With total assets listed at $60 billion-plus market value and debts worth $31.2 billion, the sudden demise of one of America’s top ten multinationals explains how power, greed, cover-ups, lust for profit and lack of transparency define the transition of corporate America from old economy to the ‘New Economy’.
The collapse was so complex that even the energy giant’s top bosses didn’t understand what was going on. The company dealt in industries as diverse as energy, water, advertising and newsprint. It conducted secret business with its own top executives, and its trading strategies were a mystery to anybody who didn’t simultaneously understand stochastic calculus and the market for the relevant product.
As Peter Coy of the Businessweek points out, Enron’s entire business network was “built in the clouds — brands, intellectual capital, transactional networks and other tricky-to-measure stuff that it will be difficult for the host of creditors to get a piece of in the bankruptcy court”. But more intriguing is the question raised by its fall: can the public depend on auditors?
Formed in the late 1980s by the merger of two gas pipeline firms, Enron’s rise was powered by the deregulation of the energy markets in the 1990s. In 1986, its revenue was 7.6 billion dollars which rose to 101 billion in 2000. Enron, rated at number seven in the Fortune 500 list with operations extending to some 40 countries, and held in high esteem in the financial press, government circles and academia, was a veritable pillar of the so-called “new economy” based on the unfettered operation of the “free market system”. Its demise has, as such, laid bare the rot, not to say the outright corruption, which lies at its heart.
As stated by The New York Times in an editorial,” its name has attained immortality on the Wall Street. Enron is now shorthand for the perfect financial storm... There have been plenty of other once unfathomable implosions on the Wall Street but none perhaps so sudden or of such magnitude.” The NYT concluded, “There is a certain irony that Enron, a champion of deregulation, now becomes a poster child for the need for strong regulation on the Wall Street.”
Enron’s dying process began in October when it disclosed that 1.2 billion dollar of its market value has vanished as a result of “related party” transactions with private partnerships that enriched company insiders. Then it admitted that it had overstated its profits during the last five years by 600 million dollars. The final straw came on November 27 when negotiations on a revised takeover deal by Dynergy, its rival and now rescuer, came down to efforts to find 250 million dollars of Enron assets that could serve as collateral for a new Dynergy cash advance. The message was clear: Even its rescuer is demanding collateral and not finding it. Enron’s stock plummeted from 90 dollars to 26 cents per share.
Enron, over the years, appeared to have become a wildly successful company by creating a new, largely unregulated financial business: energy trading which it ran on credit. The users of energy signed contracts and Enron was to meet obligations months later. In other words, the company became something like a bank which takes depositors’ money and promises to pay it back later. But unlike the actual banks, it had no federal deposit insurance to reassure the customers when rumours began to spread that it was in trouble.
The deregulated trading was a gift from Wendy Gramm, wife of the Texas Republican Senator Phil Gramm, who was the commodities regulator in the first Bush administration. She joined Enron in 1993 just five weeks after the Commodities Futures Trading Commission (which she headed) brought down a ruling exempting energy contracts from regulation.
Deregulation opened up new opportunities for profit, not through new facilities but by buying and selling in the energy market. Enron was more than just a trader — also acting as a broker, arranging a deal between a buyer and a seller. Its activities were not confined to energy sector. Enron moved from trading in gas and electricity to pulp, paper, water and communication bandwidth.
The key to success lay in constant inflow of funds from banks and other financial institutions. But, of late, its debts began to accumulate touching billions of dollars. And to continue to enjoy investors confidence and have more funds, good publicity was needed. The result of the well-organized publicity campaign was: It was named “the most innovative” corporation by Fortune magazine for six years in a row; and the weekly “Economist” of Britain described it the “most successful internet venture of any company in any industry anywhere.”
The company’s greatest asset was its chairman Kenneth Lay’s close friendship with Bush family. It was a major fund-raiser for Bush Sr. in the 1980s. When Bush Jr. became Texas governor in 1994, Lay became head of the Governor’s Business Council. These connections got a big boost when Bush became president this year.
