History of Enron

Enron was created in 1986 by Ken Lay to capitalise on the opportunity he

saw arising out of the deregulation of the natural gas industry in the USA.
What started as a pipelines company was transformed by the vision of a
McKinsey consultant, Jeff Skilling, who had the idea of applying models
used in the financial services industry to the deregulated gas industry.
He persuaded Enron to set up a Gas Bank through which buyers and
sellers of natural gas could transact with each other using an intermediary
(Enron) whose contractual arrangements would provide both parties with
reliability and predictability regarding pricing and delivery. Enron duly
recruited him to run this business and he rapidly built up a major gas
trading operation through the early nineties.
During this time Enron was extending its pipeline operations into a wider
power supply business, initially in the USA and then on an international
scale, completing a large plant at Teesside in the UK and contracting to
build a huge plant near Mumbai in India. In due course it had deals all
round the globe, from South America to China. The hard driving
expansion of Enrons power business worldwide created a global
reputation for Enron.
Skillings vision was to transform Enron into a giant, asset-light
operation, trading power generally and his next target was trading
electricity. Lay was lobbying Washington hard to deregulate electricity
supply and in anticipation he and Skilling took Enron into California,
buying a power plant on the west coast.
Enrons national reputation rested on the rapid expansion of its domestic
business and its steadily growing revenue and earnings from trading. So
on the back of his track record, Skilling was appointed Chief Operating
Officer by Ken Lay and he then embarked upon transforming the whole
of Enron to reflect his vision.
Observing the dotcom boom, Skilling decided Enron could create a
business based on a broadband network which could supply and trade
bandwidth and he set out to build this at a great pace.

However, the experiment in deregulation in California didnt work well

and in due course was reversed with recriminations all round. Moreover,
the international business expansion wasnt underpinned by adequate
administration and many of the contracts later turned bad.
So Enron then took the decision to build on its international presence by
becoming a global leader in the water industry and bought a big water
company in the UK, following it up with a big deal in Argentina.
At this point, around 2000, Enrons reputation was still riding high and
Lay and Skilling were looked up to as visionary thinkers and top business
leaders.
However, as we see elsewhere in this case study, the rapid expansion had
run well ahead of Enrons ability to fund it, and to address the problem, it
had secretly created a complex web of off-balance sheet financing
vehicles. These, unwisely, were ultimately secured, and hence dependent,
on Enrons rapidly rising share price.
Also, its hard driving culture was underpinned by incentive schemes
which promised, and delivered, huge rewards in compensation packages
to outstanding performers. The result was that, to achieve results,
aggressive accounting policies were introduced from an early stage. In
particular, the use of mark to market valuation on contracts produced
artificially large earnings, disguising for some years underlying poor
profitability in major parts of the business.
This, of course, meant that Enron was not generating adequate cashflow,
while spending extravagantly on expansion, and eventually it blew up
suddenly and dramatically. Colleagues of this author who met Lay and
had dealings with Enron confirm that there was scepticism in the market
about Enrons profitability and its cash position. Suspicions grew that
Enrons earnings had been manipulated and in late summer 2001 it
emerged that its Chief Finance Officer had privately made himself rich at
Enrons expense through the off-balance sheet vehicles. About this time
the dotcom boom ended suddenly and for Enron, this coincided with the
international power business going radically wrong, the broadband
business having to be shut down, the water business collapsing and the

electricity services business getting into serious trouble in California.

