The real, painful reform has only just begun.
It has been almost a year since Enron imploded into bankruptcy, but rather than solve problems, the event has only brought uncertainty-credit rating downgrades, a drop in investor confidence, and heightened scrutiny from the Congress, the Securities and Exchange Commission (SEC), the Federal Energy Regulatory Commission (FERC), and the Commodity Futures Trading Commission (CFTC). Many utility stock indices (composed of regulated and unregulated companies) have hit all-time lows over the past several months.
Some measures, including a more vigorous enforcement of securities laws, could well ease investor worries. As Erroll Davis, chairman, president, and CEO of Alliant Energy, says, "To the extent the reforms provide investors with more information, I think they'll feel better."
Nevertheless, the SEC created an uproar when it listed Enron and Dynegy, in particular, among eleven companies that failed to certify their most recent financial statements under the newly enacted Sarbanes-Oxley Act, which required top corporate executives to certify information contained in quarterly and annual reports.
Dynegy spokesman John Sousa took the heat for his company's no-show. As he put it, Dynegy instead had chosen to file documents explaining why its interim CEO, Dan Dienstbier, (who recently replaced CEO Chuck Watson), and then-CFO, Louis Dorey, were each unable to validate the financial statements. Sousa laid the blame on pending restatements of Dynegy's 2001 financial results and the re-audits of the company's 1999, 2000, and 2001 financial statements. Sousa said he expects PricewaterhouseCoopers to complete its re-audit by year-end. At that time, he promised, Dynegy's leadership would certify the prior statements.
Alliant's Davis downplays the importance of CEOs certifying financial statements. "I don't know whether my signing a financial statement will make you feel better about investing in my company," he says. "Certainly, over time ethical performance of managers and companies will do more to restore confidence than anything else."
Others raise doubts. Leonard Hyman, senior industry advisor at Salomon Smith Barney, fears that the new law does not go far enough.
"I think the changes in law just affect obvious instances of wrongdoing," he says. "They don't get at, deep down, what was going wrong. The proposals assume that the whole problem is criminality. I don't think that's the case at all.
"You have to look at the reforms in two ways," Hyman continues. "One way is to think they will be effective because the new laws will prevent something 'sleazy' from happening." On the other hand, he notes, the new law may do nothing more than make people feel better.
In other words, Hyman suggests that the measures may not achieve much in the way of prevention, because perhaps there might not be that many sleazy events. Barring auditors from doing consulting work for the same company, he says, may prevent very little in the way of bad conduct, because maybe very few bad things have happened.
Instead, he says, "I think a much more important issue is the question of the responsibility of directors. I'm not convinced that directors have been doing the job properly." The main problem, he says, is that directors are frequently handpicked by the executives of the company, and often will not rock the boat. "I don't know that you've got people who represent the large shareholders… What are the directors doing, do they really represent the interests of the shareholders?"
But Hyman concedes that investors may now feel more confident, knowing that auditors are being watched.
"To the extent that you say you can't do certain things because these things might lead to harm, if that makes investors more comfortable, then it does something worthwhile."
Grooming Directors and Auditors
At Enron, despite outside directors (some from academic institutions), the board failed either to detect what was going on, or to rein in management. As New York University business professor Baruch Lev says, "It's very difficult to constantly challenge managers. It's just unpleasant."
Hyman sees a remedy for inattentive directors-allow large investors to control at least some seats on the board.
"In many companies in other parts of the world, there are directors who have actually been put in by large shareholders. In other words, so-and-so owns five percent of the stock, and as part of the deal, gets to nominate a director." Hyman notes that many European, Asian, and Latin American corporations have such an arrangement, which he says makes sense. "If I owned 20 percent of the stock, you could be damn sure I have somebody there watching my interest."
Consider also that management often will control the hiring of auditors. Typically the audit committee, usually composed of outside directors, hires the auditors-but almost always the firm that management suggested. Yet as Lev notes, "Auditors represent shareholders, period."
