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NUST BUSINESS SCHOOL

ENRON AND
DERIVATIVES
Submitted To: Maam Shamsah
Nawaz
Submitted By:
Fatima Ali
Haseeb Munir
Maryam Ali
Mehwish Abid
Mohsin Iqbal
Sehrish Mehmood
Sidra Rafiq
MBA-2K14-A

EXECUTIVE SUMMARY
How a success story can turn into a big time failure is being highlighted in this
report. The case under study is on Enrons use of Derivatives and how that
turned into a failure. The report starts off with the history and causes of
failures and highlights the derivatives used by Enron for their benefit.
Furthermore the discussion revolves around the parties involved in the scandal
as well as the stakeholders who got affected due to it.
Then the analysis identifies the reasons of the internal control failures as well
as what lessons can be learnt from Enron to avoid the scandal of the same
scale in the future. Later on the recommendations were provided to avoid the
repetition of the scandal as well as the conclusion was drawn from the analysis
of the case under discussion.

INTRODUCTION
In 1985 Enron was established as a result of merger between Inter-North and
Houston Natural Gas companies. Enron became worlds leading integrated
electricity and Natural Gas provider. In addition to natural gas and electricity, it
established its business in multiple domains such as risk management,
physical commodities and financial services. By 2001 it had won the title of
most innovative company by fortune magazine for six consecutive years.
Enron had embedded culture of innovation and creativity. It had overall
strategy to remain competitive by identifying new opportunities. Enron often
comes up with innovative products which were not available in the market;
such as energy-based derivatives. These derivatives were created to minimize
risk in energy sector of US. Enron exploited derivatives in order to cover its
debts and future commitments and went bankrupt in 2002.

CASE HISTORY AND RELATED ISSUES


In terms of synergy creation, merger of Inter-North and Houston Natural Gas
wasnt so successful. For the execution of the merger Enron borrowed a large
amount of money as debt. For Enrons survival pipeline business wasnt
enough, it needed business strategies to generate handsome amount of funds
and profits. Although Enron had enough debt already however the
management kept on borrowing. To cater the credit obligations Jaffrey Skilling
(Enrons consultant) decided to start new business unit as Gas Bank. In Gas
Bank Enron will buy gas from multiple suppliers and will sell it to the network
of customers. That new business had significant potential to grow but that SBU
needed money for its operations. In order to resolve this issue Enron
introduced the innovative product in the market the energy derivatives.
In order to run the business Enron Skilling kept on expanding. In 1996, Enron
applied the gas bank model to new strategic business unit of energy. In 1997,
it acquired Portland General Electric Corporation for $2 billion .It became a
major player as an electric power and natural gas provider. In the eyes of the
financial world Enron was one on the leading and most profitable company of
US as they were the largest buyer and seller of the energy.
Enrons reputation in global financial network was extremely impressive and
was constantly improving however their internal culture was flawed as their
focus was on the results rather than on the means.

In mid of 1990s Enron incorporated the mark to market accounting for energy
business. Under mark-to-marketing rules Enron used new rules of accounting
in the business.
In 2001 recession struck the economy and most of energy companies were
facing losses and were closing their energy units however Enron was making
super normal profits in that period. Enrons stock price was $80 per share and
it was expected to reach $126 very soon. Financial Accounting Standard Board
(FASB) established a team for heuristic financial investigation of Enron. FASB
team asked Enron to disclose their basic assumptions and estimation
methodologies for derivatives. Investigation revealed that Enrons books were
reporting unrealized trading gains of $700 million.
All future contacts were terminated and on October 16, 2001 Enron announced
its first quarterly loss. In February 2001 Enron stock was trading at $80 which
was reduced to $60. All stockholders sold their stocks immediately, due to
which in December 2001, the stock price reached to $0.57.

TYPES OF DERIVATIVES BEING USED


Enron created the market for the energy derivatives to raise credit for their
business. Using the same concept of energy derivatives Enron created number
of other derivatives as well such as;

Energy based derivative: Enron made this derivative with multiple


trading partners. This was unregulated energy derivatives used to
minimize volume risk. It had two types 1) floor cap provided protection to
customer if by the end of transaction period actual cumulative degreedays were below the threshold. 2) If variable went above the established
level seller of ceiling cap will pay compensation to buyer (Ceiling Cap).

Credit rating derivative: It was based on companys credit rating. If


targeted companys rating improved/ declined then Enron will made
payment/receive accordingly.

Price Swap derivative: Enron made this derivative with Raptor


Corporation. In this contact Enron will give its own stock to Raptor if
value of Raptors assets declines. Secondly Enron will even give more
stock to Raptor if Enrons stock price declined.

Make whole derivative: Enron made this derivative with LJM2. This
derivative is same as price swap derivatives except it had some
additional features.

Futures contacts derivative: Enron future contract derivative in 1999


and they were traded at Chicago Mercantile Exchange. They were based
on temperature variation and also backed by clearing house.

WHY DERIVATIVES WERE USED?


Merger of Inter-North and Houston Natural Gas wasnt so successful; Enron
borrowed a large amount as debt to execute that merger. After that merger
Enron introduced above derivatives to cater following issues;

To manage working capital because Enron had no cash to run its day to
day operations.

To manage long term investment funds to invest in new businesses.

To pay debt.

To inflate value of its assets.

To inflate its profitability to get loan at lower cost of capital.

CAUSES OF FAILURE
As by now it is clear that Enron was using derivatives and according to Mr.
Partnoy Enron was primarily a derivative trading company.
Causes of failure are:

OVER THE COUNTER TRADING

Enron was using over the counter trading for derivatives which itself
contributed to the failure of Enron as this was a totally unregulated market and
no one questions the practices of the companies. Also the company was not
liable to submit any official reports to the SEC. Due to this unregulated nature
of the trade many customers face huge losses. This raised the issue of making
derivatives market a regulated one but the proposals from the Commodity
Futures Trading Commission were rejected and further on congress passed a
Commodity Futures Modernization Act under which it was made clear that the
derivative market will keep on working as an unregulated market. (2016)

ENRON DEALS WITH SPES

Enron was involved into partnerships with some special purpose companies
which were continuously used to hide the losses due of the core units. These
entities were off balance sheet companies which were around 3000 in numbers
and will constitute a six page single spaced document. Some of the reported
companies are JEDI, Raptor, and LJM. These companies were basically formed

by Enron executives by taking loans from banks and putting Enrons stock as a
guarantee for that. These companies were also violating the rules of financial
accounting standards board. Enron does not disclose the ownership of these
companies and used them to understate its debt liabilities to make it appealing
to the creditors.

COMPENSATION FOR THE EMPLOYEES

Compensation for the employees who establish off balance sheet entities also
encouraged the culture rewarding unethical behavior. As a result more
companies where established and to finance then with debt more and more
credit derivatives were used.

ARTHUR ANDERSON AUDITING TEAM

The auditors team over sight the problems in the financial statement. Some of
the employees where even involved in destruction of records that can go
against Enron. This also encouraged unethical practices to continue.

SEC LOOSE CONTROL

SEC was not vigilant and thus do not focus on the unregulated market and
even they do not studied in detail the reports filed with them.

HIDING LOSSES

Enron hide its huge losses on the technology stocks. A stock named Rhythms
Net Communications was bought by Enron which was highly successful in
1999. At that time Enron sold the stock to one of the special purpose entity
and reported gains in financial statements. As the stock fall badly in the
following year Enron made a Fake transaction of a derivative in order to avoid
realizing loses.

HIDING DEBT

It also hides the debt which was taken by using credit derivatives to finance
the newly opened special purpose entities.

ENRONS OFFICERS

Enrons offices knew very well that sometimes of derivatives trade is going on
in the company but they intentionally hide this fact from other stake holders so
that a bad word of mouth do not spread.("Expert: Enron derivatives traders
overstated profits", 1999)

PARTIES TO BE BALMED

Arthur Andersen LLP was the accounting firm in charge of auditing


Enrons external and internal statements and reports. Andersen kept a
staff on permanent assignment at Enron offices and some of Enrons
internal accounting staff had worked at Andersen formerly, which should
have raised concerns about their impartiality, or lack of it. The firm had
the responsibility of notifying the SEC if and when it found discrepancies
in accounting occurring at Enron, Andersen also later admitted of
destroying thousands of documents related to audits of Enron for 1997
through 2000.

Lynda Clemmons was given charge of the weather derivatives


department when she was only 27. In a span of a mere seven years
Clemmons advanced from analyst, associate, manager then director and
lastly vice president of the division. It was employees such as her, who
were given immense authority, able to make decisions worth $5 million
unsupervised, with no questions asked.

Ken Lay and Jeffrey Skilling as the Chairman and CEO of Enron had
sufficient knowledge of what was going wrong in the company, and
purposefully chose to keep this information from all the stakeholders,
while taking bonuses for themselves. While the investors and the
general public was reassured that the company was thriving. (Kirby,
2012).

Andrew Fastow, the CFO since 1998, had created several shell
companies which helped keep millions of dollars of debt off Enrons
financial statements, because debt accumulated by subsidiaries of a
company did not have to be reported in the parent companys books, if
the parent company owned less than 50% of the subsidiary. (Oh, the
Games Enron Played, 2001).

REASONS OF INTERNAL CONTROL FAILURES


Enron was the first energy company to start trading online. The practices
which brought Enron towards its downfall were usage of sophisticated
accounting procedures in order to have a favorable accounting picture of the
organization. They used Structured financing, as called by bankers and
accountants in order to hide the illegitimated financial transactions. Jeff Skilling
when took over as CEO, he introduced the method of mark-to-market
accounting in to the organization. They started projecting future revenue for
any specific project they started and started showing the projected revenue in
the books right from the day a project was started instead of waiting for initial
profits to flow in.

To hide the excessive amount of debt, they used Special Purpose Entities
(SPEs). The CFO, Andy Fastow established White wing in 1997, by borrowing
$1079 million from Citigroup and a Citigroup affiliate. Enron treated White wing
as a minority interest transaction, hence hiding all the debt as investment in
a joint venture. In 1999 Enron established another SPE named Osprey. Osprey
borrowed money from banks and institutions on fixed return payments,
however instead of treating the money as loan Enron treated it as stocks in
Osprey, hence showing a very favorable position of the company and thus high
stock price. Whenever Enron was in trouble, Osprey was used to buy some
assets from Enron, giving it a financial boost.
The performance system used ensured laying-off at least 10-15% employees
every year. In order to avoid the fate of getting laid off, employees became
aggressive in order to increase companys earnings, so all legal and illegal
means were used to project Enron as a successful organization.
Enron hid its indiscernible profits, by trading in energy derivatives. It mainly
used over the counter energy swaps and weather derivatives. Enron tried
illegal means to increase energy prices in order to earn more on the energy
derivatives. Enrons traders become ruthless and used every mean possible in
order to increase companys earning as an effect of earning based bonus
policies of the organization. The auditing firm i.e. Arthur Anderson turned a
blind eye on Enrons illegitimate accounting policies due to a vested interest in
company and a lack of incentive to show loyalty towards the investors.
The board of a company is responsible for overseeing all the business activity
an organization is getting involved into. However, the board at Enron had
much less to gain and more to lose due to the handsome packages and
incentives being provided to them, so they preferred staying silent about the
anomalies in the financial statement of Enron.

EFFECT ON STAKE HOLDERS

Enrons downfall affected a significant number of participants starting


from the executive management to the Enron employees, stockholders
and other third parties that were involved with the business dealings
with the company including auditing firms. Arthur Anderson, an
accounting firm was found guilty in shredding Enrons documents amid
an investigation hence, helping the company cover up billions of dollars

in losses. This put an end to its long history of auditing, till today it does
not offer auditing services of any kind.
Over 30,000 employees were laid off and their retirement savings were
lost as the staff has invested their pension funds in the firms stock
leaving them to struggle to make ends meet during their golden years.
Business Insider reports that the collapse had not only led to thousands
of individuals jobless but the worth of these jobs is said to be $60 billion
in market value and a total of $2 billion in pension plans. It was due to a
few bad guys that led to the downfall of Enron and that the employees
were entirely innocent. Enron workers, to discourage diversification of
holdings, were told by top executives that loyal workers should buy
and hold Enron stock. When the stock price of Enron came crashing
down. The employees were not allowed to unload any stock from these
accounts.
Investors such as the most prominent the Belfer family were affected
badly. The family has had a stake in the company since 1983. Arthur B
Belfer who was a Polish immigrant built an empire of an oil dynasty in
America. Known as one of the wealthiest families, Arthurs sons, Robert
Belfer and other family members invested heavily in Enrons stock. In
total the family owned about $2 billion worth of ordinary shares as well
as preference shares which after the companys collapse was worthless.
Mutual fund investors lost millions. Over $325 million of pension fund
was lost.
J. Clifford Baxter a former Enron Vice Chairman committed suicide.
US tax payers were also disadvantaged as Enron abused the tax code by
playing around with accounting and also was able to exploit these tax
payers and managed to get $450million to underwrite its India
investment.
Externalities such as confidence in the market and the accounting
profession are aspects which may take a while to recover.

GOVERNMENT ACTION
After the Enrons scandal, the US government developed the Sarbanes-Oxley
Act of 2002 which affected companies all over the world. The main reason of
passing the Sarbanes Oxley Act was to protect investors from any fraudulent
accounting activities.

LESSONS LEARNT
It is safe to say that even investors cannot trust the companies that they are
investing in. there is no such thing as blind trust anymore. Even though
Enrons slogan was Ask Why, however employees and investors failed to do
this when making their investment. Building up from this, investors and
employees could not turn a blind eye to the operations of the companies that

they have invested it. Investors could not merely rely on the reputations of
companies such as McKinsey or Arthur Anderson who were advisors and
auditors for Enron. After the scandal such reputable names did not provide
security that their investment was in good hands.
The Special Purpose Entity account used by Enron to reduce indebtedness and
paved way to its downfall shows us that investors should investigate such
SPEs to find out what exactly the company is using these accounts for. The
SPEs were used to reduce risk of borrowing and in general is a legitimate way
of separating the risk of a companys core operations. The mark to market
accounting has been proven to have problems as the results could easily be
manipulated. Hence, red flags should be raised if a company claims to be the
best or the most innovative firm in the industry.

COULD, OR SHOULD, THESE PROBLEMS HAVE BEEN


FORESEEN?
In hindsight it is always easy to say that the problems could have been
foreseen, but still there were some events that should have raised suspicion
among shrewd analysts and investors. These are described below:
Jeffrey Skilling abruptly resigned as CEO of Enron on August 14, 2001,
only eight months after he took on the role, claiming there were personal
reasons behind his decision. His resignation followed the departure of
several other high level executives from Enron like Clifford Baxter and
Kenneth, the Vice-Chairman and Chairman of Enrons Broadband
Services respectively. The chief executive officers of high profile
companies do not abruptly resign from their positions, these
announcements are usually preceded by a comprehensive PR program.
It was uncertain where Enron was generating its cash from, while the
company continued to report earnings and earnings growth. Enron did
not disclose where exactly the money came from; saying that the details
were confidential because of competitive reasons (McLean, 2001). Wall
Street analysts were unable to clearly define what business Enron was in,
and because they had no idea what the company did, they could not
proclaim anything about the volatility of the earnings and thus the high
stock price could not be justified.
For several years before they declared bankruptcy, management had
been extremely interested in maintaining and increasing stock price. The
entire company had become obsessed with the price of the stock, with
the stock price displayed on a giant electronic board at the entrance and
television screens in elevators that displayed financial news (Fox, 2003).

POSSIBILITY OF REPETITION OF SAME SCANDAL

No, now the occurrence of same scandal is not possible as after the Enron case
government passed the Sarbanes-Oxley Act in 2002 to protect investors from
fraudulent activities. Moreover SEC requires the companies to disclose the
complete details of their activities to bring malfunction activities on the
surface. Therefore, now for a public company it is not possible to carry out
such activities.

MECHANISMS OR PROCEDURES TO AVOID A REPETITION OF


SUCH A SCANDAL

In order to prevent another such scandals, the auditing system for the
organizations should be more regulated. Auditors should not be allowed
to involve in business with the firms they are auditing, as in the case of
Arthur Andersons. The rules permitting the conflict of interest should be
changed.
The top leadership of any organization should instill use of ethical
practices in its employees in order to ensure honest operations and
projections.
The financial statements of special purpose entities (SPEs) established
by a corporation should be consolidated with the corporations financial
statements, in order to ensure transparent accounting practices.
The over the counter Derivative markets should be supervised to some
extent in order to ensure that the investors have required information of
the transaction they are entering into.
There should be more rules and regulations in place to keep a check and
balance on all the entities involved i.e. auditors, analysts, board of
directors and employees so that such a scandal can be stopped in the
very initial stages.

CONCLUSION
After the detailed analysis and review of the Enrons Case in detail we hereby
conclude that

Unregulated trade of derivatives can easily fall into black holes.


Companies can intentionally window dress financial statements.
Culture of the organization and vision of the leader is the biggest force
determining the direction of the business.
Blindly trusting the ratings without further analysis is not the right
decision.
SEC should be vigilant enough.
Sarbanes Oxley Act 2002 is a great move to control unethical and illegal
activities.

REFRENCES

Fox, L. (2003). ENRON: The Rise and Fall. John Wiley & Sons, Inc.

Kirby, P. A. (2012). Geoengineering For Financial Gain: A History Of


Weather Derivatives. Activist Post. Retrieved May 07, 2016, from
http://www.activistpost.com/2012/08/a-history-of-weatherderivatives.html

McLean, B. (2001). Is Enron Overpriced? It's in a bunch of complex


businesses. Its financial statements are nearly impenetrable. So why is
Enron trading at such a huge multiple? Fortune Magazine. Retrieved May
05, 2016, from
http://archive.fortune.com/magazines/fortune/fortune_archive/2001/03/0
5/297833/index.htm

Oh, the Games Enron Played. (2001). Knowledge at Wharon. Retrieved


May 03, 2016, from http://knowledge.wharton.upenn.edu/article/oh-thegames-enron-played/

(2016). Retrieved 8 May 2016, from


http://www.ragm.com/enron/elib/107hearings.pdf
Expert: Enron derivatives traders overstated profits.
(1999). tribunedigital-chicagotribune. Retrieved 8 May 2016, from
http://articles.chicagotribune.com/2002-0125/business/0201250009_1_enron-officials-derivatives-frank-partnoy

HENRIQUES, DIANA. "ENRON's COLLAPSE: THE DERIVATIVES; Market That


Deals In Risks Faces A Novel One". Nytimes.com. N.p., 2016. Web. 6 May
2016.

"The Rise And Fall Of Enron". Journal of Accountancy.N.p., 2002. Web. 6


May 2016.

Partnoy, Frank. "Enron And Derivatives". SSRN Electronic Journal n.


pag.Web. 6 May 2016.

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