Memorandum submitted by the Bank of England
ISSUES RAISED BY THE COLLAPSE OF ENRON
1. The issues arising from Enron's collapse remain the focus of intensive investigations in the US and elsewhere (including the UK) and the full facts and their implications are not yet clear. In particular, it is hard at present to know how far the collapse was symptomatic of more pervasive weaknesses or, on the other hand, represented in isolated and extreme case. It is probably therefore too early to draw firm conclusions. With these provisos, however, the Bank welcomes the opportunity to offer the Committee some preliminary views.
2. This paper first describes briefly the events leading up to the collapse and comments on the immediate impact. It then identifies a number of issues under four headings: corporate governance and the independence of auditors; accounting standards; the failure of market discipline; and the protection of employees' pensions.
3. The chronology immediately before the collapse was as follows. On 16 October 2001 Enron announced a $618 million third quarter loss, including a $1.01 billion charge mainly relating to off-balance sheet partnerships. On 8 November it revised its financial statements for the previous five years to consolidate five partnerships and took a further $586 million charge. On 28 November Dynegy pulled out of its proposed acquisition and Moody's/S&P downgraded Enron from investment (BBB/Baa) to sub-investment (B) grade, triggering early repayment obligations on Enron bond issues and collateralisation requirements on Enron's derivatives exposures. Faced with liquidity demands of nearly $4 billion, Enron filed for Chapter 11 protection on 2 December.
4. The effect on Enron's collapse on oil, gas and electricity prices and trading volumesthe markets in which Enron was most activewas limited. While there remains a large gap between the sum of Enron's liabilities ($52 billion) and exposures disclosed by creditors (around $7 billion), the immediate spillovers to the global financial system have been limited. On the one hand, this provides reassuring evidence about the resilience of that systemwhich in turn perhaps partly reflects the role of new instruments in dispersing risk.
There were, however, other reasons why Enron's failure was not "systemic". First, its energy book seems to have been largely matched (through EnronOnline, its electronic trading facility). Second, it was not actually as big a trader in financial markets generally as widely perceived (or, perhaps, as Enron itself liked to imply). Third, its problems became evident before its final ratings downgrade and collapse, giving market participants some time to eliminate or hedge exposures.
5. The underlying causes of Enron's fall are not yet fully clear. Its (physical) energy trading businesses do not seem to have been loss-making overall, although they generated a decreasing proportion of total earnings Rather, losses seem to have stemmed from ill-judged investments in fibre optic bandwidth, retail gas and power distribution, water supply, technology companies and other projects of exotic types or in exotic locations.
6. A report to the Enron board by William Powers of the University of Texas School of Law, published on 2 February, explains how Enron used limited partnerships and Special Purpose Entities ("SPEs") to (i) exclude losses from its published accounts; (ii) shift debt (and assets) more generally off its balances sheet; (iii) give the impression that risks had been shed when in fact they had not; and (iv) bring forward and capitalise "expected" future earnings which were highly uncertain.
7. The following sections discuss briefly some of the major areas of concern raised by the Enron case.
CORPORATE GOVERNANCE AND THE INDEPENDENCE OF AUDITORS
8. The available evidence suggests that Enron's management exploited the letter of US accounting rules toand in some cases beyondthe limit. It did so with the apparent approval of the Andersen audit partner. Indeed, the auditor appears to have played an active part in helping to set up the complex structures which concealed, but eventually proved ineffective in managing, various risks, and were belatedly recognised as infringing accounting standards. The board of Enron does not appear to have been aware of these questionable accounting practices or, therefore, to have pressed management on the reasons for adopting them.
9. It is widely recognised that effective non-executive directors have an important part to play in corporate governance. However, were changes to the present EU and UK regime to be contemplatedand it is not clear that the case for such changes has yet been madeit would be important to balance any increase in personal liability with positive incentives, or at least safe harbours in recognition of reasonable efforts. Otherwise, there is a danger of discouraging talented and experienced people from joining companies' boards, with the potentially perverse result of weakening corporate governance and impairing economic performance.
10. Sound accounting standards need to be supported by high quality independent auditing, together with appropriate sanctions when accounting and/or auditing standards have been deliberately breached.
11. US accounting standards are highly rules-based with, for example, the approach to the accounting treatment of SPEs focussing on the technical conditions evidencing a transfer of control rather than a transfer of risks. Arguably this reliance on detailed rules encourages companies to put form over substance. It is part of a broader pattern of "rules arbitrage" in the areas of accounting, regulation and tax which can have, as one of its effects, the setting up of complex structures, impairing transparency and perhaps market discipline. The problem may be less acute under UK and international accounting standards because both include a "true and fair" override in the preparation of accounts. Furthermore, practices in the UK on the non-consolidation of SPEs were challenged at the end of the early "nineties recession which resulted in a tightening of the rules.
12. All that said, SPEs can play an important and constructive part in securitisation mechanisms which deepen the market in risk transfer and thereby contribute to overall economic efficiency. Many of the structures used are long-established and well understood by the markets. Any change in accounting rules which hindered legitimate activity in an attempt to eliminate relatively rare instances of doubtful practice would need to weigh the potential costs.
13. There is pressure in the US to replace self-regulation of the accountancy and auditing profession with a statutory framework. Again, it is not clear that the case for this in the UK (or the EU) has yet been made. Indeed, so far as Andersen is concerned, the market has itself now been seen to impose a severe discipline, providing a clear incentive for other accounting firms (and professional firms more generally) to tighten their internal controls and review processes, and for professional associations to strengthen their own disciplinary procedures.
FAILURE OF MARKET DISCIPLINE
14. In the developed economies at leastand in an increasing number of emerging marketscorporate governance arrangements, disclosure requirements and the rules and regulations associated with financial markets are intended to provide appropriate checks and balances so as to expose and restrict reckless or dishonest behaviour. No such regime can, at realistic cost, be 100 per cent effective; but it is nevertheless striking that, in the Enron case, a significant number of these control mechanisms, involving the board, the auditors, the rating agencies, market analysts, large institutional investors, creditors, market regulators and others, apparently failed to operate. All of them might have been expected to monitor Enron closely, to probe Enron's opaque off-balance sheet activities and/or to be suspicious of oddities in the relationship between its published earnings and its balance sheet.
15. The Enron episode has reinforced concerns that surfaced at the time of the Asian crisis regarding an over-reliance on rating agencies. The "hard wiring" of ratings into the terms of loan contracts and other credit facilitiesfor example, requiring issuers to buy back their debt if their credit rating falls below a certain pointcan seriously aggravate liquidity problems for companies suffering downgrades and accelerate their collapse. It may also encourage lenders to rely too heavily on external ratings rather than there own credit assessment.
16. Rating agencies, lenders and investors are taking more notice of rating triggers. For example, the recent introduction of liquidity risk assessments by Moody's is a useful initiative, although it remains important for creditors to make their own assessments. Market practice may already be changing for the better, at least for now. The proposed revision to the Basel capital adequacy regime will also provide incentives for banks to develop their internal capacity for credit risk assessment.
17. Chairman Greenspan has recently supported initiatives being promoted by the National Association of Securities Dealers and the New York Stock Exchange. These call for more effective market discipline of analysts through publication of the (current and historic) proportion of the "buy", "hold" and "sell" recommendations they make, and the date of the most recent change in their recommendation. In the UK, the FSA has detailed codes of conduct in the wholesale market designed to address market abuse, conflicts of interest, etc.
Banks and Other Creditors
18. The Enron has shown that some creditors may have problems in identifying the extent of their group-wide exposures to a particular borrower. There are, therefore, lessons for banks internal monitoring and controls, particularly in cases where counterparty exposures may take very complex forms. Many Wall Street firms were also involved as co-investors in or arrangers of Enron's off-balance sheet transactions and there are questions about why this did not alert them to the accounting and risk transfer issues.
PROTECTION OF EMPLOYEES' PENSIONS
19. A further group of issues relate to the pensions of Enron's employees. The employees' pension fund held a large amount of Enron stock and indeed Enron's (employer) contributions to the fund had typically been made in such stock. Employees were not permitted to reallocate these latter contributions to different assets until the age of 50. In the US, "own company" investment of this kind has been less constrained than in the UK. In addition, many Enron employees chose voluntarily to invest part of their own (employee) contributions in Enron shares, perhaps at least in part on the basis of information which in retrospect may turn out to have been incomplete or misleading.
20. In the UK, excessive investment in employer-related assets is prohibited by Section 40 (1) of the Pensions Act 1995. Current regulations limit exposure to 5 per cent of a scheme's resources. Thus, losses arising from a firm's own failure on the scale now in prospect with Enron seem less likely to occur in the UK, absent a failure of a scheme's trustees or managers to comply with clearly stated legal requirements.
21. Any incident of this kind is likely to have wider lessons. Some of the issues raised may be peculiar to the USfor example, its emphasis on rules-based accounting, the incentives that may result from the granting of stock options to non-executive directors and the size of exposure of pension fund to employer-related stock. Others, such as the non-consolidation of off-balance sheet entities which remains under the effective control of the sponsoring company, have arisen in the UK in the past but have since been addressed by reforms to the accounting and corporate governance regime. There are certainly, nevertheless, areas which merit reconsideration, as outlined above. But before deciding on remedial action, the problems need to be identified clearly and the potential costs and benefits of responses need to have been thoroughly assessed.
5 April 2002
1 Professor Powers was appointed as a non-executive director for the duration of his work on the report. The full text of the report is available at a number of web sites including the Houston Chronicle http://www.chron.com/content/news/photos/02/02/03/enron-powersreport.pdf Back
2 In contrast to defined benefit pension schemes, defined contribution (money purchase) schemes in the US (typically 401K plans) are not guaranteed (up to defined limits) by the Pension Benefit Guaranty Corporation Back