the fall of enron -...

The Fall of Enron

Paul M Healy and Krishna G Palepu

F rom the start of the 1990s until year-end 1998 Enronrsquos stock rose by311 percent only modestly higher than the rate of growth in the Standardamp Poorrsquos 500 But then the stock soared It increased by 56 percent in 1999

and a further 87 percent in 2000 compared to a 20 percent increase and a10 percent decline for the index during the same years By December 31 2000Enronrsquos stock was priced at $8313 and its market capitalization exceeded $60 bil-lion 70 times earnings and six times book value an indication of the stock marketrsquoshigh expectations about its future prospects Enron was rated the most innovativelarge company in America in Fortune magazinersquos survey of Most Admired CompaniesYet within a year Enronrsquos image was in tatters and its stock price had plummeted nearlyto zero Exhibit 1 lists some of the critical events for Enron between August andDecember 2001mdasha saga of document shredding restatements of earnings regulatoryinvestigations a failed merger and the company ling for bankruptcy

We will assess how governance and incentive problems contributed to Enronrsquos riseand fall A well-functioning capital market creates appropriate linkages of informationincentives and governance between managers and investors This process is supposedto be carried out through a network of intermediaries that include professionalinvestors such as banks mutual funds insurance and venture capital rms informationanalyzers such as nancial analysts and ratings agencies assurance professionals such asexternal auditors and internal governance agents such as corporate boards Theseparties who are themselves subject to incentive and governance problems are regu-lated by a variety of institutions the Securities and Exchange Commission bankregulators and private sector bodies such as the Financial Accounting Standards Boardthe American Institute of Certied Public Accountants and stock exchanges

y Paul M Healy is the James R Williston Professor of Business Administration and KrishnaG Palepu is the Ross Graham Walker Professor of Business Administration both at HarvardBusiness School Boston Massachusetts Their e-mail addresses are phealyhbsedu andkpalepuhbsedu respectively

Journal of Economic PerspectivesmdashVolume 17 Number 2mdashSpring 2003mdashPages 3ndash26

Despite this elaborate corporate governance network Enron was able to attractlarge sums of capital to fund a questionable business model conceal its true perfor-mance through a series of accounting and nancing maneuvers and hype its stock tounsustainable levels While Enron presents an extreme example it is also a useful testcase for potential weaknesses in the US capital market system We believe that theproblems of governance and incentives that emerged at Enron can also surface at manyother rms and may potentially affect the entire capital market We will begin bydiscussing the evolution of Enronrsquos business model in the late 1990s the stresses thatthis business model created for Enronrsquos nancial reporting and how key capital marketintermediaries played a role in the companyrsquos rise and fall

Enronrsquos Business

Kenneth Lay founded Enron in 1985 through the merger of Houston NaturalGas and Internorth two natural gas pipeline companies1 The merged companyowned 37000 miles of intra- and interstate pipelines for transporting natural gas

1 Sources for information on Enronrsquos business include Enron annual reports and 10-Ks for the period1990ndash2000 Tufano (1994) Ghemawat (2000) and Salter Levesque and Ciampa (2002)

Exhibit 1Timeline of Critical Events for Enron in the Period August 2001 to December 2001

Date Event

August 14 2001 Jeff Skilling resigned as CEO citing personal reasons He was replaced byKenneth Lay

Mid- to late August Sherron Watkins an Enron vice president wrote an anonymous letter toKenneth Lay expressing concerns about the rmrsquos accounting Shesubsequently discussed her concerns with James Hecker a former colleagueand audit partner at Andersen who contacted the Enron audit team

October 12 2001 An Arthur Andersen lawyer contacted a senior partner in Houston to remindhim that company policy was not to retain documents that were no longerneeded prompting the shredding of documents

October 16 2001 Enron announces quarterly earnings of $393 million and nonrecurringcharges of $101 billion after tax to re ect asset write-downs primarily forwater and broadband businesses

October 22 2001 The Securities and Exchange Commission opened inquiries into a potentialcon ict of interest between Enron its directors and its special partnerships

November 8 2001 Enron restated its nancials for the prior four years to consolidate partnershiparrangements retroactively Earnings from 1997 to 2000 declined by$591 million and debt for 2000 increased by $658 million

November 9 2001 Enron entered merger agreement with DynegyNovember 28 2001 Major credit rating agencies downgraded Enronrsquos debt to junk bond status

making the rm liable to retire $4 billion of its $13 billion debt Dynegypulled out of the proposed merger

December 2 2001 Enron led for bankruptcy in New York and simultaneously sued Dynegy forbreach of contract

4 Journal of Economic Perspectives

between producers and utilities In the early 1980s most contracts between naturalgas producers and pipelines were ldquotake-or-payrdquo contracts where pipelines agreedeither to purchase a predetermined quantity at a given price or be liable to pay theequivalent amount in case of failure to honor that contract In these contractsprices were typically xed over the contract life or increased with in ation Pipe-lines in turn had similar long-term contracts with local gas distribution companiesor electric utilities to purchase gas from them These contracts assured long-termstability in supply and prices of natural gas

However changes in the regulation of the natural gas market during themid-1980s which deregulated prices and permitted more exible arrangementsbetween producers and pipelines led to an increased use of spot market transac-tions By 1990 75 percent of gas sales were transacted at spot prices rather thanthrough long-term contracts Enron which owned the largest interstate network ofpipelines pro ted from the increased gas supply and exibility resulting from theregulatory changes Its returns on beginning equity in the years 1987 to 1990 whenit was primarily a pipeline business were 142 130 159 and 131 percent respec-tively compared with an estimated equity cost of capital of around 13 percent2

In an attempt to achieve further growth Enron pursued a diversi cationstrategy It began by reaching beyond its pipeline business to become involved innatural gas trading It extended the natural gas model to become a nancial traderand market maker in electric power coal steel paper and pulp water andbroadband ber optic cable capacity It undertook international projects involvingconstruction and management of energy facilities By 2001 Enron had become aconglomerate that owned and operated gas pipelines electricity plants pulp andpaper plants broadband assets and water plants internationally and traded exten-sively in nancial markets for the same products and services A summary ofsegment results for the company in Exhibit 2 shows how dramatically the domestictrading and international businesses grew during the late 1990s3

This growth impressed the capital markets and few asked fundamental ques-tions about the companyrsquos business strategy Could Enronrsquos expertise in owningand managing energy assets and then developing a trading model to help buyersand sellers of energy manage risks be extended to such a broad array of newbusinesses Moreover was Enronrsquos performance sustainable given the limitedbarriers to entry by other rms that wished to mimic its success To have a sense ofhow Enronrsquos business model evolved it is useful to consider in more detail how itsoperations expanded

2 This estimate is based on the average 30-year government bond rate for the period of 865 percent amarket risk premium of 7 percent and an equity beta of 06 The cost of equity capital is calculated usingthe capital asset pricing model 865 percent 1 (06 3 7 percent) 5 1285 percent3 It is dif cult to gure out which parts of Enronrsquos business model were working and which were notsince the company provided minimal segment disclosure In addition its 2000 domestic tradingperformance was affected by the California energy crisis where illegal price manipulation by Enron andothers is being investigated

Paul M Healy and Krishna G Palepu 5

From Regulated Industry to Energy TradingJeff Skilling who subsequently became Enronrsquos CEO in August 2001 envi-

sioned Enronrsquos trading model during a 1988 McKinsey engagement at EnronWhile deregulation generally led to lower prices and increased supply it alsointroduced increased volatility in gas prices Further the standard contract in thismarket allowed suppliers to interrupt gas supply without legal penalties By creatinga natural gas ldquobankrdquo Skilling foresaw that Enron could help both buyers andsuppliers manage these risks effectively The ldquogas bankrdquo would act just as a nancialbanking institution except that it would intermediate between suppliers and buyersof natural gas Enron began offering utilities long-term xed price contracts fornatural gas typically at prices that assumed long-term declines in spot prices

To ensure delivery of these contracts and to reduce exposure to uctuations inspot prices Enron entered into long-term xed price arrangements with producersand used nancial derivatives including swaps forward and future contracts4 Italso began using off-balance sheet nancing vehicles known as Special PurposeEntities to nance many of these transactions

