ap. 8 Values and the Virtuous Manager • 295 Chapter 8 TRADITIONAL BUSINESS Values and the Virtuous Manager way that energy traded. Case Study joined The Enron Collapse STEWART HAMILTON When Enron filed for bankruptcy protection on December 2, 2001, the fi- nancial world was shocked. How could this high profile leader in the world of energy trading have failed? The employees, many of whom had a large part of their retirement and other savings tied up in Enron shares, were deve astated. Not only were they likely to be out of a job but they also faced fin nancial ruin. Enron was the seventh largest company by revenues in the United States. It employed 25,000 people worldwide. The readers of Fortune maga- zine had voted it as one of the most admired companies in the United States. Its performance had been lauded in the media, and business school cases had been written holding it up as a glowing example of the transfor- mation of a conservative, domestic energy company into a global player. In fact, other, more traditional, energy companies had been criticised for not producing the performance that Enron had apparently achieved. Indeed, the consulting firm McKinsey had frequently cited Enron in its Quarterly as an example of how innovative companies can outperform their more traditional rivals. As more and more facts emerged, it became clear that Enron had many elements of a "Ponzi” scheme. The drive to maintain reported earnings growth, and thus the share price, led to the extensive use of "aggressive" ac- counting policies to accelerate earnings. In particular, the “Special Purpose Entities" (SPEs) Enron used to move assets and liabilities off the balance sheet attracted the most attention. The financial involvement of Enron offi- cers and employees in the SPEs increased that interest. BACKGROUND: FOUNDING OF ENRON AND GROWTH OF THE which started with allowing open market prices for new natural gas discov- The advent of energy deregulation in the late 1970s in the United States, eries, was to fundamentally change the Kenneth Lay, who at one point in his career had been an energy econ- tary, was a convinced "free marketer.” After his stint in Washington, he first omist at the U.S. Interior Department, rising to the rank of Under Secre- an energy company in Florida and ultimately ended up as CEO of Houston Natural Gas. After he engineered the merger with InterNorth, a larger traditional gas pipeline company, to form Enron in 1985, he became chairman and CEO of the new entity. This combination created the largest company-owned natural gas pipeline system in the United States of some 37,000 miles stretching from the border of Canada to Mexico and from the Arizona-California border to terests, which later would be spun off as a separately quoted company. Florida. It also had significant oil and gas exploration and production in- Lay, with the help of Richard Kinder as chief operating officer (COO), set about building up Enron through a series of new ventures and acquisi- tions. Many of these were financed by debt, including some deals under- written by the “Junk Bond King,” Michael Milken of Drexel Burnham Lambert. In the meantime, Enron had to buy off a potential hostile bidder, a hangover from the merger, which cost the company some $350 million. By the end of 1987, Enron's debt was 75% of its market capitalisation. There- after, managing the debt burden was to be one of Enron's constant preoc- cupations. Kinder, a lawyer by training, was a traditional oil and gas man who in- sisted on rigorous controls and who had a reputation for being a fair but tough manager. He was considered the perfect foil to Lay. Lay knew that, as energy deregulation progressed, the process would create commercial opportunities for the more farsighted energy companies, and would open the way to energy trading. Anxious to take advantage of the new environment, in 1985, Enron had opened an office in Valhalla, New York to trade oil and petroleum products. However , unauthorised dealing by two employees led to substantial losses and the office was closed in 1987. Enron took a charge of $85 million, and one of the employees concerned was jailed for fraud. In 1989, Lay hired Jeffrey Skilling, a Harvard MBA and the partner in charge of McKinsey's energy practice in Houston, to be head of Enron Fi- hance. Skilling had advised Lay on how to take advantage of gas deregula- tion. In particular, he had been responsible for Enron's establishing a "gas bank," a mechanism to provide funding for smaller gas producers to enable provide Enron with reliable sources of natural gas to feed its pipeline sys- tem. The following year Enron Gas Services was formed as a trading and arm. At the end of the 1980s, the vast proportion of electricity generated in the United States came from coal fired or nuclear power stations. Gas fired marketing Professor Stewart Hamilton wrote this case with assistance from Research Associate Inna Francis as a basis for class discussion rather than to illustrate either effective or ineffective han- dling of a business situation. Copyright © 2003 by IMD—International Institute for Manage ment Development , Lausanne, Switzerland. All rights reserved. Not to be used or reproduced without written permission directly from IMD, Lausanne, Switzerland. 