Enron:

the scandal, the

legend
 Derivative
 A derivative is an instrument whose value is “derived”
from the underlying value of something else, such as a
stock, a bond, or in the case of Enron’s derivatives, a
unit of electricity.
 Derivatives are useful because they enable an investor to
hedge against a decline in value.
 Example: Enron could enter a contract with a purchaser
of electricity, such as a utility, guaranteeing that the
purchaser would pay a certain price for a certain amount
of electricity at a certain date in the future.
 Whistle Blower
 The technical term for these often brave people
is "whistle blower," as in the expression "blowing
the whistle on corruption (or on government
lies, etc)."
 Whistle blowers are people who reveal generally
harmful or very unfair activities, often of which
they have become aware because of their
employment position within their employer's
organization and, or their access to otherwise
unavailable communications from within the
organization.
 Internet bandwidth
 By the late 1990s Enron controlled some 25
percent of all electricity and natural gas
contracts traded worldwide and were considered
the best in the business.
 This success led Enron to act as a market
middleman for other commodities as diverse as
lumber and Internet bandwidth (the rate at
which data can be delivered over the Internet).
 401k Plan
 Pension Plans- Employee 401k contributions are
automatically deducted from their paycheck
each pay period. This money is taken out before
the employees’ paycheck is taxed.
 The contributions are invested at the employees’
direction into one or more funds provided in the
plan.
 Employers often "match" employee
contributions, but are not required to do so.
 While the investments grow in the employees
401k account, they do not pay any taxes on it.
 SPE
 SPE- Acronym for Special Purpose Entities.
 SPE’s reflect a common financing technique for companies.
Companies can cut their risk by moving assets into separate
partnerships that can be sold to outside investors.
 In Enron’s case, assets that were losing money were sold to
partnerships. Enron listed the sales of these assets as earnings.
However, to be legitimate, accounting rules require that an SPE be
legally isolated from the company that created it.
 In Enron’s case this was not true. The SPE’s relied upon Enron
managers for leadership and Enron stock for capital. When outside
auditors told Enron to treat some of the 4,000 SPE’s it had created
as part of Enron, the company had to take the $1-billion charge
against earnings.
 Key Players in the Enron
Scandal
 Kenneth Lay
 Former CEO of Enron, helped start the company.
 Enron extended to him $7.5 million revolving credit line, which
he reportedly used and repaid with Enron stock 15 times within
a period of just several months
 He quit as CEO in February 2001
 He returned as CEO in August 2001until he resigned on Jan.
23, 2002
 He quit the Enron board altogether on Feb. 4.
 Sherron Watkins said Lay was "duped" by top executives
 Jeffrey Skilling
 Enron's chief executive in the first half of 2001
 Since joining the company in 1990, Skilling helped
transform Enron from a natural-gas pipeline company
into an energy-trading powerhouse.
 Between January and August 2001 he sold off about $20
million in Enron stock
 Resigned after the close of markets on Aug. 14 2001
 Being charged with conspiracy, fraud and insider trading
 David Duncan
 Enron's chief auditor at Anderson
 His job was to check Enron’s accounts
 He is accused of ordering the shredding of thousands of
Enron-related documents in an effort to hide them from
Securities and Exchange Commission investigators
 Andrew Fastow
 Former Chief Financial Officer of Enron
 The mastermind behind the deceptive accounting
practices
 Lea Fastow (his wife) also plead guilty to signing and
filing a tax return that did not include income the
Fastow’s had received from Mike Kopper
 Sherron Watkins
 Known as the "Enron whistle-blower"
 Was Enron's vice president of corporate development
 Wrote a letter to Kenneth Lay about “suspicions of
accounting improprieties"
 Not really a “whistle-blower” because she never went
public with her suspicions
 Enron

What Went Wrong?

