Enron could engage in their derivative trading strategy with no fear of government intervention because derivative trading was specifically exempted from government regulation. Due in part to a ruling by the Commodity Futures Trading Commission's (CFTC) chairwoman, Wendy Graham, derivatives remained free of regulatory oversight. Ms. Graham, wife of Texas senator Phil Graham, made this ruling 5 weeks before resigning as chairwoman of the CFTC and joining the Enron Board of Directors in 1993.
Derivative accounting is further complicated because there is no consistent way to fairly report their value and risk in a company's financial report. In 1998 Rule No. 133, "Accounting for Derivative Instruments and Hedging Activities" was developed by the Financial Accounting Standards Board (FASB), an independent agency that sets guidelines for corporate auditors. Rule 133 contains more than 800 pages, which further complicates its adoption and consistent interpretation by various companies. SFAS No. 133 was subsequently amended by SFAS rules 137 and 138. These rules must be applied to all "derivative instruments and certain derivative instruments embedded in hybrid instruments and requires that such instruments be recorded in the balance sheet either as an asset or liability measured at its fair value through earnings, with special accounting allowed for certain qualifying hedges." In its 2000 annual report, Enron stated that they would adopt SFAS No. 133 as of January 1, 2001 and that due to this adoption, "Enron (would) recognize an after-tax non-cash loss of approximately $5 million in earnings and an after-tax non-cash gain . . . Of approximately $22 million . . .(and) will also reclassify $532 million from long-term debt to other liabilities.
Derivative trading to hedge risk was carried out with related-party, special purpose entities. According to an article found in The CPA Journal a special purpose entity (SPE)
'is a trust, corporation, limited partnership, or other legal vehicle authorized to carry out specific activities as enumerated in its establishing legal document." An SPE supplies its guarantor with liquidity and financing while giving creditors protection against the guarantor's bankruptcy. Usually a sponsor creates an SPE to carry out a specific function through an asset transfer. The journal presents an example of an SPE explaining that "an SPE might borrow cash from a third-party creditor. In exchange for that cash, the sponsor sells an asset to the SPE and then leases it back under an operating lease (sale-leaseback). Under certain circumstances, the debt used by the SPE to acquire the asset would be its own liability and would not appear on the sponsor's balance sheet (Holtzman et al., 2003)."
Holtzman et al., 2003 also explain that businesses may use SPEs to gain entrance into capital markets and to control risk. For instance, "an SPE might issue debt or equity, using the proceeds to acquire financial instruments (such as home mortgages) from its sponsor. Such a transfer of financial assets, if it qualifies as a sale or purchase, lowers the sponsor's cost of capital, because it isolates the assets from the risk of sponsor bankruptcy. Loan underwriters and credit-rating agencies often require business entities involved in synthetic leasing and commercial mortgage-backed securities to be SPEs (Holtzman et al., 2003)."
Additionally, the transferor usually derives a tax advantage because the SPE is a pass through entity that does not pay its own taxes. Businesses usually establish SPE's because the benefits of lower financing costs, lower taxes, and off-balance sheet financing usually outweigh the cost of establishing and manafing the SPE (Holtzman et al., 2003). "In short, the SPE was designed, in part, to minimize risk, but also to bypass accounting treatments that would otherwise increase leverage and decrease earnings (Holtzman et al., 2003)."
In Enron's case, the SPEs were created to allow the company to transfer assets, hide losses, provide a method of recognizing the increased value of its stock on its financial statements, and create the impression that Enron had hedged its gain in stock and other assets. The most controversial SPEs were headed by Enron employees who realized an incredible return on their small investments in the SPEs. The SPEs were supposed to be structured and run so that their results did not have to be consolidated on Enron's financial statements. To do this the SPEs were supposed to have outside investments of at least 3%, the investment should be at risk, and the SPEs should be independent. In reality, Enron provided more than 97% of the funding so the SPEs had little to no risk. The SPEs gave the appearance of hedging Enron's gains, but in fact, Enron was really hedging its own gains and insuring against its own losses. This system worked well as long as stock prices kept going up, but when they started to drop the losses became overwhelming. Enron had to declare bankruptcy.
What no one realized was the depth of the problem Enron had created for itself, due in large part to individual and corporate greed. The very system that the company had created to improved the performance of employees became a system full of deceit and secrecies. Thomas (2002) asserts that the employees began to believe that 'the only real performance measure was the amount of profits they could produce. In order to achieve top ratings, everyone in the organization became instantly motivated to "do deals" and post earnings. Employees were regularly rated on a scale of 1 to 5, with 5s usually being fired within six months. The lower an employee's PRC score, the closer he or she got to Skilling, and the higher the score, the closer he or she got to being shown the door. Skilling's division was known for replacing up to 15% of its workforce every year. Fierce internal competition prevailed and immediate gratification was prized above long-term potential. Paranoia flourished and trading contracts began to contain highly restrictive confidentiality clauses. Secrecy became the order of the day for many of the company's trading contracts, as well as its disclosures (Thomas 2002)."
In his article, Jackson asserts that the methods used to review employee performance created an environment in which people were afraid to anger those who might mess up their reviews (Jackson). Progressively the culture transformed into a "yes-man" environment (Jackson). In addition, Jackson contends that Andrew Fastow had a reputation of using the review system as a bludgeon to retaliate against those voicing opposition (Jackson).
This mindset ultimately led to the debacle that was Enron. Top-level executives became so greedy that they did not consider the ramification of their actions. They developed such an auspicious view of the condition of the company that they could not see the mess that had been created as a direct result of their actions. Over the next few paragraphs, we will discuss the manner in which the company viewed itself.
Enron's view of itself and the Media's Depiction of Enron
Indeed by the year 2000 the company had succeeded in creating certain view of the company that was appealing to investors. For instance, on the first page of Enron's 2000 annual report is the following description of how the corporation perceived itself and its future:
"Enron manages efficient, flexible networks to reliably deliver physical products at predictable prices. In 2000 Enron used its networks to deliver a record amount of physical natural gas, electricity, bandwidth capacity and other products. With our networks, we can significantly expand our existing businesses while extending our services to new markets with enormous potential for growth."
The 2000 financial highlights portrayed a company with accelerating revenues, net income, total assets, and most importantly, stock prices. During 2000, Enron stock prices ranged from a low of 41 3/8 to a high of 90 9/16 with the year-ending close of 83 1/8. Another graph in the annual report compared Enron's "Cumulative Total Return" through 2000 with that of the S & P. 500 over various periods of time. The following summarizes that comparison:
Cumulative Total Return
S & P. 500
Ken Lay's and Jeffery Skilling's letter to shareholders in the 2000 annual report painted a rosy picture of past successes and an unlimited potential for future growth. The following quote shows the optimist tenor of the 2000 Annual report:
"Enron's performance in 2000 was a success by any measure, as we continued to outdistance the competition and solidify our leadership in each of our major businesses. In our largest business, wholesale services, we experienced an enormous increase of 59% in physical energy deliveries. Our retail energy business achieved its highest level ever of total contract value. Our newest business, broadband services, significantly accelerated transaction activity, and our oldest business, the interstate pipelines, registered increased earnings. The company's net income reached a record $1.3 billion in 2000."
The 2000 annual report gave no indication of trouble ahead, but by December, 2001, Enron had been forced into Chapter 11 bankruptcy. Lay and Skilling had resigned. Enron had announced a loss of $1.01 billion after-tax for the 3rd quarter…