The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A) On July 19, 2002, Senator Paul Sarbanes (D-Maryland) and US Representative Michael Oxley (R-Ohio) met t

UV7338 Rev. Jul. 24, 2018

The Panic of 2001 and Corporate Transparency, Accountability, and Trust (A)

On July 19, 2002, Senator Paul Sarbanes (D-Maryland) and US Representative Michael Oxley (R-Ohio) met to shape legislation aimed at limiting corporate fraud and manipulation of earnings. This meeting was a “conference committee” of senators and representatives who would seek to produce a “reconciliation” draft that could pass both houses and be presented to President George W. Bush for his signature. The two houses of Congress had approved their own versions of such legislation. It now depended on the conferees to shape a final recommendation to both houses. The laws passed by each house differed in some respects. The House version was passed on April 24 by a majority vote of 334 to 90. The Senate version was passed on July 15 by a majority vote of 97 to zero. Could the differences in the two acts be attributable to timing? In any event, how should the conferees settle their differences? What prompted this outcome? What was the purpose of the act? How successful would it be?

The Dot-Com Bubble and Bust

From 1992 to March 2000, the US economy and stock market boomed, particularly in the technology sector. Exhibit 1 shows that the NASDAQ Index displayed a 679% increase from January 1, 1995, to March 10, 2000, compared to a 303% increase for the Standard & Poor’s 500 Index (S&P 500).a During this time, venture financing of early-stage technology companies surged. The price increases reflected buoyant investor expectations about growth of the World Wide Web, growth in transmission speeds owing to high-capacity optical fiber cable, and general growth in telecommunications volume. Growing access to the internet meant that tech-based services could become part of everyday life, rather than luxuries for a few.

The appeal of so-called internet stocks reflected powerful economic phenomena, such as network effects, economies of scale, first-mover advantage, and winner-take-all. The strategy of many tech start-ups was “bet big fast; worry about profitability later.” This led to aggressive, if not rash, spending and investment by tech companies. For instance, Boo.com, an online apparel retailer launched in 1999, spent $188 million of venture capital funding and went into liquidation in May 2000.1 Optical fiber telecom cables were laid in a frenzy but later went dark as transmission volume declined. The internet boom was also a time of remarkable hype: breathless media reports profiled new internet millionaires and urged investors to climb aboard.

On March 10, 2000, the NASDAQ Index peaked at 5,132.52. Then the stock market declined dramatically. This reflected the onset of a recession, rising interest rates, and growing disillusionment with the promise of

a The S&P 500 was a market-capitalization-weighted index of shares of the 500 largest companies traded on both the New York and American Stock Exchanges.

This case was prepared by Robert F. Bruner, University Professor, Distinguished Professor of Business Administration, and Dean Emeritus. With his permission, discussion of some topics is drawn from Robert F. Bruner, Deals from Hell, M&A Lessons That Rise Above the Ashes (Hoboken, NJ: John Wiley & Sons, 2005). This case was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright  2017 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an email to [email protected] No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Our goal is to publish materials of the highest quality; please submit errata to [email protected] D

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the information technology sector. Shares of Cisco fell 86% in the crash; Amazon.com shares also fell, from $107 to $7. Prominent internet-related IPOs, such as Webvan and Pets.com, simply disappeared. From March 2000 to October 2002, about $5 trillion in equity value disappeared in the crash.2

Other events around that time served to amplify anxieties. The presidential election of November 2000 was so close that it had to be settled by a decision of the Supreme Court on December 12, 2000—an outcome that left bitterness and taunts of illegitimacy. An economic recession began in March 2001 and ended in November of that year—the 8-month downturn followed a remarkable 120-month period of growth. During the dot-com bust and the recession, the US economy experienced a period of modest deleveraging, as indicated by slight declines in revolving credit (Exhibit 2) and tightening credit standards by banks (Exhibit 3). The recession was relatively short and shallow: real GDP declined only −0.3%, the slightest of any recession since 1836. And unemployment peaked in June 2003 at 6.3%, the fourth-smallest of 14 recessions since 1929. However, the terror attacks on September 11, 2001, amplified security concerns among Americans. Two financial measures of investor anxiety, the VIX Indexb and the high-yield bond credit spread,c vaulted upward on September 11 (see Exhibits 4 and 5). The period from 2000 through 2002 marked a dramatic turnaround in attitudes and sense of economic well-being from the long period of economic growth, 1992–2000.

