Enron's ex-role: model of ethics

Perhaps the ultimate irony about Enron Corp. is how it charmed ethical investors, even the pros, for so long.

The Houston-based energy giant not only said the right things, it also invested in solar energy, addressed questionable labor practices at overseas facilities, and supported diversity in the workplace.

Small wonder, then, that it earned a spot on the respected Domini 400 Social Index. Or that last March, the socially minded Calvert Group added the company to its index. Or that just months before the firm filed for bankruptcy in a still-unfolding tale of apparent financial chicanery, the nation's oldest socially responsible fund - Pax World Balanced Fund - still held Enron as its top holding.

How did ethical-investing professionals get tangled up with such an unethical company? That story, plus the lessons those professionals have learned since Enron's downfall, could help socially responsible investors navigate through the minefields of corporate balance sheets to find truly great and good companies.

But first, a caveat. While the gurus of SRI (social-responsibility investing) are wiping egg off their faces, so are many other Wall Street pros. Fraud of the kind alleged at Enron turns out to be very difficult for outsiders to detect.

"Everyone has gone back and done a postmortem on this," says Anita Green, director of social research at Pax World Funds, in Portsmouth, N.H. "It simply wasn't there to see."

That's why many SRI mutual funds are pushing the government for rules that would force more disclosure.

"We learned what everybody has learned," says Julie Gorte, interim director of social research at Calvert, based in Bethesda, Md. "We need a better system of disclosure and transparency. It's really the bedrock of all investing."

Of course, corporate officers who collude to hide transactions aren't going to reveal them, no matter how stringent disclosure rules become, these analysts say.

The trick, then, is to beef up firms' internal oversight. SRI experts point to two areas of special concern: auditors and independent board members.

Even before the Enron scandal broke, Pax World last year adopted a rule of thumb: If an auditor made at least 75 percent of its revenues from consulting with (rather than auditing) a firm, the fund would vote against the auditors at that firm's annual meeting.

At the time, Ms. Green thought the standard too loose. Even so, Pax World wound up voting against the auditors 37 percent of the time. "It's very alarming," she says. With auditors earning such a high percentage of their money from consulting, "how can you possibly be independent?... I think you're going to be looking at us significantly lowering that threshold."

Another problem: the independence of the corporate board. "This whole thing is a wake-up call for the SRI community," says Jay Falk, president of SRI World Group in Brattleboro, Vt., which runs several Web sites on social investing. "Investors don't have a whole lot of say in who is on their board of directors. It doesn't make any difference how many people vote against candidates if they're the only ones running."

At the very least, he says, the board's audit committee should be run by a board member who is truly independent of the company, he says. But assessing that independence can get tricky. Outside directors can have ties to companies that aren't always apparent. "If that information is not available, it's extremely difficult to determine how clean a corporation's governance is," Mr. Falk says.

Another caveat: Just because a company shows up on an SRI index doesn't mean it's a good investment. Typically, a listing means the firm has passed certain criteria - such as no involvement in tobacco - that a particular organization emphasizes, but not always the rigorous financial analysis used in actively managed portfolios.

Sometimes, SRI indexes will list companies with many ethical problems if management is making progress in addressing them. That's why Calvert, which offers more SRI funds than any other US mutual-fund company, added Enron to its social index last March.

"There were lots of concerns with Enron, but we thought, 'here is a company we can engage with,' " says Alya Kayal, senior analyst with Calvert.

Throughout last year, Enron officials showed a willingness to look at problems Calvert raised about the firm's impact on the environment, indigenous communities, and human-rights concerns at its foreign facilities.

Then the scandal broke, and Calvert, which had very little money invested, de-listed Enron in December. Enron also fell from the Domini index. Pax World sold most of its shares of Enron before the company tanked. Originally enamored with the company's move into solar power, its balanced fund had accumulated some 1 million shares - its top holding - before selling most of them in the middle of last year. The reason: Other investments looked more compelling.

That's about the time Jeffrey Schappe, director of research at Citizens Funds, took a fresh look at Enron. But he dismissed the company because its financial statements were too opaque. "If I don't understand them, I throw in the towel," he says.

The problem with screening companies solely by social criteria is that fundamental financial analysis sometimes suggests ethical problems that social screens miss, he says. For example, executive compensation should be linked to a firm's long-term performance. If it looks too lavish, he gets wary.

Such varying approaches by SRI practitioners have led to different stands on other controversial companies. For example, while Citizens Funds has never invested in Wal-Mart, Pax World owned the stock in the early 1990s before divesting in the middle of the decade after witnessing a lack of responsiveness by management.

The Domini 400 index continued to list Wal-Mart until a year ago, when it determined vendors weren't meeting human-rights and labor standards.

On the other hand, Microsoft Corporation remains an SRI darling. "We felt that the antitrust case was more of a legal matter," explains Green of Pax World. "It didn't violate our screens."

"Microsoft's behavior was not shown to harm consumers," adds Mr. Schappe of Citizens Funds, although he continues to monitor its handling of its settlement of the suit with the US Justice Department and nine states.

"There are no perfect companies out there," cautions Mr. Falk. "What you're looking for is companies that are heading in the right direction."