Enron:Enron:the scandal, the the scandal, the

legendlegend

DerivativeDerivative A derivative is an instrument whose value is A derivative is an instrument whose value is

“derived” from the underlying value of something “derived” from the underlying value of something else, such as a stock, a bond, or in the case of else, such as a stock, a bond, or in the case of Enron’s derivatives, a unit of electricity. Enron’s derivatives, a unit of electricity.

Derivatives are useful because they enable an Derivatives are useful because they enable an investor to hedge against a decline in value. investor to hedge against a decline in value.

Example: Enron could enter a contract with a Example: Enron could enter a contract with a purchaser of electricity, such as a utility, purchaser of electricity, such as a utility, guaranteeing that the purchaser would pay a guaranteeing that the purchaser would pay a certain price for a certain amount of electricity at certain price for a certain amount of electricity at a certain date in the future. a certain date in the future.

WhistleWhistle BlowerBlower The technical term for these often brave The technical term for these often brave

people is "whistle blower," as in the people is "whistle blower," as in the expression "blowing the whistle on expression "blowing the whistle on corruption (or on government lies, etc)." corruption (or on government lies, etc)."

Whistle blowers are people who reveal Whistle blowers are people who reveal generally harmful or very unfair activities, generally harmful or very unfair activities, often of which they have become aware often of which they have become aware because of their employment position because of their employment position within their employer's organization and, within their employer's organization and, or their access to otherwise unavailable or their access to otherwise unavailable communications from within the communications from within the organization.organization.

InternetInternet bandwidthbandwidth

By the late 1990s Enron controlled some By the late 1990s Enron controlled some 25 percent of all electricity and natural gas 25 percent of all electricity and natural gas contracts traded worldwide and were contracts traded worldwide and were considered the best in the business. considered the best in the business.

This success led Enron to act as a market This success led Enron to act as a market middleman for other commodities as middleman for other commodities as diverse as lumber and diverse as lumber and InternetInternet bandwidthbandwidth (the rate at which data can be delivered (the rate at which data can be delivered over the Internet).over the Internet).

401k401k PlanPlan Pension Plans- Employee 401k contributions Pension Plans- Employee 401k contributions

are automatically deducted from their are automatically deducted from their paycheck each pay period. This money is paycheck each pay period. This money is taken out before the employees’ paycheck is taken out before the employees’ paycheck is taxed. taxed.

The contributions are invested at the The contributions are invested at the employees’ direction into one or more funds employees’ direction into one or more funds provided in the plan. provided in the plan.

Employers often "match" employee Employers often "match" employee contributions, but are not required to do so. contributions, but are not required to do so.

While the investments grow in the employees While the investments grow in the employees 401k account, they do not pay any taxes on 401k account, they do not pay any taxes on it. it.

SPESPE

SPE- Acronym for Special Purpose Entities. SPE- Acronym for Special Purpose Entities. SPE’s reflect a common financing technique for companies. SPE’s reflect a common financing technique for companies.

Companies can cut their risk by moving assets into Companies can cut their risk by moving assets into separate partnerships that can be sold to outside investors. separate partnerships that can be sold to outside investors.

In Enron’s case, assets that were losing money were sold to In Enron’s case, assets that were losing money were sold to partnerships. Enron listed the sales of these assets as partnerships. Enron listed the sales of these assets as earnings. However, to be legitimate, accounting rules earnings. However, to be legitimate, accounting rules require that an SPE be legally isolated from the company require that an SPE be legally isolated from the company that created it. that created it.

In Enron’s case this was not true. The SPE’s relied upon In Enron’s case this was not true. The SPE’s relied upon Enron managers for leadership and Enron stock for capital. Enron managers for leadership and Enron stock for capital. When outside auditors told Enron to treat some of the 4,000 When outside auditors told Enron to treat some of the 4,000 SPE’s it had created as part of Enron, the company had to SPE’s it had created as part of Enron, the company had to take the $1-billion charge against earnings. take the $1-billion charge against earnings.

