Reacting To Red Flags, The Enron Experience
Andrew Fastow was ashamed with what he did when he was with Enron. The former CFO of this company which fell from fame spectacularly in early 2000 admitted that he was guilty and felt sorry for all those people who suffered losses. He was in town to share some of his experience which could be good lessons for those in boardrooms to learn from.
When Enron was growing, it required a lot of financing but the shareholders did not prefer to inject new capital. Structured finance was used by Andrew to allow Enron to borrow money using special purpose vehicles resulting in the liabilities was not recognised on the balance sheet of Enron, making its financial looked sound, cost of capital reduced and the shareholders were relieved from being required to inject capital. For this he was awarded the CFO of the year by one of the influential financial magazines in the United States. The same conducts landed him in prison!
Was the board ignorant of what what happened? No, according to Andrew.
For example, the board was supplied with information which reconciled Enron’s internal credit scoring which was assessed as closer to junk status to the market scoring where it was rated as an investment grade. How did the board reacted to this? Instead of being worried about the misalignment in the assessment of Enron’r risks by the banks, he was praised by one of the board members as a brilliant CFO.
The focus of everyone at that time was whether the transactions were compliance with the rules. This, according to Andrew, was the main factor which provided everyone with comfort that everything was fine. What about independent professionals such as legal counsels and auditors? When their views were sought, they were not just required to provide opinions on whether rules were complied or not. If they felt that there were no compliances, they were expected to provide ideas and ways so that compliance was achieved.
One of the reasons why Andrew was hired by Enron was for his talents in unlocking the value of Enron’s assets. Through structured finance and fair value accounting, the future values of those assets could be booked, enhancing the value of Enron’s shares.
Fair value accounting relies on the availability of market prices. In their absence, prices of similar assets could be used. When there is not such prices, complex valuation models would be used instead. On top of the issue of market price, fair value accounting also requires future stream of cashflows generated by those assets to be estimated. They are then capitalised at certain rates which reflect the risks carried by the assets, to arrive at their fair values. The exercise rely heavily on assumptions and estimates which achievements are subjected to ranges of risks.
While those rules appeared complex, Enron capitalised them to its benefits. In fact the more complicated the rules, the more they were seen as opportunities by Enron as such complexity made the transactions and valuations more opaque. Again, the focus then was whether all those rules were complied with!
Although two senior executives of Enron were sent to prison, Enron-like cases kept on appearing including during the recent global financial crisis. The scary thing is the market appears to tolerate certain level of envelope pushing until certain events occur when they would then be crying for blood. At this point, compliance with rules would not be adequate, people would be asking whether things are right, instead.
Enron had a very prominent board. Why didn’t they react with horror when they knew the market was wrong about their financial standing?
There could be a number of factors behind this. Enron was the darling of the market and it provided good financial returns, at least before it collapsed. Everyone was chasing the money and nobody was concern as long as the rules ‘were followed’. Instead of taking a pause and asking the question of ‘are we doing the right thing’ the board decided to continue to dance to the music liked by the market.
The board also had the comfort of independent professionals providing opinions that every rules were complied with. While what happened to Enron was a catastrophe, how many of the present members of the board would sign off a deal based on the comfort that it is in compliance with all relevant rules? As board tends to achieve consensus in making decision, such culture would deter people who have opposing views from staying the cause.
Andrew believes that by adopting the 10th man rule, where someone would play the role of a devil advocate and keep on opposing the views of the board until it is clear that the views are premised on sound judgment, is the way forward.
So, what would be your reaction in the next board meeting when, in supporting their proposals, management comfortably explains that all the rules are complied with?