Laws and rules do not stop scandals, principles of ethical behaviour do
Enron was a pioneer of `mark to market' basis of accounting and took the principles of hedges and structured financing through special purpose vehicles to a different realm.
Kenneth Lay died on July 6, 2006, at the age of 64. Ken Lay, as he was known, founded Enron and turned it into the seventh largest company in the US with a revenue of over $100 billion in 2001, significantly larger than the annual GDP of some of the countries in Asia and Africa. Lay faced the prospect of spending the rest of his life in prison after a Houston court found him guilty in May of conspiring to inflate Enron's share price and actively misleading shareholders for personal gains. The sentencing was to happen in September.
Ken Lay's successor in 2001, Jeffrey Skilling, a graduate of Harvard Business School, had worked for McKinsey & Co., the legendary consulting firm. According to Tom Peters, the management guru, who worked with him in McKinsey, `Skilling could argue out God'. Such was the talent working for Enron.
Among `most admired'
Through the 1990s, Enron had earned a reputation as a company which had some of the best human resource and innovative business models. Italso had `best in class' risk and control processes, which had over 150 people evaluating both financial and non-financial risks to Enron.
Embodied in the control structure was Enron's Code of Ethics, a 64-page document that outlined ethical behaviour. All employees needed to certify in writing their compliance with the Code. This was way before Sarbanes-Oxley became an Act and the control processes of Enron were way beyond what SoX would have considered adequate.
Growth and innovation driving decline
In 1995, 40 per cent of Enron's earnings came from businesses that did not exist 10 years back and it expected that in the next five years, 40 per cent of the company's earnings will come from businesses that did not exist five years ago.
From an electricity generation and distribution company, between 1994 and 2001, Enron was trading in currency, weather, derivatives, emission, water distribution, Internet and broadband, pulp and paper, coal, plastics, etc., along with acquisitions or green-field projects in the UK, Brazil, Scandinavia, and India (Dabhol).
Enron was often dealing with commodities weather, energy, emissions and complex swap derivatives where there was no established public market to set prices. Traders were required to estimate the direction of prices to value the deal in the present. Of course, longer the timeframe, the greater the subjectivity required in estimating prices and values. Some traders reportedly took advantage of this subjectivity to set high curves and even fabricated outcomes to establish higher values so that they could report as profits immediately and earn the bonus.
The drive to show performance, real or cooked up, ran through the whole fabric of the company. All controls and processes got confined to paper and anything under the guise of a business call could run down all sane checks and balances.
A culture of rapid and compulsive innovation and creating something new, even when it was not required, led to the downfall of Enron.
Earnings fraud and deception
Enron restated its accounts from 1997 to 2000 because of accounting errors, mainly from the off-balance-sheet transactions. The restatements included an overstatement of net income by $586 and understatement of loans by $711 million, which is small change compared to WorldCom's restatement of $3.8 billion for only five consecutive quarters.
Enron was a pioneer of "mark to market" basis of accounting and took the principles of hedges and structured financing through special purpose vehicles (SPVs) to a different realm.
The company used SPVs owned by Enron employees and senior management to enter into hedging transactions with Enron. Profits from such transactions were akin to "selling to yourself" as Enron owned both the entities. These profits were recognised in the books of Enron and loans were taken "off balance-sheet" to finance them. Complex structures were built to give this an appearance of independence from Enron.
The huge loans Enron had taken to finance these transactions had an interest rate or payment terms that were linked to the company's share price. If the share price fell below investment grade, the lenders would recall the loans or the interest rates would become punitive. This forced aggressive earnings fabrication to keep the share price afloat and once the restatement happened, the share price came crashing down and loans were recalled. Enron filed for bankruptcy, and mayhem followed.
Did this end the scandals?
The fear following the scandals and low levels of tolerance for fraud have not induced company managements to stay clean. Parmalat, Ahhold and, recently, Refco, happened after Enron and on a much bigger scale too.
Laws and rules do not stop scandals; principles of ethical behaviour do. In India, we have companies that for years have beaten their earnings estimates growth each quarter over 50 quarters and have given earnings guidance with a band of 10-15 per cent tolerance. For a large part of India Inc., corporate governance is a fashionable statement in public forums and is intended for someone else to follow. Corporate India boasts of world-class processes and controls and rarely have instances of corporate scandals - no CEO/CFO in 2006 has yet given a qualified opinion on the controls under Clause 49. We have not heard any significant rumblings from Indian companies about efforts or costs involved in complying with Clause 49, which borrows heavily from SoX. In the US, the compliance costs for SoX ran into millions of dollars and about 12 per cent of the listed companies failed the compliance tests.
Either we live in a perfect world or is it a lull before the storm?
Kshama V. Kaushik
(The authors are chartered accountants.)