American Economic Association

The Fall of Enron

Author(s): Paul M. Healy and Krishna G. Palepu
Source: The ,Tournal of Economic Perspectives, VoI. 17, No. 2 (Spring, 2003), pp. 3-26
Published by' American Economic Association
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 Joumal of Economic Pmputiaa-vorume 17, Nurnber 2-spring 2003-paga 3-26

The Fall of Enron

Paul M. Healy and Krishna G. palepu

rom the start of the l9g0s until year-end 1ggg, Enron's stock rose
by
3llpercent, only modestly higher than the rate of growth in
the standard
& Poor's 500. But then the stock soared. It increased by 56 percent
in 199g
and a further 87 percent in 2000, compared to a 20 p.....r,
i.r...ur. and a
10 percent decline for the index during the same years.
By December g1, 2000,
Enron's stock was priced at $83.r3, and its market capitalization
exceeded $60 bil-
lion, 70 times earnings and six times book value, an indication
of the stock market,s
high expectations about its future prospects. Enron was rated
the most innorative
Iarge compan' in America in Fofturu magazine's sune\.
of NIost Admired companies.
Yet $jthin a I'ear. Enron's image rras in tatten and
ir srock price had plummeted nearlv
to zero Lxhibit I lists some of the crincal e'enls for Enron berrreen
.{ugr.ur and
December 2001-a saga of document shredding. resatemenu.
of eaming:, reg.uJaton.
investigarions, a failed merger and the compan\. filing
for bankruprcr.
\'t'e n'il] assess how govemance and incendve problems
conu-ibuted to Enron,s rise
and fall' A well-fi'mctioning capital market creates appropriate
lintages of ilformation,
incentives and governance between managers u.,d irr=rto.r.
This process is supposed
to be carried out through a network of intermediaries that include
professional
investors such as banks, mutual funds, insurance and
venture capitar firms; information
anallzers such as financial analysts and ratings agencies;
professionals such as
extemal auditors; and intemar governance agents such ^.r*r..
* .o.po*,. boards. These
parties, who are themselves subject to incentive
and governance problems, are regu_
lated by a lariety of institutions: the Securities and Exchange
commission, bank
regulators and prhate sector bodies such as the Financial
Accorriri.rg Standards Board,
the American Insdnrte of cerffied public Accountants
and stock exchanges.

M' R
lP1ul Healy i"s theJames Williston Professm of Business Ad,ministration and, Krkhna
G. Palcpu is the Ross Grahamwarker professm of
Bwiness Ad,ministration, both at Haruard,
Busi.ness school, Boston, Massachusetts. Their
e-mail addresses are (pnea$ohbs.ed.u) and.
(hpalepu@hbs.edu), respectiuely.

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 4 Joumal of Economic Perspectiues

Exhibit 1
Timeline of critical Events for Enron in the period August Zfi)l to December 2001

Date Eumt

August 14, 2001 Jeff Skilling resigned as CEO, citing personal reasons. He was replaced by
Kenneth Lay.
Mid- to late August Sherron Watkins, an Enron vice president, wrote an a.non)rynous letter to
Kenneth Lay expressing concems about the firm's accounting. She
subsequently discussed her concerns withJames Hecker, a former colleague
and audit partner at Andersen, who contacted the Enron audit team.
October 12, 200f An Arthur Andersen lawyer contacted a senior partner in Houston to remind
him that company policy was not to retain documents that were no longer
needed, prompting the shredding of documents.
October f6, 2001 Enron announces quarterly eamings of $393 million and nonrecurring
charges of $1.01 billion after tax to reflect asset writedowns primarily for
water and broadband businesses.
October 22,2001 The Securities and Exchange Commission opened inquiries into a potential
conflict of interest between Enron, its directors and its special partnerships.
November 8, 2001 Enron restated its financials for the prior four years to consolidate partnership
arranBements retroactively. Earnings from lggT to 2000 declined by
$591 million, and debt for 2000 increased by g658 million.
November 9, 2001 Enron entered merger agreement with Dynegy.
November 28, 200f M4lor credit rating agencies downgraded Enron's debt to junk bond status,
making the firm liable to retire g4 billion of its 913 billion debt. Dynegy
pulled out of the proposed merger.
December 2, 2001 Enron filed for bankruptcy in New York and simultaneously sued Dynegy for
breach of contract.

Despite thls elaborate corporate governance nen\'ork. Enron rras able to at6act
iarge sums of capital to fund a quesrionable br,r-siness model. concea-l its true perfor-
mance through a series of accounring and financing manew.ers, and hrpe its srock ro
urxustainable lerels. \\trile Enron presents an extreme exarnple. ir is also a usfi.rl test
case for potential
weaknesses in the U.S. capital market s\stem. \\'e beiieve that *re
Problems of governance and incenti!'es that emerged at Enron can also surface at many
other firms and may porenrially affect the entire capital marker. we will begrn by
discussing the evolution of Enron's business model in the late 1990s, the stresses that
this business model created for Enron's financial reporting, and how key capital market
intermediaries played a role in the company's rise and fall.

Enron's Business

Kenneth Lay founded Enron in 198b through rhe merger of Houston Natural
Gas and Internorth, two natural gas pipeline companies.l The merged company
owned 37,000 miles of intra- and interstate pipelines for transporting natural gas

1
Sources for information on Enron's business include Enron annual reports and IGIG for the period
1990-2000, Tufano (1994), Ghemawat (2000), and Salter, Levesque and Ciampa (2002).

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 1
Paul M. Healy and, Krishna G. Palapu 5

between producers and utilities. In the early 1980s, most contracts between natural
gas producers and pipelines were "take-or-pay" contracts, where pipelines agreed
either to purchase a predetermined quantity at a given price or be liable to pay the
equivalent amount in case of failure to honor that contract. In these contracts,
prices were tlpically fixed over the contract life or increased with inflation. Pipe-
lines, in turn, had similar long-term contracts with local gas distribution companies
or electric utilities to purchase gas from them. These contracts assured long-term
stability in supply and prices of natural gas.
However, changes in the regulation of the natural gas market during the
mid-1980s, which deregulated prices and permitted more flexible alTangements
between producers and pipelines, led to an increased use of spot market transac-
tions. By 1990, 75 percent of gas sales were transacted at spot prices rather than
through long-term contracts. Enron, which owned the largest interstate network of
pipelines, profited from the increased gas supply and flexibility resulting from the
regulatory changes. Its returns on beginning equity in the years 1987 to 1990, when
it was primarily a pipeline business, were 14.2, 13.0, 15.9 and 13.1 percent, respec-
tively, compared with an estimated equity cost of capital of around 13 percent.2
In an attempt to achieve further grorath, Enron pursued a diversification
strategy. tt began by reaching beyond its pipeline business to become involved in
natural gas trading. It extended the natural gas model to become a financial trader
and market maker in electric power, coal, steel, paper and pulp, water and
broadband fiber optic cable capacity. It undertook international projects involving
construction and management of energ)'facilities. 81'2001, Enron had become a
conglomerate Lhat ortrred and operated gas pipelines. electriciq'plans, pulp and
paper plants. broadband a-ssec ard h-arer plants internationallr'and traded exten-
sivelv in financial markes for the same producr and senices. -{ summan' of
segmenr resulu for the compan\'. in Exhibit 2, shor*s horr'dramaricallv the domestic
trading and internarional businesses grelr during the late 1990s.5
This growth impressed the capital markets, and fert asked fundamental ques-
tions about the company's business strategy. Could Enron's expertise in owning
and managing energy assets, and then developing a trading model to help buyers
and sellers of energy manage risks, be extended to such a broad array of new
businesses? Moreover, was Enron's performance sustainable given the limited
barriers to entry by other firms that wished to mimic its success? To have a sense of
how Enron's business model evolved, it is useful to consider in more detail how is
operations expanded.

2
This estimate is based on the average 3O-year government bond rate for the period of 8.65 percent, a
market risk premium of 7 percent and an equity beta of 0.6. The cost of equity capital is calculated using
the capital asset pricing model: 8.65 Percent + (0.6 x 7 percent) : 12.85 Percent.
3
It is difficult to figure out which pars ofEnron's business model were working and which were not,
since the company provided minimal segment disclosure. In addition, its 2000 domestic trading
performance was affected by the California energy crisis, where illegal price manipulation by Enron and
others is being investigated.

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 6 Journal of Economic Pmpectiues

Exhibit 2
Enron Segment and Stock Market perfonnance, lggS to 2000

($nillim) 1993 19% 1995 1996 1gs7 1gg8 lggg 2000

Domestic: Pipelines
Revenues $1,466 $e76 $831 $806 $r,416 $r,84e $2,032 $2,955
Eamings' 382 403 359 570 580 637 685 732
Domestic: Tmding & Other
Revenus $6,624 $6,e77 $7,269 $10,858 $16,65e $23,668 $28,684 $7?,031
Eamings" 316 359 344 332 766 403 592 2,074
International
Rwenues $9r4 $1,380 $1,334 $2,027 $2,9$ $6,013 g9,936 $22,898
Eamings" 134 189 196 300 (36) 574 722 351
Stock Perfomance
Enron 25Vo 5% 257o 13% -4% 37% 56% 87%
s&P 500 7% -2% 34% 20Vo SlVo 27Vo 20Vo -t0%
M{or Business Events Teesside Begins Begins Acquires Acquires Creates Trading
opens electricity constnrc- Pordmd Wessex Enron- contmcxs
trading of
tion General Water Online double
Dabhol Corp. in U.K Calif.
plant energr
crisis

Soura; Enron lO.Ks.

" Eamings are memured before subtracting interest and taxes.
Nole: The figrrres reported are m originally announced bv the cornpany.

From Regulated Indusu)* to Energ.v'f6rting

Jeff Skilling. \iho subsequenLh became Enron's CEo in -\ugr_rst 2001. enri-
sioned Enron s trading model during a lg-qE \IcKnser- eng'aqemenr ar Enron.
\\hile dereg"ularion generallr' led to lorr-er prices and increased supplr.. ir also
introduced increased volalilin-in gas prices. Further. the standard conrracr in this
market allowed suppliers to inrerrupr gas supplr'rrithour legal pena_k.ies. Bl.crearing
a natural gas "bank," skilling foresaw thar Enron could help both bul,ers and
suppliers manage these risla effectively. Th. "g^ bank" would acrjusr as a financial
banking institution, except that it would intermediate berween suppliers and buyers
of natural gas. Enron began offering utilities long-term fixed price contracts for
natural gas, typically at prices that assumed long-term declines in spot prices.
To ensure delivery of these contracts and to reduce exposure to fluctuations in
spot prices, Enron entered into long-term fixed price arrangements with producers
and used financial derivatives, including swaps, forward and future contracts.4 It
also began using off-balance sheet financing vehicles, known as Special purpose
Entities, to finance many of these transactions.
By all accounts, the gas trading business was a huge success. By 1g92, Enron was

4
A swaP is a transaction that exchanges one security for another with different characteristics.
A forward
contract is for the purchase or sale of a specific quantity of a good at thc current (spot) price, but with
PaFnent and delivery at a sPecified future date. A futures contract is an agreement to bry specified
quantity of a good at a particular price on a specified future date. "

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 -\

The Fall of Enron 7

the largest merchant of natural

gas in North America, and the
gas trading business
became a major contributor to
inron,s net income, with earrings before
and taxes of $122 milion. The interest
creation of the on-line trading model,
in November 1999 enabled_ the company Enrononrine,
to develop further and extend its
to negotiate and manage these financial abilities
contracts. By the fourth quarter
Enrononrine accounted for armost of 2000,
harf of E.r.o.rj. transactions for a[
business units and had enabled of is
transact.lons per commercial person
3,084 from 672 in Ig99. to Srow to
In the late r990s, Skilring refined the trading
moder further. He noted that
"heary" assets, such as piperines,
were not a source of competitive
would enabre Enron to earn economic advantage that
rents. Skilring u.g.r.a that the key
dominating the trading market was to
information; Enron shlourd, therefore,
hold "heavy" assets if they were usefur onry
for generadng information. consequentry,
the company began divesting "heavy"
assets and prr.*i.rg an ..asset
As a result of this strategy, by late light,, strategy.
2000, Enron owned 5,000 fewer m,es
gas piperine than when-the company of natural
was founded in lgg5-but its gas
transactions represented 20 times financial
is pipeline capacity.
Through its extensive network orpipetirrer,
E.r.o., was initially weil positioned
to intermediate between producers ani
utilities. The company had expertise
managing the physical logistics of derivering in
gas to customers through its
It quickly developed expertise_ in pipelines.
included exposure to-generar g^ -u.rugi.,g the trading business risks. These risks
rpoi *1*., vorat,iry, exposure to gas
fluctuations at particular p.oar.tro' price
and derivery locations (since gas
transported costlesslt, from one location cannot be
to another), exposure to resen,e risks
(since Enron had to eruure
that it rr'ouid har-e sufficient gas resen.es
meet it. commitmenE to urilities) to be able to
and the risk that .or.ri.pu-i.s in
transaclioru n ould defau]t. is derivatir.e
Horverer, u-hetherthe company courd expect to conlinue
from gas trading was uncrear. Skilling ro earn high returns
believed that the m4or baJer to
trading was Enron's market Lro*tlag. entry in gas
achieved through its dominanr
position' However, many other firms market
ivere well positionld to charenge
dominance, including large gas Enron,s
p.odrr...l such as Mobil, gas marketers such
and clearinghouse and financial as
PT"'-
citibank' In
comparable markets, .urly."rrt" to
firms such as phibro, ArG, chase
and
first-movers had quickly dissipated
as competitors entered. For
example, in the interest .u,. ,*uplarket, margins
declined tenfold during the lg90s.i
The Internet provided a low_cosr
pratform for
comperitors to develop eners.y markets
ffiTf,.::S:f;.1, that could compete

5
In the interest rate swap ma+el tw:
agree to make paymcnts to each
(or imaginary) quantity of principat. larties "truo other based on a notionar
ir,. p"yi-*" uy trre pr.,i., ,.. iirlJ ol 0,rr....,, inrerest
f#:: ftiloo, ";,' l'ro"Xflng:lgi::it
p"Gillj.d o,, u nxea inte rest ra-t.*,t,.,r,. rher makes
o
tnterest rate' Thus' swaps provide
and of hedging risk. a way of seeking lor...ort financing

--;ifi;-Jfrfi ;e;fr8f
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8 Joumal of Economic perspectiaes

Extending the Natural Gas Trading

/ Model
In the mid-r990s, Fnron b.gL e*t.rding
/ markets' It sought markets with -certain
its gas trading moder to other
chu.act..ist"ics: the markets were frag-
mented, with comprex distribution
systems, the commodity was fungibre,
pricing was opaque. Markets identified and
as targets incruded electric power,
steel, paper and coal,
purp, water and broadband cable
capacity. Enron,s model was to
acquire physical capacity in each
market and then ler.."g. inuii.rr.r*ent
through
flexible pricing structures
for market participants, using
;[".Jff,:..Xr:imore
exp.ertiseitn"au.ql,li.lTr_::Ifrl?:ffi :;.i:Jn;::i:Hl,**::m:;li
trading moder therefore was toutei
as a way for Enron to continue to
spectacularly as it diversified from grow
a pure energy firm into a broad_based
services company. financiar
The first market to be deveroped
was electric power. To implement
in this market, Enron had to ngure out its model
how to ensure that it courd meet
men6 to provide power in peak periods. commit_
unlike natural g^, .r..tri.ity cannot be
stored to satis$ peak demand, Ieadi.rg
to even higher pricJvolatility than
market' Enron responded to this .h"ult..,g. in the gas
by constructing .,peaking prants, de_
signed to meet short_term peaks in
dema.ra.
Enron had som
irybuttheviabilirye jffi'.':'#.i1:iilff
expansion was uncerrain. would the
:'.?":#:i#i:3rT::.1#;,:T,[.;
additional contractuui n.*iuitiry offered
Enron in the gas and electricity markets by
be as popular in the new markets?
each new market posed unique chalenges. Further,
For example, rvhile customers courd
disringuish dif[erences in the sources "ot not
* or erectriciq,, thel, cared about and
could obsen'e changes.in r,arer qualin'.
lire chalrenges of seriing long_term con-
u-acr for broadband cable accesslncluded
the use oi.,.rp.or.., ai,rd nonstandard-
ized technoiogr', d-ifficulries in extending
fiber opdc nenr.orks o'er the "last
into buildings and excess capaciq'. Finalr],', mile,
even if Enron was successful in
these new marke6, it was uncrear creadng
whether earry rents courd be sustained
potential competition in each market. given

,rternational Expan.sigp; Energy Asset

Construction and Management
As Enron expanded beyona the natural
gas piperine b*i;'.;;; it also reached
beyond u.S. borders. Enron Internationar,
u *t orryt*.,ed subsidiary
created to construct and manage energy of Enron, was
assets outside the United States,
larly in markets where en-ergy was being particu_
deregurated. major project The unit,s first
was the construction of the Teesside
ei-ectric power prant in the United
which began operation in 1993. Enron Kingdom,
subsequently enteredcontrac* to construct
and manage projects in Eastern Europe,
Africa, the Middle East, India, China
central and south America. These projects and
represented significant investments
these economies. in
while the privatization of energy producers
and deregulation of energy rnar-
kets created demand for the ,,,".ru'g.*.rrt
of energy assets outside the United
states, Enron faced some distinctive
.i.t i., entering these new markets. Some of

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 \

paul M. Healy pabpu

and. Krishna G. g

I the international projects were

company's
for the construction and m:rnagement
where Enron had a core competence,
core expertise be extended to
of piperines,
but many o*rers were not. could the
other types of energy assets, such zrs
plants? Also, international diversification,
such as India and Ch.
particularly in developing economies
power

powerprojecti"r"J;,,:;1:::l,H'n,:,il1$*#:I#:ffi*;ff
project until that time in India, and .r,,1::;:
it attracted considerable political opposition
and controversy. Given its rimited
business experience in developing
did Enron have expertise in managing economies,
th.
its asset expropriated after constru"ctiJ,
ri* that any returns would be taxed or
or tn. prant? Even if Enron was successfur
in the inhrnational energy marke! questions
could be raised about whether the
company could create a sustainabre
advantage over competitors that
enter the market' Many existing prayers rater sought to
hai expertise in managing the construc-

Financial Reporting

Enron's comprex business model-reaching

across many products, incruding
physical assets and trading operations,
and crossing national borders-stretched
the limits of accounting.d r.rro., took
ful or ul.orr.r,irrg limitations
"drrr.rdg.
its earnings and balance sheet to p"ortray ; ;;;y picture or its
;:ffilT::
Trvo sets of isst_
in'orred complex,"[,:H :1;H::"':r:rob]ematic' First' its trading business
accounting rules use the present
rarue framerr-t.k to record these
ransa.utt't
H':*,',*T.:*::l1-l'i"pp'oJ"ff ;fi ';'H?-TffiiT:::.:""fi ,!:
,o:...:*.r.,..;r'n'l',';'o;',".T::T,:1ffi '*::til';,H:::..:".JjT*i
relied extensively on strucrured finance
transactions that invorved setting
purpose entities. These fansactions up special
shared ownership of specific
risks with outside investors and cash flows and
lenders. Traditional accounting, which
arms-length transactions between focuses on
independent entities, fu.., .liull.rges
with such transactions_. Accounting in dearing
*le--ak... have been aebating appropriate
accounting rules for these transactions
for severar years. Meanwhile, mechanical
conventions have been used to record
these transactions, creating a divergence
between economic reality and accounting
numbers.

Trading Business and Mark-to-Market

Accounting
In Enron's originar natural gas business,
the. accounting had been fairly
straightforward: in each time periold,
the company listed actual costs of
the gas and actuar revenues received supprying
from selling it. However, Enron,s trading

of information on the financial reporting

failures at Enron was powers, Troubh
"ffm:laffi;:

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10 Joumal of Economic paspectiaes

business adopted mark-to-market

accounting, which meant that once a
/ contract was signed, the present varue
of
rong_term
the stream of future
inflows under the
/ contract was recognized as revenues
and the present value of the expected
costs of
fulfilling the contract were expensed. Unrealized
gains and losses in the market
value of long-term contracts (that were
not hedgea; were then required to be
reported later part ofannual earnings when thly occurred.
as
Enron's primary challenge in using-mark-to-market
accounting was estimating
the market ralue of the contracts, which
in some cases ran as long as 20 years.
Income was estimated as the present
value of net future cash flows, even though
some cases there were serious questions in
about the viability olJ... contracts and
their associated costs.
For example, inJuly 2000 Enron signed
a2hyearagreemenr with Blockbuster
video to introduce entertainment on d-emand
to multiple u.S. cities by year_end.
Enron would store the entertainment and
encode and sffeam the entertainment
over its global broadband network. pilot
projects in portland, Seattre and salt
city were created to stream movies to a iew Lake
dozen apartments from servers set up
in the basement. Based on these plot projects,
Enron went ahead and recognized
estimated profits of more than
$lr0 -ittio., from the Brockbuster dear, even
though there were serious questions about
technical viability and market demand.
In another exampre, Enron entered into a
$1.3 b,rion, r5-year contract to
supply electricityto the Indianapolis company EIi Lilly. Enron
was able to show the
present r,alUe Of the confrart ren^"todt,l r
revenuesEnron".:'"ltiil$:.",T!:1,*Iff Ji:l;3T.:':i".:,i1ff
contract as an expense. Horvever, Indiana ;#
had not vet deregulated electricirT_,
requiring Enron to pred.ict r'hen Indiana
rrould deregurate *aiorr,much impact
ha'e on the costs of senicing rhe contracr
o'er the ten \.ears (xrugman,
iffirt,'ltto

Reporting r"ues for Special purpose

Entities
Enron used special purpose entities to
fund or manage risks associated with
specific assets. special purpose entities
are sheil n.-. ..."u,.i by u ,porro.,
funded by independent equity investors b.r,
and debt financing. For exampre, Enron
used special purpose entities to fund
the acquisition
rn return, the investors^in the special prr.po.. of gas ..rr.*.. from producers.
entity received the stream of
revenues from the sale of the reserves.
For financiar reporting purposes, a
series of rules is used to determine
a special purpose entity is a separate whether
entity from the sponsor. These require that
independent third-party owner have an
a substantive equity stake that is "at
specia] purpose entiry, which has been risk,, in the
interpreted as at least 3 percent of the
special purpose entity's.totar debt and
equity. The ird;p;;a.", ,t i.a-party owner
must also have a controring (more than
sb pe.cent; financiar interest in the
purpose entity. If tr-rese rules are not speciar
satisfied, the special p".f"r.'.ruty must
consolidated with the sponsor firm,s business. be
Enron had used hundreds of special purpose
entities by 2001. Many of these
were used to fund the purchase of forward
contracts *ith g^ producers to suppry

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 The Fall of Enron I l

gas to utilities under long-term fixed

contracts.T However, severar
controversial
:ff::Xl,:Jffi' primar,v to *r,i.* n n anc iar reportin
:":;}H,ffi; fi ffi'"i g
of 1 ts m any j oi,
i r"r, r,r..s. Howeve r, ."
financing the acuullltion or from
ff ':i.t""rffi
j
:Jfr ff :il:HX
special purpose entity that
,n..;*, venture on its barance sheet.
chewco, a
*u, .orr,rJ[.a uy u, Enron .;;;;;
rhat was guaranreed by Enron, and raised debt
u.q.ri..J ,rr. joint ventur.;;;
The transaction was sructured for g3g3 m,rion.
in such a way that Enron did
chewco or thejoint venture into not have to consolidate
its financials, enabling ii.rr.*r"ry
ro acquire the
recosnizins any addition-al
::H::lt;lllTrr-*,n"ut
are presented in the Appendix
debt on its books. More
Winokur (2002). and also in Powers, Troubh
and

.u*,11'J,'"ffi :1xTilxg,H1ffi'.ffiTr';1,:ffi
standards that require at least
s p....ri
i:,,:,*T:ff :i:::
,o u. of assers
by independent
equiry investors. By ignoring
"#.ato avoid
ni. ..qrri..*ent, Enron was able
ing these speciar purpose entities. consoridat_
As-a result, Enron,s nr"r..
liabilities and overstated its equityurrjiu.u-ings. .rr..t understated its
announced that restatem.rt on october 16,200I, Enron
io its financial statements for years
colrect these violations would 1gg7 to 2000 to
reduce earnit
n ( or 2 s
ri o p..;
; ;r re p o rte d o u J,., X;ifJ,ff
end of 2000 by g628 milion (6 -
o
p.*.;;;;.eporied
ff :-I?:L.J,"#J:,1 H:
r,",r,r,o., urd 5.5 percent of
reduce
;'.:il1.T:;klt 'q,,irl at the end or 2000 b'. si; i,iri", (10 percent
In addiuon to the accor,.rina f.;t,.-^. r
n rs re r a ri o,,
o i
", ",.
invesrors rhar ir had hedged :i .*[l ;t[:? :::?:.H:.
ao":lr,aJ^i
l;:l;]"J;1,1..T:I" ..J

ffi f ;H.',:i"'ff ::l PurPose' "' *'

,

l: ;J'ffi :: *i: f :
lni' ;l:,,:*,
tees ro carrv .", ;:i,:'i:;'.Tt
an
Hi:-.:tri,T::,,:::l^ilrr3::::: ilT
Enron alrorved se'era.t r.1 .*p"l=.,1-.,,0,"*
i:H:,'ff#Lffi;:".., its chier
rnsubsequen,*";';.:,I[i!]::ffi :T.:il,ffi'.1]: j[::"*:x*x:
employees profited handsomery, .aising
their fiduciary responsibility uborrt ql..rt"r. *t.tt..;.y had fulfilled
to E.r.or,i ,1olihoro.r.,

Other Accounting problems

Enron's accounting probrems
in late 2001 were compounded
tion that several new businesses by is recogni_
were ,roi"p..ro.*ing as welr
october 2001, the company announced as expected. In
a series of asiet writedowns,
after tax charges of $zsi *iltio.,
gI80 miltion for broadbana
*.or,r.i*, ,he water urrirr.r. *quiredincluding
in r99g,
mu.rt*.r,i;;;'$;;; ffi;";;il;l,u.r*.r,o. r,
7
see Tufano (lgg4) for a detailed description
of these financial arrangements.

