Enron Company Enron, the 7th largest U.S. Company in 2001, filed for bankruptcy in December 2001. Enron investors and retirees were left with worthless stock. Enron was charged with securities fraud (fraudulent manipulation of publicly reported financial results, lying to SEC, etc.). Enron Corporation was an American energy company based in Houston, Texas. Before its bankruptcy in late 2001, Enron employed approximately 22,000 and was one of the world's leading electricity, natural gas, pulp, paper, and communications companies, with claimed revenues of nearly $101 billion in 2000. Fortune named Enron & “America's Most Innovative Company” for six consecutive years. Enron was originally involved in transmitting and distributing electricity and natural gas throughout the United States. The company developed, built, and operated power plants and pipelines while dealing with rules of law and other infrastructures worldwide. In just 15 years, Enron grew into one of America's largest companies, but its success was based on artificially inflated profits, dubious accounting practices, and some say “fraud”. The history of Enron falls into two distinct parts. The first act was the rise of a company that mastered, for a brief while, the "new economy" of the Information Age, the second act contained a spectacular fall from wealth and power, a cautionary tale full of accounting scandals and corporate malfeasance. Understanding the history of Enron gives clues to the complexity of modern trading markets and underscores the importance of ethical behavior in business. Origins Enron was formed in 1985 by Kenneth Lay. Lay merged his company, Houston Enron Natural Gas, with Omaha, Nebraska's InterNorth to form Enron. Lay was Enron's CEO. In addition to traditional sales and transportation of natural gas, Enron, under Lay's direction, bought into futures markets. The 1980s had seen considerable deregulation of energy markets under Ronald Reagan's presidency; this allowed Enron and other futures players to buy and sell energy futures, or contracts for delivery at a future date. The company relocated its headquarters from Omaha to Houston in 1986. Innovations Kenneth Lay brought former consultant Jeffery Skilling to join Enron in 1990. Skilling would eventually become Enron's chief operating officer; his focus was on moving Enron's business from old ways of doing business-the physical building of power plants, for instance, to a largely information-based business model. Under Skilling's plan, therefore, Enron became heavily focused on contracts for delivery of energy, as well as selling pieces of those contracts as "derivatives," matching big suppliers with smaller customers. Skilling next lead Enron, in conjunction with the company's accounting firm Arthur Andersen, to request permission to change accounting procedures. Skilling lobbied the Securities and Exchange Commission to allow Enron to use "mark-to-market" accounting, which would permit Enron to account for profits from long-term contracts in the first year of the contract. Enron history author Malcom S. Salter explains that Enron was thus the first nonfinancial company to be permitted to use the mark-to-market method. Gas prices would stabilize, further cementing Enron's appearance as a crucial firm. Business Segments Enron was divided into five different specific business segments and a sixth general unit. 1. Transportation and Distribution: This segment included regulated industries (e.g., electric utility operations), interstate transmission of natural gas, and the management and operation of pipelines. 2. Wholesale Services: This included a large portion of Enron’s trading operations, energy commodity sales and services, and financial services of wholesale customers, and the development and operation of energy-related assets (such as power plants and natural gas pipelines). 3. Retail Energy Services (Enron Energy Services or EES): Sales of energy-related products (including expertise) to end-use customers (including commercial and industrial firms). On 30 June 2001, Enron had 730,000 retail customers. 4. Broadband Services: Construction and management of fiber-optic networks; the marketing and management of bandwidth; trading bandwidth. 5. Exploration and Production: Exploration and production of natural gas and crude oil. 6. The catch-all segment: This included water and renewable energy; the supply of water and energy to end-use customers, the provision of wastewater services; construction and operation of wind generated power projects. The Retail Energy Services and Broadband Services were the two primary problem areas identified by the US Attorneys prosecuting Skilling and Lay. The Three Components While Enron was organized into five business segments and a sixth catch-all segment, it is useful in analyzing its collapse to describe Enron as consisting of three basic components: 1. A trading unit; 2. Real assets (generating and transportation); 3. Merchant assets (ownership interests in other firms). While the initial investment in the merchant assets was less than that in the other two components, it was transactions related to the merchant assets that contributed most