An Enron Case Study

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In December 2001, the world's biggest natural gas and electricity trading company Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code. It was the largest corporate bankruptcy in U.S history until WorldCom declared bankruptcy in 2002. Its share price plummeted from the highest price at $90 per share in mid 2000 to $0.1 per share in Oct 2001. That caused its share holders lose about $11 billion and investment banks lose about $200 billion. Nearly 4000 employees lose their jobs. Furthermore most of employees invested their all retirement funds in the Enron and then they have nothing just overnight. Enron's scandal also caused its accounting and auditing firm Arthur Andersen voluntarily surrendered its licenses to practice as Certified Public Accountants in United States in 2002. Arthur Andersen was one of the Big Five accounting firms in the world.

In the late 2001 just before its bankruptcy, Enron had about 22,000 employees around world. It was a conglomerate that owned and operated gas pipelines, electricity plants, pulp and paper plant, water plants internationally and broadband assets and trade some financial products and services in the financial market. It was listed on "100 Best Company in American" by Fortune magazine. And also Fortune named Enron as "America's Most Innovative Company" for six consecutive years from 1996 to 2001.

This essay will analyze the factors of which may result Enron failed in bankruptcy. And discuss what we leaned from the Enron Scandal. The essay contains three parts. In the First part I will introduce the background and history of Enron. And how it growth to a world's leading energy company in just ten years time. The second part I will present three main reasons that may caused Enron's collapse. They are blindly expansion; use Special Purpose Entities to remove debts from its balance sheet and fraudulent auditing service. At the end I will discuss how important of an efficient risk management system in a corporate.

2. Background

Enron's history

Enron was formed in 1932 in Omaha, Nebraska. Originally it was called Northern Natural Gas Company. In 1979, after the reorganization, InterNorth became it holding company. In 1985, it bought the smaller rival Houston Natural Gas. After the merge, the new company changed the name to Enron and Houston Natural Gas's CEO Kenneth Lay became the CEO of the new merged company. Then Kenneth move the Enron's headquarter to Houston. The newly merged company owned about 32,000 mails gas pipeline in the Unite States. Initially, Enron engaged in transmitting and distributing electricity and gas throughout the United States. The company developed, built and operated power plants and pipelines while dealing with rules of law and other infrastructures world wide. With the fast develop of the business; Enron owned a large network of natural gas pipelines. The company became one of the largest electricity and gas producers in the Unite States.

In the early 1990s, the Congress of the United States of the America passed legislation deregulating the sale of natural gas. This change influenced the price and transport of natural gas in the energy market. The price volatility was increased and the supply of natural gas became unstable. Under this situation, Kenneth Lay believes the US government will keep deregulating the energy market. So he was looking for a new strategy for Enron to avoid the negative influence. In 1989, Skilling advised the new idea of "Gas Bank" to Enron. This idea introduced Enron as an intermediate between the gas buyers and sellers. The company deal with gas suppliers on the one hand and the gas purchasers on the other hand, and at the same time Enron arranged hedges for both suppliers and purchasers and facilitated market transactions. Under this idea, Enron running as a traditional bank and gas producers become the gas depositors and the gas purchasers become the gas borrowers. From early 1990s, Enron changed from a gas developing and supply business to a gas trading business.

As the successful exercises of the "Gas Bank", Enron was growth very fast. By 1992, Enron was the largest natural gas trader in the North American. And the gas trading business became the second biggest contributor to Enron' net income. In that year, the earning before tax and interest was about $122 million. The gas bank likes a pool of the gas suppliers. In order to hedge the gas price volatility, the company had to trade lots of financial contracts on the future market which based on the gas price. Many financial derivatives were used by the Enron, such as swaps, options, futures and some other complex financial instruments. From early 1990 to the 1994, the Enron's company value was raised from $2.65 billion to $8.26 billion. Until the year 1995, Enron controlled the nearly 20% of the North American gas market.

