munzig - 2003 - enron and the economics of corporate governance

The following paper attempts to reconcile our existing theories on corporate governance, executive compensation, and the firm with the events that took place at Enron.. I will argue that

Enron and the Economics of Corporate Governance

June 2003

Peter Grosvenor Munzig Department of Economics Stanford University, Stanford CA 94305-6072 Advisor: Professor Timothy Bresnahan

ABSTRACT

In the wake of the demise of Enron, corporate governance has come to the forefront of economic discussion The fall of Enron was a direct result of failed corporate governance and consequently has led to a complete reevaluation of corporate governance practice in the United States The following paper attempts to reconcile our existing theories on corporate governance, executive compensation, and the firm with the events that took place at Enron This paper first examines and synthesizes our current theories on

corporate governance, and then applies theoretical and economic framework to the factual events that occurred at Enron I will argue that Enron was a manifestation of the principal-agent problem, that high-powered incentive contracts provided management with incentives for self-dealing, that significant costs were transferred to shareholders due

to the obscurity in Enron’s financial reporting, and that due to the lack of board

independence it is likely that management rent extraction occurred

Acknowledgements: I would like to thank my family and friends for their continued

support throughout this paper In particular, my mother Judy Munzig was instrumental with her comments on earlier drafts I also thank Professors Geoffrey Rothwell and George Parker for their help, and finally to my advisor Professor Bresnahan, for without his support and advice this paper would not have been possible

“When a company called Enron… ascends to the number seven spot on the Fortune

500 and then collapses in weeks into a smoking ruin, its stock worth pennies, its CEO, a confidante of presidents, more or less evaporated, there must be lessons in there somewhere.”

-Daniel Henninger, The Wall Street Journal

CONTENTS

I INTRODUCTION 3

II THE THEORY OF CORPORATE GOVERNANCE 7

Corporate Governance and the Principal- Agent Problem 7

Executive Compensation and the Alignment of Manager and Shareholder Interests 11

Corporate Governance’s Role in Economic Efficiency 14

Recent Developments in Corporate Governance 15

III WHAT HAPPENED: FACTUAL ACCOUNT OF EVENTS LEADING TO BANKRUPTCY 17

Background/Timeline 18

Summary of Transactions and Partnerships 19

The Chewco/JEDI Transaction 20

The LJM Transactions 22

IV ANALYSIS OF CORPORATE GOVERNANCE ISSUES 26

Corporate Structure 27

Conflicts of Interest 30

Failures in Board Oversight and Fundamental Lack of Checks and Balances .33

Audit Committee Relationship With Enron and Andersen 35

Lack of Auditing Independence and the Partial Failure of the Efficient Market Hypothesis 38

Director Independence/Director Selection 41

V POST-ENRON GOVERNANCE REFORMS AND OTHER PROPOSED SOLUTIONS TO GOVERNANCE PROBLEMS 45

Sarbanes-Oxley Act of 2002 45

Other Governance Reforms and Proposed Solutions 48

VI CONCLUSION 51

I INTRODUCTION

Often referred to as the first major failure of the “New Economy,” the collapse of Enron Corporation stunned investors, accountants, and boardrooms and sent shockwaves

across financial markets when the company filed for bankruptcy on December 2, 2001

At that time, the Houston-based energy trading company’s bankruptcy was the largest in history but was surpassed by WorldCom’s bankruptcy on July 22, 2002 Enron

employees and retirement accounts across the country lost hundreds of millions of dollars when the price of Enron stock sank from its peak of $105 to its de-listing by the

NASDAQ at just a few cents Arthur Andersen, once a Big Five accounting firm,

imploded with its conviction for Obstruction of Justice in connection with the auditing

services it provided to Enron Through the use of what were termed “creative accounting techniques” and off-balance sheet transactions involving Special Purpose Entities (SPEs), Enron was able to hide massive amounts of debt and often collateralized that debt with

Enron stock Major conflicts of interest existed with the establishment and operation of

these SPEs and partnerships, with Enron’s CFO Andrew Fastow authorized by the board

to manage the transactions between Enron and the partnerships, for which he was

generously compensated at Enron’s expense

In addition to crippling investor confidence and provoking questions about the

sustainability of a deregulated energy market, Enron’s collapse has precipitated a

complete reevaluation of both the accounting industry and many aspects of corporate

governance in America The significance of exploring the Enron debacle is multifaceted

and can be generalized to many companies as corporate America evaluates its governance practices The fall of Enron demands an examination of the fundamental aspects of the

oversight functions assigned to every company’s management and the board of directors

of a company In particular, the role of the subcommittees on a board and their

effectiveness are questioned, as are compensation techniques designed to align the

interests of shareholders and management and alleviate the principal-agent problem, both theoretically and in application Companies such as Worldcom, Tyco, Adelphia, and

Global Crossing have all suffered catastrophes similar to Enron’s, and have furthered the need to reevaluate corporate governance mechanisms in the U.S

