I am submitting testimony to allow the Committee to better understand Wall Street securities analyst attitudes about Enron Corporation (hereafter occasionally ENE, per its former market symbol). Why and how did analysts miss the largest bankruptcy in the history of the nation? If things went bad so fast, why weren't the analysts downgrading the stock? What went wrong on Wall Street? 

In particular, I will briefly discuss: (1) Enron's previous star like status on Wall Street; (2) Gaming the analyst system; and (3) Could this have been prevented by better accounting and financing disclosures? 

Background:

In the interest of our own full disclosure, several points need to be made at the outset.

• I have spent my 35-year career as a Sell side (brokerage house) analyst covering all parts of the energy industry.
• I currently manage a sixteen-analyst Research department for Sanders Morris Harris, the largest securities firm in the Southwest. Prior associations have included Merrill Lynch, Goldman Sachs, First Boston, Drexel Burnham, and Smith Barney. 
• I had not recommended Enron as a Strong Buy for well over the past ten years. What looked so good on Wall Street did not look so good to us back in Houston. This did not sit particularly well with former ENE top management.
• However, once the stock collapsed from $90.25 to $27.25 by late September 2001, I did recommend the stock as a Strong Buy and as a rebound story, for all of about five weeks. I did not have a clue about the enormity of the internal financial/accounting abuses at hand. Disaster struck.
• ENE shares rose ten points to $37.00 into mid-October, before tumbling twenty points in the aftermath of the third quarter earnings call (October 16) and the wholly unexpected media disclosures about the partnerships. So much for our analytical foresight.

In regard to today's presentation, I have covered Enron since before it was Enron. I have long known many of the principals in the company, and more of its alumni. I would like to point out that there were (and are still) many very fine people at Enron. They relied on the natural presumption that all of ENE's workings had been approved by the Board, outside auditors and outside counsel. They have paid a very heavy price for the alleged misdeeds of a very few. 

The Rise and Fall:

Like so many investing debacles, the moral of the Enron story is that it didn't need to happen. There were no acts of God, War or Nature. This was entirely man-made. It reflected a complete and utter run on the stock and bond markets, the credit ratings; and finally the counter parties (trading clients). Three attempts by Dynegy Inc. to work a merger failed, mostly because the Enron stock sank to the penny level. It took Long Term Capital Management five weeks to fail; ENE took a little longer, six weeks. 

This brought to a terrible end one of the most popular and profitable stocks of the 1990s. Enron did not merely have a good 90's: it had a great 90's:

• ENE delivered 27% average annual total returns (capital appreciation plus dividend yield) over the decade versus 21% for the stock market as a whole (S&P 500).
• In the 1995-2000 crescendo phase of the bull market, ENE delivered 40% average annual total returns versus the market's 18%.

It is axiomatic on Wall Street that if a stock price is rising arithmetically, management egos tend to rise exponentially. Such appears to have been the case at Enron. Some of this is normally expected by analysts: indeed, some of it was deserved.

But in ENE's case, a different mentality emerged. Call it overconfidence, arrogance or whatever; ENE's trading and adrenalin-driven culture began to sound dangerously invincible in 1997 and after. The adrenalin was boosted by an exceptionally aggressive agenda to expand on four or five fronts at once. This left little room for failure. The Company particularly sought to manage its "externalities" by proactively shaping the debates in both operating and financial arenas. Worse, its rhetoric seemed to rise much faster than its business realities.

 All of the attempted diversifications proved to be fiascoes. By 2000, Enron ended up with $10-$15 billion (about one-third) of its real asset base mostly dead in the water. Around the same time, the Company began to aggressively mutate its assets into the partnerships (or Special Purpose Vehicles: SPVs): and it dove head first into all kinds of derivatives. The latter jumped from $4 billion to nearly $23 billion in only two years' time.  

Gaming The Analyst System:

The rapid market disintegration of Enron from October 16^th through December 2^nd is familiar to most observers, and I will not dwell on it.

What is more germane for today's discussion is the gamesmanship displayed by Enron on its public fronts? Make no mistake about it: Enron was very, very good at gaming the system.

• It obviously gamed Wall Street very well.

• It apparently gamed its auditors, and

•  It presumably gamed its lawyers.

Unfortunately, in what appears to have been an rogue/financing/accounting operation, some insiders may have gamed Enron.

Given its trading culture, Enron became increasingly combative, both externally and internally. The Company appeared to commit far more funds and people to its investor and media relations teams than its competitors. This also was the case for its lobbyists.

Insofar as analysts were concerned, ENE's investor relations effort was especially proficient and, I might add, highly professional. It did not attempt to strong-arm me for having a neutral viewpoint; nor did it ever shut me out of the dialogue, such as it was.

• It controlled and massaged the information flow to analysts. Its own oversight was close, and seemed to come from the highest levels of management.
• Over the 1995-2001 years alone, ENE's asset base grew from $12 billion to $65 billion. In the process, its businesses became very dynamic and terribly complicated
• Because of both financial and accounting complexities, ENE was able to better stage manage the analyst dialogue.
• ENE became a nearly impossible company to model. There were a tremendous number of moving parts. Analysts increasingly had to rely on company guidance to make the numbers work. This turned out to be very dangerous.

Most analysts understandably were guided towards all the high profile aspects of Enron: and away from its darker sides. Indeed, if you listened to top management, there were no dark sides, accounting issues, or even off balance sheet financings. Analysts of my generation were trained to be fair and agnostic. ENE's top management was not remotely interested in objectivity. You were either for them or against them. Some purely anecdotal evidence.

