Internet and Enron
Robert M. Hayes
2002
Overview
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Preface
The Internet and Enron
Equity Funding Corporation of America
Deregulation
Preface
 This presentation will discuss the relationships between the
Internet and Enron, the largest bankruptcy in the history
of the United States and, apparently, one of the most
massive cases of corporate fraud ever perpetrated.
 It will cover the available data on the history leading up to
the bankruptcy and roles of the Internet in the operations
of Enron.
 It will then present an earlier case of proven fraud that has
striking parallels to the case of Enron (Equity Funding, in
1973) .
 It concludes with a discussion of the role of “deregulation”
as the context for Enron operations, including arguments
both pro and con.
The Internet and Enron
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The Start as a Gas Pipeline Company in 1985
Deregulation
Enron Finance in 1990
Enron Communications and Internet Structure
Enron Online and Internet Brokering
Enron and the Market in Broadband
The Catches—one after another!
The Collapse
Enron and E-Mail's Lasting Trail
The Fallouts
Gas Pipeline Company in 1985
 In 1985, Kenneth Lay, using proceeds from junk bonds,
combined his company, Houston Natural Gas, with
another natural-gas pipeline to form Enron. From that
start, the company then moved beyond selling and
transporting gas to become a big player in the newly
deregulated energy markets by trading in futures
contracts. In the same way that traders buy and sell
soybean and orange juice futures, Enron began to buy
and sell electricity and gas futures.
Deregulation
 In the mid-1980s, oil prices fell precipitously. Buyers of
natural gas switched to newly cheap alternatives such
as fuel oil. Gas producers, led by Enron, lobbied
vigorously for deregulation. Once-stable gas prices
began to fluctuate.
 Then Enron began marketing futures contracts which
guaranteed a price for delivery of gas sometime in the
future.
 The government, again lobbied by Enron and others,
deregulated electricity markets over the next several
years, creating a similar opportunity for Enron to trade
futures in electric power.
Enron Finance in 1990
 In 1990, Lay hired Jeffrey Skilling, a consultant with
McKinsey & Co., to lead a new division—Enron
Finance Corp.
 Skilling was made president and chief operating officer
of Enron in 1997.
 Even as Enron was gaining a reputation as a "neweconomy" trailblazer, it continued—to some degree
apparently against Skilling's wishes—to pursue such
stick-in-the-mud "old-economy" goals as building
power plants around the world.
 Enron's Overseas Boondoggle Probe: The bankrupt
energy trader's grandiose, U.S-funded projects, which
sprouted in places no other firm would go, appear not
to have earned it a dime. With operations in 20
countries, Enron Corp. set out in the early 1990s to
become an international energy trailblazer, with
grandiose projects and huge U.S. government-backed
investments in places no other company would go.
 Enron launched bold projects in poverty-ravaged
countries such as Nigeria and Nicaragua. It set up huge
barges--with names like Esperanza, Margarita and El
Enron--in ports around the world to generate power for
energy-starved cities.
 In mid-February 2002, the Overseas Private
Investment Corp., which backed many of the projects,
moved to stem its $1-billion Enron exposure by
canceling $590 million in loans to the company, once
one of its largest clients. Enron had missed deadlines
for OPIC requirements in financing projects in Brazil,
an OPIC spokesman said. OPIC's decision shifted more
of the burden for the troubled projects from the U.S.
government to Enron's creditors, lenders and partners.
 System Encouraged Executives to Gamble
 Like other parts of Enron's vast operation, its
international division was fueled by intense internal
competition and huge financial incentives.
Executives pocketed multimillion-dollar bonuses for
signing international deals under a structure that
based their rewards on the long-term estimated
value of projects rather than their actual returns.
The system encouraged executives to gamble
without regard to risk, said Louis Wells, a Harvard
Business School professor who has studied Enron's
overseas investments.
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Enron's international investment totaled more than
$7 billion, including more than $3 billion in Latin
America, $1 billion in India and $2.9 billion to
develop a British water-supply and waste-treatment
company.
It enlisted U.S. ambassadors and secretaries of
State, Commerce and Energy to buttonhole foreign
officials. Enron cultivated international political
connections, recruiting former government officials
and relatives of heads of state as investors and
lobbyists.
