Enron-corporate governance

Enron and the Economics of Corporate Governance

June 2003

Peter Grosvenor Munzig Department of Economics Stanford University, Stanford CA 94305-6072 Advisor: Professor Timothy Bresnahan

ABSTRACT

In the wake of the demise of Enron, corporate governance has come to the forefront of  economic discussion. The fall of Enron was a direct result of failed corporate governance and consequently has led to a complete reevaluation of corporate governance practice in the United States. The following paper attempts to reconcile our existing theories on corporate governance, executive compensation, and the firm with the events that took  place at Enron. This paper first examines and synthesizes our current theories on corporate governance, and then applies theoretical and economic framework to the factual events that occurred at Enron. I will argue that Enron was a manifestation manifestation of the principal-agent problem, that high-powered incentive contracts provided management with incentives for self-dealing, that significant costs were transferred to shareholders due to the obscurity in Enron’s financial reporting, and that due to the lack of board independence it is likely that management rent extraction occurred.

Acknowledgements : I would like to thank my family and friends for their continued

support throughout this paper. In particular, my mother Judy Munzig was instrumental instrumental with her comments on earlier drafts. I also thank Professors Geoffrey Rothwell and George Parker for their help, and finally to my advisor Professor Bresnahan, for without his support and advice this paper would not have been possible.

“When a company called Enron… ascends to the number seven spot on the Fortune 500 and then collapses in weeks into a smoking ruin, its stock worth pennies, its CEO, a confidante of presidents, more or less evaporated, there must be lessons in there somewhere.”

-Daniel Henninger, The Wall Street Journal

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“When a company called Enron… ascends to the number seven spot on the Fortune 500 and then collapses in weeks into a smoking ruin, its stock worth pennies, its CEO, a confidante of presidents, more or less evaporated, there must be lessons in there somewhere.”

-Daniel Henninger, The Wall Street Journal

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CONTENTS

I.

INTRODUCTION ...................................................... ..............................3

II.

THE THEORY OF CORPORATE GOVERNANCE ..............................7 Corporate Governance and the Principal Principal-- Agent Problem ...............7 Executive Compensation and the Alignment of Manager Manager and Shareholder Interests ...........................................11 Corporate Governance’s Role in Economic Efficiency.................14 Recent Developments Developments in Corporate Governance Governance ...........................15

III.

WHAT HAPPENED: FACTUAL ACCOUNT OF EVENTS LEADING TO BANKRUPTCY......................................17 Background/Timeline.....................................................................18 Summary of Transactions and Partnerships...................................19 The Chewco/JEDI Transaction......................................................20 The LJM Transactio Transactions ns ................................................. ...................................................................22 ..................22

IV. IV.

ANALYSIS OF CORPORATE GOVERNANCE ISSUES ...................26 Corporate Structure........................................................................27 Conflicts of Interest........................................................................30 Failures in Board Oversight and Fundamental Lack of Checks and Balances ...................................................... 33 Audit Committee Relationship With Enron and Andersen............35 Lack of Auditing Independence and the Partial Failure of the Efficient Efficient Market Market Hypothesis Hypothesis ...................................38 Director Independence/Director Selection.....................................41

V.

POST-ENRON POS T-ENRON GOVERNANCE GOVERNANCE REFORMS AND OTHER PROPOSED SOLUTIONS TO GOVERNANCE PROBLEMS............45 Sarbanes-Oxley Act of 2002..........................................................45 Other Governance Reforms Reforms and Proposed Solutions.....................48 Solutions .....................48

VI.

CONCLUSION.......................................................................................51

I. INTRODUCTION

Often referred to as the first major failure of the “New Economy,” the collapse of  Enron Corporation stunned investors, accountants, and boardrooms and sent shockwaves 4

across financial markets when the company filed for bankruptcy on December 2, 2001. At that time, the Houston-based energy trading company’s bankruptcy was the largest in history but was surpassed by WorldCom’s WorldCom’s bankruptcy on July July 22, 2002. Enron employees and retirement accounts across the country lost hundreds of millions of dollars when the price of Enron stock sank from its peak of $105 to its de-listing by the NASDAQ at just a few cents. Arthur Andersen, once a Big Five accounting firm, imploded with its conviction for Obstruction of Justice in connection with the auditing services it provided to Enron. Through the use of what were termed “creative accounting techniques” and off-balance sheet transactions involving Special Purpose Entities (SPEs), Enron was able to hide massive amounts of debt and often collateralized that debt with Enron stock. Major conflicts of interest existed with the the establishment and operation of  these SPEs and partnerships, with Enron’s CFO Andrew Fastow authorized by the board to manage the transactions between Enron and the partnerships, for which he was generously generously compensated at Enron’s expense. expense . In addition to crippling investor confidence and provoking questions about the sustainability of a deregulated energy market, Enron’s collapse has precipitated a complete reevaluation of both the accounting industry and many aspects of corporate governance in America. The significance significance of exploring the Enron debacle debacle is multifaceted multifaceted and can be generalized to many companies as corporate America evaluates its governance practices. The fall of Enron demands an examination of the fundamental aspects of the oversight functions assigned to every company’s management and the board of directors of a company. In particular, the role of the subcommittees on a board and their effectiveness are questioned, as are compensation techniques designed to align the interests of shareholders and management and alleviate the principal-agent problem, both theoretically and in application. Companies such as Worldcom, Tyco, Adelphia, and 5

Global Crossing have all suffered catastrophes similar to Enron’s, and have furthered the need to reevaluate corporate governance mechanisms in the U.S. My question then becomes, what lessons can be learned from the fundamental breakdowns that occurred at the corporate governance level at Enron, both from an applied and theoretical standpoint? This paper attempts to offer an analysis that reconciles the events that occurred inside the walls of Enron and our current theories on corporate governance, governance , the firm, and executive compensation. In particular, I look at the role the principal-agent problem played at Enron and attempt to link theories of  management’s expropriation of firm funds with the Special Purpose Entities Enron management assembled. I question Enron’s executive compensation practices and the effectiveness of shareholder and management alignment with the excessive stock-option packages management received received (and the resulting incentives to self-deal). Links between the information asymmetry and the transfer of costs to shareholders is explored, as well as the efficient market hypothesis in regards to Enron’s stock price. And finally, the lack  of director independence at Enron provides a foundation for the excessive compensation practices given managers were extracting rents. From an applied standpoint, I argue that following can be learned from Enron: •

Enron managed their numbers to meet aggressive expectations. They were less concerned with the economic impact of their transactions as they were with the financial statement impact. Creating favorable earnings for Wall Street Street dominated dominated decision making.

•

The Board improperly allowed conflicts of interest with Enron partnerships and then did not ensure appropriate oversight of those relationships. There was a fundamental lack of communication and direction from the Board as to who should be reviewing the related-party transactions and the degree of such review. The Board was also unaware of other conflicts of interests with other transactions.

•

The Board did not effectively communicate with its auditors from Arthur Andersen. The idea that Enron’s employed accounting techniques were "aggressive" was not communicated clearly enough to the board, who were blinded by its trust in its respected auditors. 6

•

The Board did not give enough consideration when making important decisions. They were not really informed nor did they understand the types of transactions Enron was engaging in, and they were too quick to approve proposals put forth by management.

•

The Board members had significant relationships with Enron Corporation and its management, which may have contributed to their failure to be more proactive in their oversight.

•

The Board relied too heavily on the auditors and did not fulfill its duty of ensuring the independence of the auditors. Given the relationship between management and the auditors, the Board should not have been so generous with its trust. The Board is entitled to rely on outside experts and management to the extent it is reasonable and appropriate - in this case it was excessive.

From a theoretical standpoint, I argue that the following are lessons learned from Enron: •

Enron was a manifestation of the principal-agent problem. The ulterior motives of management were not in line with maximizing shareholder value.

•

The high-powered incentive contracts of Enron’s management highlight more of  the costs associated with attempting to align shareholders with management to counter the principal-agent problem and provided management with extensive opportunities for self-dealings.

•

Significant costs were transferred to shareholders associated with asymmetric information due to management’s sophisticated techniques for obscuring financial results. Such obscuring also lead to a partial failure of the efficient market hypothesis.

•

Due to the lack of board independence, the theory of rent extraction more likely explains management’s actions and compensation than the optimal contracting theory.

This analysis of the Enron case attempts to explain what happened at Enron in the context of existing theories on the firm, corporate governance, and executive compensation, as they are innately linked. Section II discusses the general theory of  corporate governance defined from two perspectives, first from an applied perspective and then from a theoretical perspective. Next is an attempt to answer the question of why 7

we need corporate governance and to explore its function theoretically. The section ends with information on changes made in corporate governance over the last two decades. Section III details the factual account of events leading to the fall of Enron. It includes the history and background of the corporation, beginning with its inception with the merger of Houston Natural Gas and Internorth in 1985 through its earnings restatements and eventual bankruptcy filing in December of 2001. It also focuses on the partnerships and transactions that were the catalysts for the firm’s failure, in particular the Special Purpose Entities like Chewco, JEDI, and LJM-1 and LJM-2. Section IV provides analysis of the corporate governance issues that arise within Enron from a theoretical approach. That is, a theoretical and economic framework are applied to Enron’s corporate structure and compensation schedules, highlighting opposing theories such as optimal contracting and rent extraction with regards to executive compensation. Further discussed is the principal-agent problem in the context of Enron and management’s expropriation of shareholder’s capital. Highlighted also are management’s conflicts of interest that were allowed and that then went unmonitored by the board. Also included is an analysis on the lack of material independence on the board and the theory that management had bargaining power because of the close directormanagement relationships. I also discuss the relationship between the audit committee and Arthur Andersen, as well Andersen’s lack of auditing independence. Included is an analysis on the partial failure of the efficient market hypothesis in the case of Enron and the transfer of costs to the shareholders because of the asymmetric information due to management’s sophisticated techniques for obscuring financial results. Section V looks at the primary legislative reform post-Enron, the Sarbanes-Oxley Act, including its key points and the likely effects and costs of its implementation on corporate governance and financial reporting. The section includes other developments 8

in corporate governance, and provides some solutions to improving governance and executive compensation.

II. THEORY OF CORPORATE GOVERNANCE

Corporate Governance and the Principal-Agent Problem Before applying theory to the case of Enron, it is important to first discuss the nature of the principal-agent problem and the reasons for a governance system, as well as to define corporate governance from an applied and theoretical approach. I then will discuss why corporate governance helps improve overall economic efficiency, followed by the general developments in corporate governance over the past two decades. On its most simplistic and applied level, corporate governance is the mechanism that allows the shareholders of a firm to oversee the firm’s management and management’s decisions. In the U.S., this oversight mechanism takes form by way of a board of directors, which is headed by the chairman. Boards typically contain between one and two dozen members, and also contain multiple subcommittees that focus on particular aspects of the firm and its functions. However, the existence of such oversight bodies begs the questions: why is there a need for a governance system, and why is intervention needed in the context of a freemarket economy? Adam Smith’s invisible hand asserts that the market mechanisms will efficiently allocate resources without the need for intervention. Williamson (1985) calls such transactions that are dictated by market mechanisms “standardized,” and can be thought of as commodity markets with classic laws of supply and demand governing them. These markets consist of many producers and many consumers, with the quality of  the goods being traded the same from producer to producer. 9

These market mechanisms do not apply to all transactions though, particularly when looking at the separation of ownership and management of a firm and its associated contracts. The need for a corporate governance system is inherently linked to such a separation, as well as to the underlying theories of the firm. The agency problem, as developed by Coase (1937) and Jensen and Meckling (1976) as well as others, is in essence the problem associated with such separation of management and ownership. A manager, or entrepreneur, will raise capital from financiers to produce goods in a firm. The financiers, in return, need the manager to generate returns on the capital they have provided. The financiers, after putting forth the capital, are left without any guarantees or assurances that their funds will not be expropriated or spent on bad investments and projects. Further, the financiers have no guarantees other than the shares of the firm that they now hold that they will receive anything back from the manager at all. This difficulty for financiers is essentially the agency problem. When looking at the agency problem from a contractual standpoint, one might initially think that such a moral hazard for the management might be solved through contracts. An ideal world would include a contract that would specify how the manager should perform in all states of the world, as dictated by the financiers of the firm. That is, a complete contingent contract between the financiers and manager would specify how the profits are divided amongst the manager and owners (financiers), as well as describe appropriate actions for the manager for all possible situations. However, because every possible contingency cannot be predicted or because it would be prohibitively costly to anticipate such contingencies, a complete contract is unfeasible. As Zingales (1997) points out, in a world where complete contingent contracts can be costlessly written by agents, there is no need for governance, as all possible situations will be anticipated in the contract. 10

Given that complete contingent contracts are unfeasible, we are therefore left with incomplete contracts binding the manager to the shareholders. As a result of the incomplete contracts, there are then unlimited situations that arise in the course of  managing a company that require action by a manager that are not explicitly stated in the manager’s contract. Grossman and Hart (1986) describe these as residual control rights-the rights to make decisions in situations not addressed in the contract. Suppose then, that financiers reserved all residual control rights as specified in their contract with management. That is, in any unforeseen situation, the owners decide what to do. This would not be a successful allocation of the residual control rights because financiers most often would not be qualified or would not have enough information to know what to do. This is the exact reason for which the manager was hired. As a result, the manager will retain most of the residual control rights and thus the ability to allocate firm’s funds as he chooses (Shleifer and Vishny 1996). There are other reasons why it is logical for a majority of the residual control rights to reside with management, as opposed to with the shareholders. It is often the case that managers would have raised funds from many different investors, making each individual investor’s capital contribution a small percentage of the total capital raised. As a result, the individual investor is likely to be too small or uninformed of the residual rights he may retain, and thus the rights will not be exercised. Further, the free-rider problem for an individual owner often does not make it worthwhile for the owner to become involved in the contract enforcement or even be knowledgeable about the firms in which he invests (Shleifer and Vishny 1996) due to his small ownership interest. This results in the managers having even more residual control rights as the financiers remove themselves from the oversight function.

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In attempting to define corporate governance from a theoretical standpoint, it is helpful to think of the contract between the owners and management as producing quasirents. In defining quasi-rents, consider the example of the purchase of a specialized machine between two parties. Once the seller has begun to produce the machine, both the buyer and the seller are in a sense locked into the transaction. This is because the machine probably can fetch a higher price from the buyer than on the open market due to its specificity, and the seller can probably complete the machine for cheaper than any other firm at that point. The surplus created between the differences in the open market prices and the price in this specialized contract constitutes a quasi-rent, which needs to be divided ex-post. The existence of such quasi-rents when produced in the contract between management and owners creates room for bargaining as the quasi-rents need to be divided, and Zingales (1997) argues that the bargaining over these ex-post rents is the essence of governance. To return to the earlier discussion of incomplete contracts, one may make the link  that the residual control rights due to the incomplete contracting can be seen as a quasirent, and thus must be divided ex-post. How, then, are these rents divided given our incomplete contracting assumption? This question gets to the heart of corporate governance and its function. Using Zingales’ (1997, p.4) definition, corporate governance is “the complex set of restraints that shape the ex-post bargaining over the quasi-rents generated by a firm.” This definition serves to summarize the primary function of corporate governance under the incomplete contract paradigm.

Executive Compensation and the Alignment of Manager and Shareholder Interests The notions of executive compensation and the attempt to align manager and shareholder interests are subsections of corporate governance and are directly linked to 12

the agency problem and firm theory. Previously discussed is why operating under the incomplete contract approach tends to leave managers with a majority of the residual control rights of a firm. As a result of these residual control rights, managers have significant discretion and are not directly (or are incompletely) tied to the interests of the shareholders. Acting independently of shareholders’ interest, managers may then engage in self-interested behavior and inappropriate allocation of firm funds may occur. In an effort to quell such misallocations by a manager, a solution is to give the manager long term, contingent incentive contracts that help to align his interests with those of the shareholders. This view of executive compensation is commonly referred to as the optimal contracting view. It is important with this contracting that the marginal value of the manager’s contingent contract exceed the marginal value of personal benefits of control, which can be achieved, with rare exceptions, if the incentive contract is of a significant amount (Shleifer and Vishny 1996). When in place, such incentive contracts help to encourage the manager to act in the interest of the shareholders. Critical to the functioning of these incentive contracts is the requirement that the performance measurement is highly correlated with the quality of the management decisions during his tenure and that they be verifiable in court. The most traditional form of shareholder and management alignment under the optimal contracting view of executive compensation is through stock ownership by the manager. This immediately gives the manager similar interests as the general shareholding population and acts to align their interest. Stock options also help to align interests because it creates incentive for the manager to increase the stock price of the firm, which consequently increases the value of his options when (if) he chooses to exercise them. Another form of an incentive contract that helps to align the interests of  shareholders and a manager is to remove the manager from office if the firm income is 13

too low (Jensen and Meckling 1976). Again, this provides quite a strict incentive for management to produce strong earnings, which aligns his interest with those of the shareholders, and hopefully serves to maximize shareholder value. It is important to mention that these incentive contracts for agents are not without costs and have come under immense scrutiny recently, particularly with the recent corporate governance scandals like Enron. They provide ample incentive for management to misrepresent the true earnings of a firm and do not completely solve the agency problem, an issue that will be discussed further in section IV. A second and competing view of executive compensation is the rent extraction view, or as Bertrand and Mullainathan (2000) call it, the “skimming view.” This rent extraction view is similar to the optimal contracting view in that they both rely on the principal-agent conflict, but under the rent extraction view “executive compensation is seen as part of the [agency] problem rather than a remedy to it,” (Bebchuk, Fried and Walker 2001, p.31). Under this view, an executive maintains significant power over the board of directors who effectively set his compensation. This power the executive, or management team, holds stems from the close relationships between management and the directors, and thus the directors and executives may be bonded by “interest, collegiality, or affinity,” (Bebchuk, Fried and Walker 2001, p.31). Also, directors are further tied to management, and in particular the CEO, because the CEO is often the one who exerted influence to have the director placed on the board, and thus the director may feel more inclined to defer to the CEO, particularly with issues surrounding the bargaining over management’s compensation. As a result of the power that management maintains, management has the ability to bargain more effectively with the board over compensation, and can effectively extract more rents as a result. These “rents” are referred to as the amount of compensation a 14

CEO, or management, receives over the normal amount he would receive with optimal contracting. Therefore it is logical to anticipate seeing higher pay for executives governed by weaker boards, or boards with little independence, which is consistent with Bertrand and Mullainathan’s (2000) findings. That is, one of their conclusions was that boards with more insiders (or less independence) are inclined to pay their CEO more. In other words, CEO’s with fewer independent directors on their boards are likely to gain better control of the pay process. More generally, it is important to mention that incentive contracts for executives are common components of their compensation packages, and there is a vast amount of  literature on the effectiveness of incentive contracts. Murphy (1985) argued from an empirical standpoint about the positive relationship between pay and performance of  managers. Murphy and Jensen (1990) later examined stock options of executives and showed that a manager’s pay increased by only $3 for every $1000 increase in shareholder wealth. Murphy and Jensen concluded that it was evidence of inefficient compensation arrangements, arrangements that included restrictions on high levels of  pay. Others suggest that there needs to be a better approach in screening out performance effects that are outside an executive’s control when looking at incentive contracts. Rappaport (1999), in particular, argues that incentive contracts for executives would provide more incentive and be better measures of executive performance if the stock  option exercise prices were indexed by broad movements in the market. This would imply that an executive would not be compensated simply because of broad movements in the market, but more by his individual firm’s performance relative to other firms.

Corporate Governance’s Role in Economic Efficiency

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Given the role executive compensation and incentive contracts play in attempting to solve the agency problem, there remains the question of what role governance plays in improving economic efficiency. In the ex-ante (which Zingales (1997) defines as the time when specific investments should be made) period, there are two situations where governance improves economic efficiency. The first is that rational agents will focus on value-enhancing activities that are most clearly rewarded, and therefore governance must help allocate resources and reward value-enhancing activities that are not properly rewarded by the market. Secondly, managers will engage in activities that improve the ex-post bargaining in their favor. As Shleifer and Vishny (1989) argue, a manager will be inclined to focus on activities that he is best at managing because his marginal contribution is greater, and this consequently increases his share of ex-post rents, or his bargaining power for residual control rights. Another area where governance may improve economic efficiency is in the expost bargaining phase for rents. That is, governance may affect the level of coordination costs or the extent to which a party is liquidity-constrained. If residual control rights are assigned to a large, diverse group, the existence of free-riders in the group may create an inefficient bargaining system. Also, if a party wishes to engage in a transfer of control rights but he is liquidity-constrained, inefficient bargaining may again occur as the transaction may not be agreed upon (Zingales 1997). A third way that governance may effect overall economic efficiency is through the level and distribution of risk. Assuming that the engaged parties have different risk  aversions, corporate governance can then act to efficiently allocate risk to those who are least risk-averse (Fama and Jensen 1983), which improves the total surplus for the parties involved.

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From a more general standpoint, it is also important to recognize that strong governance in a system of capital markets such as the U.S. promotes an efficient medium for those who are lending money and those who are borrowing, as well as provides some security outside of the legal framework for lenders of capital. The nature of the firm requires that financiers, or lenders of capital, will indeed lend their money to managers who will in turn run a firm and hopefully create a return for the financiers. If the financiers did not feel comfortable that they would be receiving their capital back at some point in the future, they would not be inclined to provide managers with capital and, as a result, innovation and industrial progression would be slowed tremendously. Strong governance helps to maintain investors’ confidence in the capital markets and helps to improve overall efficiency in this manner.

Recent Developments in Corporate Governance Besides the theoretical basis of efficiencies provided by governance, it is important to consider a more applied look at governance and how it has evolved over the past two decades in the U.S. Indeed, corporate governance has changed substantially in the past two decades. Prior to 1980, corporate governance did little to provide managers with incentives to make shareholder interests their primary responsibility. As Jensen (1993) discusses, prior to 1980 management thought of themselves as representatives of  the corporation as opposed to employees and representatives of the shareholders. Management saw their role as one of balancing the interests of all related parties, including company employees, suppliers, customers, and shareholders. The use of  incentive contracting was still limited, and thus management’s interests were not well aligned with that of its shareholders. In fact, “in 1980, only 20% of the compensation of  CEOs was tied to stock market performance,” (Holmstrom and Kaplan 2003, p.5). Also, 17

the role of external governance mechanisms like hostile takeovers and proxy fights were rare, and there tended to be very little independence on a board of directors. The 1980s, however, were defined as an era of hostile takeovers and restructuring activities that made companies less susceptible to takeovers. Leverage was employed at high rates. As Holmstrom and Kaplan (2003) argue, the difference between actual firm performance and potential performance grew to be significant, or in other words, firms were failing to maximize value, which lead to a new disciplining by the capital markets. The 1990s, by contrast, included an increase in mergers that were designed to take advantage of emerging technologies and high growth industries. Changes in executive compensation throughout the two decades also changed significantly. Option-based compensation for managers increased significantly as executives became more aligned with shareholders, specifically, “equity-based compensation in 1994 made up almost 50% of CEO compensation (up from less than 20% in 1980),” (Holmstrom and Kaplan 2003, p.9). There were also changes in the makeup of U.S. shareholders during the two decades, as well as changes in boards of directors. Institutional investors share of the market increased significantly (share almost doubled from 1980 to 1996, Holmstrom and Kaplan 2003), which came alongside an increase in shareholder activism throughout the period. The increase in large institutional investors suggests that firms will be more likely to be effective monitors of management. The logic follows because if an investor (take a large institutional investor for example) owns a larger part of the firm, he will be more concerned with the firm’s performance than if he were small because his potential cash flows from the firm will be greater. It is important to note that often the large shareholders are institutional shareholders, which means that presumably more sophisticated investors with incentives to show strong stock returns own an increasing 18

share of firms. Such concentration of ownership tends to avoid the traditional free-rider problem associated with small, dispersed shareholders and will lead to the large shareholders more closely monitoring management. “Large shareholders thus address the agency problem in that they both have a general interest in profit maximization, and enough control over the assets of the firm to have their interests respected,” (Shleifer and Vishny 1996, p.27). Other developments in corporate governance over the two decades, aside from the regulatory and legislative changes post-Enron, include the fact that boards took great strides to remove their director nominating decisions from the CEO’s control through the use of nominating committees. The number of outside directors (referring to those directors who are not members of management) also increased during the period, as did directors’ equity compensation as a percentage of their total director compensation (Holmstrom and Kaplan 2003). However, despite such improvements over the past two decades, the case of  Enron suggests that corporate governance was not immune from failure, and it highlights many of the theoretical and applied issues with the current theories on corporate governance, the firm, and executive compensation.

III. WHAT HAPPENED AT ENRON: FACTUAL ACCOUNT OF EVENTS LEADING TO BANKRUPTCY

Background/Timeline Enron was founded in 1985 through the merger of Houston Natural Gas and Internorth, a natural gas company based in Omaha, Nebraska, and quickly became the major energy and petrochemical commodities trader under the leadership of its chairman, 19

Kenneth Lay. In 1999, Enron moved its operations online, boasting the largest online trading exchange as one of the key market makers in natural gas, electricity, crude oil, petrochemicals and plastics. Enron diversified into coal, shipping, steel & metals, pulp & paper, and even into such commodities as weather and credit derivatives. At its peak, Enron was reporting revenues of $80 billion and profits of $1 billion (Roberts 2002), and was for six consecutive years lauded by Fortune as America’s most innovative company (Hogan 2002). The sudden resignation, however, of Enron Vice-Chairman Clifford Baxter in May of 2001 and subsequent resignation of CEO Jeffrey Skilling in August of 2001, both of whom retired for undisclosed personal reasons, should have served as the first indication of the troubles brewing within Enron. Mr. Skilling had been elected CEO only months before, and Mr. Baxter had become Vice-Chairman in 2000. Eventually, amidst analysts’ and investors’ questions regarding undisclosed partnerships and rumors of  egregious accounting errors, Enron announced on October 16, 2001 it was taking a $544 million dollar after-tax-charge against earnings and a reduction in shareholder equity by $1.2 billion due to related transactions with LJM-2. As will be discussed in the following section, LJM-2 was partnership managed and partially owned by Enron’s CFO, Andrew Fastow. The LJM partnerships provided Enron with a partner for asset sales and purchases as well as an instrument to hedge risk. Less than a month later Enron announced that it would be restating its earnings from 1997 through 2001 because of accounting errors relating to transactions with another Fastow partnership, LJM Cayman, and Chewco Investments, which was managed by Michael Kopper. Mr. Kopper was the managing director of Enron’s global finance unit and reported directly to the CFO, Mr. Fastow. Chewco Investments was a

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partnership created out of the need to redeem an outside investor’s interest in another Enron partnership and will be discussed at length in the following section. Such restatements sparked a formal investigation by the SEC into Enron’s partnerships. Other questionable partnerships were coming to light, including the Raptors partnerships. These restatements were colossal, and combined with Enron’s disclosure that their CFO Mr. Fastow was paid in excess of $30 million for the management of LJM-1 and LJM-2, investor confidence was crushed. Enron’s debt ratings subsequently plummeted, and one month later, on December 2, 2001, Enron filed for bankruptcy protection under Chapter 11.

Summary of Transactions and Partnerships Many of the partnership transactions that Enron engaged in that contributed to its failure involved special accounting treatment through the use of specifically structured entities known as a “special purpose entities,” or SPEs. For accounting purposes in 2001, a company did not need to consolidate such an entity on to its own balance sheet if two conditions were met: “(1) an owner independent of the company must make a substantive equity investment of at least 3% of the SPE’s assets, and the 3% must remain at risk  throughout the transaction; and (2) the independent owner must exercise control of the SPE,” (Powers, Troubh and Winokur 2002, p.5). If these two conditions were met, a company was allowed to record gains and losses on those transactions on their income statement, while the assets, and most importantly the liabilities, of the SPE are not included on the company’s balance sheet, despite the close relationship between the company and the entity.

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The Chewco/JEDI Transaction The first of the related party transactions worthy of analysis is Chewco Investments L.P., a limited partnership managed by Mr. Kopper. Chewco was created out of the need to redeem California Public Employees’ Retirement System (“CalPERS”) interest in a previous partnership with Enron called Joint Energy Development Investment Limited Partnership (JEDI). JEDI was a $500 million joint venture investment jointly controlled by Enron and CalPERS. Because of this joint control, Enron was allowed to disclose its share of gains and losses from JEDI on its income statement, but was not required to disclose JEDI’s debt on its balance sheet. However, in order to redeem CalPERS interest in JEDI so that CalPERS would invest in an even larger partnership, Enron needed to find a new partner, or else it would have to consolidate JEDI’s debt onto its balance sheet, which it desperately wanted to avoid. In keeping with the rules regarding SPEs, JEDI needed to have an owner independent of Enron contribute at least 3% of the equity capital at risk to allow Enron to not consolidate the entity. Unable to find an outside investor to put up the 3% capital, Fastow selected Kopper to form and manage Chewco, which was to buy CalPERS’ 3% interest. However, Chewco’s purchase of CalPERS’ share was almost completely with debt, as opposed to equity. As a result, the assets and liabilities of JEDI and Chewco should have been consolidated onto Enron’s balance sheet in 1997, but were not. The decision by management and Andersen to not consolidate was in complete disregard of the accounting requirements in connection with the use of SPEs, despite the fact that it is was in both Enron’s employees’ interest and in the interest of Enron’s auditors to be forthright in their public financial statements. The consequences of such a 22

decision were far-reaching, and in the fall of 2001 when Enron and Andersen were reviewing the transaction, it became apparent that Chewco did not comply with the accounting rules for SPEs. In November of 2001 Enron announced that it would be consolidating the transactions retroactively to 1997. This consequently resulted in the massive earnings restatements and increased debt on Enron’s balance sheet. Not only was this transaction devastating to Enron, but its manager, Mr. Kopper, received excessive compensation from the transaction, as he was handsomely rewarded more than $2 million in management fees relating to Chewco. Such a financial windfall was the result of “arrangements that he appears to have negotiated with Fastow,” (Powers, Troubh, and Winokur 2002, p.8). Kopper was also a direct investor in Chewco, and in March of 2001 received more than $10 million of Enron shareholders’ money for his personal investment of $125,000 in 1997. His compensation for such work should have been reviewed by the board’s Compensation Committee but was not. This transaction begins to shed light on a few of the many corporate governance issues arising from Enron, one being the dual role Kopper played as manager and investor of the partnership while an employee of Enron. This is a blatant conflict of  interest, explicitly violating Enron’s own Code of Ethics and Business Affairs, which prohibits such conflicts “unless the chairman and CEO determined that his participation ‘does not adversely affect the best interests of the Company,’” (Powers, Troubh and Winokur 2002, p.8). The second governance issue is in connection with the Compensation Committee’s lack of review of Kopper’s compensation resulting from the transactions. The third governance issue deals with the lack of auditing oversight from the Audit and Compliance Committee concerning the decision not to consolidate the entity.

