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Enron as Icarus

The Motley Fool – by Bill Mann – December 1, 2001

This has to be the most fascinating, tragic, business story of the decade. Enron, less than a year ago valued at $66 billion, collapsed in a heap of ignominy with nothing left before it but bankruptcy. It is a story where the seeds of the company's destruction were sown as it was achieving its biggest success. When a management team seems more interested in appearances than good corporate governance, look out.

The story of the demise of Enron, a company with a market capitalization of more than $60 billion less than one year ago, has already been and will continue to be reported (and misreported) to death over the next weeks and months. This is a company that had no natural predators, it was the top of the food chain, and it was a company with which institutions, analysts, journalists, and individual investors all fell deeply in love.

If you follow the Enron story at all, you are going to find a few things. First, there will be a great deal of revisionist history, with pundits wagging their fingers at investors for taking big (read obvious) risks with Enron. You will find more than a little glee at the comeuppance of Enron's heretofore lionized management team as they are dragged through the dirt for their poor decisions, their lack of fiduciary control, their exorbitant (read undeserved) pay packages, their complete lack of ethics.

To some extent, this will all be true, which is exactly why revisionist history even exists. But it misses several points, first and foremost is that the thing that should define Enron is hubris. Over the last two decades, its management, from CEO Ken Lay on down, was unwilling to accept Enron's position as a regional natural gas pipeline company, and simply ignored the playbook every other company used. Enron created trading markets for commodities where none previously existed, and in doing so not only carved an ironclad position for itself, but solved some real inefficiencies in these markets. Enron even went so far as to attempt to create a bandwidth-on-demand market at a time when most of the providers of bandwidth needed a minimum of 60 days to turn up a data circuit. The incumbents laughed, but you can bet that they watched Enron very closely.

Yes, Enron's success, and its ultimate destruction, were both caused by hubris. Like Icarus, who tried to escape captivity with wings made of feathers and wax, a lack of respect for the conventional wisdom released Enron from its minor role in an obscure business. And just as Icarus' success was also the seed of his destruction, Enron flew too close to the sun, leveraging its assets higher and higher, and using increasingly deceptive accounting legerdemain in order to maintain its highly lucrative image as one of the most successful companies in America.

Enron revenues reached $100 billion in 2000, up from an already enormous $31 billion two years prior as companies rushed to trade on its proprietary platforms. Management basked in the glow of running one of America's most admired companies, all the while exploiting weaknesses in U.S. GAAP (generally accepted accounting principles) by hiding enormous amounts of risk in unconsolidated subsidiaries. Presumably, some of the sophisticated institutional investors in Enron, such as CalPERS would have assigned it a much lower multiple had they known the risks management was taking in its derivative trades.

I wish I could say I had sniffed out Enron's problems ahead of time. No, I swallowed the Enron story hook, line, sinker, pole, fisherman, and boat. I lobbied hard for Enron to be included in the FOOL 50 Index. The only thing that prevented me from investing in Enron was my complete inability to make sense of the company's financial statements, a condition that would seem prophetic once all of the company's off balance sheet shenanigans came to light. Once the run against Enron's assets started, there was nothing that could be done to stop the bleeding. Each reduction in asset value increased implied leverage, which caused partners to trade less with Enron, which caused debt covenants to be violated, which decreased asset value further, until the company disintegrated. The problem was that the original risks were never disclosed.

The reality is that Enron did a great job of hiding the risks that ultimately brought it down. But the company has given off hints of potential impropriety that started years ago, that through the degree of its cynical treatment of its shareholders' (and employees!) interests have only recently come to light. And that's why Enron story is truly sad. The seeds of its destruction were sown by a lack of management honesty.

Companies that use derivative instruments have a great deal of latitude when reporting assets and particularly liabilities -- even those who are scrupulously honest can have sharp disagreements in regard to trading reserves, debts, and other components. It is for this reason that banks and insurance companies are so heavily regulated, particularly in regard to asset/deposit ratios. Even in the hands of well-intentioned managers, mistakes can happen. In the hands of people willing to hide liabilities in unconsolidated subsidiaries, such esoteric notions as derivative liabilities become a playground for unsavory financial practices.

