Reference no: EM131050632

Enron's PRC and RAC - Loose and Tight

Story Enron's traders risked losing money every time they made a trade, especially in unpredictable areas like weather and broadband futures. Signing long-term contracts to provide gas and electricity, a market they pioneered, required an understanding of all kinds of risks - pricing, delivery, credit, etc. - and knowing how to hedge those risks. Since all their longterm deals were marked to market, the credibility of their revenue figures were directly related to risk and interest components over time. It is hard to image a more important concept for Enron than managing risk. Controls are management's best resource for managing risk. Jeffery Skilling, who served as Enron president and COO from 1996 to early 2001, was widely quoted as saying that Enron had "one of the best control systems in the world," with hundreds of lawyers and accountants vigilant against financial risk. When analysts inquired about the company's risk-management abilities Skilling had a ready answer: he pointed to Enron's Risk Assessment and Control (RAC) department. Skilling knew Wall Street wanted to see a strong system of internal controls, and he made RAC a centerpiece of management presentations to Wall Street analysts, investors, and credit-rating agencies. Thanks to RAC, Enron was able to portray itself as a company that could safely take more risk than other companies, precisely because it had the right controls in place. Skilling often described the minimal risk trading culture of Enron under his charge as "loose and tight," one of the eight attributes of the successful companies profiled by Peters and Waterman Jr. in their best-selling book, In Search of Excellence. The idea is to combine tight controls with maximum individual authority to allow entrepreneurship to flourish without the culture edging into chaos. (Byrne 2002)

Risk Assessment and Control RAC

Skilling imposed a requirement that Risk Assessment and Control had to review virtually all Enron deals - even international ones - and he bragged constantly about the sophisticated oversight that RAC provided. RAC would look at issues like currency devaluation, interest rate projections, commodity price projections, and other elements that might factor into a given deal. RAC employed former bankers, accountants, statisticians, and MBAs - experts in every aspect of a commercial transaction. RAC had resources - by the late 1990s it had 150 professionals, a $30 million budget, and access to a $600 million computer system. RAC had a director (Rick Buy) who reported directly to Skilling and Skilling characterized him as Enron's "top cop." (McLean 2003)

RAC failure

Unfortunately, even though Skilling bragged about Enron's sophisticated controls, they were undermined at every turn. As one director put it, RAC "was a façade for Skilling to point to when he wanted to impress the rating agencies and outside investors." (Bryce 2002) The analysis and recommendations of the RAC was undermined by their director, control and subversion by the deal makers whose deals they reviewed, and by another control at Enron, the personnel evaluation system run by the Performance Review Committee (PRC). Rick Buy, the RAC director, was a man uncomfortable with confrontation. The corporate culture was such that you never said no to a deal. In interviews after the fall, Buy insisted that saying no wasn't even part of his job description. He told his staff that RAC's charge was simply to describe a transaction, analyze its risk and possible returns, and tell senior management "you guys make up your mind." (McLean 2003) After completing its analysis, RAC had to circulate its draft comments on a transaction to the deal makers who had the right to edit the comments. Entire deals went to RAC just a few days before the close of the quarter, leaving little time to scrutinize transactions involving hundreds of millions of dollars, and putting enormous pressure on RAC to sign off, because the company needed to deal to hit its numbers. (McLean 2003) Dr. Vince Kaminski, head of the risk control part of RAC, told of how his own mounting worries last fall caused him to refuse to let his research team do further work on partnership-related transactions. Dr. Kaminski said that when he tried to pass along his concerns to Enron's outside auditor, Arthur Andersen LLP, he was told by a senior Enron official to stop such communications. He said that in response to his criticisms, he and his research group were for a time cut off from certain financial information about the partnerships by top management, including Enron's then-president, Jeffrey Skilling. (Emshwiller 2002) The performance review process by the PRC was another way to beat RAC. One employee commented, "No one would stand in front of a deal because you could get killed in the PRC. People who questioned deals would get attacked by the business units because they weren't as cooperative on a deal as the developers wanted." Members of the RAC feared retribution if they ever wanted to work in other parts of Enron after leaving RAC (McLean 2003)

Performance Review Committee (PRC)

Under Enron's peer-review process, a select group of 20 people were named to a performance review committee (PRC) to rank more than 400 vice-presidents, then all the directors, and finally all of Enron's managers. The stakes were high because all the rewards were linked to ranking decisions by the PRC which had to unanimously agree on each person. Managers judged "superior" - the top 5 percent - got bonuses 66 percent higher than those who got an "excellent" rating, the next 30 percent. They also got much larger stock option grants. (Byrne 2002) Enron's Performance Review Committee created a highly politicized work environment. Traders and originators sat on panels that ranked the same RAC executives who reviewed their transactions. The process made honest evaluations virtually impossible. One Enron RAC employee commented, "Once you get there and you realized how it was, do you stand up and lose your job? It was scary. It was easy to get into ‘Well, everybody else is doing it, so maybe it isn't so bad.' " (Byrne 2002) Another said "It didn't matter how good you were. It only mattered who you knew." (Bryce 2002) Every employee had to be graded - on paper - by several peers. Skilling told one reporter, "The performance evaluation was the most important thing for forging a new strategy and culture at Enron - the glue that holds the company together." (Durgin 2000)

Two Things Not Subject to Negotiation

Skilling was quoted in a financial journal as saying, "Only two things at Enron are not subject to negotiation: the firm's personnel evaluation policy and its company-wide risk management program." (McLean 2003)

Discussion Questions

¦ How would you assess the RAC control and the PRC control: weak or strong? Why?

¦ Why would the RAC control be considered material to the financial statements?

¦ What tests of control would you recommend to determine if the RAC was effective in operation?