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Enron and the Economics of Corporate Governance

June 2003

Peter Grosvenor Munzig

Department of Economics

Stanford University, Stanford CA 94305-6072Advisor: Professor Timothy Bresnahan

ABSTRACT

In the wake of the demise of Enron, corporate governance has come to the forefront of

economic discussion. The fall of Enron was a direct result of failed corporate governanceand consequently has led to a complete reevaluation of corporate governance practice inthe United States. The following paper attempts to reconcile our existing theories on

corporate governance, executive compensation, and the firm with the events that tookplace at Enron. This paper first examines and synthesizes our current theories oncorporate governance, and then applies theoretical and economic framework to the

factual events that occurred at Enron. I will argue that Enron was a manifestation of theprincipal-agent problem, that high-powered incentive contracts provided management

with incentives for self-dealing, that significant costs were transferred to shareholders dueto the obscurity in Enrons financial reporting, and that due to the lack of boardindependence it is likely that management rent extraction occurred.

Acknowledgements : I would like to thank my family and friends for their continuedsupport throughout this paper. In particular, my mother Judy Munzig was instrumentalwith her comments on earlier drafts. I also thank Professors Geoffrey Rothwell and

George Parker for their help, and finally to my advisor Professor Bresnahan, for withouthis support and advice this paper would not have been possible.


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When a company called Enron ascends to the number seven spot on the Fortune

500 and then collapses in weeks into a smoking ruin, its stock worth pennies, its

CEO, a confidante of presidents, more or less evaporated, there must be lessons in

there somewhere.

-Daniel Henninger,

The Wall Street Journal


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CONTENTS

I. INTRODUCTION ....................................................................................3

II. THE THEORY OF CORPORATE GOVERNANCE..............................7Corporate Governance and the Principal-Agent Problem ...............7

Executive Compensation and the Alignmentof Manager and Shareholder Interests ...........................................11

Corporate Governances Role in Economic Efficiency.................14Recent Developments in Corporate Governance ...........................15

III. WHAT HAPPENED: FACTUAL ACCOUNT

OF EVENTS LEADING TO BANKRUPTCY......................................17

Background/Timeline.....................................................................18Summary of Transactions and Partnerships...................................19

The Chewco/JEDI Transaction......................................................20The LJM Transactions ...................................................................22

IV. ANALYSIS OF CORPORATE GOVERNANCE ISSUES ...................26

Corporate Structure........................................................................27Conflicts of Interest........................................................................30

Failures in Board Oversight and FundamentalLack of Checks and Balances ......................................................33

Audit Committee Relationship With Enron and Andersen............35Lack of Auditing Independence and the PartialFailure of the Efficient Market Hypothesis ...................................38

Director Independence/Director Selection.....................................41

V. POST-ENRON GOVERNANCE REFORMS AND OTHERPROPOSED SOLUTIONS TO GOVERNANCE PROBLEMS............45

Sarbanes-Oxley Act of 2002..........................................................45Other Governance Reforms and Proposed Solutions.....................48

VI. CONCLUSION.......................................................................................51

I. INTRODUCTION

Often referred to as the first major failure of the New Economy, the collapse of

Enron Corporation stunned investors, accountants, and boardrooms and sent shockwaves


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across financial markets when the company filed for bankruptcy on December 2, 2001.

At that time, the Houston-based energy trading companys bankruptcy was the largest in

history but was surpassed by WorldComs bankruptcy on July 22, 2002. Enron

employees and retirement accounts across the country lost hundreds of millions of dollars

when the price of Enron stock sank from its peak of $105 to its de-listing by the

NASDAQ at just a few cents. Arthur Andersen, once a Big Five accounting firm,

imploded with its conviction for Obstruction of Justice in connection with the auditing

services it provided to Enron. Through the use of what were termed creative accounting

techniques and off-balance sheet transactions involving Special Purpose Entities (SPEs),

Enron was able to hide massive amounts of debt and often collateralized that debt with

Enron stock. Major conflicts of interest existed with the establishment and operation of

these SPEs and partnerships, with Enrons CFO Andrew Fastow authorized by the board

to manage the transactions between Enron and the partnerships, for which he was

generously compensated at Enrons expense.

In addition to crippling investor confidence and provoking questions about the

sustainability of a deregulated energy market, Enrons collapse has precipitated a

complete reevaluation of both the accounting industry and many aspects of corporate

governance in America. The significance of exploring the Enron debacle is multifaceted

and can be generalized to many companies as corporate America evaluates its governance

practices. The fall of Enron demands an examination of the fundamental aspects of the

oversight functions assigned to every companys management and the board of directors

of a company. In particular, the role of the subcommittees on a board and their

effectiveness are questioned, as are compensation techniques designed to align the

interests of shareholders and management and alleviate the principal-agent problem, both

theoretically and in application. Companies such as Worldcom, Tyco, Adelphia, and


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Global Crossing have all suffered catastrophes similar to Enrons, and have furthered the

need to reevaluate corporate governance mechanisms in the U.S.

My question then becomes, what lessons can be learned from the fundamental

breakdowns that occurred at the corporate governance level at Enron, both from an

applied and theoretical standpoint? This paper attempts to offer an analysis that

reconciles the events that occurred inside the walls of Enron and our current theories on

corporate governance, the firm, and executive compensation. In particular, I look at the

role the principal-agent problem played at Enron and attempt to link theories of

managements expropriation of firm funds with the Special Purpose Entities Enron

management assembled. I question Enrons executive compensation practices and the

effectiveness of shareholder and management alignment with the excessive stock-option

packages management received (and the resulting incentives to self-deal). Links between

the information asymmetry and the transfer of costs to shareholders is explored, as well

as the efficient market hypothesis in regards to Enrons stock price. And finally, the lack

of director independence at Enron provides a foundation for the excessive compensation

practices given managers were extracting rents.

From an applied standpoint, I argue that following can be learned from Enron:

Enron managed their numbers to meet aggressive expectations. They were lessconcerned with the economic impact of their transactions as they were with thefinancial statement impact. Creating favorable earnings for Wall Street

dominated decision making.

The Board improperly allowed conflicts of interest with Enron partnerships and

then did not ensure appropriate oversight of those relationships. There was afundamental lack of communication and direction from the Board as to whoshould be reviewing the related-party transactions and the degree of such review.The Board was also unaware of other conflicts of interests with other transactions.

The Board did not effectively communicate with its auditors from Arthur

Andersen. The idea that Enrons employed accounting techniques were"aggressive" was not communicated clearly enough to the board, who were

blinded by its trust in its respected auditors.


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The Board did not give enough consideration when making important decisions.

They were not really informed nor did they understand the types of transactionsEnron was engaging in, and they were too quick to approve proposals put forth by

management.

The Board members had significant relationships with Enron Corporation and itsmanagement, which may have contributed to their failure to be more proactive intheir oversight.

The Board relied too heavily on the auditors and did not fulfill its duty of ensuring

the independence of the auditors. Given the relationship between managementand the auditors, the Board should not have been so generous with its trust. The

Board is entitled to rely on outside experts and management to the extent it isreasonable and appropriate - in this case it was excessive.

From a theoretical standpoint, I argue that the following are lessons learned from

Enron:

Enron was a manifestation of the principal-agent problem. The ulterior motivesof management were not in line with maximizing shareholder value.

The high-powered incentive contracts of Enrons management highlight more of

the costs associated with attempting to align shareholders with management tocounter the principal-agent problem and provided management with extensive

opportunities for self-dealings.

Significant costs were transferred to shareholders associated with asymmetric

information due to managements sophisticated techniques for obscuring financialresults. Such obscuring also lead to a partial failure of the efficient market

hypothesis.

Due to the lack of board independence, the theory of rent extraction more likely

explains managements actions and compensation than the optimal contractingtheory.

This analysis of the Enron case attempts to explain what happened at Enron in the

context of existing theories on the firm, corporate governance, and executive

compensation, as they are innately linked. Section II discusses the general theory of

corporate governance defined from two perspectives, first from an applied perspective

and then from a theoretical perspective. Next is an attempt to answer the question of why


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we need corporate governance and to explore its function theoretically. The section ends

with information on changes made in corporate governance over the last two decades.

Section III details the factual account of events leading to the fall of Enron. It

includes the history and background of the corporation, beginning with its inception with

the merger of Houston Natural Gas and Internorth in 1985 through its earnings

restatements and eventual bankruptcy filing in December of 2001. It also focuses on the

partnerships and transactions that were the catalysts for the firms failure, in particular the

Special Purpose Entities like Chewco, JEDI, and LJM-1 and LJM-2.

Section IV provides analysis of the corporate governance issues that arise within

Enron from a theoretical approach. That is, a theoretical and economic framework are

applied to Enrons corporate structure and compensation schedules, highlighting

opposing theories such as optimal contracting and rent extraction with regards to

executive compensation. Further discussed is the principal-agent problem in the context

of Enron and managements expropriation of shareholders capital. Highlighted also are

managements conflicts of interest that were allowed and that then went unmonitored by

the board. Also included is an analysis on the lack of material independence on the board

and the theory that management had bargaining power because of the close director-

management relationships. I also discuss the relationship between the audit committee

and Arthur Andersen, as well Andersens lack of auditing independence. Included is an

analysis on the partial failure of the efficient market hypothesis in the case of Enron and

the transfer of costs to the shareholders because of the asymmetric information due to

managements sophisticated techniques for obscuring financial results.

Section V looks at the primary legislative reform post-Enron, the Sarbanes-Oxley

Act, including its key points and the likely effects and costs of its implementation on

corporate governance and financial reporting. The section includes other developments


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in corporate governance, and provides some solutions to improving governance and

executive compensation.

II. THEORY OF CORPORATE GOVERNANCE

Corporate Governance and the Principal-Agent Problem

Before applying theory to the case of Enron, it is important to first discuss the

nature of the principal-agent problem and the reasons for a governance system, as well as

to define corporate governance from an applied and theoretical approach. I then will

discuss why corporate governance helps improve overall economic efficiency, followed

by the general developments in corporate governance over the past two decades. On its

most simplistic and applied level, corporate governance is the mechanism that allows the

shareholders of a firm to oversee the firms management and managements decisions. In

the U.S., this oversight mechanism takes form by way of a board of directors, which is

headed by the chairman. Boards typically contain between one and two dozen members,

and also contain multiple subcommittees that focus on particular aspects of the firm and

its functions.

However, the existence of such oversight bodies begs the questions: why is there

a need for a governance system, and why is intervention needed in the context of a free-

market economy? Adam Smiths invisible hand asserts that the market mechanisms will

efficiently allocate resources without the need for intervention. Williamson (1985) calls

such transactions that are dictated by market mechanisms standardized, and can be

thought of as commodity markets with classic laws of supply and demand governing

them. These markets consist of many producers and many consumers, with the quality of

the goods being traded the same from producer to producer.


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These market mechanisms do not apply to all transactions though, particularly

when looking at the separation of ownership and management of a firm and its associated

contracts. The need for a corporate governance system is inherently linked to such a

separation, as well as to the underlying theories of the firm. The agency problem, as

developed by Coase (1937) and Jensen and Meckling (1976) as well as others, is in

essence the problem associated with such separation of management and ownership. A

manager, or entrepreneur, will raise capital from financiers to produce goods in a firm.

The financiers, in return, need the manager to generate returns on the capital they have

provided. The financiers, after putting forth the capital, are left without any guarantees or

assurances that their funds will not be expropriated or spent on bad investments and

projects. Further, the financiers have no guarantees other than the shares of the firm that

they now hold that they will receive anything back from the manager at all. This

difficulty for financiers is essentially the agency problem.

When looking at the agency problem from a contractual standpoint, one might

initially think that such a moral hazard for the management might be solved through

contracts. An ideal world would include a contract that would specify how the manager

should perform in all states of the world, as dictated by the financiers of the firm. That is,

a complete contingent contract between the financiers and manager would specify how

the profits are divided amongst the manager and owners (financiers), as well as describe

appropriate actions for the manager for all possible situations. However, because every

possible contingency cannot be predicted or because it would be prohibitively costly to

anticipate such contingencies, a complete contract is unfeasible. As Zingales (1997)

points out, in a world where complete contingent contracts can be costlessly written by

agents, there is no need for governance, as all possible situations will be anticipated in the

contract.


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Given that complete contingent contracts are unfeasible, we are therefore left with

incomplete contracts binding the manager to the shareholders. As a result of the

incomplete contracts, there are then unlimited situations that arise in the course of

managing a company that require action by a manager that are not explicitly stated in the

managers contract. Grossman and Hart (1986) describe these as residual control rights--

the rights to make decisions in situations not addressed in the contract. Suppose then,

that financiers reserved all residual control rights as specified in their contract with

management. That is, in any unforeseen situation, the owners decide what to do. This

would not be a successful allocation of the residual control rights because financiers most

often would not be qualified or would not have enough information to know what to do.

This is the exact reason for which the manager was hired. As a result, the manager will

retain most of the residual control rights and thus the ability to allocate firms funds as he

chooses (Shleifer and Vishny 1996).

There are other reasons why it is logical for a majority of the residual control

rights to reside with management, as opposed to with the shareholders. It is often the

case that managers would have raised funds from many different investors, making each

individual investors capital contribution a small percentage of the total capital raised. As

a result, the individual investor is likely to be too small or uninformed of the residual

rights he may retain, and thus the rights will not be exercised. Further, the free-rider

problem for an individual owner often does not make it worthwhile for the owner to

become involved in the contract enforcement or even be knowledgeable about the firms

in which he invests (Shleifer and Vishny 1996) due to his small ownership interest. This

results in the managers having even more residual control rights as the financiers remove

themselves from the oversight function.


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the agency problem and firm theory. Previously discussed is why operating under the

incomplete contract approach tends to leave managers with a majority of the residual

control rights of a firm. As a result of these residual control rights, managers have

significant discretion and are not directly (or are incompletely) tied to the interests of the

shareholders. Acting independently of shareholders interest, managers may then engage

in self-interested behavior and inappropriate allocation of firm funds may occur.

In an effort to quell such misallocations by a manager, a solution is to give the

manager long term, contingent incentive contracts that help to align his interests with

those of the shareholders. This view of executive compensation is commonly referred to

as the optimal contracting view. It is important with this contracting that the marginal

value of the managers contingent contract exceed the marginal value of personal benefits

of control, which can be achieved, with rare exceptions, if the incentive contract is of a

significant amount (Shleifer and Vishny 1996). When in place, such incentive contracts

help to encourage the manager to act in the interest of the shareholders. Critical to the

functioning of these incentive contracts is the requirement that the performance

measurement is highly correlated with the quality of the management decisions during his

tenure and that they be verifiable in court.

The most traditional form of shareholder and management alignment under the

optimal contracting view of executive compensation is through stock ownership by the

manager. This immediately gives the manager similar interests as the general

shareholding population and acts to align their interest. Stock options also help to align

interests because it creates incentive for the manager to increase the stock price of the

firm, which consequently increases the value of his options when (if) he chooses to

exercise them. Another form of an incentive contract that helps to align the interests of

shareholders and a manager is to remove the manager from office if the firm income is


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too low (Jensen and Meckling 1976). Again, this provides quite a strict incentive for

management to produce strong earnings, which aligns his interest with those of the

shareholders, and hopefully serves to maximize shareholder value.

