The Controversies and Fall of Enron Corporation

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This paper examines what went wrong inside Enron Corporation. The paper presents what went wrong with Enron’s decision-making, leadership, and further uncovers the conflicts that ultimately contributed to the company’s demise. Review of the company’s history, and the abundant amount of information available on Enron Corporation, this paper exhibits how Enron’s executive compensation policies and ineffective shareholder and management alignment allowing for management’s excessive stock-option packages had devastating affects on the organization. Enron the outcome of a merger between two-gas pipeline companies in the mid eighties skyrocketed into one of the largest companies in America during the late 90’s.

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The companies' success would later be known as an elaborate scandal. Enron misinformed the media about its earnings, withheld important information, and concealed debt from its accounts. As the intensity of the corruption unfolded, investors and creditors withdrew, driving the company into a chapter 11 bankruptcies in December of 2001. This paper attempts to answer who, what, and when the company went wrong.

Introduction

Enron Company was the first major bankruptcy of a large corporate entity in the history of America. The Enron downfall stunned the business and financial sectors of the world and had severe lasting effects on the financial markets after news of the company’s file for chapter 11 got out.

At the time this was the largest bankruptcy ever heard of. Hit the hardest were the employee’s, losing millions of dollars in retirement and pension funds after the stock collapsed. Arthur Anderson the accounting company used by Enron also collapsed after being convicted for obstruction of justice in connection with services provided to Enron.

With the help of deceptive accounting techniques and off balance sheet transactions Enron was able to hide large amounts of debt.

This study will explore the world of Enron to find out where the letdowns happened, could they have been averted, and it will look at the story of Enron. This paper questions Enron's executive compensation policies and the ineffectiveness of shareholder and management alignment with the excessive stock-option packages management received. Connections between the information irregularity and the transfer of costs to shareholders is studied, as well as the effective market theory in regards to Enron's stock price and finally, the absence of director freedom at Enron. This analysis of the Enron debacle attempts to explain what happened at Enron.

History

Enron was founded in 1985 through a merger of Houston Natural Gas and Internorth.

Kenneth Lay supervised the merger as head of Houston Natural Gas and was later named chairman and CEO. In 1996, Lay promoted Jeffrey Sltilling to president and COO. Skilling had joined the company as a senior executive in 1990. Before that, he worked for McKinsey and worked for Enron as a consultant. Over the years, Sltilling would promote a business philosophy that de-emphasized hard assets such as plants and pipelines in favor of trading and wholesale management services. 1990 was also the year Andrew Fastow, a former banker, joined Enron. By 1998, he was CFO. In 1993, Enron joined a partnership with the California Public Employees Retirement System (CALPERS) to develop energy projects. Its initials referred to the partnership: JEDI. It is not known if this was Enron's first SPE; but it was not the last. By

2001, Enron had registered more than 3000 partnerships. With the exception of a few, what they were all for remains a mystery. In July 2000, Enron entered a 20-year deal with Blockbuster to supply video-on-demand. Eight months later the deal was abandoned, and there was still no video-on-demand. The agreement provided that profits would be shared equally, Enron claimed a profit of $1 11 million. Blockbuster's profit: zero.

In 1986, Enron had sales of $7.5 billion. Sales rose for a few years and then fell. By 1993, they had recovered to just under $8 billion, slightly higher than where they started seven years earlier. In 1995, two years later they took off, rising by 38% in one year, then by 53%, then 54%, and then 28%. Between 1999 and 2000, Enron's sales increased by 151 % to $101 billion, and then went bankrupt the next year. At the top of its games, Enron was reporting revenues of $111 billion in 2000, fortune magazine acclaimed Enron as Americas most innovative company for six consecutive years (McLean and Elkind 2003). The resignation of Vice-chairman Cliff Baxter in May 2001 and COE Jeff Skilling in August 2001 was the first indication that something was not right, Jeff Skilling was only elected a few months before hand, and Cliff Baxter became Vice-Chairman in 2000. Amid speculation about the financial stability of Enron it was announced on the 1 6 ' ~ 0ctober 2001 that it was taking a $544 million after tax charge against earnings and a reduction in shareholder equity of $1.2 billion due to related transactions with LJM-2.LJM-2 was a partnership managed and partially owned by CFO Andy Fastow. The partnership provided Enron with a partner for asset sales and purchases as well as to hedge risk. Less than a month after Enron announced its first restatements it announced it would also be restating its earnings from 1997 to 2001 because of accounting errors relating to other partnerships LJM Caymen and Chewco Investments.

These restatements caused a formal investigation by the SEC into Enron's partnerships. The restatements were colossal and with the disclosure that Andy Fastow was paid over $3O million for the management of LJM-1 and LJM-2, investor confidence was crushed. Enron's debt ratings plummeted and just 28 days later on 2nd December 2001 Enron filed for Chapter 11 bankruptcy.

The Fall

It was the partnership transactions that Enron engaged in that had a major part in its ultimate demise. This occurred through the use of special accounting treatment for its Special Purpose Entities, which lead to the restatements in 2001. The company would not have needed to consolidate these SPE's if two conditions were met the first is the must be independent of the company and invest 3% of the assets, the second condition is the owner should retain control of the SPE at all times.

