BU 667 June 13 2006 ENRON A Seminar by: Darren Hallsworth David Mehta Michelle Mueller.

BU 667June 13 2006

ENRON

A Seminar by:Darren Hallsworth

David MehtaMichelle Mueller

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BU 667June 13 2006

Agenda

Introduction/Overview Accounting Conflicts of Interest MOVIE Implications GAME

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OVERVIEW

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ENRON America’s largest corporate bankruptcy Took 16 years to go from $10 Billion in

assets to $65 Billion in assets and 24 days to go bankrupt

House of cards built upon oil fields 4000 employees lost their jobs and life

savings and pensions During 2001, Enron shares fell from over US

$90.00 to US$0.30.

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Why did Enron Fail?

Conflicts of interest Lack of attention by board of directors

to off-books financial entities Lack of truthfulness Culture of Enron

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The “Smartest Guys in the Room”

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Ken Lay Chairman/CEO Huge ambition to make wealth for himself Advocate for deregulating energy

markets. Founded Enron in 1985 Positioned Enron to take advantage of the

governments decision to let gas prices float with the market

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Jeff Skilling

CEO & President Huge risk taker Transformed energy industry into a

stock market for natural gas In 1992, Enron became the largest

buyer/seller of natural gas in North America

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Jeff Skilling Implemented mark to market

accounting Arthur Anderson signed off on it

and the SEC backed it. Allowed Enron to book potential

future profits on the day a deal was signed.

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Jeff Skilling Instituted the PRC performance

review committee also known as “Rank and Yank”

Employees were graded on a scale through 1 to 5.

10% of employees had to be ranked a 5 and fired each year.

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Andy Fastow CFO Used ‘structured finance’ or “off balance sheet

transactions “to hide debt while keeping the stock price up

Created Special Purpose Entities (SPE’s) to bury the debt

LJM was Enron’s most ambitious endeavour. Involved transactions with investors using Enron’s stock as collateral.

Huge conflict of interest as Fastow was the head of LJM and the CFO of Enron.

LJM signed off by Skilling & Lay, and also Anderson and Vincent & Elkens.

LJM allowed Fastow to take $45 M for himself.

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Perception as the Reality Executives were fixated on pushing Enron’s stock up. Huge public relations campaign to encourage investors

to buy Enron stock. Convinced investment community that Enron was new,

different, and innovative. Fortune named Enron "America's Most Innovative

Company" for six consecutive years If Enron met or exceeded quarterly EPS, the stock would

rise Everyone had a huge stake to see profits go up Enron convinced investors that profits were increasing

by 10-15% every year. In reality, they were loosing money.

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India

In 1992 Enron built a power plant in Dabhol India.

But India couldn’t afford to pay for the power the plant produced

This project lost appox. $1 Billion while paying executives multi million dollar bonuses based on imaginary profits that never materialised.

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California Failure was not an option for Enron Enron bought out Portland General Electric

(PGE) based in California. All PGE stock became Enron stock.

This merger put Enron in the electricity business and gave them access to the newly de-regulated market in California

Positioned Enron to become the largest marketer of electricity and natural gas at the wholesale and retail market world wide.

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California Energy Crisis Took advantage of the rolling blackouts by tampering

with supply and demand. Exported power out of California to lessen supply and

when prices soared due to higher demand, they brought it back in and sold it at a premium.

By shutting down power plants they could create artificial shortages that would push prices higher.

Shut down 3 or 4 plants at the same time to create demand

Enron made $2 Billion in profits and traders made multi-million dollar bonuses.

Cost California $30 Billion dollars to their economy.

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Project Braveheart July 2000, Enron announced a deal with

Blockbuster to deliver movies on demand via Enron’s Intelligent Network

The plan was to introduce the entertainment on-demand service in multiple U.S. cities by year-end

By March 2001 the deal was called off. Using mark to market accounting, Enron

reported more than $110M as profit from the project. Auditors from Arthur Anderson approved the accounting transaction

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Pump and Dump

During Enron’s fall, executives would encourage employees and investors to buy more stock, telling them the company would rebound, while selling large amount of Enron stock themselves.

By Enron’s collapse Skilling made over $200M in Enron stock Lay made over $300M in Enron stock

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Running out of gas2001 Aug 14 – Skilling resigns for ‘personal reasons’ Aug 15 – Lay receives Watkins letter warning him that Enron’s accounting

is an elaborate hoax. Aug 20 - Lay sells $2M worth of shares and dishonestly told employees

and others that Enron stock was “an incredible bargain” even after he had been warned of “potential scandal”

Oct 16 – Enron announced a $1.2 Billion decrease in company value Oct 17 – Nov 19 – Enron Employees were not allowed to sell their Enron

stock in 401K plans due to a change in their pension fund administrator while the executives were cashing in stock options During this time, the stock plummeted from $32 to $9.06 when it emerged that the company had been concealing losses by setting up shell companies

Oct 23 – Anderson shreds 1 ton of Enron related documents Oct. 31 - SEC inquiry upgraded to a formal investigation Nov 8 – Enron admits to overstating income by $586 Million from 1997.

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The Guiltiest Guys in the RoomOctober 31, 2002 Fastow was indicted by a federal grand jury in Houston, Texas on 78

counts including fraud, money laundering, and conspiracy. January 14, 2004, Fastow pled guilty to two counts of wire and securities fraud, and

agreed to serve a ten-year prison sentence. He also agreed to cooperate with federal authorities in the

prosecutions of other former Enron executives. Fastow, although convicted, remains out of prison until completion of

the investigation.May 25, 2006 Skilling was found guilty on 19 counts of conspiracy, fraud, false

statements and insider trading. He was found not guilty on nine counts of insider trading.

Lay was found guilty of one count of conspiracy, three counts of securities fraud, two counts of wire fraud, three counts of making false statements to banks and one count of bank fraud.

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Accounting Scheme

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The House of cards begins to fall

Oct 22 Enron announces the SEC is looking into related party transactions

Nov 8 Enron announces a restatement of its F/S back to 1997

Results of the restatement: $591million loss; and additional $628 in liabilities

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Blame game begins Arthur Anderson audited Enron’s year end

2000 and prior financial Andersen received ‘previously undisclosed

information’ while performing their 2000 audit

Andersen concluded that the partnerships were not independent of Enron b/c of a technical violation

Partnerships were disclosed in notes but they were ‘arms length’ transactions

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Blame game begins

Enron was not constrained by the accounting rules to report the partnerships as it did

Losses from partnerships should have been reflected on the income statement

If Andersen believed that following GAAP would mislead investors; duty to disclose

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Conflicts of Interest? Ethically, Enron officials had the duty to

disclose all relevant information. Auditors should have been more diligent Auditors aren’t motivated to

aggressively audit their important clients -- $52million in annual fees from Enron

Consulting and internal auditing Future implications of F/S Audit

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Off BS! Financing

Large Cap Ex are excluded from B/S Legal Separate entities are set up –

Permissible under GAAP and tax laws Finance new business ventures Transfers risk from the parent to the

subsidiary

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Off BS! Financing Enron sponsored 100’s, if not 1000’s of

SPE’s it did business with. GAAP- did not need to be consolidate in F/S

because Independent third parties held 3% of SPE’s assets

SPE’s main assets were restricted Enron Shares

Created an SPE specifically for losses from merchant investment portfolio business

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The ENRON way Disclosed in the F/S that dealings with the

SPE’s were ‘Arms Length’ transactions 3rd quarter 2000 to 3rd quarter 2001

reported earnings were $1506m , w/o their ‘Raptor’ SPE it was $429m or 28% of the Reported amount

Violated Revenue recognition principal by recording income as current for services rendered in the future.

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The Good, the bad, the Enron

Finance new ventures – transfers risk from the parent

No dilution of existing shareholders No additional debt on balance sheet Separate from Core business

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To late to Sell!?

Used off- balance sheet vehicles to pump up financial results

Place to hide losses from bad trades Manipulate debt/equity ratios and

other leverage ratio to ensure they were in an acceptable range.

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Mark-to-Market Incorporated ‘mark-to-market’ in mid 90’s MTM – State that when a company has

outstanding energy derivatives contracts on their b/s, they can adjust to FMV

Realize any gains or losses for that period Complication with rules when accounting

for long-term future contracts in commodities like gas

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Mark-to-Market cont’

No quoted prices for LT – Future contracts Companies are free to develop and use

discretionary valuation models based on the companies assumptions and methods.

Enron used this to their advantage to beat earnings estimates and boost their stock price

Estimates were considerably overstated and trading gains accounted for more than half the companies 1.41 billion profit in 2000

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MOVIE !!!

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IMPLICATIONS

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Wide Ranging Fallout

Scope of the Enron collapse Huge ripple effect Social Economic Political

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Who Was Impacted

Enron executive and board 5600 employees Shareholders Arthur Andersen Investment Bankers Lawyers George Bush

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Immediate Fallout

Long term implications unclear Political fallout in US and UK Enron gave approx US $6 million to

political figures Approx 75% of US contributions went

to the Republican Party, including heavy contributions to George W. Bush's presidential campaign

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Arthur Andersen The trial of Arthur Andersen on charges of

obstruction of justice related to Enron also helped to expose its accounting fraud at WorldCom

The subsequent bankruptcy of the telecommunications firm quickly set off a wave of other accounting scandals.

At the time of its collapse, Enron was the largest bankruptcy in history, since then it has been eclipsed by the collapse of WorldCom.

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Arthur Andersen June 15, 2002, Andersen was convicted of obstruction of justice for

shredding documents related to its audit of Enron The U.S. Securities and Exchange Commission does not allow convicted

felons to audit public companies so firm agreed to surrender its licenses and its right to practice before the SEC on August 31.

