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I.

Company Background/Information

Enron Corporation was an American energy company located in Houston, Texas. Enron

began as a gas pipeline company in the days when natural gas prices were federally regulated

(Regan, 2005). Enron vision was to be the number one company in the world with its tagline

“From the World Number One Energy Company” to “The World Number One Company”. Aside

being leading electricity company, Enron’s other product line included natural gas, pulp, and

paper and communication companies with claimed revenues of $ 111 billion in 2000.

Enron had its started in Omaha, Nebraska, under Northern Natural Gas Company which

was formed in early 1930’s. After a more than 50 years of operation, Natural Gas Company

established the InterNorth, which served as holding company, and suddenly purchased the

Houston Natural Gas in 1985. During this time, Kenneth Lay was former CEO of Houston

Natural Gas and then named as new CEO of the merged company.

In the 1980s, energy corporations lobbied Washington to deregulate the business.

Companies including Enron said the extra competition would benefit both companies and

consumers. Washington began to lift controls on who could produce energy and how it was

sold. New suppliers came to the market and competition increased. Enron saw its chance to

make money out of these fluctuations. It decided to act as middle man and guarantee stable

prices - taking its own cut along the way.

However, those changes in the regulation led to an increased use of spot market

transactions. By 1990, 75 percent of gas sales were transacted at spot prices rather than

through long-term contracts (Palepu & Healy, 2003). Deregulation resulted in much more

volatile gas prices for both producers and utilities. Table 1 portrays the impact of the

deregulation.

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Enron certainly wasn't the only company lobbying for energy deregulation, but

deregulation helped Enron establish the trading markets that became its core business.

Directors built relationships with both Democrats and Republicans. Kenneth Lay himself had

strong personal ties to two Republican presidents, George Bush Sr. and his son, George W

Bush. As Enron expanded, there was little scrutiny of how it was managing the expansion.

Kenneth Lay had been anxious to expand the business right from the word go. Jeff

Skilling, an ambitious thinker from the world famous consultancy firm McKinsey, offered a way

to do it. Skilling believed that Enron could profit from trading futures in gas contracts between

suppliers and consumers - effectively betting against future movements in the price of gas-

generated energy. Buyers and sellers use futures markets to get what they hope will be a better

deal on commodity prices than they would do on the open market. Enron offered to do the same

with gas by buying and selling tomorrow's gas at a fixed price today. In the deregulated energy

world, it appeared to make sense to many suppliers and industry consumers who took up the

offer. The new Enron was emerging.

Table 1
Energy Deregulation in US
Sector Before After Impact
Utilities owned Mixed. Critics attack
Generating Plants sold; New owners
stations and sold removal of strategic
Power compete to sell to utilities
directly to customers planning
Monopolies tightly Utilities compete to win Enron and others created
Distributing
controlled to protect consumers and contracts new markets focusing on
Power
consumers on basis of price energy trading
Special commissions
Market competition Mixed political reaction;
Regulating monitor prices
theoretically to set prices, some legislators opposed
the Industry charged to
but some controls remain unhindered markets
consumers

In a few short years, Enron became a massive player in the US energy market,

controlling at its height a quarter of all gas business. Buoyed by the success, the company went

on to create markets in myriad energy-related products. Enron began to offer companies the

chance to hedge against the risk of adverse price movements in a range of commodities

including steel and coal. By the end of the decade it had expanded its trading arm to include

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hedging against external factors such as weather risk. Enron was not the only company in the

game but through its Enron online trading arm it was becoming the biggest on what was dubbed

Energy Alley - 90% of its income came from trades. Jeff Skilling wanted to rid Enron of its last

physical assets but the company was also expanding internationally, moving into water in the

UK and power generation in India. In 1998, Enron expanded their business into water and

wastewater services by investing in Azurix Corporation in UK, which was part-floated on the

New York Stock Exchange (NYSE) in June 1999. Azurix failed to break into water utility market,

and one of its major concessions in Buenos Aires was a large scale money loser. Enron

pronounced their intention to break up Azurix and sell its assets.

