Enron

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Definition: Enron


Enron

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Dictionary Definition


Enron Corporation was an American energy, commodities, and services company based in Houston, Texas.


Full Definition of Enron


Enron or Enron Creditors Recovery Corporation was an energy company headquartered in Houston, Texas, USA. Enron was recognized as a preeminent American energy company. It had approximately 22,000 employees and was a leader in providing electricity, natural gas, and other energy services.

Initially, Enron started off as a firm responsible for transmission and distribution of electricity and gas throughout the United States. Gradually, this firm started building power plants and pipelines that aided in the development of infrastructure worldwide.

Enron developed further and owned a large network of natural gas pipelines that extended across the US. Major holdings of this company include Northern Natural Gas, Florida Gas Transmission, Transwestern Pipeline company, not only this company also shared a partnership with Northern Border Pipeline of Canada. Enron climbed further steps of success with investment in the water sector and formed Azurix Corporation.

Scandal Associated With Enron

In late 2001, news of the Enron scandal was one of the top stories. Enron with its accounting firm Arthur Anderson was involved in a financial scandal. There was a series of irregular illegal accounting process that revealed fraud of company, which started from the 1990s and finally the company was on the verge of bankruptcy. This was the largest bankruptcy second to the case of Lehman Brothers. A similar group of energy Company indented to aid Enron but was unsuccessful. As soon as the scandal was revealed, shares of this company dropped from US$90.00 to just a few pennies. Collapsing of such a big venture due to financial scandal was a threat to the financial world.

Settlement amount amounted up to $ 7.2 billion, which was a penalty for participating in a fraud. This sum was accruing interest since the year 2002 and amounts up to $688 million-plus interest in the form of attorney fees. Plan of distribution of sum was declared as each investor will get an average of $6.79 per share of common stock and an average of $168.50 per share of preferred stock.

The Enron Debacle

During the late 1990s and early 2000s, Enron was a trading powerhouse. The firm, which had started as a US natural gas pipeline company, started trading energies, then launched into new markets, including metals, paper, water, weather and bandwidth. For a time, it seemed that everything Enron touched turned to gold. The firm attracted some of the best talent, first from the energy industry, and then from Wall Street. In 2001, the Enron empire collapsed. The firm’s bankruptcy was the largest in US history, surpassed seven months later by WorldCom’s bankruptcy.

Kenneth Lay (“Kenny Boy” to friend George W. Bush) was Enron’s Chairman and CEO. He formed the company by merging Houston Natural Gas and InterNorth in 1985. The company adopted the name Enron in 1986. Both of the merged companies were primarily pipeline companies. In 1986, the new Enron owned a 37,000-mile pipeline system stretching across North America. It also had a mountain of debt.

Richard Kinder had worked under Lay at Houston Natural Gas and became President of Enron. A tough, prudent businessman who kept a tight handle on expenses, Kinder was the perfect person to oversee the cash-generating pipeline system and gradually pay down the firm’s debt.

Ken Lay was different. A hands-off manager and a business visionary, he saw an opportunity in the rapid deregulation of energy markets in the United States and around the world. He attracted subordinates who wanted to seize these opportunities. Of these, the two most influential were Rebecca Mark and Jeff Skilling.

Mark was a strikingly beautiful and charming woman. Her business wardrobe included fur coats and stiletto high heels. Aggressive and accustomed to getting her way, her nicknames came to include “Mark the Shark” and “Hell in High Heals.” Like Lay and Kinder, Mark had come to Enron from Houston Natural Gas. At Enron during the late 1980s, she worked in the electric power division, learning how to negotiate international power generation projects in a market that was just beginning to attract investors. One important deal was a gas-fired electricity generating project at Teesside in Northern England. Lay was impressed with Mark’s style and facilitated her advancement in the firm. After taking two years off to earn a Harvard MBA, Mark convinced Lay to let her form an international division that would pursue more energy projects around the world. Enron Development Corporation was formed in 1991 with Mark as CEO. In 1993, this would become Enron International.

Jeff Skilling is known as a cold-hearted businessman whom Enron employees called “Darth Vader” behind closed doors. He earned a Harvard MBA in 1979. He became a consultant for McKinsey where he advised Enron on how to manage its gas pipeline in the rapidly deregulating US natural gas market. He came up with the idea of forming a “gas bank” that, much as a financial bank does with capital, would intermediate between short-term and long-term buyers and sellers of natural gas. The gas bank would be named Enron Gas Services, and later, Enron Capital and Trade Resources (ECT). Its formation was a crucial development that established Enron as an innovator in the energy industry. To ensure adequate supplies of natural gas for his bank, Skilling suggested that Enron get in the business of providing financing to third party oil and gas producers. In August 1990, Enron Finance Corp was formed and Skilling was hired away from McKinsey to be its CEO.

In the early 1990s, Rebecca Mark and Jeff Skilling were the rising stars of Enron. A fierce rivalry developed between them. Mark was globetrotting around the world, acquiring or building power plants and related projects. Skilling was modelling ECT as an investment bank of sorts for the energy industries. Their competing visions came to be known as “asset-heavy” and “asset-light.” Mark promoted the acquisition of physical assets. Skilling promoted the use of Enron’s balance sheet for intermediating deals.

For years, Mark seemed to be successful. She and her team of dealmakers fashioned themselves as missionaries of privatization. They were closing deals, but the actual profitability of those deals would not be known for years. Employees—and especially Mark—stood to earn enormous bonuses just for closing deals. Many of those deals would later come back to haunt Enron.

By far, Mark’s biggest deal was a two-stage power project that she built in Dabhol India. The first stage burned oil. The second, larger stage burned liquefied natural gas (LNG). LNG is an expensive fuel, so the output from the plant would be four times as expensive as other electricity available in India. India had widespread poverty. Much of the electricity produced in India was stolen. The government never cracked down on theft for fear of a popular backlash. The World Bank refused to support the Dabhol project, claiming that it made no economic sense. There was widespread popular opposition to the project, so Mark had her political work cut out for her. When Indian protestors were forcefully dispersed from the building site, Enron was accused of human rights abuses. With fits and starts, the project moved forward, only to collapse in 1996, when India’s Congress Party was voted out of office.

Mark worked tirelessly to restart the project, flying back and forth between Houston and India. Lay recruited the involvement of the Clinton administration, which actively pressured the new Indian Government to restart the project. After some renegotiation, the project was relaunched. Enron’s deal with the Indian government required the state-owned electric utility to buy power from the Dabhol plant whether it was needed or not. By some estimates, the utility would have to make payments totalling USD 30 billion over the life of the project.

For Mark, the project was a stunning success, generating fame and enormous bonuses. In 1998, she made the cover of Forbes magazine. She was appointed to the Board of Overseers of Harvard Business School and the Advisory Board of Yale’s School of Management. Enron proxy statements indicate that her combines compensation for 1996 to 1998 was USD 25.7MM

While Mark was launching the Dabhol project, Skilling was back in the United States pursuing his “asset lite” strategy. Following on the heels of his success of the gas bank, he launched ECT into natural gas trading, creating an active market where none had existed. Deregulation in the United States opened the door for electricity trading, and ECT jumped in. By the mid-1990s, it had 200 power marketers working out of two trading floors in Houston. In 1995, Enron hopped the Atlantic to open a London office to trade power and natural gas. The firm would soon become a dominant force in European energy markets. Skilling started exploring new markets in which to apply the “Enron model.” These would come to include: weather, paper pulp, plastics, and metals.

Skilling also set his sights on retail electricity markets in the United States. These were deregulating more slowly than the wholesale markets, but the vision was for residences to someday choose an electricity provider in the same way they chose a phone provider. This vision never panned out, but, for a time, Enron devoted considerable resources to building brand awareness. Television ads ran in several markets displaying the Enron company logo and promoting Enron’s innovative spirit.

Skilling’s vision was to trade energies and other commodities the way Wall Street trades capital. In 1991, he convinced Enron’s Audit Committee to allow him to apply mark-to-market accounting to ECT’s trading books. For liquid trading activities, mark-to-market accounting is appropriate and far superior to accrual accounting. It is widely used in the capital markets. In Enron’s case, it wasn’t always appropriate. Many of the markets ECT was trading in were not liquid. Enron was launching those markets. ECT was entering into long-dated gas and power deals for which no liquid markets existed. In this context, mark-to-market accounting became mark-to-model accounting. Traders who were performing trades had considerable influence on how the deals were marked to model. With their bonuses depending upon the profitability of deals, there was an unaddressed conflict of interest. Skilling’s trading businesses were generating considerable profits, but much of these were dubious mark-to-model profits on long-dated deals.

Skilling was also working to outmanoeuvre Mark. He arranged things so that ECT would provide financing to other divisions of Enron, including Mark’s Enron International. If Skilling tried to block Mark’s financing, Mark could always go directly to Lay or raise financing outside Enron. Still, Skilling’s strategy enabled him to slow Enron International and give him a context to criticize Mark’s heavy spending on projects.

In 1996, Skilling won a significant victory over Mark. That year, Kinder had a falling out with Layover a situation involving Lay’s assistant, Nancy McNeil. Kinder and McNeil left Enron and were married soon after. Lay tapped Skilling to replace Kinder as President and COO. Now Skilling was in line to eventually replace Lay as CEO. Mark remained a significant force within Enron, but Skilling was consolidating his position, promoting a circle of cronies into senior positions. In Ken Lay and Jeff Skilling, Enron now had two business visionaries at its helm, but there was no one to replace Richard Kinder’s prudence.

Enron still had considerable debt, and its credit rating was barely investment grade. Lay, Skilling and Mark were all spendthrifts. Mark had already established a reputation as a big spender, jet setting around the globe, spending lavishly on Enron International corporate offices and sparing no expense to entertain clients and counterparties. With Kinder gone, Lay immediately sold off the firms fleet of modest corporate jets and purchased a more expensive fleet, including a USD 41.6MM Gulfstream V for his personal use. Worst of all was Skilling, who was not about to let creditors get in the way of his business vision. He went on a hiring spree. Between 1996 and 1997, Enron’s staffing doubled, going from 7,456 employees to 15,555.

Skilling established a harsh corporate culture that pitted employees against each other, constantly weeding out non-performers or the politically isolated and replacing them with new hires. Central to his scheme was the performance review committee (PRC), also known as “rank and yank.” Skilling had long employed PRC in ECT, but now he implemented it company-wide. Every six months, every employee’s performance was reviewed by a committee of managers. Employees were rated on a scale of 1 to 5, with 5 being the worst. It was required that 15% of the entire workforce be rated a 5 in each PRC. These employees were “redeployed.” They were moved to a separate area of the company, given a desk, phone and computer and granted several weeks to find another job within Enron. After that, they were let go.

Managers on the PRC frequently wouldn’t know the employees they were reviewing, so other employees would submit written feedback. Each employee could ask five associates to submit letters commenting on his performance, but anyone else could submit unsolicited comments as well. The process was extremely political. Employees could undermine each other by submitting negative comments. Employees would enter into deals with one another to submit good reviews. Managers would horse trade. If one wanted to eliminate more than 15% of his staff and another wanted to keep most of hers, they might collude. Managers used the PRC to reward friends, and all employees were under pressure to enlist a senior manager as a protector.

The PRC undermined risk management within Enron. Complex deals and mark-to-model valuations had to be approved by risk management. Risk managers knew that they would suffer in the PRC if they blocked deals or did not support favourable mark-to-model valuations. Risk management became little more than a rubber stamp and a stepping stone for employees moving around the company.

Andrew Fastow was a 1986 MBA from Northwestern University. He worked at Continental Bank doing asset securitization deals before joining Enron in 1990. There, he worked on Enron’s initiative to enter retail electricity markets. He befriended Skilling, and was appointed Enron’s CFO in 1996 at the age of 37.

In 1993, Enron had formed a limited partnership with the California Public Employees’ Retirement System (Calpers), an enormous and highly influential pension fund. Called the Joint Energy Development Investment Limited Partnership (JEDI), the partnership invested in natural gas projects. Participation of Calpers meant that JEDI was an independent entity from Enron. Enron earned profits from the partnership, but none of JEDI’s debt appeared on Enron’s balance sheet.

In 1997, Enron wanted to launch a new and larger limited partnership called JEDI II, but it thought that Calpers would be loath to invest while it was still invested in JEDI. Enron couldn’t simply buy out Calpers investment in JEDI, which was worth USD 383MM. This would make Enron the sole investor in JEDI. JEDI would no longer be independent, and its debt would have to appear on Enron’s balance sheet. Fastow proposed forming a new venture, called Chewco Investments, to take Calpers place as an investor in JEDI.

Enron’s culture was heavily influenced by the movie Star Wars. Employees referred to the corporate headquarters as the “Death Star.” The name JEDI was no coincidence. The new partnership’s name was a reference to the Star Wars character Chewbacca.

By replacing Calpers as an independent investor, Chewco would allow Enron to keep JEDI’s debt off its balance sheet. This would only work if Chewco were also independent of Enron. Rather than find a truly independent investor for Chewco, Fastow decided that one of his subordinates, Michael Kopper, would play the role of independent investor in Chewco. This was absurd. Kopper didn’t have the personal resources to make such an investment. Fastow’s solution was an elaborate scheme involving multiple special purpose entities and a direct investment by JEDI of USD 132MM in Chewco—JEDI was investing in Chewco so that Chewco could invest in JEDI. Except for USD 125,000 put up directly by Kopper and his domestic partner, William Dodson, all of Chewco’s funding originated either from Enron or as loans guaranteed by Enron. Enron’s board approved the Chewco deal without knowing the details of Kopper’s role or specifics of how the deal was financed. Enron treated Chewco as an independent entity for accounting purposes, but it wasn’t.

In 1998, Rebecca Mark was looking to shape a new role for herself, preferably as far removed from Skilling as possible. Enron had been toying with the idea of developing a water trading market, and she perceived this as her opportunity. In 1998, she purchased Wessex Water, one of England’s most profitable water utilities. She paid USD 2.2 billion, a 30% premium over the utilities market capitalization. Her new water venture was called Azurix. To keep its debt off Enron’s books, a number of outside investors were found to form an SPE, Marlin Water Trust, to take a 50% stake. Mark started acquiring more assets. The biggest, after Wessex Water, was a 30-year concession to provide water and sewage services to 2 million residents of Argentina’s Buenos Aires province. The concession was awarded in a bidding process in which Mark paid USD 439MM, three times the second-highest bid.

Mark was determined to take Azurix public. This would give her an independent company far removed from Jeff Skilling. In June 1999, she floated a third of the company at USD 19 per share, raising USD 695MM.

Azurix was doomed from the start. Water is a localized business that lacks the continent-spanning pipelines and transmission systems that allow natural gas, oil and power to be moved and traded between locations. Water could never be traded the same way. The regulated water business has extremely low margins. Utilities made money by cutting expenses to the bone, but Mark was oblivious to this hard reality. She ran Azurix as if money was never an issue. She overpaid for acquisitions and spent lavishly on office space, salaries and travel. At the same time, her acquisitions were turning sour. In Argentina, Azurix discovered that its new acquisition did not include the home office, staff or billing system of the existing utility. Thousands of billing records were mysteriously missing, which meant people would be receiving water, but Azurix would have no idea who they were or where to send bills. In November 1999, UK regulators ordered a 12% cut in the prices Wessex could charge customers. That same month, Azurix cut its staff by a third, incurring a one-time hit to earnings of USD 30MM. In August 2000, Mark resigned as Chairman and CEO of Azurix and left Enron for good. She sold her Enron stock, netting an estimated USD 82MM. Enron would later buy back outstanding Azurix stock at USD 7 per share. The Argentina investment would be written off. In 2002, Wessex Water would be sold to a Malaysian company for a fraction of the price Enron had paid.

One of Enron’s most visible successes was EnronOnline, an Internet-based trading platform launched in 1999. This was the brainchild of Louise Kitchen, head of gas trading in Europe. The system allowed clients to log on, check bid and ask prices and perform trades directly with Enron while online. Initially, transactions could be booked in only certain energies, but soon the offerings were expanded to include metals, plastics, paper pulp, weather, etc. Volumes grew rapidly to several thousand transactions a day. EnronOnline had the effect of squeezing bid-ask spreads, but lost revenues were made up by increased volumes. EnronOnline had an Achilles heel. Because all transactions were with Enron, every customer who traded on the system was taking credit exposure to Enron. If Enron’s credit rating were to falter, trading volumes could dry up.

By the late 1990s, Enron had established a reputation for itself as a preeminent global enterprise. Most of Rebecca Mark’s staggering losses on international power and water projects had not yet been realized. In energy markets, Enron was the 600-pound gorilla that shaped markets to its will. It was the envy of competitors. Wall Street knew there were problems, but they were also dazzled by Enron’s successes in trading new markets and launching EnronOnline. The world economy was in the midst of a technology-driven bubble. The Internet was going to change all the rules. Capital was cheap, and stock prices were soaring. Office workers who had never given much thought to investing started trading stocks on-line and tracking market gossip in Yahoo chat rooms. Wall Street firms raked in profits taking firms like pets.com or furniture.com public.

