Safeguards Failed to Detect Warnings in Enron Debacle
Enron Corp.’s slide into bankruptcy, the largest in U.S. history, met little resistance from the safeguards that represent the first line of defense in the U.S. financial system for investors, employees and the general public.
A congressional hearing this week made clear that the Enron debacle, which destroyed billions of dollars in investor funds, is a watershed that will foster a tougher corporate oversight system. Until now, efforts to strengthen the system were stymied by powerful corporate lobbying and special interests.
Traveling its meteoric rise and crash, Enron employed loopholes in accounting regulations to hide debt and in some instances obtained the passive approval of its auditor, Arthur Andersen, which was supposed to root out such practices, accounting experts say.
The story of how the company’s problems escaped scrutiny is based on a wide range of interviews with top accounting industry executives, Wall Street analysts, leaders in the credit-rating industry, former senior federal regulators and corporate governance experts, as well as an examination of Enron’s regulatory filings.
The review shows how Enron hoodwinked Wall Street analysts and investors with stories of creating a “new” business for the new millennium. It convinced credit-rating agencies, which were supposed to pass judgment on the risk of Enron’s debt, that the energy trader deserved a solid rating.
And Enron won the acquiescence of a board of directors, which looked sophisticated enough to pick up warnings about the company’s business but had its own conflicts of interest, according to corporate governance experts. In one instance, a director was put on the payroll as a consultant and on several other occasions the company made large contributions to nonprofit groups that directors were involved with.
Enron’s practices were orchestrated by company Chairman Kenneth Lay and former Chief Executive Jeffrey K. Skilling, who dazzled Wall Street with explosive growth but disclosed little about the company’s businesses or practices. They recruited a cadre of executives, attorneys and outside financial advisors, who set up business deals so complex that outsiders were both mesmerized and blinded.
Stricter rules that could have detected Enron’s problems were blocked by business and accounting lobbies, said Lynn Turner, former chief accountant of the Securities and Exchange Commission who now heads the Center for Quality Financial Reporting at Colorado State University.
“The more you make the rules clear and concise, the more problems you make for management,” Turner said. “Shareholders will hold management accountable when what’s happening at a company is more transparent. Business doesn’t want that.”
The immense breadth of Enron’s failure, which ranks as the largest bankruptcy based on the amount of its assets, could change the landscape.
“Public outrage is what brings change, and I don’t think that it has been big enough until now,” said Arthur Levitt, former chairman of the SEC, the government’s top stock market watchdog.
The SEC and Congress have launched probes into the actions of Enron’s top executives and its auditing firm. Additionally, the company faces dozens of shareholder lawsuits and a Justice Department criminal investigation.
The following is a breakdown of some of the factors that contributed to Enron’s downfall and examples of how they have been long-standing, thorny issues for companies, accountants, regulators, investment banks and politicians.
Accounting Questions
In November, Enron disclosed that the profit it had reported to shareholders and government regulators over the last four years was overblown by 20%, or $586 million, dealing a giant blow to the shareholders and sending the stock tumbling from more than $90 a share to less than a dollar. The meltdown cost more than 4,000 employees their jobs, jeopardizes thousands more and destroyed the retirement savings of employees with company-sponsored savings plans.
The massive accounting adjustment was a public confession that the company had excluded losses at several partnerships on its financial statements. The event focused immediate attention on its auditor, Arthur Andersen, and its interpretation of accounting rules that allowed the company to exclude the partnerships from its reporting. Enron and Andersen dispute which is to blame for the faulty accounting.
Enron created numerous partnerships that held company assets and in many cases employed company executives as managers. Key financial details about the partnerships, which invested in energy companies, water facilities, telecommunications and other ventures, remain undisclosed, but it is known that some executives earned millions of dollars in fees operating them.
These partnerships are frequently used by businesses but are a long-standing source of controversy in the investment community.
The Financial Accounting Standards Board, which makes most accounting rules in the United States, looked at creating stricter rules for disclosing the finances of such ventures in the 1980s but failed to follow through because of the objections of the major accounting firms, said Turner, who sat on the committee.
They were scared of the backlash from their clients, he said.
Last week, the accounting industry acknowledged a problem with the way it handles these partnerships when the five largest firms--including Andersen--jointly offered to help develop better disclosure guidelines.
If Enron’s collapse and the damage to investors is ultimately laid at Andersen’s doorstep, it would not be the first time the accounting giant has run afoul of regulators and shareholders.
In May, it agreed to pay $110 million to settle an accounting fraud lawsuit involving appliance maker Sunbeam Corp. A month later, the SEC fined Arthur Andersen $7 million to settle a landmark fraud lawsuit over the firm’s audits of Houston-based Waste Management Inc.
Another key issue in the Enron case are huge consulting fees accounting firms collect from the same companies they are auditing.
Major accounting firms have moved aggressively to expand their business from auditing and accounting to more general consulting on financial issues, personnel, management and information technology. Some of the major accounting firms, for example, booked huge revenues consulting on the Y2K computer changeover.
“The fear is that the auditor will fold in any disputes with the company because they want to keep all the fees coming in,” said Harry DeAngelo, a USC professor of finance and economics.
Accounting firms collect billions annually from major corporate customers. A survey of 307 companies of the Standard & Poor’s 500-stock index found that they reported a combined $909 million in audit fees and more than $2.65 billion for other services, according to the September issue of the Journal of Corporate Accounting & Finance. Andersen collected $1 million a week from Enron last year.
“The accounting profession spent a phenomenal amount of money on Capitol Hill last year to fight our efforts to tighten up the independence rules,” Turner said.
Enron paid Andersen $27 million last year for non-audit work and $25 million for its audit.
“Could that million dollars a week have played a role in their clouded judgment here?” Rep. John D. Dingell (D-Mich.) asked in a recent letter about Enron to SEC Chairman Harvey Pitt.
Moreover, the accounting industry’s self-regulatory system intended to review performance and conflicts is toothless, according to critics.
The American Institute of Certified Public Accountants has a professional ethics board. But the board’s most severe sanction is to kick members out of the trade association. The National Assn. of Securities Dealers, by comparison, has the power to publicly sanction and fine stockbrokers.
The Board of Directors
The independence of a corporate board is generally considered crucial to protecting shareholder interests, but Enron directors had a number of apparent conflicts of interest. Corporate governance experts say the board fell down on the job.
None of the directors, who are facing a number of shareholder lawsuits, returned telephone calls for comment.
The board included Robert A. Belfer, an oil-patch billionaire; Wendy Gramm, the former chief regulator of the Commodity Futures Trading Commission--one of Enron’s core businesses; Robert K. Jaedicke, a Stanford accounting professor and former dean of the Stanford Business School; and other business veterans.
The directors may have dropped their guard partly because of what Nell Minow, a longtime critic of boardroom practices, called “a certain sloppiness about conflict of interest.”
For example, director John Wakeham, a British nobleman who once headed the House of Lords and founded a large accounting practice, took in $72,000 in consulting fees from Enron last year for advice on its European operations.
Directors John Mendelsohn and Charles A. LeMaistre are president and former president, respectively, of the M.D. Anderson Cancer Center at the University of Texas, which has received more than $500,000 in donations from Enron and its employees.
Gramm, wife of Sen. Phil Gramm (R-Texas), directs the Mercatus Center at George Mason University, which has received $50,000 in contributions from Lay and others at Enron.
The amounts may seem trivial by the standards of typically well-heeled directors of Fortune 500 companies, but such conflicts shouldn’t exist at all, said Charles Elson, director of the Center for Corporate Governance at the University of Delaware.
“Directors shouldn’t be consultants,” Elson said flatly. Their only financial ties to companies they oversee should be through stock ownership, he said, and they should own enough company stock “that if they lost it, it would really hurt.”
The Gramms’ role affected Enron in other ways. Legislation backed by Sen. Gramm excluded electronic exchanges, such as EnronOnline, from regulation by the Commodity Futures Trading Commission last year. At the CFTC, Wendy Gramm helped lift regulation on many of the types of energy contracts Enron traded in 1993, shortly before she joined the company’s board.
The Enron board’s worst failure, governance experts said, was to overlook the dual role of Andrew S. Fastow, who was chief financial officer yet reaped $30 million in profit by simultaneously running limited partnerships that did business with Enron.
The blowup of one of these Fastow-run partnerships, LJM Cayman, was one of the key events in Enron’s downfall, as it finally began disclosing details of the deals in mid-October. When, on Nov. 8, Enron issued a humiliating restatement of its earnings for the last four years, it disclosed a $103-million loss related to LJM.
“Transactions between a company and its officers are very rare,” Elson said. “To me, that would have been a red flag to the board. Having your CFO on both sides of a transaction reflected bad judgment by management.”
The Credit Raters
Although credit-rating agencies are neither regulators nor, like auditors, official overseers of corporate bookkeeping, their opinions about companies’ financial strength carry enormous weight in the marketplace.
When S&P; finally downgraded Enron bonds to “junk” status Nov. 29, followed the same day by Moody’s and smaller rival Fitch Inc., it yanked out the last prop from Enron’s stock and scuttled a planned acquisition by rival Houston energy company Dynegy Inc.
By that time, however, many Enron bonds had lost more than half their value as investors reached their own conclusions about Enron’s stability and stampeded to sell.
Sean Egan, managing director of Saline, Mich.-based Egan-Jones Ratings Co., argues that the big agencies were conflicted because they take fees from the corporations whose debt they rate.
Egan-Jones, who dropped Enron’s rating to junk status a month before the other agencies, accepts no fees from bond issuers, instead selling their opinions on a subscription basis to bond investors.
Ronald M. Barone, head of the S&P; team that handles Enron, acknowledged that there was pressure on S&P; not to downgrade Enron precipitously.
“We take care not to overreact to any developing situation so that we don’t cause a deterioration [in a company’s finances] rather than just opine on it,” Barone said.
Although Enron arguably had slid below investment grade in early to mid-November, S&P; was justified in waiting because Enron had signed deal with a respected and well-financed partner, Dynegy, that would have restored the organization to credit-worthy status, Barone said.
Ralph Pellecchia, who co-heads the coverage of Enron for Fitch, made a similar point. Rating agencies, he said, aren’t trying to give minute-to-minute updates on companies’ financial status but are seeking to describe a firm’s condition over a period of time that takes into consideration such future events as a merger.
The ‘Story’ Stock
Every year, there’s some stock that defies gravity. The company preaches why time-honored fundamentals such as earnings or conservative debt ratios no longer applied to its business model. Analysts would swallow the story, the financial press would gush praise, and investors would buy shares. In the end, however, the market always learns that there is no real substitute for a sound balance sheet, and the stock plunges.
In previous years, Amazon.com and the Home Shopping Network filled that role. Last year, it was Enron. Shares of the energy trader rose from a low of $35.43 in November 1999 to a high of $90 by August 2000.
Enron officials claimed to be on the cutting edge of using deregulation to match buyers and sellers of everything from electricity to natural gas to water to telecommunications services.
“Enron got so much favorable publicity that people bought into the story line,” said DeAngelo, the USC business professor. “The stock market put enormous valuations on the company without regard to the prospect of what a liquidity crisis might do to Enron in the future.”
The Enron case demonstrates that even savvy financial minds can become befuddled by these speculative bubbles.
Enron typically received kid-glove treatment during the periodic conference calls its executives hosted for analysts. Enron officials lashed out at even the mildest challenge. In April, as the company’s shares were sliding toward the $50 mark, Richard Grubman of Highfields Capital Management in Boston asked on a public conference call for a copy of Enron’s balance sheet.
Enron refused, and Skilling, its chief executive at the time, responded to the request by calling Grubman an obscenity while others listened in, Grubman recalled.
Enron is a wonderful example of “group think,” said Jane Siebels-Kilnes, chairwoman of Green Cay Asset Management, which made money selling Enron shares short, essentially a bet that a company’s stock price will decline.
“As long as investment management becomes more institutionalized, the more group think we will have,” she said. “As the old saying goes, ‘nobody gets fired for buying IBM’ or a big name like Enron. I think the old issues will only be addressed with more rigor when somebody does get fired for not thinking independently.”
