DRAFT

Enron, Fraud and Securities Reform:

An Enron Prosecutor’s Perspective

John R. Kroger1

Introduction

From June 2002 to July 2003, I took a leave of absence from teaching to
serve as a prosecutor with the United States Justice Department’s Enron Task
Force.2 When people ask me about the case, their focus is almost always on
questions of individual criminal liability. They want to know if Ken Lay is ever
going to be indicted, and whether the large number of executives already charged
with crimes are likely to be convicted at trial.3 These are important questions: if

1
B.A., M.A., Yale University, 1990, J.D. Harvard Law School, 1996. The author, an
Assistant Professor at Lewis and Clark Law School, served as a Trial Attorney with the
United States Department of Justice’s Enron Task Force from June 2002 to July 2003. The
author previously served as an Assistant United States Attorney in the Eastern District of
New York from 1997 to 2002. I would like to thank Jim Cox, Joel Seligman, Jennifer
Johnson, and Susan Mandiberg for their many helpful comments.
2
My status as a former prosecutor in the Enron case places limits on the information
presented in this Article. Most importantly, I am bound by Rule 6(e) of the Federal Rules
of Criminal Procedure, which prohibits me from disclosing matters that occurred before the
Enron Special Grand Jury sitting in Houston. More generally, I have not disclosed in this
essay any non-public confidential information that I obtained in my role as a participant in
the Enron case. As a member of the Connecticut bar, I am also bound by Rule 3.6 of the
Connecticut Rules of Professional Conduct. Rule 3.6 provides, in relevant part, that a
lawyer who has participated in the investigation or litigation of a matter may not make
extrajudicial statements that a reasonable person would expect to be disseminated publicly
if the lawyers knows or reasonable should know that that the statements will have a
substantial likelihood of materially prejudicing an adjudicative proceeding in the matter.
Rule 3.6 provides, however, that such a lawyer may repeat, inter alia, information in a
public record. Pursuant to Rule 3.6, I have avoided any significant discussion of individual
criminal liability in this Article (aside from conduct of persons who have already pleaded
guilty) so as to avoid having any impact on the ongoing criminal litigation. Instead, I focus
on structural legal and regulatory issues raised by the Enron case. I also generally write
about "Enron's" actions rather than the actions of particular Enron executives. In addition,
I have based my analysis of the Enron collapse on information disclosed in public records
or otherwise in the public domain.
3
Though I am obviously biased, I believe the Enron Task Force has achieved very
significant results in the case to date. On April 12, 2002, David Duncan, Arthur Andersen's
lead partner on the Enron engagement, pleaded guilty to destroying documents with the
intent to impede an SEC investigation in violation of 18 U.S.C. § 1512(b)(2). Duncan has
not yet been sentenced. United States v. David Duncan, Cr. No. H-02-209 (S.D. Tex.).
Arthur Andersen was subsequently convicted of the same charge after a jury trial on June

1
persons who commit crimes in highly publicized financial scandals are not held
responsible for their actions, our efforts to deter similar conduct in the future will
suffer a serious blow. But for me, the significance of individual questions of guilt
or innocence pales when compared to what seems to be the more pressing
structural issue: could an Enron-style collapse happen again?4

15, 2002, and the firm collapsed shortly thereafter. United States v. Arthur Andersen LLP,
Cr. No. H-02-121 (S.D. Tex.). On August 20, 2002, former Enron and LJM executive
Michael Kopper pleaded guilty to conspiracy to commit wire fraud and money laundering
in violation of 18 U.S.C. §§ 1956(h), 1957 and 371. Kopper has not yet been sentenced.
United States v. Michael Kopper, Cr. No. H-02-0560 (S.D. Tex.). On October 17, 2002,
Enron energy trader Timothy Belden pleaded guilty to conspiracy to commit wire fraud in
violation of 18 U.S.C.§ 371 for crimes relating to manipulating the California electricity
market. Belden has not yet been sentenced. United States v. Timothy Belden, Cr. No. 02-
0313-MJJ (N.D. Ca.). On November 26, 2002, Enron executive Lawrence Lawyer
pleaded guilty to filing a false tax return in violation of 26 U.S.C. § 7206(1). United States
v. Lawrence Lawyer, Cr. No. 02-___ (S.D. Tex.). Lawyer has not yet been sentenced. On
February 4, 2003, Enron energy trader Jeffrey Richter pleaded guilty to conspiracy to
commit wire fraud in violation of 18 U.S.C.§ 371 and two counts of making false
statements to a government agency in violation of 18 U.S.C. § 1001, for crimes related to
manipulating the California energy market. Richter has not yet been sentenced. United
States v. Jeffrey Richter, Cr. No. 03-0026-MJJ (N.D. Ca.). On September 10, 2003, former
Enron Treasurer Ben Glisan pleaded guilty to conspiracy to commit wire fraud and
securities fraud in violation of 18 U.S.C. § 371. Glisan is currently serving a five year
sentence. United States v. Ben F. Glisan Jr., Cr. No. H-02-0665 (S.D.Tex.). On January
14, 2004, Andrew Fastow, Enron's former CFO, pleaded guilty to two counts of conspiracy
to commit wire fraud and securities fraud in violation of 18 U.S.C. § 371. Pursuant to his
plea agreement, Fastow faces a minimum of ten years in prison and agreed to forfeit $28
million. Fastow has not yet been sentenced. United States v. Andrew Fastow, Cr. No. H-
02-0665 (S.D. Tex.). On the same day, Lea Fastow, a former Enron executive and wife of
Andrew Fastow, pleaded guilty to filing a false tax return in violation of 26 U.S.C. §
7206(1). Lea Fastow has not yet been sentenced. United States v. Lea Fastow, Cr. No. H-
03-150 (S.D. Tex.). A number of indictments remain pending and are scheduled for trial in
2004 or pending extradition of defendants. See, e.g., United States v. Jeffrey K. Skilling
and Richard A. Causey, Cr. No. H-04-25 (S.D. Tex.) (Enron Chief Executive Officer and
Chief Accounting Officer charged with securities fraud and other crimes); United States v.
Rice et al., Cr. No. H-03-93-01 (S.D. Tex.) (seven Enron executives charged with fraud
relating to Enron's telecommunications unit); United States v. Dan Boyle, Cr. No. H-02-
0665 (S.D. Tex.) (Enron Vice President Dan Boyle charged with multiple crimes); United
States v. Boyle, Cr. No. H-03-__(S.D. Tex.) (Enron Vice President Dan Boyle and Merrill
Lynch executives James Brown and Robert Furst charged with conspiracy, obstruction of
justice and perjury); United States v. Bermingham, Cr. No. H-02-0597 (S.D. Tex.) (three
British bankers charged with wire fraud).
4
Scholarly commentary on Enron is already quite extensive. Among the articles I have
found most insightful are: Neil H. Aronson, Preventing Future Enrons: Implementing the
Sarbanes-Oxley Act of 2002, 8 STAN. J. L. BUS. & FIN. 127 (2002); Deborah L. Rhode &
Paul D. Paton, Lawyers, Ethics and Enron, 8 STAN. J. L. BUS. & FIN. 9 (2002); Anthony J.
Luppino, Stopping the Enron End-Runs and Other Trick Plays: The Book-Tax Accounting
Conformity Defense, 2003 COLUM. BUS. L. REV. 35 (2003); Douglas G. Baird and Robert

2
 When Enron went bankrupt on December 2, 2001,5 after stunning
revelations about the company's insider deals and faulty accounting, some 4500
Enron workers lost their jobs in Houston alone.6 Enron's employees, who had been
encouraged to place their retirement savings in Enron stock, lost some $1.3 billion
in 401(k) accounts.7 Nationwide, Enron's countless investors, who had seen the
stock price decline over the course of the year from $84 to mere pennies per share,
lost some $61 billion.8 This disaster occurred largely because of a troubling gap
between perception and reality.
Throughout the 1990s and up to late 2001, most investors and
commentators believed Enron was one of the most successful, innovative and
profitable companies in America. Fortune, for example, rated Enron "The Most
Innovative Company in America" for five straight years, from 1997 to 2001.9 At
its peak, Enron traded at a price-earnings ratio of fifty-five to one, four times
higher than comparable energy and trading firms.10 In 2001, in the midst of the
dot.com implosion, Fortune even identified Enron as one of the most reliable "10
Stocks to Last the Decade."11 These assessments were horribly inaccurate. In
truth, Enron was a deeply troubled company, well on its way to financial collapse.

K. Rasmussen, Four (or Five) Easy Lessons from Enron, 55 VAND. L. REV. 1787 (2002);
John C. Coffee, Understanding Enron: "It's About the Gatekeepers, Stupid," 57 BUS.
LAWYER 1403 (2002); David Milton, Who 'Caused' The Enron Debacle?, 60 WASH. & LEE
L. REV. 309 (2003); George J. Benston, The Regulation of Accountants and Public
Accouting Before and After Enron, 52 EMORY L.J. 1325 (2003); Jeffrey N. Gordon, What
Enron Means for the Management and Control of the Modern Business Corporation: Some
Initial Thoughts, 69 U. CHI. L. REV. 1233 (2002).
5
On December 2, 2001, Enron Corp. and certain Enron affiliates filed voluntary petitions
for relief under Chapter 11, Title 11, of the United States Code. The petition was filed in
the United States Bankruptcy Court for the Southern District of New York, apparently
because that court allows for electronic filing of petitions on Sundays. Enron continues to
operate as debtors in possession pursuant to 11 U.S.C. §§ 1107 and 1108.
6
Patty Reinert, The Fall of Enron: Watkins to Discuss Now-famous Memo, Enron Exec
Plans to Bring More Documents to Hearing, HOUSTON CHRONICLE, Feb. 13, 2002, at __
(4500 Enron employees in Houston lost their jobs after Enron's bankruptcy).
7
Michael Lietdke, Proud 'Papa' Recognizes Some Faults in 401(k)s, HOUSTON
CHRONICLE, Sept. 23, 2002, at __ (Enron employees lost 1.3 billion in retirement
accounts); James K. Glassman, Diversify, Diversify, Diversify, WALL STREET JOURNAL,
Jan. 18, 2002, at __ (Enron stock price plummeted from $84 to practically zero; the average
Enron employee had 60% of their 401(k) assets in Enron stock).
8
Floyd Norris, After Two-Year Drop, Calendar Turns on Note of Hope, NEW YORK
TIMES, Jan. 1, 2002, at __ (Enron's market value fell $61 billion); James K. Glassman,
Diversify, Diversify, Diversify, WALL STREET JOURNAL, Jan. 18, 2002, at __ (Enron stock
price plummeted from $84 to "practically zero").
9
America's Most Admired Companies, FORTUNE, Mar. 3, 1997, at 73; Mar. 2, 1998, at 86;
Mar. 1, 1999, at 70; Feb. 21, 2000, at 100; Feb. 19, 2001, at 104.
10
Douglas G. Baird and Robert K. Rasmussen, Four (or Five) Easy Lessons from Enron,
55 VAND. L. REV. 1787, 1789 (2002).
11
David Ivanovich, Everybody Knows Enron's Name, HOUSTON CHRONICLE, Oct. 31,
2002, at __.

3
 The extent of the gap in the Enron case between outsider perceptions and
company reality inevitably draws our attention to the role of Enron's senior
management, who created and profited from this gap. We must not let our concern
with individual conduct distract us, however, from the larger issue. The next time
senior management of a major American company tries to mislead investors by
making their company appear more successful than it truly is, will we catch the
problem before it explodes, or will we be fooled again?
Since the 1930s, America has relied on a complex and evolving public-
private system of checks and deterrents to prevent companies and their executives
from misleading investors. This regime relies on four primary institutional
watchdogs to prevent and deter misconduct before it happens and to catch and
disclose actual misconduct when it occurs: independent auditors, corporate boards
of directors, private securities analysts, and securities regulators at the Securities
and Exchange Commission (“SEC”). Behind this initial line of defense lies a fifth
institutional force, the criminal prosecutors with the United States Department of
Justice (“DOJ”), who enforce the federal criminal laws. Though motivated by
disparate goals, these five players collectively work to protect investors from false
and misleading information and ensure that our securities market functions in a
safe, reliable, and efficient manner.12 If we are going to prevent more Enron-style
disasters in the future, it is these five institutional players that will do it.
Does our regulatory system work? Are investors safe? Analysis of the
Enron case suggests, unfortunately, that the answer to these questions is “no.”
Simply put, Enron sought to mislead investors about its financial position and
commercial success, and it got away with this deception from 1997 to late 2001
because all five institutional players failed massively in their task. Enron’s board
of directors was apparently clueless, possessing no idea it was presiding over a

12
Lawyers who work at businesses, auditing firms, and law firms retained by businesses
are a critical sixth watchdog. Deborah Rhode and Paul Paton suggest that in the Enron
case, "[t]oo many members of the legal profession were part of the problem, rather than the
solution." Deborah Rhode and Paul Paton, Lawyers, Ethics, and Enron, 8 STAN. J.L. BUS.
& FIN. 9, 9 (2002). These authors also decry the fact that “lawyers' roles and rules too often
have been absent from the discussion" about the case and needed reforms.” Id. at 10. Alas,
I add to this problem by declining to discuss the role of lawyers in the Enron case in this
Article because I believe I could not adequately address the subject without disclosing
confidential non-public information I obtained as an Enron prosecutor. For excellent
discussions of the role of lawyers in the Enron case, see Rhode and Paton, supra note 4;
Michael L Fox, To Tell or Not to Tell: Legal Ethics and Disclosure after Enron, 2002
COLUM. BUS. L. REV. 867; John C. Coffee, Jr., The Attorney as Gatekeeper: An Agenda for
the SEC, 103 COLUM. L. REV. 1293 (2003). Many commentators also view credit rating
agencies as a securities investment watchdog. I do not analyze performance of the credit
agencies in this Article, largely because I think their views have a less significant impact on
the investment decisions of ordinary Americans that those of equity analysts. For a first-
rate analysis of the conduct of the credit rating agencies in the Enron case, see STAFF TO
THE SENATE GOVERNMENTAL AFFAIRS COMMITTEE, FINANCIAL OVERSIGHT OF ENRON:
THE SEC AND PRIVATE SECTOR WATCHDOGS 97–127 (Oct. 8, 2002) [hereinafter SENATE
GOVERNMENTAL AFFAIRS REPORT].

4
sinking ship;13 Arthur Andersen’s accountants helped perpetuate the fraud rather
than working to stop it;14 Wall Street’s securities “analysts” were more interested
in pumping up Enron’s stock price and repeating Enron management's inaccurate
claims than they were in analyzing the company’s actual business performance;15
the SEC was asleep at the wheel, not even bothering to review Enron’s publicly
filed quarterly financial statements;16 and the federal criminal laws ultimately
proved to be no real deterrent at all.17
The Enron case provides us with a perfect map of the shortcomings in our
regulatory scheme, and those shortcomings are clearly enormous, calling for
serious reform. Since Enron's collapse, Congress, the SEC, and other securities
and accounting regulators have worked hard to fix these problems. Recent
reforms, such as the 2002 Sarbanes-Oxley Act, have made several significant
improvements to our securities laws. Unfortunately, these reforms did little to
combat some of the most significant problems evident in the Enron case. As a
result, another Enron could happen tomorrow. Given the importance of the United
States securities market to the international economy and our own national
retirement system, we have to do better.
In this Article, I call for three significant changes in the way we regulate
the sale of securities issued by publicly traded companies: an organizational and
institutional overhaul of the SEC, criminalization of negligent conduct by
executives of publicly traded companies, and implementation of mandatory auditor
rotation. These proposals would change our current regulatory scheme in
fundamental ways, and I do not advocate them lightly. Indeed, I expect resistance
to these ideas to be intense, particularly from Wall Street, the Final Four
accounting firms, and the corporate and white collar defense bars. To overcome
this resistance, policy makers, practicing lawyers, academics and the general
public need to be aware of how poorly our current regulatory scheme protects
investors. To assist in this educational process, this Article uses the Enron
financial collapse as a case study in the operation of our current regulatory scheme.
This case study revolves around two basic, fundamental questions—the
same questions I asked myself almost every day I worked on the Enron
investigation. First, how did Enron convince the public that a failing company,
heavily in debt and hemorrhaging cash, was actually one of the most profitable and
innovative companies in the world? Second, how is it possible that none of the
front-line institutional players that collectively serve to protect investors—Arthur
Andersen, the Enron Board of Directors, stock analysts, the SEC, and the federal
criminal justice system—prevented this deception from taking place or caught and
disclosed it before it was too late? Answering these two questions will help us

13
See infra, Part III at __.
14
See infra, Part III at __.
15
See infra, Part III at __.
16
See infra, Part III at __.
17
See infra, Part III at __.

5
identify the precise problems with our current securities regulation regime. This,
in turn, will help us understand areas where further reforms are necessary.18
Part I of this Article discusses Enron Corp.'s business operations in the
years before its bankruptcy. During this period, Enron was engaged in a costly and
ultimately disastrous diversification strategy, starting a series of business
initiatives in water, telecommunications, energy and other sectors of the economy
that cost the company billions but failed to produce significant revenue. To meet
its rapidly escalating costs, Enron had to raise billions of dollars in capital markets
but it needed to do so quietly, so as not to alarm banks and investors. Faced with
this quandary, the company resorted to deception.
Part II explains how Enron's deception worked. Enron wanted to appear
profitable, raise billions of dollars in cash, and keep its reported debt low. To
accomplish this legerdemain, Enron employed a series of schemes to manipulate
its financial statements. These techniques helped Enron dramatically inflate its
reported revenue and hide billions of dollars in debt. They also misled investors
and violated both federal criminal laws and relevant accounting rules.
In Part III, I discuss what may be the most alarming aspect of the Enron
case—the failure of Arthur Andersen, the Enron Board of Directors, Wall Street
equity analysts, and the SEC to catch and disclose Enron’s deception before it was
too late, despite some critical warning signs. I analyze the performance of each of
these institutions in the Enron debacle and try to assess what went wrong. I argue
that the existence of systematic conflicts of interest, lack of incentives for diligent
work performance, and the absence of meaningful checks on or reviews of
institutional performance made protection of investors a low priority for the Enron
board, auditors and stock analysts. In the case of the SEC, I suggest that its
performance was derailed by poor management and a misplaced sense of priorities.
Since Enron, we have seen a period of intense reform. In Part IV, I briefly
discuss and assess some of these efforts to improve securities laws and regulatory
practices, including the Sarbanes-Oxley Act, amendments to the United States
Sentencing Guidelines, rule changes by the SEC and FASB, and reforms that
resulted from litigation brought by New York's Attorney General, Elliot Spitzer. I
argue that many of these changes are useful, but that others are actually counter-
productive. I also address the most critical practical issue: where do we go from
here? The most basic question we need to ask is whether the reforms implemented
since 2002 are adequate—whether they sufficiently address and correct the
problems with our system of securities regulation evident in the Enron debacle and
similar cases. I argue that Sarbanes-Oxley and related reforms, though very useful
in many respects, fail to mitigate sufficiently some of the major problems in the
securities market, leaving investors extremely vulnerable to fraud and deception.
Finally, in Part V, I discuss my three reform proposals to improve
securities market oversight, protect investors, and prevent more Enrons in the
future. These measures will improve the accuracy of information provided to

18
This approach assumes that the Enron case was not an anomaly or aberration. I briefly
discuss this issue in Part IV, infra.

6
investors and ensure that our equity markets continue to function in a safe, reliable,
and efficient manner.

I. Enron's Business Operations: A Study in Failure

Enron: Background

When I was a child growing up in Houston, there was no Enron.19

Instead, we had good old Houston Natural Gas ("HNG"). HNG started as our local
natural gas utility, providing gas to retail customers for home and business energy
needs. In the 1980s, HNG sold off its retail business and focused instead on

19
This section contains a brief analysis of Enron's business operations from roughly 1980
to 2001. This section draws upon, among other sources, three excellent books on Enron:
R. SMITH & J. EMSCHWILLER, 24 DAYS: HOW TWO WALL STREET JOURNAL REPORTERS
UNCOVERED THE LIES THAT DESTROYED FAITH IN CORPORATE AMERICA (2003); B.
MCCLEAN AND P. ELKIND, THE SMARTEST GUYS IN THE ROOM, THE AMAZING RISE AND
SCANDALOUS FALL OF ENRON (2003); and ROBERT BRYCE, PIPE DREAMS: GREED, EGO,
AND THE DEATH OF ENRON (2002). Another significant source for this and subsequent
parts of this Article is the four public reports filed by Neal Batson, the examiner appointed
by the United States Bankruptcy Court, Southern District of New York, to assist the Court
in untangling Enron's complicated accounting and finance schemes. Batson filed his First
Interim Report on September 21, 2002. In re. Enron Corp., First Interim Report of Neal
Batson, Court-Appointed Examiner, No. 01-16034 (AJG) (Bankr. S.D.N.Y. Sept. 21, 2002)
[hereinafter First Report]. This first preliminary report investigated six suspect Enron
transactions. Batson filed his Second Interim Report on January 21, 2003. In re. Enron
Corp., Second Interim Report of Neal Batson, Court-Appointed Examiner, No. 01-16034
(AJG) (Bankr. S.D.N.Y. Jan. 21, 2003) [hereinafter Second Report]. This report, perhaps
the most significant, investigates virtually all of the Enron "special purpose entity" or
"SPE" transactions the examiner could identify. The report concludes that Enron
manipulated its financial statements, in violation of Generally Accepted Accounting
Principles, to dramatically overstate its reported income and funds flow and understate its
debt. Batson filed his Third Interim Report on June 30, 2003. In re. Enron Corp., Third
Interim Report of Neal Batson, Court-Appointed Examiner, No. 01-16034 (AJG) (Bankr.
S.D.N.Y. June 30, 2003) [hereinafter Third Report]. The Third Report examined whether
certain individuals and companies were responsible for Enron's accounting abuses. The
Third Report concluded, inter alia, that there was sufficient evidence to conclude that
Enron executives violated their fiduciary duties, and that certain financial institutions knew
of this wrong-doing and assisted it. Batson filed his Final Report on November 4, 2003. In
re. Enron Corp., Final Report of Neal Batson, Court-Appointed Examiner, No. 01-16034
(AJG) (Bankr. S.D.N.Y. Nov. 4, 2003) [hereinafter Final Report]. The Final Report
examined the responsibility of Arthur Andersen, in-house and retained counsel, senior
Enron executives, the Enron Board of Directors, and certain financial institutions in the
Enron debacle. In addition to these sources, Baird and Rasmussen's Four (or Five) Easy
Lessons from Enron, which discusses significant bankruptcy issues raised by the Enron
case, provides a brief but very useful analysis of Enron's business successes and failures
that reaches many of the same conclusions I have reached during the two years I have spent
thinking about Enron as a business.

7
natural gas production and transportation.20 It soon became a major regional gas
powerhouse.
In 1985, a large mid-western gas pipeline company called InterNorth,
headquartered in Omaha, Nebraska, acquired HNG.21 The InterNorth acquisition
is something of a legend in Houston business circles. Though InterNorth thought
it was buying HNG, within a short period of time it became clear that HNG's
management was calling all the shots for the newly merged company. HNG-
InterNorth was based in Houston, not Omaha, and the CEO of HNG ran the show.
His name was Ken Lay, and he renamed the new company "Enron."22
Enron was a company built on deregulation. From the 1930s to the 1980s,
natural gas was heavily regulated by the federal government, which set the price
for both the sale and transportation of the product.23 In the mid-1980s, however,
the Reagan Administration began to eliminate price controls and give gas
producers and pipeline companies the ability to contract freely.24 Some major
companies like Columbia Gas Transmission could not adjust to the rapidly
changing market and perished.25 Others thrived, and none more than Enron.
Enron understood that the newly deregulated market was grossly inefficient, with a
large number of producers struggling to identify and contract with an even vaster
number of customers. Enron exploited these inefficiencies, stepping into the
middle between producers and users and rationalizing the entire market. It bought
huge quantities of gas from producers at steep discounts, often obtained by
financing gas exploration and production in the tight 1980s Texas credit market,
and then delivered that gas to wholesale customers through its own nationwide
pipeline system.26 Soon, both producers and users gave up trying to enter the
market on their own, preferring simply to deal with Enron. Within a few short
years, Enron's strategy totally transformed the gas sector. The company captured a
huge percentage of the market and pocketed substantial profits. By the early
1990s, Enron was the leading natural gas company in the United States.
Unfortunately, Enron's success in the rapidly deregulating natural gas
sector held the key to the company's ultimate demise. Success built on exploiting a
rapidly deregulating market is inevitably short-lived. Other companies watch the
market leader's operations, copy its innovations, and compete for the same
business. As the market becomes more efficient, opportunities decline,
competition stiffens, and profit margins shrink. This happened rapidly in natural
gas. Companies like El Paso and Dynegy monitored Enron closely and based their

20
BRYCE, supra note 19, at 23.
21
For excellent discussions of the HNG-InterNorth merger, see BRYCE, supra note 19, at
31-33. See also MCCLEAN & ELKIND, supra note 19, at 10–13.
22
HNG-InterNorth's selection of the name "Enron" is equally legendary in Houston.
Originally, the company selected the name "Enteron," only to abandon it at the last moment
when the company learned that "enteron" is a term for the intestines or alimentary canal.
23
BRYCE, supra note 19, at 52; MCCLEAN & ELKIND, supra note 19, at 2.
24
BRYCE, supra note 19, at 53; MCCLEAN & ELKIND, supra note 19, at 9.
25
BRYCE, supra note 19, at 53.; MCCLEAN & ELKIND, supra note 19, at 34-36.
26
BRYCE, supra note 19, at 54-56.

