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At the end of 2001, Enron Corporation, the largest American, even the world's biggest, energy, natural gas and electricity supply and trading company, was announced bankrupt. The share price of Enron suffers a drastic decline form 40 to 50 dollars at October to 0.26 dollars at 30 of November, and Wall Street Journal published the net loss of Enron is around 400 billion dollars. This collapse was like the other "9.11 iceberg" for financial market of United State of American.
Suddenly, Enron became the global focused point because its collapse was considered as the most dramatic bankruptcy in the history of United State of American. The impacts of Enron's scandal are tremendous: the one of the Big Five American accounting and consulting firms, Authur Andersen, who was responsible for Enron's auditing works, surrendered its licenses voluntarily after the scandal; American investment banks lost almost 200 billions dollors; 4000 Enron's employees forced to leave their jobs; and forthermore, some employees who invested heavily with all their retaiment funds in their own company lost everything overnight.
Enron's bankruptcy did not occur accidentally, the American telecommunication company Wolrdcom exposed creatively planned accounting frauds and disreputable inside trading right after Enron's scandal. Those series of collapse of American large organizations not only produce enormous negative influences on the financial market of American but seriously break investors' confidence. Once, Enron was the "America's Most Innovative Company" named by Fortune magazine for six years, from 1996 to 2001, but now become a founding for most of the investors.
How can Enron, such a world energy magnate, ended in the most embarrassed bankruptcy? How can such a world leading company, dishonestly reported inflated and fraudulent assets and profits? How did a $100 billion company collapse in a matter of weeks? Many economists and savants investigated the case and tired to find the true pictures of its collapse. The aims of this essay are to evaluate the factors that may concerns the failure of Enron, and emphasize the lessons to be learned by the origination's risk management.
The discussion contains three parts. The first part is the background of Enron's growth and decadence to help reader get brief ideas of development of the company and understand main strategies that used by Enron. In second part of discussion, the four main reasons that possibly cost Enron's collapse will be critically evaluated; and they are corporate governance failures, unsuccessful expansion and investment, using of off-balance sheet partnerships and using of inadequate auditing services. The third part is the discussion on the lessons that risk management should learn form Enron's failure.
The limitation of this essay is that my research uncovered details of the intense corporate culture of Enron and the recklessness with which the company conducted its strategies. These could be possible reasons that coursed Enron's bankruptcy.
Background of Enron
Start-up Stage of Enron
July 1985, Texas-based Enron was set up by the merger of Houston Natural Gas which was run by Kenneth L. Jay, Huston economist, and one of the worlds biggest natural gas pipeline company, Internorth of Nebraska, based in Omaha. At the time of 1980s, takeovers and mergers were favorite corporate tactics of North American. Based on takeover, the new organization held almost 37,000 miles gas pipeline of its own and formed as an interstate and intrastate natural pipeline company. Kenneth Lay became the founder, chief executive and the leader of the new joined company. After a while, the name "Enron" of the company was chosen after rejecting "Enteron". However, the new entity existed with a huge amount of debts after the merger.
From 1985 to 1989, Enron focused originally on the physical side of American natural gas industry; primarily engaged in exploration, production, distribution of electricity and gas of United States and transmission them by their independent intersected pipelines throughout the contry. Promptly, Enron became a large eletriciy and gas producer in that period as maketing in natural gas products.
Exercised Gas Bank Strategy
However, at late 1980's, American government deregulation was spliting the gas industry into a regulated business and unregulated business and this change influenced the natural gas market by putting some restrictions on priceing and transporting natural gas. The nagative impacts of government deregulation constrained Enron to think about other strategies to avoid high price voladality and unsteady supply of the natural gas. At the time, Enron was intending to change form a gas selling business to a gas trading business to fit in with the deregulations. They brought and sold standard amounts of natural gas as the way the stock trading might do by buying some quantity of shares and then selling at a small profit.
However, buying and selling gas was just one part of Enron's plans. At the year 1989,
Jeffrey Skilling's idea was known as "Gas Bank" was intruduced to the company with aim to allow gas suppliers and wholesale gas purchasers to trade gas and also, at the meantime, hedge the high fluctuate gas price risk. This fresh strategy turned Enron becomeing an intermediate between buyers and sellers of nateral gas. After exerciseing this strategy, Enron successfully transferred from a single seller of natural gas to a 'gas bank'; the individual producers of gas became the gas 'depositor' and the wholesale customers turned to the gas "borrowers". At this stage, one of Enron's innovations was to sturture financing arrangement called Volumetric Production Paymants. By using this arrangement with oil and gas producers, Enron's gas 'deposits' were pooled in significantly. The VPP was the first kind of Special Purpose Entity which was perfectly legal and useful finacial deals.
In fact, the Gas Bank definitely pooled various gas suppliers for Enron. In addition to hedge the risk of gas price fluctuation, Enron also wanted to trade financial contracts based on the price of gas on the futures markets. Many derivative financial instruments such as swaps and options were offered and some physicial delivery contracts start bundle together with financial instruments. The trading business eventrauly brought Enron's growth, the value of Enron rised from $2.65 billion at the start of 1990 to $8.26 at 1994.
Enron's Expansions and Company's Reputations Build-up
Enron expanded rapidly during the nineties by conducting international investments and trading variable products. At the year 1993, one of the international expansion plans, Teesside power plant in England, started operation and the agreement with Indian Maharashtra to build the large power plant was reached. By the year 1995, nearly 20ï¼… of the north American gas market was controlled by Enron. Enron firstly conducts its electricity trade at 1994; traded its first weather derivative and began to trade water, coal, metal products, paper and plastics, wood and petrifaction products; moreover, they built high speed bandwidth and planed to trade internet and medium services from 1997. Enron definitely become not only an energy leading company around the world but a trader with a variety of products and financial services.
At the end of 1990s, Enron had more than 20,000 employees around the world; and 70 billion assets include 50,000 miles of natural gas pipeline and almost 15,000 miles of fiber optic networks. Enron's stock price peaked to $90.56 at 2000. It was listed on "100 Best Companies in American" by Fortune magazine at the year 2000 and was also designated as "American's Most Innovative Company" for six successive years by Fortune.
Inaccurate Assets and Debts
Enron's boom was significant after diversified its market into other variable commodities. Unfortunately, the trading empire was just an appearance. Enron's trading businesses and overseas developments required large amount of cash, and Enron was a big debts holder with issuing bonds and other debts securities; a healthy balance sheet was real needed for the company. As a result, Enron formed a series of partner companies which were known as Special Purposed Entities in order to transferring debts that it did not want to be showed on its balance sheet (Ottawa, 2002).
Additionally, Jeffrey Skilling brought mark to market accounting approach to the firm by which most of the contracts and trades were taken into the future and then calculated how much would be their values based on current market price. By using this approach, many captivating profits are inflated and some nonexistent and fraudulent profits were recorded.
Enron released its third-quarter result on 16 October, 2001. It reported a loss of $618 million and also disclosed that shareholder's equity shrink by $1.2 billion because of bad debts transactions conducted from Andrew Fastow, Enron's Chief of Financial Officer's trading partners. The share price suddenly dropped form around $40 USD at October to $8 dollars on 9 September.
More seriously, Enron restated its earning for the period form 1997 to 2001; surprisingly, $586 million net incomes were deducted over those four years and debts were expanded by $2.6 million. Dynegy as Enron's competitor at one time announced to buy Enron on 9 November, however, on 28th, Dynegy disposed of its agreement to buy Enron because Enron's bond were largely downgrade.
The share price of Enron expeditiously bottomed down to $0.26 USD at the end of October. On 2 December, 2001, Enron used Chapter 11 of American Bankruptcy Act for bankruptcy protection. Enron is the biggest American bankrupt company with $62 billion in assets in American history up to that time (Loren, 2003). How could such a wealth company ended at this result? It there an internal strategy problem or financial market over react? Following sections of this essay try to analyze the facts of Enron's operation and evaluate how these hidden perils caused the company failed.
Possible Reasons caused collapse of Enron
Corporate Governance Failures
After Enron's scandal, many committees and economists investigated the company and tried to find out the reasons of the collapse. According to some literatures, the discussions are concentrated mainly on Enron's inadequate strategy of developing Special Purpose Entities to obtain external funding and hide debts, and also focused on fraudulent auditing service arranged by Arthur Andersen auditing and consulting firm.
