislate, or do
we legislate, in ways that can provide some protection that
this sort of thing will not happen again?
We have a number of witnesses today. I indicated, Senator
Nelson, that I will not be able to stay for the entire hearing,
but you will be chairing when I have to depart.
Mr. Glassman, welcome.
Mr. Glassman. Thank you.
Senator Dorgan. Is that Dow still going to hit $30,000?
Didn't you have a book--all right, then one of these days I'm
going to start buying again then. I don't have a lot of money
to buy with, but we'll consult privately, I guess, about that.
It's nice to see you again. I haven't seen you for some while.
Others of you on the panel, thank you for being with us. I
would like to begin by asking Mr. Tom Herndon, from the Florida
State Board of Administrators, the executive director. He will
give testimony. And I believe two of his colleagues are here,
as well, to answer questions, Mr. Coleman Stipanovich and Mr.
Trent Webster. Coleman Stipanovich is Florida State Board of
Administrator's deputy executive director, and Trent Webster is
portfolio manager of Florida State Board of Administrators.
Following that, we will hear from Mr. Bruce Calvert, CEO of
Alliance Capital Management, Alfred Harrison, account manager,
Alliance Capital Management, and then we will have Mr.
Glassman. And then we will have a second panel of three people:
Michael Musuraca--I hope I've got that name right--American
Federation of State, County, and Municipal Employees, AFSCME,
Travis Plunkett, Consumer Federation of America, and Sarah
Teslik, Council of Institutional Investors.
So why don't we proceed, Mr. Herndon? Your entire statement
will be made a part of the record, and you may summarize for
us, if you would.
STATEMENT OF TOM HERNDON, EXECUTIVE DIRECTOR,
FLORIDA STATE BOARD OF ADMINISTRATION;
ACCOMPANIED BY C. COLEMAN STIPANOVICH, DEPUTY
EXECUTIVE DIRECTOR, FLORIDA STATE BOARD OF
ADMINISTRATION; AND TRENT WEBSTER, PORTFOLIO
MANAGER, FLORIDA STATE BOARD OF ADMINISTRATION
Mr. Herndon. Thank you, Mr. Chairman, Senator Nelson. It's
nice to see you. With me this afternoon, as you pointed out is
Coleman Stipanovich, the deputy director of the State Board of
Administration, and Trent Webster, portfolio manager on the
staff of the State Board of Administration in our Domestic
Equities Division. I have a brief statement, and I'd like to
work through that very quickly for all three of us.
The opportunity to comment on the Enron disaster is not one
that we really take any relish in. Unfortunately, Florida has
the distinction of losing more money on Enron stock than any
other known organization, but that is definitely not a
distinction that we enjoy or we relish. Unfortunately,
approximately 90 percent of the Enron losses were realized in
an account managed by Alliance Capital Management. So for us at
the State Board of Administration, the current situation could
be more aptly called the ``Alliance Disaster.''
Let me give you a brief background on who we are and how we
operate. The Florida State Board of Administration is the
investment arm of Florida State Government, with $125 billion
under management. We are governed by three trustees: the
Governor, the state comptroller, and the state treasurer. We
invest funds on behalf of approximately 25 government clients,
with the largest being the Florida retirement system at
approximately $100 billion.
We're a broadly diversified investment organization with
assets in the U.S. stock market, the U.S. bond market, the
international stock market, real estate, and private
investments, and serve approximately 600,000 active members and
approximately 200,000 retirees. Under our defined benefit plan,
payments to retirees, as Senator Nelson has pointed out, are
guaranteed by the employers regardless of the gains or losses
in the investment portfolio.
As a quick aside, Mr. Chairman, I might add that we're
currently in the midst of transitioning to a defined
contribution program, 401(a), for all of our members, and that
might be of some interest to the Committee at a future date
when you talk about social security.
Now, back to the main issue, Alliance's Enron investments
for the Florida Retirement System. Our Enron experience started
in November of 2000 when Alliance first began to acquire a
position in Enron. Our domestic equities unit has 14 outside
managers who are charged with exercising their expertise to
select sound investments for our portfolio. Alliance is one of
those 14 managers. These investment firms are given full
discretion by contract and are paid a handsome fee for the
diligent deployment of their resources and expertise. In this
case, the lion's share, by far, of our Enron position was
acquired by Alliance Capital Management, and specifically their
Minneapolis-based large-cap growth investment team headed by
Mr. Harrison.
Alliance's contract with the Florida SBA recognizes
Alliance's fiduciary duties and committed it to certain
investment protocols, including the obligation to perform
rigorous company-specific research. In this case, however, Mr.
Harrison and Alliance failed to meet their obligations under
our investment advisory agreement. Alliance's Enron purchases
ultimately caused a principal loss of $280 million to the
Florida Retirement System, and we believe Alliance was
negligent in its job performance. As a result, we have filed
litigation against Alliance to recover our losses, and a copy
of that complaint has been furnished to the Committee.
We've all read stories about the inadequacy of Enron's
financial disclosures and conflicts of interest at Enron as
well as the conflicts that exist generally in the financial
markets. While these subjects are worthy of your investigation,
any investigative action you undertake should not allow
financial professionals such as Alliance to shift the blame for
their own negligence to the corporations in which they invest.
As detailed in our complaint, sufficient Enron information as
publicly available to inform a sophisticated investment manager
such as Alliance of the extreme risks of Enron investments.
Remember, before Alliance even invested in Enron, the footnotes
of Enron's financial statement disclosed the supposedly, quote/
unquote, ``secret partnerships'' controlled by Andrew Fastow.
Sadly, Mr. Harrison has admitted, quote, ``nobody ever really
dug into the footnotes,'' unquote.
Our concerns about Alliance's investments in Enron
coincided with our broader concerns about Alliance's
performance for the Florida Retirement System. Alliance had
suffered a period of poor performance unrelated to and before
Enron investments began. In calendar year 2000, we had put
Alliance on a watch list where they stayed until terminated in
December of 2001. Throughout this period, in spite of
continuing red flags that were raised associated with Enron's
death spiral, the Alliance investment team continued to buy
Enron stock in an accelerated fashion. And all of this is
detailed in the court complaint.
You will note that Alliance kept buying, even though the
Enron news was getting worse and worse. As we've observed the
Enron investments being made, we assumed, to our detriment,
that Alliance was conducting the, quote, ``rigorous company-
specific research'' they had promised. When we questioned
Alliance about the Enron purchases, we were assured of this
fact. It is now clear to us that Alliance was buying Enron on
faith, not on research.
However, this hearing is not the place to try the case.
That'll be done later on in the court. Rather, the Committee's
invitation to this hearing stated that the scope of your
inquiry is focused on the practice of Enron officials
contacting pension funds or institutional investors in order to
tout Enron stock. We have no information to offer on that
subject. We at the Florida State Board of Administration we
were never contacted by Enron officials. We were informed by
Mr. Harrison that he and members of the Alliance team met with
high-ranking Enron officials, and we understand that such
contacts are routine between money managers and corporate
officials. They're certainly not unique to Enron or Alliance.
However, we at the State Board of Administration have no direct
knowledge about what was discussed between Enron and Alliance
or if these discussions were in any way different than those
which commonly take place in the industry.
Much has been written about the conflicts of interest that
surround Enron and Alliance, most notably, Mr. Frank Savage,
who was an Enron board member and, in fact, on the finance
committee that approved the off-balance-sheet partnerships and
waived the conflicts of interest, and also served as a senior
officer and board member of Alliance. We've been assured by
Alliance that this was a conflict without consequences. Because
the effects of Mr. Savage's conflicts are unclear to us at this
time, our lawsuit against Alliance currently makes no claims
relating to Mr. Savage's conflicts of interest.
We understand that this committee or others in Congress are
investigating conflicts in the investment industry. While we
encourage a thorough review of this conflict practices, as a
governmental body, the Florida SBA does not engage in the types
of practices now under investigation. But clearly one lesson
that needs to be learned from this experience is that conflicts
of interest in the public financial marketplace should be at
least fully and openly disclosed. And some conflicts of
interest should be prohibited altogether. Investment firms
should install and enforce policies that prohibit investment
firm employees from serving on boards of directors of firms
they analyze. Just as it is inappropriate for accounting firms
to be auditors and consultants, or for investment bankers to
not public analytical reports on firm clients, it is
inappropriate that the board members of investment firms be on
the boards of companies whose stock they are recommending and
buying. There is simply too much opportunity for the wrong kind
of alignment of interest.
In closing, I've tried to highlight what happened to us as
a pension fund as a result of the negligence on the part of
Alliance Capital Management. As long as pension funds have
active portfolio management, the pension industry must be able
to rely on and fully trust expert outside financial advisors to
exercise their fiduciary duty based upon independent research
which is not compromised by conflicts of interest. Any actions
you can take to ensure the integrity of the research and
investment activities from Wall Street firms like Alliance
Capital would be most worthwhile.
Thank you for your attention, and we'll be happy to answer
any questions.
[The prepared statement of Mr. Herndon follows:]
Prepared Statement of Tom Herndon, Executive Director, Florida State
Board of Administration; Accompanied by C. Coleman Stipanovich, Deputy
Executive Director, Florida State Board of Administration; and Trent
Webster, Portfolio Manager, Florida State Board of Administration
Thank you for this opportunity to comment on the ``Enron disaster''
and its implications for Florida State Board of Administration
(``Florida SBA'') and other pension funds. The Florida SBA has a unique
distinction in this situation, namely, that we lost more money on Enron
stock than any other known organization. I can assure you that this is
not a distinction that we relish. Approximately 90 percent of our Enron
losses were realized in an account managed by Alliance Capital
Management. So, for us at the Florida SBA, the current situation could
more aptly be called ``the Alliance disaster.''
Let me give you a brief background on who we are and how we
operate. Briefly, the Florida SBA is the investment arm of Florida
State government, with $125 billion under management. The Florida SBA
is governed by three members of the Florida Cabinet--the Governor, the
Comptroller and the Treasurer. We invest the funds of approximately 25
government clients, with the largest being the Florida Retirement
System at approximately $100 billion. We are a broadly diversified
investment organization with assets in the U.S. stock market, U.S. bond
market, international stock market, real estate and private
investments. The Florida Retirement System serves approximately 600,000
active members and 200,000 retirees. Under our defined benefits plan,
payments due to retirees are guaranteed regardless of the gains or
losses in the investment portfolio.
As a quick aside, I might add that we are currently in the midst of
transitioning to a new Defined Contribution program, which might be of
interest to the Committee members at the point in time that you discuss
privatizing Social Security.
Now, back to the main issue at hand--Alliance's Enron investments
for the Florida Retirement System. Our Enron experience in Florida
started in November, 2000 when Alliance first began to acquire a
position in Enron. Our Domestic Equities unit has 14 outside money
managers who are charged with exercising their expertise to select
sound investments for our portfolio. Alliance was one of those 14
managers. These investment firms are given full discretion by contract,
and are paid a handsome fee for the diligent deployment of their
resources and expertise. In this case, the lion's share, by far, of our
Enron position was acquired by Alliance Capital Management, and
specifically their Minneapolis based large cap growth investment team
headed by Al Harrison. Alliance's contract with the Florida SBA
recognized Alliance's fiduciary duties and committed it to certain
investment protocols, including the obligation to perform ``rigorous
company-specific research.''
In this case, however, Mr. Harrison and Alliance failed to meet
their obligations under our investment advisory agreement. Alliance's
Enron purchases ultimately caused a principal loss of over $280,000,000
to the Florida Retirement System. We believe Alliance was negligent in
its job performance. As a result, we have filed litigation against
Alliance to recover our losses. A copy of our Complaint has been
furnished to this Committee as an attachment to a copy of this
statement.
We have all read stories about the inadequacy of Enron's financial
disclosures, conflicts of interest at Enron as well as conflicts, which
exist generally in the financial markets. While these subjects are
worthy of your investigation, any investigative action you undertake
should not allow financial professionals such as Alliance to shift the
blame for their own negligence to the corporations in which they
invest. As detailed in our Complaint, sufficient Enron information was
publicly available to inform a sophisticated investment manager such as
Alliance of the extreme risks of Enron investments. Remember, before
Alliance even invested in Enron, the footnotes of Enron's financial
statements disclosed the supposedly ``secret'' partnerships controlled
by Andrew Fastow. Sadly, Mr. Harrison has admitted, ``nobody ever
really dug into the footnotes.''
Our concerns about Alliance's investments in Enron coincided with
our broader concern about Alliance's performance for the Florida
Retirement System. Alliance had suffered a period of poor performance
unrelated to and before the Enron investments began. In 2000, we had
put Alliance on a ``watch list'' where they stayed until terminated in
December 2001. Throughout this period, in spite of continuing ``red
flags'' that were raised associated with Enron's death spiral, the
Alliance investment team continued to buy Enron stock in an accelerated
fashion. All of this is detailed in the Court Complaint, which we have
furnished to you. You will note that Alliance kept buying, even though
the Enron news was getting worse each day.
As we observed the Enron investments being made, we assumed, to our
detriment, that Alliance was conducting the ``rigorous company specific
research'' they had promised. When we questioned Alliance about the
Enron purchases, we were assured of this fact. It is now clear to us
that Alliance was buying Enron on ``faith''--not on research. However,
this hearing is not the place to try our case; that will be done later
in court.
Rather, the Committee's invitation to this hearing stated that the
scope of your inquiry is focused on the practice of Enron officials
contacting pension funds or institutional investors in order to tout
Enron's stock. We have no information to offer on this subject. We at
the Florida SBA were never contacted by Enron officials. We were
informed by Mr. Harrison that he and members of his Alliance team met
with high-ranking Enron officials. We understand such contacts between
corporate officials and large money managers are common and not unique
to Enron nor Alliance. However, we at the Florida SBA have no direct
knowledge about what was discussed between Enron and Alliance, or if
these discussions were in any way different than those which commonly
take place in the investment industry.
Much has been written about the conflicts of interest that surround
Enron and Alliance, most notably, Mr. Frank Savage, who was an Enron
Board Member (in fact on the Finance Committee) while also serving as a
senior officer and board member of Alliance. We have been assured by
Alliance that this was a conflict without consequences. Because the
effects of Mr. Savage's conflicts are unclear to us at this time, our
lawsuit against Alliance currently makes no claims relating to Mr.
Savage's conflicts of interest. We understand that this Committee, or
others in Congress, are investigating conflicts in the investment
industry. While we encourage a thorough review of these conflict
practices, as a governmental body, the Florida SBA does not engage in
the types of practices now under investigation.
One lesson that needs to be learned from this experience is that
conflicts of interest in the public financial marketplace should at
least be fully and openly disclosed, and some conflicts of interest
should be prohibited altogether. Investment firms should install and
enforce policies that prohibit investment firm employees from serving
on boards of directors of firms they analyze. Just as it is
inappropriate for accounting firms to be both auditor and consultant,
or for investment bankers to not publish analytical reports on firm
clients, it is inappropriate that board members of investment firms be
on the boards of companies whose stock they are recommending and
buying. There is simply too much opportunity for the wrong kind of
alignment of interest.
In closing, I've tried to highlight what happened to us as a
pension fund as a result of negligence on the part of Alliance Capital
Management. As long as pension funds have active portfolio management,
the pension industry must be able to rely on and fully trust expert
outside financial advisors to exercise their fiduciary duties based
upon independent research which is not compromised by conflicts of
interest. Any actions you can take to ensure the integrity of the
research and investment activities from Wall Street firms like Alliance
Capital would be most worthwhile. Thank you for your attention, and I
am happy to answer any questions.
Senator Dorgan. Mr. Herndon, thank you very much. I
understand Mr. Stipanovich and Mr. Webster are here to answer
questions, but you do not have a statement.
Let me ask to have the testimony from Alliance next, and
then we will ask some questions and then have the testimony of
Mr. Glassman from this panel.
Mr. Calvert, how would you like to proceed? Do you and Mr.
Harrison both have a statement, or do you have a statement on--
--
Mr. Calvert. Yes, Mr. Chairman, we do.
Senator Dorgan. All right. Why don't you proceed, and your
entire statement will be made a part of the permanent record.
STATEMENT OF BRUCE W. CALVERT, CHAIRMAN AND CEO, ALLIANCE
CAPITAL MANAGEMENT
Mr. Calvert. Thank you, Mr. Chairman, Senator Nelson. Would
it be all right if we just switched chairs here for----
Senator Dorgan. Let me note that the Ranking Member of the
full Committee has just joined us, Senator McCain, and I've
asked if he has an opening statement. He does not. So we will
proceed, Mr. Harrison, with your testimony.
Mr. Calvert. Good morning. My name is Bruce Calvert, and
I'm the chairman and chief executive officer of Alliance
Capital Management, which is an investment management company.
With me today is Al Harrison, vice chairman of Alliance Capital
Management.
Mr. Harrison is among the most highly regarded and well-
respected managers in the industry. Over the last 30 years, he
has developed a superb investment record and also a well-
deserved reputation for honesty and integrity. As many of you
know, Mr. Harrison purchased Enron stock on behalf of a number
of Alliance clients. He will address some of the reasons why he
made these investments, including his reliance on the
statements made to him by Enron's management, statements that
we now know to be untrue. But first, some background.
Alliance is one of the world's largest investment managers.
Investment management and research is our only business. We
manage approximately $450 billion for a global clientele:
institutions and individuals directly and through a family of
mutual funds. For example, we manage money for 45 of the
Fortune 100 companies, and we manage money for public
retirement systems in 43 of the 50 states.
Our interests are directly tied to the interests of our
clients. Alliance is paid advisory fees based on the assets it
manages for each account. Simply stated, when we buy securities
or make investments that appreciate in value, our revenues
increase. Conversely, if we make investments that decline or
depreciate in value, our revenues decline proportionately. We
do not earn investment banking fees, nor do we trade for our
own account. We prosper when our clients prosper.
Alliance offers a broad range of investment services to
meet the diverse needs of our clients. Today I'm going to focus
on our large-cap growth product, Al Harrison's team, which
consists of 25 portfolio managers, each of whom manages
accounts in accordance with the team's philosophy and
investment process. Each of these managers is also involved in
researching potential investment candidates. The team is
supported by Alliance's investment research organization. Some
320 analysts cover companies throughout the world. Each analyst
is assigned a limited number of companies in the same or
related industries so that they can develop a focused
expertise.
I would now like to turn to our investment in Enron. The
decision to invest in Enron was based on extensive research
into Enron's business, its growth prospects, and the company's
fundamentals, importantly, always in relationship to the price
of the shares. I believe the judgment of Alliance's investment
professionals with respect to Enron was entirely reasonable
based on the information available to them at the time. Of
course, we would have acted differently based on the
information that we have today, but this information was hidden
from us.
While we deeply regret having invested in Enron, the root
problem rests not with the judgment of our portfolio managers,
but with Enron itself. I believe that the blame for the
collapse of Enron and the resulting loss to countless investors
lay with Enron's management and its officers who we now--and I
emphasize ``now''--know were on a course to deliberately
mislead the investors, analysts, rating agencies, and others.
I believe that meetings with management are a crucial part
of the investment decisionmaking process. At Alliance, these
meetings are serious and substantive. Our researchers and
portfolio managers had many such meetings with Enron. During
these meetings, senior members of Enron management
misrepresented numerous material facts. Mr. Harrison can
elaborate on some of these misrepresentations, and I will leave
that subject matter to him.
But we also know that others were misled. For example, a
representative from Standard and Poor's testified that far from
providing anything like complete, timely, and reliable
information, Enron committed multiple acts of deceit and fraud,
just as it did to many others with whom Enron dealt.
Significantly, under federal securities laws, Standard and
Poor's enjoys preferred access to Enron's books, access that
investment advisors, such as Alliance, do not enjoy. Despite
this preferred access, Standard and Poor's were still unaware
of Enron's fraud and continued to rate Enron's credit
investment grade until November 28th, 2001, more than 2 weeks
after Alliance's last purchase of Enron.
Many other investors were similarly deceived. Press reports
have confirmed that a number of money managers invested in
Enron in October and November. Moreover, hundreds of millions
of shares--hundreds of millions of shares--traded in October
and November. As Alliance's purchases represented only a very
tiny fraction of these trades, it is clear that many others
were buying Enron at what they perceived to be very attractive
prices.
It has been reported in the press that, excluding Florida,
at least 5 state pension funds lost more than $100 million in
Enron stock. Alliance did not make the Enron investments for
these funds. Other investment managers had been similarly
misled.
The truth is this. If a management of a corporation is bent
on deceiving the investment public, and if they are vetted by a
major auditing firm in that enterprise, it is very difficult
for investment professionals to discern the truth. This is the
case even where those investment professionals performed
extensive research, as Alliance did with Enron.
If I may, I'd like to just address one final issue relating
to Frank Savage, a director of Alliance Capital. Until July,
Mr. Savage was also an employee of Alliance with responsibility
for sales and marketing in the Middle East and Africa. He did
not have investment responsibilities. Mr. Savage also served on
the board of directors of Enron, beginning in mid October 1999.
Mr. Savage joined the Enron board at Enron's request and
his service was personal to him. Alliance did not ask Mr.
Savage to serve on the Enron board, nor did he so as a
representative of Alliance. Alliance permitted him to join the
board only after he had agreed to comply with our policies
governing employee service on unaffiliated boards which, among
other things, required that he be walled off from any
discussion with Alliance personnel concerning investments in
Enron. Mr. Savage re-certified his compliance with these
policies annually thereafter.
To be perfectly clear, Mr. Savage never participated
directly or indirectly in any decisions by Alliance to buy,
hold, or sell Enron stock, and his membership on the Enron
board had nothing to do with those investments. There was, in
fact, no conflict.
Thank you.
[The prepared statement of Mr. Calvert follows:]
Prepared Statement of Bruce W. Calvert, Chairman and CEO, Alliance
Capital Management
Good morning Mr. Chairman and Members of the Subcommittee. My name
is Bruce Calvert and I am the Chairman and Chief Executive Officer of
the investment management firm Alliance Capital Management (``Alliance
Capital''). I have been with the firm for nearly thirty years, during
which time I served as Chief Investment Officer, Director of Equity
Research and an active equity portfolio manager. I would like to thank
the Subcommittee for the opportunity to appear before you to discuss
Alliance Capital's investments in Enron Corporation (``Enron'').
I am appearing with Alfred Harrison, a Vice Chairman of Alliance
Capital and its most senior portfolio manager. Mr. Harrison is not only
one of Alliance Capital's best managers, he is among the most highly
regarded and well-respected managers in the entire industry. Over the
last thirty years, he has developed one of the most successful
investment track records, and also a well-deserved reputation for
honesty and integrity. As many of you know, Mr. Harrison purchased
Enron stock on behalf of a number of Alliance Capital's clients, and he
can address some of the reasons why he made those investments,
including his reliance on the statements made to him by Enron's
management--statements that we now know to have been untrue.
Alliance Capital is one of the world's largest investment managers.
Investment management and research is our only business. Alliance
Capital provides a wide range of investment management services to a
diverse group of investors worldwide, including U.S. pension plans,
institutional investors and high-net-worth individuals. For example,
Alliance Capital has been selected to manage money for 45 of the
Fortune 100 companies, public retirement systems in 43 of the 50
states, as well as by foundations, endowments, central banks and other
global institutions. Alliance Capital is also one of the largest mutual
fund sponsors, with a diverse family of globally distributed mutual
fund portfolios. As of March 31, 2001, Alliance Capital's total assets
under management were approximately $452 billion.
Significantly, Alliance Capital's revenue is directly tied to
achieving positive performance for its clients. For its investment
management services, Alliance Capital is paid advisory fees based on a
percentage of the net assets it manages for each account. This fee
structure is important in looking at Alliance Capital's incentives with
respect to the investments it made in Enron on behalf of its clients.
Because its investment management revenue is based on a percentage of
assets under management, if Alliance Capital invests in a company whose
stock drops in value, its advisory fees will drop proportionately.
You should also know that Alliance Capital offers its clients
multiple products. Our clients have greatly varying needs, and in
response to those needs, we offer a full range of investment
disciplines. In broad terms, we offer growth equities, value equities
and fixed income. Within these broad categories, we offer more specific
services. In growth equity, we offer such products as large-cap growth,
mid and small-cap growth, international growth and others. A product
wheel identifying these many offerings is attached to my statement as
Exhibit A.
Of the broad spectrum of investment disciplines Alliance Capital
offers, I am going to talk today about our Large Capitalization Growth
product. Alliance Capital's large cap growth team is headed by Alfred
Harrison. The team consists of portfolio managers and investment
professionals based in Minneapolis, Chicago and Cleveland, all of whom
are responsible for managing accounts pursuant to a large
capitalization growth investment strategy. Collectively, these managers
use their independent knowledge and experience to research potential
investment candidates. These portfolio managers work as a team, and
very often, but by no means always, invest in the same securities.
Although there will typically be a broad degree of overlap in the
holdings of the large cap growth portfolio managers, each portfolio
manager does have a meaningful degree of individual discretion with
respect to portfolio composition, and it would be unusual to see two
portfolio managers have identical holdings in their portfolios.
It is critically important to understand that Alliance Capital is a
research-driven organization. We have more than 320 analysts covering a
broad universe of companies throughout the world organized into growth,
value and fixed income teams. The number of analysts is important
because it permits us to assign each analyst to a specific industry
sector with a limited number of companies to follow so that the
analysts can develop a depth of knowledge about the companies they
follow. We often assign multiple analysts to cover a single company
from different viewpoints, such as equity and fixed income. The sole
purpose of these analysts is to assist in improving performance of
client accounts. That is how we grow our revenues. We do not earn
investment banking fees, nor do we engage in trading for our own
account.
With that background, I would like to turn to Alliance Capital's
investments in Enron. The decision to invest in Enron was based on
extensive research by the Alliance Capital research and portfolio
management team into Enron's business, its growth prospects, and the
company's fundamentals in relation to the price of its shares. Without
question, I believe that the judgment of Alliance Capital's investment
professionals with respect to Enron was entirely reasonable based on
the information available to them at the time. We at Alliance Capital
deeply regret having invested in Enron, but the root of the problem
rests not with the judgment of our portfolio managers, but with Enron
itself. That is, I believe the blame for the collapse of Enron and the
resulting loss to countless investors lay with Enron's management and
its auditors, who now appear to have been on a course to deliberately
mislead investors, analysts, rating agencies and others.
I understand that Alliance Capital's research and portfolio
management team had many meetings and conversations with Enron
management to discuss Enron's business. Based on my years of
experience, I believe that meetings with management are a very
important part of the investment decision-making process. These
meetings tend to be serious and substantive.
In the course of Alliance Capital's meetings with Enron, senior
members of Enron management misrepresented numerous material facts. Mr.
Harrison can elaborate on some of those misrepresentations, and I will
leave that subject matter to him. But we do know, based at least in
part on the testimony before this Subcommittee and other Senate
Committees, that many others were similarly deceived by Enron and its
management.
For example, a representative from Standard & Poor's testified that
Enron failed to disclose that certain Enron insiders had a financial
stake in Enron's off-balance-sheet partnerships and failed to disclose
the nature of compensation that was paid to Enron's CFO in connection
with these partnerships. Specifically, he testified that ``far from
providing anything like complete, timely and reliable information to
Standard & Poor's, [Enron] committed multiple acts of deceit and fraud
on Standard & Poor's, just as it did to many others with whom Enron
dealt.'' Significantly, under federal securities laws, Standard &
Poor's enjoyed preferred access to Enron's books, records and financial
condition--access that investment advisors such as Alliance Capital do
not enjoy. Despite this preferred access, Standard & Poor's was still
unaware of Enron's fraud and continued to rate Enron's credit as
investment grade until November 28, 2001, almost two weeks after
Alliance Capital's last purchase of Enron stock.
Similarly, an analyst for Credit Suisse First Boston stated that
the ``inaccuracies and lack of information in Enron's financial
reporting affected [his] conclusions and ratings on Enron.'' He
explained that ``[i]f the information a company provides is incomplete,
incorrect or misleading, [his] analysis will be undermined.''
Obviously, we concur with this statement.
As I have said, it is plain that many institutions and private
investors relied on the statements of Enron management and the
company's audited financials. At this point, it is not clear which
institutions were investing in Enron in the fourth quarter of 2001, but
certainly many firms bought Enron stock during this time. Press reports
have confirmed that a number of money managers invested in Enron in
October and November on behalf of public pension funds. Moreover, there
were many millions of shares being traded each day in October and
November, and in some cases, hundreds of millions of shares. As
Alliance Capital's purchases represented only a minor fraction of these
trades, it is clear that many others were buying Enron in large
quantities at what they believed to be bargain prices. And many
investors who did not buy Enron during this time period still owned
substantial quantities they previously purchased, but did not sell. It
has been reported in the press that, excluding Florida, at least 5
state pension funds each lost more than $100 million in Enron stock.
(Alliance Capital did not make the Enron investments for those funds.)