8
own business models on Enron's. As early as 1993, Enron's profit margins in gas
began to decline.27
As the low-hanging fruit in the natural gas market disappeared, Enron's
management faced a difficult business strategy decision: it could remain a natural
gas company and grow content with a smaller return on its capital, or it could
diversify into other sectors of the economy and try to replicate its great success in
natural gas. Enron was a confident and aggressive company. It chose to diversify.

Enron's Diversification Strategy and Cost Structure

Over the course of the 1990s, Enron rapidly diversified into an enormous
array of new business areas in the United States, Europe, and the developing
world: energy derivatives trading, water, power generation, coal, paper and forest
products, telecommunications, retail electricity, metals.28 This diversification
strategy was asset-heavy. Enron, for example, built or purchased pipelines in
Brazil, steel mills in Thailand, newsprint mills in Canada, and power plants in the
United Kingdom, the Philippines, Guatemala, India and Guam.29 These
investments cost tens of billions of dollars. Enron paid out approximately $1
billion to construct its Dahbol power plant in India30; some $2.4 billion for
purchase of the Wessex water utility in the United Kingdom;31 $3.2 billion for
Portland General Electric;32 $2 billion in cash and debt for metals trading company
MG;33 $1.3 billion for an electricity company in Brazil;34 $300 million for a paper
mill in Quebec.35 The rate of investment was dizzying. In July 1998, Wall Street
equity analysts from DLJ noted that Enron had spent some $3.5 billion to purchase
water and electricity assets within a few short weeks alone.36
Enron's diversification strategy should serve as a case study for business
students for years to come, for it teaches important lessons. As Enron expanded
into new areas, it did not generally hire experienced senior managers from these
sectors of the economy to guide its business operations. Instead, Enron dispatched
senior natural gas and energy trading executives to drive its new businesses. Enron
assumed that success in natural gas and trading could be replicated in other fields

27
BRYCE, supra note 19, at 137; MCCLEAN & ELKIND, supra note 19, at 105.
28
See Second Report, supra note 19, at 15-16 (describing Enron's diversification strategy
in the 1990s).
29
BRYCE, supra note 19, at 136, 154; MCCLEAN & ELKIND, supra note 19, at xxiv, 74,
225.
30
BRYCE, supra note 19, at 288.
31
BRYCE, supra note 19, at 179, 359; MCCLEAN & ELKIND, supra note 19, at 247.
32
MCCLEAN & ELKIND, supra note 19, at 107.
33
BRYCE, supra note 19, at 218; MCCLEAN & ELKIND, supra note 19, at 225.
34
MCCLEAN & ELKIND, supra note 19, at at 259.
35
BRYCE, supra note 19, at 154.
36
Donaldson, Lufkin & Jenrette, Comment on Enron Corp., Acquisition of U.K. Water
Company Adds to EPS and Opportunities for Growth, July 24, 1998, discussed in Second
Report, supra note 19, at 15 n.42.

9
because markets are markets, functioning in more or less the same manner. Enron
failed to understand, unfortunately, that its success in natural gas was the direct
result of its superior knowledge about the market, knowledge gained through
decades of experience as a gas producer, transporter, and retail marketer. When
Enron's extremely successful gas executives were plugged into new industrial
sectors, they failed virtually across the board, often through sheer ignorance,
producing very little or no revenue for the company.37
Consider, for example, the effort of Enron's water subsidiary, Azurix, to
enter the water market in Latin America.38 In 1999, Azuriz made a sealed bid of
$439 million to take control of Buenos Aries's water utility. Azuriz won the
auction, but its bid was more than three times higher than the next largest offer.39
Once Azurix took control of its prize, it discovered that the utility was crumbling
and that Azurix's purchase did not include critical assets like the utility's billing
system. The bid ultimately resulted in enormous losses.40 This example is typical
of Azurix's performance over the course of its short life. As a result of
management errors and outrageous overhead, Azurix, journalist Robert Bryce has
commented, "didn’t burn cash, it incinerated it."41
By decade's end, Enron's costly diversification strategy had put the
company in a very vulnerable position. Though the energy trading business may
have been prospering,42 virtually every other major new Enron initiative—
international power, retail electricity, water, telecommunications—was failing. 43
The true extent of Enron's losses in these years may never be known with
precision, but informed estimates are staggering. In India, Enron's Dabhol power
plant never became operational, with an ultimate cost to Enron of almost $1
billion.44 Enron's telecommunications division, Enron Broadband Services, lost at
least another $1 billion within two short years.45 Metals: at least $400 million in
losses.46 These losses were matched or exceeded in other areas. Fortune's

37
BRYCE, supra note 19, at 289.
38
For discussions of Azuriz, see BRYCE, supra note 19, at 175-189.
39
BRYCE, supra note 19, at 184; MCCLEAN & ELKIND, supra note 19, at 253.
40
BRYCE, supra note 19, at 184; MCCLEAN & ELKIND, supra note 19, at 253-254.
41
BRYCE, supra note 19, at 176. Bryce notes that Azuriz executives spent $60 million per
month on hotels, consultants, and airfare alone during the company's short existence.
42
There is serious question whether Enron's energy trading business was profitable or not.
See MCCLEAN & ELKIND, supra note 19, at 412; SMITH & EMSCHWILLER, supra note 19, at
378; BRYCE, supra note 19, at 220. Even if the trading business was profitable, those
profits may have been derived, in part, from fraud. See, e.g., United States v. Timothy
Belden, Cr. No. 02-0313-MJJ (N.D. Ca.) and United States v. Jeffrey Richter, Cr. No. 03-
0026-MJJ (N.D. Ca.) (defendants, who traded electricity from Enron's office in Portland,
Oregon, pleaded guilty to fraudulent manipulation of the California electricity market).
43
BRYCE, supra note 19, at 9; MCCLEAN & ELKIND, supra note 19, at 78, 104, 184, 260;
SMITH & EMSCHWILLER, supra note 19, at 320.
44
MCCLEAN & ELKIND, supra note 19, at 83.
45
MCCLEAN & ELKIND, supra note 19, at xxiv.
46
MCCLEAN & ELKIND, supra note 19, at 131.

10
Bethany McClean and Peter Elkind, two of Enron's most savvy observers,47 have
estimated Enron's total business losses in the late 1990s at "well over $10 billion in
cash"48—a figure that boggles the mind.
Enron's difficulties were exacerbated by a cost structure that was totally
out of control.49 In the first half of the 1990s, before Jeff Skilling took control of
the company, Enron had kept a tight lid on personnel costs, with virtually no
employment growth during a five-year period of increasing revenue and profits.50
Under Skilling, however, Enron abandoned serious cost controls. Employment
rolls sky-rocketed as Enron diversified, from 7500 in 1996 to over 20,000 in
2001.51 Employee compensation also went through the roof. In 2000, for
example, some 200 Enron executives made $1 million or more in compensation,
and 26 made over $10 million.52 A new office tower in Houston added another
$200 to 300 million in costs.53

Enron's Need for Capital

How do you stay in business if, like Enron, you are spending billions of
dollars per year to buy expensive new assets and hire more well-paid staff, but
none of your new business ventures are generating sufficient profit to meet these
costs? There is really only one answer: you meet your costs by raising money in
capital markets, by issuing equity or going into debt. Enron chose debt, borrowing
some $30 billion over a few short years. What made Enron unique was the way it
borrowed these sums.
Corporations that precipitously increase their debt load are taking a serious
risk. Publicly traded companies are required to report their debt positions to the
SEC, and this can have a huge impact on the company's fortunes. If, for example,
a company raises billions of dollars on capital markets over a very short period of
time, credit rating agencies will lower the company's credit rating. This, in turn,
will increase the company's cost of capital and, in extreme situations, cause access
to capital to dry up altogether. When, for example, lenders got an accurate picture
of Enron's true debt position in late November 2001, they immediately cut off
access to funds and Enron went bankrupt.
Raising capital is particularly tricky for companies like Enron that engage
in substantial derivatives trading. Over the course of the 1990s, Enron had become
a major player in energy futures markets, and though this may have been
profitable, it increased Enron's vulnerability. When companies sell futures, they

47
McClean was the first business journalist to publicly suggest that Enron was
significantly over-valued. See B. McClean, Is Enron Overpriced?, FORTUNE, Feb. 19,
2001.
48
MCCLEAN & ELKIND, supra note 19, at 412.
49
MCCLEAN & ELKIND, supra note 19, at 119.
50
BRYCE, supra note 19, at 115.
51
BRYCE, supra note 19, at 115; 134.
52
MCCLEAN & ELKIND, supra note 19, at 241.
53
BRYCE, supra note 19, at 216, 304; MCCLEAN & ELKIND, supra note 19, at 239.

11
are promising to deliver a commodity to their customer at a future date. This
entails risk for the customer, since there is no guarantee that the selling company
will be in a position to meet its obligation when the future delivery date arrives.
As a result, only companies with solid credit ratings and a reputation for reliability
can play in derivatives markets in any substantial way. If one's credit rating
declines, counter-parties demand more collateral before entering into trades,
making extensive trading prohibitively expensive. Unfortunately for Enron,
nothing drives down one's credit rating faster that large-scale borrowing. Thus,
Enron's cash-hungry diversification strategy posed enormous risks to Enron's
critical energy trading business.54
In summary, poor management put Enron in a very difficult position by
the late 1990s. Enron needed to raise billion of dollars to meet its costs, but it
needed to do this in a manner that would not spook capital markets and jeopardize
its trading business. Surprisingly, Enron managed to pull this trick off, quietly
borrowing over $30 billion to meet its costs without significant impact on its credit
rating. The company accomplished this miracle through deception.

II. Enron's Deceptions

Enron's Financial Statements: An Introduction

How do you know if a company is successful or not? In the past, you

could actually use a company's product or service, or talk to persons who did, and
judge for yourself. Indeed, the first time I read a book on investing, back in the
1980s, investment guru Peter Lynch recommended just this approach. In today's
world of multi-national conglomerate corporations with radically diverse product
and service offerings, this method is useless for all but the smallest companies.
Today, investors trying to decide whether to invest in a company or not have only
one real option: to search for and read as much information about a company as
possible. Interestingly, however, there are very few objective sources of
information available to investors about any particular company. Instead,
investors, stock analysts, and business journalists are forced to base their
judgments largely upon the company's own statements—its press releases, annual
meeting statements, stock analyst presentations, and, above all, the financial
statements it files with the SEC. The fact that we now rely almost exclusively on
information provided by large companies themselves to judge their operations is a
dangerous development. In the Enron case, investors had no idea Enron was
heavily in debt and losing money fast for a very simple reason: Enron did not tell
them.
The most important way in which companies communicate with investors
is through the mandatory securities reporting system established by the Securities
Exchange Act of 1934 and overseen by the SEC. Under this system, publicly

54
For a discussion of this problem, see SMITH & EMSCHWILLER, supra note 19, at 78, 162;
Second Report at 18-19.

12
traded companies file mandatory financial statements with the SEC at the end of
each quarter, and these reports are then made available to investors and analysts.55
These reports, referred to by investors and securities lawyers as "10-Qs," and "10-
Ks,"56 inform investors about a company through two different mechanisms. First,
companies provide a narrative description of their operations and new initiatives
during the relevant reporting period in a "Management's Discussion and Analysis
of Financial Condition and Results of Operations," or "MD&A."57 Second, the
company supports this narrative by disclosing hard financial data covering basic
performance metrics, such as the amount of company's debt, revenue, and cash
flow.58 Companies are required to report information accurately and in compliance
with "generally accepted accounting principles," or "GAAP."59 They are also
required to report any additional "material" information needed to insure that its
disclosures in the MD&A or metric sections are not misleading.60 The materiality

55
15 U.S.C. § 78o(d). For a primer on securities reporting requirements, see LOUIS LOSS
& JOEL SELIGMAN, FUNDAMENTALS OF SECURITIES REGULATION 471–477 (2001).
56
Companies file SEC Form 10-Q at the conclusion of the first three quarters of the year,
and a Form 10-K, covering the entire year, at the conclusion of the fourth quarter.
Companies must also file Form 8-Ks after the occurrence of specified events of an
extraordinary character that have not been previously reported.
57
See 17 C.F.R. § 229.303 (discussing MD&A). According to the SEC, the MD&A is
necessary because "a numerical presentation and brief accompanying footnotes alone may
be insufficient for an investor to judge the quality of earnings and the likelihood that past
performance is indicative of future performance. MD&A is intended to give the investor
an opportunity to look at the company through the eyes of management by providing a
short and long-term analysis of the business of the company." Securities and Exchange
Commission, SEC Interpretation: Management's Discussion and Analysis of Financial
Condition and Results of Operations; Certain Investment Company Disclosures, at
http://www.sec.gov/rules/interp/33-6835.htm, at Section III.A.
58
See generally SEC Regulations S-K and S-X, 17 CFR §§ 210 and 229 (detailing
requirements for financial statements).
59
LOSS & SELIGMAN, supra note 55, at 471, 474. The SEC has statutory authority to set
accounting principles. See, e.g., Securities Act of 1933 §19(a), 15 U.S.C. § 77s(a) (2000);
Securities Exchange Act of 1934 § 13(b)(1), 15 U.S.C. § 78m(b)(1) (2000). The SEC has
delegated this task since 1973 to the Financial Accounting Standards Board, or FASB,
whose members are appointed by an oversight body comprised of major stakeholders,
including business executives, investors, and accountants. FASB promulgates standards
which serve as the basis for GAAP. For a discussion of this process, see, Recent Events
Relating to Enron Corporation, Hearing Before the House of Rep. Subcomm. on Capital
Markets, Insurance, and Government Sponsored Enterprises 3-4 (Dec. 12, 2001)
(testimony of Robert K. Herdman, Chief Accountant of the SEC) [hereinafter Herdman
Testimony]; SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 21. For an
excellent critique of FASB's performance in this task, see Concerning Accounting and
Disclosure Reform and Oversight: Before the House of Rep. Financial Services Comm., 9-
10 (Apr. 9, 2002 ) (testimony of Richard C. Breeden, former Chairman of the SEC)
[hereinafter Breeden Testimony].
60
Rule 12b-20, 17 C.F.R. § 240.12b-20. Compliance with disclosure requirements is
policed by the SEC pursuant to the anti-fraud provisions set forth in Section 10(b) of the

13
requirement means, in practice, that companies must disclose all major
developments, both good news and bad. The importance of these publicly filed
financial statements to equity and debt markets cannot be over-estimated.
Ultimately, virtually all business news and analysis available to lenders and
investors is based on these quarterly SEC reports.
In the Enron case, the investing public did not know Enron was falling
apart because from 1997 onward, its 10-Qs and 10-Ks were grossly inaccurate.61
In late 2001, William Powers, Dean of the University of Texas Law School, joined
the Enron Board of Directors and began to investigate the true condition of the
company. What he found, he later testified before Congress, was "appalling": a
"systematic and pervasive attempt by Enron's Management to misrepresent the
Company's financial condition."62
Enron's narrative descriptions of company operations in 10-Q and 10-K
MD&A disclosures was misleading, according to bankruptcy examiner Neil
Batson. Enron, Batson found, kept important "bad news" to itself, hiding the
corporation's growing economic vulnerability, its reliance on structured finance
transactions for liquidity, and the extent of its financial obligations to lenders. This
was accomplished through both simple non-disclosure and by "incomplete and
uninformative" footnotes that were virtually incomprehensible.63
Ultimately, however, a company's narrative disclosures are less important
than the hard financial data included in the financial statements. Even if a
company wants to put a positive spin on its setbacks, numbers don’t lie, right?
Alas, the Enron case demonstrates conclusively that if a company wants to deceive
investors, it can easily do so by manipulating its publicly disclosed financial data.
This is the crux of the Enron case.
From a financial reporting perspective, Enron faced two "challenges."
First, the company was making very little money the old fashioned way, by selling
a product or service, particularly from its new business initiatives. To state the
obvious, revenue and cash shortfalls matter to investors and lenders. Revenue and

Securities Exchange Act and Rule 10b-5, codified at 17 C.F.R. § 240.10b-5. Section 10(b)
provides, in relevant part, that "it shall be unlawful for any person directly or indirectly . . .
to use or employ in connection with the purchase or sale of any security . . . any
manipulative or deceptive device or contrivance." Rule 10b-5 provides, in relevant part,
that "[i]t shall be unlawful for any person, directly or indirectly . . . (a) to employ any
device, scheme or artifice to defraud, (b) make any untrue statement of material fact or to
omit to state a material fact necessary in order to make the statements made, in light of the
circumstances under which they were made, not misleading, or (c) to engage in any act,
practice, or course of business which operates or would operate as a fraud or deceit upon
any person, in connection with the purchase or sale of any security."
61
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 39 ("Enron's financial
statements back to at least 1997 contain inaccurate, and likely fraudulent, information").
62
Hearing Before the House of Rep. Comm. on Financial Services, at 2 (Feb. 4, 2002)
(Testimony of William C. Powers, Chairman of the Special Investigative Committee of the
Board of Directors of Enron Corp.) [hereinafter Powers Testimony].
63
Second Report, supra note 19, at 55-56.

14
cash flow are two of the most important metrics that companies report in their 10-
Qs and 10-Ks, and if a company reports bad numbers, or numbers that are positive
but lower than expected, investors and lenders will head for the hills. Second,
Enron desperately needed cash—billions of dollars of cash—to meet the
company's exploding costs, compensate for its poor business performance, and fuel
its diversification strategy. If, however, the company met these cash needs through
traditional means, such as additional stock offerings or loans, investors reading
Enron's financial statements would quickly realize that Enron was not making
enough money to pay for its operations and the company's stock price and credit
rating would decline accordingly. Enron, then, faced a conundrum. It could either
report its financial condition accurately and take its lumps in the market, with
potentially disastrous results for its credit rating and trading business, or it could
try to conceal its true financial position.
Enron, fatefully, chose the second option.64 In the late 1990s, senior Enron
executives set out to manipulate Enron's reported financial data to improve the
company's apparent financial success. As Enron CFO Andrew Fastow explained
in his recent guilty plea allocution to federal securities fraud charges, "While CFO,
I and other members of Enron's senior management fraudulently manipulated
Enron's publicly reported financial results. Our purpose was to mislead investors
and others about the true financial position of Enron and, consequently, to inflate
artificially the price of Enron's stock and maintain fraudulently Enron's credit
rating."65 Enron Treasurer Ben Glisan confirmed these facts in his own recent
guilty plea allocution, stating: "I and others at Enron engaged in a conspiracy to
manipulate artificially Enron's financial statements."66 How did this fraud work?
In a rudimentary securities fraud case, a company wishing to mislead
investors simply reports inaccurate financial data to the SEC and to investors.
This, for example, is what happened at WorldCom. There, the company took
billions of dollars in costs and improperly reported them as capital expenditures, a
simple mechanism that transformed a $662 million loss in 2001 into a reported 2.4
billion profit.67 Enron's deception was significantly more sophisticated.

Enron's Pre-Pay Transactions

Let's begin with Enron's biggest problem in the late 1990s: it needed to
borrow billions of dollars without reporting the loans to investors. How do you

64
Neal Batson, the Enron bankruptcy examiner, has reached the same conclusion about
the factors that motivated Enron's efforts to manipulate its financial statements. See
Second Report, supra note 19, at 15 (Enron manipulated its financial statements as a result
of need for cash and to maintain credit rating).
65
Plea Agreement Exhibit A, United States v. Andrew S. Fastow, Cr. No. H-02-0665
(S.D. Tex.) (statement of defendant, dated January 4, 2004).
66
Plea Agreement Exhibit I, Glisan Statement – Count Five, United States v. Ben F.
Glisan Jr., Cr. No. H-02-0665.
67
Kathleen F. Brickey, From Enron to WorldCom and Beyond: Life and Crime After
Sarbanes-Oxley, 81 WASH. U.L.Q. 357, 369 (2003).

15
borrow billions of dollars without disclosing that fact? One of Enron's methods of
accomplishing this trick was to create a financial transaction called a "prepay."68
Say, for example, that Enron needed to borrow $1 billion from a bank to meet its
expenses or buy a steel mill in Thailand. Enron could simply borrow the money
from a lender, but this debt, once reported on the company's 10-Q and 10-K
statements, would lower the company's credit rating and alarm investors.69 To
avoid this outcome, Enron would offer to sell to major financial institutions energy
futures for $1 billion.70 At the same time, Enron would offer to buy back the same
energy futures in one year for, say, $1.2 billion. The bank would agree to this
proposal because for all intents and purposes it is a loan: the bank would provide
Enron $1 billion for one year, and in return receive the principal back plus $200
million in interest once the term of the loan was over.
For Enron, too, the pre-pay transactions were loans, functionally and
practically: it borrowed money for a period of time and in return assumed
obligations to pay the money back with interest. Since, however, Enron structured
and labeled these debt transactions as "trades of energy futures," it would record
the $1 billion it borrowed as cash flow from trading operations, and the $1.2
billion it owed as a "price risk management liability"—a derivative trading
liability.71 As a result, $1.2 billion that should have been reported to the SEC and
investors as debt was hidden in the corporation's enormous multi-hundred billion
dollar derivatives trading budget. Investors reading Enron's financial statements
would have no way to learn that Enron was going further into debt.
How important were these pre-pays to Enron? According to the
bankruptcy examiner, pre-pay transactions, primarily conducted with Citibank and
JPMorgan,72 became "the quarter-to-quarter cash flow lifeblood of Enron."73 From

68
The pre-pay transactions are discussed in Second Report, supra note 19, at 44-45 and
58-66. Because the structure of the pre-pays and other Enron structured finance
transactions was immensely complicated, I have simplified the transactions to a degree in
order to make them comprehensible to persons lacking a background in structured finance.
Thus, in the pages that follow, I typically conduct a functional analysis of the described
transactions rather than describing all of the formal transactions steps taken by Enron and
its counter-parties. For example, most of Enron's finance deals were typically structured
through use of multiple Special Purpose Entities, or SPE's, Enron affiliates created
specifically to facilitate preferable accounting treatment. In my summaries, I have treated
SPE's functionally, as a part of Enron itself, rather than formally, as technically quasi-
independent entities. My effort to explain these and other Enron transactions in a
straightforward manner has not, in my estimation, resulted in inaccuracy. For these
interested in details of these and other Enron finance transactions, I recommend the four
Bankruptcy Examiner's Reports.
69
Second Report, supra note 19, at 15; Third Report, supra note 19, at 14.
70
The figures in my example are made-up to serve an illustrative purpose.
71
Second Report, supra note 19, at 59.
72
Second Report supra note 19, at 59, 65. According to the bankruptcy examiner,
Citibank and JPMorgan helped Enron structure the prepays, provided the funds, and helped
create the SPE's designed to improve accounting treatment.
73
Second Report, supra note 19, at 45.

16
1992 to 2001, Enron borrowed at least $8.6 billion through pre-pays—money,
according to the examiner, that should have been reported as debt.74 Pre-pays
increased in importance to Enron as the company headed toward bankruptcy. In
2000 alone, for example, pre-pays provided over 50% of Enron's reported funds
flow from operations. 75 By June 2001, Enron was keeping over $5 billion in debt
improperly hidden on its balance sheet as "price risk management liabilities."76
These transactions violated GAAP, because they resulted in substantial under-
reporting of Enron's true debt position.77

Mark-to-Market Manipulation and Accounting Hedges

Pre-pays brought in badly needed cash, but the transactions led to a

revenue loss. This would not have been a problem if Enron had substantial real
revenue to report to investors and the SEC, but unfortunately, it did not. Thus,
Enron faced another tough question: how do you find revenue to report to investors
when you do not have cash coming in from sales of products and services?
Enron's answer was, in part, to manipulate mark-to-market accounting.
Under traditional accrual accounting, a company typically records revenue
when cash comes in the door from its customers or is otherwise realized. Not so
under mark-to-market accounting ("MTM"). Under MTM, a company's assets are
carried on the books not at purchase price, but at "fair value." Each quarter,
companies using MTM value their assets and record quarterly changes in the fair
value of those assets as gains or losses.78 So, for instance, if a company using
MTM originally bought 10 units of a commodity at a unit price of $1, and the price
of the commodity shot up to $2 in a particular quarter, the company would record
$10 in revenue in that quarter, even though it had not sold the commodity in
question. If the price subsequently dropped back to $1, and the company still
owned the commodity, the company would report a $10 loss. Companies that are
engaged almost exclusively in the trading of stocks, commodities or their
derivatives often use MTM accounting because it arguably provides a more
accurate picture of the company's true financial position. Unfortunately, the Enron
case shows that in the wrong hands, MTM can be severely misused.
In 1992, after extensive lobbying, Enron received approval from the SEC
to use MTM to value its natural gas trading business.79 This made good sense at

74
Second Report, supra note 19, at 58, 66.
75
Second Report, supra note 19, at 45.
76
Second Report , supra note 19, at 59, 66.
77
Second Report, supra note 19, at 66.
78
For a brief discussion of MTM, see Second Report, supra note 19, at 23.
79
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 40–42; BRYCE, supra note
19, at 66–67; MCCLEAN & ELKIND supra note 19, at 41–42; Second Report, supra note 19,
at 22-23. Significantly, Enron promised during this lobbying effort that its MTM
valuations of assets would not be based on subjective analysis, a promise which Enron
violated repeatedly. SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 42; and
see analysis of Mariner investment below.

