Four Years After Enron: Assessing the Financial-Market Regulatory Cleanup via CSInvesting

Last year was the tenth anniversary of the beginning of the tech bubble in the stock market that began after the commercialization of the Internet and, through it, the development of a “new economy” led by “dot.coms” and other Internet-enabled companies. These developments drove a tremendous stockmarket expansion from 1995 until the end of the 1990s, during which the NASDAQ index increased fivefold.

Early in 2000, however, the air began to leak out of the bubble, and by the end of the year a widespread reduction of approximately 30 percent in the valuation of technology stocks had occurred. This market drop sharply affected other businesses that relied on Internet technology, causing several to fail outright, to slide out of control, or to engage in accounting gimmickry in order to shore up their profits. By December 2001, when Enron, the seventh-largest company in the United States and one of its leading “new economy” concept companies, filed for bankruptcy, the NASDAQ index had fallen 74 percent from its high of less than two years earlier. In 2001, 171 large corporate bankruptcies occurred, involving liabilities of $230 billion, more than twice as many bankruptcies as in 2000, the previous record year. In July 2002, WorldCom, the country’s second-largest longdistance telecom company, with $107 billion in assets, filed for bankruptcy after revealing massive accounting fraud. Throughout 2002, bankruptcies continued to occur, involving liabilities of $338 billion, thus establishing a three-year period in which U.S. bankruptcies—the ultimate form of corporate failure—broke all previous records (Altman 2002).

In addition, instances of accounting failures in the form of “restatements” of prior audited financial results because of accounting errors nearly quadrupled to 616 cases in the four-year period 1998–2001 (Wu 2002). Restatements continued to occur in record numbers during 2002 and 2003, when 389 cases were reported (Huron Consulting Group 2003). As a consequence of these failures, there was an explosion of securities-fraud class-action lawsuits seeking damages from all involved officers, directors, and advisers of the companies. In all, 489 such suits were filed in 2001 (of which 312 were related to initial public offerings), and 259 more were filed in 2002, as compared to an average of 194 filings per year during the three years prior to passage of the Private Litigation Reform Act of 1995, a bill designed to limit substantially the number of such class-action lawsuits (Stanford Law School 2006). Many of these lawsuits were the consequence of stock prices that fell rapidly after sudden news of changed financial information.

The financial losses caused by these failures were considerable. Bank-loan write-offs for 2001–2002 were in the tens of billions of dollars. Publicly traded noninvestmentgrade bond defaults for 2002 were (at par value) $96.9 billion—the highest amount of such defaults then recorded—representing 12.8 percent of outstanding issues. In 2001, the default rate of these bonds was 9.8 percent, the highest since 1999. On the assumption that the bond defaults will result in recoveries (through bankruptcy or other workout arrangements) equal to the ten-year historical average of about 30 percent, the expected losses from loan write-offs and from bond defaults for the two-year period will be about $100 billion (Altman 2004).

Equity-market losses in 2001–2002 attributable to fears of corporate failures caused by misgovernance were far greater: the S&P 500 peaked at 1,527 in March 2000 and then, reflecting the collapse of the technology bubble, fell steadily to 966 in September 2001, before recovering to nearly 1,200 by the end of the year. Even after clear signs of recovery in the economy and in corporate earnings were evident late in 2001, however, the Enron bankruptcy in December 2001 and other corporate surprises affected the market, and the S&P 500 index reversed direction and fell farther. Unlike the periods following recovery from previous recessions, the stock market continued to sag, with the S&P 500 index reaching a five-year low of 798 on July 23, 2002, down 33 percent for the year (a loss of approximately $4 trillion of market capitalization) and lower by more than 47 percent from its all-time high two and a half years earlier. For many industries suspected of accounting or governance shortcomings (for example, telecom, health care, energy services, and technology), share-price declines were even greater.

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