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 \

12 toumal of Econorni,c perspectiaes

total, these charges represented 2p percent

of Enron,s capitar expenditures for the
three years lg98 to 2000. In addition, on
October b,260l,Errro' agreed to sell
Portland General the electric power plant it had acquired in
""-rp:,, rg97, for
$1.9 billion, at a loss of $t.t binion oo.. ,h. acquisition price. These
write_offs and
losses raised questions about the viability
of Enron,s strategy of pursuing it g^
trading model in other markets.
In summary Enron's gas trading idea was probably
a reasonabre response to
the opportunities arising out of derefrrhtion.
However, extensions of this idea into
other markets and internationar expansion were
unsuccessfi.rr.s Accounting games
allowed the company to hide this reality for
several years. capitar markets largely
iryo1d red flags associated with
Enron's spectacular ,"port d performance and
aided the company's pursuit of a flawed expansion
strategy by providing capital at
a remarkably low cost Investors seemed r,,ittirrg
,o ur.rrri. ,frri f"r""i ;t;;
growth and profitability would be sustained
fu.irrto future, a.rpt,. ,i,,r. economic
basis for such a projection.
The market response to the announcements
.business
- of accounting irregurarities and
failures was to halve Enron's stock price and
to in.ierse its borrowing
costs' For a company that had relied heavily
on outside finance to fund its trading
businesses and acquisitions, the resurts
were equivarent to a run on the bank. on
November 8, 200r, Enron sought to avoid
nantruptcy by agreeing to being ac-
quired by a smaller competitor, Dynergy.
on Novemb.. ig,i.rrorr,s public debt
was downgraded to junk.bond status, and
Dynergy withdrew from the acquisition.
Finally, with its stock price at only
$0.26 on December Z,z,,l,Enron fiIed for
bankmptcy.

Goveraance and Intermed.iation Failures

at Enron

How could Enron's problems remain undetected

for so long? Most of the
blame for failing to recognize Enron's probrems
hrr;; to rhe firm,s
auditors, Arthur Andersen, and to the "sell-side"
analysts who ^.t*.0
wirk for brokerage,
investment banking and research firms,
and sell or make their research available to
retail and professional investors. However,
we hypothesize that the intermediation
problems are deeper than this and affect
each of the key prayers that provided a
link betrveen Enron's managers and investors, as
illustrated in Exhibit 3. on the
information supply side of the market, this
includes top management and Enron,s
1u{it lolmittee along with Arthur Andersen. on the irrro.-aiion demand side, it
includes fund managers and financiar regulators
along with seil-side anarysts. we
consider these parties in turn.

8
In this discussion' we do not consider profits Enron
allegedly earned illegally through the manipula-
tion of electricity prices in california. r ,n.r"
p.ono *"re excluded, Enron,s performance would
been even worse. have

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ffi[Jii;3r31ti3,i,'#,if e'"'"]ffi# t3 23: t2:3e
 \

Paul M. Heall and. Krishna patepu

G. 13

7 Exhibit 3
The Links Between Managers
and Investors

Standard.Setrrs and Cryiel Martet Regulafis

1sec, rAsB, sd.k erchange"f._*."

Role.of Top Management Compensation

As in most other.u's' comianies,
Enron's management was heavily
sated using stock options. compen-
H.uuy use of stock optionl*a.as
stock price may exprain the focus rir*.a to short_term
of Enron,s management on creating
of rapid
growth and its-efforts to puff,rf expectations
,.po.t.d earnings to meet wa, street,s
expectations.
In its 2001 proxy .tatem..rt, Enron
noted that within 60 days of the
proxy date (February 15),^the
foilowing stock option awards *orta
cisable: 5,28b,b42 shares for become exer_
Kenneth'tuy,- az+,oz-g shares for
12'611,385 shares for all officers Jeff sk,ling and
and di.eciors combined. on Delember
Enron had 96 minion shares orrt"t 3r, 2000,
rrairrg;;;". stock option
cent of common shares outstanding. ;; armost
Acrording to Enron,s proxy statement,
13 per_
awards were likery to be exercised these
within three years, and there was no
any restrictions on subsequent mention of
sale of stock acquired.
The stated intent of stock options
i. to uiig, the interests of management
shareholders' But most programs with
award sizable option grants based
on short-term

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 14 Journal of Economic perspectiaes

accounting performance,

I and there arr

I1*:x':t"H*r*1;:-J$,iT,*Hid{fI;:T[l,:HiT.:il:rr::
;:i::::1,:I",i.".,p-so.,,,;._:.-T;l;+[I#T"'ffi l::J.H,],,;*;j
medium-
".
i;;*::;T,tr ifi}fi'j'trJ:;i'"n.i;",l'., 0,, ar to'.."utl
RoIe of Audit Committees

usuallv meetjust a
,n.r.?*#iiff9itt"**ittees few times during the
year, and

i',tt.#:#.?l:',^il.1ffi:1tiil:i']"',xJ,k;iil,:l*ru:il.1i::l:;
the audit ."*.",u.. is fraudulent or the
audito.r;;i,
Enron's
o."ilii;;:JlT"gementa',..i,riJ
Dr.-RobertJaedicke of ""0::'.oJ,HIfil:
stanford
Y::'"expertise than
0."i,.", rast enough.
many. tt inclidea
u.rir..ri,ott
andrormeideanorstanro.ou",r.*i.JnJ.fjJii,.il::::,:ffi
University of rexas' nn.
dent and chief executive
,. a"a.r*;;;... center; pu,rro p...i.u, :;::Jf.fl**:
officer or ,rr. Jat. Bank former presi_
wakeham, formerrr.Kg.*."o of Rio * 1rr.o" in Brazir;
wendv t*"r,;,, C#..
,1.
"iil,. il;;;;#;;,",
John
a Hong Kong
i"J':ffil};and .r,ui. or-'s.
Futures rrad- i"--lo,ry
But Enron's audit committee
seemed to share the
common pattern of a
:'*lHi,:. *.:: : t":: u *
few
.,."- 0,.,
,ry;!ff.TTf, :il T.iff co n sid e .,h e

ll,':i;l'H;'il:;1l,::.',ffi ##:l,"',ffi :;i:#:i"il:,T;:',;:

ry:lffi fii;lll:;::liii:::!';.#li:'.';:i.1';.'r|:,":.','#:i
and ge.,.ies : 0,, ..0..,
con ri n
;r;.ffi ;; rttl*#:;::,:;,: ;ff:i
i":"".,:':ili.*:,"H-"T1,Xm
Report;o air."r.i.,
*:T-
.lll,-o. ;;., ;n th
Compliance committee
e * ho r esar e
of a revision
,, *. o,Li,.'t1r1a1t^ana
sl . report on executive and director compliance committee
111 rr,oo" "to char-
:Hx?il'#;'liff *:a*
i:h,':'i*:;:*:l*1i',*.J1..*:{fi
control.effo.* uyi,rri.r.sses
for 200t com.a
d a summary of changes
in internal

i : ffX ;; ;.ffi XIi#:r fi iffit :::'. :L*: ff ill' *',1 ;:fi t *i

Audit commirtee was in
r',,1T,?::[##:;: ffiXl I*.,El.o.,', no
the ar u.p or.L u.l:,:
sp e ci p
;
)". rtorr.u.i
top management representations. ;, ;;;;'LT:;.;r:::; : l: ::::# ;,,lrt ;
the Audit
did not chal_
";;;1;;.
e
See Findlaw.c om: (http:/ /news.findlaw.comllegalnews,/lir,/enron/index.html#rninutes).

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 The Fall of Enron 15

t Ienge several important transacdons

goals, was not skepticar,about

fiU:t
require full disclosure
that were primarily moti\/ated
potential conflicts
by accounting
in related party transactions and
"r,r,.r.Lrsactions (powers, iroubh and winokur,

Role of External Auditors

Enron's auditor, Arthur Andersen,
has been accused of applying
in their audits because of a conflict lax standards
of inl
generatedbyEnron.rn2000,ertr,.,,a.,i j::Tt.ffi
$27 million in consulting fees. It ir
:t-?fl ,'fl.#lJf
airi."it to derermine wtrettrer Andersen,s
ill*:[T
problems at Enron arose from audit
the financiar incentives ,, ,"or,
consurting client, as an audit the company as a
client or both. However, the ,ir.
is likely to have had an important of ttr. audit fee alone
t;p;! on locar partners in their negotiations
with Enron's management. Enron's
the audit fees of public clients
u,.rii, f.., accounted for roughry 22 percent
of
f". artt * arrdersen,s Houston office.

,".u.Hi3 ll#:r::i:T,il# H:A,|id connicted i.,..., tiu.,.,:I;,,i?..",j..1.i;

o. whe ther thev
exe rc
designed
ise,o,,,,d busin e ss j udgm
for financial ..po.ti-rg .uth.. trian
e n t il ilH:f 1T;'iJff:ff
b,rsin.rs purposes. when the credit
risks at the special purpose
endties beci
writedown, the aud.
menrando..*,,,.1"1i:;H.Jjr:*:*:.j.J#XT'["];ffi
controls at Andersen, designei
ro prorect against confli-cted incendves
:il[*;
parmers' fa,ed' For sxarnplg, of local
Andersen's Houston orn..,
,rt i.r, performed the
l"-: audir. rr-zu permitted ro or_errule critical rer.ierr.s of Enr
cecisions br -{,dersen's pracuce parrrer accounting
in chicago. Finarlr.. -*',dot'
ro coler up an,, improprieries
in ir audir br.
invesdgaritn, orpr,.o., u, tr.,.
\\-ithout makinq excuses for
s.*.r;; ;o,**:t*#Xllm#
the,{nderson auditors, it is useful
beharior against a bact<drop of to see their
horv the a
major chaiges in the ,e70s
costs and seek arternative
*eated *b,;T:,:il11,T:T:?ffifi..*r;.i::
revenue sources. First, in tt
Trade commission, concerned e mia_tgi,s, the Federar
with a potential oligopoly by the
firms' required the profession rarge audit
to.trurrgt-its standards to allow
audit firms to
1*Tltr'il$'::Tfii: H'T;H?1"T1':::: ::t"' i" 'rf,""* s'-"a' resal
ing probtem, ,,o ,o,g.. had to show
accounting information in making
that ;ffi:1;:j,;Ifl::t::;*ri,."ffi:
their invest*..r, a..irio.rJ; i.r.t.ad,
could assert that they had reried they
o., tt. ,,o.t price itself, which has been
affected by the misleading disclosures -(iurr..u.ook
and Fischer, rgg4). This
increasing litigiousness, dramaticalry
ilil?i;1,i1,1X" ir...ur.i the litigation
Audit firms responded to the new
business environment in several
lobbied for mechanical accounting ways. They
standards and developed standard
operating procedures to reduce
th-e
""d;;;;rg
variability in audits. This approach reduced
the

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 16 Joumal of Economi.c pa.spectiaa

cost of audits and provided a defense in the case

of litigation. But it also meant that
7 auditors were more likery to view their job narrowly, ,uthe,
7 than as matters of
broader business judgment. Furthermore, while mechanical
standards make aud.it-
ing easier, they do not necessarily increase corporate transparency.lo
Audit firms decided that profit margins wourd be perpetually
thinin a world
of mechanized, standardized audits, and they responded
in two ways. one way was
by aggressively pursuing a high-volume strategy, and
so audit partner compensation
and promotion became more closery linked to a cordial rerationship
with top
management that attracted new audit clients and retained
existing clients. This
made it difficult for partners to be effective watchdogs.
The large audit firms also
responded to challenges to their core business by dwelopirrg
,rlw higher-margin,
highergrowth consurting services. This diversification ,t.utefi
deflected top man-
agement energy and partner talent from the audit side of
the business to the more
profitable consulting part.
The Enron debacle dramatizes the problems with a system
of mechanicar,
standardized audits. It has led talented professionals to
perceive that the audit
profession is unattractive. It has led. clients to perceive
that audits are a regulatory
obligation, not a value added service. It has led investors to perceive
that audited
reports are not really reliable. It has led regulators and the
general public to
perceive that auditors are beholden to their clients. It has
not worked as a strategy
for managing litigation risk, either, as Andersen's Iegar troubres
fogowing the falr
of Enron dramatically show.

Role of Fund Managers

At the height of Enron's populanh'in late 2000 and earlv 200r, large
insrirutional in'esrors orrned 60 percent of its stock. These
included presrigious
mone'management firms such asJanus capital corp., Barclar,'s
Global In'es-
tors. Fidelin'\{anagement & Research, putnam In'estment
}{anagement, .{mer_
ican Express Financial Adrisors, smith Barnel,Asset \{anagement,
vanguard
Group, california Pubric Employees Retirement Fund, van
x"-p.., Asset Man-
agement' TIAA-CREF Investment Management, Dreyfus
corp, Merrill Lynch
Asset Management, Goldman Sachs Asset Management
and Morgan Stanley
Investment Management.
By the end of 200e some dissenting voices were speaking
up with regard to
Enron. The Economisl ("The Energetic Messiah," 2000) questioi.i
rrr.orr,s perfor-
mance, and James chanos, a hedge fund manager, identified
problems from
disclosures on related party transactions invorving the
fi.m,, ,.rri,o. officers and
insider trading in late 2000. In November 2000, chanos shorted.
the stock, and in
February 2001, he tipped off a reporter at Fortune, Bethany
Mclean, who subse-
quently wrote the March article "Is Enron overpriced?,,
However, institutional
ownership of Enron continued to exceed 60 percent
as late as october 2001, before

r0
For example, Nelson, Eliott and rarptey (2002) show that
mechanical accounting rules for structured
finance transactions lead to more carnings management.

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All use subjrct to JSTOR Tems and bonditiirni -- --'
 Paul M. Heaty and. Krishna pabpu lZ
G.

in December 2001 after rhe

,T'*:'xi flfi".f,fill0,.percent company announced
Several reas, have been proposed
were so slow to .ons for why the leading fund
managers
insstatemen;*Hf#_,., jIl;,"r:,fl
out high-quarity informu,ior, :t.T:T,,ff ffi **1i.:.ffi
,..'. fol.. L.t .r, .orrrid.. th... .*prurutions in
The difficultv with the. first explanationr,h:, fund
managers were misred by
il :: ";:,:-:::"'I' ffix: ";f *i:,l,;:i d e an arvs ts-is th a t,i,. . o* p*y,s s to c k

#:,.,.#m:**
[f"ffiil::;uJ,,no,,.assumed***::":J,ffi:1ffi
*t*'**tilrt*r*:i.","--rT#ilJr"',"':.".THffi
company that begins wi& ffi f -:
retum on the current book value
in this
the .*p..ia
and then incorporates
about the g.o*rt oruook lalue and the assumptions
.oltut
di scoun tin"g,r,.,. l*,,-s .,n. o..IIl;[+. :XT.:ilTX [
assess the embedded expecrarions
Enron's cost of equity *u,
back
t" f".i1, , ,r".u pii., o.iri'by ffi;r,
urr.r*irrg that
*,
tz p....ri, ,;;; as a horizontat
Iines on the graph showing..,r." tirr-. i., Exhibit 4.12 The
.o"riry r.ra revenue are based
up unt, 2000; after that pli.,t,
tt.y ""u..',i*.d on actual data
justify the stock price of on what r.u.r, *orra be
$bo t,
needed to
wouldjusri' this price would ^"gr.,2rio. tr, .,-,.t, a framework, one scenario that
hai;..;;.. Enron to earn a ret
,::"r". ::Tj
I; ;
sro rr re, e n u e s rro m s r 0 0 b i r i o n
annual gror'-th rate) and-
r . d
; ; r:T ;,,ffi T:I.."t
cenr per r.u, *...uitJpound grlrr'r;'r:.r-,res by l0 per-
These assumprioru are
h_rqhri aggressir-e. For
on equin rras lg percenr exa,mpre, Enron,s acruar
in tggO, 2l;'r... return
12 peicent rn reei-rhus,
i-,
;;"fi'ff:j;:r,:::.1?.i.TTHll.,l11#:
". r, r".."...'rh. ..u..r.-g.;-*l..oed
in rerurn on equiry and sustain
Enron's peak stock price to jusrift
r'ould n"* ..0"r.* a dramadc-extension
of its bruiness
ffi:1,,ffi.,,i1T;l another u.,.r,'J-i
for the ..^.,;;i;;.,-, or*...
n*trical averages for u.S. p,ruri.-.o.rrpanies expec_
period 1979-199g: i/erage over the
",llll return on equity of ll percen,, u-ra*.r_y.ar average
ll This approach to valuation
is equivalent to the discountedcash
flow varuation approach,
;'#:Liliffi bers ins tead
"r
.*n n.*,. i*'i,l,i1[.,",, .; ;]; ;;#,i,1tf , but reries on
rr.o,, Heary and
12
Enron in 2000 was a diff

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.-:3r*iffi
fl -;"41i:i#J'iH#l;.:li:,":.,*x*:1,:** j:*:::;tllg,.Jl;
ror tle a--",i. i'. i"^,r,. ,to.r.',nu.r.*
rn*.ro..,'*. #:},:'i::l"t
ili """i::H:li,il;;$lil:t:fii;.:#:"T# "J-ffi], this period,
.,,.-;;;;;"*#i',.ouna we
lj.-"r::" 5 percent
l2 percent. white rhis number + 1.7 * 4 percent, or approximarely
frame' it is based on a different
r..r"'r".r, i,,}rtr; l;"t^f:ttt"t
company's cost of capital
set of assumptions. t, ,rrJ !r.rr.l',1,n1

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 18 Joumal of Economb perspectiaes

I
Exhibit 4
Forecasted Retum on Equityand Rerrenues forEnr,on Consistentwith
a $90 Stockprice

Forecasted

EI

o
&
25.0%

20.0%

15.0Vo

to.0%

5.OVo
a [^'3 -r-- Return on Equity
600 e
5oo H
!
4oo e

200 &
o

o
300 oe

Revenues 100
0.0%

,otn"o*ro*9$$$reqr$rdirsrss*slq.sbq.sobq;s$q.os$$ff

No&as" This analysis is based on the following

valuation model, where Vis the ralue of equity, RoE, is
expected return on book equity in period t, BW is the period 0 book
value of equity, g, is the
expected cumulative c-rnrh i".!99I equity from periodO to ,, and
Ra is the ."p1",.a cost of equity.
For further details see Ohtson (1g95).

