ENRON- A Study of FAILURES

Who, How, Why!

Arthur Gudikunst, Ph.D. Revised: April, 2003
Professor of Finance
Finance Department
r!ant "olle#e
Introduction:
$he sa#a of the %&R'& "orporation has (een unfoldin# in the media for )ell over a
!ear. *n the span of onl! three !ears, %&R'& has #one from pu(lic and professional
acclaim of the compan! and its senior e+ecutives to scorn, infam! and (ankruptc!. *ts
pu(lic auditin# firm, Arthur Andersen, has (asicall! (een destro!ed, as )ell as pu(licl!
dis#raced. $ens of thousands of emplo!ees and investors have (een emotionall! and
financiall! affected. ,a-or financial services firms in (ankin#, securities (rokera#e and
insurance have (een, and ma! !et (e, dra)n into the le#al (attles re#ardin# )ho is to
(lame for the %&R'& failure.
Overview of ENRON:
$he follo)in# timeline for %&R'& is presented to set the ma-or milestones for the
compan!:
.ul! /0123 4ouston &atural Gas mer#es )ith *nter&orth to form %&R'&, as an interstate
natural #as pipeline compan!. 5enneth 6a! is "%'.
/0103 %&R'& starts tradin# natural #as commodities and commodit! derivative financial
contracts.
/0073 %&R'& (e#ins tradin# electricit! as a commodit! and related financial derivative
contracts. .effre! 8killin# is e+ecutive in char#e of this ne) (usiness venture.
&ov. /0003 %nron'nline is launched as a )e( site for the #lo(al tradin# of ener#!
commodities and derivative contracts. .effre! 8killin# leads this continued transformation
from a natural #as pipeline compan! to a #lo(al marketer and trader of oil, #as and
electric ener#!. 8tock price trades at 972 per share.
20003 8tock price trades at hi#h durin# !ear of 90/ per share.
Fe(. 200/3 .effre! 8killin# takes position as "%', and 5en 6a! remains as "hairman of
the oard. 8tock price is tradin# at hi#h ran#e of 917 per share.
Au#. 200/3 .effre! 8killin# resi#ns as "%', and 5en 6a! returns to position as "%' and
"hairman. %&R'& vice president, 8herron :atkins, )rites anon!mous letter to 5en 6a!
a(out severe pro(lems )ith partnerships kno)n as 6., and Raptor, the accountin# for
those partnerships, the role of the %&R'& "F' in the partnerships, and the possi(le
adverse effect of these partnerships and their accountin# if the information )ere ever
revealed to the investment markets.
.an.3Au#. 200/3 6a! and 8killin# sell 97/ million of %&R'& stock. 'ther corporate
insiders sell 9;/ million of stock. %mplo!ees are restricted from sellin# stock from
70/<k= retirement accounts unless retirin# or leavin# emplo!ment.
8ep. 200/3 8tock price trades around 921 per share, after 0>// terrorist attacks.
'ct. 200/3 %&R'& reports a 9?/1 million loss for the third @uarter, and restates past
financial statements that results in 9/.2 (illion )ritedo)n of %&R'&As stockholder
e@uit!. 6oss and )ritedo)ns result from 8pecial Purpose %ntities <partnerships= created
under the direction of "hief Financial 'fficer <"F'= Andre) Fasto). $he 8ecurities and
%+chan#e "ommission <8%"=, re@uests further e+planation and information on the
reported losses and financial restatements. "F' Andre) Fasto) is relieved of his
position. %&R'&As pro(lems lar#el! related to Ba##ressiveB accountin# related to
reportin# of inde(tedness on (alance sheet, reportin# of profits from asset sales and
reportin# of earnin#s and cashflo) from on3#oin# operations.
&ov. 200/3 8%" up#rades in@uir! into %&R'& to a Bformal investi#ationB. %&R'&
states that its profits over last five !ears have (een BoverstatedB (! 921? million. Pu(lic
auditin# firm, Arthur Andersen, receives re@uest from 8%" for its records on the %&R'&
audits. %&R'& attempts to raise cash (! dela!in# loan repa!ments and seekin# ne)
sources of short term capital. ,er#er attempt )ith D!ne#! "orp. is cancelled.
Dec. 200/3 %&R'& files for "hapter // (ankruptc! protection. "%' of Arthur Andersen
tells "on#ress that %&R'& mi#ht have violated securities la)s.
.an. 20023 .ustice Department (e#ins criminal investi#ation of %&R'&As failure. Reports
are received a(out document destruction at %&R'& and Arthur Andersen after 8%"
investi#ation )as announced. %&R'& stock trades at prices (et)een 90.20 and 90.20 per
share.
