The fall

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Journal of Economic Perspectives—Volume 17, Number 2—Spring 2003—Pages 3–26

The Fall of Enron

Paul M. Healy and Krishna G. Palepu

F

rom the start of the 1990s until year-end 1998, Enron’s stock rose by 311 percent, only modestly higher than the rate of growth in the Standard & Poor’s 500. But then the stock soared. It increased by 56 percent in 1999 and a further 87 percent in 2000,compared to a 20 percent increase and a 10 percent decline for the index during the same years. By December 31, 2000, Enron’s stock was priced at $83.13, and its market capitalization exceeded $60 billion, 70 times earnings and six times book value, an indication of the stock market’s high expectations about its future prospects. Enron was rated the most innovative large company in America inFortune magazine’s survey of Most Admired Companies. Yet within a year, Enron’s image was in tatters and its stock price had plummeted nearly to zero. Exhibit 1 lists some of the critical events for Enron between August and December 2001—a saga of document shredding, restatements of earnings, regulatory investigations, a failed merger and the company ling for bankruptcy. We will assess how governanceand incentive problems contributed to Enron’s rise and fall. A well-functioning capital market creates appropriate linkages of information, incentives and governance between managers and investors. This process is supposed to be carried out through a network of intermediaries that include professional investors such as banks, mutual funds, insurance and venture capital rms; information analyzerssuch as nancial analysts and ratings agencies; assurance professionals such as external auditors; and internal governance agents such as corporate boards. These parties, who are themselves subject to incentive and governance problems, are regulated by a variety of institutions: the Securities and Exchange Commission, bank regulators and private sector bodies such as the Financial AccountingStandards Board, the American Institute of Certi ed Public Accountants and stock exchanges.

y Paul M. Healy is the James R. Williston Professor of Business Administration and Krishna
G. Palepu is the Ross Graham Walker Professor of Business Administration, both at Harvard Business School, Boston, Massachusetts. Their e-mail addresses are phealy@hbs.edu and kpalepu@hbs.edu , respectively.

4Journal of Economic Perspectives

Exhibit 1 Timeline of Critical Events for Enron in the Period August 2001 to December 2001
Date August 14, 2001 Mid- to late August Event Jeff Skilling resigned as CEO, citing personal reasons. He was replaced by Kenneth Lay. Sherron Watkins, an Enron vice president, wrote an anonymous letter to Kenneth Lay expressing concerns about the rm’s accounting. Shesubsequently discussed her concerns with James Hecker, a former colleague and audit partner at Andersen, who contacted the Enron audit team. An Arthur Andersen lawyer contacted a senior partner in Houston to remind him that company policy was not to retain documents that were no longer needed, prompting the shredding of documents. Enron announces quarterly earnings of $393 million and nonrecurringcharges of $1.01 billion after tax to re ect asset write-downs primarily for water and broadband businesses. The Securities and Exchange Commission opened inquiries into a potential con ict of interest between Enron, its directors and its special partnerships. Enron restated its nancials for the prior four years to consolidate partnership arrangements retroactively. Earnings from 1997 to 2000 declinedby $591 million, and debt for 2000 increased by $658 million. Enron entered merger agreement with Dynegy. Major credit rating agencies downgraded Enron’s debt to junk bond status, making the rm liable to retire $4 billion of its $13 billion debt. Dynegy pulled out of the proposed merger. Enron led for bankruptcy in New York and simultaneously sued Dynegy for breach of contract.

October 12,...
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