The first of these related party transactions is Chewco Investments a limited partnership managed by Michael Kopper. Chewco was needed to redeem California Public Employees Retirement System (CalPERS) interest in a previous partnership with Enron called Joint Energy Development Investment Limited Partnership (JEDI). JEDI was a $500 million joint investment controlled by Enron and CalPERS. Enron benefited from this joint investment by only recording the gains and losses from the partnership and not the debt on its balance sheet. To redeem CalPERS interest in JEDI Enron needed to get a new partner or it would have to consolidate the debt of JEDI into its balance sheet. Chewco was set up to be this new partner and was managed by Michael Kopper who was selected for the job by Andy Fastow. Chewco bought out CalPERS portion of the investment but it turned out to be almost all debt, this should have been consolidated at this point in 1997 but it was not. This decision was made by management and Arthur Anderson and was in complete violation of the accounting requirements in connection with SPE's. It would have been in the best interests of all involved to consolidate at this point and the consequences of this decision were only truly known in 2001. In November 2001 Enron announced that it would be consolidating the transactions from 1997, this completely changed the earnings and increased the debt on Enron's Balance sheet. Not only did these restatements devastate Enron but also it emerged that Michael Kopper received more than $2 million in management fees relating to Chewco. Kopper was also an investor in Chewco and in March 2001 he received more than $10 million of Enron shareholders money for and investment of $125,000 in 1997. This begins to show some of the corporate governance issues within Enron, one being the roles Michael Kopper had being both a manager and investor in Chewco and an employee in Enron, this is a barefaced conflict of interest, and it also violated Enron's Code of Ethics and Business Affairs, this prohibits such conflicts unless the chairman and CEO signs off on it. Another issue that arises is the Audit Committee it did not review the decision to not consolidate the partnership on to the balance sheet. In June 1999, Enron once again got involved in a related party transaction with the development of LJM-1 and again with LJM-2. The two of these partnerships were structured so that Andy Fastow was general partner as well as Enron's manager of the transactions with the SPE's, another obvious conflict of interest. The LJM partnerships provided distinct roles; they provided a partner to Enron for asset sales and also acted to hedge economic risk for Enron investments. Near the end of a quarter Enron would sell assets to the LJM partnerships, while there is nothing wrong with this if there was true independent ownership which was not the case with Enron. At the end of a quarter in 1999 Enron bought back five of the seven assets just after the close of the financial period, this appears to be just for financial reporting purposes, another casting doubt on the authenticity of the sales is that LJM seemed to make a profit on all the transactions even though the market value of the assets seems to have declined. This appears to show that LJM was merely a tool for Enron to boost earnings, conceal debt and enrich investors involved in the partnerships. During 2000 and 2001 SPE's called Raptors were hedging Enron investments with payments made in Enron stock if necessary. Anderson approved these transactions despite the dangers involved with Enron essentially hedging with itself. Enron restructures its transactions just before the quarter end, a short-term solution to seriously flawed transactions. The Raptor SPE's could no longer make payments and in October 2001 Enron took a $544 million after tax charge against earnings as a

Conclusion

Since the downfall of Enron the volumes of accounting fraud, corporate abuses and governance failures has been unprecedented and has questioned basic aspects of company management and oversight. The bankruptcies and earning restatements for corporations such as WorldCom highlight that Enron was not unique and that corporate governance as a whole needed to be reexamined and strengthened. As a response to Enron and other cases of corporate abuse, governments, boards of directors, and the public have taken great measures to raise awareness and take action to prevent something like this from happening again.

When gauging the lessons learned from the Enron debacle, it is imperative to note the intrinsic value of o publicly traded company. It is evident through their dealings with Anderson that Enron was driven by reported earnings, and subsequently had large aggressive earnings targets, which were only met by entering into intricate transactions. Enron's primary concern was structuring their deals to enhance revenue and stock price, and to make the company look as favorable and positive as possible to outside investors. It is normal and sometimes quite positive for managers to focus on earnings to maximize the companies share price, unfortunately for Enron, because managers maintained significant control rights and had excessive financial incentives through stock options to manipulate these earnings. Even though management had massive stock options they still expropriated company funds to the SPE's they created, owned and managed. This is a direct result of the lack of oversight adopted by the Enron board, and an indicator of the agency theory. The shareholders of Enron many of which were employees who owned stock in their 401k plan, which they were National College of Ireland advised by senior officers to do, were transferred significant costs because of the elaborate accounting techniques used by management and approved by Anderson.

The off balance sheet transactions and complex reporting methods created information asymmetry, and also disrupted the efficient market hypothesis for Enron stock.

The most important lesson to be learned from Enron is less corporeal and focuses on the element of corporate boards. For effective corporate governance and auditing oversight, this should come from a rehabilitated sense of accountability boards should have in the wake of Enron. This should also lead to a board that is not afraid to ask questions about management, financial statements and to question the company's auditors. It is only when this occurs that the oversight procedures in place take action, and companies can run more effectively.

This dissertation has a more complete reflection of the people associated with the downfall of Enron. It has showed the events that took place with Enron that lead to the Corporate Governance failures. It has shown the problems associated with high incentive contracts for management. It also has shown the costs, which were transferred, to shareholders because of the complex financial reporting methods, leading to the partial failure of the efficient market hypothesis. Finally it shows the excessive compensation received by management. "We're the bad guy. We're the criminals. And don't think it's just this company. There's hundreds of Enron's out there, a thousand, cooking the books, inflating the earnings, hiding the debt, buying off the watchdogs. " Mr Blue, The Crooked E: The Unshredded Truth About Enron (2003).