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, and was for six consecutive years lauded by Fortune as America's most innovative company.
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.
Q. 1)What were the measures which Enron had missed to govern during the entire scandal?
At the time of its filing for bankruptcy in December 2001 the complex industrial structure of Enron was fully grasped by few outsiders, and more complete information as to the true levels of its assets, liabilities and off-balance-sheet positions was still unfolding. An idea of the firm's complexity can be obtained from such features as its 2,800 offshore units and the 54 pages required to list people and companies owed money by Enron. This was a far cry from the firm which in the 1980s specialized in the provision of natural gas pipelines and related services. But from these origins Enron expanded relentlessly into trading activities in 1,800 products or contracts and 13 currencies.
Part of the motivation of Enron's conduct was similar to that of many other firms in the 1990s, deriving from the links between stock prices and executives' remuneration and wealth, above all through stock options. However, in Enron's case the factor of its credit rating was also important. The firm's rapid expansion required access to large amounts of financing; and as its involvement in trading activities grew, so did the importance of its credit rating since this determined its financing costs and crucially the willingness of its counterparties to trade with it.
In order to maintain the firm's credit rating Enron sought it to be essential that it portrays a favourable income, while avoiding an excessive leverage on Enron's balance sheet. So as to achieve this, the firm resorted to extraordinary departures from transparency which affected the firm's relations with investors and creditors, its own board of directors (and thus an important part of its internal control), and other stakeholders of the corporation. The firm's use of special purpose entities (SPEs) was part and parcel of the practices employed to manipulate the firm's earnings figures and balance sheet, as was recourse to hedging and the use of derivatives in conflict with reporting rules or business logic (or both). Many of the transactions associated with this manipulation were also associated with self-dealing by Enron executives leading to substantial personal enrichment. In summation the causes for Enron's fall are ascribed to
Enron's failure to observe good corporate governance.
Enron's flamboyant usage of mark to market accounting.
Enron's complex transactions with special purpose entities.
This analysis has been restricted to Enron's non observance of good corporate governance.
Corporate governance is concerned with the relationships between a business's management and its board of directors, its shareholders and lenders, and it's other stakeholders such as employees, customers, suppliers, and the community of which it is a part. The subject thus concerns the framework through which business objectives are set and the means of attaining them and otherwise monitoring performance are determined. Good corporate governance follows principles which still vary significantly among countries and which are currently the subject of various initiatives designed to achieve agreement on an acceptable framework of basic standards. Implementation of principles of good corporate governance presupposes satisfactory performance on the part of several different parties from both the private and public sectors. The role of these parties must be complemented by effective regulation, which in the case of a firm with operations as complex as Enron includes not only major regulators of the financial sectors but also the regulator of the energy sector. Certain aspects that will be dealt, herein, are:
Enron's system of incentives and sanctions
Board of directors
Banks, Financial analysts and SECs
Enron's system of incentives and sanctions
The influence of the firm's stock price on the incentive system for Enron's employees became increasingly important during the long financial boom of the 1990s. In the case of senior staff this reflected a remuneration system of which a key part consisted of stock options. For other staff much of their savings was invested in Enron stock with the active encouragement of Enron's own management. An important part of this process consisted of retirement savings plans under which staff's own contributions were topped up by contributions from Enron itself.
Many of Enron employees had invested substantial sums in Enron's own stock; this was actively encouraged by Enron's management itself. But at the same time Enron officers and a few directors were themselves selling the firm's stock on a massive scale, sales no doubt partly due to normal portfolio diversification but also likely to have been increasingly influenced by insider knowledge of the growing precariousness of Enron's real situation.
Board of directors
In order to achieve good corporate governance an important role is attribute 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 bearing on the fulfilment of these responsibilities.
It should be emphasized that when looking at the directors of Enron's Board it was evident that the directors did not function independently. Financial ties between Enron and a majority of its directors seem to have weakened their objectivity in their oversight of Enron. Such relationships with Enron may have made it difficult for such board members to be objective or critical of Enron management. Many of these Enron Board members may have felt that their compensation might be endangered by questioning such concerns in Board meetings, thus, producing weak "nodders and yes-men" as directors and thereby, contributing to the fall of Enron.
One widely accepted principle of good corporate governance is that the board be independent of management. It is essential that a board be capable of looking objectively at the management and outside professional advisors of a firm, and Enron's Board was not capable in this respect. It should also be mentioned here that of the compensation paid to the board a substantial proportion was in the form of stock options, a practice capable of exerting on the board pressures to approve decisions likely to have a favourable influence on the firm's stock price similar to those also exerted on management. The Board should function to help avoid conflicts of interest, ensure auditing independence and accurate financial reporting, oversee compensation practices, as well as many other breakdowns that occurred within Enron. Compromised by its constraints and conventionality the Board failed in its task.
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. The history of relations between Enron and Arthur Andersen suggests that they were frequently characterised by tensions due to the latter is misgivings concerning several features of Enron's.
Materials from Audit Committee meetings indicate that its members were aware of such high-risk accounting methods being employed by Enron, but did not act on them. These concerns, however, were never properly addressed and were not effectively communicated to the Audit and Compliance Committee by Andersen.
It is important to emphasize that Enron was using technologies (or complex financial techniques) that helped to obscure the firm's true financial results. Had investors been more aware of and understood the significance of such highly structured partnerships, they would not have been as deceived by the financial results and would have looked more sceptically at the firm's financial condition. The lack of financial reporting transparency represents the failure of another layer of corporate governance protection that shareholders are normally provided. Shareholders rely on the financial reports and information that management produces. When such reports are inaccurate and have been manipulated shareholders are stripped of another mechanism that helps to truly monitor the performance of management, which is what happened with the case of Enron.
Banks and Financial analysts
Enron's banks were deeply involved in the firm's recourse to techniques for the manipulation of its reported earnings and balance sheet. The Finance Committee should have taken a more proactive role in examining and monitoring the transactions. It should be seen that the Finance Committee having been aware of the precarious nature of the related-party transactions in Enron, failed in its responsibility of monitoring the transactions. A forum for more extensive questioning from directors regarding the transactions was the reason that such a committee existed. Their job was to probe and take apart the transactions that they reviewed and to oversee risk, neither of which they did for these related-party transactions. Most financial analysts covering Enron stock continued to recommend it to investors well into the autumn of 2001, even as revelations concerning Enron's accounting and management failings began to proliferate. Many of the analysts made this recommendation even though they admitted that they did not fully understand the firm's operations and structure.
Q.2 Lacuna in the existing law due to which the Enron scandal took place
The Enron Loophole
The Commodity Exchange Act exempts certain energy derivatives contracts from regulation by the Commodity Futures Trading Commission (CFTC). These exemptions are popularly known as the "Enron loophole." Soaring energy prices have raised concerns about whether the CFTC has enough information about these unregulated markets to monitor energy trading in a comprehensive manner. The Farm Bill established a more stringent regulatory regime for electronic trading facilities that offer contracts that play a significant role in setting energy prices. A number of other bills in the 110th Congress would impose new reporting or regulatory requirements on the bilateral energy swaps market, which was not addressed by the Farm Bill. This report will be updated as legislative developments warrant.
In 2000, Congress passed the Commodity Futures Modernization Act whose central purpose was to set out the conditions under which derivative financial contracts - instruments like futures, options, or swaps, whose value is linked to the price of some underlying commodity - could be legally traded in the over-the counter (OTC) market, that is, off the futures exchanges that are regulated by the Commodity Futures Trading Commission (CFTC). The CFMA established three categories of commodities and made them subject to varying degrees of regulation: financial commodities (such as interest rates, currency prices, or stock indexes) were defined as excluded commodities. Excluded commodities can be traded in the OTC market with minimal CFTC oversight, provided that small public investors are not allowed to trade. A second category is agricultural commodities; here, because of concerns about price manipulation, the law specifies that all derivatives based on farm commodities must be traded on a CFTC-regulated exchange; unless the CFTC issues a specific exemption after finding that a proposed OTC agricultural contract would be consistent with the public interest.
Finally, there is a third "all-other" category - an exempt commodity - which includes whatever is neither financial nor agricultural. In today's markets, this means primarily metals and energy commodities. The statutory exemption from regulation provided by the CFMA for exempt commodities is commonly known as the "Enron loophole." Before its collapse in 2001, Enron Corp. was a pioneer in OTC energy trading and developed an electronic market (Enron Online) for trading physical and derivative contracts based on a number of energy products. Defined in the law as financial institutions, insurance companies, broker/dealers, government units, professional futures traders, and businesses and individuals meeting certain asset and income thresholds. The presumption is that these are sophisticated traders who do not need the protections offered by government regulation.
"Trading facility" is defined in law as a "facility or system in which multiple participants have the ability to execute or trade agreements, contracts, or transactions by accepting bids and offers made by other participants that are open to multiple participants in the facility or system."
These are defined as eligible contract participants who (1) deal in the physical commodity or (2) regularly provide risk management or hedging services to those who do. Defined as a trading facility, that operates over an electronic or telecommunications network and maintains an audit trail of transactions.
Essentially, one of the ways to counter financial scandals is to improve the quality of auditing services. Nonetheless, the current legal, regulatory and corporate governance framework is robust and sufficient to protect the market. This is difficult because the number of financial scandals involving auditors is increasing. Furthermore, whilst corporate governance may have improved but the auditors' duties and responsibilities are shrouded in mystery and mystique as ever. There is a lacuna in the current legal framework as the duties and obligations reposed on auditors under common law, 'the Companies Act', BAFIA and the CMSA are inadequate in countering the financial scandals.
Enron, an energy trading company is the first scandal which shook up the auditing profession although there were many cases involving auditors since the 18 century. Enron has caused a crisis to the confidence in auditors and the reliability of financial reporting. The audit quality and the independence of the auditors were questionable. This is because the auditors, who were Arthur Andersen, were not only receiving fees for auditing but for non-audit services too i.e. for consultancy services. In 2001, Arthur Andersen earned US $55 million for non-audit services. Furthermore, there were regular exchanges of employees within Enron from Arthur Andersen.
Under the common law duties and obligations, there is no duty reposed on the auditors to avoid conflict of interests. Thus, the fact that Arthur Andersen was offering non-audit services is not a breach of law in the first place.
Under 'the Companies Act', although independence of the auditors is essential as can be seen in S. 9 of 'the Companies Act' which disqualifies certain persons from being eligible as auditors, the provision does not deal with issues concerning the offering of non-audit services to the company. This is because the provision only prohibits an employee, officer, partner or employee or employer of an officer from being appointed as an auditor. The offering of the non-audit services by the auditors to a company is in the capacity of an independent contractor. The law assumes that such persons are independent. This is because independence is the cornerstone for auditing. Nevertheless, there will be conflict of interest and therefore the independence of the auditor will be affected.
Although Arthur Andersen was making a report on the company's accounts, they did not report fraud to the stakeholders. This is because the fraud was committed by the management. Kenneth Lay took home US$152 million although the company was facing a loss. If the auditors were to report they probably will not be appointed in subsequent years or be engaged for non-audit services. They made sure that they were in the management's good books. They maintained confidentiality but for the wrong reasons.
The U.S. government assured the stakeholders that Enron was just a case of one bad apple. Nonetheless, in 2002, WorldCom which is one of the biggest telecommunications company in US collapsed. The issue regarding auditors reached a high level due to Enron. It was found that the auditors, Arthur Anderson, did not take proper steps in detecting accounting irregularities. Although it is the duty of the auditors to detect accounting irregularities, they failed to do so. Since they failed to do so rightfully, they should be liable. As a result of Enron, the audit firm Arthur Andersen in Malaysia was dissolved.
On the other hand, it is difficult to determine the ambit of the auditors' duties and obligations. This is because in at least four matters, the American International Group Incorporated's auditor i.e. PricewaterhouseCoopers are aware of problematic accounting but decided that they were not material. If the view is shared by the auditing profession, it can be considered that the auditors have performed their duties and obligations accordingly. Nonetheless, the view must also be agreed by the courts before establishing whether the auditors have performed their duties and obligations accordingly.
When Enron took place, it was thought it could not happen in Malaysia. In fact the SC believed that since Malaysia practices different set of accounting and auditing rules. However, much before Enron, there have been cases which involved auditing scandals. In fact the scandals pose a constant threat to the regulatory structure, public trust and confidence in the market economy. Thus, it has raised concerns regarding the credibility of the audit profession.
The effect of these changes was that, what had previously been a system of healthy checks and balances became a united front at the expense of investors. Instead of having opposed interests that served to protect investors, they now had an unhealthy common interest. The fiduciary duty that executives owed to shareholders took a back seat to the pursuit of a short-term increase in stock price. Accountants, who had formerly policed financial reports in order to protect the public, now had a strong incentive to help executives to do whatever it took to boost share price in order to keep them as consulting clients. And investment bankers no longer served as trusted advisers to their customers, scouting out the best securities. They found it more advantageous to work with executives and accountants to finance deals that raised stock prices, even if it meant selling out their customers.
Q.3) What were the Amendments that were brought in post Enron Issue?
The Enron Scandal caused a loss of an estimated $74 billion to the shareholders. After the collapse of Enron, several issues were earmarked for the attention of reformers including:
- The role of business funds in political campaigning.
- The extent of energy companies' influence on national energy policy.
- The need to reform pension laws to stop over-exposure to one stock and prevent a company from investing its pension funds in its own stock.
- The need for higher standards of transparency and disclosure in the audit profession.
- Potential conflicts of interest between consultancy and auditing work undertaken by financial houses.
- The need for tighter regulation on financial derivatives trading.
Sarbanes -Oxley Act (SOX) of 2002
The sudden collapse of Enron Corporation in late 2001, amid revelations that its public accounting statements had been manipulated and falsified to conceal the company's true financial position, was the first in a series of major accounting scandals involving American corporations. The response of the 107th Congress was to pass the Sarbanes-Oxley Act (P.L. 107-204), sometimes described as the most sweeping amendments to the securities laws since the 1930s. The SOX came as a US legislative response to the recent spate of accounting scandals. It provided for compliance with comprehensive reform of accounting and required for publicly held companies to promote and improve the quality and transparency of financial reporting by internal and external auditors. Companies must "list and track performance of their material risks and associated control procedures." Companies can no longer make loans to company directors.
SOX Act also did not address other key causes:
misaligned incentives (e.g., shift from cash to stock option compensation
focus on short-run profits rather than longer run profit performance.
Congress's intent in passing Sarbanes-Oxley was to restore confidence in financial markets by increasing corporate accountability, enhancing public disclosures of financial information, and strengthening corporate governance. More severe criminal penalties for securities fraud were also enacted. The Securities and Exchange Commission (SEC) has adopted more than a dozen final rules to implement the Act's provisions. These rules raise standards of accountability for corporate executives, boards of directors, independent auditors, and corporate attorneys.
Some of the important features of the Act were:
The Act created a national Accounting Oversight Board that, among other activities, must establish the ethics standards used by CPA firms in preparing audits.
It was required that the auditors retain audit working papers for specified periods of time.
It was required that auditor rotation prohibiting the same person from being the lead auditor for more than five years.
It was required that the CEO and CFO certify that the company's financial statements are true, fair and accurate.
The Act prohibited corporations from extending personal loans to executives and directors.
It was required that the audited company discloses whether it has adopted the code of ethics for its senior financial officers.
It was required that the SEC regularly review each corporation's financial statements.
The Act prevented employers from retaining against research analysts that write negative reports.
It imposed criminal penalties on auditors and clients for falsifying, destroying, altering or concealing records.
It imposed fine or punishment on any person that defrauds shareholders.
It increased penalties for mail and wire defraud from 5 to 20 years in prison.
The Act establishes criminal liability for failure of corporate officers to certify financial reports.
A Few Possible Lessons and actions
â-We need a structural overhaul of the system, including:
New rules prohibiting firms that do the accounting for a company from doing any consulting for that company
Through campaign finance reform, a committed effort is needed to get big money out of politics
Reregulation and oversight of energy trading and distribution
â-We must punish corporate irresponsibility: More effort and diligence is needed in tracking and exposing corporate irresponsibility and government must strengthen the current slap-on-the-wrist punishments. At a start, this includes a continued thorough investigation of the Enron/Andersen by Congress, the SEC, and the Justice Department, with the public not accepting a watered down version from the government.
â-Workers should have more participation and power in management decisions, especially when pension funds are involved. If this had been in place, Enron possibly wouldn't have collapsed, and the employees certainly could have salvaged some of their savings. Losing one's entire pension fund is good grounds for demanding employee decision making power to prevent it in the future.
â-We need to struggle against trade agreements - need to continue to build a strong, widespread struggle against these trade agreements such as the GATS, and expose them for what they really are: mechanisms for exploitation of the world's people, land, resources, and public services. The mandate of these agreements is to allow for the Enron's of the world unrestricted access to privatize which will likely only lead to more Enron's on a global scale. Without this struggle, local and public services will continue to be lost.