News cb-Rom Enron’s Fall! In its April 2001 issue, Fortune magazine called Enron, then the seventh-largest company in the United States, the “most innovative” company in America. Six months later, ‘on December 2, 2001, Enron filed for bankruptcy, the out ‘come of what has been called the greatest accounting fraud of the 20th century. Twelve thousand employees lost not only their jobs but their entire retirement and life savings, which had been invested in Enron stock. Other owners of Enron stock—including thousands of ordinary Americans whose pensions were also invested in Enron stock—lost a total of $70 billion when the value of their stock collapsed to zero. Inside Enron, Sherron Watkins, an Enron vice president, watched in horror as the company she had struggled to save by alerting others to what was going on, nevertheless crashed down around her. Kenneth Lay, an economist and former undersecretary atthe U.S. Interior Department, formed Enron in 1985 by engineering the merger of two natural gas companies whose combined pipeline systems, when joined together, formed the first nationwide system capable of distributing natural gas to utilities around the country. Lay expanded the company by borrowing money to buy up other compa- nies, and by 1987 Enron's debt was 75 percent of its stock market value, creating an ongoing problem for the com- pany. In 1989, Lay hired a young Harvard MBA named Jefirey Skilling to be head of Enron's finance department. ‘The U.S. government had only recently “deregu- lated” the energy business by lifting many of the regula- tions that had kept energy prices fixed. With the lifting of all regulations, gas prices began to fluctuate widely, mak- ing the natural gas market extremely risky for both buyers and sellers. Small gas producers, in particular, had trouble raising money for exploration and drilling because the risky markets drove lenders away. Skilling came up with the innovative idea of having Enron serve as the intermediary between buyers and sellers, in a way that would reduce the risks deregulation created. Enron would sign contracts with sellers to buy their gas over 4 certain number of future years at a certain fixed price and then sign contracts with buyers to sell them gas during those years at the same price, plus a profit that Enron kept. Because these long-term contracts fixed the price of gas for several years, they removed the risk for both buyers and sellers, so both groups began trading with Enron and Enron soon became the leading company in the profitable energy trading business. Skilling put together a team of traders con- sisting mostly of MBAs whom he pushed hard with a ruthless system that each year fired the bottom 10 percent in per~ formance and lavishly rewarded the top performers. Enucs ano Business Skilling now decided to have Enron apply the same trading idea to other commodity markets, and eventually Enron’s eager traders were buying and selling long-term contracts for electricity, coal, paper pulp, aluminum, steel chemicals, lumber, water, broadband, and_plastics— altogether a total of 1,800 different kinds of products. The contracts in these commodities also reduced risk by fixing the price of the underlying commodity for anywhere from 10 12 years into the future. In 1990, Skilling had hired Andrew Fastow, a fina wizard, to help run the trading business, and the two had come ‘up with an ingenious idea for reporting the value of the long- term contracts they were buying and selling. They persuaded the US. Securities and Exchange Commission to allow them tose the “mark to market” accounting method for these con- tracts Inthe “mark to market” method, the value ofan asst is marked” (reported) on the company’s financial reports as the ‘current “market value” of the asset, that is, the amount for which the asset theoretically would sell on the open market. To calculate the market value of a contract, Enron traders would forecast the future price of the underlying commodity (ea. gas, electricity, coal, etc) during the years of the con- tract. Using this forecast, they would then add up the theoret- ical furure cash flows of the contract, apply a discount rate, and compute the net present value of the contract. This net present value was then reported asthe “true value” ofthe con- tract. Ifthe net present value was higher than what Enron had “originally paid for the contract, then the difference could be reported as a “profit” on Enron's financial sheets. Enron traders were pressured to forecast high furure cashflows and low discount rates on their contracts, allowing Enron to re- port high asset (contract) values and profits to investors. In 1996, Skilling was made president and chief operating officer of Enron, and Fastow became chief financial officer. Early on, Enron encountered a problem. In order to enter many of the markets it traded in, it had to borrow substantial amounts of money to purchase the infrastructure needed to transport, store, and deliver the commodities it ‘was trading, But if Enron took on large amounts of debt, in addition to the high debt it already carried, buyers and sell- «ers would be reluctant to sign agreements with the company since high debt levels increase the possibility that a company will fil. Higher debt levels would also lower its investment grade with lenders and possibly trigger banks co recall their current Enron loans. To get around these problems, Enron had to find a way to access borrowed money without having to report the debt on its own financial statements. Andrew Fastow found a clever way of getting around the debt problem and simultaneously getting rid of the 53BASIC PRINCIPLES ‘many overvalued contracts on Enron's financial sheets while generating additional “revenues.” Paying handsomely (sev- eral million dollars) for consulting expertise provided by Arthur Andersen's consulting division, Fastow, with Archur ‘Andersen’ expert assistance, set up a series of “limited part- nerships” called “Special Purpose Entities.” Accounting rules allow a company to exclude a special purpose entity from its own financial statements if an independent party has control of the special purpose entity, and if this inde~ pendent party owns at least 3 percent of the special purpose entity. To meet these conditions, Fastow appointed himself and other Enron people as heads ofthe special purpose ent- ties. These individuals then invested enough of their own money inthe special purpose entities to satisfy the 3 percent rule, and Fastow transferred enough Enron stock into the entity to make up the other 97 percent. The special purpose entities then borrowed large sums of money, using their Enron stock as collateral. The borrowed money was then paid to Enron to “buy” the overvalued contracts on Enron's books and other filing investments, and Enron was able to record the money as “sales revenues” instead of debt. The special purpose entities also agreed to take over large amounts of Enron's existing debt and in return, Enron transferred more of its stock to the special purpose entities. Fastow gave the entities unusual names like “Chewco,” “Jedi,” “Talon,” “Condor,” and “Raptor,” and he and other Enron peopl paid themselves milins of dollars a salaries and income from thei 3 percent ownership ofthe ent The end result was that the special purpose entities were left holding debt, secured by Enron stock, and also holding the overvalued contracts and other fuiing invest- iments as “assets.” Since the debts and assets purchased from Enron by the special purpose entities did not have to be reported on Enron’ financial reports, stockholders be- lieved that Enron's own debts were not increasing, that the company was profiting handsomely on the sale ofthese contracts and other assets to these entities, and that rev- enues were increasing each year. As the company’s auditor and “ouside” accountant, Anhur Andersen’ auditing divi, sion cert thatthe company financial reports provided an accurate accounting ofthe firm, Sherron Watkin, an honest, ouspoken, and straight- forward person who had begun working for Enron in 1993 ‘who was now working asa vce president under Faroe became alarmed by the accounting practices F: : troduced. So long as th: “ss Fastow had in- as the price of Enron stock remuined high enough, its value would be sufficient to b debe the special purpose entities held and the tk ao ha ‘main off of Enron's books. But she knew thar ieee declined sufficiently, this would trigger eke ge eee force the company to dissolve the Sein ae Mou debs and overvalued assets back onto its han po He Unfortunately, in the second half ono “tock began to decline from its high of $80 4 <4 at ‘as a result of a March 5, 2001 in Fortune pein ‘shich argued that Enron’ financial statements ‘were “nearly impenetrable” and that the stock was over= priced. As its stock price declined, Enron accountants Struggled to regroup the debts and assets of the special purpose entities s0 as to avoid having ro include them on Fhe company’s financial statements. Sherron Watkins was horrified both by the increasing risks the decline created and Fastow’s attempts to cover them over, In July of 2001, as investors became more