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Enron Briefing
Clarkson Centre for Business Ethics
& Board Effectiveness—CC(BE)CC(BE)22
& Executive Programs
Rotman School of Management
March 19, 2002
Rotman School of Management, March 19, 2002 2
Agenda Background
• Enron• Accounting Disclosure Manipulation
Enron Problems• Structures, activities and disclosures• Control and culture
Lessons• Governance• Accounting standards and profession• Director’s Behaviour
Questions
Rotman School of Management, March 19, 2002 3
Rotman Briefing Team Ramy Elitzur – Accounting, Audit
Former Director, MBA Program, [email protected]
Irene Wiecek – Accounting, AuditAssociate Director, MMPA, [email protected]
Eric Kirzner – Finance, Governance Director, Market Regulation Services, + [email protected]
Len Brooks – Governance, Ethics, Accounting, AuditExec. Dir. , The Clarkson Centre for Business Ethics & Board EffectivenessDirector , Master of Management & Professional Accounting (MMPA)Director, Diploma in Investigative & Forensic Accounting (DIFA)
Rotman School of Management, March 19, 2002 4
The Enron Affair Management was:
• out of control, and engaged in self-dealing• manipulating transactions & financial reports
Company imploded - Chap. 11 in Dec. 2001 Investors misled, pensions lost Executives plead the 5th, poor memory,
ignorance, incompetence Outrage Auditor savaged, profession to be changed
Rotman School of Management, March 19, 2002 5
Overview of Key Problems Governance failure at the Board level
• Too much trust• Incompetence - awareness and/or understanding of
role , control & reporting systems• Lack of motivation, conflicts of interest
Dishonest management, conflicts of interest Culture of deception, self-interest Manipulation of accounting and disclosure Poor standard setting Auditor deficiencies Regulatory short-sightedness
Rotman School of Management, March 19, 2002 6
Enron Stock Chart
Source: www.globe investor.com
Weekly Prices 1997- 2002
Rotman School of Management, March 19, 2002 7
Enron’s Business (10K-2000) Transportation and distribution Wholesale services
• Commodity sales & services, risk management products, plants, etc
Retail energy services - gas, electricity Broadband services
• Nationwide fiber-optic network - build, market, etc. Corporate and other
• operation of water, renewable energy, and clean fuels plants plus other corporate activities
Rotman School of Management, March 19, 2002 8
Enron’s Income (IBIT):Income Before Interest, Minority Interest and Income Taxes
2000 1999 1998
Transport & distribution ($ mil.) Trans. Services 391 380 351Portland General 341 305 286
Wholesale Services 2,260 1,317 968Retail Energy Services 165 (68) (119)Broadband Services (60)Exploration & prod. - 65 128Corporate and other (615) (4) (32)
IBIT 2,482 1,995 1,582
Rotman School of Management, March 19, 2002 9
Enron’s Wholesale Services
…creation of networks involving selective asset ownership, contractual access to third-party assets and market-making activities. 10K p.36.
…uses portfolio and risk management disciplines, including offsetting or hedging transactions, to manage exposures to market price movements (commodities, interest rates, foreign currencies and equities). 10K p.37.
… sells interests in certain investments and other assets to improve liquidity and overall return, 10K p.37
Rotman School of Management, March 19, 2002 10
Enron’s Financial Data2000 1999 1998
Revenues(in Billions) 100.8 40.1 31.3
Operating income (Millions) 1,953 802 1,378IBIT 2,482 1,995 1,582Net Income before Cumulative
Accounting Changes 979 1,024 703Net Income 979 893 703EPS (in dollars) - basic 1.22 1.17 1.07
- diluted 1.12 1.10 1.01
Rotman School of Management, March 19, 2002 11
Enron’s Financial Data2000 1999
Current assets (Billions) 30.4 7.3
Investments, other 23.4 15.4
Property, plant, equip, net 11.7 10.7
Total Assets 65.5 33.4
Current liabilities 28.4 6.8
Long-term Debt 8.6 7.2
Deferred credits and other 13.8 6.5
Shareholders’ Equity 11.5 9.6
Total Liab. & Shareholders’ Equity 65.5 33.4
Rotman School of Management, March 19, 2002 12
Enron’s Changing Risk Profile
Early By Risk 1990’s 2000 Level
Pipelines, distribution networks LowRetail energy LowPower generation LowOil and gas exploration Med.Alternative energy M/HHedging transactions HighCommodity trading transactions HighBroadband optical fiber networks V. High
Related party transact. (SPEs/Partnerships) ???
