The Lesson from the Sink of Energy Giant

The US energy giant Enron will go down in corporate history as one of the more dramatic business failures, as well as the largest. The company’s accounts are being examined by the US Securities and Exchange Commission (SEC) to uncover why they overstated profits over five years by $568m.

Enron was one of the US’ leading energy suppliers. It is also a major supplier in energy markets across Europe and is committed to major energy projects in several parts of the world, including India and Brazil. Its collapse will have far reaching implications.

What caused the No. 7 company in USA to collapse within a few months time? Besides the overstatement of the profit of $568m, Enron had also revealed over $9bn of debts to be repaid by the end of this year, with just $2bn in cash and likely credit lines. But it was the failure of a rescue deal with Dynegy - as additional potential liabilities began to emerge – that threw Enron into bankruptcy. Contracts entered into by off-balance sheets trusts to finance expansion into new international markets appear to have generated hidden liabilities of at least $1.25bn. Doubts also emerged about the profitability of trades conducted by Enron with partnerships controlled by Enron’s own employees, which earned those staff massive bonuses.

The bankruptcy is extremely embarrassing to Enron’s auditor Andersen, one of the world biggest five accountancy firms. Although Andersen was warned of the problem as early as last August, instead of taking proper action, it destroyed thousands of Enron related documents. Andersen is likely to face a massive compensation claim and potential litigation. And it is further suspected that there may have been criminal activity linked to Enron’s demise.

 The failure of onetime wallstreet darling reflects several aspects of problems in both the financial industry and corporate governance.

First, one might concern about the adequacy of the current accounting standard. The disclosure of related party, the classification of loan and the accounting of off-balance sheet finance are the areas that are likely to be put under concern. The current standards under International Accounting Standards (IAS) are claimed to be too subjective, while the US standards are mostly rule based. The collapse of Enron may make a difference in this area.

Second, the relationship between accountancy firms and their big customers should be scrutinized. Enron is one of the biggest clients of Anderson. The consultation income from Enron was more than half of the total fees charged in year 2000. The point is that for accountancy firms, the most profitable income is from the consultation. There is a possibility that the accountancy firms may compromise on certain questionable accounting practice adopted by their customers in order to get more lucrative consultation job. In wake of the Enron fallout, industry sources were quoted as saying the new coming audit rules drafted by SEC together with the accounting industry would create a private-sector regulatory organization that would not be controlled by accounting firms. It is still a question whether such measure will be effective in preventing future ‘Enron’. But at least this debatable area is being given more attention after Enron scandal.

Third, the company’s self-regulatory system is questionable. Doubts emerged about the profitability of trades conducted by Enron with partnerships controlled by Enron’s own employees, which earned those staff massive bonuses. And days before the company filed for bankruptcy, the directors decided to pay large bonuses to selected staff. And at the same time, most of the employees were told by the company that the company was still in good shape and the directors were seeing upswing share price. It was also claimed that Enron illegally froze employee retirement plans to prevent them moving investments out of the company’s stock.

Fourth, the banks may have misled their shareholders by dressing up loans to their clients under other labels. Citigroup and JP Morgan Chase are the two biggest creditors to the failed energy trader. Elaborate structures were used to extend credit but do not appear on banks’ balance sheet as loans. The SEC is concerned that such practices may be allowing banks to take on more credit risk than their shareholders know.