At one time Enron was one of the world's largest producers of natural gas, oil, and electricity. It also appeared to be one of the most profitable companies, taking shareholders from $19.10 in 1999 to $90.80 by the end of 2000. Enron's top management answered to a Board of Directors whose responsibility was to question and challenge new partnerships, ventures, and decisions within the company. On several occasions, Andrew Fastow, the company's Chief Financial Officer approached the board of directors with new investment partnerships which the board approved with very little questioning. Some of these partnerships created a conflict of interest due to the fact that Fastow was not only managing the partnerships, but he was also an investor in an outside entity that took part in buying and selling assets with Enron. Fastow was able to create and manage several of these partnerships while still maintaining his role as CFO of Enron. This was due to the rule set in place by the Financial Accounting Standards Board (FASB) which states, "if an outside investor puts in 3 percent or more of the capital in a partnership, the corporation, even if it provides the other 97 percent, does not have to declare the partnership as a subsidiary. Therefore, assets and debt in the partnership can be withheld from the corporation's balance sheet." With this rule and the many partnerships Fastow created, Enron did not have to declare the assets and debts from these partnerships, therefore hiding hundreds of millions of dollars in losses and debt. The board of directors however did not consider Fastow's interaction with the partnerships to be a serious problem due to the fact that the financial gain potential to Enron was great. In fact Enron had a 65 page code of ethics that was given to all employees. Enron was a child of the deregulated energy markets in the late 1980s. Before then, most utilities were publicly provided, and Enron realized it could turn a profit by selling and trading these utilities. Sometime around 2000, Enron began trading through the internet, a revolution in the industry. The problem was that this strategy required a perpetually high share price. Thus, Enron's strategy shifted from energy trading to share price as the company's primary focus. Most experts believe that it was around this time that Enron began using financial engineering to keep its share prices high and maintain a high profit on the books.
To do this, Enron in essence "leveraged itself through debt, which it used to grow its non-core wholesale energy operations and service business by keeping most of this debt from appearing on the balance sheets with elaborate financial engineering. When the stock price began to fall, though, these same off balance sheet entities ended up downgrading Enron's credit rating. Suddenly, Enron was in over its head--it could not borrow money due to its low credit rating, nor could it use its own money to transact business, because it did not actually have any. In fact, Enron had kept such a monumental amount of debt off the books--enough to encumber every asset Enron claimed and then some--that the company simply imploded under its own weight.
Enron: The Nigerian Barge Deal
Enron Corporation was an energy company based in Texas and created when InterNorth
acquired Houston Natural Gas Company in 1985. Enron's growth was fast, it was named
\America's Most Innovative Company" for six consecutive years and it soon became the
seventh largest company in the United States, until its bankruptcy was declared in 2001.
Accounting fraud, money laundering and conspiracy are some of the charges which Enron
stood accused of in a series of scandals that finally came to a head in the largest bankruptcy
in history. One of these scandals was named the Nigerian Barges case ([Fleischer1, 2005]). Enron tried to sell an interest in three power-generating barges in the coast of Nigeria unsuccessfully. When Enron failed to sell it by December of 1999, Merrill Lynch, one of the world's leading financial management and advisory companies, agreed to buy that interest. That transaction was closed at the end of December 1999, and therefore Enron could book about twelve million dollars in earnings that year and meet earning targets. But the transaction was a fraud ([Kirkendall, 2005]). The main problem with this deal was that Merrill Lynch acted only as a temporal buyer to help Enron look more profitable than it really was . Enron's Chief Financial Officer Andrew Fastow promised verbally to Merrill Lynch that Enron would buy back the barges at a determined profit within six months, or Enron would find a third company to do so. This fact turned the transaction to be a simple loan, and not a true sale, as Enron claimed. Enron's objective with this transaction was not other than making its financial statements look better so that it could improve the income statement and then, for instance, borrow money from banks and the public at a lower interest rate, or simply pay the executives in Enron unwarranted bonuses. The idea, announced in 1999, was that Enron would build gas-fired power plants near Lagos. Estimated costs put the project at about $500 million. Before the main plant was built, Enron would start supplying power from three 30-megawatt barge-mounted plants burning either oil or gas, according to a 1999 article in Global Power Report, citing an Enron spokesman. The barges were to begin operation as early as the fall of 1999, though plans had not been finalized. The initial report was that Enron would begin construction, probably in the first half of 2000, and complete the project in 22 months.