Rotman School of Management, March 19, 2002 13
Corporate Governance
Role of the Board of Directors - traditional strategic objectives - set or approve company policies and procedures:
• set or approve• ensure dissemination and compliance
laws, regulations, & expectations of society• ensure monitoring and compliance• act as ethical conscience (Dey Report & CICA)
Rotman School of Management, March 19, 2002 14
Enron’s Governance Failure Begins
1997 - Board suspends code of conduct to deal with an SPE (JEDI/Chewco) emergency (alternative controls considered …not implemented)• Can’t find outside investor before year-end• Non-consolidation tests not satisfied:
• Outside investor - 3%investment at risk, control. Fastow (CFO) has Koppers - who reports to
Fastow - appointed to run/invest/control SPE Realization that guard is down/can be controlled
Rotman School of Management, March 19, 2002 15
Enron’s Governance Structure
BoardKen Lay: Chair; Co-chair ZZZ
Audit, Compensation Cees.
ManagementLay, Skilling: CEO
Fastow, CFO; KoppersCausey, CAO; Buy, CRO
Watkins; Kaminsky; McMahon
Company Policies
Code of Conduct
Internal Audit ?
Whistleblowers ?
AuditorArthur
Andersen
Outside Law Firm
Consultant: Arthur Andersen
MissingSuspended
Compliance
GuidanceFinan.
ReportsSPEs
© L. Brooks
Rotman School of Management, March 19, 2002 16
Governance Failure Allows Fastow to control SPE transactions:
• Sales of assets at inflated prices (False gains)• False hedging of losses on Enron investments
(Falsely keeps losses off Enron Income Stat.)• Exorbitant payments to Fastow & helpers• Hiding of SPE debt ultimately to be borne by
Enron Fastow to create more SPEs (LJMs…) Manipulation of accounting disclosure
Rotman School of Management, March 19, 2002 17
Partial Impact
Payments to Fastow & helpers Invest._ Return Other
Fastow $25,000 $4.5 mil in 2 mo. $30 mil+stock options+Koppers 125,000 10 mil (incl. $2 mil in fees
friend)2 others 5,800 1 mil
Manipulated transactions in Q3 & Q4, 1999Asset sales, plus 1 hedge $229 profit of $570 before tax
and 549 after tax (~50%)
Rotman School of Management, March 19, 2002 18
Manipulation of Accounting Disclosure
A Backgrounder
The Accounting Art of WarBy Ramy Elitzur
Rotman School of Management, March 19, 2002 19
The Accounting Art of War
“A Strategy of Positioning evades Reality and confronts through Illusion.”
The Art of War by Sun Tzu
© R.Elitzur
Rotman School of Management, March 19, 2002 20
The Accounting Art of War
“Appearance and intention are fundamental to the Art of War. Appearance and intention mean the strategic use of ploys, the use of falsehoods to gain what is real.”
The Book of Family Traditions on The Art of War, Yagyu Munenori
© R.Elitzur
Rotman School of Management, March 19, 2002 21
The Accounting Art of War
The accounting art of war incorporates the entire menu of reporting strategies that management employs to manipulate financial statements.
Involves much more than earnings management.
© R.Elitzur
Rotman School of Management, March 19, 2002 22
The Agency Framework
Modern corporations have a separation of ownership and management.
