(10-07) enron presentation

8/4/2019 (10-07) Enron Presentation

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2002-2007

Robert T. Sherman, Jr.

Leadership, Ethics, and

the Texas Two-Step

The Truth Behind the Fall of

Enron and Arthur Andersen


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Id rather be a huge part of the problem

than a tiny part of the solution.2

2002-2007


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On December2,2001, Enron Corporation sought

protection under Chapter11 of the U.S. Bankruptcy Code It is the second largest bankruptcy in U.S. history (after

WorldCom)

Enrons auditors, Arthur Andersen, were convicted ofobstruction of justice for destroying documents related to

the Enron account in anticipation of an SEC investigation;conviction was overturned

Ten congressional committees have investigated thecollapse of Enron

Thousands of employees were fired, two former CEOswere convicted of criminal charges and more than 30executives have been indicted; many are serving jail terms

Cliff Baxter, a former Enron Vice-Chairman, committedsuicide in despair over the companys demise; he triedvainly to call attention to Enrons misdeeds

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The Good Ol Days

Enron was formed in the mid-1980s by Ken Lay, from the formerNorthern Natural Gas Co., a large interstate pipeline

Under Lay, Enron became the largest natural gas and electricitytrader in North America

Jeff Skilling was hired by Lay in 1990; Skilling earned his

reputation at McKinsey and advised Enron and other gas pipelineson unraveling take or pay gas purchase agreements

Enron became the 7th largest company in America under Lay andSkilling, with a market capitalization of nearly $70 billion

Enron became the global market leader in trading gas, electricity,broadband and even weather-related derivatives

The companys earnings grew by double digits every year formany years

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Growth in Market Capitalization

In January 1998, Enrons market capitalization was

approximately $12 billion

The companys market capitalization approached $30

billion in August 1999 following an initial public offeringof its water subsidiary (Azurix) and launching its

broadband capacity trading and EnronOnline

Enrons market capitalization exceeded $60 billion in

September2000 after tripling net income; in April 2000EnronOnline handled $27 billion worth of transactions

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The Dark Side of the Moon

Lay and Skilling only hired perceived superstars, but eachyear all employees were force ranked and the bottom 20%were fired; top employees were paid exceptional bonuses instock and cash

Enrons feared Performance Review Committee was perceived

as a means by which the company would reward and punishemployees based solely on paper profits booked for thecompany that year

Enrons business required billions of dollars of capital to buildpipelines and power plants, purchase gas, and develop a

world-class commodities trading floor in Houston The company developed a reputation of being the toughest in

the business while offering 10-20 year commodities contractsthat competitors would/could not match

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Enrons Vision Statement

Like many companies, Enron had a visionstatement and a detailed corporate compliancepolicy

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Enron people always

do what they say they will do

A popular paperweight had that statement on oneside and the following on the reverse side:

If Enron says it will rip your face off, it will

One of the tenets in Enrons vision statement:


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The Beginning of the End

Sometime in the mid to late 1990s, Lay and Skilling recognized

that earnings from gas and electricity generation and tradingwould decline and that the booming U.S. economy of the 1990s

would end

Enrons acquisition of Portland General Electric did not meet

expectations and it was put up for sale The Dabhol project in India was repeatedly challenged by the

Indian government; construction stopped several times, and

litigation ensued

Enron settled charges that it and others manipulated pricing forpower and gas in the California energy crisis of2000/2001;

allegations include selling gas at inflated prices to power

producers and receiving electricity at inflated prices that was

then sold to California consumers

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More Bad News Skilling began to push Enrons trading activity into broadband,

which began to falter in March 2001 when a venture calledBraveheart with Blockbuster unraveled precipitously

The company began to book and project rosy earnings from

power and gas sales, using aggressive assumptions; Enron used

mark-to-market calculations of earnings in illiquid markets,

but assumptions were designed to inflate earnings in early years,using discounted present value analyses that understated risk

Board meeting minutes and company documents show the CFO

(Andy Fastow), Lay and Skilling, as well as the Board of

Directors, approved a waiver of the companys conflict of

interest policies to allow Fastow to become a partner in someSpecial Purpose Entities (SPEs) to remove large amounts of

debt from Enrons balance sheet and to generate higher earnings

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More Bad News

InJ

anuary 2001, Enron came under fire from California politiciansalleging extraordinary profits from spiking electricity prices; the

companys market capitalization began to fall from $60 billion to

approximately $30 billion in August 2001

On August 14,2001 CEOJeff Skilling quit for personal reasons and

Chairman Lay resumed the role of CEO; market capitalization fell to$20 billion in October2001