The Advent of Private Standards for Internal Control and Fraud Prevention

Prominent instances of ethically challenged corporate political contributions and bribes in foreign countries in the 1970s outraged the public and Congress. In 1985, five professional accounting organizations chartered the Treadway Commission to research and recommend new practices and policies to fight fraudulent corporate financial reporting. This commission published its Report of the National Commission on Fraudulent Financial Reporting in 1987.3 Subsequently, the five accounting organizations formalized their work by organizing the Committee of Sponsoring Organizations (COSO) to produce a more detailed framework for internal control. The resulting four-volume report was published in 1992, entitled Internal Control—Integrated Framework.4

The reports proved to be very influential; the COSO standards for internal control were widely adopted by corporations. Yet the adoption of those standards remained voluntary. Failure to faithfully implement the standards could result in a qualified audit opinion but not in penalties or criminal liability. And COSO itself acknowledged that even faithful implementation of its standards might result in errors arising from human errors in processing or judgment and that its controls might be weakened by managerial coercion or collusion among employees.

Fraud and Earnings Manipulation among Large Corporations in 2001–02

In 2001 and 2002, a number of large corporate frauds and blunders (see Exhibit 6 for a representative list) seized public attention. Enron was exposed in October 2001, Tyco in February 2002, WorldCom in April 2002, and AOL in August 2002. Sarbanes and Oxley received thousands of constituent calls and letters related to these cases.

b VIX was the ticker symbol for the Chicago Board Options Exchange Volatility Index. This measured near-term volatility of equity prices, as implied in the prices of stock options. Higher VIX values suggested greater investor uncertainty and/or anxiety. The VIX index peaked on September 20.

c The high-yield credit spread measured the difference in yields between a portfolio of least-risky corporate bonds (AAA-rated) and speculative-grade corporate bonds (BB-rated). Higher spreads suggested an increase in actual risk and/or in investor risk-aversion. The credit spread peaked on October 4. D

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October–December 2001: Enron Corp.

On December 2, 2001, Enron Corp. filed for bankruptcy in what was the largest industrial filing to date— Enron had been the seventh-largest firm in the Fortune 500 with sales of about $101 billion and assets of $66 billion. The collapse resulted from the revelation of accounting manipulation and fraud, which triggered a liquidity crisis and ultimately a solvency crisis. Short-term lenders to Enron canceled their loans. And trading counterparties ceased to do business with Enron. It was a classic “run on the bank,” even though Enron called itself an energy trading company. Its bankruptcy concluded a frenetic month of merger negotiations with Enron’s closest competitor, Dynegy Inc. The failure of merger negotiations sealed the evaporation of $70 billion in market value for Enron’s shareholders, the partial liquidation of the firm, the layoff of 60,000 employees, and an explosion of civil and criminal litigation.

Enron was formed from the 1985 merger of two gas pipeline firms and transformed into the nation’s biggest energy trader. Deregulatory reforms of the United States’ natural gas distribution and electric utility industries opened the field to new ways of doing business. Enron seized the opportunity to shape the wholesale power industry in transition. Enron envisioned and developed a marketplace for energy where prices could be set by open bidding, buyers and suppliers could be brought together, and power contracts could be tailored to meet the exact needs of a customer. Soon Enron was trading not just energy but also paper, steel, bandwidth, and even dynamic random access memory (DRAM) chips—Enron had morphed into an entirely different entity. Whereas in 1990 around 80% of its revenue came from the gas pipeline business, by 2000 its trading business accounted for 95% of revenue.5 Enron’s forays into trading earned it the accolade “Most Innovative Company” from Fortune magazine for six years in a row. Enron’s share price skyrocketed, while share prices of other companies in the energy sector rose only modestly.

Enron’s share prices peaked on August 23, 2000, at $90. A month later, a journalist, Jonathan Weil, published an article that questioned mark-to-market accounting and its possible abuses—it called attention to Enron. A leading short-seller, Jim Chanos, read the article, and by November 2000 he had taken a major short position on Enron. Other short-sellers followed suit; by July 2001, the short-interest in Enron’s stock had grown by 30%6 and then grew from 13.8 million shares to 31.1 million shares between September and November.7 The accelerating decline of the firm from its peak in August 2000 to bankruptcy in December 2001 can be traced in several parallel developments.