My question then becomes, what lessons can be learned from the fundamental

breakdowns that occurred at the corporate governance level at Enron, both from an

applied and theoretical standpoint? This paper attempts to offer an analysis that

reconciles the events that occurred inside the walls of Enron and our current theories on

corporate governance, the firm, and executive compensation In particular, I look at the role the principal-agent problem played at Enron and attempt to link theories of

management’s expropriation of firm funds with the Special Purpose Entities Enron

management assembled I question Enron’s executive compensation practices and the

effectiveness of shareholder and management alignment with the excessive stock-option

packages management received (and the resulting incentives to self-deal) Links between the information asymmetry and the transfer of costs to shareholders is explored, as well

as the efficient market hypothesis in regards to Enron’s stock price And finally, the lack

of director independence at Enron provides a foundation for the excessive compensation practices given managers were extracting rents

From an applied standpoint, I argue that following can be learned from Enron:

• Enron managed their numbers to meet aggressive expectations They were less

concerned with the economic impact of their transactions as they were with the

financial statement impact Creating favorable earnings for Wall Street

dominated decision making

• The Board improperly allowed conflicts of interest with Enron partnerships and

then did not ensure appropriate oversight of those relationships There was a

fundamental lack of communication and direction from the Board as to who

should be reviewing the related-party transactions and the degree of such review The Board was also unaware of other conflicts of interests with other transactions

• The Board did not effectively communicate with its auditors from Arthur

Andersen The idea that Enron’s employed accounting techniques were

"aggressive" was not communicated clearly enough to the board, who were

blinded by its trust in its respected auditors

• The Board did not give enough consideration when making important decisions They were not really informed nor did they understand the types of transactions

Enron was engaging in, and they were too quick to approve proposals put forth by management

• The Board members had significant relationships with Enron Corporation and its management, which may have contributed to their failure to be more proactive in their oversight

• The Board relied too heavily on the auditors and did not fulfill its duty of ensuring the independence of the auditors Given the relationship between management

and the auditors, the Board should not have been so generous with its trust The Board is entitled to rely on outside experts and management to the extent it is

reasonable and appropriate - in this case it was excessive

From a theoretical standpoint, I argue that the following are lessons learned from

Enron:

• Enron was a manifestation of the principal-agent problem The ulterior motives

of management were not in line with maximizing shareholder value

• The high-powered incentive contracts of Enron’s management highlight more of

the costs associated with attempting to align shareholders with management to

counter the principal-agent problem and provided management with extensive

opportunities for self-dealings

• Significant costs were transferred to shareholders associated with asymmetric

information due to management’s sophisticated techniques for obscuring financial results Such obscuring also lead to a partial failure of the efficient market

hypothesis

• Due to the lack of board independence, the theory of rent extraction more likely

explains management’s actions and compensation than the optimal contracting

theory

This analysis of the Enron case attempts to explain what happened at Enron in the context of existing theories on the firm, corporate governance, and executive

compensation, as they are innately linked Section II discusses the general theory of

corporate governance defined from two perspectives, first from an applied perspective

and then from a theoretical perspective Next is an attempt to answer the question of why

we need corporate governance and to explore its function theoretically The section ends with information on changes made in corporate governance over the last two decades

Section III details the factual account of events leading to the fall of Enron It

includes the history and background of the corporation, beginning with its inception with

the merger of Houston Natural Gas and Internorth in 1985 through its earnings

restatements and eventual bankruptcy filing in December of 2001 It also focuses on the partnerships and transactions that were the catalysts for the firm’s failure, in particular the Special Purpose Entities like Chewco, JEDI, and LJM-1 and LJM-2

Section IV provides analysis of the corporate governance issues that arise within Enron from a theoretical approach That is, a theoretical and economic framework are

applied to Enron’s corporate structure and compensation schedules, highlighting

opposing theories such as optimal contracting and rent extraction with regards to

executive compensation Further discussed is the principal-agent problem in the context

of Enron and management’s expropriation of shareholder’s capital Highlighted also are

management’s conflicts of interest that were allowed and that then went unmonitored by

the board Also included is an analysis on the lack of material independence on the board and the theory that management had bargaining power because of the close director-

management relationships I also discuss the relationship between the audit committee

and Arthur Andersen, as well Andersen’s lack of auditing independence Included is an

analysis on the partial failure of the efficient market hypothesis in the case of Enron and

the transfer of costs to the shareholders because of the asymmetric information due to

management’s sophisticated techniques for obscuring financial results

Section V looks at the primary legislative reform post-Enron, the Sarbanes-Oxley Act, including its key points and the likely effects and costs of its implementation on

corporate governance and financial reporting The section includes other developments

in corporate governance, and provides some solutions to improving governance and

executive compensation

II THEORY OF CORPORATE GOVERNANCE

Corporate Governance and the Principal-Agent Problem

Before applying theory to the case of Enron, it is important to first discuss the

nature of the principal-agent problem and the reasons for a governance system, as well as

to define corporate governance from an applied and theoretical approach I then will

discuss why corporate governance helps improve overall economic efficiency, followed

by the general developments in corporate governance over the past two decades On its most simplistic and applied level, corporate governance is the mechanism that allows the shareholders of a firm to oversee the firm’s management and management’s decisions In the U.S., this oversight mechanism takes form by way of a board of directors, which is

headed by the chairman Boards typically contain between one and two dozen members, and also contain multiple subcommittees that focus on particular aspects of the firm and

its functions

However, the existence of such oversight bodies begs the questions: why is there

a need for a governance system, and why is intervention needed in the context of a

free-market economy? Adam Smith’s invisible hand asserts that the free-market mechanisms will

efficiently allocate resources without the need for intervention Williamson (1985) calls

such transactions that are dictated by market mechanisms “standardized,” and can be

thought of as commodity markets with classic laws of supply and demand governing

them These markets consist of many producers and many consumers, with the quality of the goods being traded the same from producer to producer