By all accounts the gas trading business was a huge success By 1992 Enron was

4 A swap is a transaction that exchanges one security for another with different characteristics A forwardcontract is for the purchase or sale of a speci c quantity of a good at the current (spot) price but withpayment and delivery at a speci ed future date A futures contract is an agreement to buy a speci edquantity of a good at a particular price on a speci ed future date

Exhibit 2Enron Segment and Stock Market Performance 1993 to 2000

($ millions) 1993 1994 1995 1996 1997 1998 1999 2000

Domestic PipelinesRevenues $1466 $976 $831 $806 $1416 $1849 $2032 $2955Earningsa 382 403 359 570 580 637 685 732

Domestic Trading amp OtherRevenues $6624 $6977 $7269 $10858 $16659 $23668 $28684 $77031Earningsa 316 359 344 332 766 403 592 2014

InternationalRevenues $914 $1380 $1334 $2027 $2945 $6013 $9936 $22898Earningsa 134 189 196 300 (36) 574 722 351

Stock PerformanceEnron 25 5 25 13 24 37 56 87SampP 500 7 22 34 20 31 27 20 210

Major Business Events Teessideopens

Beginselectricitytrading

Beginsconstruc-tion ofDabholplant

AcquiresPortlandGeneralCorp

AcquiresWessexWaterin UK

CreatesEnron-Online

Tradingcontractsdouble

Califenergycrisis

Source Enron 10-Ksa Earnings are measured before subtracting interest and taxesNote The gures reported are as originally announced by the company


the largest merchant of natural gas in North America and the gas trading businessbecame a major contributor to Enronrsquos net income with earnings before interestand taxes of $122 million The creation of the on-line trading model EnronOnlinein November 1999 enabled the company to develop further and extend its abilitiesto negotiate and manage these nancial contracts By the fourth quarter of 2000EnronOnline accounted for almost half of Enronrsquos transactions for all of itsbusiness units and had enabled transactions per commercial person to grow to3084 from 672 in 1999

In the late 1990s Skilling re ned the trading model further He noted thatldquoheavyrdquo assets such as pipelines were not a source of competitive advantage thatwould enable Enron to earn economic rents Skilling argued that the key todominating the trading market was information Enron should therefore onlyhold ldquoheavyrdquo assets if they were useful for generating information Consequentlythe company began divesting ldquoheavyrdquo assets and pursuing an ldquoasset lightrdquo strategyAs a result of this strategy by late 2000 Enron owned 5000 fewer miles of naturalgas pipeline than when the company was founded in 1985mdashbut its gas nancialtransactions represented 20 times its pipeline capacity

Through its extensive network of pipelines Enron was initially well positionedto intermediate between producers and utilities The company had expertise inmanaging the physical logistics of delivering gas to customers through its pipelinesIt quickly developed expertise in managing the trading business risks These risksincluded exposure to general gas spot market volatility exposure to gas price uctuations at particular production and delivery locations (since gas cannot betransported costlessly from one location to another) exposure to reserve risks(since Enron had to ensure that it would have suf cient gas reserves to be able tomeet its commitments to utilities) and the risk that counterparties in its derivativetransactions would default

However whether the company could expect to continue to earn high returnsfrom gas trading was unclear Skilling believed that the major barrier to entry in gastrading was Enronrsquos market knowledge achieved through its dominant marketposition However many other rms were well positioned to challenge Enronrsquosdominance including large gas producers such as Mobil gas marketers such asCoastal and Clearinghouse and nancial rms such as Phibro AIG Chase andCitibank In comparable markets early rents to rst-movers had quickly dissipatedas competitors entered For example in the interest rate swap market marginsdeclined tenfold during the 1990s5 The Internet provided a low-cost platform forexisting or potential competitors to develop energy markets that could competewith EnronOnline

5 In the interest rate swap market two parties agree to make payments to each other based on a notional(or imaginary) quantity of principal The payments by the two parties are based on different interestrates For example one party might make payments based on a xed interest rate while the other makesa payment based on a oating interest rate Thus swaps provide a way of seeking lower-cost nancingand of hedging risk

The Fall of Enron 7

Extending the Natural Gas Trading ModelIn the mid-1990s Enron began extending its gas trading model to other

markets It sought markets with certain characteristics the markets were frag-mented with complex distribution systems the commodity was fungible andpricing was opaque Markets identi ed as targets included electric power coalsteel paper and pulp water and broadband cable capacity Enronrsquos model was toacquire physical capacity in each market and then leverage that investment throughthe creation of more exible pricing structures for market participants using nancial derivatives as a way of managing risks Enron argued that the systems andexpertise it had acquired in gas trading could be leveraged to the new markets Thetrading model therefore was touted as a way for Enron to continue to growspectacularly as it diversi ed from a pure energy rm into a broad-based nancialservices company

The rst market to be developed was electric power To implement its modelin this market Enron had to gure out how to ensure that it could meet commit-ments to provide power in peak periods Unlike natural gas electricity cannot bestored to satisfy peak demand leading to even higher price volatility than in the gasmarket Enron responded to this challenge by constructing ldquopeaking plantsrdquo de-signed to meet short-term peaks in demand

Enron had some successes in applying the gas bank trading model to electric-ity but the viability of the model for some of the other products selected forexpansion was uncertain Would the additional contractual exibility offered byEnron in the gas and electricity markets be as popular in the new markets Furthereach new market posed unique challenges For example while customers could notdistinguish differences in the sources of gas or electricity they cared about andcould observe changes in water quality The challenges of selling long-term con-tracts for broadband cable access included the use of unproven and nonstandard-ized technology dif culties in extending ber optic networks over the ldquolast milerdquointo buildings and excess capacity Finally even if Enron was successful in creatingthese new markets it was unclear whether early rents could be sustained givenpotential competition in each market

International Expansion Energy Asset Construction and ManagementAs Enron expanded beyond the natural gas pipeline business it also reached

beyond US borders Enron International a wholly owned subsidiary of Enron wascreated to construct and manage energy assets outside the United States particu-larly in markets where energy was being deregulated The unitrsquos rst major projectwas the construction of the Teesside electric power plant in the United Kingdomwhich began operation in 1993 Enron subsequently entered contracts to constructand manage projects in Eastern Europe Africa the Middle East India China andCentral and South America These projects represented signi cant investments inthese economies

While the privatization of energy producers and deregulation of energy mar-kets created demand for the management of energy assets outside the UnitedStates Enron faced some distinctive risks in entering these new markets Some of


the international projects were for the construction and management of pipelineswhere Enron had a core competence but many others were not Could thecompanyrsquos core expertise be extended to other types of energy assets such as powerplants Also international diversi cation particularly in developing economiessuch as India and China exposed Enron to political risks For example the Dabholpower project in India represented the single largest foreign direct investmentproject until that time in India and it attracted considerable political oppositionand controversy Given its limited business experience in developing economiesdid Enron have expertise in managing the risk that any returns would be taxed orits asset expropriated after construction of the plant Even if Enron was successfulin the international energy market questions could be raised about whether thecompany could create a sustainable advantage over competitors that later sought toenter the market Many existing players had expertise in managing the construc-tion and operations of power plants

Financial Reporting

Enronrsquos complex business modelmdashreaching across many products includingphysical assets and trading operations and crossing national bordersmdashstretchedthe limits of accounting6 Enron took full advantage of accounting limitationsin managing its earnings and balance sheet to portray a rosy picture of itsperformance

Two sets of issues proved especially problematic First its trading businessinvolved complex long-term contracts Current accounting rules use the presentvalue framework to record these transactions requiring management to makeforecasts of future earnings This approach known as mark-to-market accountingwas central to Enronrsquos income recognition and resulted in its management makingforecasts of energy prices and interest rates well into the future Second Enronrelied extensively on structured nance transactions that involved setting up specialpurpose entities These transactions shared ownership of speci c cash ows andrisks with outside investors and lenders Traditional accounting which focuses onarms-length transactions between independent entities faces challenges in dealingwith such transactions Accounting rule-makers have been debating appropriateaccounting rules for these transactions for several years Meanwhile mechanicalconventions have been used to record these transactions creating a divergencebetween economic reality and accounting numbers

Trading Business and Mark-to-Market AccountingIn Enronrsquos original natural gas business the accounting had been fairly

straightforward in each time period the company listed actual costs of supplyingthe gas and actual revenues received from selling it However Enronrsquos trading