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In reports to investors, the company played down or
obscured what analysts and others saw as inevitable
losses. But in an interview with academic
researchers nine months ago, Jeffrey K. Skilling,
who then was chief operating officer, conceded that
Enron "had not earned compensatory rates of
return" on investments in overseas power plants,
waterworks and pipelines. Skilling said the projects
had fueled an "acrimonious debate" among
executives about the wisdom of its heavy foreign
investments.
An internal investigation released this month
showed that two foreign projects, in Brazil and
Poland, were entangled in Enron's off-the-books
partnerships, accounting devices controlled by thenChief Financial Officer Andrew S. Fastow that
shielded huge debts from investors.
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The report showed that Enron engaged in an
unusual transaction to add $65 million to the
revenue of the Brazilian pipeline project before it
had even been completed. The Polish plant was
briefly sold to an insider partnership and sold back
to Enron a few months later. Those arrangements
allowed Enron to present a more optimistic report to
investors.
Other partnerships at the center of the Enron
investigation also were involved, an Enron
spokesman said. The Whitewing partnership had
interests in the Trakya power plant in Turkey and
Elektro, a power distributor in Brazil. It also owned
a controlling interest in Promigas, a natural gas
pipeline operator in Colombia, and the Sarlux
power plant in Italy.
Another partnership, called Ponderosa, had
interests in the CEG, CEGRIO and Gaspart gasdistribution companies in Brazil, the Centragas
distribution system in Colombia and the TGS gas
transportation company in Argentina.
 U.S. Supplied Billions for Enron Expansion
 The U.S. government has been a major backer of
Enron's overseas expansion. Since 1992, OPIC
provided about $1.7billion for Enron's foreign deals
and promised $500million more for projects that
didn't go forward. The Export-Import Bank put
about $700 million into Enron's foreign ventures.
Both agencies provide financing and political-risk
insurance for foreign projects undertaken by U.S.
companies.
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Enron already has filed a $200-million claim with
OPIC in connection with its troubled power plant in
Dabhol, India, which is up for sale but considered
unlikely to recover Enron's full investment.
OPIC spokesman Larry Spinelli said Enron was
notified Wednesday that the agency would not
proceed with processing $590 million in loans. Asked
if they could be resurrected as Enron attempts to
restructure under bankruptcy protection, Spinelli
said, "Not under these circumstances. This is over
now." Enron spokesmen declined to discuss the
foreign projects in detail but acknowledged trouble
at certain projects.
"There might have been some where we paid too
much," Enron spokesman John Ambler said. "And
there are others where there have been operational
difficulties. But a large number of them are still
good."
Enron Communications
 January 21, 1999: “Enron Communications, Inc.,
introduced today the Enron Intelligent Network (EIN),
an application delivery platform … that will enhance
the company’s existing … fiber-optic network to create
next generation applications services. The EIN brings
to market a reliable, bandwidth-on-demand platform
for delivering data, applications and streaming rich
media to the desktop.
 “The Enron Intelligent Network architecture is based
on a unique approach to networking through
distributed servers … that supports the development
and maintenance of distributed applications across
network environments.”
Enron Communications
 “In November 1999, Enron Communications (as a
wholly owned subsidiary of Enron) joined with Inktomi
Corporation in a strategic alliance in which the Inktomi
Traffic Server cache platform was to be integrated into
the Enron Intelligent Network. The objective was to
offer high quality network performance and bandwidth
capacity to support broadband content distribution
and e-business services. The integration of Inktomi's
caching software into the Enron Intelligent Network
was to enhance the ability of Enron Communications to
seamlessly and selectively push content to the desktop
while handling massive volumes of high bit rate
network traffic in a scalable manner.”
Enron Communications
 About Inktomi: ”Inktomi develops and markets
scalable software designed for the world's largest
Internet infrastructure and media companies.
Inktomi's two areas of business are portal services,
comprised of the search, directory and shopping
engines; and network products comprised of the Traffic
Server network cache and associated value-added
services. Inktomi works with leading companies
including America Online, British Telecom, CNN,
Excite@Home, GoTo.com, Intel, NBC's Snap!,
RealNetworks, Sun Microsystems, and Yahoo!. The
company has offices in North America, Europe and
Asia.”
EnronOnline
 EnronOnline was launched Nov. 29, 1999.
 “EnronOnline offers customers a free, Internetbased system for conducting wholesale transactions
with Enron as principal.”
 “EnronOnline is your best tool for trading energy-related
products and other commodities quickly, simply and
efficiently. Our Web-based service combines real-time
transaction capabilities with extensive information and
customization tools that increase your knowledge of what's
happening around the world-even as it happens.
EnronOnline sharpens your sense of the marketplace to
make you a more knowledgeable trader.”
EnronOnline
 “No matter what commodity you want to buy or sell,
you're almost certain to find a live, competitive quote
on EnronOnline. We cover markets all over the world
including gas, power, oil and refined products, plastics,
petrochemicals, liquid petroleum gases, natural gas
liquids, coal, emission allowances, bandwidth, pulp
and paper, metals, weather derivatives, credit
derivatives, steel and more. EnronOnline covers almost
every major energy market in the world. And we're
not sitting still. We're adding new markets and new
products all the time.”
 An ironic example of "Trading Markets":
Credit Risk Management Tools,
including Bankruptcy Swaps
EnronOnline Claims
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Real-Time Pricing
Fast, Free, Secure Execution
Price Limit Orders
Option Contracts
Market News and Quotes
Industry Publications
Weather Insights
Complete Customization Capabilities
Brokering (?) over the Internet
 Note that Enron served NOT as a broker but as
a Principal—active participant in transactions.
Enron High-bandwidth Venture
 December 3, 1999: "Cutting the red ribbon for bandwidth
commodity trading, high-bandwidth application service
company Enron Communications Inc. Friday introduced
its new approach to bandwidth."
 "This is 'Day One' of a potentially enormous market,"
said Jeff Skilling, Enron president and chief operating
officer. He compared the present inflexible agreements for
pre-set capacity amounts to pre-reform "oil contracts in
the 1970s, natural gas contracts prior to 1990 and electric
power contracts prior to 1994."
 May 2, 2000: “Enron Corp. announced today the
expansion of EnronOnline to include products for the
purchase and sale of bandwidth capacity.”
Enron Broadband Trading Strategy
 The Purpose: Effect on Enron Stock Prices
 The Technique
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Step 1. Sell to an affiliated partnership
Step 2. Set an internal value on the sale
Step 3. Sell from one partnership to another
Step 4. Act as underwriter for the sale
 The Lack of Substance
 The Beginning of the Collapse
 The Collapse
The Catches—one after another!
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Acting as Principal in transactions!
Failing really to make money
Creating trading shell companies
Acting as partner in transactions!
Playing games with financial reporting
Being Greedy
The Collapse
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Sudden announcement of losses in Oct 2001
File for bankruptcy in Dec 2001
Bankruptcy
Congressional Investigations began in Dec 2001
Attempted destruction of documents
Enron and E-Mail's Lasting Trail
 It is almost impossible to hide transactions:
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Paper records at the source
Local computer system records
Internet communication records
Recipient records
Paper records at the destination
The Fallouts of Enron Collapse
 On the Workers
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Effects on their retirement accounts
 On the Stock Market
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Effects of “sophisticated accounting”
Effects on Internet-related stocks
Effects on Communications-related stocks
 On the Accounting Profession
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Effects of conflicts-of-interests:
Combining Auditing & Consulting
 On the Halls of Government
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Effects on Energy Policy-Making
Effects on Political funding
Equity Funding Corporation of America
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The insurance funding program
The first scam
The next scam
The really BIG scam
The final scam
The house of cards collapses
The fallout from Equity Funding
An analysis of the causes
The Lessons Learned
The insurance funding program - 1
 Equity funding Corporation of America was founded in
1960. Its principal line of business was selling "funding
programs" that merged life insurance and mutual
funds into one financial package for investors.
 The deal was as follows: first, the customer would
invest in a mutual fund; second, the customer would
select a life insurance program; third, the customer
would borrow against the mutual fund shares to pay
each annual insurance premium. Finally, at the end of
ten years, the customer would pay the principal and
interest on the premium loan with any insurance cash
values or by redeeming the appreciated value of the
mutual fund shares. Any appreciation of the investment
in excess of the amount paid would be the investor's
profit.