These market mechanisms do not apply to all transactions though, particularly

when looking at the separation of ownership and management of a firm and its associated contracts The need for a corporate governance system is inherently linked to such a

separation, as well as to the underlying theories of the firm The agency problem, as

developed by Coase (1937) and Jensen and Meckling (1976) as well as others, is in

essence the problem associated with such separation of management and ownership A

manager, or entrepreneur, will raise capital from financiers to produce goods in a firm

The financiers, in return, need the manager to generate returns on the capital they have

provided The financiers, after putting forth the capital, are left without any guarantees or assurances that their funds will not be expropriated or spent on bad investments and

projects Further, the financiers have no guarantees other than the shares of the firm that they now hold that they will receive anything back from the manager at all This

difficulty for financiers is essentially the agency problem

When looking at the agency problem from a contractual standpoint, one might

initially think that such a moral hazard for the management might be solved through

contracts An ideal world would include a contract that would specify how the manager

should perform in all states of the world, as dictated by the financiers of the firm That is,

a complete contingent contract between the financiers and manager would specify how

the profits are divided amongst the manager and owners (financiers), as well as describe appropriate actions for the manager for all possible situations However, because every

possible contingency cannot be predicted or because it would be prohibitively costly to

anticipate such contingencies, a complete contract is unfeasible As Zingales (1997)

points out, in a world where complete contingent contracts can be costlessly written by

agents, there is no need for governance, as all possible situations will be anticipated in the contract

Given that complete contingent contracts are unfeasible, we are therefore left with incomplete contracts binding the manager to the shareholders As a result of the

incomplete contracts, there are then unlimited situations that arise in the course of

managing a company that require action by a manager that are not explicitly stated in the manager’s contract Grossman and Hart (1986) describe these as residual control rights the rights to make decisions in situations not addressed in the contract Suppose then,

that financiers reserved all residual control rights as specified in their contract with

management That is, in any unforeseen situation, the owners decide what to do This

would not be a successful allocation of the residual control rights because financiers most often would not be qualified or would not have enough information to know what to do

This is the exact reason for which the manager was hired As a result, the manager will

retain most of the residual control rights and thus the ability to allocate firm’s funds as he

chooses (Shleifer and Vishny 1996)

There are other reasons why it is logical for a majority of the residual control

rights to reside with management, as opposed to with the shareholders It is often the

case that managers would have raised funds from many different investors, making each

individual investor’s capital contribution a small percentage of the total capital raised As

a result, the individual investor is likely to be too small or uninformed of the residual

rights he may retain, and thus the rights will not be exercised Further, the free-rider

problem for an individual owner often does not make it worthwhile for the owner to

become involved in the contract enforcement or even be knowledgeable about the firms

in which he invests (Shleifer and Vishny 1996) due to his small ownership interest This

results in the managers having even more residual control rights as the financiers remove

themselves from the oversight function

In attempting to define corporate governance from a theoretical standpoint, it is

helpful to think of the contract between the owners and management as producing

quasi-rents In defining quasi-rents, consider the example of the purchase of a specialized

machine between two parties Once the seller has begun to produce the machine, both

the buyer and the seller are in a sense locked into the transaction This is because the

machine probably can fetch a higher price from the buyer than on the open market due to its specificity, and the seller can probably complete the machine for cheaper than any

other firm at that point The surplus created between the differences in the open market

prices and the price in this specialized contract constitutes a quasi-rent, which needs to be divided ex-post The existence of such quasi-rents when produced in the contract

between management and owners creates room for bargaining as the quasi-rents need to

be divided, and Zingales (1997) argues that the bargaining over these ex-post rents is the essence of governance

To return to the earlier discussion of incomplete contracts, one may make the link that the residual control rights due to the incomplete contracting can be seen as a quasi-

rent, and thus must be divided ex-post How, then, are these rents divided given our

incomplete contracting assumption? This question gets to the heart of corporate

governance and its function Using Zingales’ (1997, p.4) definition, corporate

governance is “the complex set of restraints that shape the ex-post bargaining over the

quasi-rents generated by a firm.” This definition serves to summarize the primary

function of corporate governance under the incomplete contract paradigm

Executive Compensation and the Alignment of Manager and Shareholder Interests

The notions of executive compensation and the attempt to align manager and

shareholder interests are subsections of corporate governance and are directly linked to

the agency problem and firm theory Previously discussed is why operating under the

incomplete contract approach tends to leave managers with a majority of the residual

control rights of a firm As a result of these residual control rights, managers have

significant discretion and are not directly (or are incompletely) tied to the interests of the

shareholders Acting independently of shareholders’ interest, managers may then engage

in self-interested behavior and inappropriate allocation of firm funds may occur

In an effort to quell such misallocations by a manager, a solution is to give the

manager long term, contingent incentive contracts that help to align his interests with

those of the shareholders This view of executive compensation is commonly referred to

as the optimal contracting view It is important with this contracting that the marginal

value of the manager’s contingent contract exceed the marginal value of personal benefits

of control, which can be achieved, with rare exceptions, if the incentive contract is of a

