Enron Case

Red flags
 Andersen auditors leave to work for Enron
 Multiple SPVs
 CFO was not an accountant – best CFO in 1999, was in jail in 2001
 Management culture was similar to Worldcom’s
 Wendy Gramm – regulator that joined Enron
o Wife of US senator that repealed Glass-Steagall
 No back office function, i.e. traders were valuing their own trades
 BNP Paribas analyst with sell recommendation was fired
 Shitty bonus structure
 Culture of not being able to talk back
 Asset-heavy industry trying to become asset-light – major red flag
 Scrutinize hedges
 If assets move from Enron to SPV, check. Fairness opinions by ML were biased because they had fees from
the mergers. ML bankers were also on board of SPVs.
 No integration of acquired companies

Accounting funnies
 Using NPV with lower WACC for derivatives then booking it as profit
o Did not follow matching principle
 To be able to deconsolidate
o Book upfront profit to SPV
o 3% must be sold
o Independent directors needed
 28% of EPS was unrelated party transactions – bad quality earnings
 Used working capital to hide debt
o In debt-heavy industries, Q4 working capital is most likely fake
o Look at ROIC
 Getting minority share (49%) of a subsidiary – does not necessitate consolidation
 Non-recourse Factoring – selling receivables to banks
 Check if opFCF can match maturities
 Look for covenants – usually secret but can be found in prospectus

Identification of Off-Balance Sheet items

1. Stop looking at pictures and start looking at videos
a. Instead of BS, check P&L.
b. Check interest paid against debt on BS – must match.
c.

