The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions

<< Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits

Classic Financial Scandals:Corruption, Discovery, Black Wednesday >>

Management of Financial Institutions - MGT 604

Lecture # 43

The Collapse of ENRON

Only months before Enron Corporations bankruptcy filing in December 2001, the firm was

widely regarded as one of the most innovative, fastest growing, and best managed

businesses in the United States. With the swift collapse, shareholders, including thousands

of Enron workers who held company stock in their 401(k) retirement accounts, lost tens of

billions of dollars. Investigations of wrongdoing may take years to conclude, but Enron's

failure already raises financial oversight issues with wider applications. This lecture briefly

examines the accounting system that failed to provide a clear picture of the firm's true

condition, the independent auditors and board members who were unwilling to challenge

Enron's management, the Wall Street stock analysts and bond raters who missed the trouble

ahead, the rules governing employer stock in company pension plans, and the unregulated

energy derivatives trading that was the core of Enron's business. Formed in 1985 from a

merger of Houston Natural Gas and Inter-north, Enron Corporation was the first nationwide

natural gas pipeline network. Over time, the firm's business focus shifted from the regulated

transportation of natural gas to unregulated energy trading markets. The guiding principle

seems to have been that there was more money to be made in buying and selling financial

contracts linked to the value of energy assets (and to other economic variables) than in

actual ownership of physical assets. Until late 2001, nearly all observers including

professional Wall Street analysts regarded this transformation as an outstanding success.

Enron's reported annual revenues grew from under $10 billion in the early 1990s to $101

billion in 2000, ranking it seventh on the Fortune 500. Several committees in the House and

Senate have held or plan to hold hearings related to Enron's fall. The Justice Department is

conducting a criminal investigation. The challenge for financial oversight, however, does

not depend on findings of wrongdoing. Even if no one at Enron did anything improper, the

swift and unanticipated collapse of such a large corporation suggests basic problems with

the U.S. system of securities regulation, which is based on the full and accurate disclosure

of all financial information that market participants need to make informed investment

decisions.

Auditing Issues

Federal securities law requires that the accounting statements of publicly traded

corporations be certified by an independent auditor. Enron's outside audits have received

much attention. While external audits do not prevent corporations from making financial

mistakes, let alone bankruptcy, problems with recent Enron audits may have contributed to

both the rapid rise and the sharp fall in its stock price. Outside investors, including financial

institutions may have been misled about the corporation's net income (which was

subsequently restated) and contingent liabilities (which were far larger than generally

known). The auditor, Arthur Andersen, has admitted some mistakes. Andersen fired the

partner in charge of Enron audits on January 15, 2002, and Enron dismissed Andersen on

January 17. One issue is whether Andersen's extensive consulting work for Enron may have

compromised its judgment in determining the nature, timing, and extent of audit procedures

and in asking that revisions be made to financial statements, which are the responsibility of

Enron's management. Questions have also been asked about Andersen destroying

documents and e-mails related to its audits. Oversight of auditors has primarily rested with

the American Institute of Certified Public Accountants (a nongovernmental trade group) and

state boards of accountancy. On January 17, 2002, the Chairman of the Securities and

Exchange Commission (SEC) proposed a new oversight board that would be responsible for

disciplinary actions.

160

Management of Financial Institutions - MGT 604

Accounting Issues

The Enron controversy involves several accounting issues. One concerns the rules

governing whether the financial statements of special purpose entities (SPEs) established by

a corporation should be consolidated with the corporation's financial statements; for certain

SPE partnerships at issue, consolidation is not required if among other things an

independent third party invests as little as 3% of the capital, a threshold some consider too

low. A second issue concerns the latitude allowed in valuing derivatives, particularly non-

exchange traded energy contracts. Third, there are calls for improved disclosure, either in

notes to financial statements or a management discussion and analysis, especially for

financial arrangements involving contingent liabilities. Accounting standards for

corporations are set by the Financial Accounting Standards Board, a nongovernmental

entity, though there are also SEC requirements. (The SEC has statutory authority to set

accounting standards for firms that sell securities to the public.)

Pension Issues

Like many companies, Enron sponsors a retirement plan a "401(k)" for its employees to

which they can contribute a portion of their pay on a tax-deferred basis. As of December 31,

2000, 62% of the assets held in the corporation's 401(k) retirement plan consisted of Enron

stock. Many individual Enron employees held even larger percentages of Enron stock in

their 401(k) accounts. Shares of Enron, which in January 2001 traded for more than

$80/share, were worth less than 70 cents in January 2002. Consequently, the company's

bankruptcy has substantially reduced the value of its employees' retirement accounts. The

losses suffered by participants in the Enron Corporation's 401(k) plan have prompted

questions about the laws and regulations that govern these plans.

Corporate Governance Issues

The role of a company's board of directors is to oversee corporate management to protect

the interests of shareholders. However, in 1999 Enron's board waived conflict of interest

rules to allow chief financial officer Andrew Fastow to create private partnerships to do

business with the firm. These partnerships appear to have concealed debts and liabilities that

would have had a significant impact on Enron's reported profits. Enron's collapse raises the

issue of how to reinforce directors' capability and will to challenge questionable dealings by

corporate managers. Specific questions involve independent or "outside" directors. (Stock

exchange rules require that a certain percentage of board members be unaffiliated with the

firm and its management.)

Securities Analyst Issues

Securities analysts employed by investment banks provide research and make "buy," "sell,"

or "hold" recommendations for the use of their sales staffs and their investor clients. These

recommendations are widely circulated and are relied upon by many investors throughout

the markets. Analyst support was crucial to Enron because it required constant infusions of

funding from the financial markets. On November 29, 2001, after Enron's stock had fallen

99% from its high, and after rating agencies had downgraded its debt to "junk bond" status,

only two of 11 major firm analysts rated its stock a "sell." This performance added to

concerns that were raised in 2000 in the wake of the "dot com" stock crash.

Derivatives Issues

The core of Enron's business appears to have been dealing in derivative contracts based on

the prices of oil, gas, electricity and other variables. For example, Enron sold long-term

contracts to sell energy at fixed prices. These contracts allow the buyers to avoid, or hedge,

the risks that increases (or drops) in energy prices posed to their businesses. Since the

markets in which Enron traded are largely unregulated, with no reporting requirements,

little information is available about the extent or profitability of Enron's derivatives

161

Management of Financial Institutions - MGT 604

activities. Did Enron earn money from dealer commissions and spreads, or was it actively

speculating on future price trends? Speculative losses in derivatives, perhaps masked by

"creative" accounting, could have contributed to the firm's downfall. On the other hand, the

trading operations may have been profitable and trouble free, and Enron's financial

difficulties the result of other unrelated operations. Enron's collapse raises the issue of

supervision of unregulated derivatives markets.

Corrective Actions

The collapse of Enron proved to be a valuable wake-up call to a number of affected groups.

The following actions have already been taken by private organizations: The Business

Roundtable, composed of the chief executives of about 150 large firms, urged corporations

to adopt a number of voluntary changes in corporate governance rules, including that a

``substantial majority'' of corporate boards be independent ``both in fact and appearance.''

The New York Stock Exchange and the National Association of Securities Dealers

approved major additions and changes in the rules for accounting, auditing, and corporate

governance as necessary conditions for listing of a corporation's stock for trade on the

exchange. The major continuing uncertainty is how the exchanges will monitor and enforce

these rules. The International Corporate Governance Network, institutional investors that

control about $10 trillion in assets, has approved a set of international standards for

corporate governance that its members would use their voting power to promote. Standard

and Poor's, one of the three major credit-rating agencies, has developed a new concept of

``core earnings'' as a measure of earnings from a company's primary lines of business.

Compared with earnings as defined by the generally accepted accounting principles

(GAAP), for example, the S&P measure will exclude gains and losses from a variety of

financial transactions. S&P plans to report this measure of earnings for all publicly held

U.S. companies.

162

Table of Contents: