A philosophical investigation into Enron
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More successful was a remarkable effort by Enron to move the
trading of energy and energy derivatives, which had previously
been conducted by telephone, onto the internet. The idea was
formulated early in 1999, and a 31-year-old gas trader in Enron's
London office led its implementation. By the end of November
1999, she and her team had EnronOnline up and running. By
June 2000, it had hosted trades worth $100 billion.
Even relatively junior Enron employees could put forward ideas
and see them implemented: "We really believed that anything
could be done," one of them told Fox. And an idea wasn't judged
according to the gender, sexual orientation or ethnic background
of its promoter. As Fox puts it, "Enron cared only about
performance, so it didn't matter if an employee was Caucasian,
just as it didn't matter if an employee had a nose ring or green
hair or was homosexual." If you could keep up with the pace,
and didn't fear the scrutiny of Enron's Performance Review
Committees (which ranked every employee on a scale from 1 to
5, with repeated 5s meaning dismissal), Enron's Houston
skyscraper was an exciting place to work.
I have emphasised that Enron had substance and was in some
ways admirable, because its failure was not the simple collapse
of a house of cards. It was a manifestation of an old faultline
lying deep in corporate capitalism. Like the majority of large
corporations, Enron was a publicly traded joint stock company,
whose ownership was thus dispersed over a perpetually
changing multitude of shareholders.
In contrast, control of the corporation was - for all the
"empowerment" of low-level employees - concentrated in the
hands of a small number of senior executives. Can the
managers of a corporation like Enron be trusted to act in the
interests of its owners (the shareholders)? The question is as
old as the joint stock company as a legal form.
Adam Smith suspected the answer was "no". In Volume III of
Capital, Marx warned that directors might swindle shareholders,
although he also welcomed the growing separation of managerial
control from legal ownership as a transitional step towards
socialism.
In 1932, Adolf Berle and Gardiner Means estimated that
"perhaps two-thirds of the industrial wealth" of the US was in the
hands of large corporations controlled by their managers rather
than their owners. This paved the way, they argued, for what we
would now call a "stakeholder" form of capitalism - one that
would recognise the legitimacy of interests other than those of
shareholders.
In 1967, JK Galbraith claimed that the separation of ownership
from control meant that corporations no longer pursued the
traditional goal of capitalist firms: maximum profit. The
corporation was in the hands of what Galbraith called the
"technostructure", a managerial cadre whose goal was growth of
output, because that would bring them larger departments to
manage and thus higher pay and better promotion possibilities.
Whether growth was the most profitable use of the corporation's
capital was a secondary matter; shareholders had no real
influence any longer. As Galbraith put it, "the annual meeting" of
shareholders of the "large American corporation is, perhaps, our
most elaborate exercise in popular illusion".
In the 1980s and 1990s, however, it seemed as if managerial
and shareholder interests had been reconciled. In the 1980s,
corporate raiders brought off a series of increasingly audacious
takeovers, largely financed by "junk" bonds (bonds which rating
agencies deem to be below investment-grade). The very names
of these raiders - Carl Icahn, T. Boone Pickens, Sir James
Goldsmith - brought fear to Galbraithian managers, whom they
ruthlessly displaced.
Underperforming corporate assets were
sold off, workforces were dramatically shrunk, bond-holders paid
- and both raiders and shareholders were greatly enriched.
Gradually, corporations built defences. Enron, for example, was
born in 1985 when InterNorth, a larger pipeline company, merged
with Kenneth Lay's Houston Natural Gas and thus avoided falling
into the hands of Irv the Liquidator, the corporate raider Irwin
Jacobs.
However, the traumas of the 1980s taught corporate managers
that they neglected share prices and profits at their peril. The
ideal new-style managers were people like Enron's
second-in-command from 1988, Rich Kinder (pronounced
Kinn-der). Although now remembered with nostalgia by the
former Enron employees who have spoken to Fox and Bryce, he
was no softy. It was he, not Lay, who was responsible for
detailed management, and he kept costs and staff numbers
firmly under control, reduced the corporation's already large
debts, and viewed any expenditure "like the money was coming
out of his own personal chequebook", as one ex-employee told
Bryce. Over-enthusiastic underlings were frequently put down by
Kinder telling them: "Let's not start smoking our own dope."
That, however, seems to be exactly what Enron started to do
after Kinder's departure in 1996.
If the office gossip recycled by
Bryce and Fox is to be believed, Enron's high-intensity buzz
contributed to numerous sexual liaisons among its workaholic
staff, and an alleged affair between Kinder and Lay's personal
assistant may have caused a rift between the two men.
Kinder's replacement, Jeff Skilling, was a "big strategy" man
rather than a tight-wad. He was a Baker scholar from the
Harvard Business School - in other words, in the top 5% of an
already elite MBA class - and before he joined Enron had been
an employee of the world's pre-eminent consulting firm,
McKinsey & Company.
In the late 1990s, Enron's creative juices flowed unrestrained:
this was the period of the "most innovative company" awards.
Control over costs, however, seems to have slackened. Staff
numbers grew rapidly, and among them were many high-flying
MBAs from leading universities, at correspondingly expensive
salaries. The private jets got more up-market.
Assets such as Wessex Water, the Buenos Aires water
company AGOSBA and the Brazilian utility Elektro Eletricidade
were bought not because they were cheap but because they
offered entry into new and potentially profitable markets such as
water trading and Latin America. Debt accumulated - but Enron
grew, becoming the seventh largest corporation in the US.
It was as if the Galbraithian technostructure was back in control,
but with two fatal differences. In the 1960s, managers had been
concerned about share prices, but only as one issue among
several.
By the 1990s, however, share prices were an obsession
for the managers at Enron, at almost all other US and British
corporations, and at an increasing proportion of companies in
Continental Europe and elsewhere.
In order to tie managers' interests
to those of their shareholders,
an increasing proportion of their pay came in the form of shares
or share options, and Enron was extremely generous in this
respect. At the entrance to its headquarters was a large
electronic display showing the second-by-second movement of
its share price. As that number ticked up and down, the
personal wealth of senior managers could rise and fall by
millions of dollars.
The second difference from the 1960s was that Enron, like many
other present-day companies, was much more dependent on the
view of it taken by credit-rating agencies, in particular the two
globally dominant ones, Moody's and Standard & Poor's. These
agencies rate the bonds of corporations, municipalities and
governments, essentially according to what they see as the
likelihood of default. Their opinion of companies mattered even in
the 1960s, but the conservatively run corporations of that period
had little difficulty achieving high ratings.
In the 1980s and 1990s, however, corporations started to issue
more and more bonds and take on increasing amounts of other
forms of debt: Enron was far from alone in this. The debt funded
necessary investment, but it also permitted expensive takeovers
and allowed corporations to buy back large amounts of their
shares - the simplest way to keep share prices high and
managers' share options valuable.
By 2002, only eight US
corporations still held Moody's highest, Aaa rating.
Ratings help determine the costs faced by a corporation or
government. The lower your rating, the higher the rate of interest
you have to pay on your bonds and the more it costs you to
service your debt, and this last can be a life or death matter for
Third World countries. It would thus be only a slight
exaggeration to call Moody's and Standard & Poor's the world's
most powerful organisations, national governments apart.
For Enron, the views of the agencies had especial significance.
Its rapidly expanding trading empire, in particular EnronOnline,
depended totally on its credit rating. It was "investment grade",
but never high in investment grade. In the late 1990s, Moody's
rated Enron as Baa2, only two notches above Ba1, the upper
tier of junk or "speculative" bonds, as the agencies politely call
them. If Enron slipped those two notches, it would cease to be
an attractive trading partner. A major and highly visible
question-mark would be placed over its capacity to meet its
obligations, and who would then enter into a futures contract
with Enron, or buy an option from it?
The twin pressures to keep its share price high and its ratings
investment grade explain why Enron started to engage in
optimistic accountancy and to move poorly performing or
high-risk investments (and more and more debt) off its own
balance-sheet into those of "special purpose entities".
These entities are limited partnerships or companies which are
set up by a corporation but legally distinct from it and are formed
because they can carry out certain transactions more profitably
than the parent corporation. An entity can be structured, for
example, so that it is provided with revenues that match the
obligations it enters into by borrowing, which means that
creditors can be persuaded to lend to it on favourable terms.
The tight nexus of share prices, ratings, debts and special
purpose entities also explains the rapidity of Enron's implosion
in 2001. The entities had been provided with, or promised, Enron
shares to enable them to meet their obligations. As those
shares slipped in value, the entities couldn't do so, and the
concealed iceberg of losses and debt began to become visible.
Shares slipped further, the markets and rating agencies grew
more sceptical, and Enron became locked into a death spiral.
Its downgrade to junk by the rating agencies on November 28
2001 sealed its fate.
Simply to cry "fraud" and call for tighter accountancy rules is to
miss the depth of the issues raised by Enron and other similar
debacles. How can investors trust that those in whom they have
invested, or to whom they have lent, will use the money
prudently and properly?
A major aspect of the answer has always been character,
reputation and virtue: investors' knowledge of the personal
qualities of those to whom they entrust their cash. That was part
of the way old-fashioned small-town bank managers made their
lending decisions, and it's an approach that has not vanished
even at the start of the 21st century.
Warren Buffet - America's most celebrated and most successful
investor - judges, among other things, the people who run the
companies he is considering. If he doesn't like them, he won't
invest, no matter how attractive an opportunity their companies
seem to present. Steven Shapin, in ongoing work on Californian
venture capitalists, finds a similar approach: they judge the
person, not just the business plan. It's a perfectly rational
attitude, Shapin points out: in a world in which technologies and
economic circumstances change rapidly, personal virtues may
be the most stable things around.
You need "face time" with someone in order to judge him or her
as a person. Warren Buffet and major venture capitalists can get
one-on-one face time with even the most senior executives, but
a small investor considering buying a hundred Enron shares
could not hope for a private meeting with Kenneth Lay or Jeff
Skilling.
When personal trust is impossible, modernity turns to "trust in
numbers" (the title of an important book on these questions by
Theodore Porter). Numbers are pervasive in finance and beyond:
share prices; price-earnings ratios (a key criterion for
professional investors); bond ratings (which are not literally
numbers, but have a quasi-numeric "hard fact" quality); school
and hospital league tables; surgeons' success rates; university
departments' Research Assessment scores. Trust in numbers,
however, works only if those who produce the numbers can be
trusted: it displaces, rather than solves, modernity's problem
with trust.
Enron's production of numbers - the accountancy practices that
generated its balance sheet - was not entirely covert. The
existence of the special purpose entities was dutifully disclosed
in footnotes to the accounts. True, those footnotes couldn't be
said to give a full and transparent version of Enron's dealings
with these entities. However, the readers of CFO (chief financial
officer) magazine must have had a notion.
In 1998, as US wholesale electricity prices started to spike
upwards, Enron used a special purpose entity to buy generating
capacity close to New York City. Enron's CFO, Andrew Fastow,
told the magazine: "We accessed $1.5 billion in capital but
expanded the Enron balance sheet by only $65 million." The
magazine seems to have approved, awarding Fastow its 1999
CFO Excellence Award for Capital Structure Management. CFO
may not be on every news-stand, but it is surely on the reading
list at Moody's, and in March 2000 the rating agency raised
Enron a notch to Baa1.
Just how unusual were Enron's accountancy practices? Were
they actually illegal? (Criminal charges have been brought
against some Enron managers, and some cases have been
settled by plea bargain, but at the time of writing no case
against a senior figure has gone to court.)
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