Special Purpose entities and its Involvement in Enron

Case

A special purpose entity (SP, special purpose vehicle/SPV, or, in some cases in each EU
jurisdiction FVC financial vehicle corporation) is a legal entity (usually a limited company of
some type or, sometimes, a limited partnership) created to fulfill narrow, specific or temporary
objectives. SPEs are typically used by companies to isolate the firm from financial risk. They are
also commonly used to hide debt (inflating profits), hide ownership, and obscure relationships
between different entities which are in fact related to each other (see Enron). Normally a
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 entire firm at risk. SPEs are also
commonly used in complex financings to separate different layers of equity infusion. Commonly
created and registered in tax havens, SPE's allow tax avoidance strategies unavailable in the
home district. Round-tripping is one such strategy. In addition, they are commonly used to own a
single asset and associated permits and contract rights (such as an apartment building or a
power plant), to allow for easier transfer of that asset. They are an integral part of public private
partnerships common throughout Europe which rely on a project finance type structure. [1]
A special purpose entity may be owned by one or more other entities and certain jurisdictions
may require ownership by certain parties in specific percentages. Often it is important that the
SPE not be owned by the entity on whose behalf the SPE is being set up (the sponsor). For
example, in the context of a loan securitization, if the SPE securitization vehicle were owned or
controlled by the bank whose loans were to be secured, the SPE would be consolidated with the
rest of the bank's group for regulatory, accounting, and bankruptcy purposes, which would defeat
the point of the securitization. Therefore many SPEs are set up as 'orphan' companies with their
shares settled on charitable and with professional directors provided by an administration
company to ensure that there is no connection with the sponsor

Enron shocked the world from being Americas most innovative company to
America's biggest corporate bankruptcy at its time. At its peak, Enron was America's
seventh largest corporation. Enron gave the illusion that it was a steady company
with good revenue but that was not the case, a large part of Enrons profits were
made of paper. This was made possible by masterfully designed accounting and
morally questionable acts by traders and executives.

Deep debt and surfacing information about hiding losses gave the company big
problems and in the late 2001 Enron declared bankruptcy under Chapter 11 of the
United States Bankruptcy Code.
Many factors affected Enron's surge to the top and its sudden fall. In this report we
will discuss and present what we think were the main reasons of their rise and fall.

Enrons surge to the top

From energy to trading
Kenneth Lay was one of the key spokesmen when it came to deregulation of the
energy market, much because of his personal connection to the Bush family. In the
early 1990's the United States congress approved a legislation that deregulated the
sale of natural gas. Not long before this Lay was one of the initiators that made it
possible to sell electricity on the free market. This major deregulation in the energy
market gave Enron the opportunity to sell their energy at higher prices, which
equivalently lead to greater revenue.
This was the start of Enron's journey from an energy company to a trading company.
The focus went from energy markets to finding new ways of earning money. Large
investments were made around the world to expand its business and open it for new
markets. Enron was named Americas most innovative company six years in a row by
Fortune's Most Admired Companies survey. This made the company attractive for top
graduates out of the best universities across America, which gave the company more
competence and a big urge to strive forward. The strive forward was the same as the
aim to increase the stock price. Enron employees were partly paid in stocks so
increasing the stock price became a main interest.

Mark-to-market Accounting
In 1990, Jeffery Skilling joined Enron Corporation and in 1997, he was appointed as
the company's Chief Executive Officer. Skilling demanded to change Enron's
accounting system from a straightforward kind of accounting were Enron had listed
actual revenue and costs of supplying and selling gas to the mark-to-market
accounting system. The mark-to-market method requires estimations of future
incomes when a long-term contract is signed. These estimations were based on the
future net value of the cash flow, costs related to the contract were often hard to
predict. This means that the estimated income from projects was included in Enron's
accounting even though the money was not yet received and if there were any
changes such as additional income or loss it would show up in subsequent periods.
Investors were given misleading information because of the deviation in the
estimations.
Enron was the first non-financial company to use the mark-to-market method. The
U.S.