suspicious and the company’s stock price dropped to $47 a share, Shilling suddenly resigned as president and CEO for “per- Sonal reasons.” Now sure that the company was headed to- ward disaster, Sherron Watkins on August 22 personally met ‘with Ken Lay and the legal department and handed over a sixepage letter describing the accounting irregularities re- Jated to the special purpose entities and alerting them to what she later termed “the worst accounting fraud I had ever seen.” “am incredibly nervous,” she wrote, “that we will im- plode in a wave of accounting scandals.” Lay and his attor- neys, however, decided nothing was amiss although the spe- cial purpose entities might have to be dismantled eventually if Enron stock continued to slide. Publiely, Lay announced to employees and investors that the future growth of the company “has never been more certain” and urged them and other investors to continue to invest in Enron stock. Lay and other executives, however, began to quietly sell much of their Enron stock. Watkins also contacted a friend at Arthur An- dersen who discussed her concerns with Andersen’ head Enron auditor. Nothing, however, was done. As Watkins on the inside continued trying to get the company to act, the price of Enron stock continued to fill On October 16, 2001, Enron announced that it had de- cided to take on the debts and assets of the special purpose entities, forcing it to take a charge of $544 million against its current earnings and to reduce the value of sharehold- ers’ equity by $1.2 billion, exactly what Sherron Watts had tried to wam would happen . One week later, on October 22, the SEC announced that it was investigating Enron's special purpose entities ‘The next day Fastow was fired. On November 8, 200! Company announced that it was being forced to restate ofits financial statements back to 1997 as a result of having been forced to consolidate its special interest entities its main financial statements, The restatement Pected to reduce shareholder's equity by $2.1 billion increase the company’s debt by $2.6 billion. By N 2001, the stock had declined to $1 a share, and the Pany collapsed into bankruptcy. On February 2002, Sherron Watkins came Congressional committee and publicly revealed she knew about the company’s accounting PP a beled a “courageous whistleblower” by the = at Andrew Fastow had tried to have her lither computer when he learned of her attempt to alert her superiors of impending trouble. Meanwhile, Arthur Andersen personnel, in an at- tempt to cover up their role in setting up the special enti- ties and then certifying the company’s financial statements, were caught shredding documents related to Andersen's involvement with Enron. In June 2001, the accounting firm was convicted of obstruction of justice because of the shredding and forced to cease operations as an auditing firm, effectively destroying the careers of thousands of its employees. Questions 1. Whatare the systemic, corporate, and individual issues raised by this case? 2. If the value of Enron's stock had not fallen, the special purpose entities perhaps could have continued to oper- ate indefinitely. Suppose that Enron's stock did not fall, and suppose that its accounting adhered to the letter, if not the spirit, of GAAP (Generally Accepted Account- ing Principles) rules (suppose, that is, that Enron's ac- ‘counting practices were allowed by generally accepted Etuics ano Business 55 accounting rules). In that case, in your view, was there anything wrong with what Enron did? Expl 3. Who, in your judgment, was morally responsible for the collapse of Enron? Notes “This case is based entirely on the following sources: Anne Lawrence, “The Collapse of Enron,” in Anne T. Lawrence, James Weber, James E. Post, Business and Society (New York: ‘McGraw-Hill Irwin, 2005), “Enron's Collapse: Audacious Climb to Success Ended in Dizzying Plunge,” New York Times, Janvary 13, 2002; “Report of the Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp.,” February 1, 2002 (the “Powers Report”); “The Enron Collapse: An Overview of Financial Issues," Congres- sional Research Service, February 4, 2002; Stewart Hamilton, “The Enron Collapse,” {ease study], (Lausanne, Switerzerland. International Institute for Management Development, 2003); Sherron Watkins, letter of August 22, 2001 to Kenneth Lay, accessed August 12, 2004 at bap//newsbbe.co.uk/ L/bifousines/ 1764308 se Sheeron Watkins, “Ethical Conflicts at Enron,” California Management Review, v. 45, no. 4 (Summer 2003), pp. 6-19; Michael Duffy, “By the Sign of the Crooked E,” Time, Jnvary 19, 2002.