As such, there is an inherent conflict of interests between shareholders and managers.
Mechanisms to alleviate the agency problem:• Compensation plan (to create goal congruence
between shareholders and managers)
• Monitoring or auditing, both internal and external.
© R.Elitzur
Rotman School of Management, March 19, 2002 23
The Agency Framework In The Context of Enron
The Mechanisms to alleviate the agency problem failed in Enron:• The compensation plan: Not only it did not
reduce the agency problem but it actually exacerbated it.
• Monitoring or auditing, both internal and external failed to bring the accounting problems to light.
© R.Elitzur
Rotman School of Management, March 19, 2002 24
Tools in The Accounting Art of War
Earnings Management Revenue Manipulation Off-Balance-Sheet Liabilities Sheer Opportunism
© R.Elitzur
Rotman School of Management, March 19, 2002 25
Tools in The Accounting Art of War
Earnings Management
Companies may want to: Increase reported earnings. Decrease reported earnings. Smooth earnings.
© R.Elitzur
Rotman School of Management, March 19, 2002 26
Earnings Management
Merchant (1990) and Merchant and Bruns (1990) find that earnings management is a widespread phenomenon.
Furthermore, the same studies surveyed managers and report that, according to these managers, earnings management is an acceptable practice.
Rotman School of Management, March 19, 2002 27
Increasing Reported Earnings
Why? This could increase bonus and other
compensation.
© R.Elitzur
Rotman School of Management, March 19, 2002 28
Examples
Enron Waste Management where the company
overstated income from 1992 to 1996 by more than US$ 1 billion.
Livent, Inc.
© R.Elitzur
Rotman School of Management, March 19, 2002 29
Income Decreasing Strategy
Why? In cases of monopoly because of anti-
trust considerations. Regulated utilities. ‘Blood Bath’.
© R.Elitzur
Rotman School of Management, March 19, 2002 30
Example
Microsoft The issue of capitalization of software
development costs. Does this strategy have a significant
impact?
© R.Elitzur
Rotman School of Management, March 19, 2002 31
1999 2000 2001 Revenue $ 19,747 22,956 25,296 Operating expenses: Cost of revenue 2,814 3,002 3,455 Research and
development 2,970 3,772 4,379
Sales and marketing 3,238 4,126 4,885 General and
administrative 715 1,050 857
Total operating expenses
9,737 11,950 13,576
Operating income 10,010 11,006 11,720 Losses on equity investees and other
(70) (57) (159)
Investment income/(loss) 1,951 3,326 (36) Income before income taxes 11,891 14,275 11,525 Provision for income taxes 4,106 4,854 3,804 Income before accounting change
7,785 9,421 7,721
Cumulative effect of accounting change (net of income taxes of $185)
– – (375)
Net income $ 7,785 9,421 7,346
Microsoft Income Statements
© R.Elitzur
Rotman School of Management, March 19, 2002 32
R&D % 1999 2000 2001Of Sales 15.04% 16.43% 17.31%Of Op. Inc. 29.67% 34.27% 37.36%
The Magnitude of R&D Expenses in Microsoft
© R.Elitzur
Rotman School of Management, March 19, 2002 33
The Accounting Art of War (Cont.)
Manipulation of Valuation Companies may want to increase
reported revenues. Example: MicroStrategy
© R.Elitzur
Rotman School of Management, March 19, 2002 34
MicroStrategy
the Securities and Exchange Commission, when moving to crack down on lax accounting standards, in December 2000 has found that MicroStrategy Inc., an inventory-management software maker, was prematurely recognizing revenue.
© R.Elitzur
Rotman School of Management, March 19, 2002 35
MicroStrategy Stock PriceAccounting Change
© R.Elitzur
Rotman School of Management, March 19, 2002 36
Sunbeam
A new CEO, "Chainsaw Al" Dunlap, was hired in mid 1996 to turn the company around. A year after he was hired, Al Dunlap Dunlap declared success in turning Sunbeam Corp. around in terms of profits and revenues.
It was later found that the revenue growth came from manipulation of revenues.
© R.Elitzur
Rotman School of Management, March 19, 2002 37
Sunbeam (Cont.)
The company instituted an "early buy" program for gas grills in the fourth quarter that gave retailers the opportunity to buy grills in November and December of 1997 but not pay until as late as June 1998.
The company also started a "bill and hold" program that allowed Sunbeam customers to use its warehouses to store goods that they had bought, but not necessarily paid for.
© R.Elitzur
Rotman School of Management, March 19, 2002 38
Sunbeam (Concluded)
Between them, these two programs accounted for a substantial part of Sunbeam's apparent revenue gains in 1997. In essence, these revenues were nothing more than future sales booked now. When this was found out the prices of Sunbeam Corp. shares plunged.
© R.Elitzur
Rotman School of Management, March 19, 2002 39
Other Notable Examples of Revenue Manipulation
Rite Aid (inflated revenues in 1998 and 1999 by over US$ 1 billion)
HomeStore.com (booked US$ 54 million to US$ 95 million as ad revenue in the first three quarters of 2001 that it never received in cash but as a result of revenue swaps with advertisers for undisclosed goods and services).
© R.Elitzur
Rotman School of Management, March 19, 2002 40
Off-Balance-Sheet Financing
Companies may want to omit debt from the balance sheet.
© R.Elitzur
Rotman School of Management, March 19, 2002 41
Example of Off-Balance-Sheet Debt
Enron Motivation:Lower cost of debt to finance
aggressive acquisition strategy. Special Purpose Entities (SPEs). Debt
omitted over $600 million. Financial Instruments. Debt not shown
on the balance sheet $1.5-3 billion.
© R.Elitzur
Rotman School of Management, March 19, 2002 42
GE
Just recently (March 2002) General Electric Co. reported that it had off-balance-sheet SPEs that held US$56 billion of assets at the end of 2001, up from US$ 41 billion a year earlier.
© R.Elitzur
Rotman School of Management, March 19, 2002 43
Kmart
Kmart has long-term lease commitments that had, based on my calculations, a present value around US $5.5 billion in 2000. When added both to the assets and liabilities of Kmart in 2000 it changed the debt to equity ratio from 1.4 to 2.3 and the debt/assets ratio from 58% to 70%.
© R.Elitzur
Rotman School of Management, March 19, 2002 44
Air Canada
A similar exercise in Air Canada resulted in an addition of C$ 7.5 billion of assets and liabilities and a jump in the debt/equity ratio from 17.72 to 38.38.
© R.Elitzur
Rotman School of Management, March 19, 2002 45
Adjustment for Off-Balance Sheet Leases - HBC (1999)
(3) B/S & financial ratios adjusted for capitalization:
Jan. 2000 Financial
Statements
Adjustments for
capitalizationTotal
TA 4,274,212 +1,362,183 5,636,395LTD 700,184 +1,362,184 2,062,367E 2,265,525EBIT 271,544
Current Adjusted DifferenceLTD/E 0.31 0.91 195%ROA 0.064 0.048 -24%
© R.Elitzur
Rotman School of Management, March 19, 2002 46
Opportunism
Example: Air Canada
© R.Elitzur
47Rotman School of Management, March 19, 2002
Air Canada Q2’01: Revenues hurt by economy, competition
(millions)Consol.
