Monday, February 13, 2006

Enron 1 comments

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Although there were a number of corporate scandals following the rise and fall of the Internet-propelled stock market boom in 1999-2000, involving companies such as Tyco, MCI Worldcom, Global Crossing, none came close in popular impact to the collapse of Enron, one of the world’s leading energy trading companies, with claimed revenues of $100 billion in 2000. The witch-hunting that inevitably organised itself after the company's bankruptcy brought about the collapse of Arthur Andersen, hitherto one of the "Big Five" in global accounting, and led to the introduction of the Sarbanes-Oxley Act by government regulators who were finally pushed into action.

In fact, the falling stock market after the dot-com bust which dragged down all stocks played an important role in the collapse of Enron. The stock price of the company was essential in maintaining the status quo capitalisation of its now-infamous special-purpose entities (SPEs) which eventually brought about the company's bankruptcy.

SPEs are essentially affliates created by a company for certain investments, a special characteristic being that they can be kept off the balance sheet (ie. hidden from investors). The company typically transfers one of its assets to the SPE which might pay for it in future cash promises. Hence, the company gets to beef up its current account, the SPE gets an asset that is pledgeable as collateral for loans from banks (and hence lower interest rates) that can be invested in the project that the SPE was set up for.

Used in the correct spirit, the SPE concept was a useful tool to finance new capital projects without burdening the parent company unncessarily. However, Enron used it as a means of moving non-performing assets off its balance sheet, to make its return on assets, for example, look good. The cash it received from these SPEs in return (obtained from loans that were secured on the basis of these assets--- a circular flow) also helped. It was estimated that by end-1999 nearly half of their $60B were off-balance sheet ie. tied up in SPEs. Then, it had become acknowledged as the global leader in energy trading and as one of the most innovative organisations (note the irony).

Of course, so long as the creditors of the SPEs had limited recourse ie. only to the SPE vehicle, and not to the parent company, the latter would be fine. However, Enron guaranteed the loans of some of its key SPEs, using its own shares as collateral. Analogous to the negative equity situation today of many Singaporeans who had bought properties at the peak in 1996 (or to margin trading in shares), if the share price dropped there would be a call for more Enron share collateral to fill the guarantee. Yet this would pull down share price further due to share overhang, creating a vicious cycle. Worst of all, Enron's exposure to such debt guarantees was unknown to most investors, since its SPE-involvements were off-balance sheet (compare that to the off-balance sheet derivatives exposures of CAO today).

At the same time, these SPEs conducted a majority of their deals with Enron affliates. The existence of Enron and Enron-created SPEs as both buyers and sellers in many transactions raises questions about the validity of these exchanges and the prices at which they were struck. It was clear that it was a case of earnings manipulation. In proper consolidation accounting, such inter-group transactions undergo elimination. However, since SPEs were accounting-wise separated from their parent company, the transactions could easily be manipulated in favour of the mother company. Partly, that was why Enron was able to brandish outstanding results year after year. But of course, over the long-term, the SPEs must suffer financially, with the fallout trickling back to the parent.

And so this was where the 2001 falling market after the dot-com bust came in. The loaded financial dice against the SPEs must have restricted their ability to service their debts, which meant Enron's share collateral was important. But the Enron shares were persistently dragged down by insider selling at the highest management levels (those who knew it was unsustainable) such that it halved from $90 to $45 within one year from Aug 2000 to Aug 2001. And the abovementioned requirement for more share collateral to balance the price drop kicked in, causing further share price meltdown. Management knew share price had to be supported, so they, led by CEO Kenneth Lay, continued to publicly exhort investors to buy "value" while they privately sold off their stock. It was a disgraceful example of capitalism.

In October 2001 one of the key SPEs became insolvent (due to inadequate share collateral) and Enron was forced to make good its guarantee to the SPE creditors in cash. It triggered a series of cash calls in other SPEs, a cut in Enron's bonds to junk bond status, and ultimately led to the collapse of the entire Enron group within one month. In November Enron filed for Chapter 11 bankruptcy.

The tales of Arthur Andersen auditors shredding Enron trial evidence to avoid implication are now legendary, and were instrumental in making the auditing giant the second biggest victim of the Enron scandal (the biggest being Enron's investors). Many banks also suffered the fallout from Enron's collapse, their notes all turning worthless. For example, JP Morgan revealed that its full exposure to the company amounted to $2.6B. They had been aware of the linkages of the SPEs to the parent, but had taken that as a sign of security that had facilitated extending new lines of credit to these SPEs. Although the size of Enron's bankruptcy was eventually surpassed by that of Worldcom (another case of accounting fraud), it is the former that sticks in people's minds, for the sheer dishonesty of its management, and as an example of how an Old Economy blue chip can turn rotten unpredictably and in double quick time (Worldcom's collapse could at least be traced to its telco roots that suffered badly from the dot-com bust).

And so Kenneth Lay and Jeffrey Skilling, both former Enron CEOs, stand trial in 2006. It will be interesting to see their judgment, after watching Bernie Ebbers of Worldcom get 25 years of free government accommodation (jail).

(1) Enron special
(2) Article: Special Purpose Entities are Often a Clever Way to Raise Debt Levels
(3) Wikipedia article: Enron Corporation