From JK Galbraith's 60s to Enron

[Michael Pollak <mpollak@xxxxxxxxx>]

London Review of Books
Vol. 25 No. 10
22 May 2003
Donald MacKenzie

Empty Cookie Jar

Pipe Dreams: Greed, Ego and the Death of Enron by Robert Bryce |
PublicAffairs, 394 pp, £9.99

Enron: The Rise and Fall by Loren Fox | Wiley, 384 pp, £18.50

<snip>

Can the managers of a corporation like Enron be trusted to act in the
interests of its owners (the shareholders)? The question is as old as the
joint stock company as a legal form. Adam Smith suspected the answer was
'no'. In Volume III of Capital, Marx warned that directors might swindle
shareholders, although he also welcomed the growing separation of
managerial control from legal ownership as a transitional step towards
socialism. In 1932, Adolf Berle and Gardiner Means estimated that 'perhaps
two-thirds of the industrial wealth' of the US was in the hands of large
corporations controlled by their managers rather than their owners. This
paved the way, they argued, for what we would now call a 'stakeholder'
form of capitalism - one that would recognise the legitimacy of interests
other than those of shareholders. In 1967, J.K. Galbraith claimed that the
separation of ownership from control meant that corporations no longer
pursued the traditional goal of capitalist firms: maximum profit. The
corporation was in the hands of what Galbraith called the
'technostructure', a managerial cadre whose goal was growth of output,
because that would bring them larger departments to manage and thus higher
pay and better promotion possibilities. Whether growth was the most
profitable use of the corporation's capital was a secondary matter;
shareholders had no real influence any longer. As Galbraith put it, 'the
annual meeting' of shareholders of the 'large American corporation is,
perhaps, our most elaborate exercise in popular illusion'.

In the 1980s and 1990s, however, it seemed as if managerial and
shareholder interests had been reconciled. In the 1980s, corporate raiders
brought off a series of increasingly audacious takeovers, largely financed
by 'junk' bonds (bonds which rating agencies deem to be below
investment-grade). The very names of these raiders - Carl Icahn, T. Boone
Pickens, Sir James Goldsmith - brought fear to Galbraithian managers, whom
they ruthlessly displaced. Underperforming corporate assets were sold off,
workforces were dramatically shrunk, bond- holders paid - and both raiders
and shareholders were greatly enriched.

Gradually, corporations built defences. Enron, for example, was born in
1985 when InterNorth, a larger pipeline company, merged with Kenneth Lay's
Houston Natural Gas and thus avoided falling into the hands of Irv the
Liquidator, the corporate raider Irwin Jacobs. However, the traumas of the
1980s taught corporate managers that they neglected share prices and
profits at their peril. The ideal new-style managers were people like
Enron's second-in-command from 1988, Rich Kinder (pronounced Kinn- der).
Although now remembered with nostalgia by the former Enron employees who
have spoken to Fox and Bryce, he was no softy. It was he, not Lay, who was
responsible for detailed management, and he kept costs and staff numbers
firmly under control, reduced the corporation's already large debts, and
viewed any expenditure 'like the money was coming out of his own personal
chequebook', as one ex-employee told Bryce. Over-enthusiastic underlings
were frequently put down by Kinder telling them: 'Let's not start smoking
our own dope.'

That, however, seems to be exactly what Enron started to do after Kinder's
departure in 1996. If the office gossip recycled by Bryce and Fox is to be
believed, Enron's high-intensity buzz contributed to numerous sexual
liaisons among its workaholic staff, and an alleged affair between Kinder
and Lay's personal assistant may have caused a rift between the two men.
Kinder's replacement, Jeff Skilling, was a 'big strategy' man rather than
a tight-wad. He was a Baker scholar from the Harvard Business School - in
other words, in the top 5 per cent of an already elite MBA class - and
before he joined Enron had been an employee of the world's pre-eminent
consulting firm, McKinsey & Company.

