Enron Case Study

Team Members
Abdul Wahid Ibrahim Raman Narayanan Suzilawati Norsalizan Ismarizal Ismayatim Ismuni Latip
Master of Business Administration College of Business, Universiti Utara Malaysia
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Questions
If business operates within the law, does it operate morally? Why or why not? Enron Case Study

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Agenda

Literature Review Introduction Enron Findings Implications Lesson Learnt

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Literature Review - Western

Busine$$ Profit$
Integrity
Comes from individual forms the culture of organization Values transparency, innovative, customer loyalty,

Business Ethics
Rules, standard, moral principles right/wrong Issues Accounting fraud, misconduct, bribery, conflict of interest

Corporate Governance
A set of processes, customs, policies, laws, and institutions affecting the administration Stakeholders BODs, employee, creditors, customers & community 1970s strengthening governance worldwide

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Literature Review - Islamic

No fraud No monopoly Mutual consent

Free market No hoarding

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Strict on weight & measures

Introduction
An energy company established in 1985 led by Kenneth Lay. Grew 311% till 1998, 56% in 1999 and 87% in 2000 Rated as Fortunes Most Admired Companies Benefited from Free Market System for selling electricity at market price. 2001 share plunged from USD80 to USD1 and declared bankruptcy.
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Enron Case Findings

1985 merger - Enron Corp. massive debt from the deregulation process. Kenneth Lay (CEO) hired McKinsey & Co. as consultant Jeffery Skiling Skiling helped Enron create a new product for the industry gas bank created a energy chain. 1990 Enron Finance Corp. Skiling as the P.I.C. Hired Andrew Fastow 1998 - CFO
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Key player Enron Corp.

Kenneth Lay Fastow

Jeffery Skiling

Andrew

3 key-player in Enron (1990 2000)

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Skiling Leadership
PRC (The Performance Review Committee) scaled from 1 5, with 5s are usually being fired within 6 months 15% of employee turnover Recruited the best & brightest from top MBA schools pampered with corporate perks, no cap merit-based bonuses Intense internal competition to justify continued employment.
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Skiling Leadership..
Skiling:
> if you cant do that, then you have to find a job at

another company or go trade pork bellies.

1996 Chief Operation Officer (COO) convinced Lay that the gas bank concept could be applied in electric energy as well. 1997 Acquired Portland General Electric Corp. Developed Enron Capital and Trade Resources Division largest wholesale buyer & seller of natural gas and electricity in US.
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MISCONDUCT OR BAD INVESTMENT? The Dabhol Power Company India:

Dispute arose after the Indias Congress Party no longer in power. Enron: GE : Bechtel: MESB 65 : 10 : 10 : 15 Enron manage the project through Enron International
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The Dabhol Power Plant

Required by contract to pay Enron at Rs. 8/kWh even no power was purchased white elephant New agreement in 1998, Enron agreed to cut the price to 20% - MESB refused to pay. Enron has almost $2 billion investment at risk Total cost climbs to $3 billion Dabhol sits silent

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EnronOnline
2000 a change was made in Commodity Futures Modernization Act after intense lobbying To exempt energy and metal trading from CFTC oversight Allows energy trades to takes place electronically, in private, with no transperancy, record,audit trail, nor any oversight to guard fraud and manipulation. EnronOnline began to trade energy bilaterally, and without being subject to proper regulatory oversight EOL became an overnight success, handling $335 billion in online
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Death-Star Trading Strategy

Created by John M. Forney, along with other infamous strategies: Ricochet, Get Shorty, Fat Boy.. Death-Star : get paid for moving energy to relieve congestion without actually moving energy or relieving any congestion. create the appearance of congestion through the deliberate overstatement of loads to drive up prices intention and attempt to manipulate market for profit. California Energy Crisis Enron plays a disturbing role
> Intentionally clogged Path 26 a key transmission path

connecting Northern and Central California

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Death-Star Trading Strategy

One of the former Enron: What we did was overbook the line that we had rights on during the shortage or in the heat wave. We did this in June 2000 when the Bay Area was going through a heat wave and the ISO couldnt send power to the North. The ISO has to repay Enron to free up the line in order to send power to San Francisco to keep the lights on. But, by the time they agreed to pay us, rolling blackouts had already hit California and the price for electricity went through the roof Enron made millions by this strategy alone, and helped California to sign expensive long-term contracts.
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Round-Trip or Wash Trades

Other competitors following Enrons lead. - Dynegy, Duke Energy, El Paso, Williams Occur when one firm sells energy to another and then the second firm simultaneously sells the same amount of energy back to the first company at exactly the same price Sends price signal to the market, and artificially boost revenue to the company Lawyer from JP Morgan Chase admitted: series of round-trip trades from Enron Not only done in electricity, but also in broadband
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Azurix Corp.
June 1998 acquired Wessex Water Company UK owned company at a premium of 28% CEO: Rebecca Mark Enron International Goal: to use Wessex as a base to launch worldwide water distribution and water treatment company. After the acquisition, British regulators asked Enron to cut price by 12% & upgrade aging infrastructure Went public at $19 per share in 1999
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Azurix Corp
End of 2000 - $100 million in profit and $ 2 billion in debt In 2000, written down by $326 million March 2002 sold to YTL Corporation for $770 million cash, after so much pressure to convert it into cash -> fire sale Re-purchase the Azurix shares after written-down? To interpreted bullish signal?

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The Broadband Division

The dot.com bubble burst in 2000 Ambitious plan to build a high-speed broadband and traded it with the same concept as in electricity. Enron & Blockbuster : Video on demand deal The most controversial SPEs: LJM1 & LJM2 created to buy shares of Rhythms NetConnections & The New Power Company LJM Lea, Jeffery & Micheal the names of Fastows children & wife. -> to buy Enrons poorly performing stocks & bolster Enrons financial statement August 2000 Enrons stock hit $90.56/s most admired & innovative companies in the world
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The Broadband Division..

Enron as of 31st December 2000:
Year 1998 1999 2000 Earnings on common stock* Net income* 686 million 703 million 827 million 893 million 896 million 979 million

*Enrons year 2000 annual report unless otherwise indicated

Both the $896 and $976 millions earnings for the year 2000 are after a $326 million charge to reflect the decrease in the value of the Azurix investment. In addition, there is a $39 million gain on The New Power Company (TNPC) stock.
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The Broadband Division..

Enron as of 31st December 2000:
Income (loss) before interest, minority interest, and income taxes (PBIT) Wholesale services Retail energy services Broadband Services Transportation and Distribution $1557 million $100 million ($137) million $335 million

*Enrons year 2000 annual report unless otherwise indicated.

Failed to fully disclose the business failure to public able to convince credit firm that they are doing well despite the loss March 2001 Blockbuster cancelled the deal
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Innovative Accounting Practices

Collapsed not because it gotten too big -> perceived to be much bigger than it really was Decentralizing -> able to hide huge derivative losses Finance Report carefully crafted using the loopholes in the States Act. Losses held off the book. Assets stated.

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The Mark-to-Market Accounting

Refers to accounting for the value of an asset or liability based on the current market price, or on assessed fair value Whenever have outstanding energy-related or other derivative contract (assets or liabilities) must adjust to the fair market value. How about future contracts in commodities no quoted price -> how to assess value? Companies free to develop and use discretionary valuation models based on their own assumptions and methods
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Special Purpose Entities (SPE)

How to lower the companys debt ratio? A company is permitted to increase leverage and ROA without having to report debt on Balance Sheet. Thousands of SPEs created by Enron. The most controversial is LJM1 & LJM2 Partnership with CalPERS (California Public Retirement System) created Joint Energy Development Investment fund (JEDI) -> selling speculative assets to the partnership in IOUs backed by Enrons stock as collateral JEDI 50:50
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Enron CalPERS partnership

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Enron CalPERS partnership..

In 1997, Skiling asked for separate investment -> must remove them from JEDI first. Dont want to show any debt in Balance Sheet -> Fastow created another SPE Chewco Investment L.P This was the idea....

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Enron CalPERS partnership..

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Enron CalPERS partnership..

Received $10 million in guarantee fee & fee based on loan balance to JEDI Total of $25.7 million revenues First quarter of 2000 -> increase in price of Enron stock held by JEDI resulted in $126 million in profits CalPERS: paid $175 million & received $171 million -> lost about $11 million Alerted by advisers resolve to improve accounting & auditing standards among companies it invests
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Conflict of Interest
Arthur Andersen LLP > External & internal audits for years > Kept permanent assignment at Enrons office > Internal accountants, CFOs and Controllers former AA > Dismissed as auditor on Jan 2002 document destruction & lack of guidance on accounting policy > Admitted to destroy thousands of documents & electronic files related according to the firms policy, before the SEC issued a subpoena to them > As at now, not formally dissolved nor bankrupt ceded to 4 limited liability corp named Omega Management I through IV
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Conflict of Interest..
Stock Transaction & 401(k) Plans: > Cancellation of Video on Demand (Blockbuster) shares dropped to mid $60s. -> senior management started to sell stock in bull market -> collect hundreds of million dollar > Skiling resigned -> personal reasons -> shares continued slide up to below $30. > 21aug2001, Lay sent email to Enron employees optimism to Enron & stock price; and again in 26Sept2001. > October 17, announced it had changed it plan administrators for 401(k) plan ->locking their investment in 30days & preventing workers to sell their shares.
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Implications
1. Social Response
a.
  

External Response Laws and regulations;

Laws and rules are constraints on bad choices not formulas for good choices; Tend to be reactive cannot anticipate new circumstances and unexpected challenge; Must achieve a difficult balance which sharply constrain a set of bad behaviour;

b.
  

Internal Response Professionalism;

Skills of management are powerful when applied to the resources of organization; Ethical behaviour in practice depends not only on knowing what choices are morally and decision in difficulty circumstances; Professional must posses specialised knowledge; must make critical commitments;
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Implications
2. Specialised Knowledge;
  penetrates the root of the matter and gives its possessor an understanding not only how things are but why they are; Obligated to use their knowledge wise and share knowledge only those personally committed to use it well;

3. Commitment to service;
  stand for something in a public context, to make a public promise to the community; commit themselves publicly to use their special knowledge to serve other

4. Autonomy in Decision-Making
 the value of professional s to a community lies precisely in their ability to devise successful plans for new situation;

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Implications
5. Conflict of Interest;
 Neither new nor avoidable, the important issues how managers managed it;

6. Bad Accounting Practise;

  Audit Committee members often are not independent, they are appointed by senior management ; Demonstrated the need for significant reform in accounting and corporate governance;

7. Failure of Western Capitalism

  The collapsed checks and balances of capitalism is that nobody likes an impersonal story about monopoly government; Western Capitalist is no longer focused on traditional concepts of profit financially engineered profit; but

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Aftermath
Shareholders lost USD 74 Billion Bankruptcy of Arthur Andersen Sarbanes-Oxley Act 2002 (SOX)

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Sarbanes-Oxley Act

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Lesson Learnt
 The Enron scandal is the most significant corporate collapse in the United States since the failure of many savings and loan banks during the 1980s.

 This scandal demonstrates the need for significant reforms in accounting and corporate governance in the United States, as well as for a close look at the ethical quality of the culture of business generally and of business corporations in the United States.

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Lesson Learnt
1. Company and people should make money in the new economy in the same ways to make money in the old economy - by providing goods or services that have real value. 2. Financial cleverness is no substitute for a good corporate strategy. 3. The arrogance of corporate executives who claim they are the best and the brightest, "the most innovative," and who present themselves as superstars should be a "red flag" for investors, directors and the public.

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Lesson Learnt cont

4. Executives who are paid too much can think they are above the rules and can be tempted to cut ethical corners to retain their wealth and perquisites. 5. Government regulations and rules need to be updated for the new economy, not relaxed and eliminated.

6. A responsible and transparent financial planning is very crucial in ensuring good corporate governance.

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Conclusion
To be successfully ethical, companies must go beyond the notion of simple legal compliance and adopt a valuebased organizational culture. A company or an organization is deemed to be operating morally if it operates within the law.

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Thank You !

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