Key Players in the Enron Key Players in the Enron ScandalScandal

Kenneth Lay Kenneth Lay Former CEO of Enron, helped start the company. Former CEO of Enron, helped start the company. Enron extended to him $7.5 million revolving credit Enron extended to him $7.5 million revolving credit

line, which he reportedly used and repaid with Enron line, which he reportedly used and repaid with Enron stock 15 times within a period of just several monthsstock 15 times within a period of just several months

He quit as CEO in February 2001He quit as CEO in February 2001 He returned as CEO in August 2001until he resigned on He returned as CEO in August 2001until he resigned on

Jan. 23, 2002 Jan. 23, 2002 He quit the Enron board altogether on Feb. 4. He quit the Enron board altogether on Feb. 4. Sherron Watkins said Lay was "duped" by top Sherron Watkins said Lay was "duped" by top

executivesexecutives

Jeffrey SkillingJeffrey Skilling Enron's chief executive in the first half of 2001Enron's chief executive in the first half of 2001 Since joining the company in 1990, Skilling helped Since joining the company in 1990, Skilling helped

transform Enron from a natural-gas pipeline transform Enron from a natural-gas pipeline company into an energy-trading powerhouse.company into an energy-trading powerhouse.

Between January and August 2001 he sold off Between January and August 2001 he sold off about $20 million in Enron stockabout $20 million in Enron stock

Resigned after the close of markets on Aug. 14 Resigned after the close of markets on Aug. 14 20012001

Being charged with conspiracy, fraud and insider Being charged with conspiracy, fraud and insider tradingtrading

David DuncanDavid Duncan Enron's chief auditor at AndersonEnron's chief auditor at Anderson His job was to check Enron’s accountsHis job was to check Enron’s accounts He is accused of ordering the shredding of He is accused of ordering the shredding of

thousands of Enron-related documents in an thousands of Enron-related documents in an effort to hide them from Securities and Exchange effort to hide them from Securities and Exchange Commission investigatorsCommission investigators

Andrew FastowAndrew Fastow Former Chief Financial Officer of EnronFormer Chief Financial Officer of Enron The mastermind behind the deceptive accounting The mastermind behind the deceptive accounting

practicespractices Lea Fastow (his wife) also plead guilty to signing Lea Fastow (his wife) also plead guilty to signing

and filing a tax return that did not include income and filing a tax return that did not include income the Fastow’s had received from Mike Kopper the Fastow’s had received from Mike Kopper

Sherron WatkinsSherron Watkins Known as the "Enron whistle-blower" Known as the "Enron whistle-blower" Was Enron's vice president of corporate Was Enron's vice president of corporate

developmentdevelopment Wrote a letter to Kenneth Lay about “suspicions Wrote a letter to Kenneth Lay about “suspicions

of accounting improprieties" of accounting improprieties" Not really a “whistle-blower” because she never Not really a “whistle-blower” because she never

went public with her suspicionswent public with her suspicions

EnronEnron

What Went Wrong?What Went Wrong?

How did the collapse begin?How did the collapse begin?

Energy companies lobbied congress Energy companies lobbied congress in the 1980s for deregulation of the in the 1980s for deregulation of the energy businessenergy business

Energy policy was changed and Energy policy was changed and Washington lifted controls on who Washington lifted controls on who could produce energy and how it was could produce energy and how it was soldsold

Jeff Skilling took and aggressive Jeff Skilling took and aggressive approach to expand Enron by trading approach to expand Enron by trading futures in gas contractsfutures in gas contracts

Skilling’s PlanSkilling’s Plan Under Skilling’s new plan Enron bet Under Skilling’s new plan Enron bet

against future movements in the price of against future movements in the price of gas-generated energygas-generated energy

““Enron bought and sold tomorrow’s gas at Enron bought and sold tomorrow’s gas at a fixed price today”a fixed price today”

With every trade, Enron took a cut for With every trade, Enron took a cut for transaction coststransaction costs

Using the internet to promote trading, Using the internet to promote trading, Enron became the most successful player Enron became the most successful player in the futures game; 90% of Enron’s in the futures game; 90% of Enron’s income came from tradesincome came from trades

EarlyEarly 20002000

Enron took advantage of the dot.com Enron took advantage of the dot.com boom and traded internet bandwidthboom and traded internet bandwidth

The value of Enron’s online The value of Enron’s online transactions was huge ($880 billion)transactions was huge ($880 billion)

The problem was Enron wasn’t The problem was Enron wasn’t making money on many of their making money on many of their online trades because they made the online trades because they made the market very efficientmarket very efficient

Fuzzy NumbersFuzzy Numbers

Enron began tweaking the numbers Enron began tweaking the numbers in their financial statements with in their financial statements with accounting techniques to hide their accounting techniques to hide their losseslosses

