“Enron: When People Who Commit Fraud Think It’s Fun” A Research Paper on the Enron Scandal BMGT289D – Frauds, Scams, & Thefts Professor Elizabeth Folsom By: Andrew Podob Podob 2 Life-long citizens, and soon-to-be immigrants alike, see the United States of America as the foremost and leading beacon for opportunity in the world. The ‘American way’, as many have termed it, is the ease with which one can start a business, pull themselves up by their own bootstraps, and live the American dream. Black or white, male or female, young or old, anyone can set out on that noble, wholeheartedly American, journey to prosperity. With that journey in mind, the narrative of Enron Corporation begins in 1985 with the purchase of the Texas-based company Houston Natural Gas by the Nebraska-based pipeline company InterNorth (Bryce, 2002, p. 31). Working out the details, the new company would be headquartered in Houston, Texas and fall under the leadership of HNS’s Chief Operating Officer, a man named Kenneth Lay. The new venture would be called Enron. As CEO of the new Enron, Lay had the power to bring along an inner-circle of executives he knew comfortably. From the beginning though, the new company was not on solid footing. As part of the final merger agreement, InterNorth agreed to absorb HNG’s debt—a whopping $4.3 billion worth. Furthermore, the deal failed to address the five-percent of shares a corporate-raider from Minnesota named Irwin Jacob now owned in the new Enron. He had to be bought out for $357 million—in cash (p. 33). Even with the shaky and uncertain beginning, Enron got off its feet more quickly than most companies its size. Enron was a publicly traded company, and with the help of deregulation in the late 1980s, its shares took off by the mid-1990s. In the year 2000, Enron had over $63.4 billion in assets on its balance sheets and reported making $7.23 billion from its derivatives business alone (p. 5-6, 241). Everything was not rosy and shiny though. The house of cards, the rollercoaster ride the shareholders and employees would be taken on, and the financial dire straights—all examined later in this paper—took the company stock price from almost one- hundred dollars a share around the year 2000 to less than a dollar a share when it declared Chapter 11 bankruptcy in December 2001. Yes, with shock and awe, that was stated correctly. The closing price on January 25, 2001, at the end of day’s trading was $82.00 (p. 245). On December 3, 2001, eleven month later, the closing price was $0.40 (p. 339). The aforementioned case paper is not a summary of the Enron scandal, with a long list of facts, figures, and explanations; rather, it is a critical and in-depth analysis of the case, presenting insights into the role different aspects of the fraud played, commentary on responses to the case, and suggestions for future prevention and detective measures. Ultimately, it would be near impossible to discuss, explain, highlight, and outline the entire Enron scandal from A-to-Z in one short and concise paper. The two books this author is using to research the topic have more than eight hundred and thirty pages when combined. Therefore, this paper is written under the assumption the reader has at least a brief understanding of the Enron case, a brief understanding of how corporate culture works, access to both books, and a brief understanding of accounting and finance practices at companies. Instead of spending more valuable page real estate narrating Enron’s history and giving a day-by-day account into the companies’ downfall, it is best to analyze the fraud using the many methods taught in the BMTG289D classroom. In the arduous process of analysis, the necessary facts and figures will be supplied and referenced when needed. Podob 3 An important place to examine is Enron’s leadership structure. Ken Lay, who helped found the company, was CEO and simultaneously Chairman of the Board of Directors. Jeffrey Skilling, one of Lay’s most important hires, was Enron President. Other executives in the company included the Chief Financial Officer Andrew Fastow, Vice-Chairman J. Clifford Baxter, Chief Accounting Officer Rick Causey, and CEOs of Enron subsidiaries Lou Pai and Rebecca Mark. There were numerous other characters at play in this case. In addition to the management group, as a publicly traded company, Enron had a Board of Directors with sixteen seats. Members of the management team, including the CEO, CFO, Managing Directors, and Vice Presidents were supposed to run the day-to-day operations of Enron, while reporting to the Board of Directors, whose main role is to protect shareholders and ensure the overall solvency of the company. At Enron, operations did not always flow in that manner. Although it was a publicly traded company, and therefore was not wholly owned by any one executive, Ken Lay was known to walk around as if he owned the place (McLean & Elkind, 2003, p. 90). In addition, numerous conflicts of interest existed between board members and Enron. Out of sixteen, some were employees, and only three of the board members were independent of Enron. Of those three, all three were friends of Ken Lay (Bryce, 2002, p. 161). Herbert Winokur, a board member since 1985, owned a company that did business with Enron, and lots of it. According to Bryce (2002), “between 1997 ad 1999, [his] company had sold Enron more than $2.1 million worth of goods and services” (p. 164). Another board member, John Urquhart, earned a stipend for sitting on the board, but was also being paid as a so-called Senior Advisor to the Chairman. Between 1991 and 1999 he was paid over $7.4 million in consulting fees (p. 165). Another board member, Joe Foy, was a retired partner from the Houston law firm that did legal work for Enron (p. 167). Foy was not paid an advisor fee the way Urquhart was, but it is still a clear conflict of interest. A fourth board member, Robert Belfer, was asked to be on Enron’s board in the 1980’s after selling his oil and gas company to Enron. He also owned over 8.4 million shares of Enron stock (p. 166). So much for choosing people independent of Enron. Perhaps the largest conflict of interest was from the only female member of the board. For five years, a woman named Wendy Gramm sat on Enron’s board (p. 166). It is doubtful many know who she is, but more likely many know of her husband—United States Senator Phil Gramm, a Republican from Texas, who served from 1985 to 2002. Besides paying Wendy about $1 million during her tenure on Enron’s board, Enron gave over $25,000 to Phil’s political campaign (p. 84). Even more interesting, Senator Gramm chaired the Senate Banking Committee, the committee with jurisdiction over the writing of regulations for companies likes Enron. According to Bryce (2002), “when a commodities regulation bill came up in the Senate that had a direct effect on Enron’s massive derivatives trading business, Phil Gramm sponsored it” (p. 240). When a bill entitled The Commodity Futures Modernization Act of 2000, which gave Enron a so-called ‘exception’ from oil and energy derivative regulation passed the Senate, it went through Gramm’s committee. Adding a cherry to the ice cream sundae, the chair of the federal body that implemented the exception was chaired by none other than Wendy Gramm (p. 240- 241). Things apparently really do go full circle. It’s nice knowing people in high places. Podob 4 Addressing the conflicts of interests simultaneously, even omitting some due to sheer volume, many questions are left to ponder. Possible questions include: Which values did board members rely upon to vote during meetings? Their wallets, their jobs, or the shareholders? How can the board operate in honest and fair ways, ensuring shareholders receive the best return on investments, when decisions made directly affected board member wallets, careers, and business dealings? What board member would openly vote against a company that pays their salary, does business with their company, or donates money to their spouse’s political campaign? The Enron scandal is a unique case study because the company unraveled so quickly. Although brewing for over a decade, the fall of Enron to junk bond status took less than one year, from seemingly perfect solvency to Chapter 11 bankruptcy. The unraveling began in 2000 when Enron switched the majority of its operations over from a pipeline-based business that transported gas and electricity to a trading business (p. 215). Jeff Skilling and others figured: “derivatives were already common on Wall Street, but no one was using them in the natural gas business” (McLean & Elkind, 2003, p. 37). Why not get involved in a business nobody else was involved in? There were boatloads of money to be made. But trading derivatives in natural gas, a 24-hour business, was much more complicated than it seemed. After taking large positions in these sophisticated markets, Enron began having cash flow problems, as they could not seem to make enough ‘actual’ money to cover high overhead, high executive compensation, and other costs. Skilling knew that if Enron’s moneymaking problems went public, as part of its quarterly earnings report, the stock price would tumble. A remedy approached in the name of CFO Andy Fastow. It is understood that Enron created off-the-balance-sheet special purpose entities to conceal heavy losses.