Companies of all sorts can look forward to increasingly tough scrutiny in 2002, writes ERisk editor-in-chief Sumit Paul-Choudhury

The drawn-out demise and ultimate humiliation of Enron would undoubtedly have been the top risk management story in any year more normal than 2001. Although the energy giant had been struggling for some months, its bankruptcy filing in early December still came as a huge shock to the stricken company’s employees, investors, creditors and trading partners.

The decision this week to delist the company’s stock from the New York Stock Exchange, amid growing scandal, is a sharp reminder of the perils of ineffectual risk management. For all that Enron’s enterprise risk management programme might (or might not) have been technically brilliant, it failed to address the fundamental risk of runaway management. And while its core problems might have been unique, its demise has forced superficially similar firms – Calpine and Dynegy prominent among them – to struggle against submergence under a tide of ill will.

But it’s not only energy companies that are having to deal with unfriendly shareholders, rating agencies and the like. With defaults climbing to levels last seen in the early-1990s recession, all manner of firms are finding themselves under the microscope. When such corporate monoliths as Ford, HP and The Gap become the subject of alarming rumours, it’s a sign no-one is safe from scrutiny. Financial institutions are particularly vulnerable, since they bear the brunt of declining credit quality and sickly markets more directly than most. Regulators, analysts and, most recently, auditors, all became increasingly keen to prove their toughness over the past year, and the trend will only accelerate in 2002.

Regulators have ample reason to be concerned, particularly in such controversial sectors as subprime retail lending – and last year’s financial disasters can only have strengthened their resolve to keep firms in line. US banking regulators, for example, have been increasingly on the offensive since being embarrassed by the failure of Superior Bank, which collapsed after it was forced to restate the value of high-risk mortgage loans. In the UK, meanwhile, the collapse of Equitable Life has led to sharp criticism of the Financial Services Authority, and on the other side of the world the Australian Prudential Regulatory Authority has admitted errors in its handling of the HIH debacle.

Modern regulators, of course, have often argued that their role should be to protect the system, not individual firms or their stakeholders – an ethos epitomised by Treasury secretary Paul O’Neill’s brusque comment earlier this week that Enron’s collapse was a result of “the genius of capitalism”. Whether depositors, policyholders, creditors, shareholders and other stakeholders agree with this stance remains to be seen – but for the moment, they are unlikely to trust regulators to safeguard their interests.

Rating agencies, too, have inspired little faith since their dismal performance during the 1997 Asian crisis. Many pundits question whether the agencies’ increasingly aggressive stance on issuing downgrades will achieve much, apart from punishing the blameless and giving only 11th-hour warning of looming disaster.

Equity analysts, who took a pounding last year for their indefatigable cheerleading during the dotcom boom, are similarly keen to demonstrate their toughness.

And auditors – until recently one of the few remaining bastions of public confidence in financial reporting – have now fallen into disrepute. Andersen’s role in the Enron debacle is only the latest in a series of discreditable run-ins with regulators, both by Andersen and by other members of the Big Five, but the calamity has highlighted the potentially huge problems that can go overlooked or unreported. Auditors, too, will have to sharpen up their act this year.

In short, scepticism is once again the order of the day. Regulators, ratings agencies, analysts and shareholders are all out looking for trouble – and action by any one of these groups can set a firm off down the slippery slope to perdition. Sell recommendations still have the power to depress share prices, which in turn can provoke credit downgrades – and that can ultimately lead to the regulator stepping in.

In this sort of climate, the initial problem needn’t be large. As history has demonstrated, business disasters often begin with a small crack in the appearance of corporate competence that widens rapidly, to the point where diminishing stakeholder confidence threatens the viability of the entire firm. The crack doesn’t even have to be real or serious.

The only response to this situation is to ensure first, that the interested parties are appropriately informed; and second, that any stumble can be corrected before it turns into a dive. As Fitch analyst Alan Spen told the Wall Street Journal in mid-December, the smart companies are those that choose to “get their balance sheets in line [and] let the market know they’re in charge of their destiny … since the market clearly has the heebie-jeebies”.

Clearly, any company would like to say it is the master of its own destiny. But how often is that the case? All too often, firms – be they traders, lenders or practically any other type of company – are engaged in businesses that involve risks they understand only vaguely, even as those businesses consume uncontrolled and unquantified amounts of capital. Even an otherwise well-run firm may boast one or more high-flying, but poorly understood, business lines. If the firm runs into trouble, these companies may find they have less capital available than they think they have – and have fewer options for defensive manoeuvring.

One way out of this situation is to resort to creative accountancy. In some cases, managers may even delude themselves that the ‘cooked’ books reflect performance more closely than a more intuitive bottom line. This kind of reliance on obfuscation is not only wrong, but also untenable. Sooner or later (as discovered by Enron, Barings and others) the truth will come out – and when it does, the consequences may well be devastating. Ultimately, the only viable answers to the pointed questions of rating agencies, regulators and investors are those that draw strength from the practice of sound risk and capital management.