Enron's expansion

In order to achieve the further growth, the company extended businesses to the oversea markets and trading variable products. Such as Teesside power plant in England, Enron operate with Indian Maharashtra to build the large power plant. By the year 1996 Enron started to touch the American electricity market. Enron pushed hardly for deregulation the US electricity market, thereby facilitating their acting as middleman for the electricity market. In year 1997, Enron invested in the water market, set up the Wessex water in UK and supply water in Argentina. At the same year, Enron traded its first weather derivative and started to trade weather. In 1999, Enron launched EnronOnline. It was the first web based transaction system that allowed buyers and sellers trade commodity product globally. But it only allowed users to do business with Enron. Enron pursued a diversification strategy. By 2001, Enron had become a conglomerate that owned and operated gas pipelines, electricity plants, pulp and paper plant, water plants internationally and broadband assets and trade some financial products and services in the financial market.

Before its bankruptcy in late 2001, Enron had about 22,000 employees around world. It owned $63.4 billion assets include 50,000 miles natural gas pipelines, 15,000 miles fiber networks and lots of electricity and water plants worldwide. Enron's stock rose by 311% from the start of the 1990s until the end of 1998. In the middle 2000, its stock price hit the historical high point of $90 per share. By the same year, Enron claimed revenues about $101 billion and was listed on "100 Best Company in American" by Fortune magazine. And also Fortune named Enron as "America's Most Innovative Company" for six consecutive years.

Enron's diversified business and overseas investments need large amount of initial capital investments, however, Enron already hold a large amount of debts since it merged with Houston Natural Gas. And also most of these investments were not generate earnings or cash flow in the short term. That placed the pressure on Enron's balance sheet. In order to solve this financial problem and maintain Enron's credit rating at investment grade and keep the percentage of earning per share, Enron formed a series of partner companies which were called Special Purpose Entities (SPE) to remove debts from the balance sheet. Additionally, in 1990 Jeffrey Skilling brought in mark to market accounting approach to the company. This approach calculates the current market value of the contracts or trades which will exercise in the future then record the profit in the current balance sheet. Enron used this approach to deceive the investors. Because of some recorded profits are inflated or nonexistent.

At the end of 2001, Enron scandal was revealed. The company was suspicion planned accounting fraud. Enron released its third quarter result on 16 Oct 2001. It reported a loss of $618 million because of bad debts transferred back from SPE to Enron's balance sheet. And restated its earning for past four years, there were about $586 million net income were deducted over the past four years and debts were expanded by $2.6 million. This event suddenly dropped Enron's share price to $0.1 in Oct 2001. The drop in share price caused its stock holders lose about $11 billion. Enron filed for bankruptcy under Chapter 11 of the United Stated Bankruptcy Code on 2nd Dec 2001. It was the largest corporate bankruptcy in US history until WorldCom declared bankruptcy in 2002.

3. Reasons for bankruptcy

Blindly pursue expansions

From early 1990s, Enron was growth rapidly as successful running gas bank idea. Its profits rose steadily and the company became one of the best energy companies in US. However, Enron's top managements thought the US market is not big enough for Enron's expansion. Therefore, Enron started to investment in the international energy market and diversified products. But some of investments were not successful, that caused a huge loss for the company and increased debts on the balance sheet. Enron's first oversea investment was operating Teesside power plant in UK. Then Enron invested $2.8 billion US dollar to construct the Dabhol power plants in Indian Maharashtra. Until 1995, Enron had developed its natural gas pipeline and power plants in many developing countries, which include India, Philippine, Argentina and China. Some international investments were not successful and generate huge loss for Enron. Further more over expansions increased debts pressures for Enron.

