Enron: The Fall from Grace/ The Worlds Biggest Fraud

Outline
A. Enrons History
B. Overview of Enrons Operations
1. Wholesale Services
2. Energy Services
3. Global Services
C. Enrons Timeline
D. Enrons Role in The Energy Crisis in California
E. The Fall of Enron
F. Why Enron Fell from Grace?
G. The Crash of Enron
1. Key Management at Enron
2. Enrons Auditor
3. Credit Rating Agencies
4. Investment Banks
5. Links with The Government (Bush Administration)
6. The Link of Enron with The British Front
7. The Victim: Employees & Pension Fund Holders
H. Investigators & Regulators Involved
1. Capital Market Regulatory Authorities
2. Judicial & Legislative Entities
I. Lessons Learned
J. Proposed Reforms to Avoid Future Enronitis
K. What Could be Done to Avoid Such Enron-like Crises in Emerging Markets
Such as Egypt?
1. In Relation to The Exchange (CASE)
2. In Relation to The Regulator (CMA)
3. In Relation to Auditing & Accounting Practices
4. In Relation to Investors
5. In Relation to Board of Directors & Management

A. Enrons History
Enron, a Houston-based energy firm founded by Kenneth Lay, transformed itself over
its sixteen years lifespan from an obscure gas pipeline concern to the worlds largest
energy-trading company (both off and online). Enron has become an interstate and
intrastate natural gas pipeline company with approximately 37,000 miles of pipe.
Enron was largely credited by creating market trading in energy, allowing energy to
be traded in the same way as other commodities such as oil.
Enron was long viewed as the star of the stock market. It experienced a meteoric rise
and ranked 22nd in the Fortunes 100 best companies list in America in 2000. The
company had offices around the world including Australia, Japan, South America and
Europe. Furthermore, Enron established itself in the UK, as the first foreign
company, to begin construction of a power plant, after the electric industry in the UK
was privatized.
B. Overview of Enrons Operations
Enron had three main business units - Wholesale Services, Energy Services and
Global Services combing broadband and transportation services. It offered its services
to thousands of customers around the world.
The Wholesale Services unit was responsible for marketing a number of wholesale
commodity products, allowing industrial companies to manage commodity delivery
and price risk. Customers could arrange selling or buying commodities on terms that
suited their needs (i.e. long term, short term, fixed price, indexed price or other
innovative variations).
Enrons Energy Services unit, the retail arm of Enron, offered companies a better
way to develop and execute their energy strategies. Enron was the largest provider of
energy services to commercial and industrial companies, with a total contract value
amounting to $2.1 billion in 2000.
Enrons Global Services unit included North American pipeline businesses of Enron
Transportation Services including Northern Natural Gas, Transwestern Pipeline,
Florida Gas Transmission, Northern Border Partners, Portland General Electric and
Enron Global Services. On an international level it encompassed engineering
businesses; Enron Wind; EOTT Energy Corp; Azurix and Wessex Water.
EnronOnline was the world's largest e-commerce site for global commodity
transactions, which provided real-time transaction tools and information for
commodity transactions.
Enron in Numbers:
Employees
Countries in which Enron Operates
Assets
Miles of Pipeline Owned
Power Projects under Construction
Power Projects in Operation
Fortune 500 Ranking

Enron in 1985
15,076
4
$12.1 billion
37,000
1
1
Not Ranked

Enron in 2000
18,000+ (worldwide)
30+
$33 billion
32,000
14 in 11 Countries
51 in 15 Countries
18

C. Enrons Timeline
With the deregulation of the energy sector in the early 1980s, Enrons rose to
stardom as energy corporations lobbied Washington to deregulate the business.
Companies including Enron argued that extra competition would benefit both
companies and consumers. As a result, the US government began to lift controls on
who could produce energy and how it was sold. New suppliers came to the market
and competition increased. However, the price of energy became more volatile in the
free market.
Enron saw its chance to make money out of these fluctuations. It decided to act as
middleman and guarantee stable prices. Encouraged by deregulation, Enron turned to
electricity to supplement its natural-gas business. Furthermore, Enron tried to buy into
the water business and to hedge London weather.
ENERGY DEREGULATION IN THE US
Before

After

Impact

Utilities
owned
stations and
sold directly
to
customers

Plants sold;
New owners
compete to
sell to
utilities

Mixed.
Critics
attack
removal of
strategic
planning

Distributing Monopolies
power
tightly
controlled to
protect
consumers

Utilities
compete to
win
consumers
and
contracts on
basis of
price

Enron and
others
created
new
markets
focusing
on energy
trading

Special
commissions
monitor
prices
charged to
consumers

Market
competition
theoretically
to set
prices, but
some
controls
remain

Mixed
political
reaction;
some
legislators
opposed
unhindered
markets

Generating
power

Regulating
the
industry

1989: Enron Trading Futures

Futures markets are used by buyers and sellers to get what they hope will be a better
deal on commodity prices than they would do on the open market. Enron profited
from trading futures in gas contracts between suppliers and consumers, effectively
betting against future movements in the price of gas-generated energy. Below is a
graph that displays how Enron traded energy futures.