There has long been a conflict of interest for investment banks whose equity analysis must rate a firm’s stock for investors at the same time its investment bankers are wooing that firm as a client. In the overcharged market environment of the late 1990s, an implicit quid pro quo of “buy” recommendations in exchange for investment banking business became increasingly blatant. Enron played the game skillfully. The firm was constantly doing deals: buying, selling and merging firms or orchestrating SPEs. Skilling and Fastow were careful to spread the business around, so every firm on Wall Street rated Enron’s stock a “buy.”

In 1998, Enron invested USD 10MM in an Internet startup firm called Rhythms NetConnections that was about to go public. The day of the IPO, Rhythms shares soared from USD 21 to USD 69. By May 1999, Enron’s investment was worth USD 300MM. Because of a six-month lockout provision, Enron was barred from immediately realizing this gain. Enron was also sitting on a large unrealized gain on a forward contract it had purchased from Union Bank of Switzerland on its own stock. Enron could not take the gain as income because accounting rules prohibit firms from including in income gains made on their own stock.

To protect these gains and recognize them as income, Andrew Fastow proposed a new SPE called LJM after the initials of his wife and two sons. LJM would be a private equity fund with Fastow as general partner. The structure was extremely complicated, involving a USD 1MM investment by Fastow and USD 15MM from outside investors. Four SPEs were formed specifically for the deal. The net effect was to transfer the forward on Enron stock to LJM, which would use this asset to hedge a put option on Rhythms stock, which LJM would issue to Enron. From a financial standpoint, the deal had little merit. If both the price of Rhythms stock and Enron stock were to fall, LJM would be underwater (ultimately, this is what happened). The accounting was dubious for many reasons. It disguised rather than eliminated the problem of Enron booking income resulting from rises in its own stock price. Assets were transferred between Enron and LJM at below market values. With Fastow as general partner, LJM was not independent of Enron — its balance sheet should have been consolidated with Enron’s, but it was not. More importantly, allowing Fastow to be general partner of LJM posed serious conflicts of interest. In negotiating deals between the two entities, Fastow—as general partner of LJM and CFO of Enron—would sit on both sides of the table.

The deal caused significant dissension both within Enron and its accounting firm, Arthur Andersen. One internal Andersen e-mail reads: “Setting aside the accounting, idea of a venture entity managed by CFO is terrible from a business point of view … Conflicts of interest galore. Why would any director in his or her right mind ever approve such a scheme?” Still, with Skilling and Fastow aggressively behind LJM, the deal moved forward. Andersen was earning tens of millions of dollars a year from Enron and was determined to keep its client happy. It signed off on the deal so long as Enron’s board approved of Fastow being a general partner. At a June 28, 1999, board meeting, Ken Lay presented LJM. The board set aside its own ethics rules prohibiting company officers from doing deals with the firm and approved LJM.

Fastow started doing deals between LJM, Enron and Chewco. He was effectively representing all three in “negotiating” the deals, so assets could be transferred at any prices he chose. If an asset changed hands at an inflated price, it would be marked-to-market at that new price, and the selling party would recognize income. Enron realized millions of dollars in market value gains from LJM. At the same time, LJM was earning high returns for its investors, including general partner Fastow himself.

Larger and increasingly dubious SPEs followed, including LJM 2 and Raptors I, II, III, and IV. Fastow ran them; Andersen signed off on them; and, for the most part, Enron’s board approved them. Outside investors were found among Wall Street firms, who were too afraid of losing Enron’s investment banking business to refuse to invest. Investors also included several Enron employees. Some of the ventures were financed primarily with Enron stock, which means they would be in trouble should the stock price fall. Fastow busily pulled the strings, flipping deals back and forth between Enron and the various SPEs. The net effect was to allow Enron to disguise debt, park assets that were losing money, and assign inflated mark-to-market valuations to other assets. The SPEs also generated extraordinary returns for investors. Over the lives of the various SPEs, Fastow is estimated to have personally pocketed USD 45MM as an investor. This was in addition to millions of dollars Enron paid him in salary and bonuses.

In February 2001, Lay passed the title of CEO to Skilling. Skilling was now President and CEO. Lay remained Chairman. Skilling’s tenure as CEO was to be short-lived.

Enron had aggressively been amassing a fibre optic cable network in the United States. Internet usage was growing. As applications, such as video-on-demand or teleconferencing became more popular, it was predicted that demand for bandwidth would increase dramatically. In many respects, bandwidth was like natural gas or electricity. Instead of flowing through pipes or wires, it flowed through fibre optic cables. Enron’s vision was to apply its trading model for energies to create a global market for trading bandwidth.

The vision was never to be. There were technical challenges in the way. More importantly, many other firms had been building fibre-optic networks. The market was seriously overbuilt. With an overabundance of supply, Enron’s own network became almost worthless, and prospects for trading bandwidth evaporated. The technology bubble was over, and stocks were entering a bear market.

On July 13, 2001, Skilling resigned as CEO. He claimed it was for family reasons. The real reason was that Enron was heading for trouble, and he didn’t want to stick around for it. The firm’s stock was down about 40% for the year. If it kept falling, several of Fastow’s SPEs—those primarily financed with Enron stock—would be underwater. India had stopped making payments for electricity generated by the Dabhol plant. Enron had shuttered the plant in May and, despite the Bush administration pressuring India on Enron’s behalf, was facing the prospect of writing off its entire USD 900MM investment. The company had recently spent USD 326MM to buy back the shares of the failed Azurix water company. Severe shortages of electricity in California had lead to rolling blackouts and accusations that Enron had been manipulating prices. The venture in bandwidth trading had failed spectacularly, and ventures in metals and pulp trading were racking up losses. The company was in a cash crunch and was trying to sell assets to raise cash. Skilling could see the writing on the wall, but so could most of Enron’s senior management. Many had been liquidating their holdings in Enron stock for months. Skilling not only resigned as president and CEO, but he also gave up his seat on Enron’s board.

The resignation shocked Wall Street. In the days following the announcement, Enron’s stock dropped from USD 42.93 to USD 36.85. It was also a wakeup call for Enron employees, who knew something was amiss. On August 15, 2001, Lay received an anonymous memo from an employ that opened: “Has Enron become a risky place to work? For those of us who didn’t get rich over the last few years, can we afford to stay?” The memo detailed the perilous shape of Enron’s finances, focusing special attention on Fastow’s SPE and associated accounting irregularities. It concluded: ” … I am incredibly nervous that we will implode in a wave of accounting scandals.” The author of the memo was Sherron Watkins, a former Andersen employee who had joined Enron in 1993. She currently worked in accounting, reporting to Fastow. Watkins soon came forward and had a meeting with Lay to discuss her concerns. She outlined essential steps that Lay should take to turn the situation around, but she may have been too late. There was no longer an easy way out of Enron’s problems. Rather than follow Watkin’s advice, Lay had lawyers look into whether it would be advisable to fire her. They advised against it, and she was transferred to another department.

Rumours were swirling about Enron. Equity analysts, who had previously assigned the company’s stock a “buy” rating without question, started to complain that the firm’s financial disclosures were opaque. They didn’t withdraw their “buy” recommendations, but there was pressure on Enron to make more complete disclosures.

On October 16, Enron reported third-quarter earnings that included a one-time charge of USD 1.01 billion. Much of the hit was due to writing down bad investments, including Azurix and the bandwidth venture. USD 35MM of it was due to losses on transactions with LJM. LJM wasn’t named in the press release, which simply referred to “early termination during the third quarter of certain structured finance arrangements with a previously disclosed entity.” Analysts were stunned, but there was more to come. That same day, in a conference call to analysts, Lay mentioned that the firm was reducing shareholders’ equity by USD 1.2 billion arising from the repurchase of 55 million shares of Enron stock from SPEs.

In the following days, the Wall Street Journal published a series of bombshell articles. One on October 17 detailed how Fastow and other investors had pocketed millions of dollars from LJM. Enron’s stock price slid to USD 32.20. An October 18 article traced the USD 1.2 billion hit to shareholder equity to Enron’s unwinding of the Raptor SPEs. These had been financed with Enron stock, and the plummeting stock price had made them insolvent. That day, Enron’s stock dropped to USD 29.00. The next day brought an article detailing how Fastow had made millions from his LJM 2 investment. Enron stock closed at USD 26.05.

By the end of October, Enron was under investigation by the SEC, a dozen class-action lawsuits were filed on behalf of Enron shareholders, Fastow left the company, and the stock closed at USD 13.90. Worst of all, counterparties were refusing to trade with Enron. Trading was Enron’s primary source of revenue, and now it was drying up. Ken Lay was feeling out officials within the Bush administration to see if a bailout might be possible, but no help was forthcoming. At Arthur Andersen, employees were shredding documents.

On November 8, Enron filed restated financial results with the SEC. These acknowledged that Chewco, and hence JEDI, were not truly independent entities. Consolidating their financials with Enron’s for the period 1997 to 2000 resulted in a USD 586MM reduction in Enron’s earnings for the period. It increased Enron’s debt by USD 2.6 billion.

Enron was in serious risk of having its credit rating downgraded to below investment grade by Moody’s or S&P. All that was preventing a downgrade was a glimmer of hope that Enron might be able to arrange a merger with its competitor Dynergy. Merger negotiations dragged on for several weeks, as bad news continued to pile up. Enron’s financial situation was deteriorating rapidly, making a merger seem increasingly less likely. On November 28, Moody’s and S&P downgraded Enron’s debt to below investment grade. Dynergy backed out of merger negotiations, claiming Enron had misrepresented its situation. On the New York Stock Exchange, 182 million shares of Enron stock changed hands, setting a record for one-day volume in a single stock. The share price closed for the day at USD 0.61. On December 2, Enron filed for bankruptcy.

Many people suffered from Enron’s failure, but employees were hit especially hard. Thousands were laid off with just USD 4,500 in severance pay. Enron had encouraged employees to invest their pension assets in the company’s stock. Employees who had done so lost pension savings as well as their jobs.

In June 2002, Arthur Andersen was convicted for obstruction of justice related to its destruction of Enron documents. Andersen, which was once the largest accounting firm in the United States, was barred from auditing clients.

Federal prosecutors conducted a multi-year investigation of Enron, seeking indictments of a number of key personnel. Fastow agreed to plead guilty and cooperate with prosecutors in exchange for a ten-year prison sentence. Lay and Skilling maintained their innocence, claiming that Enron was a healthy firm done in by irresponsible reporters, short-sellers and panicky investors.

After a lengthy trial, both men were convicted on May 26, 2006, of multiple counts of fraud and conspiracy. Six weeks later, awaiting sentencing and possible appeals of his convictions, Kenneth Lay died suddenly of a heart attack. Jeff Skilling was sentenced to serve over 24 years in prison.


Enron FAQ's


What was the Enron Scandal?

Dur­ing the late 1990s and early 2000s, Enron was a trad­ing pow­er­house. The firm began as a US nat­ural gas pipeline com­pany, started trad­ing en­er­gies, then launched into new mar­kets, in­clud­ing met­als, paper, water, weather and In­ter­net band­width. For a time, it seemed every­thing Enron touched turned to gold. The firm at­tracted the best tal­ent, first from the en­ergy in­dus­try, and then from Wall Street. In 2001, it all fell apart.

That was a trau­matic year for Amer­ica. The “dot-com” tech­nol­ogy stock bub­ble had burst the pre­vi­ous year, and now the broader mar­ket also fell. Ter­ror­ists struck the World Trade Cen­ter and Pen­ta­gon with dev­as­tat­ing ef­fect. With that back­drop, Enron de­scended into an ac­count­ing scan­dal and filed for bank­ruptcy in early De­cem­ber.

As Amer­ica eased into both a re­ces­sion and a “global war on ter­ror”, a string of sim­i­lar ac­count­ing scan­dals con­tin­ued into 2002, en­snar­ing firms such as Adel­phia, Global Cross­ing, Qwest Com­mu­ni­ca­tions and Tyco. When World­Com suc­cumbed in July 2002, its bank­ruptcy was big­ger than even Enron’s. That same month, the Sar­banes-Ox­ley Act was signed into law with the pur­pose of pre­vent­ing sim­i­lar abuses in the fu­ture.

Ori­gins of Enron

Enron’s char­man and CEO Ken­neth Lay (“Kenny Boy” to friend George W. Bush) formed the com­pany by merg­ing Hous­ton Nat­ural Gas and In­ter­North in 1985. The com­pany adopted the name Enron in 1986. Both of the merged com­pa­nies were pri­mar­ily pipeline com­pa­nies. In 1986, the new Enron owned a 37,000-mile pipeline sys­tem stretch­ing across North Amer­ica. It also had a moun­tain of debt.

Richard Kinder had worked under Lay at Hous­ton Nat­ural Gas and be­came Pres­i­dent of Enron. A tough, pru­dent busi­ness­man who kept a tight han­dle on ex­penses, Kinder was the per­fect per­son to over­see the cash-gen­er­at­ing pipeline sys­tem and grad­u­ally pay down the firm’s debt.

Ken Lay was dif­fer­ent. A hands-off man­ager and a busi­ness vi­sion­ary, he saw op­por­tu­nity in the rapid dereg­u­la­tion of en­ergy mar­kets in the United States and around the world. He at­tracted sub­or­di­nates who wanted to seize these op­por­tu­ni­ties. Of these, the two most in­flu­en­tial were Re­becca Mark and Jeff Skilling.

The Mark-Skilling Ri­valry

Re­becca Mark was strik­ingly beau­ti­ful and charm­ing. Her busi­ness wardrobe in­cluded fur coats and stiletto heals. Ag­gres­sive and ac­cus­tomed to get­ting her way, her nick­names in­cluded “Mark the Shark” and “Hell in High Heals.” Like Lay and Kinder, Mark had come to Enron from Hous­ton Nat­ural Gas. At Enron dur­ing the late 1980s, she worked in the elec­tric power di­vi­sion, learn­ing how to ne­go­ti­ate in­ter­na­tional power gen­er­a­tion pro­jects in a mar­ket that was just be­gin­ning to at­tract in­vestors. One im­por­tant deal was a gas-fired elec­tric­ity gen­er­at­ing pro­ject at Teesside in North­ern Eng­land. Lay was im­pressed with Mark’s style and fa­cil­i­tated her ad­vance­ment in the firm. After tak­ing two years off to earn a Har­vard MBA, Mark con­vinced Lay to let her form an in­ter­na­tional di­vi­sion that would pur­sue more en­ergy pro­jects around the world. Enron De­vel­op­ment Cor­po­ra­tion was formed in 1991 with Mark as CEO. In 1993, this would be­come Enron In­ter­na­tional.

Jeff Skilling was per­ceived as cold-hearted. Em­ploy­ees called him “Darth Vader” be­hind closed doors. He earned a Har­vard MBA in 1979 and be­came a con­sul­tant for McK­in­sey, where he ad­vised Enron on how to man­age its gas pipeline in the dereg­u­lat­ing US nat­ural gas mar­ket. He came up with the idea of form­ing a “gas bank” that, much as a fi­nan­cial bank does with cap­i­tal, would in­ter­me­di­ate be­tween short-term and long-term buy­ers and sell­ers of nat­ural gas. The gas bank would be named Enron Gas Ser­vices and, later, Enron Cap­i­tal and Trade Re­sources (ECT). Its for­ma­tion was a cru­cial de­vel­op­ment that es­tab­lished Enron as an in­no­va­tor in the en­ergy in­dus­try. To en­sure ad­e­quate sup­plies of nat­ural gas for his bank, Skilling sug­gested that Enron gets in the busi­ness of pro­vid­ing fi­nanc­ing to third party oil and gas pro­duc­ers. In Au­gust 1990, Enron Fi­nance Corp was formed and Skilling was hired away from McK­in­sey to be its CEO.

In the early 1990s, Re­becca Mark and Jeff Skilling were the ris­ing stars. A bit­ter ri­valry de­vel­oped be­tween them. Mark was glo­be­trot­ting—ac­quir­ing or build­ing power plants and re­lated pro­jects. Skilling was mod­el­ing ECT as an in­vest­ment bank of sorts for the en­ergy in­dus­tries. Their com­pet­ing vi­sions came to be known as “as­set-heavy” and “as­set-light.” Mark pro­moted the ac­qui­si­tion of phys­i­cal as­sets. Skilling pro­moted the use of Enron’s bal­ance sheet for in­ter­me­di­at­ing trans­ac­tions.

As­set-Heavy Enron

For years, Mark seemed to be suc­cess­ful. She and her team of deal mak­ers fash­ioned them­selves as mis­sion­ar­ies of pri­va­ti­za­tion. They were clos­ing deals, but the ac­tual prof­itabil­ity of those deals would not be known for years. Em­ploy­ees—and es­pe­cially Mark—stood to earn enor­mous bonuses just for clos­ing deals. Many of those deals would later come back to haunt Enron.

By far, Mark’s biggest deal was a two-stage power pro­ject that she built in Dab­hol India. The first stage burned oil. The larger sec­ond stage burned liq­ue­fied nat­ural gas (LNG). LNG is an ex­pen­sive fuel, so out­put from the plant would be four times as ex­pen­sive as other elec­tric­ity avail­able in India. India had wide­spread poverty. Much of the elec­tric­ity pro­duced in India was stolen. The gov­ern­ment never cracked down on theft for fear of a pop­u­lar back­lash. The World Bank re­fused to sup­port the Dab­hol pro­ject, claim­ing that it made no eco­nomic sense. There was wide­spread pop­u­lar op­po­si­tion to the pro­ject. When In­dian pro­tes­tors were force­fully dis­persed from the build­ing site, Enron was ac­cused of human rights abuses. With fits and starts, the pro­ject moved for­ward, only to col­lapse in 1996, when India’s Con­gress Party was voted out of of­fice.

Mark worked tire­lessly to restart the pro­ject, fly­ing back and forth be­tween Hous­ton and India. Lay re­cruited the in­volve­ment of the Clin­ton ad­min­is­tra­tion, which ac­tively pres­sured the new In­dian Gov­ern­ment to restart the pro­ject. After some rene­go­ti­a­tion, the pro­ject was re­launched. Enron’s deal with the In­dian gov­ern­ment re­quired the state-owned elec­tric util­ity to buy power from the Dab­hol plant whether it was needed or not. By some es­ti­mates, the util­ity would have to make pay­ments to­tal­ing USD 30 bil­lion over the life of the pro­ject.

For Mark, the pro­ject was a stun­ning suc­cess, gen­er­at­ing fame and enor­mous bonuses. In 1998, she made the cover of Forbes mag­a­zine. She was ap­pointed to the Board of Over­seers of Har­vard Busi­ness School and the Ad­vi­sory Board of Yale’s School of Man­age­ment. Enron proxy state­ments in­di­cate that her com­bines com­pen­sa­tion for 1996 to 1998 was USD 25.7MM

As­set-Light Enron

While Mark was launch­ing the Dab­hol pro­ject, Skilling was back in the United States pur­su­ing his “as­set-light” strat­egy. Fol­low­ing on the heals of his suc­cess with the gas bank, he launched ECT into nat­ural gas trad­ing, cre­at­ing an ac­tive mar­ket where none had ex­isted. Dereg­u­la­tion in the United States opened the door for elec­tric­ity trad­ing, and ECT jumped in. By the mid-1990s, it had 200 power mar­keters work­ing out of two trad­ing floors in Hous­ton. In 1995, Enron hopped the At­lantic to open a Lon­don of­fice to trade power and nat­ural gas. The firm would soon be­come a dom­i­nant force in Eu­ro­pean en­ergy mar­kets. Skilling started ex­plor­ing new mar­kets in which to apply the “Enron model.” These would come to in­clude: weather, paper pulp, plas­tics, and met­als.

Skilling also set his sights on re­tail elec­tric­ity mar­kets in the United States. These were dereg­u­lat­ing more slowly than the whole­sale mar­kets, but the vi­sion was for res­i­dences to some day choose an elec­tric­ity provider in the same way they chose a phone provider. This vi­sion never panned out, but for a time, Enron de­voted con­sid­er­able re­sources to build­ing brand aware­ness. Tele­vi­sion ads ran in sev­eral mar­kets dis­play­ing the Enron com­pany logo and pro­mot­ing Enron’s in­no­v­a­tive spirit.

Enron's company logo. It prompted employees to refer to the firm as the "Crooked E."

Enron’s com­pany logo. It prompted em­ploy­ees to refer to the firm as the “Crooked E.”

Skilling’s vi­sion was to trade en­er­gies and other com­modi­ties the way Wall Street trades se­cu­ri­ties. In 1991, he con­vinced Enron’s Audit Com­mit­tee to allow him to apply mark-to-mar­ket ac­count­ing to ECT’s trad­ing books. For liq­uid trad­ing ac­tiv­i­ties, mark-to-mar­ket ac­count­ing is ap­pro­pri­ate. It is widely used in the cap­i­tal mar­kets. In Enron’s case, it wasn’t al­ways ap­pro­pri­ate. Many of the mar­kets ECT was trad­ing in were not liq­uid. Enron was launch­ing those mar­kets. ECT was en­ter­ing into long-dated gas and power deals for which no liq­uid mar­kets ex­isted. In this con­text, mark-to-mar­ket ac­count­ing be­came mark-to-model ac­count­ing. Traders who were per­form­ing trades had con­sid­er­able in­flu­ence in how the deals were marked to model. With their bonuses de­pend­ing upon the prof­itabil­ity of deals, there was an un­ad­dressed con­flict of in­ter­est. Skilling’s trad­ing busi­nesses were gen­er­at­ing con­sid­er­able prof­its, but much of these were ques­tion­able mark-to-model prof­its on long-dated deals.

Skilling was also work­ing to out­ma­neu­ver Mark. He arranged things so that ECT would pro­vide fi­nanc­ing to other di­vi­sions of Enron, in­clud­ing Mark’s Enron In­ter­na­tional. If Skilling tried to block Mark’s fi­nanc­ing, Mark could al­ways go di­rectly to Lay or raise fi­nanc­ing out­side Enron. Still, Skilling’s strat­egy en­abled him to slow Enron In­ter­na­tional and give him a con­text to crit­i­cize Mark’s heavy spend­ing on pro­jects.

Kinder De­parts Enron

In 1996, Skilling won a sig­nif­i­cant vic­tory over Mark. That year, Richard Kinder had a falling out with Lay over a sit­u­a­tion in­volv­ing Lay’s as­sis­tant, Nancy Mc­Neil. Kinder and Mc­Neil left Enron and were mar­ried soon after. Lay tapped Skilling to re­place Kinder as Pres­i­dent and COO. Now Skilling was in line to even­tu­ally re­place Lay as CEO. Mark re­mained a sig­nif­i­cant force within Enron, but Skilling was con­sol­i­dat­ing his po­si­tion, pro­mot­ing a cir­cle of cronies into se­nior po­si­tions. In Ken Lay and Jeff Skilling, Enron now had two busi­ness vi­sion­ar­ies at its helm, but there was no one to re­place Richard Kinder’s pru­dence.

Enron still had con­sid­er­able debt, and its credit rat­ing was barely in­vest­ment grade. Lay, Skilling and Mark were all spend­thrifts. Mark had a rep­u­ta­tion for spend­ing lav­ishly on travel, of­fice space and client en­ter­tain­ment. With Kinder gone, Lay im­me­di­ately sold the firms fleet of mod­est cor­po­rate jets and pur­chased a more ex­pen­sive fleet, in­clud­ing a USD 41.6MM Gulf­stream V for his per­sonal use. Skilling went on a hir­ing spree. Be­tween 1996 and 1997, Enron’s staffing dou­bled from 7,456 em­ploy­ees to 15,555.

Rank and Yank

Skilling es­tab­lished a harsh cor­po­rate cul­ture that pit­ted em­ploy­ees against each other, con­stantly weed­ing out non-per­form­ers or the po­lit­i­cally iso­lated. Cen­tral to his scheme was the per­for­mance re­view com­mit­tee (PRC), also known as “rank and yank.” Skilling had long em­ployed PRC in ECT, but now he im­ple­mented it com­pany-wide. Every six months, every em­ployee’s per­for­mance was re­viewed by a com­mit­tee of man­agers. Em­ploy­ees were rated on a scale of 1 to 5, with 5 being the worst. It was re­quired that 15% of the en­tire work­force be rated a 5 in each PRC. These em­ploy­ees were “re­de­ployed.” They were moved to a sep­a­rate area of the com­pany, given a desk, phone and com­puter and granted sev­eral weeks to find an­other job within Enron. After that, they were let go.

Man­agers on the PRC fre­quently wouldn’t know the em­ploy­ees they were re­view­ing, so other em­ploy­ees would sub­mit writ­ten feed­back. Each em­ployee could ask five as­so­ci­ates to sub­mit let­ters com­ment­ing on his per­for­mance, but any­one else could sub­mit un­so­licited com­ments as well. The process was ex­tremely po­lit­i­cal. Em­ploy­ees un­der­mined each other by sub­mit­ting neg­a­tive com­ments. Some en­tered into deals with one an­other to swap good re­views. Man­agers would horse trade. If one wanted to elim­i­nate more than 15% of his staff and an­other wanted to keep most of hers, they might col­lude. Man­agers used the PRC to re­ward friends, and all em­ploy­ees were under pres­sure to en­list a se­nior man­ager as a pro­tec­tor.

The PRC un­der­mined risk man­age­ment within Enron. Com­plex deals and mark-to-model val­u­a­tions had to be ap­proved by risk man­age­ment. Risk man­agers knew that they would suf­fer in the PRC if they blocked deals or did not sup­port fa­vor­able mark-to-model val­u­a­tions. Risk man­age­ment be­came lit­tle more than a rub­ber stamp and a step­ping stone for em­ploy­ees mov­ing around the com­pany.

An­drew Fas­tow

An­drew Fas­tow was a 1986 MBA from North­west­ern Uni­ver­sity. He worked at Con­ti­nen­tal Bank doing asset se­cu­ri­ti­za­tion deals be­fore join­ing Enron in 1990. There, he worked on Enron’s ini­tia­tive to enter re­tail elec­tric­ity mar­kets. He be­friended Skilling and was ap­pointed Enron’s CFO in 1996 at the age of 37.

In 1993, Enron had formed a lim­ited part­ner­ship with the Cal­i­for­nia Pub­lic Em­ploy­ees’ Re­tire­ment Sys­tem (Calpers), an enor­mous and highly in­flu­en­tial pen­sion fund. Called the Joint En­ergy De­vel­op­ment In­vest­ment Lim­ited Part­ner­ship (JEDI), the part­ner­ship in­vested in nat­ural gas pro­jects. Par­tic­i­pa­tion of Calpers meant that JEDI was an in­de­pen­dent en­tity from Enron. Enron earned prof­its from the part­ner­ship, but none of JEDI’s debt ap­peared on Enron’s bal­ance sheet.

In 1997, Enron wanted to launch a new and larger lim­ited part­ner­ship called JEDI II, but it thought Calpers would be loath to in­vest while it was still in­vested in JEDI. Enron couldn’t sim­ply buy out Calpers in­vest­ment in JEDI, which was worth USD 383MM. This would make Enron the sole in­vestor in JEDI. JEDI would no longer be in­de­pen­dent, and its debt would have to ap­pear on Enron’s bal­ance sheet. Fas­tow pro­posed form­ing a new ven­ture, called Chewco In­vest­ments, to take Calpers place as an in­vestor in JEDI.

By re­plac­ing Calpers as an in­de­pen­dent in­vestor, Chewco would allow Enron to keep JEDI’s debt off its bal­ance sheet. This would only work if Chewco were also in­de­pen­dent from Enron. Rather than find a truly in­de­pen­dent in­vestor for Chewco, Fas­tow de­cided that one of his sub­or­di­nates, Michael Kop­per, would play the role of in­de­pen­dent in­vestor in Chewco. This was ab­surd. Kop­per didn’t have the per­sonal re­sources to make such an in­vest­ment. Fas­tow’s so­lu­tion was an elab­o­rate scheme in­volv­ing mul­ti­ple spe­cial pur­pose en­ti­ties (SPEs) and a di­rect in­vest­ment by JEDI of USD 132MM in Chewco—JEDI was in­vest­ing in Chewco so that Chewco could in­vest in JEDI. Ex­cept for USD 125,000 put up di­rectly by Kop­per and his do­mes­tic part­ner, William Dod­son, all of Chewco’s fund­ing orig­i­nated ei­ther from Enron or as loans guar­an­teed by Enron. Enron’s board ap­proved the Chewco deal with­out know­ing the de­tails of Kop­per’s role or specifics of how the deal was fi­nanced. Enron treated Chewco as an in­de­pen­dent en­tity for ac­count­ing pur­poses, but it wasn’t.

Water Trad­ing

In 1998, Re­becca Mark was look­ing to shape a new role for her­self, prefer­ably as far re­moved from Skilling as pos­si­ble. Enron had been toy­ing with the idea of de­vel­op­ing a water trad­ing mar­ket, and she per­ceived this as her op­por­tu­nity. In 1998, she pur­chased Wes­sex Water, one of Eng­land’s most prof­itable water util­i­ties. She paid USD 2.2 bil­lion, a 30% pre­mium over the util­i­ties mar­ket cap­i­tal­iza­tion. Her new water ven­ture was called Azurix. To keep its debt off Enron’s books, a num­ber of out­side in­vestors were found to form an SPE, Mar­lin Water Trust, to take a 50% stake. Mark started ac­quir­ing more as­sets. The biggest, after Wes­sex Water, was a 30-year con­ces­sion to pro­vide water and sewage ser­vices to 2 mil­lion res­i­dents of Ar­gentina’s Buenos Aires province. The con­ces­sion was awarded in a bid­ding process in which Mark paid USD 439MM, three times the sec­ond high­est bid.

Mark was de­ter­mined to take Azurix pub­lic. This would give her an in­de­pen­dent com­pany far re­moved from Jeff Skilling. In June 1999, she floated a third of the com­pany at USD 19 per share, rais­ing USD 695MM.

Azurix was doomed from the start. Water is a lo­cal­ized busi­ness that lacks the con­ti­nent-span­ning pipelines and trans­mis­sion sys­tems that allow nat­ural gas, oil and power to be moved and traded be­tween lo­ca­tions. Water could never be traded the same way. The reg­u­lated water busi­ness had ex­tremely low mar­gins. Water util­i­ties made money by cut­ting ex­penses to the bone, but Mark was obliv­i­ous to this hard re­al­ity. She ran Azurix as if money was never an issue. She over­paid for ac­qui­si­tions and spent lav­ishly on of­fice space, salaries and travel. At the same time, her ac­qui­si­tions were turn­ing sour. In Ar­gentina, Azurix dis­cov­ered that its new ac­qui­si­tion did not in­clude the home of­fice, staff or billing sys­tem of the ex­ist­ing util­ity. Thou­sands of billing records were mys­te­ri­ously miss­ing, which meant peo­ple would be re­ceiv­ing water, but Azurix would have no idea who they were or where to send bills. In No­vem­ber 1999, UK reg­u­la­tors or­dered a 12% cut in the prices Wes­sex could charge cus­tomers. That same month, Azurix cut its staff by a third, in­cur­ring a one-time hit to earn­ings of USD 30MM. In Au­gust 2000, Mark re­signed as Chair­man and CEO of Azurix and left Enron for good. She sold her Enron stock, net­ting an es­ti­mated USD 82MM. Enron would later buy back out­stand­ing Azurix stock at USD 7 per share. The Ar­gentina in­vest­ment would be writ­ten off. In 2002, Wes­sex Water would be sold to a Malaysian com­pany for a frac­tion of the price Enron had paid.

Enron On­line

One of Enron’s most vis­i­ble suc­cesses was En­ronOn­line, an In­ter­net-based trad­ing plat­form launched in 1999. This was the brain­child of Louise Kitchen, head of gas trad­ing in Eu­rope. The sys­tem al­lowed clients to logon, check bid and ask prices, and per­form trades di­rectly with Enron. Ini­tially, trans­ac­tions could be booked in only cer­tain en­er­gies, but soon the of­fer­ings were ex­panded to in­clude met­als, plas­tics, paper pulp, weather, etc. Vol­umes grew rapidly to sev­eral thou­sand trans­ac­tions a day. En­ronOn­line had the ef­fect of squeez­ing bid-ask spreads, but lost rev­enues were made up by in­creased vol­umes. En­ronOn­line had an Achilles heel. Be­cause all trans­ac­tions were with Enron, every cus­tomer who traded on the sys­tem was tak­ing credit ex­po­sure to Enron. If Enron’s credit rat­ing were to fal­ter, trad­ing vol­umes could dry up.

Cul­ti­vat­ing Wall Street

By the late 1990s, Enron had es­tab­lished a rep­u­ta­tion for it­self as a pre­em­i­nent global en­ter­prise. Most of Re­becca Mark’s stag­ger­ing losses on in­ter­na­tional power and water pro­jects had not yet been re­al­ized. In en­ergy mar­kets, Enron was the 600-pound go­rilla that shaped mar­kets to its will. It was the envy of com­peti­tors. Wall Street knew there were prob­lems, but they were also daz­zled by Enron’s suc­cesses in trad­ing new mar­kets and launch­ing En­ronOn­line. The world econ­omy was in the midst of a tech­nol­ogy-dri­ven bub­ble. The In­ter­net was going to “change all the rules.” Cap­i­tal was cheap, and stock prices were soar­ing. Of­fice work­ers who had never given much thought to in­vest­ing started trad­ing stocks on-line and track­ing mar­ket gos­sip in Yahoo chat rooms. Wall Street firms raked in prof­its tak­ing firms like pets.​com or furniture.​com pub­lic.