2001Q2
AC & CA2000 Q2
(adjusted) Change
Oper. Revenue $ 2,564 $2,772 $ (208)
Oper. Expense 2,635 2,571 64
Oper. Income (Loss) (71) 201 (272)
Non-oper. Income (Exp) (76) (49) (27)
Income (Loss) Before Tax (147) 152 (299)
Tax (Provision) Recovery 39
Net Income (Loss) $ (108)
Per Share $ (0.90)© R.Elitzur
48Rotman School of Management, March 19, 2002
Air Canada
Q1’01: Difficult Economic, Cost Environment (millions)
Consol.2001Q1
AC & CA2000Q1 Change
Oper. Revenue $ 2,344 $2,305 $ 39
Oper. Expense 2,637 2,462 175
Oper. Income (Loss) (293) (157) (136)
Non-oper. Income (Exp) (1)
Income (Loss) Before Tax (294)
Tax (Provision) Recovery 126
Net Income (Loss) $ (168)
Per Share $ (1.40)
Per Share Ex. 1x $ (1.84)
© R.Elitzur
Rotman School of Management, March 19, 2002 49
How Fastow/Enron Misused SPEs
To manipulate financial reports and
siphon off funds to Fastow & helpers
until the company imploded.
By Irene Wiecek
Rotman School of Management, March 19, 2002 50
Guiding Financial Reporting Principles Economic substance over legal form – portrayal of reality
• Which assets and liabilities are part of the company?• When is a transaction a bona fide transaction? • Management intent
Arm’s length presumption - party is unrelated and bargaining on its own account – therefore price and terms fairly arrived at.• Versus related party transactions – fiduciary
responsibilities Transparency – also a fundamental principle of efficient
capital markets
The difficulty with Enron lay with sifting through the complexity
Rotman School of Management, March 19, 2002 51
Decision making principles
All the relevant information available? Quality of information i.e. based on
reality, numbers reliable? Understandable?
“Enron’s SPEs were a mystery to most people at Enron”
Rotman School of Management, March 19, 2002 52
• Economic entity concept - extends beyond legal entity
Economic Entity
Legal Entity
Which assets & liabilities are part of the company?
For Enron, the big issue was whether the SPEs were part of the entity
Rotman School of Management, March 19, 2002 53
Economic entity concept
Report on resources controlled by the company – where the company has the potential to reap the benefits but is also exposed to the risks
Consolidated financial statements recognize that even though there may be separate legal entities, together, they constitute an economic unit
Rotman School of Management, March 19, 2002 54
The Concept of Control
Continuing power to determine strategic policies without the cooperation of others
Spectrum
No control Significant Joint Control
Influence Control
Related parties
Rotman School of Management, March 19, 2002 55
Control Benchmarks
General presumption regarding control• Normally – equity ownership >50% - must
also prove control exists• SPE – U.S. equity investment (at risk) >3%
(now 10%), Canada >10% - must also prove control exists
Rotman School of Management, March 19, 2002 56
SPE Primer
Consider the following:• Demonstrably distinct – cannot be unilaterally
dissolved by transferor, outside ownership• Restrictions on activities • Legal form - may be corporation, partnership or
trust
SPEs are meant to be outside entities
Rotman School of Management, March 19, 2002 57
SPE Primer
Business reasons for creating SPE• Economic benefits i.e. collateralize assets, share risk,
obtain more favourable financing, cash out,
• Examples - synthetic leases, pools of similar assets (AR, mortgages, investments)
Wrong reasons • get debt off financial statements, hide losses/risks,
generally manipulate financial statements, “P&L protection”
Rotman School of Management, March 19, 2002 58
Enron’s SPEsChewco/JEDI Syndicated
investment
Off balance sheet liabilities ($628 million), revenues recognized early, profits on own shares
LJM Provided market
for assets
Artificial profits
Equity overstated($1.2 billion)
LJM1/Rhythms Investment
“hedge”
Unrecognized losses($508 million ‘97-’00)
LJM2/Raptors Investment
“hedge”
Unrecognized losses ($544 million)
Rotman School of Management, March 19, 2002 59
Chewco/JEDI
Intent - JEDI Originally formed in 1993 with CalPERs to syndicate investment opportunities. Enron wanted to find another investor in 1997 so that CalPERs would invest in another vehicle.