6 The primary source of information on the nancial reporting failures at Enron was Powers Troubhand Winokur (2002)


business adopted mark-to-market accounting which meant that once a long-termcontract was signed the present value of the stream of future in ows under thecontract was recognized as revenues and the present value of the expected costs offul lling the contract were expensed Unrealized gains and losses in the marketvalue of long-term contracts (that were not hedged) were then required to bereported later as part of annual earnings when they occurred

Enronrsquos primary challenge in using mark-to-market accounting was estimatingthe market value of the contracts which in some cases ran as long as 20 yearsIncome was estimated as the present value of net future cash ows even though insome cases there were serious questions about the viability of these contracts andtheir associated costs

For example in July 2000 Enron signed a 20-year agreement with BlockbusterVideo to introduce entertainment on demand to multiple US cities by year-endEnron would store the entertainment and encode and stream the entertainmentover its global broadband network Pilot projects in Portland Seattle and Salt LakeCity were created to stream movies to a few dozen apartments from servers set upin the basement Based on these pilot projects Enron went ahead and recognizedestimated pro ts of more than $110 million from the Blockbuster deal eventhough there were serious questions about technical viability and market demand

In another example Enron entered into a $13 billion 15-year contract tosupply electricity to the Indianapolis company Eli Lilly Enron was able to show thepresent value of the contract reportedly for more than half a billion dollars asrevenues Enron then had to report the present value of the costs of servicing thecontract as an expense However Indiana had not yet deregulated electricityrequiring Enron to predict when Indiana would deregulate and how much impactthis would have on the costs of servicing the contract over the ten years (Krugman2002)

Reporting Issues for Special Purpose EntitiesEnron used special purpose entities to fund or manage risks associated with

speci c assets Special purpose entities are shell rms created by a sponsor butfunded by independent equity investors and debt nancing For example Enronused special purpose entities to fund the acquisition of gas reserves from producersIn return the investors in the special purpose entity received the stream ofrevenues from the sale of the reserves

For nancial reporting purposes a series of rules is used to determine whethera special purpose entity is a separate entity from the sponsor These require that anindependent third-party owner have a substantive equity stake that is ldquoat riskrdquo in thespecial purpose entity which has been interpreted as at least 3 percent of thespecial purpose entityrsquos total debt and equity The independent third-party ownermust also have a controlling (more than 50 percent) nancial interest in the specialpurpose entity If these rules are not satis ed the special purpose entity must beconsolidated with the sponsor rmrsquos business

Enron had used hundreds of special purpose entities by 2001 Many of thesewere used to fund the purchase of forward contracts with gas producers to supply


gas to utilities under long-term xed contracts7 However several controversialspecial purpose entities were designed primarily to achieve nancial reportingobjectives For example in 1997 Enron wanted to buy out a partnerrsquos stake in oneof its many joint ventures However Enron did not want to show any debt from nancing the acquisition or from the joint venture on its balance sheet Chewco aspecial purpose entity that was controlled by an Enron executive and raised debtthat was guaranteed by Enron acquired the joint venture stake for $383 millionThe transaction was structured in such a way that Enron did not have to consolidateChewco or the joint venture into its nancials enabling it effectively to acquire thepartnership interest without recognizing any additional debt on its books Moredetails on Chewco are presented in the Appendix and also in Powers Troubh andWinokur (2002)

Chewco and several other special purpose entities however did more than justskirt accounting rules As Enron revealed in October 2001 they violated accountingstandards that require at least 3 percent of assets to be owned by independentequity investors By ignoring this requirement Enron was able to avoid consolidat-ing these special purpose entities As a result Enronrsquos balance sheet understated itsliabilities and overstated its equity and its earnings On October 16 2001 Enronannounced that restatements to its nancial statements for years 1997 to 2000 tocorrect these violations would reduce earnings for the four-year period by $613 mil-lion (or 23 percent of reported pro ts during the period) increase liabilities at theend of 2000 by $628 million (6 percent of reported liabilities and 55 percent ofreported equity) and reduce equity at the end of 2000 by $12 billion (10 percentof reported equity)

In addition to the accounting failures Enron provided only minimal disclosureon its relations with the special purpose entities The company represented toinvestors that it had hedged downside risk in its own illiquid investments throughtransactions with special purpose entities Yet investors were unaware that thespecial purpose entities were actually using Enronrsquos own stock and nancial guar-antees to carry out these hedges so that Enron was not actually protected fromdownside risk Moreover Enron allowed several key employees including its chief nancial of cer Andrew Fastow to become partners of the special purpose entitiesIn subsequent transactions between the special purpose entities and Enron theseemployees pro ted handsomely raising questions about whether they had ful lledtheir duciary responsibility to Enronrsquos stockholders

Other Accounting ProblemsEnronrsquos accounting problems in late 2001 were compounded by its recogni-

tion that several new businesses were not performing as well as expected InOctober 2001 the company announced a series of asset write-downs includingafter tax charges of $287 million for Azurix the water business acquired in 1998$180 million for broadband investments and $544 million for other investments In

7 See Tufano (1994) for a detailed description of these nancial arrangements

The Fall of Enron 11

total these charges represented 22 percent of Enronrsquos capital expenditures for thethree years 1998 to 2000 In addition on October 5 2001 Enron agreed to sellPortland General Corp the electric power plant it had acquired in 1997 for$19 billion at a loss of $11 billion over the acquisition price These write-offs andlosses raised questions about the viability of Enronrsquos strategy of pursuing its gastrading model in other markets

In summary Enronrsquos gas trading idea was probably a reasonable response tothe opportunities arising out of deregulation However extensions of this idea intoother markets and international expansion were unsuccessful8 Accounting gamesallowed the company to hide this reality for several years Capital markets largelyignored red ags associated with Enronrsquos spectacular reported performance andaided the companyrsquos pursuit of a awed expansion strategy by providing capital ata remarkably low cost Investors seemed willing to assume that Enronrsquos reportedgrowth and pro tability would be sustained far into future despite little economicbasis for such a projection

The market response to the announcements of accounting irregularities andbusiness failures was to halve Enronrsquos stock price and to increase its borrowingcosts For a company that had relied heavily on outside nance to fund its tradingbusinesses and acquisitions the results were equivalent to a run on the bank OnNovember 8 2001 Enron sought to avoid bankruptcy by agreeing to being ac-quired by a smaller competitor Dynergy On November 28 Enronrsquos public debtwas downgraded to junk bond status and Dynergy withdrew from the acquisitionFinally with its stock price at only $026 on December 2 2001 Enron led forbankruptcy

Governance and Intermediation Failures at Enron

How could Enronrsquos problems remain undetected for so long Most of theblame for failing to recognize Enronrsquos problems has been assigned to the rmrsquosauditors Arthur Andersen and to the ldquosell-siderdquo analysts who work for brokerageinvestment banking and research rms and sell or make their research available toretail and professional investors However we hypothesize that the intermediationproblems are deeper than this and affect each of the key players that provided alink between Enronrsquos managers and investors as illustrated in Exhibit 3 On theinformation supply side of the market this includes top management and Enronrsquosaudit committee along with Arthur Andersen On the information demand side itincludes fund managers and nancial regulators along with sell-side analysts Weconsider these parties in turn

8 In this discussion we do not consider pro ts Enron allegedly earned illegally through the manipula-tion of electricity prices in California If these pro ts were excluded Enronrsquos performance would havebeen even worse


Role of Top Management CompensationAs in most other US companies Enronrsquos management was heavily compen-

sated using stock options Heavy use of stock option awards linked to short-termstock price may explain the focus of Enronrsquos management on creating expectationsof rapid growth and its efforts to puff up reported earnings to meet Wall Streetrsquosexpectations In its 2001 proxy statement Enron noted that within 60 days of theproxy date (February 15) the following stock option awards would become exer-cisable 5285542 shares for Kenneth Lay 824038 shares for Jeff Skilling and12611385 shares for all of cers and directors combined On December 31 2000Enron had 96 million shares outstanding under stock option plans almost 13 per-cent of common shares outstanding According to Enronrsquos proxy statement theseawards were likely to be exercised within three years and there was no mention ofany restrictions on subsequent sale of stock acquired

The stated intent of stock options is to align the interests of management withshareholders But most programs award sizable option grants based on short-term

