Reforms no guarantee against fraud

Collapse of Enron has money managers on uncertain footing

March 10, 2002|By Eileen Ambrose | Eileen Ambrose,SUN STAFF

In the wake of Enron Corp.'s collapse, local money managers say reforms are needed, ranging from fuller disclosure by companies to greater independence of auditors and analysts who recommend stocks.

But even then, some say, reforms can't guarantee that companies won't mislead investors.

"If they want to break the rules, they will break the rules," said Donald J. Hoelting, a principal with Investment Counselors of Maryland in Baltimore.

The Securities and Exchange Commission held a round table last week with investment professionals and others on how to improve financial disclosure and auditor oversight as a result of Enron's implosion.

Since Enron filed the nation's largest bankruptcy in December, other companies with complicated finances have found their accounting practices questioned, sometimes justifiably and sometimes unfairly, local managers said.

And Enron's fall, on the heels of the dot-com bubble burst and the Sept. 11 attacks, has jolted not only small investors but also professional money managers.

"Our confidence has been shaken. It's hard to protect yourself against fraud. Whether fraud actually occurred remains to be seen," said Christopher Frink, a portfolio manager with Mercantile Capital Advisors in Baltimore. "The market reaction has been slightly overdone, but it does make it tough to invest in stock when there's a black cloud hanging over a lot of the numbers you research."

"I'm going to be more cautious," said Doug Ober, chief executive officer of Adams Express Co. and Petroleum & Resources Corp., closed-end funds in Baltimore that invested in Enron. "I am less willing to take a chance on a company that I don't understand pretty well or that my analyst doesn't understand pretty well."

Enron's troubles continue to be felt in the market, some said.

"It will stretch out the recovery in the market," said James Hardesty, president of Hardesty Capital Management in Baltimore. "The Enron situation is disturbing in that there clearly has been a series of major accounting failures. And to the extent these failures expand beyond Enron, the confidence of the investor will be further eroded."

Some suggested reforms will help restore investor confidence.

"Once the reforms that are sorely needed are clarified and put in place, confidence will be restored very quickly," said Ed Brown, president of Brown Capital Management in Baltimore.

Many local investment professionals said fuller disclosure is essential.

Bill Stromberg, director of equity research at T. Rowe Price Associates in Baltimore, said he favors better disclosure of off-balance sheet businesses and transactions, including those involving insiders. Enron, for instance, hid millions of dollars of debt through partnerships not on the books.

Mercantile's Frink wants more stringent rules on how revenue and expenses are recognized, so that companies match revenue with the costs incurred to generate those sales. Some companies recognize revenue immediately but string out expenses for years, making their bottom line fatter in the near term, he said.

John P. Hussman, a portfolio manager of the Hussman Strategic Growth Fund in Ellicott City, said the Financial Accounting Standards Board, which sets accounting rules, should require companies to begin earnings reports with the bottom line - net income.

Sometimes net income is buried in the report, he said, while companies trumpet operating earnings, which exclude one-time charges, taxes and debt service. Or they tout pro forma figures - what earnings would have been under certain assumptions - which might not, in fact, be true, he said.

"They use whatever number best suits them," Hussman said. "There is really a great lack of uniformity in corporate reporting. That makes our job much harder as investment managers."

Reporting of stock options also isn't uniform, said Eric Leo, chief investment officer of Allied Investment Advisors in Baltimore. He supports more information on executives' options, such as how companies are accounting for their cost.

Ober said he would like to see more aggressive criminal prosecution of company managers who mislead the public.

Auditors have come under fire in the post-Enron era. Critics say auditors are less likely to challenge management if the company is paying millions of dollars in consulting fees to the accounting firm. A little more than half of the $52 million Arthur Andersen earned from Enron in 2000 was for consulting. "If you have a consulting and auditing contract, there is a shift of power from the auditor to the company," said David Citron, managing director of Carret & Co. in Towson.

Some suggest that accounting firms provide auditing or consulting services for a client, but not both at the same time, or that accounting firms build a stronger firewall between their departments handling those two functions.

As an added check, a company's own audit committee, which reviews audit reports and procedures, needs to do a more thorough job and ask more questions, Brown said.

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