Section 402

In 2002, The Sarbanes Oxley Act was created essentially to avoid another Enron debacle. It requires companies to do things such as: have the financial statements certified by both the CEO and the CFO, increase independence of external auditors, implement an anonymous mechanism for reporting fraud, and enhance civil and criminal penalties for violating securities laws. After reading the latest chapters in The Smartest Guys in the Room, I wondered if Sarbanes Oxley included anything about extending private loans to corporate executives.

In chapter seven when Rich Kinder left Enron, he left in high fashion. He was given $2.5 million in cash, took $109,472 in unused vacation pay, was forgiven an outstanding loan of almost $4 million, and quickly sold over 1 million shares of Enron stock worth $40 million. The cash, the vacation pay, and the money collected from stocks all seemed typical (used loosely in Enron’s case), but the $4 million made me think. Why would a company offer an executive a private loan, and why would a man making so much money even need a loan?

I did a little research and found that the extension of credit lines to executives was pretty common in the late 90’s and early 2000’s. In 2001, The Corporate Library, a non-profit organization that provides information to help investors, did an analysis of the frequency of company loans being issued. They found “that over one-third of the largest 1,500 companies in the U.S. have outstanding loans to company executives.” And, according to the report, “the average size of these loans was $10.7 million and the total amount of lending exceeded $4.5 billion.” In the company’s annual reports there were three main reasons stated for the issuance of these loans: 1. Stock-related purposes, such as to allow a company executive to exercise stock options, purchase stock, or retain stock after a margin call (35%); 2. To help an executive relocate to a new area, including buying a house (27%); 3. Unspecified reasons, otherwise interpreted as millions of dollars of stockholder funds loaned without disclosing to the stockholders the purpose of the loans.

Sarbanes Oxley does include the extension of credit in the form of a personal loan in section 402.

(1) IN GENERAL. – It shall be unlawful for any issuer (as defined in section 2 of the Sarbanes-Oxley Act of 2002), directly or indirectly, including through any subsidiary, to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of that issuer.

This is exactly what I was looking for when trying to understand this issue. It seemed fishy to be offering such enormous loans without much explanation and the government officials who approved the Act must have thought similarly. The only reasonable reason for offering a line of credit, in my mind, would be for the down payment on a house if the company relocated you. These days, companies can give their support when an employee goes to a bank to get a loan. But, it is just to help them get a better rate, not actually offering the loan themselves. I think Enron had so much money, the employees, the executives, and the shareholders didn’t know what to do with it, so they gave frivolous compensation packages that the executives arguably didn’t need or deserve.

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7 Responses

  1. This is quite insane. I wonder if organizations have come up with an alternative way to cheat the system after the introduction of this law. In most cases, I feel that such legislature is unlikely to get popular support (even from legislators) if it is really going to hurt the big guns, since many politicians rely on money from these folks. But an honest and good-willed attempt to curb corruption cannot be ruled out.

    Toward the end of your post you speculate that perhaps Enron had too much money and did not know what to do with it. While some stake holders (like the executives) may have had plenty of money that they could stuff their pockets with, the company as a whole did not really have this money. Shareholders in Enron might have been blinded by the financial statements of the company and could have turned a blind eye to such gross misappropriations…

    A last thought… somehow I am never convinced that the smartest guys out there are working for the government.

  2. Megan–

    I found your post to be really intriguing. It looks like the government did something right for once. I’m also curious to see whether the book we are reading mentions the Sarbanes Oxley Act (since it was passed in 2002 and the book was published in 2003). Although this act seems to have a strong hold on solving dilemmas like Enron’s, I’m sure businesses will continue to find loop holes. The part about having the financial statements certified by both the CEO and the CFO are one way in which I think Enron wouldn’t have been affected by the issue. Ken Lay continuously signed off and approved measures in order to avoid personal conflict. The government could require signatures, and Ken Lay would have no problem providing them. This doesn’t mean that it was an appropriate move to make in any way. Overall I think this act was a step in the right direction, but I think it would be most appropriate if the government made revisions to it every year to prevent loop holes.

  3. Fishy indeed. Thank you for tracking down this answer.

    I can think of some things they could have done with that money. Invest it in innovation, or simply give back to shareholders as a dividend. We haven’t talked enough about the idea of a growth stock and how much that fueled Enron story.

  4. I find it amazing, if not scary, that Enron made so much money that they were able to support such lucrative lones to their top executives. Hopefully later in The Smartest Guys in the Room, the expiriences of the lower level people at Enron will be revieled. I am interested to see how they reacted throughout the entire collapse, and what they think today of the organizational structure utilized by Ken Lay.

  5. I think the most interesting thing about all this is that Enron DID NOT make enough money to do this. With the majority of their “profits” not being realized – I can’t fathom how they could simply write of a $4 million dollar loan. For cash flow purposes that would have been a huge amount of money for them to bring and they simply let that kite go with Kinder. I can only hope that the first job I leave treats me as well as Enron treated their fleeting employees.

  6. I think your last phrase almost sums up the reason why, they were doing this. But how can you not be worried on how this is going to show on your books?? I mean even if you are “cooking” them, those sums were an absurd amount of money, or maybe I am just poor.

  7. Nadir, I think you hit the nail on the head when you say that the smartest guys in the room are not working for the government. We recently spoke about this in another class. Where was the SEC during Enron and again during the recently economic collapse? What were the rating agencies doing? As it turns out, it’s fairly common for the large banks like Goldman or Morgan Stanley to pull employees from the SEC or Moodys. The employees can provide good information on how the government goes about rating and investigating the banks. In general SEC and rating agency employees are underpaid and under appreciated. This must contribute to the fact that the smartest guys in the room go private instead of public.

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