Fe(.3Au#. 20023 'n#oin# investi#ations (! 8%", C.8. .ustice Department, C.8. 4ouse of
Representatives, C.8. 8enate, et al. "ompanies such as ,errill 6!nch, "iticorp and ..P.
,or#an "hase are called to testif! a(out their dealin#s )ith %&R'&. Role of %&R'& in
the "alifornia ener#! crisis is investi#ated. %&R'& emplo!ees sustain massive losses in
70/<k= retirement accounts and emplo!ee la!offs continue. Federal #overnment evaluates
need for ne) la)s related to emplo!ee pension accounts, re#ulation and oversi#ht of
pu(lic auditin# firms, and corporate fraud and #overnance issues.
ENRON Failure: Who's to Blame?
At first #lance, it )ould appear that %&R'&As senior e+ecutives, nota(l! 6a!, 8killin#
and Fasto), are the primar! suspects. 4o)ever, the! claim that the! )ere operatin# )ith
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the consent and approval of the %&R'& oard of Directors. $he Auditin# "ommittee of
the oard of Directors continued to rel! on its pu(lic auditin# firm, Arthur Andersen,
)ho continued to )rite favora(le opinion letters that %&R'&As accountin# )as Bade@uate
to provide reasona(le assurance as to the relia(ilit! of financial statementsB for the !ears
/001, /000 and 2000. Arthur Andersen pu(lic auditors )ere usin# the accountin# s!stem
that )as developed (! %&R'& in con-unction )ith the advice and counsel of the
consultin# arm of Arthur Andersen. $he accountin# s!stem )as developed also to
conform to Generall! Accepted Accountin# Principles <GAAP=, as interpreted (! -oint
a#reement of Arthur Anderson auditors and the consultin# unit, %&R'& accountin#
personnel and, to some e+tent, (! the le#al firms passin# favora(le opinions on
accountin# and ta+ treatments of the %&R'& related partnerships <8P%As=.
$hrou#hout %&R'&As histor!, up to the 'cto(er3&ovem(er, 200/, restatement of the
income statement and (alance sheet due to the 6., and Raptor partnerships, all of the
pla!ers indicated a(ove )ere #ivin# each other confirmation and approval for the
accountin# and (usiness practices that suddenl! )ere (ein# undone in 'cto(er. *n the
previous !ear, %&R'& paid over 920 million to Arthur Andersen for their consultin# and
auditin# services. $he la) firms, providin# services and opinions to %&R'&, received
a(out 920 million in fees. As a result, the various %&R'& pla!ers )ere all confident that
the! )ere operatin# in a s!stem )here each )as (ein# covered (! the actions and
confirmations of others in the s!stem. &o(od! did an!thin# )ron#, (ecause the actions
)ere all (lessed (! the other pla!ers in the s!stemD
ut )ho else )as involved in %&R'& de(acleE 6ets us not for#et the various mem(ers
of the financial communit!, i.e., the (anks, credit ratin# a#encies and the securities
(rokera#e firms. Recent hearin#s in the C.8. 8enate e+plored the activities of ..P. ,or#an
"hase and "iti(ank <the (ankin# side of "iti#roup= )ith %&R'&. Apparentl! (oth of
these (anks )ere involved in )hat are called Bprepa!B ener#! transactions. %mplo!ees of
the (anks )ere dealin# )ith %&R'& and %&R'& partnerships to provide cash to
%&R'& for its da!3to3da! financial operations, in )a!s that could (e reported as
Boperatin# activitiesB versus Bde(t financin#B activities. $he (anks )ere findin# )a!s,
supported (! le#al and accountin# opinions, that ena(led %&R'& to en#a#e in practices
that had the effect of hidin# its de(t o(li#ations off3the3(alance sheet, )hile appearin# to
report positive profits and flo) of funds from operations.
,errill 6!nch dealt )ith an %&R'& partnership <the &i#erian ar#e Pro-ect= in a
transaction that allo)ed %&R'& to report a 9/2 million addition to profits -ust (efore the
end of fiscal !ear /000. ,errill 6!nch claimed that the transaction )as a 9; million
purchase of e@uit!, )ith attendant e@uit! risks, (ut even ,errillAs o)n compan!
ne)sletter and e+ecutive e3mails )ere indiscriminant in referrin# to the deal as Be@uit!B
in some documents, and a BloanB in other documents. *n essence, ,errillAs Be@uit! B
investment )as #uaranteed to (e repaid in ? months at a stated /2 F rate of return, in
addition to %&R'& pa!in# a 9222,000 fee )hen the documents )ere si#ned, and
a#reein# to compensate ,errill for all its e+penses of dra)in# up the le#al papers for the
transaction. <As a professor of finance and investments, this BdealB sounds a lot to me like
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a #uaranteed BloanB at a fi+ed rate of interest, and not a real Be@uit!B position )ith price
risk to the investor.=
ut )here )ere the various credit a#encies that )ere supposed to provide independent
advice a(out %&R'&As financial a(ilit! to repa! its inde(tednessE ,ood!As and 8tandard
and PoorAs credit ratin#s indicated that %&R'& )as an Binvestment #radeB credit risk
until )ell into the !ear 200/, althou#h the ratin# )as softenin#. $he massive restatement
of financial statements in 'cto(er, 200/, and further insi#hts into the Boff (alance sheetB
financin# methods of %&R'& led to ratin#s do)n#rades to B-unkB or hi#h risk status of
%&R'& as a creditor. 4o)ever, even the credit ratin# a#encies, )ith their supposed
accountin# and anal!tical e+pertise, failed to full! understand the condition of %&R'&
and to #ive earl! )arnin# of the potential failure to the investin# pu(lic and financial
institutions.
:here )ere the #overnmentAs re#ulator! a#enciesE $he 8ecurities and %+chan#e
"ommission, our federal #overnment oversi#ht of pu(licl! traded companies and the
securities markets, )ere apparentl! cau#ht flat3footed )ith the %&R'& 'cto(er, 200/,
revelations. $he 8tate of "alifornia dere#ulated electric ener#! )ith a plan that
esta(lished the rules for ener#! tradin# and pricin#, (ut the rules )ere apparentl! so
comple+ that there )as an incentive for ener#! producers and tradin# companies to
B#ame the s!stemB in order to make profits (! findin# loopholes in the s!stem. $he
"alifornia ener#! dere#ulation also had some interestin# characteristics, such as, the
ener#! prices to consumers )ere fi+ed in price, (ut the firms transmittin# ener#! to
consumers )ould have to pa! an ener#! price )hich )as dere#ulated and ad-usted to
prevailin# market conditions. "ould the politicians have also (een un)ittin# partners in
the %&R'& failureE
And lets not fail to identif! the role of %&R'& rank3and3file emplo!ees and the #eneral
investin# pu(lic. %&R'& emplo!ees )ere seein# the da!3to3da! compan! operations up
close and personal. $he accountin# department had hundreds of professionall! trained
accountants )orkin# on the reportin# of compan! transactions. ,an! of the accountants
)ere also prior emplo!ees of the auditin# firm, Arthur Andersen, trained to look at the
transactions )ith an BindependentB auditorAs perspective. Finall!, one emplo!ee, 8herron
:atkins, did attempt to (lo) the )histle on suspected accountin# pro(lems, (ut onl! in
an anon!mous communication to the "%' of %&R'&. And )hat )as drivin# the
e+ecutives of %&R'& to do the thin#s that are no) linked to the failure of the compan!E
$he o(vious ans)er )as a desire to satisf! the profit and stock price e+pectations of the
investin# pu(lic, in an effort to fulfill the corporate o(-ective, as stated in the financial
mana#ement te+ts, to Bma+imiGe the value of the firm to the shareholdersB. *n the /000As,
investors in e@uit! securities (ecame enamored )ith the e+pectation of 22330F annual
rates of returns, and re)arded companies )ith fast #ro)in# earnin#s )ith ver! rich stock
prices, (ut also severel! punished compan! stocks )hich failed to meet the B:all
8treetAsB e+pected ne+t period earnin#s num(ers. "an !ou sa! investor B#reedBE As a
result, %&R'& e+ecutives and emplo!ees )ere cau#ht up in the desire to report ever
increasin# earnin#s in order to keep stock prices risin#, and to protect their -o(s and
)ealth in their retirement plans.
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*n summar!, )ho caused the %&R'& failureE Ans)er: a lot of individual and
institutional pla!ersD :hile it ma! (e comfortin# to -ust fi+ (lame on a fe) Brotten
applesB in the compan!, there are a lot more cooks )ho contri(uted to the terri(le ste)
served (! %&R'&. :e )ill see later )ho is Ble#all!B to (lame, once the le#al process
)orks its )a! throu#h the court s!stem.
ENRON Failure: How did it happen?
$he precipitous pu(lic event that reall! led to the %&R'& failure )as most likel! the
announcement of the financial and profit restatements in 'cto(er, 200/. ut this )as -ust
the Btip of the ice(er#B. $he real e+planation lies in the operations and activities of
%&R'& for man! !ears leadin# up to 'cto(er, 200/. Pivotal to this )as the nature of the
chan#e in %&R'&As (usiness activities, from that of a producer and transporter of ener#!,
to a #lo(al marketer and trader of ener#!, )ith production and tradin# of ener#!, ener#!
financial derivatives products, and telecommunications s!stems and other derivative
products tradin#. %&R'& )as even developin# ne) financial products on )eather and
corporate credit enhancement, i.e., financial contracts that )ould make pa!ments (ased
on outcomes of )eather and chan#es in the credit )orthiness of (usinesses. 4o)ever, the
issue of accountin# and auditin# for these ne) activities, and the increasin# use of off3
(alance3sheet partnerships and financin# activities are intricatel! ent)ined )ith the issue
of ho) the failure occurred. And finall!, the corporate, economic and political
environment impact should (e included as contri(utin# factors.
*t is likel! that (ooks and learned tomes )ill (e )ritten on this topic for !ears to come, so
* )ill onl! raise the issues * see as ke! to ho) %&R'& descended so @uickl! into
(ankruptc!.
$he (irth of %&R'& in /012 )as as a compan! that transmitted natural #as to customers
throu#h its ph!sical pipeline s!stem. *t (uilt pipelines )ith lon# ph!sical lifetimes, and
used de(t capital to raise mone! for the construction of the facilities. Government
re#ulation, at the state and federal level, of ener#! companies and prices )as ver!
comprehensive. ut there )as a trend in #overnment and economic polic! to dere#ulate
the industr! and let market forces prevail, )hich )ould also chan#e the risk and re)ard
characteristics of the companies in this industr!. $he move to)ard dere#ulation also
opened up ne) possi(ilities for compan! activities and products. %&R'& em(arked on
the development of financial products and commodities tradin# platforms <%nron'nline=
that moved the compan! to)ard (ecomin# a financial services and information
technolo#! (ased (usiness enterprise. Producin# ener#! and transportin# it to the end
user )as the (orin#, old line of (usiness, )ith limited #ro)th potential and investor
appeal. %&R'&As ne) focus on (ecomin# a #lo(al marketer and trader of ener#! and
other financial products )as the ne) )ave that )ould offer prospects of rapidl! #ro)in#
earnin#s and stock prices for the shareholders.
ut, the ne) operational environment involved the need to finance development of
entirel! ne) (usiness activities, and chan#ed the characteristics of funds flo)in# into and
2
out of the compan!. Risks to %&R'& from this ne) corporate strate#! )ould include
varia(ilit! of funds needed to finance the ne) activities, the varia(ilit! of economic
profits caused (! ne) market factors, and comple+it! of implementin# accountin#
s!stems to handle the ne) products>(usinesses. 8o %&R'& needed ne) capital sources
)ith )hich to invest in its ne) corporate direction. $his )ould chan#e in the future the
a(ilit! of the compan! to meet its financial o(li#ations to those providin# the ne) capital.
anks and (ondholders )ould (e providin# loans )ith interest and principal repa!ment
o(li#ations fi+ed (! le#al contract, )ith )ell3defined risks and penalties if repa!ment
)as not made. %@uit! investors (u!in# ne)l! issued shares of %&R'& stock )ere
makin# decisions (ased on future e+pected profits and risks @uite different from that of
an ener#! production and transportation compan!. Future returns to purchasers of these
ne) %&R'& shares )ould (e dependent on the success of the ne) corporate strate#ic
investments.
:ith this (ack#round, 6a! and 8killin#, )ith the advice and consent of the mem(ers of
the oard of Directors <elected, in theor!, (! and for the interests of the stockholders=
proceeded to implement the ne) corporate strate#!. A ne) emplo!ee, Fasto), )as
(rou#ht to the firm from the (ankin# industr! and rose to (ecome the "hief Financial
'fficer. $o#ether, 6a!, 8killin# and Fasto) had the responsi(ilit! to conduct the
financin#, accountin# and operatin# activities of the compan! as it transformed itself in
the corporate future. $he pressure on this mana#ement team )as to (rin# a(out the
transformation of the compan!, to produce #ro)in# profits from old and ne) operations,
and to #ro) the value of the firm, as indicated (! the market price of its common stock.
$he sta#e )as set. %&R'&As (usiness transformation )as firml! set in place in the
middle and late /000As. 4o)ever, ne) markets and ne) products (rin# ne) risks and
ne) competitors. Forecasts of ho) much ne) financin# is needed to fund the ne)
activities ma! prove to (e too lo). ,ore ne) capital must (e raised from e+ternal capital
sources. 6enders )ant assurance that loans can and )ill (e repaid, determined partl! (!
the credit a#enc! ratin#s on the compan!, )hich are (ased on the compan!As reported
financial statements )hich are #iven the seal of approval (! the pu(lic auditors. *nvestors
purchasin# ne) shares of %&R'& stock )ill onl! (e re)arded if the stock price
continues to rise, (ut that lar#el! depends on the compan! continuin# to produce ever
hi#her reported after ta+ accountin# profits.
