Sindh Madressatul Islam University

THE ENRON SCAM

FINAL PROJECT STRATEGIC FINANCE

Presented to: Sir Najeeb Ur Rehman

Presented by:
Rashid Ahmed Soomro MMS-22S-004
Jawad Hussain Jandan MBA-21F-202
Two Enron auditors walk into a bar. The bartender asks them if capitalism failed Enron or Enron
failed capitalism. First auditor says, “Capitalism is when you have two cows. You sell one cow and
buy a bull. Your herd multiplies and the economy grows. You sell the herd and retire on the
income.” Second auditor says, “Enron capitalism is when you have two cows. You sell three of them
to your publicly listed company, using letters of credit opened by your brother-in-law at the bank.
You then execute a debt/equity swap with an associate general offer so that you get all four cows
back, with a tax exemption for five cows. You then transfer the milk rights of six cows via an
intermediary to a Cayman Island company secretly owned by the majority shareholder of your
publicly listed company who sells the rights to all seven cows back to your publicly listed company.
The Annual Report to Shareholders says the company owns eight cows, with an option on one
more”.
 ENRON- THE BEGINNING
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 7th Largest Company in America with

• 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
 Key Players

Kenneth Lay Jeffery Skilling Andrew Fastow

• Founding CEO & Chairman BOD
• Hire Skilling
• Envioned Company Growth and make
most of Deregulation opportunity
• Have Political Connections with
Houston State Government as well as
Bush Administration
• CEO of ENRON
• Initially Engage with Mackinsey
Audit
• Envisioned the Spot Market and
gas deregulations
• Use of Gas Bank and Credit
SWAP, Futures and Other
Derivatives.
• Introduce mark to market method
• CFO of ENRON
• Use Complex accounting
Methods
• Use of SPV’s
• Loans from SPV’s cleverly
rotated in all Companies
• Hide Financial Irregularities
Gas Deregulation creates Opportunity
 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
 Opportunity Maximization

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
 Diversification

ENRON BELIEVED THAT HEAVY 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
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:
 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
 APPLYING MARK-TO-MARKET
ACCOUNTING

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
 OFF BALANCE SHEET
THROUGH SPE
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

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
What Fraud they were Doing

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
 BOARD OF DIRECTORS ROLE

 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
INEFFICIENCY &
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
 “Greed is good” culture …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
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
 DISCLOSURE – TRANSPARENCY
– SHAREHOLDERS
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
 HOW THEY CAUGHT; THE
WISTLE BLOWING
On August 15 2001, Sherron Watkins, an Enron VP, wrote an anonymous letter to Ken Lay
that suggested Skilling had left because of accounting improprieties and other illegal actions.
She questioned Enron's accounting methods and specifically cited the Raptor transactions.
Later that same month, Chung Wu, a UBS PaineWebber broker in Houston, sent an e-mail to
73 investment clients saying Enron was in trouble and advising them to consider selling their
shares.
Sherron Watkins then met with Ken Lay in person, adding more details to her charges. She
noted that the SPEs had been controlled by Enron's CFO, Fastow, and that he and other Enron
employees had made their money and left only Enron at risk for the support of the Raptors
 How Regulations were
changed

• The US Congress passed the Sarbanes-Oxley Act  in 2002. Also known as the SOX Act,
this legislation enacted a comprehensive reform of business financial practices. SOX is
generally credited with having reduced corporate fraud and increased investor protections.
• The American Institute of Certified Public Accountants (AICPA) made changes in
Auditing Rules and Regulation provide Full disclosure of information, segregation of
Consultancy services and Auditing.
• SEC strengthen the role of Corporate Governance Structures. Issues Guidelines regarding
Structure and Independence of Board. Gives Guidelines and procedures for material
information disclosure.
 RECOMMENDATIONS

1. Good corporations establish a structure of reasonable rules to guide their executive

decision-making and their employee behavior.
 2. A good corporation reports accurately and adequately to its shareholders, its regulators, its
suppliers, and its communities.
 3. A good corporation keeps its employees informed of developments that would affects its
customers, the marketability of its products and services, and the employees' own financial
position.
 4. A good corporation develops and implements a practical code of ethics, including fair play
in dealing with customers, fair treatment and training of employees, and respect for human
rights and dignity.
THANK YOU