ABSTRACT

This paper explores the fall of Enron Corporation in early 2000s. It also sees to what extent the corporate governance has its role to play in the collapse of Enron.

There are flaws in the corporate governance and the same time loop holes in the accounting standards also gave way to the manipulation of financial statements that had caused Enron and other corporate to collapse. Besides that, independent of directors and auditors have also been identified as one of the main reason to the fall of Enron.

Changes were made to enhance the corporate governance and also the related laws. Many of these changes were made to avoid firms manipulating accounts, violating rules and at the end destroying investor’s confidence. The importance of independence was also enhanced.

INTRODUCTION

Enron Corporation was one of the world’s largest corporations in its prime time. It was awarded the most innovative company by Fortune Magazine six times. Enron’s share rose by 311% from early 1990s to the end of 1998 (Healy and Palepu, 2003). It continued to increase by 56% in 1999 and another 87% in 2000. Its share price reached UD$83.13 and market capitalisation was nearly US$80 billion by 31 December 2000.

However, all this came crumbling down by the end of 2001. It started when Enron announced that it was restating its’ financial statements, reducing after tax net income by US$544 million and its shareholders’ equity by US$1.2 billion. Enron restated it’s previously reported income from 1997-2000 (Benston and Hartgraves, 2002). By the end of 2001, Enron’s share was downgraded to junk bond status by Standard and Poor’s and the share price was valued for less than US$1.

On 2 December 2001, Enron finally filed for bankruptcy under chapter 11 of United States Bankruptcy Code. This was the largest US corporate bankruptcy at that time, which was later surpassed by Worldcom. Many investors say their assets worth of millions of dollars to almost nothing.

Many people conducted studies on the reason of the collapse of Enron. For example Gillian, S. I. and Martin, J. D. (2007), Benston, G.J. and Hartgraves, I. J. (2002), Chartterjee, S. (2003) and many other. Most of these studies saw a common ground of failure of corporate governance and violation of rules by Enron and its auditor Arthur Anderson. This lead to many reforms in corporate governance including the Sarbanes — Oxley Act of 2002 (SOX).

BACKGROUND OF ENRON

The merger of 2 natural gas pipeline companies in 1985, Houston Natural Gas and Internorth created a new company called Enron. It owned intrastate and interstate pipelines to transport natural gas and utilities. It stated trading in commodities where it buys and sells wholesale energy contracts. At that time most contracts between gas producer and pipelines were take-or-pay contracts with a prearranged price generally fixed over the life of the contract or increased with inflation. Changes in regulation in the natural gas market lead to deregulation of prices which gave more flexibility in arranging contracts. The use of spot prices did not offer the long-term natural gas supply and price stability which was present before the deregulation (Healy and Palepu, 2003).

Deregulation led to lower prices and increased supply, leading to increase in volatility of gas prices. This coupled with the fact that the standard contracts allowed interruption in supply of gas without any penalties lead to the creation of Gas Bank. This is where Enron would buy gas from networks of suppliers and sell it to customers charging them transaction fees and assuming the risk associated with it. It would act just as a financial banking institution with the exception that it would be mediators between supplier and buyers of natural gas. Enron dominated the market for natural gas contracts.

In 1990 a new division was created. Kenneth Lay the CEO than hired Jeffery Skilling as the head of this division. He was previously a consultant with McKinsey & Co who helped Enron develop its Gas Bank idea. Enron entered into long-term contract with producers to ensure delivery and to reduce exposure arising from the fluctuation of spot rates. They also used financial derivatives like swaps, forwards and futures contract to reduce this exposure. This brought in a new concept to the industry, the energy derivatives (Hearly and Palepu, 2003 and Thomas, 2002).

In order to gain further growth, Enron went into diversification. Mid 1990s Skilling wanted to extend this gas trading model into other markets and become financial trader. It ventured into electricity power, coal, steel, paper and pulp and broadband fiber optic cable markets. By 2000, Enron become a conglomerate owning and operating gas pipelines, electricity plants, broadband assets and water plants internationally.

FINANCIAL REPORTING

Enron had an intricate business model that comprised of many products and across border. This stretched the limits of accounting. They took full advantage of accounting limitation to portray healthy earnings and to appear profitable in the financial statements. Benston and Hartgraves (2002), identified six accounting and auditing issues as follows:

• The accounting policy of not consolidating Special Purpose Entities (SPEs) appear to have permitted Enron to hide losses and debt from investors
• The accounting treatments of sales of Enron’s merchant investments to unconsolidated SPEs as if these were arm’s length transaction.
• The income recognition practice of recording revenue from sales of forward contracts, which were actually disguised loans,
• Fair-value accounting resulting in restatements of merchant investments that were based on estimates.
• Accounting for stocks that were issued and held by SPEs
• Inadequate disclosure of related party transactions and conflicts of interest.

