The Enron Debacle

Background
With hindsight, most observers agree that Enrons problem were caused by a failure of the
board of directors to exercise adequate oversight. This allowed the misuse of special purpose
entities (SPEs), a form of partnership, to manipulate financial reports, mislead investors, and
self-remunerate the perpetrators. Arthur Andersen, Enrons audit firm, has essentially
disintegrated, and the accounting profession, as well as corporate governance, will be forever
altered. All of this was not apparent until almost the end of the story.
Throughout the late 1990s, Enrons stock rose slowly on the New York Stock Exchange,
within a trading range from $20 to $40. During 2000, Enrons stock traded in a range of $60
to $90.
How and why did this occur? Who was to blame? What were the repercussions to be?
Investors were scandalized, pensioners lost their life savings, the public was outraged, and the
credibility of the financial markets and of the corporate world was shaken.
Officials and politicians hurriedly looked for answers that would restore that credibility and
the trust that had been lost. So great was the concern that President Bush himself pledged that
the guilty would be punished aggressively by government agencies. Bush called for
governance reforms and offered a ten-point plan legislative action.
After considerable delay and outcry, Enrons audit firm, Arthur Andersen LLP (AA), the fifth
largest audit firm in the United States and one of the largest in the world, was charged on
March 7, 2002, with obstruction of justice for shredding documents allegedly important to the
governments investigation. As a condition of the charge, the SEC placed restrictions on AA
to serve its SEC-registered clients, thus jeopardizing the ability of AA to continue as a firm.
Ultimately, it disintegrated and was taken over piecemeal by competitors. A separate section
is included later in this chapter that contains a full discussion of the troubles of Arthur
Andersen, and how probably less than 100 AA people were responsible for the disaster that
ruined a once-revered firm that employed 85.000 worldwide. In addition, the self-regulatory
framework that the profession had enjoyed in the United States was further eroded.

What Happened? Who Was to Blame?

The Powers Report. The powers report was prepared by a three person subcommittee of the
Enron board chaired by William Powers, Jr., who joined the board in September 2001 and
resigned in February 2002. After investigation, the Powers Report presented the following in
its Summary of Findings:
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Employees enriched themselves by millions without proper approvals- Fastow by $30

million, Kopper by at least $10 million, two others by at least hundreds of thousands
of dollars.

Partnership Chewco, LJM1, and LJM2 were established and used to enter into
transactions that could not be arranged with independent entities, were designed to
accomplish favorable financial statement results, not to achieve bona fide economic
objectives or to transfer risk and did not conform to U.S accounting rules that could
have enabled the hiding of assets and liabilities (debt)
Other transactions were improperly entered into hedge or offset almost $1 billion in
losses on Enrons merchant investments and thus improperly keep reported profit
approximately $1 billion higher between the third quarters of 2000 and 2001. Only
Enron had assets at risk in these transactions.
The original accounting treatments for the Chewco and LJM1 transactions were
wrong, as were many others, in spite of extensive involvement and advice from
Arthur Andersen.
Much of the need for restatement arose because of the failure to satisfy two conditions
required for special purpose entities (SPEs) to be independent from Enron.

Failure of the Directors to Oversee or Govern Enron Adequately

What Are Directors Expected to Do?. Directors operate under state laws that impose fiduciary
duties on them to act in good faith, with reasonable care, and in the best interest of the
corporation and its shareholders. Courts generally discuss three types of fiduciary obligations.
Within this governance framework, Enrons directors were responsible for oversight of
Enrons lines of business and strategies for financing them. One of the lines of business-the
online energy trading business-required access to large lines of credit to ensure settlement of
trading positions at the end of each day. At the same time, the nature of this business caused
large earnings fluctuations from quarter to quarter, which made it a challenge to maintain low
credit rating, and therefore access to low cost financing. Other lines of business, such as
optical fiber networks (that were mostly not in use), represented cash drains as well.
How Was Enrons Board Organized, and How Did It Function? In 2001, Enrons board of
directors had 15 members, several of whom had 20 years or more experience on the board of
Enron or its predecessor companies. Many of Enrons directors served on the boards of other
companies as well. Enron board members uniformly described internal board relations as
harmonious. They said that board votes were generally unanimous and could recall only two
instances over the course of many years involving dissenting votes. The Enron Board was
organized into five committees:
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The Executive Committee met on an as-needed basis to handle urgent business

matters between scheduled Board meetings.
The Finance Committee was responsible for approving major transactions.
The Audit and Compliance Committee reviewed Enrons accounting and compliance
programs, approved Enrons financial statements and reports, and was the primary
liaison with Andersen.
The Compensation Committee established and monitored Enrons compensation
policies and plans for directors, officers, and employees.

The Nominating Committee nominated individuals to serve as Directors.

The board normally held five regular meetings during the year, with additional special
meetings as needed. Committee meetings generally lasted between one and two hours and
were arranged to allow board members, who typically sat on three committees, to attend all
assigned committee meetings.
Committee chairmen typically spoke with Enron management by telephone prior to
committee meetings to develop the proposed committee meeting agenda. Board members
said that Enron management provided them with these agendas as well as extensive
background and briefing materials prior to Board meeting including, in the case of Finance
Committee members, numerous deal approval sheet (DASHs) for approval of major
transactions.
During the committee meetings, Enron management provided presentations on company
performance, internal controls, new business ventures, spesific transactions, or other topics of
interest. The subcommittee interviews indicated that, altogether, board members appeared to
have routine, contact with less than a dozen senior officers at Enron. The board did not have a
practice of meeting without Enron management present.
Regular presentations on Enrons financial statements, accounting practices, and audit results
were provided by Andersen to the Audit Committee. The Audit Committee chairman would
then report on the presentation to the full board. The Audit Committee offered Andersen
personnel an opportunity to present information to them without management present.
Minutes summarizing Committee and Board meetings were kept by the corporate secretary,
who often took handwritten notes on committee and board presentations during the boards
deliberations and afterward developed and circulated draft minutes to Enron management,
board members, and legal counsel. Outside of the formal committee and board meetings, the
Enron directors described very little interaction or communication either among Board
members or between Board members and Enron or Andersen personnel, until the company
began experiencing serve problems in October 2001.
Enron board members were compensated with cash, restricted stock, phantom stock units,
and stock options. The total cash and enquiry compensation of Enron board members in 2000
was valued by Enron at about $350.000 or more than twice the national average for board
compensation at s U.S publicly traded corporation.