Enron created partnerships, and then Enron created partnerships, and then passed the assets (losses) to these passed the assets (losses) to these partnerships which eliminated the partnerships which eliminated the losses from their balance sheetslosses from their balance sheets

Andrew Fastow Andrew Fastow (Chief Finance (Chief Finance Officer) created the Officer) created the partnershipspartnerships

Condor and Raptor Condor and Raptor were two major were two major partnershipspartnerships

Sherron Watkins, the Sherron Watkins, the Enron “Whistleblower” Enron “Whistleblower” noticed the fuzzy noticed the fuzzy accounting that had accounting that had been used in been used in relationship to the relationship to the Condor and Raptor Condor and Raptor partnerships and wrote partnerships and wrote a letter to Kenneth Lay a letter to Kenneth Lay and Arthur Anderson and Arthur Anderson warning him that the warning him that the Enron was unstable.Enron was unstable.

WhyWhy wasn’twasn’t EnronEnron caughtcaught earlier?earlier?

Throughout all of this, Throughout all of this, Enron and its key Enron and its key members were members were making political making political contributions to the contributions to the white house and white house and congress.congress.

Kenneth Lay donated Kenneth Lay donated $100,000 to President $100,000 to President Bush in 2000, and in Bush in 2000, and in 2001 Bush invited Lay 2001 Bush invited Lay to become an advisor to become an advisor to his transition team.to his transition team.

In the year 2000, In the year 2000, Kenneth Lay met Kenneth Lay met three times with three times with Dick Cheney to Dick Cheney to discuss energy discuss energy policy review.policy review.

When the review When the review was published in was published in May 2001, it was May 2001, it was very favorable to very favorable to the Enron and the the Enron and the energy sector. energy sector.

Aug 14, 2001 Jeff Skilling resigned, Aug 14, 2001 Jeff Skilling resigned, Kenneth Lay became CEO once again.Kenneth Lay became CEO once again.

Stock prices began to fall, as investors Stock prices began to fall, as investors were uncertain about the company’s were uncertain about the company’s stability. stability.

This started a chain reaction: Enron had This started a chain reaction: Enron had hedged against its own stock, so as hedged against its own stock, so as long as the stock price was declining, it long as the stock price was declining, it could not recover its losses. could not recover its losses.

December 2001, December 2001, Enron filed for Enron filed for chapter 11 chapter 11 bankruptcybankruptcy

It’s share price had It’s share price had collapsed from collapsed from about $95 to under about $95 to under $1.$1.

ChapterChapter 1111 BankruptcyBankruptcy

Companies and large firms that are facing Companies and large firms that are facing severe and unmanageable debt may seek severe and unmanageable debt may seek to file chapter 11 bankruptcy, which allows to file chapter 11 bankruptcy, which allows them to re-organize so they can either them to re-organize so they can either continue their day-to-day operations or go continue their day-to-day operations or go out of business entirely. out of business entirely.

Under chapter 11, a company is protected Under chapter 11, a company is protected from damaging lawsuits and other negative from damaging lawsuits and other negative measures, but in exchange the company is measures, but in exchange the company is usually required to have all its major usually required to have all its major business decisions approved by the business decisions approved by the bankruptcy court.bankruptcy court.

WhatWhat NowNow

““Enron is in the midst of Enron is in the midst of restructuring various businesses for restructuring various businesses for distribution as ongoing companies to distribution as ongoing companies to its creditors and liquidating its its creditors and liquidating its remaining operations.”remaining operations.”

Investor SentimentInvestor Sentiment ``Enron has been elevated to a symbol,''``Enron has been elevated to a symbol,''

says Woody Dorsey of Market Semiotics, says Woody Dorsey of Market Semiotics, an institutional forecasting service,an institutional forecasting service, ``There's a whole new level of uncertainty ``There's a whole new level of uncertainty about profits, about the integrity of the about profits, about the integrity of the accounting profession and of Wall Street.''accounting profession and of Wall Street.''

With a crisis like Enron,With a crisis like Enron, during a bear during a bear market, stocks typically take about 12 market, stocks typically take about 12 months to recover. months to recover.

From 2000 to mid-2002 prices of stocks From 2000 to mid-2002 prices of stocks for the nation’s largest companies fell by for the nation’s largest companies fell by more than 33 percent, while technology more than 33 percent, while technology stocks dropped 70 percent (more factors stocks dropped 70 percent (more factors than just Enron).than just Enron).

But, then again…But, then again…

Market EfficiencyMarket Efficiency

````The market has already responded The market has already responded to the potential of overstated profits to the potential of overstated profits in the same way it responds to an in the same way it responds to an unexpected negative event:unexpected negative event: ready, ready, fire, aim,''fire, aim,'' says Jeffrey M. Applegate, says Jeffrey M. Applegate, chief investment strategist at chief investment strategist at Lehman Brothers Inc. Lehman Brothers Inc.

This assumes a fully efficient market, This assumes a fully efficient market, one where all current information is one where all current information is already included in the prices.already included in the prices.

Rocking WashingtonRocking Washington After investors’ reaction to Enron and fear After investors’ reaction to Enron and fear

of more such scandals, Conservatives of more such scandals, Conservatives have learned a sobering lesson:have learned a sobering lesson:

““The clamor for accountability in the The clamor for accountability in the financial system means more rules financial system means more rules and regulations in a sector they have and regulations in a sector they have spent decades trying to deregulate.”spent decades trying to deregulate.”

Democrats, though, were soon out calling Democrats, though, were soon out calling for limits on the amount of company stock for limits on the amount of company stock in 401(k) plans and moves to ease in 401(k) plans and moves to ease shareholder suits against corporate shareholder suits against corporate officers, directors, and auditors. officers, directors, and auditors.

Dems vs. RepsDems vs. Reps Democrats see Enron as justification for a Democrats see Enron as justification for a

strong assertion of government power to strong assertion of government power to outlaw conflicts of interest and even outlaw conflicts of interest and even restore the ban on companies operating in restore the ban on companies operating in both the banking and securities industries. both the banking and securities industries.

The GOP would instead cater to the The GOP would instead cater to the Investor Class with more transparency:Investor Class with more transparency:

On Feb. 13, the SEC took a large step in On Feb. 13, the SEC took a large step in that direction by announcing plans to that direction by announcing plans to impose far stiffer disclosure rules on impose far stiffer disclosure rules on companies, like insisting that significant companies, like insisting that significant trading in company stock by officers and trading in company stock by officers and directors must be revealed immediately & directors must be revealed immediately & that any important changes in business that any important changes in business must be reported within days.must be reported within days.

CCorruption & Regulation$orruption & Regulation$

After Enron, 89% of investors strongly favor After Enron, 89% of investors strongly favor the criminal prosecution of corporate officials the criminal prosecution of corporate officials who are implicated in serious financial fraud.who are implicated in serious financial fraud.

New York Stock Exchange and the National New York Stock Exchange and the National Association of Securities Dealers issued a Association of Securities Dealers issued a proposal that would limit compensation that proposal that would limit compensation that analysts can receive from investment-banking analysts can receive from investment-banking activity.activity.

Other rules: restrict analysts' trading of Other rules: restrict analysts' trading of stocks they cover, ban them from reporting to stocks they cover, ban them from reporting to their firm's investment bankers, and prohibit their firm's investment bankers, and prohibit them from promising favorable ratings to them from promising favorable ratings to companies they cover.companies they cover.

Public Company Accounting Reform & Public Company Accounting Reform &

Investor Protection ActInvestor Protection Act created the Public Company Accounting created the Public Company Accounting

Oversight Board under the SEC’s supervisionOversight Board under the SEC’s supervision board given the power to set accounting board given the power to set accounting

standards and to investigate whether standards and to investigate whether companies and certified public accounting companies and certified public accounting (CPA) firms are conforming to the standards(CPA) firms are conforming to the standards

board also had the power to fine certified board also had the power to fine certified public accountants (CPAs) and their firms public accountants (CPAs) and their firms for violations, suspend CPAs and their firms, for violations, suspend CPAs and their firms, and recommend criminal investigations by and recommend criminal investigations by the Justice Departmentthe Justice Department

law also required CPA firms to separate law also required CPA firms to separate their consulting & auditing services in order their consulting & auditing services in order to avoid conflicts of interest like those in to avoid conflicts of interest like those in the Enron scandalthe Enron scandal

The Best Advice!The Best Advice!

Investors were left wondering Investors were left wondering whether they could trust whether they could trust corporations, auditors, or stock corporations, auditors, or stock analysts.analysts.

And theAnd the best outcome from the best outcome from the present wave of angst would no present wave of angst would no doubt be a return to commonsense doubt be a return to commonsense investing. Investors should place investing. Investors should place their bets on their bets on rationalityrationality, not the next , not the next skyrocketing stock.skyrocketing stock.

A Quick look:A Quick look: