[Senate Prints 107-75]
[From the U.S. Government Printing Office]



107th Congress 
 2d Session                 COMMITTEE PRINT                     S. Prt.
                                                                 107-75
_______________________________________________________________________

                                     




                     FINANCIAL OVERSIGHT OF ENRON:

                  THE SEC AND PRIVATE-SECTOR WATCHDOGS


                               __________


                              R E P O R T

                         PREPARED BY THE STAFF

                                 of the

         COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE



[GRAPHIC] [TIFF OMITTED] TONGRESS.#13


                            October 7, 2002






                       U. S. GOVERNMENT PRINTING OFFICE
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                   COMMITTEE ON GOVERNMENTAL AFFAIRS

               JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan                 FRED THOMPSON, Tennessee
DANIEL K. AKAKA, Hawaii              TED STEVENS, Alaska
RICHARD J. DURBIN, Illinois          SUSAN M. COLLINS, Maine
ROBERT G. TORRICELLI, New Jersey     GEORGE V. VOINOVICH, Ohio
MAX CLELAND, Georgia                 THAD COCHRAN, Mississippi
THOMAS R. CARPER, Delaware           ROBERT F. BENNETT, Utah
JEAN CARNAHAN, Missouri              JIM BUNNING, Kentucky
MARK DAYTON, Minnesota               PETER G. FITZGERALD, Illinois
           Joyce A. Rechtschaffen, Staff Director and Counsel
                  Laurie R. Rubenstein, Chief Counsel
                       Beth M. Grossman, Counsel
                     Cynthia Gooen Lesser, Counsel
                  John N. Wanat, Congressional Fellow
              Richard A. Hertling, Minority Staff Director
                Gary M. Brown, Minority Special Counsel
                     Darla D. Cassell, Chief Clerk







                            C O N T E N T S

                                 ------                                

                                                                   Page

INTRODUCTION.....................................................     1

PART ONE: THE SEC AND OTHER WATCHDOGS WITH LEGAL OBLIGATIONS.....     6

  I. BACKGROUND..................................................     7

    A. The SEC...................................................     7

      1. Mission and Organization................................     7

      2. Review of Public Filings................................     8

      3. Enforcement.............................................    11

    B. Private-Sector Gatekeepers................................    13

      1. Boards of Directors.....................................    13

      2. Auditors................................................    16

  II. EXPERIENCE WITH ENRON......................................    20

    A. Private-Sector Gatekeepers................................    21

      1. Enron's Auditor.........................................    21

      2. Enron's Board of Directors..............................    22

    B. The SEC...................................................    23

      1. Review of Enron's Public Filings........................    24

      2. Enron's Shift to Mark-to-Market Accounting..............    31

      3. Exemptions from the Public Utility Holding Company Act..    36

      4. Exemption from the Investment Company Act of 1940.......    43

  III. RECOMMENDATIONS...........................................    46

PART TWO: MORE WATCHDOGS--WALL STREET SECURITIES ANALYSTS AND 
  CREDIT RATING AGENCIES.........................................    52

  I. ENRON AND THE WALL STREET ANALYSTS..........................    53

    A. Investment Research Analysts..............................    54

    B. The Wall Street Analysts' Assessments of Enron............    55

    C. GFactors Affecting the Objectivity of Sell-Side Analyst 
  Recommendations................................................    62

    D. Solutions.................................................    69

  II. ENRON AND THE CREDIT RATING AGENCIES.......................    76

    A. History and Uses of Credit Ratings........................    77

    B. Efforts to Regulate Credit Rating Agencies................    80

    C. Chronology of Enron's Ratings.............................    84

    D. Problems With the Agencies' Analyses and Actions..........    89

    E. Conclusions and Recommendations...........................    98

APPENDIX: Note 16 to Financial Statements, Enron Corp. Form 10-K 
  for the Year Ended December 31, 2000...........................   100

 
                     FINANCIAL OVERSIGHT OF ENRON:


 
                  THE SEC AND PRIVATE-SECTOR WATCHDOGS

                            October 7, 2002

INTRODUCTION

    On December 2, 2001, Enron Corp. (together with its 
subsidiaries, collectively referred to in this report as 
``Enron'') filed for bankruptcy protection, making it--at the 
time--the largest company to declare bankruptcy in the nation's 
history.\1\ Enron's collapse deprived thousands of employees of 
their jobs, severely diminished their retirement savings, and 
led to the loss of billions of shareholder dollars. Perhaps 
most significantly, the company's failure and the months of 
revelations that followed triggered a crisis in investor 
confidence in U.S. capital markets. The repercussions of 
Enron's collapse continue to be felt today.
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    \1\ Since that time, WorldCom has superseded Enron as the largest 
corporate bankruptcy. See Simon Romero and Riva D. Atlas, ``WorldCom's 
Collapse: The Overview; WorldCom Files for Bankruptcy; Largest U.S. 
Case,'' The New York Times, July 22, 2002.
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    The misdeeds that led to Enron's demise were, in the first 
instance and ultimately, the responsibility of Enron and its 
management. Enron, however, functioned within a larger 
environment consisting of private and public entities alike 
that were supposed to monitor or regulate the company's 
activities and public disclosures. In January 2002, Senate 
Committee on Governmental Affairs Chairman Joseph I. Lieberman 
and Ranking Member Fred Thompson initiated a wide-ranging 
review of the actions of the various governmental and private 
watchdogs that were supposed to monitor Enron's activities and 
help protect the public against these sorts of calamities. The 
Chairman and Ranking Member charged the Committee with 
examining whether these watchdogs did their jobs correctly and 
whether different actions by those watchdogs could have 
prevented--or at least detected earlier--the problems that have 
come to be associated with Enron.
    The Committee took a broad look at a range of entities that 
play some role in monitoring the financial activities of 
publicly held companies, from the company's Board of Directors 
to the accounting firm that audited Enron's books to stock 
analysts and credit rating agencies that purported to give the 
public accurate and objective information about Enron's 
financial health.\2\ The Committee placed a particular focus on 
the most important watchdog of all, the Securities and Exchange 
Commission (the ``SEC'' or the ``Commission''). Each of these 
entities plays a particular role in monitoring our capital 
markets. Together, they are supposed to ensure that the markets 
operate fairly, with complete, accurate and comprehensible 
information available to all investors.
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    \2\ The Committee's Permanent Subcommittee on Investigations 
(``PSI'') also has been investigating aspects of Enron's collapse, and 
has held a series of hearings on the role of Enron's Board of Directors 
and the role of financial institutions in Enron's collapse. See The 
Role of the Board of Directors in Enron's Collapse, Hearing Before the 
Permanent Subcommittee on Investigations, Senate Governmental Affairs 
Committee, 107th Cong., S. Hrg. 107-511 (May 7, 2002); The Role of 
Financial Institutions in Enron's Collapse, Hearing Before the 
Permanent Subcommittee on Investigations, Senate Governmental Affairs 
Committee, 107th Cong., S. Hrg. 107-618 (July 23 and 30, 2002) (Printed 
Hearing Record Pending). PSI also has issued a report on the role of 
the Board of Directors in its collapse. See Report of the Senate 
Permanent Subcommittee on Investigations on ``The Role of the Board of 
Directors in Enron's Collapse,'' S. Prt. 107-70 (July 8, 2002).
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    In looking at the array of purported checks on financial 
misbehavior, what Committee staff discovered was deeply 
disturbing--not so much because they uncovered malfeasance or 
intentional wrongdoing on anyone's part (although that seems to 
have been present in some cases as well), but because what 
emerged was a story of systemic and arguably catastrophic 
failure, a failure of all the watchdogs to properly discharge 
their appointed roles. Despite the magnitude of Enron's 
implosion and the apparent pervasiveness of its fraudulent 
conduct, virtually no one in the multilayered system of 
controls devised to protect the public detected Enron's 
problems, or, if they did, they did nothing to correct them or 
alert investors. Not one of the watchdogs was there to prevent 
or warn of the impending disaster: Not Enron's Board of 
Directors, which asked few, if any, probing questions of 
Enron's management and which authorized various related-party 
transactions that facilitated many of Enron's fraudulent 
practices; not Enron's auditor, Arthur Andersen, which 
certified the apparently fraudulent financial statements; not 
the investment banking firms, which structured and sold 
securities and other financial products that appear to have 
allowed Enron to obfuscate its financial position; not the 
attorneys, whose opinions and work were critical to certain 
transactions that may have been central to Enron's collapse; 
not the Wall Street securities analysts, many of whom continued 
to recommend Enron as a ``buy'' up until the bitter end; not 
the credit rating agencies, who rated Enron's debt as 
investment grade up until 4 days before the company filed for 
bankruptcy; and not the SEC, which did not begin to seriously 
investigate Enron's practices until after the company's demise 
became all but inevitable.
    These failings call into question the basic assumptions on 
which our financial regulatory framework is built. The SEC, 
with its relatively small staff, does not, and is not set up 
to, directly perform many of the tasks necessary to root out 
corporate fraud. Instead, we have a system in which the public 
relies on a partnership of both the SEC and private gatekeepers 
in order to keep tabs on the enormous U.S. markets. But this 
foundational assumption--that the SEC can depend on private 
entities as the first and primary restraint against massive 
corporate wrongdoing--proved terribly wrong in the case of 
Enron. And the failure of this premise, along with the 
insufficiency of the SEC's adjustment for it, raises questions 
about whether the SEC is effectively functioning as the lead 
market watchdog that it is meant to be.
    That the Enron collapse, moreover, has been followed by a 
seeming flood of allegations about large-scale financial fraud 
at other prominent companies, including WorldCom, Global 
Crossing, Tyco, Adelphia, and Rite Aid, precludes any easy 
characterization of Enron as simply a ``bad apple'' or the 
lapses of the gatekeepers and regulators as isolated breakdowns 
in an otherwise sound system. Indeed, even if the malfeasants 
are viewed as but rogue corporations, it is precisely the role 
of the gatekeepers to spot and protect against such rogues. 
That none of them did so suggests that there have been some 
basic flaws in our system of market regulation, ones that well 
warrant the re-examination that the system is currently 
undergoing.
    Furthermore, while Enron is now the poster company for all 
of the failures of due diligence and objectivity on the part of 
the watchdogs, portents of such problems should have been seen 
for some time. The SEC, for example, had reason for years to 
question the validity of financial statements; restatements of 
filings with the SEC skyrocketed from just 3 in 1981 to 270 in 
2001.\3\ Former SEC Chairman Arthur Levitt, moreover, in a now 
famous speech called the ``Numbers Game,'' was talking about 
gaps in the system of gatekeepers more than 3 years before 
Enron imploded. In that speech, then-Chairman Levitt expressed 
deep concern about ``earnings management''--the manipulation of 
accounting in order to meet Wall Street's earnings expectation. 
``Too many corporate managers, auditors and analysts are 
participating in a game of nods and winks,'' he warned. ``I 
fear that we are witnessing an erosion in the quality of 
earnings, and therefore, the quality of financial reporting. 
Managing may be giving way to manipulation; Integrity may be 
losing out to illusion.'' In the conclusion to the speech 
Levitt asked this ominous question: ``Today, American markets 
enjoy the confidence of the world. How many half-truths, and 
how much accounting sleight-of-hand, will it take to tarnish 
that faith?'' \4\
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    \3\ See Ianthe Jeanne Dugan, ``Depreciated: Did You Hear the One 
About the Accountant? It's Not Very Funny,'' The Wall Street Journal, 
March 14, 2002; Financial Executives International, ``Quantitative 
Measures of the Quality of Financial Reporting,'' June 7, 2001, 
available at http://www.fei.org/download/QualFinRep-6-7-2k1.ppt; Huron 
Consulting Group, ``A Study of Restatement Matters,'' June 11, 2002, 
available at http://www.huronconsultinggroup.com/files/tbl--s6News/
PDF134/50/restatement--study.pdf.
    \4\ Arthur Levitt, ``The Numbers Game,'' Remarks at the NYU Center 
for Law and Business, September 28, 1998, available at http://
www.sec.gov/news/speech/speecharchive/1998/spch220.txt. See also The 
Fall of Enron: How Could It Have Happened, Hearing Before the Senate 
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-376 (January 
24, 2002) at 26-27 (Statement of the Honorable Arthur Levitt, Jr., 
former SEC Chairman) (``Enron's collapse did not occur in a vacuum. Its 
backdrop is an obsessive zeal by too many American companies to project 
greater earnings from year to year. When I was at the SEC, I referred 
to this as a `culture of gamesmanship'--a gamesmanship that says it is 
okay to bend the rules, to tweak the numbers, and let obvious and 
important discrepancies slide; a gamesmanship where companies bend to 
the desires and pressures of Wall Street analysts rather than to the 
reality of the numbers; where analysts more often overlook dubious 
accounting practices and too often are selling potentially lucrative 
investment banking deals; where auditors are more occupied with selling 
other services and making clients happy than detecting potential 
problems; and where directors are more concerned about not offending 
management than with protecting shareholders.'').
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    Sadly, the Enron debacle and those that have followed may 
have provided the answer to Levitt's question. The size and 
number of these corporate frauds, coupled with the failure of 
all of those charged with protecting against such fraud to do 
so, appear to have left many investors with doubts about 
whether they can rely on any of the financial information in 
the marketplace.\5\ And because the proper functioning of U.S. 
financial markets rests on the cornerstone principle that all 
individuals have access to accurate basic information about the 
companies in which they invest, this crisis in investor 
confidence is widely seen as contributing significantly to the 
current downturn in the stock market and as being a drag on any 
economic recovery.\6\
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    \5\ In one recent survey, for example, 57 percent of respondents 
indicated that they do not trust corporate executives or brokerage 
firms to give them honest information, and one third indicated that 
they believed that what happened at Enron is typical of what goes on at 
most or many companies. John Harwood, ``Americans Distrust Institutions 
in Poll,'' The Wall Street Journal, June 13, 2002 (reporting the 
results of a Wall Street Journal/NBC News Poll). In another poll, 72 
percent of respondents said they thought stockbrokers acting in their 
own interest rather than that of their clients was a somewhat or very 
widespread practice; 73 percent said they thought financial audits 
hiding damaging information about a company was somewhat or very 
widespread; and 77 percent said they thought improper, self-serving 
actions by top executives were somewhat or very widespread. Gary 
Strauss, ``Bush's Call for Reform Draws Mixed Reviews,'' USA Today, 
July 10, 2002 (reporting the results of a USA Today/CNN/Gallup Poll; 
complete survey results available at http://www.usatoday.com/news/2002-
07-09-poll.htm).
    \6\ See, e.g., Steven Pearlstein, ``Corporate Scandals Taking Toll 
on Markets,'' The Washington Post, June 26, 2002; Joseph Nocera et al., 
``System Failure,'' Fortune, June 24, 2002. See also David W. Moore, 
``Corporate Abuses, 9/11 Attacks Seen as Most Important Causes of 
Economic Downturn,'' Gallup News Service, August 5, 2002, available at 
http://www.gallup.com/poll/releases/pr020805.asp?Version=p (poll found 
that 77 percent of respondents said that greed and corruption among 
corporate executives was ``the major reason'' or ``one of the most 
important reasons' for the current state of the economy). The lack of 
confidence resulting from these scandals has also reportedly led to a 
decline in foreign investment in U.S. markets. See Louis Uchitelle, 
``Foreign Investors Turning Cautious on Spending in U.S.,'' The New 
York Times, August 4, 2002; Philip Coggan, ``Losing Faith,'' Financial 
Times (London), June 27, 2002; Pearlstein, above.
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    Fortunately, with the recent enactment of the Sarbanes-
Oxley Act of 2002 \7\--which, among other things, strengthens 
the oversight of accountants, takes steps to reduce the 
conflicts of interests faced by auditors and stock analysts, 
and enhances the SEC's enforcement tools--things seem to be 
moving in the right direction. There are additional actions, 
however, that can and should be taken by the various actors in 
our system of market oversight themselves to improve the 
information and protection they provide to the public. No one 
watchdog--governmental or nongovernmental--alone can restore 
the investor confidence that is vital to the continued robust 
operation of our markets; all of those entrusted as gatekeepers 
will need to take action to ensure the public that fraud will 
be uncovered and that financial chicanery will not be 
tolerated.
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    \7\ Pub. L. No. 107-204.
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    This report documents the results of the Committee's review 
of the financial oversight of Enron. It is divided into two 
parts. Part One discusses Committee staff's findings with 
respect to the SEC's oversight of Enron. As discussed below, 
the SEC staff failed to review any of Enron's post-1997 
financial filings even though the company was undergoing 
significant growth and substantially changing the nature of its 
business and the SEC itself was aware that other gatekeepers, 
such as boards of directors and auditors, were proving 
increasingly unreliable. Had SEC staff reviewed these filings, 
they would have had an opportunity to uncover some of the 
problems with the company's financial practices that appear to 
have been signaled in those documents. In addition, the SEC 
staff made administrative determinations that allowed Enron to 
engage in certain accounting practices and exempted the company 
from certain regulatory requirements. Whether or not these 
decisions were reasonable at the time, what is particularly 
troubling is that the SEC lacked any procedures by which to 
monitor the effects of these determinations to see whether they 
were being applied appropriately by the company and/or whether 
the circumstances that underlay them had changed. The leeway 
afforded Enron by these determinations in certain cases appears 
in fact to have been abused by the company in ways that 
ultimately played a role in Enron's collapse. In short, the 
SEC's interactions with Enron reveal the downside to the 
Commission's largely reactive approach to market regulation and 
should provide an impetus for the Commission to reorient some 
of its activities toward more proactive anti-fraud measures. 
Unfortunately, although the Commission has stepped up its 
enforcement activities post-Enron, it has been less than 
proactive in attempting to address fraud at an earlier stage, 
before it becomes a corporate calamity.
    The report's second part describes the roles of two 
additional groups of private sector watchdogs--Wall Street 
securities analysts and credit rating agencies--and how each 
group failed the market by not ringing the alarm bells about 
Enron until it was too late.\8\ Along with other investigations 
into securities analysts, Enron exposed a dirty little secret--
apparently known widely among market insiders, but 
unfortunately kept from average investors--that Wall Street 
analyst recommendations were of questionable reliability. Of 15 
analysts at major Wall Street firms who covered Enron, all 15 
were recommending that investors buy Enron stock when the news 
about the company's financial misdeeds was first revealed. 
Three weeks later, after the company had announced an SEC 
investigation, its Chief Financial Officer had resigned and it 
had announced that it was restating its financial results for 
the past 4\1/2\ years due to accounting irregularities, 10 of 
those 15 analysts continued to encourage the public to buy 
Enron stock. Why, after so much bad news, would these experts 
hold to their rosy assessment of this company? It turns out 
that Enron, which tapped the capital markets for funds on a 
regular basis, had a great deal of investment banking business, 
and the Wall Street firms that wanted that business also had 
research departments with analysts assessing Enron stock. This 
kind of conflict of interest is rife in the industry, and only 
now, with the historic passage of the Sarbanes-Oxley Act, is 
there a chance that investors may obtain the unvarnished stock 
advice that they had thought they were receiving all along.
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    \8\ This report focuses on groups about which the Committee has 
already conducted hearings. Committee staff, however, is mindful that 
there are other groups that can, and in fact, do function as 
gatekeepers, particularly in the public securities markets. One of 
these groups, securities underwriters, has been the subject of an 
extensive investigation and hearings by PSI. It is also Committee 
staff's understanding that some firms are being investigated by other 
governmental bodies. A second group is attorneys. The role of lawyers 
and law firms as gatekeepers should not be overlooked. See Soderquist, 
Understanding the Securities Laws, Sec. 1:7 (Practising Law Institute 
2002) (discussing the special position of securities lawyers); ``SEC 
Enforcement Actions Against Securities Lawyers: New Remedies vs. Old 
Policies,'' 22 Del. J. Corp. L. 537 (1997) (same). The Sarbanes-Oxley 
Act requires the SEC, within 180 days from the law's enactment, to 
promulgate rules regarding lawyers' conduct. Pub. L. No. 107-204 
Sec. 307.
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    The credit rating agencies, though unhampered by the kind 
of conflicts faced by securities analysts at major Wall Street 
firms, similarly failed to warn the public of Enron's 
precarious situation until a mere 4 days before Enron declared 
bankruptcy. Until that time, the rating agencies gave Enron an 
``investment grade'' rating, which indicated that Enron was 
creditworthy and its bonds were a safe investment. How could 
the creditworthiness experts consider a company less than a 
week away from bankruptcy to be a solid investment? This is 
particularly troubling given that numerous Federal and State 
statutes and regulations rely on credit ratings to set the 
standard for the kind of investments that funds of public 
importance, such as money market funds, State pension funds or 
insurance companies, may make. Based on interviews with the 
credit rating agencies about their coverage of Enron, Committee 
staff concluded that, at least with respect to Enron, the 
rating agencies failed to detect Enron's problems--or take 
sufficiently seriously the problems they were aware of--until 
it was too late because they did not exercise the proper 
diligence. They did not ask sufficiently probing questions and, 
despite their mission to make long-term credit assessments, did 
not sufficiently consider factors affecting the long-term 
health of the company, particularly accounting irregularities 
and overly complex financing structures. Committee staff 
recommends increased oversight for these rating agencies in 
order to ensure that the public's trust in these firms is well-
placed.

PART ONE: THE SEC AND OTHER WATCHDOGS WITH LEGAL OBLIGATIONS

    Of those entities that participate in our public-private 
system of market oversight, a number have legally required 
responsibilities to serve an interest broader than their own. 
Corporate boards of directors, for example, are responsible to 
the corporation's shareholders, while auditors owe duties to 
the company's shareholders and creditors and, indeed, to the 
investing public. The SEC occupies a unique position in this 
system as the public institution responsible for overseeing the 
financial markets, and, accordingly, has the most comprehensive 
mandate to act in the public interest and protect the interests 
of investors.
    This Part looks at this set of mandated watchdogs, focusing 
in particular on the actions of the SEC.\9\ It starts with an 
overview of the role each entity plays in our system of market 
oversight. Looking first at the SEC, this Part reviews the 
Commission's operations and describes its role in preventing 
and combating financial fraud. It then turns to the roles and 
responsibilities of the private-sector gatekeepers and 
describes the integral part boards of directors and auditors 
are supposed to play in protecting against fraud.
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    \9\ This Part of the report is based on a Committee investigation 
that began with letters from the Committee to the SEC on February 15, 
2002 and March 27, 2002, seeking information concerning the 
Commission's dealings with Enron from 1992 to the present, as well as 
certain additional information about the operations of the agency. The 
SEC provided the Committee with written responses to the Committee's 
letter request, and over the course of the months that followed, 
Committee staff held numerous meetings and telephone calls with staff 
from various offices in the SEC and received supplementary documents as 
requested. (The SEC staff has been consistently responsive and helpful 
to Committee staff throughout this process). The telephone calls, of 
various lengths and range, are cited in this report as ``Committee 
staff interview with SEC staff''; face-to-face meetings are cited as 
``Committee staff meeting with SEC staff.'' In addition, Committee 
staff has consulted with numerous outside individuals with relevant 
knowledge, including former SEC employees, experts in securities law, 
accounting, and public management, consumer and investor advocates, 
independent stock analysts and others, and has reviewed documents 
produced by Enron in response to the Committee's subpoenas to the 
company on February 15, 2002 and March 22, 2002.
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    This Part next examines the actions of each of these 
players in the case of Enron. It begins with a brief discussion 
of what Enron's Board of Directors and its auditor did--or, 
more importantly, failed to do--to head off the company's 
fraudulent practices. Against this backdrop of failings by the 
private-sector gatekeepers, the report turns to the SEC, 
describing the Commission's review of Enron's public filings 
over the past decade, including its failure to review Enron's 
filings in recent years. It then examines some of the SEC's 
other regulatory actions with respect to Enron and their 
implications, including the SEC's determination in 1992 to 
allow an Enron subsidiary to use so-called ``mark-to-market'' 
accounting to record certain of its transactions, and 
exemptions the SEC granted Enron and its affiliates from the 
requirements of the Public Utility Holding Company Act of 1935 
(``PUHCA'') and the Investment Company Act of 1940 (the 
``Investment Company Act'').
    Part One of the report concludes by offering 
recommendations about how, within our overall system of 
oversight, the SEC can improve its ability to protect investors 
against future cases of financial fraud and thereby help 
restore confidence to the financial marketplace.

I. BACKGROUND

  A. The SEC

    1. Mission and Organization

    In the wake of the 1929 stock market crash, Congress 
created the SEC in an effort to restore stability and 
confidence to the U.S. capital markets. Then and now, the SEC's 
mission has been to protect investors and ensure the integrity 
of the securities market. The core principle of the fundamental 
Federal securities statutes, the Securities Act of 1933 \10\ 
(the ``Securities Act'') and the Securities Exchange Act of 
1934 \11\ (the ``Exchange Act'') is one of disclosure: That all 
investors should have access to basic information about a stock 
or other security before investing in it.\12\
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    \10\ 15 U.S.C. Sec. 77a et seq.
    \11\ 15 U.S.C. Sec. 78 et seq. The Exchange Act established the 
SEC.
    \12\ See Louis Loss and Joel Seligman, Fundamentals of Securities 
Regulation (4th ed. 2001) at 29-31; Joel Seligman, The Transformation 
of Wall Street: A History of the Securities and Exchange Commission and 
Modern Corporate Finance (Rev. ed. 1995) at 39-40, 561-62.
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    The SEC is divided into four ``divisions'' and 18 
``offices.'' The four divisions, reflecting the scope of the 
Commission's responsibilities, are: (1) the Division of 
Corporation Finance, which oversees corporate disclosures 
through review of companies' public filings; (2) the Division 
of Market Regulation, which regulates major market 
participants, including broker-dealers and self-regulatory 
organizations, such as NASD (formerly known as the National 
Association of Securities Dealers) and the eight stock 
exchanges; (3) the Division of Investment Management, which 
oversees investment companies, including mutual funds, and 
investment advisers, and which administers PUHCA; and (4) the 
Division of Enforcement, which investigates possible violations 
of U.S. securities laws and brings legal action where 
appropriate.\13\ Altogether, the Commission employs 
approximately 3,000 people.
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    \13\ The SEC's 18 ``offices'' include the Office of the General 
Counsel, the Office of the Chief Accountant, the Office of Compliance 
Inspections and Examinations (which administers the SEC's examination 
and inspection program for broker-dealers, self-regulatory agencies, 
investment companies and others), the Office of Investor Education and 
Assistance, the Administrative Law Judges, and assorted other 
administrative and policy offices. Also, in addition to its 
headquarters in Washington, D.C., the SEC has 11 regional offices.
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    With respect to fighting financial fraud, the SEC plays 
perhaps its most essential roles within the broader public-
private scheme in two areas. First, the SEC establishes 
requirements that companies disclose certain information to 
investors and works to ensure compliance with those disclosure 
requirements by reviewing the public filings companies submit. 
In doing so, the SEC both directly discourages shady accounting 
practices and, by ensuring that material, comprehensible 
information is publicly available, empowers the entire 
marketplace--stock analysts and credit raters, individual 
shareholders and institutional investors--to evaluate the 
information provided. This is particularly true after the SEC 
implemented electronic filing and on-line availability of 
company filings through its EDGAR (Electronic Data Gathering 
And Retrieval) System. Second, when preventive measures fail, 
the SEC has the authority to enforce the law and bring legal 
action against those who have committed fraud.

    2. Review of Public Filings

    The SEC's Division of Corporation Finance employs 
approximately 330 people, of whom approximately 144 are lawyers 
and 107 are accountants; \14\ together, they are charged with 
reviewing the public filings of more than 17,000 public 
companies in the United States.\15\ The Division's staff is 
organized into 11 groups, with each group responsible for 
reviewing the filings of a different industry category.\16\
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    \14\ Correspondence from SEC staff to Committee staff (August 9, 
2002).
    \15\ See Letter from Harvey L. Pitt, Chairman, Securities and 
Exchange Commission, to Joseph I. Lieberman, Chairman, and Fred 
Thompson, Ranking Member, Senate Committee on Governmental Affairs, 
dated March 4, 2002 (``SEC Response'') at 4.
    \16\ One of these groups is not industry-specific but instead 
devoted to the review of small businesses. Until recently, Enron's 
filings were reviewed by the natural resources and food companies 
group. In February 2001, representatives from Enron's investor 
relations department, arguing that Enron was no longer primarily a 
natural gas pipelines company, asked that the Corporation Finance 
Division reassign Enron to the group that reviews filings from 
companies that deal with commodities pools. Corporation Finance 
declined to do this, but did reassign Enron to the financial services 
group (which reviews filings made by securities and commodities brokers 
and dealers), based on the fact that Enron's revenues were at that time 
primarily derived from its wholesale trading business. No reviews of 
Enron's filings have been conducted since the reassignment was made. 
SEC Response at 20-21; Committee staff interview with SEC staff, 
Division of Corporation Finance (April 24, 2002).
---------------------------------------------------------------------------
    The public filings required to be submitted to the 
Commission fall largely into two general categories: 
Transactional filings and periodic reports. Transactional 
filings are those associated with a particular transaction--
e.g., the sale of securities (including initial public 
offerings) or a merger. They contain information about the 
transactions as well as about the company's financial 
condition. Transactional filings are prospective (that is, they 
address events that have not yet happened) and often call for 
action by Commission staff. A sale of securities, for example, 
requires the Division to declare the registration statement 
submitted by the company to be effective before the sale can go 
forward. Periodic filings include annual reports (Forms 10-K) 
and quarterly reports (Forms 10-Q) that set forth a company's 
financial condition.\17\ They are historical in nature, 
describing the last period's events, and do not require further 
Commission action. Transactional filings typically contain or 
incorporate the historical information available in periodic 
filings.
---------------------------------------------------------------------------
    \17\ In addition to annual reports and quarterly reports, companies 
are required to file so-called ``current reports'' on Form 8-K to 
report certain specified events which are material to shareholders so 
that this information is made available sooner than the next quarterly 
or annual filing.
---------------------------------------------------------------------------
    The Corporation Finance Division does not have the 
resources to review every filing submitted; accordingly, it 
employs a screening process to select the filings to be 
reviewed fully. This ``screening'' process is distinct from an 
actual ``review'' of the filings. Although it involves an 
initial examination of the filings, the screening process is 
intended only to determine whether a filing merits a further 
``review.'' Unlike a ``review,'' it does not involve a 
substantive evaluation of the disclosures made in the filing. 
The screening process employs a variety of criteria, both 
financial and otherwise (including the length of time from last 
review), to determine which filings warrant further scrutiny. 
These criteria can vary by industry group. The criteria are 
kept confidential by the SEC, but are intended to target those 
filings that ``most warrant[ ] staff review''--presumably those 
most likely to pose the greatest risk to investors.\18\ The 
screening process relies heavily on initial, direct staff 
examination of the filings, although it incorporates computer-
based financial data as well. As a result of the screening 
process, a filing may be selected for one of four levels of 
review: A full review (that is to say, a review of the entire 
filing), a financial statement review (a review only of the 
company's financial statements and Management Discussion and 
Analysis (``MD&A'')), \19\ a limited review or ``monitor'' (a 
review of a specific item or items in the filing), or no review 
at all.
---------------------------------------------------------------------------
    \18\ SEC Response at 2.
    \19\ These financial statements--including balance sheet, income 
statement, and statement of cash flows--are accompanied by explanatory 
footnotes, which are also reviewed. MD&A (formally, ``Management 
Discussion and Analysis of Financial Condition and Results of 
Operations'') is a required supplementary analysis of the financial 
statements in which the company is required to provide other 
information necessary to understand its financial condition. See 
generally SEC Regulation S-X, 17 C.F.R. Part 210 (detailing the 
requirements for financial statements); SEC Regulation S-K, 17 C.F.R. 
Part 229 (detailing other requirements for information contained in SEC 
filings, including Form 10-K; MD&A is discussed at 17 C.F.R. 
Sec. 229.303).
---------------------------------------------------------------------------
    All transactional filings go through the screening process 
because the Division must take action on them. The Corporation 
Finance Division, furthermore, has given priority to initial 
public offerings (IPOs) because of the risks to investors 
inherent in a company's first sale of stock.\20\ Accordingly, 
all IPO filings are reviewed by Corporation Finance Division 
staff. Although this may reflect a reasonable risk assessment, 
it nonetheless leaves fewer resources to devote to other types 
of filings. This became a particular problem in the mid-to-late 
1990's, when the number of initial public offerings increased 
substantially.\21\ According to SEC staff, the focus on IPO 
reviews has meant that even those non-IPO transactional filings 
that meet the screening criteria are not necessarily reviewed.
---------------------------------------------------------------------------
    \20\ According to SEC staff, IPOs, which constitute a company's 
first filing with the Commission, often raise a greater number of 
disclosure and securities law concerns than other filings; they also 
provide an opportunity for staff to correct improper disclosures early, 
before they appear in later periodic reports. Correspondence from SEC 
staff to Committee staff (August 9, 2002). One former SEC official, 
agreeing that the greatest risk of misrepresentations lies with 
companies attempting to raise capital, opined that many company 
officials had adopted more brazen attitudes in the late 1990's with 
respect to IPO filings, deliberately testing the limits of what the SEC 
would allow them to do. Interview with Lynn Turner, Director, Center 
for Quality Financial Reporting, Colorado State University College of 
Business and former SEC Chief Accountant (June 24, 2002).
    \21\ The number of IPO filings examined by the SEC peaked at 1,350 
in 2000; as recently as 1995, the number was 805. By 2001, the number 
decreased to 745. Correspondence from SEC staff to Committee staff 
(August 9, 2002); see also U.S. General Accounting Office, ``SEC 
Operations: Increased Workload Creates Challenges,'' GAO-02-302, March 
2002, at 17.
---------------------------------------------------------------------------
    As for periodic reports, screening of these is uncertain 
and is subject to the time and resources available after 
screening and review of transactional filings. In other words, 
many periodic reports are not screened at all, even to 
determine whether they should be examined further.\22\ The 
SEC's stated goal has been to review every company's annual 
report at least once every 3 years, but in recent years, it has 
fallen far short of this mark. In fiscal year 2001, for 
example, the Division completed a full or financial statement 
review of only 2,280 of 14,600 Forms 10-K filed, or 
approximately 16 percent. Of more than 17,300 public companies, 
approximately 9,200, or 53 percent, have not had their Forms 
10-K reviewed in the past three years.\23\
---------------------------------------------------------------------------
    \22\ The SEC does not track the number of periodic reports that go 
through the screening process. Committee staff interview with SEC 
staff, Division of Corporation Finance (June 25, 2002); Correspondence 
from SEC staff to Committee staff (August 9, 2002).
    \23\ SEC Response at 4. Following the Enron collapse, the SEC 
announced that it will ``monitor'' the Forms 10-K of each of the 
country's 500 largest companies (by revenue) each year for selected 
disclosure issues and, where problems are identified, will select these 
filings for expedited review. ``Program to Monitor Annual Reports of 
Fortune 500 Companies,'' SEC News Digest, Issue 2001-245, December 21, 
2001. The SEC staff hopes to conduct reviews of approximately half 
these filings. As of August 2002, they had screened over 400 of these 
filings and issued comments on approximately 100. Committee staff 
meeting with SEC staff (June 10, 2002); Committee staff interview with 
SEC staff (August 22, 2002). The Sarbanes-Oxley Act now requires the 
SEC to review a company's filings at least once every 3 years. Pub. L. 
107-204 Sec. 408.
---------------------------------------------------------------------------
    For those annual reports actually reviewed by the 
Corporation Finance Division, the review generally is limited 
to the four corners of the document. One SEC staff member 
referred to this process as a ``desk audit--'' that is, 
information one can get while sitting at one's desk. The review 
may thus incorporate information gleaned from news stories and 
analyst and industry reports, but the focus is on the filings 
themselves.\24\ The primary goal is to ensure that required 
disclosures are set forth in the report and that the 
disclosures themselves are facially accurate and 
comprehensible.\25\ If the staff has questions or concerns 
about disclosures that do not comply with the requirements, are 
incomplete or are inconsistent with other information in the 
filings or that is otherwise available, the company will 
receive a comment letter listing the staff's concerns. In some 
cases after the initial reply by the company, another round or 
rounds of comments may follow. These formal exchanges may be 
supplemented by informal conversations between the SEC staff 
and the company, its counsel, or its auditor. When a resolution 
is reached about the changes to be made, the company may, at 
the staff's discretion, be required either to amend an existing 
filing or to incorporate the changes in the future filings 
submitted by the company.\26\
---------------------------------------------------------------------------
    \24\ Committee staff interview with SEC staff, Division of 
Corporation Finance (April 24, 2002).
    \25\ Id.
    \26\ Id.
---------------------------------------------------------------------------
    The review of a company's periodic filings, however, is not 
intended to serve as a second audit of the financial statements 
or otherwise validate the numbers set forth.\27\ Thus, SEC 
reviewers may look at whether a company has clearly explained 
its accounting policies (e.g., how it calculates certain 
revenue or how it determines in what period it records that 
revenue), but they generally will not look at whether those 
policies have been applied appropriately in a particularly 
instance. Should a company simply lie about the amount of 
revenue it got from a particular source or record that revenue 
in an earlier period than would be permitted under its stated 
policies, a routine SEC review of the company's filings may 
well not detect this--and is not designed to.\28\ To look 
behind the numbers of all the filings SEC staff reviews is too 
resource-intensive; as further explained below, the SEC relies 
on auditors to perform this function.\29\ Nonetheless, when the 
Corporation Finance Division staff's review of a company's 
filings does reveal a troubling item or some indicia of fraud 
that the company is unable to explain adequately, Corporation 
Finance Division staff may refer it to the Division of 
Enforcement for further investigation.\30\
---------------------------------------------------------------------------
    \27\ Committee staff interview with SEC staff, Division of 
Corporation Finance (April 24, 2002); Committee staff meeting with SEC 
staff (June 10, 2002).
    \28\ SEC staff explained that, among other things, no single 
transaction is likely to be material in and of itself to a company's 
overall financial condition.
    \29\ In the case of a large corporation, even auditors typically do 
not look behind each transaction that contributes to the numbers on the 
company's financial statements; rather, they review a sample of notable 
or representative ones. See American Institute of Certified Public 
Accountants Professional Standards, AU Section 350 (Audit Sampling). 
Full-scale forensic accounting is generally done only when there is 
already evidence that fraud has occurred. See Michael R. Young, 
Accounting Irregularities and Financial Fraud (2d ed. 2002) at 102-105 
(describing the difference between ordinary audits and forensic 
investigations).
    \30\ Committee staff interview with SEC staff, Division of 
Corporation Finance (April 24, 2002).
---------------------------------------------------------------------------

    3. Enforcement

    Another important way in which the SEC combats financial 
fraud is through its Division of Enforcement. The Enforcement 
Division's role--investigating and prosecuting fraud under the 
securities laws--is essential not only to punish wrongdoers but 
also to deter those who might be considering committing similar 
misdeeds. Although the Commission cannot on its own bring 
criminal prosecutions, it may nonetheless obtain significant 
civil sanctions against those found to have violated the 
securities laws--and may (and frequently does) refer to the 
Department of Justice matters that it believes warrant criminal 
charges.\31\
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    \31\ See Securities Act Sec. 20(b), 15 U.S.C. Sec. 77t(b); Exchange 
Act Sec. 21(d)(1), 15 U.S.C. Sec. 78u(d)(1). For a general discussion 
of the relationship between civil and criminal enforcement of the 
securities laws, see Thomas C. Newkirk and Ira L. Brandriss, SEC 
Division of Enforcement, ``The Advantages of a Dual System: Parallel 
Streams of Civil and Criminal Enforcement of the U.S. Securities 
Laws,'' Remarks at the 16th International Symposium on Economic Crime, 
Jesus College, Cambridge, England, September 19, 1998, available at 
http://www.sec.gov/news/speech/speecharchive/1998/spch222.htm.
      Many of the securities laws that are civilly enforced by the SEC 
also provide that willful violations may be prosecuted criminally. See, 
e.g., Securities Act Sec. 24, 77x; Exchange Act Sec. 32, 15 U.S.C. 
Sec. 78ff. In addition, the recently enacted Sarbanes-Oxley Act of 2002 
establishes the new Federal crime of ``securities fraud'' for the 
knowing execution of a scheme to defraud any person in connection with 
any security, or to obtain money or property by means of false or 
fraudulent pretenses in connection with the purchase or sale of any 
security. Pub. L. No. 107-204 Sec. 807 (to be codified at 18 U.S.C. 
Sec. 1348). The Sarbanes-Oxley Act also increases the criminal 
penalties for violations of the Exchange Act, and for other associated 
white-collar crimes, such as mail and wire fraud. See Pub. L. No. 107-
204 Sec. Sec. 901-904, 1106.
---------------------------------------------------------------------------
    Potential financial fraud cases, like other cases brought 
by the Enforcement Division, are identified for investigation 
by a variety of means. Often, Commission staff receives a tip 
from an insider at the company warning of a potential fraud. 
Other times, there may be something anomalous about a company's 
performance or something reported in the news that causes staff 
to take a closer look. Sometimes, Corporation Finance staff 
will make a referral of a disclosure matter they deem 
suspicious (although, by the accounts of staff of both 
divisions, these referrals account for a small portion of the 
Enforcement Division's cases).\32\ Once there is some reason to 
believe that a company has misreported financial information, 
the Enforcement Division can conduct an in-depth investigation 
of that company's accounting and reporting practices to 
determine whether and to what extent there has been financial 
fraud. The Commission has the power, and may authorize its 
staff, to subpoena documents and witnesses.\33\
---------------------------------------------------------------------------
    \32\ Committee staff interviews with SEC staff, Division of 
Enforcement (May 7, 2002), and Division of Corporation Finance (April 
24, 2002).
    \33\ Securities Act Sec. 19(b), 15 U.S.C. Sec. 77s(b); Exchange Act 
Sec. 21(b), 15 U.S.C. Sec. 78u(b). SEC staff may begin its 
investigation by conducting an informal inquiry--that is, opening a so-
called ``matter under inquiry.'' If and when staff seeks to use 
compulsory process, it will seek a formal order of investigation from 
the Commission. Committee staff interview with SEC staff (July 24, 
2002).
---------------------------------------------------------------------------
    If the Enforcement Division staff's investigation uncovers 
violations of the securities laws, the Commission may bring an 
enforcement action either in Federal court or through an 
administrative proceeding (with a trial before an 
administrative law judge, with a right of appeal to the 
Commission itself). Depending on whether it is a court or the 
Commission imposing the sanctions, the available remedies 
differ somewhat, but can include injunctions, \34\ monetary 
penalties, \35\ disgorgement of ill-gotten gains, \36\ and bans 
on a person serving as an officer or director of a publicly 
held company.\37\
---------------------------------------------------------------------------
    \34\ Securities Act Sec. 20(b), 15 U.S.C. Sec. 77t(b); Exchange Act 
Sec. 21(d)(1), 15 U.S.C. Sec. 78u(d)(1) (providing for injunctive 
relief in Federal court). The equivalent remedy in an administrative 
proceeding is a cease-and-desist order. See Securities Act Sec. 8A, 15 
U.S.C. Sec. 77h-1; Exchange Act Sec. 21C, 15 U.S.C. Sec. 78u-3.
    \35\ Securities Act Sec. 20(d)(1), 15 U.S.C. Sec. 77t(d)(1); 
Exchange Act Sec. 21(d)(3), 15 U.S.C. Sec. 78u(d)(3) (providing for 
monetary penalties in a Federal court action). In some, more limited 
circumstances, the Commission is also able to impose monetary penalties 
in administrative cases. See Exchange Act Sec. 21B, 15 U.S.C. Sec. 78u-
2.
    \36\ Disgorgement can be imposed by Federal courts as part of their 
inherent equitable powers. See, e.g., SEC v. Materia, 745 F.2d 197, 
200-01 (2d. Cir. 1984); SEC v. Texas Gulf Sulphur Co., 446 F.2d 1301, 
1307-08 (2d. Cir. 1971). In 1990, Congress gave the Commission the 
power to require disgorgement in an administrative proceeding as well. 
See Securities Act, Sec. 8A(e), 15 U.S.C. Sec. 77h-1(e); Exchange Act 
Sec. 21C(e), 15 U.S.C. Sec. 78u-3(e)
    \37\ Securities Act Sec. 20(e), 15 U.S.C. Sec. 77t(e); Exchange Act 
Sec. 21(d)(2), 15 U.S.C. Sec. 78u(d)(2) (providing for such bans by a 
Federal court). The Sarbanes-Oxley Act now gives the Commission the 
power to impose such bans in an administrative proceeding as well. Pub. 
L. No. 107-204 Sec. 1105 (to be codified at 15 U.S.C. Sec. Sec. 77h-
1(f) and 78u-3(f)).
---------------------------------------------------------------------------
    In recent years, the Commission has brought approximately 
500 enforcement cases annually and, of these, approximately 100 
have involved financial fraud.\38\ Though financial fraud 
matters make up only about 20 percent of the cases, Division of 
Enforcement staff estimate that these matters consume half of 
the Division's resources, because of their complex and 
document-intensive nature.\39\ Not surprisingly, Commission 
staff expects the number of financial fraud cases brought to 
increase substantially this year.\40\
---------------------------------------------------------------------------
    \38\ Committee staff interview with Commission staff, Division of 
Enforcement (May 7, 2002; see also Securities and Exchange Commission, 
2001 Annual Report, at 1, 134, available at http://www.sec.gov/about/
annrep01.shtml.
    \39\ Committee staff interview with SEC staff, Division of 
Enforcement (May 7, 2002).
    \40\ Id.
---------------------------------------------------------------------------
    Essential as it is, the Enforcement Division's method of 
operation has two important (and inherent) limitations. First, 
though it may punish wrongdoers and deter others, it generally 
comes after the damage has been done and so can do little to 
make whole those shareholders and employees who have seen the 
value of their holdings substantially diminished as a result of 
others' financial fraud.\41\ Second, by its nature, it can only 
be undertaken where there is already some reason to believe 
that fraud has been committed. Thus, it is impossible to know 
how many cases of fraud--cases where no tip has been received 
or the fraud has not yet snowballed to the point of inevitable 
discovery--are not being found and therefore not being brought 
and the wrongdoers not being punished.
---------------------------------------------------------------------------
    \41\ When feasible, disgorgement proceeds may be used to compensate 
victims, see, e.g., SEC v. Levine, 881 F.2d 1165 (2d Cir. 1989); SEC v. 
Certain Unknown Purchasers, 817 F.2d 1018 (2d Cir. 1987), and, under 
the Sarbanes-Oxley Act, civil penalty amounts now may be added to 
disgorgement funds to be used for this purpose, see Pub. L. No. 107-204 
Sec. 308. Although such procedures provide important potential remedies 
to investors, payments received thereby are highly unlikely to fully 
compensate shareholders for their losses.
---------------------------------------------------------------------------

  B. Private-Sector Gatekeepers

    As the discussion above suggests, the SEC plays a key but 
nonetheless circumscribed role in addressing financial fraud. 
The Commission's reviews of corporate filings, limited as they 
are in number and nature, are not (and have not been intended 
to be) a reliable mechanism for identifying fraud, and 
enforcement actions can only be brought when fraud has already 
been identified. The system contemplates that much of the 
front-line work for prevention and discovery of financial 
misconduct will be done by private-sector gatekeepers--most 
importantly, corporations' boards of directors and auditors--a 
role implicitly recognized in the legal obligations that govern 
the conduct of these groups.\42\
---------------------------------------------------------------------------
    \42\ There are other private actors that can serve as gatekeepers 
as well, such as securities lawyers and investment bankers. See note 8 
above.
---------------------------------------------------------------------------

    1. Boards of Directors

    One of the first lines of defense against management 
wrongdoing is the company's board of directors. Boards are not 
supposed to run a corporation's day-to-day operations--that is 
the job of the full-time management--and they are not supposed 
to work full-time in their capacity as board members. 
Nevertheless, as the elected representatives of the 
shareholders, directors are charged with protecting their 
interests by setting the direction for the corporation and by 
watching over management.\43\ The board should provide 
leadership and oversight with an eye toward maximizing 
shareholder value. Unfortunately, this is a difficult job for 
the board on a part-time basis, as corporations, their 
businesses and the transactions they enter into become ever 
larger and increasingly complex.
---------------------------------------------------------------------------
    \43\ Boards of directors typically are composed of both outside 
directors, who are elected by the company's shareholders, and 
management directors who sit on the Board by virtue of their position 
in the company (such as CEO). Notably, outside directors are not 
necessarily ``independent'' directors as that term is generally 
understood. For example, the New York Stock Exchange's new rules, which 
await SEC approval, define an independent director as one with no 
``material'' relationship with the company. See New York Stock Exchange 
Listed Company Manual Sec. 303A(2) (proposed). Thus, a director who has 
had extensive business dealings with the company but is elected by the 
shareholders would be an outside director, but not an independent one.
---------------------------------------------------------------------------
    The duties and responsibilities of corporate directors are 
set mostly by State law, which governs the general structure 
and function of corporations. State law is fairly consistent 
with respect to the duties of directors. Directors are 
fiduciaries owing the two basic duties to the company and its 
shareholders: A duty of care and a duty of loyalty.\44\ As the 
Delaware Supreme Court, which many courts and commentators view 
as a leading authority on corporate law, has stated: ``Duty of 
care and duty of loyalty are the traditional hallmarks of a 
fiduciary who endeavors to act in the service of a corporation 
and its stockholders.'' \45\ The duty of loyalty requires a 
director to be independent and objective, and to put the 
interests of the corporation before others, including his 
own.\46\ The duty of care requires a director to act in good 
faith with the diligence that an ordinary prudent person in a 
similar position would exercise under similar 
circumstances.\47\ Beyond these general duties, the law 
generally provides few specific requirements or prohibitions 
for directors; they are merely to oversee the corporation 
consistent with their fiduciary duties. The SEC, however, has 
placed certain specific requirements on directors. One of the 
most significant is the directors' responsibility to sign the 
company's annual report. This is supposed to signal to 
investors that the directors have reviewed and approve of its 
contents.
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    \44\ Most States, when confronted with a lack of precedent on a 
particular matter, follow the corporate law of Delaware, a State in 
which many companies have incorporated, and whose law generally is 
recognized as the most developed in this area. Enron originally was 
incorporated in Delaware; in 1993, it reincorporated in Oregon. Oregon 
law, like Delaware law, requires directors to fulfill fiduciary duties 
of both care and loyalty. Oregon Revised Statutes Sec. 60.357; Klinicki 
v. Lundren, 298 Ore. 662, 667; 695 P.2d 906, 910 (1985). In any event, 
Oregon will often look to Delaware precedent on corporations law 
issues. See, e.g., Stringer v. Car Data Systems, Inc., 314 Ore. 576, 
841 P.2d 1183 (1992).
    \45\ Cede & Co. v. Technicolor, 634 A.2d 345, 367 (Del. 1993).
    \46\ Guth v. Loft, 23 Del. Ch. 255, 273; 5 A.2d 503, 511 (1939), 
aff'd, 19 A.2d 721 (Del. 1941).
    \47\ Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).
---------------------------------------------------------------------------
    Despite their weighty responsibilities, directors in 
reality have little personal accountability or oversight. The 
SEC can sue directors for violations of the Federal securities 
laws (as it can with any person), and if it proves a violation, 
can among other things request a Federal court to issue an 
injunction barring that person from serving on the board of any 
other public company in the future. In addition, the Sarbanes-
Oxley Act permits the SEC to prohibit an individual who has 
committed securities fraud from serving as a director on the 
boards of public companies without the need to go to Federal 
court.\48\ The SEC, however, has no jurisdiction over State law 
violations by corporate directors; such violations, generally 
breaches of their fiduciary duties, are enforced by private 
shareholder lawsuits in State court. Holding directors 
personally accountable is not easy. After the Delaware Supreme 
Court held directors responsible for grossly negligent conduct 
in Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), some States 
reacted by enacting ``exculpation statutes.'' \49\ These laws 
allow corporations to provide in their charters that directors 
are not liable for breaches of the duty of care involving 
simple negligence. Furthermore, even when a director might be 
held liable for such a breach, or for a breach of the duty of 
loyalty, a director may be entitled to indemnification from the 
corporation or covered by directors and officers liability 
insurance, except in cases of fraud on the corporation by the 
director.
---------------------------------------------------------------------------
    \48\ Pub. L. No. 107-204 Sec. 1105. See also Pub. L. No. 107-204 
Sec. 305 (easing the standard for obtaining a Federal court order 
barring an individual from serving on a board of directors).
    \49\ See, e.g., 8 Del. C. Sec. 102(b)(7) (permitting corporate 
charters to excuse directors from liability for any breach of fiduciary 
duty except a breach of the duty of loyalty, intentional misconduct or 
knowing violations of law, or any transaction from which the director 
improperly derived a personal benefit).
---------------------------------------------------------------------------
    In addition, decisions of the board are presumptively 
protected from liability by the doctrine known as the 
``business judgment rule,'' unless it can be shown that the 
directors breached one or both of their duties.\50\ The initial 
burden is on shareholders to prove that the directors did 
something wrong in order to convince a court to second-guess 
the board's decisionmaking, and to determine that the board did 
something that hurt the company. Thus directors, in general, 
have little at stake personally if they do not properly 
discharge their duties, at least with respect to the duty of 
care.
---------------------------------------------------------------------------
    \50\ See In Re Unitrin, Inc., 651 A.2d 1361, 1373 (Del. 1995).
---------------------------------------------------------------------------
    Because of the part-time and big-picture nature of their 
work, directors by law are entitled to rely on experts in 
discharging their duties.\51\ This reliance, however, may not 
be blind: The statutes require that the reliance be reasonable 
under the circumstances. In addition, directors may delegate 
certain functions or responsibilities to a committee of the 
board, although such delegation does not relieve the full board 
of its fiduciary obligations. One of the most common committees 
formed by a board of directors is the audit committee. 
Typically, an audit committee focuses on the corporation's 
retention of auditors, financial reporting and internal 
financial controls.\52\ Audit committees are not required by 
SEC regulations, \53\ but they are mandated by listing 
requirements for both the New York Stock Exchange (``NYSE'') 
and the NASDAQ.\54\ NYSE requires that all the members of the 
audit committee be independent of the corporation (that is, not 
affiliated with management or a large shareholder), and NASDAQ 
requires a majority of the audit committee members to be 
independent. By maximizing use of committees and the full 
board, directors are supposed to maintain a strong foothold on 
what is going on in the company and ensure management's efforts 
are serving the needs of the shareholders.
---------------------------------------------------------------------------
    \51\ See 8 Del. C. Sec. 141(e); Oregon Revised Statutes 
Sec. 60.357.
    \52\ ``The primary functions of the audit committee generally are 
to recommend the appointment of the public accountants and review with 
them their report on the financial reports of the corporation; to 
review the adequacy of the system of internal controls and of 
compliance with material policies and laws, including the corporation's 
code of ethics and conduct; and to provide a direct channel of 
communication to the board for the public accountants and internal 
auditors and, when needed, finance officers, compliance officers, and 
general counsel.'' Statement on Corporate Governance, The Business 
Roundtable, September 1997.
    \53\ Nevertheless, the SEC does require each company, in its annual 
proxy statement, to disclose the existence, composition, functions, and 
number of annual meetings of its audit committee. 17 C.F.R. Sec. 14a-
101, Item 7, Paragraph (e)(3).
    \54\ Subject to SEC approval of their rules, stock exchanges (of 
which there are currently eight) are self-regulatory organizations, 
allowed to govern the conduct of their members--broker-dealers that 
trade or make markets in equities--and the companies that list 
securities on those exchanges. Exchange Act Sec. 19(b), 15 U.S.C. 
Sec. 78s(b). To those who prefer market solutions, listing requirements 
generally are viewed with more favor than SEC regulation because they 
come from market participants rather then government. Stock exchanges 
can fine, penalize or delist listed companies that do not comply with 
their rules; they can fine, penalize or suspend the membership of 
members that fail to comply.
---------------------------------------------------------------------------
    The series of corporate collapses that began with Enron has 
caused concern about the independence and vigilance of 
corporate boards, and has led to calls for board reform. There 
has been some response. On June 6, 2002, the New York Stock 
Exchange Corporate Accountability and Listing Standards 
Committee published a list of recommendations for changes in 
the Exchange's listing requirements to enhance corporate 
governance. Many of these address directors in an effort to 
tighten their sense of accountability and diligence. Among 
them: A majority of directors on boards of listed companies 
must be independent directors; boards must convene regular 
sessions without management in attendance; the chair of the 
audit committee must have financial or accounting expertise; 
and audit committees must have sole responsibility for hiring 
or firing independent auditors and for approving all non-audit 
work by the auditors. The recommendations also attempt to 
enhance the independence of independent directors by requiring 
that the board affirmatively determine, with respect to each 
independent director, that he or she has no material 
relationship with the company and that directors fees 
constitute the sole compensation received from the company by 
any audit committee member. These recommendations were adopted 
by the NYSE Board of Directors on August 1, 2002, following a 
2-month public comment period. On August 16, 2002, the proposal 
and summary of comments was submitted by the NYSE Board to the 
SEC for review and approval, which involves an additional 
public comment period.\55\ Similar changes have been proposed 
for NASDAQ's listing requirements.\56\
---------------------------------------------------------------------------
    \55\ See ``NYSE Files Changes to Listing Standards with SEC, NYSE-
Approved Measures Aim To Strengthen Corporate Accountability,'' NYSE 
Press Release August 16, 2002, available at http://www.nyse.com/pdfs/
corp--gov--pro--b.pdf. The proposed standards filed with the SEC are 
available at http://www.nyse.com/report.
    \56\ See ``Nasdaq Takes New Actions on Corporate Governance 
Reform,'' NASDAQ Press Release, July 25, 2002, available at http://
www.nasdaqnews.com/news/pr2002/ne--section02--141.html; ``Summary of 
NASDAQ Corporate Governance Proposals,'' September 13, 2002, available 
at http://www.nasdaq.com/about/Corp--Gov--Summary091302.pdf.
---------------------------------------------------------------------------

    2. Auditors

    Beyond the watchdog role boards of directors are supposed 
to play, the securities laws add a second layer of oversight: 
The independent auditor. As discussed above, our market 
regulatory system rests upon the supposition that companies 
offering their securities to the public provide broad and 
accurate disclosure to investors. In order for the information 
to have meaning--and for investors to be able to compare apples 
to apples--it must be presented according to a set of uniform 
standards. For financial information, those standards are 
accounting standards. The accounting standards now applicable 
in the U.S. markets are known as Generally Accepted Accounting 
Principles (GAAP). In addition, to assure investors that each 
company is preparing its financial statements in accordance 
with applicable accounting standards, which should result in 
statements that provide a fair depiction of the company's 
financial position, \57\ companies must have their books 
audited by independent certified or public accountants. This 
requirement, so basic to the scheme of securities regulation, 
was incorporated into the securities laws in the Securities 
Act, even before the SEC was created the following year in the 
Exchange Act.\58\ During the hearings on the bill that was to 
become the Securities Act, several senators suggested that 
auditors working for the government, rather than the private 
sector, should inspect public company financial statements. 
Representatives of the accounting profession and others, 
however, urged rejection of that proposal due to the size and 
the complexity of the market.\59\ With an ever-expanding and 
ever-changing set of industries, this remains the approach. The 
SEC relies entirely on private-sector auditors to ensure that 
the financial statements of public companies comply with GAAP; 
as discussed above, the SEC does not do audits.
---------------------------------------------------------------------------
    \57\ Although compliance with GAAP is expected to result in a fair 
presentation of a company's financial statements, this is not always 
the case. See United States v. Simon, 425 F.2d 796 (2nd Cir. 1969) 
(despite technical compliance with GAAP, conviction of defendant for 
preparing false and misleading financial statements was proper where 
the statements did not fairly present financial position of company). 
But see SEC v. Arthur Young, 590 F.2d 794 (9th Cir. 1979) and Escott v. 
Barchris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968) 
(compliance with GAAP is a defense to auditor liability for false 
financial statements).
    \58\ Exchange Act Sec. 4, 15 U.S.C. Sec. 78d.
    \59\ Hearings on S. 875 Before the Senate Committee on Banking and 
Currency, 73rd Cong., 1st Sess., at 57-62 (1933).
---------------------------------------------------------------------------
    Although the SEC has the power to promulgate accounting and 
auditing standards, \60\ since its inception the SEC has chosen 
to delegate the primary responsibility for these matters to 
private bodies. Until 1973, the American Institute of Certified 
Public Accountants (AICPA) or its predecessor organization--the 
trade association for accountants--set both accounting and 
auditing standards. In the late sixties and early seventies, 
widespread dissatisfaction developed with AICPA's process for 
setting accounting standards; not only was the process slow, it 
was handled by professionals from corporations and the 
accounting industry only on a part-time basis. This led to the 
creation in 1973 of the Financial Accounting Standards Board 
(FASB), an independent organization, which was charged by the 
SEC to set GAAP. The AICPA and its member firms, however, 
continue to have influence in the standard-setting process. 
Most of the funding for the FASB comes from the accounting 
industry, and members of accounting firms and representatives 
from AICPA and other trade groups sit on the board of FASB's 
parent organization, which chooses the members of the FASB. 
FASB, like its predecessor, has been subject to criticism for 
its lack of speed in promulgating standards and for being too 
close to the accounting industry.
---------------------------------------------------------------------------
    \60\ Securities Act Sec. 19(a), 15 U.S.C. Sec. 77s(a); Exchange Act 
Sec. 13(b), 15 U.S.C. Sec. 78m(b).
---------------------------------------------------------------------------
    The SEC also has allowed the AICPA to set auditing 
standards for the industry. This raised doubts almost from 
inception. In 1940, the SEC investigated McKesson & Robbins, a 
reputable accounting firm that failed to prevent senior 
officers of one of its audit clients from embezzling millions, 
while overstating inventory and accounts receivable and 
reporting profits from a non-existent business. Based on the 
findings of that investigation, the AICPA adopted a number of 
changes to auditing practices. The reforms essentially 
persuaded the SEC to continue allowing the industry to set its 
own standards.\61\ Doubts arose again, in the wake of the 
collapse of the Penn Central Company, the massive Equity 
Funding Corporation fraud, foreign bribery scandals, and other 
corporate abuses revealed in the early to mid-1970's.\62\ 
Senate and House subcommittees initiated investigations into 
the perceived failure of accounting firms serving as 
independent auditors to detect and to disclose business 
reversals or fraudulent conduct of managements of publicly held 
corporations. The leaders of this Congressional effort, Senator 
Metcalf and Representative Moss, tried to convince the SEC to 
take direct control of audit standards.\63\ When the SEC did 
not, Moss introduced a bill to establish a self-regulatory 
organization in the style of NASD, called the ``National 
Organization of SEC Accountancy'' to oversee the accounting 
industry.\64\ The legislation was never adopted, and the AICPA, 
through the Auditing Standards Board, continues to set audit 
standards today. The Board, which has 15 members, promulgates 
Statements on Auditing Standards.\65\ In addition, for 25 
years, the Auditing Standards Board was overseen by the Public 
Oversight Board, a private entity of five members funded by 
AICPA, which provided guidance with respect to the audit 
process.\66\
---------------------------------------------------------------------------
    \61\ See Louis Loss and Joel Seligman, Fundamentals of Securities 
Regulation (4th ed. 2001) at 178.
    \62\ Id.
    \63\ Michael S. Luehlfing, ``The Politics of Self-Imposed 
Regulations--Has a New Day Dawned?'' Accounting Horizons, June 1995.
    \64\ Id.
    \65\ See ``The Enron Crisis: The AICPA, The Profession & The Public 
Interest,'' available at http://www.aicpa.org/info/regulation02.htm.
    \66\ The Public Oversight Board disbanded in March 2002 after SEC 
Chairman Pitt announced his intention to form a new body to oversee the 
accounting industry.
---------------------------------------------------------------------------
    In addition to setting its own standards for auditing, the 
accounting industry until recently also, for the most part, 
disciplined itself. The SEC may bar or suspend from practice 
before the Commission any professional--including an 
accountant--who has engaged in ``unethical or improper 
professional conduct.'' \67\ Beyond that, however, until the 
recent passage of the Sarbanes-Oxley Act, accountants were 
subject to direct professional discipline only from two places. 
First, to the extent accountants are licensed (Certified Public 
Accountants--the only accountants who may serve as external 
auditors in satisfaction of the securities laws--must be 
licensed), they receive their licenses from the State in which 
they practice; the applicable State board of accountancy may 
fine, suspend or bar a CPA from practice. Second, the AICPA, 
through its Professional Ethics Division, investigates 
allegations of unethical or wrongful conduct and, if 
appropriate, expels or suspends accountants from AICPA 
membership. These avenues of professional discipline for 
accountants have been criticized--particularly in the wake of 
the Enron scandal--as fairly ineffective.\68\ State boards of 
accountancy vary in their approaches and do not have sufficient 
resources to monitor the professionals in their States. 
Meanwhile, the AICPA, as the industry trade association, tends 
not to act aggressively, particularly against accountants in 
the most established firms. The Sarbanes-Oxley Act, however, 
has changed this system by providing for a centralized, 
independent disciplinary body for accountants.\69\ The Public 
Company Accounting Oversight Board will issue rules 
establishing standards for accountants with respect to auditing 
practice, ethics, and independence.\70\ The Board will also 
monitor accounting firms for compliance with these and other 
applicable rules and may investigate and punish violations with 
fines, censures or suspensions from the practice of auditing 
public companies.\71\
---------------------------------------------------------------------------
    \67\ SEC Rule of Practice 102(e).
    \68\ David S. Hilzenrath, ``Auditors Face Scant Discipline; Review 
Process Lacks Resources, Coordination, Will,'' The Washington Post, 
December 6, 2001.
    \69\ Pub. L. No. 107-204 Sec. Sec. 101-109.
    \70\ Pub. L. No. 107-204 Sec. 103(a).
    \71\ Pub. L. No. 107-204 Sec. 105.
---------------------------------------------------------------------------
    One specific issue regarding auditors that has been the 
subject of attention in recent years concerns auditors' 
responsibility for independence and objectivity in carrying out 
audits. In auditing companies, accountants are supposed to 
approach the books with a skeptical eye and with allegiance 
only to the company and its investors.\72\ For example, 
auditors are required to make efforts to detect fraud in their 
audits and report what they find to the Board, and if not 
appropriately dealt with at that level, to the SEC.\73\ 
Management and its decisions are supposed to be questioned and 
scrutinized. Consulting services, on the other hand, are 
provided at the pleasure and direction of management. 
Consulting services, which can be anything non-audit related, 
such as advice on tax issues, information technology design, 
internal audits, or assisting in accounting aspects of 
structured finance, are seen by clients as value-added services 
(unlike audits, which are just an expensive necessity), and 
therefore, they are more lucrative for accounting firms than 
auditing. Accordingly, allowing the same firm to audit a 
company and provide consulting services for that company might 
tempt the firm to work with and please management in the audit 
function in order to assure itself further consulting work. 
Moreover, to the extent that some of the consulting work may 
involve setting up internal audit systems or even helping to 
structure transactions, the firm might end up auditing its own 
work, perhaps leading it to be either less critical or more 
trusting than it should be.
---------------------------------------------------------------------------
    \72\ ``By certifying the public reports that collectively depict a 
corporation's financial status, the independent auditor assumes a 
public responsibility transcending any employment relationship with the 
client. The independent public accountant performing this special 
function owes ultimate allegiance to the corporation's creditors and 
stockholders, as well as to the investing public. This `public 
watchdog' function demands that the accountant maintain total 
independence from the client at all times and requires complete 
fidelity to the public trust.'' United States v. Arthur Young & Co., 
465 U.S. 805, 817-818 (1984) (emphasis in original).
    \73\ Exchange Act Sec. 10A, 15 U.S.C. Sec. 78j-1. Nevertheless, 
according to a recent study, only 41 percent of auditors--as opposed to 
71 percent of investors--believe auditors serve as ``public 
watchdogs.'' John McEnroe and Stanley Martens, ``Auditors' and 
Investors' Perception of the `Expectation Gap,' '' Accounting Horizons, 
December 2001. This is the case despite the Supreme Court's clear 
pronouncement in the Arthur Young case (see note above).
---------------------------------------------------------------------------
    In June 2000, the SEC proposed new rules to enhance auditor 
independence, which would have prohibited a firm auditing a 
public company from providing much of the consulting work it 
was then permitted to provide. The rule was controversial, 
however, and faced strong objections from the accounting 
profession as well as from Congress. The rule that the SEC 
eventually promulgated in November 2000, in addition to setting 
new guidelines, required mainly that companies disclose the 
amounts they paid the firms that audited them for audit work 
and consulting work.\74\ The Sarbanes-Oxley Act, however, 
passed in the wake of the Enron scandal, includes auditor 
independence provisions that borrow in significant part from 
the initial SEC proposal, particularly with respect to the 
consulting services that are considered a conflict for auditors 
to provide. Under the Act, accounting firms are barred from 
providing companies they audit with many non-audit services, 
including bookkeeping, financial information systems design and 
implementation, appraisals, and investment adviser and 
investment banking services. The Sarbanes-Oxley Act also 
requires lead audit partners at accounting firms to rotate 
every 5 years.\75\
---------------------------------------------------------------------------
    \74\ Securities Act Release No. 7919, Exchange Act Release No. 
43602 (November 21, 2000); 65 Fed. Reg. 76008 (December 5, 2000). In 
addition, the rule specifies a limited number of non-audit services 
that firms conducting audits may not provide. 17 C.F.R. Sec. 210.2-
01(c)(4).
    \75\ Pub. L. No. 107-204 Sec. Sec. 201-209.
---------------------------------------------------------------------------
    In sum, the Federal securities and State corporate laws 
place at least three tiers of oversight over public companies--
the board of directors, who are supposed to keep tabs on 
management inside the company; the independent auditors, who 
are supposed to make sure the company is keeping--and 
disclosing--its books honestly; and the SEC, which is supposed 
to watch over and keep tabs on the whole system and make sure 
the other watchdogs are doing their jobs. As the next section 
discusses, they all failed--to one degree or another--in the 
Enron case.

II. EXPERIENCE WITH ENRON

    Before addressing how the watchdogs reacted to Enron's 
financial practices, it is worth noting what Enron is alleged 
to have done wrong--and therefore what more effective watchdogs 
might have discovered. Beginning at least as early as 1997 and 
gaining momentum in 1999 and 2000, Enron is alleged to have 
engaged in complex and ultimately pervasive accounting fraud 
designed to make it look like the company had more revenue and 
earnings, less debt, greater operating cash flow, and generally 
healthier financial statements than it in fact had.
    The various investigations into Enron--including those of 
the SEC, Justice Department, and Congress--are still ongoing, 
but a number of allegations about Enron's specific practices 
have come to light which, if true, are likely to have involved 
violations of Federal securities laws. The alleged practices 
include: Not fully disclosing the extent and nature of 
transactions the company engaged in with so-called ``related 
parties''--primarily partnerships operated by Enron's Chief 
Financial Officer, Andrew Fastow, and those who worked for him; 
\76\ improperly excluding the debt of certain so-called 
``special purpose entities'' (SPEs) \77\ from the company's 
balance sheet; \78\ treating certain transactions as asset 
sales (in order to get poorly performing assets off the 
company's books and/or to realize immediate revenue) without 
actually transferring the risks of ownership; \79\ executing 
transactions that, in reality, were loans disguised as 
commodity trades and treating them as trading liabilities 
rather than debt and treating the cash received as cash flow 
from operations rather than cash flow from financing; \80\ 
failing to disclose the full extent of contingent liabilities--
i.e., debt that would come due if Enron's stock price and/or 
credit rating dropped below a specified level; \81\ 
misaccounting for a note received in exchange for the company's 
stock so that it was considered an asset and increased 
shareholder equity instead of (properly) reducing shareholder 
equity; \82\ and engaging in transactions that purportedly 
hedged the company's risk in certain investments but, not being 
true hedges, were designed instead to keep losses from these 
investments off Enron's books and left Enron open to 
significant financial risk.\83\
---------------------------------------------------------------------------
    \76\ See ``Report of Investigation by the Special Investigative 
Committee of the Board of Directors of Enron Corp.,'' February 1, 2002, 
(``Powers Report'') at 178-203.
    \77\ Special purpose entities are entities created by a sponsoring 
company for a limited purpose, such as to hold a particular asset. 
Enron used a number of these entities in the transactions that have 
come under scrutiny since its collapse. In some cases, SPEs can be 
treated as unconsolidated entities for financial reporting purposes: 
That is, their assets and liabilities need not be included (i.e., 
``consolidated'') on the sponsoring company's balance sheet. In order 
to qualify for nonconsolidation, an SPE must meet two requirements: (1) 
at least 3 percent of the total capital in the SPE must come from an 
independent outside equity investor; and (2) the SPE must be under the 
control of the outside investor--that is to say, the outside investor 
must hold a majority of the SPE's stock. See Powers Report at 36-40.
    \78\ See Powers Report at 49-54, 66-67.
    \79\ See Powers Report at 134-147; The Role of Financial 
Institutions in Enron's Collapse, Hearing Before the Permanent 
Subcommittee on Investigations, Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-618 (July 30, 2002) at-- (Printed Hearing 
Record Pending) (evidence of Enron's purported sale of interest in 
three power barges located in Nigeria to Merrill Lynch).
    \80\ The Role of Financial Institutions in Enron's Collapse, 
Hearing Before the Permanent Subcommittee on Investigations, Senate 
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-618 (July 23, 
2002) at-- (Printed Hearing Record Pending) (evidence that Enron used 
questionable structured finance transactions to disguise loans as 
trading liabilities in order to avoid reporting such financing as 
debt).
    \81\ See William W. Bratton, ``Enron and the Dark Side of 
Shareholder Value,'' 76 Tulane L. Rev. -- (forthcoming May 2002) 
(Draft), available at http://papers.ssrn.com/sol3/papers.cfm?abstract--
id=301475, at 43-47, 65-67.
    \82\ See Powers Report at 125-26; Bratton, at note 81 above, at 37-
38.
    \83\ See Powers Report at 97-118; Bratton, at note 81 above, at 38-
40.
---------------------------------------------------------------------------
    Not only do these fraudulent practices appear to have been 
many and varied, but they also involved substantial--in some 
cases staggering--amounts of money. The loans-cum-commodity 
trades, for example, alone accounted for an estimated $7-8 
billion in allegedly improperly recorded liabilities and cash 
flow; \84\ not disclosing contingent liabilities kept the 
potential for almost $4 billion in losses out of Enron's 
financial statements; \85\ the disclosure of the failure to 
consolidate two Enron SPEs (and a related partnership) led to 
an approximately $500 million restatement of net income over 4 
years; \86\ the improper hedging transactions led to a charge 
against earnings of $710 million ($544 million after taxes); 
\87\ and the improper accounting of the note-for-stock exchange 
resulted in a $1 billion reduction in shareholder equity.\88\
---------------------------------------------------------------------------
    \84\ The Role of Financial Institutions in Enron's Collapse, 
Hearing Before the Permanent Subcommittee on Investigations, Senate 
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-618 (July 23, 
2002) at-- (Printed Hearing Record Pending).
    \85\ Enron Corp. Form 10-Q for the quarter ended September 30, 2001 
(filed November 19, 2001), Part I, Item 2, at 66.
    \86\ Enron Corp. Form 8-K (filed November 8, 2001), Section 2, at 
3-5. In addition to recording a reduction in net income, the 
restatement also resulted in a significant reduction in shareholders' 
equity and a significant increase in reported debt. See also Powers 
Report at 3.
    \87\ Enron Corp. Form 10-Q for the quarter ended September 30, 2001 
(filed November 19, 2001), Part I, Item 1, Note 4, at 23; see also 
Powers Report at 128.
    \88\ Enron Corp. Form 8-K (filed November 8, 2001), Section 3, at 
6-7.
---------------------------------------------------------------------------

  A. Private-Sector Gatekeepers

    The private-sector gatekeepers--such as Enron's Board of 
Directors and its auditor, Arthur Andersen--were the first 
lines of defense against the apparent fraud described 
above.\89\ The failure of these parties to discharge their 
duties have been delved into more deeply and reported on more 
thoroughly elsewhere.\90\ They are recounted here in brief to 
give context to the SEC's actions with respect to Enron.
---------------------------------------------------------------------------
    \89\ Indeed, other private sector gatekeepers, such as some of the 
investment banks with which Enron worked, appear to have actively 
participated in some of the transactions described above. In recent 
hearings held by PSI, e-mails, memoranda and presentation materials 
revealed that financial institutions structured and marketed 
transactions apparently used by Enron to disguise loans as energy 
trades, characterize loan proceeds as cash flow from operations rather 
than cash flow from financing, and generate proceeds from asset sales 
that, in fact, were not true asset sales. See The Role of Financial 
Institutions in Enron's Collapse, Hearing Before the Permanent 
Subcommittee on Investigations, Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-618 (July 23 and 30, 2002) at-- (Printed 
Hearing Record Pending) (Hearing Exhibits 102, 158, 201 and 203.)
    \90\ See, e.g., Report of the Senate Permanent Subcommittee on 
Investigations on ``The Role of the Board of Directors in Enron's 
Collapse,'' S. Prt. 107-70 (July 8, 2002).
---------------------------------------------------------------------------

    1. Enron's Auditor

    Audit failures have increasingly occurred over the last 
decade--restatements have reached record numbers, at over 270 
in 2001--and every major accounting firm has been involved in 
at least one significant financial fraud case in the last few 
years.\91\ Nevertheless, Enron appears to be the straw that 
broke the camel's back in instigating a climate for change in 
auditor regulation. Even beyond its conviction for obstruction 
of justice in connection with its shredding of documents 
related to Enron, Andersen appears to have failed miserably in 
its responsibility as Enron's auditor. In its report about 
failures at Enron with respect to the related-party 
transactions, the special committee of Enron's Board of 
Directors concluded that ``Andersen did not fulfill its 
professional responsibilities in connection with its audits of 
Enron's financial statements, or its obligation to bring to the 
attention of Enron's Board (or the Audit and Compliance 
Committee) concerns about Enron's internal controls over the 
related-party transactions.'' \92\ In addition, Andersen helped 
structure many of the transactions Enron used to improve the 
appearance of its financial statements but which had no 
economic purpose, such as the so-called ``Raptor'' 
transactions.\93\ Indeed, the Committee's Permanent 
Subcommittee on Investigations (``PSI'') concluded as part of 
its investigation into Enron's collapse that Andersen was aware 
of how problematic these transactions were and warned the Board 
of Directors that they represented ``high-risk accounting.'' 
\94\ Among themselves, Andersen partners involved on the Enron 
engagement were even more frank. In its yearly client risk 
analysis on Enron, Andersen expressed concern about some of 
Enron's business as ``form over substance transactions''; in an 
e-mail describing the content of one annual client retention 
meeting regarding Enron on February 6, 2001, Andersen 
acknowledged ``Enron's dependence on transaction execution to 
meet financial objectives,'' and how ``aggressive'' Enron was 
in its accounting.\95\
---------------------------------------------------------------------------
    \91\ Though Andersen has surely had its share of audit failures 
with Sunbeam, Waste Management, Enron, and now WorldCom, the other big 
four accounting firms can hardly boast spotless records: 
PricewaterhouseCoopers audited Microstrategy, Ernst & Young audited 
Cendant, KPMG audited Rite-Aid and Xerox, and Deloitte & Touche audited 
Adelphia, all of which resulted in significant audit failures.
    \92\ Powers Report at 24.
    \93\ Powers Report at 24-25. The Raptors were SPEs purportedly set 
up to hedge certain of Enron's investments but which were in fact used 
to avoid reflecting losses in those investments on Enron's income 
statement. Id. at 97.
    \94\ Report of the Senate Permanent Subcommittee on Investigations 
on ``The Role of the Board of Directors in Enron's Collapse,'' S. Prt. 
107-70 (July 8, 2002) at 15-20.
    \95\ Id. at 18-19.
---------------------------------------------------------------------------
    One of the major concerns about Andersen as the auditor of 
Enron has been that it did not exhibit sufficient independence 
and objectivity in discharging its responsibilities. In 2000, 
Andersen earned $52 million in fees from Enron. Less than half 
of that amount, $25 million, was for audit work; $27 million 
related to consulting services. As discussed above, it is 
difficult to comprehend how such large consulting fees could 
not have created a serious conflict of interest for Andersen. 
But regardless of the cause, the result is clear: Enron's 
auditor failed to discharge its role of verifying the accuracy 
of Enron's books.

    2. Enron's Board of Directors

    After the Enron scandal broke, the company's Board of 
Directors appointed a special committee of the Board to 
investigate the company's transactions with partnerships 
controlled by Enron's Chief Financial Officer, Andrew Fastow, 
and others who worked with Fastow.\96\ The special committee 
concluded that the Board did not act with sufficient diligence 
in approving these transactions. Moreover, the special 
committee further faulted the board for failing to carefully 
monitor the precarious situation once they allowed it to go 
forward.\97\ PSI went further, and concluded that the board of 
the directors did not take appropriate care to protect 
shareholder value from management overreaching in a number of 
respects. PSI, based on an extensive investigation involving 
over one million documents and numerous interviews, including 
interviews of 13 former Enron board members, found that 
although the directors argued that management misled and 
concealed key facts about the company's activities from them, 
the board in fact had substantial amounts of information about 
the high-risk accounting and structured finance vehicles used 
by Enron. And instead of responding with probing questions to 
what corporate governance and accounting experts at a May 7, 
2002 hearing before PSI characterized as obvious red flags, the 
board simply and unreasonably (in light of the warning signs) 
relied on management. Indeed, the board and its committees met 
only about five times annually, \98\ and spent under an hour 
reviewing even the most complicated transactions.\99\
---------------------------------------------------------------------------
    \96\ Powers Report at 1.
    \97\ Powers Report at 10.
    \98\ Report of the Senate Permanent Subcommittee on Investigations 
on ``The Role of the Board of Directors in Enron's Collapse,'' S. Prt. 
107-70 (July 8, 2002) at 9.
    \99\ Id. at 32.
---------------------------------------------------------------------------
    Despite their apparent lack of diligence, Enron board 
members enjoyed compensation that was among the highest offered 
to any corporate directors in the country. Their compensation, 
which was paid in cash, stock and stock options, was valued in 
2000 at approximately $350,000 per director--more than twice 
the national average for a U.S. publicly traded 
corporation.\100\ In addition, some of the directors received 
other forms of compensation or had other financial ties with 
Enron. The expert witnesses at the May 7, 2002 PSI hearing not 
surprisingly opined that all of this remuneration may have 
compromised the directors' objectivity with respect to 
management.\101\
---------------------------------------------------------------------------
    \100\ Id. at 11, 56.
    \101\ Id. at 56-57.
---------------------------------------------------------------------------

  B. The SEC

    Since Enron's auditors and Board of Directors failed to 
ensure the accuracy of the company's public reports, the SEC 
was left as the watchdog of last resort for Enron. The 
Committee set out to review the SEC's interactions with Enron 
and determine what, if anything, the SEC could have done 
differently to prevent, or at least detect sooner, the problems 
that led to Enron's collapse. Most of Enron's dealings with the 
SEC, staff learned, were in connection with the public filings 
the company was required to submit to the Commission--its 
periodic reports, proxy statements, securities registration 
statements, and the like. In fact, before it undertook its 
current investigation of Enron's accounting practices, the SEC, 
in the past decade, had opened only one other investigation 
involving Enron: An informal probe of an affiliated entity on a 
relatively minor matter that was subsequently closed without 
further action.\102\ The Commission similarly received few 
substantive complaints about Enron, none of which appear 
relevant to the allegations that later surfaced.\103\ 
Furthermore, in contrast to its aggressive lobbying of other 
agencies and in other forums, Enron appears to have presented 
its views to the SEC on a major policy matter only once: In 
September 2000, CEO Kenneth Lay sent a letter to then-SEC 
Chairman Levitt opposing the Commission's proposed auditor 
independence rules.\104\ Enron did, however, on a number of 
occasions, successfully seek exemptions from applicable 
statutes or other favorable determinations. In at least two 
instances, Enron was the first company to present the issue to 
the SEC.
---------------------------------------------------------------------------
    \102\ This was a ``matter under inquiry''--that is to say, an 
informal investigation that had not yet risen to the level that the SEC 
staff had requested the authority to issue subpoenas--involving the 
Enron affiliate Zond Panaero Windsystems concerning its disclosure 
regarding the potential for year 2000 problems. The matter was opened 
in April 1999 and closed in September 1999, after the company revised 
the disclosure. SEC Response at 90; Committee staff interview with SEC 
staff (September 6, 2002).
      The general partner of Zond Panaero Wind Systems is a subsidiary 
of Enron Wind Systems (formerly Zond Systems), which is (through at 
least one further layer of ownership) a subsidiary of Enron Corp. In 
1997, Enron Wind Systems sold part of its interests in various wind 
farms to an entity called RADR, which was allegedly controlled by 
former Enron executives Andrew Fastow and Michael Kopper. These 
transactions formed part of the basis for the civil and criminal 
charges recently brought against Fastow and Kopper. See Complaint, SEC 
v. Kopper, Civ. Action No. H-02-3127 (S.D. Tex. August 21, 2002); 
Information, United States v. Kopper, Cr. No. H-02-0560 (S.D. Tex. 
August 20, 2002); Complaint, SEC v. Fastow, Civ. Action No. H-02-3666 
(S.D. Tex. Oct. 2, 2002); Criminal Complaint, United States v. Fastow, 
Cr. No. H-02-889-M (S.D. Tex. Oct. 1, 2002). No interest in Zond 
Panaero, however, was ever transferred to RADR and the 1999 
investigation of Zond Panaero Windsystems is, from all indications, 
unrelated to the subsequent charges. For further discussion of Enron's 
transfer of its interests in various windfarms, see note below and the 
accompanying text.
    \103\ See SEC Response at 86-89.
    \104\ The letter was treated as a public comment and placed on the 
public record. It has subsequently been revealed that the letter was 
sent at the urging, and with the assistance, of Enron's auditor, Arthur 
Andersen. See, e.g., Alexei Barrionuevo and Jonathan Weil, ``Duncan 
Knew Enron Papers Would Be Lost,'' The Wall Street Journal, May 14, 
2002 (reporting on testimony by David Duncan, a former Andersen 
partner, at the Arthur Andersen obstruction of justice trial that he 
and an Andersen lobbyist had enlisted Lay to write such a letter to the 
SEC Chairman).
      In addition, Enron's lobbying disclosure forms indicate that it 
had at least one lobbying contact with the SEC during the first half of 
2001. Enron Corp. 2001 Amended Mid-Year Lobbying Report (March 1, 
2002). The SEC has no record of such a contact. SEC staff speculated, 
however, that Enron's disclosure might refer to an interview with Enron 
that was conducted for a Joint Report on Retails Swaps issued in 
December 2001 pursuant to the Commodity Futures Modernization Act of 
2000 by the SEC, the Board of Governors of the Federal Reserve System, 
the Department of the Treasury and the Commodity Futures Trading 
Commission. Committee staff interview with SEC staff, Office of General 
Counsel (June 7, 2002).
---------------------------------------------------------------------------
    Committee staff's investigation points to a number of 
problems that need to be addressed. As discussed more fully 
below, Enron's case suggests that the SEC's largely passive 
interaction with companies (particularly large companies) 
likely led it to miss warning signs of corporate misconduct. 
Moreover, the Commission's failure to follow up on a change in 
Enron's accounting deprived the Commission of an important 
opportunity to better scrutinize and therefore sooner discover 
Enron's questionable activities. More broadly, the Enron case 
suggests that the SEC needs to re-examine the way it operates: 
In particular, its assumption that it can rely as fully as it 
does on private gatekeepers to play a significant role in 
ensuring the flow of honest and accurate information. Without 
the ability to rely as extensively on these private watchdogs, 
the SEC must find ways to more proactively detect and root out 
financial fraud.

