Corporate governance

Case Study : Enron

Summary :
I- Presentation and chronology
II- The financial arrangement
III- How the governance can explain it ?
IV- Questioning the corporate governance model
V- Conclusion
I- Presentation and chronology:
nron Corporation was an !merican energy" commodities" and services company #ased in
Houston" Texas$ nron employed approximately %&"&&& staff and was one of the world's
ma(or electricity" natural gas" communications" and pulp and papercompanies" It was created in
)*+," #y the merger of the Houston -atural .as company with Inter-orth$ This merger was
management/s first attempt to develop a national pipeline system for natural gas$ The following
year" the former C0 of Houston -atural .as" 1enneth 2ay" #ecame the chairman and C0 of
nron$ !t the #eginning" its #usiness model was very classic3 production and transportation of gas"
and distri#ution essentially on whosales mar4ets$ Quic4ly it #ecame the ma(or energy and
petrochemical commodities trader in 56$ Throughout the late )**&s" nron was almost universally
considered one of the country's most innovative companies$ The maga7ine 8ortune named nron
9!merica's :ost Innovative Company9 for six consecutive years" from )**; to %&&&$ In )**;"
<effrey 64illing" old consultant of :c1insey" #ecame the president and Chief 0perating 0fficer of
nron" seven years after his enter his entry in the company$ nron has =>& #illions in )***" and
=)&& #illions in %&&&" than4s to the launching of nron0nline" a trade platform where there is a#out
%)&& products derived which can #e exchange$ It was a the largest trading exchange as one of the
4ey mar4et ma4ers in natural gas" electricity" crude oil" petrochemicals and plastics$
nron diversified into coal" shipping" steel ? metals" pulp ? paper" and even into such commodities
as weather and credit derivatives$ +&@ of its revenues came from this 4ind of activities$
This launch was sustained #y the Texan senator" who convainced the citi7en that the deregulation of
the mar4et would divide their invoice #y %$ !t this moment the company #ecame one of the sixth
largest energy company in the world$
In %&&)" <effrey 64illing #ecame nron/s new C0 #ut only for four months" after which
1enneth 2ay too4 the title again for an un4now reason$
Aeferences
But (ust after it" the cotation decreased" following the #ursting of the internet #u##le$ The
losses of the company" which where hidden #y ingenious financial arrangement" appears in the
financial statement$ 0n novem#er %&&)" the 6ecurities and xchange Commission open an
investigation$ 0ne month later The company announce its #an4ruptcy$
Its leads a decrease of the Cuotation under )=" the dismissing of %&"&&& employees" financial losts
for investors" savers$$$
Then" the treasurer Ben .lisan was condemned at , years of (ail" and the ex-C0 <effrey
64illing at %> years of (ail$ 1enneth 2ay died #efore go to (ail$ Dere also accused the partners of
nron 3 !rthur !ndersen" Citigroup" <P :organ" :errill 2ynch" Eeutsche Ban4" la CIBC" and the
#an4 Barclays$
The Financial arrangement
nron announced on 0cto#er );" %&&) it was ta4ing a =,>> million dollar after-tax-charge against
earnings and a reduction in shareholder eCuity #y =)$% #illion due to related transactions with
2<:-%
2ess than ) month later" nron announced that it would #e restating its earnings from )**F through
%&&) #ecause of accounting errors relating to transactions with another 8astow partnership" 2<:
Cayman" and Chewco Investments $ !ctually those companies were (ust created to dissimulate the
losses$ It was possi#le than4s to special accounting treatment through the use of specifically
structured entities 4nown as a Gspecial purpose entities"H or 6Ps$ nron was a#le to hide massive
amounts of de#t and often collaterali7ed that de#t with nron stoc4$ :a(or conflicts of interest
existed with the esta#lishment and operation of these 6Ps and partnerships" with nron/s C80
!ndrew 8astow authori7ed #y the #oard to manage the transactions #etween nron and the
partnerships" for which he was generously compensated at nron/s expense$
8unctionnement of this system" exemple3
- nron sell =)million of gas to a fictive company
- The #an4 #uy =) million of to this company
- The #an4 sell =) million plus interests to nron
It permess to transform loans in commercial sales" and to increase the revenue$Company didn't have
to consolidate it" and they are not included in the #alance sheet$ nron created more than I"&&&
offshore company in order to use this system$
Here there is the case of ChewcoJ<edi transaction" which is very representative 3
Chewco is a =I+I million investment partnership allegedly arranged #y nron's former chief
financial officer !ndrew 8astow in )**F to 4eep nron's de#t off its #alance sheets$
Chewco" named after a 6tar Dars character Chew#acca" was part of a cluster of partnerships that
executed different roles in #illion-dollar financing deals$ 8unded #y money invested in nron and
without investor 4nowledge" the partnership involved 8astow and an off-shore financial group he
controlled$
The story of Chewco #egan nearly a decade ago in )**I when nron and the California Pu#lic
mployees Aetirement 6ystem KCalpersL created a ,&-,& partnership 4nown as the <oint nergy
Eevelopment Investment 2imited K<EIL$ !t the time" nron did not include <EI in its earnings
since it did not own more than ,& percent of the partnership$
Then in )**F" 8astow created Chewco which #ought Calpers' sta4e in <EI$ Dith the purchase"
nron and 8astow essentially owned <EI$ However" since 8astow and his partners had organi7ed
Chewco in such a way" the entire partnership was 4ept off of nron's #oo4s$ 6ince Chewco was not
included" the <EI partnership" still apparently run #y nron and an outside group" also remained
off the #alance sheet$
ConseCuently" the Chewco 9partnership9 made it possi#le for nron to 4eep roughly =;&& million
off its #oo4s$ 0nce federal investigators and auditors discovered that Chewco was actually nron"
the 6C forced nron to restate its earnings since )**F$ Hence" nron's restated earnings included
Chewco's" and <EIs" huge losses into its #alance sheets$ The <EI and Chewco deals also allowed
some nron executives to turn personal profits in the millions$ !s the largest of these partnerships"
the Chewco deal accounted for a#out +& percent of profit overstatements related to such
partnerships$
How the governance of Enron can explain it
Corporate structure 3
There is a#out ), #oard mem#ers" most of them were then or had previously served as Chairman or
C0 of a ma(or corporation$ They had , annual meetings$
6u#committies 3
xecutive committee met on an as needed #asis to handle urgent #usiness matters #etween
scheduled Board meetings$
8inance Committee was responsi#le for approving ma(or transactions which" in %&&)" met or
exceeded =F, million in value$ It also reviewed transactions valued #etween =%, million and =F,
millionM oversaw nron/s ris4 management effortsM and provided guidance on the company/s
financial decisions and policies$
!udit and Compliance Committee reviewed nron/s accounting and compliance programs"
approved nron/s financial statements and reports" and was the primary liaison with !ndersen$
Compensation Committee esta#lished and monitored nron/s compensation policies and plans for
directors" officers" and employees
-ominating Committee nominated individuals to serve as Eirectors$
Enron was the su!"ect of many conflicts of interests:
N Between the consulting and the company 3
!ndersen consulting received =,& millions each year for their activities Kcf The relationship
#etween nron and !ndersen
!ndersen consulting received =,& millions each year for their activities
N Concerning the people who wor4s #oth for the government and for nron 3
Between 1990 and 2002, the company or its managers gave $5.9m in political contributions, according
to the non-partisan entre !or "esponsive #olitics. $eventy-one o! the 100 senators received %nron
largesse& they included 19 o! the 2' members o! the energy committee, which is investigating the !irm(s
collapse.
:oreover .eorge Bush is a very good O friend P of the founder of ron
N Concerning the remuneration of the leadership
The Board mem#ers had significant relationships with nron Corporation and its management"
which may have contri#uted to their failure to #e more proactive in their oversight$
They received =I,&"&&& in compensation and lot of stoc4 options annually
1enneth 2ay Knron ChairmanJC0L$QQQQQQQ$Q$=),%$F Kin millionsL
:ar4 8evert KChair and C0" nron Dholesale 6ervicesLQ$=I)$*
<effrey 64illing Knron C0LQQQQQQQQQQ$$$Q$$$$$$$$=I>$+
<$ Clifford Baxter Knron Vice-ChairmanLQQQQQQ$$Q$$$$=);$%
!ndrew 8astow Knron C80LQQQQQQQQQQQQ$$$$$$=>$%
In %&&&" :r$ 2ay/s compensation was in excess of =)>& million" including the
value of his exercised options$ This level of compensation was )& times greater than the
average C0 of a pu#licly traded company in that year" which was =)I$) million K5$6$
6enate 6u#committee %&&%" p$,%L$ It is important to note that =)%I million of that =)>&
million came from a portion of the stoc4 options he owned" which represents a significant
percentage of total compensation from stoc4 options
The Board improperly allowed conflicts of interest with nron partnerships and then did not
ensure appropriate oversight of those relationships$ There was a fundamental lac4 of
communication and direction from the Board as to who should #e reviewing the related-party
transactions and the degree of such review$ The Board was also unaware of other conflicts of
interests with other transactions$
!nother exemple of conflits of interest concern th 6P that we have see previously 3
Chewco$1opper" an nron employee" controlled Chewco" and there was no third-party eCuity in
Chewco$ There was only de#t$ The intention was" #y year end" to replace the #ridge financing with
another structure that would Cualify Chewco as an 6P with sufficient outside eCuity$ Ben 8$
.lisan" <r$" the nron 9transaction support9 employee with principal responsi#ility for accounting
matters in the Chewco transaction" #elieved that such a transaction would preserve <EI's
unconsolidated status if closed #y year end$
Failures in #oard $versight and Fundamental %ac& of 'hec&s and #alances
nron managed their num#ers to meet aggressive expectations$ They were less concerned
with the economic impact of their transactions as they were with the financial statement impact$
Creating favora#le earnings for Dall 6treet dominated decision ma4ing$
N 8ailure in the management of acCuisitions
The 8inance Committee failed in its role in examining and monitoring the transactions$ It did not
give enough consideration when ma4ing important decisions$ They were not really informed nor did
they understand the types of transactions nron was engaging in" and they were too Cuic4 to
approve proposals put forth #y management$
N The !udit and Compliance Committee also failed to closely examine the nature of the
transactions" as is outlined in their duties
N The Compensation Committee failed in its duty to monitor Gnron/s compensation policies and
plans for directors" officers" and employeesH
The relationship between Enron and Andersen
It was one of the big reason of the bankruptcy
Its independence wasn't respected" #ecause !ndersen auditors wor4ed permanently in the nron$
They shared all events officers of the company" and$ +; people were nron employees since )*+*$
In )**I" !ndersen too4 over nron's internal audit in addition to the financial audit$
The Board did not effectively communicate with its auditors from !rthur !ndersen$ The idea that
nron/s employed accounting techniCues were 9aggressive9 was not communicated clearly enough
to the #oard" who were #linded #y its trust in its respected auditors$ The Board relied too heavily on
the auditors and did not fulfill its duty of ensuring the independence of the auditors$ .iven the
relationship #etween management and the auditors" the Board should not have #een so generous
with its trust$ The Board is entitled to rely on outside experts and management to the extent it is
reasona#le and appropriate - in this case it was excessive$ :oreoverThe Board relied too heavily on
the auditors and did not fulfill its duty of ensuring the independence of the auditors$ .iven the
relationship #etween management and the auditors" the Board should not have #een so generous
with its trust$ The Board is entitled to rely on outside experts and management to the extent it is
reasona#le and appropriate - in this case it was excessive
(uestioning the corporate governance model
!fter the nron scandal" some solutions were adopted to face to this dangerous deregulation$
The principal is the 6ar#anes-0xley !ct of %&&%
Composed in ; parts 3
)- !ccounting certification 3
C0 and C80 have to certifiate the financial statement
the C0 should sign the company tax return$
%- The contents of the reports 3
!ll the complementary informations must #e pu#lished
It reCuires the comptroller genrerall and the 6C to perform various studies and report their
findings$ 6tudies and reports include the effects of consolidation of pu#lic accounting firms" the role
of credit rating agencies in the operation of securities mar4ets" securities violations and enforcement
actions" and whether investment #an4s assisted nron and others to manipulate earnings and
o#fuscate true financial conditions$
I- !uditors independance 3
It consist to esta#lishes standards for external auditor independence" and to limit conflicts of
interest$ It also addresses new auditor approval reCuirements" audit partner rotation" and auditor
reporting reCuirements$ It restricts auditing companies from providing non-audit services
>- control from the 6C 3
The 6C must control the pu#lic limited companies minimum every I years It can resort to
temporarily free7ing transactions or payments that have #een deemed 9large9 or 9unusual9$
,- Creation of the Pu#lic Company !ccounting 0versight Board$
It to provide independent oversight of pu#lic accounting firms providing audit services
K9auditors9L$ It also creates a central oversight #oard tas4ed with registering auditors" defining the
specific processes and procedures for compliance audits" inspecting and policing conduct and
Cuality control" and enforcing compliance with the specific mandates of 60R$
;- -ew and #igger sanctions
Criminal penalties associated with white-collcar crimeand conspiracies are increased$ The text
recommends stronger sentencing guidelines and specifically adds failure to certify corporate
financial reports as a criminal offense$ It descri#es specific criminal penalties for manipulation"
destruction or alteration of financial records or other interference with investigations" while
providing certain protections for whistle-#lowers$ It identifies corporate fraud and records
tampering as criminal offenses and (oins those offenses to specific penalties$ It also revises
sentencing guidelines and strengthens their penalties$
'onclusion
nron is a very good exemple of a failure of Corporate .overnance$ Dhich can #e compare
to the :adoff system 3 nron needed new investments and loan to purchase its economics
development" #ut without external apport of money" it's not profita#le$
The conflicts of interests are u#iCuitous" the customers misleads" the investors as well$
This case" #y its amplitute" contri#uted to the evolution of regulation rules$ It permess to control
corporate governance in order to always favor the interests of the company rather personal interests$