Case Study 1

The Enron Fraud Enron Corporation began as a small natural gas distributor and over the course of 15 years grew to become the seventh largest company in the United States. Soon after the federal deregulation of nat- ural gas pipelines in 1985, Enron was born by the merg- ing of Houston Natural Gas and InterNorth, a Nebraska pipeline company. Initially, Enron was merely involved in the distribution of gas, but it later became a market leader in facilitating the buying and selling of futures of natural gas, electricity, broadband, and other products. However, Enrons continuous growth eventually came to an end as a complicated financial statement fraud and multiple scandals sent Enron on a downward spiral to bankruptcy.

During the 1980s, several major national energy cor- porations began lobbying Washington to deregulate the energy business. Their claim was that the extra compe- tition resulting from a deregulated market would bene- fit both businesses and consumers. Consequently, the national government began to lift controls on who was allowed to produce energy and how it was marketed and sold. But, as competition in the energy market increased, gas and energy prices began to fluctuate greatly. Over time, Enron incurred massive debts and no longer had exclusive rights to its pipelines. It needed some new and innovative business strategies.

Kenneth Lay, chairman and CEO, hired the consult- ing firm McKinsey & Company to assist in developing a new plan to help Enron get back on its feet. Jeff Skilling, a young McKinsey consultant who had a background in banking and asset and liability management, was assigned to work with Enron. He recommended that Enron create a gas bank to buy and sell gas. Skilling, who later became chief executive at Enron, recognized that Enron could capitalize on the fluctuating gas prices by acting as a middleman and creating a futures market for buyers and sellers of gas; it would buy and sell gas to be used tomorrow at a stable price today.

Although brilliantly successful in theory, Skillings gas bank idea faced a major problem. The natural gas pro- ducers who agreed to supply Enrons gas bank desper- ately needed cash and required cash as payment for their products. But Enron also had insufficient cash levels. Therefore, management decided to team up with banks and other financial institutions, establishing partnerships that would provide the cash needed to complete the transactions with Enrons suppliers. Under the direction of Andrew Fastow, a newly hired financial genius, Enron also created several special purpose entities (SPEs), which served as the vehicles through which money was funneled from the banks to the gas suppliers, thus keep- ing these transactions off Enrons books. As Enrons business became more and more complicated, its vulner- ability to fraud and eventual disaster also grew. Initially, the newly formed partnerships and SPEs worked to Enrons advantage. But, in the end, it was the creation of these SPEs that culminated in Enrons death.

Within just a few years of instituting its gas bank and the complicated financing system, Enron grew rapidly, controlling a large part of the U.S. energy market. At one point, it controlled as much as a quarter of all of the nations gas business. It also began expanding to create markets for other types of products, including electricity, crude oil, coal, plastics, weather derivatives, and broad- band. In addition, Enron continued to expand its trading business and with the introduction of Enron Online in the late 1990s, it became one of the largest trading companies on Wall Street, at one time generating 90 percent of its income through trades. Enron soon had more contracts than any of its competitors and, with market dominance, could predict future prices with great accuracy, thereby guaranteeing superior profits.

To continue enhanced growth and dominance, Enron began hiring the best and brightest traders. But Enron was just as quick in firing its employees as it was in hiring new ones. Management created the Performance Review Committee (PRC), which became known as the harshest

employee ranking system in the country. Its method of evaluating employee performance was nicknamed rank and yank by Enron employees. Every six months, employees were ranked on a scale of 1 to 5. Those ranked in the lowest category (1) were immediately yanked (fired) from their position and replaced by new recruits. Surprisingly, during each employee review, management required that at least 15 percent of all the employees ranked were given a 1 and therefore yanked from their position and income. The employees ranked with a 2 or 3 were also given notice that they were liable to be released in the near future. These ruthless performance reviews created fierce internal competition between fellow employ- ees who faced a strict ultimatumperform or be replaced. Furthermore, it created a work environment where employees were unable to express opinions or valid con- cerns for fear of a low-ranking score by their superiors.

With so much pressure to succeed and maintain its position as the global energy market leader, Enron began to jeopardize its integrity by committing fraud. The SPEs, which originally were used for good business purposes, were now used illegally to hide bad invest- ments, poor-performing assets, and debt; to manipulate cash flows; and eventually, to report over $1 billion of false income. The following examples illustrate how specific SPEs were used fraudulently.

Chewco In 1993, Enron and the California Public Employees Retirement System (CalPERS) formed a 50/50 partnership called Joint Energy Development Investments Limited (JEDI). In 1997, Enrons Andrew Fastow estab- lished the Chewco SPE, which was designed to repurchase CalPERS share of equity in JEDI at a large profit. However, Chewco crossed the bounds of legality in two ways.