Chewco formed 1997 as SPE Nov 2001 – accounting reviewed and
determined to be in error – consolidated retroactively
Rotman School of Management, March 19, 2002 60
Chewco/JEDI Kopper/Dodson Dodson
LP/GPBig/Little
SONR River
$11.4
GP LP
$11.4
ENRON Chewco
$132 LP Barclays GP
$240 JEDI$240 + $11 +132 = $383
© I. Wiecek
Rotman School of Management, March 19, 2002 61
Chewco/JEDI
Economic substance
At issue
Consolidate
Chewco
Part of economic entity? 3% test not met due to $6.6 million cash reserves
Kopper’s involvement
Joint venture
JEDI
Part of economic entity? Equity accounting, full consolidation due to Chewco?
Capital Transaction
Jedi investment in Enron CS
Non - event Cannot recognize gains on investment in own shares
Revenue Recognition
Guarantee fees,
Management fee
Fees for services over time
Upfront/ early recognition
Related Party Transactions
All transactions
Arm’s length? In best interests of Enron? I.e. Kopper received $10 million on repurchase and $2 million in fees
Rotman School of Management, March 19, 2002 62
LJM1/Rhythms
Intent – Transfer of risks/provide additional markets
Fastow GP – seek outsides investors Formed 1999 - 20 transactions to 2001 Rhythms/Net connections
• Little market for CS (Enron had large holding). Worried about price risk.
Unwinding
Rotman School of Management, March 19, 2002 63
LJM1/Rhythms Fastow
LP/GPERNB/
Campsie LJM Partners
Fastow $15 GP GP LP
$1
LJM Swap LJM1 Co
LP
LJM GP Swap Sub
3%- test not met since negative equity
© I. Wiecek
Rotman School of Management, March 19, 2002 64
LJM1/Rhythms 3.4 million CS Enron FV $276 ($168 discounted)
ENRON LJM1/Swap Rhythms CS Sub
$64 Note $104 Put option on Rhythms CS (Swap to $168 buy Rhythms CS at $56) FV $104
Rotman School of Management, March 19, 2002 65
LJM1/RhythmsEconomic substance
At issue
Consolidation? Part of economic entity?
3% test not met L > A; Fastow GP
Hedging
Put option on $5.4 million shares Rhythm
True economic
hedge?
68% prob that structure would default i.e. if Enron CS declined
Related Party Transactions Arm’s length Fastow’s involvement, payout skewed
Unwind – large windfall to LJM1 $4.5 million to Fastow
Unwinding Arm’s length Settlement – value to Enron
Rotman School of Management, March 19, 2002 66
LJM/Other
Issues• Selling to LJM assets that it could not sell
elsewhere – subsequently repurchased• Economic substance? Bona fide transaction?
Guarantee against losses• At issue – gain recognition
Rotman School of Management, March 19, 2002 67
LJM2/Raptors
Intent • Syndicate capital investments• Hedge• Create markets
Fastow GP- Formed Oct 1999 Significant contribution to NI $1 billion
3Q 2000 to 3Q 2001 4 Raptors – 2 of which discussed below
Rotman School of Management, March 19, 2002 68
LJM2/Raptors Fastow/Kopper
LP/GP50 Limited
Partners LJM2 CMLP
$394 GP LP
LJM2 $30
LP
Talon
Enron
© I. Wiecek
3%- test unclear
Rotman School of Management, March 19, 2002 69
LJM2/Raptor 1/Talon Capitalization and $41 put
$350 - 3.4 million CS Enron FV $537 ($350 discounted)
$50 million note
$41 million premium on put
ENRON/ LJM2/Talon
Harrier
LCC interest
$400 million Note
Put option on Enron CS – Talon to buy Enron CS @$57.50
© I. Wiecek
Rotman School of Management, March 19, 2002 70
LJM2/RaptorsEconomic substance
At issue
$41 million put Intent? Credit risk? Arm’s length
Impact on 3% test
ConsolidationLJM2, Talon
Part of economic entity?
