munzig - 2003 - enron and the economics of corporate governance

Enron and the Economics of Corporate Governance




June 2003




Peter Grosvenor Munzig
Department of Economics
Stanford University, Stanford CA 94305-6072
Advisor: Professor Timothy Bresnahan






ABSTRACT

In the wake of the demise of Enron, corporate governance has come to the forefront of
economic discussion. The fall of Enron was a direct result of failed corporate governance
and consequently has led to a complete reevaluation of corporate governance practice in
the United States. The following paper attempts to reconcile our existing theories on

corporate governance, executive compensation, and the firm with the events that took
place at Enron. This paper first examines and synthesizes our current theories on
corporate governance, and then applies theoretical and economic framework to the
factual events that occurred at Enron. I will argue that Enron was a manifestation of the
principal-agent problem, that high-powered incentive contracts provided management
with incentives for self-dealing, that significant costs were transferred to shareholders due
to the obscurity in Enron’s financial reporting, and that due to the lack of board
independence it is likely that management rent extraction occurred.


Acknowledgements: I would like to thank my family and friends for their continued
support throughout this paper. In particular, my mother Judy Munzig was instrumental
with her comments on earlier drafts. I also thank Professors Geoffrey Rothwell and
George Parker for their help, and finally to my advisor Professor Bresnahan, for without
his support and advice this paper would not have been possible.

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“When a company called Enron… ascends to the number seven spot on the Fortune

500 and then collapses in weeks into a smoking ruin, its stock worth pennies, its
CEO, a confidante of presidents, more or less evaporated, there must be lessons in
there somewhere.”


-Daniel Henninger,
The Wall Street Journal

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CONTENTS


I. INTRODUCTION 3


II. THE THEORY OF CORPORATE GOVERNANCE 7
Corporate Governance and the Principal-Agent Problem 7
Executive Compensation and the Alignment
of Manager and Shareholder Interests 11
Corporate Governance’s Role in Economic Efficiency 14
Recent Developments in Corporate Governance 15


III. WHAT HAPPENED: FACTUAL ACCOUNT
OF EVENTS LEADING TO BANKRUPTCY 17
Background/Timeline 18
Summary of Transactions and Partnerships 19
The Chewco/JEDI Transaction 20
The LJM Transactions 22

IV. ANALYSIS OF CORPORATE GOVERNANCE ISSUES 26
Corporate Structure 27
Conflicts of Interest 30
Failures in Board Oversight and Fundamental
Lack of Checks and Balances 33
Audit Committee Relationship With Enron and Andersen 35
Lack of Auditing Independence and the Partial
Failure of the Efficient Market Hypothesis 38
Director Independence/Director Selection 41


V. POST-ENRON GOVERNANCE REFORMS AND OTHER
PROPOSED SOLUTIONS TO GOVERNANCE PROBLEMS 45
Sarbanes-Oxley Act of 2002 45
Other Governance Reforms and Proposed Solutions 48


VI. CONCLUSION 51

I. INTRODUCTION
Often referred to as the first major failure of the “New Economy,” the collapse of
Enron Corporation stunned investors, accountants, and boardrooms and sent shockwaves

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across financial markets when the company filed for bankruptcy on December 2, 2001.
At that time, the Houston-based energy trading company’s bankruptcy was the largest in
history but was surpassed by WorldCom’s bankruptcy on July 22, 2002. Enron
employees and retirement accounts across the country lost hundreds of millions of dollars
when the price of Enron stock sank from its peak of $105 to its de-listing by the

NASDAQ at just a few cents. Arthur Andersen, once a Big Five accounting firm,
imploded with its conviction for Obstruction of Justice in connection with the auditing
services it provided to Enron. Through the use of what were termed “creative accounting
techniques” and off-balance sheet transactions involving Special Purpose Entities (SPEs),
Enron was able to hide massive amounts of debt and often collateralized that debt with
Enron stock. Major conflicts of interest existed with the establishment and operation of
these SPEs and partnerships, with Enron’s CFO Andrew Fastow authorized by the board
to manage the transactions between Enron and the partnerships, for which he was
generously compensated at Enron’s expense.
In addition to crippling investor confidence and provoking questions about the
sustainability of a deregulated energy market, Enron’s collapse has precipitated a
complete reevaluation of both the accounting industry and many aspects of corporate
governance in America. The significance of exploring the Enron debacle is multifaceted
and can be generalized to many companies as corporate America evaluates its governance
practices. The fall of Enron demands an examination of the fundamental aspects of the
oversight functions assigned to every company’s management and the board of directors
of a company. In particular, the role of the subcommittees on a board and their
effectiveness are questioned, as are compensation techniques designed to align the
interests of shareholders and management and alleviate the principal-agent problem, both
theoretically and in application. Companies such as Worldcom, Tyco, Adelphia, and

