Enron

The Rise and Fall of Enron

When a company looks too good to be true, it usually is.

By C. William Thomas April 2002

If you’re like most, you’ve been astonished, disillusioned and angered as you learned of the meteoric rise and fall of Enron Corp. Remember the company’s television commercial of not so long ago, ending with the reverberating phrase, “Ask why, why, why?” That question is now on everyone’s lips. The Enron case is a dream for academics who conduct research and teach. For those currently or formerly involved with the company, such as creditors, auditors, the SEC and accounting regulators, it’s a nightmare that will continue for a long time.

Formal investigations of Enron are now under way, headed by the company’s board, the SEC, the Justice Department and Congress. The exact causes and details of the disaster may not be known for months. The purpose of this article is to summarize preliminary observations about the collapse, as well as changes in financial reporting, auditing and corporate governance that are being proposed in response by Big Five accounting firms, the AICPA and the SEC. IN A WAY IT'S SIMPLE, IN A WAY IT'S NOT

On the surface, the motives and attitudes behind decisions and events leading to Enron’s eventual downfall appear simple enough: individual and collective greed born in an atmosphere of market euphoria and corporate arrogance. Hardly anyone—the company, its employees, analysts or individual investors—wanted to believe the company was too good to be true. So, for a while, hardly anyone did. Many kept on buying the stock, the corporate mantra and the dream. In the meantime, the company made many high-risk deals, some of which were outside the company’s typical asset risk control process. Many went sour in the early months of 2001 as Enron’s stock price and debt rating imploded because of loss of investor and creditor trust. Methods the company used to disclose (or creatively obscure) its complicated

financial dealings were erroneous and, in the view of some, downright deceptive. The company’s lack of transparency in reporting its financial affairs, followed by financial restatements disclosing billions of dollars of omitted liabilities and losses, contributed to its demise. The whole affair happened under the watchful eye of Arthur Andersen LLP, which kept a whole floor of auditors assigned at Enron year-round. THE BEGINNING PRESAGES THE END

In 1985, after federal deregulation of natural gas pipelines, Enron was born from the merger of Houston Natural Gas and InterNorth, a Nebraska pipeline company. In the process of the merger, Enron incurred massive debt and, as the result of deregulation, no longer had exclusive rights to its pipelines. In order to survive, the company had to come up with a new and innovative business strategy to generate profits and cash flow. Kenneth Lay, CEO, hired McKinsey & Co. to assist in developing Enron’s business strategy. It assigned a young consultant named Jeffrey Skilling to the

engagement. Skilling, who had a background in banking and asset and liability management, proposed a revolutionary solution to Enron’s credit, cash and profit woes in the gas pipeline business: create a “gas bank” in which Enron would buy gas from a network of suppliers and sell it to a network of consumers, contractually guaranteeing both the supply and the price, charging fees for the transactions and assuming the associated risks. Thanks to the young consultant, the company created both a new product and a new paradigm for the industry—the energy derivative.

Lay was so impressed with Skilling’s genius that he created a new division in 1990 called Enron Finance Corp. and hired Skilling to run it. Under Skilling’s leadership, Enron Finance Corp. soon dominated the market for natural gas contracts, with more contacts, more access to supplies and more customers than any of its competitors. With its market power, Enron could predict future prices with great accuracy, thereby guaranteeing superior profits. THE BEST, THE BRIGHTEST AND THE DREADED PRC

Skilling began to change the corporate culture of Enron to match the company’s transformed image as a trading

business. He set out on a quest to hire the best and brightest traders, recruiting associates from the top MBA schools in the country and competing with the largest and most prestigious investment banks for talent. In exchange for grueling schedules, Enron pampered its associates with a long list of corporate perks, including concierge services and a

company gym. Skilling rewarded production with merit-based bonuses that had no cap, permitting traders to “eat what they killed.”

One of Skilling’s earliest hires in 1990 was Andrew Fastow, a 29-year-old Kellogg MBA who had been working on leveraged buyouts and other complicated deals at Continental Illinois Bank in Chicago. Fastow became Skilling’s protg in the same way Skilling had become Lay’s. Fastow moved swiftly through the ranks and was promoted to chief

financial officer in 1998. As Skilling oversaw the building of the company’s vast trading operation, Fastow oversaw its financing by ever more complicated means.

