Andrew Fastow was ashamed with what he did when he was with Enron Corp. The former CFO of this company which fell from fame spectacularly in early 2000 admitted that he was guilty and felt sorry for all those people who suffered losses.
He was in Kuala Lumpur to share some of his experiences which could be good lessons for those in boardrooms to learn from. I conducted a fishbowl session with the former Enron CFO recently.
When Enron was growing, it required a lot of financing. The shareholders preferred not to inject new capital. Fastow used structured finance to allow Enron to borrow money using special-purpose vehicles (SPVs) resulting in the liabilities not recognised on the balance sheet of Enron.
It made its financials looked sound, cost of capital reduced and the shareholders were relieved from being required to inject capital. For this he was awarded the CFO of the year by an influential financial magazine in the US. The same conducts landed him in prison!
Was the board of directors ignorant of what had happened? No, according to Fastow. The board was supplied with information that reconciled Enron’s internal credit scoring, which was assessed as closer to junk status, to the market scoring where it was rated as an investment grade.
How did the board react? Instead of being worried about the misalignment in the assessment of Enron’s risks by the banks, he was praised by one of the board members as a brilliant CFO.
Everyone’s focus at that time was whether the transactions complied with the rules. This, according to Fastow, was the main factor which provided everyone with comfort that everything was fine.
What about independent professionals such as legal counsels and auditors? When their views were sought, they were not just required to provide opinions on whether rules were complied with or not. If they felt that there were no compliances, they were expected to provide ideas and ways so that compliance was achieved.
One of the reasons why Fastow was hired by Enron was for his talent in unlocking the value of Enron’s assets. Through structured finance and fair value accounting, the future values of those assets could be booked, enhancing the value of Enron’s shares.
Fair value accounting relies on the availability of market prices. In their absence, prices of similar assets could be used. When there is no such price, complex valuation models would be used instead.
On top of the issue of market price, fair value accounting also requires future stream of cashflows generated by those assets to be estimated. They are then capitalised at certain rates which reflect the risks carried by the assets, to arrive at their fair values. The exercise relies heavily on assumptions and estimates with its results subjected to a wide range of risks.
While those rules appeared complex, Enron capitalised them to its benefits. In fact, the more complicated the rules, the more they were seen as opportunities by Enron. The complexities made the transactions and valuations more opaque. Again, the focus then was whether all those rules were complied with!
Although two senior executives of Enron were sent to prison, Enron-like cases keep on appearing including during the recent global financial crisis. The scary thing is the market appears to tolerate a certain level of envelope pushing until certain events occur when they would then cry for blood.
At this point, compliance with rules would not be adequate and people should be asking whether things are right instead.
Enron had a very prominent board. Why didn’t they react with horror when they knew what was wrong about their financial standing?
There could be a number of factors behind this. Enron was the darling of the market and it provided good financial returns, at least before it collapsed. Everyone was chasing the money and nobody was concerned as long as the rules “were followed”.
Instead of pausing and asking the question “are we doing the right thing”, the board decided to continue to dance to the music liked by the market.
The board also had the comfort of independent professionals providing opinions that every rule was complied with. While what happened to Enron was a catastrophe, how many of the present members of the board would sign off a deal based on the comfort that it is in compliance with all relevant rules?
As boards tend to achieve consensus in making decision, such culture would deter people who have opposing views from staying the course.
Fastow believes that adopting the 10th man rule is the way forward. Here, someone would play the role of a devil’s advocate and keep on opposing the views of the board until it is clear that the views are premised on sound judgment.
So, what would be your reaction in the next board meeting when, in supporting their proposals, management comfortably explains that all the rules are complied with?
This article was published in The Malaysian Reserve under the column Boardroom View http://themalaysianreserve.com/new/story/reacting-red-flags-enron-experience-—-lessons-boardrooms
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