Enron and the Economics of Corporate Governance June 2003 Peter Grosvenor Munzig Department of Economics Stanford University, Stanford CA 94305-6072 Advisor: 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 governance and consequently has led to a complete reevaluation of corporate governance practice in the United States. The following paper attempts to reconcile our existing theories on corporate governance, executive compensation, and the firm with the events that took place at Enron. This paper first examines and synthesizes our current theories on corporate 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 the principal-agent problem, that high-powered incentive contracts provided management with incentives for self-dealing, that significant costs were transferred to shareholders due to the obscurity in Enron’s financial reporting, and that due to the lack of board independence it is likely that management rent extraction occurred. Acknowledgements: I would like to thank my family and friends for their continued support throughout this paper. In particular, my mother Judy Munzig was instrumental with 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 without his support and advice this paper would not have been possible. 3 “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 4 CONTENTS I. INTRODUCTION 3 II. THE THEORY OF CORPORATE GOVERNANCE 7 Corporate Governance and the Principal-Agent Problem 7 Executive Compensation and the Alignment of Manager and Shareholder Interests 11 Corporate Governance’s Role in Economic Efficiency 14 Recent Developments in Corporate Governance 15 III. WHAT HAPPENED: FACTUAL ACCOUNT OF EVENTS LEADING TO BANKRUPTCY 17 Background/Timeline 18 Summary of Transactions and Partnerships 19 The Chewco/JEDI Transaction 20 The LJM Transactions 22 IV. ANALYSIS OF CORPORATE GOVERNANCE ISSUES 26 Corporate Structure 27 Conflicts of Interest 30 Failures in Board Oversight and Fundamental Lack of Checks and Balances 33 Audit Committee Relationship With Enron and Andersen 35 Lack of Auditing Independence and the Partial Failure of the Efficient Market Hypothesis 38 Director Independence/Director Selection 41 V. POST-ENRON GOVERNANCE REFORMS AND OTHER PROPOSED SOLUTIONS TO GOVERNANCE PROBLEMS 45 Sarbanes-Oxley Act of 2002 45 Other 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 5 across financial markets when the company filed for bankruptcy on December 2, 2001. At that time, the Houston-based energy trading company’s bankruptcy was the largest in history but was surpassed by WorldCom’s 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 Enron’s CFO Andrew Fastow authorized by the board to manage the transactions between Enron and the partnerships, for which he was generously compensated at Enron’s expense. In addition to crippling investor confidence and provoking questions about the sustainability of a deregulated energy market, Enron’s 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 company’s 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 6 Global Crossing have all suffered catastrophes similar to Enron’s, 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 management’s expropriation of firm funds with the Special Purpose Entities Enron management assembled. I question Enron’s 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 Enron’s 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 less concerned with the economic impact of their transactions as they were with the financial 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 a fundamental lack of communication and direction from the Board as to who should 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 Enron’s employed accounting techniques were "aggressive" was not communicated clearly enough to the board, who were blinded by its trust in its respected auditors. 7 • The Board did not give enough consideration when making important decisions. They were not really informed nor did they understand the types of transactions Enron 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 its management, which may have contributed to their failure to be more proactive in their 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 management and 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 is reasonable 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 motives of management were not in line with maximizing shareholder value. • The high-powered incentive contracts of Enron’s management highlight more of the costs associated with attempting to align shareholders with management to counter 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 management’s sophisticated techniques for obscuring financial results. 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 management’s actions and compensation than the optimal contracting theory. 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 8 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 firm’s 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 Enron’s 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 management’s expropriation of shareholder’s capital. Highlighted also are management’s 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 Andersen’s 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 management’s 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 9 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 firm’s management and management’s 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 Smith’s 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. 10 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. 11 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 manager’s 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 firm’s 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 investor’s 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. [...]... 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 Enron s stock price was sagging, and two of the SPEs lacked the funds to pay Enron on the hedges Enron creatively... 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,... 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... In June of 1999, Enron again entrenched itself in related-party transactions with the development of LJM-1 and later with LJM-2 Both partnerships were structured in such a way that Fastow was General Partner (and thereby investor) of the entities as well as Enron s manager of the transactions with the entities, an obvious conflict of interest LJM-1 (Cayman) and LJM-2 served two distinct roles They provided... (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 27 Fastow’s familiarity with the Company and. .. 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 Enron s Executive Committee, spoke of. .. connection with the use of SPEs, despite the fact that it is was in both Enron s employees’ interest and in the interest of Enron s auditors to be forthright in their public financial statements The consequences of such a 22 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... define corporate governance from a theoretical standpoint, it is helpful to think of the contract between the owners and management as producing quasirents In defining quasi-rents, consider the example of the purchase of a specialized machine between two parties Once the seller has begun to produce the machine, both the buyer and the seller are in a sense locked into the transaction This is because the. .. compensation for their management of the partnerships at Enron s expense Audit Committee Relationship with Enron and Andersen During Board meetings Andersen auditors briefed the Enron Audit and Compliance Committee members about Enron s current accounting practices, informed them of their novel design, created risk profiles of applied accounting practices, and indicated that because of their unprecedented... to the separation of ownership and management, management, vis-à-vis the firm’s CFO Andrew Fastow and Michael Kopper, was able to expropriate the firm’s 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 . 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 governance and consequently. 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. 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