As Enron’s reputation with the outside world grew, the internal culture apparently began to take a darker tone. Skilling instituted the performance review committee (PRC), which became known as the harshest employee-ranking system in the country. It was known as the “360-degree review” based on the values of Enron—respect, integrity, communication and excellence (RICE). However, associates came to feel that the only real performance measure was the amount of profits they could produce. In order to achieve top ratings, everyone in the organization became instantly motivated to “do deals” and post earnings. Employees were regularly rated on a scale of 1 to 5, with 5s usually being fired within six months. The lower an employee’s PRC score, the closer he or she got to Skilling, and the higher the score, the closer he or she got to being shown the door. Skilling’s division was known for replacing up to 15% of its workforce every year. Fierce internal competition prevailed and immediate gratification was prized above long-term potential. Paranoia

flourished and trading contracts began to contain highly restrictive confidentiality clauses. Secrecy became the order of the day for many of the company’s trading contracts, as well as its disclosures. HOW HIGH THEY FLY

Coincidentally, but not inconsequentially, the U.S. economy during the 1990s was experiencing the longest bull market in its history. Enron’s corporate leadership, Lay excluded, comprised mostly young people who had never experienced an extended bear market. New investment opportunities were opening up everywhere, including markets in energy

futures. Wall Street demanded double-digit growth from practically every venture, and Enron was determined to deliver. In 1996 Skilling became Enron’s chief operating officer. He convinced Lay the gas bank model could be applied to the market for electric energy as well. Skilling and Lay traveled widely across the country, selling the concept to the heads of power companies and to energy regulators. The company became a major political player in the United States,

lobbying for deregulation of electric utilities. In 1997 Enron acquired electric utility company Portland General Electric Corp. for about $2 billion. By the end of that year, Skilling had developed the division by then known as Enron Capital and Trade Resources into the nation’s largest wholesale buyer and seller of natural gas and electricity. Revenue grew to $7 billion from $2 billion, and the number of employees in the division skyrocketed to more than 2,000 from 200. Using the same concept that had been so successful with the gas bank, they were ready to create a market for anything that anyone was willing to trade: futures contracts in coal, paper, steel, water and even weather.

Perhaps Enron’s most exciting development in the eyes of the financial world was the creation of Enron Online (EOL) in October 1999. EOL, an electronic commodities trading Web site, was significant for at least two reasons. First, Enron was a counterparty to every transaction conducted on the platform. Traders received extremely valuable information regarding the “long” and “short” parties to each trade as well as the products’ prices in real-time. Second, given that Enron was either a buyer or a seller in every transaction, credit risk management was crucial and Enron’s credit was the cornerstone that gave the energy community the confidence that EOL provided a safe transaction environment. EOL became an overnight success, handling $335 billion in online commodity trades in 2000.

The world of technology opened up the Internet, and the IPO market for technology and broadband communications companies started to take off. In January 2000 Enron announced an ambitious plan to build a high-speed broadband telecommunications network and to trade network capacity, or bandwidth, in the same way it traded electricity or natural gas. In July of that year Enron and Blockbuster announced a deal to provide video on demand to customers throughout the world via high-speed Internet lines. As Enron poured hundreds of millions into broadband with very little return, Wall Street rewarded the strategy with as much as $40 on the stock price—a factor that would have to be discounted later when the broadband bubble burst. In August 2000 Enron’s stock hit an all-time high of $90.56, and the company was being touted by Fortune and other business publications as one of the most admired and innovative companies in the world.