Securities and Exchange Commission gave Enron their approval to use the method on
January 30, 1992. (The smartest guy in the room, 2004)

Special Purpose Entity

Special purpose entities are legal entities that are created only to carry out a specific
or temporary task. The purposes are to handle assets either by funding or by risk
management.
A sponsor creates the entities but the funding comes from investors. The financial
reporting has many rules about if the entity is separated from the sponsor. In Enron's
case the special purpose entities were not only used to dodge the traditional
accounting conventions but also so they could hide debts. The entities made it
possible for Enron to underestimate, hide its debts and overestimate its equity.

A new strategy
Enron was by 1992 the largest seller of natural gas in North America, their earnings
before interest and taxes were $122 million. To grow further, Enron followed a
differentiation strategy that were based on that the company owned and operated a
variety of assets, pipelines, broadband services, paper plants, water plants and
electricity plants. Enron did not only make money on its assets, it also traded actively
with contracts of the products and services it provided, making further revenue. This
made Enron a favorite among investors and between 1990 and end of 1998 Enron's
stock price increased 311%. The increase didn't stop there, 1999 it increased 56%
and 2000 it increased an additional 87%. The index for the market the same two
years was +20% and -10%. Enron's stock price was 83.13 dollars and its market
value was just above 60 billion dollars the 31 December of 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 their derivatives business. One
example was during the California electricity crisis (2000-2001) where they
manipulated the California energy market and sent electricity prices surging by at
least a factor of eight. During that time, the price of natural gas was trading as much
as $60 per thousand cubic feet in California (which was previously selling for about
$3 per thousand cubic feet). This kind of manipulation increased Enron's stock price
and revenues. But this not so clever manipulation of Enron made itself a political
target and accelerated the ruins of their finances.

Enrons collapse
Mark-to-market Accounting
The use of mark-to-market accounting later backfired. The company's aggressive
accounting had corrupted Enron's books and had allowed the company to be far too
optimistic in its assumptions about the future profits. Cash is a necessity for any
company to run and Enron mostly had paper revenue, so by the middle of 2001, they
came to the conclusion that the cash crisis had struck them.

The Enron Culture

In Enron, bonuses and incentives in form of cash or stock options came in bundles,
only if you were good enough and if you were considered one of the moneymakers.
This mentality made Enron a very competitive work place. Everyone was in a hurry to
close deals (good or bad) because right after a closed deal, they got their bonuses
regardless of the result of the deal. This became a problem since there were a lot of
projects being made but no follow-ups.
No one wanted to be responsible of a done deal, they just wanted to close it and get
their bonus.
Performance review committee was also a factor why employees in Enron were so
aggressive. It created a culture within Enron that replaced cooperation with
competition. The committee gave ratings from 1 to 5, 1 being the highest and in
Enron, the 1 mark meant that you will get a good sum of bonus. If you were in the
lowest 5 to 6 percent of this rankings, that meant that you are not good enough to
stay in Enron and you had to pack your things because you will lose your job anytime
soon.

Special Purpose Entity

In order to hide losses and fabricate earnings, Andrew Fastow created multiple SPEs.
Some SPE's are Chewco, LJM1, LJM2 and Raptor. When news about the debt hiding
surfaced, Enron's stock began to fall and several SPEs began to collapse as a result of
the drop of Enron's stock price. For an SPE to legal, they have to satisfy 3
requirements: (1) at least 3% of the equity had to come from outside investors (i.e.
not-Enron), (2) the entity could not be controlled by Enron, and (3) Enron was not
liable for any loans or other liabilities. (Bryce, 2002) An internal investigation of the
SPEs showed they were not independent since they were run by Enron employees
(i.e. LJM was run by Andy Fastow while Chewco was run by Kopper). Therefore, they

