Monday, November 28, 2011

Enron - Breakdown of Corporate Governance - Case Study

Donald DePamphilis
Clinical Professor of Finance
(Article available on Knol under creative commons 3.0 license)

This article is taken from Mergers, Acquisitions, and Other Restructuring Activities, 5th edition, 2009 by Donald M. DePamphilis. For more information or to buy this book online, click here.


What started in the mid-1980s as essentially a staid "old-economy" business became the poster child in the late 1990s for companies wanting to remake themselves into "new-economy" powerhouses. Unfortunately, what may have started with the best of intentions emerged as one of the biggest business scandals in U.S. history. Enron was created in 1985 as a result of a merger between Houston Natural Gas and Internorth Natural Gas. In 1989, Enron started trading natural gas commodities and eventually became the world's largest buyer and seller of natural gas. In the early 1990s, Enron became the nation's premier electricity marketer and pioneered the development of trading in such commodities as weather derivatives, bandwidth, pulp, paper, and plastics. Enron invested billions in its broadband unit and water and wastewater system management unit and in hard assets overseas. In 2000, Enron reported $101 billion in revenue and a market capitalization of $63 billion.

The Virtual Company

Enron was essentially a company whose trading and risk management business strategy was built on assets largely owned by others. The complex financial maneuvering and off-balance-sheet partnerships that former CEO Jeffrey K. Skilling and chief financial officer Andrew S. Fastow implemented were intended to remove everything from telecommunications fiber to water companies from the firm's balance sheet and into partnerships. What distinguished Enron's partnerships from those commonly used to share risks were their lack of independence from Enron and the use of Enron's stock as collateral to leverage the partnerships. If Enron's stock fell in value, the firm was obligated to issue more shares to the partnership to restore the value of the collateral underlying the debt or immediately repay the debt. Lenders in effect had direct recourse to Enron stock if at any time the partnerships could not repay their loans in full. Rather than limiting risk, Enron was assuming total risk by guaranteeing the loans with its stock.

Enron also engaged in transactions that inflated its earnings, such as selling time on its broadband system to a partnership at inflated prices at a time when the demand for broadband was plummeting. Enron then recorded a substantial profit on such transactions. The partnerships agreed to such transactions because Enron management seems to have exerted disproportionate influence in some instances over partnership decisions, although its ownership interests were very small, often less than 3 percent. Curiously, Enron's outside auditor, Arthur Andersen, had a dual role in these partnerships, collecting fees for helping to set them up and auditing them.
Time to Pay the Piper

At the time the firm filed for bankruptcy on December 2, 2001, it had $13.1 billion in debt on the books of the parent company and another $18.1 billion on the balance sheets of affiliated companies and partnerships. In addition to the partnerships created by Enron, a number of bad investments both in the United States and abroad contributed to the firm's malaise. Meanwhile, Enron's core energy distribution business was deteriorating. Enron was attempting to gain share in a maturing market by paring selling prices. Margins also suffered from poor cost containment.

Dynegy Corp. agreed to buy Enron for $10 billion on November 2, 2001. On November 8, Enron announced that its net income would have to be restated back to 1997, resulting in a $586 million reduction in reported profits. On November 15, chairman Kenneth Lay admitted that the firm had made billions of dollars in bad investments. Four days later, Enron said it would have to repay a $690 million note by mid-December and it might have to take an additional $700 million pretax charge. At the end of the month, Dynegy withdrew its offer and Enron's credit rating was reduced to junk bond status. Enron was responsible for another $3.9 billion owed by its partnerships. Enron had less than $2 billion in cash on hand.

The end came quickly as investors and customers completely lost faith in the energy behemoth as a result of its secrecy and complex financial maneuvers, forcing the firm into bankruptcy in early December. Enron's stock, which had reached a high of $90 per share on August 17, 2001, was trading at less than $1 by December 5, 2001.

In addition to its angry creditors, Enron faced class-action lawsuits by shareholders and employees, whose pensions were invested heavily in Enron stock. Enron also faced intense scrutiny from congressional committees and the U.S. Department of Justice. By the end of 2001, shareholders had lost more than $63 billion from its previous 52-week high, bondholders lost $2.6 billion in the face value of their debt, and banks appeared to be at risk on at least $15 billion of credit they had extended to Enron. In addition, potential losses on uncollateralized derivative contracts totaled $4 billion. Such contracts involved Enron commitments to buy various types of commodities at some point in the future.

