CORPORATE AFTERSHOCK 1 PHẦN 2 docx

Given that Enron was primarily an energy services firm that was both active and successful in energy and derivatives activities, what can we learn from Enron’s failure that might impact

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PR EFACE

Dashing into the wreckage of a building following an earthquake

may seem both the honorable thing to do and perhaps the best way to save lives But the threat of aftershocks makes this a risky business Taking time to consider carefully the structural damage caused

by the earthquake not only helps protect the rescuers, but also may better protect the survivors Moving the wrong brick even a little, however, can bring the rest of the building down In other words, without proper analy-sis before mounting a rescue effort, manmade aftershocks can cause more damage than the original earthquake

This book provides a public policy analysis of the Enron failure in an effort to avoid unnecessary manmade aftershocks Specifically, Enron’s failure begs questions in at least four policy areas that should be analyzed before rushing into political action:

1 Was Enron an innovator, a sham, or a bit of both? What kinds of so-cial institutions and corporate governance mechanisms can best dis-tinguish legitimate but aggressive business and financial innovation from fraudulent, deceptive, and unethical business practices?

2 Given that Enron was primarily an energy services firm that was both active and successful in energy and derivatives activities, what can we learn from Enron’s failure that might impact the future op-eration and regulation of energy and derivatives markets?

3 Is “structured finance” and the use of special purpose entities a le-gitimate form of financial and risk management? What role did ac-counting and disclosure policies play in Enron’s apparent abuses

of otherwise-legitimate structured finance activities? What changes might be adopted to mitigate the potential for similar abuses in the future?

4 Did the widespread proliferation of financial contracts and tech-niques designed to help firms manage their credit exposure to ail-ing counterparties exacerbate or mitigate the impact of Enron’s

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failure? What lessons can be learned from Enron about credit risk management practices and products prospectively?

These questions are addressed in the five parts of this book

S T RUC TU R E OF TH E BOOK

Enron was, in many ways, an innovative firm, both in its primary business activities and in the process by which Enron raised funds As the chap-ters in this book further explain, Enron often walked a tight line between legitimate and beneficial innovation and excessively “creative” schemes that ultimately were designed more to confuse outsiders than inform them

of Enron’s true activities But even in its legitimate business practice, Enron was often engaged in activities that were novel and had not been attempted before Apart from complicating any analysis of Enron, this also makes it critically important to distinguish between Enron’s role as

a legitimate, albeit maverick, innovator and its role as a fraudulent prop-agator of half truths and f inancial deceptions All the chapters in this book attempt to draw this distinction carefully

Part One of the book explores the very broad theme of the role of the corporation in the process of innovation, and how corporations in the in-novation business are monitored and governed In Chapter 1, Culp and Hanke contend that Enron’s basic business strategy was not only legiti-mate, but actually quite beneficial for the marketplace Although not the first firm to pursue this “asset lite” business strategy, Enron will certainly not be the last to do so—nor should it be At the same time, the authors argue that Enron’s innovative business activity was inherently risky, and

predicting which firms will succeed and which will fail ex ante is

essen-tially impossible The competitive market is the best adjudicator of such decisions Culp and Hanke further argue that analyzing firms like Enron through the traditional lens of “neoclassical” price theory paints only a partial picture A “neo-Austrian” approach in which variables like time, knowledge, and disequilibrium are explicitly considered delivers a better method of analysis

In Chapter 2, Bassett and Storrie explore some of the corporate ac-counting and disclosure implications of Enron’s failure Their analysis and commentary on the importance of cash f low accounting is relevant

to any corporation, but especially those involved with developing finan-cial products and strategies that might be considered novel and may not

be easily understood by outsiders They argue that earnings represent opinions, whereas cash f low is a fact From that perspective, Bassett and Storrie argue that much more information was contained in Enron’s

PREFACE x i x financials about its delicate financial situation than many people real-ized The authors further argue that accounting based on principles may provide a more accurate picture of a firm’s true financial condition than accounting based on rules

Harris and Kramer conclude Part One with a comprehensive survey of the history of the consensus model of corporate governance in the United States and analyze the trend toward relying more and more on monitoring boards—a trend that the Enron failure seems to have reinforced, but in no way initiated Harris and Kramer question the efficacy of these proposals for strong independent boards and argue that the time has come for a fun-damental change in the rules of corporate governance in this country

In Part Two of the book, the contributors take a closer look at the en-ergy and derivatives markets in which Enron was an active participant As Neves explains in Chapter 4, wholesale power trading remained a primary prof it center for Enron right up to the end Recent attention to power markets is not because they “sank Enron,” but rather because of the reg-ulatory concerns that Enron may have abused its position in the market Neves’ chapter is an invaluable introduction to this complex market, whose uniqueness and opacity make it otherwise difficult for outsiders to assess the merits and costs of proposed regulatory changes Chapter 4 also summarizes the development of electricity markets under partial dereg-ulation, the special problems that arose in those markets in 1998 and