These large and widespread losses underscore one unfortunate fact--
that as a general matter, if management of a corporation is bent on
deceiving the investing public, and they are abetted by a major
auditing firm, it is very difficult for investment professionals to
discern the truth. This is the case even where those investment
professionals perform extensive research into the company's business,
as Alliance Capital did with Enron.
I would also like to take the opportunity to address one final
issue relating to Frank Savage, a director of Alliance Capital
Management Corporation, the general partner of Alliance Capital. Until
the end of July of 2001, Mr. Savage was an employee of Alliance
Capital, with responsibility for sales and marketing in the Middle East
and Africa.
Mr. Savage also served on the board of directors of Enron beginning
in mid-October 1999. Mr. Savage joined the Enron board at Enron's
request, and his service was personal to him. Alliance Capital did not
ask Mr. Savage to serve on the Enron board, nor did he do so as a
representative of Alliance Capital. Alliance Capital permitted him to
join the Enron board only after he had agreed in writing to comply with
Alliance's policies governing employee service on unaffiliated boards,
which among things required that he be ``walled off'' from any
discussion with Alliance Capital personnel concerning investments in
Enron. Mr. Savage re-certified his compliance with those policies
annually thereafter. To be perfectly clear, Mr. Savage never
participated directly or indirectly in any decisions by Alliance to
buy, hold or sell Enron stock, and his membership on the Enron board
had nothing to do with those investments.
Thank you, Mr. Chairman. I appreciate the opportunity to answer any
questions the Subcommittee might have.
Exhibit A
Senator Dorgan. Mr. Calvert, thank you very much.
Mr. Harrison, you may proceed.
STATEMENT OF ALFRED HARRISON, VICE CHAIRMAN, ALLIANCE CAPITAL
MANAGEMENT
Mr. Harrison. Good afternoon, Mr. Chairman and Members of
the Subcommittee, and thank you for the opportunity to appear
here today to discuss events related to Enron. My name is
Alfred Harrison, and I'm a vice chairman of Alliance Capital
Management. I also lead the large capitalization growth team,
which has over $50 billion in assets under management.
For 17 years, I have been responsible for managing the
Florida State Board of Administration account. During that
time, the account grew from an initial funding of $50 million
in 1984 and subsequent contributions of $294 million to more
than $3.6 billion in assets, a total return of over 1500
percent, versus comparative returns for the S&P 500 of 978
percent, the Russell 1000 growth index of 863 percent, and 843
percent for a benchmark unique to Florida. Even allowing for
the $280 million loss on Enron and all fees paid to Alliance
Capital by the SBA, this means that we added more than $1
billion to the account than would have been achieved by
indexing in any benchmark. I believe the pensioners of Florida
would be very pleased with this result.
Our investment philosophy centers on using intensive
research to find the correct balance between a company's
fundamentals, on the one hand, and using judgment to assess its
price. We call this the ``V factor.'' It sometimes means buying
a stock into a price period of weakness if we believe it
underprices a company's long-term core earnings power. We've
followed this buy-low/sell-high methodology on many successful
occasions benefiting the fund by several hundreds millions of
dollars.
If I could just interject here, painful though it is, I
bought the airlines stocks immediately--the market opened after
September the 11th and made a very strong recovery in price as
a result of that.
My original investment in Enron was in November 2000. Its
reported annual earnings were growing at 25 to 35 percent at a
time when technology stocks were beginning to collapse. Enron's
reported growth stood out by comparison.
I have been asked how I viewed Jeff Skilling's departure on
August the 14th. My colleagues and I considered the return of
Ken Lay and the promise of openness and a commitment to get rid
of non-core assets as a positive. We met with Ken Lay and
colleagues in Minneapolis on August the 21st and intensively
questioned them all. On October the 16th, the company took a
one-time charge in writing off its investment in failed
entities such as broadband, but noted that its quarterly
recurring earnings increased by 26 percent on the core
business. They also took a $1.2 billion equity writeoff for
losses incurred in a partnership, but took back from Enron
shares that had been pledged as collateral to that partnership.
The next day, I and six members of Alliance Capital from
Minneapolis and New York on both the equity and fixed income
sides met with the entire Enron team in New York. We concluded
that Enron's core business was still intact.
Senator Dorgan. Excuse me. What date was that?
Mr. Harrison. That was October the 17th, sir.
We concluded that Enron's core business was still intact
and that Ken Lay was doing what he had promised in terms of
acknowledging past investment mistakes and clearing the decks.
Senator Dorgan. Mr. Harrison, excuse me for interrupting
again. Did that include Mr. Lay and Mr. Fastow?
Mr. Harrison. No. Mr. Fastow was not there at that meeting.
Just Mr. Lay, CEO Greg Whalley, Executive Vice President Mark
Koenig, Jeff McMahon, the treasurer, and Paula Rieker, investor
relations.
Senator Dorgan. Thank you.
Mr. Harrison. Enron's management insisted that it had
completely unwound its relationship with the partnership and
that everything was now out in the open. He insisted that no
further negatives would be revealed. Based in part on the false
reassurances directly from the most senior levels of Enron
management, we continued to add to our Enron positions in the
ensuing price weakness.
On November the 9th, Dynegy made a bid for Enron, which
seemed to validate our confidence in its core operations. The
bid was backed by $1.5 billion from Chevron Texaco, who owned
27 percent of Dynegy. This was like Avis making a bid for
Hertz.
We met with Dynegy management, who had seen Enron's book.
We met them in New York, Chicago, and Minneapolis in the next
few days and were convinced that the resulting company could be
a powerhouse, assuming regulatory approval. We bought more
Enron stock, around $9 a share. Since the SBA gets daily
electronic transmission of all of our trades, they are aware of
these purchases. Unfortunately, Dynegy withdrew their offer in
late November when the rating agencies downgraded Enron's debt
two notches to junk status and bankruptcy was imminent, as we
sold our shares.
Let me stress that only a little over 10 percent of my
dollar investments in Enron took place in October and November
before this bankruptcy. Throughout our ownership of Enron, our
analysts on my team researched the company extensively, met
with management over a several-year period. We talked with Wall
Street energy traders, suppliers, and the rating agencies,
amongst many others. Unfortunately, we know now that Enron was
a massive fraud. Its audited financial statements were
misleading and grossly incomplete. We, along with other
investors, suffered greatly as a consequence.
Before closing, let me also address the subject of Frank
Savage, who served on the board of Alliance Capital's general
partners and who, until the end of July 2001, was an Alliance
Capital employee. Let me say emphatically that I did not
discuss Enron with Mr. Savage, and he played no part in my
decisions on Enron.
I would be happy to answer your questions.
[The prepared statement of Mr. Harrison follows:]
Prepared Statement of Alfred Harrison, Vice Chairman, Alliance Capital
Management
Good morning Mr. Chairman and Members of the Subcommittee, and
thank you for the opportunity to appear here today to discuss events
related to Enron Corporation (``Enron'').
My name is Alfred Harrison and I am the Vice Chairman of Alliance
Capital Management (``Alliance Capital''). I also lead the large
capitalization growth team at Alliance Capital with over $50 billion in
total assets under management.
For seventeen years, I have been the portfolio manager with
ultimate responsibility for managing the account of the Florida State
Board of Administration (``SBA''), the state agency charged with
responsibility for managing Florida's public pension fund. During the
17 years that I managed the SBA portfolio, we grew the account from
$344 million in contributions to more than $3.6 billion in assets--a
total return of approximately 1,500 percent versus comparative returns
for the S&P 500 Index of 978 percent, the Russell 1000 Growth Index of
863 percent and the benchmark selected by Florida itself of 843
percent--even allowing for the approximately $280 million loss on Enron
and all fees paid to Alliance Capital by the SBA.
This means that Alliance Capital achieved a return for the SBA
account of more than $1 billion more than would have been achieved by
investing in any index benchmark during that period. I believe the
pensioners of Florida should be very pleased with this result.
Our investment philosophy, which has been consistently applied,
involves finding the correct marriage between Fundamentals as they
relate to each company--which is a product of intensive research--and
then applying a Price judgment in relation to the facts we ascertain.
We call this the ``V factor''.
Enron appeared to have many of the qualities we look for in a
growth stock. For example, when I originally invested in Enron in
November 2000, it was the seventh largest U.S. company, with a dominant
market position in the newly deregulated area of gas and electricity
distribution and trading. It had reported annual earnings growth of 25
percent-35 percent. Enron's management had been widely heralded as
among the brightest and most visionary management teams in the world.
Although market opinion is never unanimous about a company's
business and prospects, Enron, because of its dominant position, was
widely held by institutional investors, including many of the largest
fund managers in the country. That notwithstanding, some have
criticized my additional purchases of Enron stock in the months before
Enron's bankruptcy. Overall, a little over 10 percent of my dollar
investment in Enron on behalf of the SBA took place in October and
November of 2001 before Enron declared bankruptcy.
A key element of our ``V'' factor'' investment philosophy is to
opportunistically add to a position in a stock that is declining in
price if the company's core earnings power is projected to remain
intact. This philosophy is clearly stated in the investment advisory
agreement between Alliance Capital and the SBA, and has worked with
enormous success for the SBA and many other clients over the years.
When Enron's stock came under price pressure but its fundamental
business appeared to remain intact, the stock appeared to be attractive
consistent with the ``V'' philosophy. That is, Alliance Capital's
purchases were based on the belief that the magnitude of the adverse
developments was more than discounted in the stock price and that
Enron's assets and long-term earnings power were undervalued. Again,
this is a time-tested investment strategy that Alliance has applied
consistently over the last two decades to achieve the outstanding
results it has for the SBA and its other clients.
I have been asked how I viewed the August 14, 2001 resignation of
Enron's then-CEO Jeffrey Skilling. At the time, we viewed Kenneth Lay's
return as CEO to be a positive development given his promise of
openness and a commitment that Enron would shed non-core assets and
focus upon its core business lines. Upon learning of Skilling's
departure, I and my colleagues immediately arranged for a meeting with
Lay, which was held in Alliance Capital's Minneapolis offices on August
21, 2001. At that meeting, we had a very detailed discussion about
Enron's business, and our questions appeared to have been answered in a
complete and satisfactory manner.
On October 16, 2001 Enron reported its third-quarter results and a
surprising $1.2 billion reduction in shareholder equity. The very next
day, I and my colleagues, including a number of portfolio managers, our
equity analyst, our fixed income analysts and our oil analyst, met in
New York with Ken Lay, COO Greg Whalley, Treasurer Jeff McMahon,
Executive Vice President Mark Koenig and Paula Rieker, from Investor
Relations. The Enron group represented to us that the reduction of
shareholder equity was offset by Enron's buyback of stock pledged to a
partnership, and that the write-off was equivalent to the company's
repurchasing the shares in the open market. Enron's management insisted
it had completely unwound its relationship with the partnership and
that everything was now out in the open. As we now know, these and
other representations were patently false. Even with the few special
purpose entities that did come to light, crucial facts were withheld
about the structure and insider relationships with Enron management.
Based in part on the false reassurances directly from the most
senior levels of Enron management, in the four weeks following October
16, Alliance Capital added to the SBA's Enron position.
Some of these additional purchases were made shortly after November
9, when Dynegy, with a $1.5 billion dollars cash commitment from
ChevronTexaco, announced its intention to merge with Enron. Based on
the fixed exchange rate stipulated in the proposed merger agreement
between Dynegy and Enron, Enron was trading at a large discount to its
indicated exchange value. Moreover, we saw the new combined entity as
offering strong appreciation potential. Before investing, Alliance
Capital discussed the proposed deal with Dynegy management in the week
following the merger announcement. We met with Dynegy management in New
York, Chicago and Minneapolis. Dynegy stated that it was confident that
the merger would be completed. Specifically, Dynegy's management stated
that, based on their due diligence and their extensive experience in
the business, Enron's books appeared to be in order and confirmed that
Enron's core energy business was very strong. Market analysts around
the country also generally believed that the deal would close, and that
the deal presented a strong upside for Enron shareholders. Again,
consistent with the ``V'' philosophy, I added to the Enron position
around $9 per share.
Alliance Capital's research was critical to all these decisions.
Typically, I select stocks for investment using judgment, experience,
and research by our analysts and my team of portfolio managers. In the
case of Enron, that research included many meetings and calls with
Enron's senior management. It included a review of Enron's public
filings, audited financial statements and press releases. It included
detailed discussions with Enron's suppliers, customers and competitors.
It included following Enron's credit ratings, discussing Enron with the
credit rating agencies, following energy industry developments,
attending major industry conferences, utilizing the expertise of sell-
side analysts that followed Enron, and analyzing Enron's apparent debt
load.
In my experience, one of the most crucial aspects of Alliance
Capital's research and evaluation process is speaking with a company's
management team. The last year's events notwithstanding, I have found
that management almost invariably provides an accurate picture of the
company's business. They are of course obligated by law to do so.
Unfortunately with Enron, this was not the case. As I have said, I and
other portfolio managers and analysts on the Alliance Capital team met
and spoke with Enron management repeatedly throughout 2001, and their
answers to our questions were false and misleading in significant
respects.
We now know, of course, that Alliance Capital was not the only
investment advisor or investor misled by Enron. Based upon published
reports, it appears that the SBA lost as much as $50 million as a
result of other investment advisers' investments in Enron, or in index
funds managed by the SBA itself. Many thousands of other investors
suffered losses in Enron, ranging from a few dollars to well over $150
million dollars. Indeed, it has been reported that apart from the SBA,
5 state pension funds each lost at least $100 million in Enron.
(Alliance Capital did not make those Enron investments).
And while we never rely uncritically on the opinions of sell-side
analysts affiliated with other firms, often the substance of the
information they convey, as well as their opinions, are helpful to our
analysis. It is interesting to note that throughout October and
November 2001, many sell-side analysts continued to rate Enron a buy or
strong buy. Goldman Sachs, J.P. Morgan, Lehman Brothers, Salomon Smith
Barney, UBS Warburg, Merrill Lynch, CIBC Oppenheimer and CS First
Boston were among the major firms that continued to recommend Enron as
an attractive stock. We consulted a number of these institutions whose
analysis of Enron appears to have been wrong-footed by Enron's
misinformation.
Alliance Capital also consulted Standard & Poor's regarding its
credit ratings of Enron. Credit rating agencies can serve as a
significant source of information about a company, as the agencies
enjoy unrivalled access to a company's books and records under the
securities laws that investment advisers such as Alliance Capital do
not have. Unfortunately, Standard & Poor's has publicly confirmed that,
despite its privileged position, it too was deliberately misled by
Enron.
I have managed money for institutional and private investors for
forty years, and I have always taken my responsibilities very
seriously. Part of this responsibility involves exercising judgment in
selecting stocks for my clients. In the case of Enron, that judgment
was impaired by false and misleading information from Enron and its
auditors Arthur Andersen. The truth is, Enron may be the single
largest, most far-reaching episode of corporate fraud of this century,
and a great number of portfolio managers around the country were likely
misled, just as Alliance Capital was.
Finally, I want to address a question that has been raised
concerning Frank Savage, who served on the board of Alliance Capital's
general partner and who, until the end of July 2001, was an Alliance
Capital employee. Let me say emphatically that I have never discussed
Enron with Mr. Savage, and he played no part with my Enron decisions.
I welcome any questions the Subcommittee may have regarding these
matters.
Senator Dorgan. Mr. Harrison, thank you very much.
I'm not quite sure where to start here, except that the
public employees pension fund in Florida lost $300-and-some
million, and I think, Mr. Herndon, you say it really wasn't
your fault. Mr. Calvert and Mr. Harrison, you say it wasn't
yours. And I think what you're saying is that you were lied to
and misled by the Enron Corporation. You did due--you say you
did due diligence, but the deception by the Enron Corporation
caused you to do things. The result is that caused the Florida
pension fund to experience a rather substantial loss.
Senator McCain, I indicated I was going to ask a couple of
questions of Alliance and then call on Mr. Glassman, if that's
all right with you.
Senator McCain. I see. All right.
Senator Dorgan. Let me try to understand this just a bit
more, if I can. Does the Florida pension management know of the
general positions that are taken and the purchases made when
they are made? Did you know, for example, that as Enron stock
was collapsing and pancaking, that additional purchases were
being made by Alliance, in your behalf, of Enron stock?
Mr. Herndon. Yes, sir, Senator. We knew that those
activities were taking place and, in response to our queries of
Alliance, were reassured that the rigorous company-specific
research they promised us was also being undertaken by
Alliance, so we continued to place our trust in them and may
have been misguided, in retrospect.
Senator Dorgan. But you trusted them. Was there internal
difficulties? Did you have discussions amongst yourselves,
amongst the three-member board, of whether this was a good
decision or whether you should continue to allow this to
happen?
Mr. Herndon. We discussed it at some length. Remember, it's
important to put in perspective the fact that we had put
Alliance on our watch list almost a year before, because their
performance had been deteriorating overall. So the Enron
situation was a specific example of concern that we had in that
broader context.
We did discuss it. We discussed it with Alliance. They
reassured us that everything was OK, that they knew what they
were doing. We don't second guess our managers' stock
decisions. We make decisions about whether to hire or fire
managers. We don't have the resources or the capabilities--nor
does any other pension fund, for the most part, in this
country--have the capability to do individual stock research.
That's what we hire the experts for.
Senator Dorgan. I understand that. But if you don't second
guess those who purchase your stocks, then why do you put them
on a watch list?
Mr. Herndon. Well, we asked them questions to try and
discern whether or not they are confident in their view that
they are, in fact, in possession of the facts, that they can
express their discipline and their professional opinion in a
sound fashion. And we were hearing comforting noises from
Alliance that were intended, at least, to reassure us that they
were doing the homework. We don't know that.
Senator Dorgan. And my question, I guess, is that the
entire country was selling Enron--that's why its stock was
collapsing--and you were discovering that you were buying more
of it through your relationship with Alliance, and I was trying
to understand if, internally, you were having second thoughts
about that and having a discussion about whether you ought not
to see that that's discontinued.
Mr. Herndon. We did have those discussions.
Senator Dorgan. Mr. Stipanovich, can you describe those
discussions for me?
Mr. Stipanovich. What we look at with a manager, and as Mr.
Herndon related, when we put a manager on a watch list, it's
really performance based. It's not really their--it's a
byproduct of their stock selection. But because we don't have
the expertise, nor do we exercise the discretion to get into
individual stock selection, we really look at overall
performance over periods of time, and that period of time is
typically 1-, 3-, and 5-year periods and then since inception
and that kind of thing, but the--more of the emphasis on the 3-
and 5-year period. So it was for overall performance that
really was the overriding problem. Enron was really the straw
that broke the camel's back.
Senator Dorgan. Let me just--an initial question about
Enron and your meetings with them. Mr. Calvert, you and Mr.
Harrison both indicated that the top officials from Enron just
lied to you, misrepresented the company. You used the word
``fraud'' a good many times in your presentation. We had Mr.
Lay sitting at the table that you're now sitting at, and he
took the Fifth Amendment. And we had Mr. Skilling, and he
talked from here to Europe, but we really didn't understand
much of what he was saying, at least he never admitted to very
much. And Mr. Fastow is nowhere to be found. And so we're
struggling to try to determine what Enron represented to people
like you.
Tell me again, if you can, with more specifics, how do you
believe Enron lied to or deceived Alliance Capital, and who did
that?
Mr. Harrison. In retrospect, I think we can see that we not
only had misleading information that came out in a very
parsimonious fashion, but it was grossly incomplete. What has
come out subsequently, in terms of literally hundreds, maybe
thousands, of partnerships would have given a totally different
picture, both as it relates to the gains and losses, and
particularly the debt position of Enron.
So I think that the key thing here is that, notwithstanding
face-to-face meetings, looking them in the eye, asking all of
the questions that we have done over the years that have led to
our successful performance, the answers that were given, in
retrospect, were just not adequate.
Senator Dorgan. Mr. Harrison, were you aware of an SPE
called ``Braveheart''?
Mr. Harrison. Was I aware at the time? No.
Senator Dorgan. You are now?
Mr. Harrison. No. I am now, yes.
Senator Dorgan. Would an analyst or someone in your
position expect to be knowledgeable about Braveheart? I mean,
would you expect the corporation to have disclosed sufficient
footnotes and information on their financial statements to
allow one to understand what a Braveheart is and how they use
the money?
Mr. Harrison. If the auditors had considered something to
be material, it very definitely should have been right out
there in front of investors, rating agencies, and everybody
else.
Senator Dorgan. So do you believe you were lied to by the
auditors with respect to this company, as well?
Mr. Harrison. Clearly, the failure to provide information
on something such as this would point to at least inadequacy on
their party.
Senator Dorgan. Senator McCain?
Senator McCain. Mr. Herndon, in March of 2002, the Tampa
Tribune quotes you as saying, ``I can probably give as many
examples on the upside as I can on the downside of investment
managers of ours who have taken relatively large positions on
companies on bad news, where the price got driven down only to
have it rebound.'' It continued, ``I'm not sure we would do
anything different today than we did last fall.''
Mr. Herndon, given those statements, why do you now believe
Mr. Harrison was negligent by investing in Enron?
Mr. Herndon. My view hasn't changed much, Senator, since
last fall, and that is that the process by which Alliance makes
its investments, we believe is sound if its rigorously applied
and done in the utmost of fiducially responsible fashion. We
don't believe that occurred in this case.
Senator McCain. You wouldn't have done anything different
than you did last fall?
Mr. Herndon. If we had been able to rest confidently that
Alliance had, in fact, done the homework, Senator, I don't
believe we would have done anything different, but we don't
believe Alliance did the homework. They've never been willing
to share that with us. So, consequently, we have no other
position to take except that they didn't do it.
Senator McCain. In the summer of 2001, SBA personnel
visited Harrison's group in Minneapolis. After the meeting, Mr.
Webster wrote in a memo to the SBA, ``My opinion of Alliance as
a first-class organization is only enhanced by our visit. The
depth and breadth of the knowledge within Alliance is
impressive.'' It continued, ``We discussed a wide range of
operational market issues with Al Harrison. He gives me no
reason to believe we should be at all concerned about Al's
ability. I continue to believe that Al is one of the best money
managers employed by the state board.''
Mr. Webster, how does the SBA reconcile the statements with
their claim now that Alliance was negligent?
Mr. Webster. Our trip up to Minneapolis was to better
understand the process by which Alliance picked stocks. Our
observations made us believe that the process was sound.
Senator McCain. Well, were you fooled, Mr. Webster?
Mr. Webster. Well, I would probably think so, yes, in this
case.
Senator McCain. And, Mr. Herndon, you were not deceived?
Mr. Herndon. Senator, we have no quarrel with the fact that
Alliance has been an outstanding investment manager on behalf
of the state board for many years. But just as I have a clean
driving record for 17 years, and then if I plow into a
crosswalk and kill a bunch of children, the fact remains that I
have been negligent in that specific instance. And that's
exactly what we think happened in this case. And Alliance has
made no effort to help us understand why, in fact, that didn't
occur.
The process is sound. We don't have any quarrel with that,
if it's diligently applied. In this case, we believe there was
negligence afoot on the part of Alliance, and we'll ultimately
let a court of law make that determination.
Senator McCain. Mr. Calvert, there have been suspicions
raised regarding a possible conflict of interest by Mr. Savage,
who sits simultaneously on the Alliance and the Enron boards of
directors. Do you believe that Mr. Savage's dual roles give, at
a minimum, an appearance of impropriety? And I'd ask you to
take the microphone, if you don't mind.
Mr. Calvert. We don't believe that there was, in fact, a
conflict. We believe it was well covered by our policies. And,
on the other hand, we do understand that perception is a
different issue, and we think people have been entirely
entitled to question at great length, and to question that
relationship to see if there was impropriety, and I believe we
have said there was not, and I believe people have concluded--
--
Senator McCain. Do you believe there was an appearance of
impropriety?
Mr. Calvert. I do not believe that, no.
Senator McCain. Should corporate board members be required
to disclose potential conflicts, in your view, Mr. Calvert?
Mr. Calvert. Yes, they should. And our 10-K discloses that
Mr. Savage was on the Enron board.
Senator McCain. Don't you think average citizens, when
seeing the very large amounts of money Mr. Savage directed
toward investments in Enron would say, ``Wait a minute. He's a
member of the board of directors of this company. Wouldn't that
give him some bias?''
Mr. Calvert. Mr. Savage didn't direct any investments for
Enron. He was not involved in any way, shape, or form at any
time, in any discussions, or any decisions that were made about
our investments in Enron.
Senator McCain. He had no involvement in the decisions made
by Mr. Harrison's team in Florida.
Mr. Calvert. Absolutely not.
Senator McCain. I thank you. I thank the witnesses, and I
thank you, Mr. Chairman. I thank the witnesses. Mr. Glassman,
welcome.
Senator Nelson [presiding]: Mr. Glassman, we'll take your
testimony, and then we'll continue the questioning.
STATEMENT OF JAMES K. GLASSMAN, RESIDENT FELLOW, AMERICAN
ENTERPRISE INSTITUTE
Mr. Glassman. Thank you, Senator Nelson and Senator McCain.
My name is James K. Glassman. I'm a resident fellow at the
American Enterprise Institute and host of the Web site
texcentralstation.com. I'm also a syndicated financial
columnist for the Washington Post and author of two books on
investing. I devoted much of my professional career to
educating small investors. I am deeply concerned about the
effects of the Enron scandal on these investors, and I
congratulate you for holding this hearing today.
Currently, more than half of U.S. families own stock,
compared with just 15 percent in the mid 1960's and 20 percent
in the early 1990's. This is an enormously beneficial
development. The Enron disaster has been costly and shameful,
but it provides a valuable educational opportunity for these
investors. It is important that Members of Congress help them
draw the right lessons.
But I worry that, in hearings like this one, investors can
get a dangerous message, that they are not personally
responsible for their investments. For example, many Florida
officials have, unwittingly or not, given the public the
impression that the way the stock market works is that you keep
your gains and sue to recover your losses since they must be
someone else's fault. Indeed, the most important lesson of the
Enron collapse should be that investors assume risks when they
invest in stocks, and that they need to protect themselves.
A smart investment strategy, then, is one that harnesses
risk, dampens it, tries to control it. But eliminating risk in
the stock market is impossible. The best way to harness risk is
through diversification. That is owning lots of stocks in
different sectors so the inevitable losers will be offset by
winners. Well-run pension funds typically hire several managers
with different, often uncorrelating investment styles. Each of
the managers is responsible for a portion of the fund's assets.
And one thing tell my readers is that stock investing is a
long-term endeavor. There will be rotten years and great ones.
The only way judge a portfolio manager is over the long-term.
As someone who follows investment managers, I can only say
that Mr. Harrison's long-term record has been exceptionally
good. Mr. Harrison can defend his own record, and he has,
although if I were Mr. Harrison, I would certainly respond to
the comments about his investment style being equated to a
drunk driver who kills children.
But let me just emphasize what I think is the relevant
information about his long-term record--his record. Long-term
records are what count. And from 1984 to 2001, according to
published reports, even with the Enron losses, he increased his
share of the Florida account from $345 million to $3.7 billion,
beating the S&P and other benchmarks. His investing style was
well known to Florida officials, or it should have been. He
buys, in an often very risky way, beaten-up stocks that are
solid but he believes are underpriced. For example, according
to the New York Times, he made a, quote, ``quick large gain,''
end quote, by buying Continental Airlines stock after the
tragedy of the terrorist attacks of September 11th, which went
down and then went back up.
Overall--and I think this is a point that has not been made
and should be--Enron represented, according to my calculations,
0.3 percent of the total Florida pension fund. If the Florida
pension fund had been invested in the Standard & Poor's 500
stock index, which is generally perceived as a good way and not
overly risky way to invest in stocks, it would have represented
0.5 percent. So, in a sense, Florida was actually under-
invested in Enron.
Let me just address a couple of specifics. Mr. Harrison was
faulted for buying Enron as the price fell. The New York Times
quoted Tom Gallaher, the Florida State Treasurer and one of the
state pension fund's trustees, as saying, quote, ``Only fools
buy on the way down,'' end quote. In fact, good investors, who
believe in the companies in which they put their money, prefer
to buy stocks at low prices rather than high.
Second, Enron's value in the stock market fell sharply
when, on October 16th, 2001, it announced a reduction of
shareholder equity of $1.2 billion because of partnership
losses. Then came the further shocks of October 22nd and
November 8th, the overstatement of profits.
Between October 22nd and November 16th, Mr. Harrison
bought, according to published reports, $35 million worth of
Enron at prices ranging from $9 to $23 a share. The question is
whether this investment was reckless. A little math is in
order. This investment represented less than 1 percent of his
total Florida portfolio under management and less than four-
one-hundredths-of-one-percent of the entire Florida pension
fund. Specifically, the New York Times cited the $12 million he
invested between November 13th and November 16th and called it,
quote, ``a huge bet that the company's prospects would turn
around,'' end quote. In fact, it was not a huge bet. It
represented one-three-hundredths of Mr. Harrison's Florida
portfolio, and about one-ten-thousandth of the entire pension
fund. Clearly, in hindsight, Mr. Harrison did make a mistake,
but it appears to me that he didn't do anything that was
reckless.