3% test
Fastow GP
Investment in Enron
Real transaction? Show NR as assets?
Rotman School of Management, March 19, 2002 71
LJM2/Raptor 1/TalonTotal return swaps
Intent to protect Enron against losses on merchant investments
Enron pay future gains on investments to Talon
Talon pay to Enron future losses on investments
Locked in value on Enron’s books
Rotman School of Management, March 19, 2002 72
LJM2/Raptor 1/TalonTotal return swaps
Economic substance
At issue
Hedge Total return swaps
Effective hedge? Credit Risk
Dating of agreements
Rotman School of Management, March 19, 2002 73
LJM2/Raptor 1/TalonCostless Collars
Intent to shore up creditworthiness of Talon
If Enron CS fall below $81, Enron pays Talon difference
If Enron CS increases above $116, Talon pays Enron difference
Costless since premiums equal
Rotman School of Management, March 19, 2002 74
LJM2/Raptor 1/TalonCostless Collars
Economic substance
At issue
Hedge Costless collars
Effective hedge?
Gains? Asset values
Investment in Raptors
Significant influence?
Gains eliminated?
Rotman School of Management, March 19, 2002 75
LJM2/Raptor 3
Issues• TNPC – held shares of the very shares that
they were meant to hedge.• Not presented to the BOD
Rotman School of Management, March 19, 2002 76
Things to think about Business model – non standard
transactions/changing business model Intent - structuring transactions to achieve
accounting objective versus economic objective Narrow interpretation of GAAP - the 3% test –
rules based versus principles based Complexity – non-standard legal structures Documentation – deal sheets, formal approvals When the legal form becomes more important
than the economic substance
Rotman School of Management, March 19, 2002 77
Enron’s Governance StructureWas Short Circuited
BoardKen Lay: Chair; Co-chair ZZZ
Audit, Compensation Cees.
ManagementLay, Skilling: CEO
Fastow, CFO; KoppersCausey, CAO; Buy, CRO
Watkins; Kaminsky; McMahon
Company Policies
Code of Conduct
Internal Audit ?
Whistleblowers ?
AuditorArthur
Andersen
Outside Law Firm
Consultant: Arthur Andersen
MissingSuspended
Compliance
GuidanceFinan.
ReportsSPEs
© L. Brooks
Rotman School of Management, March 19, 2002 78
Enron’s Ethical Culture Code suspended, alternate controls ignored Bogus trading floor for visiting analysts Whistleblowers/doubters came forward (to), but
• Co-chair (Lay) resigned, 32 mil. … suicide?• Kaminsky (Fastow) …….. ignored• McMahon (Fastow)...transferred …now CFO• Sharon Watkins (Lay)… Enron’s law firm
found no problem …fox in the chicken coup No protected whistleblower path to the Board Do we need an Ethics Committee?
Rotman School of Management, March 19, 2002 79
New Board Responsibilities Comprehensive Risk Management
• Broad understanding of business model• Financial literacy• Guidance & Control framework• Focus on corp. culture, ethics & reputation• Business ethics…whistleblower protection plan• Ethics Risk Management
Trust, but challenge, don’t turn away • Caremark National Case, trend
© L. Brooks
Rotman School of Management, March 19, 2002 80
Comprehensive Risk Management requires understanding the business
Risk Events Causing Drops of Over 25% Share Value,Percentage of Fortune 1000 companies, 1993-1998
Strategic ……………………………. 58%Customer demand shortfall (24) Competitive pressure (12)M & A Integration problems (7) Mis-aligned products (6)
Operational …………….31%Cost overruns (11) Accounting irregularities (7)Management ineffectiveness (7) Supply chain pressures (6)
Financial ………..6% [Foreign macro-eco, interest rates ]Hazard …….0% [Lawsuits, natural disasters]
Source: Mercer Management Consulting/Institute of Internal Auditors, 2001
Rotman School of Management, March 19, 2002 81
Comprehensive Risk Management includes Ethics Risk Management
Ethics Risk Reputation Success
Reputation is important Arthur Andersen…………… survival RBC Dominion………reputational capital Tylenol ……………competitive advantage
Selling trust and credibility, not pills, …
© L. Brooks
Rotman School of Management, March 19, 2002 82
Comprehensive Risk Management depends upon the Corporate Ethical Culture
Comprehensive Risk Management utilizes both:A. Key risk factor identification & measurementB. Review of key business processes including the ethical
culture that underpins process integrity Ethical culture provides guidance for employees
about when to adhere to the Code, when actions are not covered in Code, in a grey area, or in a crisis - tools to measure ethical culture do exist
Enron’s Board failed to consider any of this!Few corporations do A, fewer do B!
