Executive compensation practices and policy implications

Business

The Ethics of Executive Compensation:

What are the Lessons of ENRON

Corporations have been in the news a lot lately - and not necessarily for the best of reasons. Corporate scandal after corporate scandal has caused many in the public to take a closer look at just what it is that is going on in America's boardrooms. Companies like Enron, WorldCom, Global Crossing, and others have gone belly up while under the not so tender care of greedy chief executive officers. In the case of Enron, rank and file employees lost billions when the corporate pension fund simply collapsed. Apparently, the business giant was not worth as much as people thought. Yet even more galling than the discovery of endemic malfeasance and gross financial mismanagement, was the realization that what had happened to Enron was part of a larger pattern. Something was very wrong with corporate America. CEO's were raking in millions from corporate benefits and incentives packages. Company officers frequently helped themselves to huge amounts of judiciously manipulated stocks... And then sold just before the inevitable disaster. And while those at the top were enjoying this "corporate feeding frenzy," many at the bottom, and in the middle, were either being laid off, or outsourced; their desperately needed health care and pension packages slashed to the bone, or rendered worthless. The rulers of America's corporate kingdom had raised themselves so far above the level of their employees, that it seemed as if they were no longer bound by the same rules. At the top, it was anything goes; anything you can get away with; anything that will make money. The sudden collapse of Enron was a rude awakening for most Americans. The debacle forced both ordinary citizens and their political representatives to step back, and take a long, hard look at precisely what had been happening behind all those closed doors. The fall of Enron was the end of an era.

Looking back, the 1990s appeared a time of great promise. New technologies - in particular the Internet - were taking America and the world by storm. Experts spoke of a worldwide web that would revolutionize society.

The Internet would change the way companies did business. The possibilities were endless... And so too were the opportunities for making huge amounts of money. Enron was but one of many innovative, high-tech corporations that stood poised to reap the profits of the new age.

Prior to the boom, Enron had been a small, local pipeline operator. It was little know outside of Texas.

In the last decade of the Twentieth Century, Enron became the classic example of an American success story. Its management team made skilful use of new trends and technologies. Enron quickly became one of the world's largest private generators and suppliers of power.

The corporation's success was based largely on the work of Jeffrey Skilling, whom Ken Lay hired in 1985. Skilling's great contribution was to apply his financial training to create an entirely new field of operation, one that would take advantage of the recently-passed deregulation of the oil and gas industry.

The young consultant arranged to turn the fledgling company into what was, in effect, a "bank" that handled energy. Energy would be bought, sold, and distributed by Lay's company, with Enron guaranteeing the price and supply.

It was a fantastic new concept.

Enron did all it could to cultivate an upstanding public image. In 1997, the energy supplier was one of a small number of companies each of which donated more than one million dollars to the Nature Conservancy.

In regard to the Kyoto Accords that were being negotiated at this time, Enron planned to benefit in two ways. By supporting the Accords, Enron was placing itself on the good side of the environmentalist public, while at the same time endorsing a document that severely limited the use of coal in energy production. Since Enron dealt only in natural gas, coal would have been competition.

Though a praiseworthy idea at the time, the company's willingness to bend regulations to its own purposes might have given cause for alarm. Ken Lay and Jeff Skilling were not only innovative, but they were also increasingly creative when it came to figuring out ways to make money, and to expand Enron's horizons. The up-and-coming energy supplier also made sure to enlist the aid of well-placed "friends" in Washington. Former Secretary of State, James a. Baker III, and Robert Mosbacher, a former Secretary of Commerce, were among the notables involved in the Texas Corporation's rise to prominence.

Lawrence Lindsey, the president's top economic adviser, received $50,000 from Enron in 2000 for consulting fees, and Karl Rove, senior adviser to the president, sold "up to $250,000" in Enron stock to avoid a conflict of interest. Army Secretary and newly named Pentagon liaison to the Homeland Security Office Thomas White was vice chairman of Enron Energy Services in charge of commodity and capital management, among other things, and a member of Enron's executive committee and CEO for Enron Operations Corp. Sen. Phil Gramm (R-Texas), former chairman of the Senate Banking Committee, can claim Enron as his 12th-largest contributor during the same time that his wife, Wendy, who has been nicknamed "the Margaret Thatcher of financial deregulation," sat on Enron's board. She also was on Enron's independent audit committee.

Although Enron politics leaned to the right, it was during the Clinton administration that the Export-Import Bank (which is supported by taxpayer funds) subsidized Enron to the tune of nearly $630 million.

Connections can be useful!

As stated above, Jeff Skilling's master stroke to operate Enron as though it were a bank. This philosophy extended to all aspects of the operation. While shares of gas were bought, sold, and redeemed, the corporation itself branched out into the world of high finance. Enron made considerable use of Special Purpose Entities, or SPE's.

An SPE is an entity that works with a corporation for the express purpose of carrying out some aspect of that corporation's business. It is a legal, contractual arrangement that helps to ensure liquidity, guarantees financing, or protects the contracting party from the demands of creditors.

In effect, the contracting party is leasing back the services of the SPE. SPE's can also assist corporations that are seeking to invest in the stock or bond markets. Again, liquidity is guaranteed, and the contracting corporation is cushioned against the sudden shocks of trading, or against any direct and immediate loss to its balance sheet.

Companies also use SPEs to access capital markets and manage risk. For example, an SPE might issue debt or equity, using the proceeds to acquire financial instruments (such as home mortgages) from its sponsor. Such a transfer of financial assets, if it qualifies as a sale or purchase, lowers the sponsor's cost of capital, because it isolates the assets from the risk of sponsor bankruptcy. Loan underwriters and credit-rating agencies often require business entities involved in synthetic leasing and commercial mortgage-backed securities to be SPEs. Furthermore, the transferor generally derives a tax advantage because the SPE is a passthrough entity that does not pay its own taxes.

As can be seen, the SPE is a wonderful accounting tool, but like any "magic" formula, it can easily be misused. The numerous subsidiary entities that become attached to the parent company can come dangerously close to being little more than fronts for less-savory business practices. Also, the more elaborate the accounting methods employed, the greater the chance of error... purposeful or accidental.

The American Public was soon to discover Enron's bag of tricks - some dirtier than others. In 2001, Sharon Watkins, a company vice-president informed Ken Lay that something was very wrong with the corporation's accounting system - "the numbers just didn't add up."

Enron had clawed its way up the corporate ladder by engaging in what was essentially an exceedingly risky venture. By offering to guarantee future prices in the natural gas market, the Corporation was taking on a potentially enormous financial burden. Such an enterprise works well only when the company can regularly purchase its shares of fuel at a lower cost than that for which it later sells them. Furthermore, it requires quite a considerable amount of capital - just in case the corporation needs to cover any shortfall in sales, or any sudden rise in price. Enron played an even more dangerous game. During its initial expansion phase in the late 1980s and early 1990s, the company had assumed a huge debt: Beyond this already sizable amount,

It used SPEs to borrow funds directly from outside lenders, often supplying its own credit and stock guarantees. The use of these SPEs included many aspects of Enron's business: synthetic lease transactions; sales to SPEs of "financial assets" (i.e., debt or equity interests that Enron owned); sales of Enron stock and contracts to "hedging" SPEs in return for Enron stock; and transfers of other assets to entities that had limited outside equity.

By cleverly moving assets from one entity to another, Enron was able to mask its losses. Removing losses from the company's books made the main corporation look more attractive. Enron appeared to be operating at a profit; a key factor in the valuation of any company's stock. By virtue of this "success," Enron was able to raise even more money for more investments.

The architects of all this "growth" profited accordingly. Ken Lay and his associates held large amounts of exceedingly valuable and overvalued stock. When Enron's cheating was finally exposed, it became painfully apparent to what extent Ken Lay, Jeff Skilling, and other Enron executives had been making vast sums of money on the backs of gullible workforce, and a gullible public:

The "Enron Nine" (if we may call them that) are J.P. Morgan Chase, Citigroup, Credit Suisse First Boston, Canadian Imperial Bank of Commerce, Bank of America, Merrill Lynch, Barclays, Deutsche Bank and Lehman Brothers. These financial institutions collaborated with the now-bankrupt energy company in its financial sleight of hand -- the deals that enabled Enron to inflate its profits, conceal its burgeoning debts and push its stock price higher and higher. Together and individually, the banks and brokerages raised at least $6 billion for Enron through the debt or stock issues sold to unsuspecting investors from 1996 through 2001, when the Enron illusion finally expired.

The participation of some of the world's leading financial institution in the Enron debacle guaranteed that the Corporation's fall would have global implications. A deluded public would finally look behind the facade.

The willingness of so many large corporations to "rip off" investors came as a shock to many. Investors and consumers had been unaware of the tremendous amount of activity going on behind the scenes at many large corporations:

Market manipulation, discrimination, pressure tactics and collusion all thrive in an environment of unequally distributed information. One can argue that the market will take care of abusive infomediaries by robbing them of public trust and thus their clientele. This presumes that we will have a chance to find out about such abuses.

Enron exposed a fact that had already been known to many Americans albeit in a different field. How attractive is a Hollywood starlet without her makeup? Ken Lay and Jeff Skilling - and a host of other corporate "leaders" - proved that you can dress up anything. All you have to do is prevent people from ever catching sight of the true reality. Unfortunately, trust consist of more than simply the ability to detect whether one has been told the "whole truth, and nothing but the truth." Business is built on trust. The ability to raise funds in the stock market depends on the public's belief in the "good faith" of the corporation that is issuing the stock. If a corporation lies about its finances this quarter, what about last quarter? Or next quarter? If a company lost certain funds, where did they go? The trust of the public, once broken, has a catastrophic effect on a corporation's future prospects. Enron lost something very valuable, but it also gained something even less valuable - corporate notoriety.