What Happened and

1
Learning From Enron

• What Happened and
• What Does it Mean for Managers?
• Chuck Daly

2
Learning from Enron

• What happened inside Enron?
• Corporate practices
• Why did Enron fail?
• File for bankruptcy
• What are the Government Agency Responses?
• What does it mean for managers

3
Scope Issues left for another day

• Enron illustrates the requirements and failings
  of Federal securities regulations
• Critique of specific audit practices
• ERISA (401k programs)
• Stock options
• Securities analysts practices

4
Learning from Enron

• Federal securities laws reporting and disclosure
  requirements
• Securities Act of 1933
• Securities Exchange Act of 1934
• Generally information collection and
  dissemination
• Primary requirement is to update financial
  information on scheduled, timely basis
• Reporting standard companies are responsible for
  reporting material facts and for omissions of a
  material facts
• Also contains a duty to correct

5
Enron The Company and its Operations

• Created by the merging of two pipeline companies
  in the mid-1980s
• Moved slowly away from its hard-assets roots
• From pipelines and energy plants
• To transmission and energy trading
• To innovative commodities trader (energy,
  bandwidth, advertising time/space)

6
Enron Problematic Practices

• Accounting Special Purpose Entities (SPEs)
• Non-compliance with FAS 57
• Used for hedging transactions
• Used to accomplish asset sales
• Leveraging the Company
• To finance operations
• Guaranteeing Obligations of SPEs
• Enrons Culture (Advancement and Incentive
  Plans)
• Promoted Greed Culture
• Encouraged employees to hide problems

7
Enron Special Purpose Entities

• What are SPEs?
• Traditionally used by finance companies for
  securitization
• Also used to isolate risky assets (aircraft
  leasing, real estate development)
• In late 1990s many companies used SPEs to
  accelerate revenue recognition
• Several additional companies suffering from SPE
  use similar to Enron
• Xerox (currently being investigated by the SEC),
  Global Crossing, Adelphia, Tyco International

8
Enron Special Purpose Entities

• Governed by Financial Accounting Standard 57
• Allows SPEs to be kept off the balance sheet if
• Outside owner invests equity capital for a 3 or
  greater share of the SPE
• Outside owner exercises control over the SPE
• If both criteria are met, gains and losses from
  transactions with the SPE can be recorded
• Assets and liabilities of the SPE are not
  consolidated

9
Enron Special Purpose Entities

• How did Enron Use SPEs?
• To circumvent accounting rules
• To boost revenues
• To hide investment losses (hedging with itself)

10
Enron Special Purpose Entities

• 2000 Annual Report illustrates use of SPEs
• Note 9 discloses investments in SPEs and shows
  revenues of 510 million
• 510 million is more than 30 of Enrons net
  income for 2000

11
Enron Special Purpose Entities
Chart From Financial Times, FT.com
12
Enron Special Purpose Entities

• Example
• Joint Energy Development Investment (JEDI)
  (formed in 1993)
• Properly established with CalPERS as controlling
  50 partner
• Enron records gains from transactions with JEDI
  but does not consolidate JEDIs debt on its
  balance sheet
• 1997 CalPERs wants to cash out
• Enron needs a new partner to avoid consolidating
  JEDI on it balance sheet
• Enron executives form Chewco
• Chewco invests borrowed capital (Enron guarantees
  Chewco debt)

13
Enron Special Purpose Entities

• Success of JEDI and Chewco inspire additional
  SPEs
• New SPEs used to
• Sell hard assets to increase income
• Engage in hedging transactions

14
Highly Leveraged for Operations

• 2000 Annual report shows a debt load of 37
  billion (up from 14 billion in 1999)
• Many lending agreements containing debt reduction
  triggers

15
Loan Guarantees and Debt Reduction Triggers

• Enron made promises to lenders to secure capital
  for itself and SPEs
• Loans and credit facilities contained credit
  rating payment clauses
• If Enrons credit rating fell below a set level
  payment would become due immediately
• Pledged stock and options to secure borrowings
  for SPEs