significantly to Enron’s collapse and to Arthur Andersen’s audit difficulties. Interestingly, the problems associated with merchant assets were created not by Enron making bad merchant asset investments, but rather by the too-clever and too-imperfect efforts to insure that gains in the value of merchant assets that had been achieved were then not lost by value decreases. The objective of hedging the gains was reasonable. The means chosen to achieve the objective by the CFO Andrew Fastow were far from reasonable. Enron Products Enron traded in more than 30 different products, including the following: Products traded on Enron Online- Petrochemical, Plastics, Power, Pulp & Paper, Steel, Weather Risk Management Oil & LNG Transportation Broadband Principal Investments Risk Management for Commodities Shipping / Freight Streaming Media Water & Wastewater Energy and commodities services Capital and risk management services Commercial and industrial outsourcing services Project development and management services Energy transportation and upstream services 4. Enron’s Accounting Scandal The sudden and unexpected collapse of Enron Corp. was the first in a series of major corporate accounting scandals that has shaken confidence in corporate governance and the stock market. Only months before Enron’s bankruptcy filing in December 2001, the firm was widely regarded as one of the most innovative, fastest growing, and best managed businesses in the United States. With the swift collapse, shareholders, including thousands of Enron workers who held company stock in their 401(k) retirement accounts, lost tens of billions of dollars. It now appears that Enron was in terrible financial shape as early as 2000, burdened with debt and money-losing businesses, but manipulated its accounting statements to hide these problems. The accounting system that failed to provide a clear picture of the firm’s true condition, the independent auditors and board members who were unwilling to challenge Enron’s management, the Wall Street stock analysts and bond raters who failed to warn investors of the trouble ahead, the rules governing employer stock in company pension plans, and the unregulated energy derivatives trading that was the core of Enron’s business. What Went Wrong? Formed in 1985 from a merger of Houston Natural Gas and Internorth, Enron Corp. was the first nationwide natural gas pipeline network. Over time, the firm’s business focus shifted from the regulated transportation of natural gas to unregulated energy trading markets. The guiding principle seems to have been that there was more money to be made in buying and selling financial contracts linked to the value of energy assets (and to other economic variables) than in actual ownership of physical assets. Until late 2001, nearly all observers, including Wall Street professional, regarded this transformation as an outstanding success. Enron’s reported annual revenues grew from under $10 billion in the early 1990s to $139 billion in 2001, placing it fifth on the Fortune 500. Enron’s problems did not arise in its core energy operations, but in other ventures, particularly “dot com” investments in Internet and high-tech communications businesses. Like many other firms, Enron saw an unlimited future in the Internet. During the late 1990s, it purchased on-line marketers and service providers, constructed a fiber optic communications network, and attempted to create a market for trading broadband communications capacity. Enron entered these markets near the peak of the boom and paid high prices, taking on a heavy debt load to finance its purchases. When the dot com crash came in 2000, revenues from these investments dried up, but the debt remained. Enron also recorded significant losses in certain foreign operations. The firm made major investments in public utilities in India, South America, and the U.K., hoping to profit in newly-deregulated markets. In these three cases, local politics blocked the sharp price increases that Enron anticipated. By contrast, Enron’s energy trading businesses appear to have made money, although that trading was probably less extensive and profitable than the company claimed in its financial reports. Energy trading, however, did not generate sufficient cash to allow Enron to withstand major losses in its dot com and foreign portfolios. Once the Internet bubble burst, Enron’s prospects were dire. It is not unusual for businesses to fail after making bad or ill-timed investments. What turned the Enron case into a major financial scandal was the company’s response to its problems. Rather than disclose its true condition to public investors, as the law requires, Enron falsified its accounts. It assigned business losses and near-worthless assets to unconsolidated partnerships and “special purpose entities.” In other words, the firm’s public accounting statements pretended that losses were occurring not to Enron, but to the so-called Raptor entities, which were ostensibly independent firms that had agreed to absorb Enron’s losses, but were in fact accounting contrivances created and entirely controlled by Enron’s management. In addition, Enron appears to have disguised bank loans as energy derivatives trades to conceal the extent of its indebtedness. When these accounting fictions – which were sustained for nearly 18 months –came to light, and corrected accounting statements were issued, over 80% of the profits reported since 2000 vanished and Enron quickly collapsed. The sudden collapse of such a large corporation, and the accompanying losses of jobs, investor wealth, and market confidence, suggested that there were serious flaws in the U.S. system of securities regulation, which is based on the full and accurate disclosure of all financial information that market participants need to make informed investment decisions. The central issue raised by Enron is transparency: how to improve the quality of information available about public corporations. As firms become more transparent, the ability of corporate insiders to pursue their own interests at the expense of rank-and-file employees and public stockholders diminishes. Several aspects of this issue are briefly sketched below, with reference to CRS products that provide more detail. Why did it happen? Individual and collective greed—company, its employees, analysts, auditors, bankers, rating agencies and investors—didn’t want to believe the company looked too good to be true. 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. Key Players Personalities behind the Enron scandal Prelude to scandal Who were these men? Ken Lay, Chairman and CEO- Big picture; optimistic; tended to avoid controversy “ Ken gravitates toward good news” Jeffrey Skilling, President- Proponent of big ideas; less interested in details “ Skilling is a designer of ditches, not a digger of ditches.” Andrew Fastow, CFO- Ambitious; unwilling to let the rules get in the way “ I don’t know that he ever had a moral compass” Auditing and Accounting Issues Federal securities law requires that the accounting statements of publicly traded corporations be certified by an independent auditor. Enron’s auditor, Arthur Andersen, not only turned a blind eye to improper accounting practices, but was actively involved in devising complex financial structures and transactions that facilitated deception. An auditor’s certification indicates that the financial statements under review have been prepared in accordance with generally-accepted accounting principles (GAAP). In Enron’s case, the question is not only whether GAAP were violated, but whether current accounting standards permit corporations to play “numbers games,” and whether investors are exposed to excessive risk by financial statements that lack clarity and consistency. Accounting standards for corporations are set by the Financial Accounting Standards Board (FASB), a non-governmental entity, though there are also SEC requirements. (The SEC has statutory authority to set accounting standards for firms that sell securities to the public.) Some describe FASB’s standards setting process as cumbersome and too susceptible to business and political pressures. In response to the auditing and accounting problems laid bare by Enron and other corporate scandals, Congress enacted the Sarbanes-Oxley Act of 2002, containing perhaps the most far reaching amendments to the securities laws since the 1930s. Very briefly, the Act does the following: Creates a new oversight board to regulate independent auditors of publicly traded companies – a private sector entity operating under the oversight of the Securities and Exchange Commission; raises standards of auditor independence by prohibiting auditors from providing certain consulting services to their audit clients and requiring preapproval by the client’s board of directors for other non-audit services; requires top corporate management and audit committees to assume more direct responsibility for the accuracy of financial statements; enhances disclosure requirements for certain transactions, such as stock sales by corporate insiders, transactions with unconsolidated subsidiaries, and other significant events that may require “real-time” disclosure; directs the SEC to adopt rules to prevent conflicts of interest that affect the objectivity of stock analysts; authorizes $776 million for the SEC in FY 2003 (versus $469 million in the Administration’s budget request) and requires the SEC to review corporate financial reports more frequently; and Establishes and/or increases criminal penalties for a variety of offenses related to securities fraud, including misleading an auditor, mail and wire fraud, and destruction of records. Role of Anderson 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 Kept a whole floor of auditors assigned at Enron year around 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 Went out of business Role of Investment & Commercial 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. 