'Constitution of boards will be questioned'

Sometimes, it is difficult to separate fact from fiction. The sudden collapse of Enron and its auditor Arthur Andersen in the closing months of 2001 seems to indicate that these organisations were run by infamous villains: Kenneth Lay and Jeffrey Skilling among them. But Latha Ramchand, Associate Professor at the University of Houston, who had a ringside view of the debacle, is inclined to be more charitable.

"It is fashionable to think that Enron did everything wrong. But they did many things right as well," she recently told an audience in Mumbai during a presentation on "The rise and fall of Enron" organised by the Indo-American Society Management Development Forum. What went wrong was corporate governance.

Among the things Enron got right: it was the first to spot a niche in the energy market and became an energy bank. In the 1990s, it converted itself from a humdrum producer and seller of energy to a market-maker in energy-related products. It almost single-handedly created a market for energy contracts and swaps. These were just what a deregulated energy market needed.

The real failures of Enron relate to lack of transparency, corporate arrogance, a cozy relationship with its auditors (which prevented the latter from blowing the whistle), a somnolent board, and poor external vigilance (the SEC and the rating agencies acted only after Enron's share prices crashed).

Among other things, Enron has been accused of hiding its debt by moving (mostly non-performing) assets to special purpose entities (SPEs) and even booking revenues on these sales; allowing CFO Andy Fastow to run these SPEs even though there was a clear conflict of interest; and penalising employees who protested against what was happening within the company.

With the share price of Enron collapsing from $60 in March 2001 to 26 cents in November, investor confidence has been shaken. Ramchand believes that the Enron tragedy could have been avoided if a few home-truths had been recognised earlier by the management: that value is created on the asset side of the business; that financial techniques can only do so much; that credibility is the biggest asset for a company that is basically a trader.

Enron also disclosed the real state of its balance-sheet in dribs and drabs. When things go wrong, the markets expect complete transparency and full disclosures; but Enron took its time to restate earnings, and disclosed conflicts of interest only after the damage had been done.

In an exclusive interview to Indian Management, Ramchand gives an academic's perspective to the Enron fiasco, and what the lessons are in the area of corporate governance and management responsibilities.

Excerpts:

On what the Enron case implies about the state of corporate governance in US companies.

Things need to be changed. There is clearly going to be a short-term effect. The top executives of Enron are not going to be on any boards. People are going to question the constitution of boards in general. I'm not saying that it is hard to be independent, but somewhere some change needs to be done.

But having said that, and having gone through the financials of companies throughout the world, it is amazing that this lack of independence is more like the norm outside the US. For instance, in some cases, people on the board do business with the company. And companies do not hesitate to admit those kinds of things.

It's time that recognition is given to corporate governance. I don't think it is going to happen overnight. To the extent that everything is being scrutinised currently, there are going to be some changes, especially given the rise of institutional ownership.

On whether all major corporates are going to come under scrutiny by the markets.

I think it is going to the other extreme now. For instance, conglomerates like Tyco have tried to spin off their divisions. But with the slightest semblance of any wrongdoing, the market is just beating down their stocks. In a way that is good. And there are issues (of concern). For instance, take the way Tyco books its revenues.

Tyco has a security division that makes alarm systems. If they get customers through their own sales force then it is an expense; however, if they contract it, it is treated as an asset and written off. So how do you determine whether any increase in revenue that comes about suddenly is going to last? It is very dependent on the way the accounting is done, and that information has to be revealed. The problem is that information is not revealed.

The nicest thing about the US is the breadth of the stockmarket. The reason it is so broad and deep is because of information. It's not that an investor in the US is much smarter than in the rest of the world.

It's only that they have access to all this information. Much of their stuff is in pension funds, and these funds have guys whose job it is to read the financials. If they do not have access to the information they need, they are not going to accord value to those kinds of companies.

And we are going to see a very big hiatus between well-run companies from a corporate governance perspective and the not-so-well-run companies. Money will just flow to the well-run companies and that is going to force companies to explain what they are doing.

On whether compensation paid to CEOs is also an issue now.

I have not seen any signficant discussion of CEO compensation related to the Enron case - rather the topic of discussion is partnerships and the compensation from the partnerships along with the conflict of interest.

If anything, I find it strange that most Enron employees that I spoke to were very supportive of Kenneth Lay. However, independent of the Enron case, its becoming increasingly known that CEO compensation as compared to the salary of the average employee has gone up tremendously. It used to be a ratio of nine to one 10 years ago; but I think today it is 245 or 250 times the average employee's salary. So something has to happen there. I don't think that (kind of differential) is going to last.

On whether companies will rethink ESOPs, since Enron's top management was found to be selling stock while advising employees to hold on to theirs.

I think what companies are focusing on is in not denying any rights to employees that the officers have. So if officers can sell stock, even employees can sell stock. The ESOP issue is hard to tell because you complain about it only if it goes wrong.

Personally, I feel people should have the independence to invest (in a company's stock). What is being planned now in the US is to have an independent firm to monitor the investments that a company makes for employees in the pension plan.

Companies are hesitant to do very much because they feel they can be sued on that. On the other hand, if you have an independent body that advises employees, then that risk is shifted to them. But it would be a mistake when politicians dictate terms on how much employees of companies should be allowed to invest in their own companies' stock. That does not make sense.

On how one can check conflicts of interest between auditors and their business interests in companies they audit.

I think what they are trying to do is to get the US Securities and Exchange Commission (SEC) to come in and manage the audit function.

On whether it is feasible for the SEC to audit thousands of companies.

The proposal to have firms change their auditors every three years makes more sense to me. However, the more rules you have, the more people are going to find ways to get around them. The other problem in countries like the US is that we have so few accounting firms now and the big companies tend to go to the big five audit companies.

And the consulting, auditing and accounting divisions have all got meshed into one. The accounting lobby is so strong that many believe the FASB (the Financial Accounting Standards Board) does not do anything (to prevent conflicts of interest). They sit on proposals for too long; meanwhile, somebody lobbies hard enough that the entire thing is shelved.

On who is blamed for the Enron fiasco? The SEC, FASB or the political system?

Right now, Andersen is bearing the brunt. And, in my opinion, rightfully so because they were also the auditors. Though difficult, the market has its own way of regulating things and that is the beauty of the system. So Andersen might be bearing the brunt right now, but rating agencies are also coming under question by people.

On whether Enron could have survived if it had merely been transparent.

Yes, I think so. The trading part of the business was actually making money. The person who ran this division was reputable. If Enron had disclosed its problems in October 2001, repercussions may not have been so severe.

It seemed like things came out in bits and pieces and the market's confidence was shattered. After all they were traders, and the counterparty had to believe in their credibility. That's what they completely lost. It was a problem that they brought on to themselves.

In August, Sharon Watkins (a senior Enron executive) went to talk to Kenneth Lay (about the problems). They had a one-hour meeting after which Lay said "I'm going to look into this". But then the message that is believed to have been passed on to the lawyers is that, "look into it but don't change too many things from what they are right now".

So nothing happened and when they had to restate their equity and earnings, they could not stop as they came under public glare. That's when the organisation of the SPEs became public.

On whether the US markets will see more regulation (just like the Sebi action in March 2001).

In the Indian instance, probably regulation might work because you are trying to correct the market in view of some monopoly or illegal activity. In Enron's case it is not yet clear because you are not trying to correct the market. You are only trying to make more information available.

I don't see a whole lot of regulatory changes happening and I think that it is good. Eternal vigilance is the only thing that is going to work. That's the point about the market. The more investors you have, eternal vigilance is more likely to happen.

On the importance of audit committees and remuneration committees in corporate governance.

I think it is very important. From an academic perspective we teach that the board is supposed to make sure that the management upholds shareholder interest.

The audit committee has to approve the formation of SPEs. The compensation committee has to approve the CEO's compensation. The problem is these committees (sometimes) do not take their roles seriously or they get compensated to approve everything.

But people are not going to take these lying down. For instance, around 1995 Disney looked at the composition of its board. There were people on the board because CEO Michael Eisner knew them. Calpers (the California state pension fund) said they had to change the board.

It took a while but it has happened. The board looks completely different now. Institutional leadership certainly has a role to play on that front. It would be great if every shareholder decided to voice his opinion.

In fact, the labour lobby is now taking a very active role in making sure that the executives on Enron's board quit any other board that they are on. An executive on the Motorola board who was on the Enron board is now under pressure. He's not been removed from the Motorola board but they are certainly going to rethink the way they constitute boards in future.

On why the pension funds failed to read Enron's problems earlier.

In fact, some of them did. UCLA, the lead plaintiff in a suit against Enron, invested a lot of money in Enron. They had invested a lot of money in the initial SPEs of Enron which worked fine. Then towards the end one SPE was not doing well and needed more funds.

They went back to UCLA to put more money into their company and the fund declined as there was a clear conflict of interest. At that point of time they could not find any other investor. Part of the reason for Enron's earnings restatement was UCLA's refusal to invest more money in SPEs.

To some extent, what came about was because somebody was alert. It's just that it took a while. There were analysts who pointed out errors in the Enron annual statement.

On the media's role in making Enron executives into superstars.

Yes, CFO magazine named Enron's CFO (Andy Fastow, who ran some SPEs) as 'CFO of the year' in 1999 for having come up with creative accounting. But then Forbes magazine raised a few points of doubt on the profit margins.

On whether improved segmental reporting, as now mandated in India, would make things more transparent.

Most financials at some point of time say that this part of revenue comes from this segment. Certainly, if more information is revealed to the market, it can never hurt a company. That is how a good company distinguishes itself from the bad ones.

If you have nothing to hide, go ahead and show it. In fact that's what is happening today. When markets were doing well with "irrational exuberance", the distinction (between good and bad companies) became very weird. That's just being corrected.

In India, one issue that prevents companies from being transparent is that Sebi is not as strict as the SEC. The complaint against SEC is that they are (too) strict. Maybe, if you have family-owned companies you do not have to worry as you can raise money through family members. You do not need to go through the discipline of the market. It is when you have a market to face, that transparency has to come along.

In fact, that is what we find when we study Indian firms that go for ADR listing. Not every Indian can do that (raise ADR money) because they have to meet SEC requirements and cross the threshold (of transparency). Indian companies (that go for ADRs) do not have any obvious benefit except of the stock price going up in the initial days. But over a period of time it distinguishes these companies from the chaff. There's some value there.

On whether top managements can distance themselves from accounting non-transparency.

The law states that you can't claim ignorance. But whether it is management oversight or connivance in Enron's case it is a little fuzzy. But, on the other hand, when you are publicly held and are responsible to shareholders and you are doing all this at the expense of them, it is morally wrong. It may be legally right, but the law needs to be changed.

This article was published in the May 2002 issue of Indian Management