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What Happened and

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Loans and credit facilities contained credit rating payment clauses. If Enron's credit rating fell below a set level payment would become due immediately ... – PowerPoint PPT presentation

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Title: What Happened and


1
Learning From Enron
  • What Happened and
  • What Does it Mean for Managers?
  • Chuck Daly

2
Learning from Enron
  • What happened inside Enron?
  • Corporate practices
  • Why did Enron fail?
  • File for bankruptcy
  • What are the Government Agency Responses?
  • What does it mean for managers

3
Scope Issues left for another day
  • Enron illustrates the requirements and failings
    of Federal securities regulations
  • Critique of specific audit practices
  • ERISA (401k programs)
  • Stock options
  • Securities analysts practices

4
Learning from Enron
  • Federal securities laws reporting and disclosure
    requirements
  • Securities Act of 1933
  • Securities Exchange Act of 1934
  • Generally information collection and
    dissemination
  • Primary requirement is to update financial
    information on scheduled, timely basis
  • Reporting standard companies are responsible for
    reporting material facts and for omissions of a
    material facts
  • Also contains a duty to correct

5
Enron The Company and its Operations
  • Created by the merging of two pipeline companies
    in the mid-1980s
  • Moved slowly away from its hard-assets roots
  • From pipelines and energy plants
  • To transmission and energy trading
  • To innovative commodities trader (energy,
    bandwidth, advertising time/space)

6
Enron Problematic Practices
  • Accounting Special Purpose Entities (SPEs)
  • Non-compliance with FAS 57
  • Used for hedging transactions
  • Used to accomplish asset sales
  • Leveraging the Company
  • To finance operations
  • Guaranteeing Obligations of SPEs
  • Enrons Culture (Advancement and Incentive
    Plans)
  • Promoted Greed Culture
  • Encouraged employees to hide problems

7
Enron Special Purpose Entities
  • What are SPEs?
  • Traditionally used by finance companies for
    securitization
  • Also used to isolate risky assets (aircraft
    leasing, real estate development)
  • In late 1990s many companies used SPEs to
    accelerate revenue recognition
  • Several additional companies suffering from SPE
    use similar to Enron
  • Xerox (currently being investigated by the SEC),
    Global Crossing, Adelphia, Tyco International

8
Enron Special Purpose Entities
  • Governed by Financial Accounting Standard 57
  • Allows SPEs to be kept off the balance sheet if
  • Outside owner invests equity capital for a 3 or
    greater share of the SPE
  • Outside owner exercises control over the SPE
  • If both criteria are met, gains and losses from
    transactions with the SPE can be recorded
  • Assets and liabilities of the SPE are not
    consolidated

9
Enron Special Purpose Entities
  • How did Enron Use SPEs?
  • To circumvent accounting rules
  • To boost revenues
  • To hide investment losses (hedging with itself)

10
Enron Special Purpose Entities
  • 2000 Annual Report illustrates use of SPEs
  • Note 9 discloses investments in SPEs and shows
    revenues of 510 million
  • 510 million is more than 30 of Enrons net
    income for 2000

11
Enron Special Purpose Entities
Chart From Financial Times, FT.com
12
Enron Special Purpose Entities
  • Example
  • Joint Energy Development Investment (JEDI)
    (formed in 1993)
  • Properly established with CalPERS as controlling
    50 partner
  • Enron records gains from transactions with JEDI
    but does not consolidate JEDIs debt on its
    balance sheet
  • 1997 CalPERs wants to cash out
  • Enron needs a new partner to avoid consolidating
    JEDI on it balance sheet
  • Enron executives form Chewco
  • Chewco invests borrowed capital (Enron guarantees
    Chewco debt)

13
Enron Special Purpose Entities
  • Success of JEDI and Chewco inspire additional
    SPEs
  • New SPEs used to
  • Sell hard assets to increase income
  • Engage in hedging transactions

14
Highly Leveraged for Operations
  • 2000 Annual report shows a debt load of 37
    billion (up from 14 billion in 1999)
  • Many lending agreements containing debt reduction
    triggers

15
Loan Guarantees and Debt Reduction Triggers
  • Enron made promises to lenders to secure capital
    for itself and SPEs
  • Loans and credit facilities contained credit
    rating payment clauses
  • If Enrons credit rating fell below a set level
    payment would become due immediately
  • Pledged stock and options to secure borrowings
    for SPEs

16
  • Incentive Plans
  • Cultivating Greed
  • compensation plans tightly geared to stock price
  • incentive to promote earnings growth and stock
    price
  • Employees focused on earnings growth instead of
    business lines or products

The Enron Culture
17
  • Advancement Practices
  • Corporate Culture Promoted Self-Interest
  • Bottom 20 of performers forced out
  • Incentives based on Enrons earnings per share
    (rewarded with stock options)
  • Practices led to
  • Following the letter but not the spirit of FAS 57
    (and sometimes not the letter)
  • Sold assets to SPEs, transferred stock to SPEs to
    cover debts, and guaranteed loans to SPEs

The Enron Culture
18
Why did Enron file for bankruptcy?
  • Greed on a spectacular scale
  • Following resignation of Jeff Skilling, Enron and
    Arthur Andersen pulled the plug on certain SPEs
  • originally deemed to satisfy the requirements for
    off-balance sheet treatment
  • review led to recategorizing SPEs and restating
    income and debt

19
Why did Enron file for bankruptcy?
  • The beginning of the end
  • October 16, 2001
  • 544 million after-tax change related to SPEs
    being consolidated
  • reduced shareholder equity by 1.2 billion
  • November JEDI and Chewco arrangement exposed
  • forced consolidation of JEDI financials
  • Enron financials for 1997-2001 restated
  • increased reported debt by 711 million in 1997,
    561 million in 1998, 685 million in 1999, and
    628 million in 2000

20
Why did Enron file for bankruptcy?
  • Increase in reported debt from JEDI and Chewco
    led to reexamination of Enrons debt rating by
    Moodys and SP (downgraded to barely investment
    grade)
  • Moodys and SP further downgrade Enron's debt to
    junk
  • Downgrading trips debt triggers in Enron loans
    (4 billion becomes due immediately)

21
Lessons for Managers
  • Liability under Federal securities laws
  • Changes in business practices (regulations)

22
Lessons for Managers Liability
  • Federal Securities Laws
  • Primarily Section 10b of the Securities Exchange
    Act of 1934
  • Section 13(b)(2) for directors and officers
  • Criminal
  • Sections 13(b)(4)-(7), 24 and 32 knowing and
    willful standards
  • Criminal fraud
  • Possible prison sentences (new federal law allows
    for up to 10 years for a fraud of over 100
    million)

23
Lessons for Managers Federal Securities Laws
  • General Scheme of Anti-fraud
  • Designed to promote disclosure
  • Section 10b (anti-fraud)
  • Common Pitfalls
  • Management Discussion and Analysis
  • Financial Reporting

24
Changes in Business Practices through Regulations
  • Corporate
  • Record keeping and Corporate Governance
  • Accounting - FAS 57
  • Securities and Exchange Commission Rules
  • Reporting Requirements
  • Enforcement Authority
  • Lending Practices - reporting of debt triggers

25
Lessons for Managers Reform Proposals
  • Likely to see a reaction similar to the
    Investment Banking scandal in the late 1980s
  • Greater oversight by regulators
  • Codification of best practices

26
Lessons for Managers Corporate Reform Proposals
  • Greater oversight by Corporate Boards
  • Changes in auditing and reporting practices
  • Could see requirements for higher percentages of
    independent directors on corporate boards
  • Increased influence of audit committees and
    information flow to and through audit committees

27
Lessons for Managers Accounting Reform Proposals
  • Overhaul Financial Accounting Standard 57
    (inclusion of partnership interests)
  • Valuation of intangible assets
  • Greater disclosure of derivatives positions

28
Lessons for Managers SEC Reform Proposals
  • Increased monitoring of accounting practices and
    financial statements
  • longer review of proxy statements
  • more thorough review of securities registrations
  • Stronger penalties

29
Lessons for Managers Lending Reform Proposals
  • Require debt triggers to be reported to rating
    agencies
  • Require debt guarantees to be reported to rating
    agencies

30
Learning From Enron
  • What Happened and
  • What Does it Mean for Managers?
  • Chuck Daly
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