significant amount (Shleifer and Vishny 1996) When in place, such incentive contracts

help to encourage the manager to act in the interest of the shareholders Critical to the

functioning of these incentive contracts is the requirement that the performance

measurement is highly correlated with the quality of the management decisions during his

tenure and that they be verifiable in court

The most traditional form of shareholder and management alignment under the

optimal contracting view of executive compensation is through stock ownership by the

manager This immediately gives the manager similar interests as the general

shareholding population and acts to align their interest Stock options also help to align

interests because it creates incentive for the manager to increase the stock price of the

firm, which consequently increases the value of his options when (if) he chooses to

exercise them Another form of an incentive contract that helps to align the interests of

shareholders and a manager is to remove the manager from office if the firm income is

too low (Jensen and Meckling 1976) Again, this provides quite a strict incentive for

management to produce strong earnings, which aligns his interest with those of the

shareholders, and hopefully serves to maximize shareholder value

It is important to mention that these incentive contracts for agents are not without costs and have come under immense scrutiny recently, particularly with the recent

corporate governance scandals like Enron They provide ample incentive for

management to misrepresent the true earnings of a firm and do not completely solve the

agency problem, an issue that will be discussed further in section IV

A second and competing view of executive compensation is the rent extraction

view, or as Bertrand and Mullainathan (2000) call it, the “skimming view.” This rent

extraction view is similar to the optimal contracting view in that they both rely on the

principal-agent conflict, but under the rent extraction view “executive compensation is

seen as part of the [agency] problem rather than a remedy to it,” (Bebchuk, Fried and

Walker 2001, p.31) Under this view, an executive maintains significant power over the board of directors who effectively set his compensation This power the executive, or

management team, holds stems from the close relationships between management and the directors, and thus the directors and executives may be bonded by “interest, collegiality,

or affinity,” (Bebchuk, Fried and Walker 2001, p.31) Also, directors are further tied to management, and in particular the CEO, because the CEO is often the one who exerted

influence to have the director placed on the board, and thus the director may feel more

inclined to defer to the CEO, particularly with issues surrounding the bargaining over

management’s compensation

As a result of the power that management maintains, management has the ability

to bargain more effectively with the board over compensation, and can effectively extract more rents as a result These “rents” are referred to as the amount of compensation a

CEO, or management, receives over the normal amount he would receive with optimal

contracting Therefore it is logical to anticipate seeing higher pay for executives

governed by weaker boards, or boards with little independence, which is consistent with Bertrand and Mullainathan’s (2000) findings That is, one of their conclusions was that

boards with more insiders (or less independence) are inclined to pay their CEO more In other words, CEO’s with fewer independent directors on their boards are likely to gain

better control of the pay process

More generally, it is important to mention that incentive contracts for executives

are common components of their compensation packages, and there is a vast amount of

literature on the effectiveness of incentive contracts Murphy (1985) argued from an

empirical standpoint about the positive relationship between pay and performance of

managers Murphy and Jensen (1990) later examined stock options of executives and

showed that a manager’s pay increased by only $3 for every $1000 increase in

shareholder wealth Murphy and Jensen concluded that it was evidence of inefficient

compensation arrangements, arrangements that included restrictions on high levels of

pay Others suggest that there needs to be a better approach in screening out performance effects that are outside an executive’s control when looking at incentive contracts

Rappaport (1999), in particular, argues that incentive contracts for executives would

provide more incentive and be better measures of executive performance if the stock

option exercise prices were indexed by broad movements in the market This would

imply that an executive would not be compensated simply because of broad movements

in the market, but more by his individual firm’s performance relative to other firms

Corporate Governance’s Role in Economic Efficiency

Given the role executive compensation and incentive contracts play in attempting

to solve the agency problem, there remains the question of what role governance plays in improving economic efficiency In the ex-ante (which Zingales (1997) defines as the

time when specific investments should be made) period, there are two situations where

governance improves economic efficiency The first is that rational agents will focus on

value-enhancing activities that are most clearly rewarded, and therefore governance must help allocate resources and reward value-enhancing activities that are not properly

rewarded by the market Secondly, managers will engage in activities that improve the

ex-post bargaining in their favor As Shleifer and Vishny (1989) argue, a manager will

be inclined to focus on activities that he is best at managing because his marginal

contribution is greater, and this consequently increases his share of ex-post rents, or his

bargaining power for residual control rights

Another area where governance may improve economic efficiency is in the

ex-post bargaining phase for rents That is, governance may affect the level of coordination

costs or the extent to which a party is liquidity-constrained If residual control rights are

assigned to a large, diverse group, the existence of free-riders in the group may create an inefficient bargaining system Also, if a party wishes to engage in a transfer of control

rights but he is liquidity-constrained, inefficient bargaining may again occur as the

transaction may not be agreed upon (Zingales 1997)

A third way that governance may effect overall economic efficiency is through

the level and distribution of risk Assuming that the engaged parties have different risk

aversions, corporate governance can then act to efficiently allocate risk to those who are least risk-averse (Fama and Jensen 1983), which improves the total surplus for the parties involved