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The LJM Transactions In June of 1999, Enron again entrenched itself in related-party transactions with the development of LJM-1 and later with LJM-2. Both partnerships were structured in such a way that Fastow was General Partner (and thereby investor) of the entities as well as Enron’s manager of the transactions with the entities, an obvious conflict of interest. LJM-1 (Cayman) and LJM-2 served two distinct roles. They provided a partner to Enron for asset sales and as well as acted to hedge economic risk for particular Enron investments. Especially near the end of a quarter, Enron would often sell assets to LJM-1 or LJM-2. While it is important to note that there is nothing inherently wrong with such transactions if there is true transfer of ownership, it would appear that in the case of the LJM transactions there were no such transfers. Several facts seem to indicate the questionable nature of such transactions at the end of the third and fourth quarters in 1999, one of which was that Enron bought back  five of the seven assets just after the close of the financial period (Powers, Troubh and Winokur 2002). It is reasonable to assume that the sale was purely for financial reporting purposes, and not for economic benefit. Another fact that casts doubt on the legitimacy of the sales is that “the LJM partnerships made a profit on every transaction, even when the asset it had purchased appears to have declined in market value,” (Powers, Troubh and Winokur 2002, p.12). Thus it appears that the LJM partnerships served more as a vehicle for Enron management to artificially boost earnings reports to meet financial expectations, conceal debt, and enrich those investors in the partnerships than as legitimate partners for asset sales and purchases. Not only were the LJM transactions used in asset sales and purchases, but also for supposed hedging transactions by Enron. Hedging is normally the act of protecting 24

against the downside of an investment by contracting with another firm or entity that accepts the risk of the investment for a fee. However, in June of 1999 with the Rhythms investment, instead of the LJM partnerships committing the independent equity necessary to act as a hedge for the investment should the value of the investment decline, they committed Enron stock that would serve as the primary source of payment. “The idea was to ‘hedge’ Enron’s profitable merchant investment in Rhythms stock, allowing Enron to offset losses on Rhythms if the price of Rhythms stock declined,” (Powers, Troubh and Winokur 2002, p.13). These “hedging” transactions did not stop with Rhythms, but continued through 2000 and 2001 with other SPEs called Raptor vehicles. They too were hedging Enron investments with payments that would be made in Enron stock should such a payment be necessary. Despite Andersen’s approval of such transactions, there were substantial economic drawbacks for Enron of essentially “hedging” with itself. If the stock price of  Enron fell at the same time as one of its investments, the SPE would not be able to make the payments to Enron, and the hedges would fail. For many months this was never a concern, as Enron stock climbed and the stock market boomed. But by late 2000 and early 2001 Enron’s stock price was sagging, and two of the SPEs lacked the funds to pay Enron on the hedges. Enron creatively “restructured” some transactions just before quarter’s end, but these restructuring efforts were short-term solutions to fundamentally flawed transactions. The Raptor SPEs could no longer make their payments, and in October of 2001 Enron took a $544 million dollar after-tax charge against earnings- a result of its supposed “hedging” activities. Though they eventually contributed to Enron’s demise, these related party transactions concerning LJM-1 and LJM-2 resulted in huge financial gain for Fastow and other investors. They received tens of millions of dollars that Enron would have never 25

given away under normal circumstances. At one point Fastow received $4.5 million after two months on an essentially risk-free $25,000 investment relating to LJM-1 (Powers, Troubh and Winokur 2002). As discussed earlier, one of the downfalls of the principal-agent problem under the incomplete contract paradigm lies with the allocation of residual control rights to managers. Because managers have much discretion associated with the residual rights, funds may be misallocated. This exact problem, the misallocation of firm funds, arose in the case of Enron. Enron shareholders had invested capital in the firm and management was then responsible for the allocation of such funds. With the residual control rights management maintained due to the separation of ownership and management, management, vis-à-vis the firm’s CFO Andrew Fastow and Michael Kopper, was able to expropriate the firm’s funds. There are many different methods a manager may employ in the expropriation of  funds. A manager may simply just take the cash directly out of the operation, but in the case of Enron, management used a technique called transfer pricing with the partnerships they had created. Transfer pricing occurs when “managers set up independent companies that they own personally, and sell output (or assets in this case) of the main company they run to the independent firms at below market prices,” (Shleifer and Vishny 1996, p.9 excluding parenthesis). The “independent firms” mentioned above were the partnerships, like Chewco, JEDI, and the LJMs that Fastow and Kopper managed and had partial ownership of. With the partnerships like the LJMs making a profit on nearly every transaction, it is clear that Enron must have been selling those assets at below market levels, which defines expropriation by way of transfer pricing. It then makes sense that as the partnerships sold back the assets, they profited each time because Enron would repurchase the assets at prices higher than what the partnerships had paid. Therefore, 26

because Enron’s asset sales and purchases were enriching the investors in the partnerships, management was effectively expropriating firm funds. Management’s expropriation of funds to the manager-owned and operated partnerships is a manifestation of the principal-agent. Management was literally enriching itself and the other owners of  the partnerships with firm funds, a problem that stems from the separation of ownership and management in a corporation. It is important to note that the expropriation of firm funds in this case was really a breakdown in the first layer of the corporate governance institutions that exist to protect shareholders. These mechanisms of corporate governance take many different forms, ranging from management decision-making and compensation, to board oversight, to outside professional advisors and their roles to monitor the workings of a company. Management of a firm, and in particular its CFO, has a fiduciary duty to the shareholders of the company, which serves to act as a governance mechanism. In this case, management abandoned their responsibility to shareholders in favor of enriching themselves and manipulating financial statements, and thus undermined one of the many mechanisms of corporate governance that contribute to its effectiveness. The expropriation of funds through transfer pricing is not an Enron-specific phenomenon. As Shleifer and Vishny (1996) mention, within the Russian oil industry managers often sell oil at below market prices to independent manager-owned companies. Korean chaebol also have reportedly sold subsidiaries to the founders of the chaebol at below market prices (Shleifer and Vishny 1996). At the formation of the LJM partnerships it was brought to the attention of the board that having Fastow both invest in the partnerships and manage the transactions with Enron would present a conflict of interest. Management, however, was in favor of  the structure because it would supply Enron with another buyer of Enron assets, “and that 27

Fastow’s familiarity with the Company and the assets to be sold would permit Enron to move more quickly and incur fewer transaction costs,” (Powers, Troubh and Winokur 2002, p.10). After discussion, the board voted to ratify the Fastow managed partnerships, despite the conflict. The board was under the impression that a set of procedures to monitor the related party transactions was being implemented, and that because of the close scrutiny the partnerships would face this would mitigate the risk involved with them. However, the Enron Board failed “to make sure the controls were effective, to monitor the fairness of the transactions, or to monitor Mr. Fastow’s LJM-related compensation” (U.S. Senate Subcommittee 2002, p.24), and will be discussed further in section IV. Despite the foregoing disparaging remarks regarding SPEs, it is important to note that SPEs are not inherently bad transaction vehicles, and can actually serve valid purposes. They are in fact very appropriate mechanisms for insulating liability, limiting tax exposure, as well as maintaining high debt ratings. They are widely used in both public and privately held corporations and are fundamental to the structuring of joint venture projects with other entities. It was the expropriation of firm funds by Enron management that was illegal, not the transaction vehicles themselves.

IV. ANALYSIS OF CORPORATE GOVERNANCE ISSUES

Corporate Structure In order to fully analyze the corporate governance issues that arose within Enron, a certain amount of background information regarding its corporate structure and the implications of its high power incentive contracts is necessary. By any standards, Enron’s Board structure with five oversight subcommittees could have been characterized 28

as typical amongst major public American corporations. The Chairman of the Board was Kenneth Lay, and in 2001 Enron had 15 Board Members. Most of the members were then or had previously served as Chairman or CEO of a major corporation, and only one of the 15 was an executive of Enron, Jeffrey Skilling, the President and CEO. In his testimony before the Senate Subcommittee on Investigations, John Duncan, Chairman of  Enron’s Executive Committee, spoke of his fellow board members as being well educated, “experienced, successful businessmen and women” and “experts in areas of  finance and accounting.” Indeed they had “a wealth of sophisticated business and investment experience and considerable expertise in accounting, derivatives, and structured finance,” (U.S. Senate Subcommittee 2002, p.8). The board had five annual meetings, and conducted additional special meetings as necessary throughout the year. As provided in U.S. Senate Subcommittee report on The Role of Enron’s Board  of Directors in Enron’s Collapse (2002, p.9), the five subcommittees, consisting of 

between four and seven members each, had the responsibilities as follows: “(1) The Executive Committee met on an as needed basis to handle urgent business matters between scheduled Board meetings. (2) The Finance Committee was responsible for approving major transactions which, in 2001, met or exceeded $75 million in value. It also reviewed transactions valued between $25 million and $75 million; oversaw Enron’s risk  management efforts; and provided guidance on the company’s financial decisions and policies. (3) The Audit and Compliance Committee reviewed Enron’s accounting and compliance programs, approved Enron’s financial statements and reports, and was the primary liaison with Andersen. (4) The Compensation Committee established and monitored Enron’s compensation policies and plans for directors, officers, and employees. (5) The Nominating Committee nominated individuals to serve as Directors.”

