ENRON 101 A lesson about the # 1 energy company that wanted to be the # 1 company in the world

1. ENRON 101A lesson about the # 1 energy company that wanted to be the # 1 company in the world Econ 295 Houghton College September 18, 2002

2. Quote from “Enron 401 (k) Plan Details” (for Employees) • “Lack of money is the root of all evil.” George Bernard Shaw

3. Enron Grows

4. On the Rapid Rise to # 7 • …if Enron had recorded trading profits as revenues (like brokerage firms do), instead of recording the entire transaction amount, then Enron would have only $6.3 billion on the revenue line…slightly less than the $100 billion that put Enron in its current #7 spot in the Fortune 500–between Citigroup and IBM. • …the revised number would put Enron at #287, right next to Campbell’s Soup.

5. What were Enron’s sins? • Insider trading • Conflicts of interest • Hiding debt • Overstating income • Execs sold stock while propping up its price

6. Enron’s Corporate Culture • On Paper • Upbeat values • Commitment to ethical behavior • In Practice • Focus on earnings per share at any cost • Aggressive and arrogant attitude • Willing to ignore risks and conflicts of interests • Pitiless • fired 15% of workers per year to maintain excellence • managers horse-traded as to who had to go to meet targets

7. Accusations about Enron • Make insiders rich • Rush jobs to get bonuses • Subic Bay (Philippines), Dabhol (India) • Other plants in Guatemala, Puerto Rico, Dominican Republic • Mute doubters and critics: “No bad news!” • 1995 report of gas leaks in San Juan, Puerto Rico • 1996 San Juan gas explosion killed thirty • Confuse observers with reorganizations, etc. • Encourage managers to lie to promote the firm • Capture auditors • Fired internal auditors • Hired inexperienced accountants from Anderson to take over internal audits.

8. Why Did Enron Fail? • Perverse incentives of bonuses for deal makers • Deals put on books immediately at full value of long-term contracts • Discounted present value of stream of future earnings • Depends on deal-maker’s estimate of future price • Deal-maker’s bonus varied directly with estimated prices • Failure of internal controls • Risk Assessment and Control (RAC)reviewed deals • Numbers often didn’t add up (inflated deal values) • Deal makers threatened RAC analysts to pass them • RAC understaffed and overruled • Andy Fastow allowed to create huge conflicts of interests • Death Spiral of a business out of favor

9. Why Did Enron Execs Hide the Facts? • Value of their stock options depended on maintaining a high value of market price of Enron shares (ENE, NYSE) • Value of the business depends on successful marketing, on media and Wall Street accepting Enron’s positive PR spin.

10. How Did Enron Hide Its Problems? • Rigged the books of the firm to show more net income and greater net worth(owner’s equity). • Income statement: • Revenue - Expenses = Net Income • Overstate revenue • Balance Sheet: • Assets - Liabilities = Net Worth • Hide debt (a liability) with subsidiaries • Value of shares of stock depend on: • Return on Investment = Net Income / Net Worth • Earnings per Share

11. Examples of Cooking the Books • Prepays turned into loans. • Close dealing with Andy Fastow’s LJM2 partnership • Merrill Lynch execs put up money and sought other financing for LJM2. • Fastow promised that LJM2 would be dealing with Enron assets (that he, being on both sides of the deal, would price assets). • Merrill put up money for Enron barges (with hidden promise to find a buyer in 6 months) • Fastow found a buyer (LJM2) • Merrill was asked to lend LJM2 money shortly after

12. Other Schemes to Hide Enron’s Problems • In 1998, senior management brought in financiers to see a new trading operation… It was all a fake. • Increasingly used fraudulent deals with subsidiaries. • Shredding Documents after SEC announced it was investigating.

13. Others Were Also Complicit • “The press loved Enron,” eagerly covering its new business ventures. • Bankers played along in schemes to hide debt. • Merrill Lynch, Citigroup, Chase and others exposed • The external auditors were not asleep at the wheel, they were greasing the skids. • Wall Street failed to look critically: • If a company condemned ENE, it would lose future business deals and the revenue. • Yet Bush Whitehouse refused a bailout.

14. Summary:Effects of Enron’s sins? • Many pensioners lost wealth. • Houston businesses and charities were hurt. • Banks have exposure to losses and lawsuits. • Trust is low in financial markets. • Markets are “repricing assets” reflecting higher risk • Markets and government are rethinking rules and regulations. • Corporate boards are rethinking incentive structures and their oversight responsibilities.

15. Enron Declared Bankruptcy Sunday, Dec. 2nd, 2001

16. Enron Corporation: energy, plus Main Offices, Houston, TX Jeff Skilling, CEO Kenneth Lay, President Brian Cruver, MBA, employed in March 2001 by Enron’s newest division, the Risk Management Group Dark Side; the Empire The Death Star Darth Vader The Emperor “another Jedi goes over to the dark side” (email from a Cruver friend) What’s What & Who’s Who “I didn’t mind joining the Death Star either–after all, the Empire offered great pay and excellent benefits.” Cruver

17. Andrew Fastow, CFO Sherron Watkins, CPA who blew the whistle… Indicted for fraud in secret, asked for a transfer, and quietly sold her Enron stock. Other Players

18. The Crooked E • “I relaxed at my new desk for about half a second when the phone rang. ‘Cruver! Welcome to the Crooked E!’ It was another friend from business school who was calling from fifteen floors above. The Crooked E? It was true: the Enron logo was the letter E tilted at forty-five degrees, though the tilt was not exactly what he was referring to.” Brian Cruver, Anatomy of Greed: The Unshredded Truth from an Enron Insider,” Carroll & Graf, 2002, p. 9.