For Nigerians, the project was important because, though Africa's largest nation is rich in energy resources, it faced persistent power crises and blackouts. By September, the cost estimate for the new power complex was up to $800 million. Enron was committed to financing it and to installing an associated 175 mile-long, 24-inch diameter, offshore natural gas pipeline to supply the plant. By February 2000, apparently before any construction, the deal was already facing political problems, according to Global Power Report. The contracts were called into question by the World Bank, Nigeria's national utility, the National Electric Power Authority and other Nigerian states. The World Bank reportedly said the deal should have been competitively bid and that the final contract was overly favorable to Enron.
Even before anything happened in the way of supplying energy, Enron was selling pieces of its deal to Merrill Lynch. That transaction and Merrill's quick sale of its interest back to an Enron-related entity is at the heart of the criminal allegations. Industry deregulation also caused new problems for Enron which, for the first time, needed to have a strong competitive focus. Enron knew that it could succeed in a deregulated environment only if it were the lowest cost producer or if it could distinguish its product from the competition. The latter would appear to be a frustrating goal, when the product is defined as a commodity like natural gas. Enron's management was struggling with how to formulate a strategy that would give customers what they wanted and develop a sustainable advantage in this new environment. They needed to find a way to "package" natural gas molecules, reliable delivery, and predictable prices such that it could define a clear product line and communicate the company's unique skills.
Ques:1 What are the ethical issues involved in this case?
Ques: 2. What are the exposure profile for Enron's customers with respect to natural gas prices?
What are the exposure profiles for Enron?
Ques: 3. What suggestions do you have for Enron?
SUMMARY OF THE CASE:
The Financial Engineering encompasses the design, analysis, and construction of financial contracts to meet the needs of enterprises." Thus we can say that Financial engineering is the phenomenon which facilitates the process/ product innovation in the financial industries which will help in enhancing the shareholders' wealth. The basic motives in going for financial engineering are as follows:
Reducing indebtedness on the balance sheet, or
Reducing expense on income statement, or
Increasing revenue on income statement, or
Increasing deductions on tax returns
Companies usually go for financial engineering to reduce their risk liability and accumulation of debt in the balance sheet.
The scope of financial engineering includes the following:
Investment Banking
Corporate Strategic Planning
Risk Management
Primary and Derivatives Securities Valuation
Financial Information Systems Management
Portfolio Management
Security Trading
The case that we have chosen here will be explained from one aspect out of the many areas covered under the scope of financial engineering that is " CORPORATE STRATEGIC PLANNING". This concept shall be explained in the context of Enron….which has been regarded as the biggest fraud in history. Under Corporate Strategic Planning Scope the company has used Financial Engineering to be-fool the the stakeholder of the company. In corporate strategic planning one very important decision includes "STRATEGIC ALLIANCE" which the companies follow for fulfilling their strategic as well as financial motives. Enron has too did the same thing .
Enron was created by a merge between Houston Natural Gas and Inter north. Houston's Natural Gas's CEO Kenneth Lay headed the merger of the two companies. Kenneth Lay became the CEO of Enron. Enron was originally solely involved with the distribution and transmission of electricity and gas in the United States. In the merger, Enron incurred a large amount of debt, and as a result of deregulation, no longer had exclusive rights to its pipelines. The company had to find a way to generate profits and cash flow. Kenneth Lay hired Jeffrey Skilling to work for Enron as an accountant. Skilling suggested the practice of buying gas from a network of suppliers and selling it to consumers at a fixed price with a contract. Enron was interested in the expansion, building, and operation of pipelines, power plants, and other infrastructure worldwide. After just a year of operation Enron merged with a company called Spectrum Seven, a company whose chairman and CEO is the former president of the United States, George W. Bush. In 1999, Enron tried to expand their company by creating the Azurix Corporation, a water utility company. Enron was named "America's Most Innovative Company" by Fortune magazine from 1996 to 2001. Enron was on Fortune's "100 Best Companies to work for In America" in 2000. The company's future appeared to be bright and promising continued success.
