Case Study Analysis: The Fall of Enron

Submitted to: Prof. Dr. Supriti Mishra Professor, Business Ethics IMI-Bhubaneswar

Submitted by: Aditya A. Dash Ajeet S. Chauhan ubin oseph IMI-Bhubaneswar

Table of Contents

1. Executive Summary 2. easons for admiration of Enron

3 3 # % & & & * *

3. Accountin! "ssues #. $overnance "ssues %. ed Fla!s

&. 'roblem in (usiness )odel *. ole of the CE+

,. Conclusion -. eferences

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Executive Summary

!hrou"hout the #ate $%%&s, Enron was a#'ost uni(ersa##y considered one of the country)s 'ost inno(ati(e co'panies -- a new-econo'y 'a(eric* that forsoo* 'usty, o#d industries with their cu'berso'e hard assets in fa(or of the freewhee#in" wor#d of e-co''erce. !he co'pany continued to bui#d power p#ants and operate "as #ines, but it beca'e better *nown for its uni+ue tradin" businesses. Besides buyin" and se##in" "as and e#ectricity futures, it created who#e new 'ar*ets for such oddba## ,co''odities, as broadcast ti'e for ad(ertisers, weather futures, and Internet bandwidth. !he Enron story was perfect for the dotco'-dri(en stoc* 'ar*et boo' of the )%&s. -ith its roots in the uti#ity business, the co'pany enjoyed a so#id reputation for o#d-econo'y stabi#ity. But un#i*e other ener"y co'panies that didn)t ,"et it,, Enron thrust itse#f head#on" onto the Internet. !he business press ate it up. so did -a## Street, sendin" the stoc* into the stratosphere. At its pea*, Enron was worth about /0& bi##ion, its shares tradin" for about /%& each. A## that ca'e crashin" down, when the co'pany ad'itted that it had 'isstated its inco'e and that its e+uity (a#ue was a coup#e of bi##ion do##ars #ess than its ba#ance sheet said In this report, we wi## c#ear#y dissect the reasons for the fa## of Enron throu"h the fo##owin" points1

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easons for admiration for Enron

Enron was +uic* to e2p#oit opportunities when dere"u#ation in the #ate $%3&s a##owed users to buy "as or e#ectricity fro' different producers. It specia#ised in contracts to de#i(er natura# "as, e#ectric power and other ener"y products to industries and uti#ities at future dates. It a#so so#d financia# instru'ents desi"ned to protect custo'ers a"ainst sharp swin"s in ener"y prices. Enron soon beca'e a dar#in" on -a## Street as ana#ysts #auded the co'pany for brin"in" hitech and co'p#e2 finance to the du## business of supp#yin" ener"y. Enron a#so cashed in on dotco' 'ania with Enronon#ine, a web-based tradin" ser(ice. A## of Enron)s senior e2ecuti(es, especia##y durin" the co'pany)s 'eteoric rise, were 'odern 'ana"ers of the 4ew Econo'y. But Enron)s three 'ost i'portant e2ecuti(es 5 Chair'an 6enneth 7ay, CE8 effrey S*i##in" and C98 Andrew 9astow 5 were the 'asters of the new order. In $%%&, 7ay hired S*i##in" and e'bar*ed on an a##-out ca'pai"n to chan"e the way

ener"y was bou"ht and so#d. 8(er the ne2t decade, the pair beca'e unstoppab#e. ust as 6en 7ay identified eff S*i##in" as so'eone who cou#d brea* barriers and transfor' Enron fro' an ener"y co'pany into a tradin" co'pany, S*i##in" reco"ni:ed a youn" financia# whi:, Andrew 9astow, as so'eone who cou#d opti'i:e the financin" behind Enron)s "rowth strate"ies.