Were Mr. Harrison's investing practices bizarre, as Senator
Nelson, you, yourself are quoted as saying? Not in my opinion.
It is important to remember humility in viewing the workings of
markets. The price of a stock is the considered judgment of
thousands of investors. For every seller, there is a buyer.
After the adverse revelations, the fact that Enron stock was
plummeting, for example, doesn't mean that it's a bad
investment. For example, by definition, $10 a share was the
best--that is to say, the most informed--price for Enron on
November 14th, one of the days on which Mr. Harrison made his
purchases. Yes, it was a mistake. It was a bad purchase, in
hindsight. But Mr. Harrison has also made many good ones.
The Enron collapse has unfortunately generated a kind of
hysteria. In fact, what is bizarre is not so much the behavior
of portfolio manages like Mr. Harrison, but the behavior of
many journalists and public officials. Enron was a costly
episode, but I fear that the search for scapegoats will end up
not merely smearing the reputations of talented and dedicated
professionals, but will send small investors--that is, your
constituents--a disastrously wrong message.
We should not frighten people away from investing. Whether
we like it or not, for most Americans, stock market investing
represents not just the best, but, in fact, the only way to
build a large enough nest egg for a comfortable retirement.
Yes, we need to protect and nurture investors, but we should
not treat them like fools or children. We need to give them the
tools, including accurate reporting and good financial
education, which is an important role for Congress to play, to
make their responsible choices.
I thank you.
[The prepared statement of Mr. Glassman follows:]
Prepared Statement of James K. Glassman, Resident Fellow, American
Enterprise Institute
Bizarre Behavior? The Story of Enron Stock Losses in the Florida State
Employee Retirement Fund
Mr. Chairman and Members of the Subcommittee:
My name is James K. Glassman. I am a resident fellow at the
American Enterprise Institute and host of the website
TechCentralStation.com. I am also a syndicated financial columnist for
the Washington Post and author of two books on investing. I have
devoted much of my professional career to educating and advising small
investors. I am deeply concerned about the effects of the Enron scandal
on these investors and congratulate you for holding this hearing today.
Currently, more than half of all U.S. families own stock, compared
with just 15 percent in the mid-1960s and 20 percent in the early
1990s. This is an enormously beneficial development. Americans
primarily own shares of individual companies, mutual funds run by
professionals, or index portfolios, which are baskets of stocks,
maintained by computer programs, that reflect broader markets. The
Enron disaster has been costly and shameful, but it provides a valuable
educational opportunity for investors. It is important that members of
Congress help them draw the right lessons.
I worry that in hearings like this one, investors get a dangerous
message--that they are not personally responsible for their
investments. For example, many Florida officials have, unwittingly or
not, given the public the impression that the way the stock market
works is that you keep your gains and sue to recover your losses--since
they must be someone else's fault. In this view, investing is an
endeavor that always produces winners, so, if there are losers, they
someone must have cheated.
Instead, the most important lesson of the Enron collapse should be
that investors assume risks when they invest in stocks, and they need
to protect themselves. This hearing asks witnesses to comment on how
losses such as those in the Enron case could be ``avoided in the
future.'' They cannot. Some stocks will always fall in value. The
market as a whole has fallen in 22 of the past 76 years. Investors need
to know that short-term losses are part of investing. Stocks are risky.
However, the risk that a company will use deceptive or illegal
accounting practices is a highly unusual one. Share prices of America's
very best companies, with good managers, good products, good employees
and good ideas, will fall from time to time--with no chicanery or
lawbreaking involved.
In early 2000, for example, the stock-market value of Procter &
Gamble, a sound corporation with great brand names like Tide and Crest,
dropped by 54 percent in just two months. Volatility is inherent in
stock investing. And volatility means that some stocks can rise by 7800
percent in a decade (as Dell Computer has done) while others, like
Enron can go from $80 to a few cents in a year.
Stocks Are Risky, But Rewards Are High
In fact, the way to understand why stocks have been such a great
investment over the past two centuries in the United States is to
recognize that investors get compensated for taking risks. Since 1926,
a portfolio the 500 stocks of the Standard & Poor's benchmark index (or
its predecessor) has returned an annual average of 7.6 percent after
inflation, compared with an annual average of just 2.2 percent, also
after inflation, for medium- and long-term U.S. Treasury bonds. In
other words, over 30 years, an investment of $1,000 in stocks rose, on
average, to $8,000, while a similar investment in bonds rose to less
than $2,000.
A smart investment strategy, then, is one that harnesses risk,
dampens it, tries to control it. But eliminating risk in the stock
market is impossible.
The best way to harness risk is through diversification--that is,
owning lots of stocks in different sectors, so that the inevitable
losers are offset by winners. Well-run pension funds typically hire
several managers with different, often uncorrelated investing styles;
each of the managers is responsible for a portion of the fund's assets.
Small investors can get the same effect by owning different kinds of
mutual funds: a growth and income fund, for example, that concentrates
on large-company stocks that pay dividends, might be balanced by a
small-cap aggressive-growth fund, whose manager looks for smaller firms
that are often ignored by the public and by analysts, or by a fund that
concentrates in Asian-based companies.
One thing I tell my readers is that stock investing is a long-term
endeavor. There will be rotten years and great ones. Bonds are short-
or medium-term investments; stocks are not. The only way to judge a
portfolio manager is over the long term.
The Alliance Losses
It is with this approach that I have analyzed the events I first
saw described in an article that appeared on March 3, 2002, in the New
York Times. It reported that Alfred Harrison, a money manager for
Alliance Capital, had lost $328 million through his investments in
Enron Corp. on behalf of the Florida State Pension Fund.
The article asked why Mr. Harrison had bought Enron at the ``11th
hour''--that is, as late as two weeks before Enron filed for
bankruptcy. The clear implication was that Mr. Harrison had done
something terribly wrong, unprofessional, even corrupt.
I had heard of Mr. Harrison since I write about mutual funds, and
knew he had an excellent reputation for his management of Alliance
Premier Growth, a fund that had consistently beaten its peers. As I
read the entire article and did some research on my own, a different
picture emerged. It became clear that Mr. Harrison's critics lacked a
basic understanding of how markets work and that they were making him a
kind of scapegoat for some reason, perhaps political. But, more
important, I worried that the way the story was treated might lead
small investors--the people for whom I write--to draw the wrong
conclusions about their own investment strategies.
Let me be specific . . .
1. The loss of $328 million in Enron stock came in a pension
fund portfolio of $95 billion. In January 2001, Enron
represented about 0.53 percent of the S&P 500 index, a good
proxy for the market as a whole. A quick calculation finds that
Mr. Harrison's peak holding of Enron represented about 0.3
percent of the Florida pension fund. In other words, if
anything, Enron appeared to be underweighted in the Florida
portfolio.
2. Mr. Harrison had been managing a piece of the Florida
pension fund since 1984, presumably with annual reviews. Why
hadn't Florida fired him earlier? Very simply because Mr.
Harrison had increased his initial stake from $345 million to
as much as $6 billion in about 15 years, according to published
reports. When his contract was terminated, the stake had fallen
to $3.7 billion--but that was still a 10-fold increase in 17
years, for an average annual return of 16 percent, considerably
above the returns of the market as a whole.
3. Mr. Harrison is well-known for a particular style of
investing. He takes extra risks and generally achieves extra
rewards. Morningstar Mutual Funds, a research firm, calculates
that, for the public fund he has managed since 1992, his
investments have been about one-third riskier than the market
as a whole. It is hard to believe that the Florida authorities
were unaware of that style. Money managers operate in public;
their records and strategies are well-known. Mr. Harrison, in
fact, has a reputation for trying to find undervalued companies
whose price, he believes, will rise. A well-run pension plan
balances a manager like Mr. Harrison with other managers who
might specialize in income-producing stocks or mid-caps or bank
stocks.
4. Mr. Harrison was faulted for buying Enron as the price fell.
The New York Times quoted Tom Gallagher, the Florida State
Treasurer and one of the state pension fund's three trustees,
as saying, ``Only fools buy on the way down.'' In fact, good
investors, who believe in the companies in which they put their
money, prefer to buy stocks at lower, rather than higher
prices. Most smart investment analysts would generalize the
opposite way: ``Only fools sell on the way down--and buy on the
way up.'' If you have found a good company in which to invest,
and have bought its shares at $50 each, then it makes sense to
buy more of those shares at $10 each. The question with Enron
was its soundness as an investment, not the fact that its price
had dropped. Indeed, Mr. Harrison frequently invested in stocks
that had dropped in price, and, if Mr. Gallagher thought this
something ``only fools'' do, then it is hard to understand why
Mr. Harrison was retained for 17 years. In the right hands, Mr.
Harrison's approach is a very effective strategy. For example,
according to published reports, Mr. Harrison made a profit in
the Florida fund by investing in Continental Airlines last
year. He bought the stock after it fell shortly after the
terrorist attacks in New York and Washington in September. Not
long afterwards, it rose strongly, and Mr. Harrison made what
the Times called ``a quick large gain.''
5. Enron's value in the stock market fell sharply when, on Oct.
16, 2001, it announced a reduction of shareholder equity of
$1.2 billion because of partnership losses. Then came further
shocks: the announcement on Oct. 22 of an SEC inquiry and the
announcement on Nov. 8 of an overstatement of profits over the
previous 5 years. Between Oct. 22 and Nov. 16, Harrison bought
$35 million worth of Enron at prices ranging from $9 to $23 a
share. The question is whether this investment was reckless. A
little math is in order. This investment represented less than
1 percent of his total Florida portfolio under management and
less than four-one-hundredths of one percent of the entire
Florida pension fund. Specifically, the New York Times cited
the $12 million he invested between Nov. 13 and 16 and called
it ``a huge bet that the company's prospects would turn
around.'' In fact, it was not a huge bet--it represented one-
three-hundredth of Mr. Harrison's Florida portfolio and about
one-ten-thousandth of the entire pension fund. Clearly, in
hindsight, Mr. Harrison made a mistake. He evidently believed
that Enron's assets remained substantial and that the company
would be bought out by Dynegy, a competitor. The Dynegy deal
fell through on Nov. 30, and Harrison liquidated his Enron
holdings that day. Two days later, Enron filed for bankruptcy
protection.
A ``Bizarre'' Decision?
Let me be clear. I certainly would not have invested in Enron in
October, nor would I have advised my readers to do so (and many of them
asked). The reason, very simply, is that for small investors I advocate
a strategy of buying companies with solid long-term (meaning 20 years
and more) prospects. But was Mr. Harrison's decision ``bizarre,'' as
Sen. Bill Nelson is quoted as saying? Not in my opinion. It is
important to remember humility in viewing the workings of markets. The
price of a stock is the considered judgment of thousands of investors--
for every seller, there is a buyer. After the adverse revelations, the
fact that Enron stock ``was plummeting,'' in Sen. Nelson's words, did
not make it an imprudent investment. For example, by definition, $10 a
share was the best (that is, the most informed) price for Enron Nov.
14, one of the dates on which Mr. Harrison made one of his purchases.
Yes, it turned out to be a bad investment, but Harrison also had many
good ones, including, according to press reports, MBNA, Motorola and
Cisco Systems. These stocks were bought according to the strategy that
had produced good results for his clients--a strategy that his
promotional literature calls ``V investing''--that is, buying companies
whose shares had fallen beyond what he believed to be reasonable levels
and then selling them when they recovered, as many did.
Overall, Mr. Harrison not only beat the S&P with his Florida-fund
portfolio but, with his public mutual fund, also beat the large-cap
growth group and the Russell 100 Growth index, according to
Morningstar. In addition, from 1994 to 1999, his fund beat the S&P in
four out of five years. It returned 46 percent in 1995, 23 percent in
1996, 32 percent in 1997, 48 percent in 1998, and 28 percent in 1999.
A Kind of Hysteria
The Enron collapse has, unfortunately, generated a kind of
hysteria. In fact, what is bizarre is not so much the behavior of
portfolio managers like Mr. Harrison but the behavior of many
journalists and public officials. Enron was a costly episode, but I
fear that the search for scapegoats will end up, not merely smearing
the reputations of talented and dedicated professions, but will send
small investors--that is, your constituents--a disastrously wrong
message.
Mr. Harrison was not the only money manager or analyst who was
impressed by Enron's historic results, its business strategy, its
management and its story. The company was lauded by Fortune magazine
for many years as America's most innovative. In late September 2001,
after Enron's stock price had fallen by two-thirds, the Value Line
Investment Survey, an independent research firm with an excellent
reputation, gave the company an ``A'' rating for financial strength and
a ``2'' (above-average) rating for ``timeliness.'' The Value Line
analyst wrote, ``We think fears are overdone . . . and . . . markets
for both wholesale and retails services are still growing strongly.''
After all, revenues had risen from $14 billion to $100 billion in 10
years, and earnings had gone from 9 cents a share in 1989 to $1.47 a
share in 2000.
Janus, one of the biggest mutual fund houses in the country, owned
5.6 percent of the company's shares by itself, and the Fidelity sector
fund that specializes in energy made Enron its largest holding.
Alliance and Mr. Harrison were not alone in their admiration of the
company. Like the entire business press and the entire investment
establishment, they were duped by what we have learned were aggressive
misrepresentations of the company's financial condition.
The bulk of Mr. Harrison's investment in Enron--approximately 90
percent by my calculation from published reports--occurred before the
company's restatements of assets and earnings. The relevant issue is
not his investment in a particular stock that lost money; it is,
instead, the structure of his portfolio. Was he dangerously
overweighted in Enron? In other words, did he have too much stock in
that one company in relationship to his other holdings? Not at all. Did
his losses in Enron seriously impair his overall performance? Again,
no. An average annual return of 16 percent over 17 years is
exceptional. Imagine one of your constituents at age 31 turning over
$10,000 to Mr. Harrison to invest for retirement at age 64. At a 16
percent rate of return, the constituent would have a nest egg of well
over $1 million.
Does Congress have a legislative role here? Again, no. The Florida
state pension fund and similar funds should select and oversee their
own managers without federal interference. They are fully capable of
deciding who should manage their money. It is a shame, however, that
the trustees have handled this matter in the politically and
emotionally charged way they have. If they don't like the way
particular managers perform, then they can fire them. If laws are
broken, they can ask for prosecution.
So what are we doing here?
Promote Financial Education
Congress can serve a constructive function in the aftermath of the
Enron scandal. That function is educational. It is a fact and a
blessing that the majority of Americans now own stock. Many of them,
however, do not understand the basics, let along the intricacies, of
investing. Teaching them is what I try to do in my columns and books,
but government leaders can also play an important role. Let me close by
listing what I believe are the lessons to small investors from the
Enron collapse:
Diversify. If a stock like Enron is among only five or 10 stocks
you own, then you're in big trouble, but if Enron is part of a widely
diversified portfolio--as it should be--then you can pick yourself up,
take your tax loss and move on.
Be skeptical of the experts. Wall Street has a herd mentality. Not
only do analysts have a bullish bias, but, worse, they have a sheepish
bias. They don't want to stand out from the flock. So if a few top
analysts start buying a story, then practically every analyst buys the
story. In the case of Enron, it was a famous short-seller, James
Chanos, who started asking questions about the company's financial
statements. Chanos, of course, had an ax to grind himself because, by
selling short, he made money if the stock fell. But he proved an
important point for small investors: Often, in the market, as in life
in general, it is better to listen to non-conforming argument than to
the conventional wisdom.
Recognize that bad things happen to good investors. Events such as
the Enron debacle are part of the risk inherent in investing. They'll
always occur. Mr. Harrison said of Enron, ``On the surface it had
always seemed to be a fairly good growth stock.'' It did, but it
wasn't. However, investment professionals who bought the stock for
their clients' portfolios were not venal or corrupt. They simply took
at face value what the company reported in its official filings, and
they were deceived. Mr. Harrison and others bought Enron stock after
adverse revelations, but they too believed that the company still had
valuable assets. This was a mistake but not an outrageous one. Through
diversification, he protected the bulk of his account. That's a key
lesson for small investors.
Take Personal Responsibility. Finally, all investors need to
understand that their choices in financial investing are their own
responsibility, just as their choices in home-buying are their own
responsibility. They should not expect to be bailed out by lawyers or
politicians. Thanks to the incredible financial democracy and diversity
that has developed in the United States, small investors can take
advantage of professional management and analysis at low cost, or, at
even lower cost, they can simply own index funds that reflect the
entire market. Investors who have proceeded in this way, with clear-
headed, long-term strategies, have done very well. Over the past 20
years, an investment in the 30 stocks of the Dow Jones Industrial
Average, with dividends re-invested, has increased about 20-fold.
We should not frighten people away from investing. Whether we like
it not, for most Americans, stock-market investing represents not just
the best way, but the only way, to build a large enough nest egg for a
comfortable retirement. Yes, we need to protect and nurture investors,
but we should not treat them like fools or babies. We need them to give
them the tools--including accurate reporting and good financial
education--to make their own responsible choices.
Thank you.
Senator Nelson. Thank you, Mr. Glassman, and thanks to all
of you for your testimony. I think the chairman will be coming
back after he finishes this interview that he's doing. In the
meantime, I've got a few questions. First, for Mr. Herndon.
Mr. Herndon. Yes, sir.
Senator Nelson. In your experience with Florida and the
knowledge of public funds across the country--and by the way, I
think we ought to state that you've headed this Florida
retirement system, otherwise known as the State Board of
Administration, for, what, about 5 or 6 years?
Mr. Herndon. 5\1/2\ years.
Senator Nelson. And is it true that you've been--that you
have decided to retire?
Mr. Herndon. Yes, sir.
Senator Nelson. And who is to be your replacement?
Mr. Herndon. The board has not made that decision yet. I
hope it's my colleague, Mr. Stipanovich, but that remains to be
seen. The trustees will make that decision.
Senator Nelson. Well, in your experience with Florida and
your knowledge of the public funds--and I might point out here
that, as I understand it, this Florida pension fund is the
fourth-largest pension fund in the country.
Mr. Herndon. Yes, sir.
Senator Nelson. Then with that kind of knowledge, give me
an estimate of the percentage of funds invested in index funds
versus fixed investments like bond funds and versus a
percentage of actively invested through money managers.
Mr. Herndon. I'd be happy to, Senator. And maybe Mr.
Glassman might want to pay attention to this as well since over
60 percent of our equity investments are in index funds, we
hire 14 different outside managers, all of whom possess
different styles so that we are a very diversified fund. It's
never been our intention to try and send a message to the
public or anyone else that they're not responsible for their
losses, provided the investment manager that they hire conducts
themselves in a responsible fashion and does the homework that
they contract for.
In this case, we don't believe that happened. In this case,
we believe Alliance was negligent. And in that case, it's
incumbent on institutional investors like us and any investor
to hold them responsible for the misdeeds that they conduct.
And in this case, that's what we're trying to do.
Senator Nelson. All right. Now, what I'm trying to find out
is a relative amount of the fund that's in the index funds and
other kinds of investments and then what percentage of your
stock portfolio is handled by outside money managers. You have
some internal managers, as well.
Mr. Herndon. About 40 percent, approximately, of the stock
portfolio is handled by outside money managers. About 60 is
indexed by both internal and external money managers. And
overall, about 60 percent of the entire pension fund is in
indexed products, both bonds, international, and U.S. equity.
And I'm setting aside, for the moment, real estate and private
investments since they're really quite a bit different
investment.
Senator Nelson. All right. Let me see if I understand. So
40 percent of your stock portfolio is handled by outside money
investors----
Mr. Herndon. Right.
Senator Nelson.--money managers. And 60 percent is handled
internally or by----
Mr. Herndon. Or by external index funds.
Senator Nelson.--by the index funds.
Mr. Herndon. Correct.
Senator Nelson. All right. You state in your testimony that
Alliance was put on an internal watch list for poor
performance.
Mr. Herndon. Yes, sir.
Senator Nelson. Tell me when that occurred, and describe to
our Committee the nature of a watch list.
Mr. Herndon. It occurred in the fall of 2000, late in the
fall of 2000, as we saw Alliance's performance for the overall
portfolio deteriorate. And I might add--Mr. Glassman has made
this comment, as well--that, at its peak, Mr. Harrison's
portfolio on behalf of the State Board of Administration was
close to $6 billion. When he was terminated, it was $3.7
billion. So they lost $2.3 billion for the State Board of
Administration, of which $280 million was Enron investments. So
it's not exactly as if we were acting in a capricious fashion.
We were very cognizant of his long track record with us.
But to the point, we tried to accelerate our monitoring of
Alliance from the quarterly process that we currently do to a
monthly review, where our analysts and our staff talk to the
staff in Minneapolis, or vice versa, every single month so that
we keep a close eye on what's going on. And we ask them, ``Why
are you doing some of the things that you're doing? We want to
be assured that you're doing it in full possession of the
facts.'' And they kept assuring us that they were. I'm not so
sure about that, but----
Senator Nelson. And you said that they were put on this so-
called watch list, which is the terminology that you've
described----
Mr. Herndon. Yes, sir.
Senator Nelson.--from the fall of 2000.
Mr. Herndon. That's correct. November or so of 2000.
Senator Nelson. Now, is--you talked about the frequency of
the meetings as a result of being on a watch list. Does this,
then, suggest--for example, in a New York Times article of
March the 3rd, they make reference to the fact that Mr.
Harrison was meeting with representatives of the Florida fund
some 31 times last year. Would that have caused the increased
frequency of these meetings?
Mr. Herndon. I'm not sure about that story, Senator. We
certainly didn't meet with Mr. Harrison 31 times. We did talk
with his office or his staff or Mr. Harrison on a number of
occasions. I don't have the count in front of me, but it was a
couple of dozen times over the course of 2001. I don't know
about 31, but----
Senator Nelson. All right. Once I get to Mr. Harrison, I'll
ask him these kinds of questions, and I'd like the Committee to
have an understanding of this. We wanted to understand what
watch lists are. Do other funds have watch lists?
Mr. Herndon. Yes, sir. It's a fairly common practice in the
industry. When an investment manager's performance
deteriorates, all of us increase our scrutiny, we increase the
attention that we're giving to the investment manager to try
and understand what's going wrong, what do we attribute the
poor performance to. In this case, that's exactly what we were
trying to do. We were trying to understand what was accounting
for the poor performance on the part of Alliance.
Senator Nelson. And so if other funds have this--do they
have that same kind of criteria as you do for putting them on
watch lists?
Mr. Herndon. Essentially they do. I mean, we're all
watching manager performance. That's what we do is hire and
fire managers, not invest in individual stocks. And most all of
the large pension funds follow a similar pattern. They may use
a slightly different screen, but they all follow a similar
pattern.
Senator Nelson. Since we're talking about the time from the
fall of 2000 until the winter of 2001, how many other money
managers were on that watch list for the State of Florida?
Mr. Herndon. As I recall, during that period of time--I
don't recall that there was anybody else that was on that watch
list at that particular time. I could stand corrected, and I'd
be happy to get that information for you, Senator.
Senator Nelson. So Mr. Harrison was on the watch list for--
somewhere I've picked out the time--it was approximately 17
months.
Mr. Herndon. That sounds about right.
Senator Nelson. What kind of action--with him being on a
watch list for that long and him being--as you have just
testified, being the only one on the watch list for the state
of Florida, what kind of specific action, other than the
meetings being accelerated from quarterly to monthly, would
occur--did occur?
Mr. Herndon. Increased communication, visits to
Minneapolis, bringing the Alliance staff down to Florida to
visit with us, watching their purchases with a closer degree of
scrutiny than we did prior to that time, trying to get more of
an explanation of just exactly what was underlying their
investment decisions.
Senator Nelson. Well, maybe you can help me understand
this, then. You know, one of the sources, as I've prepared for
this hearing, was this New York Times article of March the 3rd,
and it says, ``As Enron edged toward bankruptcy, Mr. Herndon
said communication from Alliance ground to a halt. `There was
an abysmal lack of communication,' he said.'' Given the fact of
this increased communication, how does that square with this?
Mr. Herndon. What I was referring to in that particular
quote was the decisionmaking process that Alliance went through
to sell the stock that we owned. They, without notice to us,
blind-sided us, in spite of repeated discussions, visits in our
office. A day after we received an e-mail from them
highlighting the value of the Enron stock, they sold the entire
position out in a sale in a private placement overseas without
telling a sole and never did tell us even til after the fact.
We found out about it on our own volition. Alliance never did
tell us until several days later that they had, you know,
bailed out and left us holding the empty sack.
Senator Nelson. Well, with this particular scenario, what
corrective action was taken in the course of the watch list,
and what was not taken, that led to the present situation?
Mr. Herndon. Well, we fired Alliance, first and foremost,
for a variety of reasons, many of which we've discussed here
this afternoon. We've also made an effort to implement a
variety of screening tools to more closely monitor the
investment decisions of our managers. But bear in mind,
Senator, as you heard the Alliance officials represent, they
had 25 analysts on their team in Minneapolis, 300 research
folks around the world. The State Board of Administration and
no pension fund in this country has that kind of resources. We
don't have the capability to monitor individual stock decisions
on the part of our managers when they're managing a $50 billion
stock portfolio.
So what we are doing is trying to understand and trying to
develop screens that help us understand exactly how focused and
disciplined that investment process on the part of the
managers, and reassure us that the reason we hired them is
still a valid one.
Senator Nelson. As I said at the outset, what--the purpose
of this hearing is for us to get to the bottom of this so we
can understand what happened and why it happened and what we
should do about it from the standpoint of reforms at the
federal legislative level. How long would you suggest to us
that we should consider, as we consider this whole matter, that
someone should stay on a watch list before corrective action
should be taken?
Mr. Herndon. Our general rule of thumb is approximately 3
years, assuming that there are not consequential events,
material events, that are at play that shorten that watch list,
as is the case with Enron. We didn't originally put Alliance on
the watch list because of Enron. It became a more profound
problem as we moved further and further into the watch list
period. But, generally speaking, I think 3 years is the
industry benchmark. That's a sufficient time to determine
whether the individual manager is skillful or not, and that is
the practice that the board generally applies, is 3 years.
Senator Nelson. Is that the practice that other states use,
as well?
Mr. Herndon. Well, that's my impression, Senator. I can't
speak for all of them, obviously, but my impression certainly
is that 3 years is a pretty common benchmark for watch list
activity.
Senator Nelson. In light of this activity, are you still
comfortable with 3 years?
Mr. Herndon. I think we're comfortable with 3 years, again,
recognizing that there are critical events that could happen.
Had we known, for example, that Mr. Savage was on the board of
Enron, we might very well have done something different, but
that was never disclosed to us. And, in fact, I think--I could
certainly stand to be corrected--but I think it's even against
Alliance's own corporate policy, but they made an exception in
this case for Mr. Savage. That's the kind of material event
that we might very well have dealt with differently had we
known that, but we didn't know that. And those kind of events
can shorten a watch list cycle.
Senator Nelson. You know, someone would know that if they
just read the annual report of the company.
Mr. Herndon. Well, that's perhaps the case, Senator. I'm
not at all sure that it's always the case, but we would hope
that that's the case.
Senator Nelson. Let me ask you about a reform. The Florida
State Board of Administration had a standard beyond which an
outside money manager was not to go, and that was that, of that
outside money manager's total portfolio, they were not to
invest in more than 6 percent of that portfolio in a single
stock. It's my understanding that that was exceeded in this
case. Is that accurate?
Mr. Herndon. It may have been, on limited occasions. I
don't know that they were consistently above that standard
throughout the period of time that they were investing in
Enron, but there may have been some instances where they
pierced that level.
Senator Nelson. Would that have been a matter of discussion
as a benchmark that would trigger certain actions in the course
of being on this watch list?
Mr. Herndon. Yes, sir.
Senator Nelson. And should that be, as part of the reforms
that we're looking at?
Mr. Herndon. It should be something that you take into
consideration, Senator, no question about it.
Senator Nelson. And in looking at reforms, what could you
suggest to us might give some signals with regard to someone on
a watch list with regard to index funds, as compared to the
performance of an outside money manager? Is there something in
the lingo of the trade that would be helpful to us there?
Mr. Herndon. Well, in most cases, outside money managers or
active managers have a benchmark against which they're
measured. It may be an index-style benchmark, like an S&P 500,
or it may be a custom benchmark that was in place, for example,
for Alliance. Anybody should be gauging the performance of the
investment manager against that benchmark. And if they
consistently underperform that benchmark over a long enough
period of time, going back to our 3 years, then they should be
dealt with. Whether they are de-funded to some degree or
terminated is up to the individual investment firm--investment
fund.