16

• Incentive Plans
• Cultivating Greed
• compensation plans tightly geared to stock price
• incentive to promote earnings growth and stock
  price
• Employees focused on earnings growth instead of
  business lines or products

The Enron Culture
17

• Advancement Practices
• Corporate Culture Promoted Self-Interest
• Bottom 20 of performers forced out
• Incentives based on Enrons earnings per share
  (rewarded with stock options)
• Practices led to
• Following the letter but not the spirit of FAS 57
  (and sometimes not the letter)
• Sold assets to SPEs, transferred stock to SPEs to
  cover debts, and guaranteed loans to SPEs

The Enron Culture
18
Why did Enron file for bankruptcy?

• Greed on a spectacular scale
• Following resignation of Jeff Skilling, Enron and
  Arthur Andersen pulled the plug on certain SPEs
• originally deemed to satisfy the requirements for
  off-balance sheet treatment
• review led to recategorizing SPEs and restating
  income and debt

19
Why did Enron file for bankruptcy?

• The beginning of the end
• October 16, 2001
• 544 million after-tax change related to SPEs
  being consolidated
• reduced shareholder equity by 1.2 billion
• November JEDI and Chewco arrangement exposed
• forced consolidation of JEDI financials
• Enron financials for 1997-2001 restated
• increased reported debt by 711 million in 1997,
  561 million in 1998, 685 million in 1999, and
  628 million in 2000

20
Why did Enron file for bankruptcy?

• Increase in reported debt from JEDI and Chewco
  led to reexamination of Enrons debt rating by
  Moodys and SP (downgraded to barely investment
  grade)
• Moodys and SP further downgrade Enron's debt to
  junk
• Downgrading trips debt triggers in Enron loans
  (4 billion becomes due immediately)

21
Lessons for Managers

• Liability under Federal securities laws
• Changes in business practices (regulations)

22
Lessons for Managers Liability

• Federal Securities Laws
• Primarily Section 10b of the Securities Exchange
  Act of 1934
• Section 13(b)(2) for directors and officers
• Criminal
• Sections 13(b)(4)-(7), 24 and 32 knowing and
  willful standards
• Criminal fraud
• Possible prison sentences (new federal law allows
  for up to 10 years for a fraud of over 100
  million)

23
Lessons for Managers Federal Securities Laws

• General Scheme of Anti-fraud
• Designed to promote disclosure
• Section 10b (anti-fraud)
• Common Pitfalls
• Management Discussion and Analysis
• Financial Reporting

24
Changes in Business Practices through Regulations

• Corporate
• Record keeping and Corporate Governance
• Accounting - FAS 57
• Securities and Exchange Commission Rules
• Reporting Requirements
• Enforcement Authority
• Lending Practices - reporting of debt triggers

25
Lessons for Managers Reform Proposals

• Likely to see a reaction similar to the
  Investment Banking scandal in the late 1980s
• Greater oversight by regulators
• Codification of best practices

26
Lessons for Managers Corporate Reform Proposals

• Greater oversight by Corporate Boards
• Changes in auditing and reporting practices
• Could see requirements for higher percentages of
  independent directors on corporate boards
• Increased influence of audit committees and
  information flow to and through audit committees

27
Lessons for Managers Accounting Reform Proposals

• Overhaul Financial Accounting Standard 57
  (inclusion of partnership interests)
• Valuation of intangible assets
• Greater disclosure of derivatives positions

28
Lessons for Managers SEC Reform Proposals

• Increased monitoring of accounting practices and
  financial statements
• longer review of proxy statements
• more thorough review of securities registrations
• Stronger penalties

29
Lessons for Managers Lending Reform Proposals

• Require debt triggers to be reported to rating
  agencies
• Require debt guarantees to be reported to rating
  agencies

30
Learning From Enron

• What Happened and
• What Does it Mean for Managers?
• Chuck Daly