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Accountin! "ssues

!he Enron contro(ersy in(o#(es se(era# accountin" issues. 8ne concerns the ru#es "o(ernin" whether the financia# state'ents of specia# purpose entities ;SPEs< estab#ished by a corporation shou#d be conso#idated with the corporation=s financia# state'ents. for certain SPE partnerships at issue, conso#idation is not re+uired if a'on" other thin"s an independent third party in(ests as #itt#e as >? of the capita#, a thresho#d so'e consider too #ow. A second issue concerns the use of deri(ati(es to 'anipu#ate accountin" resu#ts. !hird, there are ca##s for i'pro(ed disc#osure, either in notes to financia# state'ents or a 'ana"e'ent discussion and ana#ysis, especia##y for financia# arran"e'ents in(o#(in" contin"ent #iabi#ities. Accountin" standards for corporations are set by the 9inancia# Accountin" Standards Board ;9ASB<, a non-"o(ern'enta# entity, thou"h there are a#so SEC re+uire'ents. ;!he SEC has statutory authority to set accountin" standards for fir's that se## securities to the pub#ic.< 9edera# securities #aw re+uires that the accountin" state'ents of pub#ic#y traded corporations be certified by an independent auditor. Enron=s outside audits ha(e recei(ed 'uch attention. 8utside in(estors, inc#udin" financia# institutions, 'ay ha(e been 'is#ed about the corporation=s net inco'e ;which was subse+uent#y restated< and its #osses and #iabi#ities ;which were far #ar"er than reported<. !he auditor, Arthur Andersen, has been indicted on cri'ina# obstruction of justice char"es, re#ated to destruction of docu'ents. 8ne issue is whether Andersen=s e2tensi(e consu#tin" wor* for Enron 'ay ha(e co'pro'ised its independence and its jud"'ent in deter'inin" the nature, ti'in", and e2tent of audit procedures and in as*in" that re(isions be 'ade to financia# state'ents, which are the responsibi#ity of Enron=s 'ana"e'ent. 8(ersi"ht of auditors has pri'ari#y rested with the A'erican Institute of Certified Pub#ic Accountants ;a non"o(ern'enta# trade "roup< and state boards of accountancy.

Another auditor issue is the pro(ision of non-audit ser(ices to audit c#ients. So'e be#ie(e that pro(ision of such ser(ices is a conf#ict of interest that tends to under'ine the ar'=s#en"th, watchdo" posture e2pected of the outside auditor. A crucia# issue wi## be whether ta2 ser(ices, a 'ajor co'ponent of accountin" fir's= re(enues, are inc#uded in the ser(ices dee'ed to co'pro'ise independence.

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$overnance "ssues

!he ro#e of a co'pany=s board of directors is to o(ersee corporate 'ana"e'ent to protect the interests of shareho#ders. @owe(er, in $%%% Enron=s board wai(ed conf#ict of interest ru#es to a##ow chief financia# officer Andrew 9astow to create pri(ate partnerships to do business with the fir'. !ransactions in(o#(in" these partnerships concea#ed debts and #osses that wou#d ha(e had a si"nificant i'pact on Enron=s reported profits. Enron=s co##apse raises the issue of how to reinforce directors= capabi#ity and wi## to cha##en"e +uestionab#e dea#in"s by corporate 'ana"ers. Specific +uestions in(o#(e independent, or AoutsideB directors. ;Stoc* e2chan"e ru#es re+uire that a certain percenta"e of board 'e'bers be unaffi#iated with the fir' and its 'ana"e'ent.< are e#ected by shareho#ders, but e2cept in (ery unusua# circu'stances these are ASo(iet-sty#eB e#ections, where 'ana"e'ent=s s#ate of candidates recei(es near#y unani'ous appro(a#. 8ne part of the fa##out fro' Enron)s de'ise in(o#(es its re#ations with ban*s. Pro'inent ban*in" co'panies, notab#y Citi"roup and .P. Mor"an Chase, were in(o#(ed in both the in(est'ent ban*in" ;securities< and the co''ercia# ban*in" ;#endin" and deposit< businesses with Enron, and ha(e suffered fro' Enron)s co##apse. Part of Enron=s core ener"y business in(o#(ed dea#in" in deri(ati(e contracts based on the prices of oi#, "as, e#ectricity and other (ariab#es. 9or e2a'p#e, Enron so#d #on" ter' contracts to se## ener"y at fi2ed prices. !hese contracts a##ow the buyers to a(oid, or hed"e, the ris*s that increases ;or drops< in ener"y prices posed to their businesses. Since the 'ar*ets in which Enron traded are #ar"e#y unre"u#ated, with no reportin" re+uire'ents, #itt#e infor'ation is a(ai#ab#e about the e2tent or profitabi#ity of Enron=s deri(ati(es acti(ities, beyond what is contained in the co'pany=s own financia# state'ents. -hi#e specu#ati(e tradin" in deri(ati(es is an e2tre'e#y hi"h-ris* acti(ity, no e(idence has yet e'er"ed that indicates that such #osses were a factor in Enron=s co##apse. E(en if deri(ati(es tradin" were not a 'ajor cause, Enron=s fai#ure raises the issue of super(ision of unre"u#ated deri(ati(es 'ar*ets.

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ed Fla!s

!here was unusua# inf#ation of operatin" re(enues fro' C& bi##ion in $%%% to $&& bi##ion in D&&& which was an increase of $E$? which #oo*ed #i*e a surprise. -hereas Dyner"y=s #ess than >& bi##ion operatin" re(enue. !he co'pany=s recei(ab#es were "rowin" faster than re(enues, with accounts payab#e "ettin" de#ayed. !he co'pany 'ade #ar"er in(est'ents into i## concei(ed projects when the F.S econo'y was just startin" to "o into recession. !he whist#e b#ower who raised the (oice, no one paid any heed. !he 'ar* to 'ar*et accountin" e(en #oo*ed as red f#a" but didn=t he#p in raisin" a#ar'.

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'roblem in (usiness )odel

!he co'pany used hi"h specu#atory financia# deri(ati(e 'ode# for earnin"s for basic uti#ities. It used standard contract that a##owed supp#iers to interrupt "as supp#y without #e"a# pena#ties. It offered uti#ities at #on"-ter' fi2ed prices for natura# "as, typica##y assu'in" unconditiona# increase in spot prices. !he co'pany e'p#oyed 8ff-ba#ance sheet financin" (ehic#es-Specia# Purpose Entities;SPE<.

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ole of CE+

/10 Fiduciary Failure: !he CE8 fai#ed to safe"uard Enron shareho#ders and contributed to the co##apse of the se(enth #ar"est pub#ic co'pany in the Fnited States, by a##owin" Enron to en"a"e in hi"h ris* accountin", inappropriate conf#ict of interest transactions, e2tensi(e undisc#osed off-the-boo*s acti(ities, and e2cessi(e e2ecuti(e co'pensation. !he Board witnessed nu'erous indications of +uestionab#e practices by Enron 'ana"e'ent o(er se(era# years, but chose to i"nore the' to the detri'ent of Enron shareho#ders, e'p#oyees and business associates. /20 1i!h is2 Accountin!: !he CE8 *nowin"#y a##owed Enron to en"a"e in hi"h ris*

accountin" -practices. /30 "na33ro3riate Conflicts of "nterest: Despite c#ear conf#icts of interest, the CE8 appro(ed an unprecedented arran"e'ent a##owin" Enron=s Chief 9inancia# 8fficer to estab#ish and operate the 7 M pri(ate e+uity funds which transacted business with Enron and profited at Enron=s e2pense. !he Board e2ercised inade+uate o(ersi"ht of 7 M transaction and co'pensation contro#s and fai#ed to protect Enron shareho#ders fro' unfair dea#in".

/#0 Extensive 4ndisclosed +ff5The5(oo2s Activity: !he CE8 *nowin"#y a##owed Enron to conduct bi##ions of do##ars in off-the-boo*s acti(ity to 'a*e its financia# condition appear better than it was and fai#ed to ensure ade+uate pub#ic disc#osure of 'ateria# off-the-boo*s #iabi#ities that contributed to Enron=s co##apse. /%0 Excessive Com3ensation: !he CE8 appro(ed e2cessi(e co'pensation for co'pany e2ecuti(es, fai#ed to 'onitor the cu'u#ati(e cash drain caused by Enron=s D&&& annua# bonus and perfor'ance unit p#ans, and fai#ed to 'onitor or ha#t abuse by Board Chair'an and Chief E2ecuti(e 8fficer 6enneth 7ay of a co'pany-financed, 'u#ti-'i##ion do##ar, persona# credit #ine. /&0 6ac2 of "nde3endence: !he independence of the board of directors was co'pro'ised by financia# ties between the CE8 and certain Board 'e'bers. !he Board a#so fai#ed to ensure the independence of the co'pany=s auditor, a##owin" Andersen to pro(ide interna# audit and consu#tin" ser(ices whi#e ser(in" as Enron=s outside auditor.

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Conclusion

9ro' the abo(e instances and se(era# outputs, the co'pany 'ade sure it wou#d ta*e the fa## in future e(en when there were red f#a"s, the business 'ode# was f#awed. -hen the CE8 and the 'ana"e'ent were a#oof fro' the happenin"s in the co'pany and wanted resu#ts in any 'anner the +uestion rises A-hat others cou#d ha(e doneGB Enron, the cha'pion of ener"y dere"u#ation that "rew into one of the nation)s $& #ar"est co'panies, co##apsed, after Dyne"y bac*ed out of a dea# in the year D&&$ to buy it and 'any bi" tradin" partners stopped doin" business with it. Dyne"y, which had a"reed on 4o(. % to buy Enron but had second thou"hts as Enron disc#osed 'ore financia# prob#e's and in(estors p#u''eted its stoc*, accused Enron of 'isrepresentin" the hea#th of its business. Enron, 'eanwhi#e, was wei"hin" whether to sue Dyne"y for breachin" the ter's of the dea#.

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eferences

$. He#as+ue:, M. I. ;D&$D<, Business Ethics Concepts and Cases, 0th ed., 4ew De#hi1 P@I 7earnin" P(t. 7td. D. @ea#y, P. and Pa#epu, 6. ;D&$><, The Fall of Enron, @ar(ard Business Schoo# Case