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Global Crossing have all suffered catastrophes similar to Enron’s, and have furthered the
need to reevaluate corporate governance mechanisms in the U.S.
My question then becomes, what lessons can be learned from the fundamental
breakdowns that occurred at the corporate governance level at Enron, both from an
applied and theoretical standpoint? This paper attempts to offer an analysis that
reconciles the events that occurred inside the walls of Enron and our current theories on
corporate governance, the firm, and executive compensation. In particular, I look at the
role the principal-agent problem played at Enron and attempt to link theories of

management’s expropriation of firm funds with the Special Purpose Entities Enron
management assembled. I question Enron’s executive compensation practices and the
effectiveness of shareholder and management alignment with the excessive stock-option
packages management received (and the resulting incentives to self-deal). Links between
the information asymmetry and the transfer of costs to shareholders is explored, as well
as the efficient market hypothesis in regards to Enron’s stock price. And finally, the lack
of director independence at Enron provides a foundation for the excessive compensation
practices given managers were extracting rents.
From an applied standpoint, I argue that following can be learned from Enron:
• Enron managed their numbers to meet aggressive expectations. They were less
concerned with the economic impact of their transactions as they were with the
financial statement impact. Creating favorable earnings for Wall Street
dominated decision making.

• The Board improperly allowed conflicts of interest with Enron partnerships and
then did not ensure appropriate oversight of those relationships. There was a
fundamental lack of communication and direction from the Board as to who
should be reviewing the related-party transactions and the degree of such review.
The Board was also unaware of other conflicts of interests with other transactions.

• The Board did not effectively communicate with its auditors from Arthur
Andersen. The idea that Enron’s employed accounting techniques were
"aggressive" was not communicated clearly enough to the board, who were
blinded by its trust in its respected auditors.

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• The Board did not give enough consideration when making important decisions.
They were not really informed nor did they understand the types of transactions
Enron was engaging in, and they were too quick to approve proposals put forth by

management.

• The Board members had significant relationships with Enron Corporation and its
management, which may have contributed to their failure to be more proactive in
their oversight.

• The Board relied too heavily on the auditors and did not fulfill its duty of ensuring
the independence of the auditors. Given the relationship between management
and the auditors, the Board should not have been so generous with its trust. The
Board is entitled to rely on outside experts and management to the extent it is
reasonable and appropriate - in this case it was excessive.

From a theoretical standpoint, I argue that the following are lessons learned from
Enron:
• Enron was a manifestation of the principal-agent problem. The ulterior motives
of management were not in line with maximizing shareholder value.

• The high-powered incentive contracts of Enron’s management highlight more of
the costs associated with attempting to align shareholders with management to
counter the principal-agent problem and provided management with extensive
opportunities for self-dealings.

• Significant costs were transferred to shareholders associated with asymmetric
information due to management’s sophisticated techniques for obscuring financial
results. Such obscuring also lead to a partial failure of the efficient market
hypothesis.

• Due to the lack of board independence, the theory of rent extraction more likely
explains management’s actions and compensation than the optimal contracting
theory.

This analysis of the Enron case attempts to explain what happened at Enron in the
context of existing theories on the firm, corporate governance, and executive
compensation, as they are innately linked. Section II discusses the general theory of
corporate governance defined from two perspectives, first from an applied perspective
and then from a theoretical perspective. Next is an attempt to answer the question of why

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we need corporate governance and to explore its function theoretically. The section ends
with information on changes made in corporate governance over the last two decades.
Section III details the factual account of events leading to the fall of Enron. It
includes the history and background of the corporation, beginning with its inception with
the merger of Houston Natural Gas and Internorth in 1985 through its earnings
restatements and eventual bankruptcy filing in December of 2001. It also focuses on the
partnerships and transactions that were the catalysts for the firm’s failure, in particular the
Special Purpose Entities like Chewco, JEDI, and LJM-1 and LJM-2.
Section IV provides analysis of the corporate governance issues that arise within
Enron from a theoretical approach. That is, a theoretical and economic framework are
applied to Enron’s corporate structure and compensation schedules, highlighting
opposing theories such as optimal contracting and rent extraction with regards to
executive compensation. Further discussed is the principal-agent problem in the context
of Enron and management’s expropriation of shareholder’s capital. Highlighted also are
management’s conflicts of interest that were allowed and that then went unmonitored by
the board. Also included is an analysis on the lack of material independence on the board
and the theory that management had bargaining power because of the close director-
management relationships. I also discuss the relationship between the audit committee
and Arthur Andersen, as well Andersen’s lack of auditing independence. Included is an
analysis on the partial failure of the efficient market hypothesis in the case of Enron and
the transfer of costs to the shareholders because of the asymmetric information due to
management’s sophisticated techniques for obscuring financial results.

Section V looks at the primary legislative reform post-Enron, the Sarbanes-Oxley
Act, including its key points and the likely effects and costs of its implementation on
corporate governance and financial reporting. The section includes other developments

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in corporate governance, and provides some solutions to improving governance and
executive compensation.


II. THEORY OF CORPORATE GOVERNANCE
Corporate Governance and the Principal-Agent Problem
Before applying theory to the case of Enron, it is important to first discuss the
nature of the principal-agent problem and the reasons for a governance system, as well as
to define corporate governance from an applied and theoretical approach. I then will
discuss why corporate governance helps improve overall economic efficiency, followed
by the general developments in corporate governance over the past two decades. On its
most simplistic and applied level, corporate governance is the mechanism that allows the
shareholders of a firm to oversee the firm’s management and management’s decisions. In
the U.S., this oversight mechanism takes form by way of a board of directors, which is
headed by the chairman. Boards typically contain between one and two dozen members,
and also contain multiple subcommittees that focus on particular aspects of the firm and
its functions.
However, the existence of such oversight bodies begs the questions: why is there
a need for a governance system, and why is intervention needed in the context of a free-
market economy? Adam Smith’s invisible hand asserts that the market mechanisms will
efficiently allocate resources without the need for intervention. Williamson (1985) calls
such transactions that are dictated by market mechanisms “standardized,” and can be
thought of as commodity markets with classic laws of supply and demand governing
them. These markets consist of many producers and many consumers, with the quality of
the goods being traded the same from producer to producer.

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These market mechanisms do not apply to all transactions though, particularly
when looking at the separation of ownership and management of a firm and its associated
contracts. The need for a corporate governance system is inherently linked to such a
separation, as well as to the underlying theories of the firm. The agency problem, as
developed by Coase (1937) and Jensen and Meckling (1976) as well as others, is in
essence the problem associated with such separation of management and ownership. A
manager, or entrepreneur, will raise capital from financiers to produce goods in a firm.
The financiers, in return, need the manager to generate returns on the capital they have
provided. The financiers, after putting forth the capital, are left without any guarantees or
assurances that their funds will not be expropriated or spent on bad investments and
projects. Further, the financiers have no guarantees other than the shares of the firm that
they now hold that they will receive anything back from the manager at all. This
difficulty for financiers is essentially the agency problem.
When looking at the agency problem from a contractual standpoint, one might
initially think that such a moral hazard for the management might be solved through
contracts. An ideal world would include a contract that would specify how the manager
should perform in all states of the world, as dictated by the financiers of the firm. That is,
a complete contingent contract between the financiers and manager would specify how
the profits are divided amongst the manager and owners (financiers), as well as describe
appropriate actions for the manager for all possible situations. However, because every
possible contingency cannot be predicted or because it would be prohibitively costly to
anticipate such contingencies, a complete contract is unfeasible. As Zingales (1997)
points out, in a world where complete contingent contracts can be costlessly written by
agents, there is no need for governance, as all possible situations will be anticipated in the
contract.

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Given that complete contingent contracts are unfeasible, we are therefore left with

incomplete contracts binding the manager to the shareholders. As a result of the
incomplete contracts, there are then unlimited situations that arise in the course of
managing a company that require action by a manager that are not explicitly stated in the
manager’s contract. Grossman and Hart (1986) describe these as residual control rights
the rights to make decisions in situations not addressed in the contract. Suppose then,
that financiers reserved all residual control rights as specified in their contract with
management. That is, in any unforeseen situation, the owners decide what to do. This
would not be a successful allocation of the residual control rights because financiers most
often would not be qualified or would not have enough information to know what to do.
This is the exact reason for which the manager was hired. As a result, the manager will
retain most of the residual control rights and thus the ability to allocate firm’s funds as he
chooses (Shleifer and Vishny 1996).
There are other reasons why it is logical for a majority of the residual control
rights to reside with management, as opposed to with the shareholders. It is often the
case that managers would have raised funds from many different investors, making each
individual investor’s capital contribution a small percentage of the total capital raised. As
a result, the individual investor is likely to be too small or uninformed of the residual
rights he may retain, and thus the rights will not be exercised. Further, the free-rider
problem for an individual owner often does not make it worthwhile for the owner to
become involved in the contract enforcement or even be knowledgeable about the firms
in which he invests (Shleifer and Vishny 1996) due to his small ownership interest. This
results in the managers having even more residual control rights as the financiers remove
themselves from the oversight function.

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In attempting to define corporate governance from a theoretical standpoint, it is
helpful to think of the contract between the owners and management as producing quasi-
rents. In defining quasi-rents, consider the example of the purchase of a specialized
machine between two parties. Once the seller has begun to produce the machine, both
the buyer and the seller are in a sense locked into the transaction. This is because the

machine probably can fetch a higher price from the buyer than on the open market due to
its specificity, and the seller can probably complete the machine for cheaper than any
other firm at that point. The surplus created between the differences in the open market
prices and the price in this specialized contract constitutes a quasi-rent, which needs to be
divided ex-post. The existence of such quasi-rents when produced in the contract
between management and owners creates room for bargaining as the quasi-rents need to
be divided, and Zingales (1997) argues that the bargaining over these ex-post rents is the
essence of governance.
To return to the earlier discussion of incomplete contracts, one may make the link
that the residual control rights due to the incomplete contracting can be seen as a quasi-
rent, and thus must be divided ex-post. How, then, are these rents divided given our
incomplete contracting assumption? This question gets to the heart of corporate
governance and its function. Using Zingales’ (1997, p.4) definition, corporate
governance is “the complex set of restraints that shape the ex-post bargaining over the
quasi-rents generated by a firm.” This definition serves to summarize the primary
function of corporate governance under the incomplete contract paradigm.

Executive Compensation and the Alignment of Manager and Shareholder Interests
The notions of executive compensation and the attempt to align manager and
shareholder interests are subsections of corporate governance and are directly linked to

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the agency problem and firm theory. Previously discussed is why operating under the
incomplete contract approach tends to leave managers with a majority of the residual
control rights of a firm. As a result of these residual control rights, managers have
significant discretion and are not directly (or are incompletely) tied to the interests of the
shareholders. Acting independently of shareholders’ interest, managers may then engage
in self-interested behavior and inappropriate allocation of firm funds may occur.
In an effort to quell such misallocations by a manager, a solution is to give the
manager long term, contingent incentive contracts that help to align his interests with

those of the shareholders. This view of executive compensation is commonly referred to
as the optimal contracting view. It is important with this contracting that the marginal
value of the manager’s contingent contract exceed the marginal value of personal benefits
of control, which can be achieved, with rare exceptions, if the incentive contract is of a
significant amount (Shleifer and Vishny 1996). When in place, such incentive contracts
help to encourage the manager to act in the interest of the shareholders. Critical to the
functioning of these incentive contracts is the requirement that the performance
measurement is highly correlated with the quality of the management decisions during his
tenure and that they be verifiable in court.
The most traditional form of shareholder and management alignment under the
optimal contracting view of executive compensation is through stock ownership by the
manager. This immediately gives the manager similar interests as the general
shareholding population and acts to align their interest. Stock options also help to align
interests because it creates incentive for the manager to increase the stock price of the
firm, which consequently increases the value of his options when (if) he chooses to
exercise them. Another form of an incentive contract that helps to align the interests of
shareholders and a manager is to remove the manager from office if the firm income is

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too low (Jensen and Meckling 1976). Again, this provides quite a strict incentive for
management to produce strong earnings, which aligns his interest with those of the
shareholders, and hopefully serves to maximize shareholder value.
It is important to mention that these incentive contracts for agents are not without
costs and have come under immense scrutiny recently, particularly with the recent
corporate governance scandals like Enron. They provide ample incentive for
management to misrepresent the true earnings of a firm and do not completely solve the
agency problem, an issue that will be discussed further in section IV.
A second and competing view of executive compensation is the rent extraction
view, or as Bertrand and Mullainathan (2000) call it, the “skimming view.” This rent
extraction view is similar to the optimal contracting view in that they both rely on the

principal-agent conflict, but under the rent extraction view “executive compensation is
seen as part of the [agency] problem rather than a remedy to it,” (Bebchuk, Fried and
Walker 2001, p.31). Under this view, an executive maintains significant power over the
board of directors who effectively set his compensation. This power the executive, or
management team, holds stems from the close relationships between management and the
directors, and thus the directors and executives may be bonded by “interest, collegiality,
or affinity,” (Bebchuk, Fried and Walker 2001, p.31). Also, directors are further tied to
management, and in particular the CEO, because the CEO is often the one who exerted
influence to have the director placed on the board, and thus the director may feel more
inclined to defer to the CEO, particularly with issues surrounding the bargaining over
management’s compensation.
As a result of the power that management maintains, management has the ability
to bargain more effectively with the board over compensation, and can effectively extract
more rents as a result. These “rents” are referred to as the amount of compensation a