Exhibit 3The Links Between Managers and Investors

ProfessionalInvestors

(Mutual fundsBanks Venture

capital rms

RetailInvestors

InformationAnalyzers(Financial

analysts Ratingagencies)

Information Demand Side

Investmentadvice

$$

$$ Financial statements andbusiness information

Managers

InternalGovernance Agents

(Board Auditcommittee

Internal auditors)

AssuranceProfessionals

(Externalauditors)Information Supply

Side

Standard Setters and Capital Market Regulators(SEC FASB Stock exchanges)


accounting performance and there are typically few requirements for managers tohold stock purchased through option programs for the long term The experienceof Enron along with many other rms in the last few years raises the possibility thatstock compensation programs as currently designed can motivate managers tomake decisions that pump up short-term stock performance but fail to createmedium- or long-term value (Hall and Knox 2002)

Role of Audit CommitteesCorporate audit committees usually meet just a few times during the year and

their members typically have only a modest background in accounting and nanceAs outside directors they rely extensively on information from management as wellas internal and external auditors If management is fraudulent or the auditors failthe audit committee probably wonrsquot be able to detect the problem fast enough

Enronrsquos audit committee had more expertise than many It includedDr Robert Jaedicke of Stanford University a widely respected accounting professorand former dean of Stanford Business School John Mendelsohn president of theUniversity of Texasrsquo M D Anderson Cancer Center Paulo Pereira former presi-dent and chief executive of cer of the State Bank of Rio de Janeiro in Brazil JohnWakeham former UK Secretary of State for Energy Ronnie Chan a Hong Kongbusinessman and Wendy Gramm former chair of US Commodity Futures Trad-ing Commission

But Enronrsquos audit committee seemed to share the common pattern of a fewshort meetings that covered huge amounts of ground For example consider theagenda for Enronrsquos Audit Committee meeting on February 12 2001 The meetinglasted only 85 minutes yet covered a number of important issues including a) areport by Arthur Andersen reviewing Enronrsquos compliance with generally acceptedaccounting standards and internal controls b) a report on the adequacy of reservesand related party transactions c) a report on disclosures relating to litigation risksand contingencies d) a report on the 2000 nancial statements which noted newdisclosures on broadband operations and provided updates on the wholesalebusiness and credit risks e) a review of the Audit and Compliance CommitteeReport f) discussion of a revision in the Audit and Compliance Committee Char-ter g) a report on executive and director use of company aircraft h) a review of the2001 Internal Control Audit Plan which included an overview of key businesstrends an assessment of key business risks and a summary of changes in internalcontrol efforts by businesses for 2001 compared to the period 1998 to 2000 andi) a review of company policy for management communication with analysts andthe impact of Regulation Fair Disclosure9

For most of the above agenda items Enronrsquos Audit Committee was in noposition to second-guess the auditors on technical accounting questions related tothe special purpose entities Nor was it in a position to second-guess the validity oftop management representations However the Audit Committee did not chal-

9 See Findlawcom httpnews ndlawcomlegalnewslitenronindexhtmlminutes


lenge several important transactions that were primarily motivated by accountinggoals was not skeptical about potential con icts in related party transactions anddid not require full disclosure of these transactions (Powers Troubh and Winokur2002)

Role of External AuditorsEnronrsquos auditor Arthur Andersen has been accused of applying lax standards

in their audits because of a con ict of interest over the signi cant consulting feesgenerated by Enron In 2000 Arthur Andersen earned $25 million in audit fees and$27 million in consulting fees It is dif cult to determine whether Andersenrsquos auditproblems at Enron arose from the nancial incentives to retain the company as aconsulting client as an audit client or both However the size of the audit fee aloneis likely to have had an important impact on local partners in their negotiationswith Enronrsquos management Enronrsquos audit fees accounted for roughly 27 percent ofthe audit fees of public clients for Arthur Andersenrsquos Houston of ce

Whether the auditors at Andersen had con icted incentives or whether theylacked the expertise to evaluate nancial complexities adequately they failed toexercise sound business judgment in reviewing transactions that were clearlydesigned for nancial reporting rather than business purposes When the creditrisks at the special purpose entities became clear requiring Enron to take awrite-down the auditors apparently succumbed to pressure from Enronrsquos manage-ment and permitted the company to defer recognizing the charges Internalcontrols at Andersen designed to protect against con icted incentives of localpartners failed For example Andersenrsquos Houston of ce which performed theEnron audit was permitted to overrule critical reviews of Enronrsquos accountingdecisions by Andersenrsquos Practice Partner in Chicago Finally Andersen attemptedto cover up any improprieties in its audit by shredding supporting documents afterinvestigations of Enron by the Securities and Exchange Commission became public

Without making excuses for the Anderson auditors it is useful to see theirbehavior against a backdrop of how the accounting industry has evolved Twomajor changes in the 1970s created substantial pressure for audit rms to cutcosts and seek alternative revenue sources First in the mid-1970s the FederalTrade Commission concerned with a potential oligopoly by the large audit rms required the profession to change its standards to allow audit rms toadvertise and compete aggressively with each other for clients Second legalstandards shifted in the mid-1970s so that investors of companies with account-ing problems no longer had to show that they speci cally relied on questionableaccounting information in making their investment decisions instead theycould assert that they had relied on the stock price itself which has beenaffected by the misleading disclosures (Easterbrook and Fischel 1984) Thischange along with increasing litigiousness dramatically increased the litigationrisks for auditors

Audit rms responded to the new business environment in several ways Theylobbied for mechanical accounting and auditing standards and developed standardoperating procedures to reduce the variability in audits This approach reduced the


cost of audits and provided a defense in the case of litigation But it also meant thatauditors were more likely to view their job narrowly rather than as matters ofbroader business judgment Furthermore while mechanical standards make audit-ing easier they do not necessarily increase corporate transparency10

Audit rms decided that pro t margins would be perpetually thin in a worldof mechanized standardized audits and they responded in two ways One way wasby aggressively pursuing a high-volume strategy and so audit partner compensationand promotion became more closely linked to a cordial relationship with topmanagement that attracted new audit clients and retained existing clients Thismade it dif cult for partners to be effective watchdogs The large audit rms alsoresponded to challenges to their core business by developing new higher-marginhigher-growth consulting services This diversi cation strategy de ected top man-agement energy and partner talent from the audit side of the business to the morepro table consulting part

The Enron debacle dramatizes the problems with a system of mechanicalstandardized audits It has led talented professionals to perceive that the auditprofession is unattractive It has led clients to perceive that audits are a regulatoryobligation not a value added service It has led investors to perceive that auditedreports are not really reliable It has led regulators and the general public toperceive that auditors are beholden to their clients It has not worked as a strategyfor managing litigation risk either as Andersenrsquos legal troubles following the fallof Enron dramatically show

Role of Fund ManagersAt the height of Enronrsquos popularity in late 2000 and early 2001 large

institutional investors owned 60 percent of its stock These included prestigiousmoney management rms such as Janus Capital Corp Barclayrsquos Global Inves-tors Fidelity Management amp Research Putnam Investment Management Amer-ican Express Financial Advisors Smith Barney Asset Management VanguardGroup California Public Employees Retirement Fund Van Kampen Asset Man-agement TIAA-CREF Investment Management Dreyfus Corp Merrill LynchAsset Management Goldman Sachs Asset Management and Morgan StanleyInvestment Management

By the end of 2000 some dissenting voices were speaking up with regard toEnron The Economist (ldquoThe Energetic Messiahrdquo 2000) questioned Enronrsquos perfor-mance and James Chanos a hedge fund manager identi ed problems fromdisclosures on related party transactions involving the rmrsquos senior of cers andinsider trading in late 2000 In November 2000 Chanos shorted the stock and inFebruary 2001 he tipped off a reporter at Fortune Bethany McLean who subse-quently wrote the March article ldquoIs Enron Overpricedrdquo However institutionalownership of Enron continued to exceed 60 percent as late as October 2001 before

1 0 For example Nelson Eliott and Tarpley (2002) show that mechanical accounting rules for structured nance transactions lead to more earnings management


collapsing to around 10 percent in December 2001 after the company announcedits accounting problems

Several reasons have been proposed for why the leading fund managerswere so slow to recognize the problems at Enron they were misled by account-ing statements or by sell-side analysts or the incentives of fund managers to seekout high-quality information were poor Let us consider these explanations inturn

The dif culty with the rst explanationmdashthat fund managers were misled byEnronrsquos aggressive accounting or by sell-side analystsmdashis that the companyrsquos stockprice prior to its dramatic fall was driven by unrealistic expectations of futureperformance even if one assumed that Enronrsquos reported historical performance wasreal Exhibit 4 offers a sense of the performance that Enron would have had toachieve to be worth its peak share price in 2000 The gure is based on applying astandard formula for the valuation of a company that begins with the expectedreturn on the current book value in this year and then incorporates assumptionsabout the growth of book value and the companyrsquos return on equity in future yearsdiscounting these returns back to the present at the expected cost of equity1 1 Toassess the embedded expectations in Enronrsquos stock price begin by assuming thatEnronrsquos cost of equity was 12 percent shown as a horizontal line in Exhibit 41 2 Thelines on the graph showing return on equity and revenue are based on actual dataup until 2000 after that point they are based on what levels would be needed tojustify the stock price of $90 in August 2000 In such a framework one scenario thatwould justify this price would have been for Enron to earn a return on equity of25 percent forever grow revenues from $100 billion to roughly $700 billion in tenyears (a 60 percent compound annual growth rate) and grow revenues by 10 per-cent per year thereafter

These assumptions are highly aggressive For example Enronrsquos actual returnon equity was 18 percent in 1996 25 percent in 1997 125 percent in 1998 and12 percent in 1999 Thus the rm would have had to achieve a dramatic increasein return on equity and sustain it forever The revenue growth needed to justifyEnronrsquos peak stock price would have required a dramatic extension of its businessmodel to new areas As another benchmark for the reasonableness of these expec-tations note the following historical averages for US public companies over theperiod 1979ndash1998 average return on equity of 11 percent a seven-year average

1 1 This approach to valuation is equivalent to the discounted cash ow valuation approach but relies onaccounting numbers instead of cash ows For further details on this approach see Palepu Healy andBernard (2000)1 2 Enron in 2000 was a different company than it was in the early 1990s Therefore in calculating itsequity cost of capital in 2000 we used a beta of 17 This beta represents the average risk for a nancialservices company rather than an energy company because the only way for the company to achieve thegrowth projections was aggressively to grow the nancial services segment of its business rather than itsenergy segment Also to account for the dramatic rise in the stock market as whole in this period weuse a lower risk premium of 4 percent The actual risk free rate at this time was around 5 percentTherefore we estimate Enronrsquos equity cost of capital as 5 percent 1 17 4 percent or approximately12 percent While this number looks very similar to the companyrsquos cost of capital in the earlier timeframe it is based on a different set of assumptions


horizon over which a companyrsquos return on equity reverts to the population meanand an annual revenue growth rate of 46 percent (Palepu Healy and Bernard2000)

Regardless of the accounting issues or the sometimes self-serving reports ofsell-side analysts these sorts of straightforward calculations surely should haveraised questions for the sophisticated fund managers who owned more than half ofEnronrsquos stock right up to October 2001

An alternative explanation is that investment fund managers failed to recog-nize or act on Enronrsquos risks because they had only modest incentives to demandand act on high-quality long-term company analysis As one example index fundsthat do not undertake any fundamental research and instead invest in a balancedportfolio of securities that track a particular index (like the Standard amp Poorrsquos 500)by de nition do not pay attention to fundamental analysis This issue is relevant forEnron since index funds were important owners of Enron stock For example inDecember 2000 Vanguard Group a leading index manager was Enronrsquos tenthlargest institutional investor

But what about non-index fund managers who supposedly do have incentivesto undertake fundamental analysis and to act on it These managers are typicallyrewarded on the basis of their relative performance Flows into and out of a fundeach quarter are driven by its performance relative to comparable funds or indicesWe postulate that this structure leads to herding behavior Consider the calculus ofa fund manager who holds Enron stock but who through long-term fundamental

Exhibit 4Forecasted Return on Equity and Revenues for Enron Consistent with a $90 Stock Price

200

150

100300

200

100

0

400

500

Forecasted

Cost of capital

Actual

600

700

800

50

00

1995

1994

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

250

300

Rev

enue

s($b

illio

ns)

Ret

urn

on

Equ

ity

Return on EquityRevenues

2006

2007

2008

2009

2010

Notes This analysis is based on the following valuation model where V is the value of equity ROEt isexpected return on book equity in period t BVE is the period 0 book value of equity gt is theexpected cumulative growth in book equity from period 0 to t and Re is the expected cost of equityFor further details see Ohlson (1995)

V 5 BVE51 1E~ROE1 2 Re

~1 1 Re1

~E~ROE2 2 Re ~1 1 g1

~1 1 Re2 1~E~ROE3 2 Re ~1 1 g2

~1 1 Re3 1 middot middot middot6


analysis estimates that it is overvalued If the manager reduces the fundrsquos holdingsof Enron and the stock falls in the next quarter the fund will show superior relativeportfolio performance and will attract new capital However if Enron continues toperform well in the next few quarters the fund manager will underperform thebenchmark and capital will ow to other funds In contrast a risk-averse managerwho simply follows the crowd will not be rewarded for foreseeing the problems atEnron but neither will this manager be blamed for a poor investment decisionwhen the stock ultimately crashes since other funds made the same mistake1 3

Given the challenges in being able to time major stock downturns such asEnron we believe most fund managers will simply follow the crowd Their effortswill focus on identifying when other investors are likely to buy or sell stocks ratherthan on their own fundamental analysis This hypothesis explains why so many fundmanagers continued to buy dot-com stocks at the height of the bubble even whenthey were skeptical of the valuations (Palepu 2001) It also explains why so manyfunds rely heavily on sell-side analysts because even if their judgment is biased thesell-side analysts focus primarily on near-term stock performance that is critical tomatching the herd

Role of Sell-Side AnalystsSell-side analysts have received considerable criticism for failing to provide an

earlier warning of problems at Enron On October 31 2001 just two months beforethe company led for bankruptcy the mean analyst recommendation listed on FirstCall (which compiles and distributes analyst recommendations) for Enron was 19out of 5 where 1 is a ldquostrong buyrdquo and 5 is a ldquosellrdquo Even after the accountingproblems had been announced in October 2001 reputable institutions such asLehman Brothers UBS Warburg and Merrill Lynch issued ldquostrong buyrdquo or ldquobuyrdquorecommendations for Enron

Why were analysts so slow to recognize the problems at Enron One popularexplanation that is that many analysts had nancial incentives to recommendEnron to their clients to support their rmsrsquo investment banking deals with EnronInvestment banks earned more than $125 million in underwriting fees from Enronin the period 1998 to 2000 and many of the nancial analysts working at thesebanks received bonuses for their efforts in supporting investment banking

To assess the impact of investment banking services on Enronrsquos sell-sideanalysts we collected their twelve-month target price estimates for the periodJanuary 1 2001 through October 16 2001 when Enron revealed the extent of itsaccounting and business problems Four analysts worked for rms that did not

1 3 Hedge funds which are allowed to sell stocks short have incentives to identify and bet againstovervalued stocks Most mutual funds are prohibited from short sales so they do not have similarincentives Dechow Hutton Meulbroek and Sloan (2001) present a full discussion of this issue Hedgefundsrsquo ability to counter the effect of mutual fund managersrsquo incentives fully however is limited Whenovervaluation persists for a long time short-selling can be a very risky strategy and to be successfulrequires a large capital base and a long horizon Many hedge funds which as a group are much smallerthan mutual funds nd it dif cult to pursue this strategy Instead they tend to sell stocks short onlywhen they anticipate a reversal of price in a relatively short period


provide signi cant investment banking services A G Edwards Bernstein ResearchCommerzbank and PNC Advisors Nine analysts worked for rms that worked onEnron investment banking deals and two analysts worked for rms that didinvestment banking but were unaf liated with Enron Exhibit 5 presents analystsrsquoone-year-ahead forecasts of Enronrsquos stock price de ated by its actual price on theforecast date Three key ndings emerge First consistent with potential con icts ofinterest from investment banking on average analysts that do investment bankingexpected to see twelve-month price appreciation of 54 percent compared with only24 percent for analysts that do not work for investment banks This difference isstatistically signi cant Second price appreciation expected by analysts of invest-ment banks with no current banking ties was as optimistic as for analysts withcurrent banking relationships (62 percent and 53 percent respectively) suggestingthat the con ict of interest is driven by the potential for future business as much ascurrent business itself Third even analysts with no investment banking business atall were subject to optimistic bias indicating that banking con icts alone do notexplain bias in analystsrsquo forecasts and recommendations

The interdependence of sell-side analysts with investment banking business isa relatively recent development Up until 1975 brokerage rms charged xedcommissions for trading and used some of these funds to nance research byin-house sell-side analysts which they distributed free to large institutional clientsIn May 1975 xed commissions were deregulated and began to bring in much lessrevenue leading brokerage houses to a search for other sources of funding forresearch (Strauss 1977) Some banks responded by charging clients directly forresearch However by the early 1990s the earnings of investment banking fromunderwriting initial public offerings and other nancial transactions had becomethe primary source of funds for supporting research

A range of academic research ndings have found evidence that sell-side an-alysts are in uenced by their proximity to investment banking Lin and McNichols(1998a b) Michaely and Womack (1999) and Dechow Hutton and Sloan (2000)show that long-term earnings forecasts and investment recommendations are moreoptimistic for analysts that work for lead underwriter banks Hutton (2002b)provides evidence that selective disclosure by companies together with a desire byanalysts to maintain access to management and to attract investment bankingbusiness to their employers has led to biased earnings forecasts In general thecon ict between research and underwriting has been used to explain a decline insell recommendations by analysts over time and the poor record of analysts thatcovered dot-com stocks

Sell-side analysts faced several other potentially serious con icts that have beenless widely discussed First analysts rely heavily on access to management forldquoinsiderdquo information and feedback on their analysis and research models Manage-ment is less likely to provide access to analysts that are critical of management andnegative about the companyrsquos prospects The selective way that management pro-vided information to favored analysts and to analysts ahead of retail investors gaverise to Regulation Fair Disclosure in October 2000 which required management to


make all material new information available to all investors at the same time14

Another potential con ict arises from sell-side analystsrsquo relationships with institu-tional investors who play an important role in the annual evaluations of analyststhrough their ratings for Institutional Investor magazine analysts that receive All-Starratings typically receive higher bonuses and prestige Relatively little research hasexamined this interaction Are analysts reluctant to downgrade a stock that isowned by key institutional clients Are there differences in recommendations byanalysts whose clients are primarily retail investors rather than institutions

Sell-side analysts do not make their projections in isolation but in a networkof ongoing relationships that include the investment bankers at their rms themanagement of the companies that they cover and the customers who read theirreports

Role of Accounting RegulationMany US accounting standards tend to be mechanical and in exible Clear-

cut rules have some advantages but the downside is that this approach motivates nancial engineering designed speci cally to circumvent these knife-edge rules asis well understood in the tax literature In accounting for some of its special

1 4 Hutton (2002b) examines earnings forecast patterns for rms whose managers actively providedguidance to analysts prior to Regulation Fair Disclosure

Exhibit 5Sell-Side Analystsrsquo One-Year Ahead Price Forecasts for Enron

130

150

Af liated IBNon-IBUnaf liated IB

170

190

210

110

090

070

050192001 2282001 4192001 682001 7282001 9162001

Year

ah

ead

pric

e fo

reca

stc

urre

nt

pric

e

Notes Analystsrsquo price forecasts are made during the period January 1 2001 to October 15 2001 andare de ated by Enronrsquos actual price on the forecast date Analysts are separated into three groups1) those that work for rms that engaged in investment banking activities with Enron (Af liated IB)2) those that work for rms that do investment banking but not with Enron (Unaf liated IB)and 3) those that work for rms that do not do investment banking (Non-IB)Source Investext


purpose entities Enron was able to design transactions that satis ed the letter ofthe law but violated its intent such that the companyrsquos balance sheet did not re ectits nancial risks

The Financial Accounting Standards Board (FASB) had recognized for severalyears that problems existed with the rules for special purpose entities HoweverFASB attempts to operate by forming a consensus between affected groups and ithad not been able to reach consensus on an alternative In setting new accountingstandards the Board solicits input from interested parties and amends its proposalto re ect feedback The Board itself is comprised of representatives of variousaffected groupsmdashauditors managers and the investment communitymdashand newstandards require approval by ve out of seven Board members Finally the Boardrsquosactions are closely scrutinized and at times overruled by the Securities and Ex-change Commission and the political establishment Setting standards through thisprocess can be slow dif cult and political Along with the delay in amending rulesfor special purpose entities the ongoing debate on whether stock options should betreated as a current expense to the rm is another prominent illustration of thepolitical nature of standard setting Moreover when standards are passed as a result ofintensive negotiations they often tend to be highly detailed mechanical and in exible

Responses

Key capital market participants were too late in recognizing the problems atEnron and at many other rms as well in the late 1990s and early 2000s Debateabout a laundry list of possible changes needed to deter future Enron situations hasbeen widespread For example the Securities and Exchange Commission hasproposed independent monitoring of audit rms called for audit rms to sell theirconsulting businesses or to eliminate certain types of consulting with audit clientsand disclosure of analyst involvement and compensation with their rmsrsquo invest-ment banking activities Other proposals have suggested changes in stock optionslike requiring rms to treat options as a current expense imposing restrictions onthe sale of stock by managers until after they leave of ce or requiring topexecutives to return gains made from selling in a market that had been in uencedby fraudulent nancial reporting Many rms are reacting by adding independentmembers to their board of directors and by assuring greater nancial expertise andlonger meetings for their audit committees While these kinds of changes are likelyto be helpful we focus here on some more fundamental changes that are poten-tially needed to address the questions raised in our earlier analysis

From Audit Committees to Transparency CommitteesInvestors want nancial transparency that is adequate information to assess

reliably how a company is being run and what its prospects and risks are But theaudit committeersquos current role is limited to the narrow and technical task ofassuring that the rm is following generally accepted accounting principles ascerti ed by the outside auditors We recommend that the audit committee be


refocused on ensuring that investors have adequate information regarding the rmrsquos economic reality In line with this change in role we propose that thecommittee be renamed the ldquotransparency committeerdquo

In its scrutiny of nancial statements the transparency committee shoulddevote most of its time to assessing the effectiveness of those few policies anddecisions that have the most impact on investorsrsquo perceptions of the company Thegoal should be to help investors and other members of the board of directorsunderstand the rmrsquos value proposition strategy key success factors and risks Forexample a Transparency Committee at Intel would focus disproportionately onproduct innovation and technological changes at Southwest Airlines perhaps oncost controls at Tyco the risk of acquisitions at Conseco the pattern of loan lossesIn questioning the auditors and management the committee should focus on theadequacy of disclosures relating to these key performance indicators so that thepicture painted in the nancial statements re ects the business discussions in theboardroom

A transparency committee is no cure-all In the case of Enron for example atransparency committee probably would not have had any impact on the companyrsquosviolations of accounting rulesmdashthe committee would have continued to rely on theadvice of the external auditors However we believe that a transparency committeewould increase the likelihood that a rmrsquos key business risks are transparent toinvestors In the case of Enron for example it might well have led to moretransparent disclosure with regard to the special purpose entities It would encour-age auditors to go beyond mechanical compliance with accounting rules and toprovide more detail and attention to issues of key importance in the businessFinally a transparency committee that plays a more proactive role with the auditoris likely to help the auditor appreciate that its primary responsibility lies with theboard not with pleasing top management

Rethinking the Auditorrsquos Business ModelMost of the proposals for improved auditing have focused on the potential

con icts between auditing and consulting practices However we believe that audit rms need to rethink their entire business model

Auditors have to realize why they exist in the rst placemdashto help investorsidentify stocks that are good investments and those that are lemons Auditors needto change their strategy from minimizing the costs and legal risks of performingthis taskmdashand trying to increase pro ts in other areas like consultingmdashand insteadfocus on maximizing the value of audits Ultimately this means audits that gobeyond a boilerplate certi cation of narrow conformity with accounting standardsbut allow a more complete re ection of the insights of the auditor on the clientrsquosperformance and risks Under this approach audit rms will be more likely to crafta distinctive value proposition targeting a select segment of clients rather thanattempting to be a one-stop shop for all types of clients

We think that any true reform of the audit profession can only happen whenaudit committees are reformed as well We think that true auditor independencecan only be achieved when auditors see audit committees as their real clients not


top management Moreover incentives inside the audit rms need to encourageaudit professionals to exercise judgment and walk away from clients that donrsquotdeserve their certi cationmdash even when they are big and important

These proposals may appear to subject auditors to increased litigation risk Wehave three answers to this potential concern First all business activities designed tocreate value entail taking risks Well-managed businesses deal with risk throughacquisition of talent right incentives checks and balances and appropriate pricingpolicies We think that audit rms should follow these practices Second rms needto be more willing to walk away from clients that are pursuing nonvalue-creatingbusiness strategies even if there are no accounting disagreements This will reducethe likelihood that audit rms are blamed for pure business failures because theyhave ldquodeep pocketsrdquo Finally we need to rethink the way our system handlesbusiness failures Instead of the approach of responding to business failuresthrough litigation we believe that signi cant failures need to be analyzed by anindependent body of expertsmdashmuch like air crashes are investigated by the FederalAviation Administration If that analysis points to shoddy work by auditors thenhold the auditor accountable But let that determination be made by experts

We believe that auditing is critical to the functioning of the capital marketsbut we also believe that regulators and industry leaders ought to focus on radicallyrepositioning the industry to make it a value-creating player in the economy

An Alternative Environment for Institutional InvestorsFailures in the supply of information attributable to the auditors and the audit

committee are important However they cannot be viewed in isolation There werealso critical failures in the demand for information from sophisticated institutionalinvestors who drove Enronrsquos stock price to very high levels based on unrealisticperformance expectations The ways in which fund managers are compensated forrelative performance which can lead to herd behavior should be rethought Inturn these demand-side phenomena have an important impact on the incentives ofauditors and analysts to invest in high-quality information supply

The case of Enron has illustrated that economists know surprisingly little about theincentives and information problems that arise in the governance and functioning ofcapital market intermediaries and the role these imperfections play in creating unsus-tainable jumps in stock market prices incentives for overly aggressive and even fraud-ulent accounting and more broadly for mismanaged rms While quick xes likeseparating auditors from consultants or sell-side analysts from investment bankers maybe worthwhile we believe that there is a need for a deeper reconsideration of the goalsincentives and interactions of these capital market intermediaries

AppendixEnronrsquos JEDI Joint Venture and Chewco Special Purpose Entity

In 1993 Enron and California Public Employees Retirement System (CalPERS)formed JEDI a joint venture Enron invested $250 million of its own stock into the


joint venture Enron accounted for this investment using the equity method Theequity method is used to record equity investments when one rm acquires 20 per-cent or more of the stock in another the ldquoassociaterdquo company Under the equitymethod the value of the investment is reported at the acquirerrsquos initial cost plus itsshare of any subsequent accumulated pro tslosses reinvested by the associate rm In addition investment income for the acquirer is its share of the associatersquosearnings for the yearquarter (adjusted for any transactions between the two rms) rather than merely any dividend income received from the associate As aresult Enronrsquos share of JEDIrsquos debt was kept off Enronrsquos balance sheet while Enronrecorded its share of JEDIrsquos earnings as equity income

One accounting irregularity that arose from the JEDI joint venture was thatEnron incorrectly included in income from JEDI the appreciation in the value ofEnron stock owned by JEDI which JEDI marked to market value This may havebeen an oversight However when Enronrsquos stock price began to decline Enronspeci cally excluded its share of the unrealized losses from equity income

In 1997 Enron wanted to buy out the CalPERS interest in JEDI However itdid not want to have to consolidate JEDI into Enron since doing so would boostEnronrsquos reported leverage A special purpose entity called Chewco was thereforecreated to acquire the CalPERS investment Chewco funded the purchase price of$383 million as follows a) $240 million of debt from Barclays Bank guaranteed byEnron b) $132 million advanced by JEDI under a revolving credit arrangementc) $01 million equity invested by Michael Kopper an Enron employee whoreported to Andy Fastow Enronrsquos chief nancial of cer and d) $114 millionldquoequity loanrdquo by Barclays Bank structured in such a way as to be recorded as a loanon Barclayrsquos books and as equity by Chewco Barclays also required the equityinvestors to establish ldquocash reservesrdquo of $66 million fully pledged to secure therepayment of the $114 million equity loan To fund this reserve JEDI sold assetsand made a special distribution of $166 million to Chewco

The result of the requirement for cash reserves was that Enron failed to satisfythe rules for nonconsolidation so that Chewco and JEDI should have been con-solidated beginning in November 1997 In addition the transaction potentiallyviolated the spirit of the rules governing special purpose entities since one of theprincipal equity investors was an employee of Enron and therefore arguably notindependent of the company In November 2001 Enron announced that it wouldconsolidate both Chewco and JEDI retroactive to 1997 As a result of this restate-ment its equity at the end of 2000 declined by $814 million and its debt increasedby $628 million

A more detailed discussion of JEDIChewco and of several other prominentspecial purposes entities that were involved in Enronrsquos accounting irregularities can befound in a report from the Special Investigative Committee of the Board of Directorsof Enron Corp (Powers Troubh and Winokur 2002) which can be accessed on theweb at httpnewsndlawcomhdocsdocsenronsicreportindexhtml

y We appreciate comments and suggestions received from Timothy Taylor Brad De LongMichael Waldman Amy Hutton Bob Kaplan Richard Zeckhauser and participants at the


London Business School Accounting Symposium and Columbia Business School AccountingWorkshop We are grateful for research support provided by Chris Allen Jonathan Barnett andBrenda Chang

References

Akerlof George A 1970 ldquoThe Market forlsquoLemonsrsquo Quality Uncertainty and the MarketMechanismrdquo Quarterly Journal of Economics Au-gust 843 pp 488ndash500

Barth James L 1991 The Great Savings andLoan Debacle Washington DC American Enter-prise Institute

Dechow Patricia Amy Hutton and RichardSloan 2000 ldquoThe Relation Between AnalystsrsquoForecasts of Long-Term Earnings Growth andStock Price Performance Following Equity Offer-ingsrdquo Contemporary Accounting Research Spring17 pp 1ndash32

Dechow Patricia Amy Hutton L Meulbroekand Richard Sloan 2001 ldquoShort-Sellers Funda-mental Analysis and Stock Returnsrdquo Journal ofFinancial Economics July 611 pp 77ndash106

Easterbrook Frank H and Daniel R Fischel1984 ldquoMandatory Disclosure and the Protectionof Investorsrdquo Virginia Law Review May 704 pp669ndash716

ldquoThe Energetic Messiah Face Value EnronrsquosEnergetic Inspiration rdquo 2000 The EconomistJune 3

Ghemawat Pankaj 2000 ldquoEnron Entrepre-neurial Energyrdquo Harvard Business School Case9-700-079

Hall Brian J and Thomas A Knox 2002ldquoManaging Option Fragilityrdquo Harvard BusinessSchool Working Paper Series No 02-100

Hutton Amy 2002a ldquoThe Role of Sell-SideAnalysts in the Enron Debaclerdquo Working PaperHarvard Business School

Hutton Amy 2002b ldquoThe Determinants andConsequences of Managerial Earnings GuidancePrior to Regulation Fair Disclosurerdquo WorkingPaper Harvard Business School

Krugman Paul 2002 ldquoCronies in Armsrdquo NewYork Times September 17 op-ed section

Lin H and M McNichols 1998a ldquoUnderwrit-ing Relationships and Analystsrsquo Forecasts andInvestment Recommendationsrdquo Journal of Ac-counting and Economics February 25 pp 101ndash27

Lin H and M McNichols 1998b ldquoAnalystCoverage of Initial Public Offeringsrdquo WorkingPaper Stanford University

McLean Bethany 2001 ldquoIs Enron Over-pricedrdquo Fortune March 5 1435 p 122

Michaely Roni and Kent L Womack 1999ldquoCon icts of Interest and the Credibility of Un-derwriter Analyst Recommendationsrdquo Review ofAccounting Studies 124 pp 653ndash 86

Nelson Mark John Eliott and Robin Tarpley2002 ldquoEvidence from Auditors about Managersrsquoand Auditorsrsquo Earnings-Management DecisionsrdquoAccounting Review Forthcoming

Ohlson James 1995 ldquoEarnings Book Valuesand Dividends in Security Valuationrdquo Contempo-rary Accounting Research 112 pp 661ndash 88

