comparative corporate governance the enron debacle
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Corporate Governance In A Post-Enron Environment
Sudeshna Akanksha Panda LL.M. II Year III Semester KIIT Law School
CONTENTS: History of Enron Does corporate ethics matter Chronology of the fall How and why did Enron happen Who was responsible: Board Auditing firm Beyond management Regulators call for changes in accounting and
auditing standards What are the repercussions Bush administration outlines reform plan The Sarbanes-Oxley Act, 2002 How has Enron effected corporate governance
practices How do board members position themselves
moving forward Conclusion
ABOUT ENRON: Formed in July,1985. The merger of Houston Natural Gas with
Omaha based Inter North resulted in the formation of Enron.
The company initially dealt with producing natural gas and pipeline operations for the same.
With deregulation of markets it branched out into brokering, trading electricity and other energy commodities.
It was one of the first energy companies to start trading online.
Kenneth Lay was the first Chairman and the CEO.
Does corporate ethics Matter:Enron’s corporate ethics best exemplified values of
risk taking, aggressive growth and entrepreneurial creativity.
But these values were not balanced by genuine attention to corporate integrity and the creation of customer - and not just shareholder - value. Because the Enron corporate ethics was not well grounded,
A single scorecard - maximized price per share of common stock - became its reason for being, and even its positive values became liabilities.
Corporate officers at Enron seem at best to have been neglectful of their responsibilities for oversight, or, at worst, outright criminal and abusive in their levels of greed and deception. It takes a special person to blow the whistle in such an environment.
Continued:All of this was preventable, long ago, but
Enron failed to create a sustainably successful corporate ethics:
that included values such as customer service, maximizing customer loyalty and satisfaction,
which would have balanced the company’s overemphasis on pure, short-term stock price.
But even more important, Enron’s corporate ethics had evolved so that it only paid cosmetic attention to integrity:
that is and was the responsibility of the Board of Directors and the executive officers of the company.
A well tended garden is never choked by weeds.
CHRONOLOGY OF THE FALL: 20th Feb,2001- A fortune story calls Enron a highly impenetrable
co. that is pilling up on debt. On 14 Aug, 2001- Jeff Skilling resigned as chief executive, citing
personal reasons. Kenneth Lay became chief executive once again. 12 Oct, 2001- Arthur Anderson legal counsel instructs workers who
audit Enron’s books to destroy all but the most basic documents. 16 Oct, 2001- Enron reports a third quarter loss of $618 million. 24 Oct 2001- CFO Andrew Fastow who ran some of the
controversial SPE’s(Special Purpose Entity) is replaced. 8 Nov 2001- The company took the highly unusual move of
restating its profits for the past four years. It admitted accounting errors, inflating income by $586 million since 1997. It effectively admitted that it had inflated its profits by concealing debts in the complicated partnership arrangements.
2Dec 2001- Enron filed for Chapter 11 bankruptcy protection and on the same day hit Dynegy Corp. with a $10 billion breach-of-contract lawsuit.
12 Dec 2001- Anderson CEO Jo Berardino testifies that his firm discovered possible illegal acts committed by Enron.
9 Jan 2002- U.S. Justice Department launches criminal investigation. Hence within three months Enron had gone from being a company claiming assets worth almost £62bn to bankruptcy. Its share price collapsed from about $95 to below $1.
How and Why did Enron Happen?• Twenty years of U.S. restructuring/reorganization limitedthe viability of cost-based strategies.• Need to “compete” with, and seek same inflated valuations, as high-flying Internet & tech companies.• Low interest rates throughout late 1990’s helped toperpetuate an already overheating economy.• Insufficient income/revenue growth created need for ever more aggressive accounting/business practices. • Creative Accounting: (SEP’s) Creation of partnerships with shell companies, run by executives of Enron. • High profits were made and it was easy to keep the debts of the books.• Board and Wall Street asleep at the wheel.
PERSONS INVOLVED: Kenneth Lay – former CEO and Chairman of Enron. Andrew Fastow – former CFO of Enron. Fastow was indicted on
78 counts of securities fraud, money laundering, wire and mail fraud, as well as conspiracy to inflate Enron’s profit.
Michael Kopper – former director in the global finance unit. Kopper pleaded guilty to financial wrongdoing in August 2002.
Jeffrey Skilling – former CEO of Enron. J. Clifford Baxter – former Vice Chairman of Enron. Accused of
securities fraud, Baxter died in an apparent suicide in January 2002.
Arthur Anderson – the accounting firm that was responsible for auditing Enron. Arthur Anderson was found guilty of obstruction of justice for shredding documents related to the Enron scandal.
Role of Andersen: Arthur Andersen – one of the world's five leading accounting firms - was the auditor to Enron. When the scandal broke. Andersen’s chief auditor for Enron, David Duncan, ordered the shredding of thousands of documents that might prove compromising. Andersen has dismissed Duncan and Andersen’s chief executive at the time of the Enron collapse, Jo Berardino, resigned at the end of March 2002 Besides obstruction of justice, Andersen also faces charges that it improperly approved of Enron's off-balance-sheet partnerships, called "special purpose entities", which the company used illicitly to hide losses from investors.
Responsibility of the Board: A fundamental role in the achievement of good corporate
governance is attributed to actors in the board of directors and independent external auditors.
Key functions of the board of directors, which were particularly relevant in the case of Enron, include:
selection and remuneration of executives, being alert to potential conflicts of interest adversely affecting the firm, and ensuring the integrity of the company’s
systems of accounting and financial reporting. Prerequisites for satisfactory performance. Include access to accurate and timely information. The role of the board in the area of conflicts of interest: clearly includes the monitoring needed to avoid self-dealing by
management. The primary finding of a report to a committee of the United States
Senate on the role of the Enron board in its collapse is damning: The Enron Board of Directors failed to safeguard: numerous indications of questionable practices by Enron
management over several years. chose to ignore them to the detriment of Enron shareholders,
employees and business associates.
Continued…In 2001 this consisted of 15 members, many
of them with 15 or more years of experience on the Board of Enron and its predecessor companies, and many of them also members of the boards of other companies.
Of the five committees of the Enron board the key Audit and Compliance Committee (the primary liaison body with the external auditors) had six members, of whom two had formal accounting training and professional experience and only one limited familiarity with complex accounting principles.
The Compensation Committee had five members, three with at least 15 years of experience with Enron.
Auditing Firm’s Responsibility: Regarding auditing good corporate governance requires
high-quality standards for preparation and disclosure, and independence for the external auditor.
Enron’s external auditor was Arthur Andersen, which also provided the firm with extensive internal auditing and consulting services.
In the period leading up to Enron’s insolvency is indicated by the fact that in 2000 consultancy fees(at $27 million) accounted for more than 50% of the approximately $52 million earned by Andersen for work on Enron.
The history of relations between Enron and Arthur Andersen suggests that they were frequently characterized by tensions due to the latter’s misgivings concerning several features of Enron’s accounting.
Both the Powers Committee and bodies of the United States Senate which have investigated Enron’s collapse have taken the view that lack of independence linked to its multiple consultancy roles was a crucial factor in Andersen’s failure to fulfill its obligations as Enron’s external auditor.
Continued: Andersen did not fulfill its
professional responsibilities in connection with its audits of Enron’s financial statements.
Or its obligation to bring to the attention of Enron’s Board (or the Audit and Compliance Committee) concerns about Enron’s internal contracts over the related party transactions.
Who Was Responsible (beyond management):
• Andersen signed off on Enron's books and helped structure its deals.
– They accepted consultancy fees, while acting as an "external auditor”. Most
of the so-called Big Five accounting firm have similar conflicts.
• Enron's board received detailed briefings as early as four years ago about
the partnerships whose losses triggered company's bankruptcy.
– Minutes, covering 4 board meetings and 3 meetings of the board's finance
committee, suggest board members approved aggressive accounting actions,
including moving debt off company books.
• Enron’s law firm, Vinson & Elkins, investigated alleged irregularities.
– They asked few real questions, failed to talk to key witnesses and blessed
Enron's controversial partnerships. V&E issued their report one day before
Enron restated its financials because of those partnerships
Conspiracy Theory?• While certainly extreme and clearly over the line, itappears unlikely the Enron cover-up began as awidespread conspiracy to commit fraud.• Rather it seems mostly a case of a business strategy notdelivering expected results (quickly enough) and a shortterm solution getting totally out of hand.• A widening circle of basically good people appear to have gotten swept up in the pressure to behave in a manner mandated by the “frenzy of greed” that characterized U.S. business practices at the time.
Was Enron Unique?• Paul Krugman notes “(U.S.) corporate profits grew rapidly between 1992 and 1997, but then stalled; after-tax profits in the third quarter of 2000 were barely higher than they were three years earlier."• However, “the operating profits of the S&P 500-- ... (large) companies reporting to investors -- grew 46% -- over those three years”.• Paul Krugman believes the main reason was that “… after 1997companies made increasingly aggressive use of accounting gimmicks to create the illusion of profit growth.”• “Corporate leaders were desperate to keep their stock prices rising, ... anything short of 20% profit growth was considered a failure.”• “Why were they desperate? In a word: options.”
Source: Paul Krugman, New York Times, Pg. A21, May 21, 2002
Regulators Call for Changes in Accounting and Auditing Standards
• In an SEC Public Statement on Accounting, Chairman Harvey L. Pitt stated:
– Today, disclosures are made not to inform, but to avoid liability.
– Financial disclosures are dense, impenetrable. We have called for plain
English financial statements.
– Corporate governance.. and role of Audit Comm. are.. in need of review.
– We need more prompt action by the FASB, the nation's accounting standard
– There is a need for reform of the regulation of our accounting profession. We
cannot afford a system ... that facilitates failure rather than success.
– Accounting firms have important public responsibilities...The Commission
cannot, and... will not, tolerate this pattern of growing restatements, audit
failures, corporate failures and investor losses. Somehow, we must put a stop
to a vicious cycle that has been in evidence for far too many years
What are the Repercussions?
• Desire to Assign Blame for What Transpired• Decreasing Investor Confidence• Retreat to Simplicity & Easy-to-Understand Models• Increased Call for Corporate Transparency• Review of Bank/Analyst Audit/Consult Relationships• Return to Fiscal Conservatism and Practices• Call for Increased Regulation and Scrutiny• Political Fallout and Maneuvering on all Levels
How Has Enron Effected CorporateGovernance Practices?
• Need for disclosure has increased dramatically.
• Investment banks reevaluate basic business
• Accountants need to walk a much finer line.
• Boards under more pressure than ever before
– Audit function in particular under intense scrutiny.
• Changes in options and compensation treatment.
• Active regulators and law enforcement.
• Many proposed changes under discussion.
Bush Administration Outlines Reform Plan:• President Bush outlined plan to hold executives more accountable through
independent audit system and better access to financial information.
• CEO’s required to attest to the accuracy of financial disclosures.
– To punish accounting abuse, top executives would be forced to forfeit bonuses and
other compensation. In extreme cases, they could be barred from serving as officers or
directors for other public corporations.
• Accounting firms would be subject to unprecedented oversight.
• The president would require top executives to disclose when they buy or sell
company stock within two days. Currently, executives can wait a year or more
without disclosing personal transactions.
• But Bush balks at a proposal by Paul O'Neill to prohibit executives from using
insurance coverage to pay legal costs arising from misconduct.
• Plan stops short of blocking auditors from consulting work for audit clients.
• White House officials said most of Bush's proposals could be carried out by the SEC within its existing authority.
The Sarbanes-Oxley Act, 2002:Provisions of the Act affecting directors and
senior executives include a requirement for certification of reports filed with the SEC, prohibition of insider lending to a firm’s executives.
Directors, penalties for accounting restatements reflecting misconduct.
Bans on trading by executives and directors in the firm’s stock during certain blackout periods for retirement plans.
A requirement for independence for members of audit committees.
The requirement that the SEC review a firm’s periodic financial reports at least once every three years.
Continued:The obligation on directors, officers and others
owning 10 per cent or more of the firm’s securities to report changes in their ownership within a specified, short period.
New requirements for disclosure concerning subjects such as off-balance-sheet transactions, internal controls,
The existence or absence of a code of ethics for a firm’s senior financial officers.
Timely disclosure of material changes in firms financial condition (so-called real time disclosure).
Auditor independence is to be strengthened by limiting the scope of non-audit and consulting services for audit clients, and by requiring that a firm’s audit committee pre-approve non-audit services provided by the firm’s auditor.
Continued: The Act also establishes a Public Company Accounting
Oversight Board (PCAOB) with wide ranging authority to ensure compliance. The PCAOB will be responsible for setting standards for auditing, this role constituting a radical strengthening of public control over auditors and accountants.
Other provisions of Sarbanes-Oxley include: rules to strengthen the independence of research analysts, lengthening the statute of limitations for litigation involving
the violation of certain securities, laws, the establishment of new securities-related offences
increases in certain criminal penalties, and new protections for employee “whistleblowers” include insider loans (since many legal regimes permit
loans to executives and directors), the rules to be followed by audit committees, the code of ethics for senior financial officers, and the
oversight of and some more detailed rules for auditors.
Steps Taken By Various Corporate Houses:• El Paso: Took off balance-sheet partnerships and put them on balance sheet to improve transparency.• IBM: Expanding information on intellectual-property income and impact on of company's pension plan.• Tyco: Weekly conference calls on accounting issues.• World com & Quest: More disclosure and Q&A• GE: Providing detail on how company's individual units--including GE Capital--churn out their earnings.
Business Ethics Magazine Outlines Four Principles:• Ensure auditors really audit by making them fully independent.• Bar law-breaking companies from government contracts.• Create a broad duty of loyalty in law to the public good.– Today a corporate duty of loyalty is due only to shareholders, not to ... otherstakeholders, and Enron behaved accordingly... Such piracy against the publicgood would be outlawed under a state Code for Corporate Citizenship,proposed by Robert Hinkley, formerly a partner with Skadden, Arps. Hischange to the law of directors’ duties would leave the current duty toshareholders in place, but amend it to say shareholder gain may not bepursued at the expense of the community, the employees, or the environment.• Find truly knowledgeable directors: Employees.– If Sherron Watkins had been on the Enron board, the whole scandal mighthave been averted.
How Do Board Members PositionThemselves Moving Forward:. • Financial literacy and an “inquiring mind” is more important than ever --
particularly on the Audit Committee.
• Board Membership requires more responsibility than ever before and
should not be seen as a retirement hobby.
• Directors need to be actively involved in understanding a companies
business -- its operation, finances & management.
• Directors cannot simply rely upon the word of management, auditors,
and outside professionals
• Directors must be independent and able to represent the interests of
shareholders as they relate to other stakeholders.
• Directors must seek to balance short term performance pressures with
the need to sustain and expand value over the long term.
“Sustainability and not Profits Alone Key to Good Corporate Governance:”
• World Council for Corporate Governance (WCFCG) recentlyorganized the 2nd Intl. Conference on Corporate Governance inMumbai which was attended by 416 business leaders and policymakers from 20 countries.• The Conference felt that most corporate collapses are theoutcome of a short sighted focus on immediate returns for the fewrather than sustainable growth of the corporation. Sustainabilityhas to be the ultimate end game of the business.• WCFCG is, therefore, launching a worldwide movement tochange the corporate ethics from short termism to sustainabilitythrough good corporate governance practices.
As Enhanced Corporate Governance Assumes an Increasingly Prominent and Important Role:
“In an age where capital flows worldwide … as quickly as information, a company that does not promote a culture of strong independent oversight risks its very stability and future health.” Kumar Mangalam Comm. on Corp. Gov., (India) 10/99
• “Continued emphasis will be placed on corporate reform. Without restructuring the corporate giants … economic reforms cannot be completed. The times have changed.” President Kim Dae-Jung (Korea)
• “The economic turmoil had, within less than a year, taught corporate Malaysia that corporate governance or rather the lack thereof, can exact a heavy toll from the markets.” High Level Finance Committee on Corp. Governance, (Malaysia)
• “We must brace ourselves for the fact ... in the new environment in which we must operate, the bar or standard of performance has been raised ... This we can ascribe partly to the (Asian) crisis, and partly to the forces of globalization.” Jaime Augusto Zobel de Ayala, President Ayala Corporation (Philippines)
Source: Building Stronger Boards and Companies in Asia, Asian Corporate Governance Association, January 2000
… Not only in the U.S., But all Over the World
Conclusion: Money in the new economy can be made in the same
ways you make money in the old economy - by providing goods or services that have real value.
Financial cleverness is no substitute for a good corporate strategy.
The arrogance of corporate executives who claim they are the best and the brightest, "the most innovative," and who present themselves as superstars should be a "red flag" for investors, directors and the public.
Executives who are paid too much can think they are above the rules and can be tempted to cut ethical corners to retain their wealth and perquisites.
Government regulations and rules need to be updated for the new economy, not relaxed and eliminated.