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The Enron Case

p prepared by :- Sourav Daga Danish Irshad Naveen

Sharma Tirthesh

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Enron’s History

In 1985 after federal deregulation of natural gas pipelines, Enron was born from the merger of Houston Natural Gas and Inter North, a Nebraska pipeline company.

Enron incurred massive debt and no longer had exclusive rights to its pipelines.

Needed new and innovative business strategy

Kenneth Lay, CEO, hired McKinsey & Company to assist in developing business strategy. They assigned a young consultant named Jeffrey Skilling.

His background was in banking and asset and liability management.

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Enron’s History (cont’d)

Created Energy derivative

Lay created a new division in 1990 called Enron Finance Corp. and hired Skilling to run it

Enron soon had more contracts than any of its competitors and, with market dominance, could predict future prices with great accuracy, thereby guaranteeing superior profits

Created Performance Review Committee (PRC) that became known as the harshest employee ranking system in the country---based on earnings generated, creating fierce internal competition

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Enron’s Corporate Strategy Was devoid of any boundary system

Enron’s core business was losing money—shifted its business to trading of derivatives

During 2000, Enron’s derivatives-related assets increased from $2.2 billion to $12 billion and derivates-related liabilities increased from $1.8 billion to $10.5 billion

Enron’s top management gave its managers a blank order to “just do it”

Deals in unrelated areas such as weather derivatives, water services, metals trading, broadband supply and power plant.

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The Company and its Operations

Created by the merging of two pipeline companies in the mid-1980s

Moved slowly away from its hard-assets roots From pipelines and energy plants To transmission and energy trading To innovative commodities trader (energy,

bandwidth, advertising time/space)

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Aggressive Nature of Enron Because Enron believed it was leading a

revolution, it pushed the rules. Employees attempted to crush not just outsiders but each other. Competition was fierce among Enron traders, to the extent that they were afraid to go to the bathroom and leave their computer screen unattended and available for perusal by other traders.

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Enron’s Arrogance

Enron’s banner in lobby: Changed from “The World’s Leading Energy Company” to

“THE WORLD’S LEADING

COMPANY”

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Problematic Practices

Accounting: Special Purpose Entities (SPEs)▪ Non-compliance with FAS 57▪ Used for hedging transactions▪ Used to accomplish asset sales

Leveraging the Company▪ To finance operations▪ Guaranteeing Obligations of SPEs

Enron’s Culture (Advancement and Incentive Plans)▪ Promoted Greed Culture▪ Encouraged employees to hide

problems

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Special Purpose Entities (SPEs) Traditionally used by finance companies for

securitization

Also used to isolate risky asset ( aircraft leasing ,real estate development)

In late 1990 many companies used SPEs to accelerate revenue recognization

Really a joint venture between sponsoring company and a group of outside investors

Cash flows from the SPE operations are used to pay investors

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Special Purpose Entities (SPEs)

Governed by Financial Accounting Standard 57

Allows SPEs to be kept off the balance sheet if: Outside owner invests equity

capital for a 3% or greater share of the SPE

Outside owner exercises control over the SPE

If both criteria are met, gains and losses from transactions with the SPE can be recorded

Assets and liabilities of the SPE are not consolidated

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Enron’s Use of SPEs

To hide bad investments and poor-performing assets Declines in value of assets would not be recognized by Enron

Quick execution of related-party transactions at desired prices. (LJM1 and LJM2)

To report over $1 billion of false income

To hide debt

To manipulate cash flows, especially in 4th quarters

Many SPE transactions were timed (or illegally back-dated) just near end of quarters so that income could be booked just in time and in amounts needed, to meet investor expectations

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Special Purpose Entities (SPEs) Example

Joint Energy Development Investment (JEDI) (formed in 1993)

Properly established with CalPERS as controlling 50% partner

Enron records gains from transactions with JEDI but does not consolidate JEDI’s debt on its balance sheet

1997 CalPERs wants to cash outEnron needs a new partner to avoid consolidating

JEDI on it balance sheetEnron executives form Chewco

Chewco invests borrowed capital (Enron guarantees Chewco debt)

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Enron : Special Purpose Entities

Success of JEDI and Chewco inspire additional SPEs

New SPEs used to:Sell hard assets to increase incomeEngage in hedging transactions

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Highly leveraged from operation 2000 Annual report shows a debt load

of $37 billion (up from $14 billion in 1999)

Many lending agreements containing debt reduction triggers

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Loan Guarantees and debt reduction triggers

Enron made promises to lenders to secure capital for itself and SPEsLoans and credit facilities contained

credit rating payment clausesIf Enron’s credit rating fell below a set level payment would become due immediately

Pledged stock and options to secure borrowings for SPEs

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Mark-to-Market Accounting Accounting and reporting standards for

marketable securities, derivatives and financial contracts are found in FAS 115 and FAS 133.

