The fallout from the Enron affair is likely to affect every sector of the financial business including, if only peripherally, venture capital. Off-balance sheet financing has not been a paradigm for emerging growth companies, particularly since 1986 when the tax shelter attractions of so-called R&D partnerships were diminished by turning paper losses from those partnerships into passive losses. However, corporate venturing represents a big percentage of the capital available for start up companies. And, most corporate venturing arrangements involve investments which do not have an immediate impact on the investor's income statement or balance sheet. The problem with the Enron scandal, or "firestorm" if you will, is that the media presentation of the case, by and large (and with some prominent recent exceptions) has been over the top. The columnists and reporters have thrown around labels like "massive securities fraud" without much attention given to the underlying facts. And, white hot reporting has created a widely shared conviction that the Enron scandal demands heroic reforms. The system somehow has broken down and it has to be fixed by imposition of drastic new rules, rules which represent dramatic changes from the current regimes.
That can be very troublesome, because of the "throw the baby out with the bath water" possibilities. The transparency of financial disclosures by U.S. public companies may need a lot of improvement. Arthur Levitt started making this point several years ago and he has made it convincingly. However, it is nonetheless true that US GAAP, as administered by the Financial Accounting Standards Board, is the best system in the world in terms of transparency. It certainly has a lot of flaws, as any complex system does, but it "ain't broke" (not entirely, anyway) and, therefore, in my opinion, does not require a complete overhaul, because that overhaul could very well make the cure worse than the disease.
That said, the question I am addressing has to do with what steps the directors of public companies in the U.S. should embark on, pending final resolution of the "scandal," to protect themselves and the company (and its shareholders, of course) against the inevitable torrent of strike suit litigation claiming that the published financial statements have been "Enroned." One of my concerns is that the Enron firestorm is so pervasive, some of the erstwhile watchdogs, particularly the SEC, are targeting corporate directors, and particularly the audit committees, as the parties ultimately responsible. The SEC has just published a lengthy advisory on the contents of the MD&A (management disclosure and analysis) section of the disclosure documents, a non-expertised section (meaning you can't rely on someone else's advice). The Commission is saying, in effect: "It is up the management and the board to make sure that investors understand complex financial disclosures." And, the problem for many boards is that the complexity is not driven by a desire to employ creative accounting but because the company itself is complex. Simplifying financial disclosures, oversimplifying if you will, could be just as, if not more, misleading than letting the disclosure stand as is. Everyone involved seems to be pointing a finger at somebody else and saying, in effect, "That's the group the Congress and plaintiffs' bar should aim at, not us," ... a phenomenon widely known as CYA.
Law firms are just now starting to work on advisories to directors of companies with complex operations, and it will be some time before matters come to rest and useful guides result. Here is my two cents worth of advice for beleaguered and worried board members ... what to do until the doctor comes, so to speak.
I advise my clients (and myself, as a director of a public company), to consider borrowing a methodology from the medical profession ... the second opinion. A principal allegation against the accountants is that they are hopelessly conflicted because they are paid not only as auditors and tax advisors but also as consultants. Eliminating the consulting revenues, however, would not necessarily solve the conflict issue; accountants, like any other service providers, compete fiercely for customers, if only in their auditing and tax advisory roles. If an accounting firm was paid $25 million a year by Enron as auditors and $25 million as a consultant, cutting that $50 million down to $25 million still suggests that the firm had a major incentive to tell the client what it wanted to hear; and, my point (which has not come out very clearly, if at all, in the current give and take in the media) is that much of what auditors do has to do with judgment calls. On the issue of consolidation vel non, for example, accountants have to make judgments which border on the subjective as to whether the quantum of control of the audited entity is so great, and/or the responsibility for the debt (even if it is de facto and not de jure) so powerful, that the two entities should be consolidated. There is literally an SOP a week, I am told, on how to make that judgment; but, in the final analysis it comes down to a question of experience, intuition, and judgment factors which are difficult if not impossible to quantify precisely. As Justice Holmes put it, it comes down to a question of where to draw the line . . . and "where to draw the line is the only question worth arguing about in the law." If the client urgently wants to keep the operations away from its own financial statements, there is obviously pressure on the service provider to agree with the client's judgment. And, the results will differ depending on how the auditing firm reacts to that pressure ... which may be subconscious desire to keep the $25 million in audit fees rather than a conscious decision to 'cook the books,' if you will.
