How to avoid an Enronesque experience

allied_capital2.jpgThis earlier post that compares American International Group, Inc.’s business model to that of Enron Corp. makes an important point about the true reason that Enron collapsed.
The general public’s perception — fueled by the Enron Task Force and most of the mainstream media — is that Enron collapsed under the weight of a massive fraud. However, as the Enron Task Force’s abysmal record in court against former Enron executives reflects, the vast majority of Enron’s business operations were entirely legitimate outside of former Enron CFO Andrew Fastow’s relatively few questionable transactions that he arranged to enrich himself and a few of his close associates. But how did the public disclosure of Mr. Fastow’s relatively small financial schemes cause a company with a $60 billion market capitalization to break apart?

The reason is that Enron’s business-model — as does AIG’s and most other financial service and insurance companies — requires its customers to rely on the company’s financial integrity and not the company’s net worth. Accordingly, when customer confidence in a company such as Enron is undermined, participants in those companies’ markets become less willing to engage in the purchase or sale of long-term contracts that might not be fulfilled. For example, as the “bid-ask” spreads on Enron’s trading contracts diverged in late 2001 amidst disclosure of Mr. Fastow’s shenanigans, Enron’s markets unraveled and Enron’s formerly profitable trading business collapsed.
Thus, bad accounting alone did not bring down Enron. However, public disclosure of the questionable accounting for a relative few of Mr. Fastow’s questionable transactions did undermine the business customers’ trust in Enron’s financial integrity, and the disappearance of that trust in the marketplace caused Enron’s business model to collapse. Regardless of the financial soundness of any such “trust-based” company, when its customers stop believing in the financial integrity of the company, the company will fail.
All of which is a long way of bringing us to this interesting Floyd Norris NY Times column in which he examines what has occurred over the past year with another such “trust-based” company, Allied Capital Corporation:

The government had opened a criminal investigation and the company’s stock plunged. What was the company to do?
At Allied Capital, the answer was clear – and effective. First, it blamed short sellers for prompting the investigation. Then it added a politician to its board and declared that henceforth it would provide less information than ever to its investors.
And it worked. More than six months later, Allied Capital’s stock is back above where it was when the company disclosed the Justice Department investigation into Business Loan Express, a subsidiary that makes government-backed small business loans.
That unit has supplied Allied with profits it used to pay dividends to investors, but disclosures Allied has made seem to indicate that it was a cash drain on Allied. Even that is no longer clear. In its latest quarterly report, Allied slashed the information it disclosed on Business Loan Express.

Meanwhile, in addition to ratcheting down on the amount of information disclosed to the public regarding its subsidiary, Allied Capital hired a former S.E.C. attorney as a lobbyist, a former Clinton Administration aide to represent it in connection with the Justice Department and S.E.C. investigations, and appointed the former head of the Bush re-election campaign organization to its board. The results of Allied’s approach are impressive:

Since Allied took its present form in 1997, shareholders who reinvested dividends have made 13 percent a year, triple the return of the Standard & Poor’s 500. It pays hefty dividends and regularly raises cash by selling new shares. Most shares are owned by individual investors.

And what has happened to the short seller?:

[The short seller] has maintained a short position in Allied stock and still questions the company’s accounting. It seems likely that he played a role in sparking the government investigations. He has lost money on the short position.

Under similar circumstances back in 2001, when another notorious short seller asked several pointed questions about Enron’s accounting to then Enron CEO Jeff Skilling during a conference call, Mr. Skilling snapped that the short seller was an “asshole” for trying to move the market on the price of Enron’s stock in favor of his position. A few weeks later, Mr. Skilling resigned, Enron proceeded to undergo a massive review of its accounting that resulted in a restatement of earnings and its balance sheet, Enron CFO Andrew Fastow was fired, and Enron subsequently became much more transparent in its financial disclosures.
You already know the result — Enron is toast and now synonomous with business fraud in American society. In the meantime, Allied Capital — while refusing to make detailed disclosure of its finances — continues to generate impressive earnings for its shareholders.
There is a lesson there, but I’m still trying to figure it out. ;^)

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