Enron and the Law

Regardless of whether the executive committed felonies, the company broke fundamental laws.

Listener: 28 January, 2006.

Keywords: Business & Finance;

I don’t know whether Ken Lay and Jeffrey Skilling, top executives of Enron, the giant US energy company that crashed in 2001, will be found guilty of the various felonies for which they are about to be tried. That is a question of what they did, and the intricacies of any statute law that they may have broken.

I do know that Enron’s crash was the consequence of its abuse of more fundamental laws. Investors score a corporation’s performance by the rise in its share price. That shapes the way the business is run. The theory that justifies the share price as the relevant indicator is based on the assumption that the collective decisions of market investors are the best way to assess a company’s commercial value. The theory does not say the share price is correct – just that it is the best measure readily available. Nor does it allow for corporations manipulating their share price by distorting the information they make available to the market.

The most important information is in the published accounts. Enron’s manipulations were numerous, but a key one was “mark-to-market” valuation of assets in its balance sheet. During the 1970s the New Zealand Government balance sheet had fixed interest loans that became less valuable when interest rates rose, since they returned a lower interest rate. Yet they remained valued there at the amount they were initially advanced. When the government sold them off, it took a capital loss. Nowadays such loans are “mark-to-market”, that is, valued at the price of a willing market buyer. Expect a big hit to the government accounts when the interest-free student loans are revalued.

New Zealand’s past practices reflected accounting conservatism: Enron’s aggressive accounting aimed to boost the share price. So what was it to do when there was no market for the asset? It had energy contracts that went on for 10 and more years. Since there was no willing buyer of the future income flow, they made the value up.

One catch with this mark-to-market strategy is that having made a big profit from a contract in one year, the business needs a bigger contract for the next year in order to inflate its profit line further to justify a higher share price. Enron added increasingly dubious projects, including one based on weather forecasting whose future profits were but optimistic conjectures that never happened.

But even had the forecasts been accurate, Enron’s reported book profits did not generate the cash flow for other investments and dividends. So it turned to “Special Purpose Entities”, which enabled it to obtain cash from financial institutions. Such SPEs are not legal in New Zealand, so they need not detain us. The way Enron did them, they were not legal in the US, either. Andrew Fastow, Enron’s chief financial officer (and chief prosecution witness), has been jailed for 10 years. (Lay and Skilling say it is all his fault.)

The institutional investors in the SPEs knew they were doubtful, so they took additional security in Enron shares. When the skyhooks fell out of the sky, the SPEs and the company crashed. So did its auditors, Arthur Anderson, and its sharebroker Merrill Lynch has had four executives jailed. It also repaid a large sum, as have a number of other financial businesses. But those who really suffered were investors, workers and retirees. The impression is that the financial sector was not acting in their interests, but conniving to rip them off.

For no matter how good a corporation’s accounts look – whether they are fiddled or true – without sufficient cash flow it will crash in the end. Whether its executives end up in the courts or jail is a matter of statute law and judicial process. The corporate collapse is the result of a higher, more demanding, law of cash flow underpinning commercial reality.

(Among the references I used for this column was The Smartest Guys in the Room, by Bethany McLean and Peter Elkind. The film is based on the book.)