The Enron
corporation
A forensic investigation
« One reason that some
look beyond Enron is
that a fundamental
question remains
unanswered: Was the
company the imperfect
child of a healthy
financial system or the
perfect product of an
unhealthy one? »
Steve Liesman, WSJ
The Enron
corporation
An energy
sector company
with a market
capitalization of
$80 billion
th
7
th
287
or
largest American
corporation?
Notional amounts of derivatives mentioned as
assets on Enron’s balance sheet
« But they never put any of those numbers side
by side so people would begin to question the
numbers » (Former Arthur Andersen's accountant Robert
McCullough)
Enron was never rated higher than « BBB »
Enron’s 46 days’
downfall
October 16, 2001: non-recurring charges totaling
$1.01 billion after-tax
November 8, 2001: a $586 MI restatement of its
reported income for the years 1997 to 2000
« A classic run on the bank. A liquidity crisis spurred
by a lack of confidence in the company » (Enron’s former
CEO Jeff Skilling’s court testimony, February 7, 2002)
Enron’s 46 days’
downfall
Skilling’s testimony before the Senate Consumers Affairs
Subcommittee on February 26, 2002: « In the 1880s
when there was a run on the bank, it was the bank that
went under. What’s happening now is that the banks can
pull their money out of a company that is threatened. And
if somebody . . . claim[s] [there is] an accounting fraud, it’s
tantamount . . . in the business world . . . to walking into a
crowded theater and screaming ‘Fire!’—everybody runs
for the exits. When they set up the Federal Reserve
Board . . . and deposit insurance [the intent] was to try to
[prevent] runs on the bank. . . . We have it now
automatically built into the contracts, material adverse
change clauses, which means that if anything happens to
the borrower, the bank can come in and pull their money
back. »
The Sarbanes-Oxley governance Act of 2002 to prevent
the worst excesses of Enron and Enron-like
corporations
Preventing Jeff Skilling’s line of defense (Enron’s CEO):
« What do I know about accounting? »
Preventing an incestuous culture developing between a
corporation (Enron) and its auditor (Arthur Andersen)
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The tail end of the dot-com bubble
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Outsized arrogance of its
executives
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S.P.V.s (Special Purpose Vehicle)
used to shelter from stockholders’
scrutiny the most worrying liabilities
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Intimidation of the local population
in
Dabhol
(India)
through
mercenaries
Fraud in the California energy
sector
Strategic plant « maintenance »
Planned scarcity
Selling and buying up to 15 times the same energy
Making horizontal a vertical sector: each segment adds its
own profit margin ==> price multiplied x 8
Fear of reregulation by States in face of excess from
Enron
What made Enron possible?
Deregulation:
•
Wendy Gramm, head of the Commodities Futures Trading Commission
(CFTC) from 1988 to 1993 prohibited the regulation of energy futures,
then joined Enron’s board of directors
•
Kurt Eichenwald: « When energy prices kept on soaring, Gray Davis
(governor of California) complained prompting a video conference call
that included Larry Summers and Aaln Greenspan and, incredibly,
George W. Bush's favorite executive, Enron CEO Kenneth "Kenny Boy"
Lay. On that call, Summers declared that Lay was doing a "pretty good
job" of supplying energy to California, Summers again suggested that the
state's energy prices were actually too low, and that maybe if the state
was so in love with low energy prices, what it needed to do was relax
environmental regulations to let more power plants get built in a hurry. »
What made Enron possible?