From a more general standpoint, it is also important to recognize that strong

governance in a system of capital markets such as the U.S promotes an efficient medium for those who are lending money and those who are borrowing, as well as provides some security outside of the legal framework for lenders of capital The nature of the firm

requires that financiers, or lenders of capital, will indeed lend their money to managers

who will in turn run a firm and hopefully create a return for the financiers If the

financiers did not feel comfortable that they would be receiving their capital back at some point in the future, they would not be inclined to provide managers with capital and, as a

result, innovation and industrial progression would be slowed tremendously Strong

governance helps to maintain investors’ confidence in the capital markets and helps to

improve overall efficiency in this manner

Recent Developments in Corporate Governance

Besides the theoretical basis of efficiencies provided by governance, it is

important to consider a more applied look at governance and how it has evolved over the past two decades in the U.S Indeed, corporate governance has changed substantially in the past two decades Prior to 1980, corporate governance did little to provide managers with incentives to make shareholder interests their primary responsibility As Jensen

(1993) discusses, prior to 1980 management thought of themselves as representatives of the corporation as opposed to employees and representatives of the shareholders

Management saw their role as one of balancing the interests of all related parties,

including company employees, suppliers, customers, and shareholders The use of

incentive contracting was still limited, and thus management’s interests were not well

aligned with that of its shareholders In fact, “in 1980, only 20% of the compensation of

CEOs was tied to stock market performance,” (Holmstrom and Kaplan 2003, p.5) Also,

the role of external governance mechanisms like hostile takeovers and proxy fights were

rare, and there tended to be very little independence on a board of directors

The 1980s, however, were defined as an era of hostile takeovers and restructuring activities that made companies less susceptible to takeovers Leverage was employed at high rates As Holmstrom and Kaplan (2003) argue, the difference between actual firm

performance and potential performance grew to be significant, or in other words, firms

were failing to maximize value, which lead to a new disciplining by the capital markets

The 1990s, by contrast, included an increase in mergers that were designed to take

advantage of emerging technologies and high growth industries

Changes in executive compensation throughout the two decades also changed

significantly Option-based compensation for managers increased significantly as

executives became more aligned with shareholders, specifically, “equity-based

compensation in 1994 made up almost 50% of CEO compensation (up from less than

20% in 1980),” (Holmstrom and Kaplan 2003, p.9)

There were also changes in the makeup of U.S shareholders during the two

decades, as well as changes in boards of directors Institutional investors share of the

market increased significantly (share almost doubled from 1980 to 1996, Holmstrom and Kaplan 2003), which came alongside an increase in shareholder activism throughout the

period The increase in large institutional investors suggests that firms will be more

likely to be effective monitors of management The logic follows because if an investor

(take a large institutional investor for example) owns a larger part of the firm, he will be

more concerned with the firm’s performance than if he were small because his potential

cash flows from the firm will be greater It is important to note that often the large

shareholders are institutional shareholders, which means that presumably more

sophisticated investors with incentives to show strong stock returns own an increasing

share of firms Such concentration of ownership tends to avoid the traditional free-rider

problem associated with small, dispersed shareholders and will lead to the large

shareholders more closely monitoring management “Large shareholders thus address the agency problem in that they both have a general interest in profit maximization, and

enough control over the assets of the firm to have their interests respected,” (Shleifer and Vishny 1996, p.27)

Other developments in corporate governance over the two decades, aside from the regulatory and legislative changes post-Enron, include the fact that boards took great

strides to remove their director nominating decisions from the CEO’s control through the use of nominating committees The number of outside directors (referring to those

directors who are not members of management) also increased during the period, as did directors’ equity compensation as a percentage of their total director compensation

(Holmstrom and Kaplan 2003)

However, despite such improvements over the past two decades, the case of

Enron suggests that corporate governance was not immune from failure, and it highlights

many of the theoretical and applied issues with the current theories on corporate

governance, the firm, and executive compensation

III WHAT HAPPENED AT ENRON: FACTUAL ACCOUNT OF EVENTS

LEADING TO BANKRUPTCY

Background/Timeline

Enron was founded in 1985 through the merger of Houston Natural Gas and

Internorth, a natural gas company based in Omaha, Nebraska, and quickly became the

major energy and petrochemical commodities trader under the leadership of its chairman,

Kenneth Lay In 1999, Enron moved its operations online, boasting the largest online

trading exchange as one of the key market makers in natural gas, electricity, crude oil,

petrochemicals and plastics Enron diversified into coal, shipping, steel & metals, pulp & paper, and even into such commodities as weather and credit derivatives At its peak,

Enron was reporting revenues of $80 billion and profits of $1 billion (Roberts 2002), and was for six consecutive years lauded by Fortune as America’s most innovative company (Hogan 2002)

The sudden resignation, however, of Enron Vice-Chairman Clifford Baxter in

May of 2001 and subsequent resignation of CEO Jeffrey Skilling in August of 2001, both

of whom retired for undisclosed personal reasons, should have served as the first

indication of the troubles brewing within Enron Mr Skilling had been elected CEO only months before, and Mr Baxter had become Vice-Chairman in 2000 Eventually, amidst analysts’ and investors’ questions regarding undisclosed partnerships and rumors of

egregious accounting errors, Enron announced on October 16, 2001 it was taking a $544 million dollar after-tax-charge against earnings and a reduction in shareholder equity by

