Enron - the Debacle and Lessons Learnt - Research Paper Example

First 28th April 2009 Enron – The debacle and lessons learnt Introduction Quoted as the “Largest bankruptcy filed in US History” by the 7th largest company in the United States, Enron is a remarkable lesson to learn in the premise of “from riches to rags”, whereby a company, specifically top management, loses its integrity in 2001, most in part due to personal greed, resulting in the worst energy crisis, billions of dollars in losses, people losing their jobs and status as a willfully fraudulent company. This research paper is an attempt to trace the roots of Enron, its executives, the steps they took to reach to the top, what exactly went wrong, and how this wrong was further fueled by an individual’s personal quest for gains, eventually turning the company into nothing more than a mere sand dune. A significant part of this research would also attempt to highlight circumstances under which auditors for the firm, Arthur Anderson failed to play its role as well as the failure of the federal government in its part to detect cracks in Enron’s policies and financial reporting to its shareholders. Research Statement The statement I wish to propose as the premise of my thesis is manifold based on a number of reasons. The research has been aimed to achieve the following objectives: 1. Underline the behavioral aspects of the decision makers in Enron’s Management 2. Identify the overall structure of how the organization was directed under these individuals. 3. Discuss Enron’s strategy to systematically create “gaps” in information reporting, especially SPEs to hide debts incurred in billions of dollars 4. Management’s influence on financial auditors to “pass on” information during the processes, in the form of huge fees, supporting 27% of their operations 5. Ken Lay’s personal disregard for his employees, touting good news towards employees while the management was busy selling their part of the stock in the company Based on the above reasons, following is the statement that would serve as the guiding principle for my research: “In an attempt to identify the relationships, organizational and individual, that played a part in Enron’s fall, I will highlight the reasons that led to the eventual failure of Enron, the role played by individuals serving the management of Enron to hide information from their employees, stakeholders and the general public to elude failures and heavy losses incurred due to malpractices and willful fraudulent activities.” Enron’s Fall – Core Issues Before we discuss the issues leading to the fall of Enron, let’s have a look at how Enron was formed, a merger of two companies InterNorth and HNG. InterNorth Based in Omaha, Nebraska, InterNorth was a very large company with investments in businesses ranging from plastics to petroleum exploration and so on. Primarily a gas pipeline manufacturer, InterNorth was also distinguished in its operations of the largest gas pipeline spread across North America. A legacy of Northern Natural Gas Company founded in 1932, InterNorth was formed as its holding company in 1979. Later in 1985, InterNorth took over Houston Natural Gas Company in 1985, in pursuit of expansionary production opportunities. For a while, the company was renamed HNG/InterNorth after the takeover, later named to Enron in just a few months. After the takeover, HNG/InterNorth fell into depth of $ 4.2 billion (Gavridis) following the acquisition of the company. In view of the critical situation, Kenneth Lay, then CEO of HNG, used Employee Stock Ownership Program to pay off the debt. After the settlement, the company, initially planned to manage two headquarters in Omaha and Houston, moved all its operations to Houston, Texas where HNG was initially based, with Ken Lay taking over as CEO of the now Enron Corporation. Houston Natural Gas Company Headquartered in Houston, Texas, HNG was a utility gas company acquired by InterNorth in 1985. With InterNorth CEO EnterOn or Enron Soon after settling the debt incurred as a result of the purchase of HNG by InterNorth, Kenneth Lay came up with the idea of using ‘EnterOn’ (in Camel case) as the name for the new company. As it was about to be released after printing all the stationary, they realized that the word when translated into Greek meant “intestines”, the name was quickly changed to Enron. Enron soon emerged into the market as a leading energy distribution company, simultaneously dealing in industries ranging from coal, paper, pulp, plastics to pipes and wind energy distribution systems etc. Enron’s Chronology (Houston Chronicle) of Events Pre-Fall June 1994 Enron trades electricity for the first time, becoming the biggest electricity marketer in the United States 1997 Enron re-brands itself to project a more socially responsible image of itself to the general public Acquisition of Zond Corporation, to enhance its presence in wind energy power development sector August 1997 Enron expands its coverage of other markets as well such as coal, pulp, paper, plastics, metals etc. 1999 Enron becomes involved in almost a quarter of all energy deals in the world November 1999 Enron launches the first global web-based commodity trading website 2000 Enron is named “The Most Innovative Company in America” for the 5th time and 24th in Fortune’s “100 Best Companies to Work for in America”. Enron becomes the 6th largest energy company in the world December 2000 Jeffrey Skilling replaces Kenneth Lay as CEO of Enron, with Lay serving as Chairman December 28, 2000 Enron’s shares hit record high of $ 84.87 August 2001 Skilling resigns amidst stressful and intellectually barren job as CEO. Lay assumes CEO position again October 16, 2001 The company reports $ 638m loss in its third quarter and announces $ 1.2b equity reduction for shareholders October 22, 2001 SEC launches an inquiry into a possible conflict of interest against Enron in lieu of its partnerships October 24, 2001 Andrew Fastow, the company’s CFO is fired. October 27, 2001 Enron borrows $ 3b to boost the confidence of its investors and customers October 31, 2001 SEC revises its inquiry into a formal investigation November 1, 2001 Enron obtains $ 1b in new loans, with its pipelines as security, with prices falling below $ 10 per share amidst rumors of further borrowing November 8, 2001 Enron enters into agreement with Dynergy, in an attempt to save its business November 9, 2001 (Healy) Dynergy backs down from its agreement December 2, 2001 Enron files for Chapter 11 bankruptcy protection and sues Dynergy for breach of contract December 3, 2001 Enron further arranges $ 1.5b to continue operations while under bankruptcy protection. The company also announces layoff of 20% of its workforce. Major Issues Some of the major issues leading to the fall of Enron as discussed below: 1. Usage of Special Purpose Entities (SPEs), shell firms formed by sponsors, that enable joint investment ventures with partners, while allowing for the disclosure of financial information (debts) but to a limited extent off the balance sheet, to hide billions of dollars of debt. SPEs require atleast in amount to 3% of the overall assets to be owned by independent equity owners (Healy). Investigations found that there were significant amounts of violations to this rule. Through ignorance of this rule, Enron was able to avoid carrying out consolidation on these SPEs, resulting in the company’s balance sheet to understate liabilities and overstating equities as well as its earnings. 2. Enron’s complex business model, largely due to many products (both physical assets and trading operations) as well as its international operations, allowed the company to take full advantage of limitations in accounting to manage its earnings and balance sheets to portray excellent performance to its customers and shareholders. Using mark-to-market to estimate the market value of contracts ran for longer periods of time, sometimes spanning two decades. This procedure has its own disadvantages in such that it might distort a correct representation of the actual situation, allowing an organization to hide its downturns, by easily shifting them from one year over to the other. 3. Several key employees being allowed to become partners in SPEs, allowing these individuals to profit to a very large extent, raising ethical and professional conduct concerns. 4. Failure in large part by the firm’s auditors in detecting that “something was going wrong”, leading to the subsequent investigation into Arthur 5. Reason for Enron’s failure to a high extent, if put on the shoulders of individuals would point largely towards the company’s policy to compensate top management (J. N. Gordon) through stock options. This resulted in forcing these individuals to focus on creating fast growth expectations, as well as using unlawful means to report a high amount of earnings to meet stock market expectations. 6. Failure of sell-side analysts to provide early signs of problem at Enron. They were branded to be “too slow” in analyzing or in small part, recognizing something wrong with Enron. 7. The accounting rules followed in the US are highly systematic. This encouraged financial engineers to get around these rules, satisfying the rule of the book, however nullifying its intent. 8. Diverse political interests also played a huge role in the growth and subsequent overconfidence in its operations due to its ties with Washington. Lay had strong relationships with the two Bushes in the White House, where he actually contributed to the electoral campaign of the two presidents in 1988 and 2001. Enron’s Management Key Players Kenneth Lay - CEO Lay rose from a poor family, with his father serving as a Baptist minister (G. Gordon) in Southern Missouri. He worked very hard and gained a Masters in Economics from the University of Missouri. With immense hard work and determination, Lay soon received a PhD in Economics from the University of Missouri. (Biography of Kenneth Lay) In 1984, Lay was CEO of HNG at the time it was bought by a much larger InterNorth. Following the departure of InterNorth’s CEO, Lay became the CEO of HNG/InterNorth and renamed the organization as Enron (after much deliberation over EnterOn). Lay remained CEO of Enron over the next 16 years, providing direction and leadership to the organization. Based on his individual characteristics and behavior profiling, Lay was an individual who looked at the bigger picture (Hodak), very optimistic and avoided incidents creating controversies. Kenneth Lay’s perception was that of a likeable person enjoying all the attention he could get while socializing (Brickley) while largely ignoring his responsibilities as CEO. Although knowing for a fact of misdemeanors by his then CFO, Fastow, he ignored much of the part in wake of gains by the company. He is also largely blamed for touting the general public and his employees about the progress Enron was making while selling his own stake in the company. Jeffrey Skilling Skilling started from modest family upbringing in Northeast and the Midwest. He was very smart and worked his way to earn his Masters in Business Administration from Harvard in 1979 (Hodak). His life started with Enron in 1990 to start its new gas trading operations. Skilling, through his skills and extempore approach formed Enron Capital and Trade Resources in 1991. He was made president of Enron in 1996, and subsequently CEO in 2001, before he resigned citing personal reasons, six months after he assumed the role. Skilling had a perception of being very smart, receptive, and followed the Darwinian view of markets and business. He encouraged innovative approaches to doing business, and was largely considered to provide the first ladder for new projects, rather than going into the intricacies of each. Andrew Fastow Fastow grew up in the limelight of New York, in a New Jersey suburb and completed his Masters in Business Administration from Northwestern University. Fastow was hired by Enron in 1990 as a financial manager, and eventually became CFO in 1998. Fastow is highly believed to be politically evasive, ambitious and most significantly “the rule bender”. Fastow was largely credited for creating LJM as means to invest in Enron assets, as well as a way of saving investment banking fees. However, with the point being raised that Fastow was behind the fraudulent activities at Enron, he was eventually fired by CEO Lay, just two days after the news broke. Conclusion Excessive greed in an effort to elude the shareholders, the organization, the employees and the society in general through illegal means can have very harmful effects. Financial engineering can be very dangerous for those who can use it for illicit purposes. Enron has written itself down in history as a symbol of an era of enormous Wall Street profits and company misdeeds. Though the case will always be considered, the (Baird) force to reform our securities structure that came as a result of Enron and similar cases has already come and gone. That is a shame, for our possibility to realize badly essential changes to our system of securities directive appears to have dissolute before the work of reform was completed. Hopefully with the advent of a new administration, these policy structures will be revised in a manner more appropriate to regulate organizations as big as Enron, Parmalat or others in a manner in which they are no longer able to pass through the rule book to make exploitations of it, and engage in fraudulent activities. Enron proved to be a very important and vital event in the history of American shareholder entrepreneurship. Many of the important institutions (J. N. Gordon) were subjected to a stress test and a particular company, however the outcome was poor. The immediate distress is that the gross overstretching at Enron is indicative of troubled behaviour elsewhere. Already improvement seems on the way, in the restructuring of accounting firms and the establishment of a new self-regulator; in clearer standards under GAAP about the behavior of specific financing instruments and modes; in new elements of mandatory disclosure; in attempts to redescribe “independent director.” But Enron also repeats in our memories that there is a difficulty that can’t be solved but can only be restricted in the stress between imperfectly fashioned incentives and self-restraint. Enron’s case shed a dark shadow over almost everyone associated with it in a manner or the other, from managers to accountants. However, there should be stricter regulations providing no chance for investors to sit down and spend years waiting on a decision about the fate of an organization. Works Cited Baird, Douglas G. and Rasmussen, Robert K. “Four (or Five) Easy Lessons from Enron.” Working Paper. 2002. “Biography of Kenneth Lay.” 1997. National Energy Technology Laboratory. 28 April 2009 . Brickley, James A. “The Role of CEOs in Large Corporations: Evidence from Ken Lay at Enron.” Research Paper. 2007. Gavridis, Michael and Ficarella, Nicola. Enron and Parmalat: Two Twin Parables. Dissertation. Nottingham: European School of Economics, 2004. Gordon, Gregg. Social Science Research Network. 2009. 28 April 2009 . Gordon, Jeffrey N. What Enron Means for the Management and Control of the Modern Business Corporation: Some Initial Reflections. Working Paper. Chicago: University of Chicago Law Review, 2002. Healy, Paul M. and Palepu, Krishna G. “The Fall of Enron.” Journal of Economics Perspectives (2003): 3-26. Hodak, Mark. “The Enron Scandal.” December 2007. Social Science Research Network. 28 April 2009 . Houston Chronicle. “Enron Timeline.” 17 January 2002. Houston Chronicle . 28 April 2009 . Kroeger, John R. “Enron, Fraud and Securities Reform: An Enron Prosecutors Perspective.” Draft. 2003. Read More