From latter 1990s, Enron entered into a series of new markets. Such as water, broadband, paper and even weather derivatives. Because of the overconfidence, Enron's top managements believe they can trade everything just like gas. Enron interested in innovation instead of concentrate on its strengthened area. In 1998, Enron moved into the water sector. Creating the Azurix Corporation which it part floated on the New York Stock Exchange in June 1999. Azurix failed to break into the water utility market. And bring a large loss for the company. In 1999, Enron launched EnronOnline. It was the first web based transaction system that allowed buyers and sellers trade commodity product globally. In the meantime, Enron began to trade bandwidth on its fiber optic network as a commodity, enabling users to trade communications capacity. EnronOnline and Enron Communication were cost Enron more than $500 million US dollars.

Invest in a new and unknown market with higher risk. Blindly pursuer expansion caused Enron lose huge amount of money and with higher pressure of debts. That was one of the indirect reasons for Enron filed for bankruptcy. In order to lower the debts pressure and maintain Enron's credit rating at investment grade to continue to operate its business. Enron formed a series of Special Purpose Entities to remove debts from the balance sheet.

Special Purpose Entity

Rapidly growth investments in global markets and innovative products required a large amount initial capital injection. However, much of these investments were not expected to generate profits or cash inflows in the short term. While Enron believed theses investment would be beneficial over a period of time. Therefore, Enron had to arrange more money to funding the new investments. Issuing additional debt was not advisable for Enron. Because the cash flow in the early years would be hardly to service the debts and also with height level of debts would place pressure on Enron's credit rating. Lower the credit rating means Enron have to pay more interests on its debts and securities. Alternatively, issuing additional equity was also not advisable for Enron. Because the company's total earning would be deducted by reducing the earning per share. In order to maintaining Enron's credit rating and higher earnings, Enron chose to use Special Purpose Entities to find funding from outside.

Special Purpose Entity is a legal entity created by a sponsor to isolate the firm from financial risk. The company will transfer assets to the SPE for management or use the SPE to finance a large project thereby achieving a narrow set of goals without putting the entity firm at risk. For financial reporting purposes, a series of rules is used to determine whether a special purpose entity is a separate entity from the sponsor. Securities and Exchange Commission indicated that an Special Purpose Entity created by a sponsor to be considered as independent must have at least 3 percent of its equity come from a third party and a party other than the sponsor must control the Special Purpose Entity.

From the entity structures we can see Enron's Special Purpose Entities were separate entities. They are funded and controlled by the individual third party. However, Enron actually indirect controlled the SPE through some limited partnerships. Enron chose to provide minimal disclosure on its relations with the SPE. Enron represented to investors that it had hedged downside risk in its own illiquid investments through transactions with SPE. But investors do not know that the SPE were actually using Enron's own stock and financial guarantee to carry out these hedges. Therefore these downside risks were not actually hedged by Enron.

For example, in 1999, LJM Cayman L.P. and LJM2 Co-Investment L.P were formed by Enron's CFO Andrew Fastow. The purpose for formed these two limited partnerships were participate in the SPE as the outside equity investors. Enron transferred to the LJM related SPEs more than $1.2 billion in assets. These SPEs had paid for all of this with their own debt instruments with face value of $1.5 billion, and had entered into derivative contracts with Enron with a notional amount of $2.1 billion. Then Enron booked the payable by them as assets on its balance sheet. From these transactions the debts were removed from the company's balance sheet and the profits were increased. By 2001, Enron had used hundreds of Special Purpose entities to maintain its balance sheet at healthy level.

The downside risks were not reduced by Enron through Special Purpose Entities. The risks were transfer from Enron to the other entities which are actually indirect owned by Enron. The risks still in the company and keep increasing with the assets transactions. Therefore, use SPEs to hedged company's financial problems were the main reason for Enron to got into accounting fraud then filed for bankruptcy.

Fraudulent auditing service

Arthur Andersen was Enron's accounting firm and acting as internal and external auditor. Arthur Andersen was one of the Big Five accounting firms in the world. It provided auditing, tax and consulting services to large corporations. In 2002, the firm voluntarily surrendered its licenses to practice as Certified Public Accountants in United States after being found guilty of criminal charges relating to the firm's handling of the auditing of Enron.

As Enron's external auditor, Arthur Andersen's responsibility was perform an audit on Enron's financial statements and provide a fairly and reliable report to the public. All outside investors will rely on the financial report which provided by external auditor to make decisions. However, Arthur Andersen failed to fulfill its professional responsibility. They provided inadequate financial reports to the public. That caused Enron was over valued by investment agencies in Wall Street. Many of investors were deceived, they were keeping investing in Enron which the company already has a serious financial problem. Finally, Enron scandal was caused investors lose a huge amount of money.

There are lots of reasons for Arthur Andersen to provided inadequate reports to the public. Firstly, Arthur Andersen was both internal and external auditor for Enron. As an external auditor, it is must independent of the entity being audited. However, as an internal auditor, Arthur Andersen provided management suggestion and strategies to the Enron and lots of Arthur Andersen's employees worked for Enron. Therefore, that is impossible for Arthur Andersen audit financial statements independently. The second reason was conflicts of interest influenced Arthur Andersen to provided inadequate reports. In 2000, Arthur Andersen earned $25 million in audit fees and $27 million in consulting fees. It apparently succumbed to pressure from Enron' management and provided financial report on Enron's interests.

4. What we learned from Enron Scandal

Efficient risk management system is very important

As everyone knows higher risk will generate higher profit. Enron was a risk taker in its expansion process. In order to achieve higher returns in the future, it invested heavily in the international energy market and numerous of new business. Invest in unfamiliar countries or industries always with much higher potential risk. However, with the successful innovation experience in trading gas in early 1990s, Enron's board directors had overconfidence in handle the high risk projects. They believed Enron could trade everything in the global market. However, blindly pursuer expansion cost Enron's billions of dollars. Most of innovative investments were failed, such as Dabhol power plant in India, Wessex Water in UK and broadband services. In Enron's expansion, its risk management system did not help the company reduce and avoid the negative effects from the risk. Enron's risk managements did not provide accurate information for investments and also did not evaluate the risk in time. The responsibility for risk management is identifying, assess and prioritization potential risks, then minimize, monitor and control the negative effects from the risk. Hence, an efficient risk management system is very important for the big corporate such as Enron.

Healthy auditing system is also very important

Fast expansion and unsuccessful investments increased pressure on Enron's debts. In the meanwhile, financial problem increased Enron's credit risk. Enron use SPE to transfer and remove debts from its balance sheet. However, the original credit risk was not removed, the risk just transferred from one entity to the other. It was still exist in Enron's system and keep increasing during the transactions. As Enron's external auditor and internal consultant, Arthur Andersen did not disclose these problems to the outside investors. And also conflicts of interest influenced Arthur Andersen; it succumbed to pressure form Enron's management and provided inadequate financial report. Enron's case told us a healthy auditing system is very important for a corporate. The external auditor must audit the financial statement independent. And provide the reliable and fairly financial report to the public. It must observe its professional standard and law.

5. Conclusion

The world's biggest energy company Enron was collapsed. From Enron's scandal we learned lots of lessons. The successful innovation in trading gas in the early 1990s, pushed the company blindly pursue expansion and innovation. Just in ten years time, Enron extend its business from develop and supply natural gas to trading electricity, water, metals, bandwidth, weather and numerous financial contracts on the financial market. Imprudent entered into the new markets caused Enron faced huge risks. Lots of investments were not successful, they bring on a large amount of lose for the company and pushed heavy pressure on Enron's finance.

In order to maintains company's credit rating at investment grade and keep a percentage increasing of earnings on their financial report. Enron used off balance sheet finance strategies to keep their balance sheet on a healthy level. It transferred large amount debts to Special Purpose Entities and recorded the notes payable on its balance sheet as assets. And also conflicts of interest influenced its accounting and auditing firm Arthur Andersen help Enron to provide inadequate report to the public.

There are many lessons we can learn for risk management from Enron's case. An effective risk management could predict the risk in advance and protect the company out of the negative effect from the risk. However, a lack risk management will cause the company collapse such Enron.

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