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Enron Scandal Essay Sample

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Enron Scandal Essay Sample

Abstract

            Enron was formed through a merger between Houston Natural Gas and InterNorth and as 1985 ended, the company was in terrible financial trouble as it no longer had exclusive rights to its pipelines because of market deregulation. However Skilling turned market deregulation to Enron’s advantage by implementing the gas bank concept according to which the company invented a new financial instrument in the form of an energy derivative. According to this instrument, the company started to act as a broker between the suppliers of gas and its consumers, making money from transaction fees in the form of assuming all the associated risks. Skilling and Lay subsequently applied the same concept to electricity as well.

Skilling formed a performance review committee which created fierce internal competitive rivalry within the organizational culture. As employees started to compete with each other, the deals they struck began to have circuitous confidentiality clauses. This was facilitated by the application of the mark-to-market accounting method which allowed the company to use any valuation models that it considered advantageous. Intensifying competition and economic recession forced the company to make some bad deals and take on underperforming assets and increasing leverage. In order to hide the high debt ratio and write off its losses, Enron used thousands of Special Purpose Entities. However because of disclosures in its financial statements that analysts could make nothing of, skepticism drove the share price down throughout 2001 until the company was forced to file for bankruptcy.

Introduction

Enron fell because of creative accounting procedures that became possible as a result of the deregulation of the energy market. At the time the company was first formed through a merger, it was in great financial difficulty and its very survival was in question. However the management of the company invented some highly innovative business models that enabled the company not only to eliminate its financial woes, but also to restructure the very nature of the energy trading industry. Enron was a big proponent of deregulating the energy market and the energy trading strategies that it formulated boosted the process of deregulation.

The management of the company used the flexibility in operations that came with this deregulation to an extent that ultimately led to the imploding of its financial statements. When the company’s collapse came, some analysts worried that the lack of supply created by the company’s departure would lead to a price hike that would greatly harm the consumers. However the competitive forces that Enron had helped to unleash in the market by lobbying for deregulation had by the time of Enron’s fall developed to a point that enabled them to take up the slack left by Enron’s departure. Therefore Enron’s legacy is vast, not only in terms of the structural modifications that it helped to bring about in the energy market but also in terms of the organizational culture run amuck as a result of ruthless internal competitiveness among its employees. It was mainly this internal competitiveness that fueled the festering of unscrupulous accounting practices that led to its ultimate demise.

Early history

            Enron was formed in 1985 through a merger between Houston Natural Gas and InterNorth which was a Nebraska pipeline company (cited in Higson, 2001). The merger incurred massive debt for Enron and the situation was exacerbated by the fact that because of market deregulation, the new company no longer had exclusive rights as far as its pipelines were concerned. As a result, there was a critical need for the development of a business model that would solve the cash flow problem. To this end, Kenneth Lay, the Chief Executive Officer at Enron at the time, hired McKinsey and Co. to help Enron develop a business strategy that would take advantage of the process of deregulation unfolding in the energy market at the time. McKinsey assigned a young consultant by the name of Jeffrey Skilling to work with Enron in developing the business strategy.

The business strategy that Skilling developed was the invention of the energy derivative (cited in Stewart, 2006). What Skilling suggested was that Enron could act as a broker in trading gas between the suppliers and the consumers. Skilling termed it as the ‘gas bank’. He had had extensive experience in banking and asset and liability management and he put this experience to use in turning the company around. Enron at the time was in the gas pipeline business without any exclusive rights to any pipelines. Skilling skirted this problem by inventing a new business model whereby Enron bought gas from a network of suppliers and delivered it to consumers and to both the suppliers and the consumers the company guaranteed supply and prices at a certain level. The company assumed all the risks associated with these transactions and made money through transaction fees (cited in Culpan and Trussel, 2004). In this manner the young consultant from McKinsey and Co. invented a new instrument, the energy derivative which helped to introduce a new paradigm in the gas industry.