    1. Review of Enron's Public Filings

    In the decade preceding its collapse, Enron submitted 
numerous filings to the SEC.\105\ These included annual and 
quarterly reports each year, as well as 29 registration 
statements for the sale of securities, \106\ and two filings in 
connection with proposed mergers.\107\
---------------------------------------------------------------------------
    \105\ According to the SEC's electronic database of public filings, 
EDGAR, Enron submitted in excess of 300 filings to the SEC from January 
1994 to the date of its bankruptcy. This total, however, includes a 
number of routine filings that would not have ordinarily been subject 
to review. In addition, Enron had an ownership interest in 50 other 
companies that were required to file separately with the SEC; in half 
of these, Enron's interest was 20 percent or greater. Memorandum from 
Alan Beller, Director, Division of Corporation Finance to Office of 
General Counsel, dated September 12, 2002, under cover of letter from 
Peter Kiernan, Deputy Director, Office of Legislative Affairs, 
Securities and Exchange Commission to Beth Grossman, Counsel, Committee 
on Governmental Affairs, dated September 18, 2002.
    \106\ This excludes registration statements that becomes effective 
without SEC action, such as registration statements for employee 
benefit plans filed on Form S-8.
    \107\ SEC Response at 23-66.
---------------------------------------------------------------------------
    During this period, the SEC's Corporation Finance Division 
reviewed four of Enron's annual reports on Form 10-K--those for 
the years 1991, 1995, 1996 and 1997.\108\ The latter three 
annual reports were reviewed as part of the SEC's consideration 
of other transactions pending with the Commission at that time. 
This fact--and, according to SEC staff, not any concerns raised 
about the filings themselves--accounts for the uneven intervals 
between reviews and the fact that reviews were conducted of the 
company's 10-Ks 3 years in a row.\109\
---------------------------------------------------------------------------
    \108\ In addition, SEC staff reviewed Enron's 10-Q for the second 
quarter of 1997 in conjunction with its review of the S-4 registration 
statement that Enron filed in connection with the merger between Enron 
Global Power and Pipelines (a 54 percent owned subsidiary of Enron) and 
another, wholly-owned subsidiary of Enron. SEC Response at 11, 31.
    \109\ Committee staff interview with SEC, Division of Corporation 
Finance (April 24, 2002). In addition to the annual reports, since 
1992, the SEC conducted full reviews of two of Enron's proxy statements 
(in 1993 and 1994), and the Forms S-4 submitted in connection with two 
mergers--Enron's acquisition of Portland General Electric (filed in 
1996) and the merger of two of its subsidiaries (filed in 1997). Only 
two of Enron's registration statements for the sale of securities were 
subject to a full review; both of these reviews took place in 1992 (in 
addition, the registration statement for an Enron subsidiary's 
proposed--and ultimately abandoned--IPO was reviewed in 1998). None of 
Enron's registration statements after 1992--the last of which was filed 
on June 1, 2001--has received a full or financial statement review, 
although seven have been monitored for specific issues. See SEC 
Response at 23-66.
---------------------------------------------------------------------------
    There appears to be little remarkable about the SEC's 
reviews of these filings. SEC staff conducted a full review of 
Enron's 1991 annual report--that is, a review of the entire 
filing. The staff issued an initial comment letter and two 
follow-up letters in the fall of 1992 that raised a number of 
concerns about the report, ranging from a request for 
additional information about potential liability for pollution 
clean-up to concerns about its discussion of net cash flows. 
Enron responded to each of the comment letters and ultimately 
amended its 10-K to conform to the SEC's comments.\110\
---------------------------------------------------------------------------
    \110\ SEC staff had agreed to permit Enron to forego amending its 
10-K and instead to conform its future filings to certain of the 
comments. After the issuance of comment letters, however, Enron decided 
to spin-off one of its subsidiaries, Enron Oil Trading and 
Transportation Company, and amended its 10-K to reflect the spin-off as 
well as ``substantially all'' of the SEC's comments. SEC Response at 
13-14.
---------------------------------------------------------------------------
    The reviews of the 1995 and 1996 annual reports, both also 
described by SEC staff as full reviews, were undertaken in 
conjunction with the Commission's review of transactional 
filings associated with Enron's acquisition of Portland General 
Corp.\111\ Although the filing concerning the acquisition--a 
so-called ``merger proxy''--received 44 separate comments from 
SEC staff (all of which appear to have been ultimately 
resolved), \112\ the annual reports led to fewer questions. In 
response to its review of the 1995 annual report, the SEC staff 
issued a letter to Enron with two comments, both relating to 
details of Enron's defined benefit plan; \113\ the review of 
the 1996 10-K, which took only 3 days, resulted in no comments 
at all.\114\
---------------------------------------------------------------------------
    \111\ SEC Response at 35. In connection with the acquisition, Enron 
filed a registration statement on Form S-4 confidentially with the 
Commission on August 14, 1996. The registration statement was declared 
effective on October 10, 1996. Subsequently, on May 16, 1997, Enron 
filed an amendment to the Form S-4. Enron's 1995 10-K was reviewed in 
connection with the review of the original registration statement. Its 
1996 10-K was reviewed in connection with the review of the post-
effective amendment. See Correspondence from SEC staff to Committee 
staff (August 9, 2002).
    \112\ SEC Response at 35-38.
    \113\ SEC Response at 12-33.
    \114\ SEC Response at 11-12. The post-effective amendment to the 
merger proxy that was reviewed at the same time also generated no 
comments. Correspondence from SEC staff to Committee staff (August 9, 
2002).
---------------------------------------------------------------------------
    SEC staff's review of Enron's 1997 Form 10-K was a 
financial review--that is, it looked only at the financial 
statements, notes and MD&A--and it was undertaken in connection 
with the SEC's consideration of a proposed initial public 
offering by two Enron affiliates.\115\ SEC staff also reviewed 
Enron's two Forms 10-Q that were filed during the pendency of 
this review. The review of the 1997 Form 10-K raised 15 
comments, covering an array of subjects. Two of the comments 
focused on Enron's description of market risk for its trading 
business, a particular focus of SEC's reviews at the time, as 
the Commission had recently changed its rules to require 
greater disclosure on this topic.\116\ Another addressed 
whether certain oil and gas exploration costs were properly 
classified as a cost associated with investing cash flows 
rather than operating cash flows.\117\ Even in hindsight, 
however, these comments address little that is directly 
relevant to the fraudulent practices that have since been 
revealed.\118\ After further communications between Commission 
staff and Enron, the company eventually agreed to address the 
SEC's concerns in its future filings; the review was completed 
in February 1999.\119\
---------------------------------------------------------------------------
    \115\ SEC Response at 5, 10. The affiliates were Enron 
International Corp. CPO LP and its wholly owned subsidiary Enron 
International Corp. CPO, Inc. (collectively, ECPO). The proposed IPO 
was ultimately abandoned by Enron in a decision the company attributed 
to changed market circumstances. SEC Response at 60-61.
    \116\ See Regulation S-K, Item 305, 17 C.F.R Sec. 229.305.
    \117\ Letter from H. Roger Schwall, Assistant Director, Division of 
Corporation Finance, SEC, to Robert G. Gay, Enron International CPO, 
L.P., dated September 16, 1998; see also Letter from H. Roger Schwall 
to Rex R. Rogers, Vice President and Associate General Counsel, Enron 
Corp., dated January 26, 1999 (following up on cash flow issue).
    \118\ As noted, the review of the 1997 10-K was done in connection 
with a review of the proposed IPO by the Enron affiliate ECPO; the 1997 
10-K of another Enron subsidiary, Enron Oil & Gas Company, was also 
reviewed as part of this process. SEC Response at 60. Commission staff 
responded to the ECPO filing with 103 comments and the Enron Oil & Gas 
filing with 20 comments (Enron never addressed the former because, as 
noted above, the IPO was ultimately abandoned). See Letter from H. 
Roger Schwall, Assistant Director, Division of Corporation Finance, 
SEC, to Robert G. Gay, Enron International CPO, L.P., dated September 
16, 1998. Although a handful of the SEC staff's comments on the ECPO 
registration statement relate broadly to themes that would later appear 
with Enron's collapse--including nonconsolidation of affiliated 
entities and conflicts of interest--those themes manifested themselves 
in the ECPO filing in ways largely unrelated to their later appearance 
in Enron's dubious accounting. Thus, for example, the conflicts of 
interest that are the subject of SEC staff comments in the ECPO filing 
have to do with the possibility that, in offering certain business 
opportunities, Enron might be required to give preference to a certain 
other Enron affiliate over ECPO--troubling, perhaps, but not the sort 
of related-party transactions involving the enrichment of Enron 
insiders that have been the focus of much of the subsequent Enron 
revelations about conflicts of interest.
    \119\ SEC staff issued its comment letter to Enron on September 16, 
1998. Enron had not responded to this letter by January 12, 1999, when 
it filed a registration statement for the sale of securities on Form S-
3. SEC staff indicated that the Form S-3 would not become effective 
until the comments raised were satisfactorily resolved. Enron then 
responded by letter dated January 14, 1999. After a subsequent exchange 
of correspondence, SEC staff concluded its review. SEC Response at 10.
---------------------------------------------------------------------------
    None of Enron's subsequently filed Forms 10-K (i.e., those 
from 1998, 1999 and 2000) were reviewed by SEC staff. The SEC 
has indicated that, in response to concerns raised in the press 
about Enron's accounting for derivatives and Enron's general 
lack of clarity in its reporting, it flagged Enron's next 
scheduled annual report--its 2001 Form 10-K--for review.\120\ 
This annual report was due to be filed April 1, 2002; because 
of Enron's collapse, it was never submitted.
---------------------------------------------------------------------------
    \120\ SEC Response at 18. The 2001 10-K, the SEC notes, would have 
been the first annual filing to reflect a new accounting pronouncement 
on audited derivative disclosures (FASB Statement No. 133, Accounting 
for Derivative Instruments and Hedging Activities).
---------------------------------------------------------------------------
    As discussed in the earlier section on the SEC's methods of 
operations, the SEC's lack of scrutiny of Enron's financial 
statements was not in and of itself unusual. Nevertheless, the 
Commission's experience in reviewing (or not reviewing) Enron's 
periodic filings raises four distinct sets of concerns, each of 
which calls into question the wisdom of the SEC's previously 
existing practice of not regularly examining large companies' 
annual reports.
    First, the fact that the SEC did not review Enron's post-
1997 financial statements--and indeed reviewed relatively few 
companies' annual reports at all during this time period--is 
troubling in part because of the backdrop against which these 
cutbacks in reviews took place. By the late 1990's, the 
vulnerabilities in the private portion of the public-private 
system of checks on financial malfeasance were becoming quite 
apparent. In fact, as noted above, the SEC was well aware of 
the burgeoning breakdown, signaled by such trends as the 
increasing number of financial restatements filed with the 
Commission. Indeed, in 1998, the SEC's Chairman had warned of 
the declining quality of financial reporting and voiced his 
belief that ``almost everyone in the financial community''--
management, analysts, boards of directors, auditors--``shares 
responsibility for fostering a climate'' in which this was 
so.\121\ Specific concerns about the potential conflicts faced 
by auditors, moreover, had led the SEC to propose significantly 
tightening the rules on auditor independence. Faced with 
increasing indications of the inadequacy of the private 
watchdogs, the SEC took some modest measures, such as the 
creation of an ``earnings management task force'' that was set 
up to pull out and review those companies' public filings that 
had certain indicia of active ``earnings management.'' \122\ 
For the most part, however, the Commission's processes remained 
unchanged just when additional efforts from government 
regulators--the other half of the public-private system of 
oversight--were most needed.
---------------------------------------------------------------------------
    \121\ Levitt, ``The Numbers Game,'' at note 4 above.
    \122\ Committee staff interview with SEC staff, Division of 
Corporation Finance (June 25, 2002).
---------------------------------------------------------------------------
    Second, even within the existing review system, better 
screening perhaps should have led SEC staff to select Enron's 
later Forms 10-K for further review. Securities law experts 
with whom Committee staff spoke suggested a couple of factors 
that should have at least triggered the SEC's interest in these 
reports, including Enron's astonishingly rapid growth, among 
the fastest of U.S. companies, and the significant change in 
the nature of its business (from energy to trading)--facts 
available from both press reports and the filings 
themselves.\123\ The sheer number of Enron-related entities--
Enron's 2000 Form 10-K lists over 50 pages of affiliates, many 
of which were not consolidated onto Enron's balance sheets--
perhaps also should have raised suspicions, if only because it 
suggests the possibility that the information in the company's 
public filings and consolidated on its financial statements did 
not reflect the full scope of its business dealings.\124\ 
Notwithstanding these facts, the SEC's selective review process 
did not identify Enron's later annual reports, including its 
2000 report, as worthy of review. One reason for this was that, 
under the Commission's priority system, Enron was not ``due'' 
to have its annual report reviewed until 2002. As noted, the 
SEC's goal was to review a company's 10-K once every 3 years. 
The SEC staff calculates this 3-year period from the time the 
last review was completed. Thus, the SEC's review of Enron's 
1997 Form 10-K having been finished in February 1999 (along 
with a review of the intervening 10-Qs), no further review was 
called for before Enron's bankruptcy in December 2001. Even 
apart from this timing, however, the SEC staff confirmed that 
Enron's 2000 Form 10-K would not have been flagged for review 
under their remaining screening criteria.\125\
---------------------------------------------------------------------------
    \123\ Committee staff interview with James D. Cox, Brainerd Currie 
Professor of Law, Duke University (June 13, 2002); Committee staff 
interview with Joel Seligman, Dean and Ethan A. H. Shepley University 
Professor, Washington University School of Law (June 3, 2001).
    \124\ See Enron 2000 Form 10-K, Exhibit 21. Notably, the extent of 
Enron's off-balance sheet entities (and the concomitant complexity of 
Enron's filings) led at least one large institutional investor to 
eschew investments in Enron in its actively managed portfolio as early 
as 1998. Committee staff interview with Scott Budde, Director, Equity 
Portfolio Analytics, TIAA-CREF (July 26, 2002).
    \125\ This is confirmed by the handling of Enron's transactional 
filings. Over the last few years, Enron submitted several registration 
statements for the sale of securities to the Commission, none of which 
were selected for full or financial reviews, despite the fact that all 
necessarily went through the screening process. Because the screening 
criteria for transactional filings are similar to (in fact, more 
inclusive than) those for periodic filings but do not include any time-
from-last review factor, it follows (as SEC staff explained to 
Committee staff) that if these transactional filings were not selected 
for review, it is likely that neither would the Forms 10-K that were 
filed close in time to them. Committee staff interview with SEC staff, 
Division of Corporation Finance (June 25, 2002).
      Late in the process, Commission staff did identify Enron as a 
company warranting further scrutiny, with the Corporation Finance 
Division determining in August 2001 that press reports about Enron's 
accounting merited checking out Enron's filings the following year. SEC 
Response at 18. At approximately the same time, staff in the SEC's Fort 
Worth office opened an informal investigation (a so-called ``matter 
under inquiry'') into Enron in the wake of these press reports as well 
as the sudden resignation of Enron's CEO, Jeffrey Skilling; as part of 
that investigation, Fort Worth staff took an initial look at Enron's 
filings, including its most recently filed annual report, the 2000 Form 
10-K. Committee staff interview with SEC staff, Division of Enforcement 
(May 7, 2002), and Office of Legislative Affairs (July 24, 2002). See 
also Alexei Barrionuevo and Jonathan Weil, ``Partner Warned Arthur 
Andersen on Enron Audit,'' The Wall Street Journal, May 9, 2002 
(reporting on the testimony of Spencer Barasch, Associate District 
Administrator of the SEC's Forth Worth office, concerning the 
initiation of the SEC's Enron investigation, at the obstruction of 
justice trial of Arthur Andersen); Tom Fowler, ``Enron's Woes Become 
Focus of Andersen Trial,'' Houston Chronicle, May 9, 2002 (same).
---------------------------------------------------------------------------
    Third, the fact that the SEC did not review Enron's later 
filings, particularly its 2000 Form 10-K, is of concern 
because, had it done so, there are a number of items that are 
likely to have led to questions by Commission staff and, 
perhaps, to the discovery of at least some of Enron's wrongful 
practices. The most notable of these, of course, is the now 
notorious footnote 16, which appeared in Enron's 2000 Form 10-
K--and, in somewhat different form in its 1999 Form 10-K as 
well.\126\ Footnote 16, which addresses ``related party 
transactions'' and runs for seven paragraphs in Enron's 2000 
Form 10-K, raises several issues.\127\ There was the inherent 
potential for conflicts of interests in such transactions; for 
this reason, every person whom Committee staff consulted 
(including SEC staff) agreed that such transactions are often a 
sign of trouble and generally merit further inquiry. In 
addition, footnote 16 makes oblique reference to a number of 
transactions that are themselves troubling--or would be if 
their details could be understood.\128\ Among these are the use 
of SPEs for purported hedging activities (which, as noted 
above, turned out not to be legitimate hedges at all) \129\ and 
the funding of these SPEs with Enron stock in exchange for a 
note receivable (the misaccounting for which led, as noted, to 
a $1 billion reduction in shareholder equity). There is also a 
particularly inscrutable reference to the sale of ``dark 
fiber,'' which, read with the benefit of subsequently disclosed 
information, turns out to involve the sale of an asset related 
to Enron's broadband business to a Fastow-controlled SPE at an 
inflated price.\130\
---------------------------------------------------------------------------
    \126\ See Enron Corp. Annual Report on Form 10-K for fiscal year 
ended December 31, 2000 (filed April 2, 2001), Item 14, Note 16 
(``Enron 2000 Form 10-K''); Enron Corp. Form 10-K for fiscal year ended 
December 31, 1999 (filed March 30, 2000), Item 14, Note 16. In the 2000 
10-K, footnote 16 references a long list of transactions with an 
unidentified ``related party'' (apparently LJM2, controlled by Enron 
CFO Andrew Fastow). Footnote 16 in the 1999 10-K discusses a more 
limited set of transactions, but identifies the related party entities 
involved (although not the individuals who control them): LJM and LJM2 
(both controlled by Fastow, identified only as ``a senior officer of 
Enron''), JEDI (whose limited partner, Chewco, was controlled by 
Michael Kopper, who reported to Fastow, and who is identified as an 
``officer of Enron''), and Whitewing, one of Enron's unconsolidated 
equity affiliates.
    \127\ See Appendix for the full text of footnote 16 as it appeared 
in Enron's 2000 Form 10-K.
    \128\ Footnote 16 is so lacking in significant information that it 
does not even name the related party involved in these transactions. 
One needs to closely read Enron's 2000 proxy statement to learn that 
the Enron ``senior officer'' referred to is its former CFO, Andrew 
Fastow. See Enron Corp. Definitive Proxy Statement (Schedule 14A) 
(filed March 27, 2001), at 29 (``Certain Transactions'').
    \129\ Among other things, footnote 16 states that, in connection 
with the hedging activity, Enron owed the SPEs ``premiums'' of $36 
million (no reason is given, but it turns out, as explained in the 
Powers Report, to be essentially a payment to Fastow). It goes on to 
say that ``Enron recognized revenues of approximately $500 million 
related to the subsequent change in the market value of these 
derivatives, which offset market value changes in certain merchant 
investments and price risk management activities,'' although it does 
not specify how the SPE would cover the $500 million loss exposure 
(with Enron's own stock, as it turns out). See Bratton, at note above, 
at 40.
    \130\ The relevant passage reads in full: ``In 2000, Enron sold a 
portion of its dark fiber inventory to the Related Party in exchange 
for $30 million cash and a $70 million note receivable that was 
subsequently repaid. Enron recognized gross margin of $67 million on 
the sale.'' Enron apparently was able to sell the ``related party'' an 
asset worth $33 million for $100 million--a deal, it turns out, the 
related party was willing to enter into because Enron had promised to 
make the investors in the SPE whole if the asset declined in value. 
(``Dark fiber'' refers to the right to transmit data over fiber-optic 
cables that are not yet ready to transmit internet data, but would 
possibly be so in the future--an asset difficult to value). See The 
Fall of Enron: How Could It Have Happened, Hearing Before the Senate 
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-376 (January 
24, 2002) at 115 (Statement of Frank Partnoy, Professor, University of 
San Diego School of Law).
---------------------------------------------------------------------------
    Beyond footnote 16, experts whom Committee staff consulted 
identified several other items in Enron's 2000 Form 10-K that 
might cause a reviewer to take a closer look. These include, in 
footnote 9, a list of unconsolidated equity affiliates in which 
Enron's interest was at or near 50 percent--just below the 
threshold for having to consolidate these entities on Enron's 
balance sheet.\131\ This fact, coupled with indications that 
Enron was providing substantial amounts of money to these 
entities, raises questions about the independence of these 
entities and, by extension, the purposes for which they were 
being used.\132\ Also noted was a reference in the MD&A to the 
contingent liabilities that ultimately were disclosed more 
fully by Enron in November 2001.\133\ The relevant passage 
states ``Enron is a party to certain financial contracts which 
contain provisions for early settlement in the event of a 
significant market price decline in which Enron's common stock 
falls below certain levels (prices ranging from $28.20 to 
$55.00 per share) or if the credit ratings for Enron's 
unsecured, senior long-term debt obligations fall below 
investment grade,'' \134\ but offers no indication of the 
magnitude of these liabilities--a whopping $4 billion. Finally, 
as one of the Committee's witnesses testified, there was 
another ``flashing red light'' in the 2000 Form 10-K, a 
notation by Enron in its discussion of risk management, that it 
had recently ``refined'' its value at risk model (a 
sophisticated and complex way of estimating its exposure in its 
trading operations) ``to more closely correlate with the 
valuation methodologies used for merchant activities'' \135\--a 
``refinement'' that raises troubling concerns that the previous 
model may have come up with unacceptable high risk values.\136\ 
None of these items (and this list is not intended to be 
exhaustive), in and of itself, is necessarily an indication of 
fraud, but each might well lead a reviewer to probe further 
into Enron's complexities. By not reviewing Enron's last three 
Forms 10-K--or any of its recent registration statements, which 
incorporated much of this information--the SEC missed potential 
opportunities to identify serious problems before the house of 
cards fell.\137\
---------------------------------------------------------------------------
    \131\ Enron 2000 Form 10-K, Item 14, Note 9. ``Unconsolidated 
equity affiliates'' refers to companies in which Enron owned at least 
some, but not more than 50 percent, of the company's stock. If Enron 
had over a 50 percent interest in a company, the assets and liabilities 
of the company would have to be included on Enron's own balance sheet--
i.e., ``consolidated.'' By maintaining an interest at 50 percent or 
below, Enron (though perhaps owning a sufficient share to effectively 
control these companies), was able to avoid including such information 
on its financial statements. According to at least one expert, having a 
large number of such entities, with little disclosure about them in 
Enron's public filings, at least raises the possibility that Enron was 
deliberately structuring them so as to keep certain information off its 
own financial statements. Committee staff interview with April Klein, 
Associate Professor of Accounting, New York University Leonard N. Stern 
School of Business (June 26, 2002).
    \132\ See Bratton, note 81 above, at 46 (noting, for example, that 
of Enron's $23.4 billion of assets reported on its balance sheet, $5.3 
billion, or 22.6 percent, represented investments in these 
unconsolidated equity affiliates); Committee staff interview with April 
Klein (June 26, 2002) (observing that Enron appeared to be loaning a 
substantial portion of its income to these entities and that it had 
recognized significant revenues from its transactions with these 
entities); Enron 2000 Form 10-K, Item 14, Note 9.
    \133\ See Enron Corp. Form 10-Q for quarter ended September 30, 
2001 (filed November 19, 2001), Part I, Item 2, at 66; Committee staff 
interview with William W. Bratton, Samuel Tyler Research Professor of 
Law, George Washington University Law School (June 19, 2002).
    \134\ Enron 2000 Form 10-K, Item 7, Capitalization.
    \135\ Enron 2000 Form 10-K, Item 7A, Value at Risk, note (c) to 
table. A value at risk model is one of three ways by which the SEC 
permits companies to disclose their market risk. Committee staff 
interview with SEC staff, Division of Corporation Finance (April 24, 
2002); see SEC Regulation S-K, Item 305, 17 C.F.R. Sec. 229.305.
    \136\ The Fall of Enron: How Could It Have Happened, Hearing Before 
the Senate Governmental Affairs Committee, 107th Cong., S. Hrg. 107-376 
(January 24, 2002) at 127. (Statement of Frank Partnoy, Professor, 
University of San Diego School of Law).
    \137\ This is not to suggest that merely by reviewing Enron's 2000 
10-K, the SEC might have averted Enron's collapse. Enron's 2000 10-K 
was filed on April 2, 2001. Allowing the SEC staff time to initiate and 
conduct a review in accordance with its ordinary timetables, it is 
unlikely that any revelations its review brought about would have come 
early enough to do more than hasten Enron's demise. Nonetheless, more 
routine reviews of Enron's filings over a course of years would likely 
have put the SEC in a better position to identify and address budding 
problems.
---------------------------------------------------------------------------
    The final concern highlighted by the SEC's review of 
Enron's public filings is the constrained nature of those 
reviews and their limited power to detect serious wrongdoing. 
For example, we now know from Enron's announced restatements 
and the Powers Report that although the most egregious 
practices appear to have occurred from 1999 on, Enron's 
financial statements back to at least 1997 contained 
inaccurate, and likely fraudulent, information.\138\ Yet the 
SEC's review of the 1997 Form 10-K did not--indeed, given that 
such reviews are not intended to re-audit the company's 
numbers, could not be expected to--identify such problems, 
which included the initial, improper structuring of certain 
unconsolidated SPEs. One accounting expert with whom Committee 
staff spoke described Enron's 1997 Form 10-K as ``murky'' but 
found no facial indicia of fraud in the filing, which mentioned 
neither related-party transactions nor SPEs.\139\ Even in 
Enron's 2000 Form 10-K, which contained some warning signs 
about some of the wrongful practices, much of the fraud was 
hidden--in off-balance sheet entities or inflated valuations--
in ways that could not be detected by a mere review of the 
filing. To uncover such fraud requires a considerably more in-
depth audit than the SEC has thus far been equipped or oriented 
to do.
---------------------------------------------------------------------------
    \138\ One recent report suggests that Enron's use of SPEs to 
improperly keep debt off the company's balance sheet may have begun as 
far back as the early 1990's. See John R. Emshwiller, ``Enron May Have 
Started Earlier On Its Off-Balance-Sheet Deals,'' The Wall Street 
Journal, September 30, 2002.
    \139\ Committee staff interview with April Klein, Associate 
Professor of Accounting, New York University Leonard N. Stern School of 
Business (June 26, 2002). It is possible that if the SEC had diligently 
insisted on the clarification of all instances of murkiness in Enron's 
disclosures, it may have affected Enron's future practices, even if it 
did not uncover fraud. It can be argued that, if Enron and its auditor 
had believed that the SEC would insist on full, clear disclosures in 
its financial statement, it would have been deterred from engaging in 
the worst of its practices, the details of which it would have been 
loath to disclose. Moreover, the murkiness of Enron's filings itself--
which only became worse with time--should likely have been a signal to 
the SEC that further inquiry was necessary.
---------------------------------------------------------------------------

    2. Enron's Shift to Mark-to-Market Accounting

    By letter dated June 11, 1991, Enron notified the SEC's 
Office of Chief Accountant of its intent to use ``mark-to-
market'' accounting to record the natural gas trades of its 
newly formed subsidiary, Enron Gas Services (EGS).\140\ Using 
mark-to-market accounting meant that when EGS entered into a 
natural gas contract, \141\ it would book the present value of 
all future profits from that contract at the time the contract 
was signed, in contrast to traditional accounting methods that 
would have required that the company spread out the recognition 
of revenue over the life of the contract. Any changes in the 
value of the contract once it had been recorded on EGS's 
books--and the contracts were required to be revalued 
quarterly--would, under mark-to-market principles, be reflected 
as subsequent increases or decreases in revenue on the 
company's income statement.\142\ EGS's accounting, moreover, 
would carry over onto Enron's consolidated balance sheet.
---------------------------------------------------------------------------
    \140\ Enron Gas Services, which engaged primarily in gas trading 
activities (including gas derivatives), later became Enron Capital and 
Trade Resources Corp., which in turn became Enron North America. At the 
time this request was made, EGS's CEO was Jeffrey Skilling.
    \141\ Only some of EGS's contracts involved the actual, physical 
delivery of natural gas; the rest involved derivatives and other 
financial instruments sold as a means of purported price risk 
management.
    \142\ Alternatively, gains and losses may be recorded in a separate 
account on the balance sheet rather than reported on the income 
statement, thus having no immediate effect on reported revenue or 
profits. This is a more conservative treatment, and according to 
experts with whom Committee staff spoke, a more appropriate one when a 
contract's value is not easily susceptible to objective measure. 
Committee staff interview with April Klein, Associate Professor of 
Accounting, New York University Leonard N. Stern School of Business 
(June 26, 2002); Committee staff interview with Bala G. Dharan, J. 
Howard Creekmore Professor of Management, Graduate School of 
Management, Rice University (August 1, 2002); see also Lessons Learned 
From Enron's Collapse: Auditing the Accounting Industry, Hearing Before 
the House of Representatives Energy and Commerce Committee, 107th 
Cong., Hrg. No. 107-83 (February 6, 2002) at 95 (Statement of Bala G. 
Dharan).
---------------------------------------------------------------------------
    Enron sought a so-called ``no-objection'' letter from SEC 
staff. Such a letter would tell Enron that SEC staff would not 
object to Enron's proposed change in accounting. At the time 
Enron requested the no-objection letter, it was unusual for 
pipeline companies or others outside the financial industry to 
use mark-to-market accounting. Enron, however, argued that EGS 
was essentially a commodity trading business and that mark-to-
market accounting was common in such businesses. In its request 
to the SEC, moreover, Enron included a letter from Arthur 
Andersen to the effect that such accounting was the preferable 
method to use in these circumstances. Enron also included a 
letter from Ernst & Young indicating that the treatment was 
consistent with GAAP.\143\
---------------------------------------------------------------------------
    \143\ Letter from Jack I. Tompkins, Senior Vice President and Chief 
Financial Officer, Enron Corp. and George W. Posey, Vice President 
Finance and Accounting, Enron Gas Services to George H. Diacont, Acting 
Chief Accountant, Office of the Chief Accountant, Securities and 
Exchange Commission, and Robert Bayless, Associate Director (Chief 
Accountant), Division of Corporation Finance, Securities and Exchange 
Commission, dated June 11, 1991 (letters from Arthur Andersen and Ernst 
& Young attached as Exhibits I and II, respectively).
---------------------------------------------------------------------------
    Over the course of the next several months, at least eight 
letters, as well as additional phone calls, were exchanged 
between SEC staff and Enron, and Enron representatives 
(including Jeffrey Skilling) met with SEC staff twice. Staff in 
the Office of Chief Accountant posed a number of questions, 
including how comparable businesses did their accounting, how 
mark-to-market results would be calculated, and how such 
accounting would interact with the accounting of Enron's non-
trading subsidiaries.\144\ In addition, at one point, SEC staff 
apparently suggested that Enron consider supplemental 
disclosure of mark-to-market results (that is, in addition to 
its traditional accounting) until it got a better sense of the 
reliability of the supporting measurements. Enron resisted, 
asserting that the mark-to-market earnings would be calculated 
based on ``known spreads and balanced positions'' and that the 
reliability of the measurements would not be ``significantly 
dependent on subjective elements.'' \145\
---------------------------------------------------------------------------
    \144\ See SEC Response at 76-81.
    \145\ Letter from Jack I. Tompkins, Senior Vice President and Chief 
Financial Officer, Enron Corp. and George W. Posey, Vice President 
Finance and Accounting, Enron Gas Services, to John W. Albert, 
Associate Chief Accountant, Office of the Chief Accountant, Securities 
and Exchange Commission, dated July 29, 1991.
---------------------------------------------------------------------------
    Ultimately, the Office of Chief Accountant sent the 
requested no-objection letter to Enron on January 30, 1992, 
indicating that it would not object to the proposed change in 
accounting method beginning in the first quarter of fiscal year 
1992.\146\ By letter dated February 11, 1992, Enron replied 
that ``upon further review,'' it had decided that the ``most 
appropriate period for adoption of mark-to-market accounting'' 
was the beginning of 1991--a year earlier than the SEC had 
approved--and represented that the impact on 1991 earnings was 
not material.\147\ Apparently, the SEC did not respond further 
to this correspondence and Enron went ahead and reported EGS's 
1991 financial information using the mark-to-market 
method.\148\
---------------------------------------------------------------------------
    \146\ Letter from Walter P. Schuetze, Chief Accountant, Securities 
and Exchange Commission, to Jack I. Tompkins, Senior Vice President and 
Chief Financial Officer, Enron Corp., dated January 30, 1992.
    \147\ Letter from Jack I. Tompkins, Senior Vice President and Chief 
Financial Officer, Enron Corp., to Walter P. Schuetze, Chief 
Accountant, Securities and Exchange Commission, dated February 11, 
1992.
    \148\ According to one press account, Enron's representation that 
its use of mark-to-market accounting for its 1991 financial statements 
would not have a material impact on earnings was false. The account 
quotes unnamed former Enron employees as saying that Enron signed two 
large natural gas supply contracts in the latter half of 1991 and used 
mark-to-market accounting for those contracts to significantly boost 
Enron's revenues for the last two quarters of the year. This enabled 
Enron to show increased earnings over the same periods in the previous 
year. Barbara Shook, ``Enron Missteps Began In 1991; Aggressive 
Accounting Blamed,'' Natural Gas Week, January 28, 2002. See also 
``Origin of Questionable Enron Accounts,'' World Gas Intelligence, 
January 18, 2002.
---------------------------------------------------------------------------
    At the time EGS changed its accounting methods, the switch 
to mark-to-market accounting was unusual and was seen by many 
as an aggressive move.\149\ Mark-to-market accounting has since 
become common in the energy trading industry.\150\ In fact, the 
experts with whom Committee staff spoke did not raise any 
general objections to the use of mark-to-market accounting and 
suggested that, at least as a theoretical matter, mark-to-
market accounting was often a preferable method of accounting, 
because, applied correctly, it can enable investors to see more 
accurately the current value of a company's assets.\151\
---------------------------------------------------------------------------
    \149\ See, e.g., Toni Mack, ``Hidden Risks,'' Forbes, May 24, 1993 
(warning that if something major happened to impair the value of the 
contracts that Enron was marking to market, the company could be forced 
to book losses, and that by accelerating income, Enron would have to 
keep doing more and more deals to show the same or rising income); 
Harry Hurt III, ``Power Players,'' Fortune, August 5, 1996 (citing 
former employees as suggesting that mark-to-market accounting 
``simultaneously inflates current earnings and creates a `feeding 
frenzy' as executives scramble to make new deals to prop up future 
profits.'').
    \150\ Committee staff interview with Bala G. Dharan (August 1, 
2002); see FASB Statement No. 133, Accounting for Derivative 
Instruments and Hedging Activities (June 1998).
    \151\ See, e.g., Committee staff interview with Lynn Turner (June 
24, 2002); Committee staff interview with Bala G. Dharan (August 1, 
2002); see also Lessons Learned From Enron's Collapse: Auditing the 
Accounting Industry, Hearing Before the House of Representatives Energy 
and Commerce Committee, 107th Cong., Hrg. No. 107-83 (February 6, 2002) 
at 95 (Statement of Bala G. Dharan). This contrasts with historical 
cost accounting, a more traditional accounting method in which assets 
are recorded at their original cost without subsequent adjustments. SEC 
staff explained to Committee staff that awareness of the problems that 
arose from historical cost accounting in the Savings and Loan crisis of 
the late 1980's had, in fact, contributed to their decision to permit 
Enron to use mark-to-market accounting. The savings and loans, pursuant 
to historical cost accounting principles, had kept on their books at 
their original cost investments that thereafter declined substantially 
in value, thereby effectively shielding from the public the true state 
of their finances (under mark-to market accounting, these investments 
would have had to be revalued quarterly and the changes in value 
recorded on the company's financial statements). This practice had 
resulted in substantial criticism. Committee staff interview with SEC 
staff, Office of Chief Accountant (April 22, 2002).
---------------------------------------------------------------------------
    Mark-to-market accounting, however, is not without its 
problems--some significant. Most importantly, it was 
questionable whether Enron could accurately value these 
contracts at the time of signing. For short-term, standard form 
contracts, there is often a public market, such as the New York 
Mercantile Exchange, that can provide the necessary values. For 
longer-term or more complex trading contracts, there would 
likely not be market quotes available on which to base the 
values. Instead, Enron would use complex models to estimate the 
value of these contracts, making assumptions about an 
assortment of variables that could range from future gas prices 
to the pace of energy deregulation to trends in interest 
rates.\152\ The assumptions underlying these models were, in 
the best case, necessarily subjective and, in the worst, 
subject to deliberate manipulation.
---------------------------------------------------------------------------
    \152\ See Floyd Norris and Kurt Eichenwald, ``Fuzzy Rules of 
Accounting and Enron,'' The New York Times, January 30, 2002; Committee 
staff interview with Bala G. Dharan (August 1, 2002).
---------------------------------------------------------------------------
    The evidence suggests that Enron, at a minimum, 
overestimated and very possibly manipulated the values of the 
energy contracts it marked to market. Enron's misuse of mark-
to-market accounting has been most widely reported in 
connection with the activities of Enron Energy Services (EES), 
the company's retail energy subsidiary (Enron ultimately used 
mark-to-market accounting at subsidiaries beyond EGS). One 
former employee with whom Committee staff spoke described the 
arcane models and aggressive assumptions--often, according to 
this employee, different even from those employed by Enron's 
own Wholesale Services division--that were used to value the 
highly complex, long-term energy contracts that EES was 
marketing to major commercial customers.\153\ The incentives to 
be optimistic about the assumptions underlying the model, 
moreover, were present not only for Enron's executives, 
concerned about the next quarter's revenue numbers, but also 
for lower level employees whose bonuses were based on the full 
marked-to-market value of the deals they completed.\154\ As the 
deals came to maturity, however, the assumptions underlying the 
valuations in many cases proved incorrect and the contracts had 
to be revalued. By Spring 2001, Enron apparently would have had 
to report significant losses from these deals, had it not 
merged the commodity risk activities of EES with those of 
Enron's Wholesale Services group, effectively hiding these 
losses amid that group's substantially larger revenues and 
allowing the remaining part of EES to appear profitable.\155\
---------------------------------------------------------------------------
    \153\ Committee staff interview with Margaret Ceconi (February 1, 
2002). One press account lists a number of specific practices cited by 
former EES employees that were used to inflate the present value of EES 
contracts, including routinely underestimating commodities prices in 
the later years of a contract, quoting prices from highly illiquid 
markets that Enron dominated, and projecting unjustifiably high 
efficiency savings. Joshua Chafin, Stephen Fidler and Andrew Hill, 
``Enron: Virtual Company, Virtual Profits,'' Financial Times (London), 
February 4, 2002. Another press account describes similar practices at 
Enron North America, a subsidiary that engaged in wholesale energy 
trading, where a former manager on the trade desk alleged that the 
price curves (the expected direction of prices in the future) on which 
the deals were valued were set unreasonably high and then were moved 
even higher, often at the end of a quarter, in order to generate 
reported income. Michael Brick, ``What Was the Heart of Enron Keeps 
Shrinking,'' The New York Times, April 6, 2002. Enron Vice President of 
Corporate Development Sherron Watkins' now famous letter to Ken Lay 
warning of various improper accounting practices (primarily 
transactions related to the so-called Raptor SPEs) also mentions 
possible ``valuation issues'' in connection with EES's mark-to-market 
positions. Letter from Sherron Watkins to Kenneth Lay (August 2001), 
reprinted in The Financial Collapse of Enron, Hearing before the 
Subcommittee on Oversight and Investigations, House of Representatives 
Committee on Energy and Commerce, 107th Cong., Hrg. No. 107-89 
(February 14, 2002) at 119.
    \154\ Committee staff interview with Margaret Ceconi (February 1, 
2002); see also Laura Goldberg and Tom Fowler, ``The Myth of Enron,'' 
Houston Chronicle, January 27, 2002.
    \155\ Id. Notably, after filing for bankruptcy, Enron sought and 
received permission to abandon 700 EES contracts as ``burdensome to the 
estate.'' Motion of Enron Energy Services Operations, Inc., Enron 
Energy Services, Inc. and Enron Energy Marketing Corp. Pursuant to 
Section 365(a) of the Bankruptcy Code for Order Authorizing Debtors to 
Reject Certain Executory Contracts, In re Enron Corp., Case No. 01-
16034 (AJG) (Bankr. S.D.N.Y., December 21, 2001); Order Authorizing 
Rejection of Certain Executory Contracts, In re Enron Corp., Case No. 
01-16034 (AJG) (Bankr. S.D.N.Y., January 4, 2002); see ``Business Folly 
As Well As Financial Fraud,'' Gas Processors Report, February 11, 2002.
      Ceconi was sufficiently concerned about the transfer of EES 
losses to another subsidiary that she contacted the SEC to inquire if 
the accounting was permissible, e-mailing her question to the SEC's 
Office of Investor Education and Assistance in July 2001. In response, 
she received a phone call from a Commission employee. In neither her e-
mail nor her telephone conversation, however, did Ceconi reveal the 
company at issue. Only after the SEC's current investigation was 
underway and had been publicly announced, did Ceconi sent another e-
mail which expressly referred to Enron. Committee staff interview with 
Margaret Ceconi (February 1, 2002); SEC Response at 86.
---------------------------------------------------------------------------
    In permitting Enron to switch to mark-to-market accounting, 
SEC staff appeared to anticipate some of the problems that 
could arise when a company was allowed to estimate the present 
value of a long-term contract. Indeed, in its no-objection 
letter, the Office of the Chief Accountant explicitly 
conditioned its acceptance of Enron's change in accounting 
methods on the company's representations that it would value 
such contracts objectively.\156\ Once the conditions were set 
forth, however, the SEC itself had no procedures to ensure that 
the company complied with these conditions. The Division of 
Corporation Finance staff would have seen the Chief 
Accountant's no-objection determination if and when they 
reviewed Enron's filings, but the complex and detailed work of 
determining whether Enron was employing appropriate valuation 
models and that trading contracts were marked to market fairly 
would have been left to Enron's auditors. The SEC, by all 
indications, did not seek to ascertain whether the auditors in 
fact had validated the models used by the company.\157\
---------------------------------------------------------------------------
    \156\ Specifically, the Office of the Chief Accountant noted, among 
other things, Enron's representations that:
      LMarket values will be based on market prices to the extent such 
prices are available. Where derived values are used because market 
prices are not available, those values will be derived using a 
valuation model that uses objective data, such as actual bid and asked 
prices from transactions in the marketplace, to develop a value;
    and that
      LAllocation of the physical risk and price risk components (price 
risk being the element of the contract subject to mark-to-market 
measurement) is objectively verifiable by the independent auditors.
    Letter from Walter P. Schuetze, Chief Accountant, Securities and 
Exchange Commission, to Jack I. Tompkins, Senior Vice President and 
Chief Financial Officer, Enron Corp., dated January 30, 1992.
    \157\ The actual validation of the models used by Enron does appear 
to be a task that is best left in the first instance to the auditors; 
the large accounting firms typically have the expertise to design and 
evaluate such models. See Committee staff interview with Lynn Turner 
(June 24, 2002). Nonetheless, the SEC has an important role to play in 
assuring that such validation is taking place and, where appropriate, 
requiring documentation of how the models work. See Committee staff 
interview with Bala G. Dharan (August 1, 2002).
---------------------------------------------------------------------------
    Even without any investigation into particular contracts or 
computer models, however, Enron's public filings suggest both 
the magnitude and the subjectivity of the company's mark-to-
market valuations--something the SEC staff might well have 
noticed had they reviewed the filings and done so with an eye 
toward this issue. For the year 2000, Enron's unrealized 
trading gains--that is, the profits it expected to earn in 
future years--constituted over half the company's $1.41 billion 
originally reported pre-tax profit.\158\ Of the basis for the 
company's mark-to-market valuations, the Forms 10-K that Enron 
filed with the SEC for the years 1997 onward state that ``[t]he 
market prices used to value these transactions reflect 
management's best estimate considering various factors 
including closing exchange and over-the-counter quotations, 
time value and volatility factors underlying the commitments.'' 
\159\ Despite the opacity of this explanation as well as the 
relative size of the valuations at issue, and despite its 
initial concerns, the SEC did not attempt to look more closely 
at Enron's mark-to-market accounting methods, or at any point 
even seek to require Enron to amend this disclosure to go 
beyond the unhelpful information that this was management's 
``best estimate'' and clarify for investors any of the key 
assumptions it was relying on in valuing the transactions for 
its financial statements.\160\ The SEC's failure to follow up 
on its initial accounting determination (and the concerns 
accompanying it) meant another lost opportunity to identify 
(and potentially mitigate) some of the accounting abuses 
perpetrated by Enron.
---------------------------------------------------------------------------
    \158\ Jonathan Weil, ``After Enron `Mark to Market' Accounting Gets 
Scrutiny,'' The Wall Street Journal, December 4, 2001. Enron's public 
financial statements do not separate out the precise amount of these 
unrealized gains, but a line item in its cash flow statement--
``additions and unrealized gains'' equal to almost $1.3 billion (though 
it may also include unrealized gains from other activities as well)--
suggests the magnitude. See Enron Corp. 2000 Form 10-K, Item 14, 
Consolidated Statement of Cash Flows; Committee staff interview with 
Bala G. Dharan (August 2000). Weil had first pointed out this issue a 
year earlier, noting that, without the inclusions of these unrealized, 
noncash gains, Enron would have in fact lost money in the second 
quarter of 2000. See Jonathan Weil, ``Energy Traders Cite Gains, But 
Some Math is Missing,'' The Wall Street Journal (Texas ed.), September 
20, 2000.
    \159\ Enron 2000 Form 10-K, Item 14, Note 1, Accounting for Price 
Risk Management; Enron 1999 Form 10-K, Item 14, Note 1, Accounting for 
Price Risk Management; Enron 1998 Form 10-K, Item 14, Note 1, 
Accounting for Price Risk Management; Enron 1997 Form 10-K, Item 14, 
Note 1, Accounting for Price Risk Management. Equally unhelpful is 
Enron's caveat that ``Judgment is necessarily required in interpreting 
market data and the use of different market assumptions or estimation 
methodologies may affect the fair value amounts.'' Enron 2000 Form 10-
K, Item 14, Note 3.
    \160\ Subsequently, the SEC has issued a statement urging companies 
to consider including additional disclosures in its financial 
statements concerning commodity contracts accounted for at fair value, 
but for which there is a lack of market price quotations. Commission 
Statement About Management's Discussion and Analysis of Financial 
Condition and Results of Operations, Release Nos. 33-8056, 34-45321, 67 
Fed. Reg. 3746 (January 25, 2002).
---------------------------------------------------------------------------