THE ROLE OF MARK-TO-MARKET ACCOUNTING

Enron incorporated “mark-to-market accounting” for the energy trading business in the mid-1990s and used it on an unprecedented scale for its trading transactions. Under mark-to-market rules, whenever companies have outstanding energy-related or other derivative contracts (either assets or liabilities) on their balance sheets at the end of a particular quarter, they must adjust them to fair market value, booking unrealized gains or losses to the income statement of the period. A difficulty with application of these rules in accounting for long-term futures contracts in commodities such as gas is that there are often no quoted prices upon which to base valuations. Companies having these types of derivative instruments are free to develop and use discretionary valuation models based on their own assumptions and methods. The Financial Accounting Standards Board’s (FASB) emerging issues task force has debated the subject of how to value and disclose energy-related contracts for several years. It has been able to conclude only that a one-size-fits-all approach will not work and that to require companies to disclose all of the assumptions and estimates underlying earnings would produce disclosures that were so voluminous they would be of little value. For a company such as Enron, under

continuous pressure to beat earnings estimates, it is possible that valuation estimates might have considerably overstated earnings. Furthermore, unrealized trading gains accounted for slightly more than half of the company’s $1.41 billion reported pretax profit for 2000 and about one-third of its reported pretax profit for 1999. CAPITALISM AT WORK

In the latter part of the 1990s, companies such as Dynegy, Duke Energy, El Paso and Williams began following Enron’s lead. Enron’s competitive advantage, as well as its huge profit margins, had begun to erode by the end of 2000. Each new market entrant’s successes squeezed Enron’s profit margins further. It ran with increasing leverage, thus becoming more like a hedge fund than a trading company. Meanwhile, energy prices began to fall in the first quarter of 2001 and the world economy headed into a recession, thus dampening energy market volatility and reducing the opportunity for the large, rapid trading gains that had formerly made Enron so profitable. Deals, especially in the finance division, were done at a rapid pace without much regard to whether they aligned with the strategic goals of the company or whether they complied with the company’s risk management policies. As one knowledgeable Enron employee put it: “Good deal vs. bad deal? Didn’t matter. If it had a positive net present value (NPV) it could get done. Sometimes positive NPV didn’t even matter in the name of strategic significance.” Enron’s foundations were developing cracks and Skilling’s house of paper built on the stilts of trust had begun to crumble.

RELATED PARTIES AND COMPLEX SPECIAL PURPOSE ENTITIES

In order to satisfy Moody’s and Standard & Poor’s credit rating agencies, Enron had to make sure the company’s leverage ratios were within acceptable ranges. Fastow continually lobbied the ratings agencies to raise Enron’s credit rating, apparently to no avail. That notwithstanding, there were other ways to lower the company’s debt ratio. Reducing hard assets while earning increasing paper profits served to increase Enron’s return on assets (ROA) and reduce its debt-to-total-assets ratio, making the company more attractive to credit rating agencies and investors.

Enron, like many other companies, used “special purpose entities” (SPEs) to access capital or hedge risk. By using SPEs such as limited partnerships with outside parties, a company is permitted to increase leverage and ROA without having to report debt on its balance sheet. The company contributes hard assets and related debt to an SPE in exchange for an interest. The SPE then borrows large sums of money from a financial institution to purchase assets or conduct other business without the debt or assets showing up on the company’s financial statements. The company can also sell leveraged assets to the SPE and book a profit. To avoid classification of the SPE as a subsidiary (thereby forcing the entity to include the SPE’s financial position and results of operations in its financial statements), FASB guidelines require that only 3% of the SPE be owned by an outside investor.

Under Fastow’s leadership, Enron took the use of SPEs to new heights of complexity and sophistication, capitalizing them with not only a variety of hard assets and liabilities, but also extremely complex derivative financial instruments, its own restricted stock, rights to acquire its stock and related liabilities. As its financial dealings became more

complicated, the company apparently also used SPEs to “park” troubled assets that were falling in value, such as certain overseas energy facilities, the broadband operation or stock in companies that had been spun off to the public. Transferring these assets to SPEs meant their losses would be kept off Enron’s books. To compensate partnership

investors for downside risk, Enron promised issuance of additional shares of its stock. As the value of the assets in these partnerships fell, Enron began to incur larger and larger obligations to issue its own stock later down the road. Compounding the problem toward the end was the precipitous fall in the value of Enron stock. Enron conducted

