Case study Enron: a classic corporate governance case

The merger of Houston Natural Gas and InterNorth in 1985 created a new

Texas energy company called Enron. In 1989, Enron began trading in

commoditiesbuying and selling wholesale contracts in energy. By 2000,

turnover was growing at a fantastic rate, from US$40 billion in 1999 to

US$101 billion in 2000, with the increased revenues coming from the broking

of energy commodities. The rapid rate of growth suggested a dynamic

company and Enron's share price rocketed. Top executives reaped large

rewards from their share options. The company's bankers, who received

substantial fees from the company, also employed analysts who encouraged

others to invest in Enron. But the cash flow statement included an unusual

item: 'other operating activities $1.1 billion'. The accounts for 2000 were the

last Enron was to publish.

The chief executive of Enron, Jeffrey Skilling, believed that old asset-based

businesses would be dominated by trading enterprises such as Enron

making markets for their output. Enron was credited with 'aggressive

earnings management'. To support its growth, hundreds of special purpose

entities (SPEs) were created. These were separate partnerships that traded

with Enron, with names such as Cayman, Condor and Raptor, Jedi and

Chewco, often based in tax havens. Enron marked long-term energy supply

contracts with these SPEs at market prices, taking the profit in its own

accounts immediately. The SPEs also provided lucrative fees for Enron top

executives. Further, they gave the appearance that Enron had hedged its

financial exposures with third parties, whereas the third parties were, in fact,

contingent liabilities on Enron. The contemporary American GAAP did not

require such SPEs to be consolidated with partners' group accounts, so

billions of dollars were kept off Enron's balance sheet.

In 2000, Enron had US$100 billion in annual revenues and was valued by the

stock market at nearly US$80 billion. It was ranked seventh in Fortune's list

of the largest US firms. Enron then had three principal divisions, with over

3,500 subsidiaries: Enron Global Services, owning physical assets such as

power stations and pipelines; Enron Energy Services, providing management

and outsourcing services; and Enron Wholesale Services, the commodities

and trading business. Enron was the largest trader in the energy market

created by the deregulation of energy in the USA.

The company had many admirers. As the authors of the book The War for

Talent (Harvard Business School Press, 2001) wrote, 'few companies will be

able to achieve the excitement extravaganza that Enron has in its remarkable

business transformation, but many could apply some of the principles'.

Enron's auditor was Arthur Andersen, whose audit and consultancy fees

from Enron were running around US$52 million a year. Enron also employed

several former Andersen partners as senior financial executives. In February

2001, partners of Andersen discussed dropping their client because of

Enron's accounting policies, including accounting for the SPEs and the

apparent conflicts of interest of Enron's chief financial officer, Andrew

Fastow, who had set up and was benefiting from the SPEs.

In August 2001, Skilling resigned 'for personal reasons'. Kenneth Lay, the

chairman, took over executive control. Lay was a close friend of US

President George W. Bush and was his adviser on energy matters. His name

had been mentioned as a future US Energy Secretary. In 2000, Lay made

123 million from the exercise of share options in Enron.

A week after Skilling resigned, Chung Wu, a broker with UBS Paine Webber

US (a subsidiary of Swiss bank UBS), emailed his clients advising them to

sell Enron. He was sacked and escorted out of his office. The same day Lay

sold US$4 million worth of his own Enron shares, while telling employees of

the high priority he placed on restoring investor confidence, which 'should

result in a higher share price'. Other UBS analysts were still recommending a

'strong buy' on Enron. UBS Paine Webber received substantial brokerage

fees from administering the Enron employee stock option programme. Lord

Wakeham, a former UK cabinet minister, was a director of Enron and chair of

its nominating committee. Wakeham, who was also a chartered accountant

and chair of the British Press Complaints Council, was paid an annual

consultancy fee of US$50,000 by Enron, plus a US$4,600 monthly retainer

and US$1,250 attendance fee for each meeting.

A warning about the company's accounting techniques was given to Lay in

mid-2001 by Sherron Watkins, an Enron executive, who wrote: 'I am nervous

that we will implode in a wave of accounting scandals.'17 She also advised

Andersen of potential problems. In October 2001, a crisis developed, when

the company revised its earlier financial statements revealing massive losses

attributable to hedging risks taken as energy prices fell, which had wiped out

US$600 million of profits. A SEC investigation into this restatement of profits

for the past five years revealed massive, complex derivative positions and

the transactions between Enron and the SPEs. Debts were understated by

US$2.6 billion. Fastow was alleged to have received more than US$30

million for his management of the partnerships. Eventually, he was indicted

on 78 counts involving the complex financial schemes that produced

phantom profits, enriched him, and doomed the company. He claimed that

he did not believe he had committed any crimes.

The FBI began an investigation into possible fraud at Enron three months

later, by which time files had been shredded. In a subsequent criminal trial,

Andersen was found guilty of destroying key documents, as part of an effort

to impede an official inquiry into the energy company's collapse. Lawsuits

against Andersen followed. The Enron employees' pension fund sued for

US$1 billion, plus the return of US$1 million per week fees, seeing the firm

as its best chance of recovering some of the US$80 billion lost in the Enron

debacle. Many Enron employees held their retirement plans in Enron stock:

some had lost their entire retirement savings. The US Labor Department

alleged that Enron had illegally prohibited employees from selling company

stock in their '401k' retirement plans as the share price fell. The Andersen

firm subsequently collapsed, with partners around the world joining other

'Big Four' firms.

In November 2001, Fastow was fired. Standard and Poor's, the credit-rating

agency, downgraded Enron stock to junk bond status, triggering interest rate

penalties and other clauses. Merger negotiations with Dynergy, which might

have saved Enron, failed.

Enron filed for Chapter 11 bankruptcy in December 2001. This was the

largest corporate collapse in US history up until then: Worldcom was to

exceed it. The NYSE suspended Enron shares. John Clifford Baxter, a vicechair

of Enron until his resignation in May 2001, was found shot dead. He

had been one of the first to see the problems at Enron and had heated

arguments about the accounting for off-balance-sheet financing, which he

found unacceptable. Two outside directors, Herbert Weinokur and Robert

Jaedicke, members of the Enron audit committee, claimed that the board

either was not informed or was deceived about deals involving the SPEs.

Early in 2002, Duncan, the former lead partner on Enron's audit, who had

allegedly shredded Enron files and been fired by Andersen, cooperated with

the Justice Department's criminal indictment, becoming a whistle blower and

pleading guilty to charges that he had 'knowingly, intentionally and corruptly

persuade[d] and attempt[ed] to persuade Andersen partners and employees

to shred documents'.

Why did it happen? Three fundamental reasons can be suggested: Enron

switched strategy from energy supplier to energy trader, effectively becoming

a financial institution with an increased risk profile; Enron's financial strategy

hid corporate debt and exaggerated performance; US accounting standards

permitted the off-balance-sheet treatment of the SPEs.

What are the implications of the Enron case? First, important questions are

raised about corporate governance in the United States, including the roles

of the CEO and board of directors, and the issue of duality; the

independence of outside, non-executive directors; the functions and

membership of the audit committee; and the oversight role of institutional

shareholders. Second, issues of regulation in American financial markets

arise, including the regulation of industrial companies with financial trading

arms like Enron, the responsibilities of the independent credit-rating

agencies, the regulation of US pension funds, and the effect on capital

markets worldwide. Third, there are implications for accounting standards,

particularly the accounting for off-balance-sheet SPEs, the regulation of the

US accounting profession, and the convergence of US GAAP with

international accounting standards. Last, auditing issues include auditor

independence, auditors' right to undertake non-audit work for audit clients,

the rotation of audit partners, audit firms or government involvement in audit,

and the need for a cooling-off period before an auditor joins the staff of a

client company.

Some British banks were caught in the Enron net. Andrew Fastow, the former

CFO, produced an insider account of how the banks had helped to prop up

the house of cards. Three British bankers were extradited to the United

States to stand trial, under legislation designed to repatriate terrorists.

Jeffrey Skilling, the former CEO, was sentenced to 24 years' prison and to

pay US$45 million restitution in October 2006. Claiming innocence, he

appealed. Kenneth Lay (aged 64) was also found guilty, but died of a heart

attack in July 2006, protesting his innocence and believing he would be

exonerated.

Although Enron collapsed with such dramatic results, international corporate

governance guidelines had in fact been followed, with a separate chair and

CEO, an audit committee chaired by a leading independent accounting

academic, and a raft of eminent independent non-executive directors.

However, the subsequent collapse owes more to abuse of their power by top

managers and their ambivalent attitudes towards honest and balanced

corporate governance.

Questions

1. Should a company's bankers, who receive substantial fees from that

company, also employ analysts who encourage investment in that company?

2. Enron's external auditor, Arthur Andersen, earned substantial consultancy

fees from the company as well as the audit fee. Enron also employed several

former Andersen partners as senior financial executives. Could the external

auditors really be considered independent?