Commentary: How Governance Rules Failed at Enron
By Louis Lavelle
One of the mysteries of Enron Corp.'s (ENE ) fall from grace is how an audit committee chock full of talent could have been blind to the company's financial sleight of hand. So far, speculation has centered around the apparent failure of Enron's auditors, Arthur Andersen LLP, to alert the audit committee to the problem until very late in the game. But the truth is, the audit committee deserves much of the blame for Enron's collapse--and the corporate governance movement deserves much of the blame for the Enron audit committee.
Whatever its flaws, the committee followed all the rules laid down by federal regulators, stock exchanges, and governance experts regarding director pay, independence, disclosure, and financial expertise. Enron collapsed in large part because the rules didn't accomplish what the experts hoped they would. For example:
-- Paying directors with stock may have aligned their interests with shareholders', but it's just as likely to have created a motive for not asking the tough questions.
-- Disclosure rules may have alerted investors to the fact that one audit committee member had a potential conflict of interest, but not that two others did as well.
-- The Enron audit committee may have been exactly what the stock exchanges had in mind in December, 1999, when they required that members demonstrate financial know-how--but the expertise may have been out of date following the changes Enron went through in the 1990s. In any case, it didn't help the committee make sense of Enron's tangled finances.
Bottom line: It may be time to rethink the rules.
Certainly there was nothing unusual about the Enron directors' heavy stock ownership. Boards in general have bought into the argument by governance experts that directors should get paid largely with stock to make sure they act in the best interest of shareholders. Of the top 200 companies, 99% pay directors with stock, up from 81% in 1995. And 62% of director pay comes in equity, up from 24% in 1995, according to pay consultant Pearl Meyer & Partners.
Clearly, stock is king. But should it be? Auditors are prohibited by the Securities & Exchange Commission from owning stock in client companies precisely because of its potential to corrupt. Yet audit committee members, like all directors, are essentially required to own stock, presumably because it keeps them honest. Three of the six audit committee members owned nearly 100,000 Enron shares worth a total of more than $7.5 million as of Feb. 15--shares that surely would have plummeted in value had directors forced management to come clean about the risks of some of the company's off-balance-sheet partnerships.
The committee's failure to force an earlier and more public explanation of Enron's finances suggests to some that the shares, instead of making shareholder interests the directors' top priority, did the opposite--in effect buying their silence. "Did greed blind them? I think it's very possible," says John M. Nash, co-founder of the National Association of Corporate Directors. In fact, one lawsuit alleges just that, claiming that Enron insiders--including three current audit committee members--sold 17.3 million shares for $1.1 billion to an unsuspecting public while issuing financial statements later revealed to be pure fiction. The audit committee members either declined to comment or did not return calls. But Enron says the board since 1999 approved the most controversial partnerships, established controls, and acted "quickly" in November to restate earnings when the problems became apparent, albeit weeks after Enron's shares plunged amid questions about the partnerships.
It's hard to argue that directors shouldn't own shares at all. But banning sales by directors for the duration of their terms would motivate directors to preserve a company's long-term value instead of taking a see-no-evil approach to oversight.
If the stock didn't blind the Enron audit committee members, their financial ties to the company may have. It's a problem that governance critics anticipated. But what's troublesome is that SEC disclosure rules required Enron to make known only one of those ties: director John Wakeham's $6,000-a-month consulting contract. One would need to venture far afield from Enron's securities filings to learn from the University of Texas that Enron, Chairman Kenneth Lay, and their foundations had given $332,150 to the school's M.D. Anderson Cancer Center since 1999. That's when center President John Mendelsohn became an Enron director. Also undisclosed by Enron: $50,000 that the company and the Lay family foundation gave to George Mason University's Mercatus Center, where Wendy Lee Gramm has been head of regulatory studies since she joined the center in 1997. Enron and its employees also made political contributions of more than $80,000 to her husband, Senator Phil Gramm (R-Tex.), since she became an Enron director in 1993.
Governance experts say the audit committee's lack of independence made it less inclined to question management. "These are humans," says Richard H. Koppes, former general counsel for the California Public Employees' Retirement System. "You're not going to want to rock the boat." At the very least, investors were entitled to know that half the committee had financial ties to the company. The SEC should move quickly to propose a rule, long sought by institutional investors, requiring the disclosure of all financial ties with directors--personal, family, business, political and philanthropic. Using that standard, about 30% of the nearly 1,200 companies tracked by the Investor Responsibility Research Center have audit committees that are less than 100% independent.
One of the few areas where Enron disclosed a wealth of information was in the qualifications of board members. On paper, the audit committee was as qualified as any, more than fulfilling the 1999 requirement by stock exchanges that members demonstrate financial literacy. Committee Chairman Robert K. Jaedicke was a Stanford University accounting professor for 30 years. Ronnie C. Chan and Paulo V. Ferraz Pereira are executives. Mendelsohn runs a university cancer center. Gramm is an economist. And Wakeham belongs to the House of Lords.
Yet, as a group, they were apparently unable to decipher the tangled web of off-balance-sheet deals that effectively hid Enron's debt and inflated its earnings. Jaedicke, 72, has been retired for more than a decade. Some have suggested privately that he may not have been up to speed on the complex financing strategies that were so integral to Enron's rapid transformation from an energy pipeline company into a trading outfit. Some governance experts now conclude that meeting the textbook definition of financial literacy is not a guarantee that directors understand sophisticated financial instruments.
The truth is that the ideal audit committee envisioned by the rules governing independence and financial literacy is to some extent a mythical beast. Big global companies are now so complex that insiders are often the only people who truly understand them. But only outsiders have the independence to rein them in. And many boards don't exercise the diligent oversight companies need. A new survey of audit committees at 50 U.S. companies by Joseph V. Carcello, an associate accounting professor at the University of Tennessee at Knoxville, found they typically meet just three times a year, only two-thirds bother to review their companies' internal audits, and fewer than one in five have unrestricted access to company records. Enron's committee met five times in 2000; the company's proxy is unclear on whether it reviewed the internal audit or had unfettered access to records.
If nothing else, the Enron debacle should occasion some soul-searching on the part of federal regulators and stock exchanges that make the governance rules. It would help if audit committees were required to convene meetings more frequently, conduct an annual review of the internal audit, and educate members in more than just the balance-sheet basics. "Ultimately," says Alan Cleveland, counsel to the New Hampshire Retirement System, an Enron shareholder, "what it comes down to is what goes on not only in the boardroom but in the minds of these outside directors." For governance to work, directors need to understand that their job is to keep tabs on management--not simply show up.
Lavelle covers management issues from New York.