Changes in accounting standards:
•
Mark-to-market accounting
Dabhol energy plant: Rebecca Mark's $54 Ml bonus; Joe Sutton's
$42 Ml
•
Based on flawed economic theory: rational expectations
Accounting shenanigans
Enron and Arthur Andersen: a common culture playing on
fiscal and regulatory arbitrage
Monthly Income Preferred Shares (MIPS): privileged shares
presented as company debt to benefit from tax exemption,
and as equity on the balance-sheet
Presenting sales as « synthetic leases » to SPVs: the lease
is then treated as tax exempted interest cash flows
Accounting shenanigans
Enron’s « Cash swaps »
Wall Street Journal: "Andersen's unsigned white paper […]
essentially argues that certain capacity exchanges aren't
barter agreements, which would prohibit two companies
swapping similar assets from recognizing any gains. […] But if
the two companies each structure the transactions so that the
capacity sold is an operating lease, and the capacity bought is
a capital lease, Andersen interprets the companies as having
not acquired "equivalent interests."
Accounting shenanigans
Enron’s « prepaid swap » (a synthetic loan)
Forward contracts used as « synthetic loans »: Enron and
the J.P. Morgan « Mahonia » partnership
Tax exemption on stock delivered as part of 401(k)s
Tax exemption on stock-options regarded as compensation
Enron paid corporate income tax only once over the years
1996 to 2000
Leveraging on the company’s
stock
Enron: a « stock-price
pump » company
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Credit and rating cliffs
Enron would compensate for any loss due
to credit rating’s downgrading
One of Enron’s SPV was backed by in-themoney warrants
Provisions for siphoning out Enron’s wealth
to the benefit of the corporation’s executives
12% return on deferred compensation
Bonuses based on the self-serving targets of Enron’s Performance Unit
Plan
Andy Fastow’s grand bonuses for the setting up of partnerships
15% return on Enron’s Friends’ quarterly balance-sheet massaging
loans
Retention bonuses: $5 MI for one employee vs. $5 MI as severance for
all rank-and-file employees (Chapter 11 bankruptcy provision)
Fully sheltered executive retirement plans
Provisions for siphoning out Enron’s wealth
to the benefit of the corporation’s executives
Fully sheltered executive retirement plans
"And how do you feel about that and the employees, one of which wrote me
recently—had $330,000 in his 401(k) account, his entire life savings, worked
many years for your company, lives in the state of North Dakota. That
$330,000 is now worth $1700. You still have most of your $66 million. That
family has lost their life savings. How do we reconcile that? How is it that the
people at the top got wealthy and the people at the bottom got broke?
. . . But it occurs to me that, at least from those of us who view Enron, if one
were to make a similar comparison, in the Titanic, the captain went down with
the ship. And Enron looks to me like the captain first gave himself and his
friends a bonus, then lowered himself and the top folks down the lifeboat, and
then hollered up and said, “By the way, everything is going to be just fine.”
—Senator Byron Dorgan, Democrat of North Dakota, questioning Enron’s
former CEO Jeffrey Skilling
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What killed Enron?
Skilling’s McKinsey & Co
philosophy
The « asset-light corporation » (« knowledge heavy »)
"Enron: Creating a new industry from embedded knowledge. .
..
Some companies succeed in defining new industries by
exploiting knowledge opportunities that are overlooked in
existing products and processes.Until the early 1990s, Enron
was a gas pipeline transmission company like many others.
But its managers realized that embedded in what appeared
to be a commodity gas business was valuable information
about product flow, supply, and demand. They established
Enron Capital and Trade Resources to exploit this
information through an innovative range of risk management
contracts. The enterprise helped Enron grow its sales by 7
percent per year and its shareholder returns by 27 percent
per year between 1988 and 1995."
Skilling’s McKinsey & Co
philosophy
Stock-options:
•
Stock holders and executives as
« capitalists »
•
The company’s stock price as
commodity and aim; Enron as an expert
in the field
Balance-sheet
massaging
« Partnerships »
End of quarter
« adjustments »
« Incidents »
British gas; fuel additive; the Azurix water
company; Dabhol; Abu Dabi
Broadband: the company began using its
inventiveness with derivatives to hide the
growing mountain of debt derived from the
unsuccessful foray into broadband
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Bad luck!
« We saw a company punishing
people who had played by the rules
and rewarding people who were
incompetent, scoundrels, or both. »
Investing in a Post-Enron World, 2003