Stage of Impact with reference to Enron

When a company suffers from governance problems their impact might be far reaching or temporary but they certainly hamper the corporate operations. We will first discuss various stages of impact on corporate operations with reference to Enron.

First Stage Impact: Reputational Damage

The initial impact of any governance problem generally centers on reputational damage. When difficulties or errors become known board of directors or executive managers are required, or advised, to disclose them publicly. This typically leads to additional coverage by financial press, credit rating analysts and sell-side equity analysts, who attempt to interpret the information and its potential impact on corporate operations. Advanced technology and communication means information circulates very quickly. Regardless of the specific nature of the problem, a firm is likely to suffer some level of reputational damage; no stakeholder likes to receive bad news about a company, and the specter of uncertainty is likely to create a negative perception. The degree of reputational damage is generally directly related to he severity of the problem. As noted, relatively minor-governance related problems, such as modest earning restatements often lead to only short lived negative perceptions. More severe problems mean greater reputational damage. Today, it has become very important for a company, to see that the press does not portray it as company in doldrums as the small shareholders who only have interest in the share price fully depend on the press to know the financial status of the company.

Some firms can weather reputational damage and limit problems to the first stage if they have a crisis management program that allows them to react aggressively and proactively to the problem before significant loss of confidence develops.

If a company can prevent erosion of confidence it preserves its liquidity, and with sufficient liquidity it can remain a going concern until it can deal with broader governance issues. Company directors and executives that are viewed by the market place as being in command of the problem, providing necessary assurance to a nervous body of stakeholders, buy themselves time and liquidity. Both are vital in order to avoid broader financial distress.

Enron in this stage

In early 2001, Enron's problems started mounting: the Internet and telecom bubble burst, calling into question the firm's aggressive and expensive expansion into the broadband sector. With a slowing economy and sliding stock market, Enron's own stock price started falling, triggering financial obligations that ultimately proved fatal.

In August 2001 CEO Skilling left the company for ‘personal reasons' unsettling the investors even further. Former CEO Lay returned to his old role (retaining the board chair as well). While this was under way whistle blowers within the firm- aware of widespread financial improprieties – were attempting to convey information to the board of directors; one employee, Walkins, was finally successful in alerting the board of directors that all was not well, but all this took time in a situation when time was precious.

Second Stage Impact: Early financial problems

When governance problems are more severe, or directors and executives fail to contain reputational damage through a crisis management program, a company enters a more difficult phase. A firm's financial operations begin to suffer noticeably during the second stage. Depending on the nature of the problem, industry, company and market cycle this can take different forms, but three of them are certain: a decline in share price, change in supplier and/or creditor relationships, and decrease in liquidity.

# Decline in share price--Since the stock price depicts the discounted expected economic value, any problem that threatens value will become evident through a falling stock price. Investors generally and institutional investors specifically, are often quick to react to negative news, and can quickly drive prices down. Just how long the stock price remains depressed is a function of the actual or perceived severity of the problem and the ability of directors and executives to manage the crisis.

# Change in supplier and creditor relationship- Difficulties related to supplier and trade creditor relationships may appear. It these stakeholders believe that a client has a problem that might ultimately lead to greater financial distress, they might change dealing terms in order to protect themselves. For instance, if a supplier normally requires net payment on invoices within 30 days, it might shorten the time frame to 15 days; if a trade creditor normally lends short-term funds on an unsecured basis it might now require collateral. These changes, designed to protect their own financial interests, might be driven by what is, hopefully, only a temporary loss of confidence; and the action, while disappointing to the company, cannot be unexpected: no party likes to be surprised by negative news.

# Decrease in Liquidity- Liquidity risk is the single most financial difficulty. In fact, liquidity risk, or the risk of being unable to sell assets or rise funding without incurring a significant cost, is one of the most critical risk facing any firm. It is common to consider liquidity in the form of asset liquidity risk, or the risk of loss arising from an inability to sell assets at, or near, their carrying value (and then using proceeds to fund operations), and funding liquidity risk, or the risk of loss arising from an inability to roll over existing funding or obtain new funding without paying a large cost. In some instances the join together to create particularly significant problems: inability to raise new funds leads to forced assets sales at distressed levels, resulting in insufficient proceeds to repay other maturing liabilities, requiring further asset sales, and so forth.[1]

A company survives by having access to enough liquidity to cover it s daily operations( and, in the prudently managed firm, an extra buffer to protect against any possible surprise or crisis, including those arriving from governance problems). If a company cannot manage its liquidity position it will soon experience a funding liquidity spiral- where the short-term creditors and lenders to pull back-leading to even less liquidity, and so forth, until cash is simply cut off. Attempts to sell assets on a distressed basis simply
accelerate the spiral.

Enron in this stage

The house of cards began collapsing shortly thereafter, as disclosure of financial errors and manipulation radically changed the financial profile of the company. Much of the problem centered on obscure and complex dealings between Enron and various special purpose entities (SPEs) , including Checo and Raptors I-IV; although these were supposed to be “arm's length” dealings they were intricately entwined with Enron's own financial structure and performance. In mid-October 2001 the company announced a US$554 million after tax-charge against LJM2, an SPE created and managed by Enron CFO Fastow. The firm also announced a US$1.2 billion reduction in shareholder's equity as a result of improperly accounted transactions between Enron and LJM2: the news shocked investors and analysts who had come to believe and support Enron's strategy and growth story (and ever escalating share price). Just one month later the firm was forced to restate its financial earnings from 1997 to 2001 as result of accounting errors between Enron, LJM1, and Chewco Investments[2]( Chewco itself was managed by one of Fastow's employees, Kooper).

Third Stage Impact: Growing Financial Distress

This critical stage can be characterized by a, number of features including: continued negative perception in the market place, causing existing investors to sell their shares and prospective investors to remain on the sidelines; credit rating downwards from rating agencies; negatvive opinion from sell-side equty analysts; further changes in the creditor and supplier terms and a further squeeze on liquidity.

The boards of directors are generally considering alternative strategies during this period. In addition to trying to manage daily crisis situation- working hopefully, in close concert with executive management – directors might be exploring other strategic options including sale of core assets in order to help to secure additional liquidity, the sale of company to another firm in order to preserve as much value as possible, or the search for a friendly strategic partner, to which it can sell a significant block of equity in exchange for much needed liquidity. The board in this stage begins to weigh the interest of creditors seriously. It is quite obvious if a company is in a financial distress and making steadily a decline towards the vicinity of insolvency, directors are forced to shift their allegiance and actions to creditors. Though this is unlikely to occur until all potential measures and actions have been taken.
Although the specific reasons a company might migrate gradually or quickly into the third stage are less important than the effect and consequences, it is relatively simple to imagine any number of scenarios. Directors announce that they have discovered a multi-year pattern of financial fraud that implicates senior executives and control officers. Internal and external auditors, having approved a long sequence of very aggressive accounting treatments, are told by regulators to reverse such entries, creating a financial picture that reflects much greater leverage and weaker earnings than previously believed.

Negative reports from equity analysts regarding the problems can create further pressure in the market. In light of the actual and potential problems faced by the company, which re almost certain to include a liquidity squeeze and lower revenue, credit rating agencies may begin a sequence of downgrades. This is a critical dimension of third stage problems, as they can create a vicious cycle, particularly if the rating actions pierce the sub investment threshold. The real difficulties occur when the company is downgraded to the sub-investment-grade category. Banks do not provide new funds to the company unless they can do so on a collateral basis, but even this has a issue: if an asset has already been pledge as security it cannot to pledged to another party; and if an asset can be pledged as collateral other unsecured debt holders will find that their seniority has been diminished through structural subordination (for example they own securities that were not subordinated in the beginning, but have become de facto subordinated through subsequent pledging actions). Rating agencies recognizing this structural subordination, go on to downgrade the rating of securities that have become subordinated, leading to the possibility of more collateral calls.

Enron in this Stage

From this point on, Enron's downfall accelerated; although fragmented details were reported in the financial press daily during late 2001, the full picture of company's problems did not become clear from some time afterwards.[3]the final cat took place in November 2001 when banks started cancelling Enron's remaining liquidity facilities, rumors of imminent bankruptcy were rampant, and rating agencies started downgrading the company's debt, triggering more liabilities and constraining its financial position even further. The firm's core trading business suffered considerably as the company was forced to post collateral it did not have.

Fourth Stage Impact: Bankruptcy

The fourth and final stage of the process ends in default (the company makes to fail payments on obligations) or insolvency (the market value of the company's assets fall below its liabilities so that it has a negative equity). This typically leads to formal filing of voluntary or involuntary bankruptcy petition; in some systems this provides for protection of creditors until through review of claims can be undertaken.[4]When a firm is in bankruptcy it follows one of two paths: liquidation or reorganization. In event of reorganization a company has the possibility of re-emerging in restructured form if it can reach an agreement with its claimholders. Chances of success are greater if the company is perceived to have strong asset value, manageable leverage, and ‘salvageable' goodwill and reputation, but the process is lengthy, involving extensive negotiation among all the parties holding a claim against the firm's assets. Depending on the nature of bankruptcy system, preference is given to the company or the creditors; incumbent management may be dismissed or permitted to stay and a DIP financing group or an administrator will take over management of the firm. In event of reorganization the company that ultimately emerges is likely to look considerably different; generally smaller and more focused, with better access to liquidity and a new capital structure featuring less leverage.

While when liquidation occurs, the claims process divides residual assets by seniority. This means senior secure creditors will be paid before senior and junior unsecured creditors, who will be repaid before any subordinated debt holder. Shareholders, ranking lowest, will be repaid at last. In fact shareholders often receive no recompense, meaning their investments become worthless. The amount that creditors, as primary stakeholders, receive is dependent on each specific bankruptcy case. The more a bankrupt company's assets are worth in liquidation and the lower the overall amount of leverage, the greater the recoveries for each individual class of creditors; the lower the value of assets the greater the leverage, the lower the recoveries.

Enron in this stage

When it became clear that Enron could not no longer survive the crisis of confidence, Lay attempted to team up with cross-town rival Dynegy for an eleventh-hour merger; Dynegy however, did not like what it uncovered in its diligence and scuttled the deal after few days. Enron file for Bankruptcy in early December 2001.[5]

Impact on the Stakeholders of Enron

Most stake holders suffered considerably: shareholders saw the value of their investments vaporize almost completely, thousands of employees lost their jobs (along with an estimated US$80 million in employee pension assets, invested in worthless Enron stock) and creditors lost billions of dollars.[6]

During the subsequent investigations[7]it became clear that the company suffered from widespread financial misinterpretations, fraud, self-dealing, conflicts of interest and unethical behavior, as well as a weak controls and a completely ineffective board of directors.[8]While most stakeholders lost quite heavily, some executives did well, selling Enron stock even as they urged employees to buy.[9]Certain other groups, including investment and commercial banks, tax advisers[10], law firms, and accountants received tens of millions of dollars in fees over the years as they helped built Enron's capabilities. Some of these firms were ultimately damaged by this collapse.

The most direct failure was Andersen[11], which, as noted below, filed for Bankruptcy just seven years after Enron's. Commercial and investment banks also suffered, largely from helping develop mechanisms that perpetuated Enron's deception. For instance JP Morgan Chase, Citibank and Merrill Lynch actively lent and/or structured transactions that helped the company increase its leverage or misstate it earnings. In the fourth quarter of 2002 JP Morgan Chase took a US$1.3 billion charge[12]to settle litigation over Enron (including nearly US$400 million related to a lawsuit with insurers who owed the bank US$1 billion on various security transactions). The banks was accused of creating and financing deals, SPEs and off-balance-sheet-transactions that helped hide Enron's true leverage position, although later such claims were dismissed. Similarly Citibank entered into settlement talks with the SEC over its role its role in financing the company through the Yosemite offshore vehicle (which appeared on Enron's balance sheet as a risk management position rather than a loan). Merrill Lynch pleaded no contest and paid US$80 million to settle civil charges that it fraudulently helped the company overstate it's through various trading strategies and vehicles; it also fires several senior executives. Many other banks, law firms and accounting firms, were implicated, and settled or defended (including Deutsche Bank, Shearman and Sterling, Ernst and Young, and Deloitte and Touche). Fastow and various other senior Enron executives were ultimately charged on a variety of civil criminal violations.

Governance Flaws

# The board failed dramatically in its oversight duties; it appears to have little notion of what executives were doing and was not forceful in barring business and transactions with potential conflicts of interest. When it approved arrangements that allowed the firm's CFO to also serve as general partner of SPEs it failed to enforce control or review performance. Directors in several instances do not appear to have understood the nature of related party transactions they were being asked to approve.[13]

# Internal counsel and auditors, external counsel and auditors, and executive management failed to exercise any meaningful oversight or control over business managers for an extended period of time.

# Ethical standards were poor. Conflicts of interest in employee dealings with corporate accounts and investment partnership were ignored or wrongly approved; the self-dealing reached egregious proportions. CFO Fastow was conflicted, putting self interests ahead of company's interests. Senior executives were actively selling large proportions of their Enron shareholdings, even as they encouraged employees to buy more.

# The audit and compliance committee failed to perform its duties in reviewing and questioning material SPE transactions; the compensation committee failed to review Fastow's compensation related to the SPEs.

# The tone from the top management was aggressive even ruthless and seems to have bread the same type of behavior throughout many parts of the organization.

# The firm experienced a collapse in its internal control; the board and the management failed to implement a proper system of control, and failed on many occasions to achieve discipline, though Watkin's was an exception.

# Financial disclosures related to the SPEs, off-balance sheet activities and related company transactions were opaque, at best. Although LJM, Chewco, and other partnerships were mentioned in the footnotes to Enron's financial statements, there was little detail about their structure and the dual roles of Fastow and other officers. In a further instance of conflict of interest, the financial disclosures given to regulators and investors were prepared by Fastow's group and subject to manipulation.

# Andersen, as auditor, failed to fulfill its professional responsibilities regarding accounting practices and audits, and failed to bring to the board's attention possible control concerns. The audit firm was conflicted, serving as independent auditor as well as consultant on financial engineering transactions.

# Vinson and Elkins, as outside counsel, failed to raise concerns about the SPEs or the nature of the financial disclosure it was charged with preparing.

# Stakeholders-including creditors, agencies, and regulators – failed to truly question Enron and its opaque dealing/financial standards for a multi-year period.

Conclusion
It is easy to conclude that, it is not only the senior executive and board of directors that are responsible for major governance problems, on the contrary often the board of directors have no idea about the improprieties in the company accounts (such as in the Enron's case). In the Enron's case it was the external and internal auditors and the senior executives of creditors (such as of Citibank) which kept the board of directors in the dark.

Though, we see it is a common practice of counsels and auditors to ignore the irregularities to ensure there fee on a perpetual basis, but what they seem to ignore, are the consequences that they have to face after the bubble bursts. The most striking example the researcher finds to support his argument is of Andersen (external auditor of Enron) which failed to perform its duties and as a consequence was wound up 7 years after the liquidation of Enron.

After the systematic study of impact on corporate operations of governance problems it is easy to construe that even a minor governance problem may lead to bankruptcy of a firm as confidence problem leads to unavailability of liquidity and which further leads to bankruptcy. Hence it is important for an organization to maintain highest standards of corporate governance amidst the environment of uncertainty to survive and grow.

Books Referred:
1.Banks Erik, Corporate Governance: Financial Responsibility Controls and Ethics, 2004,Palgrave Macmillan, New York.
2.Das S.C., Securites law in India An Evaluation, 2ndEd., PHI Learning Private Ltd, New Delhi.
3.Securities Scam the Current Crisis and the Way Out, 2005, ICFAI University Press, Hyderabad.

End-Notes
[1]See Banks and Dunn 2003
[2]Chewko was created to hold stake in another SPE.
[3]Special Investigation Committee of Board of Directors released a study in February, 2002.
[4] Under US Bankruptcy code, for instance, a company can file bankruptcy petition under Chapter 11 (reorganization) or Chapter 7 (liquidation).
[5]Portions of energy trading business were acquired by UBS in 2002
[6]According to subcommittee investigation by US Senate.
[7]According to Batson Report.
[8]A group that was paid US$350,000 per year per director according to US Senate.
[9]Lay sold US$100 million stock over 3 years
[10]Tax department was a separate unit in the company.
[11]The external auditors of Enron
[12]This in addition to charge-offs of US$500 million
[13]For e.g. The board remained silent on Raptor transactions.