v: nw{r.
ffi#.qgffiArO * @"oqi r*#
r, * *r * . ..y

horizon over which a company,s return on equity reverS to the populaLion

mean;
and an annual resenue growth rate of 4.6 percent (Palepu, Healv and
Bernard,
20oo).
Regardless of the accounring issues or the sometimes self*ening reports of
seil*ide analrsts, these sorts of straighdonrard calcularions surely should
have
raised quesrions for rhe sophisticated fund managers who o,uned
more than half of
Enron's stock right up to October 2001.
An alternative explanation is that investment fund managers failed to
recog-
nize or act on Enron's risks because they had only modest in-centives
to demand
and act on highquality, long-term company anarysis. As one example,
index funds
that do not undertake any fundamental research and instead invest in
a balanced
portfolio of securities that track a particular index (like the Standard & poor's
500),
by definition do not pay attention to fundamental analysis. This issue
is relevant for
Enron, since index funds were important owners of Enron stock. For
example, in
December 2000, vanguard Group, a leading index manager, was Enron,s
tenth
largest institutional investor.
But what about non-index fund managers, who supposedly do have incentives
to undertake fundamental analpis and to act on it? These managers are
tFpically
rewarded on the basis of their relative performance. Flows into and
out of a fund
each quarter are driven by its performance relative to comparable
funds or indices.
We postulate that this structure leads to herding behavior. Consider the
calculus of
a fund manager who holds Enron stock but who, through long-term
fundamental

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All use subject ro JSTOR Tems and Conditions
 The Fall of Enron Ig

anallris, estimates that

it is overvarued. If the manager
reduces the fund,s holdings
7 q,,u.,.r, the run d wi, sh ow
;::,ffi : ##H:f.'j *T #rT" "L s uperior reratiie

*..,:",
r* ;;;:?.'ff##r;lr.:#HH*i
perrorm we, in
benchmark and capitar
w,l frow ,;;;;. tunds. rr, .orri*,, u risk_averse
;lirff.ll fJ:J' the crowd *,i"", u. rewarded for foreseeing
manager

whenrhe,,o.uu,'ul,Lt,filffi
:fl ::H:Ifl ft .;:nlj*l*];t"..*
the probrems at

i" u.i,,s:;il. to time *qio.,toJ-dowrt,.rr,

u".":T:$;#'*"to simplv t"r'"*,r,?.."wd.
such as
will focus rheir efforts
"r,a."-,rfrl'jff.1Til;-,J.*ll
th an on th e i r own tun
managers continued to
aI*.., t r u., ;,ilIfi :li."Ii,.ll, :liff; fi] ::"ffi illT
buy dot-com,rr.r*
"i,rI. ffi,.ifi'Joroore, even when
j*r1,,,1:i:;;;"J,,-,whysomany
i,ry;:'"ltxl,'ffi ;'::ffi
I#ilT:l'f.*'*o.i.',.iiffi ;ff ff JTX.l:'il:*T;[jJ:Iffi ]i*
Role of Sell_Side Analysts
Selr-side analysts have
received consid_erabre
earlier warning of proble..r. criticism for fairing to provide
ut E.r.or. On O.rot .3l, an
the company fired ior bankruptcy, 2001,just two months before
;; ;";" anaryst...o,,-..riurion Iisted
call (which compires ana arstribu,.r-*"r]", on First
a "strons u'v" -commendadons) for Enron was r.9
fir:,1,,1 ffi';.!' '"0-'u
is a "ser." il;;;.
the accounring

k**.:i:T.T*,,,n:p:,,:"3..,,..H1,?,11.,,.i11?,,,i]:*J"[*,",ff
\th'rr'ere anarrsts so slorr' to
recognize the problems

;::ffiH.,H:.;, th,t -u.,y *ffi1; at Enron? one popular

nnanciar ,".."i,=, ro
recommend

ffi'[:*jJt*#S[#1*T'XH;,ili'r;::1,":fx-*^#H#
ranu,eceiv.a;;'.:ij.';ff
To the impact of investment
assess
l.HX:iffin:*mru*;,;::'J
anallrts' we co'ected tr,.i. rurri.irrg **..,
n .ru.orr""ri o.r., price "r""rr.orr,, sell-side
estima,.,
January l, 2001,
through October ,U, ZOOi, ,o. the period
accounting and business rh.r, Err.orr.."."f.i*. extent
problems. Four analysts of irs
worked ro.-i*, that did not

,,:*^.0 to sefl stocks

.r#::aTa:;:il:l,ui. short, have incendves
to identiry and bet against

:i'*iffi i.;]il,:::ti;;i;ffi [T:;]:;:r

'.t'."*"Tlmlx]::',Tm.l:*{,?f:1""il::l;f
overvaluadon persists foru
ti-", short-sellins
rong fully, however, is limited. whe'n
requires a large capital .rjiT^tl:t"uves
be a
very risky stratesv and,
ania long n.rr.r.'iiXr*
base to be .r....rn i,
than mutual irna', n,a
ii arm.",, ..],,.,J',^,, liJ",1T,*i*:1?
^ y,n,.n u!.orp are much smauer
when thev anticipate a reversar ^
thev tend . ..ir
of price in a relatively;?;'li[ij: ',".t"'io.i'l,iy

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Aii;;;,,:t1ilfi Jtei66i'+3#lY,"f L?;1fi L2.01323:12:3epM
 20 Journal of Economic perspectiaes

provide significant,inves]ment
banking services: A. G.
commerzbank and pNC Edwards, Bernstein Research,
Advisors--Nii. urruryrts
Enron investmenr banking worked ro. i.-, that worked on
a.ut, ura two anarysts worked
investment banking uut
wei.
for firms that did
".r"mrru,.a with Enron. iliil
analysts, 5 presents
il:ffi:1L."+n?recas..
of Enron,s stock price
keyfirrdings emerge. Firrt,
d.fi";;;;;;
actuar price on the
interest r.o* i.ru.ll .o*irt.rr-,#*-oo,.ntial conflicts
of
expected,",..*:fl.#,:T:ll.#ili=-f{},f_.r}::ff
24 percent for analysts that
at for investmen, uurrr.r. This
""ri,iri difference is
ffiH***i
Second, price appreciation
x11T:J-r'fff;T', expected bv anarvsts of invest-

:urre.nruu,,ru.,g,.L1:i$;-1:r-".1,::i::";=ltH*##*,H
:ll'ff ffilli ;i t:^,=:, ; ilJ;;,;. potentiat rorr,,t,.. business as much as
a,, were,,or..i,J l[,#l1l
ilf ffifi: # T,:: ;ilr,**f
explain bias in analysts, forecasts :-, i*,trtI
,.1"^_endations.
The interdependence of ""0
sell-side u.ruryro with investment
a relativery recenr developmen. banking business is
uo Igib, broke;;^;;.
commissions for trading
and used ,o_."",r, charged fixed
in-house selr-side r,aly.t",
of tlese funds to firl
*nr.n *.f ot.Lur,.a free to,".*.
In May 1g75, fixed commissions
,,".. d...g,rlated and begu, to
rrrTririffiiT:"I
revenue, leading brokerage bring in much less
ho,ses to a search ror othe-r
research (Strauss' .o,r..a. of funding for
t"-: re'pondea bv charging clients
research Horr'ever.':iii ri1*
br rhe ea-ri\ 1gg0s. rhe earnings directi'for
of inie.il,enr banking from
e r n n in c i a: ou,.o.
;1T HJ,] i i::: :' iill::I':::":*-:,h o o s h ad be c o m
"
e
A ranse oi
"."a.-i.';,:;.;
alrss are influenced
f.'fiH ;'"::*r::,0 e,,idence drai se.*ide
br their an-
0..*_,;-;;:,
,l3i?"li;I-:l*5,;:[*Jf ::l'xff ffi ::iiJ,:fl:r'1JT);',X;T
;i,jfi:[#;::1,I:T#iHlfi jTlT:,,T,tT:.;H[.f;:IT#,T;
tosether
analysts to mainhin ;;;.;; with a desire by
;,:;:::j'companies,
-,Ji
*i*:,'.";::l:[rq,T:,i,"^Tfi i:'ilr::]*#r.::::;:ll;*ff
:i**[tr*;1,,r11;:,:x,..ffi ;::]':..JJjr*;:l':l;m$,il1
Sell-side analysts f
,*.*i'.,f o;::'J,HHtT:,r,"':ilTI11r,r"TT:::T,ff##.T::Hl
"inside" information and
feedbacu ." *it. and research models. Manage_
,. "ralysis
ffi:t#lI.ll1.il.".::"'o'access ";;t; thar are critical orrnanagement
and
vi ded nro rm r.
i
*Xl::i ;ffi :: ;:, H;[T;H e n t pro_
"
rise to Regulation",.
Fair Disclosu.. i" o.;;;;;
:]:*,f:g:-
zooo, rvtrictr required
-ilffifil;

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Aom 123-z
,-1*[o#J'"?X#;iot323:12:3eplM
 Paul M. Healy and
Krishna G. palepu 2l

Exhibit 5
SeII-Side Anarynsts'
7 Oneyear Ahead price
Forecasts for Enron
2.10
o
I
1.90
o. +r +A
o 1.70 +l
++ +'+ I
o + +
+ a*
d
U
1.50 +
t
f+ tt
o
L 1.30- + 4 +t .+ +
c)
+++ +
+
I + +
o. { AA A
+
'd(!
o 0.90 A
d + Affiliated I,/B
d
.o
o.70 A Non-I,/B
r Unaffiliated I/B
0.50
7/9/2007 2/28/2oor /ts/zoot urr)r*, ,Eii nili,
Naras.. Analysts, price fo
are made during the
are deflatei by'E;;;;:"':'^ts. p.1." PlriodJanuary I'
,r,l'i".".;rc 2001' to october I5,
I) those rhat work ro. olut1ul "n 200r, and

3.dtr#,:.;:rf.i#51;:*,'ll.:x'l}ffi
_.^ ror firms ,rr", a"
t*F$irffJ:";ffi Hl:::*;:;;;r'"
"#,I;1"";";;;*#T[.J"lffifj?rJ,:,'
so,,r.; rnvesrex;:.
"lii"
make all materiai r

f"*:;:::,;$1#i;r:,,.#:::ffi,::1il:J:Jl,:::.::il;j,*;,Ttr,x11
*:tl ;.;; ;,# i::', f,,,:Xf,::,;;,., ",h. ;; ;' .",;
rHnr#i';::;::y.:t'.,*-,Jj;11?:f*,'&ti[T:I#iX
owned by key i,,.tr,,rtio.,ur
anall'sts whose crients
;#?.;:..,.r:ff;::.:::T*ff " stock that is
in recommendations
serr-side ".. p,i;;;;..;,;i::'"::t:::'^:::'rather than institutions? bv
^ "";i;;t'#',:H:Xj';'#',::1""^
or ongoing ..t"tio.,rr,ip, in.isoladon, but in a
nerwork
management of the ""ii".iro.;:':]:.::.'"s bankers ar their n.-r,
.r;o;;';;';:::l"vestment
:ompanies that they cover and ,:r. ,r,.
reports. .,rr,o,.,.., who read their

RoIe of Accomti.g
Regrrlation

::: :,:it#
financial
:ffi :::*ilH:il1' ;'J:J':
mechanicar and inn exib,e
that this approach
c,ear-
engineering designed modvates
specifica,y tu
,J::L: "
clrcurlVent
is well understood i" these knife_edge rules,
,-frJ * ,ir.."*..7 . accounting for some as
of it" ,p..iut
ra
Hutton (2002b) examine
guidance," ror nrms whose manasers
""t;;;;#,]f:fiil,f:"t#3.,Iij::T: activery provided

rhis mntent downroaded,traff*#ft,f:,ll,Her;ffir;,

t3 z3it2:3s pM
 22 Joumal of Economic perspecti.aes

purpose entities, t::"i was able to design

transactions that satisfied the retter of
7 the law, but violated its intent such that
its financial risks.
tlie company's barance sheet did not reflect

The FinancialAccounting Standards Board (FASB) had recognized

years that probrems existed with the
for severar
rures for special purpose entities. Irowever,
FASB attempts to operate by forming
a consensus betrvlen a ected groups, and
had not been able to reach .orrr"rrrr-, on it
an alternative. In setting new accounting
standards, the Board solicits input from interested
parties and amends its proposal
to reflect feedback' The Board itself is comprised
of representatives of various
affected groups-auditors, managers and
the investme.r, .o*-,rrity-and new
standards require approval by five tut of
seven Board members. Finally, the Board,s
actions are closely scrutinized and at times
overmred by the Securities and Ex_
change commission and the political establishment.
setting standards through this
process can be slow, difficurt and political.
Arong with the ia"y i' amending rules
for special purpose entities, the ongoing debate
on whether stock options should be
treated as a current expense to the firm is
another prominent ilrrutration of the
political nature of standard setting. Moreover,
*h.n st nd".d, -. p^r.a as a result of
intensive negotiations, they often iend
to be highly detailed, mechanical and inflexible.

Responses

Key capital market participants were too

rate in recognizing the probrems at
Enron, and at manl' other firms as rve[, in
the late 1990s Ind ."'.ty zooor. Debate
about a laundT list of possible chaages needed
to deter future Enron situations has
been rtidespread. For example, *Le Securiries
and Excha.rg. co--ission has
proposed independent monitoring of aud-it
firms, caued fo. ,,riit firms ro ser their
consulting businesses or to etminate certain
npes of coruuking lrith audit clients
and disclosure of anarl'st invorr.ement and
compensation rrith their firms, invest_
ment banking acri'ities. other proposals
have suggested changes in stock optioru,
like requiring firms to treat options as a
current expense, imposing restrictions on
the sale of stock by managers until after they
ieave orfice, oi requiring top
to return gains made from selling in a market
-exe^cutiles that had been influenced
by fraudulent financial-regTtins. Many
firis are reacting by adding independent
members to their board.of directors and
by assuring gr.uti. financiar expertise and
longer meetings for their audit commiu..r.
whit. thlse kinds of changes are rikely
to be helpful, we focus here on some more
fundamental changes that are poten_
tially needed to address the questions raised
in our earlier urruiyoir.
From Audit Committees to Transparency
Committees
Investors want financial transparency;
that is, adequate information to assess
reliably how a company is being run andwhat
its prospects and risks are. But the
audit committee's current rore is limited to the narror{ and technicar
assuring that the firm is following generally task of
accepted accounting principles as
certified by the outside auditors. we recommend
that the audit committee be

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 The Fatt of Enron 23

7 ;*l:'.1"L;:'::iH T';::'*T have adequate inrormation

resarding the
change in role, we propose
committee O. *""_.?",1;::"::.this that the
ir,.*alfT rffi;i"fl1lf.L:[}lX;"..""
r,,
j:::::Jil:,il: jH jj,*:::H;,!:#:"Hr.'r,'ffi ,:ff;ffi
,:l'":,:
soarshou,d*i'+;,,,fl :H:':::H.::T.mi**tii*i"irmff
uut'" p'opo'iti'J,, strates.v,
::"H,::i fl:X'-'' committee at lntet woulj
key success ,u.,o^ and risks. For
product rrr.roruo,tPutency ;;;;
cos,contro,s,",,;:;Tf
In questioni"* *:-i.:1lro.:
.::t:?Tfi :ffi:ilffi
u:;;;;;;**t, the committee srroura
t:i*#d$X[.:J#iir
adequacy of disclosures focus on the
rerating to thJse rcy p..ro.*u.rr.
in the nrrur.i,-r,r;:;"..fl..t" rior.u,o.r, so that the
fi:ff":fted tt. u,rrirr"r, discussions in the
A transparency.committee
is no cure_all. In the
case of Enr
;il',|;ffii;:ffi [Tl?.1,,;y;;*::luu-r,"a-u,vi"-r;L]fi lffi [1f;l
advice or the externar.auaito.s. continued
il-.;;;1:'r.H;:iffi to rely ;" ;;
would increase dre Iikerihood
investors. In the case
;;;;';;-,, key business ,r*iu*rrrcommittee
transparent disclosure
of Enron, .*r*pt., it might r* i:;."rlTrrTT:i: il
with regard to trr. rp..rut
pu.pole .r;;;;. It wourd
encour-
il,iT; 1,H*T*i::mpriance *,r,
i::#.''f::.", "..",, tining rures and to
of kev importance
Finallv, *.,rp".ln.f;;#,,,*:ij:j,Ytt the bustness.
is likei' ". ;.,;;;'ffilffi:H:'#l:1*"1'p.o,.,iu..o,. *,r, the auditor
board, ,rot priman'responsibilitv
*tth pleasing rop managem..r,l''* ti.r *ltt trr.

Rethinking the Auditor,s

Business Model
ro. i*p.ou.-J auditing have
.r"#f;.1I::::.ry**
-..*];f focused on rhe potentiar
nrms d ; f.1.":1r....T:#ffi ;.;;;;;
;. ri eve ti a t audi t
n e e

Auditors have t< realize why they exist

#
identi$, stocks that ,: in the first place-to help investors
good investmen* and
to change their stratr those that il;;;
Auditors need

:::io:;ffi
tocus on maximizing
:"1"*T.S::;:,i:r"[;;".::1i j*m,*r:rfffi
the value'of 5
beyond a boiremlate
certification or ""orJ"rr,r-"r.ry,
in*-*""r, audits that go
rru.ro* conformity
but alrow a more complete
..n..tio, oiii. i.rrigtrt or *,r, ,.."rrting standards,
trre auaitor on the crient,s
performance and risks.
,11.. ,*rrr
"fp."".i, audir firms *r, i.-*o.. likery to craft
:,1+H:J111: flo{'itio1'' t';';*s;',erect segment or crienrs rather than
we,h-i n k ;;;.J;HLTiil.T,;, .; ;,
",;
L*[ii:[:r;;
audir committees are reformed h app e n wh en
*.,,.-r" ;;;.il
can onty be achieved ^
when audito*;.; ;;;;
committees as"roi]lr*o.pendence
their real clients, not

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 24 Joumal of Economic paspectiaes

top management. Moreover,

incentives inside the
audit firms
7
::$HT,,:;T':J#.:#1.:.":i:f,.iFTry:llff ;"ff :#a.:,:T[
, rhese o-o"lXiTilil:::,:Hl,:Tl ::: nig,"J'i*p;.on,
to increased litigation
urr*.r, ," ,ntloiffi;."#:t'auditors
t*:i
have three risk. we

fi lil:T:r',:f 'oru'sn"*;;j#[]if ',1,::i::'ixiff*:ff

r#**isHti:qiTnffiHr.ff#**j**11'r*r"::*{d
f,,."-; "*,:: .: I ill ;##[ :::: :l ", ;.;;; s g :_ ".,:J
p n on var u e-crea tin

i1;i't::;'i"H;t',*il:t*:[,;*"'::!1ii;:ilT,ffi i:ff.H**;
business rur,r..r. ;"r;'^'l'.I: "tto to rethink the way or
th1oush,, u*"

ffi,?ff ffi i:lv

u",,',ll'i11,.i1 :ff
or. e xp e rts-rn
, :iffi1;1
*n rjt. ui.
T, ##:#
ras h es
#.,'.: }.ffi ::
r*. u*llJlf
are,
,ff
c
analysis points to shoddy $.?.ll
hold the auditor *o.i uy auditors, rhen
".1t1_t:-]:,"at
;-*:,Hr.;**1,;T:ffi li:xx*ffi li:fr in'"T-::,ri:lt,*T::,;
repositioning the inaustry leaders ought to fo.,rs
to make i, on
uurtttY ;;i*il
" plaver in the economv.
An dternative **"J:, -::^:- .vatue-creadng

. ;i*H*,ffiffi il is#ffi:Tlll!i,::,h e au di,o rs an d,h

*-.nu.",ii;;::::T: I..J"T?jf; cannot be viewed irr,,oi,,io" rn"..e *...i, au d

inves ro
perrorman ce .;;;
'#*i;JI*#
rs, .,rt o a.or. rli# r' .l''j:r."^::lo-T rd"l from sop his d in tionat ri c ate d ru

:;,L,il.r
s

ffi:H: H f
ffiT.:: T:ilil:.l; J l[**i*nrrffi"i;:ffiffi:Tiilff
*: * :l ::l^,;;:;;ff ;.th.re,h.ugh, rn
auditors and anarysts.,,. i.,...iu.. or
il:.., -
. The case of Enron has illustrated AJ;;;;
incentives know surrisingly little
and information problem, about the
capital market intermediarie, ,rru, u.irlTis*ts
Sovernance and tunctioning of
tainabrejumps in stock
*Jil;;;'::^_Tjt
marker prices, *..rrrli il.':ffi;;:ll:";Tlx:f,
more bioadlv, ro. *ir.,,u,,ug.a
nrms.
HH
wh,e quick fixes like
':'iLffif*::*t
l.:rtr[x**'H5:."1,,HH*r*:T[.*#tr#i**.T*::*:.i#i

Enron,s JEDrJoint vuot

oua#ftfrewco Special pulpose Eotity
In lgg3, Enron and canfornia pubric
rormedJEDr, ajoinr r.","r* Emproyees Retirement
a,,il;;ffi;hr# ;,iiil;;,o
sptem (carpERs)
"l#r..u into rhe

rhis conrenr downroaded

trslij,il,}tr.,+*Lw#L?, t 3 23 : t2:3e pM
 Paul M. Healy and Krkhna G. patepu 25

joint venture. Enron accounted

for this ir
equi tv m e tho d is use d to record
cent or more of the stock in another,
.0,, o r*ffi;i::-.f.' ;TIff.*'l6 Il:
rhe "associat." ."*p;;;. under the
method, the varue of the investment equity
is reported. at the u.qri...;. initial
share of any subsequent accumurated cost plus its
profits/losses .ei.rvested by the associate
firm' In addition, investment income foi
the acquirer is its share
larn|nss
for the year/quarter (adjusted for any transactions of the associate,s
firms), rather than mereh any diviiend between the two
income received from the associate. As
result,Enron's share ofJEDI's debt was kept a
offEnron,s balance sheet while Enron
recorded its share ofJEDI,s earnings
as equity income.
one accounting irregularity that arose from
the JEDI joint venture was that
Enron incorrectly included in income
fromJEDI the appreciation in the varue
Enron stock owned-byJEDI, whichJEDI of
marked ,o *-k., value. This may have
"Enron's
been an oversight. Flowever, wh.n
stock price began to decline, Enron
specifically excruded its share of the
unrearized losses fr"*'.oii,y income.
In lgg7, Enron wanted to buy out the carpERS
did not lvant to have to consolidate
i.,t...rrirlrDl. However, it
JEDI into Enron, since doing so wourd boost
Enron's reported
entity cared chewco was therefore
created to acquire 'ru.r1*::1T-.iaipurpose
the carpERS investment. chewco funded
trr. fr..t price of
$383 milrion as follows: a) $240 milrion of ^e
debt from Barclays nurit , g.ruonteed
Enron; b) $132 m,rion advanced byJEDI by
under a revorving credit arrangement;
c) g0'l million equiry invested. by iaicrraet Kopper,
reported to Andy Fastow, Enron's chief
u, irr.o, emproyee who
financial officer; and d) $11.4 million
"equity loan" by Barclays Bank, structured
in such a r\,a),as to be recorded as a loan
on Barclay's books and as equitl.' b' chervco.
Barcravs also requrred the equin.
investors to establish "cash resen'esj
of g6.6 mill_ion ir,, pr.Jg.o ro secure
repa)menr of the 911..4 million equin'roan. rhe
To fund tt ir.es.n.!.
-'
and made a special d.istriburion oiSiO.O ' -rEDI sold a:ser
million . Cfr._r.o.
The result of the requirement for cash
resen.es lras tiat Enron fa,ed
the rules for nonconsolidation, so that to satisfi.
cher'co and pDI should ;;;;"':;:
solidated beginning in November 1997.
In addition, rhe rransacrion potentially
violated the spirit of the rules governing
special purpose entities, since one
principal equity investors was an emptJyee of the
of Enron and therefore arguably not
independent of the company. In
Novemter 2001, Enron announced that it
consolidate both chewco andJEDI wourd
retroactive to tgg7. fu a resurt of this
ment, its equity at the end of 2000 d.ecrined restate_
by $gr4 million, and is debt increased
by $628 million.
A more detailed disctusion of
JEDI/Chewco, and of several other prominent
special pulposes entities that were invorved
in Enron,s accounting irregurarities,
found in a report fiom can be
special Investigative committee of the
{
of Enron cory. (powers, Troubh and win"okur,2ooz),which
Board of Directors
can be accessed
web at (http://neun.findlaw.comlhdocs/docs/enron/sicreport/index.htrnl). on the

t we appreciate commcnts and suggesti.ons rueiae!

Michael waldman, Am1 Hutton, ait frlyTimothl Tayrm, Brad De Long,
Koptor, Richard, kckhau,ser and. pafiici.pants
at the

This content downloaded from 123.4

att ur" ,ru;""t to rfS6Ji3",i'.Mo4 7 Mav2.013 23:12:39 PM
 26 Joumal of Economic petspctiua

Iandan Busincss schoot Accounti.ng

symposium and corumbia Business
workshop'
we are gratefutt*ror*in t"ppipro**o r, schoor Accounting
chris Atten,Jonathan Bamett and,
Brmda Chang.

References

Akerlof, George A_ 19i0. "The Market

.-
'Lemons': for Lin, H. and M. McNichols. lggga. "Underwrit-
euality Uncertainty and the Market ing Relationships and Analysts, fo...rr*
Mechanism." euanerly
Joumat of Economics. Au- Investrnent Recommendati i"r."
rri
gust, 84:3, pp. 488_500.
counting and Economics. Febntary,
1*r."i ,1 ir-
Barth, James L, lggl. The Great iS, pp. tOi_Zi.
Saaings and rin, H. and M. McNichols.'l99Sh
Inan Debaclz. Washington O.C.,
e_..i..n inte._ Coverage of Initjal public Offerings."
e"a*i
pnse Institute.
Paper, Stanford Universiry.
W".d;
Dechgw, patricia, Amy Hutton
and Richard Mclcan, Bethany. 2001. "Is Enron
^-
sloan. 2000. .,The Relation Berween e"aptr; Over-
priced?" Fortutu. March b, 143:b,
of Long-Term Earnings G."*,h ;;; p. 122.
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Harr.ard Business School Case 9-29+076.

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