• In one telephone call several years ago, the then CEO told me quite succinctly: "we are for our friends," and proceeded to itemize the monthly history of my own "unfriendly" Enron ratings over the prior two years.
• Enron had a considerable investment banking agenda every year, and attracted bankers like roaches to honey. The common unspoken, unwritten understanding came back thus: ENE would be happy to do banking business, provided the analyst had a strong buy recommendation on the stock.

It is not my intention to beat on other analysts covering Enron. I am in no position to cast any stones. Indeed, some were true believers, others perhaps were more opportunistic. They were probably no better or worse than the rest of the analyst pack. 

But if this Committee wonders aloud why, oh why, there was such an embarrassment of Buy recommendations on this Company; they need not look farther than the interface between investment banking and research. In recent years, investment banking held all the marbles on Wall Street. There were bankers who were installed as Research directors, and the bankers had a significant say in yearend analyst bonuses. In the words of one Salomon/ Smith Barney analyst/banker quoted last year in the New York Times: "What used to be perceived as a conflict is now regarded as a synergy." In the context of the biggest bull market in history, followed by the worst bear market (in dollar terms), these words may have especial resonance for Enron shareholders. Why didn't analysts change their ratings from $90 to $80 all the way down to zero in some cases? It made no sense not to. These people are not dumb. But perhaps they still felt sufficiently intimidated by the bankers to remain frozen in their tracks. This analyst jumped into the fray when the stock had fallen 70% from its highs: but this analyst didn't have any bankers seeking to influence the recommendation. No excuses. We took our own licking in the $9--$13 area.

 

Woulda, Coulda, Shoulda:

There has been a great deal of finger pointing and blame spread all over the investing community about the Enron meltdown. The obvious question is why didn't Wall Street analysts discover the huge activity in Enron's partnerships? The answer is simple. They weren't disclosed.

• There was either a minimum of disclosures or else a disconnect in the footnotes.
• No one understood how these deals were actually financed or what kinds of assets were in them.
• Most analysts thought that ENE's "unconsolidated equity affiliates" were conventional asset and liability structures. Special purpose vehicles (SPVs) are nowhere defined or mentioned.
• Enron claimed confidentiality as to the nature of the LJM and other partnerships, saying it was unable to disclose any details. Again, analysts had no idea of the LJM assets, nor of how much they had been mutated.
• There was no mention of doing speculative derivative trading or mark to market accounting in them. How much was real; how much was paper?
• No one could recognize the large degree of "fair value" accounting adjustments that were being made to manage the earnings up to the parent company.

 

After reviewing the Powers report, the Watkins memo to Ken Lay, and the restated 8K and 10Q data of last November, it is my personal opinion that analysts were looking at only one of three sets of Enron books: (1) the public filings; (2) the SPVs: and (3) the derivatives book. All of us were trained on accrual accounting. Marks to Market and fair value accounting appeared to have been taken to extremes by Enron. 

Indeed, if I had been aware of these extremes being created in the SPVs by all of the transactions, I (or any analyst) would never have moved to a Strong Buy about two weeks before ENE blew up. 

Recommendations:

From a securities analyst point of view, there are some very pragmatic fixes that need to be made in the marketplace. These are itemized in the following points: 

On Wall Street:

Undertake a thorough review to minimize or remove Investment Banking influences/ pressures/ and personnel from Securities Research.

• This has been one of the biggest problems in the capital markets. The integrity of the business has been badly compromised in recent years.
• In my opinion, Investment Banking has gamed Research, solely to their advantage. Investors do not need analysts who simply make Strong Buy recommendations. Robots can do that.
• Terrible IPOs have been done, which essentially compromised the system with bad deals coupled with favorable research recommendations. Azurix and New Power Company were cases in point  

 From Accounting:

Recapitalize Special Purpose Vehicles.

• Their usage has been so extreme in the Enron debacle that their future utility has become minimal.
• A 97-3 debt-equity capital structure will not pass any laugh test in today's equity markets.
• For the past ten years, Corporate America has run about 50-50 total debt-equity capital structures. Why should equity investors get blitzed with off-balance sheet deals, which can either, be gamed, or which can backfire badly through abuse.
• Something like 70-30 capital structures for SPVs would be more reasonable.

Eliminate or cap Mark-to-Market accounting for energy trading contracts.

• The actual or potential abuse of longer-term deal valuations via M-t-M has all but destroyed the credibility behind this system. No one on Wall Street seriously believes in "paper earnings" any more after the Enron experience.
• There are few (if any) true long-term contracts in the energy arena any more. Tolling agreements, yes, but these usually have plenty of loopholes. The use of  "Mark-to-Model" accounting for these contracts has lost all credibility on Wall Street as well.

Fair Value accounting similarly has become seriously debased. Its usage should be severely restricted.

• The JEDI and Whitewing partnerships were largely accounted for on a fair value basis. Who knows how many other SPVs were used to create artificial earnings or bury more dead assets?

Disclosures and Footnotes have again proved to be insufficient. This minimalist policy must change; otherwise the credibility of the entire accounting framework will be debased even further.

• The Enron experience literally demands full disclosure of all SPVs, and not in a rolled up or summary form. Analysts and investors were blindsided by ENE's very clever accounting cosmetics. This can happen again.
• The financial reporting discussions, or footnotes, need to highlight all unusual items, and not bury them a la Enron.

We are mindful of the adage that Hard Cases Make Bad Law. Enron may have turned out to be the hardest case in the history of the republic. The fixes we are recommending above can only serve to mend the corporate and investor damage done. They are not draconian; and they reflect the investing temperament of our times.