Free «The Fall of Enron» Essay Paper

Introduction

The fictional superhero Spiderman once said, “With great power comes great responsibility.” This balance between power and responsibility exists not just in our personal life, but also in business. Peter Drucker stated that “There is neither a separate ethics of business nor is one needed” and that “the ultimate responsibility of the company directors is not to hurt.” (Drucker, 1981) Business ethics include several guidelines, ranging from social responsibility of the business towards the environment; responsibility of the company towards its shareholders, that is, maximizing shareholder value without any unethical practices; fair inter-company dealings and negotiations, be it during the normal business cycle or for special events such as take-overs and mergers; protection of its stakeholders, including employees, customers and the public in general; and, the fundamental business of the company, such as ensuring the use of quality products, hiring legal labor and paying them at least minimum wage, and not spreading false rumors about their products. (King, 2011)

Enron Corporation was originally set up in 1932 as Northern Natural Gas Company in Nebraska and it was only in the mid-1990s that the name was changed to Enron. The company was led by Kenneth Lay and during the late 1990s and 2000, it was considered to be America’s most innovative company. It was started as a natural gas producer and marketer and slowly diversified into several energy and energy related projects across more than 30 countries. It also started acting as a trader and service provider for energy related matters and expanded its business portfolio across multiple lines.

 

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Enron’s business was divided into 3 main units – wholesale services, that dealt with marketing of many commodities; energy service or retail of energy related services to commercial and industrial companies; and a global services unit that comprised of its pipelines business as well as wind and hydro energy projects across the globe and EnronOnline, a global commodity e-commerce website.

Enron’s was also one of the loudest voices fighting the case for deregulation of energy during the California crisis. While market data was confidential, a 40% YOY increase in Enron’s reported earnings during the second quarter of 2001 sparked speculation that Enron was one of the companies to profit from deregulation of energy and had manipulated energy prices to profit out of California’s poor deregulation plan.

Enron’s fall from the most innovative and fastest growing company to a bankrupt business with a “opaque business model” was primarily due to its unethical business practices and botched up financial accounting, where debts were kept off the balance sheet and profits were added even before they were made just in order to keep the stock price up. Stock prices went off the charts and reached unrealistic levels, but analysts kept pushing and promoting the stock without any in-depth knowledge about the company’s work. In fact, merely two months before Enron declared bankruptcy, analysts recommended its stock as a “strong buy”.

The primary aim of this research paper will be to delve into the details of the Enron case and bring to light the main reasons behind Enron’s fall. Secondarily, it will talk about the side effects of Enron’s bankruptcy and its effects on its stakeholders. Further, it will cover the changes that were made in the laws after the Enron case so as to ensure that the accounting systems become more transparent for the future and such crises can be prevented.

The Fall of Enron

Enron was named “America’s most innovative company” by Fortune magazine for eight consecutive years from 1992 to 2000 and during this period, it was a favorite amongst stock analysts. From the early 1990s to 1998, the value of Enron’s stock increased by 311%. In 1999, it rose another 56% and during 2000, it gained an astonishing 87%. During these 2 years, the stock index in comparison to Enron’s stock growth of over 190% had only risen by an average 8%. This surge in share prices was attributed to Enron’s diversification into trading and service and its acquisition of several pipelines and energy related projects in many parts of the world.

In the mid-1980s, regulatory changes allowed Enron, the owner of the largest interstate network of natural gas pipelines, to make huge profits. Skilling, who later became Enron’s CEO, created a natural gas “bank” which acted as an intermediary between suppliers and buyers and signed long-term fixed price deals with both parties; to ensure that they did not lose money due to price fluctuations, Enron used financial derivatives, and indulged in future trading. An online trading portal EnronOnline was created to reach out further and better management and negotiate financial contracts. Skilling believed that by divesting some of Enron’s heavy assets, like pipelines, they would be able to operate better with a higher return on investment and so the company sold large chunks of its pipelines and focused more on its financial transaction business.

Following this, Enron decided to expand its portfolio to include financial trading and market creation for electric power, steel, coal, water, paper, pulp and broadband fiber optic cables. By this, it stepped out of its comfort zone of production and supply and entered into  management and service-oriented sectors. Enron’s chosen markets were typically fragmented, with complicated distribution systems and opaque pricing. The strategy for this diversification remained unclear. However, blinded by the pace of its growth, nobody questioned or challenged the sustainability of profits from these markets and the immense increase in its stock prices until much later.

While in its natural gas production and supply business, the accounts listed the costs and revenues of actual leading to a transparent understanding of its finances, Enron’s trading business was based on long-term contracts and its accountants started using a mark-to-market method of accounting where they kept a record of all future earning forecast in their books. In some cases, the net present value of future revenues was mentioned as profits regardless of the viability of such contracts. Often, Enron’s books continued to recognize future profits from contracts even long after they had been called off and had in actual, resulted in losses. Eventually, when these profits could no longer be included due to failure of contracts, new income had to be included from more similar projects so as to keep the income growing and to make investors happy. Enron also booked costs of failed projects as assets regardless of what the money spent on the project had resulted in and whether or not it would be useful in the future. Their rationale behind such a strategy was that there had been no official announcement that the project had been cancelled. Almost $200 million had been listed on Enron’s records as such “profits” by 2001.

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Secondly, for some of its financial transactions, Enron relied on investments by special purpose entities. Ideally, special purpose entities are shell firms funded by independent investors or debt financing and are used to hedge the risks involved in large transactions or acquisitions, by getting these projects funded by special purpose entities. However, Enron’s purpose of using special purpose entities was to keep debts off their books. For example, a special purpose entity, Chewco, was created by an Enron executive and raised debt guaranteed by Enron in order to buy out the stake of its partner in one of its joint venture firms. However, Enron did not consolidate either Chewco or cost of acquiring the joint venture’s shares into its books, but went ahead and added the earnings generated from this acquisition into its profit. By 2001, Enron had used several hundred of such entities to conceal its debts from its books. Accounting standards require that independent equity investors own at least 3% of the assets in special purpose entities. Enron, however, chose to ignore these legal requirements and as a result understated its debt and overstated its earnings and assets in its balance sheet. The exact dimensions of these misevaluations were brought to light when in late 2001, Enron announced that it would be restating its financial statements from 1997 to 2000, reduced declared earnings by $613 million (23%), increased liabilities by $628 million (6%) and reduced equity by $1.2 billion (10%).  (Healy & Palepu, 2003)

Enron had reassured its investors that the company’s investments were hedged against risk by the use of special purpose entities. Enron’s typical style was to set up a partnership firm using its stock as funding. The partnership firm would then set up a special purpose entity, which would hedge Enron’s contracts or investments in future trading by compensating for any decline in value of the contract or losses incurred on it. When the value of such investment declined, the SPE compensated Enron for it using Enron’s own money and this compensation was reported as profit in Enron’s books. However, the investors were unaware that the company guaranteed these hedges using their own stock and finances, removing all protection from risk. Often, these special purpose entities involved key employees as partners and they made a lot of money in these transactions, thereby reducing profits for Enron shareholders.

By keeping debts and losses out of its account statements, Enron was able to hide the reality of its state of affairs and its unsuccessful ventures. The company took complete advantage of the loopholes in accounting standards and in some cases, even went against the law, kept its books in consistent profit.

Thirdly, even in its trading deals where Enron served as an agent or intermediary party between seller and buyer, they listed the full value of the transactions as revenue instead of reporting only their trading or brokerage fee. By following this strategy, Enron’s revenues increased by more than 750% from 1996 to 2000, compared to the average growth rate of 2-3% prevalent in the energy industry.

The employee compensation system was short sighted and aimed at promoting short-term earnings for the company by rewarding high-volume deals with little or no thought to the assurance and quality of profits from them. Often employees hurried to close deals in order to maximize their bonuses and this led to failed contracts and losses in the long term perspective. Skilling also believed that following a cost-centric approach with the employees hindered creativity and encouraged high salaries and expense accounts. Also, stock options were a preferred form of reimbursement and bonuses for top management and this was another reason why the Enron stock value kept rising.