8o realit! sets in. $he compan! discovers that the ne) investments are not as profita(le
as forecasted or desired. $he financial officer is responsi(le for raisin# continuousl!
increasin# amounts of ne) capital to fund the #ro)in# investments re@uired to fulfill the
ne) corporate strate#!. :all 8treet securities anal!sts e+pect to see #ro)in# assets and
#ro)in# corporate revenues (ein# reflected in the after ta+ reported profits and earnin#s
per share <%P8=. $he mana#ement team must deliver ne) capital to meet needs, must
continue to pa! and meet its past loan repa!ments, and must deliver the (ottom line
income num(ers on the profit statement. 4o) do !ou accomplish this )hen the
underl!in# economics of the (usiness is short of e+pectationsE 'ne ans)er is to ad-ust
the corporate operations to reflect the chan#ed economic environment <potentiall!
disappointin# the shareholders of the compan! and havin# the senior mana#ement team
?
replaced (! the oard of Directors=. $he other ans)er is to find )a!s to raise the ne)
capital )ithout it appearin# adversel! on the firmAs financial statements, and to find
accountin# methodolo#ies that )ill allo) stated profit reports to investors to (e inflated
(e!ond the true level of )hat )ould (e called BeconomicB profits for the firm. $he
information and le#al accusations re#ardin# %&R'& seem to indicate that mana#ement
took the latter course of action.
$he results of the 6a!38killin#3Fasto) leadership decisions em(arked %&R'& on a path
of usin# availa(le accountin# devices to (oth understate the amount of (orro)ed capital
actuall! (ein# used (! the compan!, and to BmanufactureB hi#her after ta+ reported
profits and %P8 to shareholders. $he issue of )hether these )ere le#al or ille#al actions
a)aits the outcome of future court trials, (ut the fact that %&R'& is no) in the le#al
condition of "hapter // (ankruptc!, )ith the massive losses in stock value and
uncertaint! a(out lenders (ein# repaid, is the result of the course of action set in place (!
%&R'&As e+ecutive officers < )ho )ere aided and a(etted to some e+tent (! mem(ers of
the oard of Directors, Arthur Andersen and various outside la) firms=.
$he stor! of 4': this occurred is ver! comple+. * )ill attempt to e+plain several of the
techni@ues used (! %&R'& to under3report the de(t re@uired to keep the compan!
operations runnin# and to overstate the profits of the firm. oth #oals )ere achieved )ith
the creation of 8pecial Purpose %ntities <8P%As or partnerships=. A compan! can enter into
a partnership )ith outside investors and lenders, and not have to consolidate that entit!
into the compan!As financial statements reported to the investin# pu(lic. 8o, %&R'&
esta(lishes a partnership )ith outside e@uit! investors )ho (u! as little as 3 percent of
the partnershipAs total capital, )ith %&R'& investin# the rest of the capital. &e+t, the
partnership (u!s assets from %&R'&, usin# the e@uit! capital from the partners and
loans from a financial institution or (ank.
As a simplified illustration, assume that %&R'& sells electric #eneratin# e@uipment to a
8P% for a price of 920 million. anks lend the 8P% 972 million for the purchase )ith a
fi+ed maturit! and interest rate. %&R'& invests 90.2 million in e@uit! of the 8P% and
sells shares for 97.2 million <over 3 percent of total capital= to outside investors. ecause
the (ank loan is not directl! to %&R'&, (ut to the 8P%, it does not #et reported as a de(t
o(li#ation on the (alance sheet. Further, if the assetHs (ook value on %&R'&Hs (alance
sheet for this e@uipment )as 921 million at the time of the sale to the 8P%, then %&R'&
no) can report in this fiscal !ear a profit on the sale of 9203921I922 million of profits.
%&R'&Hs cash receipt from the 8P% is 920 million minus its e@uit! investment in the
8P% e@uit! <970.2 million net ne) cash to %&R'&=. *f the 8P% successfull! uses the
asset to #enerate future cash inflo)s to repa! the loan to the (ank and have remainin#
profits for the 8P% partners, then %&R'& )ill (ook future profits.
ut )hat happens if the assets are overpriced and do not #enerate sufficient future
revenues to repa! the (ank loanE Does this mean that the (anks mi#ht not #et repaid the
principal of the loanE $he ans)er lies in )hat mi#ht have (een a separate a#reement, oral
or )ritten, that %&R'& promised to the (anks that loaned mone! to the 8P%. $he
a#reement mi#ht look like the follo)in#. %&R'& )ill a#ree to #ive to the 8P% <or
;
directl! to the (anks= additional shares of %&R'& stock in sufficient market value for the
8P% to sell the stock and repa! the (ank loan principal. $his action mi#ht also (e re@uired
in the case )here %&R'& either has a do)n#rade of its o)n credit ratin# (elo)
investment #rade, or )hen the %&R'& stock price falls to a lo)er (oundar! level.
