The Enron Affair EMBA 21 Program, 2003 Prof. L.J. Brooks.
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Transcript of The Enron Affair EMBA 21 Program, 2003 Prof. L.J. Brooks.
L.J. Brooks, Rotman School of Management, University of Toronto 2
Overview Management was:
out of control, and engaged in self-dealing manipulating transactions & financial
reports Company imploded - Chap. 11 in Dec. 2001 Investors misled, pensions lost Executives plead the 5th, poor memory,
ignorance, incompetence Outrage Auditor savaged, profession to be changed
L.J. Brooks, Rotman School of Management, University of Toronto 3
Enron Stock Chart
Source: www.globe investor.com
Weekly Prices 1997- 2002
L.J. Brooks, Rotman School of Management, University of Toronto 4
Enron’s Business (10K-2000) Transportation and distribution Wholesale services
Commodity sales & services, risk management products, plants, etc
Retail energy services - gas, electricity Broadband services
Nationwide fiber-optic network - build, market, etc.
Corporate and other operation of water, renewable energy, and clean
fuels plants plus other corporate activities
L.J. Brooks, Rotman School of Management, University of Toronto 5
Enron’s Income (IBIT): Income Before Interest, Minority Interest and Income Taxes
2000 1999 1998Transport & distribution ($ mil.)
Trans. Services 391 380 351Portland General 341 305 286
Wholesale Services 2,260 1,317 968Retail Energy Services 165 (68) (119)Broadband Services (60)Exploration & prod. - 65 128Corporate and other (615) (4)
(32)IBIT 2,482 1,995 1,582
L.J. Brooks, Rotman School of Management, University of Toronto 6
Enron’s Wholesale Services
…creation of networks involving selective asset ownership, contractual access to third-party assets and market-making activities. 10K p.36.
…uses portfolio and risk management disciplines, including offsetting or hedging transactions, to manage exposures to market price movements (commodities, interest rates, foreign currencies and equities).
10K p.37. …sells interests in certain investments and
other assets to improve liquidity and overall return, 10K p.37
L.J. Brooks, Rotman School of Management, University of Toronto 7
Enron’s Financial Data2000 19991998
Revenues (in Billions) 100.8 40.1 31.3
Operating income (Millions) 1,953 802 1,378IBIT 2,482 1,995 1,582Net Income before Cumulative
Accounting Changes 979 1,024 703Net Income 979 893 703
EPS (in dollars) - basic 1.22 1.17 1.07
- diluted 1.12 1.10 1.01
L.J. Brooks, Rotman School of Management, University of Toronto 8
Enron’s Financial Data2000 1999
Current assets (Billions) 30.4 7.3Investments, other 23.4 15.4Property, plant, equip, net 11.7 10.7
Total Assets 65.5 33.4Current liabilities 28.4 6.8Long-term Debt 8.6 7.2Deferred credits and other 13.8 6.5Shareholders’ Equity 11.5 9.6
Total Liab. & Shareholders’ Equity 65.5 33.4
L.J. Brooks, Rotman School of Management, University of Toronto 9
Enron’s Changing Risk Profile
Early By Risk 1990’s 2000 Level
Pipelines, distribution networks LowRetail energy LowPower generation LowOil and gas exploration Med.Alternative energy M/HHedging transactions HighCommodity trading transactions HighBroadband optical fiber networks V.
High
Related party transact. (SPEs/Partnerships) ???
L.J. Brooks, Rotman School of Management, University of Toronto 10
Corporate Governance
Role of the Board of Directors - traditional strategic objectives - set or approve appoint CEO, approve other officers company policies and procedures:
set or approve ensure dissemination and compliance
laws, regulations, & expectations of society ensure monitoring and compliance act as ethical conscience (Dey Report & CICA)
L.J. Brooks, Rotman School of Management, University of Toronto 11
Role of the Board of Directors, cont’d
“to supervise, direct or oversee”…”day-to-day management must be delegated to others” Dey Report (1994)
5 core functions (CICA/TSE, 2001): Choosing the CEO and ensuring the team is sound Setting the broad parameters the management team
operates within Coaching the CEO and team Monitoring and assessing the performance of the CEO,
setting the CEO’s compensation and approving the team’s Providing assurance to shareholders and stakeholders
about the integrity of the corporation’s financial performance, incl. Quarterly Reports.
