ENRON SCANDAL One of the largest bankruptcies in

ENRON SCANDAL One of the largest bankruptcies in U. S. History: A failure of Corporate Governance? Course: Business Corporate Governance and

The Enron Scandal “Good days” - 2000 Stock price reached $90 Revenues of $101 bn “Bad days” - 2001 Stock price fell to $0, 30 Bankruptcy

A quick look in Enron’s history Dec 2001: BANKRUPTCY Oct 2001: Enron Scandal 2000 -2001: Enron’s stock price skyrockets ’ 90’s: Enron’s diversification strategy 1990: Volatility of gas prices, Enron’s “gas bank” Mid ’ 80’s: Deregulation of gas prices 1985: Foundation of Enron

Strong foundation in Energy n n Enron was founded in 1985 through the merger of Houston Natural Gas and Inter. North n 37. 000 miles of pipelines n With a wide natural gas distribution network Fast growth: Became the 7 th largest company in America n n n Core business in energy However, much of phenomenal growth was occurring through its other non-energy-related interests Profits were mainly coming from trading and brokering

Gas deregulation opens opportunities n n Deregulation of natural gas in the 1980’s led to: n Intensive competition n Deregulated / lower prices n Increased gas supply n More flexible arrangements between producers & pipelines But also it brought high volatility in prices n Increased use of spot market transactions n n Questionable market practices n n 75% of gas sales were transacted at spot prices Failure in gas supply: fictitious shortage (no legal penalties) Involved high risk for both producers & consumers

Enron: a clever strategy n Enron established a natural “gas bank” as an answer to the increased volatility in gas prices n n n Absorbed fluctuations & offered stable prices for the future (like a financial banking institution) Earned profits from energy brokering & intermediation between suppliers & buyers Enron secured stable long term prices through hedging against prices fluctuations n Offered long-term fixed price contracts with producers n Used financial derivatives: n Swaps, forward and future contracts

Enron moves away from pipelines n Enron believed that heavy assets, assets such as pipelines, were not a source of competitive advantage n n Energy brokering & commodity trading were more attractive for growth & profitability The key to dominating the trading market was information So, by late 2000, Enron owned 5. 000 fewer miles of natural gas than in 1985 Enron entered on line energy trading n Established the first operational system for transactions via internet “Heavy assets strategy” “Asset-light strategy”

Expansion with the same model n Enron expanded in new markets & commodities internationally (diversification strategy): n n n n Electric power Coal Iron Paper & pulp Water resources Optical fibres Using the same trading model n Acquiring some physical capacity in each market & then leveraging investments through: n the creation of flexible pricing structures & the use of financial derivatives for managing risks

Enron in 2000 n By early 2001, Enron had evolved to the largest buyer/seller of natural gas and electricity n n n n Revenues reached $101 billion Stock price reached $90 21. 000 employees 1. 500 salespeople 1. 800 different products 1996 - 2001 “America’s most innovative company” Ranked among the 100 most appealing employers in USA

But what went wrong? n Complex business model n n Reaching across many products & crossing national borders but with reduced physical assets Was core competitive advantage thrown away with the sale of gas pipelines? Fast expansion required huge capital investment n $10 b yearly for financing expansion to new sectors n New markets though provided low return (=yield) Financing problems n Stretched the limits of accounting

“Greed is good” culture … n n “Enron had a ruthless and reckless culture that lavished rewards on those who played the game, while persecuting those who raised objections. ” (Journal of Business Ethics) “PLAY THE GAME, EXPECT THE PAY” n n n Heavy use of stock option rewards to motivate managers towards the increase of short term stock performance Appraisal based upon how much paper profit the employee had generated (not on core values) Control from Performance Review Committee to force into line

Lax creative accounting n Hiding the true picture of liabilities n By using Special Purpose Entities (SPE) to achieve better financial reporting & attract investors n n n Debt was not reported in balance sheet Liabilities were understated while equity & earnings were overstated Fictional sales to SPE with agreement to repurchase or sham swaps n By providing minimal disclosure of its relation with SPEs n By applying mark-to-market accounting n Evaluation of assets in market prices

Accounting practices n Enron was allowed to count projected earnings from long-term energy contracts as current income n n In 1992, Jeff Skilling (then president of trading operations), convinced federal regulators to permit Enron to use the "mark-to-market“ accounting method This technique was previously only used by brokerage & trading companies The current price of long term contracts was reported as current income in the profit & loss accounts, even though this money might not be collected for many years Results improved, so the stock prices remained high n But the use of this technique, as well as some of Enron's other questionable practices, made it difficult to see how it was really making money

Special purpose entities (SPE) n n Enron had been forming off balance sheet entities to: n Move debt off of the balance sheet n Overstate earnings n Transfer risk to other business ventures These SPEs were also established to keep Enron's credit rating high n As the company's stock values were high, Enron used the company's stock to hedge its investments in these other entities

The collapse… n n The largest ever bankruptcy n Immediate lay-off of 4. 000 employees n Employees also lost their pension funds and savings Share price fall from $90 to $0, 30 n n n Loss of $70 b for stakeholders International-scale market “shock” Dissolution of Arthur Andersen, one of the five largest audit & accountancy partnerships worldwide

Enron stock price: DISASTER STROKE in December 2001 A $10, 000 investment in January 2001 was worth $6. 25 by December

Bankruptcy: events evolve fast n n n On October 16, 2001, in the first major public sign of trouble, Enron announces a huge third-quarter loss of $618 million On October 22, 2001, the Securities & Exchange Commission (SEC) begins an inquiry into Enron’s accounting practices On December 2, 2001, Enron files for bankruptcy 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, …)

Investigative Findings n 1993 -2001: Enron senior management used complex and murky accounting schemes: n to reduce tax payments n to inflate income & profits n to inflate stock price & credit rating n to hide losses in off-balance-sheet subsidiaries n n to engineer off-balance-sheet schemes to funnel money to themselves, friends & family to fraudulently misrepresent Enron’s financial condition in public reports

Corporate Governance in letter. . n On paper, Enron had remarkable corporate governance n Only 2 out of 14 members of Bo. D were insiders n n n Compensation of managers by offering company’s shares n Internal Audit Committee Exceptionable code for corporate ethics containing safeguards against conflicts of interest and self-dealing transactions Establishment of Performance Review Committee

Corporate Governance in spirit. . ? CG Failures. . in all fields: BOARD OF DIRECTORS ROLE & INDEPENDENCE AUDITING EFFICIENCY & INDEPENDENCE PAY FOR PERFORMANCE SHAREHOLDERS’ MANAGEMENT

BOARD OF DIRECTORS ROLE & INDEPENDENCE n Independent Bo. D members had other “ties” with the firm n n Bo. D members’ incumbency had been long term n n 6 of the 14 outside directors had serious conflicts of interest (Enron’s shareholders/ Shareholders of SPEs ) They had become “natives” & reluctant to question practices Kenneth Lay was both the Chairman and CEO n Concentration of power negates the possibility of the board to control management

AUDITING EFFICIENCY & INDEPENDENCE n The Enron audit committee failed (didn’t challenge transactions) n Internal Auditing – inefficient n Dependent external auditors n n n 2 of the top accountants of Enron had come from Andersen Some of the auditors had been placed to Enron’s offices, becoming imbued with the company’s corporate culture Auditors’ remuneration for 2000 reached $25 m for audit services and $27 m for consultancy

PAY FOR PERFORMANCE n Managers were compensated by stock options n n n Managers aimed at rapid short term increase of stock price But they failed to create medium or long-term value Performance Review Committee n Remunerate those who fall into line n Persecute those who object

DISCLOSURE – TRANSPARENCY – SHAREHPLDERS MANAGEMENT n Use of internal information from top management for own benefit n Gaming with shares n Investors community deception n Certain information revealed to stakeholders n n Enron took full advantage of “accounting services” to portray a rosy picture of its performance Use of substantial funds for politicians’ bribe n $6 since 1990 “The company and its chairman, Mr. Lay, may have been Mr. Bush's biggest financial backers, donating nearly $2 million to his campaigns”

Results n Corporate 2001 - Declaration of Bankruptcy n n Financial n n Sale of Fixed Assets & of profitable subsidiaries to competitors Shock for international stock markets Social n Millions of employees lost their savings, pensions & funds for their children studies

Boss charged with fraud Jeff Skilling and Kenneth Lay have been charged in a federal indictment released in June 2004 for fraud, insider trading and giving false statements to Auditors

Where Are They Now? n Jeff Skilling n n n Was convicted of 19 counts of conspiracy, fraud, insider trading and making false statements On October 23, 2006, Skilling was sentenced to 24 years in prison Kenneth Lay n n Was convicted of 6 counts of conspiracy and fraud. In a separate trial, he was also found guilty on 4 counts of bank fraud He died of heart attack on July 5, 2006, and a federal judge ruled that his conviction was void because he died before he had a chance to appeal

Where Are They Now? n Andrew Fastow (Enron’s CFO) n n n Was behind the complex network of partnerships & many other questionable practices He was charged with 78 counts of fraud, conspiracy, and money laundering & he accepted a plea agreement in January 2004 He was given a 10 -year prison sentence & ordered to pay $23, 8 million in exchange for testifying against other Enron executives

Enronomics - Enronitis “Enronomics, is a fraudulent accounting technique that involves a parent company making artificial paperonly transactions with its subsidiaries to hide losses the parent company has incurred through business activities. ” Source: Investopedia. com “Enronitis is the nervousness over a company because of suspected accounting problems. ” Source: your. Dictionary. com

Considerations Were these decisions just poor business judgments made within current laws and accounting rules? Or was the fatal flaw due to the unethical behaviour of the players? Could the strict application of ethical principles have averted this financial disaster?

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