Coporate Governance and Theory
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Transcript of Coporate Governance and Theory
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 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 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.
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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-Agent Problem ...............7 Executive Compensation and the Alignment of Manager and Shareholder Interests ...........................................11 Corporate Governance’s Role in Economic Efficiency.................14 Recent Developments in Corporate 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 Transactions ...................................................................22
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 Market Hypothesis ...................................38
Director Independence/Director Selection.....................................41
V. POST-ENRON GOVERNANCE REFORMS AND OTHER PROPOSED SOLUTIONS TO GOVERNANCE PROBLEMS............45
Sarbanes-Oxley Act of 2002 ..........................................................45 Other Governance Reforms and Proposed 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
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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 bankruptcy on 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 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 compensated at Enron’s 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 of exploring the Enron debacle is 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
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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, 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 (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 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.
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• 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
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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 director-
management 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
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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 free-
market 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.
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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.
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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 quasi-
rents. 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 quasi-
rent, 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
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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
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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
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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 ex-
post 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,
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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
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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,
20
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
21
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
23
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.
24
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
25
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
26
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 re-
purchase the assets at prices higher than what the partnerships had paid. Therefore,
27
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
28
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
29
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.”
30
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.
31
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,
32
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
33
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
34
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
35
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
36
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
37
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
38
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
39
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
40
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
41
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
42
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
43
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.
44
• 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
45
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
46
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
47
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 principal-
agent 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
48
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 non-
compliance, the CEO and CFO must reimburse the company for any bonus or incentive-
based 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
49
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
50
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
51
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.
52
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
53
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
54
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 high-
powered 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
55
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 decision-
making 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
56
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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