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. Beginning of the End On July 13, 2001, Skilling resigned as CEO. He claimed it was for personal reasons. The real reason was that Enron was heading for trouble, and he didn’t want to face the music. There were at least five reasons that could foreseeable lead to disaster: (i) The firm’s stock was down about 40% for the year. If it kept falling, several of Fastow’s SPEs – those primarily financed with Enron stock – would be under water. (ii) India had stopped making payments for electricity generated by the Dabhol plant. Enron had shuttered the plant in May and, despite the Bush administration pressuring India on Enron’s behalf, was facing the prospect of writing off its entire $900 million investment. (iii) The company had recently spent $326 million to buy back shares of the failed Azurix water company. (iv) Severe shortages of electricity in California had led to rolling blackouts and accusations that Enron had manipulated prices. (v) The venture in bandwidth trading failed lamentably, and ventures in metals and pulp trading were racking up losses. The company was in a cash crunch and was trying to sell assets to raise cash. Skilling could see the writing on the wall, but so could most of Enron’s senior management. Many had been liquidating their holdings in Enron stock for months. The economic crisis exposed by Enron’s fall 1. The free market is shaken The ‘free’ market ideology of unregulated markets, tax breaks for the rich that allegedly ‘trickle down’ to the poor, and privatization of the public sector has been brought into question by this collapse. This ideology, championed by the likes of Enron, Bush, Congress, and many intellectuals and media pundits, has taken over our economic and social planning, but is leading directly to problems exemplified by the Enron disaster. Effective regulation and oversight, restrictions on campaign financing, and an arms length approach of government in dealing with business may have prevented this. 2. The myth of deregulation is exposed The mantra of deregulation has taken the hardest hit, especially energy deregulation, as the California power crisis and now Enron’s fall have brought under the microscope all of those deregulatory actions that have taken place over the past ten years. Proper regulation of energy supply, energy derivatives, and accounting procedures very likely would have prevented this disaster. Enron made off like bandits in the California energy crisis, as the massive rise in costs of energy translated into massive profits for suppliers like Enron. A cartel of companies including Enron is also being investigated by California state investigators for holding back the supply of power through plant shutdowns in order rapidly raise the cost and earn mega-profits. Tellingly, California’s two publicly owned utilities, in Sacramento and in Los Angeles, have both been immune to the crisis, a sign of the value of public ownership and regulation. 3. Campaign Financing Campaign Finance Reform has been given a big boost in the wake of the Enron/Andersen scandal, as the lavish amounts of funds going to Enron and Andersen have been uncovered. With Enron having spent over $6,000,000 throughout Washington over the past decade, including being George Bush’s top contributor over that period and Andersen being Bush’s 5th largest contributor in the 1999-2000 election cycle, a lot of heads have been turned in recognition of the corrosive nature of financing campaigns. 4. Wall Street’s Role Uncovered Of course, Wall Street had to have a role in all this right? Simply put, the big investment banks play two contradictory roles: one as investment bankers for the big corporations; the other, in the words of William Greider, “as stock analysts whipping up enthusiasm for the same companies’ stocks.” A scheme like this is bound to cause stock analysts to fudge a bit on the strength of a company they are investing with. The contradictory, and ultimately corrosive, nature of this dual role is spelled out with this fact: of all of the stock analysts following Enron, only one recommended that Enron stock be sold last fall as it was collapsing. 5. Enron and the case against Social Security privatization The reality that the life savings of many Enron employees were wiped out when Enron collapsed calls for the serious reconsideration of the idea of allowing taxpayers to keep part of their Social Security payments to invest in private accounts. Given the volatility of the economy today, people are beginning to see the insecurity of playing the stock market in order to see their retirement savings grow. Enron and its employees’ losses highlight this fact and also serve as a warning 6. This also about our culture of greed Though Enron, Andersen, Wall Street, and Washington are at the heart of this fiasco, we can not escape that on some level it is also about us and the culture of greed we have created. Enron, in many ways, is a reflection of our belief in everlasting stock returns, that anything goes in the search for a profit, and that the ‘new economy’ was never ending, if we just let the market decide our fate. It is about the cutthroat society we have cynically proclaimed to be ‘inevitable’. It is about the ‘values’ we hear so much of from ‘leaders’ looking for cheap political capital being stripped to their core and exposed to simply mean money. It is time we take a look at this crisis and used it as a mirror, one which lets us see that it reflects our own moral crisis. If do this, maybe next time we will see it coming.