Organizational Restructuring

Enron had a first mover advantage with this business model and soon it had developed a network of suppliers and consumers that was bigger than any that the company’s competitors possessed. As a result of this huge network, Enron began to get more and more contracts from its consumers and suppliers and soon built up a commanding position in the industry. Because of the massive volume of transactions that was far superior to any its competitors engaged in, Enron was in an enviable position to predict what the energy prices were going to be in future. That helped the company to boost its profits further. At this time the energy derivative instrument was wildly successful and the CEO was so impressed that he created a new division under Enron called Enron Finance Corporation and hired Jeffrey Skilling to run the division (cited in Deakin and Konzelmann, 2006). Under his guidance, the division soon became the market leader in winning contracts in natural gas. The division had more suppliers and consumers and as a result more contracts than any of its competitors. The profit situation was impregnable as the company’s superior market share enabled it to predict the direction of price movements more accurately than its competitors.

            Enron had started its life through a merger as a pipeline company. But by 1990, when the Enron Finance Corporation was formed, it had become the industry’s foremost energy trading business. Thus Skilling’s new instrument, the energy derivative, had shaken up the company to the very core by changing the very nature of its business. Using his new-found influence, Skilling began to transform the organizational culture to suit the transformed image of the company. He began to hire the best and the brightest by hiring MBAs from the best business schools and though he made them work grueling long hours, he also showered them with exorbitant corporate perks. Skilling’s most significant contribution was the formation of the Performance Review Committee the purpose of which was to conduct performance appraisal on the employees (cited in Deakin and Konzelmann, 2006).

The appraisal system assigned a rating of one to five to all the employees and those who got a rating of five were thrown out and those who got a rating of one were brought closer and closer to Skilling to work with him. The performance appraisal system was formally known as the ‘350 degree performance review’ where the measurements took place in the areas of respect, integrity, communication and excellence. Formally the appraisal system took all these aspects into consideration. However, over time the employees came to feel that the only aspect that their performance was measured on was profit. Thus the strategic focus of the company became extremely short-term and it became the maximization of profits. In this respect, Enron is a classic example of what happens when an organization sacrifices long-term strategies in favor of the short-term.

That was the state of affairs prevailing in Enron at the time as the employees began to vie with each other in winning the greatest number of contracts. All other considerations were subordinated to that one objective: winning the highest number of contacts. In this area, employees found themselves in severe competitive rivalry and thus the transactions began to be clothed in secrecy in order to limit the possibility of one employee gaining an unfair advantage from the knowledge of another. Circuitous confidentiality clauses and disclosures became the order of the day in trading contracts. In this respect, Skilling instituted merit-based bonuses the only limit in which was the number of contracts that the employees could bring in (cited in Swartz and Watkins, 2005). This only whetted the competitive rivalry even further and employees began to pursue obsessively the short-term objective of getting contracts. The management of the company had no regard for what the long term consequences of this state of affairs would be.

            Trading businesses have risk management models that allow them to predict the movements of prices. The competitive rivalry at Enron was so intense in the early 1990s that employees began to disregard the confines of this model in order to get more and more contracts. As such, at this time, as the company’s ventures grew riskier, the exclusive focus on the short-term began to tell on the long-term profitability of the company.

            One of the hires that Skilling made during the early 1990s was Andrew Fastow who was an MBA from Kellogg and was 29 years of age at the time (cited in Deakin and Konzelmann, 2006). Fastow’s specialty was in creating unique financial arrangements through the complex interaction of different instruments and this specialty he put to use in Enron in creating ever more innovative financing outlets for the trading business the size of which was rising meteorically under Skilling’s leadership.

Thus Enron at this time was launching a two-pronged attack on the energy trading industry: on the one hand it had Skilling’s business model according to which Enron could ensure demand and supply of gas to both the suppliers and the consumers through a vast network of contacts that was the biggest in the country, on the other hand it had Fastow’s brilliant financial engineering through which it could ensure favorable financial arrangements to both the suppliers and the consumers (cited in McLean and Elkind, 2005). Even with the blind obsession with the short-term which Skilling’s performance review committee had brought into the company, Enron began to post record profits. Fastow became a protégé to Skilling just as Skilling was a protégé to Kenneth Lay. Fastow rose through the ranks very quickly to become the chief financial officer in 1998 (cited in Deakin and Konzelmann, 2006).

Diversification

During the 1990s, the US economy was experiencing one of the longest periods of economic prosperity and this opened up new investment opportunities. However most of the employees working in Enron at the time had not experienced such prosperity before and therefore they began to make investment decisions that were outside the confines of the risk management model practiced at the company. The company’s investments began to have increasingly higher risk elements and the situation was exacerbated by the fact that the Wall Street at this time was demanding double digit growth figures which the management of Enron was determined to deliver (cited in Fusaro and Miller, 2005). To this end Skilling, who had become the chief operating officer in 1996, began to see the possibility of expanding the energy derivative concept to other sectors of the energy industry as well.

Skilling and Lay went around the country selling the concept to power companies and they also lobbied with energy regulators to deregulate the market further so that the buying and selling of gas could be done in the electricity market as well (cited in Culpan and Trussel, 2004). In fact, the concept of buying and selling energy was applicable to whatever forms of energy were in question: steel, water, coal, paper. In 1997, the company invested $2 billon in buying up the electric utility company called Portland General Electric Corporation (cited in Deakin and Konzelmann, 2006). The concept of buying and selling natural gas and electricity was so successful that a division under Enron named Enron Capital and Trade Resources grew from $2 billion to $7 billion in revenue and the number of employees in this division rose from 200 to 2,000 (cited in Higson, 2001). Enron at this time also became a major political player as it began to put on increasing pressure on energy regulators to deregulate the energy market further.

            The formation of Enron Online was another major milestone in the company’s rise to greatness (cited in Bennett, 2006). This was an electronic commodities trading website which allowed traders to participate in transactions in all of which Enron was the counterparty. The website ensured that the traders received critical information on the ‘long’ and ‘short’ parties to the transactions and that they could also access data on commodity prices in real time.

However because Enron was a trader in all of the transactions in this website, an important issue was credit risk management. At this time Enron’s credit ratings were very high and this ensured that the website began to do business on a massive volume. EOL was an overnight success processing nearly $335 billion worth of commodity trade in 2000. Online trading was further facilitated by the internet boom that was going through the economy at the time. The internet boom meant that venture capital for technological startups was easy to find and nearly all of the startups were taking off. This widespread success was however not real and mostly on paper as the IPO market began to take off in response to booming investor expectations in technology.

            The flexibility of the energy trading concept that Skilling invented proved itself again as Enron jumped on to the Internet bandwagon by developing a high-speed broadband communications network through which the company would trade network capacity with consumers. This was application of the same business model that Skilling had applied when it came to trading gas and electricity. In addition to brokering energy deals, Enron was now brokering technology deals as well using the same concept that had catapulted the company to the commanding position in the energy market. In addition to trading in network capacity, Enron also began to offer other services through its broadband communications network. One of the first services it offered, in collaboration with Blockbuster with which it formed a partnership in July 2000, was that of providing video of demand (cited in Deakin and Konzelmann, 2006). At this time, Enron was pouring millions into its technological venture even though there were no returns to justify those investments. This was in keeping with what was happening in the rest of the technology industry.

            The technology boom occurred as e-commerce business models such as Amazon.com began to take off. E-commerce business models had the advantage of lower operating expenses because companies using these business models did not have to maintain physical facilities. These advantages prompted many entrepreneurs to build e-commerce businesses of their own and they had no problem in locating venture capital as investors were only too willing to put money in ventures which they were sure would take off in one way or the other. One way was e-commerce as mentioned before. The other was business process reengineering through the application of information technology. Major companies during the latter part of the 90s were automating their business functions or building paperless functions through the deployment of information technology. Because the economy was booming during this time, business organizations had financial statements in beautiful health and so they had all the cash they needed to invest in implementing information technology.

These factors prompted a level of demand which created the tremendous flurry of investments in the technology sector. In keeping with this trend, Enron also made massive investments in its broadband communications network even though those investments were not generating any returns. The conventional wisdom at this time was that any investments in technology were well worth the risk. As a result, Wall Street turned a blind eye to Enron’s inability to show any returns on its broadband communications network and rewarded the company with a share price of $40. This nearly doubled in August 2000 as Enron’s share price hit $80 (cited in Fusaro and Miller, 2005). All these returns were however mere consumer perceptions and had no basis in actual performance of the company’s assets. Because these astronomical figures were just mathematical constructs fashioned by the technological bubble, they would have to be discounted later on when the bubble burst. At the time however, in August 2000, Fortune magazine called Enron as one of the most admired and innovative companies in the world (cited in Fusaro and Miller, 2005).