Creative Accounting

CFIMITYM
Company Background
1. Enron was the seventh largest company by revenues in the US.
2. It was seen as a glowing example of the transformation of a conservative, domestic energy company into
a global player. Others have been criticized for not living up to Enron’s thunder.
3. It became clearer that Enron ran a Ponzi scheme through using aggressive accounting and through using
SPVs to move assets and liabilities off the balance sheet.
4. Founding: US energy market was deregulated in 1970’s.
a. Kenneth Lay, a former US Interior Department Undersecretary, engineered a merger between
Houston Natural Gas and InterNorth (a larger traditional gas pipeline company) to form Enron in
1985. He became Chairman and CEO of the new entity.
b. Enron is now the largest company-owned natural gas pipeline system in the US with 37,000 miles
from Canada to Mexico, California to Florida. It also had interests in oil and gas exploration and
production.
5. Growth: Lay, with Richard Kinder as COO, started a series of new ventures and acquisitions.
a. Many are funded by debt including some deals underwritten by Junk Bond King Michael Milken.
b. Meanwhile, Enron had to buy off a potential hostile bidder for USD 350 million.
c. By 1987, Enron’s debt was 75% of its market capitalization.
d. In 1989, Lay hired Jeffrey Skilling, a Harvard MBA and partner in charge of McKinsey’s energy
practice in Houston, to be head of Enron Finance.
e. In 1990, Enron Gas Services was formed as a trading and marketing arm – similar to ETS.
f. A vast proportion of electricity in the US came from coal and nuclear plants. Gas was not favored
due to volatility in supply and price. Enron had to find new industrial customers for its gas.
g. It was able to find this customer with a 20-year deal with Site Energies where Enron would supply
the gas for a 1,000-MW plant in New York worth USD 3.5 billion over the lifetime of the contract.
Price was fixed for the first five years and would then fluctuate with the market. It was favorable
enough to choose gas over coal.
6. Overseas Expansion: Rebecca Mark led the drive for international M&A.
a. Signed a USD 3 billion power project in India, the largest FDI in the country.
b. Bought energy plants in Brazil, Bolivia, Argentina, and the UK.
c. In 1994, Enron was operating power and pipeline projects in 15 countries.
d. In 1998 in its desire to build a worldwide water utility company, Enron purchased Wessex Water
in the UK for USD 2.2 billion and formed a new company, Azurix, which in turn pursued projects
in Europe, Asia, and Latin America.
7. Trading Operations: In 1989, Enron entered into a JV with Bankers Trust (predecessor of Deutsche Bank’s
IB arm) to established a trading desk.
a. It hired traders from investment banks and brokerage firms and new MBAs from top schools.
b. In 1990, Skilling hired Andrew Fastow to head Enron Capital and Trading. His background was on
asset securitization and structured finance.
c. From contracts for physical delivery, Enron expanded into gas and electricity futures.
d. It lobbied hard for exemption from normal regulatory oversight of derivatives trading to avoid
restrictions on margin trading.
e. In 1993, this exemption was granted by outgoing chairman of US Commodities and Futures
Trading Commission Wendy Gramm who later joined Enron’s board as a non-executive director.
f. In 1994, after obtaining exemption from regulation as a utility company, Enron began trading
electricity.
8. Internal Conflicts: Rebecca Mark (Enron International M&A) favored traditional power generating assets
whereas Jeff Skilling (Enron Finance) wanted an “asset light” strategy – focusing on energy trading rather
than generation.
a. Following Kinder’s resignation (and refusal to forever become COO), Skilling became President
and COO and pursued his asset light vision.
b. Skilling promoted Fastow to CFO. The latter was voted “most creative financial officer of the
year” by CFO Magazine in the US.
9. Volumetric Production Payments (VPPs): An innovation in which a large number of small gas producers
who lacked access to capital were provided liquidity by Enron by prepaying for long-term fixed-price gas
supplies with the payment secured on the gas itself and not on the assets of the producer. This meant the
following:
a. It secured its long-term supply of gas.
b. It reduced risk of default to Enron who had first call on gas.
c. Enron was being repaid in gas and not cash.
d. To finance these liquidity deals with small producers, Enron sold rights to future cash flows from
each deal with investors through a series of off-balance sheet SPVs.
e. First deal was with Forest Oil where Enron paid USD 44 million for the right to receive 32 billion
cubic feet of gas over the next five years. Many deals followed.
10. Mark-to-Market Accounting
a. VPP opened the way for the use of MTM accounting.
i. Dr VPP
ii. Cr Income
b. Enron applied to the SEC to be allowed to mark VPPs to market.
c. It was granted in 1991 and Enron became the first non-financial company to use the MTM
method. While it was supposedly temporary, SEC never revisited it.
d. Enron bled cash on years 1-5 in exchange for potential “earnings” in years 6-10.
11. Accountants: Arthur Andersen LLP
a. They were Enron’s auditors since 1985.
b. David Duncan is their engagement partner who is a known “client advocate” who practices
“aggressive accounting”.
c. Andersen was generating USD 25 million in audit fees and USD 26 million in consulting fees from
Enron.
d. Carl Bass was removed from the engagement after Enron complained that he was deliberately
obstructive – with doubts about Enron’s treatment of off-balance sheet items.
e. Andersen provided a pool of future accountants for Enron.
12. SPVs and culture: Source of cash where VPPs sat
a. Enron had a little over 3000 subsidiaries and unconsolidated associates with 400 registered in the
Cayman Islands.
b. There is nothing inherently wrong with using SPVs. What was weird was the sheer number.
c. Rank or yank: bottom 10% were shown the door
i. Pressure was particularly acute in the last quarter where “Friday night specials”
happened – deals put together at the last moment.
ii. NPV must always be positive so it can be booked as profit. If not, managers would be
approached by their bosses to “revisit the deal and tweak the numbers” – aka “marking
up the curve”.
iii. Despite or because of this, the top 200 employees received remuneration totaling USD
1.4 billion in 2000, up from USD 193 million in 1998.
iv. Skilling and other executives knew: they were selling their Enron shares while
simultaneously talking them up. Booted employees in lower ranks used their severance
package to buy shares.
13. Enron Broadband Services: Expanded to selling bandwidth to data heavy companies so they can book
profits from this similar to how gas futures were booked as profit.
a. Spent huge CAPEX for infrastructure but given the overcapacity of data, it was not able to attract
enough subscribers to make it pay. Still, they practiced MTM.
14. Market and Other Pressures
a. In late 1990’s, Enron was trading at a PE of 60x, thrice the sector average.
b. Good performance raised market expectations, i.e. EPS growth.
c. Major power projects needed cash but it no longer had any.
d. Did not want to raise further debt because it would affect its credit rating.
e. Did not want to issue equity because it would dilute EPS and affect share price.
15. Solution: Move debt off the balance sheet
a. US GAAP: An independent owner must have substantive capital in an SPV to avoid consolidation.
b. FASB: 3% of total capital is the minimum acceptable level of equity in an SPV.
c. Hard to find independent owners so Enron turned to related parties.
d. First deal: SPV Chewco
i. LLP formed in 1997 to acquire a pension fund’s interest in an earlier JV with Enron called
JEDI (Joint Energy Development Investment) where initial investment of USD 250 million
in 1993 was valued in 1997 at USD 383 million.
ii. Chewco would then borrow an equal amount on an unsecured basis.
iii. The loan is guaranteed by Enron.
iv. Debt was provided by Barclays subsidiary BZW.
v. Enron charged Chewco a fee of USD 40 million for providing the guarantee and booked
it as profit.
vi. GPs in Chewco were Enron employees, particularly Fastow’s assistant Michael Kopper.
e. Second deal: SPV LJM1
i. Registered in June 1999 in the Cayman Islands
ii. Name was derived from Fastow’s wife and two children.
iii. Fastow raised USD 15 million through SPV, which would purchase from Enron certain
assets and associated liabilities.
iv. Fastow was sole member of LJM Partners LLC
1. LJM Partners was GP of LJM Partners LP
a. LJM Partners LP was GP of LJM1
i. LJM1 entered into transactions with Enron.
2. This structure shielded Fastow from personal liability.
v. Enron bought into Rhythms NetConnections stock at USD 1.85 a share but IPO’d at USD
21, eventually rising to USD 69. Enron wanted to protect this profit but due to the lock-
up period until the end of 1999, Enron went long on a put option on the Rhythms shares
that requires an LJM subsidiary to buy said shares at a price that would crystallize the
profit (and no longer subject to price changes whatever it is by the end of 1999).
f. Third deal: SPV LJM2
i. Registered in 1999 in Delaware as LLP
g. Other deals: Raptor Vehicles
i. Purpose: Hedge Enron’s own investments
ii. Funded by Enron shares
iii. Unclear description of business per Lay’s comments of what Enron does: “We are an
energy and broadband company that also does a lot of other stuff.”
16. Impact of deals
a. Enron sold interests in seven assets to LJM1 and LJM2.
b. It bought back five of seven shortly after the close of the respective financial reporting periods.
c. In June 2000, Enron sold USD 100 million of dark fiber optic cables to LJM, booking a profit of
USD 67 million.
i. The assets grew in value by 53% from the deals while market value suggests that these
should have fallen by 67% in the same period.
17. Shit starts to happen
a. Lay remains Chairman but handed CEO role to Skilling.
b. Investments in broadband and overseas operations was starting to put a strain on its liquidity.
c. India: Plant was shut down due to government refusing to honor its obligations.
d. Brazil: local currency was devalued and asset values were impaired.
e. Argentina: USD 326 million writedown
f. UK: Financial and operational difficulties
g. Broadband venture was bleeding cash with no chance of generating profits in the short-term.
h. Hedge funds started to short Enron
 i. Bethany McLean: Hard to ascertain company profits; profits do not seem to generate
commensurate cash; lack of transparency (“Enron entered into transactions with limited
partnerships whose GP’s managing member is a senior officer of Enron”)
i. Skilling resigned and Lay became CEO again: “Everything’s fine. Chill.”
j. Share price continued to slide.
18. Post-Mortem: “Many of the most significant transactions apparently were designed to accomplish
favorable financial statement results ,not to achieve bona fide economic objectives or to transfer risk”
I. Goal – Learning about Creative Accounting teaches the following to a corporate finance practitioner:
1. Reiterate the importance of examining assumptions for how things are computed or done
2. Assess how culture makes creative accounting possible
3. Realize that what adheres to accounting standards is not necessarily best practice
4. Understand the possible motivations behind deceit
II. Creative Accounting
1. Stretching to but nevertheless staying within the limits of the standards of accounting
2. Can be countered by forensic accounting – ability to cut through the crap