Enron began 2000 with a plan to move into broadband internet networks and trade

bandwidth capacity as the dot.com and related derivatives as tradable financial instruments,

including exotic items such as weather derivative Enron’s economy prospered. Enron's dynamic

ideas, coupled with its stable old-economy energy background, appealed to investors and the

share price soared. It was one of the first amongst energy companies to begin trading through

the internet, offering a free service that attracted a vast amount of custom. Because of original

concept and pioneering, Enron was named “America’s Most Innovative Company” by Fortune

magazine for six consecutive years from 1996 to 2001. Enron was admired by many, including

labor and the workforce as an overall great company because of their large long-term pensions

benefit and extremely effective management. In fact, Enron was on the list of Fortune’s “100

Best Companies to Work for in America” in 2000. But while Enron boasted about the value of

products that it bought and sold online – a mind-boggling $880bn (£618bn) in just two years –

the company remained silent about whether these trading operations were actually making any

money. At about this time, it is believed that Enron began to use sophisticated accounting

techniques to keep its share price high, raise investment against it own assets and stock and

maintain the impression of a highly successful company. Enron could also legally remove losses

from its books if it passed these “assets” to an independent partnership. Equally, investment

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money flowing into Enron from new partnerships ended up on the books as profits, even though

it was linked to specific ventures that were not yet up and running. One of these partnership

deals was to distribute Blockbuster videos by broadband connections. The plan fell through, but

Enron had already posted some $110m venture capital cash as profit.

Since then, Enron became a popular symbol of willful corporate fraud and corruption.

Their corporate directors and officers headed by Kenneth Lay and Jeff Skilling sentenced into

jail and needed to settle the suit by paying significant amounts of personal money.

Enron still exist as an asset less Shell corporation after their bankruptcy. The fall of

Enron is considered to be one of the biggest and most bankruptcy cases in the US history.

Enron Corporation will be dissolved at the conclusion of the restructuring process which was

completed on September 7, 2006.

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II. Financial Highlights

Prior to its collapse in late 2001, Enron was perceived by most analysts and investors as

a company that could do no wrong. The market considered Enron's management talented and

aggressive, and its business model cutting edge and innovative. Investor demand for the

Company's stock soared, pushing its stock price from almost $7 per share in 1990 to over $83

per share a decade later. As Figure 1 indicates, much of the stock price increase actually

occurred between October 1997 and September 2000. In fact, for all of 2000, Enron's stock

even outperformed the NASDAQ composite index which began to stumble as technology

retreated (Catanach & Catanach, 2003).

Figure 1
Enron Stock Price Performance vs. NASDAQ Composite Index
October 1997 - January 2001

Catanach & Catanach (2003) analyzed that Enron's reported earnings increased

eightfold between 1997 and 2000. Enron’s net income in that period was $979 million in 2000

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compared to $893 million in 1999, and $703 million in 1998. Net income before item impacting

comparability was $1,266 million, $ 957million and $698 million, respectively in 2000, 1999, and

1998. The result of company’s performance of Enron was come from its five operating business

segment with includes from Transportation and Distribution, Wholesales Services, Retail Energy

Services, Broadband Services, and Corporate and other.

Table 2
Schedule of Enron's Revenue from 1998 to 2000
2000 1999 1998
(in millions Dollar)

After-tax results before items impacting


1266 957 698
comparability

Items impacting comparability:

(326
Charge to reflect impairment by Azurix -
) -

Gains from TNPC, Inc.(The new Power 3


-
Company), net 9 -

3 4
Gains on sales of subsidiary stocks -
45 5

(2 (40
MTBE-related charges -
78) )

(1
Cumulative effect of accounting changes - -
31)

Net Income 979 893 703

Table 3 shows the operating expense of Enron including depreciation and amortization

decreased by $230 million in year 2000 compared to last year increased of expenses $1,048

including the effects of impairment loss on long lived assets. Enron Financial Report 2000

discussed the increased of expenses which primarily as a result of higher overhead cost related

to information technology and employee benefits. On the other hand, a decrease in operating

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expense was the result of the expiration of certain transition cost recovery surcharges which

had been recovered through revenues.

Table 3
Schedule of Enron's Operating Expenses from 1998 to 2000
2000 1999 1998
(in millions Dollar)

Operating Expenses 3184 3045 2473


Depreciation and amortization 855 870 827
Taxes and other income taxes 280 193 201
Impairment of Long Lived Assets 441

Total Operating Expenses 4319 4549 3501

The financial condition of Enron through it summary cash flow is presented in Table 4.

Net cash provided by operating activities increased $3,551 million in 2000, primarily reflected

decrease in working capital, positive operating results and a receipts of cash associated with the

assumption of contractual obligation. Net cash provided by operating activities decreased $412

million in 1999, primarily reflected increases in working capital and net assets from price risk

management activities, partially offset by increased earnings and higher proceeds from sales of

merchants assets and investment. The 1998 amount reflected a positive operating cash flow

most probably as a result from proceeds from sale of interest in energy related merchant assets

and cash from timing and other changes related to Enron’s commodity portfolio, partially offset

by new investment in merchant assets and investments.

Net cash used in investing activities primarily reflected capital expenditures and equity

investment, which total $3,314 million in 2000, $3,085 million in 1999 and $3,564 million in

1998, and cash used for business acquisitions. Partially offsetting these uses of cash were

proceeds from sales of non-merchant assets.

Cash provided by financing activities in 2000 included proceeds from the issuance of

subsidiary equity and issuance of common stock related to employee benefits plans, partially

offset by payment dividends. Cash provided by financing activities in 1999 included proceeds

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from the net issuance of short and long term debt, the issuance of common stock and the

issuance of subsidiary equity partially offset by payments of dividends. Cash provided by

financing activities in 1998 included proceeds from the issuance of short and long term debt, the

issuance of common stock and the sale of minority interest in subsidiary, partially offset by

payment of dividend.

Table 4
Summary of Enron's Cash Flow 1998 to 2000
2000 1999 1998
(in millions Dollar)

Cash provided by (used in):


Operating activities 4,779 1,228 1,640
Investing activities (4,264) (3,507) (3,965)
Financing activities 571 2,456 2,266

Furthermore, Figure 2 illustrates a graphical representation of Enron reported operating

performance in the last four years of the decade were a marked improvement over the

preceding six years. However, Figure 2 also highlights an interesting development in Enron's

performance measures. Four financial indicators are commonly used to evaluate corporate

performance: income before extraordinary items (IBE), cash flow from operations (CFO),

comprehensive income (CI), and free cash flow (FCF). According to Figure 2, these measures

generally moved in tandem between 1991 and 1996 and within a narrow range. But in 1997,

these four indicators not only diverged dramatically, but also appear to have increased in

volatility.

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Figure 2
Enron Operating Performance 1991-2000

Between 1993 and 1996, Enron and the California Public Employees' Retirement

System (Calpers) were 50 percent joint-venture partners in the Joint Energy Development

Investments Limited Partnership (JEDI). Enron (the general partner) and Calpers (the limited

partner) each initially contributed $250 million to JEDI to fund a variety of investment

transactions (Powers et al., 2002). Because Enron did not have a controlling interest (greater

than 50 percent) in the limited partnership during this three year period, JEDI's assets and

liabilities were not required to be included in the Company's balance sheet. Additionally, Enron

recognized income (or loss) for JEDI only to the extent of its ownership percentage (50 percent)

as required by APB No. 18.

