After Enron:

An Age of Enlightenment?
Simon Deakin
Ernst & Young, 13 September 2002
 After Enron
• Three interpretations of Enron’s fall: ‘don’t
worry’, ‘bad apples’, ‘dark side’
• What Enron was doing and why it went bankrupt
• The aftermath of Enron: the Sarbanes-Oxley Act
and its implications
• Lessons of Enron for UK and European corporate
governance: ‘enlightened shareholder value’?
 We have been here before
• ‘One of the evils of the system of “boom” finance,
of which [?] was not the only exponent in the City,
is the interlocking of companies whose balance
sheets are designed to conceal their mutual
relations. Under this system it is possible to
buttress up the credit of A company of the group
by B company of the group operating in A’s
shares on the Stock Exchange. Such methods of
finance cannot always be detected or eliminated
…’
 Back to the Future
• ‘…The new Companies Act, which came into force
on November 1 last year, failed to require a holding
company to publish a consolidated balance sheet and
income account or an interlocking company to
publish details of its holdings. It is, of course,
impossible to legislate the unscrupulous promoter out
of the City, but his operations would be rendered less
easy if an amendment to remedy this defect of the
Companies Act were brought on the Statute-book…’
E.H. Davenport, ‘After Hatry’ (1930)
 Interpreting Enron (1):
‘Don’t worry, be happy’
• The current system worked well: once the corrections to
Enron’s financial statements were made, the markets
responded by marking down its stock; its bankruptcy will
ensure that assets are used more productively in the
future.
• ‘Perversely, what is happening to WorldCom might
actually be a reason to be more confident about corporate
America. After all, those responsible for the fraud at the
company have been driven out, as have overweening
bosses responsible elsewhere for shortcomings at firms
that include Enron… (Economist June 2002)
 Don’t worry, be happy: markets
work
• ‘Markets work, however imperfectly…They
register feedback on company performance
and expectations in real time. What is
interesting about Enron is not the fact that
the energy giant collapsed but how fast the
market bought it down’ Benefits Canada
May 2002
 Don’t worry, be happy:
bankruptcy is good
• ‘In the end, the best lessons of all will come from
the mere fact of Enron’s bankruptcy. Investors and
bankers may learn not to trust companies that
report mysteriously spectacular profit growth;
auditors will be warier of bosses’ pressure to sign
dodgy accounts; rating agencies and regulators
may be more nervous about companies that do not
come clean about all their activities. In the drama
of capitalism, bankruptcy plays an essential part –
until the next boom’ Economist August 2002
 Interpreting Enron (2):
Bad Apples
• ‘It would be wrong to conclude that Andersen was
simply one bad apple amid a barrel of good ones. The
revelations of corporate misdeeds at Enron, Global
Crossing and WorldCom confirm that there is an
urgent need to rein in greedy and overmighty chief
executives, and to curb rampant abuse of stock
options. But in the same way, the audit scandals
swirling around Andersen testify not only to the sins
of a single firm; they also point to something rotten in
the state of auditing itself. And that is where action is
most pressing’ Economist, June 2002.
 Corporate governance takes the
blame for Enron
• Lack of effective oversight by the board and audit committee
• Conflicts of interest in audit committee
• Board waved through self-dealing by Enron officers in
contradiction of company’s ethics code
• Conflicts of interest and ineffective oversight on the part of
the auditor
• Share options rewarded senior managers whether or not the
company thrived
• By contrast to the one-way bet for top executives, other
employees’ pension plans were exposed to risk of company
failure
 What was the board up to?
• ‘One of the few areas where Enron
disclosed a wealth of information was in the
qualifications of board members. On paper,
the audit committee was as qualified as
any… Committee Chairman Robert K.
Jaedicke was a Stanford University
accounting professor for 30 years… And
John Wakeham belongs the House of
Lords…’ Business Week, January 2002
 The need for corporate
governance reform
• ‘It is time for another effort to realign the system to
function more in shareholders’ interests. Companies
need stronger non-executive directors, paid enough to
devote proper attention to the job; genuinely
independent audit and remuneration committees;
more powerful internal auditors; and a separation of
the jobs of chairman and chief executive. If corporate
America cannot deliver better governance as well as
better audit, it will have only itself to blame when the
public backlash becomes both fierce and unpleasant’
Economist, September 2002
 Even if shareholders end up
paying
• ‘Corporate governance is big business…It’s a
growth industry. But it’s not clear whether it’s
going to be an industry that creates wealth or
destroys it… stockholders might not only have to
shoulder the costs of the bureaucracy created by
the new regulatory environment; they might also
have to make do with less capable, less results-
oriented CEOs – and more humble returns on their
investments’ Canadian Business, June 2002
 Interpreting Enron (3):
‘Dark Side of the Moon’
• Enron’s failure represents the ‘dark side of
shareholder value’
• Enron was ‘laser focused on earnings per share’
(Enron Annual Report, 2000)
• Enron’s business strategy was shaped by
acceptance of the ‘shareholder primacy norm’ in
US corporate governance and practice, the legacy
of the takeover wave of the 1980s and 1990s, the
rise to prominence of institutional shareholder
interests, and the long bull market.
 ‘Dark side of shareholder value’
• ‘Enron’s collapse was wrought into the fabric of our
corporate governance system every bit as much as Jack
Welch’s GE was in success. Like GE under Jack Welch,
Enron under Ken Lay and Jeff Skilling pursued maximum
shareholder value. Like GE’s business managers, Enron’s
pursued a plausible and innovative business plan. The firm
collapsed for the most mundane of reasons – its managers
suffered the behavioural biases of successful entrepreneurs…
The pursuit of immediate shareholder value caused them to
become risk prone, engaging in levered speculation, earnings
manipulation and concealment of critical information’
William Bratton, (2002) Tulane Law Review
Enron’s business plan: asset light
• Enron had long ago ceased to be a normal utility
company; it was an energy trader acting as a
market intermediary in the chain of supply. It
aimed to out-compete traditional, vertically
integrated forms of organisation through
sophisticated forms of risk management. This
depended on having a large market share and
being able to hedge the risks involved through
derivatives markets.
 Virtual integration vs. physical
integration
• ‘In Volatile Markets, Everything Changes but Us.
When customers do business with Enron, they get
our commitment to reliably deliver their product at a
predictable price, regardless of market condition.
This commitment is possible because of Enron’s
unrivalled access to markets and liquidity … Market
access and information allow Enron to deliver
comprehensive logistical solutions that work in
volatile markets or markets undergoing fundamental
changes, such as energy and broadband’ Enron
Annual Report, 2000.
 ‘Asset light’
• ‘The fundamental advantage of a virtually
integrated system is you need less capital to
provide the same reliability…It’s very hard
to earn a compensatory rate of return on a
traditional asset investment… In today’s
world, you have to bring intellectual content
to the product, or you will not earn a fair
rate of return …’ Jeffrey Skilling,
BusinessWeek Online February 2001
Enron’s HRM strategy: employee
light
• ‘Rank and yank’: regular dismissal of
proportion of new intake based on internal
rankings of performance
• Substantial bonuses and other performance-
linked remuneration for those who stayed
the course
• s. 401(k) pension plans heavily invested in
Enron stock
Why Enron failed (1): Enron was
not particularly profitable
• Revenue growth increased from $13 bn in 1996 to
$101 bn in 2000 but net earnings only increased from
$493m to $1,300 million in the same period, leading to
a decline in the return on capital employed in the
second half of the 1990s: ‘Enron was probably not
creating value by 1999 and 2000’ (Chris Higson,
Business Strategy Review, 2000), thanks to poor cost
control and intensifying competition
• While this calls into question investor attitudes to
Enron’s share price in 2000-1 it does not account for
the company’s implosion in autumn 2001.
 Why Enron failed (2): self-
dealing by corporate officers
• Enron had over 3,000 affiliated subsidiaries
• If a ‘parent’ owns more than 50% of a subsidiary, accounting
rules require the accounts of the companies to be consolidated
• Enron kept debts off the balance sheet by shifting them into
‘equity affiliates’ in which it held less than 50% of the stock
• In addition, SPEs (special purpose entities) were set up for the
purpose of certain specific transactions aimed at inflating
Enron’s reported earnings; under GAAP rules,the outside
investor must supply 3% of total capital and be able to control
the asset being sold by the ‘transferor’ (here, Enron)
 Enron’s SPEs: the
Chewco/JEDI/LJM connection
• Enron used LLPs owned by its own finance director (Andrew
Fastow) as SPEs in order to boost its own accounting earnings, but
(unsurprisingly) could not find outside investors to take the
necessary 3% stake
• An LLP called ‘Chewco’ was supported financially by Enron in an
effort to give the impression that there was a legitimate outside
investor
• When this was revealed, Chewco’s accounts had to be
consolidated with Enron’s, increasing its indebtedness by $628
million and leading to a reduction of earnings of $405 million
between 1997-2001.
• Fastow personally benefited from self-dealing but was this the
cause of the company’s downfall?
Why Enron failed (3): reliance on
the stock market bubble
• Rather than using its SPEs to hedge risks through the derivatives
markets, Enron provided its own hedge by supporting the Talon
and Raptor SPEs with Enron stock, in return for debt instruments
issued by the SPEs which were then recorded as assets on Enron’s
balance sheet
• When Enron’s share price fell, these transactions unravelled and
the company was seen to have inflated its own earnings by over
$1 billion
• Enron was in effect using its own market capitalisation to support
the value of its shares by boosting reported earnings; this only
worked as long as the shares kept on rising but once the stock
market bubble burst, its position was unsustainable: it was like a
‘run on the bank’ (Skilling)
 The aftermath of Enron: the
Sarbanes-Oxley Act and auditors
• Client rotation of audit and reviewing
partners after 5 years
• Audit firm may not supply services to a
company whose CEO and chief accounting
officers were employed by the auditor and
took part in an audit of the issuer within the
preceding year.
 Sarbanes-Oxley and corporate
officers
• Certification of annual and quarterly reports by CEO and other
leading officers
• Reimbursement of gains from stock options if earnings restated.
• Prohibition on sale of shares by top officers during ‘pension
blackout’ under s. 401(k).
• Prohibition on loans to top officers.
• Duty to disclose ‘on a rapid and current basis’ additional
information ‘concerning material changes in the financial
condition or operations of the issuer, in plain English’
• Protection of whistleblowers
• Extra-territorial reach: application to companies with US listing
or debt
 Implications of Enron
• ‘Don’t worry’ option not acceptable: there were real
losers from the bankruptcy (in particular employees)
• ‘Bad apples’ theory may lead to some useful
corporate governance reforms, but some relevant
proposals (e.g. delaying vesting of executive share
options) were not included Sarbanes-Oxley
• Sarbanes-Oxley is unlikely to lead to better
monitoring but it will increase costs (including
D&O insurance), deter potential non-execs, and
heighten still further short-term earnings pressures
 Implications of Enron
• The likely ineffectiveness of tighter CG controls will
encourage the search for scapegoats (audit firms, failed
CEOs) in a falling market
• In the US, the wider implications of ‘shareholder
primacy norm’ will not be addressed, and fallout from
the CG revolution of the 1990s will continue: more
Enrons
• Some scepticism of the US model in mainland Europe
and Japan is only to be expected
• In the UK, what are the prospects for the idea of
‘enlightened shareholder value’?