THE

FALL

OF

ORIGINS• Kenneth Lay founded Enron in

1985 through the merger of Houston Natural Gas and Internorth, two natural gas pipeline companies.

• Lay was Enron's CEO.• The merged company owned

37,000 miles of intra- and interstate pipelines for transporting natural gas

• Changes in the regulation of the natural gas market during the mid-1980s, which deregulated prices and permitted more flexible arrangements between producers and pipelines.

• Enron, which owned the largest interstate network of pipelines, profited from the increased gas supply and flexibility resulting from the regulatory changes.

DIVERSIFICATION

• It began by reaching beyond its pipeline business to become involved in natural gas trading.

• It became a financial trader and market maker in electric power, coal, steel, paper and pulp, water and broadband fiber optic cable capacity.

• It undertook international projects involving construction and management of energy facilities

By 2001, Enron had become a conglomerate that owned and operated gas pipelines, electricity plants, pulp and paper plants, broadband assets and water plants internationally and traded extensively in financial markets for the same products and services

GROWTH• From the start of the 1990s until year-end 1998,

Enron’s stock rose by 311 %.• It increased by 56 percent in 1999 and a further 87

percent in 2000.• By December 31, 2000, Enron’s stock was priced at

$83.13, and its market capitalization exceeded $60 billion, 70 times earnings and six times book value, an indication of the stock market’s high expectations about its future prospects.

• Enron was rated the most innovative large company in America in Fortune magazine’s survey of Most Admired Companies.

• Yet within a year, Enron’s image was in tatters and its stock price had plummeted nearly to zero

CAUSES OF THE DOWNFALL OF ENRON

• The name Enron has entered the American lexicon as being synonymous with greed and excessive profit by whatever means possible. Enron was a corporation that went bankrupt and some of the outrageous corporate misdeeds occurred in an effort to stave off bankruptcy.

MARK TO MARKET ACCOUNTING

• Mark-to-the-Market accounting that was insisted upon by Jeff Skilling when he reached the highest level of management of Enron.

• Mark-to-the-Market accounting is a legitimate form of accounting for an enterprise involved in buying and selling securities. It is a very dangerous form of accounting for a firm engaged in building projects

• As one former employee stated “It was a moral hazard being able to record your profits immediately…It created many temptations”

For example, suppose a firm decides to build an electrical power plant which is going to last 50 years and is expected to bring in a net cash flow of $1 million per year. The present value of those fifty years of a million dollars a year, when the market interest rate is 10 percent, is $9.9 million. If the plant cost $4 million to construct that is a net gain of $5.9 million. Under the Mark-to-the-Market accounting system Enron was using the completion of that power plant which would show up as an entry of $5.9 million even thought the company had not yet received a penny of revenue.

OFF-THE-BALANCE-SHEET FINANCING

• Enron had a great array of foreign assets such as powerplants and pipelines that were not doing as well financially as the company hoped and counted on in its accounting.

• Enron set up a subsidiary in 1997 called Whitewing. Whitewing was created to purchase the underperforming Enron assets

• Suppose Enron built a small power plant for $8 million expecting the project to be worth $10 million and entered a $2 million profit on its books. When the power plant did not perform up to expectations and had a market value of only $7 million Enron should have cancelled the $2 million profit and entered a $1 million loss on its accounts. Instead it sold the plant to Whitewing for $10 million thus validating its booked $2 million profit. Whitewing would then sell the power plant for $7 million and get $3 million worth of Enron stock under the agreement. The $3 million of stock issued to Whitewing would not show up as a loss for Enron and thus Enron would have turned a $1 million loss on an investment into a $2 million accounting profit.

SPECIAL PURPOSE ENTITIES

• Special purpose entities are shell firms created by a sponsor, but funded by independent equity investors and debt financing.

• For example, Enron used special purpose entities to fund the acquisition of gas reserves from producers. In return, the investors in the special purpose entity received the stream of revenues from the sale of the reserves.

For financial reporting purposes, a series of rules is used to determine whether a special purpose entity is a separate entity from the sponsor. These require that an independent third-party owner have a substantive equity stake that is “at risk” in the special purpose entity, which has been interpreted as at least 3 percent of the special purpose entity’s total debt and equity. The independent third-party owner must also have a controlling (more than 50 percent) financial interest in the special purpose entity. If these rules are not satisfied, the special purpose entity must be consolidated with the sponsor firm’s business.

As Enron revealed in October 2001, they violated accounting standards that require at least 3 percent of assets to be owned by independent equity investors. By ignoring this requirement, Enron was able to avoid consolidating these special purpose entities.As a result, Enron’s balance sheet understated its liabilities and overstated its equity and its earnings

On October 16, 2001, Enron announced that restatements to its financial statements for years 1997 to 2000 to correct these violations would reduce earnings for the four-year period by $613 million and increase liabilities at the end of 2000 by $628

UNHEALTHY INTERNAL COMPETITION

• The human resources department at Enron was told to hire strong outgoing ruthless applicants.

• Enron implemented a “rank and yank’ employee evaluation system where employees ranked each other from 1 to 5 on their contribution toward the company.

• Each division was required to rank 20 percent of their employees at the lowest ranking. Employee were quick to rank others less favorable in order to increase their own standings

MISMANAGEMENT• There was also lack of control in top management.• The CEO and Chairman interchanged roles and

responsibilities. • The Board of Directors performed only a rubber

stamp duty in reviewing the actions of top management.

• Enron had developed a bonus system in which the bonus was paid when the contract was signed instead of when the contract was completed.

• This upfront bonus system encouraged managers to sign any deal regardless of the viability of the contract.

• Top managers were paid up to 3 percent of the total value of the deal, which encouraged the managers to sign as many large scale deals as possible.

• In addition, managers then tried to inflate the total value of the deal to increase their bonus levels.

• The level of inflation became so rampant that Enron Energy Services, one of the divisions of Enron, had to cancel their bonus systems since they could not afford to pay the bonus based on inflated values.

FOREIGN PROJECTS

Teeside, England: The project was the building of a gas-powered electrical generating plant at Teeside, England. Enron negotiated a long term contract with the companies operating the offshore natural gas wells. The contract called for Enron to purchase much more gas than it needed for the Teeside plant but the expectation was that Enron would be able to market the excess. The problem later turned out to be that the market price of natural gas in Britain fell below the contract price and Enron spent years resolving this problem.

The Dabnol Power Project in Maharastra State, India: The project suffered due to politics and peculiarities of IndiaEnron had invested about a billion dollars in the plant. The loss on this project alone was enough to put the Enron company into financial difficulties. But in Houston Enron had passed beyond the mundane world of profit and loss into a nether world of Special Purpose Entity financing.

The Azurix Water Company:•Wessex Water Co. was acquired and a new Enron

company called Azurix was created.•One of the first ventures of Azurix was the purchase of

a water company and franchise to supply water in the Buenos Aires area. •Azurix won the bid but its bid was almost three times

higher than the next highest bid indicating that Azurix did not know what it was doing.

• Azurix was not prepared for the differences between operating a water company in England and operating one in Argentina.

• First there was a large number of missing records of customers. There was a strong possibility that the employees of the old water company were deleting the names and records of their friends and relatives so that Azurix would have no way of knowing of their existence and billing them.

• Second the customers who came in to pay their water bills in person had no way of finding the new Azurix offices.

Extravagant Corporate Expenditures

• In the case of Enron, in the latter stage of the firm operation before its bankruptcy, the luxuries of the managers were paid for from the firm's borrowing because it had no real profits.

• Thus those extravagances were at the expense of the company's creditors rather than its stockholders

• The company had two Hawker 800‘s. • They cost $10 million a piece and cost $4200 per

hour to operate.• Enron moved up from the Hawker 800's with the

purchase of two Falcon 900's.• Falcon has a price tag of $30 million and cost about

$5200 per hour to operate

• In March of 2001, Ken Lay decided that the prestige of Enron required an even bigger airplane. He petitioned the Board of Directors of Enron for the company to purchase a GulfStream-V corporate jet. This plane would carry 16 passengers and could fly nonstop from Houston to Europe. Its cost was $42 million and it had lost only $464 million in that first quarter of 2001.

TIMELINE OF CRITICAL EVENTS FOR

ENRON IN THE PERIOD AUGUST 2001 TO DECEMBER 2001

August 14, 2001: Jeff Skilling resigned as CEO, citing personal reasons. He was replaced by Kenneth Lay.

Mid- to late August: Sherron Watkins, an Enron vice president, wrote an anonymous letter to Kenneth Lay expressing concerns about the firm’s accounting. She subsequently discussed her concerns with James Hecker, a former colleague and audit partner at Andersen, who contacted the Enron audit team.

October 12, 2001: An Arthur Andersen lawyer contacted a senior partner in Houston to remind him that company policy was not to retain documents that were no longer needed, prompting the shredding of documents.

October 22, 2001: The Securities and Exchange Commission opened inquiries into a potential conflict of interest between Enron, its directors and its special partnerships.

November 9, 2001: Enron entered merger agreement with Dynegy.November 28, 2001 Major credit rating agencies downgraded Enron’s debt to junk bond status. Dynegy pulled out of the proposed merger.

December 2, 2001: Enron filed for bankruptcy in New York and simultaneously sued Dynegy for

breach of contract

AFTERMATH• 4500 employees lost their jobs. • Investors lost some 60 billion dollars within a few

days; for many it meant losing their old-age security.• The pension fund for the company's employees was

obliterated.• Citizen’s trust in the American economic system was

destroyed.• Losses on the financial market amounted to the

worst stock value loss in peaceful times.

• The auditing firm Arthur Anderson lost its accreditation.

• The rules for company financial reporting were drastically sharpened

• The close ties of the company's founder, Kenneth Lay, to US President George W. Bush – Lay was an important financial supporter of Bush – came under sharp criticism.

• Kenneth Lay and Jeffrey Skilling were both indicted in 2004 on financial conspiracy charges; Enron accountant Richard Causey agreed to testify against the two Enron chiefs in exchange for Causey's own reduced sentence for his role in the matter.

• In 2006, Lay and Skilling were convicted of conspiracy and fraud charges. Lay passed away from heart disease in July 2006. That October, Skilling was sentenced to 24 years, four months in prison.

• In 2004, Enron emerged from bankruptcy court as Enron Creditors Recovery Corp., charged with reorganizing and liquidating assets to help repay Enron's creditors.

"The jury has spoken, and they have sent an unmistakable message to boardrooms across the country -- you can't lie to shareholders. You can't put yourself in front of your employees' interests. No matter how rich and powerful you are, you have to play by the rules."

There are somethings money cant buy.Integrity is one of them