Changes in market values are reported in the income statement

Gains often determined by proprietary formulas depending on many assumptions about interest rate, customers, costs and prices

Enron often recognized revenue at the time contracts (even private) were signed based on net present value of all future estimated revenues and costs.

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The Enron culture

Incentive PlansCultivating Greed

compensation plans tightly geared to stock price

incentive to promote earnings growth and stock price

Employees focused on earnings growth instead of business lines or products

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The Enron culture

Advancement Practices Corporate Culture Promoted Self-Interest

Bottom 20% of performers forced out Incentives based on Enron’s earnings per

share (rewarded with stock options)

Practices led to:Following the letter but not the spirit of FAS 57

(and sometimes not the letter)Sold assets to SPEs, transferred stock to

SPEs to cover debts, and guaranteed loans to SPEs

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The Famous “Misleading Earnings Release” on October 16, 2001 Headline: “Enron Reports Recurring Third Quarter

Earnings of $0.43 per diluted share…”

Projected recurring earnings for 2002 of $2.15

Enron actually lost $618 million or $0.84 per share—they had mislabeled $1.01 billion of expenses and losses as non-recurring.

Shockingly, there was no balance sheet or cash flow information with the release

There was no mention of a $1.2 billion charge against shareholder’s equity, including what was described as a $1 billion correction to an accounting error

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Change in stock price

01.08.2000 15.08.2001 $42 31.10.2001 $15 28.11.2001 $0.8$0

$10

$20

$30

$40

$50

$60

$70

$80

$90

stock price

stock price

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Timelines of downfall drop of share price by 30% in the year 2000

Year 2001 :-Erratic cash flow and huge debt found by McLean

Losses from different projects like logistic and dabhole as well as from India.

resignation of CEO,Mr.Skilling.

Selling of fixed assets and projects to different in the year of 2001

On Dec 2,Enron filled bankruptcy.

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Why did Enron file for bankruptcy?

“Greed on a spectacular scale”

Following resignation of Jeff Skilling, Enron and Arthur Andersen pulled the plug on certain SPEsoriginally deemed to satisfy the

requirements for off-balance sheet treatment

review led to recategorizing SPEs and restating income and debt

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Enron’s revenues and income

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Why Enron filed for bankruptcy? The beginning of the end

October 16, 2001$544 million after-tax change related to SPEs

being consolidatedreduced shareholder equity by $1.2 billion

November – JEDI and Chewco arrangement exposedforced consolidation of JEDI financialsEnron financials for 1997-2001 restatedincreased reported debt by $711 million in 1997,

$561 million in 1998, $685 million in 1999, and $628 million in 2000

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Why Enron filed for bankruptcy? Increase in reported debt from JEDI and

Chewco led to reexamination of Enron’s debt rating by Moody’s and S&P (downgraded to barely investment grade)

Moody’s and S&P further downgrade Enron's debt to junk

Downgrading trips debt triggers in Enron loans ($4 billion becomes due immediately)

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Role of Andersen

Was paid $52 million in 2000, the majority for non-audit related consulting services.

Failed to spot many of Enron’s losses

Should have assessed Enron management’s internal controls on derivatives trading—expressed approval of internal controls during 1998 through 2000

Enron was Andersen’s second largest client

Provided both external and internal audits

CFOs and controllers were former Andersen executives

Accused of document destruction—was criminally indicted

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Role of Banks

Enron paid several hundred million in fees, including fees for derivatives transactions.

None of these firms alerted investors about derivatives problems at Enron.

• In October, 2001, 16 of 17 security analysts covering Enron still rated it a “strong buy” or “buy.”

Example: One investment advisor purchased 7,583,900 shares of Enron for a state retirement fund, much of it in September and October, 2001

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Role of Law Firms

Enron’s outside law firm was paid substantial fees and had previously employed Enron’s general counsel

Failed to correct or disclose problems related to derivatives and special purpose entities

Helped draft the legal documentation for the SPEs

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Role of Credit Rating Agencies The three major credit rating agencies—Moody’s,

Standard & Poor’s and Fitch/IBCA—received substantial fees from Enron

Just weeks prior to Enron’s bankruptcy filing—after most of the negative news was out and Enron’s stock was trading for $3 per share—all three agencies still gave investment grade ratings to Enron’s debt.

These firms enjoy protection from outside competition and liability under U.S. securities laws.

Being rated as “investment grade” was necessary to make SPEs work

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So Why Did Enron Scam Happen?

Individual and collective greed —company, its employees, analysts, auditors, bankers, rating agencies and investors

Atmosphere of market euphoria and corporate arrogance

High risk deals that went sour

Deceptive reporting practices—lack of transparency in reporting financial affairs

Unduly aggressive earnings targets and management bonuses based on meeting targets

Excessive interest in maintaining stock prices

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Changes in business practise through regulation

Corporate Record keeping and Corporate Governance

Accounting - FAS 57

Securities and Exchange Commission Rules Reporting Requirements Enforcement Authority

Lending Practices - reporting of debt triggers

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