May 31, 2005, the Supreme Court of the United States unanimously overturned Andersen's conviction due to flaws in the jury instructions

Despite this ruling, it is highly unlikely Andersen will ever return as a viable business.

The firm lost nearly all of its clients when it was indicted, and there are over 100 civil suits pending against the firm related to its audits of Enron and other companies

From a high of 28,000 employees in the US and 85,000 worldwide, the firm is now down to around 200 based primarily in Chicago. Most of their attention is on handling the lawsuits.

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Criminal Behavior and Existing Frameworks

Audit independence Conflicts of interest Investor confidence in capital markets How to close the gaps and restore Trust?

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Societal and Legal Impacts Enron's collapse led to the creation of the

U.S. Sarbanes-Oxley Act, signed into law on July 30, 2002

Considered the most significant change to federal securities laws since FDR's New Deal in the 1930s

Other countries have adopted new corporate governance legislations.

Securities law historian Joel S. Seligman was quoted in The Washington Post saying, "[this was the most important corporate scandal of our lifetimes. It was one of the

immediate causes of the Sarbanes-Oxley Act, the governance reforms of the New York Stock Exchange and NASD, and the most consequential reorientation of corporate behavior in living memory."

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Sarbanes-Oxley Legislation

Summary Page from AICPA site

http://www.aicpa.org/info/sarbanes_oxley_summary.htm

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Sarbanes-Oxley Legislation What did it cover? Broad strokes

Increased oversight of accounting profession through appointment of new oversight board - granted additional powers to the SEC.

Increased corporate governance obligations of publicly listed companies, incl requirements that CEOs & CFOs personally certify the accuracy of financial information and related disclosures in SEC reports.

Increased level of disclosure required in reports filed with the SEC, incl disclosure of material off-balance sheet transactions.

Provided job protection to & prohibited organizational retaliation against whistleblowers.

Required lawyers report evidence of a corporate officers’ misconduct to audit committees and corporate boards.

Imposed tougher, new criminal penalties for violations of the act and existing securities laws and increased the statute of limitations for violations of the securities laws.

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Sarbanes-Oxley Legislation Specifically re Audit Practice 1. Accounting firms must be responsible solely to audit

committees of the boards, which be comprised solely of independent outside directors.

2. Auditors be barred from providing several non-audit services (including bookkeeping, actuarial, management functions, appraisal, broker or dealer, internal audit outsourcing services, investment advice, investment banking services, and legal services) and the provision of services not expressly prohibited be allowed only if approved in advance by the audit committees.

3. Audit partners be rotated every five years and auditors be barred for one year from accepting employment with clients as CEO, CFO or Controller.

4. An auditor oversight board be established, subject to SEC review.

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In Canada Bill 198 is the Canadian version of SOX Does not quite go as far No Attorney reporting (noisy withdrawal) No mandatory codes of conduct No mandatory compensation

committees no forfeit of bonuses Requires more of a policy re-statement

than outright required rules

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Pensions Thousands of Enron employees and

investors lost their life savings, children's college funds, and pensions when Enron collapsed. A lawsuit on the behalf of a group of Enron's shareholders has been filed against Enron executives and directors. This lawsuit accuses twenty-nine of these executives and directors of insider trading and misleading the public.

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Pensions

Because the 401(k) plan is a defined contribution plan, there was no Pension insurance and employees lost the money they invested in Enron stock.

Legally they could only sue those considered a fiduciary for breach of their duty of care

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Miscellany Enron Field baseball stadium in Houston, Texas, named after the

company, was renamed to Astros Field to avoid negative publicity. The park's name was later changed to Minute Maid Park. The Houston Astros had to pay Enron $5 million to get out of the deal.

David Tonsall, a former Enron employee, became a rapper under the name N Run, which is a play on the name "Enron" and also stands for "never run." He released his CD Corporate America on December 3, 2003.

The 2003 non-fiction book Enron: The Smartest Guys in the Room, written by Bethany McLean and Peter Elkind, was a bestseller. The book was turned into a film that was nominated for the 2005 Academy Award for Documentary Feature.

As a result of their investigation the FERC made a large portion of Enron's email database available to the public. This database comprises roughly 500,000 email messages and has become a standard dataset in email research

The movie Fun with Dick and Jane, starring Jim Carrey and Tea Leoni, features a special thank you to individuals involved in the scandal, as well as the company. The thank you includes other companies involved in similar cases, and precedes the cast listing in the credits to the film.

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Challenges Corporations need to adjust and buy-in to

restrictive legislation Imposition of substantial burdens and costs Will SOX be diminished by amendments

over time? Will courts become bogged down in SOX

interpretations? Easy to impose strong legislation when

outrage is high and widespread Will it be as easy to maintain the standards

as the memories of the scandals fades?

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MAP OF BLAME GAME

http://www.slate.com/?id=2061470

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THANK-YOU

QUESTIONS?