A report in The New York Times on June 3 noted: “At least three top White House advisers involved in drafting President Bush’s energy strategy held stock in Enron or earned fees from the company which lobbied aggressively to shape the administration’s approach to energy issues.” Lay was even expected at one point to become energy secretary but remained a key adviser on policy.
Karl Rove, Bush’s chief political adviser, Lawrence Lindsey, his economics adviser and Lewis Libby, Vice-President Cheney’s chief of staff, all had share-holdings in Enron. Lindsey received 50,000 dollars from Enron in consultancy fees last year. Enron gave 2.4 million dollars to federal candidates in 2000 elections, was among Bush’s biggest donors, spent 4 million dollars on lobbying in Congress and White House in last two years and was able to win over James Baker, Mack Mclarty and Johnny Hanes (of Gore camp) to help push its corporate agenda.
The debris the company’s collapse leaves behind is enormous. Among the worst victims are about 20,000 employees. They lose jobs and also the retirement funds, since many of them had under a plan invested them in the company’s stocks. Banks that gave loans to Enron are key losers. The Citigroup and J.P. Morgan lent a total of 1.6 billion dollars, 540 million of which is unsecured.
The Washington Post in an editorial on December 5 expressed anxiety over “a conflict of interest” that is fast developing at stockbrokers and auditing firms and is undermining transparency and fairness in business practices. In one case, Lehman Brothers, one of the leading financial analysts, rated Enron a “strong buy” even when it was heading towards disaster. It did so because it was in line to earn a large fee for advising on the takeover of Enron that later fell through.
Similarly, the auditors are supposed to serve the investors by certifying the accuracy of companies’ financial statements. But they also earn by charging consulting fees when they advise companies on management issues. The desire to win consulting contracts makes them agree to cover up “bad health” of the companies’ finances. Enron’s auditor, Arthur Andersen, earned 27 million dollars in consulting fees from the company last year and 25 million dollars for auditing the books, and, hence, some of the company’s dubious business in partnerships went unreported on the balance sheet.
According to David S. Hizenrath of The Washington Post, the number of corporations retracting and correcting earning reports has doubled in the past three years to 233. Major accounting firms are known to have disregarded glaring book-keeping problems at companies such as Rite Aid Corp., Xerox Corp., Sunbeam Corp., and MicroStrategy Inc. Financial fraud has cost investors over 100 billion dollars in last six years. The US accounting industry, which was a role-model for the world, has changed markedly. Known as the “Big Five” — Arthur Andersen, Deloitt & Touche, Ernst & Young, KPMG and Pricewaterhouse Coopers — now do business in a manner which is at odds with accounting industry’s ‘public watchdog’ mission.
For instance, a report published in The Washington Post on December 5 points out that:
(1) Major firms often make more money from selling advice to clients than they do from auditing their books. They help businesses pick computer systems, lobby for tax breaks, even evaluate takeover targets.
(2) Auditors frequently leave their watchdog positions for jobs at the companies they audit. This encourages them to make improper compromises.
(3) When things go wrong, audit firms decline to answer for their work, invoking client confidentiality.
(4) Since the fees the companies pay their auditors are often set in advance, the audit firms usually send inexperienced staff to check records.
Fees for non-audit services often exceed those for audits. For instance, KPMG billed Motorola Inc. 3.9 million dollars for auditing but 62.3 million for other services. Ernst & Young billed Sprint Corp. 2.5 million for auditing but 63.8 million for other services. AT&T Corp. paid Pricewaterhouse Cooper 7.9 million for auditing and 48.4 million for other services.
The New York Times says: “Arthur Andersen’s failure to uncover flawed accounting by Enron or to forcibly question some of the company’s shadier transactions, raises serious concerns about auditors’ commitment to be sufficiently diligent in reviewing the actions of the major companies.”
But The Washington Post has rightly warned: “Without objective auditing, there will be more and more Enrons and more and more investors, lenders and employees who get unfairly burned.”