 How did the collapse begin?
 Energy companies lobbied congress in the
1980s for deregulation of the energy
business
 Energy policy was changed and
Washington lifted controls on who could
produce energy and how it was sold
 Jeff Skilling took and aggressive approach
to expand Enron by trading futures in gas
contracts
 Skilling’s Plan
 Under Skilling’s new plan Enron bet against
future movements in the price of gas-generated
energy
 “Enron bought and sold tomorrow’s gas at a
fixed price today”
 With every trade, Enron took a cut for
transaction costs
 Using the internet to promote trading, Enron
became the most successful player in the futures
game; 90% of Enron’s income came from trades
 Early 2000
 Enron took advantage of the dot.com
boom and traded internet bandwidth
 The value of Enron’s online transactions
was huge ($880 billion)
 The problem was Enron wasn’t making
money on many of their online trades
because they made the market very
efficient
 Fuzzy Numbers
 Enron began tweaking the numbers in
their financial statements with accounting
techniques to hide their losses
 Enron created partnerships, and then
passed the assets (losses) to these
partnerships which eliminated the losses
from their balance sheets
 Andrew Fastow (Chief
Finance Officer)
created the
partnerships
 Condor and Raptor
were two major
partnerships
 Sherron Watkins, the
Enron “Whistleblower”
noticed the fuzzy
accounting that had been
used in relationship to the
Condor and Raptor
partnerships and wrote a
letter to Kenneth Lay and
Arthur Anderson warning
him that the Enron was
unstable.
Why wasn’t Enron caught
earlier?
 Throughout all of this,
Enron and its key
members were making
political contributions to
the white house and
congress.
 Kenneth Lay donated
$100,000 to President
Bush in 2000, and in
2001 Bush invited Lay to
become an advisor to his
transition team.
 In the year 2000,
Kenneth Lay met
three times with Dick
Cheney to discuss
energy policy review.
 When the review was
published in May
2001, it was very
favorable to the Enron
and the energy sector.
 Aug 14, 2001 Jeff Skilling resigned,
Kenneth Lay became CEO once again.
 Stock prices began to fall, as investors
were uncertain about the company’s
stability.
 This started a chain reaction: Enron had
hedged against its own stock, so as long
as the stock price was declining, it could
not recover its losses.
 December 2001,
Enron filed for
chapter 11
bankruptcy
 It’s share price had
collapsed from about
$95 to under $1.
 Chapter 11 Bankruptcy
 Companies and large firms that are facing
severe and unmanageable debt may seek to file
chapter 11 bankruptcy, which allows them to re-
organize so they can either continue their day-
to-day operations or go out of business entirely.
 Under chapter 11, a company is protected from
damaging lawsuits and other negative measures,
but in exchange the company is usually required
to have all its major business decisions approved
by the bankruptcy court.
 What Now
 “Enron is in the midst of restructuring
various businesses for distribution as
ongoing companies to its creditors and
liquidating its remaining operations.”
 Investor Sentiment
 ``Enron has been elevated to a symbol,'' says
Woody Dorsey of Market Semiotics, an
institutional forecasting service, ``There's a
whole new level of uncertainty about profits,
about the integrity of the accounting profession
and of Wall Street.''
 With a crisis like Enron, during a bear market,
stocks typically take about 12 months to
recover.
 From 2000 to mid-2002 prices of stocks for the
nation’s largest companies fell by more than 33
percent, while technology stocks dropped 70
percent (more factors than just Enron).
 But, then again…
 Market Efficiency
 ``The market has already responded to
the potential of overstated profits in the
same way it responds to an unexpected
negative event: ready, fire, aim,'' says
Jeffrey M. Applegate, chief investment
strategist at Lehman Brothers Inc.
 This assumes a fully efficient market, one
where all current information is already
included in the prices.
 Rocking Washington
 After investors’ reaction to Enron and fear of
more such scandals, Conservatives have learned
a sobering lesson:
 “The clamor for accountability in the
financial system means more rules and
regulations in a sector they have spent
decades trying to deregulate.”
 Democrats, though, were soon out calling for
limits on the amount of company stock in 401(k)
plans and moves to ease shareholder suits
against corporate officers, directors, and
auditors.
 Dems vs. Reps
 Democrats see Enron as justification for a strong
assertion of government power to outlaw
conflicts of interest and even restore the ban on
companies operating in both the banking and
securities industries.
 The GOP would instead cater to the Investor
Class with more transparency:
 On Feb. 13, the SEC took a large step in that
direction by announcing plans to impose far
stiffer disclosure rules on companies, like
insisting that significant trading in company
stock by officers and directors must be revealed
immediately & that any important changes in
business must be reported within days.
 Corruption & Regulation$
 After Enron, 89% of investors strongly favor the
criminal prosecution of corporate officials who
are implicated in serious financial fraud.
 New York Stock Exchange and the National
Association of Securities Dealers issued a
proposal that would limit compensation that
analysts can receive from investment-banking
activity.
 Other rules: restrict analysts' trading of stocks
they cover, ban them from reporting to their
firm's investment bankers, and prohibit them
from promising favorable ratings to companies
they cover.
 Public Company Accounting
Reform & Investor Protection Act
 created the Public Company Accounting Oversight
Board under the SEC’s supervision
 board given the power to set accounting
standards and to investigate whether companies
and certified public accounting (CPA) firms are
conforming to the standards
 board also had the power to fine certified public
accountants (CPAs) and their firms for violations,
suspend CPAs and their firms, and recommend
criminal investigations by the Justice Department
 law also required CPA firms to separate their
consulting & auditing services in order to avoid
conflicts of interest like those in the Enron
scandal
 The Best Advice!
 Investors were left wondering whether
they could trust corporations, auditors, or
stock analysts.
 And the best outcome from the present
wave of angst would no doubt be a return
to commonsense investing. Investors
should place their bets on rationality, not
the next skyrocketing stock.
A Quick look: