Transcript Chapter 2 Mini Case - Dixie State University

Governance Failure at Enron
Did Enron fail because of illegal activities,
falsified accounting, governance
failure, or something else?
Governance Failure at Enron:
Case Questions
1.
Which parts of the corporate governance system, internal and external,
do you believe failed Enron the most?
2.
Describe how you think each of the individual stakeholders and
components of the corporate governance system should have either
prevented the problems at Enron or acted to resolve the problems
before they reached crisis proportions.
3.
If all publicly-traded firms in the United States are operating within
the same basic corporate governance system as Enron, why would
some people believe this was an isolated incident, and not an example
of many failures to come?
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Exhibit 1 Enron’s Actual Operating
Income
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Report of Investigation
Special Investigative Committee of the
Board of Directors of Enron
Corporation
February 1, 2002
“The tragic consequences of the related-party transactions and
accounting errors were the result of failures at many levels and by
many people: a flawed idea, self-enrichment by employees,
inadequately-designed controls, poor implementation,
inattentive oversight, simple (and not-so-simple) accounting
mistakes, and overreaching in a culture that appears to have
encouraged pushing the limits. Our review indicates that many of
these consequences could and should have been avoided.”
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The Structure of Corporate Governance
Equity Markets
Analysts and other market agents
evaluate the performance
of the firm on a daily basis
Entities with capital at risk in the corporation,
but can also reap gains or returns from
activities with the corporation
The Corporation
Debt Markets
Ratings agencies and other
analysts review the ability
of the firm to service debt
(internal)
Board of Directors
The Marketplace
Chairman of the Board and
members are accountable
for the organization
(external)
Regulators
SEC, the NYSE, or other
regulatory bodies by country
Management
Chief Executive Officer (CEO)
and his team run the company
Auditors
Legal Counsel
External opinion as to the fairness
of presentation and conformity
to stds of financial statements
Provides legal opinions and
recommendations on legality
of corporate activities
Entities whose services are
purchased by the corporation
Discrepancy Between
Earnings & Cash Flow
• Enron’s original business model consumed capital
• The asset-heavy side of the business, power plants and pipelines, required massive amounts of
capital up-front for their construction, yet would not generate cash in-flows for many years to
cover (if ever)
• As the asset-heavy businesses aged, they did not really produce the net operating cash in-flows
which had been promised; as a result, Enron needed more and more capital to “feed the beast”
• The asset-light side of the business, primarily power trading, required substantially less capital;
trading is a service-oriented activity which does not require substantial capital infrastructure
• Enron needed more and more capital to grow the business
• But it had existed for most of its short corporate life as BBB-, on the edge of being considered
“speculative grade” by the rating agencies given the industries it was operating in and its
relatively high levels of debt
• It therefore saw the Special Purpose Entities (SPE) as a way for the company to acquire more
and more debt and yet not have that debt show up on its balance sheet – raising debt and hiding
it in-short
• The following exhibit illustrates the growing financing needs of the firm by simply illustrating
how its statement of cash flows evolved over time
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Growing Discrepancy Between Earnings & CF (millions)
$1,000
$500
$0
-$500
-$1,000
-$1,500
-$2,000
-$2,500
1991
1992
1993
1994
Earnings
1995
1996
1997
1998
1999
2000
Operating CF - Investing CF
The difference between operating cash flow and investing cash flow is a basic measure of the added
Financing the firm needs from year to year assuming on changes in cash balances.
Governance Failure at Enron:
Case Questions
1. Which parts of the corporate governance system, internal and external, do you
believe failed Enron the most?
• The failures at Enron were so wide and deep, it is difficult to say which failed most. Clearly
Enron’s leadership – its Board and senior executives, failed to protect all stakeholders in the
company.
• Internally, although there were a few cases proven of malfeasance and illegal activities and
fraudulent reporting, much of the internal failure appears to have been a combination of
corporate culture failure and what many authors have characterized as “massive
incompetence.”
• Externally, it appears that nearly every institution which is part of the U.S. governance
system failed as a result of self-interest and greed.
• If pushed, it might be argued that the massive failures and internal culture of accounting
earnings and self-enrichment at all costs led to a contagion of the external governance.
• Because many of Enron’s businesses such as power trading fell between the cracks of many
regulatory systems, some failures were inevitable. In other cases, however, such as with its
auditors and the debt and equity markets, the failures were in many cases related to the selfenrichment and profits at all costs culture which permeated many of these businesses inside
and out.
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Governance Failure at Enron:
Case Questions
2.Describe how you think each of the individual stakeholders
and components of the corporate governance system should
have either prevented the problems at Enron or acted to
resolve the problems before they reached crisis proportions.
• As it turns out, much of what Enron reported as earnings were not. Much of the
debt raised by the company via a number of partnerships which was not disclosed
in corporate financial statements should have been.
• massive compensation packages and bonuses earned by corporate officers were
inappropriate.
• It appears that the executive officers of the firm were successful in managing the
Board of Directors towards their own goals. Management had moved the company
into a number of new markets in which the firm suffered substantial losses,
resulting in redoubled attempts on their part to somehow generate the earnings
needed to meet Wall Street’s unquenchable thirst for profitable growth.
• The Board failed in its duties to protect shareholder interests due to lack of due
diligence and most likely a faith in the officers which proved unfounded. It is also
notable that Enron’s legal advisors, some of whom report to the Board, also failed
to provide leadership on a number of instances of malfeasance.
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Governance Failure at Enron:
Case Questions
2.
Describe how you think each of the individual stakeholders and components
of the corporate governance system should have either prevented the
problems at Enron or acted to resolve the problems before they reached crisis
proportions (continued).
•
•
Enron’s auditors, Arthur Andersen, committed serious errors in judgment
regarding accounting treatment for many Enron activities including the
above partnerships. Andersen was reported to have had serious conflicts of
interest, earning roughly $5 million in auditing fees from Enron in 2001,
but more than $50 million in consulting fees in the same year.
Enron’s analysts were, in a few cases, blinded by the sheer euphoria over
Enron’s latent successes in the mid to late 1990s, or working within
investment banks which were earning substantial investment banking fees
related to the complex partnerships. Although a few analysts continued to
note that the company’s earnings seemed strangely large relative to the
falling cash flows reported, Enron’s management was generally successful
in arguing their point.
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Governance Failure at Enron:
Case Questions
3. If all publicly-traded firms in the United States are
operating within the same basic corporate governance
system as Enron, why would some people believe this was
an isolated incident, and not an example of many failures
to come?
•
•
This may, in the end, be the most critical question related to Enron. Why
did it happen? Was it indeed the “perfect storm,” in which the wrong
combination of leadership, business evolution, market behaviors, and the
‘times’ all combined to create a monster, or was it something else?
This is commonly the most hotly debated question in any classroom, and
often is the concluding thought for further debate. Many argue that
although many of the corporate governance and regulatory systems failed
in the case of Enron, the core cause was human failure – the failure of
leadership in many organizations to do the numbers, know the law, and do
the right thing.
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What Happened at Enron?
“What I can tell you straight up-front is that life hasn't been the same ever
since the collapse. Working at Enron was like dope. You couldn't get enough
of it. You're surrounded by talent, money is good, lavish expense accounts,
and you're all on a race against a snowball called MTM - aka, the
accounting magic called market-to-market! Pretty exciting, huh? Well, not
if you were one of the thousands who ‘doubled or nothing’ their 401k’s on
Enron... how's that for starters? I see the corporate world and life under a
whole different light now. Unfortunately, I see Enrons everywhere. They are
just not as good, and are probably still around because they are not as
greedy as Skilling, Fastow and Lay.”
---
A former Enron employee
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