4.1 civil proceedings and damages awards
While the criminal prosecution cases attracted most worldwide public attention, a blizzard of private litigation was launched against firms, managers, board members, audit firms, insurance companies, and any parties alleged to have been complicit in financial reporting malpractices. Civil litigation is prosecuted by private litigants who allege they were harmed by the actions of others. Litigants included stockholders, creditors, bondholders, employees, labor unions, and pension plans. Defendants found guilty in securities cases are punished by the courts awarding monetary compensation to the litigants for the damages they have incurred as a consequence of the harmful actions. Unlike criminal proceedings, civil litigation is a private, market process of enforcing explicit and implicit contracts among firms, managers, auditors, creditors, shareholders, and other contracting parties.26
The press attention given to the criminal trials makes it easy to overlook the scale of the market-based penalties that have been meted out. Total damages settlements in securities litigation over 2000 to 2007 exceeded $50 billion (Simmons and Ryan ). In the Enron case alone, extensive private litigation against banks alleged to have been complicit in just some aspects of Enron's financial misreporting has been settled for a total of approximately $9 billion (for comparison, Enron's total assets peaked at approximately $70 billion). WorldCom settlements exceeded $6 billion, and Cendant settlements exceeded $3 billion. Some litigation arising from the 2001 to 2002 scandals is still ongoing.
4.2 reputation, bonding, and insurance effects: who killed arthur andersen?
Reputation effects have long been viewed as a powerful market mechanism, imposing penalties on parties found to have acted inappropriately (for example, Telser  and Kreps and Wilson ). Karpoff and Lott  document substantial reputational costs to firms committing fraud generally. In the audit industry, the audit firm's reputation for independent, professional work is central to performing its economic role of verifying financial statements for use by uninformed outsiders (see Jensen and Meckling , Watts , and Watts and Zimmerman [1983, 1986]). DeAngelo  argues that large audit firms, like Arthur Andersen before its demise, earn substantial quasi-rents, which they stand to lose if they perform poor-quality work. Research has shown that audit firm reputation is associated with audit fee premiums (Simunic , Francis , Francis and Simon , Palmrose , Craswell, Francis, and Taylor ) and with the market valuation of their clients (Kellogg , Beatty ). Palmrose [1986, 1987] links litigation risk to audit quality. Events that could reduce auditors' reputations, such as regulatory action or private litigation against them, are associated with stock price reductions for clients (Loebbecke, Eining, and Willingham , Firth , Moreland , Franz, Crawford, and Johnson ), with loss of clients (Firth , Wilson and Grimlund ), and with reductions in audit fees (Davis and Simon ).
By the time it ceased business as an auditor, Andersen's reputation for quality, independent auditing was in tatters due to a series of deficient audits. These included its audits of Enron, Sunbeam, Waste Management, and WorldCom, which garnered international attention. But there were lower-profile transgressions, including its audit of the Baptist Foundation of Arizona, which became the largest bankruptcy of a religious nonprofit in U.S. history. Further, there was evidence (discussed below) that Andersen's responsibility for deficient audits was not due to isolated rogue engagement partners, but was systemic and reached the top of the company. Based on prior research on the economic role of auditor reputation, one could expect that by the time Andersen's clients digested the implications of its deficient audits and had been able to negotiate a replacement auditor, reputation effects alone would have caused it to shed much of its client base.
A related market mechanism for enforcing discipline on audit firms is bonding. Audit firm partners are jointly and severally liable for partnership debts, and hence in principle the entire pool of capital in the audit firm is available to satisfy damages arising from the actions of individual partners.27 This acts as a bonding mechanism, giving the audit firm incentives to create high standards of behavior for individual partners, monitor their performance, and enforce compliance. Andersen's capacity to bond itself to provide high audit quality was impaired by another market mechanism, civil litigation. As discussed in the previous subsection, civil litigation is a market process for recovering damages from parties who do not follow accepted standards of behavior. Investors and lenders are owed a duty of care by audit firms which, if not performed, can trigger lawsuits to recover damages. Because litigation is on behalf of damaged parties, it usually occurs in relation to client firms whose stock prices have fallen substantially (Lys and Watts ) and whose capacity to pay therefore is limited. Audit firms then are named as defendants.
Andersen was deluged with lawsuits. Its settlements included: Sunbeam for $110 million, the Baptist Foundation of Arizona for $217 million, Waste Management for $27 million including fines, WorldCom for $65 million, and Enron for $40 million. These amounts do not include legal expenses. Andersen currently is named as a defendant in more than 100 suits still pending in the courts (Wikipedia Contributors ). Settlements and legal expenses depleted Andersen's resources, to the point where its ability to credibly bond itself to investors and lenders against future financial reporting negligence and fraud would have been severely impaired.
