Disorganized Crimes

Why Corporate Governance and Government Intervention Failed, and What We Can Do About It

Bernard E. Munk

• Publisher: Palgrave Macmillan
• Year: 2013
• Print ISBN: 9781349460908, 9781137330260
• eBook ISBN: 9781137330277
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

Corporate misgovernance and the failure of government regulation have led to major financial fiascos. 'Disorganized crimes' are disruptive and costly. Munk links the two major eras of corporate misgovernance during the last decade to explain how these events occur and what can be done to prevent them from re-occurring.

Chapter 1

Who’s the Fish?

This book stemmed from my curiosity over the spectacular growth and ultimate collapse of Enron in 2002. I had first become familiar with Enron as an oil trader in the 1980s, then as a terminal owner and utility fuel supplier, and finally as an energy consultant to a Wall Street investment bank in the 1990s. Along with a number of other companies whose (common) stock had first soared and were later revealed as financial fiascos as the so-called “Long Boom” ended, Enron filed for bankruptcy on December 2, 2001.¹ The similarities between these financial fiascos were beguiling. Each displayed a common equity price pattern of a comparatively long period of rising prices followed by a sudden and rapid disintegration.²

Story stocks often display this pattern of a long period of ascent followed by a rapid price collapse when unanticipated, often shocking, information suddenly emerges. A cascade of bad news frequently accompanies the first disclosures of misleading financial statements. Earlier financial results had featured a sequence of good news, and investors climbed aboard. Unexpected revelations cause their rose-colored glasses to first develop cracks and finally shatter. Investor faith in the stock and trust in the company vanishes. Markets are supposed to be efficient, meaning that all the information about a stock at any given moment is contained in the price of the stock.³ Sometimes, however, critical information is not available or misinformation prevails for quite some time. This absence of essential information suggests that shareholders can operate in the dark, often for long periods. A long sequence of good news that is then followed by bad news is costly to the shareholders who purchased shares during the happy years.

Newly revealed bad news can usher in striking losses. Is this pattern an accident, or was there a deliberate fraud in the making that lay concealed under a sequence of good news announcements? To answer that question, one would have to know who in the company possessed the real story; which facts did they know and when did they learn about them? Only then can we understand whether the company’s misfortunes constituted a fraud. After the fall, denial becomes the most common behavioral mode for the many of the critical actors in the drama: denial that they had done anything wrong; denial that they had known the company’s financial statements were in error; denial that the company was in trouble.⁴

During the rapid decline of stock prices beginning in 2000 and continuing through the terrorist attack of 9-11 on the World Trade Center and the mild recession of 2001–2, there seemed to be a plethora of companies surrounded by financial scandals. Their sudden equity price collapses triggered a massive journalistic effort to explain these shocking developments. The best known of that era were the financial implosions of Enron and WorldCom. Their bankruptcies were the largest in our financial history up to the time. These burnouts also punctuated the decompression of the Long Boom during which many fortunes had been created. In the ensuing bust, much paper wealth was destroyed.⁵

The rapid destruction of wealth is the father of conspiracy theories, but these kinds of financial failures are often the normal outcome of wild dreams being confronted by a more somber reality. This raises the pertinent issue of whether any special significance should be attributed to a particular financial fraud, or should our focus be the boom–bust cycle itself?

Explaining the rise and fall of these companies has provided numerous writers with ample material for speculating about recent financial history. Many of the popular accounts suggest that deliberate financial chicanery and outright dishonesty lie at the root of each of these scandals. Journalists claimed this was the natural result of excessive “greed and hubris.” While this is a popular explanation for media types, an explanation that can draw audiences and sell books and movies, it is not a satisfying explanation. Why not? Greed is one of the seven deadly sins. It has always been with us. What was so different this time? What differentiates the companies that produce financial fiascos from those that have less of a meteoric rise and a spectacular collapse? What about the companies whose fortunes show ups and downs over much longer time spans?

The more one learned about these companies whose fortunes suddenly collapsed, the companies we group under the heading the “Enron Era,” the more obvious it became that these companies shared common behavioral traits. Their managements often took big risks and their boards rubber-stamped these managerial choices if and when they knew about them at all. Greed – particularly among the managers – was certainly in evidence, but is greed sufficient to explain the seemingly systematic managerial preference for risky investment strategies paired with the later revealed complacency or ignorance of directors? Why did managers choose these ostensibly high-risk–high-return paths and why didn’t their directors pay more attention to the possible downside consequences of these strategies? Did the directors know and merely acquiesce in those strategies? How much information about these risky strategies was withheld from the market, information that might have retarded the rapidly rising price path that we frequently observed? How was the bad news hidden for so long? Does the herding behavior of investors in these circumstances suggest that there was much to learn about these companies that was “not in the price” of the shares of these companies?

Economics is about incentives and the impact of incentives on the behavior of economic agents. What kind of incentives operated on the managers and the directors of these scandal-ridden companies? Did these incentives create this outcome? The financial upsets of this period and the particular managerial behavior of these companies provide a rich environment for the study of managerial capitalism as we have come to know it in the twentieth and twenty-first centuries.⁶ Evidently, some aspects of our current system need to change, but which changes are truly critical?

Enron in many ways was the poster child of that era. The company was around during most of my commercial energy career. I was always wary of Enron and had made it a practice not to trade with them. My reasoning was quite simple. Each time one of their energy traders called me suggesting a possible trade, their offers seemed too good to be true. I had trouble understanding why they made the offer – what was in it for them? I must have missed something in the deal because their end of it seemed strange. How would they profit from their side on the proposed deal?

When I couldn’t understand what the Enron traders were trying to accomplish with their proposed trade, I became sorely troubled. I was reminded of the old adage about how a newcomer should enter a poker game. “First, look around the table and try to decide which player is the ‘fish.’ If you can’t decide, you’re the ‘fish!’”⁷ Trading with Enron made me feel I was the fish!

Shortly after my partner and I acquired an oil terminal and petroleum facilities management company in 1987, and began supplying fuel oil to utilities on the East Coast, Enron announced a huge loss at their futures trading group housed in Valhalla, New York. The loss was said to be some $145 million. At the time, this was a huge setback for Enron.⁸ We were puzzled over the size of the loss and Enron’s subsequent explanation. Enron’s leaders first claimed that they had been duped by their own futures traders. There was stage one “denial.” That seemed very strange to us. How could a major oil and gas company not control its own futures trading book? How could senior management not have known what its trading unit was doing as this loss developed? Had they no controls? Each margin call would have required cash from Enron’s treasury. Who was monitoring the risk of its futures trading unit at Enron? A loss of this magnitude could not have developed overnight. It must have been building over time, and at least someone at Enron must have gotten word of the growing problem.

We came to the conclusion that either Enron’s management controls were very weak or else Enron had not provided a truthful explanation of the loss.⁹ In either case, it was not an inducement for a small, privately owned company such as ours to get involved in trading with Enron. We were much too worried about our own balance sheet because it had a significant proportion of our own “skin in the game.” A faulty counterparty performance could have posed a life threatening problem for us. Trading with Enron seemed too risky against the possible benefits that might accrue from the seemingly attractive offers they made to us.

My curiosity about Enron continued after we sold our company and I migrated to an academic and financial advisory career. My next involvement with Enron came when I did a study for a major Wall Street investment bank that wished to build an energy trading division as part of their proprietary trading activities. They were also bankers for Enron and raved about the company. Enron provided substantial fee income to the bank and Enron stock had done well. Maybe I had been wrong in my earlier judgment that something was not right at Enron?

Subsequently, I did some energy research for a boutique investment bank headed by the CEO of my former investment bank client. The new firm was working on a number of proposals involving the construction of power barges with electric generators powered by diesel engines. Electric power from such barges could be easily plugged into a developing country’s electric grid under a long-term power supply contract. Such projects were seemingly designed to provide a quick and easily financed way to enlarge the power supply of a developing nation. The barge construction costs were aided by a significant US government subsidy to build these barges in the US. Enron was already heavily involved in the power barge business in several developing countries. I was asked to make a trip to Guatemala on behalf of my client to do a feasibility study for their potential power barge project there.

Enron had a power barge in operation in Guatemala. The electrical output was sold to the national power authority under a long-term take-or-pay contract. Coupled to the power supply contract was a supply contract by which Enron would supply diesel fuel for the engines that drove the generators on the barge. The prospective local partners of the investment bank provided a copy of the Enron power supply contract and Enron’s underlying fuel supply contract that we reviewed. It became quite clear that much of Enron’s profits from the project would come from this fuel supply contract. The contract used a formula that would be quite favorable to Enron in virtually all circumstances. It fitted well into Enron’s energy derivative business, but it left the cost of power generation in Guatemala hostage to the price of diesel fuel. High fuel prices would mean high cost power generation that would translate into higher cost electricity. Since the barge contracted the sale of its generated power to the national power grid under a take-or-pay clause, circumstances could easily arise that would result in good profits on fuel sales for Enron but very high cost power for the national power grid. If fuel costs got very high, the take or pay clause in the power supply contract would saddle the power authority with power costs far in excess of its delivered electricity prices to its customers. That would create an unstable political situation that would invite a breach of the power supply contract by the government power supply authority.

Little did I know at the time that this paradigm would later confront Enron in its major project in Dabhol, India. The Dabhol contract blew up owing to high power prices that in turn caused power bills to various public authorities to go unpaid. The Maharashtra state government in India, under whose jurisdiction the power plant operated, found the contract too onerous and suddenly and simply stopped payments on the project.

Were our client to enter into a similar arrangement for a new barge, the risk would be that the power authority could become adversarial to the barge power supply – notwithstanding its contracted purchase obligations – because high priced public utility power is a hot political potato in any developing country. We thought that the second power barge (desired by our client) could encounter this problem, depending upon how world fuel oil prices behaved. If the embedded cost of power got too high – even though the local utility had signed a take-or-pay power supply contract, it could cause a breech of the contract.

Public power authorities, particularly in developing countries, are typically unable to take the political pressure that arises with high priced electrical power. For investors, it was a story too good to be true and we know what happens in that case. We recommended that our client drop the project, a recommendation that did not make the client happy. We were also asked to evaluate a similar project in the Philippines and discovered the same sort of embedded structural issue – namely the offer of apparently cheap, alternative power, tantalizing to a power-starved nation, but with a power supply contract and its attendant take-or-pay clause that could ultimately prove to be onerous if generating costs rose sharply. Under these conditions, the contract would be subject to a default even though it might be politically inspired.

When Enron first announced the Dabhol project I made a mental note to watch how it evolved. I thought it would be subject to the same problem I had seen earlier in Guatemala. I could find no discussion regarding the attendant risks that might underlie Enron’s ability to collect on its sales and to expand the project as planned. I should have shorted Enron’s stock then because it was a clear signal that much risk had been concealed.

When such projects are proposed they seem to be “win-win”: cheap power in a power starved economy and good profits to the project developer. The kicker is often the cost of the fuel used to generate that electrical power. The risk to investors can be hidden by a company’s presentation to its own board. The presentation can keep risks below the surface while the benefits are stressed, much like the proverbial iceberg whose mass is 90 percent underwater! Dabhol was only one of many overseas power projects that Enron had developed, each of which had its own risk characteristics. These projects seemed to have very good prospects when announced, but often proved to be disastrous over time. Each of the projects suffered from a lack of transparency. Also, it appears that not all of the directors were aware of the kind of risks that these projects when first presented to the Enron board. Enron wasn’t a fully transparent company even then.

Transparency is essential to investors because transparency allows markets to properly evaluate the risk characteristics of a venture. For this reason, transparency should be critical to boards in their role as monitors. If boards are to do their job properly, they need to understand the risks embedded in the presentations that managers use to describe such business operations. Too often, however, directors are celebrants, not investigators, cheerleaders as opposed to watchdogs. Too often, public investors learn about the undisclosed risks only after they have invested in the company and only after a major problem has occurred.

Just before Enron’s bankruptcy, the story of Enron’s “flip” of its African power barges to Merrill Lynch came to light. That story highlighted another important theme to be explored, namely how a supplier of capital to Enron could compromise its own due diligence process, apparently lured by lucrative fees. During the prosecution of the Merrill Lynch officials who helped to engineer this flip, it became evident that several capital market participants were influenced by the fees to be earned on a capital market undertaking for a valued client. The sale and buy-back of these barges was a ruse to dress up Enron’s financial statements for a quarter during which their other earnings undershot their Street targets. Merrill’s personnel knew that at the time. That knowledge made Merrill a party to a fraudulent financial report. The affair also hinted at the potential for other financial frauds within Enron, perhaps extending to more than just power barges. Applying the “cockroach theory” to Enron’s reported balance sheet would prove to be very rewarding to short sellers.¹⁰

The involvement of Merrill Lynch in Enron’s financial machinations illustrated the potential for capital market suppliers with a significant relationship to Enron becoming involved in Enron’s financial cover-up process. It also strongly suggested that if there were significant fees to be earned, other risks might be taken by other capital market participants that could turn out to be devastating to the reputation of the participant. The most outstanding example of this was Arthur Andersen, Enron’s auditor. The immense fees earned by Arthur Andersen clearly blinded them to the underlying risks to their own firm.¹¹

The barge affair contributed to my earlier suspicions that Enron was not at all what it claimed to be as a public company, but, perhaps more significantly, that Enron had capital market co-conspirators assisting it in covering up some of its dubious financial reporting, and that the monitoring process on which we as investors relied was badly flawed.

As evidence of Enron’s fraudulent financials developed, several themes became obvious. First, Enron was managing its earnings apparently at the behest of managers who could benefit significantly from their stock options. At critical points, the reported earnings were not just managed. They were “manufactured.” Second, a major investment bank had become “a willing partner” in Enron’s financial manipulation that succeeded in creating profits from a “wash sale” of the barges at a time when Enron was having trouble meeting the Street’s earnings expectations. Enron used a wide variety of banking relationships. Other bankers were also involved in dressing up Enron financials. Third, the public accounting p...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• List of Tables
• List of Figures
• Acknowledgments
• 1. Who’s the Fish?
• 2. Behind Every Great Fortune Is a Great Crime
• 3. Seeing One’s Friends Getting Rich Is Upsetting
• 4. Round Up the Usual Suspects
• 5. Carrots for Good Governance
• 6. The Conflicts of Managerial Capitalism
• 7. Call Them Disorganized Crimes
• 8. Connecting the Dots
• 9. The Corporate Governance Dilemma
• 10. Micro Risks and Macro Disturbances
• 11. Crime and Punishment
• 12. Foolish Bankers and Burdened Taxpayers
• 13. No Place to Hide
• 14. Remediation
• 15. Financial Alchemy
• 16. Epilogue
• Notes
• Bibliography
• Author Index
• Subject Index