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Monday, October 24, 2011

The Fall of Enron

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Not so long ago, Enron’s name was amid a lexicon of corporate and political power. However in a matter of months Enron transformed from one of the greatest corporate success stories in US history to the centre of perhaps the largest corporate scandal the business community has ever seen, engulfing company executives, one of the worlds largest accounting firms, politicians and Wall street traders. This paper analysis’s the amazing journey of Enron form an organisation held in the highest of esteem by the community and envied by competitors, to its shocking demise leaving its name a disgrace and sparking a long line of investigations and criminal and civil charges laid upon its officers and accountants from burned investors and former trading partners.


In the early eighties when takeovers were the business strategy of choice, Kenneth Lay successfully fended off a hostile takeover of his pipeline company, Houston Natural Gas. It was then that Lay realised that the key to the company’s survival was, ‘to make itself to big to devour’ (Henriques 00). So in 185 Lay orchestrated the merger of his company with the largest pipeline company in the world, Internorth of Nebraska. The merged company changed its name and Lay was put in charge. Enron was born.


Initially the company was faced with enormous challenges. Beyond being saddled with debt from the merger, Enron was submerged into a rough, deregulated marketplace. Lay was not satisfied with Enron simply being a mover and seller of gas. Lay saw wide spread opportunities in the industry and moved the company into the commodities trading world of electricity, gas, wood pulp, steel, advertising time on television, insurance against credit default and later moved into the world of e-commerce adding high speed data and internet capacity to it lengthening list of company resources.


Business boomed and Enron was thriving. By 15, Enron had become the biggest participant in the natural gas industry, controlling one fifth of North Americas market (Eichenwald 00). Enron was ranked number seven by Fortune magazine in April 001 in Fortunes ranking by market capitalization of the five hundred largest corporations in the United States (Gomez 00). At its peak Enron had annual revenues of more than $100 billion, employed more than 0,000 people and was widely recognised as the biggest e-commerce company in the world � carrying a bubble era inflated stock price to match.


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Kenneth Lay, Enron’s CEO created strong relationships with many of the nations politicians, including president George W Bush as well as making large contributions to many political campaigns. By the time Mr Bush was inaugurated in 001, Enron and its executives were the largest contributors over Mr Bushes career with an amount exceeding $750 000 (Eichenwald 00), It was through these relationships in which Enron became a pioneer in deregulating Energy markets in the US. According to Mr Hebert, chairman of the Federal Energy Regulatory Commission, conversations with Mr Lay carried a clear message, ‘Enron, a generous contributor to the Bush campaign, would use its White House access to advance its interests’ (Henriques 00).


All told, Enron represented a collective investment of $10 million, however in reality it was producing minimal returns (Schultz 00). From the outside looking in few of Enron’s problems were evident.


18 saw Enron earn its highest ever annual profit. Earnings continued to rise and Enron’s stocks climbed to $0 a share, showing a promising future for the company. However, what none knew was that this success was not only unsustainable, but also was to be short lived. In mid 1, Enron executives began the manoeuvres that set the thriving company on its doomed path.


Enron was in desperate need of additional capital to continue its growth, despite the substantial debt it already held. Funding new investments by issuing additional debt or raising capital was unappealing as it diluted earnings per share and was unattractive on financial statements. Andrew Fastow, Enron’s chief financial officer was able to solve the company’s problem, or so they thought. Fastow set up several partnerships which allowed Enron to move debt off its balance sheets and provide an influx of cash flows from outside investors such as banks. The partnerships set up were defined as Special Purpose Entities (SPE). The use of SPE’s are common among US corporations. They provide that as long as at least % of capital comes from outsiders, an SPE can be left off the consolidated financial statements of the parent company (Reinstein & Weirich). This enabled Enron to raise cash flows through debt under SPE‘s without it being recorded as a debt on financial statements or disclosed to shareholders. On the surface, this arrangement represented a common financing technique decreasing the company’s risk by moving it debts to separate partnerships that were not included on the parent companies financial statements (Schultz 00). However, later it was revealed that these partnerships were used by Enron as a tool for making the company appear far more profitable than it really was. At least a dozen of these partnerships were set up.


