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.