Enrons share price started to slide and Skilling, appointed Chief
Executive Officer in January 2001, resigned in August.
Enrons share price then rapidly declined, triggering repayment clauses in
the financing vehicles which Enron couldnt handle. Its credit rating went
to junk status, which caused the share price to collapse and triggered
further crystallising of debt obligations. Banks refused further finance,
suppliers refused to supply and customers stopped buying.
At the beginning of December 2001, Enron filed for the biggest
bankruptcy the USA had yet seen.
This, in turn, took down one of the largest accounting firms in the world,
Arthur Andersen, which was deemed to have so compromised its
professional standards in its dealings with its client Enron that it was in
many ways complicit in Enrons criminal behaviour.
Ethical assessment
Enron didnt start out as an unethical business. As we have seen in this
case study, what introduced the virus was the pursuit of personal wealth
via very rapid growth. This led to the introduction of quite extreme
incentive schemes to attract and motivate very bright and driven people,
which, in turn, led to an unhealthy focus on short term earnings.
The next step was, naturally, to look at how earnings could be massaged
to achieve the aggressive revenue and earnings targets. Since the
massaged figures for growth in earnings still left a shortfall in cash, Enron
quickly maxed out on its borrowing abilities.
But issuing more equity would have hurt the share price, on which most
of the incentives were based. So schemes had to be created to produce
funding secretly and this funding had to be hidden. In this way, an amoral
and unethical culture developed in Enron in which customers, suppliers
and even colleagues were misled and exploited to achieve targets. And the
top management, who were rewarding themselves with these same
incentive schemes, boasted that a pure, market-driven ethos was
propelling Enron to greatness and deluded themselves that this equated to

ethical behaviour. Lay even lectured the California authorities, whom

Enron was cheating, that Enron was a model of business ethics.
Finally, the respected Arthur Andersen allowed greed for fees to over-rule
the strong business ethics tradition of its founder and caused it to succumb
to bending and suspending its professional standards, with fatal results.
Impact on Corporate Governance
Our five Rules of Good Corporate Governance start with the need for an
ethical culture. Having established that Enrons culture became
progressively more deficient in this regard, lets consider briefly the
impact of this failure in business ethics on the other Rules.
Clear goal shared by all key stakeholders
Lay and, particularly Skilling, engendered in all the staff of Enron the
goal of driving up the share price to the virtual exclusion of all else. The
goal of achieving a long term satisfaction from a stable customer base
took a distant second place to signing up deals. In California, the
customers were deliberately exploited by the traders to the maximum
extent their ingenuity could achieve. Even internally, the Chief Finance
Officers funding scheme was designed to make him rich at his
employers expense.
Strategic management
As a McKinsey consultant specialising in strategy, Skilling had a very
clear vision, at least initially, of what he wanted Enron to achieve.
However, he wasnt interested in management per se and allowed
operational management to wither. But his vision of a huge trading
enterprise wasnt carried down to the next level of developing and
implementing practical business plans, as evidenced by his crazy launch
into broadband, a field in which he had no personal knowledge or
experience and in which Enron had almost no capability or likelihood of
raising the funds required to implement the project
Organization resourced to deliver

Skilling became COO on the departure of a very tough and experienced

predecessor. Even at that point, Enron had been expanding at a rate which
outran its ability to set up appropriate and adequate administrative
systems and controls. Added to which it had always been short of funds.
Skillings lack of interest in operational management meant that on his
appointment at COO, he made a poor situation much worse by making
bad managerial appointments. His focus on rapid growth incentivised by
very generous compensation schemes, and with inadequate spending
controls, created a totally dysfunctional organization.
Transparency and accountability
From the early stages, Enrons focus on earnings and share price growth
and the related financial incentives led to a necessary lack of transparency
as the figures were fiddled.. One could argue that Enron felt very much
accountable to their shareholders for delivering consistent above average
growth in Enrons market capitalization. However, this growth was
achieved by subterfuge and deception. Certainly the dealings in California
were as far from transparent as it was possible to be.

Financial Issues in Enron

Auditing and Accounting Issues

Federalsecuritieslawrequiresthattheaccountingstatementsofpublicly
tradedcorporationsbecertifiedbyanindependentauditor.Enrons
auditor,ArthurAndersen,notonlyturnedablindeyetoimproper
accountingpractices,butwasactivelyinvolvedindevisingcomplex
financialstructuresandtransactionsthatfacilitateddeception.