To remedy the problem of auditors with mixed loyalties, Lev proposes to have shareholders appoint auditors directly. Lev points to proxy contests as a method for shareholders to select auditors. Allowing shareholders to appoint auditors could result in better, and clearer, financial statements, Lev says. "If you remember, there were constant complaints about Enron, before its demise, that you cannot understand the financial report, that it was so obscure, so complicated, so this, so that … . It was impossible to understand what was going on there."
Lev's proposal, which originally appeared in the Wall Street Journal, has its critics. Management typically does not want to give up control over selection of auditors. But some say that pushing the auditor decision onto the shareholder will not cure much, either. Stephen Peck, president of Flèche Inc., a Palo Alto, Calif.-based consulting firm, maintains that a company's current shareholders actually have the same incentives as the incumbent management.
"Imagine a situation," says Peck, "where the Enron board was meeting, and they were deciding whether or not to disclose all these off-balance transactions that they had done. The vote wouldn't be taken, because all the existing shareholders in the room would be calling their brokers, telling them to sell. So in fact, the existing shareholders have the same incentives as the existing management, which is to have the auditors produce positively biased results until they can sell their shares."
Peck suggests that would-be investors have a greater interest in obtaining honest audits, and should look to the stock exchanges for help.
"It should be the stock exchanges who hire the auditors," he argues, though he acknowledges that that the exchanges don't yet have that capability.
"If in fact there is competition between stock exchanges, if the stock exchanges compete on providing information, as opposed to competing as the companies do now on obfuscating information, [they could] compete on having the right incentives. If you get incentives aligned right, then things will work fine."
Dynegy already has begun some internal reforms. On August 27 it announced a new organizational approach that in effect will eliminate the position of CFO. Instead, the Dynegy board appointed three senior officers to direct financial, accounting, and strategic planning duties. "Each is committed to working together to ensure that Dynegy develops and executes a solid strategy for our future and meets the highest standards of corporate governance," said Dienstbier.
Other companies may follow.
On August 28, the board of directors of Cinergy adopted new corporate governance guidelines, plus a code of business conduct and ethics for directors and employees, and said it hoped the move would encourage investors.
Cinergy also turned to Institutional Shareholder Services (ISS), the world's largest provider of proxy advisory and corporate governance services. Recently, ISS implemented a rating system considering a variety of corporate governance matters, called the Corporate Governance Quotient (CGQ). Under the CGQ scoring criteria, Cinergy calculated that it outperforms about 95 percent of the companies in the S&P 500 index, with its new guidelines in place.
"We are taking action to ensure a leadership position in adopting practices that are considered best in class while complying with new SEC regulations, the Sarbanes-Oxley Act, and the proposed listing standards of the NYSE," said Cinergy chairman, president, and CEO James E. Rogers.
Wash Trades and Market Manipulation
Wash trading continues to haunt the energy industry.
Wash, or round-trip, trading is prohibited in all regulated futures markets, according to Neal Wolkoff, executive vice president and chief operating officer at the New York Mercantile Exchange (NYMEX). Prior to 2000, wash trading was banned for energy trades. But during the drafting of the Commodities Future Modernization Act of 2000, provisions were adopted that eliminated the prohibitions against wash trading for energy. In addition, the legislation "made very unclear whether fraud and manipulation rules applied [to energy trades], and whether or not they applied to some transactions seemed to depend on whether they happened against Enron or not," according to Wolkoff. Indeed, he says, "It was clear that provisions were adopted with the idea that Enron would be the sole recipient [of the legislation's benefits]."
Regardless of the legality of wash trades, Hyman says, "I think the wash trade business is something that certainly doesn't make me happy as an investor, again, because it shows that people are doing business to make something look bigger, as opposed to make more money … As a shareholder, I don't want to think that some of the reported revenue came about because people were playing games."
