Fall of Enron, WorldCom, and Arthur Andersen

¶ … Fall of Enron, WorldCom and Arthur Andersen

What a tangled web we weave, when first we practice to deceive." Deception is what Enron was all about. From the beginning of its rise to prominence, it was little more than a shell game, designed to make a few selected executives rich, at the expense of other employees and shareholders.

Enron was formed in 1985 by the merger of Houston Natural Gas (HNG) and InterNorth, engineered by HNG CEO Kenneth Lay. Eight days into the Lay chairmanship, the name was changed to Enteron with announcement of a sharholder vore in April. Millions of dollars had been spent on consulting services to come up with the name, but no one bothered to check the dictionary. According to Websters, it was the word for the digestive tube that runs from the mouth to the anus, an interesting meaning given that Enron produced natural gas. The new name had to go and a week later it was shortened to Enron.

In December 1988, Jeff Skilling, a partner at McKinsey & Co., was working with Enron on the concept of a gas bank. McKinsey, a high-end strategic consulting firm, had been helping Enron on several projects and Skilling had come up with the idea of this gas bank. Although some were initially skeptical of the concept, Rich Kinder, Enron's vice chairman, liked it and pushed it forward. It got off to a slow start, and by the end of 1989, it was lanquishing. Kinder's reaction was to offer Skilling the position of chairman and chief executive of Enron Finance, and on August 1, 1990, the Skilling era began. The gas bank would be named Enron Gas Services, and later, Enron Capital and Trade Resources (ECT). Its formation was a crucial development that established Enron as an innovator in the energy industry. Within several months, Skilling would add a new employee to his team, who would have far-reaching affects on Enron. On December 3, 1990 Andy Fastow began work at Enron.

Another major decision was made in 1986 which would have a later impact on Enron. At the time of the merger, HNG had used Deloitte Haskins and Sells as their auditor. InterNorth had used Arthur Andersen. With the decision to move the headquarters to Houston, a decision was made to retain Andersen as the auditor, in spite of Andersen's recent legal troubles. Andersen had built a dominant position in Houston and in the energy business, but during the first half of the 1980s, the firm had paid out more than $140 million in malpractice lawsuits, far exceeding any of the other Big Eight firms.

Arthur Andersen was founded in 1913 by Arthur Andersen and Clarence DeLany as Andersen, DeLany & Co. The firm changed its name to Arthur Andersen & Co. In 1918. In the 1950s, Andersen entered into the field of management consulting with a computer system installation project for General Electric. In the 1960s and 1970s, it grew this practice area and became a dominant player in the field of computer software development. By the middle 1980s, not only did Andersen have the largest audit practice among the Big Eight in Houston, but its consulting practice was larger than all of the other Big Eight put together. As the 1980s progressed, tensions between consulting partners and audit partners intensified as consulting grew. These tensions reached the breaking point when Andersen created a second consulting group, AABC (Arthur Andersen Business Consulting) which began to compete directly with AC in the marketplace. Arthur Andersen and Andersen Consulting split in 2000, and as a result of that split, Andersen Consulting was forced to change its name, which it did on January 1, 2001. The new company, free now of Arthur Andersen, named itself Accenture.

Following on the heels of his success of the gas bank, Skilling launched ECT into natural gas trading, creating an active market where none had existed. Deregulation in the United States opened the door for electricity trading, and ECT jumped into that. By the mid 1990s, it had 200 power marketers working out of two trading floors in Houston. In 1995, Enron crossed the Atlantic to open a London office to trade power and natural gas. The company would soon become a dominant force in European energy markets. Skilling started exploring new markets in which to apply the Enron model. These would come to include: weather, paper pulp, plastics, and metals.

Skilling's vision was to trade energies and other commodities the way Wall Street trades capital. In 1991, after much discussion with the auditors, he convinced Enron's Audit Committee to allow him to apply mark-to-market accounting to ECT's trading books. For liquid trading activities, mark-to-market accounting is appropriate and far superior to accrual accounting, and is widely used in the capital markets. For an oil and gas company, however, it wasn't always appropriate. Many of the markets ECT was trading in were not liquid because Enron was launching those markets. ECT was entering into long-term gas and power deals for which no liquid markets existed. Traders who were performing trades had considerable influence in how the deals were marked-to-market, and with their bonuses depending upon the profitability of deals, there was a conflict of interest. Skilling's trading businesses were generating considerable profits, but much of these were dubious mark-to-market profits on long-term deals.

Meanwhile the rivalry between Skilling and Rebecca Mark was intensifying. Mark and her team of deal makers saw themselves as missionaries of privatization. They were closing deals, but the actual profitability of those deals would not be known for years. Employees, and especially Mark, stood to earn enormous bonuses just for closing deals. Many of those deals would later come back to haunt Enron. In 1996, Skilling won a significant victory over Mark, when Kinder had a falling out with Lay and left Enron. Lay tapped Skilling to replace Kinder as President and COO. Now Skilling was in line to eventually replace Lay as CEO. Mark remained a significant force within Enron, but Skilling was consolidating his position, promoting a circle of cronies into senior positions. In Lay and Skilling, Enron now had two business visionaries running the company, but there was no one to replace Richard Kinder's prudence.

Andy Fastow was hard at work. In 1993, Enron had formed a limited partnership with the California Public Employees' Retirement System (Calpers), an enormous and highly influential pension fund. Called the Joint Energy Development Investment Limited Partnership (JEDI), the partnership invested in natural gas projects (Andy Fastow had an obsession with Star Wars, naming most of his partnerships from the movie). Participation of Calpers meant that JEDI was an independent entity from Enron. Enron earned profits from the partnership, but none of JEDI's debt appeared on Enron's balance sheet.

In 1997, Enron wanted to launch a new and larger limited partnership called JEDI II, but Fastow thought that Calpers would be reluctant to invest in the new partnership while it was still invested in JEDI. Enron couldn't simply buy out Calpers investment in JEDI, which would make Enron the sole investor. JEDI would no longer be independent, and its debt would have to appear on Enron's balance sheet. Fastow proposed forming a new venture, called Chewco Investments, to take Calpers place as an investor in JEDI.

By replacing Calpers as an independent investor, Chewco would allow Enron to keep JEDI's debt off its balance sheet. This would only work if Chewco were also independent from Enron. Rather than find a truly independent investor for Chewco, Fastow decided that one of his subordinates, Michael Kopper, would play the role of independent investor in Chewco. Kopper didn't have the personal resources to make such an investment, and Fastow's solution was an elaborate scheme involving multiple special purpose entities and a direct investment by JEDI of $132 million in Chewco. JEDI was investing in Chewco so that Chewco could invest in JEDI. Except for $125,000 put up directly by Kopper and his domestic partner, William Dodson, all of Chewco's funding originated either from Enron or as loans guaranteed by Enron. Enron's board approved the Chewco deal without knowing the details of Kopper's role or specifics of how the deal was financed. Enron treated Chewco as an independent entity for accounting purposes, but it wasn't, and in the end, when this was exposed, it would be the deal that would put the final nail in Enron's coffin.