Why Enron Remains Relevant

Michael W. Peregrine is a partner at McDermott Will & Emery LLP. This post is based on an article by Mr. Peregrine; his views do not necessarily reflect the views of McDermott Will & Emery or its clients.

The fifteenth anniversary of the Enron bankruptcy (December 2, 2001) provides an excellent opportunity for the general counsel to review with a new generation of corporate officers and directors the problematic board conduct that proved to have seismic and lasting implications for corporate governance. The self-identified failures of Enron director oversight not only led to what was at the time the largest bankruptcy in U.S. history, but also served as a leading prompt for the enactment of the Sarbanes-Oxley Act, and the corporate responsibility movement that followed. For those reasons, the Enron bankruptcy remains one of the most consequential governance developments in corporate history.

Enron evolved from a natural gas company to what was by 2001 a highly diversified energy trading enterprise that pursued various forms of particularly complex transactions. Among these were the soon-to-be notorious related party transactions in which Enron financial management executives held lucrative economic interests. (These were the so-called “Star Wars” joint ventures, with names such as “Jedi”, “Raptor” and “Chewco”). Not only was Enron’s management team experienced, both its board and its audit committee were composed of individuals with broad and diverse business, accounting and regulatory backgrounds.

In the late 1990s the company experienced rapid growth, such that by March 2001 its stock was trading at 55 times earnings. However, that rapid growth attracted substantial scrutiny, including reports in the financial press that seriously questioned whether such high value could be sustained. These reports focused in part on the complexity and opaqueness of the company’s financial statements, that made it difficult to accurately track its source of income.

By mid-summer 2001 its share price began to drop; CEO Jeff Skilling unexpectedly resigned in August; the now-famous Sherron Watkins whistleblower letter was sent (anonymously) to Board Chair Ken Lay on August 15. On October 16, the company announced its intention to restate its financial statements from 1997 to 2007. On October 21 the SEC announced that it had commenced an investigation of the related party transactions. Chief Financial Officer Andrew Fastow was fired on October 25 after disclosing to the board that he had earned $30 million from those transactions. On October 29, Enron’s credit rating was lowered. A possible purchaser of Enron terminated negotiations on November 28, and the company filed for Chapter 11 bankruptcy protection on December 2.

The rest became history: the collapse of the company; the individual criminal prosecutions and convictions; the obstruction of justice verdict against company and, for Arthur Andersen (subsequently but belatedly overturned); the loss of scores of jobs and the collateral damage to the city of Houston; Mr. Lay’s sudden death; and, ultimately the 2002 enactment of the Sarbanes Oxley Act, which was intended to prevent future accounting, financial and governance failings as had occurred in Enron and other similar corporate scandals. But a 2016 Enron board briefing would be much more than a financial history lesson. For the continuing relevance of Enron is at least two-fold:

First, it provides jaw-dropping examples of problematic governance conduct from which no board, at any time, is safely immune. As chronicled in the report of its own Special Investigations Committee (the so-called “Powers Report”), the Enron board—once acclaimed for its performance—committed a series of significant failures of oversight with respect to the fatal related party transactions. These failures were grounded in the “flawed” decision to proceed with the concept of related party transactions with the CFO. Indeed, as the Powers Report noted, the need for such an extensive set of controls and procedures to address transaction related conflicts suggested that the transactions should never have been approved in the first place.

Other oversight failures included the inadequacy of board-directed controls over those transactions, and the failure to adequately implement those controls; the failure to make sure that senior management exercised sufficient oversight of the transactions, and their failure to respond adequately when problems arose that required rigorous response; the cursory manner in which the Audit and Compliance Committee carried out its assigned transaction review duties; the denial to the board of important transaction information that might have led it to take responsive action, and the failure of the board to fully appreciate the significance of the specific transaction information with which it was provided.

What is the prudence and reasonableness—much less the legality—of major transactions so complex that even the board lacks an understanding of their purpose and structure?

Second, it provides a clear explanation for the corporate accountability environment along with the enactment of Sarbanes Oxley. Indeed, the credibility of the Powers Report was such that it served as a major reference for the governance findings of the U.S. Senate Subcommittee that conducted a separate investigation of the Enron collapse; the investigations that ultimately provided the building blocks for the Sarbanes legislation.

In essence, Enron is the “root” of the modern corporate governance “tree.” The emphasis on director-independence; governance principles; “best practices”; codes of corporate ethics; financial transparency; whistleblower access; informed decision-making; enhanced board oversight; conflicts and compensation sensitivity and ”constructive skepticism” can be directly traced to the perceived and admitted failures of the Enron board. In addition, subsequent amendments to the compliance program effectiveness standards of the influential Federal Sentencing Guidelines, dealing with governance responsibilities, reflect a clear Enron/Sarbanes theme. Thus was the focus of corporate leadership was recalibrated from the executive suite back to the board room.

These are worthwhile lessons for today’s board members and senior executives, many of whom were not serving in executive or fiduciary positions fifteen years ago. These officers and directors likely lack the near-visceral reaction to the word “Enron” that more senior, and perhaps now retired, corporate leaders retain. Indeed, familiarity with the Enron saga strongly supports effective corporate governance in multiple ways. For example, it provides a clear rationale for a company’s set of governance policies and procedures, which may otherwise seem like an emphasis on process rather than substance to the uninitiated observer (i.e., the so-called “compliance board”). The more that a director understands about the failures of the Enron board, the more likely he/she is to support compliance with the board’s governance process focus.

In addition, while the nature of the problematic related party transactions was somewhat unusual, there was nothing particularly unusual with respect to the oversight responsibilities called for under the circumstances; e.g., attentiveness, diligence, inquisitiveness, and the ability to ‘see the forest for the trees’ (particularly with respect to the impact of the conflicts controls). Furthermore, the Enron facts suggest that problematic conduct can arise even with the most sophisticated of boards; that pedigree and experience alone are not guarantors of always sterling fiduciary practices.

Finally, the Enron circumstances should provide a little “ping” in the back of the brain, that “the smartest guys in the room” have a nasty habit of popping up again, and again, in executive suites across industry sectors, year after year. Human nature and competitiveness being what they are, there is always a “type” of executive who will “push the edge of the envelope” in support of what he or she reasonably and good faith believes to be in the best interests of the company—even despite warning signals that it is not. The strong and effective board oversight provides the necessary checks and balances to spirited, aggressive management, especially in those situations when the “edge of the envelope” begins to appear.

Enhanced director education programs are clearly in vogue, following last summer’s publication of the Commonsense, and Business Roundtable, statements of governance principles (discussed on the Forum here and here, respectively). Leveraging the fifteenth anniversary of the Enron bankruptcy—one of the most auspicious governance events of a generation—into a director briefing would be a valuable exercise, and could contribute to greater board and executive commitment to the organization’s portfolio of governance policies and procedures.

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