It is important to mention that these incentive contracts for agents are not without

costs and have come under immense scrutiny recently, particularly with the recent

corporate governance scandals like Enron. They provide ample incentive for

management to misrepresent the true earnings of a firm and do not completely solve the

agency problem, an issue that will be discussed further in section IV.

A second and competing view of executive compensation is the rent extraction

view, or as Bertrand and Mullainathan (2000) call it, the skimming view. This rent

extraction view is similar to the optimal contracting view in that they both rely on the

principal-agent conflict, but under the rent extraction view executive compensation is

seen as part of the [agency] problem rather than a remedy to it, (Bebchuk, Fried and

Walker 2001, p.31). Under this view, an executive maintains significant power over the

board of directors who effectively set his compensation. This power the executive, or

management team, holds stems from the close relationships between management and the

directors, and thus the directors and executives may be bonded by interest, collegiality,

or affinity, (Bebchuk, Fried and Walker 2001, p.31). Also, directors are further tied to

management, and in particular the CEO, because the CEO is often the one who exerted

influence to have the director placed on the board, and thus the director may feel more

inclined to defer to the CEO, particularly with issues surrounding the bargaining over

managements compensation.

As a result of the power that management maintains, management has the ability

to bargain more effectively with the board over compensation, and can effectively extract

more rents as a result. These rents are referred to as the amount of compensation a


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CEO, or management, receives over the normal amount he would receive with optimal

contracting. Therefore it is logical to anticipate seeing higher pay for executives

governed by weaker boards, or boards with little independence, which is consistent with

Bertrand and Mullainathans (2000) findings. That is, one of their conclusions was that

boards with more insiders (or less independence) are inclined to pay their CEO more. In

other words, CEOs with fewer independent directors on their boards are likely to gain

better control of the pay process.

More generally, it is important to mention that incentive contracts for executives

are common components of their compensation packages, and there is a vast amount of

literature on the effectiveness of incentive contracts. Murphy (1985) argued from an

empirical standpoint about the positive relationship between pay and performance of

managers. Murphy and Jensen (1990) later examined stock options of executives and

showed that a managers pay increased by only $3 for every $1000 increase in

shareholder wealth. Murphy and Jensen concluded that it was evidence of inefficient

compensation arrangements, arrangements that included restrictions on high levels of

pay. Others suggest that there needs to be a better approach in screening out performance

effects that are outside an executives control when looking at incentive contracts.

Rappaport (1999), in particular, argues that incentive contracts for executives would

provide more incentive and be better measures of executive performance if the stock

option exercise prices were indexed by broad movements in the market. This would

imply that an executive would not be compensated simply because of broad movements

in the market, but more by his individual firms performance relative to other firms.

Corporate Governances Role in Economic Efficiency


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Given the role executive compensation and incentive contracts play in attempting

to solve the agency problem, there remains the question of what role governance plays in

improving economic efficiency. In the ex-ante (which Zingales (1997) defines as the

time when specific investments should be made) period, there are two situations where

governance improves economic efficiency. The first is that rational agents will focus on

value-enhancing activities that are most clearly rewarded, and therefore governance must

help allocate resources and reward value-enhancing activities that are not properly

rewarded by the market. Secondly, managers will engage in activities that improve the

ex-post bargaining in their favor. As Shleifer and Vishny (1989) argue, a manager will

be inclined to focus on activities that he is best at managing because his marginal

contribution is greater, and this consequently increases his share of ex-post rents, or his

bargaining power for residual control rights.

Another area where governance may improve economic efficiency is in the ex-

post bargaining phase for rents. That is, governance may affect the level of coordination

costs or the extent to which a party is liquidity-constrained. If residual control rights are

assigned to a large, diverse group, the existence of free-riders in the group may create an

inefficient bargaining system. Also, if a party wishes to engage in a transfer of control

rights but he is liquidity-constrained, inefficient bargaining may again occur as the

transaction may not be agreed upon (Zingales 1997).

A third way that governance may effect overall economic efficiency is through

the level and distribution of risk. Assuming that the engaged parties have different risk

aversions, corporate governance can then act to efficiently allocate risk to those who are

least risk-averse (Fama and Jensen 1983), which improves the total surplus for the parties

involved.


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From a more general standpoint, it is also important to recognize that strong

governance in a system of capital markets such as the U.S. promotes an efficient medium

for those who are lending money and those who are borrowing, as well as provides some

security outside of the legal framework for lenders of capital. The nature of the firm

requires that financiers, or lenders of capital, will indeed lend their money to managers

who will in turn run a firm and hopefully create a return for the financiers. If the

financiers did not feel comfortable that they would be receiving their capital back at some

point in the future, they would not be inclined to provide managers with capital and, as a

result, innovation and industrial progression would be slowed tremendously. Strong

governance helps to maintain investors confidence in the capital markets and helps to

improve overall efficiency in this manner.

Recent Developments in Corporate Governance

Besides the theoretical basis of efficiencies provided by governance, it is

important to consider a more applied look at governance and how it has evolved over the

past two decades in the U.S. Indeed, corporate governance has changed substantially in

the past two decades. Prior to 1980, corporate governance did little to provide managers

with incentives to make shareholder interests their primary responsibility. As Jensen

(1993) discusses, prior to 1980 management thought of themselves as representatives of

the corporation as opposed to employees and representatives of the shareholders.

Management saw their role as one of balancing the interests of all related parties,

including company employees, suppliers, customers, and shareholders. The use of

incentive contracting was still limited, and thus managements interests were not well

aligned with that of its shareholders. In fact, in 1980, only 20% of the compensation of

CEOs was tied to stock market performance, (Holmstrom and Kaplan 2003, p.5). Also,


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the role of external governance mechanisms like hostile takeovers and proxy fights were

rare, and there tended to be very little independence on a board of directors.

The 1980s, however, were defined as an era of hostile takeovers and restructuring

activities that made companies less susceptible to takeovers. Leverage was employed at

high rates. As Holmstrom and Kaplan (2003) argue, the difference between actual firm

performance and potential performance grew to be significant, or in other words, firms

were failing to maximize value, which lead to a new disciplining by the capital markets.

The 1990s, by contrast, included an increase in mergers that were designed to take

advantage of emerging technologies and high growth industries.

Changes in executive compensation throughout the two decades also changed

significantly. Option-based compensation for managers increased significantly as

executives became more aligned with shareholders, specifically, equity-based

compensation in 1994 made up almost 50% of CEO compensation (up from less than

20% in 1980), (Holmstrom and Kaplan 2003, p.9).

There were also changes in the makeup of U.S. shareholders during the two

decades, as well as changes in boards of directors. Institutional investors share of the

market increased significantly (share almost doubled from 1980 to 1996, Holmstrom and

Kaplan 2003), which came alongside an increase in shareholder activism throughout the

period. The increase in large institutional investors suggests that firms will be more

likely to be effective monitors of management. The logic follows because if an investor

(take a large institutional investor for example) owns a larger part of the firm, he will be

more concerned with the firms performance than if he were small because his potential

cash flows from the firm will be greater. It is important to note that often the large

shareholders are institutional shareholders, which means that presumably more

sophisticated investors with incentives to show strong stock returns own an increasing


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share of firms. Such concentration of ownership tends to avoid the traditional free-rider

problem associated with small, dispersed shareholders and will lead to the large

shareholders more closely monitoring management. Large shareholders thus address the

agency problem in that they both have a general interest in profit maximization, and

enough control over the assets of the firm to have their interests respected, (Shleifer and

Vishny 1996, p.27).