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CEO, or management, receives over the normal amount he would receive with optimal
contracting. Therefore it is logical to anticipate seeing higher pay for executives
governed by weaker boards, or boards with little independence, which is consistent with
Bertrand and Mullainathan’s (2000) findings. That is, one of their conclusions was that
boards with more insiders (or less independence) are inclined to pay their CEO more. In
other words, CEO’s with fewer independent directors on their boards are likely to gain
better control of the pay process.
More generally, it is important to mention that incentive contracts for executives
are common components of their compensation packages, and there is a vast amount of
literature on the effectiveness of incentive contracts. Murphy (1985) argued from an
empirical standpoint about the positive relationship between pay and performance of
managers. Murphy and Jensen (1990) later examined stock options of executives and
showed that a manager’s pay increased by only $3 for every $1000 increase in
shareholder wealth. Murphy and Jensen concluded that it was evidence of inefficient

compensation arrangements, arrangements that included restrictions on high levels of
pay. Others suggest that there needs to be a better approach in screening out performance
effects that are outside an executive’s control when looking at incentive contracts.
Rappaport (1999), in particular, argues that incentive contracts for executives would
provide more incentive and be better measures of executive performance if the stock
option exercise prices were indexed by broad movements in the market. This would
imply that an executive would not be compensated simply because of broad movements
in the market, but more by his individual firm’s performance relative to other firms.

Corporate Governance’s Role in Economic Efficiency

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Given the role executive compensation and incentive contracts play in attempting
to solve the agency problem, there remains the question of what role governance plays in
improving economic efficiency. In the ex-ante (which Zingales (1997) defines as the
time when specific investments should be made) period, there are two situations where
governance improves economic efficiency. The first is that rational agents will focus on
value-enhancing activities that are most clearly rewarded, and therefore governance must
help allocate resources and reward value-enhancing activities that are not properly
rewarded by the market. Secondly, managers will engage in activities that improve the
ex-post bargaining in their favor. As Shleifer and Vishny (1989) argue, a manager will
be inclined to focus on activities that he is best at managing because his marginal
contribution is greater, and this consequently increases his share of ex-post rents, or his
bargaining power for residual control rights.
Another area where governance may improve economic efficiency is in the ex-
post bargaining phase for rents. That is, governance may affect the level of coordination
costs or the extent to which a party is liquidity-constrained. If residual control rights are
assigned to a large, diverse group, the existence of free-riders in the group may create an
inefficient bargaining system. Also, if a party wishes to engage in a transfer of control
rights but he is liquidity-constrained, inefficient bargaining may again occur as the

transaction may not be agreed upon (Zingales 1997).
A third way that governance may effect overall economic efficiency is through
the level and distribution of risk. Assuming that the engaged parties have different risk
aversions, corporate governance can then act to efficiently allocate risk to those who are
least risk-averse (Fama and Jensen 1983), which improves the total surplus for the parties
involved.

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From a more general standpoint, it is also important to recognize that strong
governance in a system of capital markets such as the U.S. promotes an efficient medium
for those who are lending money and those who are borrowing, as well as provides some
security outside of the legal framework for lenders of capital. The nature of the firm
requires that financiers, or lenders of capital, will indeed lend their money to managers
who will in turn run a firm and hopefully create a return for the financiers. If the
financiers did not feel comfortable that they would be receiving their capital back at some
point in the future, they would not be inclined to provide managers with capital and, as a
result, innovation and industrial progression would be slowed tremendously. Strong
governance helps to maintain investors’ confidence in the capital markets and helps to
improve overall efficiency in this manner.

Recent Developments in Corporate Governance
Besides the theoretical basis of efficiencies provided by governance, it is
important to consider a more applied look at governance and how it has evolved over the
past two decades in the U.S. Indeed, corporate governance has changed substantially in
the past two decades. Prior to 1980, corporate governance did little to provide managers
with incentives to make shareholder interests their primary responsibility. As Jensen
(1993) discusses, prior to 1980 management thought of themselves as representatives of
the corporation as opposed to employees and representatives of the shareholders.
Management saw their role as one of balancing the interests of all related parties,
including company employees, suppliers, customers, and shareholders. The use of

incentive contracting was still limited, and thus management’s interests were not well
aligned with that of its shareholders. In fact, “in 1980, only 20% of the compensation of
CEOs was tied to stock market performance,” (Holmstrom and Kaplan 2003, p.5). Also,

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the role of external governance mechanisms like hostile takeovers and proxy fights were
rare, and there tended to be very little independence on a board of directors.
The 1980s, however, were defined as an era of hostile takeovers and restructuring
activities that made companies less susceptible to takeovers. Leverage was employed at
high rates. As Holmstrom and Kaplan (2003) argue, the difference between actual firm
performance and potential performance grew to be significant, or in other words, firms
were failing to maximize value, which lead to a new disciplining by the capital markets.
The 1990s, by contrast, included an increase in mergers that were designed to take
advantage of emerging technologies and high growth industries.
Changes in executive compensation throughout the two decades also changed
significantly. Option-based compensation for managers increased significantly as
executives became more aligned with shareholders, specifically, “equity-based
compensation in 1994 made up almost 50% of CEO compensation (up from less than
20% in 1980),” (Holmstrom and Kaplan 2003, p.9).
There were also changes in the makeup of U.S. shareholders during the two
decades, as well as changes in boards of directors. Institutional investors share of the
market increased significantly (share almost doubled from 1980 to 1996, Holmstrom and
Kaplan 2003), which came alongside an increase in shareholder activism throughout the
period. The increase in large institutional investors suggests that firms will be more
likely to be effective monitors of management. The logic follows because if an investor
(take a large institutional investor for example) owns a larger part of the firm, he will be
more concerned with the firm’s performance than if he were small because his potential
cash flows from the firm will be greater. It is important to note that often the large
shareholders are institutional shareholders, which means that presumably more
sophisticated investors with incentives to show strong stock returns own an increasing

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share of firms. Such concentration of ownership tends to avoid the traditional free-rider
problem associated with small, dispersed shareholders and will lead to the large
shareholders more closely monitoring management. “Large shareholders thus address the
agency problem in that they both have a general interest in profit maximization, and
enough control over the assets of the firm to have their interests respected,” (Shleifer and
Vishny 1996, p.27).
Other developments in corporate governance over the two decades, aside from the
regulatory and legislative changes post-Enron, include the fact that boards took great
strides to remove their director nominating decisions from the CEO’s control through the
use of nominating committees. The number of outside directors (referring to those
directors who are not members of management) also increased during the period, as did
directors’ equity compensation as a percentage of their total director compensation
(Holmstrom and Kaplan 2003).
However, despite such improvements over the past two decades, the case of
Enron suggests that corporate governance was not immune from failure, and it highlights
many of the theoretical and applied issues with the current theories on corporate
governance, the firm, and executive compensation.


III. WHAT HAPPENED AT ENRON: FACTUAL ACCOUNT OF EVENTS
LEADING TO BANKRUPTCY
Background/Timeline
Enron was founded in 1985 through the merger of Houston Natural Gas and
Internorth, a natural gas company based in Omaha, Nebraska, and quickly became the
major energy and petrochemical commodities trader under the leadership of its chairman,

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Kenneth Lay. In 1999, Enron moved its operations online, boasting the largest online

trading exchange as one of the key market makers in natural gas, electricity, crude oil,
petrochemicals and plastics. Enron diversified into coal, shipping, steel & metals, pulp &
paper, and even into such commodities as weather and credit derivatives. At its peak,
Enron was reporting revenues of $80 billion and profits of $1 billion (Roberts 2002), and
was for six consecutive years lauded by Fortune as America’s most innovative company
(Hogan 2002).
The sudden resignation, however, of Enron Vice-Chairman Clifford Baxter in
May of 2001 and subsequent resignation of CEO Jeffrey Skilling in August of 2001, both
of whom retired for undisclosed personal reasons, should have served as the first
indication of the troubles brewing within Enron. Mr. Skilling had been elected CEO only
months before, and Mr. Baxter had become Vice-Chairman in 2000. Eventually, amidst
analysts’ and investors’ questions regarding undisclosed partnerships and rumors of
egregious accounting errors, Enron announced on October 16, 2001 it was taking a $544
million dollar after-tax-charge against earnings and a reduction in shareholder equity by
$1.2 billion due to related transactions with LJM-2. As will be discussed in the following
section, LJM-2 was partnership managed and partially owned by Enron’s CFO, Andrew
Fastow. The LJM partnerships provided Enron with a partner for asset sales and
purchases as well as an instrument to hedge risk.
Less than a month later Enron announced that it would be restating its earnings
from 1997 through 2001 because of accounting errors relating to transactions with
another Fastow partnership, LJM Cayman, and Chewco Investments, which was
managed by Michael Kopper. Mr. Kopper was the managing director of Enron’s global
finance unit and reported directly to the CFO, Mr. Fastow. Chewco Investments was a

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partnership created out of the need to redeem an outside investor’s interest in another
Enron partnership and will be discussed at length in the following section.
Such restatements sparked a formal investigation by the SEC into Enron’s
partnerships. Other questionable partnerships were coming to light, including the
Raptors partnerships. These restatements were colossal, and combined with Enron’s

disclosure that their CFO Mr. Fastow was paid in excess of $30 million for the
management of LJM-1 and LJM-2, investor confidence was crushed. Enron’s debt
ratings subsequently plummeted, and one month later, on December 2, 2001, Enron filed
for bankruptcy protection under Chapter 11.

Summary of Transactions and Partnerships
Many of the partnership transactions that Enron engaged in that contributed to its
failure involved special accounting treatment through the use of specifically structured
entities known as a “special purpose entities,” or SPEs. For accounting purposes in 2001,
a company did not need to consolidate such an entity on to its own balance sheet if two
conditions were met: “(1) an owner independent of the company must make a substantive
equity investment of at least 3% of the SPE’s assets, and the 3% must remain at risk
throughout the transaction; and (2) the independent owner must exercise control of the
SPE,” (Powers, Troubh and Winokur 2002, p.5). If these two conditions were met, a
company was allowed to record gains and losses on those transactions on their income
statement, while the assets, and most importantly the liabilities, of the SPE are not
included on the company’s balance sheet, despite the close relationship between the
company and the entity.

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The Chewco/JEDI Transaction
The first of the related party transactions worthy of analysis is Chewco
Investments L.P., a limited partnership managed by Mr. Kopper. Chewco was created
out of the need to redeem California Public Employees’ Retirement System (“CalPERS”)
interest in a previous partnership with Enron called Joint Energy Development
Investment Limited Partnership (JEDI).
JEDI was a $500 million joint venture investment jointly controlled by Enron and
CalPERS. Because of this joint control, Enron was allowed to disclose its share of gains
and losses from JEDI on its income statement, but was not required to disclose JEDI’s

debt on its balance sheet. However, in order to redeem CalPERS interest in JEDI so that
CalPERS would invest in an even larger partnership, Enron needed to find a new partner,
or else it would have to consolidate JEDI’s debt onto its balance sheet, which it
desperately wanted to avoid.
In keeping with the rules regarding SPEs, JEDI needed to have an owner
independent of Enron contribute at least 3% of the equity capital at risk to allow Enron to
not consolidate the entity. Unable to find an outside investor to put up the 3% capital,
Fastow selected Kopper to form and manage Chewco, which was to buy CalPERS’ 3%
interest. However, Chewco’s purchase of CalPERS’ share was almost completely with
debt, as opposed to equity. As a result, the assets and liabilities of JEDI and Chewco
should have been consolidated onto Enron’s balance sheet in 1997, but were not.
The decision by management and Andersen to not consolidate was in complete
disregard of the accounting requirements in connection with the use of SPEs, despite the
fact that it is was in both Enron’s employees’ interest and in the interest of Enron’s
auditors to be forthright in their public financial statements. The consequences of such a

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decision were far-reaching, and in the fall of 2001 when Enron and Andersen were
reviewing the transaction, it became apparent that Chewco did not comply with the
accounting rules for SPEs. In November of 2001 Enron announced that it would be
consolidating the transactions retroactively to 1997. This consequently resulted in the
massive earnings restatements and increased debt on Enron’s balance sheet.
Not only was this transaction devastating to Enron, but its manager, Mr. Kopper,
received excessive compensation from the transaction, as he was handsomely rewarded
more than $2 million in management fees relating to Chewco. Such a financial windfall
was the result of “arrangements that he appears to have negotiated with Fastow,”
(Powers, Troubh, and Winokur 2002, p.8). Kopper was also a direct investor in Chewco,
and in March of 2001 received more than $10 million of Enron shareholders’ money for
his personal investment of $125,000 in 1997. His compensation for such work should
have been reviewed by the board’s Compensation Committee but was not.

This transaction begins to shed light on a few of the many corporate governance
issues arising from Enron, one being the dual role Kopper played as manager and
investor of the partnership while an employee of Enron. This is a blatant conflict of
interest, explicitly violating Enron’s own Code of Ethics and Business Affairs, which
prohibits such conflicts “unless the chairman and CEO determined that his participation
‘does not adversely affect the best interests of the Company,’” (Powers, Troubh and
Winokur 2002, p.8). The second governance issue is in connection with the
Compensation Committee’s lack of review of Kopper’s compensation resulting from the
transactions. The third governance issue deals with the lack of auditing oversight from
the Audit and Compliance Committee concerning the decision not to consolidate the
entity.

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The LJM Transactions
In June of 1999, Enron again entrenched itself in related-party transactions with
the development of LJM-1 and later with LJM-2. Both partnerships were structured in
such a way that Fastow was General Partner (and thereby investor) of the entities as well
as Enron’s manager of the transactions with the entities, an obvious conflict of interest.
LJM-1 (Cayman) and LJM-2 served two distinct roles. They provided a partner
to Enron for asset sales and as well as acted to hedge economic risk for particular Enron
investments. Especially near the end of a quarter, Enron would often sell assets to LJM-1
or LJM-2. While it is important to note that there is nothing inherently wrong with such
transactions if there is true transfer of ownership, it would appear that in the case of the
LJM transactions there were no such transfers.
Several facts seem to indicate the questionable nature of such transactions at the
end of the third and fourth quarters in 1999, one of which was that Enron bought back
five of the seven assets just after the close of the financial period (Powers, Troubh and
Winokur 2002). It is reasonable to assume that the sale was purely for financial reporting
purposes, and not for economic benefit. Another fact that casts doubt on the legitimacy

of the sales is that “the LJM partnerships made a profit on every transaction, even when
the asset it had purchased appears to have declined in market value,” (Powers, Troubh
and Winokur 2002, p.12). Thus it appears that the LJM partnerships served more as a
vehicle for Enron management to artificially boost earnings reports to meet financial
expectations, conceal debt, and enrich those investors in the partnerships than as
legitimate partners for asset sales and purchases.
Not only were the LJM transactions used in asset sales and purchases, but also for
supposed hedging transactions by Enron. Hedging is normally the act of protecting

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against the downside of an investment by contracting with another firm or entity that
accepts the risk of the investment for a fee. However, in June of 1999 with the Rhythms
investment, instead of the LJM partnerships committing the independent equity necessary
to act as a hedge for the investment should the value of the investment decline, they
committed Enron stock that would serve as the primary source of payment. “The idea
was to ‘hedge’ Enron’s profitable merchant investment in Rhythms stock, allowing Enron
to offset losses on Rhythms if the price of Rhythms stock declined,” (Powers, Troubh and
Winokur 2002, p.13). These “hedging” transactions did not stop with Rhythms, but
continued through 2000 and 2001 with other SPEs called Raptor vehicles. They too were
hedging Enron investments with payments that would be made in Enron stock should
such a payment be necessary.
Despite Andersen’s approval of such transactions, there were substantial
economic drawbacks for Enron of essentially “hedging” with itself. If the stock price of
Enron fell at the same time as one of its investments, the SPE would not be able to make
the payments to Enron, and the hedges would fail. For many months this was never a
concern, as Enron stock climbed and the stock market boomed. But by late 2000 and
early 2001 Enron’s stock price was sagging, and two of the SPEs lacked the funds to pay
Enron on the hedges. Enron creatively “restructured” some transactions just before
quarter’s end, but these restructuring efforts were short-term solutions to fundamentally
flawed transactions. The Raptor SPEs could no longer make their payments, and in

October of 2001 Enron took a $544 million dollar after-tax charge against earnings- a
result of its supposed “hedging” activities.
Though they eventually contributed to Enron’s demise, these related party
transactions concerning LJM-1 and LJM-2 resulted in huge financial gain for Fastow and
other investors. They received tens of millions of dollars that Enron would have never

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given away under normal circumstances. At one point Fastow received $4.5 million after
two months on an essentially risk-free $25,000 investment relating to LJM-1 (Powers,
Troubh and Winokur 2002).
As discussed earlier, one of the downfalls of the principal-agent problem under
the incomplete contract paradigm lies with the allocation of residual control rights to
managers. Because managers have much discretion associated with the residual rights,
funds may be misallocated. This exact problem, the misallocation of firm funds, arose in
the case of Enron. Enron shareholders had invested capital in the firm and management
was then responsible for the allocation of such funds. With the residual control rights
management maintained due to the separation of ownership and management,
management, vis-à-vis the firm’s CFO Andrew Fastow and Michael Kopper, was able to
expropriate the firm’s funds.
There are many different methods a manager may employ in the expropriation of
funds. A manager may simply just take the cash directly out of the operation, but in the
case of Enron, management used a technique called transfer pricing with the partnerships
they had created. Transfer pricing occurs when “managers set up independent companies
that they own personally, and sell output (or assets in this case) of the main company they
run to the independent firms at below market prices,” (Shleifer and Vishny 1996, p.9
excluding parenthesis). The “independent firms” mentioned above were the partnerships,
like Chewco, JEDI, and the LJMs that Fastow and Kopper managed and had partial
ownership of. With the partnerships like the LJMs making a profit on nearly every
transaction, it is clear that Enron must have been selling those assets at below market
levels, which defines expropriation by way of transfer pricing. It then makes sense that

as the partnerships sold back the assets, they profited each time because Enron would re-
purchase the assets at prices higher than what the partnerships had paid. Therefore,