The insurance funding program - 2
 The company had a huge sales force. The thrust of the
salesman's pitch to a customer was that letting the cash
value sit in an insurance policy was not smart; in fact,
the customer was losing money. The customer was
encouraged to let his money work twice by taking part
in the above deal.
 The development of such creative financial investments
was a trademark of Equity Funding in the early years
of its existence. After going public in 1964, Equity
Funding was soon recognized across the country as an
innovative company in the ultraconservative life
insurance industry.
The insurance funding program - 3
 This kind of leveraging of dollars is a concept used by
sophisticated investors to maximize their returns. They
use an asset they already own to borrow money in the
expectation that earnings and growth will be greater
than the interest costs they will incur. However, it's a
concept that is fraught with risks for the investor and
should not be promoted by an ethical company without
fully informing the investor of the risks.
 Even so, there was nothing illegal or even immoral
about the basic concept. Indeed, it was a captivating
idea, except it didn't make enough money for the
company or its executives. So some executives—led by
the president, chief financial officer and head of
insurance operations—got a little more creative with
the numbers on their books.
The first scam
 "Reciprocal income“
Preparing to take the company public in 1964, there
was concern that its earnings were too low. To
correct this "problem", the owners decided that
Equity Funding was entitled to record rebates or
kickbacks from the brokers through whom the
company's sales force purchased mutual fund
shares. The resulting income, called "reciprocal
income" was used to boost 1964 net income for
Equity Funding. So the fraud apparently began in
1964 when the commissions earned on sales of the
Equity Funding program were erroneously inflated.
The next scam
 Borrowing without showing liability
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In subsequent years, to supplement the reciprocal
income so as to achieve predetermined earnings
targets, the company borrowed money without
recording the liability on its books, disguising it
through complicated transactions with subsidiaries.
The fraud expanded in 1965, when fictitious entries
were made in certain receivable and income
accounts.
By 1967, revenues and earnings of Equity Funding
had increased dramatically, and the stock price rose
accordingly. Equity Funding began to take over
other companies, and it became critical to maintain
the price of the stock of Equity Funding so it could
be used to pay for the companies being acquired.
The Really BIG Scam
 Reinsurance
 Fictitious policies
 Forging files
The Final Scam
 Killing off the policy holders
The computer makes it possible
The failure of the auditors
The house of cards collapses
The fallout from Equity Funding
 Accounting and auditing practices
 Insider trading
 The aftermath of Equity Funding
An analysis of the causes
 The Management
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The ethics and integrity of management and
employees
Management's philosophy and operating style
 The Auditors
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The independence of the auditors
Professional skepticism of the auditors
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External impairments to the audit
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The Management
 The ethics and integrity of management and employees
 Management's philosophy and operating style
The Auditors
 The independence of the auditors
 Professional skepticism of the auditors
The Lessons Learned
Deregulation
 Background
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Free-Market Mania of 1980s and 1990s
Retail Competition in States
Restructuring is not Deregulation
Deregulation and Enron: Apologia?
Background
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Energy Crisis of 1970s
National Energy Act of 1976
Federal Energy Regulatory Commission (FERC)
The Public Utilities Regulatory Policy Act of
1978 (Public Law 95-617)
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PURPA's Limits
Questioning the Rationale of Natural Monopoly for
Regulation
Free-Market Mania of 1980s and 1990s
 Energy Policy and Conservation Act of 1992
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Exempt Wholesale Generators
Utilities Could Expand Outside their Franchise Areas
Wholesale Competition Only
 Deregulation in the States (starting in 1996)
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Door Left Open for Retail Competition in States
Some of the issues
Retail Competition in States
 Background
 Historical
 No undue preference
Some of the Issues
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Stranded costs
Taxes
Stranded benefits
Others
Restructuring is not Deregulation
 Need for New Institutions
 Problems with Traditional Regulation
 Management of Electric Utility Companies
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During the Golden Years
Good Natured Competition
Troubled Times and Competition
New Leadership
Splits in the Ranks
New Strategies for Competition
 New Technologies Can Change Everything
 Coming Full Circle?
Deregulation and Enron: Apologia?
 Enron is but a Pebble in the Wave
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He did wrong but he had the right idea
Deregulation is Good
Commodity Trading is Good
• Equilibrium between supply and demand
• Bringing new ideas into production
• Risk Taking
 Effects of bad people
 Effects of lack of integrity
THE END
THE END