In 1997, Calpers sought to liquidate its investment in JEDI in order to pursue another

investment opportunity. To accommodate Calpers' wishes, Enron created a new investment

partnership to purchase Calpers' investment 50 percent limited partner investment. This new

partnership, Chewco Investments LP (Chewco), was funded with $383.5 million from the

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following sources: a $240 million unsecured subordinated loan to Chewco from Barclays Bank

PLC (guaranteed by Enron), a $132 million advance from JEDI to Chewco under a revolving

credit agreement, and $11.5 million in equity from Chewco's general and limited partners (Big

River LLC and Little River LLC). Chewco then purchased Calpers' interest with these funds.

JEDI continued to be reported as an unconsolidated entity at the end of 1997. This treatment

was based on the assertion that Chewco owned 50 percent of JEDI, thus precluding Enron from

having a "controlling interest" which would trigger consolidation of JEDI. Accordingly, Enron

continued to record 50 percent of JEDI's income and losses in its income statement.

However, several Enron related loan guarantees associated with the initial funding of

Chewco made this treatment inappropriate. When Chewco was initially formed as an SPE,

Enron carefully crafted its capitalization such that it would not have to be consolidated into

Enron's financial statements either. Enron made sure that Chewco's investors (Big River LLC

and Little River LLC) appeared to meet the 3 percent "at risk" provisions of EITF 90-15.

However, the investors' entire $11.5 million investment was funded by Barclays Bank PLC,

which required that $6.6 million of the loan be secured by a reserve provided by JEDI. Since

Enron owned 50 percent of JEDI, Enron effectively guaranteed $3.3 million of the Chewco

investors’ contribution. This meant that the investors in reality had less than 3 percent of their

monies "at risk" thus failing EITF 90-15's test. Moreover, since Enron guaranteed most of

Chewco's debt and also shared in substantially all of Chewco's risks and rewards, EITF 90-15

required that Chewco be consolidated into Enron's financial statements. Requiring Chewco's

consolidation results in Enron (the consolidated entity) now owning (and controlling) 100 percent

of JEDI. Therefore, JEDI should have been consolidated with Enron as well.

The effects on Enron's balance sheets and income statements were dramatic. As

indicated in Table 5, net income and stockholders' equity were overstated by a total of $405

million between 1997 and 2000 by the failure of Enron to properly consolidate both JEDI and

Chewco in its financial statements. Failure to correctly apply EITF 90-15 also resulted in an

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understatement of liabilities on Enron's balance sheet by amounts ranging from $561 million to

$711 million during the same period.

Table 5
Summary of Enron's Accounting and Reporting Adjustments (000's)

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III. Company’s Use and Policy on Financial Derivatives

Under Skilling’s prodding, Enron eventually began trading not only gas, but the contracts

to buy and sell gas at certain prices. These contracts essentially were derivatives, financial

instruments whose prices were based on the underlying price of gas (Regan, 2005). To ensure

delivery of its contracts and to reduce exposure to fluctuations in spot prices, Enron entered into

long-term fixed price arrangements with producers, and used financial derivatives, including

swaps, forward and future contracts (Palepu & Healy, 2003). This gave natural gas users a

measure of predictability by allowing them to lock in maximum prices for the gas they needed to

purchase. In these transactions, Enron acted not only as broker, but actually took possession of

gas in order to meet its contractual obligations to deliver it. Enron therefore had to hedge its own

risk that it might have to acquire gas to meet its commitments at prices higher than the prices it

would be receiving under its contracts with utilities. It did so by entering into contracts with gas

producers that set the maximum prices that Enron would have to pay (Regan, 2005). It also

began using off-balance sheet financing vehicles, known as Special Purpose Entities, to finance

many of these transactions. In total, Enron had used hundreds of special purpose entities by

2001. Many of these were used to fund the purchase of forward contracts with gas producers

that were used to supply gas to utilities under long-term fixed contracts (Krugman, 2002, as

cited in Palepu & Healy, 2003).

To create the market in natural gas derivatives, Skilling urged Enron set up a “gas bank.”

