So Scandalous

Thoughts on Enron: What Happened, Why, and How It Can Be Avoided Again. Frank Partnoy. Financial Engineering News. 24 Jan. 2002. 12 Feb. 2007. http://www.fenews.com/fen26/enron2.html

So how did all these new ethics courses in schools come about? What caused the government to restrict its laws and codes of conduct on business ethics? The current scandals faced brought this whirlwind about. Therefore, the figures I plan to focus on will include Ken Lay, Former Enron Chairman, Jeff Skilling, former Enron CEO, and Arthur Andersen, Enron's Financial Statements Auditor . My subject is business ethics, but I really would like to look into businesses and business people who are or were not very ethical. Therefore, the figures I would like to use can perfectly describe some unethical business practices. I don't know if I should change my subject to unethical business practices, or leave it where it stands. I do know that I want to look into these unethical practices, and see what the government and universities are doing to help prevent this behavior. Also, these figures, and the entire Enron operation could be described as finance or accounting. The way I see it, marketing, finance, accounting, management, and economics are all topics in business. My major is business management, which actually in my eyes is a major in business and a minor in management. I learn about all aspects of business, and also learn specifics in my field of management. I project this view onto my project. I will cover all aspects of business, and then cover specifically what it has to do with management.

So on to Enron. Let's take a look at what really happened, and how it became management's fault, Ken Lay and Jeff Skilling. Although it may be difficult to accurately describe every false operation that Enron pulled, I found an article written by Frank Partnoy that extremely helps to describe these things. The following is a summary of his article, which basically explains the business aspects of this topic.

Enron began as a basic energy company. Further on, it became what can be described as a derivatives trading firm. The definition of derivatives with relation to mathematics can be described as 1) The limiting value of the ratio of the change in a function to the corresponding change in its independent variable and 2) The instantaneous rate of change of a function with respect to its variable. Easily described, derivatives are complex financial instruments whose value is based on one or more underlying variables, such as the price of a stock or the cost of natural gas. So basically, in Enron's case, if they were trading a product, its value would be would be based on the price paid by the buyer. Derivatives can be traded in two ways. The way we will focus on is the one that Enron pursued, called over-the- counter (OTC) markets. These markets, keep in mind, are unregulated. Sometimes OTC derivatives can seem too obscure to be relevant to average investors. Half of Enron's scandal was keeping its investors confused. Somehow, Enron's OTC derivatives-related assets and liabilities increased more than five-fold during 2000 alone. This is because it's trading operations were not regulated, and not audited, until recently. OTC derivatives trading is beyond the normal, regulated exchanges. Therefore, Enron, like many other firms that trade OTC derivatives, can easily slip into illegal activity. The key problem at Enron involved the combination of derivatives and special purpose entities. I will describe these two things for you, because most people, including the investors in Enron, did not clearly understand what they meant. Enron had made derivatives transactions with other businesses to hide its unpredictable assets from quarterly financial reporting and to inflate artificially the value of specific assets. Enron used these transactions to manipulate its financial statements in three ways.