Senator Nelson. Tell me your recommendation with regard to
reforms that--in many states, I understand that the governing
board--in this case, as you have described it, the State Board
of Administration board of trustees are the Governor, the
treasurer, and the comptroller--in many states, I understand
that there is a representative of the participants in the fund,
such as a retiree who is drawing from the fund or a state
worker that is paying into the fund, instead of just elected
officials. What is your observation there?
Mr. Herndon. I count ourselves as one of the fortunate
organizations, in that we have a board of, as you say,
statewide elected officials that are ultimately accountable to
not only the members of the pension fund, but to the taxpayers,
ultimately. And, as you observed early on in the testimony in
the hearing today, ultimately the taxpayers are the ones that
are responsible for the pension fund in some respects.
So I think the form that we currently have is a good one.
It's very effective. It is a well-managed organization, from
the standpoint of the trustees. We have an advisory council. In
fact, we have two advisory councils that have representatives
of the various labor unions and so forth on them, and I think
that gives everybody a very rational way to communicate their
interests and concerns.
Senator Nelson. Has there been any concern for you, as we
consider this legislation, that you could advise us about
potential conflicts of those elected officials? For example,
either by law or rule, I don't know which, anyone participating
as a member of the Florida cabinet in the capacity as the
Division of Bond Finance cannot receive contributions from any
bond company. Do you think that there should be similar kinds
of prohibitions with regard to elected officials being the
trustees on any kind of the investments that are in that state
retirement fund and/or the money managers and the principals of
those money managers? What is your advice to us there?
Mr. Herndon. This issue was considered, I believe, two or 3
years ago by the SEC. At the time, there was discussion about
prohibiting investment managers, investment companies like
Alliance, from making campaign contributions to trustees of
various pension funds. For whatever reason, that idea didn't
ever quite get implemented, to the best of my knowledge, but I
think it's one that is worth considering, Senator.
Senator Nelson. Well, thank you for your testimony. I may
come back, so thank you. What we're trying to do is to see if
we can put things in place here to get to the heart of the
issue.
Mr. Stipanovich, let me ask a couple of questions of you.
And thank all of you for your time and your patience. We'll
take as long as we need to get this whole issue aired, and then
we'll be looking forward to going on to the second panel, as
well.
The statement was made, and I don't remember who--it may
have been you, Mr. Calvert; it may have been you, Mr. Herndon,
I don't know--but, for the record, have any of the three of you
had any conversations with anyone from Enron?
Mr. Stipanovich. I'll answer for myself, Senator. I have
not had any conversations with anyone from Enron. And----
Senator Nelson. We're talking basically in this 2-year
period.
Mr. Stipanovich. Right.
Senator Nelson. We're talking about 2000 and 2001.
Mr. Stipanovich. That's correct.
Senator Nelson. Or representatives of people from Enron
specifically about the Enron stock.
Mr. Stipanovich. I have not. We did learn this morning that
our--Trent Webster had a marketer call on him in mid 1999 from
Enron, and that was before--well before we owned Enron or even
knew what Enron was. And he had a fairly brief meeting with
her. And that's--it's fairly standard for them to go out around
the country and talk up their stock. And we just learned about
that this morning from Trent, who said that he had never had
any conversations subsequently, with Alliance or otherwise,
about this meeting or making any kind of recommendations about
Enron.
But we did learn for the first time--we had actually
thought no one had ever had any contact with Enron at the
board, and we really went to great lengths to try to ascertain
that, if there was anybody that possibly had contact with
Enron, and we learned of this development this morning, which
we think is inconsequential. It's not an official. It's a
marketer that basically promotes their stock, and this was,
like, in mid 1999, and we did nothing with the information or
made no recommendations or did not buy the stock, internally or
otherwise, except in certain portfolios which we have no
control over.
Senator Nelson. Mr. Stipanovich, who would have made the
decision to put Enron on--correction.
Who would have made the decision to put Alliance on the
watch list?
Mr. Stipanovich. That would have been the chief of domestic
equities, Senator.
Senator Nelson. And is that someone that reports to you?
Mr. Stipanovich. That's correct, Senator.
Senator Nelson. And is that someone that Mr. Webster works
for?
Mr. Stipanovich. Yes, it is.
Senator Nelson. And what is that person's name?
Mr. Stipanovich. That would be Susan Schueren. Susan
Schueren.
Senator Nelson. Susan Schueren.
Mr. Stipanovich. Yes, sir.
Senator Nelson. And when that decision to make a particular
company put on the watch list, then is that reported to you
from Mrs. Schueren, and how does it go through the pecking
order?
Mr. Stipanovich. At that point in time, Senator, it was not
a formal, formal process. It was more of an informal process.
We now are implementing, as you were talking about earlier,
these watch list monitoring guidelines, which there will be
protocol as to how that's reported, but there was no process in
place that necessarily there was a list, an authentic list,
produced of managers on this watch list that they would
actually produce in hard copy and distribute to Tom or myself.
It was an informal kind of watch list. This came about with
deterioration in Alliance's performance that began late August.
And unofficially they went on this watch list, as Tom said--it
was late December 2000 or early 2001.
And to kind of digress here a moment in this context of
answering your question, Senator, this watch list--we spent
considerable time, post-Enron, trying to refine how we
developed a watch list and better monitoring procedures for the
managers. And these major consultants around the country have a
lot of expertise in the industry counseling with all of the
major funds in the country, and we have come up with and
adopted a monitoring list that has actually been adopted and
been implemented that we are now formally using. And so there's
very specific criteria that we look at that would then produce
managers on the watch list.
We went back and back-tested that watch list against
Alliance, and actually did this as an afterthought. This
monitoring watch list was not developed around Enron--you know,
around Alliance; it was really developed based on consultants',
you know, expert advice in what the industry is doing and what
we might best do to better monitor managers and increase
communications. And in that back-test thing, they actually
would have gone on the watch list officially about the same
time that they did unofficially, but in stone there's some very
specific criteria, Senator, and it's not quite so--note quite
as simple as, like, a 3-year period. It's a combination of
things where the three kind of standards that we look at are
extraordinary events, which would deal with organizational
issues, and that was part of what Trent's objective was in
going up there, where you would look at changes in the
ownership or control of the manager or revisions of the
business plan of the manager, or a key decisionmaker in the
organization leaves, like the portfolio manager to my right, or
a rapid increase or decrease in assets and that kind of thing.
The other thing would be a short-term performance in
relation to an appropriate index or peer group, and there's two
ways that we look at that. We look at that versus an index, and
that's the benchmark that you've heard us talk about here
today. And in addition, we are now using a universe peer
analysis called TUCS, Trust Universe Comparative Service, is
the major type of service like that in the country. And because
we're such a big firm, as you know, the fourth largest in the
country, we are in this universe where it's large funds. So in
this universe, you would be looking for a fund manager that
significantly underperforms the appropriate peer group over
four consecutive quarters--and this is on a short-term basis,
and you're just looking at a 1-year snapshot. And then on a
longer-term basis, you would be looking at under performance
for 3- and 5-year periods, and we get into so much of that time
being under median or so much of that time being in bottom
quartile. And so the three kind of variables begin to kind of
interrelate.
And this is not a science, Senator. This is an art, and it
will always be an art. And so it's those kind of factors that
would come into play, but it is at least quantifiable enough
now that it would trigger an official watch list. And at that
point, it's really up to our discretion for about a 6-month
period whether or not we would terminate that manager
immediately or maybe keep him on another 6 months or so.
Senator Nelson. Since Mrs. Schueren would report to you,
what role did you play as the deputy director to oversee the
watch list?
Mr. Stipanovich. Let me qualify that, if I may, Senator. I
serve Mr. Herndon as a full deputy executive director. In our
organization, we do not have a, quote/unquote, ``chief
investment officer.'' When I was moved into this position in
June of 2001, it was to--my primary responsibilities were to
assist the executive director, who was the closest thing to a
CIO that we have, but we, in fact, do not have a CIO, with the
asset classes. And in addition to that, I do do some other
things in terms of initiatives and projects and some
operational things.
So, to answer your question, Senator, she actually reports
to both of us.
Senator Nelson. I see. And what was the role that you would
play, back then, up until the end of 2001 with regard to the
watch list? Is that part of your responsibility to see that the
watch list is watched?
Mr. Stipanovich. At this point in time, over the last few
months, I have been very directly involved in the development
of an official performance monitoring watch list. Earlier on,
because it was such an earlier period, with me not coming
onboard until June, I was not as involved in the, you know,
watch list and what it might look like at that point in time,
but I was certainly aware that there was a watch list, and that
the Alliance was put on this watch list. They would discuss it
with me, in terms of what, you know, my thoughts were and was I
in agreement or disagreement. And so I was certainly involved,
Senator.
Senator Nelson. And did you say earlier that there was no
written procedure for monitoring companies on the watch list?
Mr. Stipanovich. Not in terms of something that literally
had gone before the board and been approved and been adopted
and become part of the contract for the investment manager.
This now is part of contracts for the investment managers where
they have these performance monitoring guidelines, but there
was certainly something in writing internally in terms of just
kind of--you know, loose kind of common practices that took
place.
Senator Nelson. And there is now a--written procedures?
Mr. Stipanovich. That's correct, Senator.
Senator Nelson. As Mr. Herndon had referred to a series of
meetings and teleconferences concerning Alliance, I have some
notes from a teleconference that occurred on September the
17th, 2001, and also October the 30th, 2001. And the
participants were Stipanovich, Menke, Hurdle, Campbell,
McKnight, Davis, Robinson, Webster, Lathum, and Al Harrison and
Elizabeth Smith, from Alliance. On this teleconference, what
did you go over? And how did that work into the decisions that
you all made to allow Alliance to continue to keep purchasing
shares?
Mr. Stipanovich. Yes, sir. The way that normally occurs, in
terms of Mr. Herndon's role and my role, the--as you know, we
have probably in excess of 40 active managers and, with
quarterly meetings, there is literally numerous meetings that
take place throughout the year. And it's my practice that when
there are issues or a manager is on a watch list--and even as
informal as it was, it was a watch list--I then began--I would
attend meetings and participate. Mr. Herndon would do that on a
much more limited basis, less so than myself.
At this particular meeting, I was attending because of
performance. It really was more--had more to do with Alliance's
performance. As you can see in the memo, there is some mention
of Enron, but we did not spend a great deal of time talking
about Enron at that point in time, but we certainly were
concerned about Enron. We did talk about Enron, and it was
literally the--following the interim and next--the following
meeting that took place on October 30th and thereafter, but
certainly September, that we really began to zone in on Enron.
Because, Senator, even with everything that we're doing now
in creating these screens and trying to identify early warnings
for stocks that we can heighten communications with managers
about these stocks, at the end of the day, we give these
managers full discretion, and we pay them well--and some would
disagree with that--but we pay them well to exercise their
discretion. We are not stock pickers. And right now, with Enron
and everything that's behind us, we still do not plan to be
stock pickers. That's what we hire them for.
So we're going to do a better in getting this information,
but there's still, you know, a challenge as to what we're going
to do with this information, because we're not going to tell
them what to buy and sell.
Senator Nelson. Well, we're trying to figure out how to
protect the public through legislation in the future to avoid
this kind of thing. Would you bring that up here and put it on
the easel? Bring it up over here, please, close to me where I
can point to it.
Now, this--have you got a pointer? See if you've got a
longer pointer. But this is a graphic that depicts the price
and the date starting at October the 17th, when the stock price
was at about $32. And here's the first signal, right here, SEC
investigation is announced when the price is at $22, 311,000
shares are bought. And then as the stock goes on down, you see
the picture, prices keep coming down, the stock keeps being
bought. And here's the date that we're talking about right now.
October the 30th is when you have this telephone conference
call with Alliance on the watch list. And so the stock now has
come down to $12.23.
And this is what the notes say of the teleconference,
``Enron was a big part of the recent under-performance.
Alliance had a couple of face-to-face meetings with the company
last week. The reality is that the core trading business is in
fine operational shape.'' Now, that's the notes that you all
have of this teleconference.
And can you comment about that since--and I'll ask Mr.
Webster, too, when we get to him. They just called a vote, so
I'm going to have to call a recess in a minute, but go ahead,
please, Mr. Stipanovich.
Mr. Stipanovich. Yes, Senator. As you--if you look at the
longer time line, there are many, many flags such as this on
the time line that, again, heightened us and we began to ask
these questions. But there's probably no one sitting at this
table that can answer that question, hopefully, better than
Alliance, because we don't--we didn't understand it. As much as
we tried, we did not understand why they were still buying it
after all of the--everything that even my mother was reading in
the paper about Enron, and they were continuing to purchase the
stocks. We were at the point that we felt they were on the
wings of a prayer and wish in this thing either stabilizing or
going back up, but we--it was incumbent upon us, as
fiduciaries, to continue to ask these questions, knowing that
we were not going to give them--tell them to sell or buy, and
they're the people that need to answer that question, Senator.
Senator Nelson. And, as a matter of fact, you just used the
word ``flags.'' I noticed that that was the statement that you
had made in a New York Times article on January 27th, of which
you were quoted, quote, ``We had a fair amount of discussions
with Alliance about what was happening with our Enron shares,''
Mr. Stipanovich said, ``There were plenty of red flags, and we
would talk about them.'' Who is the ``we'' in this particular
case?
Mr. Stipanovich. That would be the domestic equity staff
under the leadership of Ms. Schueren. And you can see, as we
take these meeting notes, we always record who are attending
these meetings--but from the executive director through myself
down to the domestic equity staff, including Trent Webster and
a number of other people, again, with the chief of domestic
equities.
Senator Nelson. And what were the red flags?
Mr. Stipanovich. Well, Senator, I've got a--you know, I can
go through the list here, but it was certainly the fact that--
it really kind of began on August 14th, when Skilling left, is
when the majority of the red flags really began to, you know,
wave red. But it was just things, in terms of the new
partnerships that we were finding off balance--off the balance
sheet and so on and so forth.
Senator Nelson. Well, of those red flags--you know, on that
same day--October the 30th, the same day that you had that
particular telephone conference call, they went out, and they
bought another 317,000 shares, and that was on October the
30th. November the 8th, Enron admits that it overstated its
profits by over a half a billion dollars. And then another
581,000 shares are bought on November the 13th; and another
478,000 were bought on November the 14th; and another 209,000
shares bought on November the 16th. And I'm curious--the
Committee would want to know why were the red flags ignored?
Mr. Stipanovich. Senator, that's a question that Alliance
would have to answer. We kept asking the same question you're
asking, ``Why are you ignoring these red flags? You bought this
stock for $79.25 in November of 2000, and it's now down in in
the single digits.'' There had been red flags literally
starting since almost January 2001--or some flags were out
there, in terms of people leaving the firm. But certainly, come
August, there were more red flags than you could shake a stick
at.
Senator Nelson. As you all went through the discussions,
once you'd hang up, for example, or when you'd have just
regular discussions among your staff about the watch list--and
in this case, only one company, you've testified, was on the
watch list--did you ever talk about, did you ever ask, whether
or not this company should be de-funded?
Mr. Stipanovich. We absolutely were talking about de-
funding Alliance at that point in time. We had actually been
talking about de-funding Alliance for several months prior to
that, because, again, at that point in time, when you get on
the watch list, you have to start considering what your
alternatives are in terms of any de-funding. Your options are
you de-fund them or you fire them or you fund them, and they
certainly weren't--they were on the de-funding--under
discussion for de-funding and, again, possible termination,
because they were on this watch list.
And, you know, there were a number of things we'd ask. For
example, the statement was made awhile ago that Mr. Glassman
said something about their weighting compared to S&P 500. In
September 2001, they had 4-percent weightings. Senator, that
was 20 times the weight of what the S&P 500 had in Enron. I
don't know--he said something about reading it in the paper,
and that kind of leads us to believe maybe you can't always
believe what you read in the paper, but this is off Bloomberg,
and they were 20 times the weight of Enron.
So these were the kind of questions that we would ask
about. You know, why the overrating? Do you really have that
much belief in the stock with this kind of, you know, warning
signals.
Senator Nelson. Well, what were some of the other red
flags? Help us to understand. Specifics would help us very
much.
Mr. Stipanovich. OK. January 2001, highly respected short-
seller shorts Enron. They continue to buy stock. Analysts,
Skilling values Enron stock at $126. Skilling becomes CIO.
Janus becomes--Janus Fund, one of the most successful funds in
the country--becomes a net seller of Enron. Also a lack of
disclosure and transparency in Enron financials reported by
Goldman Sachs analysts. This is March of 2001. March 5th, Enron
accounting again arises material red flags. Skilling, ``People
want to throw rocks at us.'' Enron in blockbuster, cancel video
and demand on deal. Enron vice chairman, Cliff Baxter leaves
after complaining of Enron partnerships. And fiberoptics
collapse of $180 million charge, May 21st. Enron's power and
generating venture in India falters. Power contracts fail. In
June, S&P credit review, concern over international assets.
Skilling abruptly resigns in August. September, Lay announces
Enron would divest $4.5 billion in assets to restructure and
emphasize trading options. September 19th, Enron claims India
calls $5 billion in damages in violating their power agreement
which caused part of their reasons for losses. Crude oil
futures were falling to the lowest level in 2 years. Release of
earnings, analyst calls, $618 million lost, shareholder equity
written off. Also 13 or 14 analysts downgraded Enron after
October 16th earnings report at a press conference. Crude oil
falls to lowest level in 1999. October, SEC opens an inquiry.
We're still buying the stock. Lay defends CFO Fastow, and CFO
Fastow resigns a week later. Egan Jones downgrades Enron debt
to junk. Enron--Alliance is talking to their creditors who do
the credit analysis in the fixed income, which is fairly--I'm
not too sure it's that usual. Enron creates special committee
on partnership. November 8th, former--reflects additional
details of accounting partnerships and restates earnings from
1997 to 2001, reduced by $586 million, largely due to these
partnerships that are out there with all the previous red
flags. Dynegy merger officially announced. And then that's all
we begin to hear about is Dynegy, and that's the answer. Lay,
Enron made billions--says, ``Billions of very bad investments
were made at Enron.'' This is a quote from Lay in November
15th. November 19th, Enron announces Enron may take additional
$700 million pre-tax charge. November 20th, Enron warns of
continuing credit worries, asset restatement, and reduced
trading activity. November 28th, S&P downgrades Enron to debt,
to junk, and triggers a billion dollar debt payment. Dynegy
calls off the merger. Crude's at $12.50 a barrel. Enron file
bankruptcy. Alliance sells.
Senator Nelson. And what in the discussions that you all
had did you decide to do about all of those red flags? Was it
as you said earlier, that you decided to keep hands off and let
the money manager do it, despite the red flags?
Mr. Stipanovich. What we decided to do was fire Alliance.
Unfortunately, we didn't fire them soon enough.
Senator Nelson. Earlier you had said that folks would ask
you whether you agreed or disagreed with the actions. And I
can't remember the specific quote, but you remember what I'm
referring to. And I would like to ask you, was there any
specific matter that you were consulted about when people would
ask you if you agreed or disagreed with actions on overseeing
the watch list? As we are doing this reform legislation, you
said folks would ask you whether you agreed or disagreed. Is
there anything in those actions that we should know about as we
craft this legislation?
Mr. Stipanovich. Actions, as in--I'm sorry, Senator.
Senator Nelson. When people--as I understand your
testimony, you said that folks would ask you whether you agreed
or disagreed with actions of a particular investor--in this
case, Alliance.
Mr. Stipanovich. Well, unfortunately, we're not in the
position to really make those kinds of decisions, which are
really what I think you're referring when you say ``agree or
disagree,'' and that is the purchase of the stocks. We are not
in a position to make stock-selection decisions. We don't have
the resources, Senator, or the staff to make those type of
decisions. That's why we hire external managers and pay them
for them to make those decisions.
What we do do is, we do serious performance monitoring, in
terms of trying to make sure that they're providing the type of
performance in the aggregate that we're looking for to reach
our investment objectives at the board.
Senator Nelson. I'm going to miss this vote if I don't get
up and go right now. So the Committee will stand in recess,
subject to the call of the chair, and it will take me about 7
minutes to go over and vote and get back. The Committee is in
recess.
[Recess.]
Senator Nelson. All right. Well, thank you very much, Mr.
Stipanovich, and excuse me for having to stop here and go vote,
but that's the way it goes around here.
Mr. Stipanovich. Thank you, Senator.
Senator Nelson. All right. Mr. Webster, why don't you
describe for the Committee your position at the SBA?
Mr. Webster. Yes. I'm a portfolio manager of domestic
equities within the State Board of Administration, and I have
two roles at the board. The first--my primary role is that I
run the special situations fund, which is the only internally
actively managed fund at the board. And I would say probably 80
or 90 percent of my job, or at least until the Enron debacle,
was managing money. The other part of my job is facilitating
the information flow of market to other staff members within
the board so that we can make a decision about whether to fund,
de-fund, terminate, hire managers. And that was the capacity
that I had when I went out to visit Alliance in June.
Senator Nelson. And who do you report to in the pecking
order?
Mr. Webster. My direct boss is Ken Menke, who is the
assistant chief of domestic equities, and ultimately to Susan
Schueren, who is the chief of domestic equities.
Senator Nelson. All right. And the lady that was referred
to earlier----
Mr. Webster. Susan Schueren?
Senator Nelson. Is that one and the same?
Mr. Stipanovich. Yes, sir.
Mr. Webster. Yes.
Senator Nelson. OK. Then I did not understand the
pronunciation of her name. It's Schueren.
Mr. Webster. Schueren.
Senator Nelson; Schueren.
Mr. Webster. Yes.
Senator Nelson. I see. And then she reports to Mr.
Stipanovich.
Mr. Webster. That's correct.
Senator Nelson. OK. Now, can you describe the Florida SBA
internal review process, in terms of putting individual money
managers on a watch list?
Mr. Webster. I don't really actually think I am the one to
answer that question. What I do is give the information about
the stocks that are in the portfolio to the people who make
that decision on what managers go on or off the watch list.
Senator Nelson. You give information about the stocks.
Mr. Webster. Yeah. Well, for example, because I manage a
portfolio, I'm in the stock market every day buying and selling
stocks. So I am probably the most connected to the stock market
at the board. And so, because of that, I have a role in
overseeing the manager's portfolio, the list of stocks in their
portfolio, to see if what they're buying and selling makes
sense relative to their strategy.
Senator Nelson. And so you'd be involved in bringing up any
of these red flags that were testified to earlier.
Mr. Webster. That's correct.
Senator Nelson. OK. And I suppose that some of the other
red flags that maybe we didn't even mention here was--you'd be
seeing different lists, like Forbes and newspapers or
publications like Forbes. You'd be looking at other analysts
and seeing what they would say you ought to buy or sell and a
commentary on it and whether or not they would give a downgrade
or an upgrade--you'd see all of that.
Mr. Webster. Well, I'd see, you know, some--the majority of
it.
Senator Nelson. All right. I'm going to put in the record
an analyst's history of the Enron Corporation over that period
of November and October 2001 with regard to analysts like
Warburg, Goldman Sachs, A.G. Edwards, Merrill Lynch, Solomon
Smith Barney, Prudential, Bank of America, so forth, all of
which had a downgrade through that period of time. *
---------------------------------------------------------------------------
* The information referred to was not available at the time this
hearing went to press.
---------------------------------------------------------------------------
Now, is that something that you would have considered at
the time?
Mr. Webster. Well, yes. Yes and no. In my decisionmaking
process, when I buy and sell stock, the analyst ratings have
some informational content, but it would certainly be one of
the things we'd be looking at.
Senator Nelson. And having seen this kind of stuff, what
did you say at that particular time about Enron and the
portfolio with Alliance?
Mr. Webster. Well, what we were inquiring about was--we
were trying to determine the decisionmaking process that
Alliance was undertaking to buy Enron. And so we would ask
Alliance about, you know, the issues surrounding Enron--for
example, the charge-offs, the resignations, things like that,
specific issues relating to Enron and if they had taken that
into account and if their decisionmaking process was consistent
and logical with what they had--you know, what they were
supposed to be doing.
Senator Nelson. And as a portfolio manager, what did your
analysis tell you about Enron as a company?
Mr. Webster. Well, I never looked in depth at Enron to make
a buy or sell recommendation. I read the press reports, and I
had listened to the analysts, but I never made--I never spent,
for example, 2 weeks learning about Enron. It was more an
amalgamation of news over time that made me familiar with the
events at Enron.
Senator Nelson. Well, you offered some commentary, did you
not?
Mr. Webster. Yes. I mean, I understood the basic issues,
but--and I was making my superiors aware of those basic issues,
but I did not take the--I did not undertake a sufficient amount
of research to at least make a buy decision on Enron.
Senator Nelson. There has been a widely quoted memorandum.
Why don't you tell us about that memorandum that you wrote?
Mr. Webster. Which memorandum is that, Senator?
Senator Nelson. October 24.
Mr. Webster. Yeah, the reason why I had written that
memorandum was to make my superiors aware of what was happening
in the Alliance account. We knew that Alliance had purchased
Enron and it was in their account. And as we watched the stock
fall, I decided, as a means of communication, to let the people
who are on--you know, who are on the memo aware of what was
happening in the Alliance account concerning Enron.
Senator Nelson. If I recall, you had some pretty strong
quotes in that memo. You want to share those with us?
Mr. Webster. Well, if you refer to them, I'll perhaps
comment.
Senator Nelson. Well, how about, ``A stock that is falling
when a company has accounting problems is almost always a bad
time to buy,'' Webster wrote. ``Alliance buying Enron since
August has clearly been a mistake,'' Are those your words?
Mr. Webster. Yes. And I think the subsequent events, at
least in this case, were borne out to be true or consistent
with what I said at that time.
Senator Nelson. Can you pull that back over here? That was
on October the 24th, over here.
Mr. Webster. Uh-huh.
Senator Nelson. And it's trading at about sixteen bucks a
share, and it continues to go down. Did you share that memo
with anybody?
Mr. Webster. Oh, yes. I distributed it on October 24th to
Susan Schueren and Ken Menke and to Martha Hurdle, and I
assumed it went up to Coleman and Tom eventually.
Senator Nelson. Did you expect this kind of buying to
continue in light of what you said?
Mr. Webster. I guess I would say that I don't expect
managers to buy or sell at any time. It's just--they either buy
or they sell.
Senator Nelson. Well, you had the--you had a concern, did
you not, when you wrote those words?
Mr. Webster. That's correct, yes. And the reason for my
concern was merely to communicate to my superiors what was
happening in the Alliance portfolio so that they were aware of
what was occurring in the Alliance portfolio.
Senator Nelson. Do you know--did the board of trustees
receive your concerns or your memo?
Mr. Webster. Well, they did eventually, but I don't--I have
no idea if it was passed on to them at the relevant time.
Senator Nelson. Well, in those pretty strong words, what
was your concern? Why don't you restate that for the record?
Mr. Webster. My concern was the stock was falling on the
issues that were in the press at the time that were being
reported. And some of the--and the issues were that, in
retrospect now, we find out that the accounting was a fraud at
Enron, and the issues were trickling out into the market
causing, or at least contributing to, the fall of Enron stock.
Senator Nelson. The previous spring, the spring of 2001,
Alliance sold Enron stock on April the 17th, sold 112,600
shares. Do you have any knowledge of that?
Mr. Webster. Yes.
Senator Nelson. Tell us about it.
Mr. Webster. I actually--well, I think for a more accurate
explanation, you probably should ask Alliance. My
understanding, though--and, you know, I don't want to put words
into Alliance's mouths, but it's my understanding that they
were executing a V strategy where they'd buy as it fell and
then sold it as it rose. But, again, I'm not the person who can
give you the exact explanation for that.
Senator Nelson. In your capacity, did you participate in
this teleconference that I have the notes of from September the
17th?
Mr. Webster. No, sir.
Senator Nelson. How about October the 30th?
Mr. Webster. Yes, sir.
Senator Nelson. OK. And you want to tell us something about
that teleconference meeting?
Mr. Webster. On October 30th?
Senator Nelson. Right.
Mr. Webster. It was part of our increased oversight of
Alliance, and we had questioned them about the purchases of
Enron and why they were continuing to purchase.
Senator Nelson. And what was your feeling at the time of
that teleconference?
Mr. Webster. I guess what we were just trying to understand
was what was the thought process and the decisionmaking process
that Alliance was undertaking in making the purchases. At the
time, we didn't know if it was correct or not. We just knew
that it was falling, and they were buying it as it was falling,
but we had--at least I certainly did not know what the outcome
of Enron would have been.
Senator Nelson. As I read some of your quotes in other
publications, it seems to me that you had some misgivings about
Enron for quite awhile. For example, you stated in a March 24th
St. Petersburg Times article, quote, ``Enron was a stock that
we had watched for years, and we couldn't understand why it
kept going up,'' end of quote.
Mr. Webster. Uh-huh.
Senator Nelson. Why don't you explain what you meant by
that?
