IndexEnron's Rise to the Top: The Fall of EnronConclusions and Recommendations: Recommendations: References: This report has been written, prepared and analyzed jointly by both members of the group. Say no to plagiarism. Get a tailor-made essay on "Why Violent Video Games Shouldn't Be Banned"? Get an Original EssayAbstract From the 1990s until the fall of 2001, Enron was famous throughout the business world and was known as an innovator, a technological powerhouse, and a fearless company. Enron's sudden fall in late 2001 shattered not only the business world, but also the lives of its employees and the people who believed their rise to greatness was genuine. Their collapse was followed by a series of revelations about how they manipulated their success. Introduction Enron shocked the world, going from being “America's most innovative company” to the largest American corporate bankruptcy of its time. At its peak, Enron was the seventh largest corporation in America. Enron gave the illusion of being a stable company with good revenues but this was not the case, much of Enron's profits were made of paper. This was made possible by masterfully designed accounting and morally questionable acts by traders and managers. The deep debt and emerging information about hidden losses gave the company major problems, and in late 2001 Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code. Many factors influenced Enron's rise to the top and its sudden fall. In this report we will discuss and present what we believe were the main reasons for their rise and fall. Ken Lay and Enron Corporation: Although a cast of characters were involved in the Enron passion play, one person stands out as the thread that ties everyone else together during Enron's rise and fall: Kenneth L. Lay. A small-town Missouri boy who wanted to get out, Lay earned bachelor's and master's degrees in economics from the University of Missouri. After brief stints at Humble Oil in Houston and in the U.S. Navy, where he found his way to the Pentagon, Lay returned to Houston where he earned his PhD in economics from the University of Houston. He later returned to government service, first at the Federal Energy Regulatory Commission (FERC), then at the Department of the Interior. During his time in Washington, Lay focused on what he believed to be the inevitable movement toward deregulation of the U.S. energy sector. And he firmly believed in its correctness. Ethical Dilemma: One of the first tests for corporate leadership occurred in 1987 in Enron's crude oil trading operations located in Valhalla, New York.3 After it was discovered that many traders were making falsified trade reservations and settlements, Ken Lay reorganized the unit and changed its reporting structure. Rich Kinder wanted it shut down, but Lay didn't. Within a few months, traders were out of control again and losses approached $150 million. Two were eventually found guilty of fraud, and Enron managed to bring the loss back to just $80 million. Outside Influence: Ken Lay hired McKinsey Consulting immediately after Enron was formed to evaluate the company's strategy. The head of the McKinsey team was Jeffrey Skilling, a graduate of Southern Methodist University's School of Engineering and Harvard Business School (MBA '79) and, by all accounts, before and since, the smartest man in the room. McKinsey Consulting was widely considered thebest and brightest of the era and among her many talents Skilling stood out. Few people had risen through the ranks faster at McKinsey, where Skilling became a partner in five years and a director in ten.4 In 1989, Jeff Skilling headed McKinsey's global energy practice and needed a new challenge. Financial Reporting: The third event that would create ripples within Enron for years to come was Jeff Skilling's insistence on using an accounting technique common to financial services but unheard of in mark-to-market (MTM) accounting energy sector. MTM would allow Enron to recognize sales and profits on operations today, even though most of the actual sales, profits, and cash flows would not actually occur until sometime in the future. Skilling, in fact, had told Ken Lay that he would not join Enron unless he could take on MTM. Skilling successfully convinced both Ken Lay and Rich Kinder, then COO of Enron, that MTM made sense if they wanted to build a trading business. After some delay and deliberation, the Securities and Exchange Commission (SEC) approved the request in January 1992Enron's Rise to the Top: From Energy to Trading: Kenneth Lay was one of the key spokesmen when it came to deregulation of the energy market, so because of his personal connection to the Bush family. In the early 1990s, the United States Congress passed legislation liberalizing the sale of natural gas. Not long before, Lay had been one of the initiators who had made the sale of electricity on the free market possible. This major deregulation in the energy market gave Enron the opportunity to sell its energy at higher prices, which equivalently leads to more revenue. This was the beginning of Enron's journey from an energy company to a trading company. The focus has shifted from energy markets to finding new ways to make money. Large investments have been made all over the world to expand their business and open up to new markets. Enron has been named America's most innovative company for six consecutive years by Fortune's Most Admired Companies survey. This made the company attractive to top graduates from top universities across America, which gave the company greater expertise and great impetus to move forward. The forward commitment was the same as the goal of increasing the stock price. Enron employees were partly paid in stock, so increasing the stock price became a primary interest. Mark-to-market accounting: In 1990, Jeffery Skilling joined Enron Corporation and in 1997, he was named CEO of the company. Skilling called for changing Enron's accounting system from a simple type of accounting in which Enron had listed the actual revenues and costs of supplying and selling gas to the mark-to-market accounting system. The mark-to-market method requires estimates of future income when a long-term contract is signed. These estimates were based on the future net value of cash flow, the costs related to the contract were often difficult to predict. This means that the estimated revenue from the projects was included in Enron's accounting even though the money had not yet been received and if there were any changes such as additional revenue or losses, they would be recognized in subsequent periods. Investors were provided with misleading information due to the deviation in estimates. Enron was the first non-financial company to use the mark-to-market method. The U.S. Securities and Exchange Commission gave Enron approval to use the method on January 30, 1992. (The smartest Guy in theRoom, 2004) Special Purpose Entities: Special purpose entities are legal entities created only to perform a specific or temporary task. The purposes are to manage the assets through financing or risk management. A sponsor creates the entities but the funding comes from investors. Financial reporting has many rules about separating the entity from the sponsor. In the case of Enron, special purpose vehicles were not only used to circumvent traditional accounting conventions, but also to hide debts. The entities allowed Enron to undervalue, hide its debts, and overstate its net worth. A new strategy: In 1992 Enron was the largest seller of natural gas in North America, its earnings before interest and taxes were $122 million. To grow further, Enron followed a differentiation strategy based on the fact that the company owned and operated a variety of assets, oil pipelines, broadband services, paper water plants, and electrical plants. Enron not only made money from its operations, but also actively traded contracts for the products and services it provided, generating additional revenue. This made Enron an investor favorite, and between 1990 and the end of 1998 Enron's stock price increased 311%. The increase didn't stop there, in 1999 it increased by 56% and in 2000 it increased by a further 87%. The market index in the same two years was +20% and -10%. Enron's stock price was $83.13 and its market value was just over $60 billion on December 31, 2000. (The fall of Enron, 2003)The Commodity Futures Modernization Act of 2000, which ensured the deregulation of over-the-counter derivatives, helped Enron with its derivatives business. One example was during the California electricity crisis (2000-2001), where they manipulated California's energy market and increased electricity prices by at least a factor of eight. During that time, the price of natural gas was as high as $60 per thousand cubic feet in California (it previously sold for about $3 per thousand cubic feet). This type of manipulation increased Enron's stock price and revenues. But this not-so-clever manipulation of Enron turned into a political target and hastened the ruin of their finances. The Collapse of Enron Mark-to-Market Accounting The use of mark-to-market accounting later backfired. The company's aggressive accounting had corrupted Enron's books and allowed the company to be overly optimistic in its assumptions about future profits. Cash is a necessity for running any business and Enron had mostly paper revenue, so in mid-2001 they came to the conclusion that the liquidity crisis had hit them. The Enron Culture: At Enron, bonuses and incentives in the form of cash or stock options came bundled, only if you were good enough and if you were considered one of the money makers. This mentality made Enron a very competitive place to work. Everyone was in a hurry to close deals (good or bad) because immediately after closing a deal, they received their bonuses regardless of the outcome of the deal. This became a problem as there were many projects in the pipeline but no follow up. No one wanted to be responsible for a closed deal, they just wanted to close it and get their bonus. The performance review board was also a factor in why Enron employees were so aggressive. He created a culture within Enron that replaced cooperation with competition. The committee assigned a score from 1 to 5, with 1 being the highest score and in Enronscore 1 meant that you will receive a good amount of bonus. If you were in the bottom 5-6% of this ranking, it meant that you are not good enough to stay at Enron and you needed to pack your bags because you will soon lose your job. Financial Focus: The financial philosophy that emerged from Enron in the 1990s was aimed almost exclusively at Wall Street. All other things ignored, it was all about profits. Both Ken Lay and Jeff Skilling believed that the market prizes earnings growth over all other factors, including cash flow and earnings quality. In the first half of the 1990s, when Enron's business results still came primarily from pipeline operations, earnings and cash flows were largely aligned. When profits have been recognized (recorded as having occurred), they have been realized (showing up as cash flow). Figure 1 illustrates this relative balance, as Enron's net cash flows from operations (cash flows from operating activities minus cash flows engaged in investing activities) remained slightly positive or balanced. Profits increased during the period between 1991 and 1996 and the story of Enron was growing in the market. But as Skilling's gas bank and related businesses grew, corporate net cash flows shifted radically into deficit. Mark-to-market accounting has been increasingly used to reflect all earnings associated with a trade or deal up front. HOWEnron's business turned into energy 7 The Dabhol project, India, is explored in depth in Enron and the Dahbol Power Company, by Andrew Inkpen, Thunderbird Case A07-02-0008. 