On October16,2001 Enron recorded a huge third quarter loss and

began reporting losses in shareholder equity due to losses from SPEs;

this followed an investigation by outside counsel precipitated by

allegations made by Sherron Watkins, an Enron Vice President, ofimproprieties related to certain partnerships that were intended to

hedge risks

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The Powers Report

A report, commissioned by Enrons Board, and prepared bythe Dean of the University ofTexas Law School, found thatexecutives, including Lay, Skilling and Fastow,intentionally manipulated profits, inflating them by almost$1 billion in the year before its collapse.

The report says the transactions which led to Enronsdemise were caused by: a flawed idea, self enrichmentby employees, inadequate controls, poor implementation,inattentive oversight, simple (and not so simple)accounting mistakes, and overreaching in a culture that

encouraged pushing the limits.

The U.S. Senate Joint Committee on Taxation found thatEnrons Board of Directors was so lax that it appears norequest for a bonus or other extra pay was ever turned

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Enrons World Class

Board of Directors Enrons Board was largely handpicked by Ken

Lay. It included some of the most experienced

and brightest directors ever assembled The Board included Wendy Gramm (former head

of the Commodities Futures Trading Corporation),

Charles Lamaistre (former Chancellor of the

University ofTexas System) and a former dean ofthe Stanford Business School

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Sherron Watkins Allegations

Sherron Watkins, who worked for CFO Andy Fastow, met withChairman Ken Lay to express concern about Enrons accountingtreatment and public disclosures for certain deconsolidated entities

known as Condor and White Wing and certain SPEs known as theRaptors

Enron engaged Vinson & Elkins LLP to review her allegations whichincluded apparent conflicts of interests by Mr. Fastow in ownership ofvarious Raptor entities, the accounting treatment for the Condor andRaptor entities and adequacy of public disclosures

V&E concluded that the [Raptor] concept appears to have been fullydiscussed with the Office of the Chairman and was presented to andapproved by Enrons Board of Directors at a special meeting on June28,1999

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Sherron Watkins Allegations

V&E further noted the Boards waiver of Enrons code of ethics topermit Mr. Fastow to act as a general partner of the Raptor SPE

A second investment partnership of similar structure was approved at

an October11,1999 meeting of the Finance Committee of the Boardof Directors

Board approval included certain requirements for internal review ofthese entities by the companys chief accounting and risk officers andan annual ethics review

V&E noted Arthur Andersens review of the transactions and found

that it was unnecessary for a third party auditor to review thesetransactions, saying AA is comfortable with the disclosure in thefootnotes to the financials describing the Condor/White Wing andRaptor structures and other relationships and transactions

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V&Es Conclusions

V&E concluded: The facts disclosed through ourpreliminary investigation do not . . . warrant a furtherwidespread investigation by independent counsel and

auditors. Our preliminary investigation, however, leavesus with concern that because of the bad cosmeticsinvolving [these] transactions . . . there is a serious risk ofadverse publicity and litigation.

V&E noted that it had reported its conclusions verbally to

Mr. Lay and to the Chairman of the Audit Committee ofEnrons Board of Directors and at his direction, gave averbal summary of their review and conclusions to the fullAudit Committee.

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Some SPEs the Justice Department pursued

in its investigation of Enron

Raptors

The Raptors were hedgingvehicles set up to protect Enronagainst losses on certain assets.To be considered independent foraccounting purposes and keptoff Enrons balance sheet atleast 3% of their capital had to bein the form of equity from outsideinvestors. Yet it isnt clear

whether the 3% accounting rulewas met. If it wasnt, prosecutorscould consider chargingexecutives with perpetrating afraud.

Chewco

Chewco was another Enron effortto keep debt off its balance sheet.In this case, the crucial 3%outside equity was supposedlyput into Chewco by independententities. But Enron itself backedmuch of the 3% infusion,eventually forcing the companyto reverse more than $400 million

in earnings.

Source: The Wall Street Journal, April 30,2002

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Southhampton Place

Several Enron executives were given a chance to get inon a limited partnership set up by Chief Financial Officer

Andrew Fastow. They reaped a windfall when an entityowned by the partnership sold Enron stock back to thecompany in at least two cases, a million dollars on a$5,800 investment. Enrons Treasurer, Ben Glisan,served three years of a five year sentence, forfeited $1.3million for his role in this scheme.