Wolkoff adds that he cannot fathom why wash trading should not be banned.
The existence of wash trading, he says, "just seems to undercut people's faith in the market. The fact that the electricity markets in California are looked at as having been gamed, or manipulated, by some of these practices, is not good for the power industry, it's not good for the commodities industry generally, or energy derivatives. It's just not good."
It appears Wolkoff may get his wish. There is growing sentiment both in Congress and in the industry to formally ban wash trading. At press time, Republican negotiators on the pending federal energy bill had agreed to add a ban on wash trades. There seems to be little, if any, opposition to the proposed ban, according to Jim Owen, director of media relations at Edison Electric Institute (EEI). He notes that in general, most of the companies have discontinued or backed away from wash trading.
Even FERC is getting into the act.
On August 13, the Federal Energy Regulatory Commission launched formal investigations into a group of energy companies-El Paso Electric, Avista, and a trio of Enron companies (Portland General Electric, Enron Power Marketing, and Enron Capital and Trade Resources). FERC sought to determine whether the companies might have manipulated electric or natural gas prices in the West after January 1, 2000. It acted following a series of orders that began with requests for information on dubious trading practices such as Enron's "death star," "fat boy," and "get shorty." More requests followed after FERC found that initial responses failed to report financial data in a manner consistent enough to allow the commission to identify any suspicious transactions.
FERC cited some particular activities in opening the investigation against Avista and El Paso Electric:
- First, whether Avista acted as a middleman in transactions between Enron Power Marketing and Portland General Electric in violation of affiliate rules, and whether it engaged in unlawful trading;
- Second, whether El Paso Electric (a) violated open access requirements; (b) failed to file jurisdictional rate schedules or dispose of (by ceding control) jurisdictional assets without prior approval; (c) failed to notify FERC on a timely basis of material changes in circumstances by which the company was granted market-based rate authority; or (d) engaged with Enron in actions that adversely affected prices.
For example, FERC questioned whether merchant affiliates at Enron or El Paso might have received preferential access to El Paso Electric's transmissions system in violation of open access requirements, in order to engage in highly profitable sale/buyback transactions with Mexican entities.
For its part, Avista challenged some of FERC's inquiries. Avista claimed, for example, that the transactions FERC had cited in a June data request addressed to its regulated affiliate, Avista Utilities (FERC's first request was directed at Avista Utilities, a unit of Avista Corp. and not at unregulated marketer Avista Energy) consisted only of standard buy/sell transactions that did not meet the definition of trading strategies under investigation by FERC. Avista added that its documentation showed that its employees had no knowledge of the strategies Enron may have been pursuing. And Avista claimed that the transactions amounted to less than one-tenth of one percent of all trading activity during the second quarter of 2000, from which Avista earned less than $2,500.
"It is abundantly clear that Avista did not initiate or promote such trading strategies," said Gary G. Ely, Avista Corp. chairman, president, and CEO.
Yet FERC charged in August that Avista admitted its role as middleman: "Avista states that it routinely acted as a middleman between affiliates such as Enron Power Marketing and Portland in order to allow transactions to proceed which affiliates would be forbidden to undertake directly."
Avista countered that its traders at Avista Utilities believed they were performing a common industry function as an intermediary between parties who were restricted from conducting trades. Yet it admitted that its own traders did question the transactions. FERC rejected Avista's claim that it was "used" by Enron.
Later, on August 30, the SEC put American Electric Power (AEP) under investigation for wash energy trades. AEP thus joins a list that includes CMS Energy, Dynegy, Reliant Resources, Duke Energy, and El Paso. Earlier (on May 30), when asked by FERC, AEP had denied any involvement in such transactions. "Our focus is profitability, not volume," said AEP's chairman, president, and CEO E. Linn Draper Jr.
(AEP said then that it had reviewed over 1.2 million trading transactions between January 1, 1999 and March 31, 2002, but had found that sequential trades with the same terms and counterparties amounted only to one-quarter of one percent of total trading volume-a figure that it termed "not material.")
By contrast, when violations are clear, some companies meet the problem head on. Consider the reaction of Ken Whipple, the new chairman and CEO of CMS Energy, who took over at the end of May, after the company's energy marketing unit, CMS Marketing, Services and Trading was found to have engaged in round-trip trading.
In a letter to shareholders, Whipple stated, "This practice does not measure up to the company's high standards of integrity or to my personal values, and we have taken a number of steps to address the issue." Indeed, CMS took the bull by the horns. It ordered a permanent halt to such trading, installed new financial controls, appointed a new president and CEO, David Geyer, to lead the division, and closed its energy trading business. It also hired new auditors, Ernst & Young LLP, to replace besieged Arthur Andersen, and to restate financial statements for 2000 and 2001. Finally, the board appointed a special committee of outside directors, assisted by the law firm Winston and Strawn, to conduct an investigation into the round-trip energy trades.
In the long run, regulators hope that improvements in corporate governance and financial reporting will boost investor confidence.
To that end, Jim Owen reports that EEI is working on several measures aimed at reassuring investors and the credit ratings agencies. One proposal aims at achieving consensus on implementing a uniform business model for risk and energy trading, which would be designed to lessen or mitigate credit risk. Another measure would include enhanced disclosure methods, to provide comparability of financial information between companies, as well as uniformity in terms of accounting principles. As it stands, comparison between companies is difficult at best, with some using mark-to-market valuation, while others don't. EEI also will be addressing master netting agreements, to develop a way of trading with a uniform method for booking revenue.
Hyman agrees that the industry's accounting practices need fixing. The industry should be sensitive to practices like booking notional value on a weather derivative, for example.
"Whether right or wrong, it brings up a question about whether you're putting in a value to boost reported results, or whether you're putting in a value that's a legitimate one. Due to the suspicions from all the scandals, I as a shareholder would feel a lot more comfortable if I knew that what was being booked does not consist of somebody's estimate of what all the profits are going to be for the next five years."
The price of not addressing such issues goes beyond the fate of a few companies. As Owen puts it, "If the capital markets and the liquidity markets continue to erode and shrink, then a lot of the very necessary improvements and expansions to our energy infrastructure are going to be at risk." He adds that failure to address transmission and other infrastructure concerns could well lead to impairing system reliability and also to costing customers billions of dollars.
Owen anticipates that EEI will roll out its new proposals sometime in October, with the master netting agreement finished next spring. The guidelines likely will be voluntary, but Owen anticipates that there will be very significant pressure to get behind the proposals. "If you're not behind that and everyone else is, that could be a problem," he observes.
It is not clear whether the credit markets will have enough patience to wait until October, or later, for such measures. Owen, though, is optimistic. "I can tell you that credit ratings agencies and others from Wall Street have been involved in these conversations, in fact most of them. We've had a number of meetings with Standard & Poor's, Fitch, the Street-the overall investment community have all been involved in these conversations … [and] they are getting the message that we're taking this pretty seriously."
Still, no one sees an easy time soon for the beleaguered industry.
At Alliant, Erroll Davis noted that at the end of July, just prior to the passage of the corporate reform package in Congress, his own company's stock was down 26 percent from its 52-week high, and that for the industry overall, the stock index overall was down 36 percent from its 52-week high.
"This is the absolute worst time for these bad behaviors to manifest themselves in the industry, when you've had a declining economy, when you've had a weather-driven industry that went through a year of cool summers and warm winters," he says.
The solution lies, in Davis' view, beyond legislation. "Everybody has to police themselves-management has to do better, accountants have to do better, the sell-side analysts have to become truly dispassionate and independent, and the credit markets have to stabilize. All of that has to happen before we're going to have investors that are truly confident again."
But Davis remains confident that the industry will survive, and again thrive. "This is a moment in time which I believe will pass … I'm sure we'll make it through and come out the back end stronger and better, as we always do, in any time of crisis."