Enron’s stock prices were the key link which enabled Enron to keep hundreds of millions of dollars of potential losses off its books. The contracts between Enron and the partnerships had provisions, called triggers, that required Enron stock prices to remain above a specific level. When Enron’s stock was trading as high as $0, the stock prices attached to these triggers were - $57.78 in one case, $47 a share in another and $8 in third. At a time when the stock prices were so high, the triggers seemed absurdly low and none though the stock would ever reach such lows (Cameron 00).


As the Nasdaq boom in technology stocks fizzled, Enron stock began to fall. Stocks hovered around $70 a share, however this was still far from the trigger prices and so alarms weren’t being raised just yet. Under accounting standards, Enron was able to keep roughly $504 million of red ink off its books as long as the SPE‘s remained financially healthy enough to fulfil their obligations. However the SPE’s were deteriorating. In March 001, accountants found ways to refinance then using a series of complex and fragile transactions, however they were merely putting off the inevitable. This allowed Enron, in April, to present first quarter results for 001, boasting $45 million in earnings, while huge losses were shuffled away in “off balance sheet” partnerships. Enron may have seemingly won the battle � but it was about to loose the war.


Enrons stocks continued to fall. By mid June 001, Enron stocks were floating alarmingly close to the trigger prices that had once seemed so ludicrously remote. “On Monday, July 001, Enron’s stocks closed at $46.66. It would never rise above $47 again” (Henriques 000).


August 14th saw the world inside Enron take another twist. Jeff Skilling, who had been made CEO just six months prior, after Lay stepped down, announced that he was resigning. Citing undisclosed personal reasons as the grounds for his decision, he left assuring investors that the finances of Enron had never been better.


By late September, Enron was essentially doomed, although it would be weeks before that reality sank in. The problems at Enron went by unnoticed by the public as the nation focused on the horror and aftermath of the September 11 terrorist attacks.


Another blow for Enron came when auditors from Anderson discovered a mistake they had made more than a year earlier. They way they accounted for Enron’s shares that had been used to finance the partnerships had incorrectly added $1 billion to the assets on Enron’s balance sheet. Correcting this mistake would reduce Enron’s assets by $1 billion. On the 16th of October Enron announced it was deducting $1 billion from its third quarter earnings, producing its first loss in more than 4 years. A loss amounting to $5 million. As a result October saw Enron stocks fall to around $0 a share and continued to decline heavily.


In late October another bomb was dropped. It appeared that Chewco, one of Enron’s SPE’s which had been treated as an independent entity which housed millions of dollars of debt, did not meet the accounting requirements of such. This meant that all Enron’s prior transactions with Chewco had essentially been transactions with itself, constituting a criminal act.


Lay, who had stepped back as CEO after the resignation of Skilling, realised Enron was in over its head and began looking for options to save the troubled company. After exhausting almost all options there appeared a light at the end of the tunnel for Enron. After talks with one of Enron’s long time rivals, Dynergy Inc, it appeared that a merger between the two companies was the answer.


On the surface, the Dynergy deal seemed to be Enron’s salvation. Boards of the two companies tentatively agreed to the merger on November 7th 001. Enron shortly after was forced to announce that its financial performance since 1 had been an illusion, largely created by Fastows partnerships and the manipulation of SPE’s. Correcting the improper accounting for its dealings with these partnerships meant that $600 million in previously reported profits were wiped out (Reinstein & Weririch 00).


The downward spiral for Enron was beginning to reach the end of the road. The company was hemorraging cash. A week after signing the merger agreement Enron burnt through $ billion and was not able to account for a large portion of where the money had gone. Payment on many debts were accelerated due to the troubles Enron was experiencing. Enron owed $60 million, payable within days. On November 0th Enron’s shares closed at $6. a share. As a result of the recent events Dynergy terminated the merger. It appeared Enron’s had reached the end of its downhill slide.


At 4.8 am December nd Enron officially filed the petition for bankruptcy. The game had ended. Enron’s audacious climb to Success ended in a dizzying plunge.


001 had seen Enron take on a new mission to become “the worlds greatest company” (Eichenwald 00). Today Enron is renoun as the world’s greatest story as the biggest, fastest corporate collapse in American history.


The demise of Enron can be largely attributed to its relationship and dealings with the partnerships it created. A weakened economy in the wake of the Nasdaq tech stock burst and September 11th also assisted in the company’s deterioration. However other issues inside the company also played a key role. Corporate culture inside Enron has been speculated as a major contributor to Enron’s brutal collapse. It was a culture of greed and arrogance which breed excessive secrecy. An insider described Enron’s culture as “ an adrenaline driven culture, with an obsession of 15% a year or better growth” (Fox 00). Enron also had a rank or yank policy � anyone not ranking well was subject to be yanked. “Employees who were yanked sometimes had just 0 minutes to get their things together and leave” (Packer 00).


The controversy surrounding Enron has seen the formation of many jokes which circulate the industry. “What is business school morality? It is the ethic that says the purpose of every living creature on Earth is to increase shareholders value. It says that conduct is acceptable if it passes an audit and pleases Wall Street analysts.” (Packer 00). “What is tooth-fairy economics? It is a body of knowledge that ignores the implications of expecting endless growth. If a company isn’t growing at a rate of 0% compounded annually, management is deemed to be incompetent” (Packer 00). While it is of a satirical nature, Packer does successfully reflect on the culture which existed inside Enron.


At the centre of the Enron storm is the accounting firm Arthur Anderson. Anderson was both, Enron’s external auditor as well as their internal accountant and advisor. Enron was Anderson’s second biggest client. Last year alone it collected $5 million in audit fees, and even more for it’s accounting and advisory work (Grey 00). This remains one of the most highly debated issues in the US today, should a public firm serve both as an auditor and a consultant? Anderson failed to raise the alarms regarding a number of accounting scandals which inevitably bought the company to its knees. Whilst Anderson denies any wrong doing, including the shredding of documents relating to Enron, is has admitted to “an error in judgement” in its treatment of Enron’s ‘off balance sheet’ vehicles which led to an overstatement of profits by more than $600 million between 17 and 000 (Reinstein & Weirich 00).


In the tragic demise of America’s seventh largest corporation there is no one person can be held accountable. Auditors who had multiple and conflicting roles did not raise alarms about improper financial statements. Directors failed in their duty to closely question management and accountants, and thus failed to ferret out the accounting irregularities. Lawyers and company officers set up partnerships that concealed the true financial plight of the company. Rating agencies yielded to the entreaties of management and only slightly downgraded credit ratings at a time when the company was failing. While Wall Street analysts from companies such as Goldman Sachs continually recommended Enron stock, even as it plummeted. As those on the outside wonder in disarray how a company boasting such power and success could collapse in just 11 months, many on the inside are still amazed that the troubled empire remained as long as it did. In essence the collapse was the result of a highly flawed vision; the consequences essentially inevitable.


Bibliography


1. Davis, J (00), “The Enron Factor”, ABA Journal, Chicago, April.


. Eichenwald, K (00), “Web of Detaild Did Enron In as Warnings Went Unheeded”, New York Times, Feb 10th.


. Eichenwald, K (00), “Audatious Climb to Success Ended in a Dizzying Plunge”, New York Times, Jan 1th.


4. Fox, L (00) “Enron The Rise and Fall”, Harper Collins Publishers, NY.


5. Goldstein, J (001), “What Was Enron”, Wall Street Journal, New York, Dec 1th.


6. Gomez, L (00), “Enron � a case for better understanding cash flows”, Business Credit, New York, Jul/Aug


7. Henriques, D (00), “Seeking a quick fix; Struggling to avoid posting huge losses, Newsweek, Jan 4th.


8. Holman, W & Jenkins, J (00), “Enron for Beginners”, Wall Street Journal, New York, Jan rd.


. Kaufman, H (00), “The Fall Out From Enron; Lessons and Consequences”, Vital Speeches of the Day, New York, May 15th.


10. Packer, A (00), “Enron � the movie”, Machine Design, Cleveland, May th.


11. Reinstein, A & Weirich, T (00) “Accounting Issues at Enron”, CPA Journal, New York, Dec.





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