17
the time, for the value of natural gas, at least in the short-term, is not based on
speculative estimates, but is set daily by the market. Over the course of the 1990s,
however, and without SEC approval, Enron gradually began to use MTM to value
much of its non-trading operations.80 This led to chronic accounting abuses.81
MTM allowed Enron to record estimated future profits from transactions
as current operating revenue long before the transactions actually generated any
cash earnings.82 For example, if Enron signed a long-term energy contract, it
would estimate how much the contract might be worth over the lifetime of the deal
and then record the estimated long-term profit as current revenue in the quarter the
deal was signed. This situation created a strong incentive for Enron employees to
enter into long-term deals regardless of whether those deals would actually make
money or not, as long as the employees could, through use of overly optimistic
estimates, claim the deals would make money. 83 The fact that Enron bonuses were
tied to the size of the estimated future profits, and not to a deal's actual
performance over time, only made matters worse. In one case, Enron actually paid
a customer $50 million up front in cash to induce the party to sign a long-term
energy contract. This made sense for Enron, from a financial statement
perspective, because it could use MTM to immediately record enormous revenue
far in excess of the $50 million expense.84 Indeed, since Enron used MTM to book
all of its expected future revenue in the quarter a large transaction was signed,
Enron employees often viewed making real profit as deals went forward as
irrelevant.85 This focus on generating paper revenue for reporting purposes, rather
than generating actual cash flow and actual profits, exacerbated Enron's need to
find cash elsewhere, through, for example, its pre-pays.
MTM abuses did not end when the initial "earnings" from a deal were
recorded. Many of Enron's physical and contractual assets were sui generis and
non-fungible, or had value based on necessarily speculative assumptions about the
long-term price of commodities. Since there was no clear and definitive market
price for these assets, Enron was forced to "estimate" fair market value for MTM
purposes.86 Inevitably, Enron "estimated" that its assets were rising in value.87
This allowed Enron to report the subsequent "gain" in estimated fair value as
revenue on its financial statements. For example, Enron marked up its investment
in Mariner Energy, a private oil and gas exploration company, from $185 million
in 1996 to $367 million in 2001, and reported the difference as revenue. Later,

80
Second Report, supra note 19, at 23; BRYCE, supra note 19, at 67-68.
81
For a brief but useful discussion of the ways in which MTM's emphasis on estimation
of potential future profits leads to easy accounting manipulation, see George Benston, The
Regulation of Accountants and Public Accounting Before and After Enron, 52 EMORY L.J.
1325, 1347–48 (2003).
82
This problem is discussed in Second Report , supra note 19, at 26.
83
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 44.
84
BRYCE, supra note 19, at 209.
85
See BRYCE, supra note 19, at 131, 134.
86
See Herdman Testimony, supra note 59, for a discussion of this process under MTM.
87
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 43-44.

18
after bankruptcy, Enron conceded that this figure was inflated by some $256
million.88
Of course, some of Enron's assets did have definite concrete market prices,
and these posed another MTM "challenge": what do you do if the value of these
assets declines? The correct answer, from an MTM accounting perspective, is
simple: you record the decline in value as a loss. Enron had another idea. In 2000,
Enron and LJM 2, a private investment fund created and run by Enron executives,
created four special purpose entities—companies that exist only as names on
transaction documents—called the "Raptors."89 Enron then entered into hedging
transactions with the Raptors, pursuant to which the Raptors would be obligated to
pay Enron one dollar for every dollar in the decline in the price of certain highly
speculative Enron investments.90 This would allow Enron to offset any MTM
losses from the investments with corresponding MTM gains from the increase in
value of the Raptor obligations.
Not surprisingly, the assets covered by the Raptor hedges plummeted
almost $1 billion in value in 2000, an enormous loss indicative of Enron's poor
diversification strategy. Pursuant to the hedging agreements, however, the Raptors
were obligated to pay Enron the same amount to offset the loss. This allowed
Enron to convert some $954 million in losses into a reported $1.1 billion in income
from the third quarter of 2000 through the third quarter of 2001.91 As Enron board
member William Powers later stated to Congress, the result of these transactions
was that "more than 70% of Enron's reported earnings from this period were not
real."92
Unfortunately, the Raptors did not provide a true economic risk hedge, but
only an accounting hedge.93 In setting up the Raptors, Enron had capitalized them
using its own stock. Thus, the Raptors' ability to compensate Enron for its
investment losses was tied directly to Enron's own stock price.94 The scheme
would "work" as long as Enron's stock price remained sufficiently high to insure
that the Raptors were solvent. If, however, Enron's stock price declined, the
Raptors would become insolvent and Enron would have a serious problem on its
hands.95 The transactions inevitably ended in disaster in fall of 2001 when Enron's
stock price dropped rapidly, leaving the Raptors insolvent and Enron with no
choice but to write off the entire mess with a $710 million pre-tax loss.96

88
MCCLEAN & ELKIND supra note 19, at 129.
89
For a discussion of the Raptor transactions, see Powers Testimony, supra note 62, at 3–
5; First Report, supra note 19, at 3-4.
90
First Report, supra note 19, at 3.
91
First Report, supra note 19, at 3; Second Report, supra note 19, at 106; Powers
Testimony, supra note 62, at 5.
92
Powers Testimony, supra note 62, at 5.
93
Third Report, supra note 19, at 12; Powers Testimony, supra note 62, at 3–4.
94
First Report, supra note 19, at 3–4.
95
This fact gave Enron's senior management a strong incentive to insure that Enron's
reported financial data looked strong, so that the stock price would remain high.
96
First Report, supra note 19, at 4.

19
Disclosure of these facts by Enron on October 16, 2001—even remarkably hazy
and partial disclosure —ultimately helped kill off the company.
The Raptor hedges violated GAAP. As Enron Treasurer Ben Glisan
explained as part of his guilty plea, "this transaction violated existing accounting
principles in that its form was misleading and was accounted in a manner
inconsistent with its economic substance."97 The transactions also violated federal
criminal securities laws. Recently, Enron CFO Andrew Fastow admitted in his
guilty plea that the entire Raptors scheme was criminal, because the accounting
hedge was "set up as a way to conceal the poor performance of certain Enron
assets" and "misled investors by fraudulently improving the appearance of Enron's
financial statements."98

Monetizations

Mark-to-Market manipulations generated revenue on paper, but the

company needed cash. Instead of relying exclusively on the pre-pays to meet this
need, Enron began in 1998 to enter into another type of structured finance
transaction, known as "monetizations," that generated both cash and reportable
revenue. These transactions were, in essence, simple sales of financial assets.
Enron, however, gave these "sales" a new twist.
Let's start with a simple example. Assume that Enron signed a contract
with another company pursuant to which Enron agreed to sell the company energy
over a twenty-year period. Using MTM, Enron could record the estimated future
profits as revenue at the time of the deal, and then retain the contract and slowly
try to collect its payments. This course produced good financial statement results
but no immediate cash. Alternatively, Enron could try to "monetize" the
contract—sell the expected revenue stream from the contract for a price calculated
by totaling the estimated future profits and then subtracting a discount representing
the time-value of money and execution/performance risk. For example, if the
contract was estimated to be worth $40 million in profit over the course of the
contract's life, Enron might try to sell the contract to another energy company for,
say, $25 million. If Enron could find a buyer, then Enron would get both badly
needed cash and a nice boost for its financial statements, for it could record the $25
million as cash flow from operations.99
There is nothing wrong with monetizations—they are simply discounted
sales of financial assets that transform future prospects into ready cash.
Unfortunately, Enron's poorly managed expansion left it with few valuable assets
to sell, and this led to serious monetization abuses. Enron, as we have seen, liked
big deals, because big deals produced large and immediate reportable revenues
under MTM accounting. Unfortunately, many of those "big deals" were actually

97
Glisan Guilty Plea Allocution, Count Five, supra note 66.
98
Fastow Guilty Plea Allocution, supra note 65, at 3.
99
This was managed through the fiction that Enron was in the business of buying and
selling assets, so that sale of such an asset was a normal business operation.

20
revenue losers, and it is hard to find buyers for contracts or assets that lose money.
How, then do you get a buyer to buy something like an energy contract that may
be, and probably is, ultimately worthless?100 The answer? You provide the buyer
a guarantee.101
In 2000, for example, Enron and Blockbuster, the video rental company,
agreed to develop a home video-on-demand business.102 This "business" never left
the testing phase, generating only several thousand dollars in revenue after
hundreds of millions of dollars in development costs.103 Nevertheless, Enron was
able to "sell" this business to the Canadian Imperial Bank of Commerce (CIBC) in
late 2000 and early 2001 for approximately $110 million dollars.104 Why, one
wonders, would a bank buy a highly speculative media delivery business for $110
million?
For one thing, Enron agreed to continue to control and operate the business
through a subsidiary—CIBC would not have to do anything. More important,
CIBC was guaranteed not to lose money. Under Enron's interpretation of the
relevant accounting rules, Enron believed it could treat the transfer of an asset to
another business entity as a "sale" as long as the other entity took 3% of the
ensuing business risk. Based on this interpretation, Enron guaranteed in writing
that CIBC would receive at least 97% of its money back after a specified term of
years through a mechanism called a total return swap.105 Still, why would a bank
risk losing even 3% of its money? Again, the answer is another guarantee, this
time orally and in secret, that CIBC would get all of its capital back plus interest,
regardless of whether the "sold" asset made any money in the future or not. In
short, the transaction, like the pre-pays, was a loan.106 CIBC gave Enron $110
million, and Enron agreed to pay the money back with interest. Because, however,
Enron treated the loan as an asset sale, it recorded the proceeds of the
transaction—$110 million in the Blockbuster deal alone—as revenue from Enron
Broadband Services ("EBS"), Enron's telecommunications division. The
transaction thus served multiple purposes. It reassured Enron's investors that EBS

100
See First Report, supra note 19, at 15-16 (in many asset sale transactions, Enron needed
to provide repayment guarantees because assets provided insufficient cash flow to support
financing or were difficult to sell to third parties on acceptable terms).
101
See Fastow Guilty Plea Allocution, supra note 65, at 2 (Fastow and others secretly
agreed that LJM would not lose money when entering into transactions with Enron); Glisan
Guilty Plea Allocution, supra note 66 (LJM guaranteed prearranged profit); Second Report,
supra note 19, at 37-39 (Enron retained obligation to repay substantially all of financing in
its asset sale transactions); First Report, supra note 19, at 14 (describing Enron obligation
to pay back money received in asset sale transactions).
102
The Blockbuster transaction is discussed in Second Report, supra note 19, at 29–32.
103
See Second Report, supra note 19, at 29 (Enron did not possess technology to deliver
VOD on commercially viable basis and Blockbuster did not have rights to the movies to be
delivered).
104
Second Report, supra note 19, at 30-32.
105
Second Report, supra note 19, at 109-110.
106
Second Report, supra note 19, at 107.

21
had significant cash flow when in fact it did not; boosted reported revenue for the
company as a whole; brought in actual cash to meet spiraling costs; and kept $110
million in debt from being reported as debt.107 Brilliant? Alas, the bankruptcy
examiner has concluded that the Blockbuster deal and similar monetizations
violated GAAP, the relevant accounting rules, because the outcomes reported to
investors did not accurately reflect the substance of the transactions and because
Enron did not report to investors the existence of its secret guarantees to repay
lenders the capital Enron received from the "sales."108 In short, loans must be
accounted for as loans.
Interestingly, Enron discovered that even with guarantees, it could not
convince lenders to "buy" certain assets. Starting in 1997, Enron solved this
problem by creating its own investment funds to buy Enron's under-performing
assets. These funds had names like "Chewco,"109 "Whitewing," "LJM Cayman,"
and "LJM2."
The LJM transactions were deceptively simple. As Enron Treasurer Ben
Glisan recently explained in his guilty plea to federal securities charges, "LJM
enabled Enron to falsify its financial picture to the public; in return, LJM received
a pre-arranged profit."110 Here's how it worked. In the LJM transactions,111 Enron
executives raised money on Wall Street by promising that LJM would be able to
cherry-pick the best investment opportunities from Enron, due to the close
relationship between fund executives—including Enron's own CFO—and
Enron.112 LJM then bought under-performing assets from Enron with the money it
had raised, giving Enron a badly needed infusion of cash.113 Enron, in return,
provided LJM with a secret oral promise that Enron would eventually buy the
assets back from LJM for the purchase price plus a profit, regardless of whether
the "sold" assets retained their value or not.114 Enron liked these deals because it
allowed Enron to "sell" assets that were otherwise unmarketable and report the
resulting proceeds as cash flow from operations, giving its financial statements a

107
Enron split the $110 million over the fourth quarter of 2000 and the first quarter of
2001. The Blockbuster "revenue" was important to perceptions about EBS's business
performance. In the fourth quarter of 2000, for instance, $53 million of EBS's reported $63
million in revenue came from the Blockbuster monetization—though investors were not
told this fact. See Second Report, supra note 19, at 31.
108
Second Report, supra note 19, at 39.
109
For Chewco, see BRYCE, supra note 19, at 137–143;
110
Glisan Guilty Plea Allocution, supra note 66.
111
For the LJM partnerships, see BRYCE, supra note 19, at 221–231.
112
SMITH & EMSCHWILLER, supra note 19, at 50. LJM 2, the second and largest LJM
fund, received investments from Merrill Lynch and Merrill Lynch executives,
JPMorganChase, Lehman Brothers, Citicorp, CSFB, and other major Wall Street firms.
BRYCE, supra note 19, at 224.
113
MCCLEAN & ELKIND, supra note 19, at 202–203.
114
Second Report, supra note 19, at 105; Fastow Guilty Plea Allocution, supra note 65,
at 2; Glisan Guilty Plea Allocution, supra note 66.

22
badly needed illicit bump.115 LJM and its investors liked the deals as well, for they
resulted in enormous risk-free profits. Indeed, Enron's CFO pocketed some $30
million from the deals.116 The only persons who lost were Enron's investors, who
had no idea what was happening.
Whitewing worked in a similar fashion.117 Enron raised money for its
Whitewing fund by secretly promising that the raised funds would be repaid by
Enron itself at a future date.118 Enron then "sold" assets of limited or decreasing
value to the Whitewing fund.119 Enron was, in practice, both buyer and seller in
the deals, and it remained the true equitable owner of the "warehoused" assets. It
treated the transactions as sales, however. This allowed Enron to move valueless
assets off its books while hiding substantial debt. The size of these "sales" was
ultimately staggering. According to the bankruptcy examiner, Enron ultimately
"sold" some $1.6 billion in under-performing assets to its own Whitewing fund.120
Monetizations with independent financial institutions like CIBC and
Enron-created funds like LJM, Chewco and Whitewing effectively disguised loans
as sales. They allowed Enron to raise billions of dollars in capital markets and
report that cash infusion as revenue or cash flow, not debt. The transactions
violated GAAP because, among other things, Enron used the transactions to
improperly overstate its "earnings" and never disclosed that it was ultimately
obligated to repay the sums.121

115
As Enron CFO Fastow recently stated in his guilty plea allocution, "The purpose of
these [LJM] transactions was to improve the appearance of Enron's financial statements by
(1) generating improper earnings and funds flow; (2) enabling Enron to set inflated
"market" prices for assets; and (3) improperly protecting Enron's balance sheet from poorly
performing and volatile assets." Fastow Plea Allocution, supra note 65, at 2.
116
Powers Testimony, supra note 62, at 2.
117
Whitewing is discussed in Second Report, supra note 19, at 73-78.
118
Second Report, supra note 19, at 73–75.
119
BRYCE, supra note 19, at 156.
120
Second Report, supra note 19, at 42-43, 73. The proceeds from these asset transfers
was declared as cash flow from operations even though Enron guaranteed that Whitewing
would be made whole and that Enron retained all control, risk and potential rewards from
the assets before and after transfer. Second Report, supra note 19, at 75–78.
121
Fastow Guilty Plea Allocution, supra note 65, at 2; Second Report, supra note 19, at
43, 77; Powers Testimony, supra note 62, at 2 (Enron's related party rules violated
accounting rules). Enron's accounting treatment of its monetizations turned on the rules
governing deconsolidation of SPEs, which results in off-balance sheet treatment. Prior to
recent changes in FAS standards, a company could take an SPE off its balance sheet as
long as it did not control the entity, an outside party made at least a 3% capital investment
in the SPE, and the outside party possessed the risks and rewards of owning the SPE's
assets. See Herdman Testimony, supra note 59, at 11. Enron violated these rules by,
among other things, secretly guaranteeing outside parties that they would not lose money,
so that the outside party did not have any true economic risk. As Herdman testified before
Congress, "If the investor's return is guaranteed or not 'at risk,' the transferor would be
required to consolidate the SPE in its financial statements." Herdman Testimony, supra
note 59, at 12.

23
 Enron did an enormous number of these deals, and they had a significant
impact on Enron's financial statements. The bankruptcy examiner has concluded,
for example, that in 2000, monetizations with outside parties like CIBC increased
Enron's reported revenue by over $351 million, comprised 36% of Enron's reported
revenue, and kept $1.4 billion in debt off Enron's balance sheet.122 Similarly, the
examiner has concluded that "related party" deals with Chewco and the LJM funds
alone helped Enron over-state its income by nearly $1.5 billion from 1997 to June
2001 and understate its debt by almost $900 million.123

Results of Enron's Financial Statement Manipulations

Pre-pays, MTM manipulation, and fraudulent "assets sales" were only the
tip of the iceberg at Enron. Enron also engaged in many additional types of
transactions designed, like those discussed above, to mislead investors into
thinking that that the company had less debt, more revenue, and greater cash flow
than it actually did.124 Enron's efforts to manipulate and "improve" its financial
statements had an enormous impact on investors' perceptions about the company.
As bankruptcy examiner Neal Batson has concluded, "through pervasive use of
structured finance techniques using SPE's and aggressive accounting practices,
Enron so engineered its reported financial position and results of operations that its
financial statements bore little resemblance to its actual financial condition or
performance. This financial engineering in many cases violated GAAP and
applicable disclosure laws, and resulted in financial statements that did not fairly
present Enron's financial condition, results of operations or cash flows."125 This
manipulation was driven not just by Enron's desire to raise cash without issuing
equity or incurring debt, but also by "the need to mask Enron's business
failures."126 The cumulative impact of these schemes on Enron's financial
statements is almost unbelievable. For 2000, 96% of Enron's reported net income
and 105% of its reported funds flow were the direct result of accounting
manipulation. Using these same accounting schemes, Enron managed to keep
almost $12 billion in debt off its books.127 Financial data manipulation, in short,
transformed Enron from a dog into a Wall Street champion.128

122
Second Report, supra note 19, at 38.
123
Second Report, supra note 19, at 104.
124
For example, Enron engaged in tax manipulation schemes, minority share financing
designed to improperly boost reported net income while decreasing reported debt, and a
host of additional transactions designed to improve Enron's reported financial position. See
Second Report, supra note 19, at 40–41, 43, 79–94, 95–103, 113–128.
125
Second Report, supra note 19, at 15, 39, 44, 77-78. "SPEs" are special purpose entities,
off-balance sheet vehicles that Enron used to hide the true nature of many of the
transactions discussed above. For a discussion of SPEs, see Herdman Tesitmony, supra
note 59, at 10–11.
126
Third Report, supra note 19, at 14.
127
Second Report, supra note 19, at 47. The examiner's conclusions about Enron's
manipulation of its reported financial data are probably conservative. On November 19,

24
III. Getting Past the Watchdogs: Why Enron's Deception Succeeded

Enron was a failing company propped up by accounting games, deceptive

transactions, and financial statement manipulation. How is it possible that one of
the ten largest companies in America could engage in serious financial deception
for years without this fact being discovered and disclosed? The answer lies in the
total failure of the watchdog institutions that collectively deter, detect, and disclose
fraud in the securities market.
In the United States, investors rely on a complex and evolving public-
private system of checks and deterrents to prevent companies and their executives
from misleading the investing public. Independent auditors are supposed to review
the company's financial statements to insure they comply with GAAP and
accurately reflect the company's business operations and financial position.
Corporation boards of directors are supposed to monitor management's conduct
and make sure the company is being run on a sound, legal and profitable basis for
the benefit of its stockholders. Securities analysts with major brokerage firms are
supposed to watch the company closely and provide investors with an insightful,
independent, objective assessment of the company's value and profitability.
Securities regulators at the SEC are supposed to oversee the entire process, to
make sure that companies play by the rules, providing investors with the complete
and accurate information they need to make wise investment decisions. And
finally, if all else fails, the federal criminal laws are supposed to deter serious
fraud.
In the pages that follow, I want to examine the role of the watchdog
institutions in the Enron debacle. I have two goals. First, I want to assess the
degree to which the watchdogs met their responsibilities to shareholders and the
investing public. I conclude that in the Enron case, all five watchdogs failed
miserably, resulting in the deception of millions of investors and the ultimate loss
of some $61 billion. Second, I want to try to understand why these institutions
failed in their assigned tasks. This requires diagnosis, a process that is speculative
to some degree, but necessary nevertheless, if we want to understand what is
actually happening in securities markets.

Independent Auditors: Arthur Andersen

2001, amidst swirling rumors and a growing scandal, Enron executives flew to New York
to meet with bankers in a private meeting at the Waldorf to beg for additional credit to keep
the company from imploding. There, the Enron executives admitted that Enron was
actually over $38 billion in debt: this suggests it had managed to hide over $25 billion in
loans from investors by keeping those loans off its balance sheet. Second Report, supra
note 19, at 9–10. The examiner reached a lower number by highlighting only the amount
of debt kept off the books by manipulations it believed clearly violated GAAP.
128
Second Report, supra note 19, at 15.

25
 As noted above, publicly held corporations are required to file annual
financial statements, or 10-K forms, with the SEC.129 These reports must be
audited by an independent certified public accountant.130 The auditor is required to
examine the corporation's books and determine whether the annual reports have
been prepared in accordance with GAAP. The auditor then issues an opinion as to
whether the financial statements, taken as a whole, fairly present the financial
position and operations of the corporation for the relevant period.131 Enron, of
course, employed the now-defunct Arthur Andersen firm to perform this vital
function.
An independent C.P.A. auditing a publicly held company holds a position
of unique responsibility. As the Supreme Court has explained,

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 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.132

How adequately did Andersen perform this "public watchdog" function?

The answer is grim. Though Enron's financial statements violated GAAP in
numerous ways and were fundamentally misleading,133 Andersen issued Enron an

129
Securities Exchange Act of 1934, §§ 13(a)(2), 13(b) (2000); 17 C.F.R. §§ 249.310,
249.460 (2003). My discussion of Arthur Andersen's conduct in the Enron case draws
extensively on Barbara Ley Toffler's FINAL ACCOUNTING: AMBITION, GREED, AND THE
FALL OF ARTHUR ANDERSEN (2003). Toffler, a former business professor at Boston
University, Harvard and Columbia, is an expert on corporate ethics and was an Andersen
partner form 1995 to 1999. As a result, she is extremely well placed to discuss the cause of
Andersen's performance failures in audits at Enron and other major companies in the
decade before its prosecution for obstruction of justice and subsequent collapse. I should
also note that my sister was a partner at Arthur Andersen before its demise. Because of the
existence of this potential conflict of interest, I was not involved in the Andersen case
brought by the Justice Department's Enron Task Force.
130
15 U.S.C. § 78d; Regulation S-X, 17 C.F.R. § 210 et seq..
131
The classic statement of these requirements and process is in United States v. Arthur
Young & Co., 465 U.S. 805, 810–811 (1984).
132
Arthur Young, 465 U.S. at 817–18 (emphasis in original).
133
Third Report, supra note 19, at 2.

