ENRON A Seminar by: Darren Hallsworth David Mehta Michelle Mueller

1. ENRON A Seminar by: Darren Hallsworth David Mehta Michelle Mueller

3. Agenda • Introduction/Overview • Accounting • Conflicts of Interest • MOVIE • Implications • GAME

4. OVERVIEW

6. ENRON • America’s largest corporate bankruptcy • Took 16 years to go from $10 Billion in assets to $65 Billion in assets and 24 days to go bankrupt • House of cards built upon oil fields • 4000 employees lost their jobs and life savings and pensions • During 2001, Enron shares fell from over US $90.00 to US$0.30.

7. Why did Enron Fail? • Conflicts of interest • Lack of attention by board of directors to off-books financial entities • Lack of truthfulness • Culture of Enron

8. The “Smartest Guys in the Room”

9. Ken Lay • Chairman/CEO • Huge ambition to make wealth for himself • Advocate for deregulating energy markets. • Founded Enron in 1985 • Positioned Enron to take advantage of the governments decision to let gas prices float with the market

10. Jeff Skilling • CEO & President • Huge risk taker • Transformed energy industry into a stock market for natural gas • In 1992, Enron became the largest buyer/seller of natural gas in North America

11. Jeff Skilling • Implemented mark to market accounting • Arthur Anderson signed off on it and the SEC backed it. • Allowed Enron to book potential future profits on the day a deal was signed.

12. Jeff Skilling • Instituted the PRC performance review committee also known as “Rank and Yank” • Employees were graded on a scale through 1 to 5. • 10% of employees had to be ranked a 5 and fired each year.

13. Andy Fastow • CFO • Used ‘structured finance’ or “off balance sheet transactions “to hide debt while keeping the stock price up • Created Special Purpose Entities (SPE’s) to bury the debt • LJM was Enron’s most ambitious endeavour. Involved transactions with investors using Enron’s stock as collateral. • Huge conflict of interest as Fastow was the head of LJM and the CFO of Enron. • LJM signed off by Skilling & Lay, and also Anderson and Vincent & Elkens. • LJM allowed Fastow to take $45 M for himself.

14. Perception as the Reality • Executives were fixated on pushing Enron’s stock up. • Huge public relations campaign to encourage investors to buy Enron stock. • Convinced investment community that Enron was new, different, and innovative. • Fortune named Enron "America's Most Innovative Company" for six consecutive years • If Enron met or exceeded quarterly EPS, the stock would rise • Everyone had a huge stake to see profits go up • Enron convinced investors that profits were increasing by 10-15% every year. • In reality, they were loosing money.

15. India • In 1992 Enron built a power plant in Dabhol India. • But India couldn’t afford to pay for the power the plant produced • This project lost appox. $1 Billion while paying executives multi million dollar bonuses based on imaginary profits that never materialised.

16. California • Failure was not an option for Enron • Enron bought out Portland General Electric (PGE) based in California. All PGE stock became Enron stock. • This merger put Enron in the electricity business and gave them access to the newly de-regulated market in California • Positioned Enron to become the largest marketer of electricity and natural gas at the wholesale and retail market world wide.

17. California Energy Crisis • Took advantage of the rolling blackouts by tampering with supply and demand. • Exported power out of California to lessen supply and when prices soared due to higher demand, they brought it back in and sold it at a premium. • By shutting down power plants they could create artificial shortages that would push prices higher. • Shut down 3 or 4 plants at the same time to create demand • Enron made $2 Billion in profits and traders made multi-million dollar bonuses. • Cost California $30 Billion dollars to their economy.

18. Project Braveheart • July 2000, Enron announced a deal with Blockbuster to deliver movies on demand via Enron’s Intelligent Network • The plan was to introduce the entertainment on-demand service in multiple U.S. cities by year-end • By March 2001 the deal was called off. • Using mark to market accounting, Enron reported more than $110M as profit from the project. Auditors from Arthur Anderson approved the accounting transaction

19. Pump and Dump • During Enron’s fall, executives would encourage employees and investors to buy more stock, telling them the company would rebound, while selling large amount of Enron stock themselves. • By Enron’s collapse • Skilling made over $200M in Enron stock • Lay made over $300M in Enron stock

21. Running out of gas 2001 • Aug 14 – Skilling resigns for ‘personal reasons’ • Aug 15 – Lay receives Watkins letter warning him that Enron’s accounting is an elaborate hoax. • Aug 20 - Lay sells $2M worth of shares and dishonestly told employees and others that Enron stock was “an incredible bargain” even after he had been warned of “potential scandal” • Oct 16 – Enron announced a $1.2 Billion decrease in company value • Oct 17 – Nov 19 – Enron Employees were not allowed to sell their Enron stock in 401K plans due to a change in their pension fund administrator while the executives were cashing in stock options During this time, the stock plummeted from $32 to $9.06 when it emerged that the company had been concealing losses by setting up shell companies • Oct 23 – Anderson shreds 1 ton of Enron related documents • Oct. 31 - SEC inquiry upgraded to a formal investigation • Nov 8 – Enron admits to overstating income by $586 Million from 1997.

22. The Guiltiest Guys in the Room October 31, 2002 • Fastow was indicted by a federal grand jury in Houston, Texas on 78 counts including fraud, money laundering, and conspiracy. January 14, 2004, • Fastow pled guilty to two counts of wire and securities fraud, and agreed to serve a ten-year prison sentence. • He also agreed to cooperate with federal authorities in the prosecutions of other former Enron executives. • Fastow, although convicted, remains out of prison until completion of the investigation. May 25, 2006 • Skilling was found guilty on 19 counts of conspiracy, fraud, false statements and insider trading. He was found not guilty on nine counts of insider trading. • Lay was found guilty of one count of conspiracy, three counts of securities fraud, two counts of wire fraud, three counts of making false statements to banks and one count of bank fraud.

23. Accounting Scheme

24. The House of cards begins to fall • Oct 22 Enron announces the SEC is looking into related party transactions • Nov 8 Enron announces a restatement of its F/S back to 1997 • Results of the restatement: $591million loss; and additional $628 in liabilities

25. Blame game begins • Arthur Anderson audited Enron’s year end 2000 and prior financial • Andersen received ‘previously undisclosed information’ while performing their 2000 audit • Andersen concluded that the partnerships were not independent of Enron b/c of a technical violation • Partnerships were disclosed in notes but they were ‘arms length’ transactions

26. Blame game begins • Enron was not constrained by the accounting rules to report the partnerships as it did • Losses from partnerships should have been reflected on the income statement • If Andersen believed that following GAAP would mislead investors; duty to disclose

28. Conflicts of Interest? • Ethically, Enron officials had the duty to disclose all relevant information. • Auditors should have been more diligent • Auditors aren’t motivated to aggressively audit their important clients -- $52million in annual fees from Enron • Consulting and internal auditing • Future implications of F/S Audit

29. Off BS! Financing • Large Cap Ex are excluded from B/S • Legal Separate entities are set up – Permissible under GAAP and tax laws • Finance new business ventures • Transfers risk from the parent to the subsidiary

30. Off BS! Financing • Enron sponsored 100’s, if not 1000’s of SPE’s it did business with. • GAAP- did not need to be consolidate in F/S because Independent third parties held 3% of SPE’s assets • SPE’s main assets were restricted Enron Shares • Created an SPE specifically for losses from merchant investment portfolio business

31. The ENRON way • Disclosed in the F/S that dealings with the SPE’s were ‘Arms Length’ transactions • 3rd quarter 2000 to 3rd quarter 2001 reported earnings were $1506m , w/o their ‘Raptor’ SPE it was $429m or 28% of the Reported amount • Violated Revenue recognition principal by recording income as current for services rendered in the future.

32. The Good, the bad, the Enron • Finance new ventures – transfers risk from the parent • No dilution of existing shareholders • No additional debt on balance sheet • Separate from Core business

33. To late to Sell!? • Used off- balance sheet vehicles to pump up financial results • Place to hide losses from bad trades • Manipulate debt/equity ratios and other leverage ratio to ensure they were in an acceptable range.

34. Mark-to-Market • Incorporated ‘mark-to-market’ in mid 90’s • MTM – State that when a company has outstanding energy derivatives contracts on their b/s, they can adjust to FMV • Realize any gains or losses for that period • Complication with rules when accounting for long-term future contracts in commodities like gas

35. Mark-to-Market cont’ • No quoted prices for LT – Future contracts • Companies are free to develop and use discretionary valuation models based on the companies assumptions and methods. • Enron used this to their advantage to beat earnings estimates and boost their stock price • Estimates were considerably overstated and trading gains accounted for more than half the companies 1.41 billion profit in 2000

36. MOVIE !!!

37. IMPLICATIONS

38. Wide Ranging Fallout • Scope of the Enron collapse • Huge ripple effect • Social • Economic • Political

39. Who Was Impacted • Enron executive and board • 5600 employees • Shareholders • Arthur Andersen • Investment Bankers • Lawyers • George Bush

40. Immediate Fallout • Long term implications unclear • Political fallout in US and UK • Enron gave approx US $6 million to political figures • Approx 75% of US contributions went to the Republican Party, including heavy contributions to George W. Bush's presidential campaign

41. Arthur Andersen • The trial of Arthur Andersen on charges of obstruction of justice related to Enron also helped to expose its accounting fraud at WorldCom • The subsequent bankruptcy of the telecommunications firm quickly set off a wave of other accounting scandals. • At the time of its collapse, Enron was the largest bankruptcy in history, since then it has been eclipsed by the collapse of WorldCom.

42. Arthur Andersen • June 15, 2002, Andersen was convicted of obstruction of justice for shredding documents related to its audit of Enron • The U.S. Securities and Exchange Commission does not allow convicted felons to audit public companies so firm agreed to surrender its licenses and its right to practice before the SEC on August 31. • May 31, 2005, the Supreme Court of the United States unanimously overturned Andersen's conviction due to flaws in the jury instructions • Despite this ruling, it is highly unlikely Andersen will ever return as a viable business. • The firm lost nearly all of its clients when it was indicted, and there are over 100 civil suits pending against the firm related to its audits of Enron and other companies • From a high of 28,000 employees in the US and 85,000 worldwide, the firm is now down to around 200 based primarily in Chicago. Most of their attention is on handling the lawsuits.

43. Criminal Behavior and Existing Frameworks • Audit independence • Conflicts of interest • Investor confidence in capital markets • How to close the gaps and restore Trust?

44. Societal and Legal Impacts • Enron's collapse led to the creation of the U.S. Sarbanes-Oxley Act, signed into law on July 30, 2002 • Considered the most significant change to federal securities laws since FDR's New Deal in the 1930s • Other countries have adopted new corporate governance legislations. • Securities law historian Joel S. Seligman was quoted in The Washington Post saying, • "[this was the most important corporate scandal of our lifetimes. It was one of the immediate causes of the Sarbanes-Oxley Act, the governance reforms of the New York Stock Exchange and NASD, and the most consequential reorientation of corporate behavior in living memory."

45. Sarbanes-Oxley Legislation • Summary Page from AICPA site http://www.aicpa.org/info/sarbanes_oxley_summary.htm

46. Sarbanes-Oxley Legislation • What did it cover? Broad strokes • Increased oversight of accounting profession through appointment of new oversight board - granted additional powers to the SEC. • Increased corporate governance obligations of publicly listed companies, incl requirements that CEOs & CFOs personally certify the accuracy of financial information and related disclosures in SEC reports. • Increased level of disclosure required in reports filed with the SEC, incl disclosure of material off-balance sheet transactions. • Provided job protection to & prohibited organizational retaliation against whistleblowers. • Required lawyers report evidence of a corporate officers’ misconduct to audit committees and corporate boards. • Imposed tougher, new criminal penalties for violations of the act and existing securities laws and increased the statute of limitations for violations of the securities laws.

47. Sarbanes-Oxley Legislation • Specifically re Audit Practice • 1. Accounting firms must be responsible solely to audit committees of the boards, which be comprised solely of independent outside directors. • 2. Auditors be barred from providing several non-audit services (including bookkeeping, actuarial, management functions, appraisal, broker or dealer, internal audit outsourcing services, investment advice, investment banking services, and legal services) and the provision of services not expressly prohibited be allowed only if approved in advance by the audit committees. • 3. Audit partners be rotated every five years and auditors be barred for one year from accepting employment with clients as CEO, CFO or Controller. • 4. An auditor oversight board be established, subject to SEC review.

48. In Canada • Bill 198 is the Canadian version of SOX • Does not quite go as far • No Attorney reporting (noisy withdrawal) • No mandatory codes of conduct • No mandatory compensation committees • no forfeit of bonuses • Requires more of a policy re-statement than outright required rules

49. Pensions • Thousands of Enron employees and investors lost their life savings, children's college funds, and pensions when Enron collapsed. A lawsuit on the behalf of a group of Enron's shareholders has been filed against Enron executives and directors. This lawsuit accuses twenty-nine of these executives and directors of insider trading and misleading the public.

50. Pensions • Because the 401(k) plan is a defined contribution plan, there was no Pension insurance and employees lost the money they invested in Enron stock. • Legally they could only sue those considered a fiduciary for breach of their duty of care