6 TB0123 trading, broadband and other market making activities, the gap between reported earnings and cash flows has grown. Special Purpose Entities: In order to hide losses and fabricate profits, Andrew Fastow created multiple SPEs. Some SPEs are Chewco, LJM1, LJM2 and Raptor. When news of the debt concealment emerged, Enron's stock began to fall and several SPEs began to collapse due to the decline in Enron's stock price. For an SPE to become legal, it must meet 3 requirements: (1) At least 3% of the capital must come from external investors (i.e. not Enron) (2) The entity cannot be controlled by Enron, and (3) Enron was not liable of any loans or other liabilities. (Bryce, 2002) An internal investigation into the SPEs showed that they were not independent as they were run by Enron employees (e.g. LJM was run by Andy Fastow while ChewCo was run by Kopper). Therefore, they had to be disclosed in Enron's financial statements, severely depressing earnings and debt levels. Key Players: Enron was hosted by bright, talented employees and everyone thinks they are so smart or smarter than others that they think they could always get away with "crime."' Jeffrey Skilling was responsible for implementing the accounting mark -to-market at Enron. Under his management, Enron launched Enron Online, an Internet-based service where energy commodity contracts can be traded with Enron. Ultimately, Enron failed to cover the capital costs of their transactions, which is also one of the reasons that sent the company into bankruptcy. Andrew Fastow was Enron's CFO, the mastermind behind special purpose entities like LJM1, LJM2, etc. at Enron. He created complicated financial structures so that Enron could hide its losses and debts. Rebecca Mark was the head of Enron's failed businesses, which were Enron International and Azurix. Some of these projects were the $3 billion power plant in Dabhol, India, and theexpensive takeover of Wessex Water. He also used the Enron Jet on his trips around the world. One executive even said that every time Mark attends a meeting, he costs the company at least $60,000 (which would just cover his transportation). Of course, who could forget Enron Chairman and CEO Kenneth Lay's input on Enron's bankruptcy. In addition to walking away from the business because he was too busy socializing, he and his family misused company assets. At one point, they were all using corporate jets for personal travel. He was also involved in conspiracies and fraud within the company to hide its failure. Consequences of Enron's bankruptcy: The bankruptcy affected at least 21,000 Enron employees. During the four years preceding the bankruptcy filing, in which shareholders lost $74 billion, approximately $40-45 billion could be traced to fraud (Wikipedia, 2012). In May 2004, 20,000 former employees won a lawsuit against Enron worth $85 million. This was compensation for nearly $2 billion in lost pension funds (Doran, 2004). Not everything is about money, many people have lost their stable income, their security of feeding their families and many people's futures have been destroyed by the loss of their pension. The Sarbanes-Oxley Act is a US federal law enacted after the Enron scandal. The law contains a set of rules governing the boards of directors, management and public accounting firms of public companies. Some of the main regulations stipulate that all companies must have a majority of independent directors, the nomination and remuneration committee must have independent directors, also the audit committee should be composed of members with financial education and one of the members must be an expert (Wikipedia, 2012). On January 14, 2004, Andy Fastow and his wife Lea both pleaded guilty and received a very unusual package. Andy was sentenced to 10 years without parole in exchange for testifying against Lay, Skilling and other former Enron executives. Prosecutors were so impressed with his performance that his final sentence was reduced to 6 years. The jury in the Lay and Skilling trial returned its verdict on May 25, 2006. Lay was convicted of all 6 charges he faced (securities and wire fraud) and subject to a maximum of 45 years in prison. Forty-one days later, Ken Lay died in Aspen of a heart attack; this even before his sentencing was scheduled. On the other hand, Skilling was found guilty of nineteen of twenty-eight counts, including securities and wire fraud. On October 23, 2006, Skilling was sentenced to 24 years and 4 months in prison. Conclusions and Recommendations: Conclusions: Both managers and traders committed morally questionable acts. One unavoidable thing is the fact that Enron employees were partially paid in stock, which motivated workers to take unethical actions in order to increase the stock price and, equivalently, their own money. As seen in the California case, traders manipulated the market in the company's favor. The Enron culture was heavily influenced by competition and because employees were motivated by large bonuses and were afraid of being fired if they did not perform well, and indeed resulted in unhealthy competition between colleagues. Colleagues prefer to stab each other in the back rather than help each other close a deal. Employees paid in stock didn't help, nor did the work environment or competition among colleagues. The work environment at Enron is?.