Take the Money Enron.

[Steve Diamond <sdiamond@xxxxxxx>]

Take the Money Enron: America's really existing capitalism

By Stephen F. Diamond*
January 29, 2002

As the Enron debacle is dissected by almost a dozen Congressional
committees, we are in the midst of one of the biggest scandals in American
history.  How could our system of corporate governance and finance have
broken down to such an extent?

Republicans hope to paint the collapse of the giant energy trading company
as a "failed business model" so that they can extol the "genius" of American
capitalism, in the words of Treasury Secretary Paul O'Neill, which allows
businesses to fail as well as succeed.  Meanwhile the Democrats are looking
for someone on Wall Street to blame.  There is certainly enough blame to go
around.  There are the analysts who notoriously pump up stocks so that their
investment banking clients can dump them on an unsuspecting public.  And
there are the accountants who indeed have grown so entangled with their
clients that they can no longer be relied upon to provide objective audits
of the actual financial condition of America's public companies.

  Scandal and fraud are certainly present, but they are not the real
problem.  In response to the demands of today's brutally competitive global
economy, conscious political and legal changes, not criminal behavior,
shaped and enabled this crisis.  Consider two obscure but crucial changes in
our securities laws that helped facilitate the Enron collapse.  In 1995
pressure from corporate America, particularly Silicon Valley, led to a limit
on the damages paid to investors who successfully sue companies,
accountants, lawyers and banks for their role in selling stock to the public
at inflated prices.  Prior to 1995, accountants, for example, were liable
for the entire amount of damages that might be imposed on the players in
this process.  That was a strong incentive for auditors to be very careful
about the information they certified in a company's public documents and
equally cautious about the financial structures they might recommend through
their consulting arms.  If a company fails, investors look for deep pockets
and a multi-billion dollar accounting company looks like a much more
attractive target than a failed dot-com.  But after the 1995 law was passed,
the accountants were only on the hook for that percentage of the verdict or
settlement that they directly and willingly caused.   Investors had lost a
powerful source of leverage over the auditors, who were now encouraged to
take greater risks in their work.

This change came at the same time that corporate America and Wall Street
were taking increasing advantage of a 1990 change in the law that provided a
"safe harbor" for private placements to large institutions of a wide range
of financial instruments.  That meant that offerings of these securities no
longer required disclosure of key information to the public or to the
Securities and Exchange Commission.  In fact, that is one important reason
it is so difficult to understand what Enron was doing with "other people's
money," in Justice Brandeis' famous phrase.  Many of those hidden
partnerships and off balance sheet vehicles used these so-called "private
placements," hidden from the view of public shareholders. There is no
publicly available disclosure of the details of these transactions.  Unless
the FBI is able to reconstruct the shredded documents now being recovered
from Enron and Arthur Anderson we may never fully understand what was going
on inside the company.

  Unfortunately, hundreds of companies now rely on this explosive
combination of private placements and off balance sheet entities.  The last
decade has seen the American economy create a massive amount of new paper
financial obligations using these structures that cannot possibly be
supported by the productive base of the economy.  In fact, little attention
is being paid to what is happening in this "real" economy, made up of steel
mills, auto assembly plants, health care services, and our physical
infrastructure, which turn out the products and services that a society
truly needs to eventually pay off all of these fictitious claims to society'
s wealth.

  To remedy this situation we must make significant institutional and
structural changes in the way that we conduct economic activity.  As a first
step, we must close these loopholes to rein in the unscrupulous behavior of
private actors.   But we must go beyond that.  We should no more leave
auditing in the hands of the private sector than we now leave airport
security - it is every bit as important as airport x-ray machines to our
survival.  Auditing should be conducted under the direct supervision of the
federal government.  Further, "public" corporations should indeed be public
corporations, committing themselves to greater transparency and
accountability.  This should mean that representatives of the public and
large institutional investors like public employee pension funds should sit
on the boards of major public corporations.  All too often today's
"independent" directors only act as a rubber stamp for the decisions of
corporate insiders.  These are the kinds of reforms needed to avoid a
downward spiral of internecine warfare between businesses, if not countries,
in a world far less hospitable to the American model of capitalism than we
once thought.

*Stephen F. Diamond is a law professor who teaches securities regulation and
corporate finance at the Santa Clara University School of Law in Santa
Clara, California.  He practiced corporate law in New York and Silicon
Valley prior to teaching.

Stephen F. Diamond
School of Law
Santa Clara University
sdiamond@xxxxxxx