26
"unqualified opinion" every year, the most favorable report an auditor can give.134
This suggests, obviously, that Andersen failed horribly in its duty to Enron
shareholders and the investing public.135
To some degree, the Enron disaster was not Andersen's fault. Both the
bankruptcy examiner and Grand Jury in the Southern District of Texas
investigating the Enron collapse, speaking through its indictments, have concluded
that in numerous transactions, Enron executives deceived Andersen auditors about
the nature and material terms of the deals in question in order to obtain favorable
accounting treatment. For example, in some of Enron's related party deals and
monetizations, Enron failed to disclose to Andersen the existence of secret
agreements by which Enron guaranteed its transaction partners that they would not
lose money, even if the assets Enron was selling ultimately lost their value. This
deception is incredibly important: it suggests that Andersen was, to some degree,
more sinned against than sinning.136
Nevertheless, Andersen's transgressions were extraordinarily serious in the
Enron case. Neil Batson, the bankruptcy examiner, closely scrutinized the role of
Andersen in Enron's demise. Batson determined, among other things, that
Andersen auditors helped design the accounting manipulation schemes Enron used
to mislead investors about its income, cash flow and financial position; that
Andersen failed to use due care to investigate whether Enron's counter-parties in
monetization transactions actually had any money at risk in the transactions; and
that Andersen failed in its duty to flag unusual transactions and controversial
accounting decisions for Enron's board.137 Batson also noted that though Andersen

134
As the Supreme Court explained in Arthur Young, an unqualified opinion "represents
the auditor's findings that the company's financial statements fairly present the financial
position of the company, the results of its operations, and the changes in its financial
position for the period under audit, in conformity with consistently applied generally
accepted accounting principles." Arthur Young, 465 U.S. at 819, n.13.
135
For analyses which reach the same conclusion, see SENATE GOVERNMENTAL AFFAIRS
REPORT, supra note 12, at 27 ("Andersen appears to have failed miserably in its
responsibility as Enron's auditor."); WILLIAM C. POWERS, JR., RAYMOND S. TROUBH, &
HERBERT S. WINOKUR, JR., REPORT OF THE INVESTIGATION BY THE SPECIAL
INVESTIGATIVE COMMITTEE OF THE BOARD OF DIRECTORS OF ENRON CORP. 24 (2002)
[hereinafter POWERS REPORT] ("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").
136
See, e.g., Third Report, supra note 19, at 41–42; United States v. Rice et al., Cr. No. H-
03-93-01 (S.D. Tex.) (seven Enron executives charged with fraud relating to Enron's
telecommunications unit; certain executives misled Arthur Andersen auditors). This
deception may also foreclose the ability of Enron executives involved in the deception to
assert professional reliance defenses in any criminal trials.
137
Third Report, supra note 19, at 40–41. For example, Andersen helped structure
deceptive transactions like the Raptor accounting hedges that had no economic purpose
other than improving the company's reported financial position. SENATE GOVERNMENTAL

27
was fully aware of the extent to which Enron's reported financial results were the
product of accounting manipulation,138 it did not insist on disclosure of these facts
to investors and the SEC in Enron's 10-Ks.139 For these reasons, Batson concluded
that Andersen gave "substantial assistance" to Enron officers seeking to
disseminate misleading financial information.140 Andersen's failure, then, appears
to have been comprehensive.141 If Andersen had not assisted and enabled Enron's
deception, Enron would have been caught years before 2001. Indeed, if Andersen
had done its job, Enron would not have been able to deceive the investing public in
the first place.142
Andersen's failure to protect Enron investors was not an isolated incident.
Throughout the 1990s, prior to Enron's bankruptcy, Andersen auditors certified
false or misleading financial statements for the management of a number of major
American companies, including Sunbeam, Waste Management, and Baptist
Association.143 From 1992 to 1997, for example, Andersen helped Waste
Management, the trash conglomerate, improperly inflate its earnings by $1
billion.144 After Enron collapsed, we learned that Andersen was also involved in
deceptive accounting at McKesson-HBOC (earnings inflated by $300 million),145
Qwest (earnings inflated by $1.2 billion),146 and WorldCom (earnings inflated by
$7 billion) as well. This pattern of misconduct—Assistant Attorney General
Michael Chertoff, chief of DOJ's criminal division, called Andersen a
"recidivist"—suggests that Andersen's failures in the Enron case were not an
anomaly, the action of one or two rogue auditors, but the result of a pervasive firm
culture that repeatedly valued the interest of management in positive earnings
statements over the interest of the shareholders and investing public in accurate
information.
Auditing firms have a concrete incentive to place management interests
before those of investors: auditors are running a business, and management pays
their bills.147 Traditionally, however, we have turned a blind eye to this problem,

REPORT, supra note 12, at 27; Hearing Before the Sen. Banking, Housing, and Urban
Affairs Comm. (Feb. 27, 2002) (testimony of John H. Biggs).
138
Third Report, supra note 19, at 41–42.
139
Third Report, supra note 19, at 41, 44–45.
140
Third Report, supra note 19, at 46–47.
141
See Third Report, supra note 19, at 39–47.
142
Third Report, supra note 19, at 41 ("Without Andersen's certification of Enron's
financial statements and various other approvals provided by Andersen, Enron would not
have been able to employ those transactions to distort Enron's reported financial condition,
results of operations and cash flow").
143
TOFFLER, supra note 129, at 150–152.
144
The Waste Management case is discussed in BRYCE, supra note 19, at 234.
145
TOFFLER, supra note 129, at 156.
146
TOFFLER, supra note 129, at 142.
147
As Roman Weil, Professor of Accounting at the University of Chicago Graduate School
of Business, testified before the House Energy and Commerce Committee, "The basic
conflict occurs because the audited pays the auditor, and, in practice, selects the auditor.”

28
on the questionable ground that no reasonable auditor would risk damaging his or
her reputation in return for mere auditing fees. This view received its classic
expression in DiLeo v. Ernst & Young, a 1990 case from the Seventh Circuit. In
DiLeo, the plaintiffs alleged that Ernst & Whinney, a precursor to Ernst & Young,
had assisted banking giant Continental Illinois Bank understate its noperforming
loans by $4 billion. Writing for the Court of Appeals, Judge Easterbrook opined
that the plaintiff's suit was properly dismissed because it offered no basis to infer
that Ernst & Whinney had knowingly assisted the fraud.

The complaint does not allege that E & W had

anything to gain from any fraud by Continental
Bank. An accountant's greatest asset is its
reputation for honesty, followed closely by its
reputation for careful work. Fees for two years'
audits could not approach the losses E & W would
suffer from a perception that it would muffle a
client's account. And although the interests of E
& W's partners and associates who worked on the
Continental audits may have diverged from the
firm's, covering up fraud and imposing large
damages on the partnership would bring a halt to
the most promising career. E & W's partners
shared none of the gain from any fraud and were
exposed to a large fraction of the loss. It would
have been irrational for any of them to have
joined cause with Continental.148

Would it be "irrational" for an auditing firm to risk its reputation by certifying

misleading financial statements in return for auditing fees? Easterbrook's
conclusion is based on two assumptions: that the risk of a rogue auditing firm
getting caught and damaging its reputation is relatively high, and that the financial
incentive to engage in misconduct is relatively low. These assumptions may have
been true in the past. Arthur Andersen, for example, voluntarily chose not to audit
savings and loan associations long before the S&L crisis broke in the 1980s
because of concerns about potential misconduct in that sector of the economy.149

Hearing Before the House of Rep. Energy and Commerce Committee, 4 (Feb. 6, 2002)
(testimony of Roman Weil).
148
DiLeo v. Ernst & Young, 901 F.2d 624, 629 (7th Cir. 1990). Other courts have
followed Easterbrook's reasoning, viewing the idea that auditing firms would assist in fraud
in return for fees "irrational." See, e.g., Melder v. Morris, 27 F.3d 1097, 1103 (5th Cir.
1994) (Jones, J.).
149
TOFFLER, supra note 129, at 19.

29
The Enron case, however, suggests that both of these assumptions may be false in
the current market.150
Let's start with an assessment of the incentive: the need for auditing firms
to earn fees in a competitive marketplace. In the 1990s, corporations were under
increasing pressure to report positive quarterly financial numbers to Wall Street,
and this may have created a demand at companies like Enron for "flexible"
auditors.151 At the same time, competition exploded in the auditing business,
putting immense pressure on auditing firms to retain business.152 This fact may
have been critical in the Enron case, for the Enron audit fee alone was worth $25
million per year to Andersen, and thus represented an important revenue stream for
the auditing firm.153
Arthur Andersen partners may have felt this competitive pressure more
keenly than other auditors because of the firm's recent history. By 1999, Andersen
had the smallest auditing business of the Big Five accounting firms, with the
slowest rate of growth.154 Andersen partners had also recently taken a major
revenue hit. In 1997, Andersen Consulting, now Accenture, split off from Arthur
Andersen, stripping Arthur Andersen partners of a major source of profits and
forcing them to try to expand their own consulting business.155 Obviously,
auditing clients like Enron were a major source of potential consulting revenue for
Andersen. As a result, Andersen auditors might reasonably have concluded that if

150
The force of reputational constraints in the auditing field is analyzed in depth in Robert
Prentice's excellent article The Case of the Irrational Auditor: A Behavioral Insight Into
Securities Fraud Litigation, 95 N.W. U. L. REV. 133 (2000) (arguing that reputational
constraint is constraint is often insufficient to check auditor misconduct).
151
This desire for "flexible auditors" may also have stemmed from increased use of stock
options to compensate management, which gave management increased interest in inflating
earnings so as to keep the company's stock price high.
152
TOFFLER, supra note 129, at 48; Prentice, supra note 150, at 206.
153
As former SEC Chairman Richard C. Breeden testified before Congress, "had Andersen
not been performing any consulting work, its pure audit fee of $25 million per year would
have been more than large enough to create powerful incentives for the managers at
Andersen to give the client the accounting treatment it wanted for SPEs. Unlike consulting
fees, which are one time assignments, the audit is generally viewed as a long term
engagement. On average, audit engagements at Coopers & Lybrand when I was there
lasted nearly twenty years. Thus, the $25 million audit fee would have a present value
much greater than $25 million in one time consulting business. Therefore, if firms
performed no consulting work whatever, there would still be issues of the willingness of
the auditors to antagonize a big client determined to use accounting games to overstate
income." Breeden Testimony, supra note 59, at 11. See also Joseph F. Morrissey,
Catching the Culprits: Is Sarbanes-Oxley Enough?, 2003 COLUM. BUS. L. REV. 801, 840
(2003). (auditing fees alone strong incentive for auditing firm to compromise objectivity);
Prentice, supra note 138, at 204-207 (client's economic clout greatly influences auditing
firm's judgment).
154
TOFFLER, supra note 129, at 98.
155
TOFFLER, supra note 129, at 93.

30
they alienated Enron management by insisting on strict application of accounting
rules, Enron might decline to provide lucrative consulting fees.
Barbara Ley Toffler, a former business and management professor at
Harvard and Columbia business schools and an expert on business ethics, worked
as a partner at Arthur Andersen from 1995 to 1999. Toffler watched the impact of
increased competition and the Andersen Consulting split on Arthur Andersen's
firm culture. Her conclusion? Because of the pressure to retain major auditing
clients and increase consulting fees, "clients had become too valuable to defy."156
As a result, Andersen was transformed into "a place where the mad scramble for
fees had trumped good judgment."157
For Andersen, Enron represented over $52 million per year in auditing and
consulting billing.158 Indeed, Enron was Andersen's largest client in 1999, with a
phenomenal 88% fee growth rate.159 These facts gave Andersen a very strong
incentive to keep Enron happy.160 Did this effect Andersen's auditing judgment?
The case of Carl Bass is instructive. Bass was an Andersen partner and a member
of Andersen's Professional Standards Group, which provided guidance to
Andersen auditors working on difficult issues. Bass opposed Enron's proposed
accounting treatment of certain high impact transactions, including the Raptor
accounting hedges discussed in Part II above, which converted approximately $1
billion in losses into $1 billion in gains. In response, Enron complained to
Andersen and had Bass removed from the Enron audit.161 The fact that Andersen
succumbed to this pressure and removed Bass clearly suggests that pleasing clients
was more important to Andersen than providing accurate and principled auditing
services. In sum, the financial incentives for accountants to help firms mislead
investors currently seems, contra Easterbrook, quite strong.
Easterbrook may also have overestimated the risk to auditors of getting
caught if they engaged in misconduct. In DiLeo, Easterbrook assumed, without
analysis, that this risk is sufficiently high to outweigh auditor incentives to place
the interests of management before that of shareholders and the investing public.
If this is correct, why, one wonders, was Andersen not deterred from misconduct in
Enron, WorldCom, Sunbeam, Waste Management, Qwest and other major
Andersen-related auditing fraud cases? The answer, put bluntly, is that our
deterrents in the 1990s actually provided no real deterrence at all.
Prior to 2002, auditors faced potential investigation, disclosure and
punishment from four sources: criminal prosecutors, the SEC, the now-defunct
Public Oversight Board, and individual investors. An auditing firm assessing the
"threat" from these sources in the late 1990s, when Enron began to manipulate its
financial statements, might have reasonably concluded that the risk of discovery

156
TOFFLER, supra note 129, at 62.
157
TOFFLER, supra note 129, at 6.
158
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 28.
159
Third Report, supra note 19, at 39 and 39, n.83.
160
See Prentice, supra note 150, at 210 (discussing study showing that auditors are more
likely to violate professional norms when dealing with a large client).
161
BRYCE, supra note 19, at 238; TOFFLER, supra note 129, at 212.

31
and disclosure from these sources was minimal. The potential risk of criminal
prosecution was and remains almost nil.162 SEC enforcement action was and
remains slow, the penalties imposed minimal.163 And self-regulation and oversight
by the accounting profession itself—an idea we have now abandoned in the wake
of Enron and WorldCom—was, unfortunately, a bad joke.164
Because the threats posed by prosecution, SEC action, and professional
discipline were and are so remote, the only real functional deterrent to auditor
misconduct has traditionally come from shareholder lawsuits. In the 1990s,

162
To my knowledge, no major accounting firm has ever been charged criminally for
helping a corporation manipulate its financial statements. My sense is that this
prosecutorial caution stems from three related aspects of auditing cases: (1) prosecutors
believe auditors can easily hide behind "professional judgment" in auditing fraud cases,
making convictions difficult to obtain; (2) in most financial statement fraud cases, the
government is more interested in prosecuting management than auditors, because
management is typically viewed as being more at fault; and (3) when prosecuting
management, prosecutors do not want to alienate auditors—potentially very important
witnesses—by seeking indictments against individual auditors or the auditing firm.
163
See generally George J. Benston, The Regulation of Accountants Before and After
Enron, 52 EMORY L.J. 1325, 1344–47 (2003) (attributing recent auditing scandals to, inter
alia, absence of punishment of auditors committing misconduct by SEC). Even when the
SEC does act, it does so in a manner unlikely to produce any deterrent effect. In the Waste
Management case, for example, the company began to manipulate its earnings statements
in 1992, but Andersen was not forced to settle the case with the SEC until June 2001, and
then it only paid $7 million without admitting fault. There is no evidence that this
settlement damaged Andersen's reputation in any significant way: there was, for example,
no measurable flight from Andersen by major auditing clients. Moreover, the $7 million
Waste Management agreement was much lower than the fees Andersen had gained for
being Waste Management's auditor in the first place.
164
Prior to 2002, the accounting profession regulated its own performance through the
now-defunct Public Oversight Board (POB). The POB was created in 1977 to supervise
peer review of accounting firms. Under the peer review program, accountants from one
firm would assess another firm's quality control systems. See Herdman Testimony, supra
note 59, at 5. John Biggs, a former trustee of POB, testified before Congress that peer
reviews are "a weak self-regulatory tool, and they appear to be universally criticized as
inadequate." Biggs also noted that the accounting profession was unwilling to change its
practices in response to POB initiatives. Biggs stated, in summary, that "no one will really
miss us." See Hearing Before the Sen. Banking, Housing, and Urban Affairs Comm. (Feb.
27, 2002) (testimony of John H. Biggs). According to Toffler, the peer review process
was merely a "back-slapping exercise." TOFFLER, supra note 129, at 176. Deloitte &
Touche, for example, gave Arthur Andersen a clean bill of health just weeks before Enron
went bankrupt. Richard C. Breedon, former Chairman of the SEC concurred, testified
before Congress that "The POB was never an effective body." Concerning Accounting and
Disclosure Reform and Oversight: Before the House of Rep. Financial Services Comm., 18
(Apr. 9, 2002 ) (testimony of Richard C. Breeden, former Chairman of the SEC). For a
discussion of poor performance of self-regulation by the accounting profession, see David
S. Hilzenrath, Auditors Face Scant Discipline, Review Process Lacks Resources,
Coordination, Will, WASH. POST (Dec. 6, 2001).

32
however, at the same time that pressures on auditors to cave in to management
were increasing, Congress and the judiciary were making it much more difficult
for shareholders to bring these suits. Acceptance of Judge Easterbrook's reasoning
in DiLeo by other courts165 meant that plaintiffs suing auditing firms were
generally required to show that the auditors had profited in some way from aiding
company fraud beyond the mere reception of auditing fees—even though these
fees may, in fact, have been all the incentive a firm needed. In 1994, the Supreme
Court made matters worse. In Central Bank of Denver v. First Interstate Bank of
Denver, the Supreme Court reversed twenty-five years of practice and precedent in
eleven federal circuits and held that auditors could not be held liable in private
causes of action for aiding and abetting securities fraud.166 And in 1995, after
extensive lobbying by the accounting profession, Congress passed the Private
Securities Litigation Reform Act over President Clinton's veto. PSLRA tightened
securities fraud pleading requirements, limited discovery prior to summary
judgment, and eliminated the ability of plaintiffs in securities fraud cases to seek
treble damages through civil RICO.167 Collectively, these actions by the judiciary
and Congress significantly decreased law suits against auditors, and thus decreased
the potential deterrent effect of private litigation.
Two additional factors may also have impacted Andersen's integrity at
Enron. Enron's financial statement manipulation increased in intensity in the late
1990s as the company's financial problems increased.168 This might have led to a
"boiled frog problem." According to popular legend—I can’t say I've tried this
myself—a frog thrown into boiling water will jump out of the pot, but a frog
placed in tepid water and subjected to slow but steady increases in heat will calmly
boil to death before it understands what is happening. At Enron, the boiled frog
may have been Andersen. Faced with a strong need to keep Enron's management
happy, Andersen may have agreed to ignore a small amount of earnings
management in the mid-1990s. As time went on, and Enron's management
gradually increased its use of accounting gimmicks to pump up its financial
statements, Andersen auditors may have been insensitive to the degree to which
this gradual escalation of earnings management had led to the creation of totally
misleading 10-Ks. Alternatively, Andersen auditors may have been aware that
Enron's manipulation was increasing, but having agreed to ignore a small number
of unprincipled transactions, they may have found it difficult to find a principled
basis to object when Enron expanded its use of such transactions. In short, like

165
See cases cited in Prentice, The Irrational Auditor: A Behavioral Insight into Securities
Fraud Litigation, 95 N.W.U.L. REV. 133, 136–137 and n.24.
166
Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994). For a
good discussion of the Central Bank Case, see Morrissey, supra note 154, at 815–820.
167
Pub. L. No. 104-67 (1995), codified in multiple places in Title 15, United States Code.
For a brief discussion of PSLRA, see Joseph F. Morrissey, Catching the Culprits: Is
Sarbanes-Oxley Enough?, 2003 COLUM. BUS. L. REV. 801, 804–805, 825–834 (2003).
168
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 24.

33
frogs in a hot pot, auditors in Andersen's shoes may have real trouble preventing
slow but gradual increases in accounting abuses by management.169
Second, most auditing firms retain clients for decades.170 Indeed, Fortune
500 corporations currently retain their auditors for an average of twenty-two
years.171 This meant that Andersen auditors had little fear that another auditing
firm was going to be reviewing their work for many years to come. This fact, in
turn, may have decreased Andersen's concern that its "compromises" with
management would ever be discovered.
Andersen's misconduct at Enron, in sum, was not an aberrant act.172
Rather, it occurred as part of a pattern of recurrent deception and accounting abuse.
That pattern of misbehavior was the result of market forces and regulatory trends.
As competition increased in the auditing market, providing greater incentives for
auditors to compromise their standards, Congress and the courts concurrently
decreased deterrence by limiting the ability of shareholders to sue. Given this
regulatory and competitive context and Andersen's own market position and firm
history, Andersen's poor auditing performance at Enron and other companies
should, perhaps, have been expected.

The Enron Board of Directors

Though the American public generally thinks of the CEO as the ultimate
authority within a corporation, the law actually imposes this duty on the
corporation's board of directors.173 Directors are charged with monitoring
management's performance on behalf of the corporation's investors.174 Like

169
For a discussion of this problem, more commonly referred to as "commitment bias,"
see Donald C. Langevoort, Seeking Sunlight in Santa Fe’s Shadow: the SEC’s Pursuit of
Managerial Accountability, 79 WASH. U.L.Q. 449, 486 (2001).
170
See Concerning Accounting and Disclosure Reform and Oversight: Before the House
of Rep. Financial Services Comm., 11 (Apr. 9, 2002 ) (testimony of Richard C. Breeden,
former Chairman of the SEC) (when he served at major accounting firm, average auditing
engagement was close to twenty years).
171
GAO, Public Accounting Firms: Required Study on the Potential Effects of Mandatory
Audit Firm Rotation, November 2003, at 6.
172
Nor, it is important to state, was Andersen the only major accounting firm responsible
for major audit failures. PricewaterhouseCoopers audited Microstrategy, Ernst & Young
audited Cerdant, KPMG audited Rite-Aid and Xerox (restatement of five years of revenue
by 6.4 billion), and Deliotte & Touche audited Adelphia. See SENATE GOVERNMENTAL
AFFAIRS REPORT, supra note 12, at 27. On Xerox, see Kathleen Day, Xerox Restates 5
Years of Revenue; 97–01 Figures Were Off By $6.4 Billion, WASH. POST (June 29, 2002);
Claudia H. Deutsch, Xerox Revises Revenue Data, Tripling Error First Reported, N.Y.
TIMES (June 29, 2002).
173
See, e.g., Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 179
(Del. 1986) ("The ultimate responsibility for managing the business and affairs of a
corporation falls on its board of directors").
174
Corporation directors are fiduciaries and owe shareholders and the company itself
duties of care and loyalty. The duty of loyalty requires directors to place the interests of

34
embedded auditors, they can monitor a company from the inside. Unlike auditors,
however, they occupy an empowered position. As we have seen, auditors may
desire to avoid confrontation with their clients because of market pressure and the
fear of losing fees. The board of a major company, in contrast, is generally filled
with powerful people possessing a right to have management answer their
questions.
The Enron Board's performance is best judged through an analysis of its
role in the LJM transactions. In 1999, Enron decided to expand the use of asset
sales to manipulate its financial statements by creating the LJM funds. The LJM
funds were capitalized by Wall Street but managed by Enron's own CFO. Over the
next few years, the LJM funds would engage in a large volume of deals with
Enron, puffing up Enron's financial statements and enriching both the CFO and
LJM's Wall Street investors. The LJM funds played a critical role in the Enron
collapse. As noted above, the related party transactions with the LJM funds
radically altered Enron's apparent financial position and operational performance,
and disclosure of the nature, purpose and terms of the deals in October 2001 by the
Wall Street Journal ultimately triggered the company's collapse.175 If, then, one
wanted to identify one primary culprit in Enron's demise, creation of the LJM
funds would be a leading candidate.
The most significant fact to keep in mind as one assesses the performance
of the Enron board of directors is that the board was the only watchdog institution
with both a clear duty and a clear opportunity to stop the JLM transactions before
they took place. Related party transactions inherently involve potential conflicts of
interest. The LJM transactions, for example, posed a conflict because they
involved negotiations and subsequent payments between Enron and investment
funds created and managed by Enron's own CFO. As a result of this arrangement,
the CFO occupied a position in which his fiduciary responsibilities to Enron and its
shareholders frequently conflicted with his duties to maximize returns to LJM's
investors. Because of this conflict, which violated Enron's code of ethics, Enron's
management was required to present the unusual LJM arrangement to Enron's
board of directors for approval. Had the board declined to approve the deals and
the necessary ethics waiver, Enron might never have gone bankrupt. Alas, the
board signed off on the deals, putting Enron firmly on the path toward bankruptcy.
The board of directors made two fatal mistakes in their review of the JLM
arrangement. First, the board should never have approved self-dealing between the
corporation and a fund led by the corporation's CFO: the conflict of interest was

the corporation before the interests of others, and to be independent and objective when
reviewing corporate policy. The duty of care requires directors to act in good faith, with
the diligence that an ordinarily prudent person in a similar position would exercise under
similar circumstances. See, e.g., Cede & Co. v. Technicolor, 634 A.2d 345, 367 (Del.
1993) (duty of care and loyalty imposed on fiduciaries); Guth v. Loft, 5 A.2d 503, 511
(1939) (defining duty of loyalty); Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)
(defining duty of care).
175
See First Report, supra note 19, at 9 (disclosure of related party deals precipitated
crisis in public confidence that led to bankruptcy).

35
simply too severe. As former SEC Chairman Richard Breeden later testified
before Congress, "Any conflict of interest on the part of the CFO is inherently
extremely dangerous, as this is the person who has the institutional capability to
circumvent review by the board and the outside auditor."176 Even Arthur Andersen
thought the LJM set-up was crazy. A 1999 e-mail from one Arthur Andersen
partner to another says it all: "Why would any director in his or her right mind ever
approve such a scheme?"177 The Powers Report, which was issued by a special
investigative committee of the Enron board of directors after Enron's bankruptcy,
concurs in this judgment.178 The LJM transactions, the report notes, were
"fundamentally flawed" and "should not have been undertaken in the first
place."179 Significantly, the board's decision to approve the LJM arrangement was
not the product of deception by Enron's management. As the Powers Report notes,
the "board approved [the CFO]'s participation in the LJM partnerships with full
knowledge and discussion of the obvious conflict of interest that would result."180
After the board approved the LJM arrangement, it had a duty to carefully
monitor the situation to insure that the deals with LJM were appropriate, that the
substance and purpose of the deals were disclosed to shareholders, and that no one
profited from the deals at Enron shareholders' expense. Here, too, the board failed
miserably. The board assigned its own Audit and Compliance Committee to
conduct an annual review of all LJM transactions. This review, however, was
meaningless, a rubber-stamp. The board, according to Powers, never conducted
"any meaningful examination of the nature or terms of the transactions," and it
"did not give sufficient scrutiny to the information that was provided to it."181
Worse, the board completely ignored one of the central problems inherent in the
LJM transactions: the fact that Enron's own CFO was profiting from the deals at
the expense of Enron shareholders. The Powers Report notes that though the
board's Compensation Committee was supposed to review the CFO's profits from
the LJM deals, the board never asked the CFO how much he was making from the

176
Breeden Testimony, supra note 59, at 13.
177
SMITH & EMSCHWILLER, supra note 19, at 293.
178
In late 2001, as the company crumbled, Enron asked William Powers, Jr., Dean of the
University of Texas Law School, to join the Enron board and supervise an investigation
into transactions between Enron and its "related parties." Powers, together with long-time
board members Herbert "Pug" Winokur and Raymond Troubh, hired the Washington, D.C.
law firm of Wilmer, Cutler and Pickering and went to work. On February 1, 2002, almost
two months after Enron filed for Chapter 11 protection, Powers delivered the "Report of
the Special Investigation Committee," generally referred to as the "Powers Report."
WILLIAM C. POWERS, JR., RAYMOND S. TROUBH, & HERBERT S. WINOKUR, JR., REPORT OF
THE INVESTIGATION BY THE SPECIAL INVESTIGATIVE COMMITTEE OF THE BOARD OF
DIRECTORS OF ENRON CORP. (2002) [hereinafter POWERS REPORT]. Though the Powers
Report focuses primarily on the "related party" transactions between Enron and the LJM
partnerships and Chewco, the report also addresses the quality of the oversight provided by
Enron's board.
179
POWERS REPORT, supra note 135, at 9.
180
POWERS REPORT, supra note 135, at 9.
181
POWERS REPORT, supra note 135, at 11.

36
arrangement until the Wall Street Journal broke the LJM story in October 2001.182
This error was critical, for the CFO, it turns out, had fraudulently pocketed at least
$30 million from the deals.183 Had the board asked about compensation and
discovered this fact, they might have terminated the LJM transactions long before
they threatened the company with destruction. In short, the Enron board's
performance of its oversight duties was, as Powers laconically concluded in his
report, "inadequate."184 Powers was more blunt when appearing before Congress.
The Enron board, he testified, "failed in its duty to provide leadership and
oversight."185
Why did the board perform its duties so poorly? Some commentators
think the Enron board was particularly incompetent, a collection of Ken Lay
cronies more interested in picking up fat checks and flying to exotic locales than
looking out for investors.186 There is a grain of truth to this view. The Directors
received approximately $350,000 per year in compensation for their very limited
service, about twice the national average,187 and they did, in fact, fly to nice locales
for some board meetings.188 But overall, I think this conclusion overstates the case
against the Enron board and, paradoxically, understates the ultimate significance of
the problem. My sense is that Enron possessed at least an average or above-
average board in terms of two classic measurements of board quality,
independence and experience. Indeed, before Enron's collapse, CEO magazine
named Enron's board one of the top five in America, and there was a reasonable
basis for this view.189
If, as I believe, Enron had a reasonably good board prior to its bankruptcy,
the implications for securities regulation are significant, for it suggests that even an
independent and competent board has a very limited ability to catch fraud or

182
POWERS REPORT, supra note 135, at 11.
183
Exhibit A to Plea Agreement, United States v. Andrew Fastow, Cr. No. H-02-0665
(S.D. Tex. Jan. 14, 2004) (statement of defendant Fastow: "I also engaged in schemes to
enrich myself and others at the expense of Enron's shareholders and in violation of my duty
of honest services to those shareholders."); Hearing Before the House of Rep. Comm. on
Financial Services, at 2 (Feb. 4, 2002) (Testimony of William C. Powers, Chairman of the
Special Investigative Committee of the Board of Directors of Enron Corp.).
184
POWERS REPORT, supra note 135, at 10.
185
Powers Testimony, supra note 62, at 5. The Report of the Senate Permanent
Subcommittee on Investigations on the Role of the Enron Board of Directors in Enron's
Collapse, Report No. 107-70 (July 8, 2002) [hereinafter SENATE INVESTIGATIONS REPORT]
goes farther, concluding that the Enron Board violated its duty of care to Enron
shareholders. See id. at 15–20.
186
See, e.g., BRYCE, supra note 19, at xii, 162-167.
187
SENATE INVESTIGATIONS REPORT, supra note 185, at 11, 56.
188
BRYCE, supra note 19, at xii, 162-167.
189
MCCLEAN & ELKIND, supra note 19, at 239. As Jeffrey Gordon has noted recently,
Enron's board "was a splendid board on paper, fourteen members, only two insiders. Most
of the outsiders had relevant business experience, a diverse set including accounting
backgrounds, prior senior management and board positions, and senior regulatory posts."
Gordon, supra note 4, at 1241.

37
deception. In short, the performance of the board of directors in the Enron case
may indicate that boards in general are highly ineffective fraud watchdogs.
Four institutional factors limit the ability of boards to protect investors
from deceptive management practices. First, the task of the directors of a Fortune
500 company like Enron—to oversee the performance of a major company with
thousands of employees, complicated financing, and multiple product and service
lines—is inherently difficult. Second, the amount of time the directors have to
commit to this difficult task is extraordinarily limited, particularly when compared
to the time devoted to the same general task by management. Directors, after all,
typically have time-consuming careers of their own to pursue, and devote only a
handful of days per year to the corporation they oversee. Third, most independent
directors have little personal stake in the direction of the corporation. Their
reputations will not seriously be effected by corporate performance, and they
typically have liability insurance to indemnify them for any liability stemming
from their actions.190 As a result, they approach their tasks dispassionately and
neutrally, and not with the ardor and deep concern with which someone with a
greater personal stake in the outcome might have. Fourth, it appears that
individual directors tend to become less critical and more trusting of management
over time. Collectively, these four factors result in boards that lack both the desire
and the capability to carefully scrutinize management performance and look for
potential problems unless someone else—auditors, the SEC, or, as at Enron, the
Wall Street Journal—identifies an issue and brings it to the board's attention.
The Enron board fits this profile. Enron was performing excellently,
according to management, analysts and investors. Given this fact, a board of
persons who were honest and capable, but also busy, trusting, and relatively
disinterested, saw little need to pay attention to details or analyze management
recommendations with a skeptical eye. Even if the board had been so motivated, it
had little time to do so. Enron's board typically met only five times per year, and
typically devoted less than one hour reviewing even the most complicated
issues.191 Given the manner in which we elect boards, the size of the tasks we ask
them to perform, and the limited time we expect them to devote to their task, the
result—a board that was tragically out of the loop—should not surprise us.

Wall Street's Stock Analysts

Every major Wall Street brokerage firm and investment bank has a team of
equity analysts who monitor the performance of major companies and report on
their potential investment value.192 These analysts typically issue reports and,

190
For a discussion of liability issues, see SENATE GOVERNMENTAL AFFAIRS REPORT,
supra note 12, at 18.
191
SENATE INVESTIGATIONS REPORT, supra note 185, at 9, 32.
192
These analysts are known as "sell-side" analysts because they work for firms that offer
brokerage services. In contrast, "buy-side" analysts work for institutional clients like hedge

38
more importantly, make concrete and specific investment recommendations: buy,
sell, hold.193 Throughout the country, millions of investors rely on this advice, in
part, I think, because they believe the recommendations of the big Wall Street
players represent a more sophisticated and informed view than an ordinary investor
could possibly reach on her own.194
Analysts play a critical role in the monitoring of corporate performance for
one very important reason: access. Ordinary investors have no chance to question
corporation management about a company's performance or financial condition. In
contrast, Wall Street equity analysts typically have numerous opportunities to
question management about their corporations, through quarterly management
conference calls, annual analyst meetings, and frequent interactions with the
corporation's investor relations staff. This access gives analysts with major Wall
Street firms a privileged position in the investor community.195
Enron was seventh on the Fortune 500 list, and thus it was the subject of
scrutiny from hundreds of equity analysts from major brokerage firms. From an
analyst's perspective, Enron posed an interesting challenge. On the one hand, there
were several powerful reasons to recommend the stock to investors: explosive
revenue growth, a good "story" from management to explain that growth, and wide
market approval, a fact reflected in Enron's very high price-earnings ratio and
stock price.196 Nevertheless, analysts also had access to serious warnings signs,
red flags signaling that something might be wrong with the stock.
The most important warning signs came in Enron's 10-Qs and 10-Ks.
Though Enron reported rapidly increasing revenue figures, it declined to disclose
the percentage of its reported revenue that came from changes in MTM valuation
of Enron assets as compared with "real" revenue: cash received or otherwise
accrued from customers.197 This made it difficult, though not impossible, for

funds and mutual funds. The discussion below is limited to the performance of Wall Street
sell-side analysts.
193
The most common scale has five tiers: strong buy, buy, hold, sell, strong sell. Less
common, but also in use, are three- and four-tier rating systems. See Hearing Before the
Joint Session of the House Subcommittee on Capital Markets, Insurance, and Government
Sponsored Enterprises and the House Subcommittee on Oversight and Investigations, 2
(Oct. 12, 2002) (testimony of Charles L. Hill, Director of Research, Thomson Financial-
First Call) [hereinafter Hill Testimony].
194
The idea that ordinary investors follow Wall Street analysts' recommendations because
they believe these recommendations are the product of more sophisticated and informed
analysis is supported by testimony before the Senate Governmental Affairs Committee.
See SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 69.
195
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 71; Jill E. Fisch & Hillary
A. Sale, The Securities Analyst as Agent: Rethinking the Regulation of Analysts, 88 IOWA
L. REV. 1035, 1042 (2003).
196
During the 1990s, Enron's stock price rose three times faster than the S&P 500 index.
SMITH & EMSCHWILLER, supra note 19, at 16.
197
Herdman Testimony, supra note 59, at 15. Analysts could try to calculate the
percentage by analyzing Enron's cash flow reporting, but this method would not have

39
analysts to judge whether Enron was actually making money or not. Indeed, this
problem was evident to many observers. In 2000, for example, the Wall Street
Journal's Texas edition ran a story suggesting that if one set aside unrealized MTM
future revenue, Enron would have lost money in the second quarter of 2000.198
A second major issue was Enron's opaque segment reporting. Publicly
held companies with multiple business lines break out separate numbers in their
financial statements for each business division, or "segment," a practice known as
"segment reporting." A company, for example, that manufactures both cars and
boats will provide Wall Street and the SEC with separate information about both
its car and boat divisions, so that investors will understand how each separate
business is performing. Enron followed this practice, but in a very peculiar
manner. Though Enron was divided into distinct divisions, Enron constantly
renamed these divisions and reallocated particular businesses among the divisions.
In spring of 2001, for example, Enron moved significant commodity risk activities
from its Enron Energy Services division to its Wholesale Services division, a move
that made failing EES look profitable.199 By changing the definitions of its
segments on a regular basis, Enron made it impossible for analysts to track
business unit performance from quarter to quarter. Because of these two factors,
one witness testified before Congress, it became "increasingly difficult to
understand how Enron was achieving its revenue growth and profitability." 200
Enron's disclosures of its related party transactions with entities like LJM
should also have alarmed Wall Street analysts. These disclosures showed that
Enron was engaging in a large and ever-increasing volume of related-party deals
with business associations it controlled. The disclosures also showed that Enron
was not interested in providing investors with a straightforward explanation of
these transactions. On the contrary, the disclosures were incredibly opaque: the
names of the "related parties" were not revealed, the identities of the "senior Enron
executives" involved in the transactions were not provided, the purposes of the
deals were not disclosed, and the descriptions of the deals themselves were so
convoluted, no one would be able to understand what the transactions actually
involved.201
In sum, Enron's earnings statements were, as one expert on Wall Street
equity research later testified, "inscrutable", not just to laypersons, but to

produced an accurate picture of the degree to which Enron's revenue was "real," because
the reported cash flow figures were artificially inflated by the pre-pay transactions.
198
Jonathan Weil, Energy Traders Cite Gains, But Some Math Is Missing, WALL STREET
J., Texas Edition (Sept. 20, 2000). Since many of the analysts who tracked Enron were
energy analysts, many of them worked in Houston, as thus had access to paper editions of
the Texas Wall Street Journal. Weil's important article is discussed in SENATE
GOVERNMENTAL AFFAIRS REPORT, supra note 12, at n.158; SMITH & EMSCHWILLER, supra
note 19, at 78-79.
199
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 44.
200
Hill Testimony, supra note 193, at 2.
201
Second Report, supra note 19, at 56.

40
sophisticated analysts as well.202 This was not a secret. Fortune, for example, ran
a story in early 2001 calling Enron's financial statements "impenetrable." In the
story, credit analysts openly joked about Enron's opacity, labeling the company a
"black box."203 This should have put a chill up the spines of careful analysts. As
one financial expert later testified before the Senate Governmental Affairs
Committee, "for any analyst to say there were no warning signs in the public
filings, they could not have read the same public filings I did."204
Faced with incomprehensible earnings statements, how did elite players in
the investment community react? In spring of 2001, major investors holding large
blocks of Enron stock, like Janus, Fidelity, and American Express, began to quietly
dump millions of Enron shares on the market.205 At the same time, many
independent equity research firms—those not associated with major Wall Street
brokerages and banks—began to recommend that investors sell their stock. In
contrast, the major Wall Street analysts remained totally bullish on Enron. Faced
with confusing financial statements, shifting segment metrics, and alarming quasi-
disclosures of self-dealing, analysts should have demanded that Enron provide
more transparent financial statements and disclose more information about the
nature and purpose of its related party deals. If Enron declined, as the company
might well have done, analysts should have refused to recommend that investors
buy Enron stock. Unfortunately, analysts did none of these things. Though some
analysts groused to Enron about the complexity of Enron's financial statements,
none chose to hold Enron accountable or declined to recommend the stock as a
result. Instead, they heartily recommended that investors buy the stock despite the
lack of clear information.
The facts are stunning. In fall of 2001, all fifteen of the largest Wall Street
firms covering Enron's stock had "buy" recommendations in place.206 By late
October 2001, ten of the fifteen continued to recommend Enron, though by this
point, the Wall Street Journal was running almost daily stories about Enron's
earnings management problems, Enron's CFO had resigned, and the SEC had
announced an Enron investigation.207 Any investors following Wall Street's advice
on Enron lost heavily. So much for "sophisticated" and "informed" analysis. As
the Wall Street Journal commented, "[r]arely have so many analysts liked a stock
they concede they know so little about."208

202
Hill Testimony, supra note 193, at 3.
203
Bethany McClean, Is Enron Overpriced?, FORTUNE (Mar. 15, 2001).
204
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 78.
205
MCCLEAN & ELKIND, supra note 19, at 340.
206
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 6.
207
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 6; BRYCE, supra note 19,
at 255; Hill Testimony, supra note 193, at 3. As late as October 26, 2001, fifteen of
seventeen top Wall Street analysts surveyed by the Wall Street Journal still had buy
recommendations on the stock, even after the forced resignation of the company's CFO.
SMITH & EMSCHWILLER, supra note 19, at 173.
208
SMITH & EMSCHWILLER, supra note 19, at 173.

41
 How, one wonders, could sophisticated Wall Street analysts fail to
understand the significance of the warning signs so evident to Janus, Fidelity, and
the independent research firms? One tempting answer is incompetence. On
August 14, 2001, Enron CEO Jeff Skilling resigned after only a few short months
on the job.209 This was, of course, another red flag indication that Enron might
have serious but concealed problems. Despite this fact, Wall Street analysts
continued blithely to recommend Enron's stock. In contrast, Wall Street Journal
reporters trying to understand why Skilling resigned began to look at the
company's 10-Qs, and there they quickly discovered that Enron was engaging in a
large number of very confusing and poorly described transactions in the billion-
dollar range with an unidentified "related party." The Journal's John Emschwiller
later wrote that although he was not sure what the related party disclosure meant,
he knew it was a big issue: though he had covered Wall Street for years, he had
"never seen a disclosure quite like this before."210 Excited, Emschwiller began to
call equity analysts to see what they thought about the related party transactions.
To his shock, it quickly became clear to him that the analysts knew "little or
nothing" about Enron's related party deals, despite the bulk of the disclosures,
which took up numerous pages in Enron's financial statements, and the enormous
dollar value of the transactions themselves.211 This ignorance was due,
Emschwiller concluded, to the fact that the analysts were simply not reading
Enron's financial statements, or reading them carefully.212 Had the analysts done
so, they might not have understood what they were reading, and they might not
have questioned their enthusiasm for the stock, but at very least, they would be
aware that Enron was entering into some very large and very curious deals,
providing fodder for questions the next time they spoke to Enron management.
Incompetence, unfortunately, is not a very satisfying explanation for the
failure of Wall Street analysts to do their jobs, for it begs the question: why? Why
weren't the analysts reading Enron's financial statements? Why weren't the
analysts looking for problems? Why, as Fortune's Bethany McClean and Peter
Elkind have noted, had many analysts "stopped doing anything that resembled
serious securities analysis"?213
Two major factors contributed to the failure of analysts to perform
adequately as watchdogs in the Enron case; both involve significant conflicts of
interest.214 Banks and brokers, one must remember, fund equity research not as a

209
SMITH & EMSCHWILLER, supra note 19, at 3.
210
SMITH & EMSCHWILLER, supra note 19, at 18.
211
SMITH & EMSCHWILLER, supra note 19, at 34.
212
SMITH & EMSCHWILLER, supra note 19, at 34.
213
MCCLEAN & ELKIND, supra note 19, at 231.
214
In addition to the explanations for analyst failure discussed above, two additional
potential causes might be relevant. One is what Fed Chairman Alan Greenspan once
termed "irrational exuberance"—a fatal lack of skepticism. During the bull market of the
1990s, stock values shot skyward, apparently without limit. One popular investment guide
from the period was titled "Dow 36,000." In this over-heated atmosphere, many of the
analysts, typically in their twenties and thirties, had never experienced a bear market. As a

42
public service, but because it helps the banks make money. There is, however, no
real direct market for equity research. Big Wall Street banks, for example, do not
make money by selling their research and recommendations to analysis
consumers.215 Instead, banks and brokers make money from research indirectly, in
two ways: research leads to increased equity transactions for firm brokers, and it
helps firm investment bankers sell their financial services to major corporations.
First, brokerage firms disseminate research reports because these reports,
once placed in the hands of investors, help stimulate the trading of stocks.216
When, for example, an influential bank or broker recommends that investors buy a
particular stock, transactions in that stock increase. This results, of course, in
increased brokerage transaction fees and commissions for the firm. Since,
however, there are always more potential buyers for a particular stock than there
are potential sellers of the same stock, "buy" recommendations, on average,
generate much larger fees and commissions for the firm than do "sell"
recommendations. Thus, from a business perspective, brokerage firms have a
direct financial incentive to issue "buy" recommendations.
The second and potentially more significant conflict arises from the fact
that large corporations are hesitant to provide an investment bank with significant
banking fees if the bank's research division is publicly panning the company's
stock.217 Indeed, some large corporations put pressure on banks to issue upbeat
analysis reports about their stocks and may threaten to stop using a bank's financial
services products if the bank declines to push the company' stock.218 Some banks,
in turn, have adjusted to this pressure and view their equity analysis programs not
as a way to educate investors, but as a method of generating and retaining clients

result, market decline, let alone the implosion of major blue chip companies, may simply
have been beyond the imagination of many analysts. Recommending stocks may have felt
like a job with no significant consequences. Another potential issue specific to Enron
analysis was the background of the Enron analysts themselves. Since Enron had started as
a natural gas company, most of the Enron analysts were persons with natural gas or, at best,
general energy analysis backgrounds. The analysts did not, as a general rule, have the
background or experience to understand and come to terms with the Enron's efforts in new
areas such as water or telecommunications, or the implications of Enron's complex
structured finance transactions. These analysts were generally impressed with Enron's
prowess in energy markets, and thus were natural prey to Enron's line that since all markets
are the same, Enron could prosper in any market. Analysts with more experience in non-
energy sectors of the economy may have been more skeptical.
215
Fisch & Sale, supra note 195, at 1045.
216
Fisch and Sale provided a good discussion and analysis of this problem in their
excellent article. Fisch & Sale, supra note 195, at 1045–46.
217
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 82; Fisch and Sale at
1047.
218
See example of relation between Merrill Lynch and Enron below. Some corporations
also restrict the access of analysts to corporate executives if the analysts file negative
research reports. See SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 88.

43
for their firms' investment banking and financial services divisions.219 As SEC
Chairman Arthur Levitt stated in 1999, before Enron collapsed, bankers expect
their analysts "to act more like promoters and marketers than unbiased and
dispassionate analysts."220 Banks, for example, have used overly rosy equity
reports as a way of ingratiating themselves with the management of major
companies with significant financial services needs, in the hopes of gaining
business for their firms. In 1992, Morgan Stanley's managing director of corporate
finance instructed his firm's analysts that "the practical result needs to be 'no
negative comments about our clients.'"221 More recently, Merrill Lynch, another
major malefactor in this area, publicly touted client stocks in positive research
reports even though the firm's analysts privately described the companies in e-mail
as "junk," "shit", and "crap."222 Analysts also share the profits from the gains in
investment banking fees.223 Obviously, this dynamic has a huge impact on Wall
Street equity analysis. It provides analysts with very little incentive to care about
research accuracy or to examine carefully any given company's pronouncements
about its current success or future prospects. Instead, it encourages analysts to
simply repeat whatever story the company's management wants to deliver to
investors.
Given these two enormous conflicts of interest,224 it is not surprising that
for Wall Street analysts, optimism about the stocks one analyzes is generally a
good career move, while pessimism is often punished.225 Indeed, according to
John Coffee, who testified about these matters before the Senate Banking
Committee, one survey found that 61% of analysts had suffered some form of
retaliation for writing a negative report at some time in their career.226 Equally

219
This problem is discussed in Neil H. Aronson, Preventing Future Enrons:
Implementing the Sarbanes-Oxley Act of 2002, 8 STAN. J. L. BUS. & FIN. 127, 131–132,
145-146; MCCLEAN & ELKIND, supra note 19, at 232-235; SENATE GOVERNMENTAL
AFFAIRS REPORT, supra note 12, at 82-83.
220
Mark Maremont and Deborah Solomon, Missed Chances: Behind SEC's Failings:
Caution, Tight Budget, '90s Exuberance, WALL ST. J. (Dec. 24, 2003).
221
Fisch & Sale, supra note 195, at 1049 (quoting Wall Street Journal, July 14, 1992, at
A6.).
222
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 80-81 (quoting filing in
Spitzer v. Merrill Lynch, No. 02-401522 (N.Y.)).
223
Julie Creswell, Banks on the Hot Seat, FORTUNE, September 2, 2002; SENATE
GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 87 (based on filings in Spitzer v.
Merrill Lynch, No. 02-401522 (N.Y.)).; Fisch & Sale, supra note 195, at 1052–1053.
224
In addition, some analysts own stock in the companies they cover. See Fisch & Sale,
supra note 195, at 1044.
225
See SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 87 (discussing
academic study by economists Harrison Hong of Stanford and Jeffrey Kubik of Syracuse
finding that analysts are more likely to be promoted if their recommendations are
optimistic, and that optimism is rewarded more than accuracy), 88 (discussing survey
finding retaliation against analysts for filing negative research reports common); Fisch &
Sale, supra note 195, at 1054-1056.
226
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 88.

44
unsurprising: Wall Street analysis of stocks is extremely positive overall. In 2002,
for example, a Wall Street director of research informed Congress that analysts
typically rate approximately 66% of stocks as "strong buys" or "buys," compared
with only 1% rated as "strong sells" or "sells."227
Enron was a major user of lending, underwriting and M&A services, and
thus a very attractive potential client for major investment banks. Indeed, Enron
burned through some $230 million in banking fees in 1999 alone.228 Did Enron put
pressure on Wall Street to praise its stock? The case of John Olsen is instructive.
In the 1990s, John Olson was a respected energy stock analyst with Merrill
Lynch. Olson tracked Enron, but unlike virtually every other major sell-side
analyst, he had significant concerns about Enron's financial health. In 1997, Olson
wrote a research report raising concerns with Enron's performance and changing
his short-term Enron recommendation to "neutral."229 In reaction, Enron
executives complained to Merrill Lynch's management and threatened to withhold
banking fees in the future unless Merrill upgraded Enron's stock rating by 1998.230
Merrill, in return, forced Olson out of the firm and replaced him. Merrill Lynch's
new Enron analyst changed Enron's rating to "buy."231 Olson later told Texas
journalist Robert Bryce that "analysts had to be very encouraging, or provide
strong buy recommendations for current or prospective banking clients, so the
firmwide bonus would be unusually generous. And if you didn’t do that, you'd get
whacked."232 Needless to say, actions like this, and the climate surrounding Wall
Street equity analysis in general, deterred other analysts from raising similar
concerns about Enron's stock. 233

The Securities and Exchange Commission

The Securities and Exchange Commission is responsible for preventing

securities fraud and protecting equity investors. The SEC had access, of course, to
most of the information about Enron available to Wall Street analysts. Thus, the
SEC knew, or should have known, that Enron's financial statements were
confusing; that it kept rearranging its business divisions, making it impossible to
follow business segment performance from quarter to quarter; that it was engaging
in a huge volume of related party transactions; that the disclosure of these related
party transactions was disturbingly opaque; and that the CEO had resigned

227
Hill Testimony, supra note 193, at 3.
228
MCCLEAN & ELKIND, supra note 19, at 163.
229
SMITH & EMSCHWILLER, supra note 19, at 35.
230
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 83.
231
MCCLEAN & ELKIND, supra note 19, at 234-35; SMITH & EMSCHWILLER, supra note
19, at 35-36.
232
BRYCE, supra note 19, at 252.
233
One should note, for what it is worth, that in testimony before the Senate Governmental
Affairs Committee on February 27, 2002, a group of analysts from major Wall Street firms
all denied that their banks' significant relationships with Enron affected in any way their
analysis of Enron's stock. SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 84.

45
suddenly in summer of 2001 under unusual circumstances. On a more basic level,
the SEC knew or should have known that Enron was spending billions to diversify
without going deeply into debt or issuing more equity. The SEC, in other words,
had plenty of reasons to examine Enron closely. At very least, SEC lawyers and
accountants reading Enron's perplexing financial statements could have demanded
that the company provide more clear and detailed disclosures in the future. Alas,
the SEC did nothing.
The most alarming part of Enron's collapse was the failure of the SEC to
see the warning signs before the collapse and open an inquiry. In our analysis of
the performance of Arthur Andersen, the Enron board of directors, and Wall Street
analysts, we have to speculate to some degree about why these institutions failed to
do their jobs. But for the SEC, we know the definitive explanation for institutional
failure, and that answer is shocking. The SEC did not know what was happening
at Enron because the SEC did not review any of Enron's 1998, 1999, 2000, or 2001
10-K and 10-Q filings.234 I have immense respect for the front-line attorneys and
accountants at the SEC, and I am sure that if they had been reading Enron's
financial statements in 1999, 2000, or 2001, they would have spotted serious issues
demanding an informal inquiry. After all, reporter John Emschwiller of the Wall
Street Journal spotted the problems in just a few minutes after pulling up Enron's
publicly filed financial statements on his computer one day.235 Unfortunately, no
one at the SEC was reading the filings, and Enron's financial manipulations went
unquestioned.
The SEC has an excuse for failing to read Enron's 10-Qs and 10-Ks, and it
is not a bad one, in some ways. SEC leadership notes that in the 1990s, the
number of regulated companies and financial filings increased dramatically, while
SEC resources grew at a much more modest rate. As a result, the SEC was forced
to prioritize. Faced with this tough decision, the SEC claims that it decided to
devote its resources to reviewing initial public offerings, and not the filings of
supposedly reliable blue chip firms of the Fortune 500.236
The SEC is correct when it asserts that the Commission needs more
resources to adequately police the securities market. Nevertheless, I find the
proffered explanation for its failure to review Enron's 10-Qs and 10-Ks from 1998
to late 2001 totally unacceptable. The Fortune 500 companies play a critical role
in the American securities market, for a huge percentage of American stock
investment goes into our largest companies. As a result, the SEC has a particular
duty to insure that these behemoths are playing by the rules. More significantly,
policing the financial statements of the Fortune 500 takes minimal resources.
Assume for a moment that it takes one week for a lawyer to make a careful review

234
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 34.
235
SMITH & EMSCHWILLER, supra note 19, at 18.
236
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 11. The SEC abandoned
reviewing all filings in 1980. See Herdman Testimony, supra note 59, at 8. In 2001, as a
result of prioritization, the SEC reviewed only 16% of 10-K forms filed. SENATE
GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 11.

46
of a 10-Q or 10-K—a very conservative estimate.237 That means that an SEC
attorney could review fifty such forms per year. Since the Fortune 500 companies
submit 500 annual reports per year, 10 SEC attorneys working slowly could review
all of their 10-K filings every year. Alternatively, 40 persons could review all of
the 10-Ks and 10-Qs. This resource commitment is obviously very small. Given
that the SEC has over 3000 employees,238 it is amazing that they failed to devote
this minimal amount of manpower to such a basic and fundamental task. The
SEC's problem was not lack of resources: it was poor management and poor
prioritization.
This fact was revealed most clearly in a post-Enron study of SEC
management practices conducted by McKinsey and Co., the consulting firm.
Though the McKinsey report has not been released publicly, portions of the study
were leaked to the Wall Street Journal in December 2003. According to the
Journal, the McKinsey study found that SEC management gave SEC employees
reviewing corporation filings numerical targets to meet. As a result, SEC
employees began "gaming the system," reviewing "smaller, easier-to-review filings
rather than more complex ones" taking more time.239 Given these incentives, it is
not surprising that SEC staff decided not to review Enron's long, difficult SEC
filings.
Even if one accepts the claim that the SEC lacked the resources to review
all Fortune 500 financial statements, it should still have reviewed Enron's under
any rational set of prioritization procedures. When a company files a 10-Q or 10-
K with the SEC, the SEC conducts a preliminary screening to determine how
carefully it will review the filing. Some filings are prioritized for full review by
SEC staff; some get a more limited review; and others are not reviewed any further
at all.240 The SEC keeps its screening criteria secret, in order to prevent companies
from gaming the system.241 As a result, we do not know precisely why Enron's
filings were not selected for review. It is clear, however, that if the SEC had sound

237
I make this claim on the basis of personal review of SEC filings.
238
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 8.
239
Mark Maremont and Deborah Solomon, Missed Chances: Behind SEC's Failings:
Caution, Tight Budget, '90s Exuberance, WALL ST. J. (Dec. 24, 2003) (quoting McKinsey
and Co. study).
240
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 10. The SEC has four
levels of monitoring beyond the initial screening. Some filings are not read at all; some
receive "monitoring," pursuant to which the SEC reviews a limited number of items in the
filing; some receive a "financial statement review," pursuant to which the SEC reads and
reviews the financial metrics and MD&A; and a few select filings receive a "full review,"
in which the entire filing is scrutinized. See SENATE GOVERNMENTAL AFFAIRS REPORT,
supra note 12, at 10.
241
SENATE GOVERNMENTAL REPORT, supra note 12, at 10; Herdman Testimony, supra
note 59, at 8.

47
procedures in place, considering all of the relevant factors, Enron's statements
would not have slipped through the cracks.242
One factor that should have been relevant to the SEC was Enron's history
of fraud. In 1987, Enron Oil, the company's oil trading division, was caught
cooking its books and engaging in fraudulent fake trades designed to enrich Enron
traders at shareholders' expense.243 Enron caught the misconduct, but amazingly,
Enron's management initially declined to fire the traders, apparently because the
trading operation was so profitable.244 Indeed, one senior executive sent the rogue
oil traders an e-mail ending: "Please keep making us millions."245 Even more
alarming, Enron's board agreed with and approved management's decision.246
Despite Enron's lackadaisical reaction, the Department of Justice prosecuted two of
the traders, and in 1990, both pleaded guilty to felonies.247 This track record of
fraud by Enron executives, and the failure of the board and management to take
these crimes seriously, should have been a signal to SEC regulators that they
needed to keep an eye on Enron. If, as the SEC claims, it had to set priorities, it
seems that examining companies with recent past records of fraud might be a
useful factor to take into account.
Second, the SEC was aware by the late 1990s that Arthur Andersen's
auditors were helping major companies like Sunbeam and Waste Management file
misleading financial statements, since the SEC was already pursuing enforcement
actions in these cases. Given this fact, the SEC should have identified the Fortune
500 companies relying on Andersen to audit their books and give those companies
extra scrutiny. Again, if prioritization is necessary, prioritized review of
companies audited by a potentially unreliable accounting firm should have been an
important factor to consider.
Third, and finally, the SEC's Chief Accountant has admitted in testimony
before Congress that because Enron never disclosed the percentage of its reported
revenue that came from changes in MTM valuation of Enron assets, as compared
with "real" revenue, Enron's true profitability was "unclear."248 The Chief
Accountant failed to acknowledge the obvious conclusion that should have been
drawn from this fact. If Enron's financial statements were unclear in such a
fundamental respect, the SEC had an obligation to inform Enron that it needed to
make more complete disclosures or face an SEC investigation.

242
As the Senate Governmental Affairs Report noted, "there is little evidence that this
relatively informal system has been particularly successful, and a more sophisticated means
of risk analysis appears to be needed." Id. at 63.
243
For discussions of fraud in Enron's oil trading business, see BRYCE, supra note 19, at
37-43; MCCLEAN & ELKIND, supra note 19, at 15-24.
244
BRYCE, supra note 19, at 39; 19-20.
245
MCCLEAN & ELKIND, supra note 19, at 20.
246
MCCLEAN & ELKIND, supra note 19, at 20-21.
247
BRYCE, supra note 19, at 42; MCCLEAN & ELKIND, supra note 19, at 24.
248
Herdman Testimony, supra note 59, at 15.

48
 The SEC, in short, was a slumbering watchdog. Had the SEC done its job,
the Enron collapse might never have occurred. 249

Deterrence: Federal Criminal Laws

When all other safeguards do not work, the only remaining protection for
investors is to hope that the possibility of criminal sanctions will deter securities
fraud. In the Enron case, the prospect of criminal prosecution clearly failed to
provide any deterrence whatsoever. I expect this was because prosecuting and
punishing white-collar crime has never been a priority in the United States.
Historically, white-collar fraud has been punished less severely than so-called
"blue-collar" theft and property destruction cases causing equivalent economic loss
to victims.250 The federal sentencing guidelines institutionalized and validated the
practice of giving white-collar defendants low sentences. Under the initial version
of the guideline fraud provisions, for example, the Commission predicted that the
average fraud defendant would serve only eight months in prison.251
This light-handed approach to sentencing in white-collar cases can be seen
in the sentences imposed in the major white-collar cases of the late 1980s.
Michael Milken and Ivan Boesky served only two years in prison, 252 and Kidder
Peabody's Martin Siegel served only two months.253 Similarly, the felons in the
1990 Enron Oil fraud cases received slaps on the wrist for committing a multi-
million dollar scam: one year in jail for one defendant, probation for another.254
The sentences imposed in these cases were substantially lower than the sentences
routinely handed out in low-level federal immigration and narcotics cases.255
Wall Street clearly got the message that white-collar crime is not serious.
A 2003 Wall Street Journal article, for example, carried a disturbing but revealing
title: "A Rare Headline: Wall Streeter Could Face Jail."256 Given these facts, it is
not surprising that Enron executives were not deterred from misconduct.

249
In its excellent report on Enron, the staff of the Senate Governmental Affairs
Committee suggest that Enron's explosive growth and the large number of affiliate entities
listed on Enron's reports—some fifty pages worth in the 2000 10-Contract—should have
put Enron on the SEC's radar screen. The Senate Governmental Affairs Report also notes
that the SEC erred when it approved Enron's use of MTM and then failing to provide any
follow-up review to insure Enron was not violating the conditions imposed by the SEC as
part of its approval process. See SENATE GOVERNMENTAL REPORT, supra note 12, at 65.
250
John R. Steer, The Sentencing Commission's Implementation of Sarbanes-Oxley, 15
FED. SENT. R. 263, *1 (Apr. 2003) (discussing conclusion reached by Sentencing
Commission after research of historical practices in U.S. sentencing). Steer is the Vice-
Chair of the sentencing Commission, and thus speaks with authority here.
251
Steer, supra note 250, at *1.
252
A Rare Headline: Wall Streeter Could Face Jail, WALL ST. J. (Apr. 24, 2003).
253
A Rare Headline: Wall Streeter Could Face Jail, WALL ST. J. (Apr. 24, 2003).
254
MCCLEAN & ELKIND, supra note 19, at 24.
255
Author's personal experiences as a federal prosecutor.
256
A Rare Headline: Wall Streeter Could Face Jail, WALL ST. J. (Apr. 24, 2003).

49
Conclusion: Watchdog Performance

In the Enron case, all five major watchdog institutions responsible for
protecting investors totally failed to meet their responsibilities. Of course, Enron's
bad deeds were ultimately discovered and publicized, primarily because of actions
of the Wall Street Journal, but that offers little consolation. Enron's financial
statement manipulation began, at very latest, in 1997, the time of the Chewco deal.
By the time Enron's misdeeds were disclosed in November 2001, it was too late.257
Hundreds of Enron executives had pocketed their misbegotten millions, most of
which will never be recovered; thousands of their employees had lost their jobs
and their retirement savings; and millions of investors had lost their invested sums,
much of which, again, represented retirement savings. This kind of delayed
disclosure is better than nothing, but it is simply not acceptable in a country that
encourages its millions of its citizens to rely on equity investments for their
retirement.258

IV. Reforms Since the Enron Collapse: A Brief Assessment

The Enron case suggests that our securities regulatory system performs
poorly in a critical area: prevention and disclosure of fraud. The case demonstrates
that executives of one of America's largest companies can mislead investors for
years without detection, even if no one understands how the company makes its
money, the company has a history of fraud, and the company files increasingly
opaque financial statements involving large-scale related party transactions. The
case indicates that boards of directors, independent auditors, financial analysts, the
SEC, and the criminal laws will not always prevent or catch serious fraud in a
timely fashion, even when the fraud involves billions of dollars, affects millions of
investors, and occurs over several years.
The Enron case, standing alone, does not necessarily suggest that
significant structural reforms to our securities regulation regime are necessary.
Indeed, after Enron's collapse, Congress and the SEC made no significant
legislative or regulatory changes: everyone treated Enron as an anomaly. Within

257
We should also be cognizant of the fact that Enron's misdeeds might never have been
uncovered but for the fact that (a) Jeff Skilling resigned as CEO under peculiar
circumstances, with an incoherent explanation, and (b) the Wall Street Journal began to
investigate Enron to figure out why Skilling had actually departed. Had Skilling stayed in
his job, been a less high-profile executive, or provided a more compelling explanation for
his resignation, the Journal would not have been interested in Enron, no muck-raking
stories would have followed, and Enron might have continued to mislead investors for
years. In the future, we cannot rely on such fortuitous events to protect investors. See
generally R. SMITH & J. EMSCHWILLER, 24 DAYS: HOW TWO WALL STREET JOURNAL
REPORTERS UNCOVERED THE LIES THAT DESTROYED FAITH IN CORPORATE AMERICA,
(2003).
258
Currently, 48 million citizens participate in 401(k) plans.

50
six months, however, investors discovered that Enron's collapse was not an
isolated event. McKisson, Tyco, WorldCom, and HealthSouth were also engaged
in massive accounting deception, and these frauds were disclosed publicly. At the
same time, regulators began to pay attention to the very large and steadily
increasing number of major American companies that were restating their
earnings.259 Policy makers quickly concluded—correctly, I think—that the
problems seen in Enron are relatively common.260
In reaction to these developments, Congress, the United States Sentencing
Commission, the SEC and state regulators initiated and implemented a series of
significant reforms to our securities regulation system in 2002 and 2003. These
reforms included major legislation like the Sarbanes-Oxley Act, 261 changes to the
federal sentencing guidelines, changes to accounting rules, changes in SEC
enforcement practices, and changes to Wall Street behavior imposed through
litigation settlements. In the following pages, I provide a brief assessment of some

259
In 1980, there were three restatements of earnings. In 2001, there were 270. SENATE
GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 3. On the increase in restatements, see
UNITED STATES GENERAL ACCOUNTING OFFICE, FINANCIAL STATEMENT RESTATEMENTS:
TRENDS, MARKET IMPACTS, REGULATORY RESPONSES, AND REMAINING CHALLENGES, 45
GAO-03-138 (2002) (annual rate of restatements increased dramatically between 1997 and
2002). Congress and the SEC were well aware of these problems long before Enron
collapsed. In 1998, then-SEC Chairman Arthur Levitt stated in a now famous speech at
New York University: "I fear 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." SENATE GOVERNMENTAL AFFAIRS REPORT, supra
note 12, at 3. Assessing why Congress and the SEC failed to act on these problems back in
the 1990s falls outside the scope of this Artivcle. Clearly, the cause was some combination
of (a) excellent lobbying by Wall Street interests and (b) the desire of Congress to avoid
killing the bull market goose that laid the golden campaign contribution egg.
260
See, e.g., SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 61 ("In the case
of Enron – and the corporate collapses that have since followed – we have witnesses a
fundamental breakdown in this system."); John C. Coffee, Jr., Limited Options, 2003-Dec
LEGAL AFF. 52, 52 (2003) (problems seen in Enron and WorldCom pervasive).
261
The Sarbanes-Oxley Act of 2002 was passed by the United States House of
Representatives by a vote of 423-3 and the United States Senate by vote of 99-0. It was
signed by the President on July 30, 2002. Sarbanes-Oxley is a remarkably complex piece
of legislation. In this Comment, I have made no effort to provide an exhaustive analysis of
Sarbanes-Oxley. Instead, I have only discussed those Sarbanes-Oxley provisions that I
believe will have the most significant impact on the securities market and in particular, on
the prevention and disclosure of fraud. Accordingly, there are numerous provisions of the
Act, some of them quite significant, that I have not discussed here. For more
comprehensive discussions of Sarbanes-Oxley, see, for example, Neil Aronson, Preventing
Future Enrons: Implementing the Sarbanes-Oxley Act of 2002, 8 STAN. J.L. BUS. & FIN.
127 (2002); Luppino, supra note 4, at 155–64; Brian Kim, Sarbanes-Oxley Act, 40 HARV.
J. ON LEGIS. 235 (2003); Kathleen Brickey, From Enron to WorldCom and Beyond: Life
and Crime After Sarbanes-Oxley, 81 WASH. U. L. Q. 357 (2003) (providing an excellent
discussion of impact of Sarbanes-Oxley whistle-blower protection measures on future
cases).

51
of the most significant of these reforms.262 I believe that many of the changes
made since 2002 are extremely positive. Other reforms, unfortunately, are
counter-productive. I also conclude that our latest wave of securities regulation
reform has failed to sufficiently address and rectify a number of major problems in
securities regulation evident from the Enron case.

Six Positive Developments

262
It may be appropriate here to situate my views about securities regulation within the
context of the current debate in the academy over the value and efficiency of our current
regulatory scheme. In recent years, that debate has been shaped primarily by scholars
whose faith in the efficient capital markets hypothesis has led them to advocate dismantling
the current federal mandatory disclosure system that governs securities markets. See, e.g.,
Paul G. Mahoney, The Exchange as Regulator, 83 VA. L. Rev. 1453 (1997) (arguing for
reducing current enforcement efforts in favor of regulation by stock exchanges); Roberta
Romano, Empowering Investors: A Market Approach to Securities Regulation, 107 YALE
L.J. 2359 (1998) (advocating replacement of federal securities regulation with competitive
state regulation); Stephen J. Choi, Regulating Investors Not Issuers: A Market-Based
Proposal, 88 CAL. L. REV. 279 (2000) (calling for regulation and limits on investor
freedom to replace current regulatory system). The general thrust of these works, as
Stephen Choi and A.C. Pritchard recently explained, is the conclusion that the "implication
of the efficient market hypothesis is that government regulation of financial intermediaries
and companies' financial disclosures may be unnecessary and potentially wasteful."
Behavioral Economics and the SEC, 56 STAN. L. REV. 1, 2 (2003). In turn, behavioral
economics scholars operating in the realist tradition have argued, based on empirical
investigation into the problems of bounded rationality, that deregulation would be a costly
error. See, e.g., Robert Prentice, Whither Securities Regulation, Some Behavioral
Observations Regarding Proposals for its Future, 51 DUKE L.J. 1397 (2001); Donald C.
Langevoort, Taming the Animal Spirits of the Stock Markets: A Behavioral Approach to
Securities Regulation, 97 NW. U.L. Rev. 135 (2003). I do not have a foot solidly in either
theoretical camp: my intellectual commitments lie elsewhere. Nevertheless, my work as a
prosecutor has taught me, if nothing else, to have little faith in the efficient market
hypothesis: I think allowing firms to select the degree of regulation to which they will be
subject would result in massive fraud and deception targeted at our most vulnerable
citizens. (As Jeffrey Gordon commented recently, the Enron case alone "provides another
set of reasons to question the strength of the efficient market hypothesis…". See Gordon,
supra note 4, at 1235–37). I am also persuaded that companies, if left unregulated, will not
disclose the socially optimal amount of financial information. See generally Merritt B.
Fox, Retaining Mandatory Securities Disclosure: Why Issuer Choice is Not Investor
Empowerment, 85 VA. L. Rev. 1335 (1999). As a result, I remain, as do the behavioralists,
an advocate of the mandatory disclosure system and an opponent of balkanizing our
securities regulation regime. Perhaps Choi and Pritchard would respond, as they have done
recently to behavioral critics, that the problem with SEC regulatory action is that "the SEC
usually focuses on the stereotypical 'widows and orphans' in crafting protections." Choi &
Pritchard at 35. I'm not really sure what to make of this claim, other than to note that some
60 million ordinary Americans, not all of them widows and orphans, are currently invested
in the market, and that the vast majority of them want to keep basic disclosure and fraud
rules in place. This outcome reflects, I take it, the efficiency of the democratic marketplace
for ideas.

52
 Since the Enron collapse, Congress, the United States Sentencing
Commission, and federal and state securities regulators have made six significant
positive changes to our securities regulation regime. The most important
development has been in the area of criminal punishment. As noted above, white-
collar crimes have historically been punished very lightly in the United States.
This scandalous practice has come to an end. Since late 2001, Congress and the
United States Sentencing Commission have radically increased criminal penalties
for persons convicted of white-collar fraud. In Sarbanes-Oxley, Congress
quadrupled the statutory maximum penalties for wire and mail fraud from five to
twenty years.263 Since, however, statutory maximums merely affect the legal
parameters of sentences, and not length of actual sentences themselves, the
promulgation of major amendments to the federal sentencing guidelines are of
greater importance. The United States Sentencing Commission has completely re-
written the sentencing guidelines applicable to fraud cases in the last several
years.264 The new provisions essentially double the penalties imposed on
defendants who commit large-scale securities fraud.265 The first major fruit of this
change can be seen in the sentence of former Imclone CEO Samuel Wachsal to
seven years in prison for insider trading—a much higher sentence than those
imposed in similar cases in the past.266 The importance of these changes in
sentencing laws cannot be over-estimated. For the first time, our society has
recognized that white-collar crimes pose a threat to the country's social and
economic fabric as significant as that of organized crime and narcotics
trafficking.267

263
Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204 § 904 (2002).
264
The first set of significant fraud amendments were promulgated by the Sentencing
Commission on November 1, 2001, before Enron collapsed. These amendments, known
collectively as the "Economic Crime Package," consolidated the old, separate fraud, theft
and property destruction guidelines into one unified guideline, 2B1.1. The new unified
guideline significantly increased recommended sentences for fraud offenders, particularly
those who committed frauds resulting in large financial losses to victims. The Commission
also provided a sentence enhancement for cases involving large numbers of victims.
Following the passage of Sarbanes-Oxley, the Commission revisited the punishment of
fraud. The Commission promulgated new amendments in January 2003 increasing
punishment once again for, among other things, crimes involving large numbers of victims,
that endanger the solvency of publicly traded companies, or that result in large dollar
losses. For an excellent discussion of the 2001 and 2003 amendment, see Steer, supra note
250. For a discussion of the 2001 amendments, see Mary Kreiner Ramirez, Just in Crime:
Guiding Economic Crime Reform After the Sarbanes-Oxley Act of 2002, 34 LOY. U. CHI.
L.J. 359, 376–81 (2003).
265
For an excellent calculation example, see Steer, supra note 250, at *9.
266
Matthew Rose and Kara Scannell, Executives on Trial, WALL ST. J. (February 23,
2004).
267
Sarbanes-Oxley also creates four new federal crimes relating to securities fraud or
obstruction of justice in the securities fraud context. These new laws are largely
duplicative of statutes already on the books, and thus are unlikely to have any significant

53
 Congress has also recognized that the accounting profession can no longer
be trusted to regulate itself. In Sarbanes-Oxley, Congress created a new public
regulatory body, the "Public Company Accounting Oversight Board," or
PCAOB.268 The PCAOB is a five-member board charged with supervising the
accounting profession on behalf of investors and the general public under the
general supervision of the SEC. To keep the board independent of the accounting
profession, only two of the board members may be CPAs. Once it is fully
operational, the PCAOB will register, inspect and discipline public accounting
firms and establish standards for auditor ethics, independence, and quality control.
Hopefully, PCAOB will also play a major role in reviewing GAAP as well,
identifying problematic rules and plugging loopholes that might lead to the filing
of essentially misleading but arguably GAAP-compliant disclosures.269 Creating
PCAOB is a major step forward in securities regulation. Getting PCAOB up and
running quickly and efficiently is of critical importance if we wish to end auditor
misbehavior like that committed by Arthur Andersen in the Enron case.
Sarbanes-Oxley also bans auditing firms from providing auditing clients
with most consulting services.270 This new prohibition will force auditors to
concentrate first and foremost on the auditing business, eliminate a major incentive
for auditors to skew their audit results in an effort to please management, and
prevent companies from trying to "discipline" principled auditors by reducing or
eliminating their consulting fees. The ban does not extend to tax consulting, and
thus does not completely resolve this problem, but it represents a sound step
toward enhanced auditor independence.
In a long overdue development, FASB has tightened the rules regarding
the proper accounting of transactions with special purpose entities like the Raptors.
In January 2003, FASB issued Interpretation No. 46, "Consolidation of Variable
Interest Entities," which requires companies to consolidate and report SPE results
on their financial statements if the reporting company is, as a matter of substance,

impact. See Recent Legislation, Congress Passes Corporate and Accounting Fraud
Legislation, 116 HARV. L. REV. 728, 730–33 (2002). For an excellent summary of all of
Sarbanes-Oxley's criminal provisions, see William S. Duffey, Jr., Corporate fraud and
Accountability: A Primer on Sarbanes-Oxley Act of 2002, 54 S.C. L. REV. 405 (2002).
268
Sarbanes-Oxley § 101.
269
There is a very strong argument that in the past, FASB has allowed the interests of
management to override the interests of investors and accuracy in general when
promulgating rules such as FAS 140, which gave a green light to many of the SPE
manipulations seen in the Enron case. For this reason, as Anthony Luppino has argued,
"history suggests that government regulators should consider taking a more active role than
in the past in shaping the rules and standards that ultimately result in the disclosures
required in public company financial statements." Luppino, supra note 4, at 153. The
PCAOB is obviously well-placed to serve in this role. Richard Breeden, former Chairman
of the SEC, has also called for the PCAOB to be directly involved in formulating
accounting standards. See Breeden Testimony, supra note 59, at 9.
270
Sarbanes-Oxley § 201. SEC Chairman Arthur Levitt had proposed this same reform
during the Clinton Administration, but was unable to overcome intense lobbying by the
accounting industry. See Peter H. Stone, Accounting Angst, THE NAT’L J., March 16, 2002.

54
the "primary beneficiary" of the SPE arrangement and absorbs the majority of the
entity's profits or losses.271 This new rule supersedes the prior FASB rulings on
this topic, which had resulted in companies like Enron taking massive amounts of
debt off their books by engaging in transactions with entities owned and controlled
almost totally by the company. In a related development, Congress and the SEC
now require companies to disclose their off-balance sheet arrangements in their 10-
Q and 10-K filings.272 Had these two new rules been in effect from 1997 to 2001,
it would have stopped many of the particular accounting manipulation gimmicks
used by Enron—though I suspect Enron might have concocted different types of
transactions to exploit different loopholes to achieve the same misleading results.
Regulators have also taken some steps to mitigate the disastrous conflicts
of interest that render much of Wall Street's disseminated sell-side equity analysis
meaningless at best and often actually pernicious. The most important
development in this area came through litigation, not legislation. In April 2003,
ten major Wall Street firms agreed to pay $1.4 billion to settle charges from New
York Attorney General Elliot Spitzer and the SEC that the firms had manipulated
their stock research to gain fees for their investment banking divisions.273 As part
of the settlement, the ten firms agreed to significant changes to their practices in
this area. In addition, Title V of Sarbanes-Oxley prohibits investment banking
executives from setting compensation for their firms' equity analysts and prohibits
banking firms from retaliating against their analysts if their analysts criticize client
companies or potential clients in their reports.
Spitzer's litigation and Title V will probably encourage Wall Street to
provide more objective, independent research. Their usefulness, however, has
probably been overestimated. If the reforms (and fears of future law suits by
regulators) achieve their intended result, it will be harder for banks to use research
to generate banking fees. But if that is the case, banks will lose their primary
incentive for funding research programs in the first place.274 As a result, banks

271
For an excellent discussion of the new rule see Luppino, supra note 4, at 79-83.
272
Sarbanes-Oxley § 401(a) and SEC Release No. 33-8182. This is just one of a host of
new reporting and disclosure requirements imposed on companies since Enron's collapse.
For a list, see SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 65. Though I
do not oppose increasing disclosure requirements, and believe that the new requirements
for off-balance sheet entities is needed, I am skeptical that increasing reporting and
disclosure requirements, on its own, will do much to deter or disclose fraud. As the Senate
Governmental Affairs Report notes, more disclosures will not do much good if no one at
the SEC is reading the disclosures. See Id. at 65. Or, I might add, if analysts are not
reading them either. More profoundly, the problem in the Enron case was generally not
lack of relevant disclosure requirements, but the poor or non-existent quality of disclosures
made pursuant to relevant requirements. This suggests that mandating additional
disclosure, while tempting to Congress and the SEC, may have largely been a waste of time
and result in unnecessary costs.
273
SMITH & EMSCHWILLER, supra note 19, at 376.
274
Thus, if one believes that Wall Street analysis leads to dramatically more efficient
markets – a idea I doubt – then these reforms might actually be counter-productive.

55
may simply cut their research budgets. In addition, the new rules do not address
the fundamental bias of brokerages in favor of buy recommendations that boost
transaction volume. For this reason, it would be naïve to think that these reforms
will bring biased analysis to an end. 275 The only way Wall Street will abandon
biased research is if the investing public comes to distrust its recommendations so
strongly that research fails to move the equity markets at all. This outcome is
unlikely.276
Finally, Congress has dramatically increased the resources of the SEC.
The SEC, in turn, has decided to devote some of its resources to providing more
careful review of the 10-K filings of the Fortune 500 companies.277 Obviously,
both of these changes are long overdue. The SEC's decision to start reading
Fortune 500 filings—announced in December 2001, shortly after Enron filed for
bankruptcy—is a little bit like barring the barn door after the cow has already
escaped. Nevertheless, provision of more resources, and devoting some of those
resources to reviewing the SEC filings of the Fortune 500 corporations, are
necessary and useful steps.278

275
It certainly will not solve the problem entirely. A recent New York Times story
covering an Intel quarterly earnings conference call is instructive. Gretchen Morgenson
reports: "Providing that the more things change, the more they stay the same, Wall Street
analysts have their pompoms out again. Yes, cheerleader analysts are not quite as
prevalent as they were in 2000. But as the Intel earnings conference call last Tuesday
showed, too many analysts still seem to think it is part of their job to high five the
companies they are supposed to be assessing for the benefit of their clients." Morgenson
went on too repeat some of the analyst comments during the call. Dan Niles, Lehman
Brothers: "Another nice quarter, guys!" Eric Gomberg, Thomas Weisel Partners: "Nice
quarter!" Mark Edelstone, Morgan Stanley: "Congratulations on a truly phenomenal
quarter!" Gretchen Morgenson, Fawning Analysts Betray Investors, THE N.Y. TIMES,
October 19, 2003.
276
See Fisch & Sale, supra note 195, at 1048 ("One might predict that the market would
discount for this excessive analyst optimism; however, empirical studies suggest that, at
least in part, the market has failed to do so.").
277
Sarbanes-Oxley § 408(c) requires the SEC to review company's periodic reports at
least once every three years. Over and above this requirement, the SEC has committed to
annual "monitoring" Fortune 500 filings. Monitoring is a process by which the SEC reads
some portion of a filing to determine whether there are issues calling for more detailed
analysis. Program to Monitor Annual Reports of Fortune 500 Companies, SEC NEWS
DIGEST 2001-245, December 21, 2001; SENATE GOVERNMENTAL AFFAIRS REPORT, supra
note 12, at 11–12 and n. 23.
278
In addition to the significant measures discussed above, Sarbanes-Oxley contains
numerous reforms that I believe will make a positive, though probably less significant,
impact on the securities market. For example, Sarbanes-Oxley obligates lawyers to report
material violations of securities law or breaches of fiduciary duty to a company's general
counsel, CEO and Boards of Directors; requires auditing firms to rotate its lead audit
partner at least once every five years (Section 203); requires CEOs and CFOs to certify the
accuracy of financial statements (Sections 302, 906); prohibits certain insider sales of stock
during black-out periods due to the likely existence of inside material information (Section
306); creates certain whistle-blower protections (Sections 806 and 1107).

56
Counter-Productive "Reforms"

Though many of the changes since Enron have been useful, several
measures represent a step in the wrong direction. I will provide two important
examples.
A major goal of Sarbanes-Oxley is to increase auditor independence. To
achieve this, Congress now requires, inter alia, that auditors report directly to
boards of directors' audit committees, and not to management. The goal here is
laudable: decreasing the ability of management to skew audit results. But the
solution invites further disasters. It provides management with a new factual
defense when accused of accounting fraud: they can argue to juries that
supervising the auditors and audit results was the board's job, not management's.
Decreasing management's apparent accountability is, I suggest, a step in the wrong
direction. Second, and more important, we have seen that boards of directors have
neither the time nor inclination to supervise audits closely, and are extraordinarily
poor fraud and deception watchdogs. Indeed, given time constraints, the board
audit committee may not even be able to understand the company's financial
statements, let alone provide careful review of the auditing process.279 Thus,
assigning the board even greater oversight responsibilities without taking any steps
to make boards more effective makes very little sense.
A second major blunder concerns corporate ethics codes.280 As we have
seen, Enron's Board of Directors agreed to waive the company's code of ethics so
that Enron's CFO could participate in the LJM related party transactions, conflict
of interest notwithstanding. In direct response to these events, Section 406 of
Sarbanes-Oxley requires companies to disclose any waivers of their codes of
ethics.281 The theory here is that if Enron had been forced to notify the market that
it had waived its code of ethics, the market might have investigated the LJM
transactions more closely. I am skeptical about this conclusion. As we have seen,
investors, market analysts and regulators were not paying any real attention to the
company's financial statements in the first place, so placing an additional ethics
waiver footnote in those statements would probably not have caused any additional
analyst inquiry. More to the point, neither Section 406 nor its implementing
regulations set forth standards with which company codes of ethics must comply.
In particular, there are no rules governing what types of ethical issues require

279
For a concurring view, opposing providing more responsibilities to audit committees,
see Hearing Before Senate Finance Comm., at 2 (Apr. 18, 2002) (Testimony of Robert C.
Pozen, former Vice Chairman of Fidelity Investments) [hereinafter Pozen Testimony] (the
"typical audit committee of a large corporation is hard pressed to understand and monitor
the auditing of the company's financial statements.")
280
My analysis here is indebted to the first-rate analysis in Notes, The Good, the Bad, and
their Corporate Codes of Ethics: Enron, Sarbanes-Oxley, and the Problems with
Legislating Good Behavior, 116 HARV. L. REV. 2123 (2003).
281
Sarbanes-Oxley § 406.

57
waivers, and what types do not.282 As a result, one suspects that any corporate
lawyers worth their salt will advise clients to write and promulgate ethics codes
that require very few waivers, or none at all. As a result, this provision may
actually lower corporation ethical standards and decrease board oversight of
corporation ethics, a perverse consequence Congress could not possibly have
intended.

Are the Reforms Implemented to Date Adequate?

The reforms noted above have addressed several major problems evident
in the Enron debacle. Boosting criminal penalties is long overdue. Eliminating
most auditor consulting fees should have a positive impact on auditor
independence. Also, steps taken in Sarbanes-Oxley and through the Spitzer
settlement to decrease analyst conflicts of interest seem useful, though the jury is
out on whether this will truly improve the quality of Wall Street analysis. That
said, I think the reform measures implemented since the Enron collapse do not
adequately address a number of major concerns I have after working on the Enron
case.
First, Sarbanes-Oxley assumes that throwing more money at the SEC will
make the SEC an effective regulatory body. I disagree. I support providing the
SEC with more resources, but the SEC will never adequately police the securities
market unless it radically changes its culture and practices as well. As we saw in
the Enron case, the SEC had sufficient resources to review Fortune 500 filings but
simply failed to do so. The SEC did not need more money to stop Enron, it needed
managers to set better priorities and implement better screening criteria. The
SEC's substandard performance in the Enron case is not an isolated incident. Since
the Enron bankruptcy, regulators have uncovered three major examples of
securities sector misconduct involving fraudulent practices on the floor of the New
York Stock Exchange,283 Wall Street analyst conflicts of interest, and trade timing
abuses in the mutual fund industry.284 In the first case, the SEC began to
investigate only after the fraud was disclosed in the Wall Street Journal.285 In the
second and third cases, the abuses were caught and disclosed by New York
Attorney General Elliot Spitzer, not the SEC. Indeed, at a time when abuses in the
Mutual Fund industry were commonplace, SEC Chairman William Donaldson was

282
Notes, supra note 280, at 2135.
283
See Deborah Solomon & Susanne Craig, Market Discipline: SEC Blasts Big Board
Oversight of 'Specialist' Trading Firms, WALL ST. J. (Nov. 3, 2003) (discussing violations
of exchange rules by specialist firms on NYSE trading floor over three years resulting in
approximately $155 million in losses to investors).
284
See John Hechinger & Tom Lauricella, Sun Life Unit Reaches Pact in Fund Probe,
WALL ST. J. (Jan. 27, 2004); Editorial, Spitzer's Fee, WALL ST. J. (Jan. 5, 2004) (noting that
Spitzer brought mutual fund scandal to light while SEC "snoozed on the job"); Tom
Lauricella et al., Spitzer Gambit May Alter Fund-Fee Debate, WALL ST. J. (Dec. 11, 2003)
(same).
285
Solomon and Craig, supra note 283, at __.

58
opposing stricter mutual fund oversight.286 Interestingly, Spitzer's securities fraud
staff in New York has approximately fifteen people.287 How, one wonders, can a
staff of fifteen out-think and out-muscle the entire SEC? The answer, of course, is
that the New York AG sets priorities carefully, follows good leads, and is not
afraid to challenge Wall Street on Wall Street's home turf. The SEC, in contrast,
appears to have little sense of what is happening in the market, frequently fails to
identify and stop problems before they explode, and is reluctant to challenge the
major Wall Street firms, even when their practices are clearly unethical.288
The SEC's problems are not limited to its inability to proactively uncover
fraud. The Commission also suffers from bureaucratic complacency. I will
provide two examples. How long did it take the SEC to review Enron's 1997 10-K
form once it was filed? Answer: almost a year.289 What happened when Congress
provided the SEC with increased resources in 2003? Answer: the SEC returned
$130 million of the increase to the Treasury.290 If we want a well-policed
securities market, the SEC must change its ways.
Second, the basic cause of the Enron debacle was the company's provision
of inaccurate and misleading financial information to the securities market.
Sarbanes-Oxley seeks to combat this problem indirectly by enhancing auditor
independence, increasing criminal punishments for intentional fraud, and by
boosting SEC resources. This effort to address the problem of information
accuracy indirectly is odd, since we could have attacked the issue directly. What
we want, in the end, is not just to marginally increase deterrence of intentional
fraud or marginally enhance auditor independence, but to improve as much as
possible the accuracy and usefulness of the information management provides to
the market. This could be done very efficiently and directly by placing an
enforceable legal duty on corporation managers to be careful when they talk about
their companies to analysts or file financial statements. Currently, senior corporate
executives can be sued for securities fraud civilly only if they commit fraud with
scienter: knowingly or recklessly, with a conscious disregard of the risk of
inaccuracy. Similarly, executives cannot be prosecuted criminally unless they
make false statements to the market knowingly and intentionally. If we are really

286
Deborah Solomon, Moving the Market: Fund Industry Faces Overhaul of Rules, WALL
ST. J. (Feb. 4, 2004).
287
Monica Langley, The Enforcer: As his Ambitions Expand, Spitzer Draws More
Controversy, WALL ST. J., December 11, 2003.
288
For a concurring assessment of SEC performance, see Choi & Pritchard, supra note
262, at 24–25 (SEC has "inability to assess all market risks and prioritize among them");
Mark Maremont and Deborah Solomon, Missed Chances: Behind SEC Failings: Caution,
Tight Budget, 90s Exuberance, WALL ST. J. (Dec. 24, 2003) (describing poor SEC
performance); Laurie P. Cohen and Kate Kelly, NYSE Turmoil Poses Question: Can Wall
Street Regulate Itself?, WALL ST. J. (Dec. 31, 2003) ("The SEC, for its part, has a poor
record of spotting risks to investors before they worsen").
289
SENATE GOVERNMENTAL AFFAIRS REPORT, supra note 12, at 36.
290
Mark Maremont and Deborah Solomon, Missed Chances: Behind SEC's Failings:
Caution, Tight Budget, '90s Exuberance, WALL ST. J. (Dec. 24, 2003).

59
interested in improving the quality of the information flow to the equity market, we
should use the criminal laws to impose a duty of care on management to take all
reasonable steps to insure their disclosures are accurate.
Finally, Arthur Andersen's conduct in the Enron case strongly suggests
that increasing deterrence of auditing misconduct and fraud should be a priority.
Sarbanes-Oxley, however, did not ease criminal prosecution of auditors in any
way, and it did not reverse the Supreme Court's 1995 decision prohibiting civil
aiding and abetting suits against auditors who assist management commit fraud.291
Instead, Congress decided to rely on the newly formed PCAOB, restriction of
auditor consulting fees, and the enhancement of responsibilities of board audit
committees to deter auditor misconduct. This reliance is misguided.
Though I support the creation of the PCAOB, I have little faith that the
PCAOB will do much to deter fraud and misconduct. The board is likely to have
only three hundred employees to review the work of tens of thousands of auditors
and thousands of publicly audited companies. What reason do we have to believe
that this review will be any more effective than the haphazard oversight provided
generally in the securities market by the PCAOB's parent organization, the SEC?
Indeed, the enormous disparity between board resources and the size of the task
will likely render the PCAOB ineffective as a monitor of auditor fraud and
misconduct.292
In addition, restricting the ability of auditors to provide most consulting
services does not eliminate the basic incentive auditors have to please their clients:
the clients pay their auditing fees. As former SEC Chairman Richard Breeden
testified before Congress,

had Andersen not been performing any consulting

work, its pure audit fee of $25 million per year
would have been more than large enough to create
powerful incentives for the managers at Andersen
to give the client the accounting treatment it
wanted for SPEs. Unlike consulting fees, which
are one time assignments, the audit is generally
viewed as a long term engagement. On average,
audit engagements at Coopers & Lybrand when I
was there lasted nearly twenty years. Thus, the
$25 million audit fee would have a present value
much greater than $25 million in one time
consulting business. Therefore, if firms

291
Morrissey proposes that we roll back the Supreme Court's Central Bank decision and
the PSLRA. Morrissey, supra note 154, at 852–56. This is a reasonable proposition, but
my sense is that we can fight fraud more efficiently through improved government policing
of the market than we can by taking steps to incentivize private enforcement, which might
easily lead to frivolous litigation.
292
For a concurring judgment, see Morrissey, supra note 154, at 838–39.

60
 performed no consulting work whatever, there
would still be issues of the willingness of the
auditors to antagonize a big client determined to
use accounting games to overstate income.293

Thus, simply eliminating most consulting fees will not eliminate the incentive
auditors have to placate their largest clients. Likewise, reliance on boards of
directors to deter or detect auditing fraud in the few days per year they devote to
company business seems extremely naïve, given what we know about board
performance. We need to try something more effective to prevent more Andersen-
style misconduct in the future.

V. Proposed Reforms

As noted above, the latest round of securities regulation reform in 2002

and 2003 failed to address three critical issues: fundamental reform of the SEC;
creation of direct legal incentives to improve the quality of the information
management provides to the market; and effective deterrence of auditor
misconduct. In the pages that follow, I provide concrete proposals to deal with all
three issues, recommending an overhaul the SEC, criminalization of negligent
conduct by corporate executives, and implementation of mandatory auditor
rotation on at least a limited basis. These reforms are necessary if we are to plug
the gaps in our securities regulation regime, protect ordinary investors, and insure
that our equity markets function in a safe and efficient manner.

Reforming the SEC

In the Enron case, the SEC's performance as a fraud and deception

watchdog was totally inadequate. As we have seen, Congress has attributed the
SEC's failure to a lack of resources. Unfortunately, more money will not solve the
SEC's problems unless we also make the Commission more efficient, more
effective, and more diligent. To accomplish this task, I propose an overhaul of the
SEC. This overhaul should include, at very least, improvements in the SEC's
litigation and settlement practices, changes in SEC attorney recruiting, passage of
legislation providing the SEC with the right to hold public hearings, and
improvements in the SEC's ability to proactively investigate and uncover
widespread and systematic securities violations.

293
Breeden Testimony, supra note 59, at 11. Morrissey reaches the same conclusion. "In
many cases," Morrissey writes, "the audit fees themselves would still typically be sufficient
for an auditing firm to compromise its objectivity in order to retain the audit business. In
fact, auditing fees themselves might even be all the more important if fees from other types
of services are reduced or eliminated. Morrissey, supra note 154, at 840. See also Joshua
Ronen, Post-Enron Reform: Financial Statement Insurance, and GAAP Revisited, 8 STAN.
J.L. BUS. & FINAN., 39, 47 (2002) (same).

61
 First, we must reform SEC litigation and settlement practices. The SEC is
currently trial-averse.294 Indeed, the SEC litigation paradigm for a "successful"
case is the "file-and-settle." Under this paradigm, the SEC typically works out a
deal with a malefactor beforehand, and then files and settles the civil complaint on
the same day. The eagerness with which the SEC pursues file-and-settle cases is
profoundly disturbing.295 Wall Street defense lawyers know that the SEC wants to
avoid trial at all cost, and they use this fact as leverage to obtain light settlements.
Moreover, the fact that the case starts and ends on the same day, usually without
any acknowledgement of fault by the malefactor, ensures that the negative
publicity for the company is limited, undercutting the deterrence force of SEC
action. As a result of this approach to litigation, Wall Street firms and other
securities law violators can typically avoid imposition of penalties high enough to
deter misconduct in the future. In short, running afoul of the SEC has become
nothing more than a minor and acceptable cost of doing business for many major
Wall Street players.
To reverse this trend, the SEC needs to push for larger settlements in the
billion dollar range when dealing with major Wall Street institutions, and to show
that it is willing to take cases to trial if defendants will not pay up. This is the only
way to make the SEC a powerful and effective deterrent force in today's securities
marketplace.
As part of this drive to become less trial-averse, the SEC enforcement
division needs to eliminate the investigation-litigation staff divide. Currently, in
many large SEC cases, one group of SEC attorneys and accountants works on a
case through the investigation phase, and then, once a suit is filed, hands the case
over to the litigation staff for trial or settlement. The problem here is twofold.
First, the litigation staff member that receives a newly-filed SEC case for
disposition starts the case with little or no information base about the case. Like
prosecutors in similar situations, they may fear that the cases they inherit possess
hidden traps, legal defenses or charging mistakes that will come back to haunt
them—and embarrass them—if they approach the case confrontationally. In
contrast, their counterparts on the defense side, who typically have been
representing their clients since the SEC opened its inquiry, tend to know their cases

294
See Donald Langevoort, Seeking Sunlight in Sante Fe's Shadow: The SEC's pursuit of
Managerial Accountability, 79 WASH. U. L.Q. 449, 477 (2001) (noting that SEC fears
losing in court, and thus prefers administrative acitons and settlements). Langevoort
attributes this problem to low pay and difficulty in retaining experienced personnel, though
as I state above, the experience of DOJ in this area suggests morale and institutional culture
may have at least as much to do with this outcome as resources.
295
The latest example of this practice was the SEC's hasty and controversial decision to
reach a quick settlement with Putnam Investments, a major target in the mutual fund
scandal. The SEC was in such a rush, it did not even bother to work out a settlement fine
amount, agreeing with Putnam to put determination as to an appropriate penalty, if any, to a
later date. See Deborah Solomon, SEC Chairman Defends Decision to Quickly Settle
Putnam Charges, WALL ST. J. (Nov. 18, 2003); Deborah Solomon & John Hechinger, SEC
Takes Heat for Quick Deal with Putnam, WALL ST. J. (Nov. 17, 2003).

62
backward and forward from day one. Wall Street litigators take advantage of this
disparity in knowledge to obtain better settlements than they could get if they were
up against SEC staff who had lived with their cases for months and were truly
confident, as only an investigator can be, that they know all of a particular case's
strengths and weaknesses in detail. Second, I know from experience that when
prosecutors receive a case for disposition that another prosecutor has investigated
and indicted, they are often less personally invested in the outcome than they
would be if they had spent months, or even years, putting the case together
themselves. Such cases—known to prosecutors as "dumps"—often result in pleas
to lower sentences than could have been obtained had the same prosecutor stayed
with the case from start to finish. Many prosecutorial offices, like my own former
office in the Eastern District of New York, recognize this problem and try, as an
institutional matter, to insure that the same prosecutor is responsible for
investigating, indicting, and disposing of a particular case as often as possible. The
SEC, in contrast, institutionalizes the "dump" mentality problem though its staffing
plan. The SEC needs to eliminate the investigation-litigation division if it is
serious about obtaining adequate penalties from persons and companies who
violate the securities laws. Instead, unified teams of lawyers and accountants
should stick with cases from the moment the inquiry opens to the day the case is
completed.296
We also need to change SEC recruiting practices. Though the SEC has
some excellent lawyers on its staff, the institution as a whole needs to hire more
talented lawyers. In my generation of lawyers—I graduated from law school in
1996—going to work for the SEC is rarely a goal for top graduates of our best law
schools. Apologists for the SEC claim that the SEC has difficulty hiring top job
candidates because the SEC cannot compete with the salaries offered by top law
firms. This explanation rings hollow. U.S. Attorney's Offices throughout the
country pay the same or less than the SEC, yet routinely have their pick of the best
young litigators in their cities. The SEC's inability to recruit and retain top talent is
not due to low salaries, but because the SEC is seen by many as a backwater – a
"timid, poorly managed bureaucracy," as the Wall Street Journal recently put it297 -
- where the chance to pick up real litigation skills and experience is limited.298 To

296
These observations are based on my observations of SEC practices and on my own
experience as a federal prosecutor in the Eastern District of New York, where I spent much
of my time trying large cases indicted by others.
297
Mark Maremont and Deborah Solomon, Missed Chances: Behind SEC's Failings:
Caution, Tight Budget, '90s Exuberance, WALL ST. J. (Dec. 24, 2003).
298
SEC personnel identify low pay as a primary reason for leaving the SEC, but I think
this reflects low morale more than pay. U.S. Attorney's Offices do not have similar
problems retaining experienced staff despite disparities between private and public salaries.
My comments on the SEC may seem unduly harsh, and I know I run the risk of alienating
my friends who work at the SEC. Nevertheless, I think we need to be brutally honest about
the SEC as a first step toward improving the institution. As a prosecutor, I was often
shocked by the incredibly disrespectful manner in which Wall Street defense lawyers spoke

63
improve SEC hiring, the Commission's senior staff need to make a greater effort to
appear personally at law firms and law schools to talk about the SEC's mission and
generate more interest in the Commission among young and prospective lawyers.
The SEC also needs to promise young litigators that if they join the SEC, they will
work on cutting edge cases and take those cases to trial, and then deliver on this
promise. This will provide the incentive to draw top trial lawyers back to the SEC,
as was the case in the past.
We need to pass legislation giving the SEC power to conduct public
hearings to discuss financial statements with corporate executives. Today, a
company like Enron can bury bad news in opaque or deceptive financial statements
and get away with it because Wall Street analysts simply will not ask executives
tough questions about their disclosures. The SEC should be empowered to step
into the breach. When the SEC staff reviews 10-Q and 10-K forms, they should
identify filings that raise as many questions as they answer, either because they are
unclear or because they contain unusual disclosures, such as large-scale related
party transactions, aggressive use of SPEs and off-balance sheet financing, or
waivers of ethical standards. The top executives of these companies should then
be subpoenaed to appear before the Commission and explain their filings. This
would have three positive effects: it would encourage companies to make their
disclosures as straightforward as possible, to avoid the risk of a hearing; it would
give the investing public, through their SEC proxy, access to ask corporate
executives questions that Wall Street analysts have been reluctant to ask; and it
would give the SEC a mechanism to try to understand filed financial statements
short of opening a formal inquiry. If companies have nothing to hide, they should
be eager to come before the SEC and explain what their 10-Qs and 10-Ks actually
mean.
We also need to improve the SEC's ability to proactively investigate and
uncover widespread and systematic securities violations before millions of
investors are harmed, instead of waiting to investigate until the problems have
exploded publicly in the headlines of the Wall Street Journal. As Chairman
Donaldson recently noted, "[f]or too long the Commission has found itself in a
position of reacting to market problems rather than anticipating them."299 In the
three major securities scandals since the Enron collapse, for example, involving
fraudulent practices on the floor of the New York Stock Exchange, Wall Street
analyst conflicts of interest, and trade timing abuses in the mutual fund industry,
the SEC either knew nothing about the problems until they were publicized by
others or, more alarmingly, knew about problems but failed to rectify them. For
example, the SEC received tips about problems in the mutual fund industry but

about SEC efforts to police the securities market. Ignoring this problem rather than
speaking out about it seems irresponsible.
299
Mark Maremont and Deborah Solomon, Missed Chances: Behind SEC's Failings:
Caution, Tight Budget, '90s Exuberance, WALL ST. J. (Dec. 24, 2003).

64
failed to act on those leads.300 In some cases, the SEC's failure to follow up on tips
has led tippers to approach other regulators rather than the SEC because the tippers
feel the SEC will simply ignore their information.301 In contrast, New York
Attorney General Elliot Spitzer, with his securities staff of fifteen, has repeatedly
been able to proactively identify and bring to light major institutional problems in
the securities industry. Spitzer is successful, and the SEC is not, because Spitzer is
able to gather intelligence about market problems in an effective manner and then
prioritize and attack those problems swiftly.
To improve SEC performance in this area, the SEC needs to create an
internal think-tank to watch the securities marketplace and try to identify potential
problems in the industry. The SEC also needs to implement a more sophisticated
method for obtaining and investigating leads it receives from industry
professionals.302 Finally, the SEC needs to link these two processes—market
observation and intelligence gathering—and create a more effective risk
assessment and enforcement prioritization capability.303
We need, in short, to reinvent the SEC for the 21st century. As the number
of regulated companies and filings increases, and as the stakes for the investing
public grow greater, the SEC needs to become smarter, more aggressive, more
efficient, more proactive, and more productive. This will require, above all,
leadership. The Bush Administration has twice chosen advocates of the status quo
to head the SEC. What we really need is an energetic reformer in that position.

300
Deborah Solomon & John Hechinger, SEC Takes Heat for Quick Deal with Putnam,
WALL ST. J. (Nov. 17, 2003) (noting criticism of SEC for failing to act on tip from Putnam
employee about mutual fund trading violations); Mark Maremont and Deborah Solomon,
Missed Chances: Behind SEC's Failings: Caution, Tight Budget, '90s Exuberance, WALL
ST. J. (Dec. 24, 2003).
301
See, e.g., Henny Sender & Gregory Zuckerman, Behind the Mutual Fund Probe: Three
Informants Opened Up, WALL ST. J. (Dec. 9, 2003) (noting one informant decided not to
approach SEC because "she wasn't confident the agency would follow up on her
allegations"); Mark Maremont and Deborah Solomon, Missed Chances: Behind SEC's
Failings: Caution, Tight Budget, '90s Exuberance, WALL ST. J. (Dec. 24, 2003) (tipper
approached Massachusetts state regulators after SEC ignored tip).
302
The SEC might borrow some techniques from the FBI to accomplish this goal. After
the September 11, 2001 attack on the World Trade Center, the FBI and the Joint Terrorism
Task Force created an effective system to gather and process an enormous number of leads
and tips virtually overnight.
303
After Enron, the SEC hired McKinsey and Co. to provide guidance and advice on how
to improve SEC performance. Though the McKinsey study has not been publicly released,
key portions were leaked to the Wall Street Journal. According to the Journal, one critical
finding was that the SEC "lacks the institutional structure and experience needed to
systematically identify risks." SEC is reportedly creating an Office of Risk Assessment to
address this problem. Mark Maremont and Deborah Solomon, Missed Chances: Behind
SEC's Failings: Caution, Tight Budget, '90s Exuberance, WALL ST. J. (Dec. 24, 2003).
The Office of Risk Assessment will not be effective, however, unless it includes tip and
intelligence processing functions in its operations.

65
Changing the institutional culture at the SEC is a big task. We need a great reform
chairman to embrace that task.

Criminalize Negligent Behavior

In addition to reforming the SEC, we need to criminalize negligent

conduct by CEOs, CFOs and other corporate executives who provide false
information to the market.304 Every legal system in the world criminalizes at least
some types of negligent conduct to protect important interests in life, limb and
property.305 The reason for this practice, which dates back to the late Roman
Empire,306 is straightforward: punishing negligent conduct creates incentives for
actors to take reasonable care when they engage in conduct that could cause harm
to others. In the United States, we currently punish a broad range of negligent
conduct through the criminal laws. In California, for example, it is a crime under
state laws, punishable by fines and imprisonment, to negligently enter into
contracts with uncertified asbestos removers,307 negligently miscalculate
commodity prices,308 negligently violate medical privacy laws,309 negligently

304
The scholarly literature regarding use of negligence standards in criminal law is
extensive. The classic analysis of the problem is George P. Fletcher, The Theory of
Criminal Negligence: A Comparative Analysis, 119 U. PA. L. REV. 401 (1971). Fletcher
concludes that negligence is a fair ground to impose criminal sanctions. See Id. at 436.
For the classic statement of the opposite viewpoint, see Jerome Hall's 1963 article
Negligent Behavior Should Be Excluded From Penal Liability, 63 COLUM. L. REV. 632
(1963). For an excellent analysis of Hall's article, arguing that Hall possessed a "simplistic
conception of the relationship between voluntariness and responsibility, and totally misread
Aristotle, on whose work he grounded his analysis, see Kyron Huigens, Virtue and
Criminal Negligence, 1 BUFF. CRIM. L. REV. 431, 440–57 (1998). For important recent
work on this topic, see Kenneth W. Simmons, Dimensions of Negligence in Criminal and
Tort Law, 3 THEORETICAL INQUIRIES L. 293 (2002). Though Fletcher notes that theorists
have long been "uneasy" about criminalizing negligent behavior, see Fletcher at 401,
subjecting persons to penal sanctions for conduct which falls below a reasonable standard
is not a rarity in criminal law. At least nine states, for example, impose criminal liability
on persons who negligently store firearms. See Ann-Marie White, A New Trend in Gun
Control: Criminal Liability for the Negligent Storage of Firearms, 30 HOUS. L. REV. 1389,
1410-13 (1993) (California, Connecticut, Florida, Hawaii, Iowa, Maryland, New Jersey,
Virginia, Wisconsin). Doctors are increasingly subject in many jurisdictions to criminal
prosecution for medical negligence. See James A. Filkins, With No Evil Intent, The
Criminal Prosecution of Physicians for Medical Negligence, 22 J. LEGAL MED. 467 (2001);
Alexander Mccall Smith, Criminal or Merely Human?: The Prosecution of Negligent
Doctors, 12 J. CONTEMP. HEALTH L. & POL'Y 131 (1995). The Model Penal Code includes
"criminal negligence" as one of the four potential mental states giving rise to criminal
liability, though the definition more closely resembles common law gross negligence than
simple negligence in tort law. See MPC § 2.02(d).
305
Fletcher, supra note 304, at 401, 415.
306
Fletcher , supra note 304, at 415.
307
CA Bus & Prof §§ 7118.5, 7118.6
308
CA Bus & Prof § 12024.2.

66
violate the state's public employee merit system for teachers,310 negligently
mishandle voter registration cards,311 negligently mishandle pesticides,312
negligently violate certain adult day care health standards,313 negligently handle
flammable materials,314 negligently start fires,315 negligently conduct medical
experiments without consent,316 negligently violate rice straw burning
regulations,317 negligently pollute the air,318 negligently pollute the water,319
negligently violate worker safety regulations,320 negligently operate steam
boilers,321 negligently discharge a firearm,322 negligently cut trees, shrubs or ferns
without a permit,323 negligently harm an animal on another person's lands while
hunting,324 negligently own or control dangerous dogs,325 negligently make a false
statement while soliciting charitable contributions,326 negligently damage a public
highway or bridge,327 negligently violate forestry or range regulations,328
negligently operate a train resulting in death,329 and negligently discharge
hazardous waste. 330 Negligent conduct, in other words, is widely criminalized in
American law, where violation of standards of reasonable care may result in
serious social harm or injury. To take a more prosaic example, driving a car
negligently is a crime in virtually all American jurisdictions because we recognize
that cars can be dangerous and must be driven responsibly and with reasonable
care.331 Similarly, when executives of publicly held companies provide
information to the equity marketplace, the potential for harm is great, because
inaccurate information may lead investors to lose their retirement savings.

309
CA Civil §§ 56.17, 56.36; CA Hlth and S § 120980; CA Ins §§ 742.407, 799.10,
10123.35.
310
CA Educ §§ 45317, 88136.
311
CA Elec § 18103.
312
CA Food & AG § 12996.
313
CA Hlth and S § 1595.2.
314
CA Hlth and S § 13001.
315
CA Pub Res § 4435.
316
CA Hlth and S § 24176.
317
CA Hlth and S § 41865.
318
CA Hlth and S § 42400.1.
319
CA Water § 13387.
320
CA Labor §§ 2658.1, 6423, 7156.
321
CA Labor § 7770.
322
CA Penal § 246.3.
323
CA Penal § 384a.
324
CA Penal § 384h.
325
CA Penal § 399.5.
326
CA Penal § 532d.
327
CA Penal § 588.
328
CA Pub Res § 4021.
329
CA Pub Util § 7680.
330
CA Water § 13265.
331
For a discussion of negligent driving, see Fletcher, supra note 304, at 415.

67
Accordingly, we need a criminal negligence statute in the securities disclosure
area.
I propose that Congress pass a new federal criminal statute making it a
misdemeanor, punishable by up to one year in jail,332 for any person to negligently
make any untrue statement of material fact about a publicly traded company's
operations, performance, or financial condition, or to negligently omit to state a
material fact necessary in order to make the statements made, in light of the
circumstances under which they were made, not misleading.333 Thus, if an
executive makes a false material statement about her company to analysts, business
journalists, or to the SEC in 10-K or 10-Q filings, without exercising reasonable
care to insure the statement is accurate, she could be prosecuted. My model here is
33 U.S.C. § 1319(c)(1)(A), the criminal negligence provision of the Clean Water
Act (CWA). 334 Section 1319(c)(1)(A) was passed in 1972 because Congress had
determined "that the enforcement of federal law regarding water quality had not
worked."335 Section 1319(c)(1)(A) criminalizes negligent violations of CWA
permits and negligent discharges or spills of pollutants into waters of the United
States. Thus, if companies are negligent in their operations, training, or
supervision of personnel, and this negligence results in impermissible water
pollution, the negligent company and its executives may be held liable
criminally—be fined or sent to prison. Just as persons and companies can and
should be held criminally responsible for negligent discharges of pollution into
American waterways, corporate executives and their companies should be held
criminally responsible for negligently releasing inaccurate information into the
equity market.
This new criminal negligence statute would provide four important social
benefits. First, it would create a direct incentive for company executives to police
their own conduct and insure that the information they release to the market is
accurate. Second, it would provide prosecutors with a badly needed and flexible
tool to pursue securities violators. It would, for example, give prosecutors a lesser
charging vehicle carrying lower penalties than full-blown securities fraud, which
might be useful in securities cases involving minor harm, minimal defendant gain,
or affecting few victims. At the same time, it would allow prosecutors to charge

332
Maximum sentence parameters for multiple violations would be aggregated, so that a
person committing three offenses could serve up to three years.
333
The language here tracks that of Rule 10b-5, so as to avoid creating huge new
interpretive issues.
334
For discussion and analysis of 33 U.S.C. § 1319(c)(1)(A), see Truxton Hare, Reluctant
Soldiers: The Criminal Liability of Corporate Officers for Negligent Violations of the
Clean Water Act, 138 U. PA. L. REV. 935 (1990); Samara Johnson, Is Ordinary Negligence
Enough to be Criminal? Reconciling United States v. Hanousek with the Liability
Limitation Provisions of the Oil Pollution Act of 1990, 12 U.S.F. MAR. L.J. 263 (1999-
2000). Currently, 33 U.S.C. § 1319(c)(1)(A) is the only federal criminal negligence
provision, though Hare notes that federal courts use an involuntary manslaughter charge
which allows conviction for negligent conduct. See Hare at 961.
335
Hare, supra note 334, at 946.

68
defendants in cases where the harm caused by release of false information is
immense, but proof of intent is hard to find. Third, it would eliminate an important
defense to current criminal securities fraud suits: the "I did not know what was
happening" defense. Finally, it would close the gap between public expectations
and legal reality in the area of securities fraud. Over one hundred and forty years
ago, Henry Maine commented that the happiness of a society depends on the
degree to which the gap between social opinion and legal sanction is minimized.336
Today, the public and commentators alike are outraged and calling for Enron CEO
Ken Lay's prosecution because they feel that even if Lay did not know about the
fraud at the company, he was the company's CEO and should have known what
was happening. The public wants him prosecuted, in short, because he was
negligent.337 No such prosecution is possible, of course, because our current
securities fraud regime requires proof that conduct is knowing, intentional or
willful before criminal liability attaches. That would not be the case if my
proposed statute were passed by Congress.338
To understand how useful a negligence statute in the securities area would
be, we need only examine thirty-plus years of experience with § 1319(c)(1)(A), the
criminal negligence provision of the Clean Water Act (CWA). Federal prosecutors
have not abused or misused this important charging provision. In a recent study
analyzing use of the negligence statute from 1987 to 1997, Steven Solow and
Ronald Sarachan found that prosecutors used the negligence provision in only 7%
of Clean Water Act prosecutions.339 Prosecutors appear to have used their
discretion wisely. According to Solow and Sarachan, prosecutors typically employ

336
HENRY MAINE, ANCIENT LAW 15 (1917).
337
In a recent New York Times opinion piece, for example, Fortune writers Bethany
McClean and Peter Elkind write: Lay's "defense can be summarized in a single word:
ignorance. He says he didn’t know about Enron's shaky financial condition. He claims he
didn’t understand the accounting rules that Enron used to keep millions in debt off its
balance sheet. He says he thought the actual businesses were as good as the company was
claiming . . . . Ignorance has often been a legitimate excuse for a corporate executive;
under the law, prosecutors must prove intent. But Mr. Lay was chief executive for all but
six months of its existence before it declared bankruptcy. He was chairman of the board
the entire time. Most of the important figures in the fraud ultimately reported to him. The
actions of people he was responsible for hiring, promoting and overseeing cost many
people many millions of dollars. Shouldn’t he have to face a criminal trial for his role in
Enron's fraud?" Bethany McClean & Peter Elkind, Uneven Justice, N.Y. TIMES (Feb. 4,
2004). A person interviewed in a recent story in the Houston Chronicle had the same
reaction. "But as CEO of a company, it's his responsibility to know. If he didn’t know, he
should have. I feel bad for him, because I truly think he was probably innocent, but
because of this job he should have known." Laura Goldberg, Skilling's indictment turns
focus to Ken Lay, HOUSTON CHRONICLE (Feb. 20, 2004).
338
I do not mean to imply that prosecutors will never be able to charge Lay under statutes
applicable today, a possibility about which I express no opinion.
339
Steven P. Solow & Ronald A. Sarachan, Criminal Negligence Prosecutions Under the
Federal Clean Water Act: A Statistical Analysis and An Evaluation of the Impact of
Hanousek and Hong, 32 Envtl. L. Rep. 11,153, __, October 2002.

69
the statute to prosecute cases involving extraordinary environmental harm and
human injuries, cases of gross negligence, and as a "compromise" disposition
where defendants agree to plead guilty.340 The authors conclude that prosecutors
have "exercised considerable restraint in this area."341
An anecdotal examination of cases brought pursuant 33 U.S.C. §
1319(c)(1)(A) also indicates the potential value of federal misdemeanor statutes.
Prosecutors, for example, have used the statute to prosecute Rockwell International
Corp. for massive water pollution at the Rocky Flats nuclear weapons plant.342
The Justice Department has also used the statute to charge and convict defendants
for negligently dumping large quantities of waste water and pollutants into the
Richmond, Virginia sewer system;343 dumping some twenty-six million gallons of
benzene-polluted water into the Los Angeles sewer system;344 discharging
pollutants into the Cahaba River watershed, which provides the drinking water for
the residents of Birmingham, Alabama;345 dumping thousands of gallons of heating
oil into Alaska's Skagway River;346 and negligently destroying wetlands that serve
as a habitat for several endangered species, including the American bald eagle.347
The obvious value of these prosecutions demonstrates how useful a tool criminal
negligence statutes can be in the hands of responsible prosecutors.
Consider one more infamous case. In 1989, the oil tanker Exxon Valdez
ran aground on Bligh Reef in Prince William Sound, Alaska, resulting in the
discharge of some eleven million gallons of crude oil into an environmentally
sensitive but economically crucial fishery, causing immense economic and
environmental damage.348 Joseph Hazelwood, the captain of the vessel, was an
alcoholic who had apparently been drinking heavily that day.349 Exxon, the ship's
owner, obviously did not intend that Hazelwood would run his tanker aground.
Nevertheless, Exxon had acted negligently, allowing Hazelwood to captain the
supertanker even though the company was aware that he had a drinking
problem.350 If the Clean Water Act criminalized only knowing or intentional acts,
Exxon could not have been prosecuted. Because, however, prosecutors were
armed with § 1319(c)(1)(A), they were able to charge and convict Exxon for
multiple negligent CWA violations. The Enron case is the Exxon Valdez of

340
Solow & Sarachan at __. Prosecutors also frequently tag misdemeanor negligence
charges onto indictments that also charge felony violations of the CWA. See id. at __.
341
Solow & Sarachan at __.
342
See United States v. Rockwell International Corp., 282 F.3d 787 (10th Cir. 2002).
343
See United States v. Hong, 242 F.3d 528 (4th Cir. 2001) (defendant prosecuted for
multiple violations; sentenced to 36 months imprisonment).
344
See United States v. Van Loben Sels, 198 F.3d 1161 (9th Cir. 1999).
345
See Burke v. EPA, 127 F. Supp. 2d. 235 (D.D.C. 2001)(discussing facts of related
criminal prosecution).
346
See United States v. Hanousek, 176 F.3d 1116 (9th Cir. 1999).
347
See United States v. Ellen, 961 F.2d 462 (4th Cir. 1992).
348
In re the Exxon Valdez, __ F. Supp. 2d. __, 2004 WL 170354 (D. Alaska 2004), at __.
349
In re the Exxon Valdez at __.
350
In re the Exxon Valdez at __.

70
securities fraud. It shows the need to have a similar negligence statute in the
securities area.
Release of false information into the equity marketplace is at least as
harmful to the nation as the discharge of pollutants into our waters. The CWA
negligence cases show that if prosecutors are empowered to charge negligence
cases criminally, they will do so carefully, sparingly, and responsibly. Immunizing
corporate executives from prosecution for negligent conduct makes no sense. This
loophole ought to be eliminated.

Implement Mandatory Auditor Rotation

Finally, we need to find some way to insure that auditors place the interest
of investors in accurate information before the interest of management in apparent
positive financial results. Though Americans have short memories, deceptive
accounting was not invented by Enron and WorldCom: we experienced a similar
wave of major bankruptcies without prior warnings from independent auditors in
the 1970s.351 We failed to do anything significant then to deter and disclose poor
auditing, and we have done little to address the problem now. Eliminating auditor
consulting fees and creating an oversight board are steps in the right direction, but
I think these measures are insufficient. After Sarbanes-Oxley, auditing firms are
still subject to pressure from corporations to audit "lightly" because auditors will
still fear termination of their auditing engagements. Moreover, auditing firms are
still allowed to provide tax consulting services, giving corporations an additional
stick to encourage "cooperative" auditing.
For these reasons, we need to implement a mandatory auditing rotation
scheme. Under mandatory auditing rotation, publicly held companies would be
required to change auditing firms periodically. The advantages of a mandatory
rotation scheme are two-fold. First, it would virtually eliminate the stick that
corporations hold over auditing firms. Since, under such a regime, auditing firms
would be prohibited from auditing a company's books after a certain number of
years, management or board threats to terminate the auditing firm's services would
be rendered almost toothless.352 Second, auditors would be placed on notice than
in a few short years, another auditing firm will be looking at their client companies'
books. This would give auditing firms a strong incentive to audit strictly.353 If, for
example, Arthur Andersen had known in 2000 that a competitor firm was going to
be auditing the Enron books in 2002, they may have been much less inclined to
fudge and compromise.354 As John Biggs testified before Congress, "Clearly, had

351
Luppino, Stopping the Enron End-Runs and Other Trick Plays: The Book-Tax
Accounting Conformity Defense, 2003 COLUM. BUS. L. REV. 35, 44. I am indebted to
Luppino's excellent article on the significance of our separate accounting systems for
securities disclosure and tax accounting for this point.
352
For a concurring view, see Biggs Testimony, supra note 137, at 7.
353
For concurring view, see Pozen Testimony, supra note 279, at 2; Biggs Testimony,
supra note 137, at 7–8.
354
For a concurring view, see Biggs Testimony, supra note 137, at 8.

71
Enron been required to rotate its auditors every five to seven years, it is unlikely
that misleading financial reporting would have continued or that the Board's Audit
Committee would have been kept in the dark, as they claim they were. It is also
conceivable that, if they had been confronted by a group of different, non-
compliant auditors, senior management might have hesitated to engage in some of
the financial manipulation they appear to have carried out."355
Mandatory auditor rotation was included in H.R. 3118, one of the primary
legislative precursors to Sarbanes-Oxley, and was endorsed by numerous experts
in House and Senate hearings on securities reform.356 Rotation was opposed
strongly by the Big Four accounting firms,357 however, and was stripped from the
legislation prior to passage. Instead of requiring rotation of firms, Congress called
for a GAO study of auditing firm rotation358 and imposed, in lieu of true auditor
rotation, rotation of firm lead audit partners every five years.359 This provision is
practically meaningless: the problem at Enron, for example, was not the corruption
of Andersen partner David Duncan, but the Andersen's firm culture. Moreover, the
accounting profession already required rotation of lead partners every seven years,
so the incremental value of this reform is slight.360
Congress's reluctance to adopt auditor rotation in 2002 reveals an
important fact: Congress and the SEC are extremely hesitant to impose far-
reaching reforms in the face of strong opposition by auditing firms and Fortune
500 management. This reluctance is, in part, reasonable—a fear of potential
negative unforeseen consequences. To deal with this reluctance, I suggest we
impose limited auditor rotation as a test. The SEC should require every company
entering into an SEC litigation settlement to agree voluntarily to adopt auditor
rotation. Alternatively, we could require corporations registering with the SEC for
the first time to adopt the scheme for a term of years. Either way, imposition of
limited auditor rotation we will provide us with valuable data on costs and benefits
of auditor rotation without imposing the scheme universally on corporate America.

355
Biggs Testimony, supra note 137, at 8.
356
Pozen Testimony, supra note 279 (supporting five to seven year mandatory auditor
rotation period); Testimony of John H. Biggs, President and CEO, TIAA-CREF and former
Government of NASD, before Senate Committee on Banking, Housing and Urban Affairs,
February 27, 2002 (endorsing mandatory auditing rotation and describing his organization's
experiences with voluntary auditor rotation); Testimony of Roman Weill, professor of
accounting at the University of Chicago Graduate School of Business, before the House
Energy and Commerce Committee, February 6, 2002, at 4–5.
357
See, e.g., Hearing Before the Senate Comm. on Banking, Housing and Urban Affairs,
at 2 (Mar. 14, 2002) (Testimony of James E. Copeland, CEO, Deliotte & Touche)
[hereinafter Copeland Testimony] (predicting increased auditing costs and destruction "vast
stores of institutional knowledge" if rotation is imposed); Peter H. Stone, Accounting
Angst, THE NAT’L J. (Mar. 16, 2002) (describing accounting industry lobbying effort and
opposition to mandatory auditing rotation).
358
Sarbanes-Oxley § 207.
359
Sarbanes-Oxley § 203.
360
Copeland Testimony, supra note 357.

72
Conclusion

The Enron case will go down in history as a symbol of an era of immense

Wall Street profits and corporate misdeeds. Though the case will always be
remembered, the drive to reform our securities system that came as a result of
Enron and similar cases has already come and gone. That is a shame, for our
chance to implement badly needed changes to our scheme of securities regulation
appears to have dissipated before the work of reform was completed. Hopefully,
someone – a new SEC Chairman, a dogged reformer in Congress, perhaps the
economic team of a new Administration – will pick up the torch and fight for the
changes we need to prevent more Enrons in the future.

73