Case study ENRON corporate governance

GROUP VI

G06102, G06122, G06127,G06140,G06141

Background of Enron Corporation(1)

Houston-based energy trading and distribution company

Famous for advocacy of energy deregulation

In just 15 years, climb to be 7th largest company in US (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 consultant

Board of director
14 members, only 2 insiders

Most of the directors owned stock

Background of Enron Corporation(2)

Employee stock ownership and retirement planning

Incentive purpose
Enhance company profit

Other shareholders:
Institutions
Management-Controlled No Single shareholder hold >20% e.g. Enron managed by professional managers

Corporations Pension funds Charities foundations Small individual investors

Key Players in the Enron Scandal

Kenneth Lay

Former CEO of Enron, helped start the company. Enron extended to him $7.5 million revolving credit line, 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 resigned on Jan. 23, 2002 He quit the Enron board altogether on Feb. 4.

Key Players in the Enron Scandal

Jeffrey Skilling

Enron's chief executive in the first half of 2001 Since joining the company in 1990, Skilling helped transform 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 insider trading

Key Players in the Enron Scandal

David Duncan

Enron's chief auditor at Anderson His job was to check Enrons accounts He is accused of ordering the shredding of thousands of Enron-related documents in an effort to hide them from Securities and Exchange Commission investigators

Andrew Fastow

Former Chief Financial Officer of Enron The mastermind behind the deceptive accounting practices Lea Fastow (his wife) also plead guilty to signing and filing a tax return that did not include income the Fastows had received from Mike Kopper

Key Players in the Enron Scandal

Sherron Watkins

Known as the "Enron whistle-blower"

Was Enron's vice president of corporate development

Wrote a letter to Kenneth Lay about suspicions of accounting improprieties" Not really a whistle-blower because she never went public with her suspicions

Broken Trust The Story of Enron 72 Pairs of Relationships

Senior Management Board of Directors Professional Associations Credit Raters

Consultants

Accountants Lawyers Analysts Investment Bankers

Enrons Bankruptcy
< Year 2001 Prosperous business performance..

2001
Jul 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) Nov Dec Overstated its profits by ~16% Bankruptcy

Oct

How did the collapse begin?

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Energy companies lobbied congress in the 1980s for deregulation of the energy business Energy policy was changed and Washington lifted controls on who could produce energy and how it was sold Ironical relationship between governmental monitoring parties and political parties Throughout all of this, Enron and its key members were making political contributions to the white house and congress. Kenneth Lay donated $100,000 to President Bush in 2000, and in 2001 Bush invited Lay to become an advisor to his transition team. In the year 2000, Kenneth Lay met three times with Dick Cheney to discuss energy policy review. When the review was published in May 2001, it was very favourable to the Enron and the energy sector.

Skillings Plan

Jeff Skilling took and aggressive approach to expand Enron by trading futures in gas contracts Under Skillings new plan Enron bet against future movements in the price of gas-generated energy Enron bought and sold tomorrows gas at a fixed price today With every trade, Enron took a cut for transaction costs Using the internet to promote trading, Enron became the most successful player in the futures game; 90% of Enrons income came from trades

ENRON in 2000-(1)

Enron took advantage of the dot.com boom and traded internet 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 the market very efficient Enron began tweaking the numbers in their financial statements with accounting techniques to hide their losses

Fuzzy Numbering

Enron created partnerships, and then passed the assets (losses) to these partnerships which eliminated the losses from their balance sheets

ENRON in 2000-(2) Condor and Raptor partnership

Andrew Fastow (Chief Finance Officer) created the partnerships Condor and Raptor were two major partnerships Sherron Watkins, the Enron Whistleblower noticed the fuzzy accounting that had been used in relationship to the Condor and Raptor partnerships and wrote a letter to Kenneth Lay and Arthur Anderson warning him that the Enron was unstable.

ENRON in 2000-(3)

Aug 14, 2001 Jeff Skilling resigned, Kenneth Lay became CEO once again. Stock prices began to fall, as investors 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 was declining, it could not recover its losses. December 2001, Enron filed for chapter 11 bankruptcy
Its share price had collapsed from about $95 to under $1.

Enrons Bankruptcy
< Year 2001 Prosperous business performance..