Enron's managers had everything to gain from playing such games, and they were willing to do so. Their perceived financial strength helped attract customers to the seeming safe haven of Enron trading floors, and their creditors kept inherently illiquid markets well capitalized. Moreover, for an executive team that had done nothing but dazzle Wall Street with double-digit growth, there is significant pressure to continue to turn in such numbers. However, in a situation such as Enron's, where its activities are necessarily going to improve efficiency in these markets and thus lower the spreads for market makers and counterparties alike, heroic, or in this case, infamous action would need to take place in order to maintain such growth.

Enron is dead because its management got caught up in playing Wall Street's stupid little games, promising and delivering big revenue and profit growth, damn the debt and other balance sheet contortions it took to get there. Management withheld key information from shareholders, and then, even after the troubles came to light last month, refused to answer questions about the nature of its deals with partnerships that were controlled by Enron executives. Looked at in this way, the pursuit of hypergrowth seems to have caused Enron executives to take undue risks with shareholder funds. Maintaining Enron's (and its managers') darling status in the investment world apparently caused these same men to take that short walk across the aisle from being aggressive with company assets to being downright deceptive by hiding information individual shareholders MUST have to make good investment decisions.

Apparently, 8-10% growth projections were not an option. In an August interview with BusinessWeek, Lay said Enron had grown earnings per share 32% in the second quarter, with operational physical volume delivery up 60%. He said investors would "continue to see strong growth in all of our business areas. Our revenues and income quarter-to-quarter continues to be strong and we have strong momentum. We think that will be sustained, and eventually, if we continue to do that, investors will recognize and reward us for that."

Contrast this with the strategy of deliberate growth and conservative asset management at crosstown rival Dynegy. This strategy, if much less exciting than Enron's way of doing things, has ultimately proven to be more successful. There may never be a better contrast to show the power of investor-centric corporate governance over that of management greed.

Unlike Icarus, who was ultimately responsible only to himself, Enron's management's actions have cost hundreds of thousands of investors, tens of thousands of employees and pensioners, and scores of partners, untold billions of dollars. The full scope of loss will not be known for some time, though we can already assume that it will be more than some can withstand. Ken Lay and company, brilliant as they undoubtedly are, seem to have forgotten just whom they were working for. I'd hope that Enron's commercials come to their minds, with dozens of suddenly poor investors and long-time employees wailing at them "Why? Why? Why?"

Fool on!

An Implosion on Wall Street

The New York Times – November 30, 2001

(11/29/01) Enron, the energy-trading company, may be on the verge of extinction with the collapse yesterday of its proposed acquisition by Dynegy, a smaller competitor, and the downgrading of its debt to junk status. But its name has attained immortality on Wall Street.

Enron is now shorthand for the perfect financial storm. Take a high-flying company terribly impressed with its sense of unique mission and ingenuity, and correspondingly contemptuous of its obligations to fully comply with the spirit of accounting rules. Then add fawning investors, Wall Street analysts, journalists and accountants unwilling to allow a company's lack of transparency about its business to get in the way of a dizzying ride, until they realize the destination is the top of a steep cliff. What you have then is an Enron.

There have been plenty of other once-unfathomable implosions on Wall Street, but perhaps none so sudden or of such magnitude. Jittery financial markets now have to contend with the possibility that an Enron bankruptcy could undermine the financial health of banks and other energy companies. Enron ranked seventh on the list of Fortune 500 companies last year, and remained one of the most hyped stories on Wall Street well into this year. A pioneer in creating private marketplaces for newly deregulated commodities, Enron was touted as a revolutionary force, bridging the dot-com world and stodgy energy markets.

Now Enron may become one of the largest bankruptcy cases in history. Its stock closed yesterday at 61 cents, as investors rushed for the exits in reaction to the fatal news that, without a bailout from Dynegy, Enron is unlikely to be able to meet its crushing debt obligations.

The company's autopsy will be a complicated affair, entailing numerous lawsuits. What is already clear, and will come as a shock to millions of trusting individual investors across America, is that the financials of a Fortune 500 company were essentially a mystery. Enron's death watch began last month when it grudgingly disclosed that $1.2 billion of its market value had vanished as a result of "related-party" transactions with private partnerships that enriched company insiders. Then Enron admitted that it had overstated its profits over the last five years by $600 million. Dynegy cited Enron's lack of forthrightness as a reason to walk away from the merger agreement.

Not very long ago, competitors and Democrats in Washington were worrying whether the close ties between Enron's chairman, Kenneth Lay, and George W. Bush would give the company too much influence. Enron has aggressively lobbied, with some success in recent years, to limit regulation and disclosure of its trading operations.