Enron relied heavily on SPEs that they set up. To avoid consolidation with the SPEs, Enron made use of US GAAP at that time. Consolidation was not necessary if independent third party had a controlling and substantial equity interest in the SPE, where substantial was defined as at least 3% of the SPEs assets (Benston and Hartgraves, 2002). Enron took SPE into new heights of complexity. Financial dealings were made more complicated when the SPEs were used to park problematic assets.

The marked-to-market accounting was used to recognise income which resulted management to forecast energy prices in future. Companies need to adjust their balance sheet if they had any outstanding derivative contracts to the market value at the end of the period and the realised gains or losses are booked to the income statement. The problem here was that, contracts on commodities like gas does not have quoted prices on which valuation can be based on. Therefore, this led to companies using their discretion to estimate the future value using their own assumptions and methods. This gives an opportunity for the managers to manipulate the net income.

The transparency of Enron’s disclosures had been of concern to many. They only provided minimal disclosure in their financial reports. There were no adequate disclosures of the related party transaction of the firm. Transactions with the SPE were not disclosed when they should have been. Andrew Fastow the CFO of Enron was the managing partner for some of the SPEs and that these SPEs had debts that were guaranteed by Enron. This increases the liabilities of Enron. However, none of these were disclosed.

GOVERNANCE FAILURES

There were a few failure in the governance identified from the fall of Enron. There are three major governance changes (Gillian and Martin, 2007) that were made. They are independent enhancement of the board, strengthening the internal control system and restriction on the provision of non-audit services to their audit clients by the audit firms. The governance failure can be divided into internal and external governance.

Internal Governance Failure

Internal governance mainly refers to the board of directors of Enron and their top management. Enron’s board of directors (BOD) may seem to be independent. Out of the 14 board members there were only 2 executives (Kenneth Lay and Jeff Skilling). The audit, nomination and compensations committees comprised of all outside directors. However, with fall of Enron the independence of the board and the key monitoring committee were questioned (Gillian and Martin, 2007). The board should not just be seen as independent but it’s also important to show it through actions.

Based on the investigations conducted on the directors of Enron, it was proved that the directors that seemed independent were actually not and faced conflict of interest. This can be seen through the business arrangement between them, charitable contribution receipts and consulting fees. The non-employee directors received a compensation package of US$350,000 in 2000. This is high comparing to its competitors whose directors’ fees do not exceed US$200,000 (Gillian and Martin, 2007).

Fundamental to all this, Enron’s board failed to understand the inherent risk associated with their business strategy. Furthermore, the Audit and Compliance Committee has also failed to understand, review and monitor the SPEs created by Fastor and Enron’s financial reporting practices (Benston and Heartgraves, 2002). This concludes that the directors did not perform the fiduciary duty assigned to them.

Just like the other firms, Enron also compensated their management using share option. This motivated the management to increase earning and the company’s share price. As mentioned above, manipulation of the financial accounts helped them achieve this.

In response to this the SOX has added on requirements for the audit committee where at least one member is to have financial expert. Besides that SOX also tighten the reporting requirement for the insider dealings and prohibited corporate loans to insiders and a few others that relates to management compensation. At the same time, The Federal Accounting Standards Board (FASB) imposed a requirement on expensing of the option based compensation. To further enhance this, the Securities Exchange Commission (SEC) made a rule on management compensation disclosures (Benston and Hartgraves, 2002 and Healy and Palepu, 2003).

External Governance Failure

The external governance includes market pressure, oversight by government regulators and oversight by private entities including auditors, equity analysts and credit rating agencies.

Government Regulators

Enron’s main business revolved around the energy related commodities and derivatives trading. This falls under the boundary of Commodities and Future Trading Commission (CFTC) and the Federal Regulatory Commission (FERC). Based on the studies conducted by Gillian and Martin 2007, the lack of oversight from them is also one of the reasons for its fall. CFTC gave exemption to Enron from the Commodity Exchange Act (CEA) for derivatives on energy products in April 1993. This gives opportunity to avoid compliance with the CEA. CFTC was chaired by Wendy who joined the board of Enron in 1993.

On the other hand, FERC regulators had sufficient information in several occasion to raise doubt on Enron’s activity but they failed to do so. If the FERC has taken more precautionary and aggressive methods, they would have been able to limit the misuse occurred especially in the price manipulation. Besides that, they had a complicated relationship where Enron was the anchor in carrying out the deregulation of energy business which fell under the care of FERC.

Role of Securities and Exchange Commission (SEC)

The SEC plays a very important role in the corporate governance in the United States. First it establishes the requirement on types of information for public companies to disclose and works to assure compliance with regulation and review company filling. Next it takes legal action against companies and individuals who it believes that have committed financial fraud. However, at that time due to understaffed and under resourced faced by SEC, they were unable to detect the problems with Enron’s filling. SEC permitted Enron relief from complying with Investment Company Act and Public Utility Company Holding Act. Due to the exemption given, Enron was not subjected to regulator security relating to the firm’s utility and investment activities. (Gillian and Martin, 2007).