2000, and the market response to the collapse of Enron

Kramer, Pantano, and Ezickson are among the top electricity regula-tion experts in the United States In Chapter 5, they discuss the legal and regulatory implications of Enron’s failure for wholesale electricity mar-ket participants They contend that Enron’s demise added to existing ju-risdictional and regulatory uncertainty, and that prompt resolution of this regulatory uncertainty is required for active volume to be restored to U.S wholesale power markets

In Chapter 6, Herron examines Enron’s Internet trading venture, EnronOnline, and the consequences of Enron’s failure for the markets

in which EnronOnline was a dominant trading platform He argues that the market response to the failure of Enron was remarkably resilient Although a short-term migration of trading volume has occurred back toward more traditional futures and commodities exchanges, Herron ar-gues that there is still an important market function to be provided by

electronic and virtual trading platforms like EnronOnline, if they are

adequately capitalized and prepared to address credit risk for their par-ticipants in a responsible manner

Mengle concludes Part Two by arguing in Chapter 7 that no aspect of Enron’s failure calls into question the current regulatory framework for

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over-the-counter derivatives On the contrary, the swaps market absorbed the Enron failure and should provide a model for other markets in a cri-sis management context

Part Three of this book pertains to structured finance, or the use of special purpose entities (SPEs) by corporations to facilitate asset-divestiture, fund-raising, and risk-management decisions Kavanagh provides a useful introduction to and summary of structured f inance

in Chapter 8 She argues that the vast majority of structured financing activities are legitimate, legal, and economically beneficial She further explores how Enron abused structured finance in certain areas, empha-sizing that accounting for and disclosing SPEs were much more the prob-lem than the SPEs themselves

In Chapter 9, Culp and Kavanagh explore the world of structured commodity finance, paying particular attention to prepaid forward and swap contracts Many have alleged that these products serve no useful purpose and were used by Enron only to conceal the firm’s true long-term borrowings from banks But as Culp and Kavanagh explain, prepaid com-modity contracts have a long history playing an important—and quite legal—role in facilitating project finance Although these structures can

be abused in principle, they are not inherently problematic in practice Chapter 10 analyzes the existing accounting and disclosure frame-work for structured f inancial transactions, concentrating on SPEs and prepaid commodity contracts Bockus, Northcut, and Zmijewski provide

a useful overview of criteria that govern when SPEs must be consolidated

on the balance sheets of participants The authors also argue that in some cases, Enron may well not have broken accounting rules, but, on the

con-trary, simply learned the rules so well that Enron knew where the

loop-holes were to get the accounting results they most wanted to see Like Bassett and Storrie, they conclude that a more principles -based accounting system might discourage such abuses more than the current rules -based approach

Part Four considers who actually lost money on Enron’s failure and what lessons can be drawn from Enron about how firms can and should manage their credit exposures In Chapter 11, Culp explores the different tools that have evolved in the last several years that enabled many of Enron’s direct creditors and counterparties to manage or transfer the risk of an Enron default to other f irms Given the widespread use of these instru-ments, Culp then explores where actual Enron credit losses seem to have oc-curred, arguing that the prevalence of credit risk transfer tools spread Enron’s default risk fairly evenly across all major sectors of the global econ-omy, thus helping ensure that Enron’s failure was not more of a systemic dis-aster than it was Distinctions between insurance and derivatives solutions

PREFACE x x i for credit risk transfer are also examined in the chapter in the context of the Mahonia debate concerning the efficacy of insurance versus deriva-tives solutions for credit risk management

Having set forth a cogent history and analysis of governance in Chap-ter 3, the Kramer/Harris team return in ChapChap-ter 12 to explore how Enron affected the vast and growing market for credit derivatives They provide

a comprehensive introduction to this new and emerging marketplace and examine how f irms used these novel transactions to address their con-cerns with Enron’s credit risk A summary of some of the important dis-tinctions between insurance-based credit risk management solutions and credit derivatives is included, along with a discussion of some recent legal issues that have been raised concerning credit risk mitigation tools

In Chapter 13, Palmer explores the importance of a credit culture in the analysis and management of credit risk—especially noninvestment-grade or complex credit risk He argues that insurance companies and banks have generally well-developed credit cultures, but the former are too heavily inf luenced by rating agencies and the latter by the Basel Accord capital requirements As a result, firms like investment banks with fewer institutional hindrances but less of a credit culture have become major play-ers in credit intermediation Yet, Palmer cautions against credit risk man-agement solutions that rely too heavily on firms lacking the appropriate credit culture to identify the most efficient and effective solutions

In Part Five of the book (Chapter 14), Smith provides a comprehensive framework in which to view the Enron saga and, in particular, the calls for greater regulation that Enron’s failure has engendered Smith argues that on the frontiers of innovation, distinctions between “cowboys” and

“cattle thieves” are hard to draw As institutions evolve to help society man-age the risks of innovation, cattle thieves must be punished, but without also punishing the cowboys whose purpose is a legitimate one on the fron-tier Although the natural tendency of society is to revert to hierarchical and political forms of risk management, Smith compellingly argues that more competitive and decentralized institutional responses are prefer-able He reminds us that in trial-and-error-based capitalism, errors are both inevitable and essential, and caution must be exercised before blam-ing innovative practices for those errors As the Enron case illustrates, tra-ditional management failures are often still to blame, even for failures involving innovative products and strategies on the economic frontier