$herefore, )hen the market price reaches 921 per share, %&R'& must #ive the 8P%
enou#h shares of stock to ena(le the 8P% to repa! all of the outstandin# (ank loan
principal. 4o)ever, if %&R'& fails to inform its stockholders a(out these future
o(li#ations, the massive amounts of ne) shares that %&R'& )ould have to issue )ould
cause hi#h e@uit! dilution, immediatel! lo)er the %P8 of the stock, and further put
do)n)ard pressure on the market price of %&R'& stock. 8ince %&R'& (! !ear 2000
had created appro+imatel! 2000 8P%Hs, an! ma-or reversal of the compan!Hs operations
)ould (e catacl!smic.
$he a(ove illustration sho)s ho) %&R'& )as a(le to use the 8P%Hs to enter into de(t
o(li#ations )ith lenders, and still not report the de(t on its o)n financial (alance sheet.
Further, the compan! could use the sales of its assets and operations to the 8P% to
#enerate an immediate profit to add to its current income statement.
&o), in keepin# )ith the classic t!pe of PonGie scheme, !ou start )ith small deals to
(oost profits and hide small amounts of de(t off3(alance sheet. $o #ro) ne+t !earHs
earnin#s, support investment in additional assets and ne) (usinesses and repa! the old
lenders, !ou need to create more and (i##er 8P%Hs in the second !ear, then the third !ear,
etc. As lon# as increasin# stock prices continue, ever!thin# is fine. :hen lenders donHt
#et repaid or stock tri##er points are reached in the loan a#reements, then thin#s start to
unravel @uickl! and in the full #lare of the investors, securit! anal!sts and credit ratin#
a#encies. For %&R'&, activities undertaken over man! !ears came to pu(lic attention in
'cto(er, 200/, and the compan! )as taken into (ankruptc! (! Decem(er of that !ear.
*n addition to the creation of the 8P%Hs, %&R'& seemed to (e e@uall! (us! creatin# the
appearance of corporate profits from other Ja##ressiveK uses of accountin#. 'ne method
of (oostin# reported earnin#s after ta+es to shareholders is to find )a!s to lo)er the
corporate ta+ (ill on reported profits. ecause GAAP and ta+ accountin# rules can (e
@uite different, it mi#ht (e possi(le for a creative compan! to raise reported after3ta+
profits usin# GAAP accountin#, (ut usin# different rules to report Gero profits for
#overnment ta+ purposes. $o the shareholders in the annual report, follo)in# GAAP
rules, the compan! )ould report its hi#her pre3ta+ profits, )hile reportin# the ta+es
pa!a(le at a much lo)er amount. 'ne report su##ests that of %&R'&Hs !ear 2000
earnin#s after3ta+ reported to shareholders, a(out 920? million or 30 F of earnin#s )ere
the result of one3time ta+ savin# strate#ies created (! the ta+ accountants. "learl!,
companies can follo) rules that allo) them to minimiGe ta+es pa!a(le to #overnment.
And, )ith the comple+it! of C8 corporate ta+ codes and the added factor that %&R'&
)as a #lo(al compan! facin# man! different countr! ta+es, (ri#ht ta+ accountants can
contri(ute si#nificantl! to lo)erin# the compan!Hs total ta+ (ill. ! 8eptem(er of 200/,
reports indicate that lo)ered operatin# profits in man! of %&R'&Hs divisions resulted in
pressure on the ta+ department to #enerate up to 9?00 million of ne) ta+ savin#s for
fiscal !ear 200/. Accountants kno) that strate#ies to JavoidK e+cess ta+ pa!ments are
1
le#al, (ut that attempts to JevadeK ta+es (! fraudulent means is ille#al. 4ere a#ain,
%&R'&As internal staff likel! made use of le#al opinions from internal and e+ternal le#al
advisors that their techni@ues )ere BappropriateB.
$hese several e+amples indicate the potential methods (! )hich Ja##ressiveK application
of accountin# can hide de(t off3(alance sheet and create the appearance of increasin#
profits. $he result can have the effect of convincin# investors that the compan! stock is
more valua(le than it mi#ht trul! (e )orth. ut these methods, )hen learned a(out (! the
investin# pu(lic and the creditors, can lead to rapid deterioration of the compan! and the
value of its common stock shares. Reports in the media a(out %&R'& su##est that the
relia(ilit! of the compan! (alance sheet and income statements in the annual reports to
the 8%" and the shareholders over the previous 3 to 7 !ears )ere hi#hl! dependent on the
Ja##ressiveK and creative skills of %&R'&Hs accountin# staff, aided (! the ac@uiescence
of the Arthur Andersen auditors, and the counsel of le#al firms hired (! %&R'&.
ENRON Failure: Wh did it happen?
* think that the ans)er to )h! it happened is relativel! strai#htfor)ard. $he 6a!38killin#3
Fasto) e+ecutive team )as tr!in# to create a (usiness enterprise that )ould deliver
increasin# )ealth for their shareholders. 4o)ever, )hen the cold li#ht of da)n sho)ed
that the JrealK economics of the firm )as less than that desired or necessar! to support a
#ro)in# stock price, it (ecame necessar! for the firm to appl! a##ressive accountin#
methods to achieve the desired effect. $o the e+tent that the ne) (usiness ventures
undertaken re@uired continuousl! increasin# amounts of ne) capital, the e+ecutive team
relied on other creative mechanisms and accountin# to (rin# in ne) de(t capital, (ut to
do it in a )a! that )ould not make the firm look to (e more risk! to the ne) capital
investors. 'nce started do)n a slipper! slope, the need to continue these t!pes of
activities simpl! increased in each succeedin# !ear. $he! )anted to keep their -o(s,
personal )ealth and pu(lic acclaim, )hich meant keepin# %&R'& movin# for)ard (!
an! means. ut )here )ere the ethical checks and (alances that should have (een
reco#niGed (! mana#ementE

:hich (rin#s me to the %&R'& oard of Directors. :here )as the corporate
#overnance process that should have (een e+ercised (! the mem(ers of the oardE
"ertainl! the Audit "ommittee of the oard should have (een more critical of the
auditors and their )ork. ut, )ith the stock price and earnin#s risin#, the! )ere perhaps
lulled into a false sense of securit! a(out %&R'&Hs internal accountin#, and the
favora(le opinion letters si#ned (! Arthur Andersen. $he oard mem(ers en-o!ed their
status at %&R'& and the remuneration paid (! %&R'&. $he! seemed )illin# to accept
information from the 6a!38killin#3Fasto) team at face value, )ithout critical anal!sis.
$he! failed to live up to their role as overseers of mana#ement on (ehalf of the
stockholders )ho elected them to the oard.
%&R'& emplo!ees also facilitated the failure of their o)n compan!, and have suffered
accordin#l!. %&R'& had an inside le#al staff of over /00 la)!ers, and an accountin#
staff of several hundred trained accountants. All seemed to (e operatin# in a )a! that
0
supported the e+ecutive mana#ement team. $here seemed to (e little incentive or
)illin#ness to @uestion the methods (ein# emplo!ed to (oost reported profits and hide
corporate de(t. As emplo!ees )ere (ein# paid #ood salaries, provided )ith full (enefits,
and investin# their pension contri(utions in risin# compan! stock, rockin# the (oat a(out
@uestiona(le activities )ould (e a supreme act of coura#e, )ith hi#h risk penalties. 8o
the! remained supportive, until 8herron :atkins finall! tried to raise a)areness of
potential pro(lems.
%&R'& e+ecutives )ere further aided and supported (! the Arthur Andersen auditors
and scores of outside le#al firms )orkin# for the compan!. %&R'& )as a ver! #ood
client for Arthur Andersen, collectin# over 920 million in revenues in !ear 2000. $he
le#al firms )ere paid a(out 920 million in fees for their services that supported and
-ustified the activities of %&R'&. Remainin# in #ood standin# )ith the e+ecutive team at
%&R'& meant future (usiness for their firms, and perhaps added (onuses for individual
e+ecutives at the auditin# and the le#al firms. %+ecutives pro(a(l! do not look favora(l!
on outside firms )ho #ive contrar! advice to that )hich the e+ecutives desire. 8o
%&R'& ma! not have (een receivin# the ne#ative responses that )ould have cut short
the activities that ultimatel! (rou#ht %&R'& do)n. :hether ille#al activities occurred is
the su(-ect of future investi#ations involvin# the auditin# and le#al firms hired (!
%&R'&.
$he #overnment also (ears some responsi(ilit!. $he federal (ud#et for the 8%" has (een
reduced in past !ears, )hile the num(er and comple+it! of companies to (e overseen (!
the 8%" has increased. Politicians have reversed 8%" enforcement rules throu#h the
le#islative process, as seen in the de(ate over the rule of havin# companies e+pense
options #rants to emplo!ees in the income statement. 6e#islative activities have reduced
re#ulator! oversi#ht of ener#! companies, and replaced old re#ulations )ith ne) sets of
rules and procedures that are onl! tested later in the real )orld, and sometimes found not
to achieve the intended economic conse@uences. * )onHt even raise the issue of campai#n
contri(utions to the politicians (! individuals and corporationsD
And finall!, ho) the %&R'& failure resulted must (e vie)ed in relation to the desires of
investors and financial institutions. *nvestors in the markets created conditions that meant
companies )hich appeared to (e J)innersK sa) rapid stock price increases, )hile Jpoor
performersK had plun#in# stock prices. Pressure on compan! mana#ement )as intense to
continue to (e seen as a J)innerK to drive prices hi#her for their stockholders. Risk
evaluation of stocks seemed to (e secondar! to investors relative to hi#her reported
earnin#s per share. *n addition, the (anks and securit! (rokera#e firms )anted to do
(usiness )ith %&R'& to #enerate profits <and perhaps individual annual (onuses for the
emplo!ees doin# the %&R'& deals= for their o)n shareholders. *t seems evident, (ased
on information concernin# %&R'&Hs 8P% activities, that the financial institutions
(enefited from the relationship, )hile the! took steps to reduce the risks of dealin# )ith
%&R'& throu#h separate side deals and #uarantees that )ere not full! understood (! or
revealed to the investin# pu(lic.
/0
*n summar!, the %&R'& failure has not (een the result of -ust @uestiona(le activities (!
%&R'&Hs e+ecutive mana#ement team. $he cast of contri(utors to the failure and
(ankruptc! are (oth inside and outside the compan!. *tHs the total s!stem that resulted in
failure that needs to (e further understood and investi#ated.
! "roposal for the !cademic #ommunit
*f !ou the reader are still )ith me, * )ill no) endeavor to e+plain m! proposal for a
s!stematic stud! of %&R'&. *n an academic communit!, containin# the J(usiness t!pesK
and the Jli(eral studiesK, the %&R'& stor! need not (e -ust of interest to the J(usinessK
side. Les, the facult! of mana#ement, finance, accountin# and mana#ement information
s!stems can stud! %&R'& for insi#hts and lessons a(out ho) corporate value can (e
destro!ed, and )hat can (e learned to prevent similar situations. ut * see a (rid#e in the
%&R'& stor! )ith links to the li(eral studies in the areas of economics, #overnment,
human ps!cholo#! and le#al studies, at a minimum. ,! proposal is simpl! to esta(lish a
series of defined )orkshops to e+plore all the dimensions of the %&R'& failure, in order
to focus on the relevant issues and understand the s!stem in )hich an %&R'&3t!pe
situation can occur. $he (enefits can (e:
/.= to (rin# the t)o sides of the facult! to#ether to e+plore a common fascinatin# stor!,
2.= to provide a mechanism for sho)in# the students the multi3faceted operation of
(usiness mana#ement and li(eral studies disciplines in our societ!,
3.= as a means to potentiall! reach the )ider mem(ers of the academic and (usiness
communities interested in learnin# more a(out this fascinatin# and distur(in# failure
of a (usiness enterprise.
Possi(le topics for the seminars>research are as follo)s:
/. Accountin# for 8P%Hs and use of off3(alance sheet financin#. Facult! leaders from
Accountin# and Finance departments.
2. Anal!sis of common stock valuation and determination of de(t credit ratin#s after the
%&R'& e+perience. Facult! leaders from Finance department.
3. %valuation of corporate strate#! chan#es at %&R'& and its lessons. Facult! leaders
from ,ana#ement and usiness Polic!.
7. Arthur Andersen: ,ana#ement 8hills or *nvestor GuardiansE Facult! leaders from
Accountin#>Auditin# and Finance departments.
2. %valuation of "orporate Governance failures at %&R'& and possi(le improvements.
Facult! leaders from ,ana#ement and 'r#aniGation $heor!.
?. %+ploration of human factors, emplo!ee responsi(ilit! and individual ethics in
(usiness. Facult! leaders from ,ana#ement and Ps!cholo#! departments.
;. Government re#ulation of (usiness and corporate ta+ policies after the %&R'&
e+perience. Facult! leaders from %conomics and $a+ Accountin# departments.
1. $he role of the le#al s!stem in the post3%&R'& era. Facult! leaders from the 6e#al
8tudies department.
* hope that this endeavor mi#ht pi@ue !our interest and support.
//
R%F%R%&"%8
/$ New %or& 'imes ne)spaper, various dates
2. Washin(ton "ost ne)spaper, various dates
3$ Houston #hronicle ne)spaper, various dates
7. 8ecurities and %+chan#e "ommission, "ivil Action "omplaint &o. 43033007?,
,arch, 2003, 4ouston, $M
2$) "owers Report of the *pecial Investi(atin( #ommittee)+ su(mitted to the oard of
Directors, %&R'& "orporation, Fe(ruar! /, 2002.
/2