The Enron Affair EMBA 21 Program, 2003 Prof. L.J. Brooks

L.J. Brooks, Rotman School of Management, University of Toronto2 Overview Management was: out of control, and engaged in self-dealing manipulating transactions & financial reports Company imploded - Chap. 11 in Dec 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 Toronto3 Enron Stock Chart Source: investor.com Weekly Prices

L.J. Brooks, Rotman School of Management, University of Toronto4 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 Toronto5 Enron’s Income (IBIT): Income Before Interest, Minority Interest and Income Taxes Transport & distribution ($ mil.) Trans. Services Portland General Wholesale Services 2,260 1, Retail Energy Services 165 (68) (119) Broadband Services (60) Exploration & prod Corporate and other (615) (4) (32) IBIT 2,482 1,995 1,582

L.J. Brooks, Rotman School of Management, University of Toronto6 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 Toronto7 Enron’s Financial Data Revenues(in Billions) Operating income (Millions) 1, ,378 IBIT 2,482 1,995 1,582 Net Income before Cumulative Accounting Changes 979 1, Net Income EPS (in dollars) - basic diluted

L.J. Brooks, Rotman School of Management, University of Toronto8 Enron’s Financial Data Current assets(Billions) Investments, other Property, plant, equip, net Total Assets Current liabilities Long-term Debt Deferred credits and other Shareholders’ Equity Total Liab. & Shareholders’ Equity

L.J. Brooks, Rotman School of Management, University of Toronto9 Enron’s Changing Risk Profile Early By Risk 1990’s 2000 Level Pipelines, distribution networks Low Retail energy Low Power generation Low Oil and gas exploration Med. Alternative energy M/H Hedging transactions High Commodity trading transactions High Broadband optical fiber networks V. High Related party transact. (SPEs/Partnerships) ???

L.J. Brooks, Rotman School of Management, University of Toronto10 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 Toronto11 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 Toronto12 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 Toronto13 Enron’s Governance Structure Was Short Circuited Board Ken Lay: Chair; Co-chair ZZZ Audit, Compensation Cees. Management Lay, Skilling: CEO Fastow, CFO; Koppers Causey, CAO; Buy, CRO Watkins; Kaminsky; McMahon Company Policies Code of Conduct Internal Audit ? Whistleblowers ? Auditor Arthur Andersen Outside Law Firm Consultant: Arthur Andersen Missing Suspended Compliance Guidance Finan. Reports SPEs © L. Brooks

L.J. Brooks, Rotman School of Management, University of Toronto14 Enron’s Governance Failure Begins 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 Toronto15 Chewco/JEDI Kopper/DodsonDodson LP/GP Big/Little SONR River $11.4 GPLP $11.4 ENRON Chewco $132 LP Barclays GP $240 JEDI $240 + $ = $383 © I. Wiecek 3% Calculation

L.J. Brooks, Rotman School of Management, University of Toronto16 Select Enron SPEs PurposeIssues Chewco/JEDI Syndicated investment Off balance sheet liabilities ($628 million), revenues recognized early LJM Provided market for 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 Toronto17 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 Toronto18 Partial Impact Payments to Fastow & helpers Invest._ ReturnOther Fastow $25,000 $4.5 mil in 2 mo. $30 mil+stock options+ Koppers 125, mil (incl. $2 mil in fees friend) 2 others 5,8001 mil Manipulated transactions in Q3 & Q4, 1999 Asset sales, plus 1 hedge $229 profit of $570 before tax and 549 after tax (~50%)

L.J. Brooks, Rotman School of Management, University of Toronto19 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 Toronto20 Stock Proceeds, 10/98 to 11/01 Lou PalChairman, Enron Accelerator$353.7 mill. Ken LayChairman Rebecca Mark-Jusbasche Director 79.5 Ken HarrisonDirector, Portland General Electrics 75.2 Kenneth RiceChairman, Enron Broadband 72.8 Jeffrey SkillingDirector (former CEO) 66.9 Mark FrevertVice Chairman 50.3 Stanley HortonGlobal Chairman 45.5 Joseph SuttonVice Chairman 40.1 J. Clifford BaxterVice Chairman 35.2 Joseph HircoCEO, Enron Broadband 35.2 Andrew FastowChief Financial Officer 30.5 Source: The Washington Post Company, January 27, 2002, A10.

L.J. Brooks, Rotman School of Management, University of Toronto21 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 Toronto22 Arthur Andersen’s Troubles Losses to Job AA Client Problem Missed, Date Shareholders Losses Fine WorldCom $4.3 billion overstatement of earnings, announced on June 25, 2002 $179.3 billion 17,000N.A. Enron Inflation of income, assets, etc., Bankrupt Dec. 2, 2001 $66.4 billion 6,100N.A. Global Candidate for bankruptcy Crossing $26.6 billion 8,700 Waste Overstatement of income Management by $1.1 billion, $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 Toronto23 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, 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 Toronto24 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 Toronto25 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 Toronto26 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 Toronto27 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 Toronto28 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 Toronto29 New Governance Issues For 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,…

L.J. Brooks, Rotman School of Management, University of Toronto30 Enron Case Discussion Group discussion: What ethical problems caused the Enron fiasco? Who was responsible? How could the problems have been prevented? Class discussion and debrief