In the late 1990s, Enron's creative juices flowed unrestrained: this was
the period of the 'most innovative company' awards. Control over costs,
however, seems to have slackened. Staff numbers grew rapidly, and among
them were many high-flying MBAs from leading universities, at
correspondingly expensive salaries. The private jets got more up-market.
Assets such as Wessex Water, the Buenos Aires water company AGOSBA and the
Brazilian utility Elektro Eletricidade were bought not because they were
cheap but because they offered entry into new and potentially profitable
markets such as water trading and Latin America. Debt accumulated - but
Enron grew, becoming the seventh largest corporation in the US.

It was as if the Galbraithian technostructure was back in control, but
with two fatal differences. In the 1960s, managers had been concerned
about share prices, but only as one issue among several. By the 1990s,
however, share prices were an obsession for the managers at Enron, at
almost all other US and British corporations, and at an increasing
proportion of companies in Continental Europe and elsewhere. In order to
tie managers' interests to those of their shareholders, an increasing
proportion of their pay came in the form of shares or share options, and
Enron was extremely generous in this respect. At the entrance to its
headquarters was a large electronic display showing the second-by- second
movement of its share price. As that number ticked up and down, the
personal wealth of senior managers could rise and fall by millions of
dollars.

The second difference from the 1960s was that Enron, like many other
present-day companies, was much more dependent on the view of it taken by
credit-rating agencies, in particular the two globally dominant ones,
Moody's and Standard & Poor's. These agencies rate the bonds of
corporations, municipalities and governments, essentially according to
what they see as the likelihood of default. Their opinion of companies
mattered even in the 1960s, but the conservatively run corporations of
that period had little difficulty achieving high ratings. In the 1980s and
1990s, however, corporations started to issue more and more bonds and take
on increasing amounts of other forms of debt: Enron was far from alone in
this. The debt funded necessary investment, but it also permitted
expensive takeovers and allowed corporations to buy back large amounts of
their shares - the simplest way to keep share prices high and managers'
share options valuable. By 2002, only eight US corporations still held
Moody's highest, Aaa rating.

Ratings help determine the costs faced by a corporation or government. The
lower your rating, the higher the rate of interest you have to pay on your
bonds and the more it costs you to service your debt, and this last can be
a life or death matter for Third World countries. It would thus be only a
slight exaggeration to call Moody's and Standard & Poor's the world's most
powerful organisations, national governments apart. For Enron, the views
of the agencies had especial significance. Its rapidly expanding trading
empire, in particular EnronOnline, depended totally on its credit rating.
It was 'investment grade', but never high in investment grade. In the late
1990s, Moody's rated Enron as Baa2, only two notches above Ba1, the upper
tier of junk or 'speculative' bonds, as the agencies politely call them.
If Enron slipped those two notches, it would cease to be an attractive
trading partner. A major and highly visible question-mark would be placed
over its capacity to meet its obligations, and who would then enter into a
futures contract with Enron, or buy an option from it?

The twin pressures to keep its share price high and its ratings investment
grade explain why Enron started to engage in optimistic accountancy and to
move poorly performing or high-risk investments (and more and more debt)
off its own balance-sheet into those of 'special purpose entities'. These
entities are limited partnerships or companies which are set up by a
corporation but legally distinct from it and are formed because they can
carry out certain transactions more profitably than the parent
corporation. An entity can be structured, for example, so that it is
provided with revenues that match the obligations it enters into by
borrowing, which means that creditors can be persuaded to lend to it on
favourable terms. The tight nexus of share prices, ratings, debts and
special purpose entities also explains the rapidity of Enron's implosion
in 2001. The entities had been provided with, or promised, Enron shares to
enable them to meet their obligations. As those shares slipped in value,
the entities couldn't do so, and the concealed iceberg of losses and debt
began to become visible. Shares slipped further, the markets and rating
agencies grew more sceptical, and Enron became locked into a death spiral.
Its downgrade to junk by the rating agencies on 28 November 2001 sealed
its fate.

Simply to cry 'fraud' and call for tighter accountancy rules is to miss
the depth of the issues raised by Enron and other similar debacles.

<end excerpt>