294 31 2000 (In $ millions) 1999 1998 124 130 979 1,000 893 Net income 703 1,000 131 855 870 827 investments) Shareholders' Equity Second preferred stock, cumulative, no par-value, 1,370,000 shares authorized, 1,240,933 shares and 1,296,184 shares issued, respectively Mandatorily Convertible Junior Preferred Stock, Series B, no par value, 250,000 shares issued Common stock, no par value, 1,200,000,000 shares authorized, 752,205,112 shares and 716,865,081 shares issued, respectively Retained earnings Accumulated other comprehensive income Common stock held in treasury, 577,066 shares and 1,337,714 shares, respectively Restricted stock and other Total shareholders' equity Total Liabilities and Shareholders' Equity Source: Company annual report CASH FLOWS FROM OPERATING ACTIVITIES Cumulative effect of accounting changes Depreciation, depletion and amortization Impairment of long-lived assets (including equity Deferred income taxes Gains on sales of non- merchant assets Changes in components of working capital Net assets from price risk management activities Merchant assets and investments: - 8,348 3,226 (1,048) 6,637 2,698 (741) 326 207 (146) 1,769 (763) 441 21 (541) (1,000) (395) 87 (82) (233) 350 (32) (148) 11,470 65,503 (49) (105) 9,570 33,381 Realized gains on sales Proceeds from sales (628) 1,434 (104) 1,838 (1,295) 1,113 4,779 Additions and unrealised gains Net Cash Provided by Operating Activities Cash Flows From Investing Activities (756) 2,217 (827) 174 1,228 (721) Other operating activities (97) 1,640 Over the four years to December 2000, while revenues from the tradi- tional physical asset energy-generating business grew relatively slowly , re ported revenues from trading grew exponentially to become 80% of Enrones turnover, which leapt from $40 billion in 1999 to $100 billion in 2000. Capital expenditures Equity investments (2,381) (933) 494 (485) (777) (182) (4,264) (2,363) (1,905) (722) (1,659) 294 239 (180) (311) (104) (405) (356) (3,507) (3,965) - THE ROLE OF ANDERSEN 3,994 (2,337) (1,595) 1,776 (1,837) 1,565 1,903 (870) (158) Proceeds from sales of non-merchant assets Acquisition of subsidiary stock Business acquisitions, net of cash acquired Other investing activities Net Cash Used in Investing Activities Cash Flows From Financing Activities Insurance of long-term debt Repayment of long-term debt Net increase (decrease) in short-term borrowings Net issuance (redemption) of company-obligated preferred securities of subsidiaries Issuance of common stock Issuance of subsidiary equity Dividends paid Net disposition of treasury stock Other financing activities Net Cash Provided by Financing Activities Increase (Decrease) in Cash and Cash Equivalents Cash and Cash Equivalents , Beginning of Year Cash and Cash Equivalents , End of Year This is not the familiar story that "recessions uncover what the auditors do not." Arthur Andersen had been Enron's auditors since the company's for- mation in 1985. In the years leading up to the collapse, David Duncan had been the client engagement partner based in Andersen's Houston office, and within the firm, was known to be a "client advocate" with a reputation for "aggressive accounting.” Enron was one of Andersen's largest clients, generating audit fees of $25 million and additional consulting fees of $26 million in 2000. A large team of Andersen staffers was based in Enron's offices and Enron had many em- ployees who had joined from the audit firm. Skilling was on record as say- ing that one of Andersen's most useful services was to provide a pool of accounting talent that Enron could tap. Within Andersen, Enron was known as difficult and demanding and was included in its "high risk” category of client. Internal Andersen memos reveal concerns being expressed by technical partners as early as 1999, and one of them, Carl Bass, was removed from the engagement after Enron complained that he was being deliberately obstructive. There were particular doubts about the accounting treatment of some of Enron's off balance sheet activities . The memos (and e-mails), released by the U.S. House Committee on Energy and Commerce in April 2002, show that the local engagement partner and his Duncan was aware that "these . risk profile ... others could have a different view." policies ... push limits and have a high 8 852 867 568 828 (467) (414) 139 13 (140) 89 2,456 2,266 177 (59) 111 170 288 111 (96) 307 500 (523) 327 (6) 571 1,086 288 1,374 CHANGES IN COMPONENTS OF WORKING CAPITAL Receivables Inventories Payables Other Total (8,203) 1,336 7,167 1,469 1,769 (662) (1,055) (133) (372) (246) 433 41 761 (1,000) (233) Source: Company annual report Values and the Virtuous Manager • 305 PART 3 CORPORATIONS, PERSONS, AND MORALITY employee recounted: commodities, 304 . The accounting policies Enron adopted, and which Andersen sanctioned, were unusual for a non-financial company. As one The issue, which was unnerving, was their focus on immediate earnings (ac- counting not cash). Whenever a transaction or business plan was presented, the focus was on how much earnings the deal would bring rather than if it made business sense or made cash. Another example is the way they conducted their trading business: Enron would create forward price curves on based in many cases on rather sketchy data or pricing points. Using these curves, Enron would enter into long-term transactions with counter parties (10 years was usual in illiquid markets like bandwidth). For Enron, it didn't matter as long as they recovered the investment and made a "profit" on years 6-10. The if they lost money in years 1-5 of a deal (i.e. sold below current market values), reason