© L. Brooks
Rotman School of Management, March 19, 2002 83
Audit Committee must
Understand key business operations Understand comprehensive risk
management model and reports Examine key/large transactions Ensure compliance with good policies Ensure fair presentation
Who wants this risk?How much should the members be paid?
© L. Brooks
Rotman School of Management, March 19, 2002 84
Accounting Standards & Disclosure
FASB’s 3% standard was too low … now changed to 10%
Need rededication to:• fair presentation, not specific rules
orientation or pro forma illusions• clarity• transparency
SEC/IASC will be more evident… Can.?
Rotman School of Management, March 19, 2002 85
Audit & Professional Standards
SEC rules on non-audit services More emphasis on professional ethics Stronger enforcement/punishment for
individual professionals:• in accounting/audit firms• in corporate clients
Is it in the public interest to shut down Arthur Andersen?
Rotman School of Management, March 19, 2002 86
Eric Kirzner:A Director’s Commentary
An eye-opening example from my experience My criteria – must be met before I accept a
Director’s post. Tradeoffs a Director must understand Process steps for a Director to consider
Rotman School of Management, March 19, 2002 87
Finance, Governance
1. AME HISTORY Listed Montreal
Exchange Board: affinity people;
friends of management Going Private transaction
• Independent committee
• NOBODY: Management; board
members understood!
Rotman School of Management, March 19, 2002 88
Membership Criteria
My criteria for serving:
1. I am an expert in the field
2. The other board members: either experts, or knowledgeable and representing key stakeholders• union reps on pension plans for example
3. No Cronyism
Rotman School of Management, March 19, 2002 89
Membership Criteria
My criteria for serving:
4. Chair is expert, experienced and understands balance between unfettered debate and accomplishments.
Rotman School of Management, March 19, 2002 90
Membership Criteria
My criteria for serving:
5. All functions in place Management; internal audit and external audit Independence of internal audit and
management Independent directors
• 50% plus?; public governor proxy
• Fee for service!
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Membership Criteria
My criteria for serving:
6. Committee Structure Governance HR Audit and finance Risk management Independent directors dominate committees?
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Understand Tradeoff
Paradigm #1
DIRECTORS TO:
“ Act in best interest of…”
Company (statutory) OR
Shareholders (regulatory)
Paradigm #2 Maximization of
Shareholder wealth
Paradigm #3 Public/ethical
responsibility
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Process For Board Member
1. A Model• Can you develop checklist of responsibilities
• Example: meet CDIC guidelines?
2. Committees• Audit, HR, finance• Appropriate trade-off approval and
recommending
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Process
3. Board self-assessment• Peer group review • Chair review
4. Independent Directors; Public Directors • Must understand everything• Ultimate sanction of voting with their feet!94
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Comments & Questions
The Last Word• Ramy• Irene
Questions
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New Governance Series
For directors and senior officers: Director’s Responsibilities Financial literacy Guidance and control systems Ethics risk management Comprehensive risk management
Thank You
on behalf of the
Clarkson Centre for Business Ethics
& Board Effectiveness—CC(BE)CC(BE)22
Executive Programs
Rotman School of Management