Corporate Law

Corporate Law

Enron In light of Corporate Governance:

In 1985 the foundations of Enron were laid when Houston Natural Gas owner Kenneth Lay decided to takeover one of its larger competitor, InterNorth based in Omaha. Kenneth Lay soon became chief executive officer (CEO) and moved the headquarters from Omaha to Houston. Lay changed the company name to Enron with a vision ‘to become the premier natural gas pipeline company in North America’. Enron performance throughout the 1990s was exemplary. In the 1990s Enron’s stock price were rising steadily. During 1999 the stock price increased dramatically and at the beginning of 2000 was standing at over $70.In 1995, Enron changed its vision statement again: ‘to become the world’s leading energy company’. By 2001 Enron was one of the world’s largest energy groups, operating mainly in the USA. Enron’s revenue was over $100 billion. Fortune magazine in early 2001 ranked Enron (on the basis of revenues) as seventh in the Fortune 500.

During the 1990s Enron expanded rapidly in the USA and into Central and South America, the Caribbean, India and the Philippines. Enron provided innovative risk management energy solution to its clients. Jefferey Skilling who was credited with creating the risk management model and Enron’s strategy of ‘business light’, was persuaded by Kenneth Lay to join him at Enron.

Under Skilling’s guidance, Enron created weather derivatives, which allowed companies to hedge risks associated with fluctuations in weather. Trading in non-asset backed commodities (derivates) meant that Enron’s wealth was essentially locked up in its intangible assets.

Enron was becoming the model of the new economy. Skilling termed his strategy as one of virtual assets. In February 2001, Lay handed over as CEO of Enron to Skilling and it was thought that Lay intended to leave business. Many thought Enron was on course to become the world’s leading company.

Unfortunately, in 2001 the company admitted that there had been a number of financial reporting irregularities over  the period 1997 to 2000.Enron created many Special purpose entities (SPV’s) without consolidating the balance sheets of these subsidiaries. Enron’s earnings (reported profits) were substantially overstated and in late 2001 the company filed for bankruptcy.

The Analysis

Corporate structure- To fully understand the co-operate governance issues that arose at Enron that we look at its co-operate structure. Enron Board structure had five oversight subcommittees namely the executive committee, the finance committee, the audit and compliance the compensation the nominating committee. The Chairman of the Board was Kenneth Lay, and in 2001 Enron had 15 Board Members. Most of the members 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.

Board members received $350,000 in compensation and stock options annually, which was significantly above the norm. In addition compensation to directors at Enron in 2001 was extraordinarily generous too. In 2000, Mr. Lay’s compensation was in excess of $140 million, including the stock based compensations .This level of compensation was 10 times greater than the average CEO of a publicly traded company in that year.

In the aftermath of Enron collapse high powered incentive contracts to executives was cited as a major reason for manipulating accounting numbers and investment policy to increase their pay at Enron.

Stock-based compensation to executive is one mechanism that helps to align manager/directors and shareholder interests and hopefully solve the principal-agent problem. This mechanism is indeed a tool of corporate governance designed to help protect investors and shareholders in the firm .Unfortunately, in the case of Enron such a technique essentially failed because of the massive incentives for management self-dealings and to manipulate financial statements.

Conflict of Interest

When Enron declared bankruptcy, one of the major issues of co-operate governance was conflict of interest. Issues involving financial officers of a company both manage and be equity holders of entities that conducted significant business transactions with Enron (LJMs).

Andrew Fastow was Enron’s chief financial officer (CFO). Fastow had been responsible for setting up three partnerships, known as LJM, LJM2 and LJM3. In Enron business with LJMs, conflicts of interest were abundant and should have been avoided. Fastow (CFO Enron) managed the LJM accounts and heavily invested in these LJM entities, an act that was approved by the Chairman and Board of Directors. Andrew Fastow was also working for Andersons, an auditing company that audited the accounts of Enron. A conflict of interest was inevitable. Fastow was responsible for expropriation of funds to LJM partnership in which he invested heavily.

Expropriation of funds to the manager-owned and operated partnerships is again a breakdown in one of the corporate governance institutions that was in place to protect shareholders. Andrew Fastow had a fiduciary duty to the shareholders, yet he elected to enrich himself and other investors in the partnerships and thus another layer of the corporate governance mechanisms had failed.

Failures in Board Oversight and Fundamental Lack of Checks and Balances-

After allowing company executives to both manage and be equity holders of entities that conducted significant business transactions with Enron (LJMs), Board of Directors had a general and specific fiduciary responsibility to closely monitor the partnerships and ensure that the policies and procedures in place were in fact regulating the partnerships. This is where they failed. The management at Enron throughout the 1990s tricked the Board into believing that it was monitoring such transactions to protect the interests of Enron, the Board did not go far enough in its monitoring of the monitors.

The Audit and Compliance Committee also failed to closely examine the nature of the transactions; annual reviews of the LJM transactions by the Audit and Compliance Committee appear to have involved only brief presentations by Management.

The Compensation Committee failed in its duty to monitor Enron’s compensation policies and plans for directors, officers, and employees, had they been reviewed by the Compensation Committee, both Fastow’s (CFO) excessive compensation for their management of the partnerships as well as their return on private investments in the partnerships would have immediately illuminated the conflicts.

The Audit Committee

Anderson auditors briefed the Enron Audit and Compliance Committee members about Enron’s current accounting practices, informed them of their novel design, created risk profiles of applied accounting practices. Unfortunately, the auditing firm and auditing committee failed to fulfill its prime responsibility to determine and provide reasonable assurance that the Enron’s publicly reported financial statements were presented fairly and in conformity with generally accepted accounting principles.

Obscurity in the financial reports, outside investors were not able to easily identify the nature of the partnerships of Enron, which is breakdown in

another layer of the corporate governance mechanisms designed to protect investors.

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