Enron Was a Texas Based, Low Profile,

Enron was a Texas based, low profile, gas pipeline Company that progressed from delivering energy to brokering energy futures. Exploiting de-regulation, it pioneered an innovative mark- to- market pricing strategy and started selling electricity in 1995, entering the European energy market in 1995. Enron broke new ground by buying, selling and hedging electricity against market risk just like shares and bonds.

In 1999 Enron entered the hi-tech, Internet bandwidth market buying and selling access to high speed broadband. Enron Online was the next cyberspace venture, a web-based commodity trading site. Enron now became an e-commerce company. Testimony to its success came from many quarters and Fortune magazine named Enron "America's Most Innovative Company" for six consecutive years from 1996 to 2001. Enron cultivated key figures in government and was especially close to the Republican Party. Enron's CEO, Ken Lay was on first name basis with President Bush.

Within 15 years the company Enron had morphed into the 7th largest publically owned corporation in America boasting revenues in excess of $100 billion and employing 20,000 workers, worldwide. The company owned or had a controlling interest in 30,000 miles of gas pipeline, 15,000 miles of fiber optic network and electricity generating operations around the world, including a giant, billion dollar plus project underway in India.

Enron was a 20th century wonder. (Eliza S. Moncarz, 2006) Yet as the century came to a close, the back slide had already started in Enron (Fig-1_ Appendix). It's innovations in structuring extremely complex financial arrangements that defied comprehension by the ordinary man in the street, and the vaulting ambition of its high flying, high spending, globe- trotting executives led to its undoing. A time came when Enron broke the law and started peddling patent falsehood as innovation. It then sealed its own fate.

Overview of the Questionable Accounting Practices and the Financial Statement Highlights.

The phrase, creative accounting or creative, aggressive accounting has become synonymous with the deliberate manipulation of financial data (DAVID R. HERWITZ, 2006) and violation of accounting rules with ulterior motive that is at the very heart of questionable accounting practices. The objective is to inflate profit and asset value, and understate debt and amounts owing, perforce.

Transparency, and the law, demands that the final accounts and Balance Sheet, properly drawn up, should correctly reflect all income, expenses, assets and liabilities germane to a business venture. This is especially important in the case of a Public Company in which shareholders with a financial stake in the company base their decision on their perception of its well being or otherwise. This will influence their current stock holding in the Company and that of prospective new investors from the market.

Typical accounting gimmicks employed to window dress accounts include off balance sheet financing, accelerated revenue recognition and the use of non-recurring items that are usually greatly exaggerated.

Debt financing that is not reflected on the Balance Sheet itself is known as off Balance Sheet financing. By removing the item from the Balance Sheet, debt stands reduced, artificially of course and that improves the Company's credit rating with investors and financial institutions like Banks.

However, removing an item from the Balance Sheet may not be as simple as it sounds. Accounts of Public Limited Companies are certified by professional accountants who stake their reputation and careers every time they affix their signature on a declaration of the veracity of a Company's accounts and Balance Sheet. When financial reporting requirements mandate that all debt contracted on transactions incidental to a Company's business ventures be shown in the financial statements, any lapse will do more than simply attract attention. That is why when the shocking decision to get rid of debt on the Company Balance Sheet, perforce, is taken, much ingenuity and daring goes into efforts to achieve this objective.

Enron used Special Purpose Entities or Vehicles (SPE / SPV) to do so.

Though created by Enron, legally, the SPE's were not Enron's property but that of an outsider trustee. That is because Enron could not be the beneficial owner if the SPE was to remain off Enron's Balance Sheet.

As the name suggests, a SPE is designed with a special objective in mind. Its management is kept flexible so that there is no need to cite the SPE as a subsidiary of the Company that created it since consolidation cannot then be avoided.

Besides camouflaging or hiding debt, accelerated revenue recognition was another reason why Enron put so much time, effort and money in setting up the SPE's.

In 1997 Enron entered into an agreement with its Limited Partner, JEDI and as per the agreement, JEDI was to pay Enron an annual management fee for services rendered. Accounting rules generally require that that such management fees be recognized as income only when the services have been rendered. In this case however, the agreement was drafted in such a way that Enron was able to recognize as income the discounted net present value of 80% of the annual management fees in advance (required payment) of the actual receipt of payment. As a result as of March 31, 1998, Enron recorded a $28 million asset which represented the discounted net present value of management fees payable over the period 1998-2003. $25 million were immediately recognized as income.

From 1993-2000, Enron pursuant to another agreement also recognized as revenue any appreciation in the value of Enron stock held by the Limited partner JEDI. Under normal accounting rules this would not have been possible. The exact amount so recognized over this period has not been determined but the accounting firm, Arthur Anderson, that audited Enron accounts and was responsible for a great deal of the 'creative accounting' that made the accelerated recognition of income possible, reported that in the first quarter of 2000 Enron recorded a $126 million increase in the value of its stock held by JEDI as its income.