$1.2 billion due to related transactions with LJM-2 As will be discussed in the following section, LJM-2 was partnership managed and partially owned by Enron’s CFO, Andrew Fastow The LJM partnerships provided Enron with a partner for asset sales and

purchases as well as an instrument to hedge risk

Less than a month later Enron announced that it would be restating its earnings

from 1997 through 2001 because of accounting errors relating to transactions with

another Fastow partnership, LJM Cayman, and Chewco Investments, which was

managed by Michael Kopper Mr Kopper was the managing director of Enron’s global finance unit and reported directly to the CFO, Mr Fastow Chewco Investments was a

partnership created out of the need to redeem an outside investor’s interest in another

Enron partnership and will be discussed at length in the following section

Such restatements sparked a formal investigation by the SEC into Enron’s

partnerships Other questionable partnerships were coming to light, including the

Raptors partnerships These restatements were colossal, and combined with Enron’s

disclosure that their CFO Mr Fastow was paid in excess of $30 million for the

management of LJM-1 and LJM-2, investor confidence was crushed Enron’s debt

ratings subsequently plummeted, and one month later, on December 2, 2001, Enron filed for bankruptcy protection under Chapter 11

Summary of Transactions and Partnerships

Many of the partnership transactions that Enron engaged in that contributed to its failure involved special accounting treatment through the use of specifically structured

entities known as a “special purpose entities,” or SPEs For accounting purposes in 2001,

a company did not need to consolidate such an entity on to its own balance sheet if two

conditions were met: “(1) an owner independent of the company must make a substantive equity investment of at least 3% of the SPE’s assets, and the 3% must remain at risk

throughout the transaction; and (2) the independent owner must exercise control of the

SPE,” (Powers, Troubh and Winokur 2002, p.5) If these two conditions were met, a

company was allowed to record gains and losses on those transactions on their income

statement, while the assets, and most importantly the liabilities, of the SPE are not

included on the company’s balance sheet, despite the close relationship between the

company and the entity

The Chewco/JEDI Transaction

The first of the related party transactions worthy of analysis is Chewco

Investments L.P., a limited partnership managed by Mr Kopper Chewco was created

out of the need to redeem California Public Employees’ Retirement System (“CalPERS”) interest in a previous partnership with Enron called Joint Energy Development

Investment Limited Partnership (JEDI)

JEDI was a $500 million joint venture investment jointly controlled by Enron and CalPERS Because of this joint control, Enron was allowed to disclose its share of gains and losses from JEDI on its income statement, but was not required to disclose JEDI’s

debt on its balance sheet However, in order to redeem CalPERS interest in JEDI so that CalPERS would invest in an even larger partnership, Enron needed to find a new partner,

or else it would have to consolidate JEDI’s debt onto its balance sheet, which it

desperately wanted to avoid

In keeping with the rules regarding SPEs, JEDI needed to have an owner

independent of Enron contribute at least 3% of the equity capital at risk to allow Enron to not consolidate the entity Unable to find an outside investor to put up the 3% capital,

Fastow selected Kopper to form and manage Chewco, which was to buy CalPERS’ 3% interest However, Chewco’s purchase of CalPERS’ share was almost completely with

debt, as opposed to equity As a result, the assets and liabilities of JEDI and Chewco

should have been consolidated onto Enron’s balance sheet in 1997, but were not

The decision by management and Andersen to not consolidate was in complete

disregard of the accounting requirements in connection with the use of SPEs, despite the fact that it is was in both Enron’s employees’ interest and in the interest of Enron’s

auditors to be forthright in their public financial statements The consequences of such a

decision were far-reaching, and in the fall of 2001 when Enron and Andersen were

reviewing the transaction, it became apparent that Chewco did not comply with the

accounting rules for SPEs In November of 2001 Enron announced that it would be

consolidating the transactions retroactively to 1997 This consequently resulted in the

massive earnings restatements and increased debt on Enron’s balance sheet

Not only was this transaction devastating to Enron, but its manager, Mr Kopper, received excessive compensation from the transaction, as he was handsomely rewarded

more than $2 million in management fees relating to Chewco Such a financial windfall

was the result of “arrangements that he appears to have negotiated with Fastow,”

(Powers, Troubh, and Winokur 2002, p.8) Kopper was also a direct investor in Chewco, and in March of 2001 received more than $10 million of Enron shareholders’ money for his personal investment of $125,000 in 1997 His compensation for such work should

have been reviewed by the board’s Compensation Committee but was not

This transaction begins to shed light on a few of the many corporate governance

issues arising from Enron, one being the dual role Kopper played as manager and

investor of the partnership while an employee of Enron This is a blatant conflict of

interest, explicitly violating Enron’s own Code of Ethics and Business Affairs, which

prohibits such conflicts “unless the chairman and CEO determined that his participation

‘does not adversely affect the best interests of the Company,’” (Powers, Troubh and

Winokur 2002, p.8) The second governance issue is in connection with the

Compensation Committee’s lack of review of Kopper’s compensation resulting from the transactions The third governance issue deals with the lack of auditing oversight from

the Audit and Compliance Committee concerning the decision not to consolidate the

entity

The LJM Transactions

In June of 1999, Enron again entrenched itself in related-party transactions with

the development of LJM-1 and later with LJM-2 Both partnerships were structured in

such a way that Fastow was General Partner (and thereby investor) of the entities as well

as Enron’s manager of the transactions with the entities, an obvious conflict of interest

LJM-1 (Cayman) and LJM-2 served two distinct roles They provided a partner

to Enron for asset sales and as well as acted to hedge economic risk for particular Enron investments Especially near the end of a quarter, Enron would often sell assets to LJM-1

or LJM-2 While it is important to note that there is nothing inherently wrong with such

transactions if there is true transfer of ownership, it would appear that in the case of the

LJM transactions there were no such transfers

Several facts seem to indicate the questionable nature of such transactions at the end of the third and fourth quarters in 1999, one of which was that Enron bought back

five of the seven assets just after the close of the financial period (Powers, Troubh and

Winokur 2002) It is reasonable to assume that the sale was purely for financial reporting purposes, and not for economic benefit Another fact that casts doubt on the legitimacy

of the sales is that “the LJM partnerships made a profit on every transaction, even when

the asset it had purchased appears to have declined in market value,” (Powers, Troubh

and Winokur 2002, p.12) Thus it appears that the LJM partnerships served more as a

vehicle for Enron management to artificially boost earnings reports to meet financial

expectations, conceal debt, and enrich those investors in the partnerships than as

legitimate partners for asset sales and purchases

Not only were the LJM transactions used in asset sales and purchases, but also for supposed hedging transactions by Enron Hedging is normally the act of protecting

against the downside of an investment by contracting with another firm or entity that

accepts the risk of the investment for a fee However, in June of 1999 with the Rhythms investment, instead of the LJM partnerships committing the independent equity necessary

to act as a hedge for the investment should the value of the investment decline, they

committed Enron stock that would serve as the primary source of payment “The idea

was to ‘hedge’ Enron’s profitable merchant investment in Rhythms stock, allowing Enron

to offset losses on Rhythms if the price of Rhythms stock declined,” (Powers, Troubh and Winokur 2002, p.13) These “hedging” transactions did not stop with Rhythms, but

continued through 2000 and 2001 with other SPEs called Raptor vehicles They too were hedging Enron investments with payments that would be made in Enron stock should

such a payment be necessary

Despite Andersen’s approval of such transactions, there were substantial

economic drawbacks for Enron of essentially “hedging” with itself If the stock price of

Enron fell at the same time as one of its investments, the SPE would not be able to make the payments to Enron, and the hedges would fail For many months this was never a

concern, as Enron stock climbed and the stock market boomed But by late 2000 and

early 2001 Enron’s stock price was sagging, and two of the SPEs lacked the funds to pay Enron on the hedges Enron creatively “restructured” some transactions just before

quarter’s end, but these restructuring efforts were short-term solutions to fundamentally

flawed transactions The Raptor SPEs could no longer make their payments, and in

October of 2001 Enron took a $544 million dollar after-tax charge against earnings- a

result of its supposed “hedging” activities

Though they eventually contributed to Enron’s demise, these related party

transactions concerning LJM-1 and LJM-2 resulted in huge financial gain for Fastow and other investors They received tens of millions of dollars that Enron would have never

given away under normal circumstances At one point Fastow received $4.5 million after two months on an essentially risk-free $25,000 investment relating to LJM-1 (Powers,

Troubh and Winokur 2002)

As discussed earlier, one of the downfalls of the principal-agent problem under

the incomplete contract paradigm lies with the allocation of residual control rights to

managers Because managers have much discretion associated with the residual rights,

funds may be misallocated This exact problem, the misallocation of firm funds, arose in

the case of Enron Enron shareholders had invested capital in the firm and management

was then responsible for the allocation of such funds With the residual control rights

management maintained due to the separation of ownership and management,

management, vis-à-vis the firm’s CFO Andrew Fastow and Michael Kopper, was able to expropriate the firm’s funds

There are many different methods a manager may employ in the expropriation of funds A manager may simply just take the cash directly out of the operation, but in the

case of Enron, management used a technique called transfer pricing with the partnerships they had created Transfer pricing occurs when “managers set up independent companies that they own personally, and sell output (or assets in this case) of the main company they run to the independent firms at below market prices,” (Shleifer and Vishny 1996, p.9

excluding parenthesis) The “independent firms” mentioned above were the partnerships, like Chewco, JEDI, and the LJMs that Fastow and Kopper managed and had partial

ownership of With the partnerships like the LJMs making a profit on nearly every

transaction, it is clear that Enron must have been selling those assets at below market

levels, which defines expropriation by way of transfer pricing It then makes sense that

as the partnerships sold back the assets, they profited each time because Enron would purchase the assets at prices higher than what the partnerships had paid Therefore,

re-because Enron’s asset sales and purchases were enriching the investors in the

partnerships, management was effectively expropriating firm funds Management’s

expropriation of funds to the manager-owned and operated partnerships is a manifestation

of the principal-agent Management was literally enriching itself and the other owners of

the partnerships with firm funds, a problem that stems from the separation of ownership

and management in a corporation

It is important to note that the expropriation of firm funds in this case was really a breakdown in the first layer of the corporate governance institutions that exist to protect

shareholders These mechanisms of corporate governance take many different forms,

ranging from management decision-making and compensation, to board oversight, to

outside professional advisors and their roles to monitor the workings of a company