had to be disclosed in Enron's financial statements depressing earnings and debt

levels severely

Key players
Enron was housed by bright and talented employees and everyone thinks they are so
smart or smarter than the others that they think they could always get away with
'crime'.
Jeffrey Skilling was the one responsible in implementing mark-to-market accounting
in Enron. Under his management, Enron launched Enron Online, which is an Internet
based service where contracts on energy commodities could be traded with Enron. In
the end, Enron could not cover the capital costs of their transactions, which is also
one of the reasons that sent the company to bankruptcy.
Andrew Fastow was the Chief Financial Officer of Enron who was the mastermind of
the
Special Purpose Entities like LJM1, LJM2, etc. in Enron. He made the complicated
financial structures so that Enron could hide their losses and debts.
Rebecca Mark was the head of the failed businesses of Enron, which were Enron
International and Azurix. Some of here projects were the $3 billion power plant in
Dabhol, India and the expensive acquisition of Wessex Water. She also used the
Enron Jet with her trips around the world. One executive even mentioned that
whenever Mark attends a meeting, it costs the company at least $60,000 (that would
cover just her transportation). Of course, who could forget the contribution of the
Chairman and CEO of Enron, Kenneth Lay, regarding Enron's bankruptcy, Aside from
straying away from the business because he was too busy socializing, he and his
family misused the company assets. At one point, they were all using the company
jets for personal travels. He was also involved in conspiracy and fraud in the
company in order to hide its downfall.

Aftermath of Enrons bankruptcy

The bankruptcy affected at least the 21,000 Enron employees. During the four years
before

the

declaration

of

bankruptcy

where

shareholders

lost

$74

billion,

approximately $40-45 billion could be traced back to fraud (Wikipedia, 2012). 20,000
former employees won a suit against Enron in May 2004 worth $85 million this was
the compensation for nearly $2 billion in pension funds that were lost (Doran, 2004).

Not everything is about money, a lot of people lost their steady income, their security
to feed their families and many people's futures were shattered due to the loss of
pension.
Sarbanes-Oxley Act is a US federal law that came after the Enron scandal. The act
contains a set of standards that regulate public company boards, management and
public accounting firms. Some of the main regulations is that all companies must
have a majority of independent directors, nominating and compensation committee
has to have independent directors also the audit committee should consist of
members that are financially educated and one of the members have to been an
expert (Wikipedia, 2012).
On January 14, 2004, Andy Fas tow and his wife Lea both pleaded guilty and got a
highly unusual package deal. Andy was sentenced 10 years without parole in
exchange of testifying against Lay, Skilling and other former Enron executives.
Prosecutors were so impressed with his performance that his final sentence was
shortened to 6 years.
The jury in the Lay and Skilling trial returned its verdict on May 25, 2006. Lay was
convicted to 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 because
of heart attack; that is even before his sentence was scheduled. On the other hand,
Skilling was found guilty on nineteen of twenty eight-counts which includes securities
and wire fraud. On October 23, 2006, Skilling was sentenced to 24 years and 4
months in prison.

Conclusions and Recommendations

Conclusions
Morally questionable acts were made from both executives and traders. One thing
that is unavoidable is the fact that employees at Enron were partially paid in stocks
which motivated the workers to take actions that were unethical in order to raise the
stock price and equivalently their own money. As seen in the California case traders
manipulated the market in favor of the company.
Enron culture was heavily influenced by competition and since the employees were
motivated by fat bonuses and scared of getting laid off if they did not perform well,
and in effect resulted to an unhealthy competition between the co-workers. The
colleagues would rather stab each other in the back than help one another to close a

deal. Employees getting paid in stock did help neither the working environment nor
the competition among colleagues.
The working environment at Enron became unbearable and from an outsiders point
of view, you can see that it is not impossible that illegal and immoral things were
done. Incentives such as money are always strong, we think that there is a higher
probability that the greed will take over and people would do anything if the price is
right.
Mark-to-market accounting mixed with the use of SPEs made Enron look financially
healthy when it actually was bleeding, bleeding severely. Misleading information was
given to the investors due to the accounting system, which eventually lead to
decreasing stock price when the information about this started to surface. We think
this was just a matter of time rather than a question about if they would get away
with it. Sooner or later more and more of the bad investments had to be questioned
because of its great sizes and also because at some time it had to show that there
were short of real cash in the company.
We think the downfall of Enron was caused by several factors. Among many are the
topics we have chosen to present in this paper, the mark-to-market method, the
competitive working environment and the use of special purpose entities. Not to
forget is the importance of the people behind this, Lay, Skilling, Fastow and Mark. The
Enron scandal is not only a story about complex accounting it is also a story about
the people who made it possible. People that made decisions affecting not only
themselves or the 21.000 employees at Enron but also America as a whole.

Recommendations
Incentives must be paid after a project is done or at least when the company is
really profiting from that certain project.

Operational risk should be minimized and there should be some sort of checkup.
Careful selection of accounting approach and financial structures to use.
Minimized payment in stocks.