Enron:

the scandal, the

legend

Derivative

A derivative is an instrument whose value is

derived from the underlying value of something
else, such as a stock, a bond, or in the case of
Enrons derivatives, a unit of electricity.
Derivatives are useful because they enable an
investor to hedge against a decline in value.
Example: Enron could enter a contract with a
purchaser of electricity, such as a utility,
guaranteeing that the purchaser would pay a
certain price for a certain amount of electricity at
a certain date in the future.

Whistle Blower

The technical term for these often brave

people is "whistle blower," as in the
expression "blowing the whistle on
corruption (or on government lies, etc)."
Whistle blowers are people who reveal
generally harmful or very unfair activities,
often of which they have become aware
because of their employment position
within their employer's organization and,
or their access to otherwise unavailable
communications from within the
organization.

Internet bandwidth

By the late 1990s Enron controlled some

25 percent of all electricity and natural gas
contracts traded worldwide and were
considered the best in the business.
This success led Enron to act as a market
middleman for other commodities as
diverse as lumber and Internet bandwidth
(the rate at which data can be delivered
over the Internet).

401k Plan

Pension Plans- Employee 401k contributions

are automatically deducted from their
paycheck each pay period. This money is
taken out before the employees paycheck is
taxed.
The contributions are invested at the
employees direction into one or more funds
provided in the plan.
Employers often "match" employee
contributions, but are not required to do so.
While the investments grow in the employees
401k account, they do not pay any taxes on it.

SPE

SPE- Acronym for Special Purpose Entities.

SPEs reflect a common financing technique for companies.
Companies can cut their risk by moving assets into
separate partnerships that can be sold to outside investors.
In Enrons case, assets that were losing money were sold to
partnerships. Enron listed the sales of these assets as
earnings. However, to be legitimate, accounting rules
require that an SPE be legally isolated from the company
that created it.
In Enrons case this was not true. The SPEs relied upon
Enron managers for leadership and Enron stock for capital.
When outside auditors told Enron to treat some of the 4,000
SPEs it had created as part of Enron, the company had to
take the $1-billion charge against earnings.

Key Players in the Enron

Scandal

Kenneth Lay

Former CEO of Enron, helped start the company.

Enron extended to him $7.5 million revolving credit
line, which he reportedly used and repaid with Enron
stock 15 times within a period of just several months
He quit as CEO in February 2001
He returned as CEO in August 2001until he resigned on
Jan. 23, 2002
He quit the Enron board altogether on Feb. 4.
Sherron Watkins said Lay was "duped" by top
executives

Jeffrey Skilling

Enron's chief executive in the first half of 2001

Since joining the company in 1990, Skilling helped
transform Enron from a natural-gas pipeline
company into an energy-trading powerhouse.
Between January and August 2001 he sold off
about $20 million in Enron stock
Resigned after the close of markets on Aug. 14
2001
Being charged with conspiracy, fraud and insider
trading

David Duncan

Enron's chief auditor at Anderson

His job was to check Enrons accounts
He is accused of ordering the shredding of
thousands of Enron-related documents in an effort
to hide them from Securities and Exchange
Commission investigators

Andrew Fastow

Former Chief Financial Officer of Enron

The mastermind behind the deceptive accounting
practices
Lea Fastow (his wife) also plead guilty to signing
and filing a tax return that did not include income
the Fastows had received from Mike Kopper

Sherron Watkins

Known as the "Enron whistle-blower"

Was Enron's vice president of corporate
development
Wrote a letter to Kenneth Lay about suspicions of
accounting improprieties"
Not really a whistle-blower because she never
went public with her suspicions

Enron

What Went Wrong?

How did the collapse begin?

Energy companies lobbied congress in

the 1980s for deregulation of the
energy business
Energy policy was changed and
Washington lifted controls on who
could produce energy and how it was
sold
Jeff Skilling took and aggressive
approach to expand Enron by trading
futures in gas contracts

Skillings Plan

Under Skillings new plan Enron bet

against future movements in the price of
gas-generated energy
Enron bought and sold tomorrows gas at
a fixed price today
With every trade, Enron took a cut for
transaction costs
Using the internet to promote trading,
Enron became the most successful player
in the futures game; 90% of Enrons
income came from trades

Early 2000

Enron took advantage of the dot.com

boom and traded internet bandwidth
The value of Enrons online
transactions was huge ($880 billion)
The problem was Enron wasnt
making money on many of their
online trades because they made the
market very efficient

Fuzzy Numbers

Enron began tweaking the numbers

in their financial statements with
accounting techniques to hide their
losses
Enron created partnerships, and then
passed the assets (losses) to these
partnerships which eliminated the
losses from their balance sheets

Andrew Fastow
(Chief Finance
Officer) created the
partnerships
Condor and Raptor
were two major
partnerships

Sherron Watkins, the

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

Why wasnt Enron caught

earlier?

