The collapse de-enron; Collapse of Enron

Era Business School, New Delhi

AJ/ Ajay K Raina; PGDM 2012-14



Plan of the Presentation

• Brief of case….. just a brush up.

• Boundaries of the case study – relating facts.

• Pictures.



Relevant Factors to the Case Study

• Social Environment – Ethics, Value and Culture.

• Political Environment – Marriage of Convenience.

• Legal Environment – Bending the Rules.



The Rise & Shine…

• 1985 – Houston Natural gas + InterNorth Omaha; Distribution of Natural gas.

• 1986 – Kenneth L. Lay becomes CEO.

• Regulated energy industry till 1980s.

• Deregulation – greater efficiency, better service and lower prices – Volatility and increased Risks.

• Jeffery Skilling’s ingenious solution – Gas Bank.

• Played Risk v/s Premium to milk the system.

• ‘Options’ and ‘Swaps’.

• 1990 – CEO of Gas Bank; 2001 – CEO of Enron; Lay becomes chairman.



• Mid 1990s – highly profitable but plateaued.

• Similar sports on identical playing grounds:-

– Electricity (from gas fired plants).

– Water and Wastewater Businesses (UK).

– Broadband (GE).

– Pulp, Paper, Lumber and Newsprint (clickpaper.com).

• 2001 – Neck deep into Metals, Spl Chemicals, Coal, Plastics, Emission Crediting, Commodities.

• 1500 traders in corporate office; 1800 products.

• 19000 employees; $100 Bn+ Revenue; 7th in F500.

…..The Rise & Shine



The Inside Story



Work Environment

• Strenuous hiring process.

• Lack of job security.

• Handsome rewards.

• Loan waivers.

• Huge compensations for top brass.



Tentacles in Politics

• Huge expenditures on lobbying.

• Large contributions towards election campaigns.

• Influenced policy making:- – Commodities Future Regulation.

– Securities and Exchange Commission.

– Commodity Future Modernization Act.



Window Dressing of Accounts

• Diversification involved high capital investments.

• Debts incurred; credibility at stake.

• A series of Special Purpose Entities (SPEs) formed through manipulation; CFO Mr Fastow played a major role in such deals.

• Existing rules violated; debts transferred to SPEs.

• Revenue manipulated by misusing clauses like:-

– Market-to-Market Accounting

– Sham swaps

– Prudency Accounting.



Hand-in-Glove • Board of Directors – loyal to individual rather than

company; huge compensations.

• Code of ethics broken.

• Auditors (Arthur Andersen) received huge fees; chose to support mal-practices. Office space shared; defied own Professional Standards Group (PSG) objections; both internal and external audits.

• Andersen worked furiously to hide important information about debts and liabilities.



Slide and Fall…

• March 2001- Media questioned share prices.

• July 2001 – Slide in share prices began.

• August – CEO, Skilling resigned; Lay took over.

• Lay makes a false claim about financial health.

• Sherron Watkins, VP and an accountant, wrote to Lay, recommending expert review.

• Lay follows her advice but only till a point.

• Vinson & Elkins, old legal pals, clear the name.

• 22 Oct - SEC probe begins; Fastow is fired.

• ‘Restatement’ of all accounts dating back to 1997.



…….Slide and Fall

• Suddenly, profits turn into losses.

• Company tries to sell itself to Dynegy (a competitor and a long time rival) for $8.9 Bn; unsuccessful.

• Rating changed to JUNK and share price ($ 90 per share 1.5 years back) dips to below $ 1.

• Tried to pull strings to secure bank loans but political and administrative pals refused to help.

• “ Companies come and go…..they get to pay the consequences of bad decisions or enjoy the fruits of good ones” – Paul O’Neill, Treasury Secretary.



Issues Involved…. • Social Conflicts.

– Claimed to be ‘Good Guys’.

– Hire and Fire policy over-shadowed ‘rewards’.

– Unethical business practices like lobbying, hiding info, manipulation of accounts and granting favours to people who mattered eg ex- bosses of regulatory bodies.

– Unethical exploitation of loop holes in the system through SPE and revenue manipulation.

– Breaking of ethic code by allowing Fastow (CFO) to be a partner in the major SPE, LJM.

– The whistle-blower.

– Sudden re-statement of finances - $ 70 Bn lost.



…..Issues Involved….

• Political Connect.

– Lay’s association with Federal Energy Commission under Nixon’s administration.

– Personal linkages with Bush family.

– Role in deregulations that meant business.

– Huge donations.

– When political masters said, “Who You!”



…..Issues Involved

• Beating Legal Tangles.

– Exemptions from oversights.

– No thorough examination of annual reports.

– “If the regulators in Washington were asleep, it was because the company had made their beds and turned off the lights”.

– SPE, MTM, Prudency Accounts formats taken for a ride.

– Auditors’ role – sham audits.

– Legal firm’s role – sham scrutiny.



Discussion Questions

• Who were the key stakeholders and to what degree were they hurt?