Source: The Wall Street Journal, April 30,2002

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Braveheart

Braveheart was an entity organized and funded byCanadian Imperial Bank of Commerce that held thecompanys stake in a joint venture with ViacomsBlockbuster unit.

Braveheart was established to create an on-demandmovie business. At its peak, the venture counted only1,000 test customers, yet Enron claimed over $116

million in profits using mark-to-market accounting. Ken Rice, the head of Enrons broadband unit, pleaded

guilty to securities fraud and faces 10 years in prison andlarge fines.

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The Skilling Tapes

The Associated Press reports that at a 1997 partyfor departing Enron President Rich Kinder, former

President Bush was shown on videotape as sayingNobody has done more than you to supportGeorge [now President] Bush

In a skit, Kinder doubted that Skilling could pulloff 600% revenue growth

Skilling jokingly replied: Were going to movefrom mark-to-market accounting to something Icall HFV, or hypothetical future value accounting

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Enron Operated Tax Free for Years

The U.S. Senate Finance Committee issued a threevolume report finding that Wall Street banks, legaland accounting firms helped Enron devise shelters thatlet the company operate tax free for years.

Sen. Grassley of Iowa said, The report reads like aconspiracy novel. Enrons tax department wasconverted into an Enron business unit, complete withannual revenue targets.

The front page of one tax shelter deal known as theSteele Project was titled Show Me The Money!

Sen. Grassley said that the people involved displayedunbridled greed and blatant disregard for the law offairness.

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Accusations in California

On May 6,2002 the Federal Energy Regulatory

Commission released memos from Enron that indicate

Enron and others may have intentionally manipulated

Californias power market using at least ten strategies

The memos refer to market-manipulation strategies knownas Death Star, Fat Boy and Ricochet; these

strategies, which may not be illegal, created artificial

conditions in the states power grid that may have resulted

in substantial profits to Enron and other power traders

One Enron memo described the net effect of the Death Star

strategy to be that Enron gets paid for moving energy to

relieve congestion without actually moving any energy or

relieving any congestion

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Executive Compensation

In 2001, Enron paid $745 million in cash andstock awards to 144 senior executives, including atleast $104 million to Ken Lay

Enron CFO Fastow received over $30 millionfrom his partnership interests serving while he hada conflict of interest

5,000 employees who were fired after thebankruptcy received a maximum of $13,500 each

($34 million total) in severance pay

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The Costliest Bankruptcy

in History

Bankruptcy costs have totaled over $500

million. More than 3,000 lawyers and otherprofessionals have worked on the case

Lawyers fees range from $300-900/hour

A reorganization plan was approved in

2004; secured creditors will receive about20 cents on the dollar, far less than creditorsin the Kmart and WorldCom bankruptcies

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Arthur Andersens Role

Until its demise, Andersen employed 85,000 people globally and

had been Enrons auditor for many years

Andersen also provided consulting services, helping set up and

opine on the validity of Enrons SPEs under accounting rules

Andersen received $58 million in fees from Enron in 2000 (less

than half of which was from auditing services) and $50-55 million

in 2001

Documents produced for congressional investigators show that

partners in Andersens Houston office debated whether to forcedisclosure of billions in off-balance sheet debt, but decided against

it, citing potential growth of fees from Enron to $100 million per

year

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Arthur Andersens Role In May 1999, Carl Bass, an Andersen partner in its standards group,

complained about Fastows plan to contribute his own money intopartnerships to meet a 3% threshold, saying Conflicts of interestsgalore. Why would any director in his or her right mind ever approvesuch a scheme?

Andersen partner David Duncan, who pleaded guilty to felony charges,replied that the whole thing was a bad idea but Andy is convinced

that this is such a win- win that everyone will buy in. The Enron Boardapproved the deal

The U.S. government asserted that, after investigation of Enron began,following its bankruptcy in December2001, Andersendestroyed/shredded thousands of documents in Houston, Portland,London and possibly other locations

Andersen was convicted of felony obstruction of justice and ceasedauditing public companies in 2002; the conviction was overturned.Appeals court found that jury instructions on intent were overly broad.

Duncans plea was withdrawn and prosecution ceased.

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The Arthur Andersen partner was on his cell phone

when he said,

Ship the Enron documents to the feds,

but his secretary heard,

Rip the Enron documents to shreds.

It turns out that it was all just a case of bad cellular.

An Explanation on the Internet

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The Bankers Roles

Enron borrowed billions from banks and raised additionalbillions in debt and equity markets worldwide

At the same time, analysts from the same banks/investmentbanks followed Enrons stock, and gave it investment graderatings on its debt, recommending both to investors

In fact, nearly all analysts did not understand Enrons complexbusiness model, and say they had no idea it was using thousandsof SPEs to keep debt off the balance sheet and pump upearnings

Ten of15 major analysts continued to recommend Enron

securities as a Buy or Strong Buy, until just days before itfiled for protection under bankruptcy law

Investigators records show that many of the same institutionsthat were touting Enrons stock/bonds were also selling, or

buying, interests in the SPEs

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The Bankers Roles

Analysts claim that so-called Chinese walls keptthem from knowing what their peers were doing andwhat Enrons true financial condition was

Two analysts who downgraded Enron securities inmid-2001 or recommended that clients sell it allegethey were fired for doing so

Citigroup,J. P. Morgan Chase, CIBC and others paidover $300 million to state and federal authorities tosettle claims that these banks assisted Enron in variousfrauds

Four Merrill Lynch bankers were charged with fraudfor sham purchases of barges designed to meetfinancial targets and maximize bonuses; convictionswere overturned by the Fifth Circuit Court of Appeals

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Mahonia

In a transaction referred to as Mahonia, Chase

Manhattan Corporation allegedly accepted

deliveries of natural gas which Enron then sold tothem in a so-called round trip trade.

A J. P. Morgan executive said in an email,

[Enron] loves these deals as they are able to hide

funded debt from their equity analysts becausethey book it as deferred rev or (better yet) bury it

in their trading liabilities.

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Whats Next for the Banks?

J. P. Morgan Chase, Citigroup and other banks have agreed tonew procedures that will require them to obtain complete andaccurate information about how their customers will accountfor transactions they advise on and how they would disclose any

deals in financial reports The settlement agreement is unusual in that it requires a bank to

perform due diligence and form an opinion about a transactionfrom the customers viewpoint

According to the SEC examiner who negotiated this settlement,

the banks who are party to the agreement may lose all theirclaims against Enron in its bankruptcy proceeding; these claimstotal nearly $5 billion

Merrill Lynch has agreed to accept responsibility for the bargedeal, agreeing to oversight by the government

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Where Did the Regulators Fail?

SPEs were legal; that is, with only 3% equity investment,which in many cases was not at risk, but was guaranteed byEnron, SPEs could be kept off balance sheet

The same firm that was auditing Enron, and certifying itsfinancials, provided consulting services that helped create the

SPEs, and did not require disclosure Banks/investment banks who promoted Enrons stock/debt

securities helped create and market SPEs; they did not disclosethem to analysts in their own firms

Despite warnings from former SEC Chairman Arthur Levitt and

others, the SEC did not challenge any of Enrons public filingsuntil after it collapsed

Mr. Levitt testified in Senate hearings that Sell-side analysts inthe U.S. today have lost all credibility . . .

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Government Investigations

Enrons activities were investigated by both the U.S.House and Senate (at least 32 bills introduced tochange laws)

Vice President Dick Cheney was sued by the GeneralAccounting Office, which sought release ofinformation on secret meetings held by Lay withCheney on energy policy. The GAO lost the casewhich Cheney won using an executive privilege

argument; now on appeal to the US Supreme Court President Bush has distanced himself from Lay and

Enron. His administration has been heavily lobbied tointervene but apparently has not

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Government Investigations

The Financial Times has reported that Enron gave over $10.2million to Washington politicians over two election cycles, andin 1997-2000 gave $1 million to Texas political actioncommittees and state candidates, while contributing $139,000 to

Texas Supreme Court candidates and spending $4.9 million onTexas lobbyists

In England, Enron gave over $1.13 million to a charity run byPrince Charles; sleaze allegations have been made against the

UK party in control

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Source: The StarTribune,Jan. 20,2003

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39Source:T

he StarT

ribune,Jan. 20,2003 39 2002-2007


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Criminal Charges Against

Companies and Individuals Arthur Andersen was acquitted of obstruction of justice; one

partner, David Duncan, pleaded guilty to a felony and hastestified against Andersen, Lay and Skilling

Fastow pleaded guilty to fraud and received a six year

sentence; his wife Lea has completed a 1 year sentence fortax fraud; the Fastows forfeited $23.8 million

Lay refused to testify in congressional hearings, citing theFifth Amendment, but publicly denied any wrongdoing;Skilling says when he left as CEO in August 2001,

everything was fine, blaming politicians for election yearpolitics in pursuing an investigation of him

Skilling says Enrons demise was due to a liquidity crisis,not illegal activities

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Ken Lay

Ken Lay was convicted of fraud, lying to Enron shareholders

and other securities law violations. He appealed his conviction

but died of a heart attack before the appeal was heard. His

conviction was overturned since he was not able to complete

his appeal. Civil suits against his estate continue.

