Enron Case Study 09-12-2013

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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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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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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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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






Jul

Oct

Nov

DecBankruptcy

2001

< Year 2001


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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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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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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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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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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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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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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






Jul

Oct

Nov

DecBankruptcy

2001

< Year 2001


Documents

Enron Case Study 09-12-2013