Enron: Why Corporate Governance Matters

Collapse of Enron; Greater public scrutiny on corporate

governance issues 
The story of Enron ends with a spectacular crash and massive
bankruptcy. Once a Wall Street darling (Wall Street is a street
in New York where the Stock Exchange and important
banks are. Wall Street is often used to refer to the
financial business carried out there and to the people who
work there.) and one of the world’s largest companies, Enron
saw their shares tumble from a high of $90.75 to $0.26 in a
matter of months. The scale of their perversion of accounting
rules was massive and done so deftly that even regulators
didn’t catch on to their criminal activity until the very end. In
hindsight, had investors and regulators assessed their
activities through a governance lens, perhaps some of the
outcomes would have been different. 
Had Enron had strong corporate governance rules and
oversight many of the activities that led to their undoing would
either never have been undertaken in the first place or may
have been discovered with enough time to take corrective
action. Not only did Enron not have any meaningful corporate
governance in place, they also engaged in outright deceptive
accounting practices and in May of 2006, two of their
executives, Kenneth Lay and Jeffrey Skilling were convicted of
fraud and conspiracy.
What were the signs and signals that were missed at Enron
and how can an investor evaluate companies through a
corporate governance lens to help ensure that the kinds of
activities, that
were prevalent at Enron, aren’t lurking behind the scenes at
companies today?
First, in the wake of the Enron and other corporate scandals, in
2002 congress passed the Sarbanes-Oxley Act, which
strengthened many of the rules that Enron had been
manipulating and increased the consequences of filing false
financial statements. Also, the Financial Accounting Standards
Board (FASB) made some changes in the wake of the scandal
to help ensure more consistent accounting practices. So some
regulatory accountability has been put in place, but companies
still have a great deal of discretion when it comes to corporate
governance.
Board of Directors
An active, independent and professionally qualified Board is
critical to effective corporate governance. Enron did not
separate the CEO and Chairman of the Board role, they were
not particularly diverse, with only one woman out of
seventeen seats. Furthermore, they had several industry
insiders and politicians who did not act consistently and
aggressively in the company’s best interests. In one
particularly alarming example from 1999, the Board decided
to waive Enron’s Code of Ethics so that Andrew Fastow, the
CFO, could act as general partner of newly formed
partnerships. On the one hand, they did have a Code of Ethics,
but suspending it should have set off alarm bells. 
Conservative vs. Aggressive Accounting
Accounting is not as black-and-white as we assume. There are
many “choices” that companies can make with regard to their
books and still be compliant with the appropriate accounting
standards. In some cases, companies may try to accelerate
revenue and defer expenses to generate more profit, but
some companies try to defer revenue and accelerate expenses
to generate less profit and thus a lower tax bill. Both are
legitimate approaches. A company’s choice of depreciation
method is one way that they can exert some control over
those factors. Another choice is through their asset valuation
method. Book value techniques vs. mark-to-market choices
can result in very different outcomes. Although Enron had SEC
approval to use mark-to-market valuation, it was abused to
Enron’s advantage. In this case, it involved estimating the
profits of some of their holding companies and booking those
profits as “actual” profits before the profits where actually
earned. That is a very aggressive approach and not
surprisingly, their poor estimates became significant issues
when the profits never materialized.
Risk Management vs. Risk for Profit
The capital markets provide opportunities to raise capital,
borrow money and manage risk. It’s a critical function to keep
an economy functioning and growing. But take the case of
Enron’s futures trading. Many companies use the futures
markets as a means to manage risk. A prime example is the
airline industry. Many airlines will use the futures market to
“lock in” prices for fuel well in advance so that they have
predictability of costs. That is a very reasonable way to
manage risk. Enron was also trading futures contracts, but was
attempting to do so for profit as well as risk management.
They even created a trading company to expand into other
areas such as electricity, commodities, weather and ironically,
default insurance. One has to ask, should an oil and gas
transportation company be attempting to trade financial
derivatives for profit? Maybe, but there is little evidence that
the board or anyone else looked at this activity critically.
There were other examples of malfeasance on the part of
Enron, but those three were hiding in plain site. One could
have evaluated the Enron Board of Directors and concluded
them to not be independent. It would have been much harder
to determine if they were consistently acting in the best
interests of the company, but that too could have be seen over
time in board meeting minutes and board actions.
On the accounting front, since they were so clever at
concealing their losses, it would have been very difficult to
ascertain the dire straits that they were actually in. However,
we did know that by any measure they were using very
aggressive accounting techniques and while the use of
aggressive accounting techniques is not by itself irresponsible,
it is a potential warning sign that can be combined with other
factors to paint a larger picture.
Finally, we also knew that Enron was aggressively trading
financial derivatives in a newly deregulated market. At the
time they were considered innovative. In hindsight we can see
that it was an incredibly risky line of business that they were
not sufficiently capitalized to undertake.
The corporate governance assessment lens isn’t perfect and
won’t catch everything, particularly outright fraud, but it can
be used in conjunction with other techniques to help
determine the true nature of a company.