Anauditorscertificationindicatesthatthefinancialstatementsunder
reviewhavebeenpreparedinaccordancewithgenerallyaccepted
accountingprinciples(GAAP).InEnronscase,thequestionisnotonly
whetherGAAPwereviolated,butwhethercurrentaccountingstandards
permitcorporationstoplaynumbersgames,andwhetherinvestorsare
exposedtoexcessiveriskbyfinancialstatementsthatlackclarityand
consistency.Accountingstandardsforcorporationsaresetbythe
FinancialAccountingStandardsBoard(FASB),anongovernmental
entity,thoughtherearealsoSECrequirements.(TheSEChasstatutory
authoritytosetaccountingstandardsforfirmsthatsellsecuritiestothe
public.)SomedescribeFASBsstandardssettingprocessascumbersome
andtoosusceptibletobusinessand/orpoliticalpressures.

InresponsetotheauditingandaccountingproblemslaidbarebyEnron
andothercorporatescandals,CongressenactedtheSarbanesOxleyActof
2002(P.L.107204),containingperhapsthemostfarreaching
amendmentstothesecuritieslawssincethe1930s.Verybriefly,theAct
doesthefollowing:

Createsanewoversightboardtoregulateindependentauditorsofpublicly
tradedcompaniesaprivatesectorentityoperatingundertheoversightof
theSecuritiesandExchangeCommission;

raisesstandardsofauditorindependencebyprohibitingauditorsfrom
providingcertainconsultingservicestotheirauditclientsandrequiring
preapprovalbytheclientsboardofdirectorsforothernonauditservices;

requirestopcorporatemanagementandauditcommitteestoassumemore
directresponsibilityfortheaccuracyoffinancialstatements;

enhancesdisclosurerequirementsforcertaintransactions,suchasstock
salesbycorporateinsiders,transactionswithunconsolidatedsubsidiaries,
andothersignificanteventsthatmayrequirerealtimedisclosure;

directstheSECtoadoptrulestopreventconflictsofinterestthataffect
theobjectivityofstockanalysts;

authorizes$776millionfortheSECinFY2003(versus$469millionin
theAdministrationsbudgetrequest)andrequirestheSECtoreview
corporatefinancialreportsmorefrequently;and

establishesand/orincreasescriminalpenaltiesforavarietyofoffenses
relatedtosecuritiesfraud,includingmisleadinganauditor,mailandwire
fraud,anddestructionofrecords

Pension Issues

Likemanycompanies,Enronsponsorsaretirementplana401(k)
foritsemployeestowhichtheycancontributeaportionoftheirpayona
taxdeferredbasis.AsofDecember31,2000,62%oftheassetsheldin
thecorporations401(k)retirementplanconsistedofEnronstock.Many
individualEnronemployeesheldevenlargerpercentagesofEnronstock
intheir401(k)accounts.SharesofEnron,whichinJanuary2001traded
formorethan$80/share,wereworthlessthan70centsinJanuary2002.
Manyemployeesretirementaccountswerewipedout.Thelosses
sufferedbyparticipantsintheEnronCorporations401(k)planhave
promptedquestionsaboutthelawsandregulationsthatgovernthese
plans.

H.R.3762(107thCongress),whichpassedtheHouseonApril11,2002,
wouldhave,amongotherthings,requiredthataccountinformationbe
providedmoreoftentoplanparticipants;improvedaccesstoinvestment
planningadvice;allowedthesaleofcompanystockcontributedby
employersafterthreeyears;andbarredexecutivesfromsellingcompany
stockwhileaplanislockeddown.Thelatterprovisionwasenactedby
theSarbanesOxleyAct.The108thCongressisexpectedtorevisitthe
issue.

Corporate Governance Issues

InthewakeofEnronandotherscandals,corporateexecutivesandboards
ofdirectorsweresubjecttocriticalscrutiny.AtEnron,WorldCom,and
elsewhere,topmanagementsoldbillionsofdollarsworthofcompany
stockwhileseriousfinancialproblemswerebeinghiddenfromthepublic.
SeveralprovisionsofSarbanesOxleywereintendedtoremindCEOsof
theirdutiestotheirfirmsandtheirpublicshareholders.Stocktradesby
corporateinsidersmustbereportedinamatterofhours,ratherthanweeks
ormonths.CEOsmustpersonallycertifytheaccuracyoftheircompanies

financialstatements.Criminalpenaltiesforsecuritiesfraudoffenseswere
increased.

TheSarbanesOxleyActalsostrengthenedtheoversightroleofcorporate
boards.Anynonauditservicesprovidedbyafirmsoutsideauditormust
beapprovedbytheboard.Theboardsauditcommittee,whichmusthave
amajorityofindependentdirectors(whoarenotaffiliatedwith
management),willnowberesponsibleforhiring,firing,overseeing,and
compensatingthefirmsoutsideauditor.Theauditcommitteemust
includeatleastonedirectorwhoisfinanciallyexpert,abletoevaluate
significantaccountingissuesand/ordisagreementsbetweenmanagement
andauditors

Securities Analyst Issues

Securitiesanalystsemployedbyinvestmentbanksprovideresearchandmake
buy,sell,orholdrecommendations.Theserecommendationsarewidely
circulatedandarerelieduponbymanypublicinvestors.Analystsupportwas
crucialtoEnronbecauseitrequiredconstantinfusionsoffundsfromthefinancial
markets.OnNovember29,2001,afterEnronsstockhadfallen99%fromitshigh,
andafterratingagencieshaddowngradeditsdebttojunkbondstatus,onlytwo
of11majorfirmanalystsrateditsstockasell.Wasanalystobjectivitytowards
Enronandotherfirmscompromisedbypressuretoavoidalienatinginvestment
bankingclients?

TheSarbanesOxleyActdirectstheSECtoestablishrulesaddressinganalysts
conflictsofinterest.InDecember2002,100investmentbanksreachedasettlement
withsecuritiesregulatorsandagreedtotakestepstomaketheiranalysts
independentoftheirbankingoperations,andtopayfinestotalingabout$1billion.

Banking Issues

OnepartofthefalloutfromEnron'sdemiseinvolvesitsrelationswithbanks.
Prominentbankingcompanies,notablyCitigroupandJ.P.MorganChase,were
involvedinboththeinvestmentbanking(securities)andthecommercialbanking
(lendinganddeposit)businesseswithEnron,andhavesufferedfromEnron's
collapse.Thetwoactivitieshadbeenseparatedbythe1933GlassSteagallAct,
untilP.L.106102(theGrammLeachBlileyAct)allowedtheirrecombination.
Observershavebeguntoquestionwhetherthat1999repealofGlassSteagall
encouragedconflictsofinterestandunsafebanklendinginsupportofthe
investmentbankingbusinesswithEnron.

SeveralaspectsofEnron'srelationswithitsbankershaveraisedseveralquestions.

(1)Dofinancialholdingcompanies(firmsthatencompassbothinvestmentand
commercialbankingoperations)faceaconflictofinterest,betweentheirdutyto
avoidexcessiveriskonloansfromtheirbanksidesversustheiropportunityto
gleanprofitsfromdealsontheirinvestmentbankingside?(2)Werethebankers
enticedorpressuredtoprovidefundingforEnronandrecommenditssecurities
andderivativestootherparties?

(3)DidtheDynegyrescueplan,proposedjustbeforeEnron'scollapse,and
involvingfurtherinvestmentsbyJ.P.MorganChaseandCitigroup,represent
protectiveselfdealing?(4)Whatistheproperaccountingforbanks'offbalance
sheetitemsincludingderivativepositionsandlinesofcredit,suchastheyprovided
toEnron?(5)DidtheEnronsituationrepresentawarningthatGLBAmayneed
finetuninginthewayitmixesthedifferentbusinesspracticesofWallStreetand
commercialbanking?

TheSarbanesOxleyAct(P.L.107204)requirestheSECtostudytheroleof
investmentbanksinaccountingdeceptionsandtoreporttoCongress.

Energy Derivatives Issues

PartofEnronscoreenergybusinessinvolveddealinginderivativecontractsbased
onthepricesofoil,gas,electricityandothervariables.Forexample,Enronsold
longtermcontractstobuyorsellenergyatfixedprices.Thesecontractsallowthe
buyerstoavoid,orhedge,therisksthatincreases(ordrops)inenergypricesposed

totheirbusinesses.SincethemarketsinwhichEnrontradedarelargely
unregulated,withnoreportingrequirements,littleinformationisavailableabout
theextentorprofitabilityofEnronsderivativesactivities,beyondwhatis
containedinthecompanysownfinancialstatements.Whiletradinginderivatives
isanextremelyhighriskactivity,noevidencehasyetemergedthatindicatesthat
speculativelosseswereafactorinEnronscollapse.

SincetheEnronfailure,severalenergyderivativesdealershaveadmittedto
makingwashtrades,whichlackeconomicsubstancebutgivetheappearanceof
greatermarketvolumethanactuallyexists,andfacilitatedeceptiveaccounting(if
thefictitioustradesarereportedasrealrevenue).In2002,energyderivatives
tradingdiminishedtoafractionofpreEnronlevels,asmajortraders(andtheir
customersandshareholders)reevaluatetherisksandutilityofunregulatedenergy
trading.Severalmajordealershavewithdrawnfromthemarketentirely.

InternalEnronmemorandareleasedinMay2002suggestthatEnron(andother
marketparticipants)engagedinavarietyofmanipulativetradingpracticesduring
theCaliforniaelectricitycrisis.Forexample,Enronwasabletobuyelectricityata
fixedpriceinCaliforniaandsellitelsewhereatthehighermarketprice,
exacerbatingelectricityshortageswithinCalifornia.Theevidencetodatedoesnot
indicatethatenergyderivativesasopposedtophysical,spotmarkettrades
playedamajorroleinthesemanipulativestrategies.

Evenifderivativestradingwasnotamajorcause,Enronsfailureraisestheissue
ofsupervisionofunregulatedderivativesmarkets.Woulditbeusefulifregulators
hadmoreinformationabouttheportfoliosandriskexposuresofmajordealersin
derivatives?AlthoughEnronsbankruptcyappearstohavehadlittleimpacton
energysuppliesandprices,asimilardealerfailureinthefuturemightdamagethe

dealerstradingpartnersanditslenders,andcouldconceivablysetoffwidespread
disruptionsinfinancialand/orrealcommoditymarkets.

Legislationproposed,butnotenacted,inthe107thCongress(H.R.3914,H.R.
4038,S.1951,andS.2724)wouldhave(amongotherthings)giventheCFTC
moreauthoritytopursuefraud(includingwashtransactions)intheOTCmarket,
andtorequiredisclosureofcertaintradedatabydealers.

Employees and shareholders

Enron's shareholders lost $74 billion in the four years before the company's
bankruptcy ($40 to $45 billion was attributed to fraud). As Enron had nearly $67
billion that it owed creditors, employees and shareholders received limited, if any,
assistance aside from severance from Enron. To pay its creditors, Enron held
auctions to sell assets including art, photographs, logo signs, and its pipelines.
In May 2004, more than 20,000 of Enron's former employees won a suit of $85
million for compensation of $2 billion that was lost from their pensions. From the
settlement, the employees each received about $3,100. The next year, investors
received another settlement from several banks of $4.2 billion. In September 2008,
a $7.2-billion settlement from a $40-billion lawsuit, was reached on behalf of the
shareholders. The settlement was distributed among the main plaintiff, University
of California (UC), and 1.5 million individuals and groups. UC's law firm
Coughlin Stoia Geller Rudman and Robbins, received $688 million in fees, the
highest in a U.S. securities fraud case.] At the distribution, UC announced in a
press release "We are extremely pleased to be returning these funds to the members
of the class. Getting here has required a long, challenging effort, but the results for
Enron investors are unprecedented."