Mark-to-Market Accounting and Its Implications

One of the creative accounting procedures that facilitated for the management to veil Enron’s earnings in secrecy was the application of the mark-to-market accounting method (cited in Swartz and Watkins, 2005). According to this method, the value of any energy-related or derivatives contracts outstanding at the end of a particular quarter had to be adjusted to fair market value and unrealized gains or losses during that period were booked to the financial statements. The complication that arose from the application of this method was that when it came to long term futures contract in gas, quoted prices were hard to find and therefore Enron had to apply its own valuation model. Valuation of long term futures contracts has been the subject of a long investigation by the Financial Accounting Standards Board’s emerging issues task force.

However the conclusion that emerged from this investigation was that a ‘one size fits all’ approach would be misleading to apply. The task force also concluded that it would not make sense to ask the management of companies applying the mark-to-market accounting method to disclose the underpinnings of their valuation models as the explanation could run for a massive number of pages and would only lead to confusion (cited in Fusaro and Miller, 2005). As a result companies like Enron using the mark-to-market accounting method were free to apply their own assumptions and methods in stating their earnings. Under constant pressure to exceed earnings estimates, the management at Enron used this state of affairs to the maximum advantage by overstating company earnings more than half of which were accounted for by unrealized trading gains in the year 2000 (cited in Deakin and Konzelmann, 2006). Investors or Wall Street had no way of verifying whether the company’s earnings were genuine or they were just accounting gimmicks.

The pressure on Enron to beat earnings estimates was exacerbated by the fact that competition was intensifying during this period. Other companies such as Dynegy, El Paso, Duke Energy were also applying Enron’s concept of energy trading and these companies were eating into Enron’s market share (cited in Culpan and Trussel, 2004). This put severe pressure on Enron’s earnings and the company was forced to use high leverage in order to maintain profitability.

As a result of the high debt-to-equity ratio, the capital structure of the company at this time began to resemble that of a hedge fund more than that of a trading company. Because market size was shrinking, Enron was no longer able to generate the level of revenue that was possible previously and as a result they turned to outside sources of financing. The shrinking size of the market was exacerbated by new entrants flooding the market at this time. The two factors of market deregulation and the revenue-generation capabilities of market volatility in energy trading drew a high number of new entrants into the industry, to the detriment of Enron’s commanding position. As a result, ironically, the same competitive forces that Enron had helped unleash in the market by promoting deregulation and by applying the energy trading concept were now corroding its balance sheets. However the worse was yet to come as the world economy headed into recession.

            As energy prices fell in the first quarter of 2001 with the world economy heading into recession, the market volatility began to disappear and so large trading gains that had been the mainstay of the company’s massive profits were no longer possible (cited in Deakin and Konzelmann, 2006). This had the effect of employees in the company desperately signing up new deals regardless of whether they were aligned to the strategic focus of the company or not. During this time, the focus was not on whether potential deals were good or bad for the company, but whether those deals had a positive net present value or not.

Even when the deals did not have a positive NPV, they were being signed up ostentatiously in the name of long term strategic advantage. This desperation on the part of Enron’s employees to strike any deals that happened to come along diluted the company’s strategic focus and corroded its assets situation even further. As a result, the importance of increasing leverage in the capital structure grew and the management at Enron continuously lobbied with credit rating agencies to enhance the company’s credit rating. In order for its credit rating to be enhanced, a company had to keep the amount of leverage within a certain range. The management at Enron made this possible by reducing its hard assets while at the same time increasing its paper profits. This served to enhance the return on asset ratio and keep the debt ratio down. The procedure that the company followed in reducing its hard assets was to make use of Special Purpose Entities.

Enron and Special Purpose Entities

            Special Purpose Entities are limited partnerships formed with outside parties. The company forming these partnerships is allowed to contribute hard assets and debt to the SPE in return for an interest (cited in Culpan and Trussel, 2004). The SPE can then carry on business on its own by borrowing without these borrowings having to be disclosed in the company’s financial statements. Thus by forming a number of special purpose entities, Enron was able to keep the level of assets down while having access to debt through the SPEs. In order to offset plunging profits, Enron was also able to sell its assets to the SPEs for a profit. In fact the range of assets that Enron used to capitalize the SPEs was extremely varied. Complex derivative financial instruments were used extensively in the capital structure of the SPEs as well as the company’s own restrictive stock (cited in Deakin and Konzelmann, 2006).

Enron also used SPEs to park troubled assets such as the broadband communications network and therefore any losses arising from these assets did not have to appear in the company’s financial statements. However, in siphoning off the underperforming assets to the SPEs, the Enron management had to assure the partnership investors returns for assuming the risk of holding these assets. In this respect, the company promised issuance of its own stock to the partnership investors (cited Stewart, 2006). However as the stock price of the company was falling precipitously during this period, Enron was incurring larger and larger obligations to its SPE partners.

Bankruptcy

            Enron used thousands of SPEs to keep up appearances in its financial statements (cited in Deakin and Konzelmann, 2006). The company engaged in extremely complex financial transactions with these SPEs which the footnotes in its 2000 financial statements did little to clarify. Thus skepticism regarding Enron’s actual financial position took root and began to grow fast as the management of the company refused to address the skeptics’ concerns. In February 2001 Kenneth Lay retired and left Skilling in charge as the Chief Executive Officer (cited in Swartz and Watkins, 2005).

In March, the partnership between Blockbuster and Enron was dissolved. All this time, share price of the company had plunged from $80 to mid $60s (cited in Deakin and Konzelmann, 2006). Risky investments that the company had made earlier began to unravel and Skilling retired within six months of being named the CEO (cited in Culpan and Trussel, 2004). In August 2001, the stock price had slipped below $30 (cited in Deakin and Konzelmann, 2006). Over the next three months, SEC began to look into the transactions between Enron and the special purpose entities forcing the company to reissue the financial statements back to 1997. The restatement revealed massive losses and after losing nearly $5 billion in cash in fifty days, the company filed for bankruptcy protection on December 2, 2001 (cited in Deakin and Konzelmann, 2006).

Conclusion

            There were two factors that led to Enron’s downfall: exclusive focus on the short term and the complex nature of the derivative instruments that it was trading in. Skilling created the sort of organizational culture where employees were desperate to sign up the maximum number of deals without any regard for their long term consequences. The complex nature of the derivative instruments also meant that the management of the company was under no obligation to explain the foundations of the valuation model that it was using in reporting the unrealized trade gains. Therefore, the general public and the analysts had to trust whatever the company was putting forward in its financial statements. This emboldened the management to undertake the highly complex transactions that it engaged in with Special Purpose Entities. Because the company was posting massive paper profits, Enron had no problem in assuring its SPE partners. As a result of the highly complex transactions that hid the financial woes of company resulting from the worldwide economic recession and intensifying competition, Enron’s share price plunged to an all time low and the company filed for bankruptcy.

References

Eichenwald, Kurt. Conspiracy of Fools. McGraw Hill/Irwin (2004)..

McLean, Bethany and Peter Elkind. Smartest Guys in the Room: The Amazing Rise and

Scandalous Fall of Amazon. Prentice Hall. (2005).

Swartz, Mimi and Sherron Watkins. Power Failure: The Inside Story of the Collapse of

Enron. Prentice Hall. (2005).

Fusaro, Peter C and Ross M Miller. What Went Wrong at Enron: Everyone’s Guide to the

Largest Bankruptcy in US History. Prentice Hall. (2005).

Deakin, Simon and Suzanne J. Konzelmann. Learning from Enron. Corporate Governance:

An International Review, 12, 134-142. (2006).

Culpan, Refik and John Trussel. Applying the Agency and Stakeholder Theories to the Enron

Debacle: An Ethical Perspective. Business and Society Review, 110, 59-76. (2004).

Higson, Chris. Did Enron’s Investors Fool Themselves. Business Strategy Review, 4, 1-6.

(2001)

Stewart, Bennett. The Real Reasons Enron Failed. Journal of Applied Corporate Finance, 18,

116-119. (2006).

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