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At the full Board meetings, in addition to presentations made by Committee Chairmen summarizing the Committee work, presentations by Andersen as well as Vinson & Elkins, the Enron’s chief outside legal counsel, were common. Vinson & Elkins provided advice and assisted with much of the documentation for Enron’s partnerships, including the disclosure footnotes regarding such transactions in Enron’s SEC filings (Powers, Troubh and Winokur 2002). Andersen regularly made presentations to the Audit and Compliance Committee regarding the company’s financial statements, accounting practices, and audit results. Board members received $350,000 in compensation and stock options annually, which “was significantly above the norm,” (U.S. Senate Subcommittee 2002, p.56). Compensation to Enron executives in 2001 was extraordinarily generous too, as shown by the following chart (Pacelle 2002), which includes the value of exercised stock options and excludes compensation from the partnerships:

Kenneth Lay (Enron Chairman/CEO).………………….….$152.7 (in millions) Mark Fevert (Chair and CEO, Enron Wholesale Services)….$31.9 Jeffrey Skilling (Enron CEO)…………………………...…...$34.8 J. Clifford Baxter (Enron Vice-Chairman)………………..…$16.2 Andrew Fastow (Enron CFO)………………………………..$4.2

In 2000, Mr. Lay’s compensation was in excess of $140 million, including the value of his exercised options. This level of compensation was 10 times greater than the average CEO of a publicly traded company in that year, which was $13.1 million (U.S. Senate Subcommittee 2002, p.52). It is important to note that $123 million of that $140 million came from a portion of the stock options he owned, which represents a significant percentage of total compensation from stock options.

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As discussed in section II, the theory behind such extensive stock option grants to the firm’s management and its directors is to align the interests of shareholders and management as a solution to the principal-agent problem. However, one of the major drawbacks of alignment of manager and shareholder interest by way of stock options is that it provides huge incentives for self-dealings for the managers. As Shleifer and Vishny (1996, p.14) discuss, high powered incentive contracts may entice managers to “manipulate accounting numbers and investment policy to increase their pay.” They also argue that the opportunities to self-deal increase with weak or unmotivated boards overseeing the compensation packages. With the case of Enron, management had significant financial incentive through its stock options to manipulate their earnings to boost stock prices, which created enormous windfalls for those with equity-based compensation when such manipulations occurred. More specifically, as Gordon (2002) argues, the value of the stock option will increase not only with the value of the underlying security but with the stock’s variance, according to the Black-Scholes option pricing. As a result, managers with significant stock options have incentive to increase the stock price of their firm, and variance, by taking on more risk. Costly risk taking was employed at Enron with the use of the highly structured and hedged partnerships. As a result, Enron in a sense “became a hedge fund, taking leveraged bets in exotic markets that if successful would produce a huge, disproportionate bonanza for its executives… the downside seemed a problem only for the shareholders,” (Gordon 2002, p.1247). That is, Enron management had huge potential and realized payoffs by way of their stock options, which provided them incentive to take on unnecessary risk and manipulate earnings. As mentioned earlier, Bertrand and Mullainathan (2000) discuss aspects of such stock compensation practices as they examine two competing views of executive pay, 31

one being the contracting view and the other being the skimming view (or rent extraction view). Included in their analysis is the mention of the constraints that limit the amount managers take from the firm within their equity compensation packages. Such executives are restrained by “the amount of funds in the firm, by an unwillingness to draw attention of shareholder activist groups, or by fear of becoming a takeover target,” (Bertrand and Mullainathan 2000, p.3). Thus, while executive stock options do provide a solution to aligning management and shareholder interests, there are significant costs associated with them, as they often come with the serious threat of manager self-dealings that are not in line with maximizing shareholder value. We have thus seen a breakdown in another one of the institutions of corporate governance with the ineffectiveness of equity compensation for executives. Stock-based compensation is another mechanism that helps to align manager and shareholder interests and hopefully solve the principal-agent problem. This mechanism is indeed a tool of  corporate governance designed to help protect investors and shareholders in the firm. However, in the case of Enron such a technique essentially failed because of the massive incentives for management self-dealings and to manipulate financial statements.

Conflicts of Interest As mentioned earlier, one of the major governance issues brought to light by the bankruptcy of Enron was the blatant conflict of interest involved with having financial officers of a company both manage and be equity holders of entities that conducted significant business transactions with Enron. Enron’s Code of Ethics and Business Affairs explicitly prohibits any transactions that involve related parties unless “the Chairman and CEO determined that his participation ‘does not adversely affect the best interests of the Company’” (Powers, Troubh and Winokur 2002, p.8). With respect to the 32

Chewco transaction, which was managed by Mr. Kopper, the Powers Report concluded that there was “no evidence that his participation was ever disclosed to, or approved by, either Kenneth Lay (who was Chairman and CEO) or the Board of Directors,” (Powers, Troubh and Winokur 2002, p.8). Mr. Kopper’s involvement in the Chewco transaction as both general manager and investor therefore was in direct violation of Enron’s Code of  Ethics and Business Practices, and should have never occurred. The management of  Enron should have recognized the conflict and either sought approval from Mr. Lay, in which case one would hope the transaction would have been restructured with a different general manager, or it should have been abandoned completely. In either case, such a conflict should not have been allowed. Again with the LJM transactions, conflicts of interest were abundant and should have been avoided. However, the LJM transactions differed from Chewco in one major respect: the conflict of interest arising from having the CFO, Mr. Fastow, manage and invest in the entities was approved by the Chairman and Board of Directors. Along with the Board’s ratification of the Chairman and CEO’s approval was the Board’s understanding that a set of controls to monitor the partnerships and ensure fairness to Enron was being implemented by management. Concerns about such a conflict of  interest were expressed amongst senior personnel at Andersen, in which it is clear that such a conflict should have never been allowed. In an email dated 5/28/99 between Andersen employees Benjamin Neuhausen to David Duncan, Neuhausen clearly identifies the issue at hand: “Setting aside the accounting, idea of a venture entity managed by CFO is terrible from business point of view. Conflicts galore. Why would any director in his or her right mind ever approve such a scheme?” Mr. Duncan’s response on 6/1/99 was as follows: “[O]n your point 1 (i.e., the whole thing is a bad idea), I really couldn’t agree more. Rest assured that I have already communicated and it 33

has been agreed to by Andy [Fastow] that CEO, General [Counsel], and Board discussion and approval will be a requirement, on our part, for acceptance of a venture similar to what we have been discussing,” (U.S. Senate Subcommittee 2002, p.26). Because the board was under the impression that a system of controls was being implemented, and because members of management had not objected to such a structuring, it seems more clear why the board came to the conclusion to support such a flawed structure. According to Board Member Mr. Blake, the LJM transactions were described as an “extension of Enron” and as an “empty bucket” (U.S. Senate Subcommittee 2002, p.27) for Enron assets. Further, the proposal for LJM transaction was faxed to Board members only three days before the special meeting took place, and discussion within the meeting about the transaction was limited. The special meeting lasted only an hour, and amongst the approval of the conflict of interest were substantial topics such as resolutions authorizing a major stock split, changes in company’s stock  compensation plan, acquisition of a new corporate jet, and discussion on an investment in a Middle Eastern power plant. This suggests that the board did not devote significant attention to consideration of the conflicts of interest. Thus, again Enron was saddling itself with more related-party transactions, transactions that would eventually lead to its demise. With the Chewco partnership, management, in particular Kopper, again took  advantage of the residual control rights he retained. The manager used these control rights to expropriate funds to the manager-owned and operated partnerships. This is a prime example of the agency problem associated with the separation of ownership and management, and is very similar to the other example of Fastow’s expropriation of funds through transfer pricing. Kopper’s expropriation of funds is again a breakdown in one of  the corporate governance institutions that was in place to protect shareholders. As an 34

employee in the finance division, Kopper had a fiduciary duty to the shareholders, yet he elected to enrich himself and other investors in the partnerships and thus another layer of  the corporate governance mechanisms had failed.

Failures in Board Oversight and Fundamental Lack of Checks and Balances These conflicts of interest highlight more of the fundamental breakdowns in governance within Enron and the lack of Board oversight once such conflicts had been approved. After approving such related-party transactions, the Board of Directors had a general and specific fiduciary responsibility to closely monitor the partnerships and ensure that the policies and procedures in place were in fact regulating the partnerships. This is where they failed. Though management told the Board it was monitoring such transactions to protect the interests of Enron, the Board did not go far enough in its monitoring of the monitors. The procedures and controls included the “review and approval of all LJM transactions by Richard Causey, the Chief Accounting Officer; and Richard Buy, the Chief Risk Officer; and, later during the period, Jeffrey Skilling the President and COO (and later CEO). The Board also directed its Audit and Compliance Committee to conduct annual reviews of all LJM transactions,” (Powers, Troubh and Winokur 2002, p.10). A system of controls as those mentioned would have provided Enron with a safeguard of checks and balances to protect the interests of Enron. Unfortunately the controls “were not rigorous enough, and their implementation and oversight was inadequate at both the Management and Board levels,” (Powers, Troubh and Winokur 2002, p.10). Both Causey and Buy interpreted their roles in reviewing the transactions very narrowly, and did not provide the level of scrutiny that the Board thought was

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occurring, which, of course, eventually resulted in the massive earnings restatements and reduction in shareholder equity. More specifically, the Finance Committee should have taken a more proactive role in examining and monitoring the transactions. As was defined by the role of the Finance Committee, they were “responsible for approving major transactions which, in 2001, met or exceeded $75 million in value. It also reviewed transactions valued between $25 million and $75 million; oversaw Enron’s risk management efforts; and provided guidance on the company’s financial decisions and policies,” (U.S. Senate Subcommittee 2002, p.9). It can be concluded that the Finance Committee failed in its responsibility of such monitoring, especially given that they were aware of the precarious nature of the related-party transactions. A forum for more extensive questioning from directors regarding the transactions was the reason that such a committee existed. Their  job was to probe and take apart the transactions that they reviewed and to oversee risk, neither of which they did for these related-party transactions. Further, the Audit and Compliance Committee also failed to closely examine the nature of the transactions, as is outlined in their duties. Indeed the “annual reviews of the LJM transactions by the Audit and Compliance Committee appear to have involved only brief presentations by Management and did not involve any meaningful examination of  the nature or terms of the transactions,” (Powers, Troubh and Winokur 2002, p.11). Such complex and risky transactions with related-parties deserved close scrutiny, not the cursory review it received. And finally, the Compensation Committee failed in its duty to monitor “Enron’s compensation policies and plans for directors, officers, and employees,” (U.S. Senate Subcommittee 2002, p.9) as was specified. Had they been reviewed by the Compensation Committee, both Fastow’s and Kopper’s excessive compensation for their 36

management of the partnerships as well as their return on private investments in the partnerships would have immediately illuminated the conflicts and abuses associated with the transactions, but no such review occurred. In fact, “neither the Board nor Senior Management asked Fastow for the amount of his LJM-related compensation until October 2001, after media reports focused on Fastow’s role in LJM,” (Powers, Troubh and Winokur 2002, p.11). This lack of oversight by the Compensation Committee was a major contributor to the financial failure of Enron, as both Fastow and Kopper received disproportionate compensation for their management of the partnerships at Enron’s expense.

Audit Committee Relationship with Enron and Andersen During Board meetings Andersen auditors briefed the Enron Audit and Compliance Committee members about Enron’s current accounting practices, informed them of their novel design, created risk profiles of applied accounting practices, and indicated that because of their unprecedented application, certain structured transactions and accounting judgments were of high risk (U.S. Senate Subcommittee 2002, p.16). However, as provided in the charter of the Audit and Compliance Committee, it was the Committee’s responsibility to determine and “provide reasonable assurance that the Company’s publicly reported financial statements are presented fairly and in conformity with generally accepted accounting principles,” (U.S. Senate Subcommittee 2002, p.16). Materials from Audit Committee meetings indicate that its members were aware of such high-risk accounting methods being employed by Enron, but did not act on them. An example is a note written by Andersen’s David Duncan, who states that many of the accounting practices “push limits and have a high ‘others could have a different view’ risk profile,” (U.S. Senate Subcommittee 2002, p.17). A more diligent Audit and 37

Compliance Committee would have probed such comments like this and questioned the accounting techniques applied. Certainly within Andersen it was clear that Enron was engaging in “Maximum Risk” (U.S. Senate Subcommittee 2002, p.18) accounting practices. In fact, amongst Andersen personnel it was noted that “[Enron’s] personnel are very sophisticated and enter into numerous complex transactions and are often aggressive in structuring transactions to achieve derived financial reporting objectives,” (U.S. Senate Subcommittee 2002, p.18). These concerns, however, were never properly addressed and were not effectively communicated to the Audit and Compliance Committee by Andersen. As Mr. Jaedicke, the Chairman of Enron’s Audit and Compliance Committee, stated before the Senate Subcommittee on Investigations about the Audit Committee meetings with Andersen, “when we would ask them [Andersen], even in executive session, about, okay, how do you feel about these, the usual expression was one of  comfort. It was not, these are the highest risk transactions on our scale of one to ten…” (U.S. Senate Subcommittee 2002, p.19-20). Despite Andersen’s wrongful approval of  such transactions, the Audit and Compliance Committee had a duty to ensure that accurate financial statements were produced. The blame for such major accounting errors is not easily assigned, and includes a web of poor decisions by management, Andersen auditors, and the Audit and Compliance Committee. First, management should not have structured their deals with such high-risk  techniques, especially those involving known conflicts of interest. Second, Andersen formally “admitted that it erred in concluding that the Rhythms transaction was structured properly under the SPE non-consolidation rules,” (Powers, Troubh and Winokur 2002, p.24). As a result, financial statements from 1997 to 2000 had to be revised. The governance issues arise when one looks at the role of the Audit and Compliance 38

Committee. While it’s not reasonable to expect Audit Committee members to know the intricacies of off-balance sheet accounting and non-consolidation rules for Special Purpose Entities, it is reasonable to expect them to ask the right questions which get at the heart of a potential problem as well as to create a framework within their oversight duties that allows for conversation, open, candid conversation with management and with external consultants like Andersen. This idea of questioning that which is approved by the supposed experts on the topic, of course, is a most delicate issue, and lies at the core of governance and oversight measures. However, again the emphasis should be on the atmosphere in which the Audit and Compliance Committee operated: it was not one that continually challenged themselves to ensure accurate financial statements for Enron. It is important to emphasize that Enron went to great lengths to employ such highly structured SPEs and partnerships, and such entities were only described to outside investors in the footnotes of Enron’s disclosure documents. The non-consolidation rules did not require that such entities be included on the balance sheet, making such transactions difficult to recognize and understand, even for sophisticated analysts and investors. In effect, Enron was using technologies (or complex financial techniques) that helped to obscure the firm’s true financial results. Had investors been more aware of and understood the significance of such highly structured partnerships, they would not have been as deceived by the financial results and would have looked more skeptically at the firm’s financial condition. Bebchuk, Fried and Walker (2001) describe such technologies for obscuring executive compensation as “camouflaging.” They argue that “efforts will be made to obfuscate the compensation data and otherwise plausibly justify the compensation programs,” (Bebchuk, Fried and Walker 2001, p.34). The effects of such technologies that obscure financial results are far reaching and directly impact the shareholders of the firm. By obscuring financial results through the 39

use of the SPEs and partnerships, there was a dramatic case of information asymmetry between those who understood Enron’s financial structures, essentially management and the auditors, and the shareholders and analysts who did not. As Gordon (2002, p.1236) mentions, Enron and its managers “reveled in information asymmetry.” The result of the information asymmetry was a transfer of costs to shareholders who were not informed of  Enron’s accurate financial status. Shareholders were now shouldering the costs associated with the highly structured and risky strategies Enron was employing, a cost they paid for as Enron’s stock price dropped with the public disclosure of the financial impact the transactions were having on the firm. The lack of financial reporting transparency represents the failure of another layer of corporate governance protection that shareholders are normally provided. Shareholders rely on the financial reports and information that management produces. When such reports are inaccurate and have been manipulated shareholders are stripped of  another mechanism that helps to truly monitor the performance of management, which is what happened with the case of Enron. This layer of corporate governance often can serve the purpose of catching the breakdowns in other institutions of corporate governance, like the conflicts of interest management engaged in. Had such entities and partnerships been thoroughly disclosed, more investors would have questioned such practices and would have triggered appropriate responses to the entities existence. However, because there was such obscurity in the financial reports, outside investors were not able to easily identify the nature of the partnerships, which is breakdown in another layer of the corporate governance mechanisms designed to protect investors.

Lack of Auditing Independence and the Partial Failure of the Efficient Market Hypothesis

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The Board of Enron also failed in its duty to ensure the objectivity and independence of Arthur Andersen as its auditor, providing yet another area in which the oversight of Enron’s Board broke down. It was well understood that Andersen provided not only internal auditing services to Enron, but consulting services as well. These two services were closely linked, and often were referred to as an integrated audit. The problems inherent to an integrated audit are of major concern, as the independence of the auditors is forfeited. The lack of independence occurs because Andersen might audit its own work, in which case “Andersen auditors might be reluctant to criticize Andersen consultants for the LJM or Raptor structures that Andersen had been paid millions of  dollars to help design,” (U.S. Senate Subcommittee 2002, p.57). Therefore Andersen’s auditing objectivity was sacrificed because of the concurrent employment of their consulting services. The onus then falls on the Audit and Compliance Committee to assess the objectivity and independence of the auditor. As Senator Collins said to Audit Committee Chairman Mr. Jaedicke in the Senate Subcommittee Investigation, “when you are making over $40 million a year, the auditor is not likely to come to the Audit Committee and say anything other than they are independent,” (U.S. Senate Subcommittee 2002, p.58). which gets right to the point that the job to determine objectivity and independence is not the auditor’s, but the board overseeing the auditors, the Audit Committee. Indeed, Andersen’s consulting and auditing fees were substantial, totaling $27 million for consulting services and another $25 million for auditing services performed in 2000 (U.S. Senate Subcommittee 2002, p.58). Enron’s Audit and Compliance Committee did very little to investigate the independence of Andersen’s auditing services, but had they been more interrogative, they might have preserved the independence of its auditors by prohibiting other services other than audit work, hopefully producing more accurate 41

financial statements. Again, this is a breakdown in yet another level of the corporate governance institutions. The Audit Committee’s role was one of oversight, and it failed to monitor and oversee the production of accurate financial statements. This level of  oversight is designed to catch failures in other layers of corporate governance like the independence of the outside auditor, yet it failed in its oversight duty. Not only should have the Audit Committee done a better job in scrutinizing the accountant’s independence, but so should have sophisticated market participants who placed such a high value on the stock. The result is the partial failure of the efficient market hypothesis for Enron stock. Gordon (2002) argues that the efficient market hypothesis, which says “the prices of securities fully reflect available information” (Bodie, Kane and Marcus 2002, p.981), was indeed disrupted when one looks at the pricing of Enron stock. It was widely understood that Andersen was providing both audit and consulting services to Enron, which, according to Gordon (2002, p.1233-4) should have “sharply diminished [the] value of Andersen’s certification for a company like Enron with complicated accounting, abundant consulting opportunities, and obvious accounting planning [and] should have been impounded in Enron’s stock price…” Further evidence in support of the partially failed efficient market hypothesis is that the analysts that were tracking Enron knew that Enron was engaging in complex, off-balance sheet transactions that were discreetly described in disclosures. Such financial reporting obscurity should have caused more skepticism from the financial community, and consequently such skepticism should have been ingrained in the company’s stock price. Such skepticism, however, was not ingrained in the price and the stock continued to soar into 2000. I refer to it as a “partial failure” of the hypothesis because there are indications that perhaps the stock price was adjusting due to leaked news of the partnerships and 42

Enron’s looming accounting crisis. The gradual fall in the stock price from January 2001 at $80 per share down to almost $40 per share by that fall, despite increased earnings throughout the period, suggest that the market was in a period of correction. However, because the supposed “correction” was so slow, this still suggests that there may have been a partial failure in the market efficiency.

