Enron – What Went Wrong: How a Sleepy Little Utility Became a Trading Giant and Through a Series of Missteps Brought Its Nefarious Dealings to Light, Precipitating Its Ultimate CollapsebyBob McCabeSeptember 25, 2002

The Cast of Characters – Kenneth Lay

CEO and Chairman of the Board The J.R. Ewing of Natural Gas –

tremendous political influence and deal-making saving.

Ph.D., Economics, University of Houston

Former: Energy Deputy Undersecretary at the

Interior Dept. Believed Fervently in Free Markets

Cast of Characters – Jeffrey Skilling

CEO and President Became COO in 1996 and was CEO from

February 2001 to August 2001 – Joined Enron in 1990

MBA, Harvard Former Partner at McKinsey & Company Came up with the Idea of the Gas Bank Known as “Darth Vader” at Enron – big

proponent of PRC – Performance Review Committee – became known as the 360 degree review or “rank and yank.”

Cast of Characters – Andrew Fastow

CFO Hired by Skilling in 1990 MBA, Northwestern; undergraduate at

Tufts in Economics, of course. Became CFO in 1998 Former Senior Director of Continental

Bank in Chicago – specialized in “securitization,” leveraged buyouts and derivatives.

Cast of Characters –Sherron Watkins

Enron Vice President Author of the famous “anonymous”

memo to Lay in August 2001. Former Andersen employee

Gas Industry

There are 200,000 miles of pipeline versus 42,000 miles of Interstate Highway.Before Deregulation prices were relatively fixed. Regulation guaranteed profits to everyone and effectively rewarded inefficiencyIn the mid 80s, the Reagan administration began the process of dismantling price regulations.Deregulation brought with it wild fluctuations in prices.Enamored of technology

Enron – Background 1

Founded in mid-80s from the merger of Houston Natural Gas and InterNorth Principal assets included:

Natural gas pipelines spanning much of the U.S. Oil and Gas wells

Highly leveraged – From its beginnings and to fight off a hostile takeover, Enron was saddled with the costs of supporting “junk bonds” that were issued with Michael Milliken’s help.

Enron – Background 2

The 1985 Pipeline deregulation meant that Enron no longer had exclusive control over them.Enron’s Strategy In the beginning, it sold off its oil wells.

EOG Resources Large asset sales enhanced Enron’s apparent earnings

growth. Lay’s fervent belief in free markets led to Enron

becoming a market maker. Lay, also believed that Enron had to grow

quickly or die.

Enron – Background 3

Enron’s Strategy Hired McKinsey & Company

Jeffrey Skilling Enron’s culture focused on two

things: 1. Profits 2. How to make greater profits

Enron – Background 4

Financials at December 31, 2000 Net income $979 million;

Comprehensive income $672 million. Total assets $65.503 billion; an

almost 50% increase from 1999. Equity $11.470 billion; a debt to

equity ratio of 4.7 Current ratio 1.06

The Gas Bank

Enron entered into long-term contracts with natural gas suppliers Outright purchases – unlike electricity, gas

can be stored. Options to purchase

“Securitized” these contracts to make them attractive to consumers. It then sold options giving the customer the right to buy the gas in the future at a stipulated price.

Energy Market Accounting Issues

Enron used “Mark-to-Market” accounting. For many of these contracts, no market reference point existed so Enron used a “Mark to Model” approach. Since Enron was the “counterparty”, i.e. for every sale, Enron was the buyer, and for every purchase, Enron was the seller. Should Enron recognize as sales the gross sales price or just the spread?

Enron – Timeline 1

1985 Set up a trading company in Valhalla, NY

that operated much like a hedge fund. Made many bets on the future price of oil and was

usually wrong. To Houston, Enron Oil, added $50 million to the

corporate profit. Two sets of books and no oversight from

Corporate Enron reported a loss of $85 million but

some estimate it as high as $142 million. Head of Enron Oil went to prison.

Enron – Timeline 2

1987 Stock Market Crash – enabled Enron to attract financial talent to Houston1990 Lay hires Jeffrey Skilling1990 Skilling hires Andrew Fastow1993 Formed Enron International with Rebecca Mark as President.1995 Enron International signed contract to build and operate a power plant in Dabhol India.

Enron – Timeline 3

1996 – Skilling appointed COO and convinces Lay that the Gas Bank model can be used to develop a market for electricity.1997 – Acquired Portland General Electric Corp for $2 billion. Revenue from trades of gas and electricity reach $7 billion.1998 – Enron spun off a water company called Azurix and took it public in 1999.

A Note on Skilling’s Strategy

While Skilling took office in 1996, it took sometime for him to implement his “asset light” strategy. For the most part, Enron under Richard Kinder and Rebecca Mark believed that hard assets could become “cash cows. Skilling believed that: Hard assets are “dogs.” Enron’s real product was to create markets.

Enron – Timeline 4

1999 - Azurix through Enron acquires a water concession to supply water to five areas of Argentina for $438 million.1999 - First stage of Dabhol project completed and plant becomes operational. However, the cost to produce power from the plant is four times that of other plants in India.

Enron – Timeline 5

1999 - Azurix announces that it is firing one-third of its employees.1999 – Launched Enron Online – investment community lauded Enron for their leadership.1999 – Enron enters Broadband market by acquiring hard assets.

Enron – Timeline 6

1999 – Enron’s trading profit margins are being pinched by its competitors (Duke Energy, Williamsen, Dynergy, etc.)2000 – Announced a plan to build a high-speed broadband telecommunications network and trade broadband capacity.2000 – Energy prices fall with downturn in world economy.

Enron – Timeline 7

2000 – Enron inks a 20-year deal with Blockbuster to supply videos on demand.2000 – Enron stock hits all time high – $90.56.2001 – Enron announces a 150% increase in sales from 1999 to 2000. Pretax profits hit $1.41 billion and a net of $1 billion. Unrealized gains account for more than half of pretax and about a third of net.

Enron – Timeline 8

February 2001, Skilling becomes CEO and President. Tells analysts that stock should be trading around $126 per share (when it was about $80).February 2001, Fortune magazine article, “Is Enron Overpriced?”March 2001, Blockbuster deal cancelled.

Enron – Timeline 9

April 2001 – At Lay’s request, Colin Powell visits India to try to salvage the Dabhol project. No success. April 2001 – Released financial results for first quarter. Earnings up 18% over last year’s first

quarter. Revenues up a whopping 280%.

Enron – Timeline 10May 2001 – J. Clifford Baxter, vice chairman resigns to “spend more time with his family.May 2001 – First quarter 10Q shows profits of $425 million. But, cash used from operations was $464 million.August 2001, Rebecca Mark resigns from Azurix blaming British government. Cashes out her Enron stock for $82 million.

Enron – Timeline 11

August 2001 – Second quarter 10-Q shows earnings of $823 million and cash used in operations of $1.337 billion.August 2001 – Jeffery Skilling resigns for “personal reasons.” August 2001 – Lay sends email to all employees announcing Skilling’s resignation and says among other things, “our performance has never been stronger.”

Enron – Timeline 12

August 2001 – The day after Skilling’s resignation, Sherron Watkins sent her famous “anonymous” email to Lay. In it she said, “I’m incredibly nervous that we will implode in a wave a accounting scandals.”September 2001 – Qwest and Enron Broadband swap broadband with a price of $500 million. How do you measure the value of nonmonetary assets? Was a gain recognized?

Enron – Timeline 13

October 2001 – Announced sale of Portland General. It’s still for sale.October 2001 – Released third quarter results showing a loss of $618 million. October 2001 – Announced change in plan administrators. Employees prevented from selling shares from their 401k plans.

Enron – Timeline 14

October 2001 – Lay fires Fastow.October 2001 – Another email from Watkins – put the blame on Skilling and Fastow.November 2001 – Enron issues corrected financial statements covering the past four and one-half years. Losses of $591 million and additional liabilities of $628 million are picked up from consolidating JEDI and Chewco.November 2001 – stock price 26 cents.

Enron – Timeline 15

November 2001 – Rating agencies finally reduce Enron’s credit rating from low investment grade to “junk bond” status. December 2, 2001 – Filed for Bankruptcy protection under Chapter 11January 17, 2002 – Enron dismisses Andersen. January 25, 2002 – Baxter commits suicide (was it?)March 2002 – Sold Wessex Water for $777 million; original purchase price $1.9 billion.

Enron – Timeline 16

August 27, 2002 – Announced the availability of “electronic data rooms” that provide detail on 11 Enron businesses. Request initial indications of interest by October with final bids in November. The businesses include Portland General, Transwestern Pipeline, Elecktro, Cuiaba, Sithe, etc.

Related Party Disclosures

From the 2000 report – “…Enron entered into transactions with limited partnerships whose general partner’s managing member is a senior official of Enron.” “Management believes that the terms of the transactions were reasonable compared to those which could have been negotiated with unrelated third parties.”

Special Purpose Entities

The basic presumption under ARB 51 is that consolidation is required. To overcome this, two conditions must be me. First, an independent owner of the SPE must make a substantive capital investment and that investment must bear the risks and rewards of ownership over the entire term of the transaction. (The SEC staff say that it shall be at least 3% of total capital (assets)). Second, the independent owner must exercise control over the SPE.

JEDI 1 (Joint Energy Development Investment)

Started in 1993 with Enron and CalPERSIn 1997 Enron wanted to redeem CalPERS interest so that CalPERS would invest in JEDI 2.Formed Chewco to acquire CalPERS interest.

JEDI/Chewco

Chewco invests $383 million in JEDI for a 50% interest. Of this $240 million was borrowed from a bank with Enron’s guarantee. JEDI advanced Chewco $132 Million. The general partner invested $11.4 million in Chewco all of which was borrowed from the same bank. Chewco sent $6.6 million back to the bank to be held as a reserve on the $11.4 million loan. Chewco paid Enron a $10 million guarantee fee. Under the terms of the contract JEDI had to pay Enron a management fee of $28 million through June 2003.

JEDI/Chewco continued

JEDI invested in Enron stock.Enron accounted for its investment in JEDI using the equity method. Can revenue be recognized from your own stock?When Chewco was unwound, Kopper received $10.5 million on his $115,000 investment.

LJM – Rythms Swap

I’ve simplified the facts below: LJM’s general partner was Andrew Fastow Enron held 5.4 million shares of Rythms that it

had acquired for $10 million and could not sell until 2000. The value in mid 1999 was $300 mill and Enron had recognized $290 in unrealized gains.

Enron issued 3.4 million restricted shares to LJM in exchange for a 5-year Put Option on Rythms at $56 a share and a note from LJM for $64 million.

Subsequently, the value of the Rythms stock fell.

LJM – Rythms continued

Enron recognized the decline in the Rythms stock as a loss but offset this loss from an unrealized gain on its put option.Is this an economic hedge, i.e. was LJM ever in a position to honor its obligation?