Lessons of Enron: How could no one have seen it?

The company had fabricated revenues. Wall Street, which had run the stock price up, was fooled. Thousands of people lost their life savings. Regulators scrambled to pick up the pieces while Congress held hearings to determine what went wrong.

No, it's not Enron. The company in question was Equity Funding, an insurance firm based in Los Angeles that went bust in 1973.

Flameouts have long been a feature of American business. In fact, every few years, a new scandal seems to surface, often with the same ingredients: corporate greed, gullible accountants, high-powered connections, and broke investors.

But the latest such collapse is a particularly spectacular one. The name "Enron" has already become shorthand for "disaster," a symbol of what can go wrong when hubris spreads through an executive suite and financial reports become a skim coat over wide cracks in finances.

If nothing else, Enron's collapse will prompt a hard look at accounting practices, retirement plans, and other key aspects of US capitalism - as well as the enforcement powers of the Securities and Exchange Commission.

"When the seventh-largest corporation crashes and burns, the wreckage is diverse and scatters in many directions," says Robert Reischauer, president of the Urban Institute in Washington.

The degree to which Enron has fallen is summed up by the fact that its stock may now be worth more as a souvenir than as a certificate of ownership. Bob Kerstein, an accountant and financial historian, is offering Enron stock certificates on his collector web site, Scripophily.com, at $100 a pop. Or he was - right now he's sold out.

Thus a firm that once was seen as an economic pioneer is now keeping company with Disney figurines and pillows crocheted with sayings that purport to be witty.

"They will be great collectibles," says Mr. Kerstein of the Enron certificates.

Not that scandal in the financial markets is anything new. In the 1920s, for example, investors bought shares in Grey Goose Airways, which promised to build a plane with wings that flapped.

Even after the Securities and Exchange Commission started patrolling the markets in 1934, fraud-tinged bankruptcies continued. In recent years, large corporate collapses have included that of the Bank for Commerce and Credit International (BCCI), which entangled Washington insiders, and Lincoln Savings Bank, which cast a long shadow over Congress.

Only two years ago, the SEC brought fraud charges against the executives of Cendant Corp. - a corporate bust that costs investors billions.

"History just repeats itself - fraud and greed," says Kerstein.

One of the reasons for the modern-day scandals could be changes on Wall Street itself.

In the past, most brokers made their money on commissions earned from the buying and selling of stock. This led Wall Street firms to employ stock analysts who scrutinized earnings statements looking for clues about the basic business. The analysts issued buy or sell recommendations, which could result in commissions.

Yet commissions have dropped dramatically over the past 20 years, particularly with the advent of discount brokers and online trading companies. As a result many brokers have downsized their research staff.

The role of the analyst has changed, too, says Don Straszheim, a former chief economist at a big securities firm.

"The analyst is much more focused on how can I bring investment banking business to the firm instead of providing valuable investment advice to the institutional investors," says Mr. Straszheim of Straszheim Global Advisers in Westwood, Calif.

This shift was most noticeable during the 1990s when the dot.com boom took off. Recruiters on Wall Street looked for analysts who could attract new business. They got paid $10 million or more. And many of those analysts became deeply committed to the companies they had helped finance.

"We saw growth rates that were completely implausible - growth rates of 50 percent a year for the next 10 years. No one would have believed this stuff," says Mr. Straszheim.

In Enron's case, the analysts who covered the firm may not have fully understood what was going on. "The company was involved in complicated transactions," says Ed Ketz, an associate professor of accounting at Penn State University in State College, Pa. "Even the experts had trouble." As a result, he thinks the analysts started to trust the company instead of maintaining a skeptical attitude.

Even the rating services that graded Enron's growing debt were fooled. On Oct. 16, after Enron announced $2 billion in write-downs, Standard & Poor's affirmed Enron's rating at triple B plus, an investment grade rating. At the time, Standard & Poor's said it expected Enron's balance sheet to bounce back.

Not exactly. By the end of November, S&P lowered the rating to junk bond status and said there was a "distinct possibility" the firm would file for bankruptcy. A ratings agency analyst who had tracked Enron says, "In the end if the company is working hard to obscure things and the audited books aren't any good and things are getting restated, it's hard to say you're going to be able to accurately portray what the true financial condition is if you're not given accurate information."

The Enron collapse has been notable in at least two aspects. The first is that the firm was politically well-wired, the largest single contributor to the Bush for President campaign and a benefactor of some top Democrats. The second is that there seemed to be different rules for Enron executives, who reaped huge financial rewards from sales of company stock, and lower-level workers, who were prevented from unloading similar shares in their personal pension funds.

Congress and the press will surely explore Enron's political connections in the months ahead. As yet, there seems no evidence that anyone in government did anything improper as the firm spiraled downward.

The problems with employee pension funds, however, have already resulted in legislative calls for changes in the rules governing such plans. President Bush has said his administration is interested in examining the issue. "We will take the necessary steps to ensure appropriate protection for the retirement nest eggs of millions of Americans," said Treasury Secretary Paul O'Neill.

Sen. Charles Grassley, ranking member of the Committee on Finance, promises to look into whether companies should be able to restrict participants in a plan from selling a matching contribution received as company stock through an employee stock ownership plan.

The Iowa Republican also says he researching whether employees should be able to sell that stock prior to an arbitrary age set by the company - a common feature of such plans or similar 401(k) plans where company stock is contributed.

Employees should be allowed to sell company-contributed stock after 90 days, says Robert Schuwerk, a law professor at the University of Houston. Legislation has been introduced, too, to mandate diversification of stock in retirement plans.

Accounting reform is receiving similar intense scrutiny in the wake of Enron's collapse.

One charge is that major accounting firms, including Arthur Andersen, the firm that audited Enron, face a conflict of interest between their auditing arms and their consulting business. Firms are accused of using their auditing practice as a means of opening the door at a firm to sell profitable consulting contracts.

Andersen served not only as Enron's regular auditor, certifying its financial statements, but also as its internal auditor. It was paid to make sure Enron had the right systems to keep its books in order and detect fraud and irregularities. It was paid $25 million for the audit, $23 million for consulting services.

Rick Antle, an accounting professor at the Yale School of Management in New Haven, Conn., sees the scandal as a "wake-up call to examine a lot of what we do." He did a study in 2000 for the Big Five accounting firms, including Andersen, which indicated they make 25 cents on every dollar of auditing fees and 17 cents on consulting dollars.

But the consulting business requires less time of managing partners. The amount of profits to Andersen from consulting are "real small" relative to the trouble the firm now faces, he notes.

Another accounting concern is the ability of Enron to count as revenues the total value of the energy contracts it traded, rather than merely the profits or losses on those deals. This enabled it to record revenues of $101 billion in 2000, up from $40 billion in l999. Such growth prompted excitement in the stock market.

An investment bank, dealing in futures or other similar contracts, records as revenues only its profits and losses on trades. A third question was the shift by Enron of various assets and liabilities to semi-independent partnerships it partly owned. This,

the critics say, enabled Enron to keep off its books large amounts of debt. Mr. Antle, after going over the financial statements of Enron, found that the company in footnotes recorded its dealings with these partnerships. "It's not the case that the whole thing was hidden," he says.

Nonetheless, Enron needed to record in its own books only the profit or loss for its share of the partnerships, not the assets and liabilities of these entities. Last year, those partnerships forced Enron to restate its earnings. It disclosed in October it had lost $618 million in the most recent quarter and lopped $1.2 billion off its net worth.

There has been a host of accounting restatements in the past three years that have cost investors billions of dollars in lost equity. These restatements were in part caused by rule changes in the SEC in 1998 that made it tougher for managements to exaggerate earnings.

Still another reform being called for deals with insider trading. At Enron, a big question is whether Kenneth Lay, the company's chief executive, and other top executives knew of the perilous financial status of the firm when they were unloading stock. That's why a letter written last summer by Sherron Watkins, an Enron Global Finance executive, to Mr. Lay warning about its accounting practices has caused a stir in Washington.

Since its 1985 founding, Enron Corp. evolved from gas pipelines into a trading company, pioneering the market for electric-power contracts. But the firm's ever-rising profits relied heavily on unusual accounting methods and little-understood financial deals that kept $500 million in debt off its books.

Then in October, the firm stunned Wall Street with a $638 million third-quarter loss. As its stock value imploded, trading partners shunned Enron. The crisis in confidence plunged the firm into bankruptcy. But deeper causes may emerge from investigations. Enron concedes it overstated profits by more than $580 million since 1997.

Calls are mounting for tighter regulation of accounting practices. Laws governing retirement plans such as 401(k)s also face new scrutiny. The company urged workers to put retirement savings into Enron stock. This fall, workers were told they couldn't sell shares because the 401(k) plan was being switched to a new administrator.

Investors have launched a fraud lawsuit against 29 current and former Enron officials who sold $1.1 billion of their own company shares since 1999.

Seth Stern in Boston contributed to this report.