Enron Scandal - MBA Case Study Notes

Enron Scandal - MBA Case Study Notes
By: Lars Holbech Sorensen

Resource http://www.mba-outline.com

Enron Scandal:
In the year 2000, Enron Corporation was the seventh-largest company on the Fortune 500 list of the largest companies in the United States and had been declared as America's ''most innovative company'' by the 'Fortune' magazine for six straight years. Its share price had climbed from $ 10 a share in 1991 to over $ 90 a share in 2000 while its revenue jumped from $31 billion to more than $100 billion in just two years from 1998 to 2000. No one could have predicted at the time that in the following year the company would be filing for bankruptcy, badly shaking the investors' confidence and effectively signalling the end of the longest bull-run in the American stock exchange's history. This paper looks at the collapse of Enron from an accounting perspective. It also includes a discussion of the reasons for the debacle, the ethical issues involved and how Enron was able to hide its precarious financial position from the public until the very end.
Enron's Birth: The Beginning of the End?
Enron was born as result of a 1985 merger of Houston Natural Gas and InterNorth-a Nebraska based gas pipeline company. The seeds of its eventual demise, were perhaps, sown at the very start: the company had incurred heavy debts during the merger process and, as a result of deregulation of the gas pipelines, no longer had exclusive right to its pipelines. (Thomas, p. 41) In order to solve Enron's formidable cash, credit and profit problems, Kenneth Lay (CEO and later Chairman of board) turned to Jeffery Skilling-a young consultant with a banking and liability management background. Skilling's innovative ideas about creation of a ''gas bank'' so impressed Lay that he hired the young Skilling to head a new division in Enron- Enron Finance Corp. This was the start of Enron's transformation from 'boringly predictable' and regulated Gas Company into one of the largest energy traders --a market middleman for energy that would eventually dominate the trading of energy contracts and financial instruments known as derivatives. While overseeing Enron's domination of the market for natural gas contracts, Skilling proceeded to hire some of the brightest talent from the top MBA schools and turned them into high-flying traders with incentives to ''eat what they killed.'' (Thomas, pp. 41-42) One of Skilling's earliest hires and special favourites was Andrew Fastow, a Kellogg MBA who was promoted as chief financial officer (CFO) in 1998. He was responsible for overseeing the financing of the company through ever more 'innovative' and complicated means. Hailed as the most successful ''cabal of cowboy/ traders from Houston'' the trio of Lay, Skillings, and Fastow oversaw Enron's dizzying rise and equally sudden fall-the company's weaknesses being in-built in its troubled birth and in the wrong turns it took from the start.
Enron's Risky Operations
When Skillings became the Enron's CEO in 1996, he convinced Kenneth Lay (the then Chairman of the board) to extend the gas trading concept to the trading of electricity as well. As Enron's revenues sky-rocketed in its initial forays into wholesale buying and selling of gas and electricity, the company was emboldened to extend the trading concept into almost any commodity that could be traded, i.e., futures contracts in coal, paper, steel, water and even weather. (Thomas, p. 42) Taking advantage of the growing use of the Internet, Enron started Enron Online (EOL) in October 1999-- an electronic commodities trading Web site, that was hugely successful almost overnight, doing online commodities trade worth $335 billion in 2000 alone.
The next frontier for Enron was the exciting new world of broadband communications. In January 2000, the company unveiled an ambitious plan that envisioned setting up of a high-speed broadband telecommunications network to trade network capacity, or bandwidth, in the same way it traded electricity or natural gas. Enron also planned to provide video on demand to customers world-wide via high-speed Internet lines. While hundreds of millions of dollars were being pumped in by Enron in such ventures, its stock price was sky-rocketing and reached an all-time high of $ 90 in August 2000.
During the times when Enron was making huge profits due to highly volatile energy prices, and there was widespread perception about the unlimited potential of online trade and technology innovations such as the broadband, things looked very rosy for the company. In the late 1990s, however, other energy companies such as Dynergy, Duke Energy, and El Paso started to enter the field of energy trading and the competition started to eat into the huge profit margins of Enron. Other factors such as falling energy prices in early 2001, the approaching world-wide recession and the broadband bubble burst began to work against Enron's 'dream' run. The company, in the meantime, had embarked on a culture of cutting trading deals that had a momentum of its own that was hard to stop.
Ethical Issues
Setting the Wrong Examples
Although Enron had its own set of Ethical Code, it was more of a paper document that existed in its rarely read manuals rather than a practiced, living document. The environment and corporate culture at the company was focused on making ''deals'' and increasing Enron's share value, while the ''outdated, theoretical concept of ethics and morality'' was kept on the back-burner.