Mr. Webster. Well, I'd like to first preface that with
saying there are thousands of stocks in the stock market, and
on some of them, we're right, and some of them, we're wrong.
And fortunately, on Enron, as it turned out, we were correct on
it. We had--we had an idea of what Enron's basic business plan
was, and we viewed it more as an arbitrage house, if you want
to say it. And that's not necessarily a bad thing, but rather,
you know, the valuation that you'd pay for something like that
was what was curious to us.
Senator Nelson. Well, that was back at a time that Enron
was still flying high in its stock price.
Mr. Webster. And we were--yeah, in money management for
that time period, we were wrong, because the stock kept going
up.
Senator Nelson. And so your comment, ``Enron was a stock
that we had watched for years, and we couldn't understand why
it kept going up,'' is that a statement that you had confidence
in it or that you did not have confidence in it?
Mr. Webster. I think that that's actually taken a little
bit of--out of a little bit of context, because we did
understand why it was going up. And the reason why it was going
up was because its earnings were growing. What we didn't
understand about it was how it grew its earnings. It just--we
didn't understand it. But we understood why the stock was
rising, because earnings were rising.
Senator Nelson. Since Alliance was on the watch list at
that point, having gone on the watch list in the fall of 2000,
was there any sharing of your statement, your concerns, as you
had these monthly meetings?
Mr. Webster. We--to my recollection, we first--we brought
it up in October--in the October meetings. Enron--even though
Enron was a stock that we didn't understand the fundamental
business model, we also didn't necessarily believe it was a
house of cards, either. And so, for example, in 1999 or 2000,
there may not have been a reason necessarily to flag it as a
potential bankruptcy. It was only after the charges--the
charge-offs from the company and the resignations and the other
red flags that Mr. Stipanovich had mentioned earlier, when it
became a real issue for us.
Senator Nelson. All right. Thank you very much, Mr.
Webster. I appreciate it.
Mr. Herndon. Senator, do you mind?
Senator Nelson. Yes, Mr. Herndon?
Mr. Herndon. I apologize, but I wonder if it's possible, if
you're going to move away from us, if I could be excused. I
have a commitment that I'd like to try and make, if that's
feasible.
Senator Nelson. Certainly.
Mr. Herndon. Thank you.
Senator Nelson. All right. Let's move to Mr. Harrison.
Mr. Calvert. Senator?
Senator Nelson. Yes?
Mr. Calvert. Pardon me. Before we begin the questioning,
would you mind if we just corrected a couple of points for the
record. Some statements have been made that are not factual.
Senator Nelson. Please, Mr. Calvert. We'll recognize you.
Mr. Calvert. OK, thank you very much. First, I'd just like
to correct a statement. We did not make an exception to our
policy for Mr. Savage. We followed that policy to the letter.
Second, we never owned a 6-percent position in Enron in the
portfolio, and that's well known by all the parties. We did not
sell the stock in a private placement. That simply is not
correct. And, as you've heard before, it is not true that the
SBA was not notified of the sale for several days. They were
notified in exactly the same way that they're notified by all
of our transactions, on the very next morning.
Thank you, sir.
Senator Nelson. Thank you for your statement.
Mr. Harrison, welcome. Let's see if we can learn something
for the Committee that will help us as we craft this
legislation.
It's my understanding--and you tell me if it's correct--
that you met during this period of time about 10 times with
Enron personnel. Is that correct?
Mr. Harrison. During the year, we met physically with them
both at the portfolio-management level and at the research-
analyst level. I have a team, as I've indicated, of 25 people
working with me. I was involved in a number of those meetings.
Other people would be involved either as portfolio managers or
the analysts on Enron stock.
Senator Nelson. And in addition to staff, you met with the
principals, as well. Is that correct?
Mr. Harrison. Oh, very definitely. I mean, we would
normally meet with the CEO, probably somebody from the
financial, the treasurer, and maybe the investor-relations
people.
Senator Nelson. You met with Mr. Lay?
Mr. Harrison. Yes, indeed.
Senator Nelson. And Mr. Skilling?
Mr. Harrison. He did a video conference with us in, I
believe, July.
Senator Nelson. And put it in context for us. When you
would meet with Mr. Lay, for example, how many people would be
in the meeting?
Mr. Harrison. There would usually be anywhere between three
and six from Enron and maybe anywhere between 10 and 20 of my
colleagues, and we would almost surely have it on oral or video
conference with our other offices so that people would be able
to hear what was going on. That is a normal part of the
Alliance research intensity, that anybody--any management
coming into any office to discuss a stock can be heard by every
other office at the same time.
Senator Nelson. And when you refer to 10 or 20 of your
colleagues, you're talking about people in Alliance.
Mr. Harrison. The people in Minneapolis would be there
physically in the room, and then the others would be there by
either phone or video conference.
Senator Nelson. Now, these meetings 10 times took place
over the entire year?
Mr. Harrison. Correct.
Senator Nelson. Did any of those meetings take place in
this period of time, from October the 17th to November 30th?
Mr. Harrison. Yes, the--as I previously mentioned, one of
the meetings took place immediately after Skilling resigned in
August, a week after he resigned. But the key meeting was when
the announcement of the $1.2 billion writeoff and the loss
reported on a--for the third quarter there, led to us having
the seven or eight people in New York meeting with management
there 1 day after their announcement.
Senator Nelson. And at the time you were having these
meetings with Enron, you were also having meetings with the
State Board of Administration of Florida.
Mr. Harrison. The meetings with the State Board of
Administration obviously were meetings that took place
sporadically during that 2-month period.
Senator Nelson. And in the March 3rd edition of the New
York Times, they refer to it--which was disputed by the SBA
people--that you had met some 31 times in that last year,
according to internal memos released by the fund.
Mr. Harrison. I don't know where the 31 times came. And I
heard Mr. Herndon, or somebody, talk about dozens of times. I
think that those numbers are picked of the wall.
Senator Nelson. When you--but it was quite a few.
Mr. Harrison. It was quite a few.
Senator Nelson. When you met with the Enron people in these
10 meetings over this period of time--and how many of those 10
were in that period of time right there represented by that
chart?
Mr. Harrison. I've already indicated, on October the 17th,
that would be the only, I think, unless your chart goes back
early, which I don't think it does.
By the way, could I just clarify one thing? When I say 10
meetings, these might be meetings over the phone, as well, not
physical meetings.
Senator Nelson. OK. And when you had these meetings, did
Enron urge you to buy their stock?
Mr. Harrison. Every time management comes in, they are
presumably trying to clarify us as to their prospects. And in
that context, I suppose they would be said to be urging us to
buy the stock, but that's our decision. Our decision is going
to be made on the basis of the research that we do and, as I
said, the combination of our understanding of the fundamentals
and where the price is at any point in time.
Senator Nelson. I understand. What I'm trying to find out
is: What did they communicate to you? Did they say, ``Buy our
stock?''
Mr. Harrison. Oh, absolutely not. No.
Senator Nelson. Well, how did they urge you to buy their
stock?
Mr. Harrison. Well, I've said that really--they only urge
indirectly through basically being very forthright as it
relates to their prospects, the businesses they're in, which
businesses they're divesting, which they're concentrating on,
where capital is flowing, and a multiple of other questions
that we would be feeding them.
Senator Nelson. OK. So you had that meeting on October the
17th, when the stock's here, and 5 days later, it's down to
here, and you purchase 311,000 shares. Tell us what was in your
mind to do that.
Mr. Harrison. Yes. As a result of the meeting on October
the 17th, we obviously had a decision to make as to whether or
not the core business was still intact, and was Mr. Lay doing
what, in essence, he had promised to do in terms of providing a
greater level of openness and also writing off non-core assets.
Our conclusions was that, yes, the core business was still
intact. He reiterated to us the $1.80 estimate for the year and
$2.15, $2.20 for the following year. This was a clearing of the
decks, as I indicated. However, the price was in free fall, and
we made our next purchase on the 22nd of October, as you've
indicated, at a price of twenty-two, eighty-two cents.
Senator Nelson. Did anybody in Florida ask you to buy this
stock?
Mr. Harrison. No.
Senator Nelson. Did anybody intimate any kind of
communication to that effect?
Mr. Harrison. No.
Senator Nelson. Who would you typically talk to when you
talked to the--your client in Florida?
Mr. Harrison. The normal contact would be Ken Menke. When I
would go down to visit Florida, the person that is not here
today, the chief investment officer of equities, Susan
Schueren, would be the chair of any meetings that we had.
Senator Nelson. You heard the quote by Mr. Webster just a
few minutes ago, and I'll give it to you again, quote, ``A
stock that is falling when the company has accounting problems
is almost always a bad time to buy. Alliance buying Enron since
August has clearly been a mistake,'' in an October 24th memo,
is what he says.
Mr. Harrison. Right.
Senator Nelson. Did you ever see that memo?
Mr. Harrison. Of course, I don't see any internal memos
that Mr. Webster is alluding to.
Senator Nelson. You did not see that memo.
Mr. Harrison. No, that would be internal to Florida.
Senator Nelson. I understand. But have you seen that
particular quote, whether you've seen that memo or not, at the
time? Was it conveyed to you verbally?
Mr. Harrison. No, not at all.
Senator Nelson. I see. Well, what do you think about Mr.
Webster's comment, since apparently the two of you have a
considerable difference of opinion on----
Mr. Harrison. Mr. Webster's comments are obviously personal
to him.
Let me just, if I could, just read the first three lines of
what we're supposed to be doing for Florida. ``Alliance
Capital's large-capitalization growth strategy emphasizes stock
selection, portfolio concentration, and opportunistic trading
to capitalize on unwarranted price fluctuations.'' This is very
clear in my mind, that what we were doing is basically
balancing all of the news that we had that was positive against
the negatives that basically was out there in the press, and
then making a price judgment. And we determined that the core
business was still intact, from the intensive research that we
had done, and we continued to buy the stock.
Senator Nelson. Were you, Mr. Harrison, aware of all of the
outside analysts that we referred to a moment ago that will be
made a part of the record--were you aware of their
recommendations that people ought to sell instead of buy?
Mr. Harrison. Not only am I aware of the firms that you
spoke to, sir, but I believe that most of them had been
carrying buy recommendations, including the one big bear on the
street that has been--hit the press, and that is an analyst
down in Houston as late as September. He turned from basically
being a bear to a very strong buy on the stock, and I think
you'll find that most analysts were still of a buying mode
right until the very end.
Senator Nelson. At one point, you were quoted in one
article--I believe it was the New York Times--as saying you
didn't know who Frank Savage--that you did not know that Frank
Savage was a member of the Enron board.
Mr. Harrison. That is correct.
Senator Nelson. Did you read the annual statement of Enron?
Mr. Harrison. I didn't read it in the sense of checking the
directors. Generally speaking, that is something that--I'm more
interested in the income statement and the balance sheet of a
company. You know, obviously every corporation has got a list
of directors. That is not No. 1 on my priority.
Senator Nelson. Tell me about the October 30th conference
call.
Mr. Harrison. The October 30th conference call was
obviously related to the fact that, for 2 years, growth stocks
had been under pressure in the marketplace. As was previously
indicated, we had taken the Florida funds up to $6.2 million.
Over that 2-year period, most growth managers suffered
something like a 30- or 40-percent decline, which was similar
to our own. And that conference call was an attempt to isolate
the various stocks that had perhaps been hurting us. And Enron
was one of those stocks. And obviously Enron, given what was
happening in the press, was probably receiving more of the
dialog than the others. But we talked about the portfolio in
general.
Senator Nelson. Did members of the State Board of
Administration staff express to you in that October 30th
teleconference their misgivings about Enron?
Mr. Harrison. No, sir. They listened to what we had to say
and presumably took note of what we had to say, that we had
been meeting with Enron management. We had basically done our
research. We were of the view that the core trading operations
of this company were still intact.
Senator Nelson. So the comments of Mr. Webster written in
an October 24th memo, some 6 days previously, was not conveyed
to you in the October 30th teleconference?
Mr. Harrison. Only to the extent that there might have been
a dissatisfaction as it relates to the losses in the portfolio
by the various stocks, of which Enron would be one, but nothing
specific on Enron, certainly no direction to do anything about
it.
Senator Nelson. And after that teleconference on October
the 30th, then you went back out and bought another 317,000
shares.
Mr. Harrison. The stock was now $12.22, correct.
Senator Nelson. And so there was nothing conveyed to you of
a concern from the staff of the State Board of Administration
about what had happened thus far on that October 30th
teleconference.
Mr. Harrison. This was obviously one of the stocks on which
we were losing money, so if you would call that concern,
obviously we talked about it.
Senator Nelson. But there was no message that was given to
you that you should not buy, therefore you felt at liberty to
go back out on that very same day, right after the telephone
conference, to purchase more.
Mr. Harrison. Absolutely. We have the authority and the
fiduciary responsibility to do the best for our clients. And as
far as we were concerned, based on all of the information that
we had and the price of the stock, it seemed very attractive.
Senator Nelson. The State of Florida, as stated by Mr.
Herndon, has filed suit against you all. They've distributed
copies of the lawsuit, the pleadings, to the entire Committee.
These are serious allegations. Are they true?
Mr. Harrison. Sir, what----
Senator Nelson. Are they true?
Mr. Harrison. The allegations?
Senator Nelson. That's correct.
Mr. Harrison. Sir, we did everything in our fiduciary role
here, as far as I was concerned, to exercise the care and skill
and prudence that is part of our mandate, and I think that we
can show that, on this particular stock, the faults were
clearly with Enron and the fact that we had misleading
information, incomplete information, and that the auditors did
not do their job. We certainly did our job.
Mr. Calvert. May I just interject, Senator?
Senator Nelson. Please.
Mr. Calvert. We've stated publicly, and we would state
again here, that we believe these allegations are totally
without merit, and we plan to defend ourselves vigorously in
this suit.
Senator Nelson. OK, were you able to hear that? OK. Thank
you, Mr. Calvert. Thank you, Mr. Harrison.
Mr. Calvert, how about giving me--give the Committee some
examples of your public and private clients, your client list.
Mr. Calvert. Well, as I said earlier, we manage money for
45 of the Fortune 100. And, you know, I don't have a client
list with me, and I'm a little nervous about--some clients ask
us not to use their names, others say it's fine. But 45 of the
Fortune 100 public funds in 43 of the 50 states.
Senator Nelson. Public funds, there wouldn't be any problem
in telling that, would there, because it would be public
record?
Mr. Calvert. Generally not. We manage money for funds in
the State of New York, the State of North Carolina, the state
of South Carolina. We manage funds, not state--well, also the
state funds in California, in Oregon, in Missouri. Those are
the ones that come quickly to mind, but that's a small sample.
Senator Nelson. Help the Committee understand, with regard
to your client in New York, that Alliance, being the money
manager for the pension fund there, sold Enron shares in the
month of August 2001.
Mr. Calvert. Uh-huh.
Senator Nelson. Whereas, the experience in Florida was the
opposite----
Mr. Calvert. Correct.
Senator Nelson.--that the funds were purchased. Share with
us there, what was the decision with regard to the selling of
those shares in New York.
Mr. Calvert. Yeah. In the final analysis, it was
mechanical. As I stated at the beginning, we are a multiple-
product firm. We offer a variety of investment services. Each
of those teams has an investment philosophy, an investment
process and so on. We don't try to coordinate across all those
teams, because that would be against the objectives of the
clients, who selected the team to do it the way they said they
would do it.
In that particular portfolio, the money is managed directly
by members of our research staff, and they have a rule that
only one-rated securities can be held in the portfolio. Perhaps
I should explain. One being their highest rating, two being
their next rating, three being their lowest rating. And the
analyst changed her rating from a one to a two on Enron
primarily because she wanted to focus on some other companies
in the same industry. And given that rule, the stock was
automatically sold in that portfolio when that downgrade
occurred.
Senator Nelson. Is it typical that, under the umbrella of
your own house, that one hand would be selling and another hand
would be buying?
Mr. Calvert. It's--it doesn't happen very frequently, but
it happens. For example, as you may know, one part of the firm
invests in growth stocks in a number of different kinds of
portfolios, but another firm, largely under the Sanford
Bernstein name, which is a company we acquired, has a value
approach to investing, and it's possible that stocks can be
sold from one portfolio manager to another. It's not a frequent
occurrence, but it happens.
Senator Nelson. Do you have any knowledge of anyone in
Enron calling you to urge you to buy Enron stock in the fall of
2001?
Mr. Calvert. No, sir. In fact, I should say, Senator, I
have never met or talked to anyone from Enron directly. I've,
you know, watched some presentations and so on, but I've never
had a personal conversation.
Senator Nelson. You have no knowledge of anyone in your
firm, other than has been represented by Mr. Harrison in his
typical kind of meetings with his colleagues, that there was
any kind of particular effort that was made by Enron to get you
all to buy Enron stock in the fall of 2001?
Mr. Calvert. No, sir, nothing out of their ordinary kind of
presentations. And I'm quite sure it would have been brought to
my attention had that occurred anywhere in the firm.
Senator Nelson. Mr. Savage, who you have previously
testified about--it's my understanding that he resigned from
Alliance along about August 2001. Is that correct?
Mr. Calvert. July. Yes, sir.
Senator Nelson. And why did he do that?
Mr. Calvert. Frank, was working on a project to raise money
for a private equity fund that was going to invest in Africa,
and he had a team of people working with him. And we had had an
agreement with Frank, made roughly 2 years prior, that Alliance
was going to support that activity for a defined period of
time, but if he had not been successful in raising funds for
that activity by a certain date, we were going to essentially
pull the plug on that project.
As that date came and went, we entered into conversations,
and we said that we were going to stop financing that project.
And at that time, Mr. Savage decided that he was going to leave
Alliance and form his own firm to pursue that project, which he
still believed in.
Senator Nelson. Was he a member of the Enron board at the
time?
Mr. Calvert. Yes, he was.
Senator Nelson. And how long had he been a member of the
board?
Mr. Calvert. I believe he went on the board in 1999.
Senator Nelson. And how long had he been with Alliance?
Mr. Calvert. We acquired a company called Equitable Capital
Management in 1992, and so Frank became part of Alliance at
that time, but he had been with that predecessor company for
considerably longer.
Senator Nelson. And you have no knowledge that he had, at
any point during this period of time--we're basically talking
year 2001--urged any acquisition of Enron stock.
Mr. Calvert. I have no knowledge of that, and I have gone
out of my way to inquire about that, and I don't believe there
were any such conversations.
Senator Nelson. When Mr. Lay came back to be chairman of
Enron last year, he told the press that his focus was investor
relations. Aside from what Mr. Harrison has testified to with
regard to promoting Enron and Enron stock, are you aware of any
additional things that Mr. Lay and/or other executives at Enron
did to promote their company and their stock?
Mr. Calvert. No, I'm not.
Senator Nelson. I understand that Alliance bought more
shares of Enron than any other shareholder in the country, some
43 million shares by the fall of 2001. Were you, as the CEO,
aware of Alliance's purchases of Enron?
Mr. Calvert. I was, and we--I don't know that we had bought
more by that time--some people may have been larger--but it is
true that on September 30, we were the largest institutional
shareholder, owning about--a little over 5 percent of the
stock.
Senator Nelson. And what was your company's strategy in
accumulating that fairly large percentage of a company.
Mr. Calvert. Actually, Senator, that's a relatively small
percentage, or it's an average sort of percentage. Recall that
Alliance manages $450 billion, and over $300 billion of that is
in equities, so usually when we take a position in a company,
we become a relatively large shareholder for the company, even
if, as in this case, it wasn't owned in all portfolios and it
was only a 3- or 4-percent position in the portfolios where it
was owned on that date, on September 30th.
Senator Nelson. How many of your portfolio managers
purchased shares in Enron during the year 2001?
Mr. Calvert. I don't know that number exactly, Senator.
I'll be happy to get it for you, but, order of magnitude, I
would say 10 or 12.
Senator Nelson. And do you know how many were purchasing
shares of Enron in the month of August?
Mr. Calvert. Perhaps Mr. Harrison can answer that
specifically, but it would have been 6 or 7 at that point,
probably.
Mr. Harrison. That's fine.
Senator Nelson. And September?
Mr. Calvert. The same.
Senator Nelson. October?
Mr. Calvert. The same.
Senator Nelson. So 6 or 7 are purchasing, while at least
some number are selling, as in the case of New York.
Mr. Calvert. Well, within the large-cap growth discipline,
others were holding. Within another discipline, yes, there were
some sales, and----
Senator Nelson. Were you aware that Mr. Harrison was on a
watch list in Florida?
Mr. Calvert. I actually was not aware of that until
recently. I am now aware of it. I wasn't aware of it at the
time. We understand that--you know, that procedure, and that
would not have been of particular concern to me. And if I can
explain----
Senator Nelson. Please.
Mr. Calvert.--why. I think all investment managers, no
matter how good, do not perform the benchmark every quarter and
every year. And, as has been said, I think it's the long-term
record that matters. And from time to time, we--if we under
perform for a short period of time, there's procedures where
people put us under closer scrutiny or say that they are going
to watch us. And I believe I'm correct in saying that we had,
in fact, been in that position with the state of Florida in
1994, and, of course, went on to have very strong performance
after that. And it would have been my belief that we would go
on to have very strong performance after this period on the
watch list.
Senator Nelson. So the bottom line is you weren't aware
that he was specifically on a Florida watch list.
Mr. Calvert. I was not.
Senator Nelson. And certainly you wouldn't have been aware,
then, that he was on it for that period of time, 17 months.
Mr. Calvert. I was not, but it--I would have viewed that--I
would not have--I would--I view that as something that's--kind
of happens in the normal course of our business, and I would
not have expected it to be reported to me. On the other hand, I
was very aware of all of our Enron purchases.
Senator Nelson. So you were aware that the Florida pension
fund was more heavily invested in Enron than most other public
funds.
Mr. Calvert. I was aware that we were making the purchases.
I was aware then, and am aware, that Mr. Harrison treated all
of his portfolios identically, as did other members of the
team, and as is required of us, but I was also aware that there
were some portfolio managers who chose not to own Enron, and
there were other groups in the firm that didn't own Enron. And
again, that's not atypical.
Senator Nelson. Back at the beginning of the year, of 2001,
Alliance sent out a notice to its clients stating--to caution
about risks associated with buying stocks in a downturn. Do you
have any knowledge of that?
Mr. Harrison. Senator, may I take that question? I sent out
a memo early in 2001 saying that, given the decimation in
technology stocks, I did not expect an early recovery in
technology stocks, and, therefore, I felt that the market
overall was vulnerable. Do remember what I said. Enron looked
like a standout in relation to the collapse of technology
stocks. So that memo that you're referring to referred to
essentially the technology stocks, which people thought of as
being leaders in the market.
Senator Nelson. And in your case, you said Enron was on the
list.
Mr. Harrison. No, I'm saying that Enron, at that time I
sent out the memo, was basically a standout in relation--its
earnings were going up at 20, 25 percent a year. Technology
stocks were totally collapsing.
Senator Nelson. Well, I--my question, though, is to the
CEO, because I think it goes beyond you, Mr. Harrison, that a
communication came from Alliance in January 2001 to its clients
and to its stockholders cautioning about the risk associated
with buying stocks in a downturn.
Mr. Calvert. The communication came from our large-cap
growth group, not from the firm as a whole. Each, again, of our
investment services, has communications with their specific
clients, which is relevant or germane to what they're doing.
And, as Al said, I think what he was cautioning against was
buying companies where earnings were falling dramatically. In
the case of Enron, we believed that earnings were still
growing, so that memo was not a concern to me.
Senator Nelson. OK. Well, thank you for your comments. I'm
sorry to have kept you here so long. Now I can get to Mr.
Glassman.
Mr. Glassman, you've heard everything here. It's gone back
and forth. Why don't you give us the benefit of your commentary
on the basis of the answers that you've heard to the questions
that have been proffered here today.
Mr. Glassman. Thank you, Senator, for that open-ended
question. Well, I think it's very important to understand the
function that someone like Mr. Harrison plays in a large state
pension fund. As has been stated earlier, there are a number of
managers who are chosen typically to have different styles and
to balance the styles in the fund. Mr. Harrison's particular
style, which I this is--I think it's well known to most people
in the investment community is, in fact, to look for companies
that have been beaten up, companies that he believes are
undervalued, and then to buy those stocks.
And I don't really think that the relevant question is did
he--was one of his investments not profitable. I think the
relevant question is the structure of his portfolio. Was he
dangerously overweighted in any one stock. And we've heard
different numbers, but I understand that in his portfolio he
never had more than, let's say, 4 percent, maybe it was 5, but
even that is not particularly high, in Enron stock. So that's
one question.
And then I think the other question is did his losses in
Enron seriously impair his overall performance. And, of course,
it depends on how far back we go with the performance, but he's
had a history the Florida pension fund over 17 years, and he's
turned in what I would say is a pretty sensational performance.
And I think it's really up to the fund--to the managers of the
Florida State Pension Fund to decide whether they want to
retain him as a manger. And I think they can say, well, he
hasn't done very well in the last couple of years. I know what
he did publicly--I mean, his public fund, which is called
Alliance Premier Growth, between 1994 and 1999, according to
Morningstar, he returned 46 percent in 1995, 23 percent in
1996, 32 percent in 1997, 48 percent in 1998. That's pretty
darn good. Then he had two bad years. I'm sorry, in 1999, he
was 28 percent. Then 2000 and 2001 were bad years. So maybe
they should fire him. I think--you know, that's up to them.
What bothers me about a lot of the testimony that I've
heard today is it almost sounds like, I don't know, sour grapes
on behalf of the managers of the Florida pension fund that he
made an investment in Enron that lost money. The chart that
you're showing up there certainly does show the stock falling
and then continuing to fall and continuing to fall. But that's
through the benefit of hindsight.
You know, if we looked at, let's say, his investment in
Continental Airlines immediately after September 11th, after
September 11th, there was no flying in this country for a week.
Airlines, subsequent to that, were in terrible shape. I mean,
some of them were on the brink of bankruptcy. People felt, you
know, who's ever going to fly? The stock price of Continental
and a number of other airlines dropped at least 50 percent. You
could have shown exactly that chart for Continental stock. He
bought it, and it went up.
He has winners. He has losers. And I think overall you need
to look at the--his entire record.
I just want to correct--or at least clarify my statement
about the proportion of Enron stock in the overall Florida
portfolio, because I think this is relevant, and actually I
think it's a credit to the Florida pension fund, the people who
manage it overall. Based on my calculations, they could be off
by a little bit, I don't think at any time Florida had more
than 0.3 percent of its entire $95 billion in assets in Enron
stock. Florida was not placing a huge bet on Enron stock. The
Standard & Poor's 500 stock index, which is a basket of pretty
much--you know, most of--the vast majority of the market's
capitalization--in January, the value of Enron was 0.53
percent. So that was my point about that.
But I think to look at Mr. Harrison's performance, you
know, I would say it's pretty good. I certainly never owned
Enron stock. I never advised any of readers to own Enron stock.
I didn't particularly like the company, never would have bought
it at that point, but I've got to say that, based on Mr.
Harrison's record over the long term, I would not want to
second guess him. If I were Florida, I would have hired him for
a specific reason, which was to invest in this style with this
amount of money while other people are investing with a
different style with other amounts of money. And I think that's
actually quite a successful practice.
But it does bother me, as I said earlier, that there's an
attitude abroad, and perhaps significantly in the halls of
Congress, that when you make money in the stock money, that's
fine, that's yours to keep. But if you lose money, somebody
must be doing something, you know, illegal or immoral. That's
not the nature of stock investing.
The nature is, over the last 76 years, stocks have lost
money 22 times. Stocks go down. Stocks go up. And I think
that's important for all Americans to understand. And they need
to protect themselves against risk. And the only way they can
do is through diversification.
Thank you.
Senator Nelson. Mr. Glassman, what's unusual is the fact
that the Florida pension funds lost more--almost as much as the
next three pension funds lost together on an Enron investment--
the University of California Regents, Georgia State Pension
Funds, and Ohio State Pension Funds. And three is clearly
something unusual about this. And this is part of the reason
we're having a hearing, because we want to see if there's
anything we can do about it.
Does the staff have any questions for the first panel? OK,
thank you all very much for your patience. We appreciate it
very much, and we'll call up the second panel.
Good afternoon. One of the witnesses on the second panel,
because of the lateness of the hour, had to leave, Mrs. Sarah
Teslik, executive director of the Council of Institutional
Investors. And we will insert her testimony as a part of the
record.
[The prepared statement of Ms. Teslik follows:]
Prepared Statement of Sarah Ball Teslik, Executive Director, Council of
Institutional Investors
You have called this hearing to ask how pension funds can avoid
losing money in the stock market. Many investors lost a lot of money in
Enron and in other corporate disasters.
There is one clearly wrong answer. It is the answer that seems like
the obvious right answer.