Other developments in corporate governance over the two decades, aside from the

regulatory and legislative changes post-Enron, include the fact that boards took great

strides to remove their director nominating decisions from the CEOs control through the

use of nominating committees. The number of outside directors (referring to those

directors who are not members of management) also increased during the period, as did

directors equity compensation as a percentage of their total director compensation

(Holmstrom and Kaplan 2003).

However, despite such improvements over the past two decades, the case of

Enron suggests that corporate governance was not immune from failure, and it highlights

many of the theoretical and applied issues with the current theories on corporate

governance, the firm, and executive compensation.

III. WHAT HAPPENED AT ENRON: FACTUAL ACCOUNT OF EVENTS

LEADING TO BANKRUPTCY

Background/Timeline

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,


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partnership created out of the need to redeem an outside investors 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 Enrons

partnerships. Other questionable partnerships were coming to light, including the

Raptors partnerships. These restatements were colossal, and combined with Enrons

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. Enrons debt

ratings subsequently plummeted, and one month later, on December 2, 2001, Enron filed

for bankruptcy protection under Chapter 11.

Summary of Transactions and Partnerships

Many of the partnership transactions that Enron engaged in that contributed to its

failure involved special accounting treatment through the use of specifically structured

entities known as a special purpose entities, or SPEs. For accounting purposes in 2001,

a company did not need to consolidate such an entity on to its own balance sheet if two

conditions were met: (1) an owner independent of the company must make a substantive

equity investment of at least 3% of the SPEs assets, and the 3% must remain at risk

throughout the transaction; and (2) the independent owner must exercise control of the

SPE, (Powers, Troubh and Winokur 2002, p.5). If these two conditions were met, a

company was allowed to record gains and losses on those transactions on their income

statement, while the assets, and most importantly the liabilities, of the SPE are not

included on the companys balance sheet, despite the close relationship between the

company and the entity.


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The Chewco/JEDI Transaction

The first of the related party transactions worthy of analysis is Chewco

Investments L.P., a limited partnership managed by Mr. Kopper. Chewco was created

out of the need to redeem California Public Employees Retirement System (CalPERS)

interest in a previous partnership with Enron called Joint Energy Development

Investment Limited Partnership (JEDI).

JEDI was a $500 million joint venture investment jointly controlled by Enron and

CalPERS. Because of this joint control, Enron was allowed to disclose its share of gains

and losses from JEDI on its income statement, but was not required to disclose JEDIs

debt on its balance sheet. However, in order to redeem CalPERS interest in JEDI so that

CalPERS would invest in an even larger partnership, Enron needed to find a new partner,

or else it would have to consolidate JEDIs debt onto its balance sheet, which it

desperately wanted to avoid.

In keeping with the rules regarding SPEs, JEDI needed to have an owner

independent of Enron contribute at least 3% of the equity capital at risk to allow Enron to

not consolidate the entity. Unable to find an outside investor to put up the 3% capital,

Fastow selected Kopper to form and manage Chewco, which was to buy CalPERS 3%

interest. However, Chewcos purchase of CalPERS share was almost completely with

debt, as opposed to equity. As a result, the assets and liabilities of JEDI and Chewco

should have been consolidated onto Enrons balance sheet in 1997, but were not.

The decision by management and Andersen to not consolidate was in complete

disregard of the accounting requirements in connection with the use of SPEs, despite the

fact that it is was in both Enrons employees interest and in the interest of Enrons

auditors to be forthright in their public financial statements. The consequences of such a


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decision were far-reaching, and in the fall of 2001 when Enron and Andersen were

reviewing the transaction, it became apparent that Chewco did not comply with the

accounting rules for SPEs. In November of 2001 Enron announced that it would be

consolidating the transactions retroactively to 1997. This consequently resulted in the

massive earnings restatements and increased debt on Enrons balance sheet.

Not only was this transaction devastating to Enron, but its manager, Mr. Kopper,

received excessive compensation from the transaction, as he was handsomely rewarded

more than $2 million in management fees relating to Chewco. Such a financial windfall

was the result of arrangements that he appears to have negotiated with Fastow,

(Powers, Troubh, and Winokur 2002, p.8). Kopper was also a direct investor in Chewco,

and in March of 2001 received more than $10 million of Enron shareholders money for

his personal investment of $125,000 in 1997. His compensation for such work should

have been reviewed by the boards Compensation Committee but was not.

This transaction begins to shed light on a few of the many corporate governance

issues arising from Enron, one being the dual role Kopper played as manager and

investor of the partnership while an employee of Enron. This is a blatant conflict of

interest, explicitly violating Enrons own Code of Ethics and Business Affairs, which

prohibits such conflicts unless the chairman and CEO determined that his participation

does not adversely affect the best interests of the Company, (Powers, Troubh and

Winokur 2002, p.8). The second governance issue is in connection with the

Compensation Committees lack of review of Koppers compensation resulting from the

transactions. The third governance issue deals with the lack of auditing oversight from

the Audit and Compliance Committee concerning the decision not to consolidate the

entity.


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against the downside of an investment by contracting with another firm or entity that

accepts the risk of the investment for a fee. However, in June of 1999 with the Rhythms

investment, instead of the LJM partnerships committing the independent equity necessary

to act as a hedge for the investment should the value of the investment decline, they

committed Enron stock that would serve as the primary source of payment. The idea

was to hedge Enrons profitable merchant investment in Rhythms stock, allowing Enron

to offset losses on Rhythms if the price of Rhythms stock declined, (Powers, Troubh and

Winokur 2002, p.13). These hedging transactions did not stop with Rhythms, but

continued through 2000 and 2001 with other SPEs called Raptor vehicles. They too were

hedging Enron investments with payments that would be made in Enron stock should

such a payment be necessary.

Despite Andersens approval of such transactions, there were substantial

economic drawbacks for Enron of essentially hedging with itself. If the stock price of

Enron fell at the same time as one of its investments, the SPE would not be able to make

the payments to Enron, and the hedges would fail. For many months this was never a

concern, as Enron stock climbed and the stock market boomed. But by late 2000 and

early 2001 Enrons stock price was sagging, and two of the SPEs lacked the funds to pay

Enron on the hedges. Enron creatively restructured some transactions just before

quarters end, but these restructuring efforts were short-term solutions to fundamentally

flawed transactions. The Raptor SPEs could no longer make their payments, and in

October of 2001 Enron took a $544 million dollar after-tax charge against earnings- a

result of its supposed hedging activities.

Though they eventually contributed to Enrons demise, these related party

transactions concerning LJM-1 and LJM-2 resulted in huge financial gain for Fastow and

other investors. They received tens of millions of dollars that Enron would have never


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given away under normal circumstances. At one point Fastow received $4.5 million after

two months on an essentially risk-free $25,000 investment relating to LJM-1 (Powers,

Troubh and Winokur 2002).

As discussed earlier, one of the downfalls of the principal-agent problem under

the incomplete contract paradigm lies with the allocation of residual control rights to

managers. Because managers have much discretion associated with the residual rights,

funds may be misallocated. This exact problem, the misallocation of firm funds, arose in

the case of Enron. Enron shareholders had invested capital in the firm and management

was then responsible for the allocation of such funds. With the residual control rights

management maintained due to the separation of ownership and management,

management, vis--vis the firms CFO Andrew Fastow and Michael Kopper, was able to

expropriate the firms funds.

There are many different methods a manager may employ in the expropriation of

funds. A manager may simply just take the cash directly out of the operation, but in the

case of Enron, management used a technique called transfer pricing with the partnerships

they had created. Transfer pricing occurs when managers set up independent companies

that they own personally, and sell output (or assets in this case) of the main company they

run to the independent firms at below market prices, (Shleifer and Vishny 1996, p.9

excluding parenthesis). The independent firms mentioned above were the partnerships,

like Chewco, JEDI, and the LJMs that Fastow and Kopper managed and had partial

ownership of. With the partnerships like the LJMs making a profit on nearly every

transaction, it is clear that Enron must have been selling those assets at below market

levels, which defines expropriation by way of transfer pricing. It then makes sense that

as the partnerships sold back the assets, they profited each time because Enron would re-

purchase the assets at prices higher than what the partnerships had paid. Therefore,


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because Enrons asset sales and purchases were enriching the investors in the

partnerships, management was effectively expropriating firm funds. Managements

expropriation of funds to the manager-owned and operated partnerships is a manifestation

of the principal-agent. Management was literally enriching itself and the other owners of

the partnerships with firm funds, a problem that stems from the separation of ownership

and management in a corporation.

It is important to note that the expropriation of firm funds in this case was really a

breakdown in the first layer of the corporate governance institutions that exist to protect

shareholders. These mechanisms of corporate governance take many different forms,

ranging from management decision-making and compensation, to board oversight, to

outside professional advisors and their roles to monitor the workings of a company.

Management of a firm, and in particular its CFO, has a fiduciary duty to the shareholders

of the company, which serves to act as a governance mechanism. In this case,

management abandoned their responsibility to shareholders in favor of enriching

themselves and manipulating financial statements, and thus undermined one of the many

mechanisms of corporate governance that contribute to its effectiveness.

The expropriation of funds through transfer pricing is not an Enron-specific

phenomenon. As Shleifer and Vishny (1996) mention, within the Russian oil industry

managers often sell oil at below market prices to independent manager-owned

companies. Korean chaebol also have reportedly sold subsidiaries to the founders of the

chaebol at below market prices (Shleifer and Vishny 1996).

At the formation of the LJM partnerships it was brought to the attention of the

board that having Fastow both invest in the partnerships and manage the transactions

with Enron would present a conflict of interest. Management, however, was in favor of

the structure because it would supply Enron with another buyer of Enron assets, and that


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Fastows familiarity with the Company and the assets to be sold would permit Enron to

move more quickly and incur fewer transaction costs, (Powers, Troubh and Winokur

2002, p.10). After discussion, the board voted to ratify the Fastow managed partnerships,

despite the conflict. The board was under the impression that a set of procedures to

monitor the related party transactions was being implemented, and that because of the

close scrutiny the partnerships would face this would mitigate the risk involved with

them. However, the Enron Board failed to make sure the controls were effective, to

monitor the fairness of the transactions, or to monitor Mr. Fastows LJM-related

compensation (U.S. Senate Subcommittee 2002, p.24), and will be discussed further in

section IV.

Despite the foregoing disparaging remarks regarding SPEs, it is important to note

that SPEs are not inherently bad transaction vehicles, and can actually serve valid

purposes. They are in fact very appropriate mechanisms for insulating liability, limiting

tax exposure, as well as maintaining high debt ratings. They are widely used in both

public and privately held corporations and are fundamental to the structuring of joint

venture projects with other entities. It was the expropriation of firm funds by Enron

management that was illegal, not the transaction vehicles themselves.

IV. ANALYSIS OF CORPORATE GOVERNANCE ISSUES

Corporate Structure

In order to fully analyze the corporate governance issues that arose within Enron,

a certain amount of background information regarding its corporate structure and the

implications of its high power incentive contracts is necessary. By any standards,

Enrons Board structure with five oversight subcommittees could have been characterized


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as typical amongst major public American corporations. The Chairman of the Board was

Kenneth Lay, and in 2001 Enron had 15 Board Members. Most of the members were

then or 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. In his

testimony before the Senate Subcommittee on Investigations, John Duncan, Chairman of

Enrons Executive Committee, spoke of his fellow board members as being well

educated, experienced, successful businessmen and women and experts in areas of

finance and accounting. Indeed they had a wealth of sophisticated business and

investment experience and considerable expertise in accounting, derivatives, and

structured finance, (U.S. Senate Subcommittee 2002, p.8). The board had five annual

meetings, and conducted additional special meetings as necessary throughout the year.

As provided in U.S. Senate Subcommittee report on The Role of Enrons Board

of Directors in Enrons Collapse (2002, p.9), the five subcommittees, consisting of

between four and seven members each, had the responsibilities as follows:

(1) The Executive Committee met on an as needed basis to handle urgent

business matters between scheduled Board meetings.

(2) The Finance Committee was responsible for approving major transactions

which, in 2001, met or exceeded $75 million in value. It also reviewedtransactions valued between $25 million and $75 million; oversaw Enrons risk

management efforts; and provided guidance on the companys financial decisionsand policies.

(3) The Audit and Compliance Committee reviewed Enrons accounting andcompliance programs, approved Enrons financial statements and reports, and was

the primary liaison with Andersen.

(4) The Compensation Committee established and monitored Enrons

compensation policies and plans for directors, officers, and employees.

(5) The Nominating Committee nominated individuals to serve as Directors.


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At the full Board meetings, in addition to presentations made by Committee

Chairmen summarizing the Committee work, presentations by Andersen as well as

Vinson & Elkins, the Enrons chief outside legal counsel, were common. Vinson &

Elkins provided advice and assisted with much of the documentation for Enrons

partnerships, including the disclosure footnotes regarding such transactions in Enrons

SEC filings (Powers, Troubh and Winokur 2002). Andersen regularly made

presentations to the Audit and Compliance Committee regarding the companys financial

statements, accounting practices, and audit results.

Board members received $350,000 in compensation and stock options annually,

which was significantly above the norm, (U.S. Senate Subcommittee 2002, p.56).

Compensation to Enron executives in 2001 was extraordinarily generous too, as shown

by the following chart (Pacelle 2002), which includes the value of exercised stock options

and excludes compensation from the partnerships:

Kenneth Lay (Enron Chairman/CEO)...$152.7 (in millions)

Mark Fevert (Chair and CEO, Enron Wholesale Services).$31.9

Jeffrey Skilling (Enron CEO)......$34.8

J. Clifford Baxter (Enron Vice-Chairman)..$16.2

Andrew Fastow (Enron CFO)..$4.2

In 2000, Mr. Lays compensation was in excess of $140 million, including the

value of his exercised options. This level of compensation was 10 times greater than the

average CEO of a publicly traded company in that year, which was $13.1 million (U.S.

Senate Subcommittee 2002, p.52). It is important to note that $123 million of that $140

million came from a portion of the stock options he owned, which represents a significant

percentage of total compensation from stock options.


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As discussed in section II, the theory behind such extensive stock option grants to

the firms management and its directors is to align the interests of shareholders and

management as a solution to the principal-agent problem. However, one of the major

drawbacks of alignment of manager and shareholder interest by way of stock options is

that it provides huge incentives for self-dealings for the managers. As Shleifer and

Vishny (1996, p.14) discuss, high powered incentive contracts may entice managers to

manipulate accounting numbers and investment policy to increase their pay. They also

argue that the opportunities to self-deal increase with weak or unmotivated boards

overseeing the compensation packages. With the case of Enron, management had

significant financial incentive through its stock options to manipulate their earnings to

boost stock prices, which created enormous windfalls for those with equity-based

compensation when such manipulations occurred.