Since actions speak louder than words, Enron's 'ethics' was personified by Kenneth Lay's exercising of his stock options and pocketing profits, even as he was promoting Enron shares as a bargain to employees. It was also reflected in the action of some Enron executives who pressurized a brokerage company (UBS PaineWebber) to take action against a broker who advised some Enron workers to sell their shares. (Wee, ''Corporate Ethics'') Other Enron employees, down the line, were therefore more likely to follow the example of its top executives in looking after their own interests and driving up the share value by whatever means, rather than adhering to the company's 'Ethical Code.'
Influencing Regulatory Laws
Arthur Levitt, the former chairman of US Security Exchange Commission (SEC) in his book ''Take on the Street'' highlights the extent of the pressure put by lobbyists to influence regulatory policies. A letter from Kenneth Lay, which is reproduced in the book, ''respectfully urges'' Levitt to re-think his pro-regulation policies, contending that the prevailing rules had been beneficial to his company. (Manjoo, salon.com)
Enron lobbied incessantly for energy deregulation: It played a major role in the drafting of the WTO's General Agreement on Trade in Services (GATS), with a view to opening up and deregulating energy markets around the world. (Pha, ''Capitalism in a Nutshell.'') In 1993 Enron persuaded the SEC to grant it an exemption from a law that prevented utilities from diversifying into unrelated risky businesses. (Marjorie) It was also able to get exemption from the Investment Company Act of 1940 that allowed the company to leave debt from foreign power plants off its books. The exemption encouraged Enron to enter into dubious offshore partnerships, which played a part in its ultimate undoing.
Other important regulations that Enron was able to circumvent by its lobbying efforts include the Glass-Steagall Act of 1933, which had separated commercial from investment banking. Enron also successfully opposed regulation for derivatives trading, and Enron's auditor, Arthur Anderson, did not let a proposal to separate auditing and consulting practices take effect. (Marjorie)
Conflicts of Interest
The Enron scandal is a text-book case for studying the damaging consequences of conflict of interest situations. Apart from the aforementioned exercising of stock options by Kenneth Lay and Anderson's consulting as well as auditing for Enron, others were also involved in 'conflict of interest' partnerships with the firm. For example J.P. Morgan, while underwriting bonds for Enron, was involved in trading derivatives contracts with the company, had a substantial share in Enron stock, and was lender of billions of dollars to the firm. At the same time, J.P. Morgan, as a brokerage and investment firm was responsible for analysing Enron's stock and kept recommending the company's share as a strong buy until substantial irregularities in Enron's financial health became public. (Ibid.) In addition, Enron's CFO, Andrew Fastow made millions in profits by doing business with the firm through secret limited partnerships. (Holtzman et. al., p. 26)
Raptor Oddities
Enron was able to hide its precarious financial position and highly risky operations largely through circumvention of accounting rules in order to artificially increase earnings through ''Raptors'' or Special Purpose Entities (SPEs). Although SPEs are legitimate instruments to access capital or hedge risk by using them as limited partnerships, without having to report debt on its balance sheet, Enron under Fastow's guidance made use of SPEs to ''park'' troubled assets that were falling in value, such as Enron's troubled overseas energy facilities, and its broadband operation. Thousands of SPEs were used by Enron to conduct business, some of them owned by Fastow himself. As an example of the several dubious accounting practices by Enron, one of these SPEs, one of the SPEs--the LJM partnerships, invested in another group of SPEs (known as the Raptor vehicles) to hedge an Enron investment in a bankrupt broadband company, Rhythm NetConnections. Enron issued its common stock in exchange for a note receivable of $1.2 billion for capitalization of the Raptor entities. Enron increased its notes receivable and shareholders' equity to reflect the transaction and failed to consolidate the LJM and Raptor SPEs into their financial statements, which are a violation of the existing accounting practices. (Holtzman et. al., p. 27-29; Thomas, p. 43) Several other examples of ''Raptor oddities'' were also discovered during investigations into the Enron scandal.
Conclusion
The meteoric rise and fall of Enron Corporation is a classic example of how market euphoria in times of an extended bull-run, individual greed, conflict of interest, disregard for ethical business, and unrelenting focus on increasing share value can combine to spell disaster. The scandal also exposes the misplaced trust placed on the benefits of deregulation by proponents of laissez faire economy. It highlights the shortcomings in accounting standards and the profession's self-regulatory mechanism. It reveals how the 'holes' in various regulatory laws can be exploited by clever but unethical professionals to mislead the investors and even hard-nosed experts. The silver lining in the whole unsavory episode, however, is that the scandal has provided enough material for the students and professionals from a number of fields such as accounting, management and business ethics (as well as the law makers) to study and come up with solutions so that such serious irregularities are not repeated in the corporate world in future.