Group 11

SANKET SHALU
KUNAL DHANUKA
CYRAIC SHAJI
LALIT SHARMA
SHEFALI AGGARWAL 1
 Enron

• Enron was established in 1985 by Kenneth Lay after merging Houston Natural Gas and InterNorth
• The company owned and operated a variety of assets including gas pipelines, electricity plants, pulp
and paper plants and broadband services
• Enron started gaining additional revenue by trading contracts for the same array of products and
services
• Its share price skyrocketed to $90.56 in 2000 and closed at $0.26 in 2001
• Enron claimed revenues of nearly $101 billion during 2000’s and won Americas most innovative
company for six consecutive years
• But since 2001 Enron is only remembered for its poor corporate governance, fraud and corruption.

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 Timeline
Merger of Houston Received SEC’s
Natural Gas and approval to transition Admits that it has been
InterNorth led to from historical cost Creation of Enron inflating income since
formation of Enron; accounting method to Online, an electronic 1997, By December
“Gas Bank” created to mark-to-market commodities trading Enron files for
buy and sell gas method . Web site bankruptcy

1990 1997 2000

1985 1992 1999 2001

A new division Enron Acquired electric utility Announced plan to build

Finance Corp created company Portland General high-speed broadband
Electric Corp.; Becomes telecommunications
nation’s largest buyer and network and to trade
seller of natural gas and network capacity
electricity
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 Genesis
Internal

• Using the same concept of gas bank, Enron •Company’s transformed image of a trading

External
was ready to create market for any trade business
• Due to market dominance, it could predict •Minimal regulations in place in mid-1990s
future prices with great accuracy, earning •Bull market experienced in US
huge profit margins •Fall in energy prices in Q1 of 2001
• Shift in accounting method to Mark to •Lack of transparency of Enron’s disclosures
Market method caught the public’s eye
• Harsh employee ranking system motivating
employees to do deals and post earnings
• Increasing leverage, subsequent creation
of SPVs to access capital and hedge risk

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 Derivatives Instruments Used

Price Swap Derivatives:

• Enron enter into price swap agreement with its SPV Raptor.
• Enron had committed to maintain Raptor’s value at $1.2 billion, if Enron’s stock declined in
value, Enron would need to give Raptor more stock.
• In this price swap, Enron committed to give stock to Raptor if Raptor’s assets declined in value.
The more Raptor’s assets declined, the more of its own stock Enron was required to post.
• This derivatives transaction carried the risk of diluting the ownership of Enron’s shareholders if
either Enron’s stock or the technology stocks Raptor held declined in price.

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 Used derivatives to inflate the value of troubled
businesses

• Enron inflated the value of certain assets it held by selling a small portion of those assets to a
special purpose entity at an inflated price, and then revaluing the lion’s share of those assets it
still held at that higher price.
• In 2000, Enron sold a portion of its dark fiber inventory to the Related Party in exchange for $30
million cash and a $70 million notes receivable that was subsequently repaid, which apparently
was valued at 33 million.

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 Used forward Contracts, but prudency reserves
was kept to show that the market is not that
much volatile.

• The traders in order to gain their incentives, didn’t record the whole profits from a trade as
actual profits realised. They used to divide the profits between actual profits and prudency
reserve.
• Whenever, there was a time with less profits the prudency reserve amount was used to show
earnings. This also helped give out a sense of low volatility among the investors.
• Enron was smoothing its income using “prudency” entries, it was misstating the volatility and
current valuation of its trading businesses, and misleading its investors.

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 Mismarking Forward Curves.

• A forward curve is a list of “forward rates” for a range of maturities, it is crucial to any
derivatives trading operation because they determine the value of a derivatives contract today.
• The NYMEX forward curve has a maturity of only six years whose quotations are publicly
available ; but Enron traders were mismarking ten-year or even greater natural gas forward
rates.

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 Irregular Business Practices

• Enron had gained significantly in the

year 2000 from derivatives which it was
using to hide the losses on technology
Stock.
• Enron had 50% stake in all its
subsidiaries (SPV) which kept them
away from all the debts incurred by
these businesses as they don’t have the
majority stake in any of the businesses.

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 Expected results and vision of Enron

• Enron’s race for revenue growth was driven by fierce market competition and rising stock
market during the 90’s due to dot com boom.
• The stock market during 90’s was rising continuously and all companies were in the race for
sustained high revenue growth to increase the company’s market cap.
• Enron’s senior management was too eager to lead the race of accelerated topline growth by
riding the wave of dot com boom.
• To drive accelerated revenue growth, Enron went on an expensive acquisition spree and also
invested huge amounts of capital in projects without careful thought and due diligence.

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 Actual results of Enron
• At the peak of dot com boom, Enron decided to build high-speed broadband telecom networks.
Hundreds of millions of dollars were spent on this project, but the company ended up realizing
almost no return.
• Similarly Enron invested huge amounts in many power plants and immediately claimed profits on
completion of projects but the projects did not earn enough revenues and were very unprofitable.
• When the recession hit in 2000 due to dot com bubble burst, Enron had significant exposure to the
most volatile parts of the market.
• Such mindless expansion of Enron led to its downfall since many of its investments turned into losses
and the huge borrowed debt for these projects were never repaid thus leading to bankruptcy.
• Since, the derivatives market was highly unregulated then – Enron could rig the valuations of its
derivatives and show huge profits.
• Enron was under ‘Price Swap’ Agreements with its Special Purpose Entities – which stated that if the
assets of the SPV reduced, Enron would provide its shares in return for the loss in value of the assets.
• Enron also used the off-balance-sheet entities to hedge its more successful investments—to avoid
having to report any declines in their value. The problem was that many of these hedges were not
real, because Enron was essentially hedging with itself.

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 Things to do Differently

• Strengthen Board oversight.

• Avoiding perverse incentives to executives.
• Concentrate on core competence of the business.
• Avoiding price swap agreements like ones made with SPV’s

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Thank You…

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