Enron\'s Collapse What Brought About

Enron's Collapse

What Brought About Enron's Collapse?

Enron Corporation was the seventh-largest company on the Fortune 500 list of the largest companies in the United States in 2000; it had been declared as America's "most innovative company" by the 'Fortune' magazine for six straight years. Its share price had climbed from $10 a share in 1991 to over $90 a share in 2000 while its revenue jumped from $31 billion to more than $100 billion in just two years from 1998 to 2000. No one could have predicted at the time that in the following year the company would be filing for bankruptcy, badly shaking the investors' confidence and effectively signalling the end of the longest bull-run in the American stock exchange's history. This paper looks at the causes behind the collapse of Enron.

Causes of the Debacle

Troubled Birth: The seeds of Enron's collapse were, perhaps, sown at the time of its birth -- the result of a 1985 merger of Houston Natural Gas and InterNorth -- a Nebraska-based gas pipeline company. The company had incurred heavy debts during the merger process and, as a result of deregulation of the gas pipelines, no longer had exclusive right to its pipelines. In order to solve Enron's formidable cash, credit and profit problems, the Company had to adopt ever more 'innovative' and 'unconventional' methods. The adoption of such 'unconventional methods' to overcome the legacy of its troubled birth would eventually prove to be Enron's Achilles heel.

Enron's Risky Trading Operations: The trio of Kenneth Lay (CEO and later Chairman of Board), Jeffery Skilling (Head of Enron Finance Corp. And later CEO) and Andrew Fastow, (promoted as Chief Financial Officer (CFO) in 1998) proceeded to transform Enron from a 'boringly predictable' and regulated Gas Company into one of the largest energy traders --a market middleman for energy that would eventually dominate the trading of energy contracts and financial instruments known as derivatives. While energy trading was initially highly successful, it was high-risk business.

Starting with Gas trading, Enron gradually started to trade in electricity as well. As Enron's revenues sky-rocketed in its initial forays into wholesale buying and selling of gas and electricity, the company was emboldened to extend the trading concept into almost any commodity that could be traded, i.e., futures contracts in coal, paper, steel, water and even weather. Taking advantage of the growing use of the Internet, Enron started Enron Online (EOL) in October 1999 -- an electronic commodities trading Web site, that was hugely successful almost overnight, doing online commodities trade worth $335 billion in 2000 alone.

In January 2000, the company announced the setting up of a high-speed broadband telecommunications network to trade network capacity, or bandwidth, in the same way it traded electricity or natural gas. Enron also planned to provide video on demand to customers world-wide via high-speed Internet lines. While hundreds of millions of dollars were being pumped in by Enron in such ventures, its stock price was sky-rocketing and reached an all-time high of $90 in August 2000.

The Turning of the Tide: During the times when Enron was making huge profits due to highly volatile energy prices, and there was widespread perception about the unlimited potential of online trade and technology innovations such as the broadband, things looked very rosy for the company. In the late 1990s, however, other energy companies such as Dynergy, Duke Energy, and El Paso started to enter the field of energy trading and the competition started to eat into the huge profit margins of Enron. Other factors such as falling energy prices in early 2001, the approaching worldwide recession and the broadband bubble burst began to work against Enron's 'dream' run. The company, in the meantime, had embarked on a culture of cutting trading deals that had a momentum of its own that was hard to stop.

Disregarding its Ethical Code. Enron had its own set of Ethical Code, but it became redundant because the top managers at the company hardly paid any heed to it. The corporate culture at the company was focused on making "deals" and increasing Enron's share value, while the "outdated, theoretical concept of ethics and morality" was kept on the back-burner.

Enron's 'ethics' was personified by Kenneth Lay's exercising of his stock options and pocketing profits, even as he was promoting Enron shares as a bargain to employees. It was also reflected in the action of some Enron executives who pressurized a brokerage company (UBS PaineWebber) to take action against a broker who advised some Enron workers to sell their shares. Other Enron employees, down the line, were therefore more likely to follow the example of its top executives in looking after their own interests and driving up the share value by whatever means, rather than adhering to the company's 'Ethical Code.'

Special Purpose Entities (SPEs). Enron was able to hide its precarious financial position and highly risky operations largely through circumvention of accounting rules in order to artificially increase earnings through Special Purpose Entities (SPEs). Although SPEs are legitimate instruments to access capital or hedge risk by using them as limited partnerships, without having to report debt on its balance sheet, Enron under Fastow's guidance made use of SPEs to "park" troubled assets that were falling in value, such as Enron's loss-making overseas energy facilities, and its broadband operation. Thousands of SPEs were used by Enron to conduct business, some of them owned by Fastow himself. As an example of the several dubious accounting practices by Enron, one of these SPEs -- the LJM partnerships, invested in another group of SPEs (known as the Raptor vehicles) to hedge an Enron investment in a bankrupt broadband company, Rhythm NetConnections. Enron issued its common stock in exchange for a note receivable of $1.2 billion for capitalization of the Raptor entities. Enron increased its notes receivable and shareholders' equity to reflect the transaction and failed to consolidate the LJM and Raptor SPEs into their financial statements, which were a violation of the existing accounting practices.