Enron Capital and Trade Resources - Essay Example

NATURE OF THE BUSINESS Until the early 1990s, Enron was a gas pipeline transmission company like many others. But its managers realized that embeddedin what appeared to be a commodity gas business was valuable information about product flow, supply, and demand. They established Enron Capital and Trade Resources to exploit this information through an innovative range of risk management contracts. The enterprise helped Enron grow its sales by 7 percent per year and its shareholder returns by 27 percent per year between 1988 and 1995 (Best practice and beyond: knowledge strategies 1998, p. 21-22) In the mid-1990s, the Internet burst into the economic landscape. All of a sudden, all bets were off. The game had changed dramatically (Jorion 2003, p. 6). A little-noticed but remarkable side effect of this revolutionary development came in the energy sector. Within about 5 years of the emergence of the Internet and the Web, electricity consumption linked to this new phenomenon had surged to 8 percent of total consumption. Naturally enough, this caught the eye of the prosperous energy trader down in Houston. How could Enron play in this exciting new game (Jorion 2003, p. 6) In order for a firm to have a reasonable chance of success in the realm of the Internet, it needed to be able to control its risks. Well, this was something that Enron was in a very good position to do. In fact, very few companies in the 1990s were as well positioned as Enron to play in this game (or so it seemed). "What Enron has been about for a long time," said Jeff Skilling, then Enron's chief operating officer, "has been making and restructuring markets. If you look at the present phenomenon, the Internet, it also comes into existing markets and dramatically overhauls them. That's something we started doing in the mid-1980s. The Internet just gives us the juice to extend more products across more markets more quickly (Jorion 2003, p. 6)." In particular, Enron got interested in the exotic-sounding world of broadband, which is a catch-all term for high-speed access to the Internet through the use of fiber-optic cable. Broadband is little more than a data pipeline of great bandwidth, or carrying capacity. (Or more precisely, bandwidth "determines the speed at which data can flow through computer and communications systems without interference (Jorion 2003, p. 6)." Even at the time-even amid all the Internet hype and hoopla-people knew that the nascent broadband/ bandwidth industry was a dicey proposition. "The market will not be for the faint of heart or the ill-prepared," one observer commented. "Success will require careful consideration of the appropriate market entry strategy. Organizations must ask the tough questions, such as 'what's my appetite for risk' (Jorion 2003, p. 6)" Well, in Enron's case, the answer was "big appetite." In the spring of 1999, Enron created a company called Enron Communications, Inc., that soon changed its name to Enron Broadband Services (EBS). It began selling a standardized bandwidth product, effectively turning the elusive concept of bandwidth into a commodity (Jorion 2003, p. 6). WHAT WENT WRONG For a while, and especially from a particular perspective, it worked. That perspective, of course, was the price of a share of Enron stock. People loved the idea of Enron and the Internet converging. Within 9 months-that is, the period between year-end 1999 and September 2000- Enron's stock price soared. In fact, it more than doubled-from $44 to $90 (Jorion 2003, p. 6-7). For a group of ambitious and self-impressed executives-especially those with heavy stock options-stock-price fever is something like heroin addiction. It goes from being a nice-to-have to the be-all and end-all. And over time, you need more and more of the stuff to get those good feelings. (In fact, when you do not get the stuff, you start feeling bad.) Management got accustomed to a high and rising stock price-and so, by the way, did Wall Street (Jorion 2003, p. 7). When stock-price fever sets in, lots of other temptations begin rearing their heads. One of them is trading in company stock. Enron turned trading in company stock into a modest cottage industry-or more accurately, an immodest cottage industry (Jorion 2003, p. 7). It is worth noting that in the dizzying stock market context of that time, Enron's stock performance was not unique or even especially remarkable. Enron's stock price consistently tracked the rising trend of the Nasdaq Index, which specializes in technology stocks. If you draw a diagram with two curves-one being the ascent of Enron's stock price over the period 1997 to mid-2001 and the other the Nasdaq Index for the same period-you find that, for the most part, Enron simply rises along with the hyperinflated Nasdaq. It is only in 2000 that Enron's stock price gains more momentum and keeps rising for another 6 months-attaining a 300 percent growth rate-while the Nasdaq stops short at a relatively paltry 250 percent (Jorion 2003, p. 7). So now Enron has created an extraordinary track record and has set expectations that are simply impossible to sustain in the long run. (Companies cannot grow 300 percent every 4 years; there is not enough universe to go around.) Meanwhile, the broadband market began to collapse around Enron. And Enron's international investments were not holding up very well either (Jorion 2003, p. 7). Enron's Securities and Exchange Commission (SEC) quarterly filing for the third quarter of 2001 described the twin calamities in cool "corporate-speak": "Non-Core businesses are businesses that do not provide value to Enron's core businesses. These primarily are part of Enron's global assets and broadband services segments. Enron has approximately $8 billion invested in these businesses, and the return from these investments is below acceptable rates. Accordingly, Enron is developing a plan to exit these businesses in an orderly fashion." When you encounter corporate-speak about "noncore businesses," you can be sure that a management team is trying to wash its hands of a venture that is going nowhere fast (Jorion 2003, p. 7-8). As already noted, Enron in the late 1990s and early 2000s was spreading its wings. Its audacious venture in broadband propelled its stock price to unprecedented heights, rising from $40 in January 2000 to $70 only 3 months later (Jorion 2003, p. 11). This proved unsustainable, but on October 15, 2001, the price of a share of Enron stock was still a respectable $33.17. The next day, the Houston-based energy-trading company issued a press release stating that it had to report "non-recurring charges totaling $1.01 billion after-tax." Two weeks later, Enron's stock was quoted at $13.90 (Jorion 2003, p. 11). Part of the Enron story hinges on a corporate reliance on something called synthetic leases, a model that Enron used when creating its shaky partnerships. Synthetic leases are specifically designed to deceive (Jorion 2003, p. 82). The true beginning of the end started in 2000 with a failed attempt-known to insiders as "Project Summer"-to raise cash for Enron, which at the time had started incurring considerable losses in its forays abroad. The company failed to complete a deal to sell the bulk of its international energy holdings for about $7 billion to a group composed primarily of wealthy Middle Eastern investors that was led by Amin Badr el- Din, a special adviser to Sheik Zayed bin Sultan al-Nahayan, the longtime president of the United Arab Emirates (Jorion 2003, p. 84-85). The project came to nothing in the summer of 2000 when Sheik Zayed was forced to travel to the United States for a kidney transplant and treatment of a fractured hip. What happened in the aftermath was that the company executives gave the task of improving the company's finances to Andrew S. Fastow, the chief financial officer. In late 2000, Mr. Fastow began selling foreign assets to a variety of off-balance-sheet partnerships as a temporary measure to improve the company's cash holdings at the end of the year. It is now clear Fastow's tricky partnerships were bailing out the company. These big transactions take six to nine months to do, minimum. Fastow would close this in two to three weeks; his people didn't have to do due diligence (Jorion 2003, p. 85). As a result of the various causes just outlined, the price of Enron's stock plunged, and this plunge, in turn, triggered a series of events that spelled the company's doom. Enron's stock price held up about 6 months longer than did those of most firms listed on the Nasdaq. In other words, there was a brief window of time within which Enron's stock price was still rising while most other technology stocks had already initiated their descent. This would have been a good thing, in most circumstances. But cash-strapped Enron soon found itself tempted to regard its own stock as an asset to which it had easy and reliable access (Jorion 2003, p. 91-92). A firm is forbidden to capitalize on its own stock-period. This was a prohibition that Sherron Watkins, Enron's whistleblower, would remind legislators of pointedly and repeatedly throughout the Senate hearings. "Under generally accepted accounting principles," the Powers Report agreed, "a company is generally precluded from recognizing an increase in value of its own stock (including forward contracts) as income. Enron sought to use what it viewed as this 'trapped' or 'embedded' value (Jorion 2003, p. 92)." However, there is a back-door tactic. Instruments known as derivatives provide a way to evade such prohibitions as long as some distance is maintained between the derivative and its underlying product. Treating Enron's stock as the underlying product rather than the product itself allowed the company to take advantage of the fact that its stock was still rising in a nose-diving market (Jorion 2003, p. 92). Then, on November 8, came a second batch of very bad news. The company issued a restatement of its reported income for the years 1997 to 2000, to the tune of $586 million. This rewriting of history was a drastic step indeed and one that was certain to shake investor confidence. Why did it have to happen Briefly put, it became inevitable when the company's auditor, Andersen, decided that the financial results of some of those complicated Enron partnerships should have been consolidated with those of the parent company after all (Jorion 2003, p. 11). On November 28, Standard & Poor's and Moody's Investors Service, the principal rating agencies, downgraded Enron's debt to junk-bond status, and this precipitated the company's collapse. "A classic run on the bank," complained Enron's former CEO Jeff Skilling, in his February 2002 testimony before a House subcommittee. "A liquidity crisis spurred by a lack of confidence in the company." By month's end, the company stock was trading at a pathetic 26 cents a share. The Chapter 11 filing that took place 2 days later was only the coup de grace (Jorion 2003, p. 11). CHANGES TO ACCOUNTING REGULATIONS The changes to accounting regulations include changes in the areas of revenue recognition, quality of earnings, acquisitions, and netting stipulated by the Sarbanes-Oxley Act. The SEC has especially in mind round-tripping, meaning double counting of transactions between companies. For obvious reasons, this is also known as corporate back scratching (Jorion 2003, p. 149). One of the primary goals of the Sarbanes-Oxley Act is to ensure that companies are reporting accurate revenue numbers (Sehringer 2005, online) Some companies improve their balance sheets "by simply changing accounting methodology and not disclosing it." For example, an asset that used to be depreciated over 5 years is now depreciated over 10 years. SEC to corporate sector: Cut it out (Jorion 2003, p. 149). Companies that have acquired others may be tempted to report improved overall earnings that actually only reflect the good health of the acquisitions (Jorion 2003, p. 149). Private companies that anticipate acquisition by public companies will need to comply with Sarbanes-Oxley's requirements on internal controls-several quarters before the acquisition-to make sure the acquiring company's CEO and CFO will be willing to certify the consolidated financials. CEO/CFO certifications in post-acquisition reports filed with the SEC will cover pre-acquisition periods. If proper controls are not in place before the acquisition, a potential acquiring company may consider the acquisition too risky (Casey 2003, online). One-time gains are improperly netted against operating expenses, making operating earnings appear better than they really are (Jorion 2003, p. 149). The Sarbanes-Oxley Act stipulates that companies must display the ability to net receivables against payables for both physical and financial settlements (Sarbanes-Oxley control 2004, online) REFERENCES Casey, M 2003, How Sarbanes-Oxley will affect privately held companies. Retrieved January 10, 2007 from http://searchstorage.techtarget.com/ateQuestionNResponse/0,289625,sid5_cid563109_tax295552,00.html 'Best practice and beyond: knowledge strategies' 1998, The McKinsey Quarterly, no. 1, pp. 19-25. Retrieved January 10, 2007, from http://www.civ.utoronto.ca/sect/coneng/tamer/Courses/1299/Ref/knwoledge%20best%20practice.pdf Jorion, P 2003, Investing in a post-Enron world, McGraw-Hill, United States of America. Sarbanes-Oxley control 2004. Retrieved January 10, 2007, from http://www.skippingstone.com/img/SOXsheet1L.pdf Sehringer, G 2005, Revenue recognition policies under scrutiny. Retrieved January 10, 2007, from http://www.s-ox.com/News/detail.cfmarticleID=1285 Read More