L.J. Brooks, Rotman School of Management, University of Toronto 12
Audit Committee must:(CICA/TSE, 2001)
Provide assurance that external auditors: are independent are satisfied accounting estimates and judgments are
sound and in accord with GAAP Develop sufficient rapport with external and
internal auditors, and management to facilitate Approve mandate of internal audit group, and
ensure it has adequate resources to ensure an effective internal control framework and culture
Disclose mandate
L.J. Brooks, Rotman School of Management, University of Toronto 13
Enron’s Governance StructureWas Short Circuited
BoardKen Lay: Chair; Co-chair ZZZAudit, Compensation Cees.
ManagementLay, Skilling: CEO
Fastow, CFO; KoppersCausey, CAO; Buy, CRO
Watkins; Kaminsky; McMahon
Company Policies
Code of Conduct
Internal Audit ?
Whistleblowers ?
AuditorArthur
Andersen
Outside Law Firm
Consultant: Arthur Andersen
MissingSuspended
Compliance
GuidanceFinan.
ReportsSPEs
© L. Brooks
L.J. Brooks, Rotman School of Management, University of Toronto 14
Enron’s Governance Failure Begins
1997 - Board suspends code of conduct to deal with an SPE (JEDI/Chewco) emergency (alternative controls considered …not implemented) Can’t find outside investor before year-end Non-consolidation tests not satisfied:
Outside investor - 3%investment at risk, control. Fastow (CFO) has Koppers - who reports to
Fastow - appointed to run/invest/control SPE Realization that guard is down/can be
controlled
L.J. Brooks, Rotman School of Management, University of Toronto 15
Chewco/JEDI Kopper/Dodson Dodson
LP/GP Big/Little
SONR River $11.4
GP LP
$11.4 ENRON Chewco
$132 LP
Barclays GP $240 JEDI
$240 + $11 +132 = $383
© I. Wiecek
3% Calculation
L.J. Brooks, Rotman School of Management, University of Toronto 16
Select Enron SPEsPurpose Issues
Chewco/JEDI Syndicatedinvestment
Off balance sheet liabilities ($628 million), revenues recognized early
LJM Provided marketfor assets
Artificial profits Equity overstated($1.2 billion)
LJM1/Rhythms Investment“hedge”
Unrecognized losses($508 mill. ‘97-’00)
LJM2/Raptors Investment“hedge”
Unexpected losses ($544 million)
L.J. Brooks, Rotman School of Management, University of Toronto 17
Governance Failure Allows Fastow to control SPE transactions:
Sales of assets at inflated prices (False gains) False hedging of losses on Enron investments
(Falsely keeps losses off Enron Income Stat.) Exorbitant payments to Fastow & helpers Hiding of SPE debt ultimately to be borne by
Enron Fastow to create more SPEs (LJMs…) Manipulation of accounting disclosure
L.J. Brooks, Rotman School of Management, University of Toronto 18
Partial Impact
Payments to Fastow & helpers Invest._ Return Other
Fastow $25,000 $4.5 mil in 2 mo. $30 mil+stock options+Koppers 125,000 10 mil (incl. $2 mil in fees
friend)2 others 5,800 1 mil
Manipulated transactions in Q3 & Q4, 1999Asset sales, plus 1 hedge $229 profit of $570 before tax
and 549 after tax (~50%)
L.J. Brooks, Rotman School of Management, University of Toronto 19
Enron’s Ethical Culture Code suspended, alternate controls ignored Bogus trading floor for visiting analysts California energy market manipulation Whistleblowers/doubters came forward
(to), but Co-chair Baxter (Lay) resigned, 32 mil. …
suicide? Kaminsky (Fastow) …….. ignored McMahon (Fastow)...transferred …now CEO Sharon Watkins (Lay)… Enron’s law firm
found no problem …fox in the chicken coup
L.J. Brooks, Rotman School of Management, University of Toronto 20
Stock Proceeds, 10/98 to 11/01
Lou Pal Chairman, Enron Accelerator $353.7 mill.Ken Lay Chairman 101.3Rebecca Mark-Jusbasche Director 79.5Ken Harrison Director, Portland General Electrics 75.2Kenneth Rice Chairman, Enron Broadband 72.8Jeffrey Skilling Director (former CEO) 66.9Mark Frevert Vice Chairman 50.3Stanley Horton Global Chairman 45.5Joseph Sutton Vice Chairman 40.1J. Clifford Baxter Vice Chairman 35.2Joseph Hirco CEO, Enron Broadband 35.2Andrew Fastow Chief Financial Officer 30.5
Source: The Washington Post Company, January 27, 2002, A10.
L.J. Brooks, Rotman School of Management, University of Toronto 21
Arthur Andersen’s Culture Emphasis on revenue generation, not on
quality assurance Final full year of fees: $52 million; $25
mil. Audit and 27 other services Previous largest fine $7 million Audit partner can veto Quality Assurance
partner – only Big 5 firm Post-AA work, alumni Franchise risk parameters? Shredding … Retention policy … optics
L.J. Brooks, Rotman School of Management, University of Toronto 22
Arthur Andersen’s Troubles
Losses to Job AAClient Problem Missed, Date Shareholders Losses Fine
WorldCom $4.3 billion overstatement of earnings, announced on June 25, 2002 $179.3 billion 17,000 N.A.
Enron Inflation of income, assets, etc., Bankrupt Dec. 2, 2001 $66.4 billion
6,100 N.A.
Global Candidate for bankruptcy Crossing $26.6 billion 8,700
Waste Overstatement of income Management by $1.1 billion, 1992-6 $20.5 billion 11,000 $7 mil.
Sunbeam Overstatement of 1997 income by $71.1 million, then bankruptcy $4.4 billion 1,700
Baptist Books cooked, Foundation largest nonprofit $570 million 165 of Arizona bankruptcy ever
Source: Primarily Business Week, August 12, 2002, 54
L.J. Brooks, Rotman School of Management, University of Toronto 23
Governance After Enron Dec. 2, 2001 – bankruptcy, outrage, crisis of
credibility, political and regulatory action accelerated
Canada - April 2002: TSE adopts most recommendations of Joint TSE/CICA Report of Nov. 2001, OSC watching US
US - SEC, NYSE, Nasdaq, President and Congress/Senate race to put forward proposals
March-June, 2002, Arthur Andersen shredding trial
June 26, 2002 - WorldCom announces 4.3 bil. Sarbanes-Oxley Act, July 30, 2002 SEC, + CICA/ICD initiatives - Audit Committee
L.J. Brooks, Rotman School of Management, University of Toronto 24
TSE Rule Changes, April, 2002, to be effective Dec. 31, 2002
Board approval of strategic plan - risks, opportunities Provide Board mandate:
Limits for Board and management; Provisions for shareholder feedback
Communications Policy - dealings with analysts and investors Disclosure on directors: related, composition, minority New Directors: full board participation in determination of skill
sets Assessments:
Board assessments - responsibility for and frequency CEO assessments
Directors meetings without management present Audit Committee:
all financially literate, at least one expert Charter of powers and responsibilities Source: Canadian Governance Review, April/May
2002
L.J. Brooks, Rotman School of Management, University of Toronto 25
Sarbanes-Oxley Act of 2002 (SOx)Worldwide coverage… new Directors’ needs: Competencies - recruitment & training
Role & new governance responsibilities Financial literacy Understanding
Strategy, policies, business model, internal control & compliance
Mandatory Whistleblower programs - anonymous CFO codes, Company codes disclosed (SEC)
No executive personal loans/arrangements
L.J. Brooks, Rotman School of Management, University of Toronto 26
Sarbanes-Oxley Act, July 30, 2002
Broad coverage, some to come – SEC, … Interesting coverage:
Audit Committees - anonymous whistleblowing process
Code of Ethics for senior financial officers No material misstatements or omissions Public Company Accounting Oversight Board Conflicts of Interest in audit services
Source Financial Reporting Release, PricewaterhouseCoopers, August 2002
L.J. Brooks, Rotman School of Management, University of Toronto 27
Emerging Governance Trends
Independence of Directors …judgement, role Chair//CEO, Audit Committee, unrelated …
Clarification of responsibilities of Directors, Officers, Audit Committee charters - oversight, strategies, compliance, internal culture, ethics, tone at the top, broader risk management, competencies (financial
literacy/financial expertise), performance measures Greater transparency
CEO, CFO sign-off certification of annual and quarterly fin. statements, compensation, stock options approved, additional disclosures… risks, internal control, earlier insider trade reporting
Independence of Auditors…not some consulting services
L.J. Brooks, Rotman School of Management, University of Toronto 28
Audit Committee key … must
Understand key business operations Understand comprehensive risk
management model and reports Examine key/large transactions Ensure compliance with good policies Ensure fair presentation
Who wants this risk?How much should the members be
paid?© L. Brooks
L.J. Brooks, Rotman School of Management, University of Toronto 29
New Governance IssuesFor directors and senior officers:
Director’s Responsibilities Financial literacy Guidance and control systems Ethics risk management Comprehensive risk management
How important is reputation, public interest,…