Director Independence/Director Selection It is important to identify the lack of independence and its implications when looking at the directors of Enron’s Board. The independence of directors can play a critical role in evaluating one’s ability to provide objective judgment. As the Business Roundtable (2002, p.11) suggests, “The board of a publicly owned corporation should have a substantial degree of independence from management. Board Independence depends not only on directors’ individual relationships- personal, employment or business- but also on the board’s overall attitude toward management. Providing objective independent judgment is at the core of the board’s oversight function, and the board’s composition should reflect this principle.”

From an outside vantage point it would appear that Enron indeed had an independent board, as it contained only one Enron executive. Financial ties, however, between Enron and a majority of its directors seem to have weakened their objectivity in their oversight of Enron. The following are examples of such financial ties contributing to the lack of true independence amongst Enron Board members, as cited was cited in the U.S. Senate Subcommittee report on The Role of Enron’s Board of Directors in Enron’s Collapse (p.55): •

Lord Wakeham received $72,000 in 2000 for his consulting services to Enron, in addition to his Board compensation.

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•

John Urquhart received $493,914 in 2000 for his consulting services to Enron, in addition to his Board compensation.

•

Herbert Winokur also served on the Board of the National Tank Company, a company which recorded significant revenues from asset sales and services to Enron subsidiaries from 1997 to 2000.

•

From 1996 to 2001, Enron and Chairman Kenneth Lay donated almost $600,000 to M.D. Anderson Cancer Center in Texas. Both Dr. Lemaistre and Dr. Mendelsohn, both of whom were currently Enron directors, served as president of  the Cancer Center.

•

Donations from Enron and the Lay Foundation totaled more than $50,000 to the Mercatus Center in Virginia, where Board member Dr. Wendy Gramm is employed.

•

Hedging arrangements between Belco Oil and Gas and Enron have existed since 1996 worth tens of millions of dollars. Board member Mr. Belfer was Chairman and CEO of Belco.

•

Frank Savage was a director for both Enron and the investment firm Alliance Capital Management, which since the late 1990’s was the largest institutional investor in Enron and one of the last to sell off its holdings (Green 2002).

Such relationships with Enron may have made it difficult for such board members to be objective or critical of Enron management. Unfortunately too often “supposedly independent directors have been anything but-- steered on to the board by powerful executives, on whom they are too often dependent for favors, loans or business,” (The Economist 2002). As Chairman of the Federal Reserve Alan Greenspan notes, “few directors in modern times have seen their interests as separate from those of the CEO, who effectively appointed them and, presumably, could remove them from future slates of directors submitted to shareholders,” (Greenspan 2002). This clearly seems to have been the case with Enron, given the long list of close business ties with supposedly independent directors. Many of these Enron Board members may have felt that their 44

compensation (as a director or to the director’s affiliated organizations) might be  jeopardized by probing and questioning extensively in Board meetings, producing weak  “nodders and yes-men” (The Economist 2002) as directors and thus weakening the imperative oversight role of the Board and contributing to the fall of Enron. The theoretical implications of a board that lacked independence at Enron fit well with the previous discussion on executive rent extraction. I argued, as presented by Bebchuk, Fried and Walker (2001), that managers will be able to extract rents when they are connected to the directors, either through friendship, employment, association, or other means. The directors, because of their close relations with management, will not be inclined to question management, and will defer to management in bargaining over executive compensation. This lack of independence on the board at Enron then likely contributed to management’s engagement in rent extraction, which could be one explanation for the abnormally high compensation Enron executives received. That is, had there been more truly independent directors on Enron’s board, one would have expected to have seen lower compensation for executives, compensation that more appropriately fit the optimal contracting view that maximizes shareholder value. These predictions again are consistent with Bertrand and Mullainathan’s (2000) findings, that compensation for executives is lower with more independent boards, suggesting that rent extraction cannot occur as easily with better governed (more independent) boards. Hermalin and Weisbach (1998) present a model in which board effectiveness is a function of its independence. In their model they predict, among other things, that poor firm performance lowers the director’s assessment of the CEO, which results in a loss of bargaining power for the CEO (and presumably a loss of rent extraction) and an increase in the probability that the number of independent directors will increase. Thus, because the Enron directors were so closely tied to management and 45

Enron as a firm, they were not as objective as they needed to be, which supports the theory of management rent extraction. The lack of independence also helps to explain the fundamental lack of oversight exhibited by the Board with regards to the conflicts of  interest presented with the partnerships. The lack of independence on Enron’s Board suggests another breakdown of one of the most fundamental corporate governance institutions. The lack of independence gets to the core oversight function of a board of directors. It is imperative that a board be capable of looking objectively at the management and outside professional advisors of a firm, and Enron’s Board was not capable in this respect. This layer of corporate governance, that is the board oversight function, should act as a final mechanism to protect investors when other governance institutions have broken down. It should serve to help avoid conflicts of interest, ensure auditing independence and accurate financial reporting, oversee compensation practices, as well as many other breakdowns that occurred within Enron. This last layer, however, failed to serve its purpose and was compromised largely because of the relationships between Enron, management, and the directors themselves. While there clearly were incentives for inside directors of Enron to remain quiet and accept without question the approaches taken by Enron management, perhaps the alternative of a completely independent board of directors would not be as successful as one might initially think. Chairman Greenspan (2002) argues that “shackling [the CEO] with an interventionist board may threaten America’s entrepreneurial business culture” by slowing down the CEO too much. Greenspan (2002) also suggests that having solely independent directors “would create competing power centers within a corporation, and thus dilute coherent control and impair effective governance.” It is also important to have directors with relevant business and industry experience, some of whom may have 46

ties with the company he or she oversees, which can provide an important perspective on issues that may arise in boardroom settings. Thus, while it is important for directors of  companies who are not members of management to maintain a certain degree of distance from the company and management, eliminating all ties and having truly independent directors might prove to actually hinder effective corporate functioning

V. POST-ENRON GOVERNANCE REFORMS AND OTHER PROPOSED SOLUTIONS TO GOVERNANCE PROBLEMS

It would be incomplete to discuss the fall of Enron without briefly discussing the legislative reforms and other proposed solutions to the issues relating to the principalagent problem and governance today. This section will highlight some of the key points in the Sarbanes-Oxley Act and some potential costs associated with its implementation, as well some other developments in corporate governance and other potential solutions to solving the principal-agent problem.

Sarbanes-Oxley Act of 2002 In response to both the collapse of Enron and the general influx of corporate malfeasance recently in the U.S., the Sarbanes-Oxley Act became law on July 30, 2002. Its federal securities provisions are the most far-reaching of any since those of the 1930s under President Roosevelt and constitute substantial changes for corporate governance and financial reporting. Many of these changes were instituted in direct response to the case of Enron. While some of the provisions will require further resolution and rulemaking, others have gone into effect ranging anywhere from one month to one year

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from the date of their enactment. Some of the key provisions of the Act are summarized below. The Sarbanes-Oxley Act substantially affects the executive officers and directors of public companies. It requires the certification of both CEO and CFO that they have reviewed the financial report and that based on their knowledge the report accurately represents the material respects of the company’s financial position. It also bans personal loans to executive officers, with exceptions for loans made in the ordinary course of  business (i.e. consumer credit, charge cards, …). The Act accelerates the reporting of  trades by insiders of their respective company’s stock from more than a month to two days. The Act prohibits insider trades during pension fund blackout periods. It also mandates that if a company is required to restate its financial statements due to noncompliance, the CEO and CFO must reimburse the company for any bonus or incentivebased compensation or gains on sales of stock received during the 12 months prior to the restatement. The next section of the Act involves financial reporting, and specifies that all material off-balance sheet transactions will have to be disclosed on all 10-Ks and 10-Qs, which is in direct response to Enron’s lack of disclosure on its Special Purpose Entity transactions. In addition, each company will be required to disclose in its reports whether or not it has adopted a code of ethics for senior financial managers, and will be required to disclose any change in or waiver of this code of ethics, which is again in direct response to Enron approving the conflicts of interest with its financial officers Kopper and Fastow. The next section of the Act focuses on audit committees and outside audit firms, and specifies that the Audit Committee must be composed of entirely independent directors, and then provides a definition of independent. The Act also prohibits an 48

outside auditor from providing any other concurrent services, namely consulting, to the company to which it is auditing. Again, this is in direct response to the lack of  independence of Andersen when auditing Enron’s books because of the consulting services they were also providing to Enron. The Act requires that the lead auditing partner and reviewing partner must rotate at least once every five years. The Act also specifies that an Accounting Oversight Board be established. This Board will have oversight over firms that audit public companies, the ability to establish rules governing audits, conduct investigations, and impose sanctions (Huber 2002). The Act continues with specific criminal penalties for securities violations as well as civil liabilities, and follows with an attorney’s obligation to report such violations of  its client. While such legislative changes mentioned above may prove to be effective changes in financial reporting and governance practices, it is important to note that such legislative changes create potential costs as well. Increasing the amount of liability for management may entice management to act more conservatively and engage in less risky projects in order to avoid a restatement of any sort because of the risk of bearing the costs of such restatements. As a result, diversified investors who can bear such risk may find managers of firms they have invested in acting more cautiously than the investors would like, thus potentially increasing agency costs as opposed to reducing them (Ribstein 2002). Increased costs may potentially occur in other forms due to the implementation of  the Sarbanes-Oxley Act. From a resource allocation standpoint such legislation may increase costs through inefficiencies. Firms that are employing accounting practices that are more uncertain, or use more complex financial instruments like hedging and derivatives, are susceptible to increased liability risk. Investors then will be less inclined 49

to supply capital to such firms, which might lead to inefficiency in asset allocation. After the Enron debacle, firms engaging in complex financial reporting will not be looked upon as favorably by the financial markets, even though such firms don’t inherently pose a higher risk of fraud. Further costs associated with Sarbanes-Oxley include information costs, in which firms will have to expend more resources to get information and perhaps pay auditors more in light of the legislation, and costs associated with cover-ups to avoid liability (Ribstein 2002).

Other Governance Reforms and Proposed Solutions Since the fall of Enron there have been many other recent developments in the reformation of corporate governance, including the massive increases in demand for board consulting services. Companies, and specifically directors, have been scrambling to avoid their own Enron debacle, and, as a result, “conferences, consultants, speakers publications, Websites, and memberships in trade groups [have] focused on the suddenly sexy issue” (Lublin 2002) of corporate governance and how it should be best employed. These consultants are being hired to “conduct formal assessments of the entire board”… which includes probing “for weak spots in board structure, procedures and members’ performance” (Lublin 2002). These are very positive steps when one evaluates the state of corporate governance in America, for these major increases in demand for consulting services for boards indicate the significance individual directors and boards are putting on the oversight work that they do or recognition of the liability they face if they don’t. An extension of the increase in consulting for boards in an effort to improve corporate governance is the idea of rating or evaluating individual directors. Many of  these consulting services “are developing rating systems for board members based on factors such as attendance and prior performance,” (Green 2002). The expectation is that 50

such review will improve the individual performance of each board member, as there would now be incentive to perform well and avoid being rated poorly by an outside firm. Though in theory such a measure might encourage board members to take greater responsibility and care in their duties, the widespread adoption of director evaluations seems an unlikely step. A ranking system such as this, though, would make it very difficult for former Enron director Frank Savage, or any other former Enron director for that matter, to serve on other boards. Savage’s record as a director is egregious. Aside from being a member of Enron’s board, he also was a director of Alliance Capital Management, one of the largest institutional investors in Enron just prior to its collapse. “By the time Alliance Capital had sold its 43 million shares of Enron stock, it had lost its investors hundreds of  millions of dollars, including $334 million from the Florida state pension fund,” (Green 2002). One would hope that it would be clear through an evaluation of Mr. Savage’s past performance as a director that he would not be a wise choice to sit on any future boards. As argued in section II, the concentration of ownership, particularly with a sophisticated institutional investor, would normally improve the governance function because the large institutional investor has a larger claim to the firm and its cash flows (Holmstrom and Kaplan 2003 and Shleifer and Vishny 1996). It is logical to then take the argument one step further, in that a representative of the institutional investor (just as Frank Savage was for Alliance Capital) sitting on the board would be an ideal director, as this would serve to help align interests. Mr. Savage, however, lost hundreds of millions of dollars of his investors’ money that had been invested in Enron while he sat on the Board. One would have anticipated that with such a significant stake in the company that Mr. Savage would have probed and questioned more diligently throughout all aspects of his oversight, which did not apparently occur. 51

While the rating or evaluation of directors may be an effective tool for assessing governance performance, it is often very difficult to identify potentially inadequate or ineffective directors. For example, the qualifications of the Chairman of Enron’s Audit and Compliance Committee, Dr. Robert Jaedicke, would suggest that he is an entirely appropriate choice to head such a committee. He had extensive director experience prior to joining Enron’s Board in 1995, and is the Dean Emeritus and a former accounting professor of the Stanford Business School. These are attributes that would suggest the ideal candidate for a member of an Audit Committee, yet it is clear that Enron’s Audit Committee failed in its oversight functions. Not only is it difficult to identify potentially ineffective directors, but identifying inadequate boards as a whole is extremely difficult. Enron’s Board had received much positive recognition for their governance role just prior to the company’s bankruptcy. In fact, “Chief Executive Magazine ranked its board as one the nation’s five best and praised its ‘overall corporate-governance structure,’” (Lublin 2002). Such rankings indicate that any assessments of boards or directors are not necessarily accurate, and therefore may not be the best solution to ensure high-quality corporate governance. Another mechanism that might help to improve executive compensation is through the use of indexed stock options. With options that are not indexed, executives may be rewarded for increases in the stock price that are not the result of a manager’s effort, but of industry or market wide performance. Indexing would serve to filter out the executive’s performance and more effectively maximize shareholder value incentives for the amount spent on such incentives (Bebchuk, Fried and Walker 2001). The ability of an executive to unwind his equity compensation incentives also poses a threat to the effectiveness of such shareholder and management alignment. Bebchuck, Fried and Walker (2001, p.77) argue that “executives generally are not barred 52

from hedging away equity exposure before these instruments vest, nor are they constrained in exercising the options and disposing of the stock acquired once vesting as occurred.” As a result, after the granting of such options executives have locked in gains or hedged their position, which acts to reduce their incentive to increase the stock price further. Eliminating, or limiting, the ability of an executive to employ such strategies would help to better align shareholders and management and provide long-term incentives for executives to show an increase in stock price.

VI. CONCLUSION

The utter explosion of accounting fraud, corporate abuses, and governance failures since Enron is unprecedented in recent U.S. history and has called into question fundamental aspects of company management and board oversight. The bankruptcies and earnings restatements for corporations such as Worldcom, Tyco, Global Crossing, and Adelphia highlight many similar issues Enron initially brought to light and have continued to reinforce the need for an examination of corporate governance. In response to Enron and the other cases of corporate abuse, politicians, boards of directors, and the public have taken great strides to raise awareness and take action to prevent another Enron-style mess. We have seen these steps in the form of regulatory and legislative responses via the Sarbanes-Oxley Act and the demand from individual investors and Wall Street analysts for more accuracy and disclosure on financial statements. When evaluating the lessons learned from Enron, it is important to highlight the inherent nature of a publicly traded company. As is apparent through both their actions and the discussion amongst Andersen personnel, Enron was driven by reported earnings. One Andersen employee noted that “Enron has aggressive earnings targets and enters into 53

numerous complex transactions to achieve those targets,” (U.S. Senate Subcommittee 2002, p.18). That is, Enron was willing focus on structuring their deals so as to boost “book” revenue and stock price and put forth the most favorable view of the company to outsiders in exchange for providing them with real economic benefits from their transactions, as evidenced by the Chewco and the LJM partnerships. Being driven by reported earnings isn’t necessarily a poor incentive. In fact, shareholders, who are hoping to have management maximize the company’s share price, should want managers to be focused on earnings. Unfortunately with Enron, managers maintained significant control rights and had huge financial incentives through their highpowered stock options to manipulate such earnings. Despite such massive option packages, management still expropriated firm funds to their SPEs they created, owned and managed. This stems directly from the lack of oversight and is a manifestation of the principal-agent problem. Enron shareholders, many of whom were Enron employees who owned the stock in their 401k plan, were transferred significant costs because of the financial reporting techniques management and Andersen employed. The off-balance sheet transactions and complex, obscure reporting created massive information asymmetry, and also promoted the disruption in the efficient market hypothesis for the Enron stock. Further, the lack of Board independence supports a conclusion of  management’s extraction of rents because of the excessive compensation Enron executives were paid. However, perhaps the most important lesson learned from Enron is less tangible and focuses on the undertone of corporate boards. The effective corporate governance and strong auditing oversight mentioned above should stem from a renewed sense of  responsibility boards should have in the wake of Enron, and it should be carried through with strict adherence to creating a boardroom atmosphere and oversight framework  54

conducive to asking candid, probing questions of management, financial statements, and of a company’s auditors. It is only when such questioning occurs that the oversight mechanisms in place take action, and companies run more efficiently and effectively. This paper has thus established a more complete indictment of the actors associated with the fall of Enron and reconciled current theories of corporate governance, executive compensation, and the firm with the events that transpired within Enron. By applying economic framework to Enron we have seen that Enron was a manifestation of  the agency problem and that there were significant costs associated with the high-power incentive contracts for management. Further, significant costs were transferred to shareholders because of the obscure financial reporting techniques, leading to a partial failure of the efficient market hypothesis. Also, management’s excessive compensation is likely explained by rent extraction because of the close relationships between the Board of Directors and management and Enron. This paper, however, has not explained two further issues surrounding the fall of  Enron. The first is the question of why these corporate governance mechanisms that were in place all failed, particularly at this level of egregiousness. That is, why were the corporate governance institutions that were designed to protect the shareholders systematically dismantled on different layers contemporaneously? And secondly, a puzzle remains as to how management anticipated eventually walking away from Enron after having reaped such benefits from the partnerships they had created. What was their “get away” mechanism that would have allowed them to sever ties without eventually being implicated in partnerships that siphoned off firm funds? The fall of Enron was a complicated case involving a web of poor decisionmaking and oversight over a several year period. All the institutions that an outsider might have relied on to learn the truth about the company were flawed or failed. The 55

interlocking between the governance mechanisms meant that everybody involved at Enron was relying on someone else to perform the governance oversight, oversight that was not properly performed. Enron, as well as the other recent accounting scandals and corporate abuses, has thus identified the need for higher moral and ethical standards among corporations. These standards start at the top of an organization, and call on the leaders of corporate America to set the appropriate tone. As Senator Joe Lieberman mentioned about such leaders, “in the privacy of their consciences, we must hope that people with economic power will know the difference between right and wrong and act on it,” (Congressional Press Release 2002). Despite such substantial changes to reporting, auditing, and governance standards that have emerged in recent months, we should constantly be reminded that, as Chairman Greenspan notes, “rules cannot substitute for character. In virtually all transactions, whether with customers or with colleagues, we rely on the word of those whom we do business,” (Greenspan 2002). Indeed, adhering to the best possible corporate governance practices is founded on maintaining that character Greenspan mentions and basing decisions and actions on the core ethical values that will continue to make our capital markets and American industry function most efficiently.

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