III. Setting the Story

1. Industry Overview
o US energy market was deregulated in the 1970’s.
2. Company History
o Enron was the seventh largest company by revenue in the US.
o Fortune: “The most innovative company in corporate America from 1995 to 2000.”
o Owned largest natural gas company pipeline from Mexico to Canada, California to Florida.
3. Strategic direction
o International M&A (Enron International)
 Bought plants in Brazil, Argentina, Bolivia, India, and a water utility in the UK
 Rebecca Mark, head of Enron International, wanted to stay in traditional power
generation assets.
o Trading Services (Enron Finance)
 Formed Enron Gas Services to function as trading and marketing arm
 Started from oil and gas future, expanded to electricity, bandwidth
 Jeff Skilling, head of Enron Finance, wanted an asset light strategy focusing on trading
o Venture into broadband (Enron Broadband Services)
 Huge CAPEX but not enough subscriptions to generate cash
4. Motivation
o Investments in broadband and abroad started putting strain on its liquidity.
o Credit rating will be downgraded if its debt level triggers breach of covenants.
o “Rank or yank” culture: bottom 10% of employees are shown the door.
IV. Red flags
1. Enron was trading at a PE of 60x, thrice the sector average.
2. Top 200 employees received remuneration totaling USD 1.4 billion in 2000, up from USD 193 million in
1998.
3. Skilling (CEO) were selling their Enron shares but were simultaneously talking them up.
4. Shady annual report: “Enron entered into transactions with limited partnerships whose GP’s managing
member is a senior officer of Enron”

V. Accounting funnies
1. Revenue recognition
o Marked to Market its Volumetric Production Payments and bandwidth sales
o Involves “creating” a price curve for its future gas-based cash inflows then booking the NPV as
profit
o Price curve depends on dubious assumptions.
o Assumes that underlying assets are liquid when in fact some are not.
o Violates matching principle by recognizing all profit upfront.
o Selling Volumetric Production Payment (VPP)
 Dr Gas Receivable
 Cr Cash
o Borrowing Cash to be Lent to VPP
 Dr Cash
  Cr Notes Payable
o Marking to Market
 Dr Gas Receivable
 Cr MTM (Gain from FV Adjustment)
2. Method of moving debt off-balance sheet
o Had to make sure leverage ratios were within an acceptable range
o Created 3,000 subsidiaries with 400 based in the Cayman Islands
o SPVs would borrow cash from banks, guaranteed by Enron shares
o Enron’s “bad assets” such as broadband were also transferred to the SPV. This prevented losses
from showing up in Enron.
o To avoid consolidation, FASB only required the 3% of the SPV to be owned by an independent
investor.
o Moving Debt to SPV
 Dr Notes Payable
 Cr Cash
o Moving Bad Plant/Broadband Assets to SPV
 Dr ENE Shares
 Cr PPE
3. Deals done
4. Impact on valuation

VI. Effect
1. Unsustainability – eventually, everything will collapse
2. Reminder that accounting is an opinion but cash is fact.
3. Changes in regulation – any loopholes in the Philippines?