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Jeff Skilling

Skilling received a 24 year jail sentence which he is now

serving in Minnesota. His case is on appeal. He may have to

pay up to $60 million in fines.


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Impact on Employees,

Shareholders,Others Enrons stock, which was once worth almost $70

billion, is now worthless

Employees 401(k) and pension plans are worth only afraction of original value; company matching portion of

401(k) benefits was required to be held in Enron stock The collapse of Enron had a major effect on the

Houston economy

Directors and officers liability insurance policies will

not cover the losses Anderson and others have reached settlements of civil

litigation but very little will go to injured parties afterlegal fees and costs

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Leadership and Ethical Failures

Creating a win at all costs earnings mentality

Conflicts of interest by officers investing privately in Enron

partnerships

Failure to disclose material information to investors

Undue pressure on Andersen, analysts

A culture of fear that prevented employees from approaching

top management to stop abusive practices

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Leadership and Ethical Failures

Not having a truly independent, active Board of Directors

Using high levels of political contributions to push aggressive

corporate regulatory agendas worldwide

Extremely high levels of performance-based compensation

provided potential rewards so great that officers were encouraged

to take unreasonable risks (see February 6,2002 report of

Frederick W. Cook & Co., Inc.)

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Whats Next?

Enrons plan of reorganization calls for distributions of

about 20 cents on the dollar to secured creditors; three

businesses to be spun off

Andersen is no longer functioning as a going concern Key executives lost tens of millions of dollars in

personal fortunes

Congress enacted Sarbanes Oxley legislation that

requires CEOs to certify financials and put bonuses,fees at risk if misleading

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Whats Next?

Many companies are now expensing stock options and lookingat new forms of compensation

FASB rules on SPEs changed to require higher equity

investment, truly at risk (but will still be too low)

FASB Interpretation Number 46 became effective July 1,2003

and will require many off balance sheet entities to be reported

on the balance sheet

SEC, others mandated a divestiture of advisory practices from

audit practices and whistleblower rules for lawyers

A crisis of confidence in Wall Street ensued, leading to calls forgreater Board oversight and revamping of executive

compensation

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Lessons Learned

There are other Enrons out there; it can happenagain (HealthSouth, WorldCom, Qwest,Tyco andXerox)

Enrons demise was not the result of concertedcrimes; it was brought about by a series ofsignificant personal leadership failures andcreeping mistakes; passing new laws andregulations will help, but not prevent such failures

Ethical Standards to Apply

Wall Street Journal standard: If you dont wantto read about it in the Journal, dont do it!

It is not enough to say its okay to do it if itslegal

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Some Practical Advice

Avoid building a culture that emphasizes winningat all costs; there are other legitimate goals such asproviding quality products and services, having asafe, enjoyable place to work, etc. that deserve

equal billing with profit maximization

Treat investors, employees, customers andsuppliers like family; dont use or mislead them

Create an active, independent Board of Directors;surrounding yourself with yes men wont getyou the clear, unbiased thinking you need to besuccessful

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Some Practical Advice

Emphasize personal accountability starting withyourself! As CEO or a senior officer, you will setthe most important standards. If you cheat onyour taxes or lie to customers, employees willknow it and will soon follow suit.

Err on the side of too much, not too littledisclosure. If what you want to do is right, themarkets will reward you, but only if they knowabout it. If what you want to do is wrong, and youcant bear to tell everyone about it, dont do it!

Install an effective ethics compliance program andencourage/reward people who do come forwardwith evidence of improper practices.

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Postscript

Even today, It cant happen in my company is aprevalent attitude among CEOs and business owners;many companies have ethics compliance policies butdont emphasize hiring ethical leaders over superstars

Some complain that Sarbanes Oxley is too expensive

and are lobbying for major changes in accounting rules Its too late to begin to teach ethical values in business

school or to senior executives; efforts need to begin athome, in elementary school and throughout theeducation process

If its too good to be true, it probably is remains greatadvice when investing; the days of triple digit P/Emultiples are (hopefully) gone

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