2001
Jul 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) Nov Dec Overstated its profits by ~16% Bankruptcy

Oct

Enrons Bankruptcy (1)

A substantial fraction of Enrons reported profits over a 4 year period (1996-2000) had been the result of accounting manipulations Investigation by special committee of the Enron board

Accounting gimmickry:

Unable to spot bad accounting practices and companys overstatement of profits The multiple conflicting roles of auditor Automatic renewal of auditing contracts Affecting the independence of auditor

Conflict of auditor:

Enrons Bankruptcy (2)

Accounting and staff policy failure

Although a professor of accounting and a dean for monitoring the company, but they all fail in their profession Disastrous loss in employees retirement fund, but the ex-CEO has cashed his own stock much earlier(Jeff skilling)

Source: Enron Posts Surprise 3rd Quarter Loss After Investment, Asset Write-Downs, Wall St. J, Oct 17, 2001

Enrons Bankruptcy (3)

Political confusion:

Ironical relationship between governmental monitoring parties and political parties

Managers attitude

Managers tend to build up their own empires and scarify the profits/benefits of the organization Enrons board of directors fail to control and oversee the management

Conflict of the board

The board had been benefited in various relationship with the company

Source: International business and strategic management at Suffolk University, Boston, US

Issues related to corporate control(1)

Stock option scheme

CEOs, Managers and employees are given STOCK OPTIONS as their compensation package Their aim is to get a maximum reporting profit so as to boost the stock price of the company

Control and Management Overlapping

Board members and corporate partnerships were not independent

Allowing private partnerships (set up by employee) to be valid Enron investment Board members could be benefited in various relationship

Issues related to corporate control(2)

Failure in Financial management

CFO badly perform his role

The financial report was very complicated to be understood

A special team of reviewing the reports fails to perform their role Over 50% of Enrons employee retirement schemes asset are invested in Enrons share All employee have a common goal to boost the stock price of the company

Employee Retirement Schemes

ENRON pit fall strategy - Investigation findings(1)

1993-2001: Enron used complex dubious energy trading schemes

Example: Death Star Energy 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.

ENRON pit fall strategy - Investigation findings(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 to fraudulently misrepresent Enrons financial

money to themselves, friends, and family;

condition in public reports.

ENRON pit fall strategy - Investigation findings(3)

One accounting Scheme

Enrons rapid growth in late 1990s involved large capital investments not expected to generate significant cash flow in short 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.

ENRON pit fall strategy - Investigation findings(4)

Enrons creation of over 3000 partnerships started about 1993 when it teamed with Calpers (California Public Retirement System) to create JEDI (Joint Energy Development Investments) fund. Enron initially thought of these partnerships as temporary solutions for temporary cash flow problems. Enron later used SPE partnerships under 3% rule to hide bad bets it had made on speculative assets by selling these assets to the partnerships in return for IOUs backed by Enron stock as collateral! (over $1 billion by 2002)

ENRON pit fall strategy - Investigation findings(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 Star Wars character Chewbacca) to buy out Calpers stake in JEDI for $383 million. Enron plans to back short-term loans to Chewco to permit it to buy out Calpers stake for $383 million.

ENRON pit fall strategy Investigation findings(6)

Chewco needs $383 million to give Calpers $240 mil loan from Barclays bank guaranteed by Enron $132 mil credit from JEDI (whose only asset is Enron stock) Chewco still must get 3% of $383 million (about $11.5 million) from some outside source to avoid inclusion of JEDIs debt on Enrons books (SEC filing, 1997).

It gets..
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ENRON pit fall strategy Investigation findings(7)

Chewco Capital Structure: Outside 3% $125,000 from William Dodson & Michael Kopper (an aide to Enron CFO Fastow) $11.4 mil loans from Big River and Little River (two new companies formed by Enron expressly for this purpose who get a loan from Barclays Bank)

Barclays Bank begins to doubt the strength of the new companies Big River and Little River.
It requires a cash reserve of $6.6 million to be deposited (as security) for the $11.4 million dollar loans. This cash reserve is paid by JEDI, whose net worth by this time consists solely of Enron stock, putting Enron in the at-risk position for this amount.

Enrons Bankruptcy
< Year 2001 Prosperous business performance..

2001
Jul 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) Nov Dec Overstated its profits by ~16% Bankruptcy

Oct