was because Enron used "mark-to-market” accounting and would take before as price points for discounting and, therefore, making a profit." The fact the NPV of the ten-year deal on day one, using the sketchy curves I mentioned in years 6-10 was usually not considered in these transactions. The only thing that the company was bleeding cash in years 1-5 in exchange for potential gains that mattered was "earnings." (Anonymous) Despite, or ployees were THE ENRON CULTURE purchase at the higher price. Nevertheless, the forecast price curve was such that. The manager who had done the deal was subsequently approached by that it showed a positive net present value and a profit was booked to reflect his boss towards the end of the quarter, and told that, as they were not going to meet their budget, he should revisit the deal and "tweak the numbers to squeeze out a bit more. This he did (an action of which he is now somewhat ashamed). This process was so common, he said, that it was known as "mark- ing up the curve.” Those who worked in Enron were reluctant to challenge such deals. One former employee described his experience: From a cultural perspective, what shocked me was that no one could explain to me what the fundamentals of the business were. As a new person I have always been used to asking questions-many might seem dumb, but it is part of the learning process. In Enron, questions were not encouraged and saying things like "This doesn't make sense” was unofficially sanctioned. Further, I got the im- pression that many people did not understand what was going on, so asking questions would show this lack of knowledge. (Anonymous) or perhaps because of, all the pressure, Enron's senior em- loyal and well rewarded. In 2000, the top 200 employees shared remuneration packages of salaries, bonuses, stock options and re- stricted stock totaling $1.4 billion, up from $193 million in 1998 (refer to Exhibit 8.4). The board also enjoyed handsome benefits well in excess of the normal levels of remuneration paid to non-executive directors of public companies in the United States. The belief that they were changing the world ran deep even after the problems emerged. Following Skilling's resignation as CEO in August 2001, there were some lay-offs in the trading and risk management areas, and in at least one case an individual used a substantial proportion of his severance package to buy more Enron stock in the market. Another, after hearing ex- pressions of sympathy for the redundant employees, said: I would disagree on your view of the "poor employees," however. When I was there it was pretty obvious that most employees knew what was going on and the fact that many people had an overly large exposure to Enron shares was based on greed and share price growth which had taken a disproportionate part of personal assets. As an example, I clearly remember discussing the sale of shares by Skilling and other executives while they were being simultaneously talked up. This was a company-wide known fact. Of course, some of the technical and lower level employees did not understand what was going on, but I fume when I see some of the VPs on U.S. television complaining about their egregious treat- ment. (Anonymous) up for The occupants of 1400 Smith Street, Houston, regarded themselves as elite Enron had largely left behind the Texan “good ol' boy" culture—and cer : tainly the culture of the regulated utility-and had embraced Lay's free market vision. Encouraged by Skilling, a highly paid army of financially lit- erate MBAs sought innovative ways to "translate any deal into a mathemat- ical formula” that could then be traded or sold on, often to SPEs set that purpose. By the end, Enron had in excess of 3,000 subsidiaries and un- consolidated associates, including more than 400 registered in the Cayman Islands. Although the SPEs set up by Enron, often with Andersen's advice, have attracted much comment and criticism, there is nothing inherently wrong with such vehicles. In fact, almost all major companies use various forms of SPEs to manage, for example, joint ventures in foreign countries, or invest- ments in hostile environments. What was unusual in this case was the sheer number of SPEs involved. Skilling had introduced a rigorous employee performance assessment process that became known as "rank or yank." Under this system the bottom 10% in performance were shown the door. There was heavy pressure to meet targets and remuneration was linked to the deals done and profits booked in the previous quarter. This pressure was particularly acute at the quarter-end and gave rise to the expression “Friday night specials." These were deals put together at the last moment, often inadequately documented, despite the efforts of the 200 or so in-house lawyers that Enron employed . The emphasis was on doing deals and not necessarily worrying about how they were to be managed in the future. Even internally it was recognised that project management was not a core competence. Enron's accounting policies led to deals being struck that would be cash negative in the early years. In one example, Enron entered into a 12-year, fixed-price gas supply deal in the Far East at a price below the current "spot, EXHIBIT 8.4. Compensation Paid to the Top-Paid 200 Employees for 1998–2000 Year 1998 1999 2000 Bonus $41,193,000 $51,195,000 $56,606,000 Restricted Stock Stock Options Total Wages $61,978,000 $23,966,000 $66,143,000 $193,281,000 $21,943,000 $244,579,000 $401,863,000 $84,145,000 $1,063,537,000 $131,701,000 $172,597,000 $1,424,442,000 Extracted from: "Written Testimony of the Staff of the Joint Committee on Taxation on the Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Hearing, February 13, 2003. Compensation Issues, and Policy Recommendations." US Senate Committee on Finance the market to THE BROADBAND STORY 1997, it had acquired Portland General Electric, an the "irrational exuberance of the time may have contributed, age. new subsidiary Enron Broadband Services (EBS), making electricity. Such Enron's shares, in the late 1990s, had significantly outperformed the market (refer to Exhibit 8,5) and at their highest price the market capitalisation of the company reached $60 billion. At this level, the share price implied a through the floor, Enron shares continued to outperform the market. Enron was not a simple "dot-com" story. When the Nasdaq index was falling Performing well on the stock market brings its own problems by raising market expectations. Consequently, there was tremendous pressure on Enron to maintain earnings-per-share (EPS) growth, which in turn led to the need to find new sources of revenue and new sources of capital. Large investments in major power projects needed cash. Such investments were not expected to or positive cash flow in the short term, placing immediate pressure on the balance sheet. The much expanded trading book added to this pressure, especially after the creation of EnronOnline. Enron was already highly leveraged, and funding new investments with debt was unattractive as they would not generate sufficient cash flow to service that debt and would put pressure on credit ratings. Enron had never been a "triple A company, but its debt had to stay within investment grade. If it did not, this would affect the company's abil- perceptions of, and its credibility with, counterparties. One answer might have been to issue new equity, but this was resisted as it would dilute EPS and in turn affect the share price. EXHIBIT 8.5. Enron Share Price Movements ket," and to trade bandwidth in a manner similar to gas or Enron's venture into broadband was more opportunistic than planned. In Oregon electricity gen- erator and distributor that had laid some 1,500 miles of fibre-optic cable and by all accounts a born salesman and rather bored with his current along its transmission rights of way. Ken Rice, a long-time Enron employee role, decided that this could be the great new thing. Enron, through its use of its own miles in 1998 and a further 7,000 the following year. The intention was to substantial rights of way, started to build its own network, adding 4,000 sell capacity to heavy data users, such as Internet providers and telecom companies, on long-term contracts which could then be “marked to mar- was the speed with which this business developed that no fundamental sup- with the likes of WorldCom and Global Crossing for customers in a mar- ply and demand analysis was carried out and indeed Enron was competing ket which had huge overcapacity. Even more worrying was that technolog- increased overheads, and in 2000 EBS lost $60 million on revenues of $415 could be carried by existing cable. Getting the dark fibre lit considerably million. The anticipated volumes of traffic did not materialise, which caused great problems as the only way to generate profits from cable is th get data flowing through it. In an attempt to generate traffic, EBS announced, in July 2000, that it had entered into a memorandum of understanding with Blockbuster Video to provide “video on demand," whereby the former would provide the means of delivery and the latter the content. Small trials in four parts of the US proved that the technology worked and the service was rolled out with much fanfare in Seattle, Portland and Salt Lake City just before Christ- mas. However, it proved impossible to attract enough subscribers to make it pay. Fearful of the cannibalising effect of the project on its existing busi- ness if it were to work, Blockbuster walked away from the deal after a few months, leaving EBS to go it alone. This did not preclude Enron from booking a “mark-to-market" profit based on its predictions of the project's future cash flows. However, despite this setback, by the end of that year broadband was seen as a major part of the company's future and was being promoted as such to the financial markets. After the collapse, a former employee posted his thoughts on his MBA class website: generate earnings or 800% 700% 600% 500% 400% 300% 200% wanna 100% -ENRON-SP500-NASDAQ 0% 01/06/1995 OK, now that it's bust, I can tell you a little bit of what was going on at least where I was. Imagine that you make a spreadsheet model of a business plan (in this case it was taking over the world). You discount it with Montecarlo simula- tions (more like Atlantic City , really), sensitise it to all possible shocks, but still make sure you obtain a huge NPV. Then you sell this "idea" to a company that does not consolidate and which finances the purchase with debt guaranteed by Enron's liquid stock (remember no consolidation). You book all the NPV (or profit) UPFRONT. 05/19/1995 09/29/1995 02/09/1996 06/21/1996 11/01/1996 03/14/1997 07/25/1997 12/05/1997 04/17/1998 08/28/1998 01/08/1999 05/21/1999 10/01/1999 02/11/2000 06/23/2000 11/03/2000 03/16/2001 07/27/2001 12/07/2001 Source: Datastream.
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