    3. Exemptions from the Public Utility Holding Company Act

    The Public Utility Holding Company Act of 1935 \161\ was 
passed to protect consumers and investors against abuses by the 
holding companies that then controlled a substantial portion of 
the country's gas and electric utilities. In the 1920's, many 
of these companies had developed complex, multistate pyramid 
structures that masked unsound financial practices, adversely 
affected the underlying utilities and their ratepayers, and 
made the companies less susceptible to State regulation.\162\ 
In response, PUHCA imposes a number of restrictions on public 
utility holding companies, defined as companies which directly 
or indirectly own 10 percent or more of a gas or electric 
public utility.\163\ These provisions require, among other 
things, that each registered holding company be limited to a 
single ``integrated public utility system'' that is 
geographically confined and physically interconnected; \164\ 
prohibit the ownership of nonutility businesses unless those 
businesses are ``reasonably incidental, or economically 
necessary or appropriate'' to the operations of the integrated 
public utility system; \165\ restrict transactions between 
holding company affiliates; \166\ and require SEC review of a 
holding company's issuance of securities \167\ or acquisition 
of securities or utility assets of another holding or public 
utility company.\168\ The SEC is charged with administering 
PUHCA, \169\ and companies that come within the definition of a 
public utility holding company must register with the SEC or 
apply for an exemption under the Act. As of March 4, 2002, 
there were 29 registered holding companies in the United States 
and 124 exempt holding companies.\170\
---------------------------------------------------------------------------
    \161\ 15 U.S.C. Sec. 79a et seq.
    \162\ See 15 U.S.C. Sec. 79a(b) (setting out factual basis for 
legislation).
    \163\ 15 U.S.C. Sec. 79b(a)(7).
    \164\ 15 U.S.C. Sec. 79k(b)(1).
    \165\ Id.
    \166\ 15 U.S.C. Sec. Sec. 79l and 79m.
    \167\ 15 U.S.C. Sec. Sec. 79f and 79g.
    \168\ 15 U.S.C. Sec. 79i and 79j.
    \169\ For the last 20 years, the SEC has advocated the repeal of 
PUHCA and the transfer of related responsibilities to the Federal 
Energy Regulatory Commission. See, e.g., Effects of Subtitle B of S. 
1766 to the Public Utility Holding Company Act, Hearing Before the 
Subcommittee on Securities, Senate Committee on Banking, Housing, and 
Urban Affairs 107th Cong., S. Hrg. 107-521 (February 6, 2002) at 7-16 
(Statement of the Honorable Isaac C. Hunt, Jr., SEC Commissioner); 
Public Utility Holding Company Act Amendments, Hearing Before the 
Subcommittee on Securities, Senate Committee on Banking, Housing, and 
Urban Affairs, 97th Cong., S. Hrg. 97-62 (June 8, 1982) at 359-421 
(Statement of SEC).
    \170\ SEC Response at 95 and n. 2. Of those companies that are 
public utility holdings companies but are exempt from registration, the 
majority have claimed an exemption because they are intrastate holding 
companies or because they are predominantly utility companies 
themselves and operate in a single State or States contiguous to that 
State. SEC Response at 95-96. In numerous other instances, companies 
have successfully sought determinations from the Commission or its 
staff that they did not come within the definition of a public utility 
holding company. SEC Response at 97, 108-16.
---------------------------------------------------------------------------
    Enron appears to have been aggressive in its efforts to 
ensure that the company would not be brought within the 
strictures of PUHCA. In the last 10 years, Enron and/or its 
subsidiaries on six occasions successfully either asserted that 
they were entitled to an exemption under the Act or sought 
determinations from SEC staff that the activities they intended 
to engage in would not bring them within the definition of a 
``public utility holding company.'' \171\ In addition, on five 
other occasions, Enron sought exemptions from the Commission or 
no-action letters from SEC staff, but no Commission or staff 
determination was reached because either Enron withdrew the 
request, the issue became moot, or the request is still 
pending.\172\ Questions have been raised publicly about two of 
these PUHCA determinations, \173\ and a third matter that is 
still pending poses some additional concerns. We will address 
each of these three matters in turn.\174\
---------------------------------------------------------------------------
    \171\ None of these required action by the Commission itself. On 
five of these occasions, Enron was issued a no-action letter by SEC 
staff. In the remaining case (involving Enron's Portland General 
Electric subsidiary, discussed below), the exemption was self-
executing--that is, Enron was able to claim the exemption by filing a 
form; in the absence of an objection by SEC staff, the exemption was 
effective.
    \172\ SEC Response at 131, 133-34. In a further PUHCA matter, Enron 
sought and received permission to include consolidating balance sheets 
for only its first-tier subsidiaries on the exemption form (Form U-3A-
2) it filed in connection with its claim for an intrastate exemption 
related to its Portland General Electric subsidiary. Id. at 131.
    \173\ See, e.g., Michael Schroeder, ``Accounting for Enron: SEC 
Feels Heat Over Exemptions to Enron,'' The Wall Street Journal, January 
21, 2002.
    \174\ The remaining four no-action requests that were granted were 
as follows:
    L  (1) a 1992 request concerning the sale and distribution of 
compressed natural gas for use in compressed natural gas vehicles. A 
no-action letter was sought on the grounds that this was not the type 
of activity contemplated by PUHCA and also that the cars constituted 
``portable containers'' equivalent to the portable cylinders of 
compressed natural gas that the SEC had exempted from PUHCA in other 
cases.
    L  (2) a 1993 request concerning an Enron affiliate that provided 
certain operation and maintenance services to an electric power plant 
in the Philippines. Enron sought a no-action letter based on PUHCA's 
exemption for foreign utility companies under section 33(a)(1) of 
PUHCA, 15 U.S.C. Sec. 79z-5b(a)(1).
    L  (3) a 1997 request by Enron Capital & Trade (the successor to 
Enron Gas Services) for a no-action letter in connection with retail 
energy activities (including hooking up individual consumers to the 
power grid and supplying electricity meters) that they believed might 
be beyond the scope of an earlier no-action letter given to EGS for 
Enron Power Marketing, Inc.'s power marketing activities, discussed 
below.
    L  (4) a 1999 request by Enron Federal Solutions for a no-action 
letter related to its proposal to own and operate electric, gas, water, 
and wastewater distribution systems at Fort Hamilton Military Base in 
Brooklyn. Enron asserted that an entity dedicated exclusively to 
provide services to the Federal Government was not the type of company 
PUHCA was intended to regulate.
      SEC staff characterized all but the last of these as routine.
---------------------------------------------------------------------------
    The first of these involved a request, in 1993, by Enron 
Power Marketing, Inc. (EPMI), a wholly owned subsidiary of 
Enron Gas Services, which was, in turn, a wholly owned 
subsidiary of Enron Corp. EPMI asked the SEC for a ``no-action 
letter''--that is, staff assurances that it would not recommend 
enforcement action--in connection with EPMI's power marketing 
activities. Although EPMI did not itself generate or transmit 
electricity, it proposed to engage in transactions such as 
purchasing and then reselling electricity. At issue was whether 
these activities made EPMI an ``electric utility company'' 
under Section 2(a)(3) of PUHCA. If so, Enron, as the parent of 
EPMI, would be considered a public utility holding company and 
subject to the restrictions of the Act.
    Enron first contacted the SEC about this issue on October 
19, 1993.\175\ At the time, Enron was one of a number of 
companies inquiring whether power marketing would subject them 
to the registration and other requirements of PUHCA.\176\ After 
speaking informally with the SEC staff and soliciting their 
advice as to how to proceed, Enron submitted for staff review a 
draft application for a declaratory order from the Commission 
that power marketers were not ``utilities'' under the Act.\177\ 
For reasons that remain unclear, Enron did not proceed with 
this application. Instead, it chose to request a no-action 
letter from the SEC staff on this issue and subsequently 
submitted draft and then final versions of such a no-action 
request in December 1993.\178\ Enron was the first power 
marketer to request an exemption from PUHCA on these grounds. 
Without commenting on the issues raised, the SEC issued the no-
action letter on January 5, 1994; \179\ since that time, 20 
other companies have received similar no-action letters.\180\
---------------------------------------------------------------------------
    \175\ Enron contacted the SEC through its attorney, who sought 
advice from SEC staff at that point without revealing the client's 
name. Memorandum to Files from T.C. Havens, Reid & Priest, dated 
October 19, 1993 (Enron document numbers EC2 000032904-EC2 000032907).
    \176\ Committee staff interview with SEC staff, Division of 
Investment Management (July 2, 2002).
    \177\ Application Pursuant to Section 2(a)(3)(A) of the Public 
Utility Holding Company Act of 1935, as Amended, for an Order Declaring 
Enron Power Marketing, Inc. Not to be an Electric Utility, dated 
November 30, 1993 (Draft) (Enron document numbers EC2 000032908-EC2 
000032928).
    \178\ Letter from William T. Baker, Jr., Reid & Priest, to Kevin 
An, Office of Public Utility Regulation, Securities and Exchange 
Commission, dated December 22, 1993 (Enron document numbers EC2 
000032929-EC2 000032952) (enclosing draft no-action request); Letter 
from William T. Baker, Jr., Counsel for Enron Power Marketing, Inc., 
Reid & Priest, to William C. Weeden, Associate Director, Office of 
Public Utility Regulation, Division of Investment Management, 
Securities and Exchange Commission, dated December 28, 1993, available 
at 1994 SEC No-Act. LEXIS 42 (request for no-action determination).
    \179\ Enron Power Marketing, Inc., Ref. No. 94-1-OPUR, Response of 
the Office of Public Utility Regulation, Division of Investment 
Management, from S. Kevin An, Staff Attorney, dated January 5, 1994, 
available at 1994 SEC No-Act. LEXIS 42.
    \180\ SEC Response at 94. Subsequently, the Commission promulgated 
a rule permitting registered holding companies to engage in power 
marketing activities that implicitly recognizes that power marketing is 
a nonutility activity. See 17 C.F.R. Sec. 250.58.
---------------------------------------------------------------------------
    Section 2(a)(3) of PUHCA defines an ``electric utility 
company'' as ``any company which owns or operates facilities 
used for the generation, transmission, or distribution of 
electric energy for sale.'' \181\ As EPMI represented that it 
did not own generating plants, transmission lines or electric 
distribution systems, the resolution of this issue turned on 
whether the contracts, books, and records associated with the 
proposed power marketing activity constituted ``facilities'' 
for the generation, transmission, or distribution of 
electricity under the statute.\182\
---------------------------------------------------------------------------
    \181\ 15 U.S.C. Sec. 79b(a)(3).
    \182\ As is their practice, SEC staff noted in their no-action 
letter that it did not purport to express any legal conclusion on the 
questions presented. Nonetheless, SEC staff now notes that ``it would 
be logical to conclude'' that the staff did not regard Enron's 
contracts and associated books and records to be ``facilities'' as 
defined in the Act and consequently concluded that power marketers were 
not ``electric utilities'' within the meaning of the Act. SEC Response 
at 94.
---------------------------------------------------------------------------
    Interestingly, some years before, the Federal Energy 
Regulatory Commission (FERC) had been faced with a similar 
question about the definition of ``facilities' under the 
Federal Power Act (FPA), \183\ a companion statute to PUHCA 
that is administered by FERC. In that case, FERC held that a 
power marketer's contracts, books, etc. were facilities under 
the FPA and that those who bought and resold electricity were 
subject to FERC's jurisdiction under the Act as utilities, even 
if they did not own traditional transmission facilities.\184\
---------------------------------------------------------------------------
    \183\ 16 U.S.C. Sec. 791a et seq.
    \184\ Citizens Energy Corporation, 35 F.E.R.C. 61,198 (1986) 
(reasoning that, among other things, a contrary decision would have 
left FERC ``without any other party over whom to assert authority with 
respect to what are clearly wholesale sales . . . in interstate 
commerce''); see 16 U.S.C. Sec. 824(b) (providing that FERC ``shall 
have jurisdiction over all facilities for such transmission or sale of 
electric energy'').
---------------------------------------------------------------------------
    At the time of its no-action request, Enron argued, and the 
SEC has since explained in its response to the Committee, that 
a contrary ruling would have effectively prohibited companies 
from creating power marketing subsidiaries as it would be 
virtually impossible for such companies to then comply with 
PUHCA's requirement for an integrated system operating in a 
single geographic area, because ``power marketing by its nature 
tends to be a nationwide activity that does not rely on 
specific, in-place assets.'' \185\ Power marketers could thus 
presumably exist only as free-standing companies, not as 
subsidiaries of holding companies. In addition, both Enron and 
the SEC have pointed to the different statutory purposes 
underlying PUHCA and the FPA and have further argued that 
precisely because FERC had asserted jurisdiction over power 
marketers, there was no danger that excluding such activities 
from PUHCA's requirements would leave them unregulated.\186\ 
Although it is possible to disagree with the SEC staff's 
reasoning, it does not appear to Committee staff that the 
conclusion they reached was insupportable.
---------------------------------------------------------------------------
    \185\ SEC Response at 94; see also Enron request for no-action 
determination, note 178 above.
    \186\ Committee staff interview with SEC staff, Division of 
Investment Management (July 2, 2002); Enron request for no-action 
determination, note 178 above.
---------------------------------------------------------------------------
    The second issue that has received a fair amount of public 
attention is Enron's claim under PUHCA Rule 2 of an exemption 
from PUHCA as an intrastate holding company when it acquired 
Portland General Electric (PGE) in 1997. Rule 2 implements 
Section 3(a)(1) of PUHCA, which provides that the SEC is to 
exempt a holding company if it and each of its subsidiary 
public utility companies ``are predominantly intrastate in 
character and carry on their business substantially in a single 
State in which such holding company and every such subsidiary 
company thereof are organized.'' \187\ The SEC has interpreted 
this provision to mean that when a holding company and each of 
its public utilities (as that term is defined in the statute) 
are located in one State, the holding company is exempt from 
PUHCA. A company that meets this requirement is not required to 
formally apply for an exemption or request a no-action letter. 
Rather, it need only file a form claiming the exemption; the 
exemption is effective unless the Commission notifies the 
company that it has questions.
---------------------------------------------------------------------------
    \187\ 15 U.S.C. Sec. 79c(a)(1).
---------------------------------------------------------------------------
    When Enron acquired PGE, it re-incorporated in Oregon (it 
had previously been a Delaware corporation). As PGE, too, was 
incorporated in Oregon and was the only Enron subsidiary that 
was considered a ``public utility,'' Enron was clearly eligible 
for this exemption under governing SEC interpretation. Although 
some have raised questions about the SEC's interpretation of 
the intrastate provisions of Section 3(a)(1) \188\--and other 
interpretations are clearly possible and perhaps more 
intuitive--the Commission's approach, first set forth in 1937, 
\189\ is well-established and the Commission's response to 
Enron's application was consistent with this precedent.
---------------------------------------------------------------------------
    \188\ See, e.g., Effects of Subtitle B of S. 1766 to the Public 
Utility Holding Company Act, Hearing Before the Senate Committee on 
Energy and Natural Resources, 107th Cong., S. Hrg. 107-521 (February 6, 
2002) at 41-62 (Statement of Scott Hempling, Attorney at Law). Hempling 
argues that Enron does not meet the literal requirements of the section 
3(a)(1) exemption because its business operations are not 
``predominantly intrastate in character'' and its worldwide business is 
not carried on ``substantially in a single State.'' Alternatively, he 
suggests that SEC should have found Enron's exemption to be 
``detrimental to the public interest'' under section (3)(a) of the Act, 
15 U.S.C. Sec. 79c(a).
    \189\ See In the Matter of Southeastern Indiana Corp., 2 SEC 156 
(1937) (holding that as long as the public utility business of a 
holding company's subsidiaries was confined to one State, the company 
could engage in non-utility activities in other States without losing 
its PUHCA exemption).
---------------------------------------------------------------------------
    Had the SEC in these cases not found Enron exempt from 
PUHCA, and the stringent requirements of PUHCA in fact been 
applied to Enron, it would theoretically have had a substantial 
effect on Enron's operations. Enron, for example, presumably 
would not have been able to own and operate a power marketing 
company, or to own other businesses that were not ``reasonably 
incidental, or economically necessary or appropriate to the 
operations'' of its public utility company, and it may have 
been subject to greater restrictions in issuing securities or 
engage in transactions among its affiliates. Indeed, had Enron 
otherwise failed to take action to remove itself from PUHCA 
jurisdiction, it could potentially have been subject to SEC 
efforts to simplify its structure. For this reason, however, it 
is also reasonable to expect that Enron, had the SEC made 
different determinations, would have gone to some lengths to 
restructure its business to avoid coming within PUHCA's 
restrictions.
    In the remaining PUHCA matter, Enron filed an application 
with the SEC on April 14, 2000, for an exemption under section 
3(a)(3) or, in the alternative, section 3(a)(5) of PUHCA. These 
provisions specify that the Commission may exempt from the 
requirements of PUHCA a company that is only ``incidentally'' a 
public utility holding company and is primarily engaged in 
other businesses \190\ or a company that ``derives no material 
part of its income'' from companies the principal business of 
which is that of a public utility company.\191\ From an SEC 
perspective, this request was unnecessary--as described above, 
Enron was already exempt from PUHCA under section 3(a)(1), the 
intrastate exemption provision. Nonetheless, Enron sought this 
exemption because doing so provided it with certain benefits 
before FERC.
---------------------------------------------------------------------------
    \190\ 15 U.S.C. Sec. 79c(a)(3).
    \191\ 15 U.S.C. Sec. 79c(a)(5).
---------------------------------------------------------------------------
    Specifically, at about the same time that it was applying 
for this PUHCA exemption, Enron was in the process of 
repurchasing its interest in certain windfarms from, among 
others, an entity (RADR) allegedly controlled by Enron 
executives Andrew Fastow and Michael Kopper, to which Enron had 
sold a 50 percent interest in these windfarms in 1997. Under 
the Public Utilities Regulatory Policies Act of 1978 (PURPA), 
administered by FERC, and its associated implementing 
regulations, the windfarms were potentially ``qualifying 
facilities'' (QFs) that were eligible for certain economic 
benefits--but only if they were no more than 50 percent owned 
by a public utility or its holding company.\192\ Because Enron 
owned a public utility (PGE), if it owned more than a 50 
percent interest in the windfarms--which it proposed to do by 
buying out RADR's and others' interests--they would ordinarily 
not be eligible for QF status.\193\
---------------------------------------------------------------------------
    \192\ See 16 U.S.C. Sec. 796(18)(b); 18 C.F.R. Sec. 292.206(b).
    \193\ The desire to preserve the projects' QF status is apparently 
what led Enron initially to sell a 50 percent interest in the windfarms 
to RADR when it acquired PGE in 1997. The sale and repurchase of these 
interests and certain associated financial transactions (which is 
alleged to have resulted in significant payments to Fastow, Kopper, and 
others) formed part of the basis for the civil and criminal charges 
recently brought against Fastow and Kopper. See Complaint, SEC v. 
Kopper, Civ. Action No. H-02-3127 (S.D. Tex. August. 21, 2002); 
Information, United States v. Kopper, Cr. No. H-02-0560 (S.D. Tex. 
August 20, 2002); Complaint, SEC v. Fastow, Civ. Action No. H-02-3666 
(S.D. Tex. Oct. 2, 2002); Criminal Complaint, United States v. Fastow, 
Cr. No. H-02-889-M (S.D. Tex. Oct. 1, 2002).
---------------------------------------------------------------------------
    What guaranteed these projects QF status, however, were 
FERC regulations that provided for an exception to the QF 
ownership rules when a company is exempt ``by rule or order'' 
under section 3(a)(3) or 3(a)(5) of PUHCA.\194\ FERC's 
practice, moreover, was to treat a company's ``good faith'' 
application to the SEC for an exemption under these sections of 
PUHCA--unless and until it was denied by the SEC--to be 
sufficient to qualify for this PURPA exception.\195\ Thus, 
merely by having an application pending with the SEC for a 
3(a)(3) or 3(a)(5) exemption under PUHCA, Enron was able to 
preserve its windfarms' beneficial QF status.\196\
---------------------------------------------------------------------------
    \194\ 18 C.F.R. Sec. 292.206(c)(1).
    \195\ See Doswell Limited Partnership and Diamond Energy, Inc., 56 
F.E.R.C. 61,170 (1997).
    \196\ See, e.g., Notice of Self-Recertification of Qualifying 
Facility Status for Small Power Production Facility, August 3, 2000, 
Zond Windsystems Holding Co., FERC Docket No. QF87-365 (notifying FERC 
that Enron, through its Zond subsidiary, had repurchased a 100 percent 
interest in a wind energy facility and that it had made a good faith 
application to the SEC for a PUHCA exemption). When no affected utility 
company raises objection, FERC accepts such self-recertifications 
without review. Committee staff meeting with FERC staff (September 6, 
2002).
---------------------------------------------------------------------------
    In its application to the SEC for the 3(a)(3) or 3(a)(5) 
PUHCA exemption and in its related communications with SEC 
staff, Enron made clear that its purpose was to get out from 
under FERC's QF ownership rules.\197\ Enron noted that it had 
contracted to sell PGE and, if it did so, it would no longer be 
a ``public utility holding company,'' and, accordingly, this 
would render the FERC QF issue moot. Enron strongly suggested 
that it had no interest in the SEC ruling on the exemption 
application before the sale of PGE was either completed or 
abandoned.\198\ If the PGE sale went through, Enron, no longer 
in need of the PUHCA exemption, would withdraw its application; 
if not, it could pursue its request for an exemption at that 
time. In the interim, the pending application served to 
maintain the QF status of the windfarms and to enable Enron to 
acquire or develop new QFs.\199\
---------------------------------------------------------------------------
    \197\ Enron Corp. Form U-1, Application under the Public Utility 
Holding Company Act, SEC File No. 70-9661 (April 14, 2000); Letter from 
Joanne C. Rutkowski, LeBoeuf, Lamb, Greene & MacRae to Catherine A. 
Fisher, Assistant Director, Office of Public Utility Regulation, 
Division of Investment Management, Securities and Exchange Commission, 
dated April 13, 2000; see also Committee staff interview with SEC 
staff, Division of Investment Management (September 3, 2002).
    \198\ Id. In a 2001 presentation to SEC staff, Enron asserted that 
``the SEC and Enron agreed to delay pursuing a formal order on the 
Application pending the PGE sale.'' Enron Corp., ``Alternative PUHCA 
Exemption for QF Relief-SEC Staff Presentation,'' July 27, 2001. SEC 
staff denied that there was such an agreement, but stated that it was 
nonetheless their priority to complete the regulatory review of the PGE 
sale before turning their attention to Enron's exemption application. 
Committee staff interview with SEC staff, Division of Investment 
Management (September 3, 2002).
    \199\ In its application to the SEC, Enron emphasizes its desire to 
bid to acquire additional QF assets and asserts that, without the 
exemption, it had been unable to do so. Enron Corp. Form U-1, 
Application under the Public Utility Holding Company Act, SEC File No. 
70-9661 (April 14, 2000), at 8-9. FERC records evidence at least one 
case in which Enron has relied on its exemption application to the SEC 
in order to first obtain QF status for a wind power facility, rather 
than simply maintaining the existing QF status of such a facility. See 
Green Power Partners I LLC, FERC Docket No. QF00-96-000 (Notice of 
Self-Certification of Qualifying Facility Status for Small Power 
Production Facility, filed September 29, 2000).
---------------------------------------------------------------------------
    To this date, the SEC has not ruled on Enron's request for 
this exemption. Since Enron's initial application--which was 
amended in response to SEC staff's comments in August 2000--a 
number of relevant events, however, have transpired. To begin 
with, on April 26, 2001, Enron and Sierra Pacific terminated 
their agreement for the sale of PGE. Thereafter, on July 24, 
2001, Enron submitted a further amended draft application, 
along with a letter setting forth Enron's request that the 
Commission now act on the application and issue an exemption 
order. A few days later, Enron met with SEC staff to discuss 
its revised application. After submitting this revised 
application, Enron then entered into another agreement to sell 
PGE, this time to Northwest Natural Gas Co. Announced on 
October 8, 2001, this agreement also eventually was terminated, 
on May 16, 2002. Finally, on March 26, 2002, Southern 
California Edison Co., which has long-term contracts with 
several Enron QF projects (and which is therefore paying higher 
rates than would be required if the projects were not 
considered QFs), filed a motion to intervene and opposition to 
Enron's application for an exemption. Southern California 
Edison argues, among other things, that Enron's collapse and 
resulting precipitous decline in revenue means that (whatever 
was the case previously) the income the company receives from 
PGE now constitutes a highly substantial portion of Enron's 
total income and so cannot be said to be nonmaterial or merely 
incidental as required by sections 3(a)(3) and 3(a)(5) of 
PUHCA.\200\ Enron filed a response to Southern California 
Edison's motion on April 30, 2002, asserting that its exemption 
request was, and continues to be, in good faith and asking that 
any hearing on the exemption be deferred further until after 
the company's bankruptcy reorganization plan is adopted.\201\
---------------------------------------------------------------------------
    \200\ Motion to Intervene and Opposition of Southern California 
Edison Company, March 26, 2002, Enron Corp., SEC File No. 70-09661.
    \201\ Memorandum of Law in Response to Motion to Intervene and 
Opposition of Southern California Edison Company, April 30, 2002, Enron 
Corp., SEC File No. 70-09661.
---------------------------------------------------------------------------
    Throughout the substantial changes that have occurred at 
Enron since the company's request for this PUHCA exemption was 
filed in April 2000--the collapse of one proposed deal to sell 
PGE, the entry into another such proposed deal and its 
termination, not to mention the bankruptcy of the whole 
company--Enron's exemption application has remained pending at 
the SEC and, as a result, the QF status of certain of its 
projects has remained intact, regardless of whether that status 
is actually merited. At no point has the SEC ruled on the 
application or, apparently, even asked that it be withdrawn in 
light of changes in circumstances. Perhaps more troubling is 
the fact that neither FERC nor the SEC has questioned whether 
the application was, or continues to be, in good faith, as FERC 
requires for it to serve as a basis for an exemption from the 
ordinary QF ownership requirements.\202\ Thus, although the 
circumstances that Enron now finds itself in are radically 
different than when it first sought the exemption nearly 2\1/2\ 
years ago, and Commission staff are aware that Enron continues 
to rely on the application in its FERC matters, the SEC has 
allowed the application to remain open throughout this period.
---------------------------------------------------------------------------
    \202\ Staff of each agency, in fact, disclaimed responsibility for 
doing so. The SEC, for its part, observed that the decision to rely on 
a good faith application was FERC's and suggested that it was up to 
FERC to determine if the application met that agency's standards for 
good faith. Committee staff interview with SEC Staff, Division of 
Investment Management (September 3, 2002). FERC, for its part, argued 
that the application was made to the SEC and that an attempt by FERC to 
determine whether such an application was in good faith before the SEC 
had a chance to rule on it would be preemptively second guessing in 
advance its sister agency's decision. Committee staff meeting with FERC 
staff (September 6, 2002). According to staff at both agencies, they 
did not discuss between the two agencies the pending application.
---------------------------------------------------------------------------
    Had the SEC reviewed Enron's application earlier, it would 
not necessarily (or even likely) have led to the SEC's earlier 
discovery of the accounting misdeeds that lay behind the sale 
and repurchase of some of its windfarms.\203\ The SEC's failure 
to take any action on Enron's application, however, may mean 
that Enron has been able to collect more money than the company 
is legitimately entitled to from ratepayers of utilities that 
purchased their electricity from Enron QFs. Moreover, the lack 
of coordination between the SEC and FERC permitted Enron to 
take full advantage of the gaps and overlaps in the agencies' 
jurisdiction and may have prevented the SEC from learning about 
the full context of the QF transactions.
---------------------------------------------------------------------------
    \203\ See note 193 above. In contrast to FERC, with which Enron 
filed a request for recertification of the QF status of its windfarms 
in 1997 that described the sale transaction between Enron and RADR, see 
Request for Recertification of Qualifying Facility Status for Small 
Power Production Facility, May 14, 1997, Zond Windsystems Holding Co., 
FERC Docket No. QF87-365-003, the SEC became involved in this matter 
only when the PUHCA exemption application was filed in 2000 in 
anticipation of that interest being repurchased. The exemption 
application submitted to the SEC did not address the windfarms' 
ownership issues.
---------------------------------------------------------------------------

    4. Exemption from the Investment Company Act of 1940

    On May 15, 1996, Enron and two of its subsidiaries, Enron 
Oil & Gas Company and Enron Global Power & Pipelines, L.L.C., 
filed with the SEC an application for an exemption from the 
Investment Company Act of 1940.\204\ The Investment Company Act 
governs companies, such as mutual funds, that engage primarily 
in investing, reinvesting and trading in securities. It 
requires these companies to comply with certain disclosure 
requirements and places certain limits on the companies' 
investment activities and affiliate transactions; it also 
provides for a particular corporate structure.
---------------------------------------------------------------------------
    \204\ 15 U.S.C. Sec. 80a-1 et seq. Enron subsequently added a third 
subsidiary, Enron International, Inc., to the application.
---------------------------------------------------------------------------
    At the time of the application, Enron's growing investments 
in foreign infrastructure projects threatened to bring it 
within the scope of the Act. Enron and its affiliates were 
engaged in developing numerous power plants, gas transmission 
lines and other infrastructure projects throughout the 
developing world and typically did so through the establishment 
of SPEs created specifically to operate these projects. For 
what Enron described as legitimate tax, liability and 
governance reasons--including the fact that certain countries 
prohibited foreign control of corporations in their 
jurisdictions--Enron generally did not own a majority interest 
in these entities. The Investment Company Act applies to a 
company that owns investment securities having a value 
exceeding 40 percent of the company's total assets. Securities 
of a subsidiary that is majority owned by the company are 
excluded from the definition of ``investment securities'' and 
do not count toward the 40 percent limit. Because the entities 
that operated the foreign infrastructure projects, however, 
were not majority owned by Enron or its affiliates, they would 
ordinarily be considered ``investment securities,'' and, 
consequently, Enron and/or its affiliates, as their foreign 
infrastructure ventures expanded, would potentially be 
considered investment companies subject to the Act.
    Enron initially sought an exemption from the Investment 
Company Act from Congress as part of what became the National 
Securities Markets Improvement Act of 1996, \205\ but was 
unsuccessful.\206\ Nonetheless, in its report on the bill, the 
House Committee on Energy and Commerce devoted three paragraphs 
to addressing this issue and appeared to urge the SEC to grant 
the exemption administratively. Specifically, the House Report 
noted that ``the Committee supports appropriate administrative 
action by the [SEC] to prevent the Investment Company Act from 
having unintended and adverse consequences to U.S. companies in 
the business of developing or acquiring and operating foreign 
infrastructure projects''; that ``the activities of U.S. 
companies involved in foreign infrastructure projects are not 
the sort of activities the Investment Company Act was designed 
to regulate''; and that, when exemptive relief was a 
requirement for investments in these projects, ``the Committee 
expects the [SEC] to take administrative action 
expeditiously.'' \207\ Although the SEC staff appears to have 
opposed the grant of a broad statutory exemption--they believed 
that a generally applicable exemption might lead to 
unpredictable results, that it might suggest that the 
Commission did not have the authority to grant such an 
exemption itself, and that it was better to proceed on a case-
by-case basis--they did not object to Enron seeking similar 
relief through the SEC's own administrative procedures.\208\
---------------------------------------------------------------------------
    \205\ Pub. L. No. 104-290.
    \206\ See Committee staff interview with SEC staff, Division of 
Investment Management (July 2, 2002); Committee staff interview with 
Barry Barbash, Attorney, Shearman & Sterling, and former Director of 
the Division of Investment Management, SEC (August 1, 2002); Committee 
staff interview with Craig Tyle, General Counsel, Investment Company 
Institute (June 24, 2002).
    \207\ H. Rept. No. 104-622, at 19 (June 17, 1996). The conference 
report, which included only a brief discussion beyond the final text of 
the bill itself, did not address this issue. See H. Rept. 104-864 
(September 28, 1996).
    \208\ Committee staff interviews with SEC staff, Division of 
Investment Management (July 2, 2002), Barry Barbash (August 1, 2002), 
and Craig Tyle (June 24, 2002).
---------------------------------------------------------------------------
    Thus, as its next step, Enron filed its application with 
the SEC to obtain an exemption administratively.\209\ Under 
section 6(c) of the Investment Company Act, the SEC has broad 
power to exempt a company from the provisions of the Act if the 
exemption is deemed to be in the public interest and consistent 
with investor protection and the purposes of the Act.\210\ 
Staff in the Commission's Division of Investment Management met 
with Enron concerning its request for an exemption \211\ and 
provided written comments on the application.\212\ Enron 
subsequently submitted three amended applications.\213\ A 
notice summarizing the penultimate version of the application 
was published in the Federal Register on February 24, 1997; 
\214\ no comments on the application were received.\215\ On 
March 13, 1997, the Division of Investment Management, acting 
under delegated authority from the Commission, issued an order 
granting the application for exemption.\216\
---------------------------------------------------------------------------
    \209\ Application for an Order of the Securities and Exchange 
Commission Pursuant to Section 6(c) of the Investment Company Act of 
1940 Exempting Applicants from All of the Provisions of the Act, May 
15, 1996, In re Enron Corp., et al., SEC File No. 812-10150.
    \210\ 15 U.S.C. Sec. 80a-6(c).
    \211\ SEC Response at 21.
    \212\ Letters from David W. Grim, Staff Attorney, Division of 
Investment Management, SEC to Robert Baird, Esq., Vinson & Elkins LLP, 
dated Sept. 17, 1996 and January 21, 1997.
    \213\ These were filed with the SEC on October 22, 1996, February 
12, 1997, and February 21, 1997, respectively.
    \214\ 62 Fed. Reg. 8279. (The application was publicly released on 
February 14, 1997, but did not appear in the Federal Register until 10 
days later).
    \215\ SEC Response at 119.
    \216\ In re Enron Corp., et al., Investment Company Act of 1940 
Release No. 22560, 1997 SEC Lexis 571.
---------------------------------------------------------------------------
    Experts with whom Committee staff spoke disagreed about 
whether the exemption was appropriate.\217\ Some suggested that 
investments in overseas ventures that Enron did not legally 
control posed substantial risks to shareholders of the sort 
that the Investment Company Act was specifically designed to 
protect against. Others argued that Enron was clearly an 
operating company, not a passive investor of the sort at which 
the Act was directed, and that the risks posed were associated 
with these operations. SEC staff, in addition to agreeing with 
the latter argument, also noted that because Enron's foreign 
infrastructure projects took the form of joint ventures, which 
are not considered investment securities, it was possible that 
Enron did not need the exemption at all.\218\ The SEC further 
reported that similar exemptions were granted to companies 
engaged in foreign infrastructure projects both before and 
after it granted an exemption to Enron.\219\
---------------------------------------------------------------------------
    \217\ See, e.g., Committee staff interview with Mark Sargent, Dean, 
Villanova University School of Law (July 29, 2002) (expressing concerns 
about the SEC decision to grant the exemption); Committee staff 
interview with Tamar Frankel, Professor, Boston University School of 
Law (July 29, 2002) (supporting the decision to grant the exemption).
    \218\ See SEC Response at 117-118 n. 25; Committee staff interview 
with SEC staff, Division of Investment Management (July 2, 2002); 
Committee staff interview with Barry Barbash (August 1, 2002). 
According to Barbash, Enron indicated that it sought a formal exemption 
because it felt that a private legal opinion that it was not an 
investment company given the joint venture nature of its projects would 
not provide it with sufficient certainty.
    \219\ See SEC response at 119, n. 28. Some of these exemptions were 
granted not under section 6(c) of the Investment Company Act but rather 
under section 3(b)(2), which allows for an exemption where a company is 
engaged in a business other than that of an investment company. 15 
U.S.C. Sec. 80a-3(b)(2).
---------------------------------------------------------------------------
    Everyone with whom staff spoke about this issue, however, 
agreed that Enron, as an operating company (in contrast to a 
classic investment company, such as a mutual fund), could not 
have functioned within the strict constraints of the Investment 
Company Act. Nevertheless, as with PUHCA, even had Enron's 
application for an exemption been rebuffed, it is likely that 
Enron would have in some fashion restructured its operations to 
remain outside the Act's restrictions.\220\
---------------------------------------------------------------------------
    \220\ It can be argued, however, that if Enron had to restructure 
its operations through increasing its formal control over these foreign 
infrastructure projects (assuming it could have done so), this in and 
of itself may have decreased risk for the company's shareholders.
---------------------------------------------------------------------------
    Of more concern, therefore, than the initial grant of the 
exemption itself--which was not clearly erroneous and had some 
Congressional support--was the SEC's lack of any means to 
monitor the continued appropriateness of the exemption. The 
exemption grant was expressly conditioned on Enron not 
``hold[ing] itself out as being engaged in the business of 
investing, reinvesting or trading in securities'' and on the 
foreign infrastructure projects not ``differ[ing] materially 
from that described in . . . [the] Application.'' \221\ It is 
unclear whether Enron violated these conditions. At minimum, 
however, as Enron's business evolved in the late 1990's and it 
became less of an energy company and more of a trading 
enterprise--dealing increasingly in derivatives, for example, 
rather than tangible items--it arguably came closer to being an 
``investment company'' as envisioned by the Act.\222\ The SEC, 
however, had not incorporated any conditions into the exemption 
it granted that would have required Enron to demonstrate in the 
future that it still merited an exemption, and the SEC staff 
did not routinely follow up on their own. As a result, the 
changing nature of Enron's business and its relationship with 
its foreign infrastructure projects--a number of which have 
ultimately been linked to problems for Enron and its 
shareholders \223\--were left unexamined by the Commission.
---------------------------------------------------------------------------
    \221\ See In re Enron Corp., et al., Investment Company Act of 1940 
Release No. 22560, 1997 SEC Lexis 571; Third Amended and Restated 
Application for an Order of the Securities and Exchange Commission 
Pursuant to Section 6(c) of the Investment Company Act of 1940 
Exempting Applicants from All of the Provisions of the Act, February 
21, 1997, In Re Enron Corp., et al., SEC File No. 812-10150, at 31.
    \222\ See Committee staff interview with Tamar Frankel (July 29, 
2002).
    \223\ Some of these projects have garnered attention as having had 
substantial financial difficulties and/or having been used by Enron in 
dubious ways to enhance its financial statements. See, e.g., Powers 
Report at 135-138 (detailing Enron's sale to, and subsequent repurchase 
from, the Fastow-controlled LJM1 partnership of an interest in an 
entity building a power plant in Cuiaba, Brazil, enabling Enron to 
avoid consolidating the entity on its balance sheet and to record as 
income projected proceeds from a gas supply contract Enron had with the 
project--as well as providing LJM1 with a substantial, and seemingly 
unjustified, return on its investment); Rebecca Smith and Kathryn 
Kranhold, ``Enron Knew Foreign Portfolio Had Lost Value,'' The Wall 
Street Journal, May 6, 2002 (reporting that Enron's portfolio of 
foreign assets had lost as much as half of its value); Saitha Rai, 
``New Doubts on Enron's India Investment,'' The New York Times, 
November 21, 2001 (reporting on the history of problems at Enron's $2.9 
billion Dabhol power plant); ``Enron Spanned the Globe With High-Risk 
Projects; Deals Lost Money but Helped Hide Troubles,'' The Washington 
Post, February 16, 2002.
---------------------------------------------------------------------------

III. RECOMMENDATIONS

    Since the first Federal securities laws were passed in 
response to the 1929 stock market crash, oversight of the 
securities markets has been entrusted to a combination of 
public and private entities. In crafting the Securities Act of 
1933, Congress expressly rejected the idea of direct government 
audits of companies' books. Reasoning that private sector 
controls would allow for a more efficient and flexible system 
of checks on wrongful conduct, our system of regulation relies 
in the first instance on boards of directors and private, 
independent auditors, responsible to shareholders and the 
public, respectively.
    In the case of Enron--and the corporate collapses that have 
since followed--we have witnessed a fundamental breakdown in 
this system. Apparently, the SEC cannot rely on company 
auditors and boards of directors to assume the lion's share of 
responsibility for ensuring honest public disclosure of company 
finances, as assumed by the securities laws. Thus, although our 
investigation found no willful malfeasance by the Commission 
with respect to Enron, Committee staff has concluded that the 
Commission's largely hands-off approach to the company--
combined with the failure of the auditors and board of 
directors to do their jobs--allowed inaccurate and incomplete 
information to flood the market, leading to significant 
financial losses for thousands of Enron employees and an even 
greater number of investors. Unfortunately, through the 1990's, 
the SEC had reason to question whether auditors and boards of 
directors were playing their appointed roles in the system--
and, indeed, did question it--yet the Commission did little to 
adjust its own role to fill the gap. The failure of the SEC's 
approach became all too evident in its limited interactions 
with Enron--its lack of review of company financial statements 
that would have raised questions, for example, and its failure 
to monitor the effects of Enron's permitted shift to mark-to-
market accounting.
    Accordingly, for our public-private method of oversight to 
continue to work effectively, significant improvements will 
need to be made. Tightening up the controls on the private 
gatekeepers is a key first step, and this effort is already 
underway. The recently enacted Sarbanes-Oxley Act provides, 
among other things, for an independent board, subject to SEC 
oversight, to oversee the practices of auditors, \224\ 
prohibits auditors from engaging in much of the consulting work 
for their audit clients causing potential conflicts of 
interest, \225\ and places additional obligations on corporate 
officers and directors.\226\ Others are taking action in this 
area as well: The New York Stock Exchange, for example, 
recently announced additional listing requirements designed to 
force boards of directors to more effectively oversee the 
accounting practices of their companies.
---------------------------------------------------------------------------
    \224\ Pub. L. No. 107-204 Sec. Sec. 101-109.
    \225\ Id. at Sec. Sec. 201-209.
    \226\ Id. at Sec. Sec. 301-308.
---------------------------------------------------------------------------
    Beyond imposing stricter standards on the private players, 
however, it is also critically important that the SEC enhance 
its effectiveness.\227\ The SEC needs not only to find ways of 
improving its performance in its traditional roles of ensuring 
compliance with disclosure requirements and enforcing the laws 
against those who commit fraud, but also to work directly to 
uncover fraud, serving as a backstop when other parts of the 
system fail. The public rightly expects that the SEC will be 
there to ensure our capital markets are operating fairly.
---------------------------------------------------------------------------
    \227\ On March 20, 2002, following GAO's call for the agency to 
engage in better strategic planning, the SEC announced that, with the 
help of an outside consulting firm, it was undertaking an ambitious, 4-
month long study to examine ``the Commission's operations, efficiency, 
productivity, and resources.'' ``Pitt Announces Special Study of SEC 
Operations, Resources,'' SEC Press Release, March 20, 2002, available 
at http://www.sec.gov/news/press/2002-42.txt. The study was to be 
completed in August, with a report expected this fall. We commend the 
SEC for this self-examination, and look forward to its results.
---------------------------------------------------------------------------
    Some of the necessary improvements at the SEC will require 
additional resources, as has already been contemplated in the 
Sarbanes-Oxley Act. More central, however, is the need for the 
Commission, in some measure, to reconceptualize its role as a 
more proactive force in protecting the marketplace against 
financial fraud. Based on our investigation, we believe, more 
specifically, that it is important the SEC take the following 
actions to more effectively protect investors and help restore 
public confidence in the markets:
    Review More Filings and Review Them More Wisely and 
Efficiently. While most types of fraud cannot be detected 
simply through an examination of a company's periodic filings, 
a greater number of reviews (particularly of the right filings) 
nonetheless increases the chances of uncovering information 
that may lead to the discovery of wrongdoing. The increased 
likelihood that a company's filings will be reviewed can also 
deter certain misleading reporting practices. In large measure, 
this is a resource question--300 people are simply not enough 
to review a meaningful portion of the filings the SEC receives. 
Indeed, the relatively stable size of the SEC's workforce in 
the face of increasingly large and complex markets has been 
well-documented, including in a recent General Accounting 
Office study, \228\ and additional resources--such as have been 
authorized in the Sarbanes-Oxley Act \229\--will undoubtedly 
have to be part of any solution.
---------------------------------------------------------------------------
    \228\ U.S. General Accounting Office, ``SEC Operations: Increased 
Workload Creates Challenges,'' GAO-02-302, March 2002.
    \229\ Pub. L. No. 107-204 Sec. 601. Such additional resources have 
not yet been appropriated, however.
---------------------------------------------------------------------------
    The Sarbanes-Oxley Act now requires that the SEC review 
companies' periodic reports at least once every 3 years.\230\ 
This is an important start, but regular reviews will not 
necessarily be enough. Rather, the Commission's challenge is to 
find better ways to identify those filings that need attention 
or that present higher risk to investors The SEC currently 
attempts to do this through its selective review criteria, as 
well as through certain ad hoc measures. Such measures include 
the creation in the late 1990's of an earnings management task 
force to identify and review those filings that had indicia of 
the sort of earnings management that former Chairman Levitt was 
publicly inveighing against at the time, as well as the 
Commission's recent decision to review the annual reports of 
the Nation's 500 largest companies. Though well-intentioned, 
there is little evidence that this relatively informal system 
has been particularly successful, and more sophisticated means 
of risk analysis appear to be needed.
---------------------------------------------------------------------------
    \230\ Pub. L. No. 107-204 Sec. 408(c).
---------------------------------------------------------------------------
    A number of those with whom Committee staff spoke 
emphasized the importance of technology in this process.\231\ 
Computer systems that can rapidly sift through large amounts of 
corporate data can be a valuable tool for SEC staff, enabling 
them to make more effective use of the available data and 
freeing staff up for less mundane tasks. Such systems, it was 
reported to us, are used by both auditing firms to spot 
problems with clients' financial reports and certain equity 
analysts seeking to identify vulnerable stocks.\232\ The SEC 
currently employs what appears to be a basic version of such 
software in conjunction with its manual screening; it is in the 
process of upgrading to a more sophisticated system that will 
enable it to access a greater range of data and sort through it 
more easily and effectively.\233\ While such technology will 
not eliminate the difficult task of identifying and continually 
revising the criteria for high-risk filings--nor the basic need 
to have capable, well-trained staff to review filings \234\--
used wisely, it can potentially facilitate this selection 
process.
---------------------------------------------------------------------------
    \231\ See Committee staff interviews with Lynn Turner (June 24, 
2002), Arthur Levitt (June 7, 2002), and David Martin, Attorney, 
Covington & Burling and former Director of the Division of Corporation 
Finance, SEC (June 25, 2002).
    \232\ Id. See also Committee staff interview with Mark Roberts, 
Director of Research and Principal, Off Wall Street Consulting Group, 
Inc. (June 6, 2002). Roberts explained that it was through his firm's 
computer screening process that he was initially able to identify Enron 
as a company with potential problems.
    \233\ Committee staff interview with SEC staff, Division of 
Corporation Finance (June 25, 2002).
    \234\ The former SEC officials who raised the issue of technology 
in their interviews with Committee staff each also noted the importance 
of hiring high quality professionals and providing them with good 
training. See Committee staff interviews with Lynn Turner (June 24, 
2002), Arthur Levitt (June 7, 2002), and David Martin (June 25, 2002). 
Though it is beyond the scope of this report, a discussion of employee 
turnover and other human capital challenges faced by the SEC can be 
found in U.S. General Accounting Office, ``Securities and Exchange 
Commission: Human Capital Challenges Require Management Attention,'' 
GAO-01-947, September 2001.
---------------------------------------------------------------------------
    Look for Fraud. One of the reasons the SEC did not uncover 
much of the fraud that has been the subject of recent scandals 
is that it does little to proactively look for it. The public 
filing review process, as discussed above, is designed almost 
exclusively to assure compliance with disclosure requirements, 
not to catch wrongdoing. On the other hand, the enforcement 
process, though it can allow investigators to dig deeply to 
unearth the details of corporate malfeasance, does not come 
into play until there is already significant evidence of 
illegality and, generally, after much of the harm has been 
done. If the SEC is to play a role in finding and rooting out 
financial fraud--as we believe it should--it will need to make 
this an explicit goal and develop new processes to support it. 
Random or targeted audits, in the manner of the IRS, though 
requiring significant resources, are one possibility that can 
be applied more broadly for uncovering not only fraud in 
particular cases, but also identifying emerging trends in how 
fraud is being carried out.\235\ The SEC has taken a more 
proactive approach in other areas, such as internet fraud, 
where it has established a group specifically dedicated to 
finding fraud on the web, and it subjects broker-dealers to 
periodic inspections. Whether any of these models can be 
applied to cases of complex financial fraud, or whether there 
is a new, more appropriate model that can be developed is 
something that the SEC, in light of the recent vulnerabilities 
displayed by other parts of the system, will need to explore. 
Though uncovering fraud will appropriately remain, in the first 
instance, the province of auditors, the SEC must play a 
meaningful part in fraud detection if it wishes to fulfill its 
role of ensuring the integrity of the markets.
---------------------------------------------------------------------------
    \235\ The Sarbanes-Oxley Act provides for the new accounting 
oversight board to conduct inspections of the auditors' work, which 
also may prove of assistance to the SEC in addressing issues of fraud 
control. See Pub. L. No. 107-204 Sec. 104.
---------------------------------------------------------------------------
    Follow Up To Ensure That Commission Mandates Are Met. When 
SEC staff raises an issue of concern, there appears often to be 
inadequate follow-up procedures to ensure that the concern is 
addressed. With respect to the SEC's decision to permit Enron 
to switch to mark-to-market accounting, we saw that the 
conditions imposed by Commission staff--that Enron rely on 
market prices where available and other objective data where 
not--were in fact the right ones and, had they been followed, 
the abuses associated with the valuation of Enron's energy 
contracts might not have occurred. Yet, the SEC staff, having 
issued its decision and set forth the conditions, apparently 
never had any intention of checking to see if they were 
complied with; indeed, they had no mechanism for doing so. 
Rather, having informed Enron of the conditions, the SEC staff 
simply assumed that the company would abide by them. Similarly, 
after imposing conditions on Enron's exemption from the 
Investment Company Act, SEC staff never attempted to ascertain 
whether these conditions continued to be met or whether the 
exemption continued to be appropriate--and did not see it as 
their role to do so.\236\
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    \236\ In implementing follow-up procedures, moreover, the SEC needs 
to ensure that there is coordination between its various offices. An 
initial policy decision may be made by one division (the Office of 
Chief Accountant and the Division of Investment Management, 
respectively, in the examples above), while later monitoring of the 
company is conducted by another (generally, the Division of Corporation 
Finance).
---------------------------------------------------------------------------
    The lack of follow through--either as a result of lack of 
resources or lack of priority--is apparent on a broader level 
as well. Thus, for example, in an effort to help get accurate 
information to investors in an era of earnings management and 
aggressive accounting practices, the Commission, both before 
and after the collapse of Enron, has proposed a variety of new 
disclosure requirements, or augmented existing requirements, 
including identification of critical accounting policies, \237\ 
increased disclosure about off-balance sheet entities, the 
valuation of mark-to-market transactions and effects of 
transactions with related parties, \238\ and additional items 
or events to be reported on, and accelerated filing of, Form 8-
K (a so-called ``current report'').\239\ Such enhanced 
disclosure requirements, if followed, may well provide 
additional and needed clarity for investors. Given the 
relatively small number of filings that are currently reviewed, 
however, the SEC staff is not in a position to ensure that 
these disclosure obligations are met. Merely issuing increasing 
numbers of edicts for disclosure without reviewing those 
disclosures or otherwise ensuring that the new requirements are 
complied with is unlikely to prove effective. As recent events 
amply demonstrate, the SEC cannot simply assume that all 
companies will comply with the letter and spirit of the law.
---------------------------------------------------------------------------
    \237\ Disclosure in Management's Discussion and Analysis About the 
Application of Critical Accounting Policies, 67 Fed. Reg. 35620 (May 
20, 2002); Cautionary Advice Regarding Disclosure About Critical 
Accounting Policies, Securities Act Release No. 8040, Exchange Act 
Release No. 45149 (December 12, 2001), 66 Fed. Reg. 65013 (December 17, 
2001).
    \238\ Commission Statement About Management's Discussion and 
Analysis of Financial Condition and Results of Operations, Securities 
Act Release No. 8056, Exchange Act Release No. 45321 (January 22, 
2002), 67 Fed. Reg. 3746 (January 25, 2002).
    \239\ Additional Form 8-K Disclosure Requirements and Acceleration 
of Filing Date, 67 Fed. Reg. 42914 (June 25, 2002).
---------------------------------------------------------------------------
    Supplement Aggressive Enforcement With Other, More 
Proactive Measures. Since the collapse of Enron, the SEC has 
announced a number of high-profile enforcement actions.\240\ 
The SEC Chairman, moreover, has frequently stated his 
commitment to aggressively pursue wrongdoers, and has 
emphasized that SEC staff will pursue a policy of ``real time 
enforcement''--that is, cases will be brought quickly, 
particularly when violations of law are ongoing.\241\ Committee 
staff strongly supports these efforts to hold those who violate 
the securities laws accountable, and believes that the prompt 
punishment of wrongdoers is important not only in and of itself 
but also to deter future fraud.
---------------------------------------------------------------------------
    \240\ See, e.g., ``SEC Charges Adelphia and Rigas Family with 
Massive Financial Fraud,'' SEC Press Release, July 24, 2002, available 
at http://www.sec.gov/news/press/2002-110.htm; ``SEC Announces Fraud 
Charges Against Former Rite Aid Senior Management,'' SEC Press Release, 
June 21, 2002, available at http://www.sec.gov/news/press/2002-92.htm; 
``Waste Management Found and Five Other Former Top Officers Sued for 
Massive Fraud,'' SEC Press Release, March 26, 2002, available at http:/
/www.sec.gov/news/press/2002-44.txt. In conjunction with the Department 
of Justice, the SEC is also, of course, conducting a far-reaching 
investigation into the Enron collapse, and has thus far brought charges 
in one case. See ``SEC Charges a Former High-Ranking Enron Official 
With Fraud,'' SEC Press Release, August 21, 2002, available at http://
www.sec.gov/news/press/2002-126.htm.
    \241\ See, e.g., Harvey L. Pitt, Remarks Before the National Press 
Club (July 19, 2002), available at http://www.sec.gov/news/speech/
spch577.htm; Harvey L. Pitt, Speech at the Fall Meeting of the ABA's 
Committee on Federal Regulation of Securities (November 16, 2001), 
available at http://www.sec.gov/news/speech/spch524.htm; Harvey Pitt, 
Remark at the PLI 33rd Annual Institute on Securities Regulation 
(November 8, 2001), available at http://www.sec.gov/news/speech/
520.htm; Hearings Before the Subcommittee on Commerce, Justice, State, 
and the Judiciary, Senate Committee on Appropriations, 107th Cong., S. 
Hrg. 107--- (March 7, 2002) at-- (Printed Hearing Record Pending) 
(Statement of the Honorable Harvey L. Pitt, SEC Chairman), available at 
http://www.sec.gov/news/testimony/030702tshlp.htm.
---------------------------------------------------------------------------
    We note, however, that large-scale financial frauds are 
perhaps the cases least amenable to real time enforcement. The 
complexities of such cases require a great deal of resources 
and the time to do a close review of the usually large number 
of pertinent documents. Trying to shortcut this process may 
well lead investigators to overlook the most deeply hidden 
practices.\242\ The Enron case itself demonstrates the array of 
complexities that a financial fraud case can present; even 
after months of intensive scrutiny, there continue to be fresh 
revelations about Enron's fraudulent practices.
---------------------------------------------------------------------------
    \242\ In cases of large-scale financial fraud, it may be easy to 
miss significant portions of the wrongdoing without a comprehensive 
review. In its recent investigation of accounting fraud at Xerox Corp, 
for example, the SEC had uncovered approximately $3 billion in 
improperly booked revenue at the time it settled the case in April 
2002; 2\1/2\ months later, Xerox revealed in a restatement that, in 
fact, over $6 billion in revenue had been improperly accounted for. See 
Kathleen Day, ``Xerox Restates 5 Years of Revenue; 97-01 Figures Were 
Off by $6.4 Billion,'' The Washington Post, June 29, 2002; Claudia H. 
Deutsch, ``Xerox Revises Revenue Data, Tripling Error First Reported,'' 
The New York Times, June 29, 2002. See also Michael Schroeder and Greg 
Ip, ``Imperfect Guardian: SEC Faces Hurdles Beyond Low Budget in 
Stopping Fraud,'' The Wall Street Journal, July 19, 2002 (noting 
problems that may arise from attempting to bring cases too quickly).
---------------------------------------------------------------------------
    The SEC's current emphasis on enforcement, moreover, needs 
to be accompanied by equally strong action on proactive 
measures related to prevention and detection. Enforcement alone 
cannot prevent shareholders from unfairly losing their money, 
and it can only address the cases where wrongful practices have 
already come to light. Moreover, an overemphasis on enforcement 
presupposes that the problems the markets face now are 
primarily due to individual bad actors. For these reasons, an 
approach that combines enforcement with other, more systemic 
remedies is necessary to fully restore public trust in the 
market and our system of oversight.
    Coordinate Better With Other Agencies. In administering 
PUHCA, the SEC's responsibilities interact substantially with 
those of FERC under the Federal Power Act, PURPA and other 
statutes relating to public utilities and public utility 
holding companies. Thus, it is essential that the SEC and FERC 
coordinate their activities in these areas. Effective 
coordination between agencies helps ensure consistency in 
policy determinations and prevents companies from exploiting 
the lack of oversight in areas where neither agency may have 
taken full responsibility--as Enron did in using its PUHCA 
exemption application to the SEC to obtain regulatory benefits 
from FERC under PURPA.
    Better communication between agencies can also enable each 
agency to more fully understand the context surrounding the 
companies and transactions that they are overseeing. Had the 
SEC staff consulted with FERC staff about Enron's 2000 
application for a PUHCA exemption, they might have learned 
important additional information about some of the ultimate 
objects of that application, the windfarms, and the ownership 
transactions surrounding them--information that Enron had 
provided to FERC, but not to the SEC. Such knowledge may have 
informed the SEC's evaluation of Enron's application and, 
perhaps, other matters as well. More generally, improved 
coordination could provide each agency with the benefit of 
additional, complementary expertise in their regulatory and 
oversight efforts, with FERC lending its broader energy and 
utility industry knowledge to the SEC, and the SEC bringing its 
experience in market oversight to FERC, an agency responsible 
for overseeing an increasingly deregulated and market-based 
energy system.
    Determine Why the SEC Did Not Act on Enron's PUHCA 
Application and Ensure That Such Oversights Do Not Happen 
Again. Under both Federal securities law \243\ and FERC 
practice, companies may obtain immediate benefits by filing a 
``good faith'' application for a PUHCA exemption with the SEC. 
Thus, the Commission's failure to act promptly on requests for 
PUHCA exemptions can provide significant, and potentially 
unwarranted, regulatory and economic benefits to companies that 
submit such applications. The handling of Enron's exemption 
application described above raises troubling questions about 
the Commission's treatment of such applications. The Commission 
should thoroughly investigate the handling of this exemption 
request to determine (1) whether it represents a pattern of 
delay that has provided unwarranted benefits to, or been abused 
by, applicants; and (2) whether, in this specific instance, 
Commission staff agreed to Enron's request to hold this matter 
in abeyance in order to facilitate Enron's regulatory goals 
before FERC. If either is found to be true, it would be very 
disturbing, and the SEC should take immediate action to correct 
the problem. Moreover, the Commission should ensure that a 
consistent practice of prompt review is in place to avoid any 
similar results in the future.
---------------------------------------------------------------------------
    \243\ See 15 U.S.C. Sec. 79c(c) (providing that the filing of 
application for a PUHCA exemption in good faith ``shall exempt the 
applicant from any obligation, duty, or liability imposed in this 
chapter upon the applicant as a holding company until the Commission 
has acted upon such application''; the subsection also provides that 
the Commission must grant, deny or otherwise dispose of the application 
``within a reasonable time'' after receipt).
---------------------------------------------------------------------------

 PART TWO: MORE WATCHDOGS--WALL STREET SECURITIES ANALYSTS AND CREDIT 
                            RATING AGENCIES

    As discussed in Part I of this report, the story of Enron 
and the financial watchdogs was one of catastrophic failure--
one in which all of those overseeing the company and providing 
information to the markets about the company's finances for a 
variety of reasons failed to get accurate information to 
investors. As this Part of the report explains, that oversight 
failure was not limited to entities with legal obligations to 
watch over the company in the name of the investing public, 
such as the SEC or the company's board of directors and 
auditors. Two other groups that provided information to the 
markets about Enron also failed to accurately report on the 
company's condition, again to the detriment of the investing 
public.
    These groups--Wall Street securities analysts and credit 
rating agencies--hold themselves out as unbiased and accurate 
assessors of various companies' financial conditions, a view 
shared, at least until recently, by large parts of the 
investing public. Yet, as with the entities discussed in Part 
I, Enron revealed both groups to be not nearly so reliable as 
the general public perceived them to be. Instead, Enron's case 
proved Wall Street analysts to be far less focused on 
accurately assessing a company's stock performance than on 
other factors related to their own employers' businesses and 
the credit rating agencies to be far less diligent and 
attentive to fulfilling their functions than they should have 
been.
    This Part examines the stories of Enron and the analysts 
and the credit raters, explores how and why entities whose 
mission is to accurately assess a company's financial health 
failed so completely to do so, and offers some suggestions for 
improving the system and ensuring that these entities do better 
what they say they are doing.\244\
---------------------------------------------------------------------------
    \244\ In contrast to the Committee staff's review of the SEC's 
interactions with Enron, Committee staff did not conduct an in-depth 
investigation of the sell-side analysts or the credit rating agencies. 
This section of the Report is instead intended as a broad summary of 
their story, based on the Committee's February 27, 2002 and March 20, 
2002 hearings and staff interviews leading up to them, as well as other 
public sources.
---------------------------------------------------------------------------

I. ENRON AND THE WALL STREET ANALYSTS

    In his testimony before the Governmental Affairs Committee 
in a January 24, 2002 hearing, Arthur Levitt declared, ``I 
think Wall Street sell-side analysis has lost virtually all 
credibility.'' \245\ This is significant, because, according to 
the testimony of Frank Torres of Consumers Union in the 
Committee's February 27, 2002 hearing, ``The Watchdogs Didn't 
Bark: Enron and the Wall Street Analysts,'' small investors 
``rely on the expertise of [Wall Street] analysts to digest raw 
data, to talk to insiders, to put together the recommendations. 
Analysts' research is likely to be the most detailed 
information some investors have.'' \246\ And investors relied 
on the recommendations they got: The PBS news magazine Now With 
Bill Moyers profiled three Jupiter, Florida women who had 
formed an investment club about their loss of thousands of 
dollars they invested in technology stocks. One, Fraeda Kopman, 
said: ``I think that we put a lot of emphasis on the work that 
the analysts were doing for the various brokerage firms. 
Especially the big ones. Because we believed in them. I guess 
we were very naive. And we thought that that information was 
correct. They were the ones that were visiting the companies. 
So obviously, they would know a lot more than I would know by 
just reading about a company.'' \247\
---------------------------------------------------------------------------
    \245\ The Fall of Enron: How Could It Have Happened, Hearing Before 
the Senate Governmental Affairs Committee, 107th Cong., S. Hrg. 107-376 
(January 24, 2002) at 34.
    \246\ The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 56.
    \247\ Transcript, Now With Bill Moyers, May 31, 2002, available at 
http://www.pbs.org/now/transcript/transcript120--full.html.
---------------------------------------------------------------------------
    Until the Enron story broke and questions started being 
asked in the mainstream media about why analysts were 
recommending the stock until just before the company collapsed, 
the average American investor probably did not know that 
analysts' recommendations were often more euphemism than 
dependable investment advice. Furthermore, until April 2002, 
when, after a year-long investigation, New York Attorney 
General Eliot Spitzer released e-mails sent by analysts within 
Merrill Lynch calling a stock they were recommending ``a piece 
of junk'' and worse, many Americans did not suspect that the 
recommendations might be influenced more by the amount of the 
investment banking revenue that company could provide than by 
the quality of the company.
    Nearly all of the Wall Street analysts who covered Enron 
recommended Enron as a stock to buy--meaning that they were 
telling investors that the stock was undervalued--well into the 
fall of 2001, even as Enron's hidden partnerships were 
revealed, the SEC initiated its investigation, and Enron 
restated its financials going back more than 4 years. Most 
troublesome, though, is that during the period well prior to 
Enron's collapse, analysts recommended the stock to investors 
even though at least some of those same analysts admittedly did 
not understand how Enron, which was generally recognized as a 
``black box,'' made its money. Many of these analysts worked 
for banks that derived large investment banking fees from Enron 
deals, invested in Enron's off-balance-sheet partnerships, and/
or had significant credit exposure to Enron.
    This section of the report gives an overview of the so-
called sell-side analysts who covered Enron. It first describes 
the role such analysts are supposed to play, then describes the 
assessments of Enron by analysts who covered the company prior 
to its bankruptcy. Following that, the report outlines factors 
affecting the objectivity of sell-side analyst recommendations, 
and then suggests some solutions that can be implemented by the 
SEC to implement the mandates of the historic Sarbanes-Oxley 
Act and to enhance the independence and therefore the integrity 
of Wall Street stock recommendations.

  A. Investment Research Analysts

    There are three types of analysts who evaluate stocks: 
Sell-side analysts, buy-side analysts, and independent 
analysts.\248\ Sell-side analysts work for broker-dealers that 
offer brokerage services, usually to both institutional and 
retail clients. Buy-side analysts work for institutional money 
managers, including mutual funds or hedge funds, counseling 
them on what securities to buy or sell. Some independent 
analysts work for a broker-dealer that does not offer any 
client services, such as investment banking services, but which 
instead makes commissions from the sale of securities through a 
third-party brokerage. Other independent analysts sell their 
research through a retainer or subscription agreement to 
clients, usually institutional money managers who can afford 
their large fees.
---------------------------------------------------------------------------
    \248\ See generally ``Analyzing Analyst Recommendations,'' SEC 
Online Publication For Investors, http://www.sec.gov/investor/pubs/
analysts.htm. This report's description of analysts and their business 
is derived from this publication.
---------------------------------------------------------------------------
    There is no consistent template for all analysts to follow, 
but sell-side analysts generally publish periodic reports on 
each company they cover. A report will contain an assessment of 
the company's business itself, where the company fits into the 
overall trends in its industry, and any current or possible 
future good points or problems. The report will probably have a 
recommendation on the stock, a variation of either buy, sell, 
or hold, with each firm using its own variations on these 
terms. For some firms, ``buy'' is their highest rating; for 
others, it is their third-tier ranking for a stock. Research 
reports may also provide a target stock price, which represents 
what the analyst believes the stock is worth based on his or 
her analysis of the company. Sometimes analysts set earnings 
estimates for companies, usually in the form of earnings per 
share, prior to the companies announcing their earnings. Sell-
side analyst reports, while much more widely disseminated than 
other analyst reports, are not freely available to the public 
at large, at least not in their entirety. Such reports are 
generally available only to firm clients, either through 
brokers or through the firm's website; some firms also sell 
their research reports through other brokerages or services, 
where investors may pay a fee to have access to them. Beyond 
firm clients and paying customers, the average investor's 
access to an analyst's research in written form is generally 
limited to the recommendation, the earnings per share estimate, 
and the target price, which are widely published on the 
internet or are discussed in financial journals or on cable 
networks like CNN Financial News Network, which regularly 
interview analysts about trends and stocks.
    As a part of their analysis, sell-side analysts--who 
generally cover a number of companies within one industry 
sector--will compile information about that industry and follow 
closely the developments of the corporations they follow. They 
participate in regular conference calls with and even attend 
on-site presentations by the companies they cover. They get to 
know the management of these companies. Outside of a company's 
officers, directors and auditors, the analysts who regularly 
cover a company are among the foremost experts on the 
operations of that company. Indeed, the SEC has recognized that 
securities analysts are important to efficient operation of the 
securities markets.\249\ This is why the information they 
provide to the market can be so valuable and why analysts can 
serve as real market watchdogs. In an ideal world, their 
expertise and close scrutiny of corporate disclosures and 
financial statements should position them to notice where 
problems may be afoot and to challenge a company on the issues 
management would prefer to avoid.
---------------------------------------------------------------------------
    \249\ See Regulation Analyst Certification, SEC Release Nos. 33-
8119; 34-46301; File No. S7-30-02 (July 25, 2002); 67 Fed. Reg. 51510 
(proposed August 8, 2002) (``[t]he Commission has stated that analysts, 
who `ferret out and analyze information,' play an important role in the 
securities markets'').
---------------------------------------------------------------------------

  B. The Wall Street Analysts' Assessments of Enron

    The analysts who covered Enron, as a group, maintained an 
optimistic outlook on that company's prospects, even as the 
stock slid over the course of 2001. After reaching a high of 
$90.75 in August 2000, the stock's high in 2001--$84--occurred 
on the first trading day of the year; by the end of September, 
the stock closed at about $25, after a fairly consistent fall 
throughout the year. Nevertheless, Enron analysts retained 
their bullish stance: Of 15 sell-side analysts who covered 
Enron, \250\ 13 had a buy or strong buy on August 7, 2001; on 
October 17, 2001, the day after the company announced a $1 
billion charge to earnings and the day that The Wall Street 
Journal broke the story of Enron's financial shenanigans 
involving related-party transactions with partnerships headed 
by Enron's own chief financial officer, 15 out of 15 of the 
major analysts who covered Enron had a strong buy or buy rating 
on the stock.\251\
---------------------------------------------------------------------------
    \250\ This list, provided by Thomson Financial, does not purport to 
include all the firms that covered Enron, but does include the largest. 
The 15 are: A.G. Edwards, Banc of America Securities, Bernstein, CIBC, 
Citigroup Salomon Smith Barney, Credit Suisse First Boston, FAC Equity, 
Fulcrum Partners, Goldman Sachs, J.P. Morgan Chase, Lehman Brothers, 
Merrill Lynch, Prudential, Sanders Morris, and UBS Warburg.
    \251\ See The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 127 (Chart entitled 
``Enron Stock Recommendation By Broker, August 7, 2001 through December 
7, 2001,'' derived from information provided by Thomson Financial).
---------------------------------------------------------------------------
    Strong Wall Street analyst support continued as the 
problems at Enron became increasingly apparent: On October 24, 
2001, Chief Financial Officer Andrew Fastow resigned, and 12 of 
15 securities analysts retained a buy or strong buy rating on 
the stock.\252\ On October 31, when Enron announced that the 
SEC had opened up a formal investigation into the allegations 
in The Wall Street Journal report, 10 analysts kept a buy or 
strong buy rating on the stock, even as the stock price had 
slid to $13.90, practically a third of where it had been at the 
beginning of that month.\253\ On November 8, when Enron filed 
with the SEC a document indicating its intention to restate its 
financial statements going back more than 4 years due to shoddy 
accounting, disclosing that it would take a charge to earnings 
of approximately $500 million--about 20 percent of earnings 
during that period--these 10 analysts did not budge from their 
buy or strong buy ratings on Enron's stock, which by then had 
gone down to $8.41.\254\
---------------------------------------------------------------------------
    \252\ Id.
    \253\ Id.
    \254\ Id.
---------------------------------------------------------------------------
    On November 9, 2001, Enron announced a planned merger with 
Dynegy, and many hoped despite the company's burgeoning 
accounting problems that this merger could save the company. 
Over the next 3 weeks, it became apparent that the merger was 
not going to go through. On November 28, 2001, Enron's credit 
rating was reduced from investment grade to junk, and the 
merger with Dynegy was called off. Still, that same day, four 
analysts retained a buy or strong buy rating on Enron's 
stock.\255\ On December 2, Enron declared bankruptcy. As of 
that date, only two analysts rated Enron as a sell. Seven firms 
rated Enron as a hold, and one still rated Enron a buy.\256\
---------------------------------------------------------------------------
    \255\ Id.
    \256\ Id.
---------------------------------------------------------------------------
    In the Committee's February 27, 2002 hearing, four of the 
Wall Street analysts who had recommended Enron stock as a 
strong buy well into the fall of 2001 were invited to explain 
the basis for their belief in Enron's stock despite its 
consistent downward movement throughout 2001: Richard Gross of 
Lehman Brothers, Anatol Feygin of J.P. Morgan Chase, Curt 
Launer of Credit Suisse First Boston, and Raymond Niles of 
Citigroup Salomon Smith Barney.
    As late as October 24, 2001, Richard Gross of Lehman 
Brothers rated Enron stock as a strong buy, Lehman's highest 
rating, which is supposed to mean that the stock will 
outperform the market by 15 percent over the next year.\257\ On 
October 16, 2001, after Chairman and CEO Ken Lay announced that 
Enron was taking a $1.2 billion charge to shareholder equity, 
Gross apparently remained unconcerned. He was quoted as saying: 
``The end of the world is not at hand. . . . We think investors 
should rustle up a little courage and aggressively buy the 
stock.'' \258\ In his last report on Enron, dated October 24, 
2001, Gross acknowledged growing concerns about Enron as its 
liquidity was waning and the scandal was mounting, but he 
maintained his strong buy rating on the stock.\259\ Gross kept 
his strong buy rating on Enron until he dropped coverage of it 
on December 7; according to Gross, he could not reconsider his 
recommendation as of late October because Lehman was advising 
Dynegy on its proposed merger with Enron, and he had been 
brought in to assist the Lehman investment bankers in their 
work.\260\
---------------------------------------------------------------------------
    \257\ Information provided by Thomson Financial.
    \258\ Ben White, ``Analysts Faulted For Forecasts,'' The Washington 
Post, January 11, 2002.
    \259\ Lehman Brothers Research Report on Enron Corp., October 24, 
2001.
    \260\ Committee staff interview with Richard Gross, February 13, 
2002. When an analyst assists the investment banking department in a 
transaction, the details of which are not yet public, that analyst, 
because of his or her exposure to this confidential information, cannot 
publicly speak about that company either until the transaction becomes 
public or until the transaction is abandoned. Referring to the so-
called ``Chinese'' or ethical wall that exists between the research 
division and the investment banking division of a firm--which is 
generally set up to prevent such information from leaking to analysts, 
who might disclose it publicly before the company intends it--analysts 
are said to be ``brought over the wall'' when they assist in 
confidential investment banking transactions.
---------------------------------------------------------------------------
    Anatol Feygin of J.P. Morgan maintained a buy 
recommendation--J.P. Morgan's highest rating--on Enron until 
October 24, 2001, when Andrew Fastow resigned as Enron's Chief 
Financial Officer amid the growing scandal. At that point, 
Feygin downgraded Enron to a long-term buy, \261\ which by J.P. 
Morgan's definition meant that he expected the stock to 
maintain its value or grow by 10 percent over the next 
year.\262\ In that report, Feygin indicated that ``the 
appearance of impropriety'' had caused ``damage'' to Enron's 
stock price, and that he agreed that ``investors are justified 
in their reservations to buy'' the stock at that point.\263\ 
Nevertheless, the next day, Feygin wrote in a report that ``we 
continue to have full faith in the propriety of Fastow's 
involvement with the controversial off-balance sheet financing 
vehicles. . . .'' \264\ Feygin retained the long-term buy 
rating on Enron until J.P. Morgan dropped coverage of Enron on 
November 29, 2001, \265\ the day after the proposed merger with 
Dynegy fell apart.
---------------------------------------------------------------------------
    \261\ J.P. Morgan Research Report on Enron Corp., October 24, 2001.
    \262\ Information provided by Thomson Financial.
    \263\ J.P. Morgan Research Report on Enron Corp., October 24, 2001.
    \264\ J.P. Morgan Research Report on Enron Corp., October 25, 2001.
    \265\ The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 127.
---------------------------------------------------------------------------
    Until October 26, 2001, by which time Enron's stock price 
had fallen to a closing price of $15.40, Raymond Niles of 
Citigroup Salomon Smith Barney recommended Enron stock as a 
buy, his firm's highest rating.\266\ At that time, he 
downgraded it two levels to neutral, \267\ which indicated, 
under Salomon Smith Barney's definition, that the stock price 
should stay steady over the following 12 months.\268\ The day 
prior to the downgrade, Niles expressed confidence that Enron 
would survive and prosper once the scandal died down: ``We are 
long term believers in the Merchant Energy story [Enron's 
trading business] and Enron.'' He added that the likelihood 
that ``lingering uncertainty over financial practices may begin 
to impair Enron's commercial operations'' was low with a 
``probability [of] 10 percent-15 percent.'' \269\ When he 
downgraded his rating to neutral, Niles reaffirmed that he 
``continue[d] to think [Enron's growth] is the most likely 
outcome,'' although he acknowledged ``a now higher probability 
`worst case' outcome.'' \270\ Although he retained the neutral 
rating, in his November 14, 2001 report, Niles expressed an 
expectation that Enron's stock price would go up due to the 
merger.\271\ Even after Enron declared bankruptcy, Salomon 
Smith Barney maintained its ``hold'' rating on Enron.\272\
---------------------------------------------------------------------------
    \266\ Id.
    \267\ Id.
    \268\ Information provided by Thomson Financial.
    \269\ Salomon Smith Barney Research Report on Enron Corp., October 
25, 2001.
    \270\ Salomon Smith Barney Research Report on Enron Corp., October 
26, 2001.
    \271\ Salomon Smith Barney Research Report on Enron Corp., November 
14, 2001.
    \272\ The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 127.
---------------------------------------------------------------------------
    Curt Launer of Credit Suisse First Boston (``CSFB'') rated 
Enron a strong buy, CSFB's highest rating, until November 29, 
2001.\273\ On September 10, 2001, Launer concluded, based on 
his ``analysis, discussions with management and reviews of 
recent filings'' that ``there is no truth'' to the speculation 
in the market that Enron might have to restate earnings from 
prior quarters due to misplaced investments.\274\ Despite the 
fact that it appears that management may have misled him on 
this point--Enron did have to restate earnings--Launer 
continued to believe in the company. In his October 19 report, 
Launer wrote that ``the so-called LJM Partnerships were fully 
disclosed in Enron's financial statements and were subject to 
appropriate scrutiny by Enron's board, outside auditors and 
outside legal counsel. . . . Considering the disclosures made 
and the appropriateness of the accounting treatment . . . we 
anticipate that the negative sentiment surrounding these issues 
will dissipate over time.'' \275\ In his October 29 report, 
Launer reiterated his confidence that no restatement would be 
required (although one did come just over 1 week later); 
moreover, despite the fact that Enron had just drawn down $3 
billion in credit (exhausting its available credit lines), 
Launer stated that he viewed Enron's ``credit ratings and 
balance sheet issues as unlikely to worsen materially.'' \276\ 
On November 29, Launer downgraded Enron to a hold.\277\ At that 
point, the proposed merger had fallen through and Enron's stock 
price had fallen to a close of 36 cents.
---------------------------------------------------------------------------
    \273\ Id.
    \274\ Credit Suisse First Boston Natural Gas & Power Research 
Report, September 10, 2001.
    \275\ Credit Suisse First Boston Research Report on Enron Corp., 
October 19, 2001.
    \276\ Credit Suisse First Boston Natural Gas & Power Research 
Report, October 29, 2001.
    \277\ Credit Suisse First Boston Research Report on Enron Corp., 
November 29, 2001.
---------------------------------------------------------------------------
    Despite the sell-side analysts' enthusiastic 
recommendations of Enron's stock throughout 2001, other 
observers correctly questioned whether Enron was a good 
investment. In the March 5, 2001 edition of Fortune, reporter 
Bethany McLean asked the question, ``Is Enron Overpriced?'' As 
she presciently noted, ``It's in a bunch of complex businesses. 
Its financial statements are nearly impenetrable. So why is 
Enron trading at such a huge multiple [of earnings per 
share]?'' \278\ In her story, analysts joked about Enron's 
opaque financial statements; even analysts from credit rating 
agencies Standard & Poor's and Fitch said they could not figure 
out Enron's numbers. McLean warned that ``the inability to get 
behind the numbers combined with ever higher expectations for 
the company may increase the chance of a nasty surprise.'' She 
quoted the J.P. Morgan equity strategist Chris Wolfe, Goldman 
Sachs analyst David Fleischer, and Bear Stearns analyst Robert 
Winters--all of whom believed in Enron--admitting that they 
could not piece together how Enron made its money.
---------------------------------------------------------------------------
    \278\ Bethany McLean, ``Is Enron Overpriced?'' Fortune, March 5, 
2001.
---------------------------------------------------------------------------
    The problem was that all along, even though Enron 
consistently beat earnings estimates by analysts by at least a 
penny per share, Enron simply was not providing answers to the 
questions about where its profits were coming from. As McLean 
reported in March 2001, Enron was giving two responses to 
concerns about its lack of transparency: (1) Enron's business 
is complicated and it would not take the time to explain it; 
and (2) how Enron made its money was ``proprietary information, 
like Coca-Cola's secret formula.'' \279\ Despite this lack of 
transparency--Enron's now infamous ``black box'' quality--and 
despite the company's falling stock price, analysts continued 
to recommend the company as a buy or strong buy. Particularly 
ironic was the comment of Carol Coale, an analyst at 
Prudential, after she was the first Wall Street analyst to 
downgrade Enron to a sell on October 24, 2001: ``The bottom 
line is, it's really difficult to recommend an investment when 
management does not disclose the facts.'' \280\
---------------------------------------------------------------------------
    \279\ Id.
    \280\ Alex Berenson and Richard A. Oppel, Jr., ``Once Mighty Enron 
Strains Under Scrutiny,'' The New York Times, October 28, 2001.
---------------------------------------------------------------------------
    Some independent analysts also questioned Enron's value 
well prior to its demise. A Forbes.com study found that, in 
contrast to sell-side analysts, six of eight independent 
investment newsletters were recommending that Enron stock be 
sold prior to November 2001--three as early as March or April 
2001.\281\ In a May 6, 2001 research report--nearly seven 
months before Enron's bankruptcy--the Off Wall Street 
Consulting Group, an independent research firm based in 
Cambridge, Massachusetts, suggested that Enron's stock was 
worth less than half of its then $60 price.\282\ Off Wall 
Street pointed out that Enron's profit margins were declining 
and would likely continue to decline because, although the 
revenues from its trading operation--its most profitable 
division--were increasing, that division's actual profits were 
shrinking due to growing liquidity and less volatility in the 
energy markets.\283\ Low return on capital was also a bad sign 
to Off Wall Street that Enron was not getting the benefit it 
should from its assets and investments.\284\ Off Wall Street 
also expressed concern about Enron's heavy reliance on related-
party transactions--including the fact that one of the entities 
with which Enron was trading was headed by CFO Andrew Fastow 
and the fact that sales to a related party of dark fiber 
(optical cable not in use) improved earnings in the previous 
quarter by 4 cents per share, allowing Enron to exceed earnings 
expectations.\285\ Off Wall Street believed--correctly, it 
turned out--that Enron was resorting to the related-party 
transactions--transactions with entities controlled by Enron 
insiders or subsidiaries--to improve earnings appearance, and 
resorted to them more and more as profits became more 
elusive.\286\ On August 15, 2001, Off Wall Street issued 
another report on Enron, noting that Enron was selling off 
assets and booking the payments as income to improve the 
appearance of profitability in its trading division in the 
second quarter; meanwhile, Enron was refusing to reveal how 
much profit it was booking from the sales, so analysts were 
unable to determine how much of its profits were recurring 
(from their business, a sign of health), as opposed to non-
recurring (from one-time deals, booster-shots to 
earnings).\287\
---------------------------------------------------------------------------
    \281\ ``Enron: An Unreported Triumph For Investment Letters,'' 
Forbes.com, December 7, 2001, available at http://www.forbes.com/2001/
12/07/1207newsletterwatch.html.
    \282\ Off Wall Street Consulting Group, Inc., Research Report 
Regarding Enron, May 6, 2001 at 1. In that report, Off Wall Street 
valued Enron, which was at the time trading at nearly $60 per share, at 
$30 per share and recommended that its clients sell the stock at the 
then-current levels.
    \283\ Id. at 3.
    \284\ Id. at 7.
    \285\ Id. at 10-11.
    \286\ Id. at 11, 13.
    \287\ Off Wall Street Consulting Group, Inc., Research Report 
Regarding Enron, August 15, 2001.
---------------------------------------------------------------------------
    An even earlier skeptic of Enron was James Chanos, 
President of Kynikos Associates, a New York investment firm. 
Chanos began to research Enron after reading a piece in the 
Texas regional edition of The Wall Street Journal on September 
20, 2000, entitled ``Energy Traders Cite Gains But Math Is 
Missing,'' \288\ questioning whether Enron's profits, which 
were largely non-cash, were inflated by accounting tricks.\289\ 
Chanos, like Off Wall Street, was concerned about low return on 
capital, large and frequent insider stock sales, and the 
general opacity of the company's financial statements. Chanos 
began shorting Enron's stock--a bet that its price would go 
down--in November 2000. (Although Enron's stock price actually 
stayed fairly stable at the $70 to $80 range from November 
through February 2001, in March 2001, Chanos' bets started 
paying off--the stock price started to decline steadily).
---------------------------------------------------------------------------
    \288\ See note 46 above and accompanying text.
    \289\ Scott Sherman, ``Enron: Uncovering the Uncovered Story,'' 
Columbia Journalism Review, March/April 2002.
---------------------------------------------------------------------------
    There were other market participants who were doubtful of 
Enron's prospects--after all, its stock price was falling 
throughout 2001. Howard Schilit, President of the independent 
research firm Center for Financial Research and Analysis, 
testified at the Committee's February 27 hearing that there 
were a number of red flags that would have been revealed by a 
mere perusal of the financial statements. Although Dr. Schilit 
did not cover Enron prior to its collapse, he testified that he 
reviewed the financial statements of the company for 1 hour on 
the evening prior to his testimony and took down ``three pages 
of warnings'' that there were problems at Enron, ``words like 
`non-cash sales,' words like `$1 billion of related party 
revenue.' '' \290\ Dr. Schilit told the Committee that ``for 
any analyst to say there were no warning signs in the public 
filings, they could not have read the same public filings that 
I did.'' \291\
---------------------------------------------------------------------------
    \290\ The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 40.
    \291\ Id. It should be noted that stock analysts, in contrast to 
government regulators such as the SEC, are not necessarily looking just 
for fraud in a company's public filings, but also for signs that a 
company's stock is overvalued. Therefore, what should be ``red flags'' 
to an analyst looking at whether a company has problems may or may not 
also be indicia of fraud. See Committee staff interview with Scott 
Budde, Director, Equity Portfolio Analytics, TIAA-CREF (July 26, 2002).
---------------------------------------------------------------------------
    Despite these red flags, nearly all the sell-side analysts 
who covered Enron were bullish on the stock. The analysts who 
testified at the Committee's February 27 hearing insisted that 
their conclusions about Enron were based on what they saw as 
positive performance by the company over the course of 
years.\292\ They cited Enron's increasing revenue, its 
``strong'' business model, and its impressive ``bench'' of 
capable managers.\293\ The analysts maintained that their 
support for Enron was reasonable given the information that was 
publicly available and the information they had been given by 
the company itself.\294\ In short, they argued that they had 
been misled, just like everyone else. Although prospects for 
the company may have dimmed by early November 2001, as more 
questions arose about Enron's related-party transactions, its 
Chief Financial Officer resigned and Enron announced it was 
restating its financial statements going back more than 4 
years, the analysts said that they believed that the 
prospective merger with Dynegy, made public on November 8, was 
a positive development that they thought would have averted the 
company's collapse.\295\ They also cited instances of what they 
believed to be affirmative misrepresentations by the company to 
dupe them into seeing Enron in a more positive light. For 
example, Curt Launer of CSFB testified that in January 1998, he 
along with 100 other analysts visited Enron to view the new 
trading floor of Enron Energy Services, Enron's retail 
business. Impressed at the time, Launer since learned from news 
reports that the trading floor had apparently been entirely 
staged.\296\ (Enron executives, including former CEO Jeffrey 
Skilling, deny this.) As Launer of CSFB put it, ``[H]indsight 
allows a view that I as an analyst never had. I based my views 
and ratings on the information that was available every step of 
the way.'' \297\
---------------------------------------------------------------------------
    \292\ The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 25, 26, 69, 84.
    \293\ Id. at 26, 69.
    \294\ Id. at 22, 38, 78-79, 85.
    \295\ Id. at 70-71.
    \296\ Id. at 19.
    \297\ Id.
---------------------------------------------------------------------------
    Nevertheless, Chanos, the independent research firm Off 
Wall Street, and those investment newsletters counseling their 
readers to sell Enron in Spring 2001 came to their conclusions 
about Enron based on the same public information that the sell-
side analysts relied on; one might wonder why these Wall Street 
analysts, who made their careers following the energy sector 
and companies like Enron, missed what Off Wall Street, Chanos, 
and the investment newsletters saw. This is particularly the 
case given that at least some of these analysts knew of Off 
Wall Street's and Chanos' reasoning about Enron and yet still 
remained firm that Enron was a strong buy. In a May 9, 2001 
report by The Street.com on the May 6, 2001 Off Wall Street 
research report advising clients to sell Enron stock, the 
reporter shared the research report on Enron with an unnamed 
Wall Street analyst bullish on Enron. That Wall Street analyst 
expressed his view that Off Wall Street misunderstood the 
energy markets, but agreed that Enron's heavy use of related-
party transactions was troubling, remarking, ``Why are they 
doing this? It's just inappropriate.'' \298\ At the Committee's 
February 27 hearing, Curt Launer of CSFB testified that he had 
``made it a practice throughout [his] career not to use other 
research reports written by anybody,'' but acknowledged that he 
was aware of the points made by Off Wall Street about Enron, 
which had been brought to his attention by institutional 
investors. Launer felt that the Off Wall Street objections to 
Enron ``were relatively easy to answer analytically through our 
own work,'' and accordingly he dismissed them.\299\
---------------------------------------------------------------------------
    \298\ Peter Eavis, ``Why One Firm Thinks Enron Is Running Out of 
Gas,'' TheStreet.com, May 9, 2001, available at http://
www.thestreet.com/comment/detox/1422781.html.
    \299\ The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 27.
---------------------------------------------------------------------------
    Launer and Niles similarly dismissed Chanos' work in early 
2001. Chanos testified before the House Energy and Commerce 
Committee on February 6, 2002 that he met sometime early in 
2001 with the analysts covering Enron from CSFB and Salomon 
Smith Barney, and he questioned them about their unwavering 
support for the company in the face of the red flags that led 
Chanos to sell the stock short. Chanos testified: ``[T]hey saw 
some troubling signs. They saw some of the same troubling signs 
we saw. . . . A year ago management had very glib answers for 
why certain things looked troubling and why one shouldn't be 
bothered by them. Basically that's what we heard from the sell-
side analysts. They sort of shrugged their shoulders. . . . 
[O]ne analyst said, `Look, this is a ``trust me'' story.' '' 
\300\ Launer and Niles confirmed at the Committee's February 
27, 2002 hearing that they each met with Chanos and had this 
conversation. However, in their testimony before the Committee, 
neither indicated that they had had concerns about ``troubling 
signs'' in early 2001, and neither suggested that their view on 
Enron was based on ``a trust me story.'' Rather, they testified 
that they formed their opinions of Enron based on what they 
believed was the strong ``core business'' of the company.\301\
---------------------------------------------------------------------------
    \300\ Developments Relating to Enron Corp., Hearing Before the 
House of Representatives Energy and Commerce Committee, 107th Cong., 
Hrg. No. 107-83 (February 6, 2002) at 133.
    \301\ The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 22.
---------------------------------------------------------------------------
    The investigation by the New York Attorney General 
involving internet stock analysts at Merrill Lynch, the results 
of which were first announced in April 2002, offers an inside 
look into other cases where analysts have produced rosy reviews 
of overvalued stocks, even when they privately doubted them. 
New York Attorney General Eliot Spitzer conducted a 10-month 
investigation into the recommendations by the internet analysts 
at Merrill Lynch from 1999 through 2001.\302\ He found that 
although they were wholeheartedly endorsing stocks of companies 
like InfoSpace, Excite@Home, GoTo.com, and Lifeminders, all 
with long-term ratings of ``buy'' and short term ratings of, at 
worst, ``neutral,'' the Merrill research analysts were 
internally saying that these equities were a ``piece of junk'' 
(InfoSpace), ``piece of sh-t'' (Lifeminders), ``nothing 
interesting about the company except banking fees'' for Merrill 
(GoTo.com) and ``such a piece of crap'' (Excite@Home).\303\ 
Based on these findings, Spitzer brought an injunctive 
proceeding against Merrill in New York State Supreme Court 
under the Martin Act, a provision of New York law that 
prohibits any fraud or deception relating to securities while 
engaged in the purchase, sale, or distribution of, or in making 
investment advice regarding, those securities in New York. In 
May 2002, Merrill settled with Spitzer, agreeing, among other 
things, to reform its research department practices and to pay 
penalties of $100 million.\304\
---------------------------------------------------------------------------
    \302\ Affidavit in Support of Application for an Order Pursuant to 
General Business Law Section 354, by Eric Dinallo, April 8, 2002, 
Spitzer v. Merrill Lynch, et al., New York Supreme Court, County of New 
York, Index No. 02-401522 (``Dinallo Affidavit'') at 2-3.
    \303\ Id. at 13.
    \304\ ``Spitzer, Merrill Lynch Reach Unprecedented Agreement to 
Reform Investment Practices,'' Press Release, Office of New York State 
Attorney General Eliot Spitzer, May 21, 2002.
---------------------------------------------------------------------------

  C. Factors Affecting the Objectivity of Sell-Side Analyst 
                    Recommendations

    Overly rosy stock recommendations by sell-side analysts 
were not unique to Enron. Instead, Wall Street analysts have 
long exhibited a clear bias towards rating stocks a ``buy.'' 
Charles Hill, Director of Research at Thomson Financial/First 
Call, testified at the Committee's February 27, 2002 hearing 
that, in 2001, about two-thirds of sell-side analysts' 
recommendations were ``buys,'' about one-third were ``holds,'' 
and less than 2 percent were sell recommendations.\305\ If 
taken at their word, this would mean that analysts believe that 
less than two of every 100 companies will experience a fall in 
stock price in the coming months; the rest would either stay 
constant or go up. This seems unlikely and especially 
questionable given that over the past 2 years, as sell-side 
analysts' recommendations have remained basically consistent, 
the S&P 500 index has fallen from over 1,500 to the lows we are 
seeing now. One explanation for this optimism--and the optimism 
of the Enron analysts--is that the context in which sell-side 
analysts work has built-in conflicts and pressures that 
discourage sell recommendations and encourage buy 
recommendations.
---------------------------------------------------------------------------
    \305\ The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 109. From March 
2002 to May 2002, there was an increase in the proportion in sell 
recommendations, according to Thomson Financial, to 2.5 percent; this 
was largely due to the poor performance of the market in general, 
although it was also due to Morgan Stanley's revision of its rating 
system, which resulted in 22 percent of its ratings being in the lowest 
category--underweight, which is the equivalent of a sell 
recommendation. See Kathleen Pender, ``Less Bull on Wall Street? What 
The Settlement With Merrill Lynch Means For Investment Research,'' San 
Francisco Chronicle, May 23, 2002.
---------------------------------------------------------------------------
    As David Becker, former General Counsel of the SEC, said in 
a speech last year: ``Let's be plain: broker-dealers employ 
analysts because they help sell securities. There's nothing 
nefarious or dishonorable in that; but no one should be under 
any illusion that brokers employ analysts simply as a public 
service.'' \306\ This ability to help sell securities affects 
the business of the analysts' employers on a number of fronts. 
Most significantly, analysts' recommendations can affect their 
firms' investment banking relationships in either a positive or 
negative way. Even though analysts and investment bankers are 
supposed to be separated by a so-called ``Chinese'' or ethical 
wall, this wall is not per se mandated by rule or law, and to 
the extent that it does exist at Wall Street firms, it exists 
mainly to protect non-public material information learned by 
bankers in the course of deals from being given to the 
analysts, who might be tempted to use it in making their 
assessments, which might violate insider trading laws.\307\ 
Therefore the wall is mainly set up--if it exists at all--to 
protect the bankers and the companies, not the independence of 
the analysts. For example, many investment banks invested in 
the partnerships run by Enron CFO Andrew Fastow while the 
analysts working for those firms were recommending Enron stock; 
the firms could not share information about the fact or 
operation of these partnerships with the analysts due to 
confidentiality agreements. Columbia University Law School 
Professor John Coffee called this an example of ``the Chinese 
wall working to injure public investors, rather than benefit 
them.'' \308\ Moreover, despite this wall, analysts are still 
influenced by investment banking considerations.\309\
---------------------------------------------------------------------------
    \306\ David Becker, ``Analyzing Analysts,'' Remarks Before the 
Committee on Federal Regulation of Securities of the American Bar 
Association, August 7, 2001, available at http://www.sec.gov/news/
speech/spch510.htm.
    \307\ See Marc I. Steinberg and John Fletcher, ``Compliance 
Programs For Insider Trading,'' 47 SMU L. Rev. 1783, 1804 (July-August 
1994).
    \308\ Kurt Eichenwald, ``Investors Lured to Enron Deals By Inside 
Data,'' The New York Times, January 25, 2002.
    \309\ In addition to the evidence uncovered by the New York 
Attorney General in his Merrill investigation, see, e.g., Roni Michaely 
and Kent L. Womack, ``Conflict of Interest and the Credibility of 
Underwriter Analyst Recommendations,'' Review of Financial Studies, 
vol. 12, no. 4, 653-686 (1999) at 683 (finding that analysts were less 
accurate and more optimistic in recommendations regarding client 
companies after initial public offerings than analysts from firms that 
were not involved in IPO).
---------------------------------------------------------------------------
    Most broker-dealers who offer investment banking services 
make much if not most of their profits from these services, 
which include such things as underwriting securities offerings 
or advising on mergers, acquisitions, or sales of businesses. 
Because fees from these services can be quite high, banks 
compete fiercely for these deals. Companies--particularly 
companies like Enron that have a lot of investment banking 
business \310\--are unlikely to choose as their business 
partner a bank whose analyst is criticizing their stock, and 
banks are unlikely to appreciate analysts who issue 
recommendations that hamper their ability to obtain lucrative 
deals. For example, as the Senate Permanent Subcommittee on 
Investigations recently showed in its July 30, 2002 hearing, 
``The Role of the Financial Institutions in Enron's Collapse,'' 
a memorandum from investment bankers at Merrill Lynch to its 
President indicated that Enron was pressuring Merrill Lynch to 
improve its rating in 1998, by threatening to withhold 
investment banking business. Soon thereafter, the analyst 
responsible for reporting on and rating Enron left Merrill, and 
was replaced by another analyst who immediately changed Enron's 
rating to a buy.\311\
---------------------------------------------------------------------------
    \310\ According to information provided to the Committee by Thomson 
Financial, Enron did about 30 securities offerings in 2000-2001.
    \311\ The Role of Financial Institutions in Enron's Collapse, 
Hearing Before the Permanent Subcommittee on Investigations, Senate 
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-618 (July 30, 
2002) at-- (Printed Hearing Record Pending) (Statement of Subcommittee 
Chairman Carl Levin), available at http://www.senate.gov/?gov--affairs/
073002levin.htm.
---------------------------------------------------------------------------
    In the New York Attorney General's investigation of 
Merrill, the evidence indicates that Merrill used its research 
department to sell its investment banking services to 
companies, essentially promising that positive ratings from the 
influential Henry Blodget, Merrill's lead internet analyst, 
would be used to convince investors to invest in those 
companies, increasing their stock price. One e-mail from a 
banker to an analyst at Merrill made clear their strategy: ``We 
should aggressively link coverage with banking--that is what we 
did with [a prior client] (Henry [Blodget] was involved) . . . 
if you are very bullish . . . we can probably get by on a 
`handshake.' '' \312\ Indeed, Blodget estimated that his group 
would spend at least 50 percent of their time on investment 
banking matters. In one e-mail, Blodget essentially conceded 
that the main driver behind his group's ratings was investment 
banking concerns; frustrated about negotiations with the 
investment banking group about a rating for one particular 
company, Blodget threatened to ``just start calling the stocks 
(stocks not companies), including [the one at issue], like we 
see them, no matter what the ancillary business consequences 
are.'' \313\
---------------------------------------------------------------------------
    \312\ Dinallo Affidavit, note 302 above, at 15.
    \313\ Id. at 19.
---------------------------------------------------------------------------
    Indeed, given the importance of investment banking fees to 
the firms, and the effect ratings can have on client 
relationships, it should not be surprising that many analysts 
have, as a matter of practice, shared their research with the 
companies they cover prior to issuing the reports. The SEC 
found in a survey conducted last year that six out of nine 
investment banks studied had analysts give companies, as well 
as the investment bankers at the analyst's firm who work with 
those companies, advance notice of any pending change in their 
recommendation status.\314\ In March 2001, a memo from the head 
of European equities research at J.P. Morgan Chase was leaked 
to the press, which set forth this policy with the additional 
requirement that the analyst incorporate any change requested 
by the company unless he or she can make an argument why the 
change should not be made, calling it ``a communication 
process,'' not an ``approval process.'' \315\ Anatol Feygin, 
the J.P. Morgan Chase analyst who testified at the Committee's 
February 27, 2002 hearing said that the rules reflected in the 
March 2001 memo did not apply for U.S. research analysts at 
J.P. Morgan. Nevertheless, a J.P. Morgan Chase Vice President 
in the United States commented to the press that providing 
advance notice to companies of a change in their rating was 
standard operating procedure on Wall Street.\316\ At Merrill, 
despite a policy that analysts were not to disclose proposed 
investment ratings to company management, the internet group 
analysts did so freely; Henry Blodget, the head of the internet 
analyst group, claimed not to even know of this policy.\317\ In 
one case, the company management agreed to a particular rating 
from Merrill only so long as its main competitor was downgraded 
to a similar rating. That company was accommodated.\318\
---------------------------------------------------------------------------
    \314\ Analyzing the Analysts, Hearing Before the Subcommittee on 
Capital Markets, Insurance, and Government-Sponsored Enterprises, House 
of Representatives Committee on Financial Services, Hrg. No. 107-25 
(July 31, 2001) at 231-33 (Statement of the Honorable Laura Unger, 
former Acting Chairman of the SEC).
    \315\ ``JP Morgan Reins in Analysts,'' The Times (London), March 
21, 2001.
    \316\ Kathleen Pender, ``Sell Ratings Were Few As Market Tanked,'' 
San Francisco Chronicle, March 28, 2001.
    \317\ Dinallo Affidavit, note 302 above, at 22.
    \318\ Id.
---------------------------------------------------------------------------
    The analysts who covered Enron and who testified at the 
Committee's February 27 hearing denied that their coverage was 
in any way affected or influenced by their firm's investment 
banking ties or other exposure to Enron, even though all of the 
banks they worked for had significant relationships with 
Enron.\319\ Enron entered into a large number of investment 
banking transactions, it actively used financial products, and 
in general it had a lot of business to give banks.\320\ Other 
deals, including structured finance and trading, earned banks 
additional fees. For example, J.P. Morgan's Mahonia Limited 
entered into natural gas trades with Enron, which may have 
earned the bank as much as $100 million.\321\ These 
transactions, and similar transactions with an entity set up by 
Citigroup, appear to have been structured so that Enron could 
obtain financing that would appear on its financial statements 
as trading liabilities rather than debt, with the proceeds 
treated as cash flow from operations rather than cash flow from 
financing.\322\
---------------------------------------------------------------------------
    \319\ The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 26.
    \320\ Beth Piskora and Erica Copulsky, ``Don't Take Stock in Buy 
Boosters--Wall Street Firms Cash in While Rating Losers High,'' New 
York Post, February 4, 2002.
    \321\ Jathon Sapsford and Anita Raghavan, ``Trading Charges: 
Lawsuit Spotlights J.P. Morgan Ties to Enron Debacle,'' The Wall Street 
Journal, January 25, 2002.
    \322\ See The Role of Financial Institutions in Enron's Collapse, 
Hearing Before the Permanent Subcommittee on Investigations, Senate 
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-618 (July 23, 
2002) at-- (Printed Hearing Record Pending) (Statement of Robert Roach, 
Counsel and Chief Investigator, Permanent Subcommittee on 
Investigations), available at http://www.senate.gov/?gov--affairs/
072302roach.pdf.
---------------------------------------------------------------------------
    Moreover, banks that invested in Enron's related-party 
partnerships or that underwrote offerings by certain SPEs knew 
that the entities were backed by Enron stock; it was clearly in 
the banks' interest to ensure that the stock price stayed up. 
Enron CFO Andrew Fastow may have sent a letter to banks, 
telling them that their profits from the partnerships were tied 
directly to the price of the stock.\323\ Investment bank 
investors in the partnerships reportedly included Merrill Lynch 
at $22 million, Wachovia at $25 million, Credit Suisse First 
Boston at $15 million, Lehman Brothers at $10 million, and 
Citigroup at $10 million, among others.\324\ During hearings 
before the House Energy and Commerce Committee, witnesses 
including Enron Vice President Sherron Watkins testified that 
banks had been pressured to invest in the partnerships by 
Andrew Fastow.\325\
---------------------------------------------------------------------------
    \323\ ``Wall Street Investment Banks Facing Lawsuits For Sharing 
Responsibility For Huge Losses Caused by Enron's Collapse,'' NBC News, 
February 22, 2002. According to this report, however, it was unclear 
whether banks had actually received the letter; the copy of the letter 
NBC obtained was unsigned.
    \324\ Charles Gasparino and Randall Smith, ``Merrill Executives 
Invested Their Money In Enron Partnership That the Firm Sold,'' The 
Wall Street Journal, January 30, 2002.
    \325\ See Financial Collapse of Enron Corp., Hearing Before the 
Subcommittee on Oversight and Investigations, House of Representatives 
Energy and Commerce Committee, 107th Cong., Hrg. No. 107-89 (February 
14, 2002), at 54 (Statement of Enron Vice President Sherron Watkins) 
(``Mr. Fastow was almost somewhat threatening; that if you didn't 
invest in LJM, Enron would not use you as a banker or an investment 
banker again. That he was threatening the institutions, that, to get 
Enron business, they should invest in LJM''); see also Kurt Eichenwald, 
``Enticements Are Cited By Bankers in Enron Case,'' The New York Times, 
February 21, 2002 (bankers confirming that pressure tactics took 
place).
---------------------------------------------------------------------------
    Another way analysts can affect their firms' bottom line 
with their recommendations is if those firms' mutual funds or 
institutional investor clients hold large positions in a stock; 
a sell-side analyst's positive recommendation can drive the 
price of that stock higher, improving those portfolios' 
performance.\326\ In Attorney General Spitzer's investigation, 
for example, an e-mail regarding the Merrill analysts' 
continued support for one company even as its stock price 
tumbled indicated that a reason for its good ratings were that 
that company was ``very important to [Merrill] from a banking 
perspective, in addition to our institutional franchise. . . 
.'' \327\ In the February 27 Committee hearing, the Enron 
analysts testified that they, unlike the Merrill analysts, were 
not aware of the positions of their firms.\328\
---------------------------------------------------------------------------
    \326\ Kent L. Womack and Leslie Boni, ``Wall Street's Credibility 
Problem: Misaligned Incentives and Dubious Fixes?,'' The Brookings-
Wharton Papers in Financial Services (2002), at 19.
    \327\ Dinallo Affidavit, note 302 above, at 35 (emphasis added.).
    \328\ The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 41-42.
---------------------------------------------------------------------------
    Another factor that could influence analysts' behavior is 
the effect a poor rating for a stock might have on their 
compensation.\329\ Although every firm compensates its analysts 
differently, the general rule of thumb on Wall Street is that 
compensation is mostly--perhaps more than 75 percent--comprised 
of a bonus, and this bonus, for some of the better paid 
analysts, can often be in the six-figure range.\330\ Despite 
their impressive salaries, the analysts' research itself does 
not generate any income for the bank; thus a bank's evaluation 
of the value an analyst brings to the firm will be based on 
other things. The specific structure of bonuses will differ, 
but at the very least, analysts' bonuses are tied to the 
success of the firm in general--the better a bank does in a 
given year, the higher the bonuses. The analysts who testified 
at the February 27 hearing said that their bonuses were 
dependent in this regard on the overall profitability of their 
firms.\331\ Given that ``buy'' recommendations contribute to 
more business for firms--particularly with respect to potential 
investment banking clients--while negative ratings of companies 
contribute to less, analysts on that count alone have incentive 
to be positive about the companies they cover.
---------------------------------------------------------------------------
    \329\ Analyzing the Analysts, Hearing Before the Subcommittee on 
Capital Markets, Insurance, and Government-Sponsored Enterprises, House 
of Representatives Committee on Financial Services, Hrg. No. 107-25 
(July 31, 2001) at 230 (Statement of the Honorable Laura Unger, former 
Acting Chairman of the SEC).
    \330\ Committee staff interview with Richard Gross, February 13, 
2002; also confirmed by information provided by Thomson Financial.
    \331\ The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 47.
---------------------------------------------------------------------------
    In an interview prior to the February 27 hearing, Richard 
Gross of Lehman Brothers gave Committee staff a more specific 
description of the factors on which his bonus was based than he 
provided at the hearing. Gross said that his bonus was 
determined by a number of factors, including the volume of 
commissions earned by the brokerage from stock sales in the 
industry he covers and the assistance he has provided to the 
investment bankers in helping them evaluate or formulate deals 
or strategy.\332\ Compensation based on specific deals is now 
prohibited by the new NASD and NYSE rules, though analysts are 
commonly compensated based on overall assistance to investment 
banking, which, for all intents and purposes, amounts to the 
same thing.\333\
---------------------------------------------------------------------------
    \332\ Committee staff interview with Richard Gross, February 13, 
2002; see also Michaely and Womack, note 309 above, at 660.
    \333\ See Melvyn Teo, ``Strategic Interactions Between Sell-side 
Analysts and the Firms They Cover,'' Working Paper, December 2000, 
available at http://papers.ssrn.com/sol3/papers.cfm?abstract--
id=258028, at 5 (``it is common for a significant portion of a research 
analyst's compensation to be determined by the analyst's `helpfulness' 
to the corporate finance department'').
---------------------------------------------------------------------------
    Attorney General Spitzer's investigation determined that 
the Merrill analysts' compensation was based, at least in part, 
on assistance to investment banking, perhaps in a way much like 
Gross was describing. In a Fall 2000 survey relating to 
compensation sent by the head of the Merrill research 
department, analysts were asked to provide details about their 
contributions to investment banking, including about 
``involvement in [each] transaction, paying particular 
attention to the degree your research coverage played a role in 
origination, execution and follow-up.'' \334\ Merrill analyst 
Blodget, in his response to this request, indicated that his 
group had been involved in all aspects of 52 transactions, 
amounting to $115 million in business for Merrill. According to 
Blodget's description, those efforts included pitching the 
client, marketing the offering and initiating follow-on 
coverage. After providing this information, Blodget's minimum 
cash bonus increased from $3 million to $12 million.\335\
---------------------------------------------------------------------------
    \334\ Dinallo Affidavit, note 302 above, at 20.
    \335\ Id. at 21.
---------------------------------------------------------------------------
    Annual compensation itself is not the only reason for 
analysts to maintain a positive outlook on companies; optimism 
also brings better job prospects. A recent study by economists 
Harrison Hong of Stanford University and Jeffrey Kubik of 
Syracuse University found that analysts are much more likely to 
be promoted if their recommendations are optimistic, and 
optimism is rewarded more in that regard than accuracy.\336\ 
Conversely, analysts who offer negative ratings can experience 
pressure to improve their outlook on companies they cover. As 
Professor John Coffee testified before the Senate Banking 
Committee, ``In self reporting studies, securities analysts 
report that they are frequently pressured to make positive buy 
recommendations, or at least to temper negative opinions. . . . 
According to one survey, 61 percent of all analysts have 
experienced retaliation--threats of dismissal, salary 
reduction, etc.--as a result of negative research reports. 
Clearly, negative research reports (and ratings reductions) are 
hazardous to an analyst's career.'' \337\
---------------------------------------------------------------------------
    \336\ Paul Taylor, ``Bullish Analysts More Likely to Be Promoted,'' 
Financial Times (London), February 1, 2002.
    \337\ See Accounting and Investor Protection Issues Raised by Enron 
and Other Public Companies, Hearing Before the Senate Committee on 
Banking, Housing and Urban Affairs, 107th Cong., 107--- (March 5, 2002) 
at-- (Printed Hearing Record Pending) (Statement of Columbia University 
Law School Professor John Coffee), available at http://
banking.senate.gov/02--03hrg/030502/coffee.htm.
---------------------------------------------------------------------------
    Finally, analysts may feel pressure from the companies they 
cover to offer positive recommendations. As Thomas Bowman, 
President and Chief Executive Officer of the Association of 
Investment Management and Research, testified at the 
Committee's February 27 hearing:

        L[S]trong pressure to prepare ``positive'' reports and 
        make ``buy'' recommendations comes directly from 
        corporate issuers who retaliate in both subtle, and not 
        so subtle, ways against analysts they perceive as 
        ``negative'' or who don't ``understand'' their company. 
        Issuers complain to Wall Street firms' management about 
        ``negative'' or uncooperative analysts. They are also 
        known to bring lawsuits against firms--and analysts 
        personally--for negative coverage. But the more 
        insidious retaliation is to ``blackball'' analysts by 
        not taking their questions on conference calls or not 
        returning their individual calls to investor relations 
        or other company management. This puts the ``negative'' 
        analyst at a distinct disadvantage relative to their 
        competitors, increases the amount of uncertainty an 
        analyst must live with in doing valuation and making a 
        recommendation, and disadvantages the firm's clients 
        who pay for that research. Such actions create a 
        climate of fear that does not foster independence and 
        objectivity. Analysts walk a tightrope when dealing 
        with company managements. A false step may cost them an 
        important source of information to their decision-
        making process and ultimately can cost them their 
        jobs.\338\
---------------------------------------------------------------------------
    \338\ The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 105-106. Accord 
Analyzing the Analysts, Hearing Before the Subcommittee on Capital 
Markets, Insurance, and Government-Sponsored Enterprises, House of 
Representatives Committee on Financial Services, Hrg. No. 107-25 (July 
31, 2001) at 240 (Statement of the Honorable Laura Unger, former Acting 
Chairman of the SEC) (``The management of companies an analyst follows 
may pressure him/her to issue favorable reports and recommendations. 
Less than favorable recommendations may not be well received by 
management and issuers may threaten to cut off an analyst's access to 
its management if the analyst issues a negative report on the company. 
This could cause the analyst to issue a more favorable report than his/
her analysis would suggest.'').

In order to do their jobs, analysts must have regular, 
meaningful contact with the companies they cover. Having a good 
relationship with those companies means that their phone calls 
will be returned and their questions will be answered. Although 
companies cannot refuse to share material information with 
certain analysts while sharing it with others--Regulation F-D, 
promulgated by the SEC in 2000, prohibits companies from 
selectively disclosing material information to any person or 
group \339\--companies can give favored analysts certain non-
material tidbits, while shutting disfavored analysts out. 
Nevertheless, the analysts who testified at the February 27 
hearing denied that Enron in any way influenced their 
recommendations.\340\
---------------------------------------------------------------------------
    \339\ 17 C.F.R. Sec. 243.100.
    \340\ The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 26.
---------------------------------------------------------------------------

  D. Solutions

    Like the SEC, Arthur Andersen, and Enron's Board of 
Directors, the analysts covering Enron failed to do what the 
market expected of them. The analysts failed to provide 
accurate and unbiased analyses of Enron and the value of its 
stock. The unreliable nature of the analysts' recommendations 
may well have been an open secret on Wall Street. However, it 
was largely unknown to individual investors like the Jupiter, 
Florida women profiled on Now with Bill Moyers who relied on 
Henry Blodget's research, probably unaware of these clear, 
inherent conflicts faced by research analysts until the Enron 
implosion and Attorney General Spitzer's investigation. They 
most likely thought that these analysts were providing their 
unvarnished opinions, based on years of expertise and study. 
Even if some analysts thought they were providing honest 
assessments, they were most likely affected in some respect by 
the business pressures of the firm, the companies they covered, 
and the potential that their own compensation could suffer. How 
else to explain these analysts' near universal bullishness on 
virtually all stocks in the face of market realities telling 
them their advice statistically just could not be right? \341\ 
Whatever the cause, Enron demonstrated without doubt that there 
was a problem.
---------------------------------------------------------------------------
    \341\ As the S&P 500 index fell, analysts' recommendations stayed 
constant overall on the S&P 500 companies. According to Thomson 
Financial, in the 2 years from January 2000 through January 2002, as 
the S&P fell from a high of 1,500 to approximately 1,100, the 
``consensus recommendation'' on those 500 companies--the average 
rating--remained at a buy, and fell only slightly in July 2001. See The 
Watchdogs Didn't Bark: Enron and the Wall Street Analysts, Hearing 
Before the Senate Governmental Affairs Committee, 107th Cong., S. Hrg. 
107-385 (February 27, 2002) at 128 (chart entitled ``S&P 500 Price 
Index Versus S&P 500 Consensus Recommendation'').
---------------------------------------------------------------------------
    So the challenge we face now is how to address this 
situation, to ensure that those who hold themselves out as 
giving unbiased, expert advice are in fact doing so. There is 
no easy or complete solution.
    Most sell-side analysts work for broker-dealers, which are 
regulated by the SEC, and are member firms of self-regulatory 
organizations (SROs) like NASD (formerly the National 
Association of Securities Dealers) and the New York Stock 
Exchange (NYSE). The SEC has delegated rulemaking and 
enforcement authority to these SROs under section 13 of the 
Securities Exchange Act of 1934, pursuant to which the SROs 
oversee broker-dealer activity. Until recently, analysts were 
not subject to any specific regulation much beyond the general 
anti-fraud provisions of the securities laws and NASD 
requirements regarding broker-dealer advertisements that all 
representations be fair, balanced and not misleading. Recently, 
however, the landscape of regulation for analysts changed 
significantly. On May 10, 2002, the SEC approved proposed rule 
changes by NASD and NYSE to address analyst conflicts of 
interests.\342\ Further, the Sarbanes-Oxley Act, which was 
signed by the President on July 30, 2002, set new standards for 
analyst conduct and conflict disclosures and required the SEC 
or the SROs to issue additional rules, which will hopefully 
close the expectation gap for investors in analyst 
recommendations.\343\ The NASD/NYSE rules, \344\ now in place, 
are:
---------------------------------------------------------------------------
    \342\ Exchange Act Release No. 45908 (May 10, 2002), 67 Fed. Reg. 
34968 (May 16, 2002). In addition to these rules, private associations 
to which analysts or their firms may belong have guidelines. Some 
analysts are Chartered Financial Analysts (CFAs), a designation 
indicating that they have at least 3 years of experience and have 
passed 3 day-long exams. The Association for Investment Management and 
Research (AIMR) administers these exams and awards the CFA. Many 
analysts are CFAs, though very few sell-side analysts are. AIMR expects 
all CFAs to follow their Code of Ethics and Standards of Professional 
Conduct, which among other things requires that analysts ``use 
reasonable care and exercise independent professional judgment,'' and 
``exercise diligence and thoroughness in making investment 
recommendations . . . [and] [h]ave a reasonable and adequate basis, 
supported by appropriate research and investigation, for such 
recommendations.'' The Securities Industry Association (SIA), the 
industry trade group covering all securities broker-dealers, has also 
issued a set of ``best practices'' for research.
    \343\ Pub. L. No.107-204 Sec. 501.
    \344\ The new rules can be found as NASD Rule 2711 and amendments 
to NYSE Rules 351 and 472.

---------------------------------------------------------------------------
Reducing Pressure/Influence on Analyst Recommendations

   LNo Control by Investment Banking Department. 
Research analysts may not be subject to the supervision or 
control of the investment banking division of the bank. To the 
extent that analysts communicate with investment bankers 
regarding research reports, such communication must be only for 
verification of accuracy or review of potential conflicts of 
interest that should be disclosed and must be monitored by the 
legal department.

   LCompanies May Not Review Ratings In Advance. 
Companies may review research reports about them in advance of 
their release only to check for accuracy, and may not review in 
advance the rating or the price target.

   LAnalyst Compensation. Analyst compensation may not 
be tied to specific investment banking transactions. To the 
extent that analysts are compensated based on investment 
banking revenues at all, it must be disclosed in research 
reports.

   LNo Quid Pro Quos. No firm may directly or 
indirectly offer a favorable rating or price target or threaten 
an unfavorable rating or price target in exchange for business.

Disclosures of Conflicts

   LDisclosure of Company Relationship With Firm. 
Research reports, or analysts in public appearances (if they 
know or have reason to know), must disclose if the analyst's 
firm or its affiliates received compensation from the subject 
company within the last 12 months, or expect to receive 
compensation in the 3 months following the report.

   LDisclosure of Firm's or Analyst's Ownership of 
Company Stock. An analyst must disclose, in reports or public 
appearances, if the analyst, or the analyst's firm, has a 
financial interest in the subject company.

Limits on Trading/Ownership

   LQuiet Periods. A firm may not issue a research 
report on a company for 40 days following its IPO or 10 days 
following a secondary offering if the firm acted as a manager 
or co-manager of the offering, unless significant events 
warrant a report.

   LBlackout Period for Analysts' Trading Before and 
After Report, Change in Rating or Price Target. Analysts may 
not trade in the stock of a company on which they issue a 
report or change their rating or price target for the 30 days 
prior, and 5 days after, such report or change. (There are some 
limited exceptions to this rule.)

   LNo Trading Against Recommendations. An analyst may 
not trade against the analyst's own recommendations.

   LNo Pre-IPO Shares. No analyst or member of the 
analyst's household may receive pre-IPO securities of a company 
in the industry sector he/she covers.

Clarifying Ratings

   LRatings Must be Defined and Firms Must Show How 
They Rated All the Companies They Cover, and Within Those 
Categories, How Many Were Investment Banking Clients. Research 
reports must clearly define rating systems (e.g., ``strong 
buy'' means the stock will go up by 10 percent in the next 
year) and must show the distribution of the firms' 
recommendations for all the companies they cover across three 
categories--buy, hold, or sell--and within those categories, 
how many were investment banking clients (e.g., of all 
recommendations, 75 percent were buys, 90 percent of which were 
investment banking clients; 20 percent were holds, 2 percent of 
which were investment banking clients; and 5 percent were 
sells, 0 percent of which were investment banking clients).

   LTrack Record Chart. A firm must include in all 
research reports a price chart that maps the price of the 
subject stock over time and indicates points at which the 
analyst assigned a rating and/or price target, enabling 
investors to compare recommendations over time with actual 
stock performance. The chart would not have to extend back 
further than 3 years.

    The Sarbanes-Oxley Act has gone further in addressing the 
issue of analyst independence and disclosure.\345\ That Act 
amended the Securities Exchange Act of 1934 to require the SEC, 
or the SROs under the direction of the SEC, to promulgate rules 
to enhance analyst independence and to require disclosures 
regarding conflict of interest. The Act requires the SEC, or 
the SROs, to issue rules to achieve the following goals:
---------------------------------------------------------------------------
    \345\ Pub. L. No.107-204 Sec. 501.

---------------------------------------------------------------------------
Enhancing Independence

   LSeparation of Research and Investment Banking. 
Structural and institutional safeguards must be established to 
ensure that analysts are partitioned from the review, pressure, 
or oversight by investment banking, activities that might 
potentially bias analysts' judgment.

   LRestrict Pre-Approval of Reports. Pre-publication 
clearance or approval of research reports by non-research 
department staff at the analyst's firm, such as investment 
bankers, must be restricted.

   LLimit Supervision/Evaluation of Analysts to 
Research Department. Supervision of analysts, or evaluations of 
analysts related to compensation, must be limited to non-
investment banking personnel.

   LNo Retaliation for Unfavorable Rating. Retaliation 
against an analyst for an unfavorable rating of an issuer, 
which may negatively affect the firm's investment banking 
relationship with that issuer, is prohibited.

   LQuiet Periods. The SEC or the SROs must establish 
certain time periods during which firms involved in a public 
offering of securities for an issuer may not issue research 
reports on that issuer.

Disclosure

   LInvestment of Analyst in Covered Issuer. The SEC or 
the SROs must adopt rules requiring analysts to disclose in 
reports or in appearances if they have investments in the 
companies covered in those reports or appearances.

   LCompensation Received by Analyst or Firm. The SEC 
or the SROs must adopt rules requiring analysts to disclose any 
compensation received from rated companies, with exceptions 
permitted to prevent disclosure of material non-public 
information, consistent with the public interest and investor 
protection.

   LClient Relationship. The SEC or the SROs must adopt 
rules requiring firms to disclose whether an issuer that is the 
subject of their research reports is also a client, and must 
disclose the types of services provided.

   LAnalyst Compensation. The SEC or the SROs must 
adopt rules requiring analysts to disclose whether they have 
received compensation from the issuer related to any research 
reports, or whether they have received compensation based on 
investment banking revenues.

    The NASD/NYSE rules are a step in the right direction--
prior to their existence there were no rules directly 
addressing these issues at all. The Sarbanes-Oxley Act, 
however, has provided the guiding principles that should govern 
SEC action going forward. The Sarbanes-Oxley Act's requirement 
that the separation between the investment banking and research 
departments be shored up is particularly important. If the SEC 
or the SROs work aggressively with the firms to find a workable 
solution to fulfill the mandate of Sarbanes-Oxley, it will 
provide meaningful protection to the independence and 
objectivity of research, which should assist in restoring 
market confidence in analyst recommendations.
    In order to meet the goals set by the Sarbanes-Oxley Act 
both to enhance the independence of analysts and provide useful 
disclosure, the SEC clearly needs to go further than the 
current NASD/NYSE rules. For instance, the NASD/NYSE rules 
prohibit analyst compensation from being tied only to specific 
investment banking transactions. Even at Merrill Lynch, with 
its alleged abuses, compensation seems to have been decided on 
overall contribution to the investment banking department, not 
individual deals. Indeed, even basing analyst compensation on 
overall profitability--particularly when investment banking 
makes up a significant portion of a firm's revenue--allows 
analysts to be compensated informally based on the work they do 
to prop up the investment banking side of their firms. Thus, 
there is an incentive to help smooth the investment banking 
relationship. Disclosure of any compensation analysts receive 
based even generally on investment banking revenue, required by 
the NASD/NYSE rules and the Sarbanes-Oxley Act, is an important 
tool for savvy investors, but disclosure is not sufficient to 
achieve the separation of investment banking from research 
envisioned by Sarbanes-Oxley.
    Similarly, the NASD/NYSE ``quid pro quo'' rule, prohibiting 
firms from offering positive ratings in exchange for business, 
whether directly or indirectly, arguably misses the mark; 
companies already public are likely to work with banks that 
favor their stock and companies going public are likely to seek 
a firm that is likely to be favorable. The Sarbanes-Oxley Act's 
prohibition on retaliation by firms against analysts who issue 
negative ratings will be helpful to minimize the effect of this 
phenomenon on analysts. To give this provision full effect, 
however, the SEC should try to address the ``carrot'' as well 
as the ``stick'' approach by firms in encouraging undue 
optimism among their analysts. Given that studies, cited above, 
have shown that analysts are promoted more often for optimism 
than accuracy, the SEC or the SROs should work with firms to 
ensure that analysts are rewarded for getting it right for 
investors, not for their rosy outlooks.
    In addition, the NASD/NYSE rule prohibiting firms from 
sharing investment ratings with subject companies in advance of 
releasing the research report does not go far enough. Analysts 
are still permitted, and may be required by their firms, to 
share the text of the report with the covered company, 
supposedly to ensure accuracy. Reading the text of the report 
will certainly give companies an indication of the ratings 
conclusion. In order to help relieve analysts of the strong 
pressure they face from the companies they cover, there should 
be a rule prohibiting sharing the full text of the reports, 
allowing analysts to provide only so much as is necessary to 
fact-check their work.
    Finally, it would be very helpful if the disclosures 
required by the NASD/NYSE rules, particularly those regarding 
the firm's rating track record, would be available more widely 
than just on the research reports themselves. Many investors 
who are not brokerage clients of a large firm obtain 
information about analyst ratings from other sources, including 
financial websites and cable financial news shows. These 
investors will not benefit from these disclosures if they only 
appear on the face of the research reports.
    In addition to the NASD/NYSE rules and just before the 
enactment of the Sarbanes-Oxley Act, the SEC proposed 
Regulation A-C, which would require that analysts personally 
certify that their reports accurately reflect their own views 
and whether they have been or expect to be compensated 
specifically for any individual rating.\346\ The first part of 
this rule may, as securities attorney Sam Scott Miller said, 
``focus people's attention''--particularly analysts, 
hopefully--on the issue of analyst independence and the 
importance of being honest.\347\ However, it does not appear to 
do much more than that; if the rating is issued under the 
analyst's name, it is reasonable to assume that the rating 
represents his or her opinion, and NASD rules already prohibit 
issuing reports that are contrary to the beliefs of the analyst 
who writes them.\348\ The second part of the rule merely 
certifies that the analyst has followed the law: If an analyst 
is compensated for a rating, the Sarbanes-Oxley Act requires 
that such compensation must be disclosed.
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    \346\ SEC Release Nos. 33-8119; 34-46301; File No. S7-30-02 (July 
25, 2002); 67 Fed. Reg. 51510-51516 (August 8, 2002).
    \347\ Michael Schroeder, ``SEC Moves on New Rule,'' The Wall Street 
Journal, July 23, 2002.
    \348\ See NASD Notice to Members 02-39 (May 2002) (``If a member 
issues a report or a research analyst renders an opinion that is 
inconsistent with the analyst's actual views regarding a subject 
company, NASD considers such action to constitute a fraudulent act and 
conduct inconsistent with just and equitable principles of trade.'').
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    In order to further enhance analyst independence and 
disclosure of analyst and firm conflicts to meet the goals set 
by the Sarbanes-Oxley Act, the Committee staff has the 
following recommendations for the SEC:

   LSeparate analysts from investment banking's 
influence. Probably the most basic conflict in this system is 
that the compensation an analyst receives if he or she works 
for a firm that does a significant amount of investment banking 
work will be derived largely from investment banking; to the 
extent that negative ratings can affect their compensation, 
analysts will be loath to issue them. This compromises their 
objectivity, a problem the SEC should address, and indeed is 
required to address under the Sarbanes-Oxley Act. Recent 
reports indicate that the SEC is considering proposing a rule 
requiring complete separation of investment banking and 
research departments at firms, perhaps by mandating that they 
operate through entirely separate, though affiliated 
entities.\349\ If these reports are accurate, the SEC is moving 
in precisely the right direction.\350\ In addition, in order to 
further strengthen the objectivity of stock recommendations, 
the system of compensation and reward for analysts should be 
structured to offer them incentives to issue their best rather 
than their most flattering assessments of companies. One 
possible path may lie in performance-based compensation, which 
would reward accuracy over optimism. At the Committee's 
February 27, 2002 hearing, Charles Hill of Thomson Financial/
First Call endorsed the system used when he was a Wall Street 
analyst, in which large customers would give feedback to the 
firms to indicate which analysts' research they relied on.\351\ 
Merrill Lynch apparently has instituted such a system as part 
of its settlement with the New York Attorney General. The SEC 
or the SROs should ensure that all other Wall Street firms 
follow suit.
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    \349\ Susan Pulliam and Randall Smith, ``SEC's Pitt Seeks Split of 
Banking, Analyst Areas,'' The Wall Street Journal, September 26, 2002.
    \350\ Concerns have been expressed, however, about whether the 
research divisions will remain economically viable without being a part 
of the same entity through which investment banking revenue flows, 
given that many Wall Street firms derive so much of their profits from 
investment banking activities. Many average investors depend on sell-
side analysis to assist them in making their investment decisions 
because most can ill-afford much more expensive independent research. 
Therefore, the SEC must be careful to craft a rule that does not have 
the unintended result of cutting off access to this relatively 
affordable information.
    \351\ The Watchdogs Didn't Bark: Enron and the Wall Street 
Analysts, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-385 (February 27, 2002) at 59.

   LFirms should not be permitted to share research 
reports with the subject companies at all prior to their 
release. If analysts know they might have to show their reports 
to companies in advance of release, analysts will feel pressure 
to soft-pedal their language and their ratings. Firms that rely 
on good relationships with these companies have no incentive to 
protect the analysts if they do not have to. There is no need 
for analysts to show companies their reports in order to fact-
check them. Fact-checking can be achieved by asking targeted 
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questions about specific matters that need verification.

   LIn addition to prohibiting retaliation for negative 
ratings, firms should be prohibited from incentivizing positive 
ratings. The Sarbanes-Oxley Act's prohibition on retaliation 
for negative ratings is an extremely important step towards 
protecting the integrity of research. In issuing rules to 
effect this prohibition, the SEC or the SROs should consider 
whether it might be equally useful to prohibit rewards for 
optimism over accuracy. A rule in this vein would further the 
spirit of the ban on retaliation, and would minimize another 
source of pressure faced by analysts to make their ratings 
rosier than they might otherwise do: Studies showing that 
optimistic research nets promotions more often than accurate 
research on Wall Street.\352\ Perhaps such an effort could be 
achieved in concert with the establishment of a performance and 
accuracy based compensation system for analysts.
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    \352\ Paul Taylor, ``Bullish Analysts More Likely to Be Promoted,'' 
Financial Times (London), February 1, 2002.

   LDisclosures should be made more widely available. 
While the NASD/NYSE rules requiring firms to indicate their 
overall ratings distribution and their track record with 
respect to the companies covered (ratings and target stock 
prices compared to actual performance) are a significant step 
in providing investors with information to assess the value of 
those firms' ratings, many investors obtain ratings information 
from places other than research reports, which are generally 
available only to clients of the firms that produce them or 
through other brokerage houses those firms may partner with. 
These disclosures should be made publicly available, either on 
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the firms' websites or on the NASD or NYSE websites.

   LWhen firms drop coverage of a company without first 
downgrading it to the equivalent of a sell, they should be 
required to publish a release indicating why they are dropping 
coverage. This was a part of the settlement agreement between 
the New York State Attorney General and Merrill Lynch; many 
firms--including Merrill--will drop coverage of a company 
rather than issuing a sell rating. This is a common practice; 
the firms of three of the four analysts who testified at the 
Committee's February 27 hearing did this with Enron. The 
problem with this practice is that unlike a downgrade, which 
comes along with an explanation, it does not provide a 
sufficient indication to investors of the problems with the 
company that brought about the analyst's change of heart. In 
the case of Enron, most investors were aware of the troubles 
with the company at the time the firms' dropped coverage: The 
earliest was J.P. Morgan Chase's drop on November 29, 2001, the 
day after the Dynegy merger fell through, when rampant news 
reports were predicting the company's imminent bankruptcy. But 
where investors have purchased stock in companies that are not 
in the center of the media spotlight based on analyst 
recommendations to buy, they should be alerted by those very 
same analysts that there are problems sufficient to lead their 
firms to abandon coverage.

II. ENRON AND THE CREDIT RATING AGENCIES

    Like the analysts, another outside watchdog failed the 
public with respect to Enron: The credit rating agencies. These 
companies do what their name implies: Rate the creditworthiness 
of entities, such as public companies, and the debt they issue, 
so that those wishing to extend credit--by buying bonds, for 
example--can better understand the risk that they may not see a 
return on that investment. Ratings have taken on great 
significance in the market, with investors trusting that a good 
credit rating reflects the results of a careful, unbiased and 
accurate assessment by the credit rating agencies of the rated 
company. But as with so many other market players, Enron caused 
this legendary reliability to be called into question. It was 
not until just 4 days before Enron declared bankruptcy that the 
three major credit rating agencies lowered their ratings of the 
company to below the mark of a safe investment, the investment 
grade rating. And as with other market participants, like 
securities analysts, auditors, and corporate directors, the 
example of Enron shows that rating agency reform is needed if 
the actual performance of these organizations is to live up to 
public expectations.
    This section of the report will provide a brief description 
of credit ratings, their use and history, and will describe how 
the credit rating agencies made their assessments of Enron, and 
where they failed. Finally, it will outline the current 
regulatory environment in which credit rating agencies operate, 
and make recommendations for how improvements can be achieved 
to restore market confidence in the operation of these firms.

  A. History and Uses of Credit Ratings

    John Moody, the founder of what is now Moody's Investors 
Service (``Moody's''), is generally credited with devising 
credit ratings for public debt issues at the beginning of the 
20th Century. At that time, the United States had the largest 
corporate bond market in the world, comprised mostly of 
railroad bond issues. Investors, however, had few sources 
beyond bankers and the financial press for information about 
the quality of those bonds. Moody's credit ratings, first 
published in 1909, met that need. It was followed by Poor's in 
1916, Standard in 1922, and Fitch in 1924. (Standard and Poor's 
merged in 1941 to become Standard & Poor's (``S&P'').) \353\ 
Moody's--now the largest of the three--offers ratings on over 
$30 trillion of debt and 4,300 corporations.\354\
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    \353\ See Richard Cantor & Frank Packer, ``The Credit Rating 
Industry,'' Federal Reserve Bank of New York Quarterly Review, Summer/
Fall 1994 at 2. Although other credit rating agencies have existed and 
still exist in the United States, many, such as Duff & Phelps and 
Thomson BankWatch, have each merged into one of the main three: 
Moody's, S&P, and Fitch. See Lawrence J. White, ``Bond Raters Troika,'' 
U.S. Banker, May 2002.
    \354\ See ``Introduction to Moody's,'' http://www.moodys.com.
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    Credit ratings, which are expressed in a letter grade, 
provide an assessment of creditworthiness, or the likelihood 
that debt will be repaid.\355\ Generally, companies will 
receive a long-term ``issuer'' rating, which is intended to 
measure the entity's ability to meet its ``senior'' financial 
obligations: Obligations that have not been ``subordinated'' to 
other obligations by law or by agreement.\356\ Each of the 
letter grades may be modified with a plus or a minus, 
indicating relative standing within the categories. S&P and 
Fitch use the same ratings system.\357\ Their first four 
categories, AAA, AA, A, and BBB, are considered ``investment 
grade,'' or of good or better credit quality, AAA+ representing 
the highest credit quality, BBB- representing the lowest 
investment grade credit quality. BBB generally indicates that 
economic conditions may weaken the capacity of the issuer to 
meet its obligations, but overall, the issuer has adequate 
ability to meet its commitments in a timely manner. Lower 
ratings--BB, B, CCC, CC, C, and D--indicate that a company is 
of ``speculative grade.'' The BB and B ratings indicate that 
company is able currently to meet its financial commitments, 
but has significant vulnerability to adverse conditions; lower 
ratings indicate a current vulnerability and significant 
likelihood of some default. Bonds given a ``speculative'' 
rating are sometimes referred to as ``junk'' bonds.
---------------------------------------------------------------------------
    \355\ See Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 82 (``Standard & Poor's 
Understanding Credit Ratings,'' January 2002, attached to the Statement 
of Ronald Barone); ``Fitch Ratings Definitions: Issuer Financial 
Strength Ratings,'' http://www.fitchratings.com.
    \356\ The issuer ratings described here are just one type of rating 
offered by the credit rating agencies; they also offer short-term 
ratings (which are most often used to determine issuers' 
creditworthiness relating to commercial paper), ratings for individual 
debt offerings, or even ratings of countries' creditworthiness. This 
report focuses on Enron's long-term issuer ratings, so for simplicity, 
the other ratings systems are not described here.
    \357\ See generally ``Standard & Poor's Understanding Credit 
Ratings,'' and ``Fitch Ratings Definitions,'' note 355 above.
---------------------------------------------------------------------------
    Moody's uses a slight variation on the S&P/Fitch approach: 
Investment grade is reflected by Aaa, Aa, A, or Baa, with Aaa 
being the most creditworthy, and Baa being the lowest 
investment grade rating.\358\ Moody's ``speculative'' or 
``junk'' ratings are Ba, B, Caa, Ca, and C. Moody's does not 
use pluses or minuses as modifiers; instead it uses numbers: 1 
being equivalent to a plus, 2 as consistent with no modifier, 
and 3 being the same as a minus. In addition to issuing letter-
grade ratings, if the agency is about to lower or raise a 
rating, S&P may put out a ``CreditWatch'' with a negative 
(likely to downgrade) or positive (likely to increase) 
outlook.\359\ Fitch has a similar ``ratings watch,'' and 
Moody's puts companies ``on review'' for an upgrade or 
downgrade.\360\
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    \358\ See ``Ratings Definitions: Issuer Ratings,'' http://
www.moodys.com.
    \359\ ``Standard & Poor's Understanding Credit Ratings,'' note 355 
above, at 2-3.
    \360\ ``Fitch Ratings Definitions: Issuer Financial Strength 
Ratings,'' note 355 above.
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    When John Moody first initiated the credit rating system, 
credit ratings simply provided guidance for investors.\361\ 
According to the credit rating agencies, this remains the 
primary driver of ratings: As S&P explains on its website, its 
``recognition as a rating agency ultimately depends on 
investors' willingness to accept its judgment.'' If history is 
a guide, credit rating agencies generally get it right: Bonds 
rated AAA have a less than 1 percent default rate over 10 years 
or more, \362\ and S&P has found that there is almost an 88 
percent likelihood that companies with ratings of A or above 
will still have that rating 1 year later.\363\ On the other 
hand, bonds rated BB (below investment grade) have an 
approximately 20 percent default rate over 15 years, while 
bonds with a B rating have a 35 percent rate of default and 
bonds with a CCC rating have a 55 percent default rate over 
that same period.\364\
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    \361\ See David C. Gates, ``Rating Agencies and the SEC Asleep at 
the Switch? Complying With the Basel Capital Accord,'' Risk Management 
Association Journal, October 1, 2001, at 3.
    \362\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 63-64; ``Moody's Rating System in 
Brief,'' provided under cover of letter from John J. Goggins, Esq., 
Senior Vice President and General Counsel, Moody's Corporation, to 
Cynthia Lesser, Counsel, Senate Governmental Affairs Committee, dated 
March 6, 2002.
    \363\ Leo Brand and Reza Bahar, ``Corporate Defaults: Will Things 
Get Worse Before They Get Better,'' S&P CreditWeek, January 31, 2001, 
at 15, 27.
    \364\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 64.
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    Nevertheless, since the days of John Moody, the uses of 
credit ratings have evolved. Ratings are currently used more as 
benchmarks for market participants than as a source of 
information for investors. Approximately 95 percent of 
corporate bonds are held by institutional investors, \365\ 
which have their own in-house analysts to assess the value of 
the bonds in which they invest.\366\ To the extent that 
sophisticated private parties use credit ratings for their own 
purposes, they tend to use them in agreements, such as merger 
or loan agreements, as conditions or triggers for certain 
rights or obligations.\367\ A contract might, for example, 
specify that if a company's rating from S&P or Fitch falls 
below a specified grade, payments may be accelerated or 
additional obligations (such as increased interest rates or 
escrows) may be imposed on the company.\368\
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    \365\ See The Status of ``Corporate Trades I,'' Hearing Before the 
Subcommittee on Securities, Senate Banking, Housing and Urban Affairs 
Committee, 106th Cong., S. Hrg. 106-537 (May 26, 1999) at 22 (Statement 
of Nelson D. Civello, Chairman, Bond Market Association).
    \366\ Even though the State statutes and regulations limiting the 
investments allowed to be held by State pension funds to bonds with a 
certain level of investment grade rating are intended as sufficient 
protection from too many defaulting bonds, State pension funds are 
looking for additional ``credit-rating tools'' beyond the ratings of 
the three credit agencies to assess the risk associated with potential 
investments in the wake of WorldCom and Enron. See, e.g., ``State 
Pension Funds Hit But Not Crippled By Enron, WorldCom,'' Associated 
Press, June 29, 2002.
    \367\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 142 (Statement of Jonathan Macey, 
Professor, Cornell University Law School).
    \368\ For example, Enron in one instance used S&P ratings in a debt 
covenant, otherwise known as a ratings trigger. The trigger was 
included in an agreement intended to provide additional credit backing 
to an affiliated limited partnership. When Enron's S&P rating fell to a 
BBB- on November 9 (the triggering event in the covenant), the 
partnership was entitled to accelerate payment of a $690 million note 
from Enron to November 27, 2001. Enron Corp. Form 10-Q for Quarter 
Ended September 30, 2001 (filed November 19, 2001) at 70. Enron also 
had ratings triggers in agreements backing two related trusts, the 
Marlin and the Osprey trusts. Those covenants required Enron to repay 
$2.4 billion for Osprey and $915 million for Marlin if Enron's stock 
price fell below a certain level and its credit rating by any of the 
three rating agencies fell below investment grade (below BBB- or Baa3). 
Enron Corp. Form 10-Q for Quarter Ended September 30, 2001 (filed 
November 19, 2001) at 69.
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    Government agencies have found additional uses for credit 
ratings. In the 1930's, the Federal Reserve began using credit 
ratings on bonds to assess the safety of the portfolio 
investments of member banks.\369\ In 1931, the Comptroller of 
the Currency adopted credit ratings as measures of quality for 
the national banks' bond accounts, first allowing non-
investment grade bonds as long as banks discounted their value, 
taking into account their riskiness, then later prohibiting 
national banks from investing in non-investment grade bonds 
altogether.\370\ State laws and regulations soon adopted 
similar standards for State banks, pension funds, and insurance 
companies, and additional Federal regulation followed.\371\
---------------------------------------------------------------------------
    \369\ Frank Partnoy, ``The Siskel and Ebert of Financial Markets: 
Two Thumbs Down For the Credit Rating Agencies,'' 77 Wash. U. L.Q. 619 
(1999), at 687.
    \370\ Id. at 688.
    \371\ Id. at 688-89.
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    In 1975, the SEC, by rule, significantly enhanced the 
importance of credit ratings. In 1970, Penn Central Railroad 
defaulted on its bonds, leading to unexpected and significant 
losses for investment firms. The bonds, like many others in the 
market at the time, had not been rated by any of the credit 
rating agencies. Due to a general concern about corporate 
creditworthiness at the time, the SEC adopted new net capital 
requirements, or asset requirements, for broker-dealers, firms 
that trade securities in the market, either for themselves 
(dealers) or on behalf of others (brokers).\372\ These 
requirements assure investors that their broker-dealers have 
sufficient assets to back up the funds that investors entrust 
them with. Informally called the ``haircut'' rule, Rule 15c3-1 
requires broker-dealers to take a larger discount on below-
investment grade bonds--a ``haircut''--when calculating their 
assets for the purposes of the net capital requirements than 
for investment grade corporate bonds. This rule specified that 
the ratings come from a ``nationally recognized statistical 
ratings organization,'' or NRSRO.\373\ The term was not 
defined, but it caught on.
---------------------------------------------------------------------------
    \372\ See Adoption of Amendments to Rule 15c3-1 and Adoption of 
Alternative Net Capital Requirements for Certain Brokers and Dealers, 
Release No. 11497 (June 26, 1975) 40 Fed. Reg. 29795 (July 16, 1975). 
See also Gates, note 361 above, at 4-5 (describing Penn Central 
collapse and aftermath); Andrew Fight, The Ratings Game, Wiley & Sons 
Ltd (2001), at 6 (same).
    \373\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 132 (Statement of the Honorable 
Isaac Hunt, SEC Commissioner).
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    The Federal Reserve and the SEC are not alone in giving 
legal significance to the ratings of NRSROs. Currently, at 
least eight Federal statutes and 47 Federal regulations, along 
with over 100 State laws and regulations, reference NRSRO 
ratings as a benchmark. On the Federal level, they are related 
primarily to banks and commodities or securities regulation, 
but a few relate to education (qualifications for schools to 
participate in a financial assistance program under Title IV of 
the Higher Education Act), \374\ to transportation (highway 
projects must be rated investment grade by an NRSRO to obtain 
funding under program), \375\ and telecommunications 
(requirements for approval of loan guarantees from the Federal 
Government).\376\ On the State level, most of the State 
statutes and regulations referring to NRSRO ratings--which 
number over 100--relate to permissible investments by insurance 
companies and State funds, banking and State securities laws 
and regulations. Because so many regulations affecting 
institutional investors incorporate NRSRO ratings, issuers must 
seek out ratings from one of the NRSROs--Moody's, S&P, or 
Fitch--in order to ensure that they have full access to the 
capital markets with respect to their debt instruments.
---------------------------------------------------------------------------
    \374\ 20 U.S.C. Sec. 1087-2.
    \375\ 23 U.S.C. Sec. Sec. 181, 182 .
    \376\ 47 U.S.C. Sec. 1103.
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  B. Efforts to Regulate Credit Rating Agencies

    Although the NRSRO designation has never been formally 
defined in statute or regulation, the SEC, as the agency that 
coined the term, has taken on the task of granting requests 
from rating firms for NRSRO status.\377\ Upon request, the 
staff of the Division of Market Regulation provide a ``no-
action'' letter to the firm granting the status.\378\ Since the 
inception of the designation, the SEC has granted NRSRO status 
to seven companies, including the three that remain today; the 
other four merged with Fitch.\379\
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    \377\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 133 (Statement of the Honorable 
Isaac Hunt, SEC Commissioner).
    \378\ See Capital Requirements for Brokers or Dealers Under the 
Securities Exchange Act of 1934, Release No. 39457, 62 Fed. Reg. 68018 
(December 17, 1994) at 68019 (describing the current process for 
determining whether an entity is an NRSRO).
    \379\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 133-34 (Statement of the Honorable 
Isaac Hunt, SEC Commissioner). Then SEC Commissioner Isaac Hunt 
recently indicated that the SEC may be planning to grant the 
designation to additional credit rating agencies; he was quoted as 
saying that ``we may have more than three by the end of the year.'' 
Alyne Van Duhn, ``Big Three Learn Lessons From Enron: Ratings 
Agencies,'' Financial Times (London), May 27, 2002. There are a few 
agencies that have been trying to achieve the designation for some 
time. John Labate and Jenny Wiggins, ``Ratings Agencies Live in Hope of 
Gaining That Elusive Rise in Status,'' Financial Times (London), May 
21, 2002.
---------------------------------------------------------------------------
    Though it has not received that much attention, the 
informal designation process and the small oligopoly it has 
created have been somewhat controversial. Throughout the 
1990's, Congressman John Dingell wrote a number of letters to 
the SEC calling for increased competition in the industry and a 
setting of national standards for NRSROs.\380\ The Justice 
Department initiated and subsequently closed an investigation 
of the credit rating agencies in 1996 to determine if they were 
engaging in anti-competitive practices.\381\ In addition, in 
the mid-1990's, a school district in Colorado sued Moody's 
after it issued unsolicited, and according to the school 
district, inappropriately low ratings of a bond issue after the 
school district had chosen to retain a different credit rating 
company. Following Moody's rating, the school district alleged 
that it had to reprice the bonds at a cost of over 
$750,000.\382\ The school district lost the suit.
---------------------------------------------------------------------------
    \380\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 135 (Statement of the Honorable 
Isaac Hunt, SEC Commissioner).
    \381\ The antitrust investigation was closed in 1999. Kenneth 
Gilpin, ``Justice Dept. Inquiry on Moody's Is Over, With No Charges 
Filed,'' The New York Times, March 13, 1999.
    \382\ Jefferson County Sch. Dist. v. Moody's Investors Service, 988 
F. Supp. 1341 (D. Colo. 1997), aff'd, 175 F.3d 848 (10th Cir. 1999).
---------------------------------------------------------------------------
    Recognizing that concerns existed and that the public was 
increasingly relying on NRSROs, the SEC in 1994 asked for 
public comment on the SEC's role in the use of the NRSRO 
designation.\383\ The Commission received 25 comment letters in 
response, encouraging it to adopt a formalized process for 
giving the designation. As a result, the SEC proposed a rule in 
1997, seeking to define the term ``NRSRO'' and provide for a 
process both for granting the status and removing it, including 
an appellate process before an Administrative Law Judge.\384\ 
The proposed rule set forth the criteria the staff had been 
relying on: Namely, whether the applicant's ratings were 
nationally recognized, and whether the applicant was 
independent, sufficiently staffed, had systematic procedures 
designed to produce credible and accurate ratings, and had 
internal procedures to protect against the misuse of inside 
information. The rule would have required NRSROs to register as 
investment advisers under the Investment Advisers Act of 1940, 
\385\ and would have required NRSROs to inform the SEC of any 
significant organizational changes. The rule would have 
officially given the SEC power to withdraw the NRSRO 
designation if a credit rating agency failed to maintain the 
required criteria. The 16 commenters on the proposed rule 
criticized it. Although the rule would have done no more than 
to codify the status quo--for example, the NRSROs have all 
voluntarily registered as investment advisers, although they 
maintain they are not required to--the credit rating agencies 
nonetheless opposed the rule because they oppose any formal 
regulation of their business.\386\ The Justice Department 
criticized the rule for perpetuating the current anti-
competitive environment of credit rating agencies.\387\ The 
proposed rule was never finalized.
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    \383\ Nationally Recognized Statistical Ratings Organizations, 
Release No. 34616, 59 Fed. Reg. 46314 (September 7, 1994).
    \384\ See Capital Requirements for Brokers or Dealers Under the 
Securities Exchange Act of 1934, Release No. 39457, 62 Fed. Reg. 68018 
(December 30, 1997).
    \385\ The Investment Advisers Act prohibits fraud, imposes 
fiduciary duties on advisers with respect to their advice, requires 
advisers to maintain certain books and records, and allows the SEC to 
examine advisers to determine compliance with the Act. See generally 15 
U.S.C. 80b-1 et seq.
    \386\ See, e.g., Comments of Moody's Investors Service in the 
Matter of File No. S7-33-97, Release No. 39457, Capital Requirements 
for Brokers or Dealers Under the Securities Exchange Act of 1934, dated 
March 2, 1998.
    \387\ Comments of the United States Department of Justice in the 
Matter of File No. S7-33-97, Proposed Amendments to Rule 15c3-1 Under 
the Securities Exchange Act of 1934, dated March 6, 1998.
---------------------------------------------------------------------------
    Even though NRSROs are not subject to any formal process 
for designation, monitoring or removal, they do receive special 
treatment in securities regulation. First, they are given 
special access to companies. SEC Regulation F-D prohibits 
issuers from making selective disclosure of material 
information in order to ensure that all investors have access 
to significant corporate news at the same time.\388\ The rule 
was prompted by concern that some favored analysts and market 
participants received information first, while the rest of the 
market had to wait to find out. Credit rating agencies, 
however, are expressly exempted from Regulation F-D.\389\ The 
analysts from Moody's, S&P or Fitch can have private 
conversations with company management that no other analyst can 
have, and the credit rating analysts can see financial 
information that no other analyst could see without the company 
disclosing it publicly. Moreover, NRSROs are officially 
shielded from liability for all but fraud under the securities 
laws. SEC Rule 436, promulgated under the Securities Act, 
expressly shields NRSROs from liability under Section 11 of the 
Securities Act in connection with an offering of 
securities.\390\ This means that NRSROs are not held even to a 
negligence standard of care for their work.\391\
---------------------------------------------------------------------------
    \388\ 17 C.F.R. Sec. 243.100.
    \389\ 17 C.F.R. Sec. 243.100(b)(2)(iii). Moody's and S&P supported 
this exemption. See Comments of Standard & Poor's in the Matter of File 
No. S7-31-99, Release Nos. 33-7787, 34-42259, IC-24209, Regarding 
Selective Disclosure and Insider Trading, April 17, 2000; Comments of 
Moody's Investors Service in the Matter of File No. S7-31-99, Release 
Nos. 33-7787, 34-42259, IC-24209, Regarding Proposed Rule: Selective 
Disclosure and Insider Trading, April 27, 2000.
    \390\ 17 C.F.R. Sec. 230.436(g)(2). Interestingly, the SEC makes 
clear in the adopting release for this rule that this rule only applies 
to NRSROs; to the extent that companies wish to disclose the ratings of 
non-NRSROs in their filings, those credit rating agencies are required 
to file consents as attachments to the registration statements 
(rendering them subject to liability under section 11 of the Securities 
Act of 1933). See 47 Fed. Reg. 11380, 11392 n. 55 (March 16, 1982).
    \391\ NRSROs argue that they would not be subject to liability 
under a negligence standard in any event because their ratings 
constitute opinions protected by the First Amendment. This has been 
accepted by at least one court. See, e.g., County of Orange v. McGraw 
Hill, 245 B.R. 151 (C.D. Cal. 1999) (where county alleged S&P had 
negligently issued defective ratings of municipal bonds, court held 
that in order to prove S&P liable for botched ratings, county had to 
show actual malice, the standard for protected speech).
---------------------------------------------------------------------------
    The NRSRO designation has had a significant beneficial 
effect on the profitability of credit rating agencies. Until 
the late 1960's, the rating agencies made their money by 
publishing their ratings and selling them to investors.\392\ 
This ceased to be profitable due to the increasing use of 
improved information sharing technology--basically the 
photocopying machine--by users of the ratings.\393\ Starting 
around 1970, the rating agencies began to charge issuers of 
debt instruments for ratings.\394\ That is the system that 
exists today. With a credit rating effectively required by law 
for so many purposes, issuers in most instances seek the 
ratings out of necessity. Credit rating agencies generally 
charge companies per transaction--for a simple transaction, 
typically 2 or 3 basis points (.02 or .03 percent of the total 
amount of the deal), or somewhat more for a complex one.\395\ 
If an issuer is extremely active in the markets, agencies also 
accept an annual fee.\396\ Some critics suggest that this 
arrangement causes a conflict of interest, \397\ although it is 
unclear how great an impact any such conflict has, given that 
issuers have no choice but to obtain a rating from one of the 
limited number of firms offering the service. In other words, 
the credit rating agencies probably do not feel pressure to 
please issuers to get their business.\398\
---------------------------------------------------------------------------
    \392\ Bethany McLean, ``The Geeks Who Rule the World,'' Fortune, 
December 24, 2001.
    \393\ Lawrence J. White, ``The Credit Rating Industry: An 
Organizational Analysis,'' February 2001 (Working Draft) at 13, 
available at http://papers.ssrn.com/sol3/papers.cfm?abstract--
id=267083.
    \394\ Bethany McLean, ``The Geeks Who Rule the World,'' Fortune, 
December 24, 2001.
    \395\ Partnoy, note 369 above, at 653.
    \396\ Committee staff interviews with Moody's (March 8, 2002), S&P 
(March 6, 2002), and Fitch (March 5, 2002), described at note 404 
below.
    \397\ The SEC solicited comments on this practice in its 1997 
proposed rule. See also Fight, note 372 above, at 227 (noting ``the 
obvious potential conflict of interest just from the fact that the 
rating company is taking ratings fees from the companies it rates''); 
Dave Lindorff, ``Judging the Judges: Are the Top Rating Agencies Too 
Slow to Downgrade?'' Investment Dealers Digest, August 13, 2001 (taking 
fees from issuers is `` `a built-in conflict,' says credit rating 
agency Egan-Jones' Managing Director Bruce Jones, previously a senior 
analyst at Moody's. `[Moody's] charges issuers for their ratings, and 
yet their public posture is to turn double cartwheels to insist that 
their constituency is the investor.' '')
    \398\ The credit rating agencies, in rare cases, also provide 
ratings even when they do not get paid. Although Moody's informed 
Committee staff in an interview that it only does this now for high-
yield junk bonds in the United States, S&P and Fitch told Committee 
staff in interviews that they provide unsolicited ratings as they see 
fit.
---------------------------------------------------------------------------
    This enviable market position appears to provide strong 
profitability: Rating agencies can benefit from active capital 
markets without having to risk any of their own capital. Though 
S&P is a division of McGraw-Hill (and therefore its individual 
profitability is not publicly available), and Fitch is a 
subsidiary of a private corporation, Moody's was recently spun 
off as its own publicly-held company by Dun & Bradstreet and 
publicly reports its earnings. Moody's--which is an S&P 500 
company and has a market capitalization of approximately $7.7 
billion \399\--had record results in 2001. Its revenue was $797 
million, an increase of a full 32 percent from 2000. Its 
operating income was $399 million, 38 percent higher than 2000. 
Its profits were $212 million in 2001, 34 percent more than 
2000.\400\ Ratings generate approximately 85 percent of Moody's 
revenues.\401\
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    \399\ Calculated based on closing price of $49.69 on September 10, 
2002.
    \400\ ``Moody's Corporation Reports Record Results for Fourth 
Quarter and Full Year 2001,'' Moody's Corporation Press Release, 
February 4, 2002; see also Moody's Corporation Annual Report on Form 
10-K for year ended December 31, 2001 (filed March 22, 2002), at Item 
7, pp. 15-16.
    \401\ Moody's Corporation Annual Report on Form 10-K for year ended 
December 31, 2001, at Item 7, p. 16.
---------------------------------------------------------------------------
    Although they do not consult with one another on ratings, 
the rating agencies generally appear to approach the business 
of rating issuers in a very similar way.\402\ They will assign 
each company to one primary analyst (that analyst will cover a 
number of companies, perhaps between 10 and 30), who typically 
works with a junior analyst. Analysts work in groups divided by 
industry sector; the analysts covering the companies within 
that sector are overseen by a managing drector in charge of 
that sector. When a company has been rated before and is being 
monitored by the rating agencies, analysts will review the 
company's periodic SEC filings and other public information 
relevant to the company, including press reports or industry 
information. The analysts will periodically meet and speak to 
the company's management and visit the company's facilities. 
The focus of the rating agencies' analysis is the company's 
ability to generate cash in comparison to the company's 
liabilities; the extent to which the former easily covers the 
latter will be a significant determinant of the rating. In 
analyzing a company's prospects for paying its obligations, in 
addition to reviewing the company's own historical performance 
and industry trends, the credit raters will generally request 
additional, non-public information. Although the credit raters 
stress that they rely primarily on public information, they 
will also ask to review the company's projections of future 
cash flows and will generally seek a breakdown of cash flows by 
company segment, to see how each of its businesses have done 
and how the company believes they will do in the future. 
According to Moody's, that ``segmentation information'' is 
fundamental to assessing a company's creditworthiness. The 
credit raters will also generally ask for full disclosure of 
all significant liabilities of the company, including those 
``off-balance sheet.'' \403\
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    \402\ The following description of the credit raters' methodology 
was derived from telephonic Committee staff interviews with officials 
from Moody's (March 8, 2002), S&P (March 6, 11, 13, 2002), and Fitch 
(March 5, 2002), described at note 404 below.
    \403\ Committee staff interviews with Fitch (March 5, 2002), 
Moody's (March 8, 2002) and S&P (March 11 and 13, 2002), described at 
note 404 below.
---------------------------------------------------------------------------
    To determine a rating, analysts will convene a credit 
committee. The committee will consist of anywhere from 4 to 12 
people, including the analysts working on the company, their 
managing director, and other analysts, management, or staff 
with useful expertise. The analyst will make a recommendation, 
and the committee will vote. The deliberations of a credit 
committee, and the identities of the participants, are kept 
confidential. The rating is usually made public through a press 
release. Companies are generally notified of their ratings in 
advance of the publication if there is a change or if it is a 
new rating to allow the issuer to respond if it believes that 
the rating does not accurately reflect its creditworthiness--
S&P refers to this process as an ``appeal.'' Such an 
``appeal,'' if the company requests it, is conducted within a 
day or two of the ratings announcement. S&P has indicated that 
it is rare that it will change a rating. With a company that 
has been rated and is being monitored, a committee will be 
convened periodically, perhaps once a year or once every 18 
months, to reaffirm or change the rating. Prior to a ratings 
change, a company may be put on a ``watch'' or ``review.'' An 
analyst may initiate a ``watch'' or ``review'' without a 
meeting of the credit committee.

  C. Chronology of Enron's Ratings

    Given the significant and market-wide impact of credit 
ratings, one would expect the rating agencies to perform a 
careful and searching inquiry into companies they rate. They 
have access enjoyed by no other corporate watchers--companies 
can and do share non-public material information with them 
without disclosing it to the public at large--and with their 
ability to downgrade a company's credit ratings, the rating 
agencies can essentially restrict a company's access to the 
capital markets. Indeed, one must question whether so many 
State and Federal laws, as well as private contracts, would 
vest such authority in the ratings of these agencies if anyone 
suspected that the credit raters were not using their power and 
access to obtain the best information possible.
    Unfortunately, at least in Enron's case, the credit rating 
agencies did not perform as expected. Based on a number of 
interviews conducted by Committee staff with officials from 
Moody's, S&P, and Fitch, \404\ Committee staff has concluded 
the agencies did not perform a thorough analysis of Enron's 
public filings; did not pay appropriate attention to 
allegations of financial fraud; and repeatedly took company 
officials at their word, without asking probing, specific 
questions--despite indications that the company had misled the 
rating agencies in the past.
---------------------------------------------------------------------------
    \404\ Staff interviewed officials from each of the agencies in 
preparation for the March 20 Committee hearing. On March 5, 2002, 
Committee staff interviewed Fitch General Counsel Charles Brown, Glenn 
Grabelski, Fitch Managing Director, and Ralph Pellecchia, the senior 
analyst on the Enron credit for Fitch. On March 6, Committee staff 
interviewed S&P officials, including Leo O'Neill, President of S&P, 
Executive Vice President Vickie Tillman, and Counsel for Regulatory 
Affairs Rita Bolger. On March 8, Committee staff interviewed Moody's 
officials, including Moody's President Ray McDaniel, Pamela Stumpp, 
Chief Credit Officer, and John Diaz and Stephen Moore. Moore was the 
primary analyst on the Enron credit for Moody's, but his work was 
closely overseen by Diaz, Managing Director for the Power and Energy 
Group. Diaz had been the Moody's analyst following Enron prior to 
Moore, and thus he maintained watch on the company after he was 
promoted to managing director. On March 11, Committee staff conducted a 
second interview with S&P officials, including Ronald Barone, Managing 
Director for the Utilities, Energy & Project Finance Group. On March 
13, Committee staff conducted a third interview with S&P officials, 
including Todd Shipman, an S&P analyst. Shipman was the primary analyst 
on Enron for S&P, but his work was also closely overseen by Barone, as 
Barone had also followed Enron when he was an analyst.
---------------------------------------------------------------------------
    As of late March 2000, the three agencies gave Enron the 
same rating: Moody's \405\ gave it a Baa1, and S&P \406\ and 
Fitch \407\ both rated Enron as BBB+, indicating an upper level 
within the category of good credit quality.\408\ Retaining this 
investment grade rating, and even improving it, was vital to 
Enron because its ability to operate and grow its trading 
business as well as to access the capital markets for its 
liquidity needs were absolutely dependent upon the stability 
that the rating provided. In fact, the company consistently 
lobbied for a higher rating.\409\ Nevertheless, given the 
volatility inherent in an industry that was in the process of 
deregulation, and given that Enron was a company that took a 
number of risks, the rating agencies did not consider a higher 
rating appropriate.\410\
---------------------------------------------------------------------------
    \405\ Paul Chivers, ``Empowering Enron,'' Euromoney Institutional 
Investor, June 1, 2000.
    \406\ ``Standard & Poor's Affirms Enron Ratings Re Cogen 
Technologies Acquisition,'' PR Newswire, November 3, 1998.
    \407\ ``Fitch IBCA Affirms Enron Corp. at BBB+,'' Business Wire, 
November 8, 1999.
    \408\ See ``Standard & Poor's Understanding Credit Ratings,'' note 
355 above; ``Fitch Ratings Definitions,'' note 355 above; ``Ratings 
Definitions: Issuer Ratings,'' http://www.moodys.com, note 358 above.
    \409\ See, e.g., Rating the Raters: Enron and the Credit Rating 
Agencies, Hearing Before the Senate Governmental Affairs Committee, 
107th Cong., S. Hrg. 107-471 (March 20, 2002) at 65-66, 122.
    \410\ As S&P's Barone pointed out in his written testimony, the 
rating agencies, in consideration of these factors, added back ``debt-
like burdens'' into the numbers it used to calculate Enron's rating. 
Barone stated that ``over the years Standard & Poor's `put back' onto 
Enron's balance sheet off-balance sheet amounts of between $2 billion 
and $4 billion in debt-like obligations for purposes of our ratings 
analysis.'' Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 66-67.
---------------------------------------------------------------------------
    In early October 2001, Enron's assistant treasurer, Tim 
DeSpain, called Moody's and S&P to tell them that Enron would 
soon announce: (1) a $1 billion writedown on after-tax income 
due to bad investments, and (2) a $1.2 billion reduction in 
shareholder's equity, which DeSpain described only as an 
accounting adjustment. Moody's analysts were surprised because 
they had been assured by Enron just weeks before, after CEO 
Skilling's resignation on August 14, 2001, that a writedown was 
not imminent. Both Moody's and S&P were concerned about the 
effect of the large writedown on Enron's financial strength, 
but neither appeared significantly concerned about the equity 
reduction.\411\ Based on information provided to Committee 
staff, it does not appear that they made any effort to obtain a 
cogent explanation for why the reduction was taking place or 
how such a significant accounting error could have occurred.
---------------------------------------------------------------------------
    \411\ Committee staff interviews with Moody's (March 8, 2002) and 
S&P (March 11 and 13, 2002), described at note 404 above. In his 
testimony at the March 20 hearing, Moody's Diaz said that Moody's was 
``questioning and scratching our heads about the type of accounting 
that they were using for that charge and how did that $1.2 billion of 
equity actually come about.'' However, he said that Moody's was ``not 
satisfied with [Enron's] explanations'' for the actions. Nevertheless, 
he testified that Moody's ``discussions [with Enron] during that time 
were concentrated on understanding the liquidity position of the 
company and how that was impacting the trading business.'' Rating the 
Raters: Enron and the Credit Rating Agencies, Hearing Before the Senate 
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-471 (March 20, 
2002) at 13.
---------------------------------------------------------------------------
    On or about October 12, Ken Lay, who had resumed his 
position as Enron CEO following Jeffrey Skilling's resignation 
in August, called both S&P and Moody's after hearing that the 
credit raters were considering a downgrade. Lay tried to 
reassure the agencies that Enron would shore up its balance 
sheet, selling off assets as necessary to create additional 
reserves to cover obligations.\412\ Neither Moody's nor S&P 
questioned Lay about the enormous equity adjustment.
---------------------------------------------------------------------------
    \412\ Committee staff interviews with Moody's (March 8, 2002) and 
S&P (March 11 and 13, 2002), described at note 404 above.
---------------------------------------------------------------------------
    On October 16, Enron made the earnings announcement about 
which it had advised Moody's and S&P nearly 2 weeks earlier. On 
October 17, The Wall Street Journal broke the story about 
partnerships run by Enron CFO Andrew Fastow being used to hide 
Enron losses and debt.\413\ On October 22, Enron revealed that 
the SEC was investigating the allegations in the report. Two 
days later, on October 24, Fastow resigned. Although all the 
analysts said that they asked Enron officials about the 
allegations in The Wall Street Journal story, they never 
received--or appear really to have pressed for--a clear 
explanation from Enron officials, who, according to the 
analysts, simply denied knowledge of the details.\414\ In fact, 
the credit analysts were not focused on Enron's questionable 
transactions or accounting, despite the possible serious 
wrongdoing these practices indicated. Despite their stated goal 
of assessing long-term corporate strength, the raters focused 
almost exclusively on the cash position of the company, a 
short-term consideration. It was only when Enron informed the 
credit rating firms that it was going to draw down on and 
exhaust its lines of credit--indicating it was in a cash crisis 
and that it was having difficulty placing its commercial 
paper--that the raters acted.\415\
---------------------------------------------------------------------------
    \413\ John Emshwiller and Rebecca Smith, ``Enron Jolt: Investments, 
Assets Generate Big Loss; Part of Charge Tied to 2 Partnerships 
Interests Wall Street,'' The Wall Street Journal, October 17, 2001.
    \414\ Committee staff interviews with Moody's (March 8, 2002) and 
S&P (March 11 and 13, 2002), described at note 404 above.
    \415\ Committee staff interviews with Fitch (March 5, 2002), 
Moody's (March 8, 2002) and S&P (March 11 and 13, 2002), described at 
note 404 above.
---------------------------------------------------------------------------
    On October 25, S&P changed Enron's ratings outlook to 
negative (though it kept Enron at BBB+).\416\ Fitch, having 
digested the news from the earnings announcement and concerned 
about the drawdown on credit, also placed Enron on watch for a 
downgrade.\417\ On October 29, Moody's downgraded Enron one 
notch to Baa2 (still investment grade) and kept it on review 
for another downgrade.\418\ According to its press release, 
Moody's main concern was Enron's shrinking access to liquidity 
and the reduction in equity: Neither the SEC investigation nor 
the underlying allegations about possible financial fraud were 
mentioned.\419\ That same day, S&P's primary Enron analyst, 
Todd Shipman, appeared on CNN Financial News Network. Even 
though S&P had placed Enron on CreditWatch negative, Shipman 
said, ``Enron's ability to retain something like the rating 
they're at today''--meaning an investment grade rating--``is 
excellent in the long term.'' \420\ When asked about the off-
balance sheet partnerships, Shipman remarked that S&P was 
``confident that there's not any long term implications to that 
situation and that's something that's really in the past.'' 
\421\ As he appears to have gotten no information from Enron 
about the allegations of questionable transactions and 
accounting, it is unclear what basis Shipman had for those 
remarks.\422\
---------------------------------------------------------------------------
    \416\ ``Ratings on Enron Corp. Affirmed; Outlook to Negative,'' S&P 
Press Release, October 25, 2001.
    \417\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 11 (Testimony of Ralph Pellecchia).
    \418\ ``Moody's Downgrades Enron Corp. Long-Term Debt Ratings 
(Senior Unsecured to Baa2) and Keeps Them Under Review For Downgrade,'' 
Moody's Press Release, October 29, 2001.
    \419\ Id.
    \420\ Interview of Todd Shipman, S&P, by Deborah Marchini (CNNFN 
Street Sweep, October 29, 2001), available on Lexis/Nexis, Transcript 
#102915cb.l06.
    \421\ Id.
    \422\ Barone testified at the March 20 hearing that Enron officials 
had told him that ``they would be surprised if they found anything 
further,'' but conceded that he had told Committee staff that Enron 
officials had said that ``they didn't know what else was out there.'' 
Rating the Raters: Enron and the Credit Rating Agencies, Hearing Before 
the Senate Governmental Affairs Committee, 107th Cong., S. Hrg. 107-471 
(March 20, 2002) at 14.
---------------------------------------------------------------------------
    Despite Shipman's public comments of confidence in Enron, 
on November 1, S&P downgraded Enron to BBB (two notches above 
junk), and placed it on negative CreditWatch, although in its 
press release, S&P indicated its belief that Enron was 
sufficiently liquid to get through ``the current period of 
uncertainty.'' \423\ On November 2, the very next day, in a 
public conference call set up by S&P to answer questions about 
Enron, \424\ Shipman, this time along with Ronald Barone, his 
supervisor and S&P Managing Director, again commented on S&P's 
``confidence'' that there would be no more revelations about 
off-balance sheet partnerships at Enron. Barone said, ``We have 
a great deal of confidence there are no more surprises to 
come.'' Shipman added, ``We're confident we capture or are 
privy to the obligations that Enron has.'' Barone finished, ``I 
think it's gonna take a little bit more time before everybody 
can get fully comfortable that there's not something else 
lurking out there. But at this point, we feel very confident 
that that's unlikely.'' \425\
---------------------------------------------------------------------------
    \423\ ``Enron Corp.'s Rating Lowered, Placed on CreditWatch 
Negative,'' S&P Press Release, November 1, 2001.
    \424\ This conference call was open to the public; anyone who 
wanted to listen in or ask questions could call into a number provided 
by S&P.
    \425\ Transcript of S&P Teleconference re: Enron, dated November 2, 
2001, provided to the Committee under cover of letter from Floyd 
Abrams, Esq. to Cynthia Gooen Lesser, Counsel, Senate Governmental 
Affairs Committee, dated March 19, 2002.
---------------------------------------------------------------------------
    On November 5, Fitch issued a two-notch downgrade on Enron 
to BBB- (just one level above junk).\426\ In its release 
regarding the downgrade, Fitch mentioned the SEC investigation 
as ``an additional uncertainty,'' and cited as a concern ``an 
erosion in investor confidence'' but expressed the belief that 
``Enron should be able to manage through this challenging 
environment, ultimately recognizing the values of the company's 
core businesses,'' which Fitch said have ``generated strong, 
predictable performance.'' Fitch expressed this confidence in 
Enron's ``strong performance'' despite the reports about its 
questionable transactions, which may have been used to make the 
company's performance seem better than it was.
---------------------------------------------------------------------------
    \426\ ``Fitch Downgrades Enron to `BBB-'; Maintains Rtg Watch 
Negative,'' Business Wire, November 5, 2001.
---------------------------------------------------------------------------
    In the meantime, on or around November 5, Moody's and S&P 
were informed by Enron about the upcoming announcement of a 
merger with Dynegy.\427\ Fitch was also notified of the merger 
plans in advance. All the credit raters said that they retained 
Enron's credit rating at above investment grade through 
November 28 solely because of the proposed merger.\428\ On 
November 9, Fitch essentially improved Enron's credit outlook 
by putting it on an ``evolving'' ratings watch, rather than a 
negative one, due to the good prospects from the merger. In its 
November 9 release, Moody's downgraded Enron to Baa3 (one notch 
above junk) due to shrinking investor confidence, but indicated 
that it would view ``a substantial near term injection of 
equity capital as a stabilizing event,'' an implicit reference 
to the merger.\429\ S&P also downgraded Enron to BBB- (one 
notch above junk), with a negative watch on November 9, with 
its investment grade rating at this point due entirely to the 
merger.\430\ Despite the fact that Enron had just 1 day before, 
on November 8, announced a restatement for the past 4\1/2\ 
years, with a charge to earnings of approximately $500 
million--about 20 percent of earnings during that period--none 
of the credit rating agencies showed concern about the 
possibility of financial fraud and the damage that such 
illegalities could cause Enron and its merger partner.\431\
---------------------------------------------------------------------------
    \427\ It was in connection with the discussions about the merger 
that Moody's received telephone calls about Enron's credit rating, 
mostly from Enron's bankers. According to a description of these calls 
provided to Committee staff by Moody's attorneys on March 19, 2002, 
after receiving a copy of the merger term sheet on November 8, 2001, 
Moody's was concerned that the merger terms too easily allowed 
Citigroup and J.P. Morgan Chase, the banks financing the merger, and 
Dynegy, Enron's prospective acquirer, to drop the deal. Moody's told 
Enron that it was seriously considering downgrading Enron below 
investment grade as a result of this uncertainty. After that, the CEO 
of Moody's, John Rutherfurd, received a number of telephone calls. 
Former Treasury Secretary Robert Rubin, Chairman of Citigroup's 
Executive Committee, and Michael Carpenter, CEO of Citigroup Salomon 
Smith Barney, conference called Rutherfurd, who was in his car on his 
cellphone at the time. Before the call got started, Rubin apparently 
was dropped from the call; he and Rutherfurd did not speak again on the 
matter. Carpenter told Rutherfurd that he was concerned about the 
possible Enron downgrade; Rutherfurd replied that he did not get 
involved with ratings matters, and told Carpenter he would have Debra 
Perry, a senior managing director and executive officer of Moody's, 
call him. Rutherfurd called Perry, who called Carpenter, and set up a 
meeting with her and James Lee, another Citigroup official, and William 
Harrison, CEO of J.P. Morgan Chase. (Harrison left a message for 
Rutherfurd also, but they never spoke.) In Perry's meeting with 
Harrison and Lee, Lee mentioned that William McDonough of the Federal 
Reserve might call, but neither he, nor any other government official 
ever did. (Richard Grasso, CEO of the New York Stock Exchange, left a 
message for Rutherfurd that day, but by the time Rutherfurd called him 
back, the issue had been resolved and they never discussed Enron.) 
Ultimately, Lee and Harrison agreed to change the terms of the merger 
to accommodate Moody's concerns; Dynegy agreed to similar changes. 
Neither S&P nor Fitch received such calls, according to their testimony 
at the Committee's March 20 hearing. Rating the Raters: Enron and the 
Credit Rating Agencies, Hearing Before the Senate Governmental Affairs 
Committee, 107th Cong., S. Hrg. 107-471 (March 20, 2002) at 28.
    \428\ Committee staff interviews with Fitch (March 5, 2002), 
Moody's (March 8, 2002) and S&P (March 11 and 13, 2002), described at 
note 404 above.
    \429\ ``Moody's Downgrades Enron Corp. Long-Term Debt Ratings And 
Keeps Them Under Review For Downgrade,'' Moody's Press Release, 
November 9, 2001.
    \430\ ``Dynegy Ratings Placed on Watch Negative; Enron Rating 
Lowered to BBB-,'' S&P Press Release, November 9, 2001.
    \431\ To the extent that the credit rating agencies expressed 
concerns in this regard, they were limited to concerns about 
counterparty and investor confidence as a result of the allegations--a 
short-term concern--not about the inherent, long-term damage that 
serious fraud could inflict on a corporation. See, e.g., Rating the 
Raters: Enron and the Credit Rating Agencies, Hearing Before the Senate 
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-471 (March 20, 
2002) at 11, 13.
---------------------------------------------------------------------------
    On November 19, Enron filed its Form 10-Q, which reported 
its third quarter results. For the first time, to the surprise 
of all the credit rating agencies, Enron disclosed that the 
November 9 S&P downgrade to BBB- had triggered a demand 
obligation for $690 million.\432\ Although the credit rating 
agencies were aware of other such agreements backing other 
special purpose entities associated with Enron, they did not 
know about this one. According to what the credit analysts told 
Committee staff in interviews, the analysts had never 
specifically asked Enron if other triggers dependent on credit 
ratings existed.\433\ Enron officials told S&P that current 
Enron management had not even known about the $690 million 
obligation; it was a surprise to them when the trustee for the 
affected entity had exercised the trigger.\434\ S&P not only 
failed to ask if there were other ``surprises'' regarding 
credit triggers or other obligations, but the S&P analysts 
appear to have also been unconcerned about the fact that Enron 
management itself appeared to lack knowledge about a major 
company commitment.\435\ On November 20, the day after this 
disclosure, S&P reaffirmed its investment grade rating with a 
negative watch. S&P said that it believed Enron could deal with 
the $690 million obligation (without mentioning the fact that 
Enron had failed to disclose a significant financial obligation 
and that S&P believed the obligation was a surprise even to 
management at Enron).\436\
---------------------------------------------------------------------------
    \432\ Enron Corp. Form 10-Q for Quarter Ended September 30, 2001, 
filed November 19, 2001, at 10, 33. News reports have indicated that 
the $690 million obligation was associated with an entity called 
Whitewing. See, e.g., Peter Behr, ``Enron Raised Funds in Private 
Offering; Shareholders in Dark, Documents Show,'' The Washington Post, 
January 22, 2002. Whitewing was an Enron-affiliated entity that the 
credit rating agencies were well aware of; they had rated debt 
offerings that were associated with Whitewing. Indeed, the other 
obligations Enron had with ratings triggers that the rating agencies 
knew about were related to Whitewing. The credit rating agencies told 
Committee staff that their understanding was that the $690 million 
obligation was associated with a partnership called Rawhide that the 
credit raters were unaware of prior to the Form 10-Q filing.
    \433\ Committee staff interviews with Fitch (March 5, 2002), 
Moody's (March 8, 2002) and S&P (March 11 and 13, 2002), described at 
note 404 above.
    \434\ Committee staff interviews with S&P (March 11 and 13, 2002), 
described at note 404 above.
    \435\ Id.
    \436\ ``Enron Corp.'s Ratings Still Watch Negative,'' S&P Press 
Release, November 20, 2001.
---------------------------------------------------------------------------
    Over the next few days, however, the credit rating agencies 
heard about a renegotiated deal for the proposed merger, and 
the likelihood of the merger seemed more and more remote. 
Finally, on November 28, after hearing that the terms had been 
revised to give Dynegy additional ways to terminate the 
transaction, and without additional cash from the banks 
involved, the rating agencies decided to give up on Enron.\437\ 
On November 28, all three agencies downgraded Enron to below 
investment grade: Moody's downgraded Enron to B2 (5 notches 
below the previous rating), \438\ S&P downgraded Enron to B- (6 
notches below previous rating), \439\ and Fitch lowered Enron 
to CC (more than 8 notches below previous rating).\440\ 
Currently, Fitch and S&P rate Enron as a D and Moody's rates 
Enron as a Ca.
---------------------------------------------------------------------------
    \437\ Committee staff interviews with Fitch (March 5, 2002), 
Moody's (March 8, 2002) and S&P (March 11 and 13, 2002), described at 
note 404 above.
    \438\ ``Moody's Downgrades Enron Corp.'s Long-Term Debt Ratings 
(Senior Unsecured to B2); Commercial Paper Confirmed at Not Prime; 
Ratings Remain Under Review For A Downgrade,'' Moody's Press Release, 
November 28, 2001.
    \439\ ``Enron Rating Cut to `B-'; Doubt Cast on Dynegy Merger,'' 
S&P Press Release, November 28, 2001.
    \440\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 12.
---------------------------------------------------------------------------

  D. Problems With the Agencies' Analyses and Actions

    While the credit rating agencies did not completely ignore 
problems at Enron when those problems became very apparent, 
their monitoring and review of the company's finances fell far 
below the careful efforts one would have expected from 
organizations whose ratings hold so much importance. Instead, 
based on what the credit rating analysts told Committee staff 
in interviews and the analysts' testimony at the Committee's 
hearing on March 20, 2002, entitled ``Rating the Raters: Enron 
and the Credit Rating Agencies,'' it appears that the credit 
raters took Enron at their word and failed to probe more 
deeply. Moreover, in general, the ratings analysts appear to 
have taken too narrow a focus in determining what Enron's 
problems were: They focused on short-term problems, like cash 
flow or counterparty confidence, rather than deep-rooted 
problems, such as questionable transactions or suspect 
accounting. In short, based on the credit rating agency 
analysts' testimony at the March 20 hearing, and what they told 
Committee staff in interviews, the Committee staff has 
concluded that the credit rating agencies' approach to Enron 
fell short of what the public had a right to expect, having 
placed its trust in these firms to assess corporate 
creditworthiness for the purposes of Federal and State 
standards. It is difficult not to wonder whether lack of 
accountability--the agencies' practical immunity to lawsuits 
and non-existent regulatory oversight--is a major problem.
    Insufficient Review of Company Materials. When asked if he 
thought the credit rating agencies had done a good job, former 
SEC Chief Accountant Lynn Turner testified that his own initial 
review of Enron's financial statements ``raised more questions 
than they answered,'' and that anyone doing a similar review 
should have been given pause by their opacity.\441\ One of the 
more glaring concerns Committee staff developed based on their 
interviews of the credit rating agencies was that the analysts 
who worked on Enron appear to have been less than thorough in 
their review of Enron's filings, even though they said that 
they rely primarily on public filings for information in 
determining credit ratings. Enron's disclosure in its 2000 Form 
10-K filing about related-party transactions--footnote 16--
where information about the company's questionable deals with 
partnerships and special purpose entities run by Enron insiders 
should have been disclosed, was very difficult to understand. 
When Committee staff asked the analysts if they understood the 
disclosures in footnote 16, Moody's and Fitch told staff they 
did not understand precisely what those disclosures referred 
to, but were only concerned about the impact these transactions 
had on cash flow, which they believed had been disclosed 
elsewhere. The analysts from Moody's and Fitch told Committee 
staff that they were not concerned about the details of the 
transactions themselves, despite that the fact that those 
details might have indicated a problem--that Enron was gaining 
significant income from deals with partnerships run by its own 
CFO--and led them to wonder whether fraud was afoot. The S&P 
analysts told Committee staff that they simply assumed that the 
opaque disclosures regarding related-party transactions in the 
2000 Form 10-K referred to the off-balance sheet entities of 
which they were aware (because S&P rated some of these in 
connection with debt offerings). According to their remarks to 
Committee staff, the S&P analysts did nothing to confirm their 
understanding.
---------------------------------------------------------------------------
    \441\ The Role of Financial Institutions in Enron's Collapse, 
Hearing Before the Permanent Subcommittee on Investigations, Senate 
Governmental Affairs Committee, 107th Cong., S. Hrg. 107-618 (July 23, 
2002) at-- (Printed Hearing Record Pending) (Testimony of Lynn Turner, 
former Chief Accountant of the SEC).
---------------------------------------------------------------------------
    In fact, the S&P analysts could have checked their 
understanding of this disclosure, to some extent, by reviewing 
Enron's proxy statement, which is required to contain 
additional information about related-party transactions. (Proxy 
statements also have other relevant information not found in 
other filings, such as disclosures about certain insider 
sales.) The analysts from S&P said that they did not read 
Enron's proxy statements.\442\ In fact, they told Committee 
staff that they did not even know how the information they 
could find in a proxy statement in this regard might differ 
from that found in the 10-K. If the S&P analysts had read 
Enron's 2001 proxy statement, they may have learned that their 
assumption about Enron's 2001 Form 10-K disclosure was 
incorrect. The proxy contains a more explicit description of 
the related-party transactions than is contained in the 10-K; 
for instance, the proxy statement specifically states that the 
company had engaged in numerous transactions with an entity 
called LJM2 (not the Whitewing, Osprey, and Marlin entities 
with which the S&P analysts said that they were familiar) and 
indicates that Enron Chief Financial Officer Andrew Fastow was 
the general partner of that entity.\443\
---------------------------------------------------------------------------
    \442\ Committee staff interviews with S&P (March 11 and 13, 2002), 
described at note 404 above. It is worth noting that proxy statements 
are incorporated by reference in Forms 10-K; a thorough review of any 
10-K would have to include a review of the proxy statement as well.
    \443\ Enron Corp. Definitive Proxy Statement (Schedule 14A) (filed 
March 27, 2001) at 26.
---------------------------------------------------------------------------
    Short Term v. Long Term Focus. The agencies told Committee 
staff that their ratings reflect an analysis of long-term 
creditworthiness. In the case of Enron, however, the credit 
raters, according to their remarks to Committee staff in 
interviews, failed to do simple things one would expect from 
someone conducting a long-term evaluation of a company's 
financial health. For example, based on the information 
gathered by Committee staff, it appears that the credit 
analysts did not look for fundamental problems at the company 
by scrutinizing the financial statements or assessing the 
aggressiveness of Enron's accounting methods. When asked by 
Committee staff whether they considered as a qualitative factor 
in their analysis whether the company was engaging in 
aggressive accounting, the agencies indicated that they rely on 
the auditors' work. This was consistent with their testimony at 
the hearing.\444\ In the Committee staff interviews, the credit 
rating analysts resisted staff's suggestion that a company's 
accounting methods should be part of their analysis, because 
even when financial statements comply with Generally Accepted 
Accounting Principles (GAAP), they nevertheless may not present 
all the information an investor would want to know, or all the 
information a credit rater would want to know. This is 
troubling, because the fact that a company may be using the 
flexibility of GAAP to hide problems should be a consideration, 
particularly if the credit raters take a long-term view.
---------------------------------------------------------------------------
    \444\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 29.
---------------------------------------------------------------------------
    Moreover, despite their stated effort to take a long-term 
approach to ratings, the credit rating agencies appear to have 
focused primarily on short-term issues with Enron, like access 
to cash in the near term, counterparty confidence, or whether 
the Dynegy merger would succeed, even as there continued to be 
revelations about Enron's questionable use of off-balance sheet 
entities run by its CFO. For example, when Enron's $690 million 
obligation was disclosed for the first time--to the surprise of 
everyone, including, S&P believed, company management--S&P 
analysts told Committee staff that they did not ask if there 
were other potential triggers (nor did any of the other credit 
rating agencies), nor did they appear to register much concern 
about Enron management's expressed lack of knowledge. Indeed, 
although the credit analysts told Committee staff that they 
asked Enron officials about The Wall Street Journal 
allegations, they acknowledged that they did not press for a 
detailed answer when none was forthcoming, even after an SEC 
investigation was announced. Both Moody's and S&P stressed to 
Committee staff that the revelations in The Wall Street Journal 
were just allegations, and the analysts were not inclined to 
render judgment until all the facts were in.\445\ In interviews 
with Committee staff, the credit analysts seemed unwilling to 
distinguish between rendering judgment and asking probing 
questions--and demanding answers.
---------------------------------------------------------------------------
    \445\ Committee staff interviews with Moody's (March 8, 2002) and 
S&P (March 11 and 13, 2002), described at note 404 above.
---------------------------------------------------------------------------
    Lack of Inquisitiveness. Leo O'Neill, S&P's President, said 
in a staff interview that fixed income analysts ask ``green-
eyeshade questions,'' referring to the green eyeshades auditors 
were noted for wearing in earlier times, and the tough, probing 
queries for which they were then known.\446\ Credit rating 
analysts should take a similar approach--they, like fixed 
income analysts, assess the ability of the company to repay 
debt (fixed income analysts focus on bonds, as opposed to 
equity analysts, who focus on stocks). Based on their testimony 
at the March 20 hearing and their remarks to Committee staff in 
interviews, however, Committee staff concluded that the credit 
rating agency analysts did not take this skeptical approach. 
Not only did they apparently fail to scrutinize Enron's public 
filings (indeed, they failed even to read all the major 
filings), the credit analysts in general appear to have taken 
the company officials at their word, simply assuming that they 
were telling the truth. As Ronald Barone of S&P testified at 
the March 20 hearing, ``we do rely on what senior management 
tells us. It is in their best interest to tell us and be 
forthright and not convey a different message, because if we 
convey a message to the market that is different that what the 
market perceives over the long term, then the credibility of 
Standard & Poor's and then ultimately the credibility of the 
company is at risk. . . . And so it is in their best interest 
to tell us the truth, and we rely on that.'' \447\ Senator 
Thompson called this reasoning ``a chicken-and-egg deal,'' 
pointing out that corporate executives might instead view it in 
their best interests ``to minimize bad news and stretch the 
truth.'' \448\
---------------------------------------------------------------------------
    \446\ Committee staff interview with S&P (March 6, 2002), described 
at note 404 above.
    \447\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 15.
    \448\ Id.
---------------------------------------------------------------------------
    In addition, from what the credit analysts told Committee 
staff, they did not pursue what even they admitted was 
fundamental information, despite the fact that the credit 
raters publicly acknowledged that Enron was a complex company. 
In a March 2001 article about Enron's opaque financial 
statements, in response to the question of how Enron makes its 
money, S&P's Todd Shipman, the analyst working under Ronald 
Barone, was quoted as saying, ``If you figure it out, let me 
know,'' and Fitch's Ralph Pellecchia joked, ``Do you have a 
year?'' \449\ The point of this article was that Enron was 
generally understood by Wall Street to be a ``black box,'' 
difficult to understand and loath to answer too many questions 
about ambiguities. While Pellecchia explained at the 
Committee's March 20 hearing that his response was merely a 
``glib answer,'' he acknowledged that the ``spirit of the 
answer was Enron's a big company, a complex company. . . .'' 
\450\ In other words, these analysts well understood that 
getting a clear picture of Enron's financial situation was not 
a simple matter. Yet, they apparently failed to use the 
necessary rigor--the ``green-eyeshade'' approach--to ensure 
that their analysis of such a company was sound.
---------------------------------------------------------------------------
    \449\ Bethany McLean, ``Is Enron Overpriced?,'' Fortune, March 5, 
2001.
    \450\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 23.
---------------------------------------------------------------------------
    As early as May 2001, the independent research firm Off 
Wall Street Consulting Group called Enron a bad bet. Off Wall 
Street's analysis showed that Enron's trading operation--its 
most profitable venture--was starting to turn weaker profits as 
the market it helped open up became more liquid and prices less 
volatile.\451\ Enron did not, in its public filings, indicate 
how much money its trading business made as distinct from the 
rest of its ``Wholesale Division,'' which contained other 
investments and businesses. Accordingly, there was no way to 
tell how its trading business was really doing. When the credit 
rating agencies asked for this information--information which 
Moody's Chief Credit Officer Pamela Stumpp told Committee staff 
was ``fundamental'' to a credit analysis \452\--Enron, 
according to the credit analysts, told them that it did not 
have that kind of detail. Enron's response appears to be either 
not credible or a sign of a company in trouble. A company must 
know how each of its businesses is performing in order to 
monitor it. Nevertheless, even though the credit rating 
agencies were allowed to ask for and receive this information 
under their exemption from SEC Regulation F-D (their special 
access to material information not shared with the rest of the 
market), and even though they knew that Enron was very 
concerned about its credit rating, the credit rating agencies 
acknowledge that they did not push for the information. 
According to what the credit analysts told Committee staff, 
they simply accepted Enron's refusal.
---------------------------------------------------------------------------
    \451\ Off Wall Street Consulting Group, Research Report Regarding 
Enron Corp., May 6, 2001 at 3.
    \452\ Committee staff interview with Moody's (March 8, 2002), 
described at note 404 above.
---------------------------------------------------------------------------
    In interviews with Committee staff, all the agencies 
acknowledged that they could withdraw a rating for failure to 
provide sufficient information. In the March 20 hearing, for 
example, S&P's Barone said that ``if we knew . . . then what we 
know now, we would have withdrawn Enron's rating for failure to 
disclose proper information.'' \453\ Nevertheless, the agencies 
told Committee staff in interviews that in response to Enron's 
refusal to provide important information--like information 
about the trading operation--they did not even raise the 
possibility of withdrawing the rating, a suggestion which, if 
made, might have convinced Enron to send the agencies the 
information requested.\454\
---------------------------------------------------------------------------
    \453\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 29.
    \454\ Committee staff interviews with Fitch (March 5, 2002), 
Moody's (March 8, 2002) and S&P (March 11 and 13, 2002), described at 
note 404 above.
---------------------------------------------------------------------------
    Similarly, and as noted above, based on what they told 
Committee staff, when S&P analysts read the related-party 
transactions disclosure in Enron's 2000 Form 10-K, they 
assumed, without asking, that the entire footnote referred to 
the Osprey and Marlin transactions. It is unclear whether the 
disclosure's text is entirely consistent with this assumption, 
but the analysts appear to have done nothing to verify their 
beliefs. Moreover, according to what the S&P analysts said to 
Committee staff in interviews, The Wall Street Journal article 
did not lead them to question their assumptions. To the extent 
that any of the analysts asked about the allegations in The 
Wall Street Journal, they accepted the answer from the company 
that a special committee would investigate, without questioning 
whether the problems were so deep that they might permanently 
scar Enron's future. In short, as Glenn Reynolds, Chief 
Executive Officer of independent credit research firm 
CreditSights, Inc., stated in his testimony before the 
Committee at the March 20 hearing, ``As we look back at the 
performance of the rating agencies in the case of Enron, we are 
hard pressed to recall a situation where the rating agencies 
held so much sway over a company and had such commanding 
leverage to extract information, and yet were so ineffective at 
doing so.'' \455\
---------------------------------------------------------------------------
    \455\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 157 (Statement of Glenn Reynolds, 
Chief Executive Officer, CreditSights, Inc.).
---------------------------------------------------------------------------
    At the Committee's March 20 hearing, the credit rating 
analysts--in particular Ronald Barone of S&P--stressed over and 
over again that they were simply duped by Enron management, and 
there was nothing they could do. When Chairman Lieberman asked 
the analysts whether in retrospect, they felt they should have 
asked more questions of Enron, Barone responded, ``Senator, we 
rely on the audited financial statements. . . . We are not 
forensic accountants, if that is the question, and we don't 
have subpoena power. . . .'' \456\ Barone attached to his 
written testimony what he referred to as the ``kitchen sink'' 
documents, which were presentations made by Enron to the credit 
raters, in October 1999 and in January 2000, to convince the 
agencies to improve Enron's credit rating.\457\ Barone pointed 
out in his testimony that, in fact, Enron did not reveal all of 
its obligations in this presentation; one example he gave was 
that Enron did not disclose that it had billions of dollars in 
derivative transactions that were, in substance though not in 
form, loans.\458\ Committee staff asked Barone and Shipman in 
interviews prior to the hearing whether they had ever asked 
about Enron's portfolio of derivatives, or whether, knowing 
that Enron was engaging in some rather complex transactions, 
they had ever consulted with a derivatives expert at S&P to get 
a more specific sense of the obligations Enron could be facing 
in connection with its derivative transactions. While they 
could not remember if they ever consulted with such an expert, 
both Barone and Shipman acknowledged that they had never 
specifically asked Enron to detail derivative transactions that 
could have loan-like characteristics.\459\ Similarly, Barone 
stated in his testimony that S&P was misled by Enron's failure 
to provide information about the LJM partnerships.\460\ 
However, if he or Shipman had reviewed Enron's proxy statement, 
they would have discovered these entities, and could have 
inquired about them. Barone summed up his attitude about S&P's 
responsibility with respect to Enron when he made the following 
statement in response to a question by Senator Bunning at the 
March 20 hearing: ``Senator, this was not a ratings problem. 
This was a fraud problem.'' \461\
---------------------------------------------------------------------------
    \456\ Id. at 29.
    \457\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 87-115.
    \458\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 70. On July 23, 2002, PSI held a 
hearing on these transactions, with witnesses from the credit rating 
agencies as well as from Citigroup and J.P. Morgan, the banks that had 
facilitated the deals. The Role of Financial Institutions in Enron's 
Collapse, Hearing Before the Permanent Subcommittee on Investigations, 
Senate Governmental Affairs Committee, 107th Cong., S. Hrg. 107-618 
(July 23, 2002) at-- (Printed Hearing Record Pending).
    \459\ Committee staff interviews with S&P (March 11 and 13, 2002), 
described at note 404 above.
    \460\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 72.
    \461\ Id. at 25.
---------------------------------------------------------------------------
    Moody's took a more measured approach at the March 20 
hearing. Diaz of Moody's had the following exchange in response 
to a question by Senator Thompson about the related-party 
transaction disclosures in Enron's 2000 10-K (which appeared in 
footnote 16 to the financial statements in that filing):

    LDIAZ: ``I think in looking at footnote 16, clearly what 
needs to be done in those situations is try to get behind it 
and try to understand a lot more of what's there. You know, 
looking in hindsight at how that impacted the ultimate 
confidence in the company, it's pretty clear that there were--
and from my point of view, we certainly look at a situation 
where we could have dug more into and tried to get behind 
that.''

    LSENATOR THOMPSON: ``It would be fair to say that if you 
ran across this same situation again, you would delve into it 
deeper?''

    LDIAZ: ``Yes sir.'' \462\
---------------------------------------------------------------------------
    \462\ Id. at 16.

    In addition, in his written testimony, Diaz stated that 
``[g]oing forward, we are enhancing the ratings process by 
putting increased focus in several areas,'' including 
``corporate governance and how aggressive or conservative are 
accounting practices'' at the companies Moody's is rating.\463\
---------------------------------------------------------------------------
    \463\ Id. at 128.
---------------------------------------------------------------------------
    Lack of Accountability. The credit rating agencies are 
aware of how much their decisions can affect the fortunes of 
the companies they rate (and therefore the fortunes of the 
companies' investors). Nevertheless, based on the testimony of 
the credit analysts at the March 20 hearing and the remarks of 
the analysts in interviews with Committee staff, Committee 
staff concluded that the credit analysts do not view themselves 
as accountable for their actions. For example, the remarks of 
S&P analysts Ronald Barone and Todd Shipman in late October and 
early November about their ``confidence'' that there would be 
no more surprises from Enron do not appear to be based on 
anything more than assumption. In his testimony at the 
Committee's March 20 hearing, Barone said that he gained the 
confidence from a conversation with Enron management, but 
conceded after specific questioning that management had told 
him that they did not know whether other entities or special 
purpose entities existed, and a special committee had just 
begun an investigation.\464\ The credit rating agencies 
acknowledged in interviews with Committee staff that others in 
the market believe the agencies have access to more information 
about companies than any other outsiders due to their market 
power (their ability to downgrade) and their exemption from SEC 
Regulation F-D. Despite this public expectation about their 
superior level of knowledge, S&P, for example, could not cite 
to Committee staff any policies to ensure that its analysts 
conducted themselves responsibly in media appearances, or in 
making public statements similar to those Shipman and Barone 
made on CNN and in the S&P conference call (which was reported 
in the press \465\).
---------------------------------------------------------------------------
    \464\ Id. at 14.
    \465\ Tom Fowler, ``S&P: `No More Surprises For Enron,' '' Houston 
Chronicle, November 3, 2001.
---------------------------------------------------------------------------
    When asked by Committee staff about accountability 
concerns, the rating agencies had two responses. First, they 
said that their concern for their reputation keeps them on 
their toes: As S&P's Barone stated in his testimony: ``Standard 
& Poor's recognition as a rating agency ultimately depends on 
the credibility of its opinions with investors, importantly, 
but also with bankers, financial intermediaries, and securities 
traders.'' \466\ The second response, which the raters stated a 
number of times in interviews with Committee staff, was that 
their ratings were just opinions, protected by the First 
Amendment.\467\ Fitch's general counsel referred to the letter 
grades given by the credit rating agency as ``the world's 
shortest editorial.'' \468\ The credit rating agencies seem to 
be trying to walk a fine line between maintaining enormous 
market power through both official and unofficial uses of their 
ratings, and insisting that their ratings are purely their 
``opinion,'' and therefore pure speech under a First Amendment 
analysis. First Amendment-protected opinions about matters of 
public concern can give rise to liability only when, to the 
extent they convey facts, they convey them with actual 
knowledge of or reckless disregard for their accuracy.\469\ 
This standard poses such a high barrier that it virtually 
insulates the speaker from liability.
---------------------------------------------------------------------------
    \466\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 60.
    \467\ S&P arranged a meeting for Committee staff with Floyd Abrams, 
its First Amendment counsel, who also prepared a memorandum for staff 
laying out the basis for S&P's First Amendment argument.
    \468\ Committee staff interview with Fitch (March 5, 2002), 
described at note 404 above.
    \469\ Milkovich v. Lorain Journal Co., 497 U.S. 1, 20-21 (1990) 
(``where a statement of `opinion' on a matter of public concern 
reasonably implies false and defamatory facts regarding public figures 
or officials, [plaintiff] must show that such statements were made with 
knowledge of their false implications or with reckless disregard of 
their truth'').
---------------------------------------------------------------------------
    Indeed, courts have extended First Amendment protections to 
credit ratings, shielding the agencies from liability.\470\ 
Courts have even refused to require that credit rating agencies 
produce records in connection with their work, citing the 
``journalist's'' privilege.\471\ However, the fact that the 
market seems to value the agencies' ratings mostly as a 
certification (investment grade vs. non-investment grade) or as 
a benchmark (the ratings triggers in agreements) and not as 
information, \472\ and the fact that the law, in hundreds of 
statutes and regulations, also uses their work that way, seems 
to indicate that their ratings are not the equivalent of 
editorials in The New York Times. The fact that the rating 
agencies have received First Amendment protection for their 
work should not preclude greater accountability.
---------------------------------------------------------------------------
    \470\ See, e.g., County of Orange v. McGraw Hill Cos., Inc., 245 
B.R. 151, 156 n. 4 (C.D. Cal. 1999) (``Standard & Poor's ratings are 
speech and, absent special circumstances, are protected by the First 
Amendment. In reaching this ruling, the Court assumed any First 
Amendment protected speech, as a matter of public concern, would 
receive the heightened protection of the actual malice standard''); 
Jefferson County Sch. Dist. v. Moody's Investors Service, 175 F.3d 848 
(10th Cir. 1999) (applying the Milkovich standard to a claim that the 
Moody's rating of the school district's bonds was an injurious 
falsehood).
    \471\ See, e.g., In re Pan Am Corp., 161 B.R. 577, 581-583 
(S.D.N.Y. 1993) (quashing subpoena to S&P for records of communications 
with Delta Air Lines based on qualified journalist's privilege because 
``S&P functions as a journalist when gathering information in 
connection with its ratings process'').
    \472\ See Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 143 (Statement of Jonathan Macey, 
Professor, Cornell University Law School) (``Academic studies tend to 
show that information in credit ratings is of marginal value at best 
because the information contained in the ratings had already been 
incorporated into share prices. One well-known study showed that the 
ratings provided by rating agencies lagged the information contained in 
securities prices by a full year.'').
---------------------------------------------------------------------------
    The rating agencies, however, have escaped regulation thus 
far. In his testimony at the March 20 hearing, then SEC 
Commissioner Isaac Hunt stated that all three of the current 
NRSROs were registered with the SEC under the Investment 
Advisers Act of 1940, \473\ which prohibits fraud, imposes 
fiduciary duties on advisers with respect to their advice, 
requires that advisers maintain certain books and records, and 
allows the SEC to examine all registered advisers to assure 
compliance with the Act. According to Commissioner Hunt's 
testimony, the Act would therefore require that NRSROs have an 
adequate basis for their ratings.\474\ Commissioner Hunt 
testified in addition that the SEC does examine NRSROs, as with 
other investment advisers, approximately every 5 years. In the 
course of those examinations, the SEC reviews the books, 
records, and the operation of the agencies. The legal 
application of the Investment Advisers Act to the credit rating 
agencies, however, is in doubt. As part of the designation, the 
agencies agreed to voluntarily register, but they insist that 
they are not covered by the Act and that any information they 
provide the SEC is given strictly on a voluntary basis, not 
pursuant to the requirements of the Act. The Act, in defining 
investment advisers, contains an exception for publishers, 
\475\ and the credit rating agencies would argue that they fit 
under that exception.\476\ To the extent that they are 
correct--and the case law on this point is very favorable to 
them--none of the requirements of the Investment Advisers Act 
would apply to them.\477\ In any event, the SEC has never taken 
enforcement action against the rating agencies based on their 
ratings, whether under the Investment Advisers Act or 
otherwise.
---------------------------------------------------------------------------
    \473\ 15 U.S.C. 80b-1 et seq.
    \474\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 136.
    \475\ 15 U.S.C. Sec. 80b-2(a)(11)(D) (exempting any publisher of 
``any bona fide newspaper, news magazine or business or financial 
publication of general and regular circulation'' from coverage of the 
Act).
    \476\ They rely on Lowe v. Securities and Exchange Comm'n, 472 U.S. 
181 (1985), which held that the publisher exception, in concert with 
the legislative history of the Act, indicates that meaning of 
``investment adviser'' cannot include those who do not provide 
personalized advice directly to clients. The Court held: ``As long as 
the communications between petitioners and their subscribers remain 
entirely impersonal and do not develop into the kind of fiduciary, 
person-to-person relationships that were discussed at length in the 
legislative history of the Act and that are characteristic of 
investment adviser-client relationships, we believe the publications 
are, at least presumptively, within the exclusion and thus not subject 
to registration under the Act.'' 472 U.S. at 210.
    \477\ It is the position of the ratings agencies that they have 
been providing information to the SEC over the years voluntarily, not 
pursuant to an examination requirement.
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  E. Conclusions and Recommendations

    Although the credit rating agencies' ratings are generally 
right, when they are wrong, the consequences can be serious. In 
the case of Enron, their poor performance, along with the 
failures of all the other market watchdogs, has had a market-
wide effect, leading investors to wonder whether they can count 
on the information upon which they may have previously relied 
in making their investment decisions. It may well be the case 
that most companies, particularly those with balance sheets 
strong enough to have an investment grade rating, are providing 
the investing public with a fairly accurate picture of their 
financial state, with disclosures that are full and fair enough 
to provide the credit rating agencies with the information they 
need to perform their analysis. We have learned, however, that 
when company officials are not honest, and their auditors are 
too entrenched or conflicted to call management out on 
problems, investors need someone to raise a red flag. Credit 
raters, with their special access, strong market power, and 
lack of conflicts, are in the perfect position to do this.
    The problem is that the credit rating agencies have no 
incentive to catch the few wrongdoers, no matter how huge the 
consequences to the market. Duke Law School Professor Steven 
Schwarcz argued in his testimony at the Committee's March 20 
hearing that reputational concerns are sufficient incentive for 
the credit rating agencies to be diligent in their work, and he 
cited their strong track record as proof.\478\ Assuming that 
most companies are honest, however, credit rating agencies will 
be correct in most cases without having to go much beyond the 
face of financial statements. Their limited liability and their 
entrenched position of power means that they do not have to go 
to additional lengths in order to expose the outlier 
corporations that are not being truthful.
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    \478\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 170.
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    Under the current system, credit rating agencies arguably 
act in many respects like government agencies. In the March 20 
hearing, Chairman Lieberman likened the role of the rating 
agencies to the Food and Drug Administration: The FDA does not 
``let a drug go out on the market . . . until [it has] gone 
over all sorts of investigations to guarantee it is safe, and 
then doctors prescribe the drug, people use it in reliance on 
that. To some extent, we have asked [the credit rating 
agencies] to play . . . a similar role with regard to 
corporations.'' \479\ As with drug companies and FDA approval, 
corporations wishing to issue debt need ratings in most 
instances. But unlike FDA, which is accountable to Congress, 
the raters answer to no authority. In addition, unlike a 
government agency, they profit from every transaction they 
rate, thereby reaping the benefits of the capital markets 
without risking any capital.
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    \479\ Id. at 30.
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    Some have suggested replacing credit ratings required in 
regulation and statute with a market indicator, \480\ but no 
market indicators appear to be sufficiently reliable.\481\ 
There have also been suggestions that the credit rating 
agencies be subject to additional liability for their 
actions.\482\ Other suggestions have been that government 
agencies--particularly the SEC--exercise additional oversight 
over the credit rating agencies' procedures and actions to 
ensure diligence and thoroughness.\483\ In fact, at the March 
20 hearing, then SEC Commissioner Hunt testified that the SEC 
planned to ``engage in a thorough examination, which may 
include hearings, to ascertain facts, conditions, practices and 
other matters relating to the role of rating agencies in the 
U.S. securities markets. . . . We believe it is an appropriate 
time and in the public interest to re-examine the role of 
rating agencies in the U.S. securities markets.'' \484\ In 
addition, the Sarbanes-Oxley Act requires the SEC to conduct a 
study into the role and function of credit rating agencies in 
the securities market, including a consideration of any 
impediments to their accurate appraisal of the financial 
resources or risks of the issuers of securities that the 
agencies rate.\485\
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    \480\ Partnoy, note 369 above, at 705.
    \481\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 144-45 (Statement of Jonathan 
Macey, Professor, Cornell University Law School).
    \482\ Partnoy, note 369 above, at 710-11; see also Comments of the 
Investment Company Institute in the Matter of File No. S7-33-977, 
Proposed Definition of Nationally Recognized Statistical Ratings 
Organization, dated March 2, 1998 (``ICI NRSRO Comments'') (suggesting 
that the Rule 436 exemption afforded NRSROs from liability under 
Section 11 of the Securities Act of 1933 be removed). The problem with 
this suggestion, of course, is that to the extent that credit ratings 
are constitutionally protected by the First Amendment, there is no way 
to impose additional liability in the courts beyond the applicable 
actual malice standard short of a constitutional amendment.
    \483\ See Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 146 (Statement of Jonathan Macey, 
Professor, Cornell University Law School); ICI NRSRO Comments, at note 
482 above.
    \484\ Rating the Raters: Enron and the Credit Rating Agencies, 
Hearing Before the Senate Governmental Affairs Committee, 107th Cong., 
S. Hrg. 107-471 (March 20, 2002) at 137.
    \485\ Pub. L. No. 107-204 Sec. 702.
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    The SEC has not finished this process, but Committee staff 
recommends that the SEC, in consultation with other agencies 
that use the NRSRO designation in their regulations--
particularly banking agencies--set conditions on the NRSRO 
designation through additional regulation. Those conditions 
should include imposing a set of standards and considerations 
that the rating agencies must use in deriving their ratings, 
such as accounting issues. In addition, the SEC should also 
require a level of training for analysts working for credit 
rating agencies, including training as to the information 
contained in the periodic filings with the SEC and other 
government agencies that oversee companies in the particular 
sector each analyst is assigned to as well as training in basic 
forensic accounting. The SEC should monitor the compliance with 
these requirements, and in the event of a future corporate 
meltdown such as Enron, the SEC should investigate to ensure 
that the ratings were derived in accordance with those 
standards. If the public and the government is to rely on the 
ratings of these agencies, and give them legal force, then it 
must ensure that they are the product of diligent and effective 
analysis. Meaningful SEC oversight is the best way to ensure 
such an outcome.

 APPENDIX: Note 16 to Financial Statements, Enron Corp. Form 10-K for 
                    the Year Ended December 31, 2000

16 RELATED PARTY TRANSACTIONS

    In 2000 and 1999, Enron entered into transactions with 
limited partnerships (the Related Party) whose general 
partner's managing member is a senior officer of Enron. The 
limited partners of the Related Party are unrelated to Enron. 
Management believes that the terms of the transactions with the 
Related Party were reasonable compared to those which could 
have been negotiated with unrelated third parties.
    In 2000, Enron entered into transactions with the Related 
Party to hedge certain merchant investments and other assets. 
As part of the transactions, Enron (i) contributed to newly-
formed entities (the Entities) assets valued at approximately 
$1.2 billion, including $150 million in Enron notes payable, 
3.7 million restricted shares of outstanding Enron common stock 
and the right to receive up to 18.0 million shares of 
outstanding Enron common stock in March 2003 (subject to 
certain conditions) and (ii) transferred to the Entities assets 
valued at approximately $309 million, including a $50 million 
note payable and an investment in an entity that indirectly 
holds warrants convertible into common stock of an Enron equity 
method investee. In return, Enron received economic interests 
in the Entities, $309 million in notes receivable, of which 
$259 million is recorded at Enron's carryover basis of zero, 
and a special distribution from the Entities in the form of 
$1.2 billion in notes receivable, subject to changes in the 
principal for amounts payable by Enron in connection with the 
execution of additional derivative instruments. Cash in these 
Entities of $172.6 million is invested in Enron demand notes. 
In addition, Enron paid $123 million to purchase share-settled 
options from the Entities on 21.7 million shares of Enron 
common stock. The Entities paid Enron $10.7 million to 
terminate the share-settled options on 14.6 million shares of 
Enron common stock outstanding. In late 2000, Enron entered 
into share-settled collar arrangements with the Entities on 
15.4 million shares of Enron common stock. Such arrangements 
will be accounted for as equity transactions when settled.
    In 2000, Enron entered into derivative transactions with 
the Entities with a combined notional amount of approximately 
$2.1 billion to hedge certain merchant investments and other 
assets. Enron's notes receivable balance was reduced by $36 
million as a result of premiums owed on derivative 
transactions. Enron recognized revenues of approximately $500 
million related to the subsequent change in the market value of 
these derivatives, which offset market value changes of certain 
merchant investments and price risk management activities. In 
addition, Enron recognized $44.5 million and $14.1 million of 
interest income and interest expense, respectively, on the 
notes receivable from and payable to the Entities.
    In 1999, Enron entered into a series of transactions 
involving a third party and the Related Party. The effect of 
the transactions was (i) Enron and the third party amended 
certain forward contracts to purchase shares of Enron common 
stock, resulting in Enron having forward contracts to purchase 
Enron common shares at the market price on that day, (ii) the 
Related Party received 6.8 million shares of Enron common stock 
subject to certain restrictions, and (iii) Enron received a 
note receivable, which was repaid in December 1999, and certain 
financial instruments hedging an investment held by Enron. 
Enron recorded the assets received and equity issued at 
estimated fair value. In connection with the transactions, the 
Related Party agreed that the senior officer of Enron would 
have no pecuniary interest in such Enron common shares and 
would be restricted from voting on matters related to such 
shares. In 2000, Enron and the Related Party entered into an 
agreement to terminate certain financial instruments that had 
been entered into during 1999. In connection with this 
agreement, Enron received approximately 3.1 million shares of 
Enron common stock held by the Related Party. A put option, 
which was originally entered into in the first quarter of 2000 
and gave the Related Party the right to sell shares of Enron 
common stock to Enron at a strike price of $71.31 per share, 
was terminated under this agreement. In return, Enron paid 
approximately $26.8 million to the Related Party.
    In 2000, Enron sold a portion of its dark fiber inventory 
to the Related Party in exchange for $30 million cash and a $70 
million note receivable that was subsequently repaid. Enron 
recognized gross margin of $67 million on the sale.
    In 2000, the Related Party acquired, through 
securitizations, approximately $35 million of merchant 
investments from Enron. In addition, Enron and the Related 
Party formed partnerships in which Enron contributed cash and 
assets and the Related Party contributed $17.5 million in cash. 
Subsequently, Enron sold a portion of its interests in the 
partnerships through securitizations. See Note 3. Also, Enron 
contributed a put option to a trust in which the Related Party 
and Whitewing hold equity and debt interests. At December 31, 
2000, the fair value of the put option was a $36 million loss 
to Enron.
    In 1999, the Related Party acquired approximately $371 
million, merchant assets and investments and other assets from 
Enron. Enron recognized pre-tax gains of approximately $16 
million related to these transactions. The Related Party also 
entered into an agreement to acquire Enron's interests in an 
unconsolidated equity affiliate for approximately $34 million.
      

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