In yet another example of accelerated revenue recognition by Enron, Chewco, another limited partner, received an unsecured subordinated loan from Barclays in Dec 1997 and Enron provided the guarantee on the loan. Pursuant to an agreement between Enron and Chewco, Chewco agreed to pay Enron a guarantee fee of $10 million plus 315 basis points annually on the average loan balance due. The objective basis on which the fee calculation was made is not evident and it appears to have been determined arbitrarily. In the one year that the loan remained outstanding, Enron received $17.4 million under the fee agreement. These fee payments were characterized by Enron for accounting purposes as "structuring fees" and $10 million upfront payment received in Dec 1997 was recognized as income. This was not consistent with accounting rules as they required that guarantee fee income be recognized over the guarantee period. The entire arrangement between Enron and Chewco regarding the guarantee fee payment's recognition was clearly designed solely to facilitate accelerated recognition in a manner not permissible in law.

The Rhythms Hedge

RhythmsNetConnections was a privately held Internet Service Provider in which Enron invested $10 million in March 1998 by purchasing 5.4 million of its shares at $1.85 per share. By May 1999 the value of this investment had gone up to $300 million and the increase was recognized as income as the investment was accounted for by Enron as part of its merchant portfolio. In order to capture the increase and hedge the investment against any future market volatility that may decrease the value of the stock, Enron sought to hedge the Rhythms investment by creating a limited partnership SPE capitalized mainly by appreciated Enron Stock from forward contracts. The appreciated value would be transferred to the Limited Partnership SPE LJM1 in exchange for a note receivable that would permit LJM1 to enter into a swap with Enron to hedge Enron's Rhythm investment. This Rhythms hedge impacted on Enron's income statement affecting gains and losses thereon but it was not a true economic hedge. An SPE (LJM1) could not have been used legitimately as a counterparty to hedge against price risk when the primary source of any payment that the SPE might make is the entity's own stock. In essence what this amounted to was Enron hedging risk with itself which is an absurdity not a bona fide hedge against risk.

The Raptors

The Rhythms Hedge was repeated in another transaction, this one between Enron and the limited partnership, LJM2. It involved the creation of four SPE's that were called "the Raptors." These were essentially structured finance vehicles (William C. Powers, 2002)designed to avoid showing losses on Enron's financial statements from any fall in the value of its merchant portfolio. This was achieved by entering into derivative transactions with the Raptors that functioned as accounting hedges. Thus if there was a decline in the value of the merchant investment the value of the Hedge would appreciate by an equivalent amount. As a result, in Enron's quarterly income statement the decline in value of the merchant investment would be offset by the increase in income from the Hedge. However, as in the case of the Rhythms Hedge, the protection that the Raptors Hedge was supposed to give was more illusory than real. The reason was the same. The Raptors were not independent, creditworthy outside parties but counterparties created by Enron and LJM2. The risk was almost all borne by Enron itself. In short, Enron was trying to protect Enron which was not an acceptable proposition by any standards. However whatever the merits of the arrangements made, Enron's financial statements reflected a rosy picture all round. And that is what the creative accounting was all about.

A basic principle of accounting stipulates that, barring exceptional circumstances, it was not permitted for a business to recognize gains as income on its income statement when the gains arose from a rise in the value of its own stock.

On paper at least, the protection that the Raptors Hedge gave Enron against a fall in the value of its merchant investments appeared to be in order so long as Enron stock was strong and its value stable or on the upswing. But when the value of Enron stock started to decline and the merchant investments also lost value, it soon became evident that the Raptors were no longer viable entities. By the third quarter of 2001 as the downswing continued for both Enron's merchant investments and its own stock, Enron ran out of options and the decision had to be taken to wrap up the Raptors. The consequences were momentous. Enron incurred an after tax charge of $544 million on its third quarter income statement and had to reduce shareholder equity by a whopping, $1.2 billion.

This is not to say that the Raptors were no good for Enron from the start. Quite to the contrary, between the third quarter 2000 and the third quarter 2001, the Raptors allowed Enron to hide almost $1 billion losses on its merchant portfolio which was no mean achievement. Looked at in another way, minus the Raptors, in the given economic scenario, Enron's earnings would have declined precipitously, by as much as 72% to $429 million.

The four Raptors were extremely complex, structured finance vehicles through which Enron entered into sophisticated hedges and derivatives transactions. The complexity was on a scale that has been described as 'mind numbing.'

Involvement of Enron leadership in fraud

The fraud that was perpetrated at Enron relates to the unwarranted loss that investors had to suffer because the doctored financial statements put out by Enron did not reflect the actual financial health of the Company. Rather, they led investors to wrongly believe that the Company was doing well and was likely to do even better in the future.

The Enron Board of Directors (AFFAIRS, 2002) sat at the apex of the Company's governing structure and had a fiduciary duty to keep investors well informed about all aspects of the Company's performance. If the Company was saddled with debt that was being camouflaged the investors lack of knowledge kept them from taking an appropriate decision at the right time. Under the leadership of Kenneth Lay, Enron managed to conceal massive debt by resorting to questionable accounting practices. These practices were discussed in Board meetings and approved. Of course they were not presented as questionable practices. They were touted instead as innovative responses to problems that the Company faced. However this does not mitigate the collective responsibility of the Board in doing things that should have been seen as questionable. In the case of the LJM partnership, for instance, Ken Lay approved the code of conduct prohibition for Andrew Fastow, Enron's Chief Financial Officer, and also asked the Board to ratify his decision although that was not really necessary. And the Board concurred. How was it that not even a single member saw that Fastow was in a conflict of interest situation? He was an officer of the company and deeply involved in managing LJM as well as deriving great personal benefit from the arrangement. It defies logic and common sense to accept that they simply rubber stamped Lay's approval of the arrangement without so much as raising a single query about its propriety. After all these were all highly experienced and qualified business people who ought to understand a conflict of interest situation when they see one.

