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Bitter lessons from Enron

Overwhelming need to please the market leads to creative accounting in companies

— PHOTO: AP

TROUBLED EXECUTIVES: Boxes of documents being rolled to the courthouse in Houston last month for use in the fraud and conspiracy trial of former Enron executives Ken Lay and Jeff Skilling.

IT MAY never be possible to downplay, leave alone forget, the tarnished legacy of Enron in India, even after its sensational demise in 2001. The notoriety the company acquired through its participation in the Dabhol power project by negotiating aggressively with the Maharashtra State Electricity Board and the State Government, eventually succeeding in drawing up one-sided contracts in its favour, are well known.

The Dabhol power project promised plenty, being one of the largest foreign direct investments ever in the country and offering power to a State and a country in need of many more such large projects. But flawed conceptually, it landed all the Indian parties, the State electricity board, the State and Central governments (which had given guarantees and counter guarantees, respectively) in a seemingly inextricable mess that came to have major commercial, legal and political dimensions.

Flawed from start

At the international level, what was most striking was India's failure to honour contractual obligations, in this case the inability of the MSEB to abide by the power purchase agreement. It did not help India's case that the original agreement was flawed, had inflated the project cost and added facilities that were not immediately needed. Many expert groups and government committees had pointed out the lacuna, some even before the project was finalised.

The woeful dearth of negotiating skills with the Government to match a rapacious multinational was well documented in the Dabhol episode. The Godbole committee had pointed out an inexcusable failure of governance by successive State governments which, coupled with their inexperience and incompetence, enabled Enron to drive a hard and ultimately disastrous bargain.

Enron's swift descent into bankruptcy in 2001 probably gave the Indian side a breather and subsequently a chance to revive the project using the vast fixed assets and infrastructure created by the Dabhol Power Company. A new company called Ratnagiri Gas and Power, promoted by National Thermal Power Corporation and Gas Authority of India Limited has just begun the task of restarting the project.

Penal U.S. action

Meanwhile, even after its demise, Enron continues to be in the news. The conviction of two of its former CEOs, Kenneth L. Lay and Jeffrey K. Skilling, recently on charges of conspiracy and wire and securities fraud brings down the curtains on what is considered one of the biggest corporate scandals in America. Both CEOs were accused of deceiving investors and employees by deliberately fudging balance sheets, inflating earnings and hiding losses. Since their remuneration was tied to the financial performance of Enron (they also held stocks of the company) it paid to manipulate stock prices by purveying false financial information.

In their defence, they sought to link the demise of Enron to some complex accounting jugglery by lower level officials who siphoned off funds for personal gain. Interestingly they also blamed a bad press and short-sellers for their misfortunes. But the jury accepted none of these and held the two officials solely responsible for Enron's plunge into bankruptcy. According to one estimate, Enron took down $60 billion in terms of market capitalisation. Especially severe has been the impact on many of its employees who had allowed their pension funds to be invested in Enron stock. Around 5,600 employees lost their jobs. The Enron verdict is seen less as another corporate criminal trial, another instance of law catching up with the misdemeanors of certain highly placed officials. Their conviction is viewed as a verdict on an era of corporate excesses and management malpractice through the 1990s in the U.S. There have been other similar trials leading to convictions in companies that once had iconic status in their respective fields, companies such as Worldcom, Adelphia and HealthSouth. These developments have led to widespread disenchantment with the corporate world and the way even mainstream companies conducted their businesses. Lawmakers in the U.S. enacted the Sarbanes-Oxley Act that has considerably tightened governance standards and fixed stringent accountability norms on senior executives.

Global impact

The developments in the U.S. have had a major impact on corporate governance and company law everywhere including in India. Much before Enron and other corporate shenanigans came to light there was a healthy debate in many countries to spruce up governance standards. In India significant regulatory initiatives such as broadbasing the board of directors by inducting independent directors are the direct outcome of the increased awareness. (The new Clause 49 of the Listing Agreement is a landmark reached after considerable effort by the SEBI to neutralise sustained lobbying against it).

SEBI's assertive stance

While legal parallels with the U.S. cannot be stretched beyond a point, it is noteworthy that Indian regulators are alive to the need to not only punish the guilty but to see that their decisions stick at the appellate level. Recently, after investigating the demat scam, the SEBI issued stringent interim orders against the culprits, all big names in the Indian capital market. Indications are that the regulator is more willing and capable than ever before to substantiate its interim orders and make them stick even after the appeal.

Enron and many other companies were in a sense victims of what has come to be viewed as the tyranny of stock markets. Although that has not been a valid defence in the criminal trial of its top executives, the fact remains that the overwhelming need to "please" the market has led to many short cuts and creative accounting in many companies. Such evidence has been uncovered not only in the U.S. and other developed countries. At the very least, it has become fairly routine for many companies everywhere to put "a spin" on their performance, to make their performance seem considerably better than it actually is. It may not always be possible even for a diligent investor to see through the clutter but the real difficulty arises when company executives start believing in all the fanciful stuff themselves. This is what is alleged to have happened at Enron.

Belief in their own bluff

The stock markets fed by a seemingly endless supply of good news, without being able to verify them, acquire froth. The resultant bubble makes senior executives of individual companies actually believe in their performance. A recurrence of this pattern quarter after quarter makes them seemingly invincible. Hubris follows and disaster cannot be far behind.

There is one final issue concerning Enron that may have a certain resonance in India too. The company was essentially an energy trader, trading in natural gas contracts although it built power plants as in India. In course of time, it ventured into trading in things such as bandwidth with which it had little familiarity. Even the usually perceptive analysts were confused as to the true nature of businesses in which Enron made its money.

The complexity of its business model made it possible for its senior executives to mislead investors by falsifying financial information. Evidently, it also required far better supervision and managerial capability than what was forthcoming.

It will be interesting to see whether any listed company here has adopted such a business model that confuses or deliberately misleads investors and regulators. It is known that despite all the compulsions for disclosures some companies conduct their business in an opaque manner. And short-term strategies to please the stock market even if they are not in the company's long-term interests are being adopted. In short, the tyranny of the stock markets is increasingly in evidence in India too.

C. R. L. NARASIMHAN

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