Scholar argues that regulatory action should reflect underlying causes of corporate fraud.
Enron.
This one name alone conjures up images of fraudsters in back rooms drawing up illegal schemes for profit.
But what if one of the biggest frauds in history was not as serious or harmful as some critics claim? And what if the regulatory response to Enron—which President Bush lauded as one of the most “sweeping” reforms of American business practices “since Franklin Roosevelt”—was little more than an overreaction that could stifle innovation?
In a recent article, Steven L. Schwarcz of the Duke University School of Law argues that the regulatory response to the Enron scandal—specifically, the passing of the Sarbanes-Oxley Act (SOX)— responded to the “posterchild of corporate fraud” dramatically but, ultimately, ineffectively.
Schwarcz argues that SOX ultimately failed to regulate corporate fraud. He asserts that executives at corporations across the nation could behave similarly to the executives at Enron, yet not necessarily commit fraud under SOX as it stands today.
Schwarcz points out that although SOX was drafted specifically to address the fraud committed in the Enron case, it failed to address the cognitive biases that can influence decision-making and lead to fraud. Nor does SOX demonstrate how corporations should handle the kind of complicated disclosures that misled Enron investors, contends Schwarcz.
He discusses the shortcomings of SOX by first detailing the Enron scandal itself and why it might not have been as serious an event as public outcry suggested following its wake. Enron’s executives transformed the company, founded in 1985, from a “stodgy natural gas pipeline company” into a sophisticated trader of energy contracts and other complex financial instruments, according to Schwarcz. The company’s success continued throughout the 1990s, when Enron was named as “the most innovative company in corporate America” for six years in a row.
The 2000 economic downturn, however, negatively impacted the underlying value of many of Enron’s assets. To continue its financial trading business, Enron executives needed to protect the company’s investment grade status, or they would risk huge financial losses that could lead to default, Schwarcz explains. A company in this position would typically sell underlying assets to offset any losses, but a series of lock-up agreements prevented Enron executives from selling these assets in time.
With limited choices to save the company, Enron’s executives “found a creative alternative,” Schwarcz claims. Upon approval from external auditors, Enron executives shifted accounting methods so that projected gains were reported on Enron’s current balance sheets, while losses were moved to books of Enron subsidiaries or third-party special purpose entities. The shift in accounting methodology and the off-balance-sheet transaction disclosures are two parts of the fraudulent conduct that landed some Enron executives in jail.
Schwarcz argues that the accounting change demonstrated a judgment failure of “optimism bias,” rather than intentional fraud. He contends that Enron collapsed because its executives did not consider the possibility that a drop in asset value might also coincide with a drop in Enron’s stock price altogether.
In addition, Schwarcz argues that the executives’ decisions did not render them fraudsters outright, but rather that these decisions showed how cognitive bias—an unconscious tendency to select certain information that often results in flawed reasoning—can corrupt decision making. Just as the Enron executives had their own cognitive biases, Schwarcz suggests that other cognitive biases led both regulators and the general public to attribute Enron’s failure to active wrongdoing when looking back on the incident.
Yet on the issue of combating cognitive bias, SOX remains silent, Schwarcz notes. Although Schwarcz does not directly offer reforms to SOX that would consider cognitive biases, he points to other scholarship, which proposes solutions for corporations to check their biases, manage potential risks in their operations, and disclose specific information on such risks.
Schwarcz asserts that, although Enron executives disclosed the off-balance-sheet transactions to investors, the transactions were so complicated that Enron’s efforts to disclose them misled investors anyway. The disclosures were either oversimplified or written in complex terms such that Enron’s investors could not fully appreciate the financial risk involved.
And although SOX imposed more stringent disclosure requirements, Schwarcz notes that SOX did not address overly complex disclosures. This issue exemplifies the real shortcoming of SOX as a response to Enron, Schwarcz contends.
To combat the still-ongoing issue of complex, potentially misleading disclosures, Schwarcz details several paths to reform, including amending SOX and creating new regulation.
One possible solution Schwarcz endorses is standardizing off-balance-sheet transactions. Some critics of the approach might claim that too much standardization could hinder financial innovation, but Schwarcz asserts that carefully curated standardization could mitigate this harm and promote innovation.
Schwarcz, in part, defends Enron’s executives, noting that corporate managers must often take risks to save their businesses. As he notes, some risks will not pay off and businesses do fail. But Schwarcz cautions against attributing all business failure to malfeasance or fraud. Instead, he encourages regulators and public commentors to resist overreacting and inhibiting innovation.
Schwarcz concludes by emphasizing that financial innovation supports competition in a global economy and should be promoted, “even at the risk of another Enron.”