Enron’s product markets grew turbulent. In the fall of 2000, the California electric power crisis began to appear, leading observers to query its possible adverse impact on Enron. Enron was a supplier to this market and could claim a positive advantage in dealing with it. An investigation later revealed price manipulation in that market by Enron. Trading in other sectors of Enron’s business (such as broadband capacity and water) was not meeting projections, perhaps reflecting new competition from financial institutions and the recession. Enron sought to create new trading arenas in pulp paper, boxcar capacity, and other commodities. But the start-up of trading operations took additional capital.

To sustain its high price/earnings multiple, Enron had carefully cultivated the market expectations of rapid growth through the ruse of warehousing certain losses and debts in special purpose entities (SPEs) whose results would not be reflected on Enron’s books. During that year, the SPEs required continuing attention because as the asset values underlying these entities declined, Enron would be required to accommodate the investors in the SPEs with fresh capital infusions.

In March 2001, Fortune magazine asked, “Is Enron overpriced? It’s in a bunch of complex businesses. Its financial statements are nearly impenetrable. So why is Enron trading at such a huge multiple?”8 The article signaled growing discontent with the lack of transparency in Enron’s financial reports. Nevertheless, Wall Street analysts continued to issue strong buy recommendations even as they admitted difficulty in deciphering Enron’s D

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financial statements. “The ability to develop a somewhat predictable model of this business for the future is mostly an exercise in futility,” a Bear Stearns analyst wrote.9

On December 13, 2000, Kenneth Lay announced that he would step down as CEO and that Jeffrey Skilling would assume that position. Three senior executives and founders of the novel businesses that Enron harbored resigned in the spring. In mid-August 2001, Skilling unexpectedly resigned as president and CEO of Enron. Largely credited with helping to transform Enron into a trading behemoth, Skilling cited family matters as the reason for his departure. He also told investors that there were “no accounting issues, trading issues, or reserve issues…I can honestly say the company is in the strongest shape it’s ever been in.”10

Then, on August 15, 2001, Sherron Watkins, a vice president at Enron, contacted Lay, who had resumed the CEO role after Skilling’s resignation. She said, “I am incredibly nervous we will implode in a wave of accounting scandals.” Her concerns focused on the use of SPEs to warehouse debt and losses that should properly have been reflected on Enron’s books. Lay said he would look into the issue.

On October 17, 2001, Enron alarmed the financial community by reporting a $618 million loss in the third quarter owing to $1.01 billion in write-downs of investments in the retail-power business, broadband telecommunications, and technology and water businesses.11 In addition, Enron had taken a $1.2 billion charged to shareholders’ equity to repurchase 55 million shares previously issued to a limited partnership called LJM2 Co-Investment LP, a partnership that had been run by Enron CFO Andrew Fastow. Enron said that the equity reduction resulted in its debt-to-equity ratio increasing to 50% from 46% previously.12 Enron’s dealings with limited partnerships, particularly those run by Fastow, had been criticized by investors for their opacity and for the possible conflict of interest from having the Enron CFO be the general partner in the limited partnerships at the same time. In response to shareholder criticism, Enron ordered Fastow to end his involvement with the partnerships in July 2001.13 These financial revelations prompted Moody’s to put Enron’s long-term debt on review for a possible downgrade. Fitch followed suit while S&P downgraded its outlook on Enron from stable to negative.

On October 22, Enron disclosed that the US Securities and Exchange Commission (SEC) had launched an inquiry into LJM2 and other Enron partnerships. Investors, worried about the impact of more undisclosed negative news and a ratings downgrade, hammered the stock. A Goldman Sachs analyst told the Wall Street Journal that “he heard people voice concerns about a possible ‘death spiral’ in which increasing credit concerns about Enron would decrease the number of people willing to do business with the company, which would, in turn, weaken its finances and lead to further business reductions.”14 On October 24, Enron CFO Fastow was fired.

By October 25, Enron’s share price had fallen 80% from the first of the year. At that point, Enron approached Dynegy about the possibility of a merger. The potential synergies were large: combining the two firms’ trading and distribution operations would grant huge market power and economies in head-office expenses. As the second-ranked energy trader, Dynegy aspired to conquer Enron and to stabilize an increasingly nervous industry—the steady stream of bad news about Enron was hurting business. It might be cheaper to buy Enron at the enormously discounted price currently than to weather the fallout of a larger collapse. Therefore, Dynegy began to negotiate a merger with Enron.

On November 1, Enron announced a $1 billion financing from Citibank and JPMorgan Chase—both large banks had been picked as advisers to the merging firms, heightening their incentive to complete the deal. That

d As later emerged, the SPEs were not entirely independent from Enron, as would have been necessary for Enron not to consolidate SPE results on Enron’s books. Not only was Fastow the managing partner of some SPEs, but Enron had given guarantees to the SPEs that linked the economic welfare of Enron to the SPEs. D

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same day, the SEC demanded fuller disclosure by November 5 (later relaxed to November 8) about the extent of Fastow’s participation in SPEs.

Despite obtaining the additional $1 billion credit line, Enron began to experience difficulty in refinancing its commercial paper. Enron seemed in desperate need of more cash to finance its trading operations and to unwind unprofitable positions. Transaction volume had begun to slow down and other parties grew wary of trading with Enron. Therefore, Enron began discussions with buyout groups and other energy concerns to seek an additional $2 billion capital infusion.

On November 2, Enron’s board met to approve the deal. Key to the board’s action were the prospective cash infusions that would restore confidence in Enron’s trading operations—the scenario of recovery was crucial to the thinking of senior management and the board. An internal assessment foresaw that Enron would consume $3 billion in cash before year-end, plainly more than Dynegy’s $2.5 billion infusion. The disparity was justifiable only on the assumption that announcement of the deal triggered a rebound in trading volume and profitability at Enron. The board minutes show that Jeff McMahon, the new CFO of Enron, “expressed concerns on the inadequate level of financial liquidity, noting that the Company had begun to defer certain trade payments currently due, noting that if the Moody’s published debt rating was not maintained at investment-grade, significant obligations would become due immediately and the Company would be illiquid.”15

Also at the board meeting, Enron’s accounting firm, Arthur Andersen, revealed that two of the largest SPEs should have been consolidated on Enron’s books.e As a result, the write-down of $1.2 billion that had previously been announced on October 16 would need to be restated.

On Monday, November 5, Enron’s general counsel called the Dynegy merger team to disclose the change in accounting that would be reported to the SEC in an 8-K filing, and to disclose the firings of two senior executives related to the SPEs. That same day, Fitch cut Enron’s debt rating to BBB−, the borderline just above junk debt status.

The merger announcement and restatement to the SEC coincided on Thursday, November 8. First, Enron disclosed the restatement consolidating the SPEs and erasing $586 million in net income over the previous four years, and disclosed that Fastow had made more than $30 million from the SPEs. But just before the merger announcement, Moody’s declared that it intended to cut Enron’s debt rating to junk-bond status—this would trigger billions in default provisions in the SPEs and would effectively terminate the merger. The Enron merger team frantically renegotiated terms of the deal with Dynegy that would give Moody’s sufficient comfort not to cut the debt rating. Specifically, the exchange ratio was revised downward to reflect Enron’s deteriorating condition, and the “material adverse change” clause of the merger agreement was strengthened to limit Dynegy’s ability to exit from the transaction. In addition, the two banks, Citibank and JPMorgan Chase, committed $500 million in new equity capital. Moody’s relented and cut the bond rating to BBB−. S&P followed suit.

Finally, on November 9, Dynegy and Enron announced the merger agreement. In reaction to the announcement, Enron’s share price rose 16%; Dynegy’s rose 19%.

In an effort parallel to the Dynegy merger negotiations, Lay reached out to US Treasury Secretary Paul O’Neill, Commerce Secretary Don Evans, and Chairman of the Federal Reserve Alan Greenspan. Lay reported on the company’s mounting difficulties. But the government officials later denied any request or discussion of a bailout. President Bush denied having any knowledge of these discussions. But the mood in the White House

e Belatedly, this confirmed that the SPEs were not independent. And it became the trigger for much of the criminal and civil litigation in the months and years to follow. D

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was opposed to government assistance of private companies. Ari Fleischer, the White House press secretary, said, “Bankruptcies happen in our economy. And it’s not uncommon for people who are in the community, business community, or in the labor community, to talk to a cabinet secretary to tell them about the financial status of their business, and it ends there.”16

Despite the promises of new cash (and its subsequent delivery on November 13) Enron’s condition continued to deteriorate. Within six days, Enron burned through $1 billion in cash as trading partners demanded more collateral or simply defected to other partners. Volume on its energy trading platform dropped by half.

That same day, Enron filed its third-quarter report with the SEC. In it, Enron reported three bad developments. First, the loss for the third quarter was $664 million, worse than previously reported. Second, Enron disclosed that the ratings downgrade had triggered obligations to the SPEs of $690 million. And the report revealed that cash was in short supply—in effect, Enron had burned through $1 billion in six days and $2 billion in the past month as it met the demands of lenders and trading counterparties to liquidate their positions in Enron.17 It was a classic “run on the bank.”

Enron shares dropped 45% in value over the next two days, to $5.01 per share, less than half Dynegy’s implied purchase price. The fall in Enron’s share price ignited fears that the deal with Dynegy would fall apart, even though Dynegy had already injected $1.5 billion into Enron. Trading on Enron’s platform slowed to a trickle as trading partners remained wary of Enron’s future.

Because of the sharp price break in Enron’s shares, the exchange ratio in the merger would have to be renegotiated. It remained to be seen whether the deal could be salvaged again.

On Monday, November 26, Dynegy called off the planned merger, invoking a “material adverse change” clause in the merger agreement.18 Dynegy’s CEO said, “We worked our butts off to make this thing work…I wasn’t about to put our balance sheet in jeopardy.”19 Though Dynegy’s finances had been managed more conservatively, it too experienced growing risk-aversion among investors. Later that morning, at 10:57 a.m. on November 28, S&P announced that it had lowered Enron’s rating two full grades, to B− from BBB−, placing Enron in junk status. Moody’s and Fitch downgraded Enron to junk status a few hours later. The downgrades triggered immediate repayment of $3.9 billion in liabilities.20 Trading at Enron’s platform ground to a halt soon after the announcements. Enron shares sank to $0.61, while its bonds traded at 20 cents on the dollar.

On December 2, Enron filed for bankruptcy. That same day Enron filed a $10 billion lawsuit against Dynegy for backing out of the merger. Enron claimed that Dynegy had no right to invoke the “material adverse change” clause:

With its eyes open, Dynegy committed itself to acquire Enron and its highly profitable energy-trading business…Dynegy knew that Enron was in a precarious financial condition, was on the verge of dropping to a non-investment grade credit rating, and was in no small measure dependent on the successful completion of the merger for its very survival.21

Dynegy filed a countersuit against Enron the next day, insisting on its right to claim Enron’s Northern Natural Gas pipeline system immediately given the two parties’ initial agreement.

Enron’s last balance sheet reported total liabilities of $13 billion, but bankers estimated that including off- balance sheet obligations brought total debt closer to $40 billion. D

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Dynegy backed out of the merger with Enron because of the surprises that Enron’s liabilities were larger and accelerating, and its profits were smaller and dwindling, more than previously estimated. The drumbeat of bad news and the apparent ignorance or unwillingness of Enron’s senior management to deal proactively with it prompted a market panic. But Skilling called it a “run on the bank” that denied Enron the liquidity or market activity it needed to stay afloat.

The fallout from Enron’s collapse drew headlines for years. In addition to the lost jobs and distress in Enron’s hometown (Houston), Lay, Skilling, and Fastow were tried and convicted of crimes broadly described as fraud on the market. Skilling and Fastow served jail sentences; Lay died before his sentence began. In early January 2002, Enron’s accounting firm, Arthur Andersen, admitted that it had destroyed documents relevant to criminal investigations and subsequently surrendered its licenses to practice as certified public accountants. Andersen had been the largest accounting firm in the world.

January–March 2002: Tyco International

On January 22, 2002, Dennis Kozlowski, CEO of Tyco International Ltd., announced a radical restructuring plan for the firm that would break Tyco into four segments. The transaction would entail three spin-offs. Kozlowski argued that the firm would be worth 50% more after the restructuring: “Acquisitions have become far less important. The model for the future is far more for organic growth.”22 Securities analysts were mystified by the announcement. Tyco had been the target of SEC accounting investigations—so far, these had turned up nothing.

But a new spate of rumors had dogged the firm since late fall 2001, speculating that Tyco’s profitability was declining and would create problems in trying to service its huge debt load, built up during its acquisition program. The sale of stakes in operating units would generate about $8 billion in cash to service and pay down some of the debt. Just a week earlier, Tyco had announced that its earnings for the current quarter would not meet forecasts. This triggered an 8.5% decline

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