American energy giant Enron was one of the brightest stars of the 1990s but by late 2001 it had imploded into a black hole, with an accounting scandal that also brought down its auditor, Arthur Andersen. Did no-one see this coming? Were there signs of the company’s impending downfall? What can today’s trustees learn from this? In this article we will look into these questions.
Sherron Watkins, Jeffrey Skilling, and Jeffrey McMahon are sworn to testify before the United States Senate Commerce, Science and Transportation Committee to examine certain issues with respect to the collapse of Enron Corporation.
In the trial that followed the scandal, Kenneth Lay, the CEO and Jeffrey Skilling, the brains behind the accounting setup, claimed that they did not know what was going on. When instructing the jury, Judge Simeon Lake laid out the legal concept of wilful blindness. The bottom line is that ignorance is no excuse; as leader you are still responsible. But let’s start from the beginning to learn what happened.
From Good to Great… to Chapter 11
The deregulation of the gas market in 1985 provided unique opportunities to market participants. That year, Enron was created through a merger of Houston Natural Gas and InterNorth, both relatively small regional companies. Kenneth Lay, a long-term proponent for the de-regulation of energy markets became the CEO and moved the headquarter to Houston. Lay, was well connected, close to the Bush administration and regularly played golf with Bill Clinton. Enron had more than 100 lobbyists in Washington DC and as a result of that political influence, they were able to develop a trading business that remained largely unregulated.
Jeffrey Skilling was hired in 1990 as president of Enron Finance Corporation in charge of trading and the business began to take advantage of the deregulated market. Under his leadership, trading activities drifted from hedging risk to propriety trading, which delivered much more attractive profits, but brought increased risk. When the Securities and Exchange Commission (SEC) approved Enron’s request to apply Mark-to-Market accounting in 1992, Enron became mainly a trading business. To improve Enron’s capital efficiency, Skilling pursued an asset light strategy and began selling off heavy assets, such as power plants and pipelines, unless they provided ‘information’ for the trading activities.
In parallel, Enron had an energy asset construction business, aimed at constructing and managing assets outside the US, providing Enron with an entry point to newly de-regulated markets. One of the first major projects was the financing of the Teesside power plant in the UK, which gave Enron direct access to gas trading in Europe.
In 1997 Enron diversified away from gas and entered the electricity market, buying production, transmission and distribution channels for both in the US and abroad. Unlike gas, electricity could not be stored, so Enron built special peak load plants that could be fired up and used as a physical hedge. Enron’s dominant market position in producing, distributing and trading electricity in a largely unregulated market was heavily exploited to maximise profit. In the context of financial market regulation, Enron’s business practices would probably have been classified as a combination of insider trading and market manipulation.
Encouraged by this success, the business also ventured into trading broadband bandwidth. In January 2000, the firm announced a new broadband strategy, prompting a 25% increase in the share price. Eight months later, the Enron stock had reached an all-time high on $90.56. Nothing seemed impossible for Enron.
Yet just five quarters later, Enron had filed for Chapter 11 bankruptcy protection, 20,000 employees had lost their jobs and, in many cases, their 401(k) pensions. The company’s four defined benefit (DB) pension funds ended up in the Pension Benefit Guaranty Corporation (PBGC). Its auditor, Arthur Andersen had lost its licence to operate. How could a corporate implosion of such scale happen?
Drift in purpose enhanced by a toxic culture
Enron started out as a robust gas utility business whose purpose was to help its customers manage the spot price fluctuations in the newly deregulated market. Enron would typically sign a fixed price contract with its clients and hedge the spot market fluctuations using financial contracts and its own heavy assets.
Once Skilling arrived, the company’s ambitions – and purpose – drifted more towards maximising profit with the shift towards proprietary trading. But the shift to a riskier business model did not stop there as the purpose drift continued, now towards an obsession with share price growth. This drift sealed Enron’s fate long before 2001 through the introduction of creative accounting tricks designed to inflate the stock price which will be discussed in the following section.
The stock price growth was important for three reasons; the various stock option programs were central to the remuneration for management and key employees; in its aggressive expansion, Enron stocks became the currency for buying other companies; and finally, Enron stocks were used as collateral in the creative financial engineering for inflating the stock price.
Surely, not everyone working at Enron could have been blind to what was going on? And if not, why was the drift in purpose not challenged by those working there? One key explanation was the toxic culture that grew out of the HR evaluation model. Each employee was rated in a 360 review by a committee, not their line manager, and those who were rated in the lower quintile risked losing their job. This was a very strong incentive for conforming and a powerful tool for weeding out potential troublemakers.
Within a ten-year period, the drift in purpose and the growth of a toxic culture had become a slippery slope - where the concept of right and wrong was blurred at the highest level and no countervailing power remained inside the organisation.
Cooking the books
For the hedging and trading book, the introduction of mark-to-market accounting was logical. But these practices were ‘creatively’ adapted into other parts of the business, including the capital heavy energy infrastructure projects. The idea was simple; when Enron initiated the construction of a new energy asset, all projected future costs and revenues were calculated as Net Present Value, which was booked as an asset on the balance sheet. This accounting magic was called embedded value and inflated the stock value immediately.
Embedded value was mark-to-assumptions accounting. Arthur Andersson, who came to consider Enron a high-risk client, internally referred to Enron’s mark-to-market accounting as “intelligent gambling”. To dress up the books even further, Enron created hundreds of Special Purpose Entities (SPE) for new projects with additional external equity and bond holders. Enron stocks were provided as collateral in each SPE. This enabled Enron to lower its construction costs and, more importantly, avoid having to consolidate project costs on the balance sheet. In some cases, Enron ended up owning and controlling underlying SPE without consolidating it into their balance sheet. With this last step, Enron had clearly gone beyond the bounds of legal practice.
Enron was building up massive leverage in its balance sheet based on optimistic assumptions. This pumped a lot of air into the Enron balance sheet, inflating the share price. To sustain its growth trajectory, Enron had to initiate even more projects than the previous year. Over time, this became a pyramid game. For each year that passed, Enron became increasingly fragile; when many of the projects did not live up to the optimistic projections, Enron was forced to do massive write downs – ultimately leading to a free fall in the share price as investors were losing their trust in Enron’s balance sheet.
Fool me once, shame on you; Fool me twice…
The Enron scandal provides several examples of wilful blindness in practice and illustrates the challenges of overcoming it. Some are structural, including differences in time-horizon, conflict of interests and creative accounting. Others, such as the gradual drift in purpose and decline of ethical practice, are more difficult to spot. What raises the eyebrows is that the SEC, Rating Institutes, Wall Street analysts, as well as investors, were not able to see through the creative accounting.
Underpinning all this, perhaps the biggest remaining question is how politicians allowed Enron to run an unregulated trading business, one of the driving factors behind the Californian electricity crisis around the turn of the Millennium.
Although most sponsors of DB schemes in the UK are not aggressively growth-oriented firms, there are some important lessons to be learnt from the Enron scandal. Enron’s business and culture shifted dramatically over a 10-year period, demonstrating the pace at which a seemingly robust system can deteriorate. Enron’s risk profile shifted dramatically within the space of a single decade - a short time period in the life of the DB scheme and its members.
Trustees of a pension fund and the management of sponsoring businesses have different responsibilities and time-horizons. It is therefore crucial to understand the legal accounting tricks that can be used to inflate apparent value or conceal a declining underlying business. Keeping up appearances can be done with financial engineering, either by applying leverage and prioritising share buyback or dividends instead of investing in the future or closing the funding gap in the DB scheme. Analysing the strength of the sponsor includes having a view of the long-term strengths of its underlying business and how that business model may change over time as a result of structural market developments.
Conflict of interests
Another casualty of the Enron scandal was Arthur Andersen, which lost its licence to operate based on its involvement and obstruction of justice. Enron was Arthur Andersen’s largest client for both auditing and consulting work and Enron also recruited from Arthur Andersen – creating complex conflict of interests between the company and its auditor, both on a structural level and an employee level.
The different responsibilities and time-horizons of trustees and management of sponsoring businesses renders all trustees’ roles both nuanced and challenging - loyalties can be easily strained, and split – especially when appointments and influence are at stake.
Today, many US public pension funds use expected return when calculating the liabilities, an example of applying embedded value calculations - which can lead to a lot of pain in case assumptions are not ultimately realised.
This is also relevant for UK DB schemes, since there is a degree of judgement and flexibility in the calculation of Technical Provisions. When assuming that the sponsor is financially robust, trustees can rely more on future investment returns to close the funding gap and accept lower cash contributions from their corporate sponsor. A form of wilful blindness could occur where trustees consider their sponsors to be there perpetually and do not question their assumptions as circumstances changes.
One of the challenges with Enron was the lack of external countervailing powers to keep management honest. The auditor was too close and the SEC, Rating Institutes and ultimately the shareholders, did not respond with strong action. Trustees must not rely on the stock market to be the watchdog keeping management honest, especially with the increasing popularity of passive investment strategies.
By focusing on the protection and benefits of members, pension fund trustees can be an important influence in keeping management honest. Through exposure to the sponsoring covenant, pension funds are long-term captive stakeholders. While they cannot vote with their feet as investors, trustees are perfectly positioned to proactively engage with the sponsor, drawing on professional support. The trustees have a responsibility to their members, but keeping the management honest will also benefit other long-term stakeholders.
The Bottom Line
Enron was a canary in the coalmine of what lay ahead for the global economy with the global financial crisis in 2008. The bottom line for trustees is that the world is continuously changing, and sponsoring companies have to adapt. To avoid becoming wilfully blind in this everchanging environment, trustees of DB schemes should not assume that sponsors’ current business model will remain unchanged in perpetuity when navigating their scheme towards the targeted end game. Tools for dealing with wilful blindness will be discussed at the Imagine Conference on Wednesday 12 February 2020.