First, it would hide extremely large losses that it suffered on technology stocks. Enron hid hundreds of millions of dollars in losses with its abstract investments in different technology firms. One such transaction involved a subsidiary of Enron investing a small amount of venture capital (spending money) somewhere around $10 million, into a technology company called Rhythms Net Connections. When this company issued its stock, allowing the public to buy, it opened at about $70 per share. This caused Enron's stake suddenly to be worth hundreds of millions of dollars. Keep in mind this was during the middle of the internet boom, which caused the price of this stock to start so high. Enron invested in many other technology companies in the same way explained here, and at first the price skyrocketed. Enron made a series of transactions with a company called Raptor. What you need to know here is that Raptor was made of up several smaller companies, including Rhythms Net Connections. So Enron made a deal with Raptor, in which they would give Raptor shares of Enron stock. In exchange, Raptor gave Enron a loan. What Enron did next is where the risky business came into play. Enron made a derivatives transaction called a "price swap derivative" with Raptor. In this price swap, Enron would give Raptor more of Enron's stock if Raptors assets declined in value. The more Raptor's assets declined, the more stock Enron gave to Raptor. So Raptor was worth $1.2 billion, and if its value declined, Enron would give them more stock to boost it back up. So on Enron's books they got the best of both worlds. They recognized the gain from the loan they received right away, and avoided recognizing on a temporary basis any future losses on the technology stocks, were such losses to occur. What happens next was the dot.com bubble burst and by 2001 the shares of Raptor, and it's including companies such as Rhythms Net Communications, were worthless. So by the contract with Raptor, Enron had to give them enough stock to keep their worth up at $1.2 billion. When Enron introduced all this stock it created a dilution. (Say a company is worth $1 million and they issue ten stock certificates. Each certificate is worth one hundred thousand dollars. If the company introduces 90 more stock certificates, then the value of each certificate becomes ten thousand dollars, and those first ten people who had one hundred thousand dollars now have only ten thousand dollars.) But here is the key point: even as Raptor's assets and Enron's shares declined in value, Enron did not reflect those declines in its quarterly financial statements.

Second, it hid the debt caused by trying to finance new businesses that became unprofitable. Enron found a loophole in some very complicated and unclear accounting rules. Enron had invested and bought 50% of a company called JEDI (Joint Energy Development Investments). According to the rules of accounting, if Enron had owned 51% of JEDI, this would have required Enron to include all of JEDI's financial results in Enron's financial statements. In turn, because there was an outside investor, which was Enron, with at least 50% percent of the equity, JEDI was allowed to issue securities to the public. So when Enron needed to record this on their financial Statements, they decided to switch things around. When they were reporting assets (money owned), they recorded all of the money brought in by the issuing of securities by JEDI. When it came time to report liabilities (money owed) they didn't report any of the debt created by the company JEDI. Apparently, Arthur Andersen, Enron's financial statements auditor, must have just missed this transaction. Here Frank Partnoy uses a very funny, yet true comparison. He said that, "Enron used financial engineering as a kind of plastic surgery, to make itself look better than it really was. Of course, it is possible to detect the flaws in plastic surgery, or financial engineering, if you look hard enough and in the right places."

And third, it inflated the value of other types of businesses they ran, such as Enron's selling of fiber-optic bandwidth. Enron first sold a small portion of this bandwidth to a company at an inflated high price. It's actual worth was $33 million, but they sold it for $100 million. Now why would a company buy this bandwidth at such a high price? Because behind the scenes Enron had entered into a 'make whole' deal with this company. As earlier explained, if this company’s value decreased whatsoever, Enron would give them stock to put their value back up where it was. This 'make whole' deal was hid in the dark, and the public only saw this company buying the bandwidth at an inflated price. As if all of this were not complicated enough, Enron's sale of bandwidth to this company also magically generated an inflated price, which Enron then could use in valuing any remaining bandwidth it still had. The company that had bought this bandwidth had, in a sense, 'validated' the value of the bandwidth at the higher price. So Enron then arguably could use that inflated price in valuing the other bandwidth assets that it still had. For example, suppose that Enron had ten units of bandwidth worth $100, and sold one unit to a company for $20, double its actual value. Now, Enron had an argument that each of its remaining nine units also were worth $20 each, for a total of $180. (Keep in mind that when a company records its assets, or money owned, it adds into that its entire inventory, including bandwidth). So basically, all the bandwidth they had recorded as assets in their inventory had just tripled in price.

And finally, if Enron had pulled all of these tricks, how did it pass through the signing of an auditor? It has been reported widely that Enron paid $52 million in 2000 to its audit firm, Arthur Andersen, the majority of which was for non-audit related consulting services, yet Arthur Andersen failed to spot many of Enron's losses. And also, how did Enron get so many investors to purchase their stock? Many investors look to credit rating agencies to know if a stock is good to purchase. The three major credit rating agencies -- Moody's, Standard & Poor's, and Fitch/ IBCA -- received substantial, but as yet undisclosed, fees from Enron. It is a wonder that all three agencies gave great investment ratings to Enron's stock.