• What factors most contributed to the collapse?

• What steps should be taken to prevent similar events from occurring in future?



Stakeholders….

• Share holders.

• Management.

• Employees.

• Creditors.

• Customers.

• Houston Community.

• Govt.

• Auditors?

• Politicians?

• Administrative Officials?



….Stakeholders…. • Management made money and personal empires.

• Employees lost their livelihood and lifetime savings.

• Customers were left in wilderness as the services shut down.

• Houston community got affected by loss of jobs and sinking of share wealth.

• Govt made certain decisions that were made under unfair political pressures.

• Auditors, Politicians and Officials made merry.



….Stakeholders • Enron's shareholders lost $70 billion ($40 to $45 billion

was attributed to fraud).

• As Enron had nearly $67 billion that it owed creditors, employees and shareholders, it held auctions to sell assets including art, photographs, logo signs, and its pipelines.

• Only $ 15 Bn could be recovered and distributed amongst stakeholders.

• Linda, Lay’s wife, sold roughly 500,000 shares of Enron ten minutes to thirty minutes before the information that Enron was collapsing went public. She was not tried for any offence.



• Most of the points have been explained. Summary of the points is as under:-

• Fiduciary failures.

• High risk accounting.

• Extensive Undisclosed Activities.

• Conflicts of Interest.

• Excessive Compensation.

• Lack of Independence.

• Ethical Procedure Breakdown.

Factors



Recommended Steps… • While a study of the underlying factors, as

explained above, would point towards the steps required to be taken, a look at the actual steps taken in USA will give us a fair idea about the same:- – Sarbanes-Oxley Act 2002 : The mirror image.

• Establishment of the Public Company Accounting Oversight Board.

• Standards for the preparation of audit reports.

• Restriction on providing non-auditing services when auditing.

• Provisions for the independence of audit committee members.

• Executives required to sign off on financial reports

• Relinquishment of certain executives' bonuses in case of financial restatements; and expanded financial disclosure of companies' relationships with unconsolidated entities



….Recommended Steps…

• NYSE Provisions 2002:-

– All companies must have a majority of independent directors.

– Independent directors must comply with an elaborate definition of independent directors.

– The compensation committee, nominating committee, and audit committee shall consist of independent directors.

– All audit committee members should be financially literate. In addition, at least one member of the audit committee is required to have accounting or related financial management expertise.

– In addition to its regular sessions, the board should hold

additional sessions without management.



Conclusions… Common Sense

• Innovations pay.

• Foresight and inside information do help companies with connections.

• Business plans are more likely to fail than succeed.

• Expansion and diversification are alright but asset growth can not be faster than profit growth.

• Unethical practices land you in soup sooner or later.

• When ships begin to sink, rats jump off first.

• There are no permanent friends in politics.



…..Conclusions The Underlying Cause : Ethical Breakdown

• Culture – harsh (20% rule) and condescending; emphasized competition and financial goals . Implications:-

– Deception; looking good = survival.

– Hiding faults led to cheating = mass cheating.

– No sharing of info; no grooming = falling proficiency.

– Focus on money and not wealth = self interests.

– No concern for employees = no concern for company.

– Both executives and most of employees behaved unethically when they encountered conflicts of interests – political linkages, audit manipulations, share prices.



Repercussions • Here, we saw the weakness of human beings; when

the executives encountered dilemmas, they chose the wrong way.

• It took Enron 16 years to go from about ten billion dollar assets to more than sixty-five billion dollar assets, and took twenty-four days to go bankrupt.

• Employees lost their jobs and pensions, and investors lost billions of dollars.

• Two years after the collapse of Enron, Arthur Andersen went from an international firm of 36,000 employees to a state of nonexistence.



What is the Way Out? • Importance of correct corporate culture because it will

impact the decision of both the employees and employers when they face ethical dilemmas.

• Need to build and follow a robust ethics infrastructure. • It is an ethical dilemma—protecting our own interest

with a predicted harm to all the investors, or just protecting most of stakeholder’s interest and give up our own short-term interest. Ways out? – As per the Utilitarian Theory, ‘resolution of ethical dilemmas

requires a balancing effort in which we minimize the harms that result from a decision even as we maximize the benefits’.

– The Categorical Imperative theory states a standard ‘you cannot use others in a way that gives you a one-side benefit’.

– OR simply, ask ourselves the following three questions: Is it legal? Is it balanced? How does it make me feel?



Do You Find Anything in Common?

ENRON ITC

Diversification; ever rising stock prices, name and fame



Fortunately, Enron and ITC are different despite the Stated similarities.

Matter of :- - Ethics; - Time factor involved; - Efficacy of systems.



Share Price Dynamics



In the Titanic, the captain went

down with the ship. And Enron

looks to me like the captain first

gave himself and his friends a

bonus, then lowered himself and

the top folks down the lifeboat

and then hollered up and said,

'By the way, everything is

going to be just fine.‘

U.S. Senator Byron Dorgan

The collapse de-enron; Collapse of Enron

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