business through thousands of SPEs. The most controversial of them were LJM Cayman LP and LJM2 Co-Investment LP, run by Fastow himself. From 1999 through July 2001, these entities paid Fastow more than $30 million in

management fees, far more than his Enron salary, supposedly with the approval of top management and Enron’s board of directors. In turn, the LJM partnerships invested in another group of SPEs, known as the Raptor vehicles, which were designed in part to hedge an Enron investment in a bankrupt broadband company, Rhythm NetConnections. As part of the capitalization of the Raptor entities, Enron issued common stock in exchange for a note receivable of $1.2 billion. Enron increased notes receivable and shareholders’ equity to reflect this transaction, which appears to violate generally accepted accounting principles. Additionally, Enron failed to consolidate the LJM and Raptor SPEs into their financial statements when subsequent information revealed they should have been consolidated. OBSCURE DISCLOSURES REVEALED

A very confusing footnote in Enron’s 2000 financial statements described the above transactions. Douglas Carmichael, the Wollman Distinguished Professor of Accounting at Baruch College in New York City, told the Wall Street Journal in November of 2001 that most people would be hard pressed to understand the effects of these disclosures on the

financial statements, casting doubt on both the quality of the company’s earnings as well as the business purpose of the transaction. By April 2001 other skeptics arrived on the scene. A number of analysts questioned the lack of transparency of Enron’s disclosures. One analyst was quoted as saying, “The notes just don’t make sense, and we read notes for a living.” Skilling was very quick to reply with arrogant comments and, in one case, even called an analyst a derogatory name. What Skilling and Fastow apparently underestimated was that, because of such actions, the market was beginning to perceive the company with greater and greater skepticism, thus eroding its trust and the company’s reputation. IT ALL COMES TUMBLING DOWN

In February 2001 Lay announced his retirement and named Skilling president and CEO of Enron. In February Skilling held the company’s annual conference with analysts, bragging that the stock (then valued around $80) should be trading at around $126 per share.

In March Enron and Blockbuster announced the cancellation of their video-on-demand deal. By that time the stock had fallen to the mid-$60s. Throughout the spring and summer, risky deals Enron had made in underperforming investments of various kinds began to unravel, causing it to suffer a huge cash shortfall. Senior management, which had been voting with its feet since August 2000, selling Enron stock in the bull market, continued to exit, collectively hundreds of millions of dollars richer for the experience. On August 14, just six months after being named CEO, Skilling himself resigned, citing “personal reasons.” The stock price slipped below $40 that week and, except for a brief recovery in early October after the sale of Portland General, continued its slide to below $30 a share.

Also in August, in an internal memorandum to Lay, a company vice-president, Sherron Watkins, described her

reservations about the lack of disclosure of the substance of the related party transactions with the SPEs run by Fastow. She concluded the memo by stating her fear that the company might “implode under a series of accounting scandals.” Lay notified the company’s attorneys, Vinson & Elkins, as well as the audit partner at Enron’s auditing firm, Arthur Andersen LLP, so the matter could be investigated further. The proverbial “ship” of Enron had struck the iceberg that would eventually sink it.

On October 16 Enron announced its first quarterly loss in more than four years after taking charges of $1 billion on poorly performing businesses. The company terminated the Raptor hedging arrangements which, if they had continued, would have resulted in its issuing 58 million Enron shares to offset the company’s private equity losses, severely

diluting earnings. It also disclosed the reversal of the $1.2 billion entry to assets and equities it had made as a result of dealings with these arrangements. It was this disclosure that got the SEC’s attention.

On October 17 the company announced it had changed plan administrators for its employees’ 401(k) pension plan, thus by law locking their investments for a period of 30 days and preventing workers from selling their Enron stock. The company contends this decision had in fact been made months earlier. However true that might be, the timing of the decision certainly has raised suspicions.

On October 22 Enron announced the SEC was looking into the related party transactions between Enron and the partnerships owned by Fastow, who was fired two days later. On November 8 Enron announced a restatement of its financial statements back to 1997 to reflect consolidation of the SPEs it had omitted, as well as to book Andersen’s