The short of the matter is that, until and unless each decision under GAAP can be precisely quantified, a task which any experienced player will quickly declare is fatuous, judgment calls will enter into the equation. This will be true no matter who the regulatory body is and no matter what power it has. There are proposals in Congress (and this is the "throw the baby out with the bath water" phenomenon) to replace the Big Five with a government agency which would, in fact, perform audits of the 12,500 (+/-) public companies in the U.S.... to federalize the process, in other words. It doesn't take much imagination to figure out how terminally stupid that prospect would be for U.S. business and industry ... and the investment community.
Back to the solution I am using as interim advice ... the second opinion. Assuming the stakes are high enough, the fuzzy areas are broad enough and the questions sufficiently difficult and/or subjective, this is a system bearing similarities to the practice available to UK law firms known as consulting the "Barrister". The Barristers are expert lawyers with offices physically inside the Inns of Court, who are consulted by the UK law firms on close and nice questions of law. The Barristers are independent; they do not solicit business (I believe they are paid a specified, fixed stipend), and their opinions are, therefore, as objective as one can imagine in a subjective world.
Thus, my advice, if the company can afford it, is to ask a second firm of accountants, or an individual accounting expert, to review decisions on close questions arrived at by the company's regularly employed public accountants ... a system roughly akin to certifying specific questions to, say, an appellate court. It is not necessary for the firm or individual offering the second opinion to do any spade work and/or to duplicate the efforts of the current auditor. The facts may be stipulated; the sole issue presented to the consultant is the question of how those facts should be interpreted in light of current accounting conventions. As my partner Jack Auspitz points out, a similar process was enthusiastically received by the court in the case of In re. Software Toolworks. 50 F. 3d 615 (9th Cir. 1995). There, the Court approved the conduct of underwriters who, when confronted with an issue of revenue recognition, not only insisted that the company's regular accountants confirm their treatment of the issue in writing but went on to contact other accountants to verify the revenue recognition treatment of the first accounting firm. As the Court noted, the underwriters did not "blindly rely" on the regular accountants but conducted a reasonable due diligence investigation.
I do not, of course, suggest the strategy is foolproof; there will be subsidiary questions involving the scope of the inquiry, the accuracy of the stipulated facts and other issues which have to be addressed; but, we are accustomed to dealing with such items, in the law more or less routinely. The trick is to get a point of view from an expert who is not employed on an on-going basis by the customer ... in this case, the audit client. In the best case, the expert would be an individual who is not in a position to compete for the audit business and, therefore, is (or should be) indifferent to which way his or her advice cuts ... a Professor of Accounting at a leading business school, for example.
I am currently testing this procedure with a couple of companies in which I am involved and a subsequent Buzz will report the results. If this system works, in my view, it could be a significant improvement over any of the other solutions I see being floated in the Congress and elsewhere ... simpler, cheaper and more reliable. The second opinion business could become a real business, perhaps originating in the academic community amongst professors of accounting. (although the head of Enron's audit committee was, we now learn, an emeritus professor of accounting).
There are, obviously, problems to sort out. What happens when the two experts disagree? From the directors' standpoint, however, accessing a second point of view means the audit committee obtains the protection of the Business Judgment Rule. The board listens to both sides, makes an independent judgment and thus, under existing case law, should be protected whichever way the board comes out, as long as the process is sufficiently diligent. The emphasis in the law today is not how the directors ultimately vote but how they reach their conclusions. A second opinion, it seems to me, should satisfy any responsible court ... and, in the process, persuade the plaintiffs' bar to look elsewhere for the low hanging fruit.
 For example, Jay Goldin's notion, that a company change auditors (like advertising agencies) every six years, is, in my view, bizarre. There should be a requirement that the audit supervisor change up every few years ... which is the practice the leading firms follow anyway, every seven years.