Case Study: the Enron Bankruptcy

This case study is extracted mainly from two major novels titled “What went wrong at Enron” by Fusaro P. C. and Miller R. M. and “The unshredded truth from an Enron insider” by Brian Cruver. The Vision Called Enron The history of Enron goes back to the 1920’s, when a pair of Houston pipeline companies was incorporated to carry gas along the coast of the Gulf of Mexico. In 1956 these companies merged under the name of Houston natural Gas (HNG). While these companies were working along the coast, another company was building a pipeline network between the Texas Panhandle and the Midwestern United states.

Northern Natural gas, which ultimately called itself InterNorth, went public on the New York Stock Exchange (NYSE) in 1947. HNG joined InterNorth on the Stock Exchange in 1968, and they continued to expand their network of pipes through new constructions and acquisitions. In 1985, these two companies merged to create a pipeline system that touched every coast and border of continental United States. Kenneth lay became CEO of the new company, which he later called Enron. Lay, born in rural Missouri was the son of a Baptist Minister.

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He Embraced the concept of Enron with a believe which many observers likened to a religious believe. The idea that drove Ken Lay and fueled Enron was that of the power of the free market system. With a PhD in Economics, Lay held many positions before setting off to Enron amongst which was Assistant Professor of Economics at the George Washington University in the United States of America. In 1987, the new company stated its first vision “to become the premier natural gas pipeline company in North America. In the late 1980’s, Enron went global with Teesside power plant in England, United Kingdom. The rapid expansion the company experienced in the natural-gas market had necessitated a change in its stated vision. The new vision stated in the 1990’s was “To become the world’s first natural gas major”. Enron was expanding like wild fire across the globe to Central and South America, the Caribbean Islands, India and the Philippines. Back in the U. S. A, Enron was the dominant force in marketing both natural gas and electricity.

In 1995, it was again time to synchronize the company’s vision with its growth potentials; this time the new vision took a totally new turn viz “To become the world’s leading Energy Company. ” The second half of the 1990’s resulted in Enron creating broader markets in water, metals, coal, paper, Internet bandwidth, weather and anything else that could be sold as a commodity. The business model employed was rather straightforward: control the assets that are needed to control the commodity, create a standard platform or “hub” for that commodity, and establish a network of trading partners to deal in that commodity.

Enron had effectively moved from trading just energy to trading all commodities under the sun; this led to a need to once again change the company’s vision, the new vision was as follows “To become the world’s leading company. ” Enron’s growth and indeed share price in the late 1990’s and early 2000’s by all means justified this vision. At the end of year 2000, Dr. Kenneth Lay, Founder of Enron stepped down as company CEO allowing his friend and business confidant, Jeffery Skilling to take his place at the helm of affairs, in control of the new vision and new millennium.

Skilling who hitherto was President of Enron now added the title of Chief Executive Officer to his ranks leaving Kenneth Lay as chairman of the Board. Jeffery Skilling Jeffrey Skilling, former chief executive officer of Enron was born on November 25, 1953 in Pittsburgh, Pennsylvania. Growing up, Skilling was physically active and broke several bones including one in his back. He obtained his bachelors degree in applied science from Southern Methodist University.

He then went to work as a corporate planning officer with First City National Bank of Houston before going on to obtain a Masters in Business Administration from the Harvard Business School (HBS) where he graduated as a Baker Scholar in 1979. From business school, Skilling joined McKinsey and Company where he rose to Senior Partner. After an extended consulting engagement with Enron, he joined the company in 1990 to head up its trading business. He was named President and Chief Executive Officer in February 2001 to take over the reins of leadership from Kenneth Lay with the mission to take Enron places. He unexpectedly resigned “for personal easons” in August 2001. Skilling was known amongst his colleagues and professors at the Harvard Business School (HBS) for his ruthlessness in business. HBS classes are typically conducted using case studies where students participate in solving real life business problems while professors oversee their progress and response to these business issues. To successfully discuss these cases, students are required to have a very good memory in order to be able to recall all the details of the case otherwise they risk being torn apart by other students who are anxious to display their astuteness in a bid to gain superior grades.

It was during these case reviews that Skilling’s professors discovered his ability to hold and unleash fine details gaining ground over most of his colleagues. According to Skilling’s Professor, former congressman John LeBoutillier, he was asked what he would do if his company was producing a product that might cause harm or even death to the customers that used it. Skilling replied: “I‘d keep making and selling the product. My job as a businessman is to be a profit center and to maximize return to the shareholders. It’s the government’s job to step in if a product is dangerous. In effect, Skilling was associated with a ruthlessness and bloodless demeanor, which was one of the major attributes that saw him ascend to the office of Chief Executive Officer of Enron. The Enron Spillover Skilling joined Enron at a time when there was chaos in the natural-gas industry. Deregulation had set in after years of government regulation causing companies to compete aggressively for business with the resultant effect that prices fluctuated wildly. The need to bring some stability back to the market for natural gas was never ever so strong.

Jeffrey Skilling came up with the solution at the same time convincing Enron to buy into McKinsey’s vision of Enron’s future. Skilling’s theory was simple: “Deregulation freed up competition, but it did nothing to create the new markets that were required in order to reap the full benefits of competition”. With fluctuation in prices, it became increasing difficult for consumers to determine a budget for their consumption needs. Skilling saw the need long before others and came up with a solution, a predetermined price for future delivery on a forward market. He adopted wall street’s slice and dice financial technology.

The slice and dice financial technology is similar to the securitization of home mortgages Investment banks normally package for sale in various tranches to various classes of customers. Skilling’s Gas Bank as the operation was called was determined to bring flexibility to the customer. The customer wanted to know in advance what his Gas would cost in the future but was not willing to be tied in the present to that future purchase in case the market moved against him. The gas bank created options on the purchase of future Gas deals and cashed in on a premium while taking up the downside risk of the market as counterparty to the transaction.

Enron would normally sell an opposite contract to another customer who in this case would be a supplier, for part of the earlier premium collected thereby transferring the downside risk as well as the upside risk, for the difference in the premium. Likewise, producers might not wish to be committed to selling natural gas that they might have difficulty acquiring or that they might need for customers who are willing to pay more. Enron allowed them enter into a contract that gave them the option to sell at a lower price than they could hope to receive, but high enough to cover their costs of production.

Enron’s Gas Bank started by arranging long-term contracts for natural gas with a group of suppliers. It then repackaged these contracts into smaller slices and dice for sale to consumers. In trading these contracts, Enron provided fixed as well as variable charges and in addition to options, provided price stability according to the needs of individual customers by selling swaps. A typical Enron swap contract is a scenario whereby Enron would design a contract that would not require it to deliver the physical product to the customer. It would guarantee a fixed delivery price and transfer the obligation to deliver to a local supplier.

It would either pay or pocket the difference between the prices charged by the local supplier and the fixed price it earlier guaranteed the consumer. Enron combined swaps and options in one contract to come up with swaptions, which gave the holder the full benefits of both swaps and options. As their exposures increased, the company realized the need to adopt specialized hedging techniques to manage its downside risk and so set up a separate division called Enron risk Management Services (ERMS). This new company had a mandate to protect Enron’s exposure as well as innovate risk management tools for sale to their numerous clients.

Skilling’s success as Chief Executive Officer in Enron’s gas bank which later became a division of it’s own known as Enron Gas Services (EGS) and later Enron Capital and Trade Resources (ECT) earned him the love and attention Kenneth Lay showered on him as well as overall Chief Executive Officer of Enron Group of Companies. The success Enron enjoyed as a world class innovator came from the model of the Gas bank which it attempted and succeeded to a large extent in duplicating in other markets such as electric power, broad band, water etc. In accounting for these, transactions, Enron adopted the Mark-to-Market accounting model.

This accounting model basically involves recording projected profits of future deals today in their accounting books as if the deals had been completed and the full profits realized. As the deal unfolds and reveals the true profit or loss position on these transactions, the accounting books are adjusted to reflect these changes. In a statement to shareholders in the 1999 Enron annual report, Ken Lay stated, “Individuals are empowered to do what they think best… we do, however, keep a keen eye on how prudent they are… we insist on results. Business as well as employee relations in Enron was short term and targeted not just towards profit making but unrealistic profit making. Enron, in spite of the lengthy and cost intensive procedure it followed to recruit staff practiced a culture that came to be known as ‘rank and yank’. In employment issues, the company insisted on only the best. The rank and yank culture conducted every six months involved categorizing all staff on a scale of 1-5 for appraisal purposes.

Those rated as ‘1’ and ‘2’ were the current best and had prospects of rising within the organization while those rated as ‘5’ were asked to leave the company. Those on a rating of ‘4’ were put in a pool for relocation to other departments within the organization and those rated as ‘3’ were watched with a keen eye as likely candidates for ‘yanking’ in the next session. Another aspect of Enron worth paying attention to are the Special Project Entities (SPE) set up by the Chief Financial Officer, Andrew Fastow. Fastow was known as a wizard in financial circles.

Before joining Enron, he was a Senior Director in Continental Bank, Chicago where he became an expert in asset securitization. The need for these SPE’s came up with the need for cash to finance the deals the company was entering into with various natural gas producers to buy gas at bargain prices. To raise these funds, Enron had to team up with those who had funds, Banks and other financial institutions. The way to formalize their partnership with Enron would be to channel money through the SPE’s created by Enron to the gas producers who will in turn give a commitment to future delivery of gas.

In a bid to remain in the market place and continue to be seen to report recurring profits, as earlier highlighted Enron continued to explore new markets ranging from electricity to paper to weather derivatives (used by manufacturing and agricultural businesses to hedge variations in temperatures that may result in losses for them), tradeable pollution rights, specialty chemicals, metals, broadband and all forms of commodities and with it created new SPEs. One such SPE Fastow created for the sale of electric energy was allegedly used to hide a huge debt of about US$1. billion off Enron’s balance sheet. The debt was used to part finance power generating assets used in the electric power generating business. The broadband market that Enron developed opened doors for companies to trade broadband by using some of the capacity of a fiber-optic cable for a specific period of time. Each month, hundreds of trades would be seen to have taken place online but in the true sense, these trades were mostly sham trades leveled at giving an impression of liquidity in a bid to deceive the public as to the volume of business going on.

By sham trades, it means Enron was using unidentified stooges to buy and sell its commodity online with a direct intent to mislead members of the public. In the wake of Enron’s financial crises, credit rating agencies had began to downgrade Enron’s bond to Junk status. Dynegy, a rival in business had placed a bid to acquire Enron but Enron could not place a figure to its worth as there were no valuable assets in place to price. Enron later surprised the world by officially correcting its financial statement for the past four and half years, erasing all those profits that had drawn investors nto the company and substantially increasing its debt. By this action, the accounting firm that signed off on Enron’s books, Arthur Andersen was immediately culpable. The firm was accused of being lax as auditors and had in fact paid millions of dollars in penalties in this regard in the past. On November 9, 2001 Dynegy made an offer of US$8. 9billion but quickly withdrew the bid due to controversies that still surrounded the validity of the restated figures.

As the Dynegy deal failed to sail through, Enron’s stock price fell below US$1 per share and no longer qualified for listing on the New York Stock Exchange. With all prospects of a white knight coming to the rescue dashed against the wall, Enron finally filed for Chapter 11 protection from its creditors under the United States of America bankruptcy law on December 2, 2001. The company’s shares continued to trade for pennies a share on a market for listed shares that do not qualify for trading on the stock exchange known as the “pink sheet”. On January 9, 2002 the U.

S Justice Department opened a major criminal investigation to look for wrongdoings at Enron that could lead to federal prosecutions, treating the Enron incidence as a full-fledged scandal. The principal players in the scandal were assumed to be Kenneth Lay, Chairman of the Board, Jeffery Skilling, Former President and Chief Executive Officer, and Andrew Fastow, Chief Financial Officer. Arthur Andersen was also being investigated for complacency in audit procedures that overlooked Enron’s use of sophisticated accounting techniques to conceal the true picture of their affairs from the general public.

In this vein, Joseph Berardino, Chairman of Arthur Andersen testified to the Capital markets, Insurance and Government Sponsored Enterprises and the Oversight and Investigations Subcommittees of the House Financial Services committee on December 12, 2001 that Andersen received over US$52million from Enron in 2001 of which only US$25million could be directly attributed to the audit. Circumstances surrounding the death of former Enron’s Vice Chairman, J. Clifford Baxter observers note are suspicious.

It is widely believed that his death was not unlikely to be linked to the fact that he knew too much about the inner workings of Enron, too much for the comfort of those who later claimed complete ignorance of what transpired all the while. Baxter was found dead in his Mercedes Benz Saloon car shot through the head in what appeared to be a suicide. REFERENCE Cruver, B. (2002), “The Anatomy of Greed: The unshredded truth from an Enron insider” Cox and Wyman, Reading, United Kingdom. Fusaro P. C. & Miller R. M. (2002), “What went wrong at Enron”, John Wiley and Sons Inc. (2002).