ENRON Smartest Guys in the Room

By Phoenix

ask why.

Company’s Profile

• Enron is a USA based Company formed in 1985 by Kenneth Lay from a merger of Houston Natural Gas Company and InterNorth Inc., It was the first nationwide natural gas pipeline network in Houston, Texas.

• Enron Corp ranked 7th on the Fortune 500 list of Companies.• Enron employed approximately 22,000 employees.• It was one of the world's leading electricity, natural gas, pulp,

paper, and communications companies, with claimed revenues of nearly $101 billion in 2000.

• Enron was named "America's Most Innovative Company" for six consecutive years.

Areas of Business

Enron

Enron Whole Sale Services Enron Energy Services Enron’s Global Assets

Wholesale Services

• Enron Wholesale Services- encompasses Enron's global wholesale businesses, and is divided into four business units.

Enron America Enron Europe Enron Global Markets Enron Net Works Energy Services

• Enron Energy Services (EES) was a business unit of Enron Corporation.• The purpose of EES was to provide gas, electricity, and energy

management directly to businesses and homes.

Global Assets

• Enron Transportation Services: It oversees Enron's regulated, interstate natural gas pipelines.

• Enron had assets spread across :Central America and the CaribbeanSouth AmericaEuropeAsia Pacific

Enron’s Products

Enron traded in more than 30 different products, which included the following:

• Products traded on EnronOnline : Petrochemical, Plastics, Power, Pulp & Paper, Steel, Weather Risk Management.

• Oil & LNG Transportation. • Broadband.• Principal Investments.• Risk Management for Commodities.• Energy transportation and upstream services.• Capital and risk management services.• Energy and commodities services, etc.

Kenneth Lay

• He was a son of Baptist Preacher.• He was an American businessman.• He was the CEO and Chairman of Enron from 1985 to 2002.• He was one of the Crusaders of Deregulation in energy sector

specially oil, natural gas and electricity.• He was America’s highest paid CEO’s with a compensation

package of $42.4 million in 1999.

Enron Oil Trading – The Vahalla Scandal

• Enron Oil Trading (EOT) was a unit of InterNorth Inc. formed in 1984 which is located in Valhalla, Newyork.

• Louis Borget was hired to head the EOT and Tom Mastroeni was another trader of EOT.

• Enron Oil Trading was a profitable unit.• It generated profit $28 million in the year 1986.• When Enron was incurring losses, EOT was reporting profits.

Enron Oil Trading – The Vahalla Scandal

• It was suspected that EOT is exceeding its oil trading limits, Oil trading is like gambling where sometimes you win and sometimes you loose, but Enron was always making profits while the others incurred losses.

• Enron Traders made bets whether the price of Oil will rise or fall. They started trading recklessly and destroyed daily trading records.

• Internal Auditor of Enron were contacted by an officer at the Eastern Savings Bank.

• He said there was some unusual transaction going on in which Enron Bank Account was involved.

Enron Oil Trading – The Vahalla Scandal

• In further investigation it was found that there was a diversion of company’s fund to the personal accounts and various Offshore Accounts of Tom Mastroeni in the name of “M. Yass” which stood for “MY ASS”.

• Ken Lay who was CEO during that time was made aware about oil trading transactions.

• Ken Lay did not take any action against both the traders Borget and Mastroeni because they were making profits for the company.

Jeffrey Skilling

• He was a MBA graduate from Harvard Business School.• He worked as a consultant for McKinsey and Company.• He helped Enron in 1987 to create a Forward market in

natural gas.• Skilling impressed Kenneth Lay in his capacity as a consultant

and was hired as a chairman and CEO of Enron Finance Corp.• His only condition while joining the company was to adopt

Mark to Market accounting.• He quit the company on August 14,2001.

Mark to Market Accounting

• Meaning of Mark to Market. • Use of Mark to Market Accounting.• Mark to Market in Enron.• Arthur Anderson signed off and the SEC approved it.• Mark to Market allowed Enron to book potential future

profits on the very day the deal was signed, no matter how little cash actually came in the door.

• To the outside world Enron’s profit could be whatever Enron said they were.

