Enron Research Paper

Name:

Lecturer:

Course:

Date:

Enron Research Paper

Business Scandal Overview

Enron was an American Corporation based in Houston, Texas. In the1990s, Enron Corporation was one of the largest incorporated natural gas and electricity companies in the world. It dealt with transmission of natural gas liquids globally, and operated one of the largest natural gas transmission systems in the world, with a total of around 36,000 miles. It had become one of the largest developers and producers of electricity in the world, and served industrial and emerging markets including individual consumers. She was a major supplier of solar and wind renewable energy internationally, had a strong risk management service for a large collection of its natural gases contract, and was one of the largest oil and gas exploring companies around the world. Enron was the largest wholesale marketer of natural gas and electricity in United States. Enron was the pioneer in the innovation of trading products that were gas futures and weather futures, hence playing a big role in development of the service industry. After rapid growth in the early 1990s, the company had trouble towards the end of the 1990s.

Scandal synopsis

Jeffrey Skilling developed a staff of executives that, that entertained the use of accounting dodges, special purpose entities (SPE), and poor financial reporting, to enable them to hide billions in debt from failed deals and projects. Chief Financial Officer Andrew Fastow with the other executives not only mislead Enron’s board of directors and audit committee on high-risk accounting practices, but also pressured Andersen, who was the external  auditor to overlook the error in the reporting of the financial statements. Through this schemes set by the executives, Enron was in a position to give force information about its profits, it also got in a position to cover up for debts so that they did not show in statements. Later, the as the scandal started to unfold, the creditors and investors withdrew and the company was forced to file for bankruptcy in December 2001.

Enron’s huge losses were concealed from stockholders by the executives of the company and the auditing firm, but it unfolded when a proposed merger with Dynegy Inc failed. The company had ranked number seven in the United States in the fortune 500. Its desire to keep a good reputation in the stock market drove the executives to do all they could to conceal information from stakeholders, using special purpose entities, and the auditor who did not disclose. It is good to note that other outsiders were involved in the scandal, such as Karl Rove, a political adviser, who was involved in the meetings of energy administration policies, and at the same time, he held stocks in energy companies, Enron being one of them.

Deregulation in Enron

Deregulation of energy market left the big companies in the market energy to control their operations, and allowed them to influence the market in their favor. This power over the market had led Enron to fake electricity shortage, to raise its demand, and in turn increase its price to gain more revenues in California. According to Public Citizen, “Enron and its chief executive officer, Kenneth Lay, have been remarkably successful in lobbying the executive branch, leaders in Congress and various federal regulatory officials to withdraw government monitoring of many corporate activities within domestic energy markets.” Further, Public Citizen says that in deregulation, the ethics of transparency, accountability, and citizen oversights, which were major causes of downfall for Enron, are ignored, yet, they are crucial factors that ensure the market is operating well (Healy and Palepu 13).

Enron was able to achieve deregulation through use of schemes that influenced elected officials and those involved in regulation of the market to favor their idea. Enron influenced such officials through supporting them financially in their campaigns, and as expected, a relationship would build up, with Enron officials expecting a favor in turn. They were actively involved in campaigns of deregulations and supported those who worked on the campaigns such as Phil Gramm and his wife. She is the one who was involved with deregulating the market when she was the chairperson. It is worth to note that Enron maintained a beneficial relationship with her family, where they financed her financially and professionally. Enron paid the Gramms from $915,000 to $1.85 million in salary, from 1993- 2001, Wendy Gramm received dividends, and her stock options had rapidly grown from $15,000 to $500,000 by the year 2000. After deregulating the market for Enron, she resigned, and soon after, she was employed by Enron as one of top officials.

Before deregulation by Wendy Gramm, Enron was just a minor one, and not among the top 20. Public Citizen notes that Enron was ranked 18^th position after offering $300,000 to congress members. Before deregulation, energy contracts were negotiated under regulated trading laws, which required that information on prices must be reported including the amount traded. After deregulation, Enron and other companies were not required to report on the price it sold its products at, the volume, or even the amount of products being traded. This would be ideal for Enron since nothing would stop them from expanding their business to other regions, and would not be limited by the government.

 

Mark-to-Market Accounting

Accounting in Enron for the original business of natural gases was fair, transparent listing the true value of its operations including costs involved in the business, and the profits generated. According to Healy and Palepu (16), “…Enron’s trading business adopted mark-to-market accounting, which meant that once a long-term contract was signed, the present value of the stream of future inflows under the contract was recognized as revenues and the present value of the expected costs of fulfilling the contract were expensed.” This allowed them to report proceeds or losses from long-term contracts that were not realized in the years they would be realized; hence, the true value would not be reflected on the statements. Enron were faced by the challenge of estimating the market value of some of the contracts, where some dated back to 20 years, since the estimation of income was through present value of the future cash flows. To some of this contracts, about their viability and costs were highly questioned (Healy and Palepu 19).

Collusion between Enron and Investment Banks 

Some of the banks where Enron banked worked with Enron board of directors to help conceal the true financial status of the company. A few examples of the banks including what they did served well to illustrate to collusion between the board of governors and the banks. Most of these banks were accused by shareholders for helping Enron in setting up offshore companies and shady partnerships that helped Enron report exaggerated cash flows. In response, these banks agreed to pay the shareholders on the allegations of helping the company commit fraud. J.P Morgan Chase was one of the banks that in 2003, agreed to pay $135 to settle the allegations of helping Enron in fraud. In 2005, the bank agreed to pay $2.2 billion to compensate the investors who claimed that it helped to conceal losses in Enron. Again, in 2005, the same bank paid $350 to settle claims that it and other banks were involved in helping Enron management in fraud. Merrill Lynch bank was accused of helping Enron in manipulating its income statements through setting up pretense trades and investments. In 2003, this bank agreed to pay $80 million for the allegations of being involved in helping Enron in its fraudulent overstating of proceeds. The Canadian imperial bank agreed to pay $2.4 billion to resolve the claims of helping Enron in concealing losses, and another $274 million to settle a lawsuit from Enron.

Culture Focus: Darwinian Survival of the Fittest

Darwinism Survival of the Fittest refers to the use of survival skills as those used by animals, in surviving in the jungle, where they compete for the recourses available under all conditions. For business, it means doing anything in ones power to ensure that the business survives and remains competitive in the market. The management in Enron was Darwinist since it aimed at making as much profit through manipulation as possible, and when things got worse, they did all that they could, including deceits to maintain the image of the company, and sustain survival. It got involved in unfair competition where it manipulated the market to its favor, in order to capture the biggest market share, and outdo all the other competitors in the market.

Enron used special purpose entities for concealing important information to the stockholders since these entities helped Enron to hide and maintain the risks that were involved with its assets and hence it seemed to be doing well since some of these assets were not included in the balance sheets of the company. According to Healy and Palepu, “Enron used special purpose entities to fund the acquisition of gas reserves from producers. In return, the investors in the special purpose entity received the stream of revenues from the sale of the reserves” (Healy and Palepu 17). Enron guaranteed to pay for the buy out that was done by Chewco, at $383 million. Some of these entities violated the laws set out for the entities to qualify as special purpose entities Money driven culture in Enron is again shown, where the management believed that it could make more money out of speculating on electricity contracts than it could through production of electricity in power plants (Public Citizen, 2001). Since the company was the leader, others were either their supporters or they would face them in the market. They acquired as much as many companies and partnerships in their power to earn as much as they could.

Macho Culture

Enron’s management was surrounded by people who were willing to do anything in their power to earn more without a care for the investors and the employees who worked so hard to make the company what it was. Neither were they concerned about the welfare of the investors and shareholders, whose interests and wealth they were supposed protect and realize the best value. Concealing losses, which were huge and yet continued to incur more expenses and pocketed huge remunerations and benefits to themselves was a clear illustration of macho character that they all embraced. They used crude means of achieving more profits for the company irrespective of the harm it caused the people and all the stakeholders.

In order to earn extra money in California, they did not mind using faked electricity shortages to imply that the cost of electricity was getting higher in order to raise prices of the electricity, which would earn them more money. This was after deregulation, which was pushed for by lay, in order to be free from regulated prices and operations, which enabled them to manipulate the market. Skilling, who was the involved in setting the macho character using terms such as “rank and yank,” which caused around 15% of employees to loose their jobs, and “pump and dump’” which meant pumping the stock and dumping it when it did not yield profits, and the other executives followed him (Ellis). Fastow was the man behind designing the partnerships that were destructive to the company, and yet, other accounting firms approved them, and he did not mind the consequences. This contributed to more growth, which encouraged them further, and did not know when to stop until the company could take no more. When things got worse, these executives, including others like Wendy Gramm, started pulling out of the company by selling out their stocks in order to escape the loss that they anticipated, and all this time they did not think about the employees, who would loose their jobs, and the shareholders, instead, they put their needs first.

The Enron myth- too complicated to explain how we make money, just trust Skilling

Enron, in a period of 15 years, had grown from nothing to a leading international company, a rapid growth that was over 1000%. This at no doubt is commendable; how Enron managed, this growth is the real question that raises concern. People could not understand how Enron made the profits, and because they wanted to believe that the company was doing well, they believed that Skilling knew what he was doing, and they choose to trust him. The past record of Enron was very good since it created value for its shareholders, and people learned to trust them, without fear of loosing.

Skilling, had come up with operations that raised the company’s revenue, and the stakeholders were happy about it. Skilling supported a business strategy that advocated for trading and wholesale management services as opposed to plant production (Forbes, 2002). According to Currall and Epstein (198), they say that trust is earned over time and out of past record. They say that in the case of Enron, “Although Enron was adept at manufacturing trust among the investor community, the dynamic between Enron and Wall Street was complex, because many financial analysts wanted to trust that Enron could deliver superior returns on its stock,” (Currall and Epstein 201). The analysts embraced the fact that Enron was growing, and they ignored other facts out of trust from previous performance. All the stakeholders trusted the executives of the company.

Biographic information: Ken Lay

Kenneth Lay was born on April 15, 1942 in Tyrone, Missouri. He received his bachelor and masters degree in the University of Missouri. Lay served in Florida Gas Company in 2074, and later was the president of Continental Resources Company. He joined Transco Energy Company in 1981 and joined Houston Natural Gas Company three years later, which merged with Internorth in 1985 to form Enron.

Lay worked in the 1970s as federal energy regulator, and when deregulation occurred, he was an executive in an energy company, and knew well how to take advantage of deregulation. He was one of the highly paid CEOs, earning around a remuneration package of about $42.4 million in 1999, and in December 2000, he was named as a potential treasury secretary for President Bush, together with J.P Morgan (Marcello 154). Lay sold most of his stock in Enron in 2001, and encouraged employees to buy more stock with the assumption that the company will recoil. He was charged with 11 counts of security fraud.

Jeff Skilling      

Skilling was born on November 25, 1953 in Pittsburgh, Pennsylvania. He received his Bachelor of Science in applied science from Southern Methodist University in 1975 and his M.B.A. from Harvard in 1979. He worked for McKinsey & Company in their energy and chemical consulting practices before he was hired to work at Enron in 1990. He managed to pull an investment strategy that was quite aggressive, which helped in propelling Enron to become the biggest trader in its market, with revenue of $27 billion in a quarter year (Bio, 2011).

Skilling adopted the mark-to-market accounting where future expected profits were accounted for at their present value ignoring historic or future value. Skilling, after helping in the launch of online trading, the internet-based trading operation, he started adopting the idea that Enron would make more money through trade rather than production at plants and argued that they did not need any assets. This propelled the company higher, as it did to him since he received a package of $132 million a year. He was accused on 35 counts of fraud, insider trading and other crimes, which related to the collapse of Enron. The accusations stated that he was aware and was directly involved in the fraudulent transactions of Enron. He had sold his shares in the Enron of about $60 million after quitting his job as CEO (Bio, 2011).

 Andrew Fastow

Fastow was born on December 22, 1961, and graduated in Bachelor of Arts in economics from Tufts University in 1983. After earning his MBA from Northwestern University, he worked for Continental Illinois National Bank and Trust Company in Chicago where he worked in the asset-backed securities where a bank moves assets off its balance sheet while creating revenue. He joined Enron in 1990 and was the chief financial officer

Fastow was the designer of the complex companies that did business with Enron, whose main purpose was to raise money for Enron, and at the same time, conceal the huge losses in their balance sheets. In this way, he also benefited as he could easily defraud Enron either directly or through the partnerships with other companies. Fastow influenced some of the investment banks such as Merrill Lynch and others to invest in Enron’s funds. His accounting statements did not include all that was required such as cash at hand, and his approach in concealing information was quite smart that despite the financial problems faced by Enron, the company’s stock was still high at $90, which blinded the stockholders. He was later charged with security fraud, wire, mail fraud, money laundering and plotting the inflating of Enron’s profits, and at the same time benefited himself from the company. After the charges, he later pleaded guilty (Saporito).

Conclusion

Since the business grew to be the biggest, these executives believed that it should remain to be the best and did anything to conceal its failing since its reputation was what kept it competitive, and attracted more investors. The three executives, Skilling, Lay and Fastow, changed the strategy of doing business in Enron, and managed to build a reputation of the company, as a highly innovative and profitable company, whose share price was high. For this reason, the executives could not afford to loose their reputation, hence any scheme that would hide the loss, was welcome. The American dream is another reason that encourages people to be involved in such crimes, since it advocates for a free market where every man’s success is measured in terms of wealth. This could have been a reason why the executives concealed information to achieve the dream.

Several mistakes were made by management, investors and other players in the market such as the analysts. One mistake of the management is changing the business strategy, where they adopted a very complex one that did not require them to report on all their operations; hence, they could alter anything in their favor. Concealing information and the illegal dealings ensured that the company remained reputable, but to the contrary, its financial troubles continued, and since they could not stop their activities without being noticed, they had to continue until the last minute. The boards of directors choose to ignore the errors in the accounting reporting. The investing banks, did not disclose the shams of Enron, since it was a huge company that brought revenues to them, they continued to invest in their fund, and helped in the schemes by cooperating to remain silent on the offshore accounts. The Wall Street, and its analysts, though threatened by Enron, played a role in ensuring that Enron conceived and executed illegal transactions since they did not give any negative recommendations about Enron, until it had to collapse. These were the major reasons behind the collapse of Enron, which went unnoticed until the last minute.

 

Work Cited

Bio. “Jeffrey Skilling Biography.” biography.com. n.d. Web. 21 April 2011.

Currall, Steven and Epstein Mark. “Lessons from the Rise and Fall of Enron.” Organizational Dynamics, 32.4 (2003): 193–206. PDF file.

Ellis, Joan. “Enron: The Smartest Guys in the Room.” joanellis.com. n.d. Web. 21 April 2011.

Forbes, Dan. “No Lessons from Enron: Only Reminders.” crawfordsworld.com. 20 May 2002. Web. 21 April 2011.

Healy, Paul and Palepu Krishna. “The Fall of Enron” Journal of Economic Perspectives, 17.2 (2003): 3-26. PDF file.

Marcello, Patricia. Ralph Nader: a biography. Westport, CT: Greenwood Publishing Group, 2004. Print.

Public Citizen. “Blind Faith: How Deregulation and Enron’s Influence over Government Looted Billions from Americans.” Public Citizen. 2001. PDF file.

Public Citizen. “Status of Charges against Banks in Cahoots with Enron.” citizen.org. 2010 Web. 21 April 2011.

Reference for Business. “History of Enron Corporation.” referenceforbusiness.com. 2011. Web. 21 April 2011.

Saporito, Bill. “How Fastow Helped Enron Fall.” time.com. 10 Feb. 2002. Web. 21 April 2011.