Throughout all of this,

Enron and its key
members were
making political
contributions to the
white house and
congress.
Kenneth Lay donated
$100,000 to President
Bush in 2000, and in
2001 Bush invited Lay
to become an advisor
to his transition team.

In the year 2000,

Kenneth Lay met
three times with
Dick Cheney to
discuss energy
policy review.
When the review
was published in
May 2001, it was
very favorable to the
Enron and the
energy sector.

Aug 14, 2001 Jeff Skilling resigned,

Kenneth Lay became CEO once again.
Stock prices began to fall, as investors
were uncertain about the companys
stability.
This started a chain reaction: Enron
had hedged against its own stock, so
as long as the stock price was
declining, it could not recover its
losses.

December 2001,
Enron filed for
chapter 11
bankruptcy
Its share price had
collapsed from
about $95 to under
$1.

Chapter 11 Bankruptcy

Companies and large firms that are facing

severe and unmanageable debt may seek to
file chapter 11 bankruptcy, which allows
them to re-organize so they can either
continue their day-to-day operations or go
out of business entirely.
Under chapter 11, a company is protected
from damaging lawsuits and other negative
measures, but in exchange the company is
usually required to have all its major business
decisions approved by the bankruptcy court.

What Now

Enron is in the midst of restructuring

various businesses for distribution as
ongoing companies to its creditors
and liquidating its remaining
operations.

Investor Sentiment

``Enron has been elevated to a symbol,''

says Woody Dorsey of Market Semiotics, an
institutional forecasting service, ``There's a
whole new level of uncertainty about profits,
about the integrity of the accounting
profession and of Wall Street.''
With a crisis like Enron, during a bear
market, stocks typically take about 12
months to recover.
From 2000 to mid-2002 prices of stocks for
the nations largest companies fell by more
than 33 percent, while technology stocks
dropped 70 percent (more factors than just
Enron).
But, then again

Market Efficiency

``The market has already responded

to the potential of overstated profits
in the same way it responds to an
unexpected negative event: ready,
fire, aim,'' says Jeffrey M. Applegate,
chief investment strategist at Lehman
Brothers Inc.
This assumes a fully efficient market,
one where all current information is
already included in the prices.

Rocking Washington

After investors reaction to Enron and fear

of more such scandals, Conservatives
have learned a sobering lesson:
The clamor for accountability in the
financial system means more rules
and regulations in a sector they have
spent decades trying to deregulate.
Democrats, though, were soon out calling
for limits on the amount of company stock
in 401(k) plans and moves to ease
shareholder suits against corporate
officers, directors, and auditors.

Dems vs. Reps

Democrats see Enron as justification for a

strong assertion of government power to
outlaw conflicts of interest and even restore
the ban on companies operating in both the
banking and securities industries.
The GOP would instead cater to the Investor
Class with more transparency:
On Feb. 13, the SEC took a large step in
that direction by announcing plans to
impose far stiffer disclosure rules on
companies, like insisting that significant
trading in company stock by officers and
directors must be revealed immediately &
that any important changes in business
must be reported within days.

Corruption & Regulation$

After Enron, 89% of investors strongly favor

the criminal prosecution of corporate officials
who are implicated in serious financial fraud.
New York Stock Exchange and the National
Association of Securities Dealers issued a
proposal that would limit compensation that
analysts can receive from investmentbanking activity.
Other rules: restrict analysts' trading of
stocks they cover, ban them from reporting
to their firm's investment bankers, and
prohibit them from promising favorable
ratings to companies they cover.

Public Company Accounting Reform &

Investor Protection Act

created the Public Company Accounting

Oversight Board under the SECs supervision
board given the power to set accounting
standards and to investigate whether
companies and certified public accounting
(CPA) firms are conforming to the standards
board also had the power to fine certified
public accountants (CPAs) and their firms for
violations, suspend CPAs and their firms, and
recommend criminal investigations by the
Justice Department
law also required CPA firms to separate their
consulting & auditing services in order to
avoid conflicts of interest like those in the
Enron scandal

The Best Advice!

Investors were left wondering

whether they could trust
corporations, auditors, or stock
analysts.
And the best outcome from the
present wave of angst would no
doubt be a return to commonsense
investing. Investors should place
their bets on rationality, not the next
skyrocketing stock.

A Quick look: