DECEMBER 18, 2001

WASHINGTON WATCH By Howard Gleckman

Enron's "Contagion Effect" If investors feel they can't trust companies' financial disclosures, the cost of capital is sure to go up for Corporate America

Everyone knows by now that Enron's collapse has cost shareholders and company employees billions of dollars. But this fiasco contains a lesson about accounting and stock pricing for the rest of Corporate America -- one that businesses ignore at their own peril.

Why should other public companies care about the financial mumbo-jumbo that wrecked the once high-flying Houston energy outfit? Because if widespread investor skepticism sets in about the truthfulness of routine financial disclosures, every company that tries to raise money in the markets will see its costs rise. "Its part of the cost of capital now," says Barry Rogstad, president of the American Business Conference, a Washington (D.C.) group of midsize companies. "As an investor, the potential for any company to be in this situation is real to me." U.S. companies, he adds, "have a truth-in-packaging problem."

Just look at the stock prices of many of Enron's (ENE ) competitors in the energy business. El Paso Corp. (EPG ) shares have plunged nearly 20% since Enron began to unravel in October. And El Paso has had to shift $2 billion in off-balance-sheet partnership debt -- a financing arrangement similar to Enron's -- onto its own books. The stock of Dynegy (DYN ), which briefly toyed with buying Enron, is down nearly 40%. Meanwhile, Calpine's (CPN ) stock price has been slashed in half, and its debt is under review by the rating agencies.

LOST CONFIDENCE.  These companies' own deals may be completely aboveboard. But jumpy investors are fleeing anyway. "Already, energy companies are suffering fallout,"

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says Wharton finance professor Jeremy Siegel. "They are suffering a contagion effect."

Enron itself collapsed because it lost the confidence of its investors. For years, it used dozens of limited partnerships and other complex financing structures to take some assets -- and $4 billion in debt -- off its balance sheet. Many of the transactions were unknown to or little understood by shareholders. And when some of the deals went south, Enron was forced to whack nearly $600 million from earnings it had claimed over the past five years. It had to slash its net worth by a staggering $1.2 billion.

If this were an isolated event, the capital markets might shrug it off. But it's just the latest in a long string of financial razzle-dazzle that has investors increasingly questioning the integrity of the U.S. markets. In recent years, two other clients of Enron auditor Arthur Andersen -- Sunbeam Corp. and Waste Management Inc. -- were caught doctoring their books. Investors in a high-tech, high-flyer, Microstrategy, saw its stock price plunge from $300 to barely a dollar after it was found to be overstating earnings.

FINANCIAL AIRBRUSH.  Investors in the scores of companies that use so-called pro forma financial statements to supplement their traditional disclosure are also sliding down this slippery slope. These documents, built largely on wishful thinking rather than hard numbers, allow companies with no earnings and even no revenues, to look healthy. They're the financial equivalent of an airbrush.

Few things in this world are more mind-numbing than income statements and balance sheets. But honest accounting is a big reason U.S. financial markets are so strong. Markets are efficient and the cost of capital is low because every investor believes that he has more or less the same accurate information about a company as any other shareholder.

Once that trust is broken -- and investors begin believing they're being misled -- they'll demand a premium for the increased risk of being lied to. Says Wharton's Siegel: "If you start to distrust those earnings, that will cause a lack of confidence. And that will cause a lack of demand for a stock."

BAD DEAL.  And if investors start to believe that the problem is systemic and that they can't trust any public company to tell them the truth, business will pay a heavy price. It won't just be the murky book-cookers that'll get hurt. Honest companies will suffer too, at least until the market eventually sorts out who's being straight and who isn't.

That's a bad deal for us all. A boost in the cost of capital will hold down profits and make less money available for companies to invest in new equipment or hire new workers. The Enron virus hasn't infected the entire market yet, but a financial flu is in the air.

Companies can begin to inoculate themselves and their shareholders by clarifying the current system of disclosure. Or they can wait for regulators to do it for them. It's their choice.

Gleckman is a senior correspondent in BusinessWeek's Washington bureau. Follow his views every Tuesday in Washington Watch, only on BusinessWeek OnlineEdited by Douglas Harbrecht

After reading this article, answer the following questions:1. What is the problem related to lack of disclosure that may affect other companies?

2. In what way could the problems at Enron affect other firm's cost of capital?