Now Enron is the best argument for the need for stronger supervision of public companies' financial data. The Securities and Exchange Commission should make sure that the energy trader's saga puts an end to any talk of lessening disclosure requirements faced by public companies. Moreover, Arthur Andersen's failure to uncover flawed accounting by Enron, or to forcefully question some of the company's shadier transactions, raises serious concerns about auditors' commitment to be sufficiently diligent in reviewing the actions of major companies.

There is a certain irony that Enron, a champion of deregulation, now becomes a poster child for the need for strong regulation on Wall Street.

Oh, the Games Enron Played

The Wharton School – November 26, 2001

In the 1990s, Houston’s Enron Corp. was Wall Street’s darling. It had thrown out the energy-industry playbook, remaking itself from a staid gas pipeline company to a high-tech trading firm that created exotic securities for betting on everything from gas prices to the number of hot days in summer.

Share prices soared from $30 to $90 between 1998 and 2000, as sales increased from $31 billion to more than $100 billion. Enron executives gained reputations as the energy industry’s visionaries.

This fall it all came apart. Share prices have fallen by 90% this year, including a plunge from just below $40 to less than $10 this fall. In October, Enron reported a third-quarter loss of $618 million. The company’s massive debt was downgraded to near junk-bond status, and the CEO and CFO were expelled. Shareholders sued and the Securities and Exchange Commission launched an investigation.

Finally, the humiliated company, which employs more than 20,000, agreed Nov. 9 to be taken over by smaller cross-town rival Dynegy Inc. for about $9 billion in stock and $13 billion in assumed debt. It is not certain the merger will take place since it is subject to regulatory approval and could be blocked on antitrust grounds. And some news accounts suggest that major Dynegy shareholders could derail the merger over concerns about inheriting liabilities from current or future lawsuits by Enron shareholders.

The Enron story is not simply a case of a lone company that played with fire and got burned. Enron was able to take enormous risks while keeping shareholders in the dark because it could exploit accounting loopholes for subsidiaries that are available to most publicly traded companies. Companies like Enron can legally conceal massive debts because rules require a full accounting of a subsidiary’s balance sheet only when the parent company owns more than half of it.

"If I’m a shareholder of Enron and I want full and fair disclosure, I would want information about the entities Enron controls," says Wharton accounting professor Robert E. Verrecchia. Yet Enron shareholders have never received such a report.

Enron’s fate is crucial to the energy industry and other markets it serves, points out Paul R. Kleindorfer, a professor of public policy and an expert on deregulation at Wharton. Producers and users of gas, oil, electricity and other forms of energy rely on Enron’s system for trading futures, forwards, options, swaps and other contracts to get the best prices and control costs far into the future. Without such a system, deregulation simply cannot work.

"If Enron’s trading platform were to go down it would not be a minor loss," Kleindorfer says. "It would be a huge loss for the industry….In the early 1990s the company single-handedly produced the backbone infrastructure that has led to a whole industry of broker intermediation."

To some extent, Enron appears to have been a victim of sagging securities prices and volatile energy costs in 2000 and 2001, and it has lost hundreds of millions by laying fiber-optic cable for which there is no demand. But although those factors may have determined the timing of the company’s troubles, they were not the chief cause. Enron appears to have lost enormous amounts of shareholder money by gambling at its own roulette wheels.

"In hindsight, we made some very bad investments in non-core businesses that performed worse than we ever could have conceived," Chairman Kenneth Lay told analysts last week.

How did Enron get into this mess?

Becoming a Market Maker

When it was created in 1985 by the merger of Houston Natural Gas and InterNorth, parent company of Northern Natural Gas, Enron’s chief business was the operation of thousands of miles of natural gas pipeline. Lay became chairman in Feb. 1986. Then early in the 1990s, the federal government took key steps to deregulate the energy industry.

Previously, large regulated utilities were vertically integrated, giving them control from wellhead to consumer, Kleindorfer says. Deregulation effectively broke apart the production, long-range transmission and local distribution functions, leaving each to a different set of players. A factory owner, for example, can now buy gas or electricity from number of producers.

To function, a free market such as this needs brokers, or intermediaries, to create, buy and sell contracts for production and delivery, and it requires a market maker to facilitate trading, just as the big Wall Street firms and exchanges facilitate trading in stocks. Enron created that marketplace. "This intermediation activity, or brokerage activity, just revolutionized the marketplace," Kleindorfer says.

Since utilities and other energy users must line up dependable supplies for many months in the future, they rely on various forms of contracts specifying quantities, prices and delivery dates. But before the commodity is delivered, prevailing prices may go up or down, and a supplier may find it has promised to sell at a price that’s now too low, while a purchaser may find that it could have bought for less than it had agreed to pay.

Suppliers and purchasers therefore use a variety of derivative contracts to benefit from prices that move in their favor and hedge in case prices move against them. A company that has contracted to buy a shipload of liquefied natural gas at a specific price in three months, could, for a much smaller sum, buy an options contract giving it the right, but not the obligation, to buy a shipload at a lower price. And it could buy an option giving it the right to sell at a higher price. Thus it is protected regardless of whether prices move up or down.

This was the business Enron invented. By permitting competition and price discovery far into the future, it brought to the marketplace the most efficient pricing and allowed energy users to predict and stabilize costs far into the future, Kleindorfer says. "Having that information historically, as well as projected into the future, could revolutionize how you plan your business," he said.

At the heart of Enron’s business strategy was the belief that it could be a big energy player without owning all the power plants, ships, pipelines and other facilities involved. Instead, it could use contracts to control the facilities in which other companies had invested, says Ehud Ronn, director of the Center for Energy Finance Education and Research at the Red McCombs School of Business at the University of Texas at Austin. The Center trains masters candidates in the use of energy securities. (Enron is one of the center’s eight corporate sponsors.)

Enron, he says, evolved into something akin to a Wall Street firm. "Enron thought of itself in very similar terms as an investment banker that wanted to tie up as little capital as possible."

By 2001, Enron had evolved into a market maker for some 1,800 different products, many of them energy- or Internet-related contracts or derivatives the company had created itself. They included products allowing customers to buy, sell, hedge or speculate in markets ranging from traditional commodities like coal, oil, gas and electricity to cutting edge markets for Internet bandwidth, pollution emissions, semiconductors, wind energy and many others. Prices for many of these products were available on the company’s free website, giving the energy markets unprecedented price transparency.

Betting on the Weather

To see how these products could be used, consider one of Enron’s "weather risk management" products meant for utilities, energy distributors, agricultural companies and financial institutions. A gas utility, for example, might use a "floor" to protect its revenue in the event of a mild winter. In exchange for a premium similar to that paid on an insurance policy, Enron will compensate the utility for every day between November and March on which the temperature rises above a set level. The payments would make up for reduced gas sales.

In another form of contract called a swap, or collar, Enron will pay the gas company a given amount if the number of warm days exceeds a set level. But if the number of cold days exceeds a threshold, the gas company will make a payment to Enron. The utility would not have to pay a premium as it would with the floor, and if it had to pay Enron, the money would come from the extra revenue received by selling more gas in a colder-than normal winter. To a layman this might look like betting. "We never use that word," says Ronn. "The worst we say is to ‘have a view.’"

In practice, other parties are often involved in such transactions, taking over the contractual obligation created by Enron. So, in addition to placing its own bets, Enron serves as a middleman, the way a stockbroker stands in the middle of a securities trade.

Like many middlemen, Enron has to be in a position to make good on any transaction should either party default. Otherwise, it would be hard to make a market in these products. In addition, says Ronn, Enron often has to pay out money before receiving payment from another party. Finally, Enron needed large amounts of capital to trade products in its own account, just as a Wall Street firm invests in stocks on its own in addition to executing customers’ trades. To accomplish all this, Enron needed vast amounts of capital. "You do need to have liquidity in huge numbers," Ronn says.

This created a dilemma. A public company can raise capital by selling additional shares, but current shareholders don’t like that because the new shares dilute the value of their holdings. The alternative is to borrow, but large debts hurt a company’s credit rating, forcing it to pay higher interest rates on its loans.

Andrew S. Fastow, who became the company’s senior vice president of finance in 1990, found innovative ways to issue new shares without dilution and to raise capital by selling old-fashioned assets like power plants and pipelines. "He has invented a groundbreaking strategy," Ted. A. Izatt, senior vice president at Lehman Brother’s Inc., told CFO Magazine in the fall of 1999. Or, as Enron president and CEO Jeffrey K. Skilling told the magazine: "We needed someone to rethink the entire financing structure at Enron from soup to nuts. We didn’t want someone stuck in the past, since the industry of yesterday is no longer. Andy has the intelligence and the youthful exuberance to think in new ways. He deserves every accolade tossed his way."

Fastow, named chief financial officer in March 1998, told the magazine: "We transformed finance into a merchant organization….Essentially, we would buy and sell risk positions." A key to the strategy: Move many of Enron’s transactions "off the balance sheet." In part, this involved exploiting a loophole in the securities and accounting regulations. As noted earlier, debts accumulated by subsidiaries, partnerships or other "entities" can be kept off the parent company’s books so long as the parent does not own more than 50% of the entity incurring the debt.

By using so-called unconsolidated subsidiaries, "you do not make transparent either the nature of the investment or the relationship between the parent and the subsidiary," said Verrecchia. Heavy hitters such as Wall Street analysts and major shareholders may have the clout to get a company to provide additional information on subsidiaries. "But if you’re just an investor picking up Enron’s annual report, you are stuck," Verrecchia added.

A Pattern of Sketchy Details

It has long been clear from company statements and SEC filings that Enron’s off-balance-sheet transactions were enormous, but details were sketchy because Enron did not have to report them, and chose not to. By this fall, however, it became obvious these transactions involved huge risks when Enron acknowledged it had improperly kept some activity off its books. Putting those debts and losses into Enron’s financial statements last month meant reducing shareholder equity by $1.2 billion. Corrected statements reduced net income by $96 million for 1997, $113 million for 1998, $250 million for 1999 and $132 million for 2000.

At issue were so-called "special purpose entities," or SPEs, set up for a variety of transactions for Enron’s benefit. Enron conceded some of these entities did not meet the accounting standards to be kept off of Enron’s books. In one case, for instance, the entity had "inadequate capitalization" for such treatment.

In 2000, Enron had created four entities known as Raptor I, II, III and IV to "hedge market risk in certain of its investments," according to an Enron filing with the SEC. Enron acquired notes receivable from the Raptors in exchange for an obligation to issue Enron shares to the entities. But Enron had improperly included the value of the notes receivable on its books without accounting for the cost of the shares it would have to issue. In correcting this violation of accounting rules, Enron said it had overstated its shareholders equity by $1 billion in March and June 2001.

Enron was particularly embarrassed in acknowledging that two special purpose entities, limited partnerships LJM Cayman and LJM Co-Investment, had Fastow as the managing partner. Fastow, who according to Enron made in excess of $30 million in this role, was forced out of the company in October. An internal committee and the SEC are investigating the use of the partnerships.

Obviously, Fastow’s role was a problem. If the partnerships were truly independent entities, he was in a conflict of interest. If he was running them on Enron’s behalf, they were not independent.

Despite the write-downs and disclosures this fall, many analysts complain they still do not have a full picture of Enron’s activities. Enron, for instance, has not fully described other partnerships it believes it can properly keep off the balance sheet. Nor is it clear to what extent Enron’s losses are due to bad bets it had made through highly-leveraged derivatives. While a stock market investor can simply hang on to shares to wait out a downturn, options and other derivatives typically have expiration dates. If the bet has not turned out as hoped, the entire investment can be lost.

"New disclosure was modest and management did not resolve concerns," Goldman Sachs analysts David Maccarrone and David Fleischer wrote in an Oct. 24 report to clients. Though Enron had long faced such criticisms, investors had tended to give the company the benefit of the doubt "because of its strong growth in earnings and acknowledged industry leading capabilities…," the two analysts said.

In other words, when stock was soaring, investors didn’t require details on how it was done. Now they are crying foul, and a number of shareholder suits have been filed. Essentially, they claim the company inflated its stock price by filing false financial statements. Investors who bought shares at those high prices have suffered huge losses.

For years, the Financial Accounting Standards Board, which sets accounting rules, has had a draft proposal for improving disclosure of subsidiaries’ activities and numbers. Essentially, it would move toward a more qualitative evaluation of whether the parent controlled the subsidiary even if it owned less than 50% of the stock. Control could be exerted by holding board seats or through contracts that effectively make the subsidiary a unit of the parent. "What the FASB has promulgated seems to me to be sensible," Verrecchia said, noting that the whole purpose of accounting is to give an accurate view of a company’s inner workings and true earnings. To conceal obligations, risk and debt, as Enron and others do, undermines that goal, he said.

But, facing heavy opposition from accountants and corporations, the FASB has not acted on the draft proposal, citing insufficient support on its board. So for the time being, off-balance-sheet transactions will continue to be a common practice among American corporations.

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