Management of a firm, and in particular its CFO, has a fiduciary duty to the shareholders

of the company, which serves to act as a governance mechanism In this case,

management abandoned their responsibility to shareholders in favor of enriching

themselves and manipulating financial statements, and thus undermined one of the many

mechanisms of corporate governance that contribute to its effectiveness

The expropriation of funds through transfer pricing is not an Enron-specific

phenomenon As Shleifer and Vishny (1996) mention, within the Russian oil industry

managers often sell oil at below market prices to independent manager-owned

companies Korean chaebol also have reportedly sold subsidiaries to the founders of the chaebol at below market prices (Shleifer and Vishny 1996)

At the formation of the LJM partnerships it was brought to the attention of the

board that having Fastow both invest in the partnerships and manage the transactions

with Enron would present a conflict of interest Management, however, was in favor of

the structure because it would supply Enron with another buyer of Enron assets, “and that

Fastow’s familiarity with the Company and the assets to be sold would permit Enron to

move more quickly and incur fewer transaction costs,” (Powers, Troubh and Winokur

2002, p.10) After discussion, the board voted to ratify the Fastow managed partnerships, despite the conflict The board was under the impression that a set of procedures to

monitor the related party transactions was being implemented, and that because of the

close scrutiny the partnerships would face this would mitigate the risk involved with

them However, the Enron Board failed “to make sure the controls were effective, to

monitor the fairness of the transactions, or to monitor Mr Fastow’s LJM-related

compensation” (U.S Senate Subcommittee 2002, p.24), and will be discussed further in section IV

Despite the foregoing disparaging remarks regarding SPEs, it is important to note that SPEs are not inherently bad transaction vehicles, and can actually serve valid

purposes They are in fact very appropriate mechanisms for insulating liability, limiting

tax exposure, as well as maintaining high debt ratings They are widely used in both

public and privately held corporations and are fundamental to the structuring of joint

venture projects with other entities It was the expropriation of firm funds by Enron

management that was illegal, not the transaction vehicles themselves

IV ANALYSIS OF CORPORATE GOVERNANCE ISSUES

Corporate Structure

In order to fully analyze the corporate governance issues that arose within Enron,

a certain amount of background information regarding its corporate structure and the

implications of its high power incentive contracts is necessary By any standards,

Enron’s Board structure with five oversight subcommittees could have been characterized

as typical amongst major public American corporations The Chairman of the Board was Kenneth Lay, and in 2001 Enron had 15 Board Members Most of the members were

then or had previously served as Chairman or CEO of a major corporation, and only one

of the 15 was an executive of Enron, Jeffrey Skilling, the President and CEO In his

testimony before the Senate Subcommittee on Investigations, John Duncan, Chairman of Enron’s Executive Committee, spoke of his fellow board members as being well

educated, “experienced, successful businessmen and women” and “experts in areas of

finance and accounting.” Indeed they had “a wealth of sophisticated business and

investment experience and considerable expertise in accounting, derivatives, and

structured finance,” (U.S Senate Subcommittee 2002, p.8) The board had five annual

meetings, and conducted additional special meetings as necessary throughout the year

As provided in U.S Senate Subcommittee report on The Role of Enron’s Board

of Directors in Enron’s Collapse (2002, p.9), the five subcommittees, consisting of

between four and seven members each, had the responsibilities as follows:

“(1) The Executive Committee met on an as needed basis to handle urgent

business matters between scheduled Board meetings

(2) The Finance Committee was responsible for approving major transactions

which, in 2001, met or exceeded $75 million in value It also reviewed

transactions valued between $25 million and $75 million; oversaw Enron’s risk

management efforts; and provided guidance on the company’s financial decisions and policies

(3) The Audit and Compliance Committee reviewed Enron’s accounting and

compliance programs, approved Enron’s financial statements and reports, and was the primary liaison with Andersen

(4) The Compensation Committee established and monitored Enron’s

compensation policies and plans for directors, officers, and employees

(5) The Nominating Committee nominated individuals to serve as Directors.”

At the full Board meetings, in addition to presentations made by Committee

Chairmen summarizing the Committee work, presentations by Andersen as well as

Vinson & Elkins, the Enron’s chief outside legal counsel, were common Vinson &

Elkins provided advice and assisted with much of the documentation for Enron’s

partnerships, including the disclosure footnotes regarding such transactions in Enron’s

SEC filings (Powers, Troubh and Winokur 2002) Andersen regularly made

presentations to the Audit and Compliance Committee regarding the company’s financial statements, accounting practices, and audit results

Board members received $350,000 in compensation and stock options annually, which “was significantly above the norm,” (U.S Senate Subcommittee 2002, p.56)

Compensation to Enron executives in 2001 was extraordinarily generous too, as shown

by the following chart (Pacelle 2002), which includes the value of exercised stock options and excludes compensation from the partnerships:

Kenneth Lay (Enron Chairman/CEO).……….….$152.7 (in millions)

Mark Fevert (Chair and CEO, Enron Wholesale Services)….$31.9

Jeffrey Skilling (Enron CEO)……… … $34.8

J Clifford Baxter (Enron Vice-Chairman)……… …$16.2

Andrew Fastow (Enron CFO)……… $4.2

In 2000, Mr Lay’s compensation was in excess of $140 million, including the

value of his exercised options This level of compensation was 10 times greater than the average CEO of a publicly traded company in that year, which was $13.1 million (U.S

Senate Subcommittee 2002, p.52) It is important to note that $123 million of that $140 million came from a portion of the stock options he owned, which represents a significant percentage of total compensation from stock options