``Don't buy losing stocks'' sounds good, but it doesn't work. Big
pension funds will not--repeat will not--avoid losing money in the
stock market by trying to pick winners and sell or avoid losers. The
more a pension fund tries to do this--the more it buys and sells--the
more it loses. Over three-quarters of managers lose money when they try
to do well by active buying and selling. With large amounts of money
you cannot, over time, avoid the losers. Instead, you aggravate losses
by incurring large fees. I am happy to explain this key point further
in plain English during the question period if you want. It takes two
minutes and I only have five. I'll just say for now that it has been
demonstrated with ample data that large funds that try to avoid
investments in losing stocks by hyperactively managing their money fail
to avoid the losers and instead incur large trading costs on top of
losses.
Pension funds, in other words, should not have been trying to avoid
Enron by hyperactive management. This is why most of the best-managed
pension funds in the country had some Enron stock. In all cases of
which I am aware, the amount of Enron stock the funds held was tiny
compared to overall assets.
But that doesn't mean that something can't be done to reduce losses
from future Enrons. A number of things can be done. Rather than reduce
the chances of particular funds holding rotten companies' stocks, we
should reduce the numbers of rotten companies. This is the better
approach and it happens to be the only approach you can promote
legislatively.
Our antiquated securities laws and conflict-ridden oversight
systems give us poor quality information and prevent us from acting
effectively on information we do get. Many companies like Enron would
not have had to implode if owners had gotten key information and been
empowered to act on it. Owners hate losing money; they don't need to be
encouraged to act. And it doesn't cost taxpayers anything when owners
spend their own money to prevent fraud and encourage good corporate
behavior.
But the information investors get is flawed, incomplete and
sometimes grossly misleading. And additional laws prevent or severely
inhibit investors from acting on the information they get. Combine
these two and you get Enron. Global Crossing. Xerox. Rite Aid. Sunbeam.
Waste Management. MicroStrategy. Cendant. And on and on.
The problems have been obvious for decades before Enron. If you
don't require companies to disclose stock option plans, and if you
don't require companies to let shareholders vote on stock option plans,
if you don't require companies to expense stock options, you get
runaway compensation that turns companies into Ponzi schemes.
If you allow companies to hide their directors' financial
conflicts, if you allow companies to hide their debt just because a
tiny portion of its equity is held by someone else, if you allow people
who want wiggle room to write accounting standards, if you let brokers
vote when shareholders do not, you will get more Enrons.
If you saddle shareholders with restrictions that make it look like
the government is overseeing pedophiles rather than property owners, if
you maintain disclosure requirements that give company managements
ammunition to sue shareholders who question them, if you fail to
prosecute individual wrongdoers and instead levying corporate fines
that hurt victims but not wrongdoers, you will get more Enrons.
Worse yet, you will get markets that start to slip. All great
societies start to crumble at some point. Many do when special
interests start to dominate. The fact that we've had a good run of it
doesn't mean we will continue to do so. We need accurate disclosure of
company financials. We need accurate disclosure whenever officers' or
directors' or auditors' interests are not aligned with shareholders.
But we need more than disclosure: being told we're being taken to the
cleaners is not helpful unless we can act to prevent it. I am
submitting previous testimony of mine in which I catalog what needs to
be done.
The key concept is this. Wall Street and some executives are
enriched when shareholders bet on the horses. Betting, indeed, is
strongly encouraged by those who profit at shareholders' and employees'
expense. But while betting on the horses is encouraged, training the
horses is actively discouraged. A significant collection of laws and
regulations make it nearly impossible for shareholders to act like the
owners they are. These laws and regulations are not accidental. There
has been a major power struggle over the past many decades over who
controls major companies, and, by and large, directors and managers
have won.
Over time, the fact that shareholders are encouraged to do a lot of
buying and selling and are discouraged from acting like owners has
meant that shareholders are betting on slower horses. If everyone bets
on the horses and no one trains them, our economy will suffer. If our
regulators do not exhibit leadership to correct these problems rather
than put Band-Aids over them, capital flight will start to occur.
I urge you to pass legislation and encourage regulation that gives
shareholders both the information and the tools they need to oversee
America's big corporations. This is America's grocery money at stake
and you are the ones who can take--or not take--the right actions to
protect it. Lean on regulatory bodies who don't demonstrate leadership.
Assist training, discourage betting, and you'll create a more
consistent field of thoroughbreds.
______
Previous Testimony
We are all Enron exhausted, so I'll start with the bottom line.
Accountants sign off on financials that trick investors because we
let them. CEOs pay themselves hundreds of millions of dollars, even
when they bankrupt their companies, because we let them. Boards look
the other way because we let them.
There are almost no consequences for individuals who commit
corporate crimes. There are almost no consequences for board members,
CEOs, auditors, analysts, rating agencies and government employees who
fail to do their jobs. Even honest people start behaving badly when
there are no consequences. Especially when the reward is hundreds of
millions of dollars.
This is not an Enron issue. Enron is already old news--questions
about Global Crossing, PNC, WorldCom and A.C.L.N. all post-date it.
People will behave badly to get great wealth if the stock exchanges
don't stop them. If the SEC doesn't deter them. If FASB and the AICPA
enable them. If prosecutors rarely go after them. And if you legislate
loopholes.
The causes of this problem are not recent. Frauds are bigger and
more frequent because the laws that were passed 65 years ago to protect
shareholders have been steadily worn down by special interests. Indeed,
our laws now protect executives, accountants and financial wheeler/
dealers at shareholders' expense instead of the other way round. We are
reaping the harvest of this multi-decade legal hijacking now.
Great civilizations in history crumble when special interests take
control of government machinery and use it for their benefit. I am well
aware that these special interests are applying heavy pressure to each
of you right now. If history is any guide, you will give in. I am
begging you not to. The fact that we've had a good run of it the past
200 years doesn't mean we will in the future unless you reverse this
erosion average Americans' protections.
What most urgently has to be done? Let's start with the auditors.
Right now we allow managers to pick and pay people to bless their
work. If fifth graders picked their teachers, fifth graders would get
As. People invariably act in their self interest.
Not only that. We allow auditors and managers to write accounting
and auditing standards. If fifth graders wrote grading standards, all
fifth graders would pass. People invariably act in their self interest.
So who can be surprised that we have loophole-ridden, outdated
standards that permit amazing things--what is permissible under current
standards is more amazing than what is not.
Not only that. We allow auditors to fund and run their own
professional oversight. You all know better than that. No profession
self polices effectively. People invariably act in their self interest.
What should you pass? Legislation that aligns auditors' interests
with shareholders' and that stops aligning auditors' interests with the
managers whose numbers they review. Unless it is in auditors' financial
interest to protect shareholders, it won't happen reliably enough. You
also need legislation that keeps oversight and enforcement power free
of undue influence by auditors and issuers.
Specifically: (1) Require the board audit committee, not the
managers, to hire the auditors. This is critical. (2) Fix FASB's and
the AICPA's accounting and audit standard-setting systems with
guaranteed funding and better accountability to investors--current
accounting principles gave Enron crater-size loopholes. In other words
fix the system for setting accounting and auditing standards, not just
a couple of the worst products of the current systems. (3) Require
CEOs, audit committee members and outside auditors to sign the
financials as true and accurate--just like you and I sign our tax
returns. (You think twice, don't you, when you sign?) (4) Remove non-
trivial conflicts of interest--conflicts affect behavior. And (5) Come
down hard on individuals--not just companies--who break the law. If you
merely fine audit companies for fraud, you simply increase a company's
cost of doing business. Anderson settled case after case, wrote checks
and moved on.
Relying on peoples' honor or professionalism will not work. Chinese
walls never work. Independent bodies don't remain independent long.
Unless you harness self interest as the legislative motivator, you will
keep getting misleading financials.
But auditors are only partly to blame for this mess. If your
legislation focuses mostly on audit reform, it will be ineffective.
It is not the auditor's job to oversee the company. It is not the
auditor's job to detect fraud, absent certain red flags. It is not the
auditor's job to prevent self dealing or make business decisions. It is
not the auditor's job to set the tone at the top and say it is wrong to
lend a rich CEO 341 million dollars. It is not the auditor's job to
create secure jobs and shareholder value. These are jobs for managers
and boards.
Why have so many boards allowed terrible things to happen? Let me
ask you this: if your staffers had absolute power to remove you from
office, would you discipline them if they were stealing? Our system
allows executives to pick the boards who are supposed to police them.
So, although boards are supposed to represent shareholders, they don't.
You participate in real elections so you care about your constituency.
We shareholders should be so lucky.
Fixing this fundamental misalignment is more important to fraud
prevention than auditor independence because a board's responsibilities
are more critical to a company's health. Yet current laws, rather than
helping shareholders keep companies accountable, do the opposite. I'll
give you a few examples.
(1) If a shareholder buys a mere 5 percent of a company's stock,
he/she has to file forms as if the government is tracking a pedophile
rather than an owner. The only way a shareholder can avoid this is to
file a form promising to be passive. I'm not making this up. So
shareholders without expensive form-filing lawyers have to promise to
remain inert. Large pension funds that might otherwise be willing to
pressure a troubled company, and who do not seek control, remain inert
rather than filing burdensome forms that bring litigation risks with
them. These requirements should be reworked.
(2) The government tells us what issues we can and cannot bring up
with our own employees--company executives. The SEC decides what issues
shareholders can raise for a shareholder vote. Have any of you read
these rules? They take almost every issue a shareholder ought to want
to raise off the table:
We cannot ask about anything that is ``ordinary business''--
which covers almost everything we should care about.
We can't ask about anything that is extraordinary business
either if an issue affects only a small part of the company.
We cannot ask about the thing we should most want to ask
about--the election of the company's actual board. I'm still
not kidding.
Many of the problems at Enron would be off limits for shareholders
to raise under current rules.
Worse, the SEC is free to, and often does, change its
interpretations of these rules, without warning or recourse, so we
don't know from one year to the next what we can ask.
(3) When the SEC does allow a shareholder to raise an issue for a
vote, it requires the shareholder to send someone to the annual
meeting, even though few companies require their own directors to
attend and most shareholders vote by proxy and not in person. If the
shareholder's rep isn't there, the company can cancel the vote. So if
you are disabled, have a job, are not rich or can't travel, forget it.
(4) As if this isn't enough, companies can, and do, move their
annual meetings to hard-to-reach places, even foreign countries, so
shareholders can't get there. Annual meetings of major U.S. companies
have been held in Russia--or in towns without airports in Alabama on
Friday afternoons before holidays. I'm not kidding.
(5) Managers can call off a shareholder vote on election day if
they see they are losing. (Though a Council member sued a company over
this recently and more or less won.) Can you imagine if a U.S. Senator
could do this--people would howl.
(6) If a shareholder wins a majority of votes cast for its
proposal, companies can, with few exceptions, ignore the vote. Most do.
Some companies ignore majority shareholder votes even when an issue
passes year after year. This makes the shareholder franchise a joke.
(7) Shareholders used to get to vote once a year on directors. But
this year AT&T and Comcast have agreed to bar shareholders from voting
again on the board of the new company until 2005.
(8) Some shareholder ballot items are rigged. The New York Stock
Exchange allows brokers to stuff ballot boxes and vote for management
when shareholders with broker accounts don't vote. Most shareholders
don't know this. Studies show this throws important votes. The SEC and
NYSE ignore our pleas to fix this.
On this subject, I would caution you not to put the New York Stock
Exchange in charge of any investor protections. The NYSE is a private
sector corporation. It gets money from corporate executives--listing
fees. Never expect private-sector bodies to act against those who fund
them--they won't do it. Not surprisingly, the NYSE has, in my opinion,
consistently used its government powers to harm investors and protect
managers, not the other way round. In my opinion, anyone who assigns
investor protections to the NYSE doesn't want to protect investors.
Democracies were designed to avoid precisely the problems we see over
and over in this guild-like, government-protected, reportedly highly
profitable franchise.
So, if you do want to make a real difference, what legislation do
you pass?
We need better and immediate information about companies' executive
compensation practices and directors' and CEOs' buying, selling,
borrowing and hedging activities. And we need better ways to control
this compensation--votes on all stock option plans and an ability to
put up board candidates if existing boards are giving away the shop.
Fraudulently calculated pay needs to be returned.
Why is all this so important? Because if we cannot control our
employees' compensation, even honest people will gradually pay
themselves more and more. It is happening all over. Power corrupts. In
extreme cases companies become Ponzi schemes. Executives siphon money
out in mega option grants and companies crash.
There is a reason that nearly a quarter of major-company CEOs get
their companies to give them huge loans--loans as high as a third of a
billion dollars to one person. There is a reason these loans are often
forgiven, subsidized and/or used to hide CEO stock dumping. When
shareholders' hands are tied behind their backs and key information
stays secret, or stays secret until it is useless, executives get more
and more generous with themselves. They do it because they can.
If you curb executive compensation abuse, frauds become less
profitable to fraudsters. Money is the main motivator. Focus on it.
Neither the SEC nor the NYSE has used the powers they already have
to address this problem adequately; if it doesn't come from you, it
won't happen.
What else? Senator Nelson's bill gets at many of the issues I've
raised today. It requires that companies disclose directors' conflicts
better--something we asked the SEC to do years ago but which just sits
over there. In fraud after fraud we discover undisclosed director
conflicts. There is no excuse for hiding this critical information.
Nelson's bill also gets at board independence effectively because
it uses a real-world definition of independence, not a weak definition,
like those used by the NYSE and some companies.
At our meeting next week Council members will be discussing
legislative language that would make it easier for shareholders to put
director candidates on the company's proxy and get issues on company
ballots. Why do you let companies ignore our majority votes? Why does
the NYSE throw shareholder votes by letting brokers, who are not
shareholders, vote? Shareholders will keep markets clean, at no
government expense, if only you'd let us by removing our handcuffs.
Corporate governance should be at the heart of this debate, not at
the periphery. Structures to stop frauds in the first place, rather
than efforts to catch them when they arrive in auditors' hands, should
be the starting point. Better information is useless without ways to
act on it. We need both.
Finally, enforcement. There is too little enforcement and too much
of it targets companies and not human wrongdoers. Five years from now
when this hubbub is history and you are an auditor or a director being
pressed privately by management to go along with a fraud, will you be
more deterred by the thought that your company may be fined or by the
thought you may go to jail?
When you punish companies, you punish innocent shareholders, the
victims. I am therefore very pleased by the enforcement proposals in
the Leahy, Daschle bill. Fraudsters will do anything you let them.
Please stop letting them. And please do not go for mid-level
scapegoats. Those who get the big bucks need to shoulder the
responsibility. A CEO or a director going to jail would be a corporate
governance shot heard round the world.
Senator Nelson. And I want to thank the remaining two
witnesses for your patience. As you see, we have intended to be
quite thorough in this hearing, and balanced, and it just took
us a long time. So you are very kind to be so patient.
So why don't I just take you all in alphabetical order, Mr.
Musuraca, assistant director, Department of Research and
Negotiations, District Council 37, AFSCME, and Mr. Travis
Plunkett, legislative director of the Consumer Federation of
America. So if you will proceed. Thank you.
STATEMENT OF MICHAEL MUSURACA, ASSISTANT DIRECTOR, DEPARTMENT
OF RESEARCH AND NEGOTIATIONS, DISTRICT COUNCIL 37, AMERICAN
FEDERATION OF STATE, COUNTY, AND MUNICIPAL EMPLOYEES (AFSCME)
Mr. Musuraca. Good evening, Senator. On behalf of District
Council 37 members and the 1.3 million AFSCME member throughout
the nation, I'd like to thank the Committee for the opportunity
to discuss Enron's collapse on public pension funds.
The nation's 37 largest public pension funds lost nearly $2
billion at the hands of Enron. AFSCME believes that in order
for this not to happen again, worker and retiree representation
is essential on all public fund pension boards. And blatant
conflicts of interest between corporate executives, auditors,
and investment advisors must be eliminated in the capital
markets.
The New York City Employers Retirement System, NYCERS, is
the largest of New York City's five pension systems, funds with
combined assets of over $85 billion. While our member benefits
were never threatened, the combined losses of New York City's
funds, due to Enron's collapse, was $109 million. The stock
losses came from holdings in the plan's domestic equity index
funds.
Now, most all institutional investors rely on index funds
to provide a relatively cheap way to reduce risk and achieve a
broad exposure to the full equity market. The obvious pitfall
for index investors is that the manipulation of a company's
financial condition can lead to a company's stock being
artificially valued in the marketplace. Hence, if a company's
filings with the SEC are fraudulent, or if market participants
have reasons other than a company's performance or prospects to
buy a stock and, thus, artificially inflate a stock's value,
the index investor is the natural victim. This certainly
happened in the case of Enron to index investors who bought
Enron shares at prices based on what we now know to be Enron's
false and misleading statements prior to the company's
collapse. Other public pension funds, like Florida, as you just
heard, lost in the stock market through accounts under active
management as a result of Enron's demise.
Now, as Florida told you here, the majority of their losses
came from an active account under management by Alliance
Capital. Alliance, I should note, also manage such accounts as
the New York City Firefighters Pension Fund and the New York
State Common Fund, neither of which system reported losses on
the scale of Florida. And AFSCME really has been unable to
determine the decisionmaking process, even after listening to
the testimony from these gentlemen, of either SBA or Alliance
Capital on how Alliance continued purchasing Enron shares after
the company was under SEC investigation. The SBA's own
investment policy on stock purchases seems to have been
breached. And the SBA analysts assigned to Alliance warned the
board that Enron's stock price was in free fall.
AFSCME members that are part of the Florida system are most
concerned that the SBA's own investment policies were broken
when Alliance's Enron purchases topped 7 percent of the Florida
portfolio, exceeding the 6-percent limit that the SBA had set
for Alliance investment in any one stock. And the AFSCME
Council 79 in Florida has recently filed a Freedom of
Information request to ascertain what exactly happened.
As a trustee from New York City, the chronology of Alliance
Enron purchases raises questions; and, moreover, the inaction
of the SBA trustees is difficult to understand in light of
their fiduciary duty that all trustees have to plan members and
beneficiaries. Such duty would have led the trustees to fully
examine the actions taken by Alliance and the warnings of its
own staff members.
AFSCME believes that the structure of the SBA in which the
three trustees are the Governor, the state controller, and the
state treasurer, may, in fact, be a big source of the problem.
Most retirement systems have an independent board of
fiduciaries which include worker representatives or plan
participants and retirees. Such representation helps to create
a nonpartisan environment where loyalty to the plan is the most
important consideration, ensures the board's independence, and
more easily allows for the necessary oversight of the
investment process. Worker representation also brings to the
boardroom a better understanding of what workers and retirees
need from their pension system. And even in plans in which one
elected official is the sole fiduciary, as in New York State or
Connecticut, there are mechanism to ensure a high level of
member input and oversight. Such, to my knowledge, is not the
case in Florida.
AFSCME asks the Committee to consider three suggestions to
help ensure that public funds act as true trustee fiduciaries
and manage retirement assets solely in the interests of plan
members and beneficiaries. These changes could help prevent
future catastrophic losses and strengthens trustees role as
fiduciaries for worker retirement assets. The first is require
all public funds to have half of the system's trustees
appointed or elected from the ranks of the plan members and
beneficiaries. Second, institute some type of pay-to-play
requirements that prevent political contributions to trustees
from investment managers that do business with the public fund
on which they serve. Third, provide incentives for states to
close the revolving door between asset managers and political
leaders.
Unlike Mr. Glassman, I believe Enron's collapse has sparked
a crisis of confidence in the nation's capital markets. In
order for Americans to regain a sense of confidence in the
capital markets and the security of their retirement funds,
equal representation of workers on public pension funds is
vital. So is worker representation on private company 401(k)
plans, as is provided in Senator Kennedy's bill.
AFSCME also strongly supports reform of our nation's
capital markets, the markets our members retirements systems
are invested in. Senators Nelson and Carnahan have proposed
strong legislation in these areas to prevent the kind of
blatant conflicts of interest that we now know exist, through
Enron.
AFSCME members are the beneficiaries of trillions of
dollars invested in our nation's capital markets. This money is
their future. Public servants and all working families deserve
better from our markets, our money managers, and the regulators
than we got at Enron.
Thank you very much for your time.
[The prepared statement of Mr. Musuraca follows:]
Prepared Statement of Michael Musuraca, Assistant Director, Department
of Research and Negotiations, District Council 37, American Federation
of State, County, and Municipal Employees (AFSCME)
Good afternoon. My name is Michael Musuraca. I am an Assistant
Director in the Department of Research and Negotiations, District
Council 37, AFSCME, AFL-CIO, and a designated trustee to the New York
City Employees Retirement System (NYCERS). On behalf of the 125,000
members of District Council 37 and the 1.3 million AFSCME members
throughout the nation, I am grateful to the Senate Commerce Committee
for the opportunity to discuss the impact of the collapse of Enron on
large institutional investors and public pension funds. The nation's 37
largest public pension funds suffered combined losses exceeding $2
billion at the hands of Enron. AFSCME believes that in order to reduce
the likelihood of this happening again, workers and retirees should be
equally represented on pension fund boards and blatant conflicts of
interest by corporate executives, auditors and investment advisors must
be eliminated.
NYCERS is the largest of New York City's five pension funds, with
over 300,000 active and retired members, the majority of which receive
an annual benefit of less than $25,000. The total assets of NYCERS, the
Teachers, Police, Fire, and Board of Education employees pension funds
is approximately $85 billion, of which NYCERS accounts for slightly
over $35 billion. While member benefits were not threatened, the
combined losses of the five funds due to Enron's collapse was $109
million, $83 million of that total was from losses in the value of
Enron stock, while $26 million came from assorted bond holdings.
The stock losses suffered by the NYCERS and the other City pension
funds came from their holdings in a domestic equity index run on behalf
of each system. Like many other large institutional investors, NYCERS
and the other City pension funds have increased their exposure to the
U.S. stock market through index funds over the past decade. NYCERS, for
example, currently allocates over $17 billion, or 87.5 percent of all
domestic equity investments, to two index funds, the Russell 3000 and
the S&P 500.
There are a number of reasons that large institutional investors
use index funds for their U.S. equity portfolios. Index funds provide a
relatively cheap method for pension funds to have a broad exposure to
the full domestic equity market. Another, and perhaps the primary
reason, that institutional investors have increased their exposure to
the U.S. equity markets, especially for large cap companies like Enron,
is that the information about the companies being traded is widely
available to investors large and small. The widespread availability of
information about companies to the investment community makes it more
difficult for active managers to add value to a client's portfolio
based on information that may not be in the public domain. Hence, not
only are index funds seen as a cheaper method for achieving broad
exposure to the equity markets, but one that allows institutional
investors to fully capture value as well.
The obvious pitfall for institutional investors who are heavily
invested in index funds is that the manipulation of a company's
financial condition can lead to the price of a company's stock being
artificially valued in the marketplace. In other words, if a company's
filings with the Security and Exchange Commission (SEC) are fraudulent,
or if market participants have reasons other than the company's
performance and prospects to continue buying a stock, and thus
artificially inflating the value of a stock within the index, the
indexed investor is the natural victim of those practices.
This certainly happened in the case of the Enron Corporation, where
NYCERS and other indexed investors held Enron as part of their S&P 500
or other indexed portfolio, stock we bought at prices based on what we
now know to be Enron's false and misleading disclosures. Then,
beginning in October 2001, the company made a number of negative
disclosures about the company's financial condition and certain
related-party dealings between Enron and entities owned and controlled
by its Chief Financial Officer, Andrew S. Fastow. The disclosures led
to a loss of over $600 million in the third quarter of 2001, the write-
down of millions in assets, and a $1.2 billion decline in shareholder
value. Shortly thereafter, the disclosure of accounting irregularities
led the company to restate its earnings from Fiscal Years 1997 through
the third quarter of 2001, so that reported net income for the period
was lowered by nearly $600 million, nearly 20 percent.
These disclosures led to a swift decline in the Enron's stock and
total market capitalization. The disclosures also accounted for the
losses suffered by NYCERS and some of the 150 other public pension
funds from New York to California in which AFSCME members participate
throughout the country, and the nation's perception that something was
seriously amiss in the nation's capital markets.
Unlike the New York City funds, other public pension funds suffered
losses in accounts under active management. The Florida State Board of
Administration (SBA), with whom the New York City funds joined in a
failed attempt to achieve lead plaintiff status in the class action
suit brought against the Enron directors, reported losses of more than
$330 million, three times greater than the next largest loss, as a
result of Enron's demise. The vast majority of the SBA's losses came
from a domestic equity account managed by Alliance Capital Management.
Alliance Capital also managed such accounts for the New York City
Firefighters Pension Fund and the New York State Common Retirement
System. The fortunes of those pension funds, however, were dramatically
different from that of Florida. While Florida reported losses of over
$330 million, neither the City Firefighters nor New York State Common
funds suffered losses of such magnitude. Indeed, the Florida SBA fired
Alliance Capital shortly after Enron's bankruptcy, and earlier this
month brought legal action against Alliance.
While it is a bit easier to fathom NYCERS' losses, we have not been
able to determine the decision making process of either the Florida SBA
or Alliance Capital that allowed Alfred Harrison, the Alliance
investment manager in control of the Florida portfolio, to continue
purchasing Enron shares even after the company was under SEC
investigation; the SBA's investment policy on stock purchases had been
breached; and the SBA analyst assigned to Alliance warned the board
that the company stock price was in a free fall.
The AFSCME members that are members of the state pension system are
most concerned that the SBA's own investment policies were broken when
Alliance's purchases of Enron topped 7 percent of the Florida
portfolio, exceeding the 6 percent limit the SBA had set for Alliance's
investment in any stock.
As a pension fund trustee in New York City, the chronology of the
Alliance Enron purchases raises additional red flags, and the inaction
of the SBA trustees is difficult to understand in light of the
fiduciary duty that all trustees have to plan members and
beneficiaries. While I do not know the specifics of the Florida
investment statutes, the common law duties of prudence and care would
have led for trustees to fully examine the actions taken by the manager
of the Alliance portfolio.
On October 22, 2001, for example, the day that the Securities and
Exchange Commission announced it would investigate Enron, Alliance
bought 311,000 shares for the State of Florida.
In an October 24, 2001 memo, SBA staff member Trent Webster, who
was responsible for reviewing the Alliance portfolio, alerted his boss,
Deputy Executive Director Susan Schueren, to Harrison's Enron buying
activity. The memo, in part, reads: ``Enron's stock is being crushed.
The primary cause is the concern about the company's accounting . . . A
stock that is falling when a company has accounting problems is almost
always a bad time to buy.''
Despite the internal staff warning, Harrison continued to buy Enron
stock on behalf of Florida, paying $23 million for 2.1 million shares
from October 25th, when Enron traded at $15 per share, through November
16th, when its shares had dipped to $9 per share.
Earlier this month, AFSCME's Florida Council 79 filed a Freedom of
Information request with the SBA for all documents and communications
with Alliance concerning purchases involving Alfred Harrison and other
Alliance personnel to get to the bottom of what took place.
The Florida Retirement System is part of the Division of
Retirement, which is headed by a director appointed by the Governor and
confirmed by the State Senate. The Division is responsible for
administering the trust and distributing benefits. The State Board of
Administration, a state agency with its own staff, handles all
investment issues. The SBA is composed of the Governor as Chair, the
State Treasurer and State Comptroller. A 6 person Investment Advisory
Council makes recommendations on investment policy, strategy, and
procedures. All of its members are financial professionals and do not
necessarily represent the interests of rank and file plan participants.
AFSCME believes that the structure of the SBA may, in fact, be a
source of the trouble. Many public retirement systems have an
independent board of fiduciaries, which include worker representatives
or plan participants and retirees. Such representation helps to create
a non-partisan environment where loyalty to the plan is the most
important consideration, ensures a board's independence, and more
easily allows for the necessary oversight of the investment process.
Worker and retiree representation also brings to the boardroom a better
understanding of what members need from their retirement system. Even
retirement systems in which one elected leader is the sole fiduciary as
in New York State and Connecticut, there are mechanisms in place that
ensure a high level of plan member input and oversight. Such is not the
case in Florida. AFSCME asks that the Committee consider 3 suggestions
to help ensure that public funds trustees act as true trustee
fiduciaries and manage retirement assets solely in the interests of
plan members and beneficiaries. These changes could help prevent future
catastrophic losses in their investment portfolios and strengthen their
role as fiduciaries for worker retirement assets.
Require all public funds to have half of the systems
trustees appointed or elected from the ranks of the plan
members and beneficiaries.
Institute some type of pay to play requirements that prevent
political contributions to trustees from investment managers
that do business with the public fund on which they serve.
Provide incentives for states to close the revolving door
between asset managers and political leaders.
The Enron debacle has sparked a crisis of confidence in the
nation's capital markets that Business Week recently suggested has
raised the public's furor at the business community to levels last seen
during the trust-buster era of Theodore Roosevelt. More recent
revelations, uncovered by New York State Attorney General Eliot
Spitzer's investigation of Merrill Lynch, about the complicity between
investment management firms research analysts and their investment
banking business, has only served to stoke the flames.
