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Case study ENRON
co rpo rate governanceGROUP VI
G06102, G06122, G06127,G06140,G06141
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Backg round of Enron Corpo rat ion(1)
Houston-based energy trading and distributioncompany
Famous for advocacy of energy deregulation
In just 15 years, climb to be 7th largest company inUS (Fortune 500, 2000), with 21,000 staff 16th largest
in the world In 2000, stock has crested at $90 a share
Market capitalization: $80 billion
Revenue $139 billion
Arthur Andersen acts as accountant and consultantBoard of director
14 members, only 2 insiders
Most of the directors owned stock
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Backg round of Enron Corpo rat ion(2)
Employee stock ownership and retirementplanning
Incentive purpose
Enhance company profit
Management-ControlledNo Single shareholder
hold >20%e.g. Enronmanaged byprofessional managers
Other shareholders:
Institutions
Corporations
Pension funds
Charities
foundations
Small individual
investors
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Key Players in the Enron Scandal
Kenneth Lay Former CEO of Enron, helped start the company.
Enron extended to him $7.5 million revolving creditline, which he reportedly used and repaid with Enron
stock 15 times within a period of just several months He quit as CEO in February 2001
He returned as CEO in August 2001until he resignedon Jan. 23, 2002
He quit the Enron board altogether on Feb. 4.
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Key Players in the Enron Scandal
Jeffrey Skilling Enron's chief executive in the first half of 2001
Since joining the company in 1990, Skilling helpedtransform Enron from a natural-gas pipeline company
into an energy-trading powerhouse. Between January and August 2001 he sold off about
$20 million in Enron stock
Resigned after the close of markets on Aug. 14 2001
Being charged with conspiracy, fraud and insidertrading
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Key Players in the Enron Scandal
David Duncan Enron's chief auditor at Anderson
Hisjob was to check Enrons accounts
He is accused of ordering the shredding of thousandsof Enron-related documents in an effort to hide themfrom Securities and Exchange Commissioninvestigators
Andrew Fastow Former Chief Financial Officer of Enron
The mastermind behind the deceptive accountingpractices
Lea Fastow (his wife) also plead guilty to signing andfiling a tax return that did not include income theFastowshad received from Mike Kopper
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Key Players in the Enron Scandal
Sherron Watkins
Known as the "Enron whistle-blower"
Was Enron's vice president of corporate development
Wrote a letter to Kenneth Lay about suspicions ofaccounting improprieties"
Not really a whistle-blower because she never went
public with her suspicions
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Broken Trust The Story of Enron
72 Pairs o f Relat ion sh ips
Board
of
Directors
Senior
Management
Accountants
AnalystsInvestment
Bankers
Lawyers
Consultants
Professional
Associations
Credit
Raters
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Enrons Bankruptcy
Enron announced a large loss in its quarter statement
3rd qtr loss of >$600 million (surprised Wall Street)
Stock price fall from the mid-$30s to the low-
$20s (triggered a crisis of confidence in the company)
Overstated its profits by ~16%
Jul
Oct
Nov
DecBankruptcy
2001
< Year 2001
Prosperous business performance..
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How did the co l lapse begin? Energy companies lobbied congress in the 1980s for
deregulation of the energy business
Energy policy was changed and Washington liftedcontrols on who could produce energy and how it wassold
1) Ironical relationship between governmentalmonitoring parties and political parties
2) Throughout all of this, Enron and its key memberswere making political contributions to the white houseand congress.
3) Kenneth Lay donated $100,000 to President Bush in2000, and in 2001 Bush invited Lay to become an
advisor to his transition team.4) In the year 2000, Kenneth Lay met three times with
Dick Cheney to discuss energy policy review.
5) When the review was published in May 2001, it wasvery favourable to the Enron and the energy sector.
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Skillings Plan
Jeff Skilling took and aggressive approach to expand
Enron by trading futures in gas contracts
Under Skillings new plan Enron bet against futuremovements in the price of gas-generated energy
Enron bought and sold tomorrows gas at a fixed pricetoday
With every trade, Enron took a cut for transaction costs
Using the internet to promote trading, Enron becamethe most successful player in the futures game; 90% ofEnrons income came from trades
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ENRON in 2000-(1)
Enron took advantage of the dot.com boom and tradedinternet bandwidth
The value of Enrons online transactions was huge($880 billion)
The problem was Enron wasnt making money on
many of their online trades because they made themarket very efficient
Fuzzy Numbering
Enron began tweaking the numbers in their financialstatements with accounting techniques to hide their
losses Enron created partnerships, and then passed the
assets (losses) to these partnerships which eliminatedthe losses from their balance sheets
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ENRON in 2000-(2)
Condor and Raptor partnership
Andrew Fastow (Chief Finance Officer) created thepartnerships
Condor and Raptor were two major partnerships
Sherron Watkins, the Enron Whistleblower noticedthe fuzzy accounting that had been used inrelationship to the Condor and Raptor partnerships
and wrote a letter to Kenneth Lay and Arthur Andersonwarning him that the Enron was unstable.
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ENRON in 2000-(3)
Aug 14, 2001 Jeff Skilling resigned,Kenneth Lay became CEO onceagain.
Stock prices began to fall, asinvestors were uncertain about the
companys stability. This started a chain reaction: Enron
had hedged against its own stock,so as long as the stock price wasdeclining, it could not recover itslosses.
December 2001, Enron filed forchapter 11 bankruptcy
Its share price had collapsed fromabout $95 to under $1.
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Enrons Bankruptcy
Enron announced a large loss in its quarter statement
3rd qtr loss of >$600 million (surprised Wall Street)
Stock price fall from the mid-$30s to the low-
$20s (triggered a crisis of confidence in the company)
Overstated its profits by ~16%
Jul
Oct
Nov
DecBankruptcy
2001
< Year 2001
Prosperous business performance..
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Enrons Bankruptcy (1)
A substantial fraction of Enrons reported profits over a
4 year period (1996-2000) had been the result ofaccounting manipulations
Investigation by special committee of the Enronboard
Accoun t ing g immick ry :
Unable to spot bad accounting practices andcompanys overstatement of profits
Conf l ic t of audi tor :
The multiple conflicting roles of auditor
Automatic renewal of auditing contracts
Affecting the independence of auditor
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Enrons Bankruptcy (2)
Acc ount ing and staff pol icy fa i lure
Although a professor of accounting and a dean formonitoring the company, but they all fail in theirprofession
Disastrous loss in employees retirement fund, but the
ex-CEO has cashed his own stock much earlier(Jeffskilling)
Source:
Enron Posts Surprise 3rd Quarter Loss After Investment,
Asset Write-Downs, Wall St. J, Oct 17, 2001
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Enrons Bankruptcy (3)
Pol it ical c onfus ion:
Ironical relationship between governmental monitoringparties and political parties
Managers att i tude
Managers tend to build up their own empires andscarify the profits/benefits of the organization
Conf l ic t of the board
Enrons board of directors fail to control and overseethe management
The board had been benefited in various relationshipwith the company
Source: International business and strategic management
at Suffolk University, Boston, US
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Issues related to co rporate con tro l(1)
Stock opt ion scheme
CEOs, Managers and employees are given STOCKOPTIONS as their compensation package
Their aim is to get a maximum reporting profit so as toboost the stock price of the company
Contro l and Management Over lapp ing
Board members and corporate partnerships were notindependent
Allowing private partnerships (set up by employee) to
be valid Enron investment
Board members could be benefited in variousrelationship
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Issues related to co rporate con tro l(2)
Fai lure in Financial m anagement
CFO badly perform his role
The financial report was very complicated to beunderstood
A special team of reviewing the reports fails to performtheir role
Emp loyee Retirement Schemes
Over 50% of Enrons employee retirement schemesasset are invested in Enrons share
All employee have a common goal to boost the stockprice of the company
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ENRON pit fal l strategy - Inves tigation
f indings(1)
1993-2001: Enron used complex dubious energy trading schemes
Example: Death StarEnergy Trading Strategy
Took advantage of a loophole in the market rules governing
energy trading in California Enron would schedule electric power transmission on a
congested line from bus A to bus B in the opposite direction
to demand, thus enabling them to collect a congestion
reduction fee for seemingly relieving congestion on this line.
Enron would then schedule the routing of this energy all the
way back to bus A so that no energy was actually bought or
sold by Enron in net terms. It was purely a routing scheme.
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ENRON pit fal l strategy - Inves tigation
f indings(2)
1993-2001: Enron also used complex & dubious accounting
schemes
to reduce Enrons tax payments;
to inflate Enrons income and profits;
to inflate Enrons stock price and credit rating;
to hide losses in off-balance-sheet subsidiaries;
to off-balance-sheet schemes to funnel
money to themselves, friends, and family; to fraudulently misrepresent Enrons financial
condition in public reports.
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ENRON pit fal l strategy - Inves tigation
f indings(3)
One accou nt ing Scheme
Enrons rapid growth in late 1990s involved large capitalinvestments not expected to generate significant cash flow inshort term.
Maintaining Enrons credit ratings at an investment grade (e.g.,BBB)was vital to Enrons energy trading business.
Create partnerships structured as special purpose entities(SPEs) that could borrow from outside investors without having
to be consolidated into Enrons balance sheet. SPE 3% Rule: No consolidation needed if at least 3% of SPE
total capital was owned independently of Enron.
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ENRON pit fal l strategy - Inves tigation
f indings(4)
Enrons creation of over 3000 partnerships started about 1993when it teamed with Calpers (California Public RetirementSystem) to create JEDI (Joint Energy DevelopmentInvestments) fund.
Enron initially thought of these partnerships as temporarysolutions for temporary cash flow problems.
Enron later used SPE partnerships under 3% rule to hide badbets it had made on speculative assets by selling these assetsto the partnerships in return for IOUs backed by Enron stock as
collateral! (over $1 billion by 2002)
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ENRON pit fal l strategy - Inves tigation
f indings(5)
In Nov 1997, Calpers wants to cash out of JEDI.
To keep JEDI afloat, Enron needs new 3% partner.
It creates another partnership Chewco (named for the StarWars character Chewbacca) to buy out
Calpers stake in JEDI for $383 million.
Enron plans to back short-term loans to Chewco to permit it tobuy out Calpersstake for $383 million.
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ENRON pit fal l s trategy -
Invest igat ion f ind ings(6)
Chewco needs $383 million to give Calpers
It gets..
1) $240 mil loan from Barclays bank guaranteed byEnron
2) $132 mil credit from JEDI (whose only asset is Enronstock)
3) Chewco still must get 3% of $383 million (about $11.5
million) from some outside source to avoid inclusionof JEDIs debt on Enrons books (SEC filing, 1997).
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ENRON pit fal l s trategy -
Invest igat ion f ind ings(7) Chewco Capital Structure: Outside 3% $125,000 from
William Dodson & Michael Kopper (an aide to EnronCFO Fastow)
$11.4 mil loans from Big River and Little River (twonew companies formed by Enron expressly for this
purpose who get a loan from Barclays Bank)
Barclays Bank begins to doubt the strength of the newcompanies Big River and Little River.
It requires a cash reserve of $6.6 million to bedeposited (as security) for the $11.4 million dollar
loans.
This cash reserve is paid by JEDI, whose net worth bythis time consists solely of Enron stock, putting Enronin the at-risk position for this amount.
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Enrons Bankruptcy
Enron announced a large loss in its quarter statement
3rd qtr loss of >$600 million (surprised Wall Street)
Stock price fall from the mid-$30s to the low-
$20s (triggered a crisis of confidence in the company)
Overstated its profits by ~16%
Jul
Oct
Nov
DecBankruptcy
2001
< Year 2001
Prosperous business performance..