Share Brokers and Credit Rating Agencies.

The fees derived from their clients keeps the investment banking business going. The analyst would be compensated based on the number of business it helped to make. However, they failed to provide an unbiased analysis of Enron share price as even in November 2001, they recommended Enron’s shares. While the credit rating agencies did not exercise their diligence properly in detecting problem in Enron until it was too late. This lead to a change in regulatory environment where analyst compensation was de-coupled from the investment banking business.

Auditors

The auditor of Enron at that time was Author Anderson. Auditors are expected to be independent of their clients. However, Anderson’s independence was questioned based on three grounds (Gillian and Martin, 2007) as follows.

• Auditors rely on repeat business. Therefore, auditors may compromise their objectivity in engaging a client.
• Author Anderson served as both external and internal auditors of Enron. They were actually reviewing their own work. Besides that, they also provided consulting services where they advised on the structure of the SPEs of Enron.
• As the audit firms also earned income from consulting rendered, they may compromise in their audit integrity to maintain the income flow.

In total Anderson earned US$52 million from the services rendered to Enron. This made Enron one of the main client of Author Anderson and the largest client of the Houston office. The firm partners made a decision to maintain this client despite knowing the high risk involved. There were many serious issues that were identified by Anderson’s employees but it was not conveyed to the audit committee of Enron. Besides, Enron was rated as high risk under Anderson’s risk portfolio analysis (Gillian and Martin, 2007). The large fees received from Enron had potential conflict of interest and continued to issue unqualified report. Anderson had violated GAAP and GAAS practices as the allowed Enron to record non cash issuance of share as increase in equity. Above all Author Anderson has failed to exercise sound judgement as an auditor in reviewing the financial statements.

The failure of Anderson as an auditor has lead to stricter and tighter rules and regulation to be enforced. SOX reinforced SEC proposition that external auditor is to be appointed by and report to the audit committee. Audit firms can no longer provide consultation services to their audit client. This was implemented in order to mitigate conflict of interest. Furthermore SOX 404 stated that it is the duty of the auditor to check and certify the internal control system of the firm and d to report any material misstatement. If this was done probably the relationship between Andrew Foster and the SPEs he set up would have been flagged out and disclosed earlier. The new rule enforced also enhances the disclosure for related party transactions, SPEs and internal control system.

OTHER CORPORATE FALLS

Besides Enron, there were many other corporate failures that occurred. Companies like Worldcom, Tyco, Global Crossing and even audit firm like Author Anderson collapsed one after another. All these companies collapse were related to similar failures. They failed in the area of corporate governance, abuse of accounting principles and outright greed. For example Worldcom which was a larger collapse compared to Enron was once the darling of Wall Street. One of the major reasons that caused the fall was the abuse of accounting rules and manipulation of the financial statement. Worldcom booked in operating expenses as capital expenses which was spread over a number of years. This gave a healthier view of their profits. Besides that there was also the issue of independence. This includes the independence of board of directors, analysts, brokers and also the auditors.

Besides that, the extensive use of derivatives also is one of the reasons that lead to corporate collapse. In the reason year, Lehman Brothers that collapsed in 2008 was due to the extensive use of derivatives or financial instrument in mortgages. Accounting for financial instruments is complex by nature. Therefore, chances for manipulation are high. Which eventually fall back to the violation and abuse of accounting principles.

CONCLUSION

Based on the review above, it can be safely said that most corporate collapse were somehow related to the failure of corporate governance and abuse of rules and regulation. Many reforms have been made in the corporate governance code of conduct both in he USA and internationally. However, there is no assurance that these fraudulent activity can be wiped out completely. Besides that, importance of independence can be enhanced but the application of it still lies with the board. Like in the case of Enron, the BOD seems to have been independent but they were infect not. This goes back to the basic integrity of an individual as a whole. As a member of the board, it is always difficult to be independent as most of them are usually appointed by the CEO.

In addition to that, auditors who are known as the gate keeper of the firm also violated their fiduciary duty towards the investors. As seen above, the violation of best practices and rules by the auditors also part of the reason for the corporate collapses that has occurred. Auditors are expected to give a better quality of audit report produced for the investors are the results expected from the enhancement in laws. However, as mentioned to for the directors, independence may still be an issue. Good relationship between the partner, directors and top management of a firm could jeopardise their independence. This is done in order to maintain the client.

Therefore, enhancement of standards, rules and regulation alone would not be able to stop fraudulent activities. The need to enhance a person’s moral values and integrity is also needed to reduce and avoid further corporate collapses.

REFERENCE

www.scu.edu/ethics/dialogue/candc/cases/worldcom.html [Accessed. ]