Much as traditional banks intermediate funds, Enron’s GasBank intermediated gas purchases,

sales, and deliveries by entering into long-term, fixed-price delivery and price risk management

contracts with customers. Soon thereafter, other natural gas firms began to offer clients similar

risk management solutions. And those producers, in turn, also came to Enron for their risk

management needs—that is, to “swap” the exposure to falling prices they created by offering

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fixed-price forwards to customers back into the “natural” exposure to price increases those

producers had before offering their customers fixed-price protection (Culp & Hanke, 2003).

Over the course of the 1990s, Enron had become a major player in energy futures

markets, and though this may have been profitable, it increased Enron's vulnerability. When

companies sell futures, they are promising to deliver a commodity to their customer at a future

date. This entails risk for the customer, since there is no guarantee that the selling company will

be in a position to meet its obligation when the future delivery date arrives. As a result, only

companies with solid credit ratings and a reputation for reliability can play in derivatives markets

in any substantial way. If one's credit rating declines, counter-parties demand more collateral

before entering into trades, making extensive trading prohibitively expensive. Unfortunately for

Enron, nothing drives down one's credit rating faster that large-scale borrowing. Thus, Enron's

cash-hungry diversification strategy posed enormous risks to Enron's critical energy trading

business (Kroger, 2005).

As an energy supplier, Enron also wanted to have comparative advantage in timing the

market for its product. Enron tried to eliminate the risk regarding the price and unusual weather

that could increase the demand by using weather derivatives (Baird and Rasmussen, 2002).

Enron began its weather derivatives market in 1997. It was the contract between Enron Capital

and Enron Trade Resources (ETR) and an eastern US electric utility.

From its Financial Statements for the year ended December 31, 2000, Enron noted its

entering into derivative transactions with the newly-formed entities with a combined notional

amount of approximately $2.1 billion to hedge certain merchant investments and other assets.

Enron's notes receivable balance was reduced by $36 million as a result of premiums owed on

derivative transactions. Enron recognized revenues of approximately $500 million related to the

subsequent change in the market value of these derivatives, which offset market value changes

of certain merchant investments and price risk management activities. In addition, Enron

recognized $44.5 million and $14.1 million of interest income and interest expense, respectively,

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on the notes receivable from and payable to the newly-formed entities. Table 6 will capture

Enron’s use of weather derivatives.

Table 6
Option-Contract Offers and Swap-Contract Bid from Enron
Reduced Tick
Basic Floor Lower Strike Swap
Size
Option Type HDD* Floor HDD Floor HDD Floor HDD Swap
Notional Amount $35,750/HDD $35,750/HDD $35,750/HDD $35,750/HDD
Effective Date Nov. 1, 2000 Nov. 1, 2000 Nov. 1, 2000 Nov. 1, 2000
Premium Payment $1,338,000 $1,253,641 $230,745 N/A
Nov. 1, 2000 – Nov. 1, 2000 – Nov. 1, 2000 – Nov. 1, 2000 –
Determination Point
Mar 31, 2001 Mar 31, 2001 Mar 31, 2001 Mar 31, 2001
Strike Amount 2925 2925 2771 3035
Cap $14,588,000 $15,265,000 $14,588,000 $14,588,000
Note: HDD = Heating Degree-Days

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IV. Identification and Discussion of Financial Events/Disasters Faced by Enron

Prior to Enron’s exposure to financial derivates in the early 1990s, at that time when the

company’s income was mainly from its gas pipeline operations, the recognition of earnings and

the resulting cash flows were mostly aligned (Moffett, 2004). However, the establishment of Jeff

Skilling’s gas bank, in which led to the creation of their own gas futures market, made it possible

for the company to recognize mark-to-market (MTM) gains in the accounting books even without

the actual cash flows from these trading operations. The company’s expansion to derivatives

trading was an indication that Enron’s was changing its core competence strategy. Its expertise

was not limited anymore to building and operating natural gas pipelines and power plants, or

even to the trading of natural gas and electric power. Its self defined competence was simply in

trading. The evolving strategy was to create markets where markets had never existed, exploit

them for all they were worth, and when profits declined with increasing competitor entry, move

on the next cutting edge market creation (Moffett, 2004).

The J-Block Contract

Enron's extended leg room in the over-the-counter market brought it trouble almost

immediately. In 1993, TGT, an Enron subsidiary in Great Britain, entered into a "take or pay"

contract with companies pumping natural gas from the J-Block field in the North Sea. A take-or-

pay contract is a form of derivative for the actual delivery of the commodity. Enron was trying to

lock down a long-term price for gas from the J-Block field, even though the pipeline hadn't been

completed yet, and agreed to take 260 million cubic feet of gas per day for 10 years to supply

one of its own power plants and to sell to others.

But when the contract matured and Enron had to take delivery, demand for natural gas

was down and the price had dropped by half--less than what Enron had agreed to pay in its

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contract. In the derivatives game, that's called tough luck--Enron should have bet the other way

on the future price of gas. The company tried to litigate its way out of the mess, valued at

$675Million, but a British court ruled that the meaning of "take or pay" was pretty clear.

Azurix

In July 1998, Enron paid $2.4Billion for Wessex, a British water utility company. The

company, like Portland General electric (PGE), was the first step in acquiring a producing

company to provide the backbone to a growth strategy of ownership, operations, and trading in

a new market. Rebecca Mark, hungry to prover her worth in an organization now under the

influence and control of Jeff Skilling, accepted the Chairman and CEO position of the newly

created water business, Azurix. Azurix’ strategy was to acquire water utility companies all over

the globe and create a consolidated giant that would be the global leader in the water industry.

In February 2000, Azurix and Rebecca Mark announced a new strategy: Azurix would become a

trading company for water rights. It was admission of failure of the utility acquisition strategy,

and in the eyes of many, and an act of desperation. But water was not a commodity by

traditional standards, and the idea simply did not fly.

Derivatives did play a role in Enron’s fall from power, but this is not the main reason for

the company’s fall (Callahan & Kaza, 2004). The Houston energy company did not go bankrupt

because it lost money in its gas futures trading. In fact, Enron was tremendously successful in

its futures trading operations, racking up billions of dollars in profits. The company went under

not because it was losing money but because it tried to use these profits to disguise heavy

losses in their failed business ventures such as the J-Block Contract and Azurix. And when

Enron’s accounting irregularities were exposed, the company’s sources of credit and cash were

also dragged. To make the long story short, the company was killed mainly due to lack of cash

flow, not a lack of profits (Callahan & Kaza, 2004).

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It is quite obvious that Enron wouldn't own up to its failure. When the company's top

executives discovered they couldn't trade water or high-speed Internet access like oil and gas,

they formed partnerships to keep losses off the balance sheets. Many of these transactions

involve an accounting structure known as a “special purpose entity” (SPE). A company that

does business with an SPE may treat that SPE as if it were an independent, outside entity for

accounting purposes if two conditions are met: (1) an owner independent of the company must

make a substantive equity investment of at least 3% of the SPE’s assets, and that 3% must

remain at risk throughout the transaction; and (2) the independent owner must exercise control

of the SPE. In those circumstances, the company may record gains and losses on transactions

with the SPE, and the assets and liabilities of the SPE are not included in the company’s

balance sheet, even though the company and the SPE are closely related. It was the technical

failure of some of the structures with which Enron did business to satisfy these requirements

that led to Enron’s restatement.

Enron’s failed businesses were shifted onto these SPEs, which triggered loans that

Enron booked as earnings. The loans were funded by Enron's investors--such as J. P. Morgan--

and backed by assets, which included a water plant and a broadband unit that Enron had

moved into the SPEs. Enron then recorded the loans as earnings on these assets in order to

again inflate its earnings commitments to Wall Street. However, as the truth about the

company’s financial health was slowly unveiling to the public, share prices for the company

slowly fell from its historical highs of $90/per share seen in August 2000 to even as low as

$0.60/share in December 2001, when the company filed for bankruptcy.