While Board members cannot be excused for failing to pay attention to the many red flags that stared them in the face in the Board meetings, information available now does suggest Kenneth Lay as Chairman of the Board and CEO bears considerable responsibility for not being forthright and candid with Board members in all matters pertaining to Enron that were discussed during Board meetings. Clearly Lay knew a great deal more than the Board members. For example Board members have stated that they had no idea that the termination of the Raptors partnership would result in a reduction in shareholder equity by as much as $1.2 billion. In fact they came to know about this from the media. Board members also did not seem to know that the reduction in shareholder equity was due to an accounting correcting at the best of Arthur Andersen Enron's accounting guru. Why did such a situation ever arise? Clearly Ken Lay was keeping information that had a vital bearing on Enron policy away from Board members thereby contributing to their lack of knowledge or partial knowledge on key aspects of Enron policy.

The fact that Enron whistleblower, Sherron Watkins, in a letter that she wrote to Ken Lay in August 2000, had described the Raptor transactions as a possible accounting -scandal, was not known to the Board members and there is every reason to believe that Enron top management deliberately kept Board members in the dark. May be they did not want to panic them. But coming from an Enron employee who had years of experience in the company, it should have been obvious to Lay that Board members should be apprised of the apprehensions raised in the letter with regard to many sensitive issues including those related to SPE's.

Board members also seemed to be ignorant that the Raptor transactions provided the LJM2 limited partnership SPE with some of its highest returns on any investment.

The fact that Enron had done so well under Ken Lays stewardship seemed to bestow an aura of invincibility on Lay and the Board meekly went along with whatever he approved as Chairman and CEO. His hubris was seen as the correct way forward in a highly competitive corporate environment. By failing to diligently and independently apply their mind to the merits of various issues and policy matters that were put before the Board, members failed to provide the prudent oversight and checks and balances that its fiduciary obligations required. Top management excess in many matters thus went unnoticed and ultimately contributed to the downfall of the Company.

Enron's fraud and the evidence thereof

Enron company employees committed securities and wire fraud on an epic scale by the systematic, illegal, overstatement of income and asset value and understatement of debt and other liabilities by resort to elaborate machinations such as the creation of, so called, Special Purpose Entities (SPE's). The corporate data borne on the financial statements filed by the Company to the SEC was misleading and the presentation was designed to convey the impression that the Company was in good financial health and its accounting practices were in conformity with the law. The value of Enron stock rose and maintained its position in the market as investors were duped into believing that the Company was doing well currently and likely to do even better in the future. They thus held on to stock they had invested in and in many cases increased their holdings and many new investors were misled into investing in Enron Stock in by the elaborate falsification of corporate data. The reporting of taxable income to the IRS was also fraudulently understated to illegally minimize due tax liability.

The charge of wire fraud is now almost an adjunct to securities fraud as most all statements and declarations required to be filed before the SEC are routed through electronic channels and thus qualify for action as wire fraud.

Central to Enron's financial misreporting of corporate data was the so called, limited partnership (LP) Special Purpose Entity (SPE).

Enron's objective was to offload from its Balance Sheet as much debt related to a transaction as possible. This Balance Sheet doctoring was achieved through the mechanism of the Special Purpose Entity.

However, the financial structure known as an SPE is not intrinsically a mechanism contrived always to promote fraud. In fact if a credible outside party has an adequate economic stake in the entity equal to at least 3% of the value of the SPE and that 3% stake is put at risk throughout the currency of the transaction and the independent owner (outside party) exercise control over the SPE, then there is nothing wrong in the arrangement.

The SPE's that Enron crafted did not meet these criteria.

The transactions that took place between Enron and unrelated commercial entities were not designed to achieve genuine economic objectives but rather were put into play to achieve favorable financial statement results.

The evidence of Enron's wrong doing lies in the financial statements submitted to the SEC and the tax returns to the IRS.

Enron's external auditors and their role in the fraud

Arthur Andersen, Enron's external auditor was also hired as consultant and was behind many of the creative accounting schemes design to keep the company's Financial Statements low on debt and high on income. This was quite clearly a conflict of interest situation but the Enron Board found nothing wrong in the arrangement. Andersen charged and received hefty fees for the fancy financial accounting structures it devised for the plethora of limited partnership SPE's. When the SEC started investigating Enron, Andersen ordered that all Enron files be shredded and electronic record deleted. Arthur Andersen was convicted for obstruction of justice but the conviction has been overturned on appeal by the U.S. Supreme Court as the jury was not properly instructed. Arthur Andersen, based in Chicago, is still in business today though only nominally.