Even Enron’s financial auditors, Anderson et al., were extremely highly paid, and this was later considered to be one of the reasons of their lax auditing of Enron’s books. In 2000, Enron paid Anderson a sum of $52 million for its consultation and auditing services. The company, in return, forced the auditors to delay writing off the debts and special purpose entities and registering losses. Anderson and his team had to ensure that Enron’s books reported increasing profits year by year and kept up with the company’s earning expectations so that the stock prices kept rising. Later, when the truth about Enron’s accounting standards was revealed and investigations were in progress, Anderson, in order to cover up his footsteps, shredded all documents related to the case.

By the end of year 2000, some voices were being raised against Enron’s opaque transactions and the involvement of senior officials in insider trading. In March 2001, Bethany McLean wrote an article in the Fortune magazine titled “Is Enron overpriced?”. However, till as late as October 2001, analysts continued to support Enron and institutional buyers still held over 60% of the stock. Analysts continued to promote the Enron stock despite the cloud that surrounded its future perspective. They failed to logically calculate that given its past performance (assuming the reported growth to be accurate), Enron’s revenues needed to grow at the rate of 60% per annum for the next 10 years and at 10% per year thereon. However, since 1996 to 1999, the average growth rate for Enron had only been 13.1%, so such high anticipations of growth were unrealistic. It appeared that fund managers based their perception of the Enron stock only on the purchase and sale of the stock by investors rather than by logically analyzing the company’s performance.

In August 2011, Skilling resigned from the post of CEO, a decision later revealed to be taken due to the falling stock prices of Enron, and Kenneth Lay reassumed the position. Lay, in an attempt to placate investors and calm the speculation, claimed that due to Enron’s risk hedging and taxation strategies

Once the financial irregularities and accounting failures were revealed, Enron’s stock price fell by half, and in October 2001, credit rating agencies like Moody’ and Standard and Poor dropped Enron’s rating drastically, so that it was barely over junk level. Since Enron’s business model was dependent on the outside funding and raising debt from the market, there was news that it was seeking financing of $1-2 billion and it faced bankruptcy unless a way out was sought. On November 8, 2001, Dynegy, a much smaller firm compared to Enron, agreed to acquire Enron at a price of around $8 billion in stock, of which $1 billion was paid upfront and the remaining amount was to be paid when the acquisition was completed. Dynegy would take over Enron with its debt of about $13 billion and any other debt that may not have been obvious yet. It was assumed that the “hidden” debt might amount to as much as $10 billion.

Analysts’ opinion about the stock stabilized in the light of these developments, however, when Enron declared that it had overstated profits by $613 million (almost 23% of the actual) in its books from the year 1997 to 2000, and accounting mistakes of over $800 million in its October 2001 accounts, Dynegy had the option of either backing out or renegotiating its deal. S&P announced that in case the acquisition deal was cancelled, it would further drop Enron’s credit rating to high B, which is equivalent to junk level.

In order to reduce its scale, Enron planned to sell assets worth $8 billion and disclosed that debts worth almost $9 billion were due for repayment by the end of 2002, an amount that was hugely in excess of available funds. It was also revealed that Enron had managed to exhaust borrowed funds of over $5 billion in just 50 days, while Dynegy was unaware of Enron’s rate of spending. Still, despite Dynegy’s dwindling faith in Enron’s business and since it was legally difficult for them to pull out of the acquisition contract unless something drastic happened, Dynegy renegotiated the contract and agreed to buy Enron for $4 billion rather than the previously decided $8 billion.

However, on November 28, 2001, Dynegy pulled the plug on the proposed contract and Enron’s stock price fell to $0.61 and its credit rating was reduced to junk level. Enron’s liabilities were estimated to be around $23 billion and filing for bankruptcy was now inevitable. On November 30^th 2001, Enron’s European division officially filed for bankruptcy, making it the largest bankruptcy in American history. In December, Enron filed a suit against Dynegy for canceling its acquisition contract with “significant reason”. On January 17 2002, Enron, citing its accounting consultancy and destruction of documents to be the reason for its downfall, fired Anderson. In January, Kenneth Lay stepped down from the post of CEO and Enron only revived a little when Stephen Cooper was appointed as Enron’s CEO in 2002.

In 2004, Enron re-emerged with a new board of directors and sued 11 financial institutions for helping the previous Enron team hide the actual position of Enron’s finances and eventually obtained nearly $20 billion from these institutions. The company has been using this money and proceeded from sale of Enron’s assets to settle creditor claims.

The Repercussions of the scandal

The Enron debacle was one of the worst financial scandals in the corporate history of the U.S and also one of the most embarrassing situations for American analysts. It was the worst possible fall for a company of that stature and the biggest audit failure in history. Enron had assets worth $63.4 billion when it filed for bankruptcy, making it the biggest ever bankruptcy declared in the USA up till 2001. Stock prices that had reached an all-time height of $90 per share fell to lower than $1 in a span of less than a year and a half and shareholders lost an estimated $11 billion. However, Enron did not go alone, along with it went not only its stockholders and stakeholders, but also the auditing firm associated with and several innocent creditors.

Arthur Anderson that was prior to 2001 one of the five largest and most prestigious audit and accountancy partnerships in the world never recovered from the scandal and lost several prestigious clients. In 2002, when it became clear that Anderson would face criminal charges, there were talks about a possible takeover by KPMG, E&Y, or Deloitte. More than 18000 employees at Anderson lost their jobs and the partnership was eventually dissolved.

4000 of Enron’s employees lost their jobs and the stock options of nearly 15000 employees, which had been worth $83 per share only months ago, were now worth almost nothing. Top Enron officials also faced criminal investigation and several including CFO Fastow, Lay and Skilling were indicted.

Since most of Enron’s assets had been used as security against loans, stockholders received hardly anything from the bankruptcy proceedings. In addition, Citigroup and JP Morgan Chase, that had aided in raising debt for Enron and several unsecured creditors lost huge amounts of money.

Steps taken to prevent future “Enrons”

Post the fall of Enron, the Securities and Exchange Commission strengthened its enforcement tools, increased strictness and the chances of criminal indictment in cases of financial fraud. The Oxley bill, which came out in 2002, directed the SEC to form an independent Public Regulatory Fund, comprising of a majority of non-accounting professionals, which would be responsible for “auditing” the quality of audits. The bill also prohibited audit companies from providing consultancy to their clients and made it mandatory to disclose on what basis certain accounting policies had been selected by the companies, a practice that would lead to better transparency of accounts. In addition, immediate disclosure of any inside trading was required by organizations.

The President, in response to the Enron scandal proposed a “ten point plan” the gist of which was that investors would be given access to financial reports and were made aware of the risks the company faced and the CEO and company officials would be responsible for ensuring ethical business practices. The company leaders would also have to inform the public whenever they bought or sold company stock for their own gain. Accounting standards were to be followed in order to ensure achievement of the best practicies and an independent regulatory board would be responsible for ensuring adherence (Dickey & Buchholz, 2002).

The board of directors of a company would be responsible to oversee the management and along with the Audit Committee, to ensure that the audit is fair and the disclosures transparent. Training in finance and auditing was suggested for board members so that their decisions would be more informed. Since most of the top management at Enron was reimbursed partly with stock options, the SEC suggested that firms be required to consider stock options as an expense and sales restrictions be imposed on sale of stock options by employees.

However, before the 2003 elections, some of these reforms have been rolled back and some have been made more relaxed, but the liability of such frauds still lies on the shoulders of the top management, the board, and the auditors.

Summary

Enron’s fall from grace was one of the biggest financial scandals in American history as it was reduced from being America’s seventh largest company to the largest bankruptcy ever declared in USA till 2001.

The crisis was the result of its “unconventional” and opaque accounting techniques where debts and losses were kept off its accounts in order to keep the share price high. The company cared more about the appearances of success rather than success itself and even its investment in failed projects was mentioned in its books as profits as the projects had not been “officially cancelled.” Investments were raised by secretly keeping its own stock and assets and this money was in turn invested in risky projects, giving investors the outward appearance of a hedged risk while in fact, the threat of risk was very real.

Analysts blindly promoted the stock without analyzing the reality behind such unprecedented growth in stock prices and the share prices touched unsustainably high levels. It was only much later that attention was called onto the poor internal policies and auditing flaws reflected in Enron’s books. In 2001, Enron was engulfed in a cloud of suspicion and had no alternative but to restate its financial statements and drastically reduce reported earnings and assets and increase reported liabilities and debts.

Its credit rating fell to just above junk level and it could no longer garner investments from the market, resulting in huge losses and near closure of operations. Dynegy agreed to purchase Enron, but further revelations of heavy debt and misuse of funds led to a cancellation of this contract. Since a takeover was the only thing that could have saved Enron at that time, Enron had to file for bankruptcy in November 2001, and its top employees along with the auditors faced criminal investigation for financial fraud.

Conclusions

The Enron case brought to light the lax way with which analysts and auditing firms had been working. The fact that Enron’s stock had been recommended as a “strong buy” by several analyst firms such as Lehmann Brothers and Merrill Lynch in October 2001, hardly two months before the company had to file for bankruptcy, cast a shadow of doubt on the workings of such firms and the reliability of their forecasts. However, such errors of judgment are commonplace in the business world where analysts believe in “following the herd” and such situations have led to the Enron debacle like the dot-com bubble. Analysts need to understand that the purpose of their existence is to help investors identify good investment options from the bad by gathering and understanding the companies’ financials, anticipated growth, and sustainability of this growth and not merely to inform them of what people are buying or selling presently.

Auditing firms often treat their clients as their bosses, succumb to pressure and forget that their actual job is to check the legality and thoroughness of the accounts. Anderson, for instance, should focus more on ensuring that the books reflect the true state of the company rather than trying to make them more appealing to investors by overstating profits and understating debts and losses. Some firms, knowing that their knowledge is far superior to those of businessmen and finance personnel in terms of accounts, have started giving their clients consultancy on ways to manipulate or cloud their books. This practice is unethical and already the Securities and Exchange Commission has proposed that auditing firms sell their consulting businesses or eliminate such departments altogether.

Strict disclosure norms need to be put in place to make sure that external finance, and debts raised from the market by giving securities are mentioned in accounts and investors are aware of the risks the companies face.

Business ethics are growing in importance and the management team and the board of directors need to take their responsibility towards investors and the public seriously. Conflict between personal and business interests often exist when employees are given performance bonuses based on value of contracts and audit firms have high paying long term contracts with companies. The solution is to base performance incentive for employees on the basis of the profits they rake in as per real time and, in case of auditing firms, to routinely switch auditors and accounting firms to ensure that the accounts remain prejudice free and report a clear picture of the company’s accounts and finances.

This case, moreover, offers a great lesson to investors that following market rallies without an in-depth understanding of the company’s finances is never a good idea. Many financial crises have resulted from investors blindly following analysts’ recommendations and it is essential for an investor to remain informed about the reasons behind the rise or fall of the share prices, the long term plans and financial projections of a company, the strategy it follows, the industry it operates in and the competition it faces.

While the SEC and government norms became strict immediately after the Enron and WorldCom crisis that followed, it has now returned to its previous lax ways. Unless auditory reforms are taken seriously and loopholes in accounting standards are not filled up, the economy will always be sitting on a time bomb waiting to explode, causing harm not just to the company but to all stakeholders alike.

The concept of special purpose entities was especially interesting and more value could have been added to this paper if a deeper understanding of these entities could be gathered, especially on the lines of whether they served another purpose also or were they solely meant to mislead investors and analysts.