Analysis/Causes of Failures

One root cause of the fall of Enron, in all its intricacies, is simply the poor application of

risk management strategies. In the J-Block contract, Enron agreed to a long-term contract

committing it to purchase a huge amount of gas. This gas would flow from a part of the North

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Sea called J-Block, which would have been ready to come on line in 1996. The problem arose

when the spot price of gas (the underlying asset on the futures price of gas) in 1995 dropped to

levels below Enron’s agreed rate. This means that Enron will now have to sell the gas they

have committed to buy at a lower spot price. In this scenario, Enron did not hedge itself to

protect its trading activities in the event that prices of the commodities move against them.

Also, Enron would have had the option to “cut their losses” short and trim their exposures; but,

because of pride and false hopes that prices will work its way back, they held on to their

positions which ultimately resulted in a loss of $675million in 1997. On the other hand, the

failure of its Azurix water venture may have been rooted on the fact that water may not yet be

ready to be commoditized much like other products. Privatizing water systems cuts against the

notion of most people that water, as a “sacred entitlement of every human being” (McLean &

Elkind, 2004) should not be sold by a private entity for the purpose of profiting from it.

These two disasters, coupled with other Enron catastrophes, triggered its executives to

take the crooked road in financial reporting: inflating the earnings, and hiding the company’s

losses, through the use of SPEs. This resulted in an artificial rise in the stock prices of Enron,

which resulted to insider trading. Most senior executives, as Enron’s share prices have started

to dwindle, cashed out their stock options and were able to get out just before the investing

public knew about the company’s dubious internal practices.

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V. Analysis/Causes of Failures

One root cause of the fall of Enron, in all its intricacies, is simply the poor application of

risk management strategies. In the J-Block contract, Enron agreed to a long-term contract

committing it to purchase a huge amount of gas. This gas would flow from a part of the North

Sea called J-Block, which would have been ready to come on line in 1996. The problem arose

when the spot price of gas (the underlying asset on the futures price of gas) in 1995 dropped to

levels below Enron’s agreed rate. This means that Enron will now have to sell the gas they have

committed to buy at a lower spot price. In this scenario, Enron did not hedge itself to protect its

trading activities in the event that prices of the commodities move against them. Also, Enron

would have had the option to “cut their losses” short and trim their exposures; but, because of

pride and false hopes that prices will work its way back, they held on to their positions which

ultimately resulted in a loss of $675million in 1997. On the other hand, the failure of its Azurix

water venture may have been rooted on the fact that water may not yet be ready to be

commoditized much like other products. Privatizing water systems cuts against the notion of

most people that water, as a “sacred entitlement of every human being” (McLean and Elkind,

2004) should not be sold by a private entity for the purpose of profiting from it.

These two disasters, coupled with other Enron catastrophes, triggered its executives to take the

crooked road in financial reporting: inflating the earnings, and hiding the company’s losses,

through the use of SPEs. This resulted in an artificial rise in the stock prices of Enron, which

resulted to insider trading. Most senior executives, as Enron’s share prices have started to

dwindle, cashed out their stock options and were able to get out just before the investing public

knew about the company’s dubious internal practices.

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VI. Lessons Learned

The collapse of Enron is probably one of the most significant events in the history of

American business. Within six months, the company went from one of the most respected in the

United States to bankruptcy. By examining the causes of its downfall, many lessons can be

learned from that tragic event.

The corporate governance in Enron, in general, was weak in almost all aspects. The

board of directors was composed of a number of people who have been shown to be of poor

moral character and willing to conduct fraudulent activity. This was the real root of the

company’s corporate governance failure. Corporate governance relies on the state of mind and

personal relationships of the directors, not a list of empty procedures or principles. In the Enron

case, the rules were in place, but were willfully and skillfully ignored. Also, the non-executive

directors were compromised by conflicts of interest. The internal audit committee did not

perform its functions of internal control and of checking the external auditing function.

Furthermore, the company’s accounting and financial reporting function also failed. Both the

financial director and the chief executive were prepared to produce fraudulent accounts for the

company. The Enron case highlights the essential functions of non-executive directors, audit

and disclosure, as well as ethicality of management. The corporate governance mechanisms

cannot prevent unethical activity but they can at least act as means of detecting such activity

before it is too late.

Another thing is that most large companies such as Enron are allowed to manage their

own employee pension funds. However, this is a conflict of interest because the company has

an incentive to use these funds in ways that advantage the company even when they may

disadvantage employees.

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VII. Recommendations

The downfall of Enron shows the need for better financial disclosure mechanisms.

Perhaps we should institute programs to replace today’s peer reviews process involving

organizations of certified public accounts. The case seems to show that the Accounting Board

needs to establish regulations and standards that are more forthright and understandable to

ordinary people.

Improvement of employee pension fund management also needs to be addressed. First,

give workers more choice. A good way to encourage diversification is to let employees sell

company stock after one year on the job and allow those who have completed the vesting

period to roll over their 401(k) plans into an IRA. IRAs provide employees with a much greater

selection of investments. To put IRAs on equal footing with 401(k)s, IRA accounts could be

protected from bankruptcy proceedings just as 401(k)s are today. Also, make financial

information truly understandable. Most employees don’t have the time, the patience, or the

understanding to wade through the rules and regulations governing pensions. In addition to that,

many cannot afford to pay a lawyer or an accountant to figure out the best investment strategy.

What the government can do to help is to reimburse companies that provide free, independent

financial advice for their employees. It would also be good to bring together the major

accounting firms and key consumer groups to develop standardized, easy-to-understand list of

important financial information, which all publicly traded companies would be required to provide

to investors and employees annually.

Lastly, the financial irregularities should be closely scrutinized. There are two primary culprits in

the Enron case. One is the substantial financial accounting irregularities that masked Enron’s

overstatement of earnings by more than $580 million from 1997 until 2001. Another is alleged

insider-trading violations, which allowed Enron’s executives to liquidate more than $1 billion in

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Enron company stock while it was trading near its peak ($83 per share in January 2001). Also,

some stock analysts often overlook dubious accounting practices, because they have a variety

of financial stakes in the firm they are reviewing. These can include a significant equity position

or underwriting a stock offering. In the future, they should be held to a higher code of conduct

and be prohibited from trading the stock of any company on which they have issued a

recommendation in the previous 60 days. Aside from that, the government should create a self-

regulatory organization for accounting firms. This self-regulatory entity would set stringent

standards for the industry – with the authority to punish those firms that fail to meet those

standards. According to Paul Weinstein (Blueprint Magazine, March 2002), to ensure the

independence of the accounting self-regulatory organization, a user fee would be assessed on

publicly traded corporations and other institutions, like mutual funds and securities firms. A

congressionally mandated self-regulatory organization would have the tools to enforce its rules,

such as the authority to issue subpoenas and fines. Last of all, the Securities and Exchange

Commission should adopt a rule as proposed by former Chairman Arthur Levitt in 2000

(Weinstein, 2002) to place a firewall between auditing and consulting activities to forbid auditing

firms from earning other fees from their clients.

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Callahan, G., & Kaza, G. In defense of derivatives. Retrieved March 29, 2007 from

Reasononline, http://www.reason.com/news/show/29033.html.

Catanach, A. H., Jr., & Catanach, S. H. (2003). Enron: A financial reporting failure? Villanova

Law Review, 48 (4), 1057-1083.

Culp, C. L., & Hanke, S. H. (2003). Empire of the sun: An economic interpretation of Enron’s

energy business. Policy Analysis, 470.

Fleck, T., & Walltsin, B. (2002). Enron’s end run. Dallas Observer. February 7.

Kroger, J. R. (2005). Enron, fraud, and securities reform: An Enron prosecutor’s perspective.

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Mclean, B., & Elkind, P. (2004). The smartest guys in the room: The amazing rise and

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International Management.

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(2), 3-26.

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Solomon, J. (2004). Enron: A case study in corporate governance failure. Corporate

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