First, it broke the 3 percent equity rule, which allowed corporations such as Enron to not consolidate if outsiders contributed even 3 percent of the capital, but the other 97 percent could come from the company. When Chewco bought out JEDI, however, half of the $ 11.4 million that bought the 3 percent equity involved cash collateral provided by Enron, meaning that only 1.5 percent was owned by outsiders. Therefore, the debts and losses incurred at Chewco were not listed where they belonged, on Enrons financial reports, but remained only on Chewcos separate financial records.

Second, since Fastow was an Enron officer, he was, therefore, unauthorized to personally run Chewco without direct approval from Enrons board of direc- tors and public disclosure with the SEC. In an effort to secretly bypass these restrictions, Fastow appointed one of his subordinates, Michael Kopper, to run Chewco under Fastows close supervision and influence. Fastow

continually applied pressure to Kopper to prevent Enron from getting the best possible deals from Chewco and therefore giving Kopper huge profits.

Chewco was eventually forced to consolidate its financial statements with Enron. By doing so, however, it caused large losses on Enrons balance sheet and other financial statements. The Chewco SPE accounted for 80 percent (approximately $400 million) of all of Enrons SPE restatements. Moreover, Chewco set the stage for Fastow as he continued to expand his personal profiting SPE empire.

LJM 1 & 2 The LJM SPEs (LJM1 and LJM2) were two organizations sponsored by Enron that also partic- ipated heavily in fraudulent deal making. LJM1 and its successor, LJM2, were similar to the Chewco SPE in that they also broke the two important rules set forth by the SEC. First, although less than 3 percent of the SPE equity was owned by outside investors, LJMs books were kept separate from Enrons. An error in judgment by Arthur Andersen allowed LJMs financial statements to go unconsolidated. Furthermore, Fastow (now CFO at Enron) was appointed to personally over- see all operations at LJM. Without the governing con- trols in place, fraud became inevitable.

LJM1 was first created by Fastow as a result of a deal Enron had made with a high-speed Internet service provider called Rhythms NetConnections. In March 1998, Enron purchased $10 million worth of shares in Rhythms and agreed to hold the shares until the end of 1999, when it was authorized to sell those shares. Rhythms released its first IPO in April 1999, and Enrons share of Rhythms stock immediately jumped to a net worth of $300 million.

Fearing that the value of the stock might drop again before it could be sold, Enron searched for an investor from whom it would purchase a put option (i.e., insur- ance against a falling stock price). However, because Enron had such a large share and because Rhythms was such a risky company, Enron could not find an investor at the price Enron was seeking. So, with the approval of the board of directors and a waiver of Enrons code of conduct, Fastow created LJM1, which used Enron stock as its capital to sell the Rhythms stock put options to Enron. In effect, Enron was insur- ing itself against a plummeting Rhythms stock price. But, since Enron was basically insuring itself and pay- ing Fastow and his subordinates millions of dollars to run the deal, Enron really had no insurance. With all of its actions independent of Enrons financial records, LJM1 was able to provide a hedge against a profitable investment.

LJM2 was the sequel to LJM1 and is infamous for its involvement in four major deals known as the Raptors. The Raptors were deals made between Enron and LJM2 that enabled Enron to hide losses from Enrons unprof- itable investments. In total, LJM2 hid approximately $1.1 billion worth of losses from Enrons balance sheet.

LJM1 and LJM2 were used by Enron to alter its actual financial statements and by Fastow for personal profits. Enrons books took a hard hit when LJM finally consolidated its financial statements, a $100 million SPE restatement. In the end, Fastow pocketed millions of dollars from his involvement with the LJM SPEs.

Through complicated accounting schemes, Enron was able to fool the public for a time into thinking that its profits were continually growing. The energy giant cooked its books by hiding significant liabilities and losses from bad investments and poor assets, by not recognizing declines in the value of its aging assets, by reporting over $1 billion of false income, and by manipulating its cash flows, often during fourth quar- ters. However, as soon as the public became aware of Enrons fraudulent acts, both investors and the company suffered. As investor confidence in Enron dropped because of its fraudulent deal making, so did Enrons stock price. In just one year, Enron stock plummeted from a high of about $95 per share to below $1 per share. The decrease in equity made it impossible for Enron to cover its expenses and liabilities, and it was forced to declare bankruptcy on December 2, 2001. Enron had been reduced from a company claiming almost $62 billion worth of assets to nearly nothing.

1. What important internal controls were ignored when LJM1 was created?

2. How might Enrons harsh Performance Review Committee have aided company executives in committing the fraud?

3. The fraud at Enron is one of many major financial statement frauds that have occurred in recent years (Qwest, Global Crossing, WorldCom, etc.). What are some factors that could explain why the falsifying of financial statements is occurring so frequently? List four factors.

4. Suppose you are a certified fraud examiner but enjoy investing in the stock market as an additional source of income. On research of Enrons stock, you notice that although its stock has a history of strong growth and a seemingly promising future, Enrons financial reports are unclear and, frankly, confusing. In fact, you cant even explain how Enron is making money. Could this lack of clarity in its financial reporting serve as a red flag in alerting you to the possibility of fraud at Enron? Why or why not?