A market mechanism closely related to bonding is a form of insurance provided by auditors. Kellogg , Wallace , Chow, Kramer, and Wallace , and Kothari et al.  develop the hypothesis that, because audit firms are named as codefendants in corporate financial reporting cases, their resources provide insurance to investors and lenders against financial reporting negligence and fraud. Whether they self-insure against this potential liability or can purchase insurance, a competitive audit market should allow audit firms to pass this insurance cost on to their client firms as a component of their audit fees (Dye ). The depletion of Andersen's resources from litigating and settling past cases would have impaired its ability to insure investors and lenders against future financial reporting negligence and fraud.
Given its loss of both reputational and monetary capital, it is not surprising that Andersen started shedding clients. It lost a net 21 clients in 2000 and 73 clients in the first three quarters of 2001, while during the same intervals the other Big 4 audit firms had net gains of 44 and 14 clients.28 These defections preceded the Enron and WorldCom scandals, suggesting that the losses were due primarily to the Waste Management case. Barton  studies Andersen's subsequent post-Enron client losses. He reports that the earliest defections were by clients that were more visible in the capital markets, in the sense that they attracted more analysts and more press coverage, had larger institutional ownership, had larger turnover, and issued more securities. By the time Andersen surrendered its license, it had lost its client base.29Barton[2005, p. 549] concludes: “Overall, my study suggests that firms more visible in the capital markets tend to be more concerned about engaging highly reputable auditors, consistent with such firms trying to build and preserve their own reputations for credible financial reporting.”
There is some debate about the relative contributions of reputation, insurance, and bonding effects in the demise of audit firms. Menon and Williams  study the fraud-induced 1990 bankruptcy of Laventhol and Horwath, then the seventh-largest U.S. audit firm. They conclude that the insurance hypothesis explains the negative stock price reaction of its clients to its bankruptcy. However, Baber, Kumar, and Verghese  conclude that the Laventhol and Horwath clients' price movements are consistent with both insurance and reputation effects. Sinason and Pacini  and Khurana and Raman  reach a similar conclusion from wider samples. Chaney and Philipich  attribute the stock price behavior of Arthur Andersen clients around the time of the Enron scandal to reputation effects, but Nelson, Price, and Rountree  document confounding effects. Weber, Willenborg, and Zhang  study the interesting German accounting scandal involving ComROAD AG, which is informative because damages awards are both rare and minor in Germany, so bonding and insurance effects are not substantial. They report that clients of KPMG, ComROAD's audit firm, experienced negative abnormal returns and tended to change auditors. They conclude that reputation effects are important.
The most likely explanation is that reputation, insurance, and bonding effects cannot be separated, either logically (because the concepts overlap) or empirically (because their effects are correlated). This seems particularly likely in common law countries, where loss of reputation is associated with litigation and consequential loss of monetary capital. Nevertheless, all are market mechanisms.
While it is impossible to completely untangle the effects of market and political/regulatory processes in the demise of Arthur Andersen, there appears to be ample evidence that the audit market would have closed Andersen on its own accord, because the firm's greatest asset (a reputation for quality, independent auditing) and its financial viability (hence, its capacity to bond the quality of the accounts it audited and to insure against harm to users) were in ruins. In addition, even if it had won its criminal trial, the flurry of private civil lawsuits ensuing from the Enron collapse surely would have bankrupted it. It seems reasonable to conclude that market forces, left to their own devices, would have closed Andersen.
Finally, it is worth reflecting on what the closure of an audit firm implies, and why an audit firm is not closed whenever a single negligent or fraudulent audit comes to light. It is important to distinguish between the actions of an individual partner, those of a regional office, and those of an audit firm as a whole. Individual partners acting alone in negligence or fraud typically lose future employment prospects, lose personal assets in damages settlements, and can be disbarred, fined, or jailed. Some financial and reputational losses also are suffered by those who are not directly implicated. Financially, under joint and several liability, the partnership as a whole is responsible for fines and damages awards, which normally exceed individual partners' wealths. Firm-wide financial and reputational losses due to the actions of a rogue partner provide an incentive for partners to monitor each other (though this mechanism apparently was not sufficient in Andersen's case). When a scandal is due to poor oversight or a corrupt audit culture in an entire regional office, but is clearly contained within that office, the penalties fall more heavily on partners in that office, but here too they typically do not threaten the entire firm.30
So why was Andersen forced to close its doors when this normally does not happen? Presumably because in Andersen's case there was clear evidence that culpability did not simply lie with individual audit engagement partners, or even with a single regional office, but involved managers at the very top. The firm itself was tainted. In the Waste Management scandal that preceded Enron, the following top-level Andersen people were directly implicated in a blatant attempt to disguise improper accounting, while at the same time Andersen was issuing clean audit opinions: Andersen's managing partner, the practice director for its central region, its director of global risk management, and the audit division head of its Chicago head office (SEC ). When this firm-level culpability was discovered, Andersen was fined a then-record $7 million, and consented to a permanent injunction against further violations. The Enron and WorldCom cases, which broke soon thereafter, flew in the face of this injunction.31 It is reasonable to conclude that Arthur Andersen's firm-wide capacity to credibly perform independent audits was severely damaged by its firm-level culpability in these events, and that this explains why the firm—and not just individual rogue partners or branch offices—went out of business.32
4.3 audit firm conflicts of interest
Part of the adverse public and political reaction to the accounting scandals was the revelation that audit firms conduct substantial non-audit work for their clients, thereby creating at least the appearance of conflicts of interest. Conflicts of interest were given at least partial blame for the scandals by the press (e.g., Herrick and Barrionuevo ) and by some researchers (e.g., Coffee ). In response to the adverse reaction, the Sarbanes-Oxley Act prohibits the type of non-audit work by the company's auditor that would compromise its independence in performing the audit. Examples include the provision of bookkeeping and internal audit services, where as an external auditor it would in effect be auditing its own work. The Sarbanes-Oxley Act sensibly does not prohibit other services, such as tax advice. There are several reasons to doubt whether this statutory prohibition was advisable or necessary.
