ENRON SCANDAL

One of the largest bankruptcies

in U.S. History: A failure of
Corporate Governance?

Course: Business and

Corporate Governance
 The Enron Scandal

“Good days” - 2000

Stock price reached $90
Revenues of $101 bn

“Bad days” - 2001

Stock price fell to $0,30
Bankruptcy
A quick look in Enron’s history

Dec 2001: BANKRUPTCY

Oct 2001: Enron Scandal

2000-2001: Enron’s stock price skyrockets

’90’s: Enron’s diversification strategy

1990: Volatility of gas prices, Enron’s “gas bank”

Mid ’80’s: Deregulation of gas prices

1985: Foundation of Enron

 Strong foundation in Energy

 Enron was founded in 1985 through the merger of

Houston Natural Gas and InterNorth
 37.000 miles of pipelines
 With a wide natural gas distribution network

 Fast growth: Became the 7th largest company

in America
 Core business in energy
 However, much of phenomenal growth was occurring
through its other non-energy-related interests
 Profits were mainly coming from trading and
brokering
 Gas deregulation opens opportunities

 Deregulation of natural gas in the 1980’s led to:

 Intensive competition
 Deregulated / lower prices
 Increased gas supply
 More flexible arrangements between producers & pipelines

 But also it brought high volatility in prices

 Increased use of spot market transactions
 75% of gas sales were transacted at spot prices
 Questionable market practices
 Failure in gas supply: fictitious shortage (no legal penalties)
 Involved high risk for both producers & consumers
 Enron: a clever strategy

 Enron established a natural “gas bank” as an answer

to the increased volatility in gas prices
 Absorbed fluctuations & offered stable prices for the
future (like a financial banking institution)
 Earned profits from energy brokering & intermediation
between suppliers & buyers

 Enron secured stable long term prices through

hedging against prices fluctuations
 Offered long-term fixed price contracts with producers
 Used financial derivatives:
 Swaps, forward and future contracts
 Enron moves away from pipelines

 Enron believed that heavy assets,

assets such as pipelines,
were not a source of competitive advantage
 Energy brokering & commodity trading were more
attractive for growth & profitability
 The key to dominating the trading market was information
 So, by late 2000, Enron owned 5.000 fewer miles of
natural gas than in 1985
 Enron entered on line energy trading
 Established the first operational system for transactions
via internet

“Heavy assets “Asset-light strategy”

strategy”
 Expansion with the same model

 Enron expanded in new markets & commodities

internationally (diversification strategy):
 Electric power
 Coal
 Iron
 Paper & pulp
 Water resources
 Optical fibres
 Using the same trading model
 Acquiring some physical capacity in each market &
then leveraging investments through:
 the creation of flexible pricing structures & the use of
financial derivatives for managing risks
 Enron in 2000

 By early 2001, Enron had evolved to the largest

buyer/seller of natural gas and electricity
 Revenues reached $101 billion

 Stock price reached $90

 21.000 employees
 1.500 salespeople
 1.800 different products
 1996 - 2001 “America’s most innovative company”
 Ranked among the 100 most appealing employers
in USA
 But what went wrong?

 Complex business model

 Reaching across many products & crossing national
borders but with reduced physical assets
 Was core competitive advantage thrown away with the
sale of gas pipelines?
 Fast expansion required huge capital investment
 $10 b yearly for financing expansion to new sectors
 New markets though provided low return (=yield)
 Financing problems
 Stretched the limits of accounting
 “Greed is good” culture …

 “Enron had a ruthless and reckless culture that lavished

rewards on those who played the game, while persecuting
those who raised objections.”
(Journal of Business Ethics)

 “PLAY THE GAME, EXPECT THE PAY”

 Heavy use of stock option rewards to motivate managers
towards the increase of short term stock performance
 Appraisal based upon how much paper profit the employee
had generated (not on core values)
 Control from Performance Review Committee to force into line
 Lax creative accounting

 Hiding the true picture of liabilities

 By using Special Purpose Entities (SPE) to achieve
better financial reporting & attract investors
 Debt was not reported in balance sheet
 Liabilities were understated while equity & earnings were
overstated
 Fictional sales to SPE with agreement to repurchase or
sham swaps
 By providing minimal disclosure of its relation with
SPEs
 By applying mark-to-market accounting
 Evaluation of assets in market prices
 Accounting practices

 Enron was allowed to count projected earnings from

long-term energy contracts as current income
 In 1992, Jeff Skilling (then president of trading operations),
convinced federal regulators to permit Enron to use the
"mark-to-market“ accounting method
 This technique was previously only used by brokerage &
trading companies
 The current price of long term contracts was reported as
current income in the profit & loss accounts, even though this
money might not be collected for many years

 Results improved, so the stock prices remained high

 But the use of this technique, as well as some of Enron's
other questionable practices, made it difficult to see how it
was really making money
 Special purpose entities (SPE)

 Enron had been forming off balance sheet entities to:

 Move debt off of the balance sheet
 Overstate earnings
 Transfer risk to other business ventures

 These SPEs were also established to keep Enron's

credit rating high
 As the company's stock values were high, Enron used
the company's stock to hedge its investments in these
other entities
 The collapse…

 The largest ever bankruptcy

 Immediate lay-off of 4.000 employees
 Employees also lost their pension funds and savings
 Share price fall from $90 to $0,30
 Loss of $70 b for stakeholders
 International-scale market “shock”
 Dissolution of Arthur Andersen, one of the five largest
audit & accountancy partnerships worldwide
Enron stock price:
DISASTER STROKE in December 2001
$90
$80
$70
$60
$50
$40
$30
$20
$10
$0

A $10,000 investment in January

2001 was worth $6.25 by December
 Bankruptcy: events evolve fast

 On October 16, 2001, in the first major public sign of

trouble, Enron announces a huge third-quarter loss of
$618 million
 On October 22, 2001, the Securities & Exchange
Commission (SEC) begins an inquiry into Enron’s
accounting practices
 On December 2, 2001, Enron files for bankruptcy
 Enron investors and retirees were left with worthless
stock
 Enron was charged with securities fraud (fraudulent
manipulation of publicly reported financial results, lying
to SEC,…)
 Investigative Findings

 1993-2001: Enron senior management used

complex and murky accounting schemes:
 to reduce tax payments
 to inflate income & profits
 to inflate stock price & credit rating
 to hide losses in off-balance-sheet subsidiaries
 to engineer off-balance-sheet schemes to funnel
money to themselves, friends & family
 to fraudulently misrepresent Enron’s financial
condition in public reports
 Corporate Governance in letter..

 On paper, Enron had remarkable corporate governance

 Only 2 out of 14 members of BoD were insiders
 Compensation of managers by offering company’s shares
 Internal Audit Committee
 Exceptionable code for corporate ethics containing
safeguards against conflicts of interest and
self-dealing transactions
 Establishment of Performance
Review Committee
Corporate Governance in spirit..?

CG Failures .. in all fields:

BOARD OF DIRECTORS ROLE & INDEPENDENCE

AUDITING EFFICIENCY & INDEPENDENCE
PAY FOR PERFORMANCE
SHAREHOLDERS’ MANAGEMENT
 BOARD OF DIRECTORS ROLE & INDEPENDENCE

 Independent BoD members had other “ties” with the firm

 6 of the 14 outside directors had serious conflicts of interest
(Enron’s shareholders/ Shareholders of SPEs )

 BoD members’ incumbency had been long term

 They had become “natives” & reluctant to question practices

 Kenneth Lay was both the Chairman and CEO

 Concentration of power negates the possibility of the board to
control management
 AUDITING EFFICIENCY & INDEPENDENCE
 The Enron audit committee failed (didn’t challenge transactions)
 Internal Auditing – inefficient

 Dependent external auditors

 2 of the top accountants of Enron had come from Andersen
 Some of the auditors had been placed to Enron’s offices,
becoming imbued with the company’s corporate culture
 Auditors’ remuneration for 2000 reached $25 m for audit
services and $27 m for consultancy
 PAY FOR PERFORMANCE

 Managers were compensated by stock options

 Managers aimed at rapid short term increase of
stock price
 But they failed to create medium or long-term value

 Performance Review Committee

 Remunerate those who fall into line
 Persecute those who object
 DISCLOSURE – TRANSPARENCY –
SHAREHPLDERS MANAGEMENT

 Use of internal information from top management

for own benefit
 Gaming with shares

 Investors community deception

 Certain information revealed to stakeholders
 Enron took full advantage of “accounting services”
to portray a rosy picture of its performance
 Use of substantial funds for politicians’ bribe
 $6 since 1990
“The company and its chairman, Mr.
Lay, may have been Mr. Bush's
biggest financial backers, donating
nearly $2 million to his campaigns”
 Results

 Corporate
2001 - Declaration of Bankruptcy
 Sale of Fixed Assets & of profitable
subsidiaries to competitors
 Financial
 Shock for international stock markets
 Social
 Millions of employees lost their savings,
pensions & funds for their children studies
Boss charged with fraud

Jeff Skilling and

Kenneth Lay have
been charged in a
federal indictment
released in June 2004
for fraud, insider trading
and giving false
statements to Auditors
 Where Are They Now?

 Jeff Skilling
 Was convicted of 19 counts of conspiracy, fraud,
insider trading and making false statements
 On October 23, 2006, Skilling was sentenced to 24
years in prison
 Kenneth Lay
 Was convicted of 6 counts of conspiracy and fraud.
In a separate trial, he was also found guilty on 4
counts of bank fraud
 He died of heart attack on July 5, 2006, and a
federal judge ruled that his conviction was void
because he died before he had a chance to appeal
 Where Are They Now?

 Andrew Fastow (Enron’s CFO)

 Was behind the complex network of partnerships &
many other questionable practices
 He was charged with 78 counts of fraud, conspiracy,
and money laundering & he accepted a plea
agreement in January 2004
 He was given a 10-year prison sentence & ordered to
pay $23,8 million in exchange for testifying against
other Enron executives
 Enronomics - Enronitis

“Enronomics, is a fraudulent accounting technique that

involves a parent company making artificial paper-
only transactions with its subsidiaries to hide losses the
parent company has incurred through business activities.”
Source: Investopedia.com

“Enronitis is the nervousness over a company because of

suspected accounting problems.”
Source: yourDictionary.com
 Considerations

Were these decisions just

poor business judgments
made within current laws
and accounting rules?

Or was the fatal flaw due to

the unethical behaviour of
the players?

Could the strict application

of ethical principles have
averted this financial
disaster?
 Thank you for
your attention!