What Happened to Enron?

The collapse of Enron caught almost everyone by surprise, from employees and investors to analysts and creditors. But how did the seventh largest company in the Fortune 500 plummet into bankruptcy and implode so quickly? The Enron story comes in three stages. Stage 1: The Company leveraged itself through debt, which it used to grow its non-core wholesale energy operations and service business. Some of this debt was reportable on the company's balance sheet, and some was not. No problem for the company, as long as the stock price held up. Stage 2: The stock price fell. When that happened, off-balance-sheet liabilities put pressure on debt agreements, and eventually led to credit downgrades. Stage 3: The margins in this business are very thin and lower credit quality increased Enron's cost of borrowing to the point where the whole company fell into a liquidity trap.

Movement of Enrons share price (USD)

Enron: A Background Enron was born in July 1985 when Houston Natural Gas merged with Omaha-based Inter-North. Kenneth Lay, an energy economist became chairman and chief executive. As the energy markets, and in particular the electrical power markets were deregulated, Enrons business expanded into brokering and trading electricity and other energy commodities. The deregulation of these markets was a key Enron strategy as it invested time and money in lobbying Congress and state legislatures for access to what traditionally had been publicly provided utility markets. Some of Enrons top executives became frequently named corporate political patrons of the Republican Party. Enron needed the federal government to allow it to sell energy and other commodities. According to the Center for Responsive Politics, between 1989 and 2001, Enron contributed nearly $6 million to federal parties and candidates It was one of the first amongst energy companies to begin trading through the Internet, offering a free service that attracted a vast amount of customers. But while Enron boasted about the value of products that it bought and sold online a mind-boggling $880bn in just two years the company remained silent about whether these trading operations were actually making any money. At about this time, it is believed that Enron began to use sophisticated accounting techniques to keep its share price high, raise investment against it own assets and stock and maintain the impression of a highly successful company. Enron's 2000 annual report reported global revenues of $100bn. Income had raised by 40% in three years. The Chronology of the fall: 20 Feb, 2001 A Fortune story calls Enron a highly impenetrable Co. that is piling on debt while keeping the Wall Street in dark. On 14 Aug, 2001 Jeff Skilling resigned as chief executive, citing personal reasons. Kenneth Lay became chief executive once again. 12 Oct, 2001 Arthur Anderson legal counsel instructs workers who audit Enrons books to destroy all but the most basic documents. 16 Oct, 2001 Enron reports a third quarter loss of $618 million.

24 Oct 2001 CFO Andrew Fastow who ran some of the controversial SPEs is replaced. 8 Nov 2001 The company took the highly unusual move of restating its profits for the past four years. It admitted accounting errors, inflating income by $586 million since 1997. It effectively admitted that it had inflated its profits by concealing debts in the complicated partnership arrangements. 2Dec,2001 Enron filed for Chapter 11 bankruptcy protection and on the same day hit Dynegy Corp. with a $10 billion breach-of-contract lawsuit. 12 Dec 2001 Anderson CEO Jo Berardino testifies that his firm discovered possible illegal acts committed by Enron. 9 Jan 2002 U.S. Justice department launches criminal investigation. Hence within three months Enron had gone from being a company claiming assets worth almost 62bn to bankruptcy. Its share price collapsed from about $95 to below $1. Role of Andersen: Arthur Andersen one of the world's five leading accounting firms - was the auditor to Enron. When the scandal broke. Andersens chief auditor for Enron, David Duncan, ordered the shredding of thousands of documents that might prove compromising. Andersen has dismissed Mr Duncan and Andersens chief executive at the time of the Enron collapse, Jo Berardino, resigned at the end of March 2002 Besides obstruction of justice, Andersen also faces charges that it improperly approved of Enron's off-balance-sheet partnerships, called "special purpose entities", which the company used illicitly to hide losses from investors. Creative Accounting: The Special Purpose Entities (SPEs) At the heart of Enron's demise was the creation of partnerships with shell companies, these shell companies, run by Enron executives who profited richly from them, allowed Enron to keep hundreds of millions of dollars in debt off its books. But once stock analysts and financial

journalists heard about these arrangements, investors began to lose confidence in the company's finances. The results: a run on the stock, lowered credit ratings and insolvency.
How Enron used SPEs for off balance sheet financing:

The above flow chart explains how Enron used the SPEs taking most of its debt off balance sheet. Merrill Lynch handled the sales pitch for one such vehicle, LJM2 Co-Investment. According to claims and counter-claims filed in Delaware court hearings; many of the most prominent names in world finance - including Citigroup, JP Morgan Chase, CIBC, Deutsche Bank and Dresdner Bank - were still involved in the partnership, directly or indirectly, when Enron filed for bankruptcy. Originally, it appears that initially Enron was using SPE's appropriately by placing non energyrelated business into separate legal entities. What they did wrong was that they apparently tried to manufacture earnings by manipulating the capital structure of the SPEs; hide their losses; did not have independent outside partners that prevented full disclosure and did not disclose the risks in their financial statements.

There should be no interlocking management: The managers of the off balance sheet entity cannot be the same as the parent company in order to avoid conflicts of interest. The ownership percentage of the off balance sheet entity should be higher than 3% and the outside investors should not be controlled or affiliated with the parent: This was clearly not the case at Enron. Enron, in order to circumvent the outside ownership rules funneled money through a series of partnerships that appeared to be independent businesses, but which were controlled by Enron management. The scope and importance of the off-balance sheet vehicles were not widely known among investors in Enron stock, but they were no secret to many Wall Street firms. By the end of 1999, according to company estimates, it had moved $27bn of its total $60bn in assets off balance sheet.

References: http://specials.ft.com/enron/FT3LTT9G2XC.html http://www.time.com/time/business/article/0,8599,193520,00.html http://www.federatedinvestors.com/commentaries/equity/01-11-30_madden.asp Authors: Anuj Thakur Samir Kalra Rahul Karkun