However, these factors just partly cost the Enron's bankruptcy in my opinion. At some stages when problems just exposed, the Board Directors of the company could have changed the current situations to stop being wrong, but Enron's Board chose to ignore the problems. An important reason that caused the seventh largest energy company collapse is the Board of Directors of Enron failed to achieve good corporate governance and unsuccessful engaged in a series of management decisions that harmed the company.
Firstly, the Board of Directors allowed Enron engage in a high risk accounting. As mentioned before, Enron was the first company used mark to market accounting. This accounting approach enables Enron to value its complex and long term contracts on a regular basis. Such an accounting depends on the assumptions about an uncertain future and provides scope for judgment, and can be a big generator for Enron's reporting earnings. Furthermore, Enron hedged the value of investments mark to markets by entering in derivative contracts with its own Special Purpose Entities. Those contracts were considered which do not have any economical value because two counterparties, Enron and its SPEs, were closely related and Enron was under the control of those entities' resources. Enron's also continued to control its assets by using Total Return Swaps. By using these derivatives, Enron retained most of the economic benefits and ownerships of the assets. Those are main high risky accounting techniques that conducted by Enron; however, the Board of Directors did not characterize Enron's accounting system as high-risk and of caused did not prevent from using them. Hence, by using this inadequate accounting system, Enron's assets were overstated, sales were inflated, and financial reports were not reliable and relevant.
Secondly, the Board of Directors engaged the idea that management should have same interest in the company as the shareholder and this result in excessive executive compensation. 1990s, company rapidly increased their executives employee stock options. So the executives focused mainly on the growth of the company because if the share price rose, their compensation option will worth millions of dollars. This is a good motivation for senior management and Enron's management really did well under this growth and reward system. However, this motivation effected management focused only on the earning of the firm. In Enron, accounting income was a criterion, which was not a reliable income as mentioned before, used to evaluate and measure corporate management's performance instead of true economic values. By the mid-1990s, executives had huge portions of their compensation on Enron's stock. By 15, 1997, Kenneth Lay owned 3 million Enron's shares which was around 1.49% of company's interest and Jeff Skilling owned nearly 619,000 shares. The numbers of the Director's share expanded, so did their ambitions. The Board of Enron did everything they could to boost company's short term earning because it positively correlated to their personal compensations and wealth. This is like an embedded boom for the bankruptcy of Enron.
Thirdly, the Board of Directors witnessed the facts that Enron existed with high level debts, instead of finding ways to enhance the ability to repay the debts, Enron chose to use Special Purpose Entities to remove the debts from its balance sheet. As we discussed, the earnings of the firm is closely connected with the managements' benefits, the management did not put any efforts to adjust the ways to eliminate the huge debts caused by expanding investment for long term benefits but decided to hide them in order to provide a preferable short term balance sheet. By the year Enron bankrupted, the United State Securities and Exchange Commission reported that there are more than 600 million of debts were removed from its balance sheet by using SPEs partnerships.
Furthermore, some arguments questioned about the Board of Directors' credibility. The Board not only rewarded the management by offering the compensation stock options and also encouraged entire employees to invest in Enron. Many of employees invested all their retirement funds into the company's stock. Unfortunately, wealthy Enron insiders, including offices and some of its directors, having knowledge about the financial positions and operational problems of Enron, start selling their shares at a huge scale. Between 1999 and 2001, nearly $1.1 billion of shares were sold by insiders themselves. On the contrary, the Directors told the investor that company had an unlimited optimistic view of future growth and responded employees who wanted to unload their shares with no-sell restrictions (Ottawa, 2002).
Therefore, the corporate governance of Enron was not happened as a good one. The information provided to decision makers was not accurate and the accountability was not provided by the Board of Directors. The poor risk management processes were exercised by them. Over years, the Boards of Enron witnessed a number of questionable exercises demonstrated by its management team but chose to walk away and avoid them. The lack of responsibility of the Broad of Directors could be a directly reason that caused company's collapse.
Unsuccessful Investments and Excessive Expansions
During 1990s, Enron was looking for the new market for its expansions. However, some investment in international energy markets and new products markets were not successful and this indirectly cost Enron's collapse. Under the leading of CEO Kenneth Lay, Enron was already climbed up at the top of the American energy industry. Enron's profits rose steadily and so did its share price. Undoubtedly, energy sector was the fundamental strengthened sector that Enron would be best benefited. However, because of its overconfidence, Enron's top management started to believe American market was relatively too small compared to the world energy market; and ambition of believing Enron should trade everything outside its highly strengthen energy products were enlarged. Consequently, Enron made tremendous investments in the globe energy market but not all investments were successful and numerous losses were occurred when the company entered in new commodity markets.
The corporate profits were boosted in general form the middle to the end 1990s, and soon steady earning growth becoming anticipated. At the middle of 1990s, Enron established a goal of increasing earning by 15 present every year. Growth meant acquiring new markets. Enron started its expansion from England market by operate Teesside power plant and after a half of year Enron signed an agreement with investment $2 billion American dollar to construct the massive Dabhol power plant in Indian. Enron's international operations were on an up swing by selling its partnership, Enron Global Power and Pipelines' share. In 1994, the company had developed its gas and power plants in many developing countries. By 1995, Enron added its natural gas pipeline and power plants in Philippines, Colombia, and Argentina and even in China. Consequently, some international investments did not actually generate any preferable profit or cash for Enron, but put company with greater debts pressures. Especially, the investment in Indian power plants cost Enron several hundred millions of dollars.
In addition, in 1990s, Enron entered in a series of new market and tired to turn the products in tradable commodity like gas. They seemed to pursue new markets just for being an innovator. The company invested huge amount of money in new ventures such as EnronOnline, broadband, water and other unfamiliar markets. After successfully traded energy, paper, and weather derivatives, Enron developed its confidence that it could handle any new business and this enhanced its mission to trade everything. Enron seemed to rely too much on innovation instead of concentrate on its more strengthened areas. Eventually, EnronOnline, which proved online exchange, cost the company more than $400 million American dollars and the bandwidth services also cost around $100 millions. Moreover, project of trading water did not bring any profit to the company.
As a company with huge pressure of debts, Enron should not expand at such a high speed to those unfamiliar markets. The losses from those now projects enhanced the company's debts and on the other hand, invest in new area indicating higher risks. As a result, Enron was tiring everything to maintain a good credit rating, which was needed for both to keeps its borrowing interest down and to continue to operate its costly business. One strategy that Enron used to manage their credit risk was using Special Purpose Entities to transfer their debts off its balance sheets
Special Purpose Entities
An SPE is simple legal structure created by a company to carry some of the company's asset; the purposes of establishing SPE are these allow the company is to borrow against those assets. As Enron's trading grew at a globe market and also variable products and services lever, SPE is an efficient way for generating cash funds for the company.
Enron did had an unguent need for a healthy balance sheet and a good credit rating. During 1990s, Enron invested huge funds in international market and series new innovative products, those investments initially required company a huge amount of capital injections. Moreover, these enormous investments were believed to be beneficial over a long term which could not bring any significant short term profits or cash to the firm. Enron was also a frequent borrower with a high level of debts pressure by issuing bonds and other debt securities. If the company's balance sheet started to look unhealthy, its debts will be too heavy compared with its assets, the firm's ability to repay its debt will be decreased. And also, the low credit rating will be existed subsequently. This means Enron will pay more interest rate for its debts and securities and this will result in a deduction of total earnings. Because of these pressures, Enron chose to form Special Purposes Entities, which eventually lead to its bankruptcy, to raise the funds and hide its debts.
However, Enron still retained the ownerships and controls over SPEs. Securities and Exchange Commission indicated that an SPE created by a company to be considered as independent must have at least 3 present of its equity come from a third party and a party other than the company must control the SPE. Nevertheless, most of Enron's SPEs were controlled by its senior officers who are not independent third parties. Enron still exercised the great control over the SPEs and made them served its special financial statements purposes.
Enron began its extensive use of Special Purpose Entities. In general, an SPE is a legitimate way of sharing some special risks from core operations of the company and also help the core operation borrow money with fewer interests. Because the SPE contains some assets invested by the company but do not included any existing debts of the company, therefore it can borrow money at lower rates from any outside lenders. Enron widely demonstrated numerous SPEs, such as Chewco, Raptors, Rhythms, and LJM and conducted many transactions in order to generating cash funds and reduce its hedge debts. For instance, the LJM partnership served as Enron's counter-parties in many circumstances involving sales of assets that enabled Enron to record gains in its financial statements. The management of Enron unanimous agreed to treat those SPEs as investment, which means the obligations raised from those Entities will be taken off from company's balance sheet but the profits will be added.
The Special Purpose Entities did not reduce the company's high financial risk actually. The risk has been transferred form one Enron to the other entity which was under the control of Enron. The risk still retained in the company and may be increased during the millions of dollars of transactions. Those SPEs partnerships that Enron engaged in its questionable accounting eventually led to Enron's collapse., Arthur Andersen, Enron's auditor, evaluated its accounting system has high risk, but the Directors did not believe this and paid Andersen millions of compensations to help providing their attractive unrealistic financial reports.
Unreliable Auditing Services
Arthur Andersen was the biggest international accounting and consulting firm. The firm was founded in 1913 and after many years' efforts, the firm growth rapidly and become one of world Big Five accounting firms. Its income was growing more than 10 present every year during 1990s and revenue rising from $3 billion in 1992 to $7.4 billion in 1999. The firm not only provided traditional auditing work but also expended its consulting works. Arthur Andersen was Enron's accounting firm and in charge of external auditing and internal consulting works.
As a statutory auditor, Andersen has responsibility to detect Enron's financial statements and to inform that whether their financial reports fairly provided reliable, relevant, understandable and comparable information for outside users. However, Andersen failed to fulfill its professional responsibility and was convicted of obstruction of justice. How could business with such good reputations choose to ignore its professional standards and codes? There are possible reasons: first is that external auditor's independence was not reached efficiently and there are many conflicts of interest influenced Andersen to perform its auditor's obligation.
Andersen was acting as both a statutory auditor and an internal consultant. As we know, the statutory audit is the financial statement auditor that separate from the management and boards of their clients. They are responsible to oversee internal control and risks independently. All outside investors will rely on the financial reports that provided by auditors to make decisions. The credibility of auditing is important and primarily depends on the independence of external auditor. However, Andersen was also an Enron's consultant included making management advices and tax strategies and many Andersen's current employees worked with Enron. They knew lots of Enron's internal information and their decisions on evaluating financial statement could not be made independently.
Many conflicts of interests made Andersen break its reputation and professional norms to provide inadequate financial reports. At some stages, Enron's auditing services team, evaluated its accounting system as high risk accounting. However, Andersen earned $47 million form its Enron's work in 1999 and $58 million in 2000. Duncan, who was Andersen's employee in charge of Enron's auditing, made more than $ 1 million personally. Thus, Andersen decided to help Enron to expose its unreliable financial reports for its self interests. Andersen was far more than an external auditor, but also an extensive internal auditor and consultant. Andersen destroyed its creditability and reputation as professional body and this indirectly affected Enron' collapses.
2.3 Lessons for Risk Management
Why organization like Enron need risk management?
Risk management is a process of identifying, qualifying and managing risks by using strategies. The large organization like Enron conducting millions of dollars' contracts, making enormous investments contains various risks at all operational levels. For instance, Enron attracted gas supplies by using long term fixed commitments which may produce significant credit risk and price risk. The big organization like Enron always carries a heavy level of debts as a result of expansions and investments are more likely to face financial distress. On the other hand, competitors always emerged against Enron, the performance risk which is the customers' performance of contracts become extremely important. Effective risk management will predict the risk in advance and find a way to operate it.
How did Enron's risk management go?
Some economist indicated "making profits need innovators take risk". The higher risks, the higher future profits will be generated. That is why Enron, a risk taker, invested heavily in new markets in order to gain greater returns. Risk management is one part of process of organization internal control. However, in Enron, not all individual transactions were limited by risk management; the Boards of Directors sometimes engaged in very high risk projects, such as Dabhol power plant and Wessex Water investments, and those high risk projects eventually cost Enron millions of dollars. The risk management did not seem to help Enron avoid the risk and reduc the negative effect of the risk, especialy when Enron's Directors had huge ambitions to expand in golbe ennegy markets and in numerous new businesses. On the contrary, the off balance sheet partnerships were formed to tranfer and reduce the credit risks of Enron; in fact the original risks haven't been reduced as expexted but the extra risks were added during the miilions of dollors' ransactions.
What should risk mangers learn form Enron's bankruptcy?
Firstly, risk management should be designed as the key mechanism for company's internal control. In Enron, risk management did not provide accurate information and accountabilities in many circumstances, risks were not evaluated and managed in time.
Secondly, Enron's internal risk management systems put its majority resources to regard trading operation but neglect company's credit risks and performance risks. Allocation of resources is an issue of risk management; the risk management term should allocate the resources on most profitable activities.
Thirdly, the contingent financing for potential growth opportunity was difficult to rise because Enron did not have a great credit rating, generating funds from SPEs placed the large credit risk pressures to the firm. The risk management should always take credit risks into account.
Moreover, many Enron's employees and subordinates of risk management term mentioned many possible risks related to the company's operations to Chief of Risk Manager; however, the CRO and the Board of Directors ignored advices and went ahead with their bad decisions. For instance, in 1999, some employees from Enron's Risk Assessment & Control Group have already noticed the CRO that Rhythms hedging deal was too risky because of both conflict of interests and the SPE was not stable on its credit standpoint. However, it was not clear if CRO passed the analyzed solution to the top management, the idea was approved eventually. Why CRO and directors ignore the advice from risk analyze? Because they were chasing for earning and earnings closely effect their personal compensations.
Lastly, Enron is an innovative company contains many risky investments in trying new thing; the company like it needs a firm board of directors to monitor the activities of management. Unfortunately, Enron did not have those sorts of directors who can confidently raise questions. The lesson here is that companies need to have a few outside directors who can understand the business but must be willing to ask questions about company's activities.
Enron once was an energy business' superstar with $70 billions of dollars of market values. Its collapse became not only the biggest financial bankruptcy case but also a case with many financial problems and risk management lessons. Enron shocked Wall Street, American energy industry and many of their investors. The company was successful for its early year's f trading gas and electricity, and for its plunge into the financial market with trading energy derivatives.
However, the greed and hubris grew up. Enron was overconfident and believed that they could trade and things in any markets. They expanded their investment beyond energy into the trading of variable commodities such as metals, bandwidth, water and other products. Enron executives obviously entered into the new markets with little research and sense of markets demand. Many investments were failed or could not provide Enron with immediate benefits.Similarly, Enron believed that its expansion into international level were positive because they placed company in more potential markets. In fact, Enron made bad business decisions that were not supported by the other country's economic, such as Indian power plant project. The unprofitable or unsuccessful business decisions pilled up; and put heavy pressures on company's finance.
At the meantime, Enron had pushed using Special Purpose Entities and other off-balance sheet financing strategies which is the worst way of managing credit risk. As Enron continued its success, it broke the rule more and more. Large amount of debts are transferred form Enron to its partners; the financial reports of Enron recorded unrealistic and irrelevant information of Enron's financial position. On the other hand, the internal and external auditors failed to provide a true and fair view of financial reports. Author Andersen auditing and consulting firm helped Enron provide inadequate financial reports for many year. As an external auditor, Andersen's independent relationship with its auditee was not achieved effectively. And Enron was paying millions of dollars for Andersen; the conflicts of interest caused Andersen to ignore its professional norms.
Kenneth Lay, Jeff Skilling and other executives failed in their duties to oversee how the company did business. The corporate governance is the main reason that fundamentally caused Enron's collapse. At many situations, the Board of Directors witnessed numerous indications of questionable practices but chose to ignore them. They failed to achieve good corporate governance and unsuccessful engaged in a series of management decisions that harmed the company. The Enron's internal control was lack of risk of management. There are many lessons that could be learn for risk managers from Enron. Risk management is a key mechanism for company's internal control. When manager was interested in huge potential profits of an investment, the risk could be large too. Management should always critically evaluate and model risk. Ignorance of risk could consequently damage the whole organization like Enron.