Executive Compensation and Incentives: Some Lessons from the ENRON Fiasco By

1. Executive Compensation and Incentives:Some Lessons from the ENRON Fiasco By Bernard Sinclair-Desgagné, Ph.D. CIRANO and HEC Montréal

2. The ENRON debacle – the facts • The company • The auditor • The politicians

3. A short history of ENRON 1985:Kenneth Lay merges Houston Natural Gas and InterNorth 1989: Enron develops energy brokerage services 1994: Enron enters newly liberalized electricity markets

4. 1998-2000: Income grows from 31 to 100 billions US $. Enron is the 7th largest US Corporation. Fortune: « Enron, one of the most innovative company » Business Week: « K. Lay is one of the 25 greatest entrepreneurs in the world » The Economist: « K. Lay, the energy messiah…» 1999: Enron’s top managers start selling their shares

5. Feb. 2001: Jeffrey Skilling is named CEO. K. Lay remains chairman. A few months later, Mr Skilling would quit for « personnal reasons », not after selling $20 millions of Enron stocks. Corporate vice-president Sherron Watkins blows the whistle. In an interview with Business Week, K. Lay says that Enron is « stronger than ever ».

6. 16 october 2001: The beginning of the end. K. Lay admits losses of 618 millions US$, and that 1,2 billions US$ have been hidden. 29 november 2001: Failure of negotiations over the purchase of Enron by Denergy, a rival company. 2 december 2001: Enron files for protection under bankrupty laws.

7. The auditor – Arthur Andersen • Fifth largest accounting company • Business: audit and accounting (45%), tax (35%), consulting (15%), other (5%). Did more money with Enron in 2000 doing consulting ($27M) than auditing ($25M). • David Duncan, head of the Andersen audit team based inside the Enron building

8. Previous problems: Waste Management ($7 M) Sunbeam ($110M) But KPMG was recently censured for breaking the rules barring investment in audit clients; and in 2000 PricewaterhouseCoopers was found guilty of no fewer than 8000 violations rules covering employee shareholding in audit clients.

9. Political ties • Contributions to campaigns of both parties. In 2000, Enron was 36th in the list of political donors, and the 12th-ranking contributor to the Bush presidential election campaign. 71 of the 100 senators have received money from Enron, including 19 of the 23 members of the energy committee. Sen. Joe Lieberman, Chairman of the senate hearing committee in charge of Enron, got $2K form Enron and $11,500 from Arthur Andersen in the past decade.

10. Former Montana Governor Marc Racicot, the new Republican National Committee boss, was an Enron lobbyist. • Chief republican organizer, Karl Rove, helped a friend get a lucrative consulting contract with Enron. • Many key people held Enron shares, including John Ashcroft, … . • Personal calls by K. Lay to key people of the Bush Adnministration: Paul O’Neil, Dick Cheney, … • Soon after W. took office, Curtis Hebert, whom K. Lay disagreed with, was replaced as Chairman of the Federal Energy Regulatory Commission.

11. ENRON never again - Some remedies • Reform accounting standards (GAAP, IASB, FASB, SEC) Off balance-sheet activities Employee share options Derivatives Intangible assets Revenue recognition

12. Guarantee auditor independence (SEC) Separate auditing from consulting activities Improve peer reviews and self-regulation Implement mandatory rotation of auditors Forbid hiring of former auditors • Reform political campaign finance • New protections for retirement savings accounts

13. Reform executive compensation: Step back on equity-based incentives

14. Management guru Peter Drucker (1993) One of the basic problems is that management has no way to judge by what criteria outside shareholders value and appraise performance. The stock market is surely the least reliable judge or, at best, only one judge and one that is subject to so many other influences that it is practically impossible to disentangle what, of the stock market appraisal, reflects the company’s performance and what reflects caprice, affects the whims of securities analysts, short-term fashions and the general level of the economy and of the market rather than the performance of the company itself.

15. Organizational behavior expert Steven Kerr (1975)On the Folly of Rewarding A while Hoping for B…

16. Governance economists (1991-2002) George Baker (2002): Problems do not arise from a lack of available performance measures, but from a lack of undistorted performance measures. To determine the weight to be placed on a given performance measure, what matters is not the correlation between this measure and firm value, but whether both would always move in the same direction and proportion as the executive’s effort.

17. Bengt Holmstrom and Paul Milgrom (1991) The desirability of providing incentives for any one activity decreases with the difficulty of measuring performance in any other activities that make competing demands on the executive’s time and attention. • Job design • Procedures and constraints

18. Bernard Sinclair-Desgagné (1999, 2002) Two tasks A and B. Task A is routinely monitored, but not task B. The principal commits to investigating about task B when task A’s outcome is high. The executive is penalized after the investigation reaches a negative conclusion. On average, however, the executive is better off when an investigation takes place.