First, the hypothesis that audit firms allow their audit judgment to be compromised by non-audit revenues does not make as much sense as one might initially believe. Why would audit firms attach such a low value to their reputations as independent auditors? Why would they willingly place the entire capital of the partnership at risk by cutting audit quality? The hypothesis might seem to make sense if one accepted the premise that they were earning quasi-rents on non-audit business, but none on audits. They then might seem to have little to lose by reducing audit quality to attract lucrative non-audit engagements. But even if one accepted that premise, the argument still would make no sense. Why would they willingly risk losing quasi-rents on their non-audit work by gaining a reputation for poor audit quality? Would not the existence of quasi-rents earned from non-audit business imply that firms with substantial non-audit revenues put up a larger bond to guarantee their audit quality and hence are less likely to compromise it? All things considered, the motives of audit firms are not as clear-cut as many commentators portray them.
Second, if client firms view their reputations as valuable assets, one would expect them to voluntarily avoid contracting for the audit firm to provide any non-audit services that could compromise audit independence. Kinney, Palmrose, and Scholz  test this hypothesis, using the need to subsequently restate previously issued financial statements as an indicator of low-quality financial reporting and auditing. They do not find a pervasive relation between non-audit services fees and restatements.
Third, one should not lose sight of the benefits non-audit work brings to clients. The accounting firms have built substantial businesses in areas such as consulting, systems, taxation, and litigation support. They have done so in a competitive market. Their comparative advantage appears to lie in a combination of training, cost, and specific client and industry knowledge. Excessive restrictions on using their comparative advantage can impair economic efficiency.
Fourth, there is substantial evidence that non-audit business in fact does not lead to audit firms compromising their audit judgments (Craswell, Francis, and Taylor , DeFond, Raghunandan, and Subramanyam , Frankel, Johnson, and Nelson , and Larcker and Richardson ). If anything, the evidence in these studies points to non-audit revenues being associated with less favorable audit treatment, most likely because financially weaker firms exhibit greater use of consultants and also receive harsher audit opinions.33
Fifth, before the passage of the Sarbanes-Oxley Act and in response to the scandal-induced perception that conflicts of interest influence audit judgment, all but one of the major accounting firms decided to cease providing internal audit and audit-related technology consulting services to clients where they are the external auditor. This decision was made by Arthur Andersen (it was still operating at the time), Ernst & Young, KPMG, and PricewaterhouseCoopers. Deloitte & Touche alone among the then Big 5 audit firms resisted the change, arguing with some justification that the issue was one of perception arising from “the level of hyperbole in the debate” (Glater ). Nevertheless, perceptions do matter, and it is not clear that Deloitte would have been able to hold out on this position for long. In any event, the Sarbanes-Oxley Act codified the standard that the market had largely moved to in response to the scandals.
The Sarbanes-Oxley Act also restricts public companies from hiring directly from their audit firms. More specifically, Section 206 prohibits a company from employing a former auditor of its accounts in a senior accounting or financial position until at least a year has elapsed since that person left the audit firm. The principal concern with “revolving door” appointments is that they induce various conflicts of interest, including those that could occur when audit firm employees have to audit a former colleague or supervisor. This Sarbanes-Oxley prohibition was fueled by public outcry upon news that former Andersen auditors had been employed by Enron, Waste Management, and other companies with deficient financial reporting. But here too, the need for such prohibition is far from clear. Lost in the argument is the potential benefit a former auditor can bring to a company, stemming from specialist skills and specific knowledge of the company. Consistent with such benefits, Geiger, Lennox, and North  report a positive share market reaction to pre–Sarbanes-Oxley revolving door appointments, in excess of the price reaction to other appointments. They also report that revolving door appointments are not associated with lower scores on measures of financial reporting quality.
In sum, there is reason to believe, and some supporting evidence, that market forces can resolve potential auditor conflicts, in the absence of regulatory prohibitions. This does not imply that there should be no regulation, but it does help place in perspective the Sarbanes-Oxley rush to heavily regulate the industry.
4.4 who killed enron and enron jobs?
Was Enron forced into bankruptcy—and did employees lose their jobs—due to the accounting scandals? Or due to bad business decisions? Here too, the political and market perspectives seem to differ.
The notion that accounting transgressions led to the Enron bankruptcy, and the associated job losses, is correct in a sequential sense: Revelation of the company's financial misrepresentations was swiftly followed by its demise. That does not mean that accounting transgressions caused the Enron bankruptcy or the job losses, because revelation of the financial misrepresentations was accompanied by revelation of the motive behind them, which was to conceal the company's true financial position. I will argue that, if anything, the accounting transgressions actually deferred bankruptcy and job losses for a short period.
The immediate press coverage of Enron dwelt extensively on job losses.34 This focus returned at the sentencing of Skilling and Lay. For example, the BBC News stated on October 23, 2006: “The scandal at the one-time energy giant left 21,000 people out of work” (BBC). When signing the Sarbanes-Oxley Act into law on July 30, 2002, President Bush stated:35“This law says to workers: We will not tolerate reckless practices that artificially drive up stock prices and eventually destroy the companies, and the pensions, and your jobs.”
At the sentencing hearing for Skilling and Lay, U.S. District Judge Sim Lake admitted testimony from several former Enron employees, including Charles Prestwood (who testified he and the other former employees were the real victims in this case) and Diana Peters (who testified her husband was diagnosed with cancer shortly before the company went bankrupt, leaving her without health insurance, and to pay for his treatment she had taken different jobs and sold her furniture, home, and assets). The prosecution team attributed Enron job losses to the financial misreporting under Skilling and Lay. After their sentences were handed down, Alice Fisher, an assistant U.S. attorney general, stated:36“Today's sentence is a measure of justice for the thousands of people who lost their jobs and millions of dollars in investments when Enron collapsed under the weight of the fraud perpetrated by the company's top executives.”
It is not a crime per se to have bad business judgment, or make bad business decisions, even if they lead to bankruptcy or unemployment. However, deliberate financial misreporting is a crime, and as Judge Sim Lake indicated, the extent of job losses is a relevant consideration in sentencing under federal guidelines. But one would have thought job losses would be relevant only if the misreporting caused them. I also hold no brief for Skilling or Lay, and the following observation has no implications for their guilt or otherwise, which is a separate issue from sentencing. But I am unaware of any reliable evidence that the accounting scandals caused (as distinct from deferred) job losses. The most plausible hypothesis is provided by Kedia and Philippon , who conclude that overstating earnings initially causes overinvestment and overemployment, distorting the allocation of real resources. When the overstatement is discovered, the firm sheds labor and capital.37
Some indication can be gleaned from Enron's financials. Between 1995 and 2000, reported revenues grew from $9.2 billion to $100.8 billion: a tenfold increase in five years. However, reported profits did not even double over the period, and consequently the net profit margin on sales fell by 2000 (using reported numbers) to less than 1%. We now know that even that slim margin actually was not earned, because reported profits that year were overstated. Based on the Bankruptcy Examiner's estimate, Enron's true 2000 profit was $42.3 million.38 The restated numbers imply a paltry 0.04% margin on sales (and a mere 0.06% of restated total assets of $69.6 billion). This estimate might be biased downward because it was made by an interested litigant, but it suggests that Enron was an unprofitable company the year before it entered bankruptcy, and that its accounting transgressions were designed to hide that fact.
It is difficult to escape the conclusion that market forces caused Enron's bankruptcy, for the simple reason that by 2000 it was not generating profits on an enormous amount of invested capital. Conditional on the company having misallocated capital and labor resources to unprofitable projects such as its energy trading and broadband businesses, its accounting transgressions most likely kept the company alive for some period (perhaps one or two years) longer than would have occurred if it had reported the true profitability. Absent misrepresentation, Enron would have been at least restructured and possibly liquidated, and many Enron employees would have lost their jobs, at an earlier point in time. If Enron managers anticipated the possibility of financial misrepresentation before committing to these businesses, they might even have been encouraged to overinvest and overemploy in them in the first instance. Whatever counter-factual is assumed, Enron's levels of investment and employment would have peaked earlier in the absence of financial misrepresentation. The welfare loss arose from employing excess capital and labor that were better used elsewhere.39