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Investor Advice: Steering Clear of Another Enron

While Congress scrambles to figure out how giant energy trader Enron Corp. could fail without advance warning from auditors, securities analysts or federal regulators, investors are left with a more immediate puzzle: How do I make sure I don’t get burned by another Enron-like implosion?

It’s not an idle question. Enron was just one of a record 143 publicly traded companies that filed for protection under Chapter 11 of the federal bankruptcy code last year, leaving behind a dismal $76 billion trail of debt, according to Moody’s Investors Service. That was up from 119 bankruptcies affecting $30 billion of debt in 2000, and a mere 58 bankruptcies affecting $11.8 billion in debt in 1990. With the economy still slumping, there is, unfortunately, little to suggest that the trend will be reversed any time soon.

The problem, of course, is that no one knows exactly where the next Enron will come from or what form its financial woes will take. After all, there aren’t many hyper-growth Fortune 100 energy-trading companies doing business with off-balance sheet partnerships run by one of their own senior financial executives, which is what Enron did. Nor is it likely that the next fallen corporate icon will exactly replicate the downfall of other prominent companies in recent years.

In such an environment, the only real solution for investors is to avoid situations which overweight the opportunity to be blindsided by corporate fraud, hubris or mismanagement. Investment guru Warren Buffet recognized the wisdom of this course decades ago when he concluded that he wouldn’t invest in any business he didn’t understand. He wound up sitting out the tech-stock boom that closed out the 20^th century, yet still managed to generate fantastic investment returns.

Lynn Turner, director of the Center for Quality Financial Reporting at Colorado State University and, until recently, the chief accountant of the Securities & Exchange Commission, has a similar message for investors. “You need to read those financial statements and footnotes, and if there’s something in there you don’t understand, you need to ask about it,” Turner says.

Of course, it’s always possible to invest in a business you believe you understand without recognizing that you really don’t. Accordingly, Turner warns investors to be wary of the following in a company’s financial statements, SEC filings or press reports:

• Related-party transactions. Enron used related-party transactions between itself and partnerships controlled by its chief financial officer to keep hundreds of millions of dollars in debt off its balance sheet, thereby masking its true financial condition and the risks the company was facing. “Related-party transactions just provide too many opportunities for management to engage in self-dealing, and that won’t work for outside investors,” Turner says.
• Excessive reliance on pro forma financial results. Pro forma financial statements typically exclude many of the charges companies are required to take under generally accepted accounting principles, which can make companies look more profitable than they really are. “If you have a management team putting out pro forma numbers all the time and telling you not to worry about their restructuring charges or one-time write-offs, that would be a real red flag,” Turner says. “It indicates that the management team is not being above-board with you. What they should be telling investors is what happened in the business that brought those charges and write-offs about. Quite often, those charges are indicative of a company that hasn’t kept up with technology or its cost structure, and may not have a management team capable of steering the ship through the rough times.”
• Declining cash flow despite rising sales. “Investors really need to hone in on companies’ cash flow statements,” Turner says. “In my opinion, cash is king. If a company is booking increases in sales and receivables but the amount of cash being generated is declining, it raises serious concerns about whether those are legitimate sales the company is going to collect. It might reflect the company giving extended payment terms to get those sales, which would indicate other underlying problems, or increased levels of vendor financing. Or it could suggest that they’re dealing with a lower class of customers who may not have the wherewithal to pay.” By way of example, Turner cites Motorola Inc., which has taken more than $3 billion in special charges since 1998. At one point, Turner says, the company was not only providing vendor financing to some of its customers but also guaranteeing the debt those companies took on to buy products from Motorola—and then booking revenue on those sales. “These were not very financially strong or stable customers, and when they didn’t make it Motorola had to take a big charge,” Turner says.

Accounting and investing experts cite these additional developments as potential warning signs of a company in distress:

• Poor return on total capital. One New York investment boutique calculated as far back as late 2000 that Enron, despite reporting ever higher profits, was earning only about 6% on its total capital, before interest and taxes, or not much more than much less risky government bonds. That’s not the kind of spread that justifies a high-flying stock price. Analyzing metrics that link a company’s income statement to its balance sheet—such as return on capital or return on equity—can be useful in comparing the company’s performance to those of its peers.
• Insider stock sales. Yes, insiders can have many reasons for selling shares of the companies that employ them. It’s still not something to be ignored. If insiders are making substantial sales at the same time they’re talking up their company’s great prospects, as Enron’s management was, investors should be wary.
• Violating loan covenants. Most banks require that companies meet various financial criteria, such as staying under a specified debt-to-equity ceiling or maintaining a specified credit rating, or risk having their loans called. If a company violates a loan covenant or appears headed in that direction, investors should be cautious. In worst-case scenarios, it could leave a company facing a debt it can’t pay, thereby forcing it into bankruptcy court.

One thing investors shouldn’t do, Turner says, is rely on a company’s outside auditors to alert them to potentially troublesome situations.

“Given the magnitude of the restated financial results we’ve seen in the last half dozen years and the resulting losses to investors, which are now approaching $200 billion, I really don’t think the (auditing) system today is working,” Turner says. “Absent some very significant changes to the regulatory system as it relates to the accounting profession, I think the credibility of the numbers (being reported by public companies) is going to be significantly questioned.”

Turner suggests that Congress set up an independent oversight board for the accounting profession that includes representatives from the investing public and other public interests, including pension boards, banks and other entities that rely on corporate financial statements. That board, he says, should have the authority to oversee the establishment of disciplinary actions against accounting firms that fail in their duties, to investigate accounting firms, and to establish auditing standards—all anathema to an accounting industry that is currently self-regulating and self-policing.

Like many other critics of the current system, Turner adds that auditor independence must be strengthened by prohibiting auditing firms from also doing lucrative consulting work for their clients, or, if they are allowed to do it, by making them subject to joint and several liability when their clients are found guilty of fraud. Under the common law rule of joint and several liability, every defendant in a lawsuit is liable for the entire amount of the plaintiff’s damages, regardless of the defendant’s proportion of fault. The Private Securities Litigation Reform Act of 1995 made it harder for plaintiffs to hold accounting firms to that standard in securities fraud cases.

Turner’s proposals are stronger than those suggested on January 18 by SEC Chairman Harvey Pitt, who has proposed creating a new entity “dominated by public members” that would have disciplinary and quality control power over accounting firms, but not to set auditing standards.

Although it has long been opposed to outside oversight of its industry, the American Institute of Certified Public Accountants pledged days after Enron’s bankruptcy filing to draft new audit standards for detecting and handling fraud and for reviewing quarterly financial statements.

Whatever the outcome of any push to strengthen the nation’s accounting system, it won’t be resolved overnight. Until it is, investors will have to let their investment activities be guided by one overriding principle: caveat emptor.

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