Palepu Krishna 2001 ldquoThe Role of CapitalMarket Intermediaries in the Dot-Com Crash of2000rdquo Harvard Business School Case 9-101-110

Palepu Krishna Paul Healy and Victor Ber-nard 2000 Business Analysis and Valuation UsingFinancial Statements Cincinnati Ohio South-western College Publishing

Powers William C Raymond S Troubh andHerbert S Winokur 2002 ldquoReport of Investiga-tion by the Special Investigative Committee ofthe Board of Directors of Enron Corprdquo

Salter Mal Lynne Levesque and Maria Ci-ampa 2002 ldquoThe Rise and Fall of Enronrdquo Har-vard Business School Case 903-032

Strauss P 1977 ldquoThe Heyday is Over forAnalystsrsquo Compensationrdquo Institutional InvestorOctober p 121

Tufano Peter 1994 ldquoEnron Gas ServicesrdquoHarvard Business School Case 9-294-076


Despite this elaborate corporate governance network Enron was able to attractlarge sums of capital to fund a questionable business model conceal its true perfor-mance through a series of accounting and nancing maneuvers and hype its stock tounsustainable levels While Enron presents an extreme example it is also a useful testcase for potential weaknesses in the US capital market system We believe that theproblems of governance and incentives that emerged at Enron can also surface at manyother rms and may potentially affect the entire capital market We will begin bydiscussing the evolution of Enronrsquos business model in the late 1990s the stresses thatthis business model created for Enronrsquos nancial reporting and how key capital marketintermediaries played a role in the companyrsquos rise and fall

Enronrsquos Business

Kenneth Lay founded Enron in 1985 through the merger of Houston NaturalGas and Internorth two natural gas pipeline companies1 The merged companyowned 37000 miles of intra- and interstate pipelines for transporting natural gas

1 Sources for information on Enronrsquos business include Enron annual reports and 10-Ks for the period1990ndash2000 Tufano (1994) Ghemawat (2000) and Salter Levesque and Ciampa (2002)

Exhibit 1Timeline of Critical Events for Enron in the Period August 2001 to December 2001

Date Event

August 14 2001 Jeff Skilling resigned as CEO citing personal reasons He was replaced byKenneth Lay

Mid- to late August Sherron Watkins an Enron vice president wrote an anonymous letter toKenneth Lay expressing concerns about the rmrsquos accounting Shesubsequently discussed her concerns with James Hecker a former colleagueand audit partner at Andersen who contacted the Enron audit team

October 12 2001 An Arthur Andersen lawyer contacted a senior partner in Houston to remindhim that company policy was not to retain documents that were no longerneeded prompting the shredding of documents

October 16 2001 Enron announces quarterly earnings of $393 million and nonrecurringcharges of $101 billion after tax to re ect asset write-downs primarily forwater and broadband businesses

October 22 2001 The Securities and Exchange Commission opened inquiries into a potentialcon ict of interest between Enron its directors and its special partnerships

November 8 2001 Enron restated its nancials for the prior four years to consolidate partnershiparrangements retroactively Earnings from 1997 to 2000 declined by$591 million and debt for 2000 increased by $658 million

November 9 2001 Enron entered merger agreement with DynegyNovember 28 2001 Major credit rating agencies downgraded Enronrsquos debt to junk bond status

making the rm liable to retire $4 billion of its $13 billion debt Dynegypulled out of the proposed merger

December 2 2001 Enron led for bankruptcy in New York and simultaneously sued Dynegy forbreach of contract














($ millions) 1993 1994 1995 1996 1997 1998 1999 2000










CreatesEnron-Online


Califenergycrisis








The Fall of Enron 7










Financial Reporting




































capital rms

RetailInvestors




Investmentadvice

$$


Managers



Internal auditors)



Side





































200

150

100300

200

100

0

400

500

Forecasted

Cost of capital

Actual

600

700

800

50

00

1995

1994

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

250

300

Rev

enue

s($b

illio

ns)

Ret

urn

on

Equ

ity


2006

2007

2008

2009

2010



~1 1 Re1

~E~ROE2 2 Re ~1 1 g1

~1 1 Re2 1~E~ROE3 2 Re ~1 1 g2























130

150


170

190

210

110

090

070

050192001 2282001 4192001 682001 7282001 9162001

Year

ah

ead

pric

e fo

reca

stc

urre

nt

pric

e





Responses






























References





































($ millions) 1993 1994 1995 1996 1997 1998 1999 2000










CreatesEnron-Online


Califenergycrisis








The Fall of Enron 7










Financial Reporting




































capital rms

RetailInvestors




Investmentadvice

$$


Managers



Internal auditors)



Side





































200

150

100300

200

100

0

400

500

Forecasted

Cost of capital

Actual

600

700

800

50

00

1995

1994

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

250

300

Rev

enue

s($b

illio

ns)

Ret

urn

on

Equ

ity


2006

2007

2008

2009

2010



~1 1 Re1

~E~ROE2 2 Re ~1 1 g1

~1 1 Re2 1~E~ROE3 2 Re ~1 1 g2























130

150


170

190

210

110

090

070

050192001 2282001 4192001 682001 7282001 9162001

Year

ah

ead

pric

e fo

reca

stc

urre

nt

pric

e





Responses






























References






























The Fall of Enron 7










Financial Reporting




































capital rms

RetailInvestors




Investmentadvice

$$


Managers



Internal auditors)



Side





































200

150

100300

200

100

0

400

500

Forecasted

Cost of capital

Actual

600

700

800

50

00

1995

1994

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

250

300

Rev

enue

s($b

illio

ns)

Ret

urn

on

Equ

ity


2006

2007

2008

2009

2010



~1 1 Re1

~E~ROE2 2 Re ~1 1 g1

~1 1 Re2 1~E~ROE3 2 Re ~1 1 g2























130

150


170

190

210

110

090

070

050192001 2282001 4192001 682001 7282001 9162001

Year

ah

ead

pric

e fo

reca

stc

urre

nt

pric

e





Responses






























References


































Financial Reporting




































capital rms

RetailInvestors




Investmentadvice

$$


Managers



Internal auditors)



Side





































200

150

100300

200

100

0

400

500

Forecasted

Cost of capital

Actual

600

700

800

50

00

1995

1994

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

250

300

Rev

enue

s($b

illio

ns)

Ret

urn

on

Equ

ity


2006

2007

2008

2009

2010



~1 1 Re1

~E~ROE2 2 Re ~1 1 g1

~1 1 Re2 1~E~ROE3 2 Re ~1 1 g2























130

150


170

190

210

110

090

070

050192001 2282001 4192001 682001 7282001 9162001

Year

ah

ead

pric

e fo

reca

stc

urre

nt

pric

e





Responses






























References






















































capital rms

RetailInvestors




Investmentadvice

$$


Managers



Internal auditors)



Side





































200

150

100300

200

100

0

400

500

Forecasted

Cost of capital

Actual

600

700

800

50

00

1995

1994

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

250

300

Rev

enue

s($b

illio

ns)

Ret

urn

on

Equ

ity


2006

2007

2008

2009

2010



~1 1 Re1

~E~ROE2 2 Re ~1 1 g1

~1 1 Re2 1~E~ROE3 2 Re ~1 1 g2























130

150


170

190

210

110

090

070

050192001 2282001 4192001 682001 7282001 9162001

Year

ah

ead

pric

e fo

reca

stc

urre

nt

pric

e





Responses






























References



























































200

150

100300

200

100

0

400

500

Forecasted

Cost of capital

Actual

600

700

800

50

00

1995

1994

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

250

300

Rev

enue

s($b

illio

ns)

Ret

urn

on

Equ

ity


2006

2007

2008

2009

2010



~1 1 Re1

~E~ROE2 2 Re ~1 1 g1

~1 1 Re2 1~E~ROE3 2 Re ~1 1 g2























130

150


170

190

210

110

090

070

050192001 2282001 4192001 682001 7282001 9162001

Year

ah

ead

pric

e fo

reca

stc

urre

nt

pric

e





Responses






























References













































130

150


170

190

210

110

090

070

050192001 2282001 4192001 682001 7282001 9162001

Year

ah

ead

pric

e fo

reca

stc

urre

nt

pric

e





Responses






























References



























Responses






























References


















































References

























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