CHRISTOPHERL CULP

Chicago, IL

November 2002

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ACK NOW LEDGMENTS

Thanks to all the contributors to this book for their time, effort,

and, in many cases, scheduling sacrifices More than one family’s Thanksgiving turkey was disrupted by our efforts to make the final production deadline The contributors represent the absolute “best of the breed” in many of the issue areas explored, and the quality of the book is entirely a result of their hard work Special thanks to Al Harris and Andie Kramer, who not only contributed multiple chapters, but who also helped Bill Niskanen and me plan the contents of the book

I am particularly grateful to Bill Niskanen and the Cato Institute for making all of this possible Dr Niskanen is an excellent co-editor, full of ideas about shaping the book’s content He has also been an excellent content and text editor I have long admired his path-breaking work on bu-reaucracy and his legacy of important intellectual contributions to eco-nomics, as well as his articulate defense of the principles of a free society

It has been a pleasure to work with him and, as expected, I have both learned much and enjoyed the process More generally, Cato’s long-standing struggle to preserve liberty and individual freedom has played

a critical role in the modern political process I am extremely grateful to have had this opportunity to work with Cato and for all the energy and re-sources that Cato has dedicated to this project and to the defense of free markets in general

At Wiley, Bill Falloon once again proved a more than capable editor, and Melissa Scuereb is the glue that holds the work together Their skills are exceeded only by their patience This is my fourth book with Bill and

my second with Melissa, and I hope not the last

Thanks also to my Autumn 2001 derivatives class at the Chicago GSB

I gained much from discussing the Enron failure with the class as it oc-curred Special thanks to “The Capitol Grill team” in that class, whose updates and insights that quarter were especially appreciated The next steak is on me, gentlemen

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Finally, a personal word of thanks and admiration go to Heinz Schim-melbusch, the former chairman of the management board of Metallge-sellschaft AG (MG AG) But first, a little background is required As many readers may recall, MG AG earned its place as one of the largest so-called derivatives disasters of the mid-1990s after booking over $1.3 billion in losses on its U.S oil marketing subsidiary, MG Ref ining and Marketing (MGRM) The decision by the MG AG supervisory board to end MGRM’s marketing program early—against loud protests from Schimmelbusch and the management board—precipitated massive international controversy Among the many who analyzed the MGRM debacle were the late Nobel laureate Merton Miller and I Together we wrote seven articles and co-edited one book attempting to explain what was really going on at MGRM.1 It is fair to say in retrospect that the Miller and Culp articles were highly sympathetic to Schimmelbusch and his team.2This is not, of course, why we wrote them In fact, Professor Miller and I resolved early

in our analysis of MGRM that to preserve our credibility in the face of growing controversy, we would neither accept any payment for any of our work nor would we communicate with any of the principal players at MGRM or MG AG Professor Miller and I were merely analyzing the facts and the economics of the case That this proved to be a defense of Schim-melbusch’s actions was a consequence of the facts, not a deliberate effort

on our parts

The first time I actually met Heinz Schimmelbusch was in July 2001, when we shared lunch at La Pavillion restaurant in Zürich’s Baur Au Lac Hotel I shall never forget what Dr Schimmelbusch said to me at that lunch, six months before Enron’s bankruptcy and three months before public signs of trouble: “Enron will fail by the end of the year.”

Even as Dr Schimmelbusch pulled spreadsheets and financials from his briefcase onto the table, I was skeptical and attributed this comment

to the two bottles of excellent Montrachet we had consumed with our veal and rösti Yet, Schimmelbusch persisted and proceeded to make a com-pelling case that Enron was in serious trouble He pointed out quarter after quarter of huge negative cash f lows coincident with huge positive earnings statements—itself a major red f lag (see Chapter 2)—together with a consistent pattern of too much R&D spending in markets where Enron had no prior experience, and a number of other questionable en-tries in Enron’s published financials

The showstopper for Schimmelbusch was Enron’s acquisition of MG PLC in mid-2000 MG PLC, a spin-off from MG AG, was at that time a global leader in the metals trading business Enron acquired the whole operation (including some 330 people in 14 countries) for $413 million

in cash and $1.6 billion in assumed MG PLC debt (Fox, 2002, p 188) But

ACKNOWLEDGMENTS x x v the integration was a disaster Fox reports that it took 50 to 70 people to oversee the information technology systems integration alone Schim-melbusch further claimed that MG PLC was too cash intensive, research dependent, and industry specif ic for Enron to make it work He felt strongly that Enron had vastly over-paid for this acquisition—and yet had figured out a way not to show that in its financials

Unfortunately, for me, I left lunch that day and went back to work on

my previous book instead of promptly shorting Enron’s stock—then still trading around $45 per share As a result, I still have to work for a living But as for Dr Schimmelbusch, honor is due He proved to be exactly

right—again.

C L C

NOTE S

1 The articles are reprinted in the book by Culp and Miller (1999).

2 In fact, MG Ref ining and Marketing was functioning as a basis trader and pursuing a strategy quite similar to Enron’s asset lite as Hanke and I discuss

in Chapter 1 of this book.