Questions remain as to why Wall Street analysts, Arthur Andersen, federal or state regulatory authorities, the credit rating agencies, and the firm's board of directors did not sound the alarm sooner. It is surprising that the audit committee of the Enron board seems to have somehow been unaware of the firm's highly questionable financial maneuvers. Inquiries following the bankruptcy declaration seem to suggest that the audit committee followed all the rules stipulated by federal regulators and stock exchanges regarding director pay, independence, disclosure, and financial expertise. Enron seems to have collapsed in part because such rules did not do what they were supposed to do. For example, paying directors with stock may have aligned their interests with shareholders, but it also is possible to have been a disincentive to question aggressively senior management about their financial dealings.

The Lessons of Enron

Enron may be the best recent example of a complete breakdown in corporate governance, a system intended to protect shareholders. Inside Enron, the board of directors, management, and the audit function failed to do the job. Similarly, the firm's outside auditors, regulators, credit rating agencies, and Wall Street analysts also failed to alert investors. What seems to be apparent is that if the auditors fail to identify incompetence or fraud, the system of safeguards is likely to break down. The cost of failure to those charged with protecting the shareholders, including outside auditors, analysts, credit-rating agencies, and regulators, was simply not high enough to ensure adequate scrutiny.

What may have transpired is that company managers simply undertook aggressive interpretations of accounting principles then challenged auditors to demonstrate that such practices were not in accordance with GAAP accounting rules (Weil, 2002). This type of practice has been going on since the early 1980s and may account for the proliferation of specific accounting rules applicable only to certain transactions to insulate both the firm engaging in the transaction and the auditor reviewing the transaction from subsequent litigation. In one sense, the Enron debacle represents a failure of the free market system and its current shareholder protection mechanisms, in that it took so long for the dramatic Enron shell game to be revealed to the public. However, this incident highlights the remarkable resilience of the free market system. The free market system worked quite effectively in its rapid imposition of discipline in bringing down the Enron house of cards, without any noticeable disruption in energy distribution nationwide.


Due to the complexity of dealing with so many types of creditors, Enron filed its plan with the federal bankruptcy court to reorganize one and a half years after seeking bankruptcy protection on December 2, 2001. The resulting reorganization has been one of the most costly and complex on record, with total legal and consulting fees exceeding $500 million by the end of 2003. More than 350 classes of creditors, including banks, bondholders, and other energy companies that traded with Enron said they were owed about $67 billion.

Under the reorganization plan, unsecured creditors received an estimated 14 cents for each dollar of claims against Enron Corp., while those with claims against Enron North America received an estimated 18.3 cents on the dollar. The money came in cash payments and stock in two holding companies, CrossCountry containing the firm's North American pipeline assets and Prisma Energy International containing the firm's South American operations.

After losing its auditing license in 2004, Arthur Andersen, formerly among the largest auditing firms in the world, ceased operation. In 2006, Andrew Fastow, former Enron chief financial officer, and Lea Fastow plead guilty to several charges of conspiracy to commit fraud. Andrew Fastow received a sentence of 10 years in prison without the possibility of parole. His wife received a much shorter sentence. Also in 2006, Enron chairman Kenneth Lay died while awaiting sentencing, and Enron president Jeffery Skilling received a sentence of 24 years in prison.

Citigroup agreed in early 2008 to pay $1.66 billion to Enron creditors who lost money following the collapse of the firm. Citigroup was the last remaining defendant in what was known as the Mega Claims lawsuit, a bankruptcy lawsuit filed in 2003 against 11 banks and brokerages. The suit alleged that, with the help of banks, Enron kept creditors in the dark about the firm's financial problems through misleading accounting practices. Because of the Mega Claims suit, creditors recovered a total of $5 billion or about 37.4 cents on each dollar owed to them. This lawsuit followed the settlement of a $40 billion class action lawsuit by shareholders, which Citicorp settled in June 2005 for $2 billion.


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