More specifically, as Gordon (2002) argues, the value of the stock option will

increase not only with the value of the underlying security but with the stocks variance,

according to the Black-Scholes option pricing. As a result, managers with significant

stock options have incentive to increase the stock price of their firm, and variance, by

taking on more risk. Costly risk taking was employed at Enron with the use of the highly

structured and hedged partnerships. As a result, Enron in a sense became a hedge fund,

taking leveraged bets in exotic markets that if successful would produce a huge,

disproportionate bonanza for its executives the downside seemed a problem only for

the shareholders, (Gordon 2002, p.1247). That is, Enron management had huge

potential and realized payoffs by way of their stock options, which provided them

incentive to take on unnecessary risk and manipulate earnings.

As mentioned earlier, Bertrand and Mullainathan (2000) discuss aspects of such

stock compensation practices as they examine two competing views of executive pay,


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one being the contracting view and the other being the skimming view (or rent extraction

view). Included in their analysis is the mention of the constraints that limit the amount

managers take from the firm within their equity compensation packages. Such executives

are restrained by the amount of funds in the firm, by an unwillingness to draw attention

of shareholder activist groups, or by fear of becoming a takeover target, (Bertrand and

Mullainathan 2000, p.3). Thus, while executive stock options do provide a solution to

aligning management and shareholder interests, there are significant costs associated with

them, as they often come with the serious threat of manager self-dealings that are not in

line with maximizing shareholder value.

We have thus seen a breakdown in another one of the institutions of corporate

governance with the ineffectiveness of equity compensation for executives. Stock-based

compensation is another mechanism that helps to align manager 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.

However, in the case of Enron such a technique essentially failed because of the massive

incentives for management self-dealings and to manipulate financial statements.

Conflicts of Interest

As mentioned earlier, one of the major governance issues brought to light by the

bankruptcy of Enron was the blatant conflict of interest involved with having financial

officers of a company both manage and be equity holders of entities that conducted

significant business transactions with Enron. Enrons Code of Ethics and Business

Affairs explicitly prohibits any transactions that involve related parties unless the

Chairman and CEO determined that his participation does not adversely affect the best

interests of the Company (Powers, Troubh and Winokur 2002, p.8). With respect to the


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Chewco transaction, which was managed by Mr. Kopper, the Powers Report concluded

that there was no evidence that his participation was ever disclosed to, or approved by,

either Kenneth Lay (who was Chairman and CEO) or the Board of Directors, (Powers,

Troubh and Winokur 2002, p.8). Mr. Koppers involvement in the Chewco transaction as

both general manager and investor therefore was in direct violation of Enrons Code of

Ethics and Business Practices, and should have never occurred. The management of

Enron should have recognized the conflict and either sought approval from Mr. Lay, in

which case one would hope the transaction would have been restructured with a different

general manager, or it should have been abandoned completely. In either case, such a

conflict should not have been allowed.

Again with the LJM transactions, conflicts of interest were abundant and should

have been avoided. However, the LJM transactions differed from Chewco in one major

respect: the conflict of interest arising from having the CFO, Mr. Fastow, manage and

invest in the entities was approved by the Chairman and Board of Directors. Along with

the Boards ratification of the Chairman and CEOs approval was the Boards

understanding that a set of controls to monitor the partnerships and ensure fairness to

Enron was being implemented by management. Concerns about such a conflict of

interest were expressed amongst senior personnel at Andersen, in which it is clear that

such a conflict should have never been allowed. In an email dated 5/28/99 between

Andersen employees Benjamin Neuhausen to David Duncan, Neuhausen clearly

identifies the issue at hand: Setting aside the accounting, idea of a venture entity

managed by CFO is terrible from business point of view. Conflicts galore. Why would

any director in his or her right mind ever approve such a scheme? Mr. Duncans

response on 6/1/99 was as follows: [O]n your point 1 (i.e., the whole thing is a bad

idea), I really couldnt agree more. Rest assured that I have already communicated and it


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has been agreed to by Andy [Fastow] that CEO, General [Counsel], and Board discussion

and approval will be a requirement, on our part, for acceptance of a venture similar to

what we have been discussing, (U.S. Senate Subcommittee 2002, p.26).

Because the board was under the impression that a system of controls was being

implemented, and because members of management had not objected to such a

structuring, it seems more clear why the board came to the conclusion to support such a

flawed structure. According to Board Member Mr. Blake, the LJM transactions were

described as an extension of Enron and as an empty bucket (U.S. Senate

Subcommittee 2002, p.27) for Enron assets. Further, the proposal for LJM transaction

was faxed to Board members only three days before the special meeting took place, and

discussion within the meeting about the transaction was limited. The special meeting

lasted only an hour, and amongst the approval of the conflict of interest were substantial

topics such as resolutions authorizing a major stock split, changes in companys stock

compensation plan, acquisition of a new corporate jet, and discussion on an investment in

a Middle Eastern power plant. This suggests that the board did not devote significant

attention to consideration of the conflicts of interest. Thus, again Enron was saddling

itself with more related-party transactions, transactions that would eventually lead to its

demise.

With the Chewco partnership, management, in particular Kopper, again took

advantage of the residual control rights he retained. The manager used these control

rights to expropriate funds to the manager-owned and operated partnerships. This is a

prime example of the agency problem associated with the separation of ownership and

management, and is very similar to the other example of Fastows expropriation of funds

through transfer pricing. Koppers expropriation of funds is again a breakdown in one of

the corporate governance institutions that was in place to protect shareholders. As an


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employee in the finance division, Kopper 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

These conflicts of interest highlight more of the fundamental breakdowns in

governance within Enron and the lack of Board oversight once such conflicts had been

approved. After approving such related-party transactions, the 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. Though management told the Board 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 procedures and controls included the review and approval of all LJM

transactions by Richard Causey, the Chief Accounting Officer; and Richard Buy, the

Chief Risk Officer; and, later during the period, Jeffrey Skilling the President and COO

(and later CEO). The Board also directed its Audit and Compliance Committee to

conduct annual reviews of all LJM transactions, (Powers, Troubh and Winokur 2002,

p.10). A system of controls as those mentioned would have provided Enron with a

safeguard of checks and balances to protect the interests of Enron. Unfortunately the

controls were not rigorous enough, and their implementation and oversight was

inadequate at both the Management and Board levels, (Powers, Troubh and Winokur

2002, p.10). Both Causey and Buy interpreted their roles in reviewing the transactions

very narrowly, and did not provide the level of scrutiny that the Board thought was


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occurring, which, of course, eventually resulted in the massive earnings restatements and

reduction in shareholder equity.

More specifically, the Finance Committee should have taken a more proactive

role in examining and monitoring the transactions. As was defined by the role of the

Finance Committee, they were responsible for approving major transactions which, in

2001, met or exceeded $75 million in value. It also reviewed transactions valued

between $25 million and $75 million; oversaw Enrons risk management efforts; and

provided guidance on the companys financial decisions and policies, (U.S. Senate

Subcommittee 2002, p.9). It can be concluded that the Finance Committee failed in its

responsibility of such monitoring, especially given that they were aware of the precarious

nature of the related-party 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.

Further, the Audit and Compliance Committee also failed to closely examine the

nature of the transactions, as is outlined in their duties. Indeed the annual reviews of the

LJM transactions by the Audit and Compliance Committee appear to have involved only

brief presentations by Management and did not involve any meaningful examination of

the nature or terms of the transactions, (Powers, Troubh and Winokur 2002, p.11). Such

complex and risky transactions with related-parties deserved close scrutiny, not the

cursory review it received.

And finally, the Compensation Committee failed in its duty to monitor Enrons

compensation policies and plans for directors, officers, and employees, (U.S. Senate

Subcommittee 2002, p.9) as was specified. Had they been reviewed by the

Compensation Committee, both Fastows and Koppers excessive compensation for their


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management of the partnerships as well as their return on private investments in the

partnerships would have immediately illuminated the conflicts and abuses associated with

the transactions, but no such review occurred. In fact, neither the Board nor Senior

Management asked Fastow for the amount of his LJM-related compensation until

October 2001, after media reports focused on Fastows role in LJM, (Powers, Troubh

and Winokur 2002, p.11). This lack of oversight by the Compensation Committee was a

major contributor to the financial failure of Enron, as both Fastow and Kopper received

disproportionate compensation for their management of the partnerships at Enrons

expense.

Audit Committee Relationship with Enron and Andersen

During Board meetings Andersen auditors briefed the Enron Audit and

Compliance Committee members about Enrons current accounting practices, informed

them of their novel design, created risk profiles of applied accounting practices, and

indicated that because of their unprecedented application, certain structured transactions

and accounting judgments were of high risk (U.S. Senate Subcommittee 2002, p.16).

However, as provided in the charter of the Audit and Compliance Committee, it was the

Committees responsibility to determine and provide reasonable assurance that the

Companys publicly reported financial statements are presented fairly and in conformity

with generally accepted accounting principles, (U.S. Senate Subcommittee 2002, p.16).

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. An

example is a note written by Andersens David Duncan, who states that many of the

accounting practices push limits and have a high others could have a different view

risk profile, (U.S. Senate Subcommittee 2002, p.17). A more diligent Audit and


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Compliance Committee would have probed such comments like this and questioned the

accounting techniques applied.

Certainly within Andersen it was clear that Enron was engaging in Maximum

Risk (U.S. Senate Subcommittee 2002, p.18) accounting practices. In fact, amongst

Andersen personnel it was noted that [Enrons] personnel are very sophisticated and

enter into numerous complex transactions and are often aggressive in structuring

transactions to achieve derived financial reporting objectives, (U.S. Senate

Subcommittee 2002, p.18). These concerns, however, were never properly addressed and

were not effectively communicated to the Audit and Compliance Committee by

Andersen. As Mr. Jaedicke, the Chairman of Enrons Audit and Compliance Committee,

stated before the Senate Subcommittee on Investigations about the Audit Committee

meetings with Andersen, when we would ask them [Andersen], even in executive

session, about, okay, how do you feel about these, the usual expression was one of

comfort. It was not, these are the highest risk transactions on our scale of one to ten

(U.S. Senate Subcommittee 2002, p.19-20). Despite Andersens wrongful approval of

such transactions, the Audit and Compliance Committee had a duty to ensure that

accurate financial statements were produced.

The blame for such major accounting errors is not easily assigned, and includes a

web of poor decisions by management, Andersen auditors, and the Audit and Compliance

Committee. First, management should not have structured their deals with such high-risk

techniques, especially those involving known conflicts of interest. Second, Andersen

formally admitted that it erred in concluding that the Rhythms transaction was structured

properly under the SPE non-consolidation rules, (Powers, Troubh and Winokur 2002,

p.24). As a result, financial statements from 1997 to 2000 had to be revised. The

governance issues arise when one looks at the role of the Audit and Compliance


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Committee. While its not reasonable to expect Audit Committee members to know the

intricacies of off-balance sheet accounting and non-consolidation rules for Special

Purpose Entities, it is reasonable to expect them to ask the right questions which get at

the heart of a potential problem as well as to create a framework within their oversight

duties that allows for conversation, open, candid conversation with management and with

external consultants like Andersen. This idea of questioning that which is approved by

the supposed experts on the topic, of course, is a most delicate issue, and lies at the core

of governance and oversight measures. However, again the emphasis should be on the

atmosphere in which the Audit and Compliance Committee operated: it was not one that

continually challenged themselves to ensure accurate financial statements for Enron.

It is important to emphasize that Enron went to great lengths to employ such

highly structured SPEs and partnerships, and such entities were only described to outside

investors in the footnotes of Enrons disclosure documents. The non-consolidation rules

did not require that such entities be included on the balance sheet, making such

transactions difficult to recognize and understand, even for sophisticated analysts and

investors. In effect, Enron was using technologies (or complex financial techniques) that

helped to obscure the firms 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 skeptically at the

firms financial condition. Bebchuk, Fried and Walker (2001) describe such technologies

for obscuring executive compensation as camouflaging. They argue that efforts will

be made to obfuscate the compensation data and otherwise plausibly justify the

compensation programs, (Bebchuk, Fried and Walker 2001, p.34).

The effects of such technologies that obscure financial results are far reaching and

directly impact the shareholders of the firm. By obscuring financial results through the


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The Board of Enron also failed in its duty to ensure the objectivity and

independence of Arthur Andersen as its auditor, providing yet another area in which the

oversight of Enrons Board broke down. It was well understood that Andersen provided

not only internal auditing services to Enron, but consulting services as well. These two

services were closely linked, and often were referred to as an integrated audit. The

problems inherent to an integrated audit are of major concern, as the independence of the

auditors is forfeited. The lack of independence occurs because Andersen might audit its

own work, in which case Andersen auditors might be reluctant to criticize Andersen

consultants for the LJM or Raptor structures that Andersen had been paid millions of

dollars to help design, (U.S. Senate Subcommittee 2002, p.57). Therefore Andersens

auditing objectivity was sacrificed because of the concurrent employment of their

consulting services.

The onus then falls on the Audit and Compliance Committee to assess the

objectivity and independence of the auditor. As Senator Collins said to Audit Committee

Chairman Mr. Jaedicke in the Senate Subcommittee Investigation, when you are making

over $40 million a year, the auditor is not likely to come to the Audit Committee and say

anything other than they are independent, (U.S. Senate Subcommittee 2002, p.58).

which gets right to the point that the job to determine objectivity and independence is not

the auditors, but the board overseeing the auditors, the Audit Committee. Indeed,

Andersens consulting and auditing fees were substantial, totaling $27 million for

consulting services and another $25 million for auditing services performed in 2000 (U.S.

Senate Subcommittee 2002, p.58). Enrons Audit and Compliance Committee did very

little to investigate the independence of Andersens auditing services, but had they been

more interrogative, they might have preserved the independence of its auditors by

prohibiting other services other than audit work, hopefully producing more accurate


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financial statements. Again, this is a breakdown in yet another level of the corporate

governance institutions. The Audit Committees role was one of oversight, and it failed

to monitor and oversee the production of accurate financial statements. This level of

oversight is designed to catch failures in other layers of corporate governance like the

independence of the outside auditor, yet it failed in its oversight duty.

Not only should have the Audit Committee done a better job in scrutinizing the

accountants independence, but so should have sophisticated market participants who

placed such a high value on the stock. The result is the partial failure of the efficient

market hypothesis for Enron stock. Gordon (2002) argues that the efficient market

hypothesis, which says the prices of securities fully reflect available information

(Bodie, Kane and Marcus 2002, p.981), was indeed disrupted when one looks at the

pricing of Enron stock. It was widely understood that Andersen was providing both audit

and consulting services to Enron, which, according to Gordon (2002, p.1233-4) should

have sharply diminished [the] value of Andersens certification for a company like

Enron with complicated accounting, abundant consulting opportunities, and obvious

accounting planning [and] should have been impounded in Enrons stock price

Further evidence in support of the partially failed efficient market hypothesis is that the

analysts that were tracking Enron knew that Enron was engaging in complex, off-balance

sheet transactions that were discreetly described in disclosures. Such financial reporting

obscurity should have caused more skepticism from the financial community, and

consequently such skepticism should have been ingrained in the companys stock price.

Such skepticism, however, was not ingrained in the price and the stock continued to soar

into 2000.

I refer to it as a partial failure of the hypothesis because there are indications

that perhaps the stock price was adjusting due to leaked news of the partnerships and


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Enrons looming accounting crisis. The gradual fall in the stock price from January 2001

at $80 per share down to almost $40 per share by that fall, despite increased earnings

throughout the period, suggest that the market was in a period of correction. However,

because the supposed correction was so slow, this still suggests that there may have

been a partial failure in the market efficiency.

Director Independence/Director Selection

It is important to identify the lack of independence and its implications when

looking at the directors of Enrons Board. The independence of directors can play a

critical role in evaluating ones ability to provide objective judgment. As the Business

Roundtable (2002, p.11) suggests,

The board of a publicly owned corporation should have a substantialdegree of independence from management. Board Independence depends

not only on directors individual relationships- personal, employment orbusiness- but also on the boards overall attitude toward management.Providing objective independent judgment is at the core of the boards

oversight function, and the boards composition should reflect thisprinciple.

From an outside vantage point it would appear that Enron indeed had an

independent board, as it contained only one Enron executive. Financial ties, however,

between Enron and a majority of its directors seem to have weakened their objectivity in

their oversight of Enron. The following are examples of such financial ties contributing

to the lack of true independence amongst Enron Board members, as cited was cited in the

U.S. Senate Subcommittee report on The Role of Enrons Board of Directors in Enrons

Collapse (p.55):

Lord Wakeham received $72,000 in 2000 for his consulting services to Enron, in

addition to his Board compensation.


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John Urquhart received $493,914 in 2000 for his consulting services to Enron, in

addition to his Board compensation.

Herbert Winokur also served on the Board of the National Tank Company, a

company which recorded significant revenues from asset sales and services to

Enron subsidiaries from 1997 to 2000.

From 1996 to 2001, Enron and Chairman Kenneth Lay donated almost $600,000

to M.D. Anderson Cancer Center in Texas. Both Dr. Lemaistre and Dr.

Mendelsohn, both of whom were currently Enron directors, served as president of

the Cancer Center.

Donations from Enron and the Lay Foundation totaled more than $50,000 to the

Mercatus Center in Virginia, where Board member Dr. Wendy Gramm is

employed.

Hedging arrangements between Belco Oil and Gas and Enron have existed since

1996 worth tens of millions of dollars. Board member Mr. Belfer was Chairman

and CEO of Belco.

Frank Savage was a director for both Enron and the investment firm Alliance

Capital Management, which since the late 1990s was the largest institutional

investor in Enron and one of the last to sell off its holdings (Green 2002).

Such relationships with Enron may have made it difficult for such board members

to be objective or critical of Enron management. Unfortunately too often supposedly

independent directors have been anything but-- steered on to the board by powerful

executives, on whom they are too often dependent for favors, loans or business, (The

Economist 2002). As Chairman of the Federal Reserve Alan Greenspan notes, few

directors in modern times have seen their interests as separate from those of the CEO,

who effectively appointed them and, presumably, could remove them from future slates

of directors submitted to shareholders, (Greenspan 2002). This clearly seems to have

been the case with Enron, given the long list of close business ties with supposedly

independent directors. Many of these Enron Board members may have felt that their


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compensation (as a director or to the directors affiliated organizations) might be

jeopardized by probing and questioning extensively in Board meetings, producing weak

nodders and yes-men (The Economist 2002) as directors and thus weakening the

imperative oversight role of the Board and contributing to the fall of Enron.

The theoretical implications of a board that lacked independence at Enron fit well

with the previous discussion on executive rent extraction. I argued, as presented by

Bebchuk, Fried and Walker (2001), that managers will be able to extract rents when they

are connected to the directors, either through friendship, employment, association, or

other means. The directors, because of their close relations with management, will not be

inclined to question management, and will defer to management in bargaining over

executive compensation. This lack of independence on the board at Enron then likely

contributed to managements engagement in rent extraction, which could be one

explanation for the abnormally high compensation Enron executives received. That is,

had there been more truly independent directors on Enrons board, one would have

expected to have seen lower compensation for executives, compensation that more

appropriately fit the optimal contracting view that maximizes shareholder value.

These predictions again are consistent with Bertrand and Mullainathans (2000)

findings, that compensation for executives is lower with more independent boards,

suggesting that rent extraction cannot occur as easily with better governed (more

independent) boards. Hermalin and Weisbach (1998) present a model in which board

effectiveness is a function of its independence. In their model they predict, among other

things, that poor firm performance lowers the directors assessment of the CEO, which

results in a loss of bargaining power for the CEO (and presumably a loss of rent

extraction) and an increase in the probability that the number of independent directors

will increase. Thus, because the Enron directors were so closely tied to management and


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Enron as a firm, they were not as objective as they needed to be, which supports the

theory of management rent extraction. The lack of independence also helps to explain

the fundamental lack of oversight exhibited by the Board with regards to the conflicts of

interest presented with the partnerships.

The lack of independence on Enrons Board suggests another breakdown of one

of the most fundamental corporate governance institutions. The lack of independence

gets to the core oversight function of a board of directors. It is imperative that a board be

capable of looking objectively at the management and outside professional advisors of a

firm, and Enrons Board was not capable in this respect. This layer of corporate

governance, that is the board oversight function, should act as a final mechanism to

protect investors when other governance institutions have broken down. It should serve

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. This last layer, however, failed to serve its purpose and was

compromised largely because of the relationships between Enron, management, and the

directors themselves.

While there clearly were incentives for inside directors of Enron to remain quiet

and accept without question the approaches taken by Enron management, perhaps the

alternative of a completely independent board of directors would not be as successful as

one might initially think. Chairman Greenspan (2002) argues that shackling [the CEO]

with an interventionist board may threaten Americas entrepreneurial business culture

by slowing down the CEO too much. Greenspan (2002) also suggests that having solely

independent directors would create competing power centers within a corporation, and

thus dilute coherent control and impair effective governance. It is also important to

have directors with relevant business and industry experience, some of whom may have


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ties with the company he or she oversees, which can provide an important perspective on

issues that may arise in boardroom settings. Thus, while it is important for directors of

companies who are not members of management to maintain a certain degree of distance

from the company and management, eliminating all ties and having truly independent

directors might prove to actually hinder effective corporate functioning

V. POST-ENRON GOVERNANCE REFORMS AND OTHER PROPOSED

SOLUTIONS TO GOVERNANCE PROBLEMS

It would be incomplete to discuss the fall of Enron without briefly discussing the

legislative reforms and other proposed solutions to the issues relating to the principal-

agent problem and governance today. This section will highlight some of the key points

in the Sarbanes-Oxley Act and some potential costs associated with its implementation,

as well some other developments in corporate governance and other potential solutions to

solving the principal-agent problem.

Sarbanes-Oxley Act of 2002

In response to both the collapse of Enron and the general influx of corporate

malfeasance recently in the U.S., the Sarbanes-Oxley Act became law on July 30, 2002.

Its federal securities provisions are the most far-reaching of any since those of the 1930s

under President Roosevelt and constitute substantial changes for corporate governance

and financial reporting. Many of these changes were instituted in direct response to the

case of Enron. While some of the provisions will require further resolution and

rulemaking, others have gone into effect ranging anywhere from one month to one year


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from the date of their enactment. Some of the key provisions of the Act are summarized

below.

The Sarbanes-Oxley Act substantially affects the executive officers and directors

of public companies. It requires the certification of both CEO and CFO that they have

reviewed the financial report and that based on their knowledge the report accurately

represents the material respects of the companys financial position. It also bans personal

loans to exe

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