There has long been a con­flict of in­ter­est for in­vest­ment banks whose eq­uity analy­sis must rate a firm’s stock for in­vestors at the same time its in­vest­ment bankers are woo­ing that firm as a client. In the over­charged mar­ket en­vi­ron­ment of the late 1990s, an im­plicit quid pro quo of “buy” rec­om­men­da­tions in ex­change for in­vest­ment bank­ing busi­ness be­came in­creas­ingly bla­tant. Enron played the game skill­fully. The firm was con­stantly doing deals: buy­ing, sell­ing and merg­ing firms or or­ches­trat­ing SPEs. Skilling and Fas­tow were care­ful to spread the busi­ness around, so every firm on Wall Street rated Enron’s stock a “buy.”

Spe­cial Pur­pose En­ti­ties

In 1998, Enron in­vested USD 10MM in an In­ter­net startup firm called Rhythms Net­Con­nec­tions that was about to go pub­lic. On the day of the IPO, Rhythms shares soared from USD 21 to USD 69. By May 1999, Enron’s in­vest­ment was worth USD 300MM. Be­cause of a six-month lock­out pro­vi­sion, Enron was barred from im­me­di­ately re­al­iz­ing this gain. Enron was also sit­ting on a large un­re­al­ized gain on a for­ward con­tract it had pur­chased from Union Bank of Switzer­land on its own stock. Enron could not take the gain as in­come be­cause ac­count­ing rules pro­hibit firms from in­clud­ing in in­come gains made on their own stock.

To pro­tect these gains and rec­og­nize them as in­come, An­drew Fas­tow pro­posed a new spe­cial pur­pose en­tity (SPE) called LJM after the ini­tials of his wife and two sons. LJM would be a pri­vate eq­uity fund with Fas­tow as gen­eral part­ner. The struc­ture was ex­tremely com­pli­cated, in­volv­ing a USD 1MM in­vest­ment by Fas­tow and USD 15MM from out­side in­vestors. Four SPEs were formed specif­i­cally for the deal. The net ef­fect was to trans­fer the for­ward on Enron stock to LJM, which would use this asset to hedge a put op­tion on Rhythms stock, which LJM would issue to Enron. From a fi­nan­cial stand­point, the deal had lit­tle merit. If both the price of Rhythms stock and Enron stock were to fall, LJM would be underwater (ul­ti­mately, this is what hap­pened). The ac­count­ing was du­bi­ous for many rea­sons. It dis­guised rather than elim­i­nated the prob­lem of Enron book­ing in­come re­sult­ing from rises in its own stock price. As­sets were trans­ferred be­tween Enron and LJM at below mar­ket val­ues. With Fas­tow as gen­eral part­ner, LJM was not in­de­pen­dent from Enron—its bal­ance sheet should have been con­sol­i­dated with Enron’s, but it was not. More im­por­tantly, al­low­ing Fas­tow to be gen­eral part­ner of LJM posed se­ri­ous con­flicts of in­ter­est. In ne­go­ti­at­ing deals be­tween the two en­ti­ties, Fas­tow—as gen­eral part­ner of LJM and CFO of Enron—sat on both sides of the table.

The deal caused sig­nif­i­cant dis­sention both within Enron and its ac­count­ing firm, Arthur An­der­sen. One in­ter­nal An­der­sen e-mail reads

Set­ting aside the ac­count­ing, idea of a ven­ture en­tity man­aged by CFO is ter­ri­ble from a busi­ness point of view … Con­flicts of in­ter­est ga­lore. Why would any di­rec­tor in his or her right mind ever ap­prove such a scheme?

Still, with Skilling and Fas­tow ag­gres­sively be­hind LJM, the deal moved for­ward. Arthur An­der­sen was earn­ing tens of mil­lions of dol­lars a year from Enron and was de­ter­mined to keep its client happy. It signed off on the deal so long as Enron’s board ap­proved of Fas­tow being gen­eral part­ner. At a June 28, 1999, board meet­ing, Ken Lay pre­sented LJM. The board set aside its own ethics rules pro­hibit­ing com­pany of­fi­cers from doing deals with the firm and ap­proved LJM.

Fas­tow started doing deals be­tween LJM, Enron and Chewco. He was ef­fec­tively rep­re­sent­ing all three in “ne­go­ti­at­ing” the deals, so as­sets could be trans­ferred at any prices he chose. If an asset changed hands at an in­flated price, it would be marked-to-mar­ket at that new price, and the sell­ing party would rec­og­nize in­come. Enron re­al­ized mil­lions of dol­lars in mar­ket value gains from LJM. At the same time, LJM was earn­ing high re­turns for its in­vestors, in­clud­ing gen­eral part­ner Fas­tow him­self.

Larger and in­creas­ingly du­bi­ous SPEs fol­lowed, in­clud­ing LJM 2 and Rap­tors I, II, III, and IV. Fas­tow ran them; Arthur An­der­sen signed off on them; and, for the most part, Enron’s board ap­proved them. Out­side in­vestors were found among Wall Street firms, who were too afraid of los­ing Enron’s in­vest­ment bank­ing busi­ness to refuse to in­vest. In­vestors also in­cluded sev­eral Enron em­ploy­ees. Some of the ven­tures were fi­nanced pri­mar­ily with Enron stock, which means they would be in trou­ble should the stock price fall. Fas­tow busily pulled the strings, flip­ping deals back and forth be­tween Enron and the var­i­ous SPEs. The net ef­fect was to allow Enron to dis­guise debt, park as­sets that were los­ing money, and as­sign in­flated mark-to-mar­ket val­u­a­tions to other as­sets. The SPEs also gen­er­ated ex­tra­or­di­nary re­turns for in­vestors. Over the lives of the var­i­ous SPEs, Fas­tow is es­ti­mated to have per­son­ally pock­eted USD 45MM as an in­vestor. This was in ad­di­tion to mil­lions of dol­lars Enron paid him in salary and bonuses.

Band­width Trad­ing

Enron had ag­gres­sively been amass­ing a fibre optic cable net­work in the United States. In­ter­net usage was grow­ing. As ap­pli­ca­tions, such as video-on-de­mand or tele­con­fer­enc­ing be­came more pop­u­lar, it was pre­dicted that de­mand for band­width would in­crease dra­mat­i­cally. In many re­spects, band­width was like nat­ural gas or elec­tric­ity. In­stead of flow­ing through pipes or wires, it flowed through fibre optic ca­bles. Enron’s vi­sion was to apply its trad­ing model for en­er­gies to cre­ate a global mar­ket for trad­ing band­width.

The vi­sion was never to be. There were tech­ni­cal chal­lenges in the way. More im­por­tantly, many other firms had been build­ing fibre optic net­works. The mar­ket was over­built. With an over­abun­dance of sup­ply, Enron’s own net­work be­came al­most worth­less, and prospects for trad­ing band­width evap­o­rated. The tech­nol­ogy bub­ble was over, and stocks were en­ter­ing a bear mar­ket.

Skilling Up and Out

In Feb­ru­ary 2001, Lay passed the title of CEO to Skilling. Skilling was now pres­i­dent and CEO. Lay re­mained Chair­man. Skilling’s tenure as CEO was to be short-lived. Six months later, on July 31, he abruptly re­signed as pres­i­dent and CEO. He also gave up his board seat.

Skilling claimed his de­par­ture was for fam­ily rea­sons. A more likely ex­pla­na­tion is that Enron was head­ing for trou­ble, and he didn’t want to stick around for it. The firm’s stock was down about 40% for the year. If it kept falling, sev­eral of Fas­tow’s SPEs—those pri­mar­ily fi­nanced with Enron stock—would be underwater. India had stopped mak­ing pay­ments for elec­tric­ity gen­er­ated by the Dab­hol plant. Enron had shut­tered the plant in May and, de­spite the Bush ad­min­is­tra­tion pres­sur­ing India on Enron’s be­half was fac­ing the prospect of writ­ing off its en­tire USD 900MM in­vest­ment. The com­pany had re­cently spent USD 326MM to buy back the shares of the failed Azurix water com­pany. Sever short­ages of elec­tric­ity in Cal­i­for­nia had lead to rolling black­outs and ac­cu­sa­tions that Enron had been ma­nip­u­lat­ing prices. The ven­ture in band­width trad­ing had failed spec­tac­u­larly, and ven­tures in met­als and pulp trad­ing were rack­ing up losses. The com­pany was in a cash crunch. Most of Enron’s se­nior man­age­ment knew the firm was in trou­ble. Many had been liq­ui­dat­ing their hold­ings in Enron stock.

Skilling’s res­ig­na­tion shocked Wall Street. In the days fol­low­ing the an­nounce­ment, Enron’s stock dropped from USD 42.93 to USD 36.85. It was also a wake-up call for Enron em­ploy­ees.

Sher­ron Watkins’ Anony­mous Memo

On Au­gust 15, 2001, Lay re­ceived an anony­mous memo from an em­ploy that opened

Has Enron be­come a risky place to work? For those of us who didn’t get rich over the last few years, can we af­ford to stay?

The memo de­tailed the per­ilous shape of Enron’s fi­nances, fo­cus­ing spe­cial at­ten­tion on Fas­tow’s SPE and as­so­ci­ated ac­count­ing ir­reg­u­lar­i­ties. It con­cluded:

… I am in­cred­i­bly ner­vous that we will im­plode in a wave of ac­count­ing scan­dals.

The au­thor of the memo was Sher­ron Watkins, a for­mer Arthur An­der­sen em­ployee who had joined Enron in 1993. She cur­rently worked in ac­count­ing, re­port­ing to Fas­tow. Watkins soon came for­ward and had a meet­ing with Lay to dis­cuss her con­cerns. She out­lined es­sen­tial steps that Lay should take, but she may have been too late. There was no longer an easy way out of Enron’s prob­lems. Rather than fol­low Watkin’s ad­vice, Lay had lawyers look into whether it would be ad­vis­able to fire her. They ad­vised against it, and she was trans­ferred to an­other de­part­ment.

Things Un­ravel

Ru­mors were swirling about Enron. Eq­uity an­a­lysts, who had pre­vi­ously as­signed the com­pany’s stock a “buy” rat­ing with­out ques­tion, started to com­plain that the firm’s fi­nan­cial dis­clo­sures were opaque. They didn’t with­draw their “buy” rec­om­men­da­tions, but there was pres­sure on Enron to make more com­plete dis­clo­sures.

On Oc­to­ber 16, Enron re­ported third quar­ter earn­ings that in­cluded a one-time charge of USD 1.01 bil­lion. Much of the hit was due to writ­ing down bad in­vest­ments, in­clud­ing Azurix and the band­width ven­ture. USD 35MM of it was due to losses on trans­ac­tions with LJM. LJM wasn’t named in the press re­lease, which sim­ply re­ferred to “early ter­mi­na­tion dur­ing the third quar­ter of cer­tain struc­tured fi­nance arrange­ments with a pre­vi­ously dis­closed en­tity.” An­a­lysts were stunned, but there was more to come. That same day, in a con­fer­ence call to an­a­lysts, Lay men­tioned that the firm was re­duc­ing share­hold­ers’ eq­uity by USD 1.2 bil­lion aris­ing from the re­pur­chase of 55 mil­lion shares of Enron stock from SPEs.

In the fol­low­ing days, the Wall Street Jour­nal pub­lished a se­ries of bomb­shell ar­ti­cles. One on Oc­to­ber 17 de­tailed how Fas­tow and other in­vestors had pock­eted mil­lions of dol­lars from LJM. Enron’s stock price slid to USD 32.20. An Oc­to­ber 18 ar­ti­cle traced the USD 1.2 bil­lion hit to share­holder eq­uity to Enron’s un­wind­ing of the Rap­tor SPEs. These had been fi­nanced with Enron stock, and the plum­met­ing stock price had made them in­sol­vent. That day, Enron’s stock dropped to USD 29.00. The next day brought an ar­ti­cle de­tail­ing how Fas­tow had made mil­lions from his LJM 2 in­vest­ment. Enron stock closed at USD 26.05.

By the end of Oc­to­ber, Enron was under in­ves­ti­ga­tion by the SEC, a dozen class ac­tion lawsuits were filed on be­half of Enron share­hold­ers, Fas­tow left the com­pany, and the stock closed at USD 13.90. Worst of all, coun­ter­par­ties were re­fus­ing to trade with Enron. Trad­ing was Enron’s pri­mary source of rev­enue, and now it was dry­ing up. Ken Lay was feel­ing out of­fi­cials within the Bush ad­min­is­tra­tion to see if a bailout might be pos­si­ble, but no help was forth­com­ing. At Arthur An­der­sen, em­ploy­ees were shred­ding doc­u­ments.

Bank­ruptcy

On No­vem­ber 8, Enron filed re­stated fi­nan­cial re­sults with the SEC. These ac­knowl­edged that Chewco, and hence JEDI, were not truly in­de­pen­dent en­ti­ties. Con­sol­i­dat­ing their fi­nan­cials with Enron’s for the pe­riod 1997 to 2000 re­sulted in a USD 586MM re­duc­tion in Enron’s earn­ings for the pe­riod. It in­creased Enron’s debt by USD 2.6 bil­lion.

Enron was at risk of hav­ing its credit rat­ing down­graded to below in­vest­ment grade by Moody’s or S&P. All that was pre­vent­ing a down­grade was a glim­mer of hope that Enron might be able to arrange a merger with its com­peti­tor Dyn­ergy. Merger ne­go­ti­a­tions dragged on for sev­eral weeks, as bad news con­tin­ued to pile up. Enron’s fi­nan­cial sit­u­a­tion was de­te­ri­o­rat­ing rapidly, mak­ing a merger seem in­creas­ingly less likely. On No­vem­ber 28, Moody’s and S&P down­graded Enron’s debt to below in­vest­ment grade. Dyn­ergy backed out of merger ne­go­ti­a­tions, claim­ing Enron had mis­rep­re­sented its sit­u­a­tion. On the New York Stock Ex­change, 182 mil­lion shares of Enron stock changed hands, set­ting a record for one-day vol­ume in a sin­gle stock. The share price closed for the day at USD 0.61. On De­cem­ber 2, Enron filed for bank­ruptcy.

Af­ter­math

Many peo­ple suf­fered from Enron’s fail­ure, but em­ploy­ees were hit es­pe­cially hard. Thou­sands were laid off with just USD 4,500 in sev­er­ance pay. Enron had en­cour­aged em­ploy­ees to in­vest their pen­sion as­sets in the com­pany’s stock. Em­ploy­ees who had done so lost pen­sion sav­ings as well as their jobs.

In June 2002, Arthur An­der­sen was con­victed of ob­struc­tion of jus­tice re­lated to its de­struc­tion of Enron doc­u­ments. As a con­victed felon, the firm was barred from sub­mit­ting au­dits to the SEC. Arthur An­der­sen, which was once the largest ac­count­ing firm in the United States, lost most of its clients. In May 2005, the US Supreme Court unan­i­mously over­turned the con­vic­tion on the grounds that the trial judge’s in­struc­tions to the jury were in­ad­e­quate. By that point, it was too late for Arthur An­der­son. The firm was down to just 200 em­ploy­ees who were fi­nal­iz­ing the dis­so­lu­tion of the part­ner­ship.Fed­eral pros­e­cu­tors con­ducted a multi-year in­ves­ti­ga­tion of Enron. Six­teen em­ploy­ees plead guilty to crimes re­lated to the scan­dal, and sev­eral oth­ers were found guilty at trial. Fas­tow agreed to plead guilty and co­op­er­ate with pros­e­cu­tors in ex­change for a ten-year prison sen­tence. Lay and Skilling main­tained their in­no­cence, claim­ing that Enron was a healthy firm done in by ir­re­spon­si­ble re­porters, short sell­ers and pan­icky in­vestors.

Mug shots of Ken Lay (left) and Jeff Skilling. Source: United States Marshals Service

Mug shots of Ken Lay (left) and Jeff Skilling. Source: United States Mar­shals Ser­vice.

After a lengthy trial, both men were con­victed on May 26, 2006, of mul­ti­ple counts of fraud and con­spir­acy. Six weeks later, await­ing sen­tenc­ing and pos­si­ble ap­peals of his con­vic­tions, Ken­neth Lay died of a heart at­tack. Jeff Skilling was sen­tenced to serve 24 years and 4 in prison.

Re­becca Mark was never ac­cused of any wrong­do­ing.


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Definition Sources


Definitions for Enron are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

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