One of the very important issue which led to the downfall of Enron was Nigerian Barge deal which was primarily done to defraud the Govt and the stakeholders. Enron had promoted that it is entering into a deal with the Nigerian Barge fields of providing energy powerhouses there. . For Nigerians, the project was important because, though Africa's largest nation is rich in energy resources, it faced persistent power crises and blackouts. The deal was a scheme to "park" Enron's assets to bolster its earnings and that no risk was transferred to Merill Lynch in the deal because of an "oral 'handshake' side deal" by Enron to repurchase the barges back from Merill or find another suitable buyer. It was a sham that allowed Enron to illegally book about $12 million in pretax profit, when in fact there was no real sale and no real profits. The role of Merill Lynch in this whole thing has been questionable since they have deviated from their basic duty and helped them in indulging into fraudulent activities. Alongwith this case and many others Enron had to atlast file for bankruptcy and it has been a matter of great concern for the US Govt. since one of its major investment bankers were involved in the case.
QUESTIONS :
Ques:1 What are the ethical issues involved in this case?
Ans: Enron showed a goody picture in front of the Nigerian Govt. Nigeria had abundant resources but lacked in expertise to utilize them efficiently. Enron promised them to provide them expertise but it was only a way to "park" their assets. They wanted to hide their earlier frauds and unethical way of profits( black money) . The most unethical part was that they were playing with their code of conduct and setting a bad example for the rest of the corporate . Butone of the board members of Merrill Lynch blew the whistle and the golden image of Enron was tarnished.
Ques: 2. What are the exposure profile for Enron's customers with respect to natural gas prices?
Ans. It has been identified that Enron's problems were not in its energy operations, but from "dot com" investments and in some foreign subsidiaries. Enron was originally solely involved with the distribution and transmission of electricity and gas in the United States. But after the merger and the deregulation in the US , people could now access gas at subsidized rate. This reduced its monopoly over the distribution of natural gas. But it had a strong political backup. The company's connection to George W. Bush, and Houston's local politics has received much attention in the recent past. In 1986, Enron was involved with Bush's company in joint drilling for oil. It has been said that George Bush and Kenneth Lay even shared good friendship relations. That is why the company always enjoyed some sort of shelter even after doing unethical practices. The customers did not have any choice except for purchasing at the prices offered by Enron.
Ques: 3. What suggestions do you have for Enron?
Ans. The only suggestion that we have for Enron is that it should accept its mistake and apologize for its fraud. This can be one way of regaining its image. Another option would be to compensate the Nigerian Barge Govt. so that it may feel that Enron is really repenting on its mistake of exploiting the abundant resources of Nigeria which remained unutilized.
SWOT ANALYSIS OF THE CASE
STRENGTHS
Strong political backup( Bush & Houston Govt.)
Good reputation with financial institutions( Merrill Lynch)
WEAKNESSES
Overconfidence and excess dependence on its reliable resources
Lack of support from top management executives in strategic planning decisions( window dressing of the accounts at middle level)
OPPORTUNITIES
Regain their lost vigour because of customers confidence in them
Promoting themselves in such a way that the deal was basically done to provide the customer services at lower rates and not to hide any corporate scandal.
THREATS
It becomes difficult to regain the lost image even if the company goes for "n" no of CSR as the saying goes " 1 dissatified customer will tell 30000 people whereas 1 satisfied customer will tell only 3". So the company officials can well imagine in what quantum their image or brand equity has tarnished.
CRITICAL APPRAISAL
This is not the first scam or fraud for which Enron has been alleged. Previously it had been into limelight when it created a fake SPV( SPECIAL PURPOSE VEHICLE) to manipulate their accounts. They have created a false SPV (Special Purpose Vehicle) to transfer all their losses to that entity. It was basically done to convert their red balance sheet into a rosy one. Strong political backup and everlasting support from the leading financial institutions urged Enron to continue these frauds since they believed that Govt will come to its rescue in case it faces any problem. Enron had not only misused the options available through financial engineering for their own motives but in a way destroyed the country's image also because they were representing US Corporate culture in Nigeria. So the country's integrity also was at stake. The upcoming companies can learn a lesson in two ways - 1. They may be encouraged to do such sort of frauds since Govt come for rescue( negative motivation) 2. It may set an example for them not to repeat such an act in future.( positive motivation). In Indian context it is very important to learn a lesson because we have been top ranked in Corporate scams this year.
