ENTERPRISE RISK MANAGEMENT

“Case Study 3: Enron Corp. – The Rise and Fall”

Term - 5
PGDM Program

Submitted to,

Dr. Gajavelli V. S.

Submitted by,

Anoop Kumar (08HR012)

Institute of Management Technology, Nagpur

2008-10

INTRODUCTION:
The History of the Natural Gas Industry:
The market for natural gas has three major types of economic units: 1. Suppliers, 2. Customers,
3. Pipeline companies. In a competitive market the fluctuations in the supply of natural gas
creates fluctuations in the spot market price of gas. Such uncertainty in the price of gas creates
problems for the suppliers and customers. Often the participants in an industry under price
controls do not perceive the source of the shortages as being price controls. In the case of the
pipeline companies, particularly in the late 1970's and early 1980's, they had customers whom
they could profitably serve if only they had additional supplies of gas. The pipeline companies
entered into long term contracts with suppliers to take all the gas the suppliers wanted to sell
them at a specified price. Those long term contracts could have specified the maximum amounts
the pipeline companies were committed to purchase but they did not. At the time it seemed to the
pipeline companies that they could use all the gas they could get. These long term contracts to
buy any amount of gas at a specified price were called take or pay contracts.

Deregulation of Industry:
When the demand for natural gas declined in the 1980's the pipeline companies found
themselves committed to purchase gas for which they had no customers. These put the pipeline
companies with take or pay contracts in a financial bind. The situation became worse when the
government started to deregulate the industry. It is easy to see how the pipeline companies in the
1980's would be under financial stress to restructure.

The Formation of Enron:

The ENRON Corporation was a corrupt energy company based in Houston, Texas that went
bankrupt as a result of committing institutionalized, systematic and well-planned accounting
fraud. Since it's fall, it has become a symbol of corporate fraud and corruption.

Enron was an energy trading and communications company based in Houston, TX employing
around 21,000 people by the middle of 2001. By early 2001, Enron had morphed into the 7th
largest U.S. Company, and the largest U.S. buyer/seller of natural gas and electricity. Careful
accounting strategies allowed it to be listed as the seventh largest company in America, and it
was expected to dominate the trading it had virtually invented in communications, power and
weather securities. Instead it became the biggest corporate failure in history.
KEY PLAYERS:
Ken Lay, Chairman and CEO
➢ Big picture; optimistic; tended to avoid controversy
“Ken gravitates toward good news”

Jeffrey Skilling, President

➢ Proponent of big ideas; less interested in details
“Skilling is a designer of ditches, not a digger of ditches.”

Andrew Fastow, CFO

➢ Ambitious; unwilling to let the rules get in the way
“I don’t know that he ever had a moral compass”

Enron’s Board

Enron had an experienced, independent board

➢ Lay, Skilling, and one retired executive were the only insiders among 17 directors
➢ Median tenure was 7 years
➢ Audit committee was headed by Stanford accounting professor

The Fall of Enron:

After a series of scandals involving irregular accounting procedures bordering on fraud involving
it and its accounting firm Arthur Andersen, Enron stood at the verge of undergoing the largest
bankruptcy in history by mid November 2001. A white knight rescue attempt by a much smaller
energy company, Dynegy, was not viable.
The fall of the value of investors' equity per share in Enron during 2001 was from $85 to 30
cents. As Enron was considered a blue chip stock, this is an unprecedented and disastrous event
in the financial world. Enron's plunge in value occurred after it was revealed that many of its
profits and revenue were the result of deals with limited partnerships which it controlled. The
result of this is that many of the losses that Enron encountered were not reported in its financial
statements.

The firm's European operations filed for bankruptcy on November 30, 2001, and sought Chapter
11 protection in the US. The long term implications of Enron's collapse are unclear, but there is
considerable political fall-out both in the US and in the UK relating to the monies Enron gave to
political figures (around $6m since 1990).

Enron was formed in 1985 with the merger of Houston Natural Gas and InterNorth, engineered
by Houston Natural Gas CEO Kenneth L. Lay. It was originally involved in the transmission and
distribution of electricity and gas throughout the United States and the development, construction
and operation of power plants, pipelines, etc. worldwide.

Enron grew wealthy through its pioneering marketing and promotion of power and
communications bandwidth commodities, and related risk management derivatives as tradable
securities, including exotic items such as weather derivatives.

As a result Enron was named "America's Most Innovative Company" by Fortune magazine for
five consecutive years, from 1996-2000. It was on Fortune's "100 Best Companies to Work for in
America" list of 2000, and was legendary even amongst the elite workers of the financial world
for the opulence of its offices.

Its global reputation was undermined, however, by persistent rumours of bribery and political
pressure to secure contracts in Central and Southern America, in Africa and in the Philippines.
Especially controversial was the $30bn contract with the Indian MSEB (Maharashtra State
Electricity Board), where it is alleged that Enron officials used political connections within the
George Walker Bush administration to pressure the Indians. On January 9, 2002, the U.S.
Department of Justice announced it was going to pursue a criminal investigation of Enron and
Congressional hearings began on January 24.

Former Enron CFO Andrew Fastow, alleged mastermind behind Enron's complex network of
offshore partnerships and questionable accounting practices, was indicted on November 1, 2002,
by a Federal grand jury in Houston on 78 counts including fraud, money laundering, and
conspiracy.
The main statement of the issue or problem:
Enron was a corporation that went bankrupt and some of the outrageous corporate misdeeds
occurred in an effort to stave off bankruptcy. Where Enron went wrong is it abandoned its core
business. It made money every year, trading derivatives on natural gas and power. But as it
expanded to other investments-- water, a power plant in India, telecommunications, Internet
stocks, broadband-- it started losing billions of dollars on each of those investments. And the
further it moved from its core business of trading, the more money it lost. The problem for Enron
was that after some successes the traders began to have some financial failures and Enron was no
longer really making a profit. The market traders, who were effectively just high-stakes
gamblers, were no source of profits but instead a major source of loss themselves. The losses,
however, could be covered up in a number of ways and the deficits covered by effectively
borrowing from Wall Street.

Off Balance sheet Activities:

The other major way Enron disguised its losses was to keep the borrowing necessary to finance
the deficits off the books. This was arranged by Chief Financial Officer Andrew Fastow. The
accounting rules allowed borrowing to be kept off the books if a portion of the source of the
borrowing was from lenders outside of the company. The portion was surprisingly small and
Andrew Fastow found it relatively easy to put together lending packages to the company that
were only nominally from outside of the company. When the power plant did not perform up to
expectations and had a market value of only $7 million Enron should have cancelled the $2
million profit and entered a $1 million loss on its accounts. Instead it sold the plant to Whitewing
for $10 million thus validating its booked $2 million profit.

Enron adopts Mark to Market accounting

Theory:
NPV vs. historical profit
Pushed by Skilling
Approved by SEC
Practice
Subjective assessment of future gains
Little incentive for follow-through
Pressure to accelerate deal flow
Foreign Projects:
Enron International constructed a lot of power plants and pipelines all across the globe. Some
today are still up and running, including the massive Teeside plant in England. Others, like a
barge mounted plant off Puerto Plata in the Dominican Republic, cost Enron loads of money
through law suits and investment losses. Puerto Plata was a barge mounted power plant next to a
hotel called Hotelero del Atlantico. When the plant was fired up, winds blew soot from the plant
onto the hotel guests' meals, blackening their food. The winds also blew garbage from nearby
slums in the plant's water-intake system. For some time the only solution was to hire men who
would row out and push the garbage away with their paddles. For Enron, the deal was a complete
waste of money. Through mid-2000 the company collected a paltry $3.5 million from a $95
million investment. Other projects considered investments in Europe, South America, Argentina,
Brazil, Bolivia, Colombia, Mexico, Jamica, and across the Caribbean.
During the summer of 2001, Enron was making an attempt to sell a lot of Enron International's
assets, many of which were not sold. It is still unclear why Enron wanted to sell all of these
assets. Most suspect it was because Enron was in need of cash.

Unwise Domestic Ventures& Derivatives Trading: in start Enron was playing safe but
afterwards:
In actuality the project probably would not have worked even if it had more suitable managers
because Enron entered the field along with a flood tide of other providers. Analysts within Enron
were warning that the price of internet services was likely to fall and continue falling. Any firm
surviving in that commercial climate was likely to be one proficient at economizing.
Unfortunately this was not the type of manager Ken Rice was or wanted to be. He was more
interested in the flashy gesture such as classy motorcycles on display at the company offices.
Some analysts at that presentation did not believe the Enron story and said in print that Enron
was overvalued at its current price and should sell for more like $53 per share. Generally Enron
could keep financial analysts in line because it had a lot of financial business their institutions
would lose out on if they ever said anything pessimistic about Enron. The analysts that said
Enron stock was overvalued worked for a financial research company that did not provide
financial services. They were not worried about offending Enron.

Extravagant Corporate Expenditures:

The cases of corporate management expending corporate funds for luxuries are innumerable. It is
only the fortunate stockholders who have management that is frugal with their funds. But in most
cases the prodigal managers are expending the corporate profits. In the case of Enron the
managers in the latter stage of the firm operation before its bankruptcy the luxuries were paid for
from the firm's borrowing because it had no real profits. Thus those extravagances were at the
expense of the company's creditors rather than its stockholders. One common extravagance of
corporate managers is on corporate airplanes. These corporate airlines cost many, many times
what the travel would cost on commercial airlines. This is not only because of the high operating
costs (in the neighborhood of $5 thousand per hour) but also because often the corporate plane
flies without any passengers to pickup the corporate executives (or family members or friends)
and takes them to their destination and flies back to the home base again without passengers.
Another Enron executive who was notorious for extravagant cost of air travel was Rebecca
Mark. Rebecca Mark, as head of Enron International, did have a great deal of required air travel.
She insisted upon using the corporate planes even when it involved flying her as a single
passenger half way around the world. Some felt that most of her trips were not really justified.
But nevertheless when a corporate airplane was not available she charted a plane at a cost
estimated to be $100,000. An outlay like this made even the corporate airplanes seem to be
bargains for air travel.

The Exploitation of Market Control in the California Electrical Power Industry:

When a firm has control over the supply of a product as a result of being the only supplier or as
being a member of a cartel then it may make extraordinary profits by reducing the quantity
supplied to the market and driving up the price. An Enron subsidiary became infamous for its
gaming of the rules in the California energy market. Because this seeking of monopoly profits
comes from the firm having effective control over the market price, the solution is simply to take
away that control of price by a government-established control price. When the natural
monopoly or a cartel cannot raise the price by reducing the quantity supplied then they go ahead
and supply the market at the control price.

The Collapse and Bankruptcy of Enron:

Bankruptcy does not mean a company ceases to exist. It means that it cannot pay its contractual
obligations and seeks protection from its creditors through the courts. In return for holding the
creditors in abeyance the court takes charge of arranging the ultimate disposition of the
company's assets in satisfying the debts of the company. Skilling did try in 2000 to sell Enron's
herd of international white elephants, projects that had a book value of upwards of $7 billion, to
investors in the United Arab Emirates but the deal fell through.
Conclusions & Learnings:
Following are the learnings on part of Enron Case:

Continuous Losses:
The problem for Enron was that after some successes the traders began to have some financial
failures and Enron was no longer really making a profit. The market traders, who were
effectively just high-stakes gamblers, were no source of profits but instead a major source of loss
themselves.

Source of Finances for the firm:

Enron made huge investments in power plants & pipelines around the world during its
international Expansion. Even in Online Enron was doing very well. For the company’s trading
operations to continue, Enron needed an Investment grade credit rating. Because if investors get
good rating then only the company will be able to raise huge amount of money from Debt. So it
financed some part with debt, additional financing come from Enron’s Special Purpose Entities
(SPE’s).

Off-the-Balance-Sheet Financing:
Enron had a great array of foreign assets such as power plants and pipelines that were not doing
as well financially as the company hoped and counted on in its accounting.

Derivatives:
Derivatives were the main problem in case of Enron. This shows sometimes company involve
themselves in derivatives so much, that they forget their actual business.

Sarbanes-Oxley Act (SOX) of 2002:

➢ U.S. legislative response to recent spate of accounting scandals (Enron, WorldCom,
Global Crossing, Adelphia Communications).

➢ Compliance with comprehensive reform of accounting procedures is now required for

publicly held companies, to promote and improve the quality and transparency of
financial reporting by internal and external auditors.
 ➢ Companies must “list and track performance of their material risks and associated control
procedures.”

➢ CEOs are required to vouch for the financial statements of their companies.

➢ Boards of Directors must have Audit Committees whose members are independent of
company senior management.

➢ Companies can no longer make loans to company directors.

➢ SOX Act Essentially a response to one cause of the financial irregularities: failure by
auditors, SEC, and other agencies to provide adequate oversight.

➢ Not clear how SOX Act will prevent misuse of “offbalance- sheet activities” that are
difficult to trace.

➢ Sox Act also does not address other key causes:

○ misaligned incentives (e.g., shift from cash to stock option compensation)
○ focus on short-run profits rather than longerrun profit performance.

In managing any Enterprise’s Risk we should take care of following aspects of ERM:

Internal Environment:
It establishes a philosophy regarding risk management. It recognizes that unexpected as well as
expected events may occur. It establishes the entity’s risk culture. Considers all other aspects of
how the organization’s actions may affect its risk culture.

Objective Setting:
It applied when management considers risks strategy in the setting of objectives. Forms the risk
appetite of the entity — a high-level view of how much risk management and the board are
willing to accept. Risk tolerance, the acceptable level of variation around objectives, is aligned
with risk appetite.

Event Identification:
Differentiates risks and opportunities: Events that may have a negative impact represent risks.
Events that may have a positive impact represent natural offsets (opportunities), which
management channels back to strategy setting.

Risk Assessment:
Allows an entity to understand the extent to which potential events might impact objectives.
Assesses risks from two perspectives: Likelihood & Impact is used to assess risks and is
normally also used to measure the related objectives. Assesses risk on both an inherent and a
residual basis.

Risk Response:
Identifies and evaluates possible responses to risk. Evaluates options in relation to entity’s risk
appetite, cost vs. benefit of potential risk responses, and degree to which a response will reduce
impact and/or likelihood. Selects and executes response based on evaluation of the portfolio of
risks and responses..

Control (Risk) Activities:

Policies and procedures that help ensure that the risk responses, as well as other entity directives,
are carried out. Occur throughout the organization, at all levels and in all functions. Include
application and general information technology controls.

Information and Communication:

Management identifies, captures, and communicates pertinent information in a form and time-
frame that enables people to carry out their responsibilities. Communication occurs in a broader
sense, flowing down, across, and up the organization.

Monitoring:
Effectiveness of ERM components is monitored through: Ongoing monitoring activities.
Separate evaluations. A combination of the two. The entirety of enterprise risk management is
monitored and modifications made as necessary. Monitoring is accomplished through ongoing
management activities, separate evaluations, or both.