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Case 4

Enron was initially admired for growing to become the largest natural gas supplier in North America through innovative trading practices. However, its downfall was due to poor accounting practices that disguised unprofitable operations, compensation structures that rewarded risky short-term deals over long-term value, and a lack of oversight as stakeholders prioritized their own profits over addressing bad behaviors.

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Zhenyi Zhu
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51 views

Case 4

Enron was initially admired for growing to become the largest natural gas supplier in North America through innovative trading practices. However, its downfall was due to poor accounting practices that disguised unprofitable operations, compensation structures that rewarded risky short-term deals over long-term value, and a lack of oversight as stakeholders prioritized their own profits over addressing bad behaviors.

Uploaded by

Zhenyi Zhu
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as ODT, PDF, TXT or read online on Scribd
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1. Why was Enron such an admired company prior to 2000?

a. At the beginning of Enron’s creation

Background:

the U.S. market was in the midst of deregulation  short-term volatility in gas spot

prices  1. To ensure steady gas prices for the duration of the contracts, Enron entered

into long-term fixed-price agreements with its customers. 2. Enron employed financial

derivatives to fulfil customer delivery promises and long-term fixed-price contracts to

buy gas from producers.

In North America, Enron grew to be the biggest natural gas vendor. It also created

EnronOnline.

Skilling refined the trading model further: pursued an “asset light” strategy, began

divesting and syndicating heavy assets.

b. Extending the trading model

Enron’s gas-trading model was extended to other markets, including electric power,

broadband services, coal, water, etc.

c. International business

Enron was active in the international energy-asset construction business, aiming at

constructing and managing energy assets in the deregulated markets.

d. Managing talent

Enron recruited the ‘best and brightest’ and constructed a performance evaluation

system to encourage the employee to create value.

e. Risk-management practices

Skilling created an independent group called Risk Assessment and Control (RAC) to
evaluate the aggregate risks and rewards of the company’s investments. It also evaluated

new business ideas by reviewing the business plans, assessing their relation to Enron’s

existing core businesses and conducting a value-at-risk analysis.

1. Why did the company fail?

Enron’s downfall is the predictable mixture of human greed, poorly structured incentives, and

lack of sanity checks.

1. Accounting practices that disguised the fundamentals

The root of Enron has to be the accounting tactics that enabled deception. Accountants let

Enron book more revenue than they actually earned; keep losses and debt off balance sheets.

If these were disallowed, the money-losing state of Enron would have been apparent far

sooner.

a. Mark-to-market accounting allowed booking the total value of a deal immediately,

rather than spaced out over time.

b. Complicated SPE deals allowed Enron to borrow money while keeping it off their

balance sheet

c. One-time asset sales were booked as recurring revenue

d. Deals that were actually dead were fictitiously kept alive to avoid a write-down that

quarter

2. Poorly constructed compensation structures that rewarded unprofitable behavior

A pattern of Enron’s compensation style was to reward short-term behaviors (like stock price
or closing deal sizes) without concern for long-term value (like profitability).

a. Deal makers were given bonuses for the deal value when it closed, not on the

generation of actual cashflow. With optimistic projections, deal makers got paid for

bad unprofitable deals.

b. Employees got bonuses for short-term stock prices, thus incenting bad behavior to

prop up stock price.

c. Senior managers like Skilling got large bonuses for stock performance. This

prompted over-optimistic projections to Wall Street, which intensified the speed of

rushing into bad businesses (Enron Broadband) and created end-of-quarter scrambles

to make earnings.

1. Stakeholders/watchdogs overlooking bad behavior as long as they were profiting

People who could have stepped in and intervened didn’t, often because they had a large

personal stake in Enron’s success. Further, the more Enron became a success (like in terms of

stock price or deal flow), the more beholden the stakeholders were to Enron.

a. Shareholders (employees and the public in general) overlooked bad behavior, as long as

the stock price rose and employees got bonuses.

b. Enron’s accountants (Arthur Andersen) couldn’t lose Enron as a client (Enron kept

accountants waiting in the wings), so they tolerated their practices despite internal

skepticism. Furthermore, Enron gave many Andersen accountants cushy jobs.

c. Investment bankers earned large fees from Enron’s complicated deals, even when they

knew they were skirting the intent of the law. Bankers who ran bigger deals got
promotions. They competed for Enron’s business.

d. Buy-side analysts at banks who were supposed to be independent were strongly pressured

to give buy ratings, since companies would only work with positive banks.

e. Short sellers were a useful counterforce, since they had a large incentive to expose

wrongdoing.

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