Clearly Americans, who as members of defined benefit pension plans
like NYCERS or who participate in their company's deferred contribution
plans, have come to believe that the deck is stacked against them as
they seek to invest a portion of their earnings for their children's
college educations and their own retirement. The daily revelations
about new Security and Exchange Commission investigations, indictments,
and company restatements of earnings only serves to convince more
average Americans that the system is rigged to their disadvantage.
In order for Americans to regain a sense of confidence in the
nation's capital markets and the security of their retirement funds
equal representation of workers and retirees on public pension funds is
vital. So is worker representation on private company 401-k plans, as
is provided in Senator Kennedy's pension reform bill. AFSCME also
strongly supports reform of our nation's capital markets--the markets
our members' retirement savings are invested in. Senators Nelson and
Carnahan have proposed strong legislation in these areas, as has
Senator Sarbanes and Senator Leahy.
In the face of inaction from the SEC and inadequate reforms passed
by the House, the Senate needs to move quickly on these measures to
protect working families' retirement savings from conflicts in the
capital markets.
AFSCME's members are the beneficiaries of trillions of dollars
invested in our nation's capital markets. This money is their future.
Public Servants and all working families deserve better from our
markets, our money managers, and the regulators than we got at Enron.
Thank you.
Senator Nelson. Mr. Musuraca, I think you brought some
very, very compelling points to the testimony with regard to
reform of the laws. I appreciate it. Mr. Plunkett?
STATEMENT OF TRAVIS PLUNKETT, LEGISLATIVE DIRECTOR, CONSUMER
FEDERATION OF AMERICA
Mr. Plunkett. Senator Nelson, it's good to be with you.
Thank you for holding such a thorough hearing on this important
topic. I am the legislative director of the Consumer
Federation. We have 300 members organizations with a combined
membership of 50 million Americans.
As you've heard extensively, many mutual funds and pension
funds, not just individual investors, also invested heavily in
Enron. As a result, workers who never heard of the energy giant
had their retirement savings put at risk by Enron's practice of
hiding debt and inflating earnings, and Arthur Andersen's
willingness to let them.
So the next question is: What are the lessons that are
learned? Let's move on. And what are the reforms that the
Congress should be putting in place?
The first thing to say is that when a company hides debt
and inflates earnings, this isn't just a stock that's getting
beaten up. These aren't just bad business decisions that are
being made. That's certainly immoral. And I think we're going
to find that it's also illegal. So Mr. Glassman's statements
about risk in the stock market--the point is well taken, but we
have an altogether different situation here.
We have a situation where the company lied to the American
people and lied to their investors. Therefore, the solution,
the fixes that Congress needs to put in place, are very
significant.
The central lesson that we've learned, the inescapable
lesson, is that the market can't function without reliable
information. And the key to reliable information is a truly
independent audit. Unless the auditor is free of bias, brings
an appropriate level of professional skepticism to the task,
and feels free to challenge management decisions, the audit has
no more value than if the company were allowed to certify its
own books. When you hear from sophisticated institutional
investors, as we have today, who say they've been easily duped,
the average retail investor, then, doesn't have a chance.
I have to say that hopes for a real reform in Congress on
this key issue now rests with the Senate, because the bill that
passed the House last month does not do what is necessary to
restore integrity to the independent audit. Several bills have
been introduced. You've put a bill in with Senator Carnahan.
And I think the possibility, given our look at these bills, of
real reform does exist.
On auditor and corporate board independence, we believe
that the gold standard is the bill that you've put in with
Senator Carnahan. Senator Sarbanes has also put in a much
broader bill. It makes a number of significant steps forward,
particularly on oversight of auditors. It's weaker on
independence. It would create a very strong, effective,
independent new regulatory body for auditors. It would enhance
the independence of the Financial Accounting Standards Board,
FASB. And both of your bills establish additional corporate
governance reforms. Taken together, these two bills are a very
strong package of reforms.
Now, let me get specific here for a minute on the key
issue, auditor independence. The Nelson-Carnahan bill is a very
comprehensive approach to auditor independence. It requires
mandatory rotation of auditors every 7 years. It strictly
limits the non-audit services that an audit firm may provide to
those--to firms that are receiving audits. Tax consulting
services are excluded from this ban, but they'd have to be pre-
approved by audit committees of the corporate board. Finally,
the bill proposes a 1-year cooling-off period before an audit
firm employee could accept employment in a management or a
policymaking position at a company that is an audit client of
the firm.
The key here, for us, is really twofold. First, the
mandatory rotation requirement. This diminishes the basic
conflict that exists, because the auditor works for the audit
client. The knowledge that a rival firm will soon be evaluating
the books should also provide an incentive to get it right.
Some have argued against this requirement by citing research
that shows the preponderance of audit failures in the first
year of an audit. But there's an inescapable fact that
investors have suffered their largest losses in audit failures
that involved ongoing, often very long-term audit
relationships. And here I'm speaking not just of Enron but
Waste Management, Microstrategy, Cendant, RiteAid, Sunbeam, and
Lucent.
The next thing the Nelson-Carnahan bill does correctly is
to further lessen the auditor's financial dependence on a
single-audit client by strictly limiting the non-audit services
that they may provide. The argument put forward by opponents of
this consulting ban, that providing consulting services makes
auditors less financially dependent on the audit itself and,
thus, more independent, is absurd on its face. It assumes that
the audit firm can challenge management to the point of losing
the company as an audit client but still retain the more
lucrative consulting services. The real world simply doesn't
work that way.
Finally, the Nelson-Carnahan bill would impose tough new
independent standards for both board audit and compensation
committees. If audit committees are to bear greater
responsibility for the oversight of the audit, as other bills,
such as the Sarbanes bill propose, and we endorse, they must
also have the independence and resources necessary to serve
that function.
Now, we have an extensive menu of proposed reforms, many of
which are reflected in other bills. I'm not going to get into
them. We need to do more on regulatory oversight of auditors.
As I mentioned, the Sarbanes bill is very good there. We need
to reform the private litigation laws and create a more fully
funded, more aggressive SEC. We need to reduce incentives for
managers so that they don't manipulate the numbers. And here,
we like very much Senator McCain and Senator Levin's bill that
require expending of stock options.
We need to do a lot of things. But the first--first and
foremost, you have to go after auditor independence and get
that right. And we think the two bills that I've mentioned,
especially the Nelson-Carnahan bill, are a step forward, a
significant step forward, and also much more effective than the
bill that has passed the House. And we'll be working hard to
get significant reforms of this type to the floor of the
Senate.
Thank you, Senator.
[The prepared statement of Mr. Plunkett follows:]
Prepared Statement of Travis Plunkett, Legislative Director, Consumer
Federation of America
Good afternoon. I am Travis Plunkett, legislative director for the
Consumer Federation of America. CFA is a non-profit association of more
than 290 organizations founded in 1968 to advance the consumer interest
through advocacy and education. Ensuring adequate protections for the
growing number of Americans who rely on financial markets to save for
retirement and other life goals is one of our top priorities.
I would like to thank Chairman Dorgan, Ranking Member Fitzgerald
and the other Members of the Subcommittee for the opportunity to offer
our comments on this extremely important issue. When Enron suddenly
collapsed last year amid allegations of accounting fraud and misleading
financial disclosures, the magnitude of the damage was difficult to
comprehend. As the dust has begun to settle, it appears that investors
have lost roughly $93 billion dollars. \1\ To put that in perspective,
this one case has caused losses that are nearly equal to the estimated
$100 billion in investor losses resulting from faulty, misleading, or
fraudulent audits over the previous six years. \2\ And that six-year
total dwarfs similar losses in previous years. It is no wonder, then,
that the Enron-Andersen fiasco has prompted Congressional, regulatory
and judicial investigations into what went wrong and how to prevent
such a debacle in the future.
---------------------------------------------------------------------------
\1\ ``The Accountants' War,'' by Jane Mayer, The New Yorker, April
22--29, 2002, pg. 64.
\2\ Ibid. The article cites an estimate by former SEC Chief
Accountant Lynn Turner.
---------------------------------------------------------------------------
Early attention focused on the tragic cases of the Enron employees
and retirees, who saw their 401(k) account balances dwindle nearly to
zero because of their heavy concentration in company stock. It soon
became clear that many mutual funds and pension funds had also invested
heavily in Enron. As a result, workers who never heard of the energy
giant had their retirement savings put at risk by Enron's practice of
hiding debt and inflating earnings and Arthur Andersen's willingness to
let them.
Among the victims were public and private pension funds. One media
account put the total of Enron losses in just 31 public retirement
funds at a little over $1.5 billion. \3\ Others have estimated that
total losses in state pension funds are closer to twice that amount.
\4\ Pension managers, while outraged at the losses and at the apparent
fraud that led to them, have nonetheless been quick to assure the
public that pension benefits are not at risk. Diversification rules
have guaranteed that, in most cases, losses totaled less than one
percent of fund holdings, though concentrations are somewhat higher at
certain individual funds.
---------------------------------------------------------------------------
\3\ ``Enron's Many Strands: Fallout; The Enron Scandal Grazes
Another Bush in Florida,'' Leslie Wayne, New York Times, January 27,
2002.
\4\ ``The Enron Wars,'' by Marie Brenner, Vanity Fair, April 2002.
---------------------------------------------------------------------------
An unknown portion of those losses resulted from the practice of
index investing which is common among pensions, and which nonetheless
remains a sound strategy for reducing risk. Of greater concern are the
funds whose private money managers invested considerable fund assets in
Enron stock, even after signs had emerged that this was a company in
serious financial distress. Money managers who are paid with taxpayer
money to manage public funds have a responsibility, arguably greater
even than the fiduciary duty that all money managers owe their clients,
to ensure that they make prudent investment decisions based on thorough
and sound research. It is certainly appropriate for Congress to explore
whether those standards were met in this case.
Still, just about everyone appears to have been fooled by Enron's
false picture of financial health--from the media, which sang its
praises, to the bankers, who loaned the company money, to the research
analysts, who touted the stock, to the professional money managers who
bought it. While Enron was clearly a speculative investment once the
stock price had entered freefall, those who bought during its
astronomical rise had little reason to think they were taking undue
risks.
There are many lessons to be learned from Enron. Lessons about the
fundamental dysfunction of a system that rewards top executives with
millions or even billions of dollars in profits while rank and file
workers and shareholders are taken to the cleaners. Lessons about the
dangers of relying on private accounts to fund retirement and the need
to enhance protections for those accounts. Lessons about the failure of
securities analysts to provide reliable research, particularly when
their firm has, or hopes to have, an investment banking relationship
with the company being analyzed. Lessons about the gross inadequacy of
Securities and Exchange Commission resources to police the nation's
financial markets.
But the central, inescapable lesson from Enron is that the market
can't function without reliable information. As this Committee's
investigation today makes clear, even the most sophisticated
institutional investors can be duped when corporate executives use
financial disclosures to mask, rather than reveal, the true financial
condition of the company. When the professionals can so easily be
duped, the average retail investor doesn't have a chance.
The beauty of our system of investor protections, of course, is
that it was designed with just this potential for misleading behavior
in mind. It was designed to protect investors, not just when corporate
executives are honest, forthcoming and aboveboard, but also when they
are greedy, unethical and deceptive. That's why we have standardized
rules that govern what companies have to disclose and how. It's why the
SEC reviews financial disclosures for accuracy, completeness, and
compliance with appropriate accounting rules. It's why rating agencies
pore over massive amounts of information to determine the
creditworthiness of companies that issue debt. It's why corporate
boards have audit committees, made up primarily of independent board
members, to supervise the audit. And, first and foremost, it is why we
require an outside, independent auditor to review and approve a
company's financial statements.
In the Enron case, as in others before it, all of those safeguards
failed. The accounting rules failed to produce an accurate picture of
Enron's finances, even where the company complied with the rules. The
corporate board failed to ask tough questions, challenge questionable
practices, or require more transparent disclosure. The auditors signed
off on financial statements that clearly presented a misleading picture
of company finances. The SEC had not reviewed the company's financial
statements in several years. The credit rating agencies and securities
analysts that investors rely on for an expert assessment of the
company's prospects failed to provide any advance warning of possible
trouble.
All of these issues deserve congressional and regulatory attention.
But none is more crucial than the failure of the independent audit to
serve its public watchdog function. Independent auditors are our first
line of defense against misleading disclosure and accounting fraud. But
as the rising tide of audit disasters in recent years makes clear, the
system of independent audits is broken. It seems to work fine when
companies are honest, and it is our good fortune that so many companies
today maintain their commitment to providing investors with full and
accurate information about their operations. But when the independent
audit is really needed, when the company is both intent on deceiving
investors about its true financial condition and powerful enough to
assert itself, some auditors are all too willing to appease the client,
devise justifications for the misleading disclosures, or, worse, earn
millions helping to design structures and transactions with no purpose
but to hide the company's true financial condition.
Investors burned by the Enron collapse and witness to a rising tide
of failed audits are understandably skeptical about the ability of the
system to produce reliable information. That doubt imposes costs on the
system that harm not just those companies that engage in misleading
disclosure, but all companies that raise capital in the securities
markets. Unless Congress fixes this central problem, investors will
continue to harbor those doubts, and with good reason.
A number of bills have been introduced with the intent of restoring
integrity to the outside audit by enhancing the independence of
auditors, improving regulatory oversight of audits, and improving the
ability of corporate boards to supervise the audit. Just last month,
the House passed a bill, H.R. 3763, that claims to do all that, though
frankly it is in our view a waste of the paper it is printed on. At
best, it codifies the status quo. At worst, it would actually make it
harder for the SEC to create an effective independent regulator for the
auditing profession.
Hopes for real reform now rest with the Senate. Several bills have
been introduced or are being drafted which could provide for truly
independent audits, effective oversight of the audit by corporate
boards, and a strong new regulator to set and enforce standards for the
conduct of those audits. On auditor and corporate board independence,
the gold standard is S. 2056, a bill introduced by Sen. Bill Nelson and
Sen. Jean Carnahan. In addition, Sen. Paul Sarbanes and the Banking
Committee will soon be marking up legislation that would, among other
things, create a very strong, effective, independent new regulatory
body for auditors, enhance the independence of the Financial Accounting
Standards Board, and establish additional corporate governance reforms.
Taken together, these two bills would provide a very strong package of
reforms.
The remainder of this statement describes in more detail what we
view as the key steps needed to restore integrity to and confidence in
the capital markets, how these and other legislative proposals would
address these issues, and the changes we recommend to make the
legislation more effective.
I. Restore real independence to the independent audit.
The whole point of requiring public companies to obtain an
independent audit is to ensure that outside experts have reviewed the
company books and determined that they not only comply with the letter
of accounting rules but also present a fair and accurate picture of the
company's finances. Auditors have profited handsomely over the years
from performing this important public watchdog function. Unless the
auditor is free of bias, brings an appropriate level of professional
skepticism to the task, and feels free to challenge management
decisions, however, the audit has no more value than if the company
were allowed to certify its own books.
A. The independent audit has never been more important.
The independent audit is arguably more important today than it has
been at any time since the requirement was first imposed in the 1930s.
More than half of all American households today invest in public
companies, either directly or though mutual funds. They do so primarily
to save for retirement. As a result, their financial well-being later
in life is dependent on the integrity of our financial markets.
At the same time, corporations today are under great pressure to
keep their stock prices on a smooth upward trajectory. As one writer
has noted:
No longer is a higher stock price simply desirable, it is often
essential, because stocks have become a vital way for companies
to run their businesses. The growing use of stock to make
acquisitions and to guarantee the debt of off-the-books
partnerships means, as with Enron, that the entire partnership
edifice can come crashing down with the fall of the underlying
stock that props up the system. And the growing use of the
stock market as a place for companies to raise capital means a
high stock price can be the difference between failure and
success. \5\
---------------------------------------------------------------------------
\5\ ``Deciphering the Black Box: Many Accounting Practices, Not
Just Enron's, Are Hard to Penetrate,'' by Steve Liesman, Wall Street
Journal, January 23, 2002, pg. C1.
Both because they will be judged by the company's success and
because much of their compensation often takes the form of stock
options, corporate managers have a strong incentive to manage their
earnings in order to present the picture of steadily rising
profitability that Wall Street rewards. And, as the Enron case clearly
illustrates, murky accounting rules that rely on numerous subjective
judgments make it easier than it should be to construct a false picture
of financial health. The Enron case also makes it abundantly clear that
an auditor whose independence is compromised may be all too willing to
sign off on financial statements that conceal, rather than reveal, the
company's true financial state.
B. Many factors undermine auditor independence.
Because of the central importance of the outside audit in upholding
the integrity of our system of financial disclosure, the Supreme Court
has stated that this ``public watchdog function demands that the
accountant maintain total independence from the client at all times.''
\6\ Unfortunately, accountants have been unwilling to accept the
responsibility for maintaining their independence that goes with the
privilege of performing audits. This lack of independence takes several
forms.
---------------------------------------------------------------------------
\6\ U.S. Supreme Court, United States v. Arthur Young, 1984.
---------------------------------------------------------------------------
Much of the debate over auditor independence has focused on their
provision of consulting and other non-audit services to audit clients.
Since the mid-1990s, most of the big firms have dramatically increased
their sales of such services to audit clients, despite the clear
conflict-of-interest that this creates. Today, virtually all big
companies receive both audit and non-audit services from their
accountants, and they typically pay between two and three times as much
for the non-audit services as they do for the audit itself. In some
cases, the disparity between audit and non-audit fees is far greater.
Furthermore, consulting services increasingly drive the profitability
of accounting firms. If an auditor's tough questioning of management
were to threaten its more profitable consulting arrangement, that
auditor might expect to face tough questioning of his own from higher
ups at the firm.
Other factors also undermine auditor independence. The lack of
independence starts with the fact that auditors are hired, paid, and
can be fired by the audit client. This basic conflict is exacerbated by
the general lack of client turnover. Auditors may reasonably expect to
keep the same client for 20, 30, even 50 years. The prospect of such
long relationships make it that much harder for the auditor to
challenge management aggressively, not only because of the friendships
that are likely to develop up between auditors and company management,
but also because they risk losing this seemingly endless stream of
future audit (and consulting) revenues if their tough stance on the
numbers causes them to lose the client.
Another problem that clearly needs to be addressed is the revolving
door that all too often exists between auditors an their audit clients.
This was true at Enron, it was true at Waste Management, and it is a
common feature in many failed audits. A constant flow of personnel from
the auditor to the audit client helps to create an environment in which
external auditors are viewed as just another part of the corporate
family. Such intimacy is not conducive to true independence.
C. Comprehensive reforms will be needed to restore auditor
independence.
Legislation to restore independence to the audit must tackle all
these issues. It must lessen the influence audit clients have by virtue
of the fact that they hire, pay, and fire the outside auditor. It must
limit the financial dependence of the auditor on the audit client that
results from providing both audit and non-audit services to the same
firm. And it must close the revolving door that all too often exists
between companies and their auditors.
The Nelson-Carnahan bill provides just this sort of comprehensive
approach to reform. S. 2056 would require mandatory rotation of
auditors every seven years. It would strictly limit the non-audit
services an audit firm may provide to those that are closely related to
the audit and pose no conflict-of-interest. Tax consulting services are
excluded from the ban, but would have to be pre-approved by the audit
committee of the board. Finally, the bill proposes a one-year cooling
off period before an audit firm employee could accept employment in a
management or policymaking position at a company that is an audit
client of the firm.
The mandatory rotation requirement is key to diminishing the basic
conflict that exists because the auditor works for the audit client.
First, an audit firm that knows it has a limited term of engagement has
far less to lose by challenging management than one that expects to
retain the client indefinitely. The knowledge that a rival firm will
soon be evaluating the books should also provide an incentive to get it
right. And the new auditor would have no reason to hesitate in setting
past mistakes right. Some have argued against this requirement by
citing research that shows a preponderance of audit failures occur in
the first year of the audit, but it is an inescapable fact that
investors have suffered their largest losses in audit failures in cases
like Enron, Waste Management, Microstrategy, Cendant, Rite Aid,
Sunbeam, Lucent, and others that involved ongoing, often very long-term
audit relationships.
The Nelson-Carnahan bill would further lessen the auditor's
financial dependence on a single audit client by strictly limiting the
non-audit services they may provide. We strongly support this approach.
The argument put forward by opponents of a consulting ban--that
providing consulting services makes auditors less financially dependent
on the audit itself and, thus, more independent--is absurd on its face.
It assumes that the audit firm can challenge management to the point of
losing the company as an audit client, but still retain the more
lucrative consulting services. The real world simply doesn't work that
way.
Our one suggestion for improving the bill in this area is would be
to add a requirement that audit committees pre-approve all non-audit
services. This would clarify that audit committees are directly
responsible for determining what non-audit services are permissible
based on a determination that they are ``directly related to the
audit'' and pose no conflict-of-interest.
Finally, we support the cooling off period in the Nelson-Carnahan
bill as a good first step, though we would like to see it strengthened.
The bill effectively addresses the clearly inappropriate practice of
members of the audit team applying for work at an audit client while
engaged in conducting the audit. A further problem is the conflict that
arises when certain high placed executives responsible for over-seeing
the preparation of financial disclosures are former partners or
employees of the audit firm. To address this problem, we advocate
adding a requirement that a company change auditors if it hires an
individual who has worked at its current audit firm during the past
three years to fill certain key positions, such as chief executive
officer, chief financial officer, or chief accounting officer.
Although it offers a less comprehensive package of auditor
independence reforms than is contained in the Nelson-Carnahan bill and
than we believe is needed, the draft bill being circulated by Sen.
Sarbanes nonetheless offers some progress in this area. First, it would
expand the list of prohibited non-audit services to reflect the
definitions in the original SEC rule proposal under Levitt. All of
those definitions were watered down in the final rules, not just those
pertaining to internal audits and financial system design and
implementation. In addition, the Sarbanes bill would require audit
committee pre-approval of non-audit services. This would clarify that
audit committees have the ultimate responsibility to ensure the
independence of the audit. We can only hope that they have learned the
lesson of Enron and other previous audit failures, that auditors who
have millions of dollars at stake in consulting contracts are not the
independent arbiters of financial disclosure that our system demands.
The bill would also enhance the ability of audit committees to oversee
the audit by requiring auditors to make separate reports on key issues
to the committee.
Unlike the Nelson-Carnahan bill, the Sarbanes draft does not
require mandatory rotation of audit firms. Instead, it calls for a
General Accounting Office study of the issue and requires rotation of
audit team members on a five-year basis. Like the Nelson-Carnahan bill,
it would impose a one-year cooling off period. However, the cooling off
period in the Sarbanes draft applies to only a few top positions at the
audited company. We believe that provision should be expanded as
outlined above.
Both Senate bills are significantly stronger than the House bill on
the issue of auditor independence. The Nelson-Carnahan bill in
particular offers the comprehensive package of reforms that we believe
the current crisis of investor confidence demands.
II. Provide effective regulatory oversight of auditors.
Auditors' lack of independence makes them vulnerable to pressures
to sign off on questionable accounting practices. This problem is
exacerbated by the fact that they face relatively little fear of
sanctions if they do so. Although a variety of groups including the
SEC, state accountancy boards, and the AICPA all have power to
discipline auditing firms and their employees for ethical and legal
infractions, even serious violations typically receive little more than
a hand slap.
A. The current ``regulatory'' system is under-funded, ineffective, and
captive of the industry.
In theory, the real authority over auditors lies with the SEC. It
has the power to bar individuals and firms from auditing publicly
traded companies. It also has authority to impose potentially
substantial fines. In reality, however, the agency does not routinely
review how auditors perform their audits, and instead delegates that
responsibility to the AICPA's SEC Practice Section and the Public
Oversight Board. Furthermore, according to past agency officials, the
SEC only has the resources to tackle the very worst cases of alleged
accounting abuse, and it typically settles even those cases without an
admission of wrongdoing. It took no action, for example, against a
former Arthur Andersen managing partner whom the SEC said had allowed
persistent misstatements on Waste Management's financial reports to go
uncorrected. \7\ Similarly, a PricewaterhouseCoopers partner ordered by
the SEC in 1999 to cease and desist violating securities laws didn't
even lose his position as lead partner on the audit in question. \8\
---------------------------------------------------------------------------
\7\ ``Deciphering the Black Box: Many Accounting Practices, Not
Just Enron's, Are Hard to Penetrate.''
\8\ Ibid.
---------------------------------------------------------------------------
The AICPA sets audit standards, the Public Oversight Board (POB)
oversees a peer review system to determine compliance with those
standards, and the AICPA has disciplinary authority over its members
for violations. According to former SEC chief accountant Lynn Turner,
however, the audit standards adopted by AICPA are ``so general that, as
a practical matter, it's difficult to hold anyone accountable for not
following them.'' \9\ The POB, \10\ which is responsible for overseeing
the industry's peer review system and other ethics investigations, is
notable for having never sanctioned a major accounting firm in its 25
years of existence, even when peer reviews have uncovered serious
short-comings in a firm's audit procedures. \11\ Furthermore, the POB
can't act against a firm without the AICPA's cooperation. In one case
where, at the SEC's prompting, the POB did attempt to investigate
possible stock-ownership violations at the major firms, the AICPA
refused funding for and cooperation with the investigation, which as a
result went nowhere. \12\
---------------------------------------------------------------------------
\9\ ``After Enron, New Doubts About Auditors,'' by David
Hilzenrath, Washington Post, December 5, 2001, pg. A1.
\10\ The POB recently voted itself out of existence in protest over
SEC Chairman Harvey Pitt's proposal to create a new self-regulatory
body for the accounting industry.
\11\ ``Peer Pressure: SEC Saw Accounting Flaw,'' by Jonathan Weil
and Scot J. Paltrow, Wall Street Journal, January 25, 2002, pg. C1.
\12\ The case is described both in a May 12, 2000 letter from Rep.
John Dingell (D-MI) to the SEC Chairman Arthur Levitt and in a May 22,
2000 Business Week editorial, ``Why the Auditors Need Auditing.''
---------------------------------------------------------------------------
Even if they had the will to act, the AICPA and POB are also
hampered by a severe lack of investigative authority. They cannot
subpoena evidence or compel testimony, for example, and as a result are
forced to rely on the public record in building a case. If the SEC
settles a case confidentially, with neither a public ruling nor an
admission of guilt, there is no public record the AICPA or POB can rely
on in bringing its own enforcement actions. Where the AICPA does act,
its maximum sanction is expulsion from the organization, which can have
serious consequences, but does not prevent the individual from
continuing to practice.
In reality, however, AICPA has shown itself to be a reluctant
regulator. According to a Washington Post investigation, the AICPA took
disciplinary action in less than a fifth of the cases in which the SEC
imposed sanctions over the past decade. Even when AICPA determined that
SEC-sanctioned accountants had committed violations, they closed the
vast majority of ethics cases without disciplinary action or public
disclosure. \13\ The disciplinary action AICPA was most likely to take,
according to the Post investigation, was issuing a confidential letter
directing the offender to undergo additional training. Ethics committee
member Dave Cotton has reported seeing ``ethical lapses that resulted
in millions of dollars of losses getting punished with as little as 16
hours of continuing education.'' \14\
---------------------------------------------------------------------------
\13\ Ibid.
\14\ ``CPAs (and I'm One) Can Reverse Their Losses,'' by Dave
Cotton, Washington Post, January 27, 2002, Op Ed.
---------------------------------------------------------------------------
B. A complete overhaul of the system is needed.
There seems to be general agreement that a new, independent
regulator is needed to oversee the auditors of public companies. We
agree that such a body, operating under SEC oversight, could offer a
vast improvement over the current system. To do so, however, it must be
entirely independent of the accounting industry, be adequately funded,
and have extensive rule-making, standard-setting, investigative,
enforcement, and sanction authority.
As one former SEC official observed to Business Week, ``The
accounting profession is very creative at taking over every group
that's ever tried to rein it in.'' \15\ For a self-regulatory
organization (SRO) to have any credibility, therefore, its independence
must be unassailable. At a minimum, a super majority of board members
must have no ties whatsoever to the accounting industry, and they must
be subject to conflict-of-interest rules that prohibit ties to the
industry for a significant period before they join the board, while
they are on it, and after they leave it.
---------------------------------------------------------------------------
\15\ ``Accounting in Crisis,'' by Nanette Byrnes with Mike McNamee,
Diane Brady, Louis Lavell, Christopher Palmeri and bureau reports,
Business Week, January 28, 2002, pg. 44-48.
---------------------------------------------------------------------------
Just as important, funding for the organization must be totally
free from threat by industry members. The AICPA and the Big Five firms
have shown their willingness to use strong-arm tactics to head off
potentially embarrassing investigations in the past. They must have no
such hold over any SRO that is created to provide enhanced oversight in
the wake of the Enron-Andersen disaster. Funding must also be adequate
to support an aggressive oversight program.
Once its independence is guaranteed, the new regulator must be
endowed with full authority for overseeing the conduct of audits of
public companies. This includes authority for setting auditing
standards. Both the bill that has passed the House and the proposal put
forward by SEC Chairman Harvey Pitt would leave authority for
developing auditing standards with the AICPA. This is unacceptable.
Rules on how to conduct audits clearly need to be strengthened and
clarified. That is the job of an independent regulator, not an industry
trade association. The AICPA, as a trade association, should have no
government-recognized role in the regulatory process.
A new regulator to oversee accountants must also have the ability
to conduct routine, thorough inspections of audit firms to determine
their compliance with auditing standards. It must have extensive powers
to conduct timely investigations of suspected abuses, including the
power to compel testimony and documents from both auditors and the
public companies they audit. And it must have the ability to impose
meaningful penalties for violations.
C. The Sarbanes draft bill offers the complete overhaul that is needed.
The Sarbanes draft would create a single new regulatory body to
which all accountants that audit public companies would have to belong.
It would be overseen by a 5 member full-time board whose members could
include up to two current or past CPAs. The board would be funded
through a combination of mandatory registration and investigation fees
paid by members and a fee imposed on issuers. This should ensure a
secure source of adequate funding that is free from influence by
accounting firms.
The bill gives the board broad authority and the powers it needs to
fulfill those responsibilities effectively. Specifically, the board
would be responsible for: registering accounting firms that audit
public companies; setting auditing, quality control, ethics,
independence, and other standards relating to the preparation of audit
reports for issuers; conducting inspections; conducting investigations
and disciplinary proceedings; enforcing compliance with the act, the
rules of the board, professional standards, and rules of the
Commission; and, when appropriate, imposing sanctions on firms or
individuals associated with a firm for violations.
Upon registering, audit firms must provide extensive information
about their operations, which information is to be made available to
the public. They must also consent to comply with requests by the board
for documents or testimony and to obtain similar consents from firm
partners and employees. Failure to comply is ground for suspension of
registration, which costs the firm the ability to audit public
companies. This gives the board the authority it needs to conduct
effective investigations.
The board is also required to conduct routine inspections of firms
on a regular basis. The bill specifies that inspections must include a
review of selected audit engagements, which may include those subject
to ongoing litigation. A written report detailing inspection findings
must be provided to federal and state regulators and be made available
to the public. The bill gives the board extensive sanction authority,
including the ability to impose civil fines of up to $750,000 per
person per violation and $15 million per firm per violation for fraud
and deceit.
The bill includes a number of provisions designed to ensure the
independence of the governing board in addition to the requirement that
they serve full-time. Members would be appointed by the SEC, the
Federal Reserve Board, and the Treasury Department. Members could not
receive any compensation, except pension payments, from an accounting
firm while serving on the board. This is a substantial improvement over
the Oxley bill, which requires that two board members be current CPAs
recently engaged in the practice of auditing public companies, permits
an additional two members to be current or past CPAs, so long as they
have not been associated with an audit firm for at least 2 years, and
only requires that 1 member of the 5 person board actually be free of
ties to the accounting industry.
Nonetheless, we are concerned that the bill does not do enough to
ensure the independence of the board. A retired academic who is a CPA
but is otherwise free of ties to the accounting industry would be
subject to limitations on his or her ability to serve. A non-CPA who
has spent a career in the accounting industry would not. To avoid these
inconsistencies, we believe a better approach would be to define strong
independence standards for the board and to require that a super-
majority of board members meet those standards. To accommodate that
requirement, the board would have to be expanded to 7 members. Despite
this one concern, we believe the Sarbanes draft bill would dramatically
improve the quality of regulatory oversight for auditors.
III. Reform private litigation laws to provide a real deterrent to
wrongdoing.
Private litigation has long been viewed as an important supplement
to regulation, since the threat of having to pay significant financial
damages provides an incentive to comply with even poorly enforced laws.
Even a reinvigorated system of auditor oversight would benefit from
this support. In 1995, however, Congress passed the Private Securities
Litigation Reform Act (PSLRA), which significantly reduced auditors'
liability in cases of securities fraud. \16\ It did so, both by making
it more difficult to bring a case against accountants and by reducing
their financial exposure where they are found to have contributed to
fraud.
---------------------------------------------------------------------------
\16\ PSLRA also all but guaranteed that Enron's victims will
receive mere pennies on the dollar in any recovery.
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Under PSLRA, it is not enough in a securities fraud lawsuit to show
that an auditor made a materially false statement. You must also show
that the auditor acted with an intent to defraud or a reckless
disregard for the truth or accuracy of the statement. PSLRA set
pleading standards with regard to state of mind that create a Catch 22
for plaintiffs' attorneys. They must present detailed facts showing the
defendant acted with requisite state of mind, and they must do this
before they gain access through discovery to the documents they need to
establish state of mind. If plaintiffs can't meet the pleading
standards, the case is dismissed. One result is a dramatic reduction in
the number of cases filed against secondary defendants. By the time
victims of fraud gain access to discovery and uncover the evidence that
would support their case against such defendants, the statute of
limitations has often expired.
In addition to making it more difficult for securities fraud
victims to bring private lawsuits against accountants, PSLRA reduced
accountants' liability when they are found to have contributed to
fraud. The primary way it accomplished this was by replacing joint and
several liability with a system of proportionate liability. Thus,
accountants who are found to have contributed to securities fraud no
longer have to fear being forced to pay the full amount of any damages
awarded should the primary perpetrator be bankrupt. Under proportionate
liability, the culpable accountant cannot be forced to pay more than
their proportionate share of damages. As a result, according noted
securities law expert Professor John C. Coffee, Jr., accountants will
rarely be forced to may more than 25 percent of the losses. \17\
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\17\ ``The Enron Debacle and Gatekeeper Liability: Why Would the
Gatekeepers Remain Silent?'' Professor John C. Coffee, Jr., Adolf Berle
Professor of Law, Columbia University Law School, testimony before the
Senate Committee on Commerce, Science and Transportation, December 18,
2001.
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PSLRA was also notable for what it didn't do. It failed to extend
the federal law's very short statute of limitations for securities
fraud of no more than 3 years from the time of the wrong-doing and 1
year from discovery. This rewards those who are able to cover up their
fraud for the relatively short period of 3 years and guarantees, for
example, that some claims against Enron and Andersen will be time-
barred. It also, as described above, helps to keep cases against
secondary defendants from being filed. PSLRA also failed to restore
aiding and abetting liability under securities fraud laws, which the
Supreme Court's 1994 Central Bank of Denver decision eliminated as a
potential cause of action. Thus, accountants can only be sued as
primary perpetrators of securities fraud, not for their role in aiding
and abetting that fraud.
The result is that the threat of private lawsuits now poses a
diminished deterrent to accounting fraud. Restoring reasonable
liability for culpable accountants should be part of any overall reform
plan. This should include provisions: to enable plaintiffs to gain
access to documents through discovery before having to meet the
heightened pleading standards regarding state of mind; to restore joint
and several liability where the defendant recklessly violated
securities laws and the primary wrong-doer is bankrupt; to restore
aiding and abetting liability for those who contribute to fraud but are
not the primary culprit; and to extend the statute of limitations for
securities fraud lawsuits.
Sen. Richard Shelby has introduced legislation to restore this
needed deterrent to fraud. In addition, Sen. Patrick Leahy included a
provision to lengthen the statute of limitations--to 5 years from the
wrongdoing and 2 years from discovery--in legislation that was recently
approved by the Judiciary Committee. We support passage of both those
bills.
IV. The independent audit must be backed up by an aggressive, fully
funded SEC.
In the wake of Enron's collapse, many have asked, ``where was the
SEC?'' Given the SEC's responsibility for reviewing public companies'
financial disclosures, why had the agency not detected the company's
problematic accounting earlier? One answer is that the SEC had not
reviewed Enron's financial disclosures since 1997. The reason is that
the agency is so understaffed it is only able to review a small
percentage of filings each year.
The General Accounting Office released a study earlier this year on
the devastating effect that under-funding is having on the SEC's
ability to perform its assigned tasks. That report looks at the growth
in workload at the agency since the start of the 1990s, and documents
the degree to which funding has failed to keep pace. It tells only half
the story. The real damage to SEC funding occurred before the period
covered by the report, in the 1980s, when staffing stayed virtually
flat while the industry experienced dramatic growth.
In 1980, for example, there were just over 8,000 publicly traded
companies filing annual reports, according to a report commissioned in
1988 by the Securities Subcommittee of the Senate Banking Committee,
\18\ and there were 710 new registration statements filed. Excluding
the staff for electronic filing and information services, 420 staff
years were devoted to disclosure matters. As a result, the agency was
able to review all transactional filings.
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\18\ Self-Funding Study, prepared by the Office of the Executive
Director of the U.S. Securities and Exchange Committee, submitted in
partial response to the request of the Securities Subcommittee of the
Senate Committee on Banking, Housing and Urban Affairs (S. Rpt. 100-
105), December 20, 1988.
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In 2000, the number of staff years devoted to full disclosure
(again excluding the staff for electronic filing and information
services), had dropped to 356, according to the SEC's analysis of the
president's proposed FY 2002 budget. As a result of diminished
staffing, dramatic growth in the number of publicly traded companies,
and increased workload associated with review of initial offerings,
``the percentage of all corporate filings that received a full review,
a full financial review, or were just monitored for specific disclosure
items'' decreased to about 8 percent in 2000, according to the GAO
report. Because of a dramatic drop-off in the number of IPOs in 2001,
the SEC was able to complete ``full or full financial reviews of about
16 percent, or 2,280 of 14,060 annual reports filed'' last year, the
GAO report found.
Among the financial statements that were passed over for review
because of this staffing shortfall were the financial statements for
Enron from 1998, 1999, and 2000. Although it is impossible to know
whether more regular, more thorough reviews would have nipped the
accounting problems at Enron in the bud, it is reasonable to think they
might have. Certainly, it is irresponsible to so grossly under-fund the
federal regulators that they can't hope to fulfill the important
responsibilities assigned to them.
Last year, Congress had a historic opportunity to fix this problem.
A decision was made not to use SEC-generated fees to fund other areas
of the government. As a result, the agency no longer had to compete
with other federal priorities in justifying its budget. Instead of
taking that opportunity to dramatically boost agency funding, however,
Congress approved a budget that required additional staffing cuts and
passed legislation to reduce agency imposed fees to reflect that
inadequate budget. The Senate fought to provide a funding boost, but
those efforts were ultimately unsuccessful.
The collapse of Enron has focused new attention on the issue of SEC
funding. Because of Enron, most of that attention is focused on
staffing issues related to full disclosure and enforcement. The
Sarbanes draft, for example, would provide a significant funding boost
for the agency targeted primarily at these two areas. These are
important priorities that certainly deserve increased funding, but
similar trends have affected all areas of SEC responsibility. Think of
what has happened in that time in the area of mutual funds or financial
planning since the beginning of the 1980s. Think of how many more
households are now participants in the markets and thus vulnerable to
wrong-doing.
The GAO report has helped to make the case for across-the-board
significant funding increases for the SEC. That case is even more
powerful when the numbers from the 1980s are taken into account.
Congress must undo the damage of last year's fee reduction legislation
and provide a budget for the SEC that is commensurate with its
responsibilities. The Sarbanes bill, which also would authorize full
funding for pay parity at the agency, offers an important step in this
direction, but it must be followed up with a more thorough analysis of
agency funding needs.
V. Study credit rating agencies to determine why they failed to provide
an earlier warning of problems.
Another troubling aspect of the Enron collapse is the failure of
credit rating agencies to provide an early warning of trouble. In fact,
both Moody's and Standard & Poor's still had Enron at investment grade
until just five days before it filed for bankruptcy. According to a
Bloomberg News account, Moody's had decided to downgrade Enron to junk
in early November, but backed down in response to lobbying from Dynegy,
which was then negotiating a takeover of Enron, and its bankers. \19\
Although this raises serious questions about the objectivity of the
ratings, it is unclear that an earlier downgrade would have changed
things for investors. A credit rating is not just an isolated measure
of a company's financial health. A downgrade may not just reflect the
company's worsening financial status, it can trigger further financial
woes, as it did for Enron.
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\19\ ``Moody's Enron Rating Shows Lack of Independence,'' Mark
Gilbert, Bloomberg News, November 15, 2001.
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We strongly encourage Congress to conduct a further study of this
issue to assess whether the operations of credit rating agencies are
adequate to ensure accurate ratings and, if not, what should be done to
enhance the quality of ratings. That study should examine the extent to
which recently announced changes by the rating agencies are likely to
provide the desired improvement. It should also examine whether lack of
competition in the industry is contributing to the problem. We expect
that a thorough review will identify areas in need of additional
reform.
VI. Provide additional protections to prevent securities analyst
conflicts-of-interest.
Credit ratings agencies were not alone in missing the warning
signs. In early November, after the SEC had already announced it was
looking into Enron's partnership transactions, 10 of 15 analysts who
followed Enron still rated it as a ``buy'' or ``strong buy.'' One
reason, as the analysts are quick to point out, is that they were not
getting good information from Enron's financial statements. Another is
that Enron was apparently actively and intentionally misleading
analysts about activity on its trading floor, for example.
However, this offers only a limited explanation. Red flags were
there for those who were looking. And many now looking back--albeit
with the benefit of 20-20 hindsight--have been able to point out
obvious danger signs. These included wide discrepancies between the
company's reported earnings and its retained earnings, negative cash
flow of $2.56 billion in 2000 once proceeds from asset sales and other
one-time activities not part of its core business were deducted, and
actual revenues on energy trading that were a mere fraction of those
that accounting rules let the company claim. \20\ Surely it is
analysts' job to look for just such clues and to probe deeper than the
surface of company disclosures.
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\20\ ``How 287 Turned Into 7: Lessons in Fuzzy Math,'' by Gretchen
Morgenson, New York Times, January 20, 2002, Section 3, page 1.
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Another reason analysts may have missed these signs is that they
simply weren't looking. Institutional investors, who vote a key annual
beauty contest ranking analysts, tend to frown on negative reports on
stocks they hold in their portfolios. Even more important, negative
reports don't attract investment banking business, and Enron was
clearly seen as a huge potential source of such deals. Since investment
banking business is far more profitable than the retail sales business
for large Wall Street firms, it is hardly surprising that those firms
use their research arms to support their investment banking business.
In the process, their research has become so compromised by conflicts
of interest that it has no real credibility.
Recently, new rules have been adopted to address analyst conflicts
of interest. They do so by attempting to limit the investment banking
department's influence over research, limit analysts' investments in
pre-IPO shares of companies in the industry they cover, limiting their
purchase or sale of securities during a window of time around the
release of a new research report, prohibiting trades against their own
recommendations, and requiring better disclosure of conflicts. We view
these rules as a positive first step. However, we believe more should
be done in several areas, including banning compensation for analysts
that is tied in any way to investment banking profits, improving the
clarity and relevance of required disclosures, and extending disclosure
to recommendations by sales representatives to retail clients based on
the company's research. We are cautiously optimistic that the
investigation being pursued by New York Attorney General Eliot Spitzer,
and somewhat belatedly by the SEC, will force additional reforms along
these lines. Absent regulatory action, Congress should intervene to
impose higher standards.
VII. Protect FASB's independence.
In the wake of Enron's collapse, Arthur Andersen has tried to blame
inadequate accounting rules--rather than its own poor performance as
auditor--for Enron's less-than-transparent financial disclosures. This
ignores the fact that Enron's financial statements have been shown to
contain several violations of existing rules. \21\ It also ignores
Andersen's responsibility as auditor to ensure not just that Enron's
disclosures complied with the letter of existing rules, but also that
they presented an accurate picture of Enron's overall financial status.
However, this is not an either-or proposition. It is in fact the case
that Andersen failed in its responsibility as auditor and existing
accounting rules are inadequate.
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\21\ In his January 24, 2002 testimony before the Senate Committee
on Governmental Affairs, former SEC chief accountant Lynn Turner
outlined four areas of noncompliance with existing rules.
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One reason is the inability of the Financial Accounting Standards
Board to produce strong rules in a timely fashion when faced with
entrenched opposition from large corporations and accounting firms. It
is difficult to criticize FASB for moving too slowly on improved
accounting rules governing special purpose entities, for example, when
their past efforts to pass similarly controversial rules--regarding
pooling of interest accounting for mergers, derivatives disclosures,
and accounting for stock options--have met strong resistance, not just
from business, but also from members of Congress.
Something needs to be done to enhance FASB's independence. This is
a difficult issue to tackle, since FASB is a private entity not subject
to government oversight. The Sarbanes draft bill seems to offer a
reasonable approach. It specifies that accounting principles recognized
by the securities laws as ``generally accepted'' must be set by a
private body, with a majority of independent board members and
procedures to ensure prompt consideration. It also guarantees an
independent funding source in the form of a fee imposed on issuers for
the board. We believe this approach offers the possibility of real
progress without exposing FASB to excessive risk of political
interference. In addition, however, certain members of Congress must
recognize that they have played a key role in undermining FASB's
independence in the past and should refrain from interfering
inappropriately in the future.
VIII. Improve corporate governance standards.
Enron's independent board members, and particularly the board audit
committee, have come in for considerable criticism for authorizing some
of the company's more controversial partnership deals and for failing
to ensure clear, accurate financial disclosures. While it may be
unrealistic to suppose that board audit committees will ever be
equipped to closely scrutinize and challenge the outside auditor's
work, steps can and should be taken to enhance the independence and
expertise of independent board members.
The Nelson-Carnahan bill would impose tough new independence
standards for both board audit and compensation committees. We strongly
support those provisions of the bill. If audit committees are to bear
greater responsibility for the oversight of the audit, as the Sarbanes
draft bill proposes and we endorse, they must also have the
independence and resources necessary to serve that function.
IX. Reduce incentives for managers to manipulate the numbers.
Although the above protections are designed to work even when
managers are corrupt, reforms are most likely to be effective if
corporate managers' incentives to manipulate the numbers are minimized.
The Sarbanes bill includes several provisions to accomplish this goal,
including: requiring CEOs and CFOs of public companies to certify in
writing that financial statements present a fair and accurate picture
of the financial condition of the issuer; making it a violation of the
law to fraudulently influence, coerce, manipulate, or mislead the
auditor; requiring forfeiture by CEOs and CFOs of bonuses and profits
on sales of company stocks during the 12-month period before an
earnings restatement resulting from material noncompliance with
disclosure requirements; enhancing SEC authority to force disgorgement
of salary, bonuses, stock option payments and other profits to
corporate officers; and expanding SEC authority to prohibit certain
individuals from serving as officers or directors of public companies.
We support all these provisions.
We also support legislation introduced by Sen. John McCain and Sen.
Carl Levin to require companies who claim stock option expenses on
their tax filings to also show those expenses on financial statements
to shareholders. The fact that corporate officers today earn a
disproportionate share of their income in the form of stock option
grants can give them a strong incentive to boost the company's share
price. While that can be a positive incentive, within limits, it can
also create an incentive to push the envelope on acceptable accounting.
By lessening the incentive for companies to grant such outsized stock
option compensation packages, the McCain-Levin bill should help to
reduce those temptations. As such, we believe it is an important part
of an overall reform package.
X. Conclusion
The collapse of Enron has provided a clarion call for reform. It
has exposed gaping holes in the investor protections we rely on to keep
corporate managers honest. Enron is not unique. These same shortcomings
apply to all publicly traded companies. We are fortunate that so many
company managers have remained committed to providing clear, accurate
disclosures to investors. But we cannot rely exclusively on their
integrity. We need a system that works even when company managers are
greedy and overly aggressive, and we need a system that reduces their
incentives to be greedy and overly aggressive. Congress can repair the
gaps in the current system. It is of paramount importance that you do
so.
Senator Nelson. It's so nice to hear so many nice things
about my bill. Thank you very much, Mr. Plunkett.
Mr. Musuraca, share with us, from your experience in New
York and your knowledge of pension funds for AFSCME, and that
is throughout the country, that you represent, tell us if you
would typically see a large-cap money manager buying large
positions of one particular distressed company.
Mr. Musuraca. Let me clarify, I'm only a trustee at NYCERS
in New York City.
Let me say, also, that when a board hires a money manager,
any money manager, whether they be an active manager in a
large-cap growth or a large-cap value or whether they be an
index fund, you put guidelines on how they are to manage the
fund's money. So if the guideline suggests that there are no
restrictions on how large a stake they can take with any one
company, then maybe perhaps you would. But, in my experience,
we usually put a guideline of no more than 5 percent of the
portfolio should be invested in any one company.
Senator Nelson. As a trustee, do you consider it part of
your responsibility to monitor your outside money managers?
Mr. Musuraca. It's one of my major responsibilities. Every
month, I receive, on a chart prepared to me by staff of the New
York City controller's office, the performance of all the
active managers and the index funds that the NYCERS portfolio
has. And it's done over a 1-month, 6-month, 1-year, 3-year, 5-
year, 10-year rolling basis so that I can gauge both the short-
term and long-term performance of the managers. And at any
meeting of the board, I can instruct staff that the performance
of any one of the managers has given me cause for concern. And
as long as I can bring along a few more votes on the board, we
can have a manager come in to sit down and discuss their
performance and how they're doing things for the members of the
fund.
Senator Nelson. And as a trustee, are you informed when a
fund staff gives reviews on money managers on watch lists? You
heard the testimony today, all about that. Give us the benefit
of your experience.
Mr. Musuraca. We have two ways of finding out what staff
believes to be going on with any given money manager at any
time. The controller's office staff will monitor the
performance of a money manager, as will our outside investment
advisor. From time to time, firms will go on a watch list that
we keep, as well, for a variety of reasons, including poor
performance, merger with another company, change in personnel.
And we will be told about meetings that have taken place
between controller office staff and our investment consultant.
They will report on how long they think the company should be--
the firm should be on the watch list. And we will--the board
will either agree that that's a long enough time, disagree that
that's a long enough time, or say, ``Listen, you know, things
have gotten so bad at Company X. We really--you need to bring
them in to see us, and we need to make some decisions.''
Ultimately, the decision to terminate rests with the board.
Senator Nelson. Was it your fund that Alliance Capital
Management sold the Enron shares in New York in August, or was
that a different----
Mr. Musuraca. That was a different fund.
Senator Nelson. That was a different fund. Well, in the
fund that you are a trustee of, does the fund have any exposure
to Enron? And did they sell? Did they buy? What's your
experience?
Mr. Musuraca. As I suggested, we had exposure through our
index fund----
Senator Nelson. I see.
Mr. Musuraca.--and you use index funds, large institutional
investors, to, in fact, diversity your risk. And because of
this--the notion--and this gets to the question that Mr.
Plunkett raised about the reliability of information--one of
the reasons you invest in index funds is that it's assumed,
especially for large-cap companies like Enron, that the
information is generally available to all investors, be they
large or small, and it's reliable information, so that an
active manager is not going to add value for you over the
index. That's why you do an index fund.
If the information is bad, as we found out, index investors
get hurt, because the regulatory agencies failed, the auditors
failed, to find the misleading information and the blatant
lies, in this instance, that Enron was putting out.
Senator Nelson. Do you want to comment about the fund that
did lose--that did sell the Enron stock, the New York Common
Fund?
Mr. Musuraca. Well, I could talk to two. One is New York
Common, and one is the New York City Firefighters, both of
which had Alliance at one period of time as an active manager.
It's my understanding that the portfolios that were run for
them from a different office, a different Alliance officer,
which had decided in August, after Skilling's resignation, to,
in fact, pare back and sell their shares of Enron. I don't know
exactly the dates that such sales took place, but I do know
that Mr. Harrison's group acted in one way, and another
Alliance group acted in a different way. And in this instance,
luckily for both the State Common and the Firefighters system,
they weren't exposed to such great losses.
Senator Nelson. Did Alliance meet with you in January of
this year, 2002?
Mr. Musuraca. Yes, sir, they did.
Senator Nelson. And was it Mr. Calvert, the CEO of
Alliance?
Mr. Musuraca. Yes, sir.
Senator Nelson. Can you describe the meeting for the
Committee?
Mr. Musuraca. This was a meeting that took place at the
request of myself, representing the New York City Employees
Retirement System, and a number of other public pension funds,
the Taft Hartley funds, to discuss two concerns that had been
raised by the Enron collapse and Alliance's stake in Enron. One
was the role of Frank Savage sitting on both the Enron board
and the Alliance board. And the other was how Alliance had come
to arrive at its decision--at least Mr. Harrison--to buy
throughout the fall--to buy Enron stock throughout the fall of
2001.
Senator Nelson. And who else attended there for Alliance?
Was it just Mr. Calvert?
Mr. Musuraca. It was Mr. Calvert, Liz Smith--I can't
remember the counsel's name, but a general counsel, as well,
and an expert on corporate governance that the firm had.
Senator Nelson. And in that explanation, did he describe
the different investment patterns of different portfolio
managers?
Mr. Musuraca. Yes, he did. He was actually fairly
forthcoming, although he could not comment directly, as he did
today--the major difference was he could not comment directly
on the relationship that Savage may have had and what Savage
may have known. It was still fairly groundbreaking news at the
time, so he hadn't come up with the formulation that he came up
with today.
Senator Nelson. And what did Mr. Calvert say in that
January meeting this year about Enron?
Mr. Musuraca. He basically made similar comments that both
he and Mr. Harrison made today, that Alliance was as much a
victim as were large institutional investors who lost money in
their index funds. Their due diligence did not produce evidence
of the lies and deceit that were involved in Enron's case, and
they kept investing thinking that they were buying a relatively
sound company as its price was going down.
Senator Nelson. With your knowledge of pension funds, do
you have any commentary on why you think Florida lost so much
money while other plans did not?
Mr. Musuraca. It's commentary, right?
Senator Nelson. Commentary.
Mr. Musuraca. I wasn't in the Florida boardroom. They
obviously have made an asset allocation decision and then
structured the asset investment in a way that I differ with. I
was--our system is much more heavily indexed. What is striking
to me, however, is that the trustees never seemed to get
involved in the process. Mr. Herndon is a very well-respected
and qualified individual. I have nothing but the utmost respect
for him. But at some point, it's the trustees' decision to make
when looking at the performance of the fund.
And I come from a board that has 3 city-wide elected public
officials: the mayor, the controller, and the public advocate.
It also has 3 representatives of the workers. At any given
time, from either side of the aisle, we can ask questions and
take initiatives that I didn't see trustees at the SBA making.
And that struck me, even here today.
I've had to defend to members of my system the losses that
we suffered. It just seems that one would expect the same.
Senator Nelson. That's well stated. And you'll remember
that Mr. Herndon also said, in response to my question whether
you ought to insulate trustees from raising money from people
that have business before the SBA--he said he thought that
would be a good reform, as well, just like it is that some of
those same trustees that sit as the Florida cabinet sitting as
the Division of Bond Finance are prohibited by law from raising
money in their campaigns from bond firms.
Mr. Musuraca. I would tend to agree with Mr. Herndon's
final comment, that it is something that should be regulated
and prohibited.
Senator Nelson. Mr. Plunkett, you've been so gracious in
your comments about Jean Carnahan's and my bill. Given the fact
of practical politics, do you have any suggestions as we go
forth, thus far, knowing that our bill is going to have an
array of opponents who don't want to see reforms enacted. Have
you got any suggestions of--that you'd share with the Committee
of how we ought to approach it?
Mr. Plunkett. Other than divine intervention?
[Laughter.]
Mr. Plunkett. Well, obviously, the major focus of your bill
is--has proven to be, in both houses, the most controversial
approach, because it is the approach the accounting industry,
which is extremely powerful, opposes. And that is a real ban on
consulting services, virtually all consulting services, in the
same year that an audit is done for a particular client. So
other than working with obvious allies who support that
approach, like the Council of Institutional Investors and
consumer groups, and all together doing our best to educate
members over here, starting with the banking committee--and
we're doing meetings on that as we speak--I don't have any
pearls of wisdom.
Our point that we keep making is if you can't assure the
independence of the audit, why bother? And any--you know, I'll
go back to Mr. Glassman's comments--any child or fool can see
that there is a conflict of interest if, on average, firms are
receiving two to three times more in consulting fees than they
are in auditing fees. And if you don't go at the heart of that
problem, you don't solve it.
Senator Nelson. You know, I'm usually an optimist, and I
still am, although sobered sometimes, but I really believe that
there is so much agitations out there in America over this
Enron situation that we ought to have a decent shot of passing
the legislation that will contain the part of separating the
auditing from the consulting functions. And if we don't, shame
on us for special interests preventing that from occurring,
because that clearly is a reform that has come out of this
whole debacle of which we have only examined one little part of
it today, but a necessary part.
Does the staff have any further questions? OK, thank you
all for being so patient. It's almost 6 o'clock.
The meeting is adjourned.
[Whereupon, at 5:55 p.m., the hearing was adjourned.]