Bond Ratings and Car Crashes
A Conversation with Erroll Davis, Alliant Energy
"When you think about it, the four pillars of investor confidence have all been shaken.
Pillar number one is the management of the company. They've always invested in management, and now management has done bad things. Pillar number two is the sell-side analysts, whom [investors] had depended on for advice. We've been shown now that their advice was not independent or dispassionate, and that in many ways [they gave advice] in concert with the investment banking arms of their companies. Accountancy. And auditing. You used to be able to believe in your auditors and accountants. And the fourth pillar is the credit markets. They are in absolute chaos. Credit ratings are being evaluated, re-evaluated. We have an analogy here our CFO came up with: A bond rating is sort of like a speed limit. We knew what the limit was-65-but everybody was doing 70. So in these turbulent times, all of a sudden, the bond rating agencies want to enforce 65, and you know what that does to traffic, that tends to slow things down. All of a sudden, we've had a few crashes, and now people are talking about changing 65 to 55, because of these crashes. While that debate is going on, no one knows what their capital structure should look like, what kind of equity levels and debt levels are acceptable, what kind of interest coverage ratios are acceptable. The number of downgrades last year, I believe S&P had 89 of them, I think this year we've had 16 in the first quarter already, and very, very few upgrades. So the four pillars of confidence for investors have just been shaken, and we're going to need certainty and regulation, we're going to need transparency, and we're going to need more understandable accountancy." -J.A.
Congress Lays Down the Law
Auditors cannot perform non-audit consulting services like building financial information systems, legal services, and investment banking for companies unless a committee of outside directors approves the work Material changes to a company's financial condition must be immediately disclosed, in "plain English" New board created to oversee, investigate, and discipline accounting firms that audit publicly traded companies CEOs and CFOs must certify the accuracy of financial reports CEOs and CFOs will be liable for knowingly deceiving the public about the company's financial condition
- If any financial report later requires correction due to misconduct, CEOs and CFOs must return bonuses given in the year the report was made
- Companies cannot make insider loans to officers and directors
- Officers and directors are prohibited from buying or selling stock during "blackout" periods of employee retirement plans
- Lawyers must report evidence of fraud and other misconduct to senior company officers
SEC and Criminal Enforcement
- Securities fraud made a criminal offense
- Prison sentences for fraud increased
- SEC must increase routine reviews of financial reports
- SEC budget boosted 50 percent
- Prosecutors and investors given more time to investigate fraud, to two years after the date of discovery and five years after the fraudulent act (formerly one and three years, respectively)
- Criminal penalties created for retaliation against corporate whistle-blowers
Source: Public Utilities Fortnightly research
States Getting Into the Act
Minnesota Tests Governance Interference Limits
The increased interest in governance also has trickled down to the state level, in a case that bears watching for its examination of how far state government can intrude on corporate decision-making. Minnesota attorney general Michael Hatch on September 3 filed a complaint at the Minnesota PUC against Xcel Energy reflecting problems cited in an August 28 letter he sent to the company's board. Hatch accused Xcel of adopting a business model similar to that of Enron, and called for the resignation of the company's CEO, Wayne Brunetti.
Brunetti responded to the August 28 letter in a letter to Hatch. "I am deeply concerned that a public official of your standing would seek to insert himself in the corporate governance of a publicly held, Fortune 500 company by not only calling for my resignation but also interjecting yourself into matters that are exclusively the domain of our board of directors," complained Brunetti. Gary Johnson, Xcel Energy vice president and general counsel, echoed Brunetti's statements upon review of the filing at the PUC. "The attorney general said previously his concern with Xcel Energy was corporate governance," said Johnson. "No corporate governance principal and none of the attorney general's legal authority authorize the attorney general to insert himself in board decisions involving personnel evaluation/retention, dividend payments, and asset disposition." -L.A.B.
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