Lou Pai

• Lou Pai is a Chinese-American businessman.• Made CEO of Enron Energy Services and Enron Xcelerator, a

venture capital division of Enron.• He and his traders went to club and spent money on strippers

which was charged to Enron’s account.• He left Enron with over $250 million but the divisions incurred a

total loss of $1 billion . He became the second largest land owner in Colorado.

Investment in India

• Enron began to investigate opportunities in the Indian power sector in 1992, when India first opened its power sector to private foreign investors.

• By June 1992, Enron had selected Dabhol as the site for a project, and, with General Electric, Enron entered a memorandum of understanding with the Maharashtra State Electricity Board (MSEB) to build the Dabhol project.

Dabhol Project - India

• But Enron had failed to see something basic, India couldn’t afford to pay for the power Enron produced. Enron lost a billion dollar on the project and paid out multimillion bonuses to executives based imaginary profits which never arrived.

Special Purpose Entities

• What is a SPE?• Rule for Consolidation of Accounts of SPE.• Important SPE’s created by Enron:

1. BRAVEHEART2. JEDI3. CHEWCO4. LJM 1 and LJM SWAP SUB L.P. 5. LJM 26. RAPTORS 1,2,3 AND 4

1. BRAVEHEART

• Enron entered into a partnership with Blockbuster (A major Video rental Company).

• Portland General Electric (PGE) – A subsidiary of Enron. • nCube – Oracle founder Jim Ellison’s private technology

company.• CIBC – Investment Banking division of Canadian Imperial Bank

of Commerce.• Braveheart – An SPE owned by Enron and CIBC.• Outcomes of the SPE.

2. JEDI – Joint Energy Development Investments

• Enron entered into partnership with CALPERS.• CALPERS – California State Retirement System.• Named after the Star Wars movie Characters. • ENRON to sell high risk assets to JEDI in return for IOU’s

backed by ENRON stock as collateral.• Outcomes of the SPE.

ENRON

CALPERS

JEDI

50% INTEREST

$250 million IN ENRON STOCK

50% INTEREST

3. CHEWCO

• Enron entered into a second partnership with CALPERS.• CALPERS wanted to cash out from JEDI and invest in new

partnership.• Enron formed a new partnership Chewco consisting of Enron

Executives and some outside investors.• Chewco was named after another Star Wars character

Chewbacca.• Legality of this SPE.• Outcomes.

Chewco Chart

CHEWCOBARCLAY’S BANK

BIG RIVER&

LITTLE RIVERJEDI

WILLIAM DOBSON &MICHAEL KOPPER

CALPERS

ENRON

$240 million

Guarantee

Credit of

$132 million

$1,25,000

$383 million

$11.4

milli

on

Loan given by Barclay’s for a cash reserve of $6.6 million (security) given by JEDI.

Andrew Fastow – CFO ENRON

• An American businessmen who served as a Chief Financial Officer of Enron Corporation.

• He was one of the key figures behind the complex web of off Balance Sheet SPE’s which were used to conceal Enron’s massive losses.

• His main job was to keep the stock prices up even though the company had a $ 30 billion debt.

• He created hundreds of SPE’s designed to transfer Enron’s Debt to an outside company and get it off the books of Enron without giving up the control of the assets that stood behind the debt.

•

Andy Fastow’s SPE strategy

4. LJM1 and LJM Swap Sub L.P.

• LJM1 was created and controlled by Fastow and was named for the initials of his wife and Children (Lea, Jeffrey and Michael).

• LJM Swap Sub L.P. (AKA Swap Sub) is a SPE created in 1999.• Enron’s investments in Rhythms NetConnections.• Creation of Enron would help Andy earn $45 million for

himself. Enron

Invests $10M for 5.4 million Shares Rhythms

Rhythms goes public

Value of after Listing.

Investment value rises to $300M

5. LJM2 Co-Investment L.P.

• In October 1999, Fastow created LJM2.• It was the second version of the same idea.• Fastow would act as a General Partner of a larger private

equity fund.• It was funded with $200 million by 96 individual bankers.• $25 million each was contributed by banks like:

a. J.P. Morgan Chase d. Citi Bank andb. Credit Suisse e. Deutsche Bank.c. Meryl Lynch

6. Raptors

Raptors1 - Talon : • LJM2 contributed $30 million in cash.• Enron Contributed $1000 in cash, a promissory note for $50

million and Enron Stock and Stock Contracts worth $537 million.• In Exchange Enron received Limited Interest in Talon and a

promissory not for $400 million.• Enron agreed to pay $41 million as a premium for put option on

7.2 million shares of Enron Stock.• This $41 million was immediately distributed to LJM2.

Talon

6. Raptors

Ex: Of a Trade in Raptor 1: Talon was used to hedge Enron’s investment in Avici Systems Inc.

an internet architecture firm. Enron owned a large share of company’s stock and on September 15, 2000 it entered into a total return swap with Talon on Avici stock. At that time it was traded at $95.50 per share. However the swap agreement was dated as of August 3rd. This was also the day on which Avici stock traded at $162.50 per share, its all time high. By september 30 when Avici had dropped to $95 per share, Enron offset $75 million in losses as result of the swap.

6.Raptors

Raptors 2 and 4: Timberwolf and Bobcat: • Essentially structured like raptor 1.• Outside partners contributed $30 million and received $41

million as premium for put options on Enron Stock.Raptors 3 – Porcupine:• Enron contributed shares in an Enron created company, The

New Power Company (TNPC) in exchange for a promissory note for $259 million.

• Enron and Porcupine had entered into a total return swap of $18 million shares of TNPC stock at $21 per share.

• Enron gained $370 million in this transaction.

Porcupine

Problems with Raptors

• The Raptors were designed to protect Enron’s financial statements against losses from declines in the market value of a variety of investments held in its “merchant portfolio”. This depended on the credit worthiness of the Raptors. If that became questionable, Enron would have to record credit reserves, negating the positive effects of the hedges. For Talon, Timberwolf, and Bobcat this required that the value of Enron stock (their only asset) increase to offset the significant losses they incurred on most of their derivative transactions with Enron. Porcupine, however, had to rely on the value of its TNPC stock, the same stock it was hedging.

CALIFORNIA ENERGY SCAM: Breakthrough

• Eyes on California to make the stock prices go up.

• Enron exploited the “DREGULATION” option in California to

manipulate electricity supply and charge high price for electricity.

• Drought, delays in approval of new power plants and market

manipulation decreased supply.

• 800% increase in wholesale prices.• “Megawatt” laundering • “Overscheduling”

Result of California Crisis

• Rolling blackouts.• Artificial demand – supply gap was created.• Electricity bills sky-rocketed.• Widespread outrage.

Result of California Crisis

Sherron Watkins – The Whistleblower

• On August 13,2001 Jeff Skilling resigns and on August 15, 2001 Sherron Watkins, an Enron Vice President writes to Lay expressing concerns about Enron’s accounting practices.

• On August 22, 2001 Sherron Watkins meets with Lay and gives him a letter in which she says that Enron might be an elaborate Hoax.

• On February 14, 2002 she testifies before congressional panel against Skilling and Lay.

Outcomes of the Scams

• Enron's shareholders lost $74 billion in the four years before the company's bankruptcy ($40 to $45 billion was attributed to fraud).

• Enron’s more than 20,000 former Employees lost $2 billion in pensions.

• Employees lost more than $1.2 billion in retirement funds.• Enron’s top executives cashed in $116 million in stock.• 20,000 employees lost there jobs and medical insurances.

Prosecutions

Andrew Fastow – faced 98 counts, pleaded guilty to one charge of conspiracy to

commit wire fraud and one charge of conspiracy to commit wire and securities fraud. Fastow has agreed to serve 6 years in prison and forfeit $23.8 million, including homes in Galveston and Vermont; and forfeit claims on another $6 million held by third parties.

Jeffrey Skilling – Named in 35-count indictment, Skilling pleads not guilty to

wire fraud, securities fraud, conspiracy, insider trading and making false statements on financial reports.

Prosecution

• On May 25, 2006 Skilling convicted on 19 of 28 counts of conspiracy, fraud, insider trading, and false statements. Skilling gets 24 years and 4 months of imprisonment and forfeits $45 million.

Kenneth Lay – Indicted on 11 criminal counts of fraud and making misleading

statements , Ken Lay, surrenders to the FBI. After pleading not guilty.

On May 25,2006 Lay convicted on all six counts of conspiracy and fraud, In July Lay dies before sentencing.

Arthur Anderson

• They where the Auditors of Enron Corporation.• In 1991, they signed off on Mark to Market Accounting.• They approved the SPE’s created by Andy Fastow.• On Oct 23, 2001 where Lay assures the employees about the

companies wellbeing at same time just a few blocks away, Arthur Anderson shredded 1 Ton of Enron Documents.

• On March 14, 2002 Arthur Anderson LLP indicted for obstruction of Justice for destroying Tons of Enron Documents.

Arthur Anderson

• On April 09, 2002 David Duncan, Enron’s Auditor pleads guilty to obstruction.

• On August 31, 2002 the firm surrenders its license to practice accounting.

• On Oct 16, 2002 sentenced to probation and a $500,000 fine and banned from auditing public companies.

• On March 13, 2007 Arthur Anderson will pay $72.5 million to investors who sued the firm for its involvement in Enron Scandal.

• July 30, 2002 by President George W Bush.

• Corporate scandals, companies such as Enron, WorldCom and Tyco.

• Senator Paul Sarbanes and Representative Michael G Oxley, who

drafted the Sarbanes-Oxley Act of 2002.

• Objective: "To protect investors by improving the accuracy and

reliability of corporate disclosures made pursuant to the security

laws, and for other purposes."

Introduction to Sarbanes Oxley Act

• Corporate accountability

• It changes how corporate boards and executives must

interact with each other and with corporate auditors.

• It removes the defense of "I wasn't aware of financial issues”

• New financial reporting responsibilities,

• Adherence to new internal controls and procedures.

An insight into the Act

• All public companies in the U.S.

• International companies that have registered equity or debt

securities with the Securities and Exchange Commission (SEC) and

• The accounting firms that provide auditing services to them.

Who the Act applies to

• Data accuracy and safeguarding financial data.

• Assessment of the Internal Controls and its effectiveness.

• Auditing firm is required to attest to that assessment.

Objectives of SOX Audit

1. All material off-balance sheet transactions

2. Special purpose entities must be disclosed in annual and quarterly financial reports.

3. If a company uses pro forma numbers earlier it must show what the financial results would be, using GAAP

4. Legal insider trading must be reported within two business days.

5. Other material changes must be reported on a “rapid and current basis.”

6. Any waiver of company’s ethical code, must be disclosed.

Disclosure Requirements

BEHAVIOUR SENTENCE The alteration, destruction, concealment of any records with the intent of obstructing a federal investigation.

Fine and/or up to 10 years imprisonment.

Failure to maintain audit or review “work papers” for at least five years.

Fine and/or up to 5 years imprisonment.

Anyone who “knowingly executes, or attempts to execute, a scheme” to defraud a purchaser of securities.

Fine and/or up to 10 years imprisonment.

Any CEO or CFO who “recklessly” violates his or her certification of the company’s financial statements. If “willfully” violates.

Fine of up to $1,000,000 and/or up tp 10 years imprisonment. Fine of up to $5 million and/or up to 20 years imprisonment.

Two or more persons who conspire to commit any offense against or to defraud the U.S. or its agencies.

Fine and/or up to 10 years imprisonment.

Any person who “corruptly” alters, destroys, conceals, etc., any records or documents with the intent of impairing the integrity of the record or document for use in an official proceeding.

Fine and/or up to 20 years imprisonment.

Mail and wire fraud. Violating applicable Employee Retirement Income Security Act (ERISA) provisions.

Increase from 5 to 20 years imprisonment. Various lengths depending on violation

Consequences of Non Compliance Consequences of Non Compliance

Conclusion

• Enron was a massive failure, partly because of its size, partly because of its complexity, partly because the controls to protect the integrity of capital markets failed, and especially because of the massive greed and collusion of key participants. Management failed, auditors failed, analysts failed, creditors/bankers failed, and regulators failed. The intersection of multiple failures sent a signal of structural problems. Suddenly, the consequence of deceptive financial data resulting from structural failure in the capital markets was not merely a hypothetical possibility. The speed with which the system responded indicates the importance of fairly presented financial information.

• .•

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