1990s: Enron Creating An Energy Commodities Business

Enron became a massive player in the US energy market, controlling a quarter of all
gas business. Buoyed by the success, the company went on to create markets in
myriad energy-related products. Enron began by offering companies the chance to
hedge against the risk of adverse price movements in a range of commodities
including steel and coal. By the end of the decade, Enron expanded its trading arm to
include hedging against external factors such as weather risk. Enron was not the only
company in the game, but through its online trading arm, Enron was becoming the
biggest on what was dubbed Energy Alley (90% of its income came from trades).
The company started expanding internationally, moving into water in the UK and
power generation in India.

Early 2000: dot.com Boom

Enron began 2000 with a plan to move into broadband internet networks and trade
bandwidth capacity as the dot.com economy prospered. Enron's dynamic ideas,
coupled with its stable old-economy energy background, appealed to investors and its
share price soared. The following chart highlights Enrons International Growth from
the time it started its operations in the 1980s till 2001 when it became an energy giant.

Enron's 2000 annual report reported global revenues of $100bn. Income had risen by
40% in three years and by the summer of 2000, Enron's shares had hit an all time high
of more than $90.
The dilemma for Enron started with the energy crisis in California, which was
blamed by many on the poor handling of deregulation. Some consider it the real
smoking gun for Enron. As the Enron mess continued to heat up, the energy crisis in
California was one of the company's biggest political embarrassment.
D. What Was Enrons Role in The Energy Crisis in California?
After a turbulent political battle, with Enron being one of the loudest voices,
California State in 1996 came up with an energy market design like no other in the
world. The new design created the Independent System Operator, which is charged
with running the power grid so that the lights stay on as well as operating a spot
market for last-minute power purchases. Another agency, the California Power
Exchange, ran the financial auction in which power companies bought and sold
megawatts. Energy experts are of the opinion that keeping these two functions
separate created an inefficient system in which a company like Enron, which dealt in
huge volumes of energy and ran sophisticated computer models, could predict
shortages in markets and accordingly was able to manipulate them. Examples include:
Power managers running the auction would stack energy bids from the least expensive
to the costliest, then select enough bids to cover the state's energy needs. But the
managers were forced to pay everyone the same price, the highest cost selected.
Companies aware of shortages knew they could bid in at high prices and make big
profits.

Companies were not penalized for failing to deliver the power they offered in the
auction. If prices were higher on the spot market, marketers could withdraw energy
from the auction and sell it on the spot market. Companies could play on the
transmission limits of the state. Companies could purposely over-schedule power
deliveries and end up getting paid to not deliver.
In the mid-1990s, California was faced with crippling energy bills and changes in
federal regulations that encouraged deregulation. Big businesses and energy officials
thought they could lower electricity prices by forcing utilities to compete with other
companies. In meetings sponsored by the State Public Utilities Commission, Enron
officials passionately argued their case for deregulation. Deregulation talks focused
on a centralized energy market that would handle both the physical process of
delivering electricity and the financial market, a model used by most deregulated
energy markets. This plan was eventually implemented and created separate entities
and fewer regulations.
Because most market data are confidential, it is unclear which companies may have
benefited the most from the Californias crisis, and whether there was any illegal
activities. What is clear is that Enron recorded earnings of about $404 million in
the second quarter of 2001, up 40 percent from the year before. And while
Enrons stock was beginning to fall even during the latter months of the energy crisis,
it crashed hardest in June 2001 after federal regulators implemented electricity price
caps in California which eased the crisis. Enron dismissed allegation, that it
artificially manipulated the price of energy to profit off California's poorly
constructed energy deregulation plan.
E. The Fall of Enron

In May 2001, Enrons executive Clifford Baxter left the company, apparently in
uncontroversial circumstances. It was rumored that Baxter, who later committed
suicide, had clashed with Jeff Skilling (Enrons CEO), over the righteousness of
Enrons partnership transactions.
7

On 14th August 2001, Jeff Skilling resigned as Chief Executive, citing personal
reasons and Kenneth Lay became Chief Executive Officer. Skillings departure was
prompted by concerns over Enron's bungled accounting and bad management.
In mid August 2001, Sherron Watkins, Enrons Corporate Development Executive,
who was later referred to as the whistleblower in the Enron scandal, wrote a letter to
Kenneth Lay warning him of accounting irregularities that could pose a threat to the
company.
This development shocked investors who suddenly panicked. The lack of
transparency sent a selling wave in the market. Investors sold millions of shares,
knocking almost $ 4 off the price to less than $40 over the course of the third week of
August 2001. In spite of the drop in price, management still insisted all was well.
Despite the air of impending doom, Kenneth Lay found two banks willing to extend
credit. But the worst of revelations were to come yet.
On 8th November 2001, the company took the highly unusual move of restating its
profits for the past four years. Enron effectively admitted that it had inflated its profits
by concealing debts in its complicated partnership arrangements (Special Purpose
Entities).
On 9th November 2001, the humiliation of Enron appeared complete as it entered
negotiations to be taken over by its much smaller rival, Dynegy.
The following graph shows how Enrons restated accounts.
ENRON'S ACCOUNTS: THE TRUE PICTURE
Reported
income

Revised
income

True debt

True equity

1997

$105m

$77m

Up $771m

down $258m

1998

$733m

$600m

Up $561m

down $391m

1999

$893m

$645m

Up $685m

down $710m

2000

$979m

$880m

Up $628m

down $754m

Reported and revised income, debt and shareholder equity 1997 - 2000
following special partnership revelations;
Source: Enron/Powers Special Report

Enron filed for bankruptcy in December 2001 and filed a suit against Dynegy for
pulling out of the proposed merger. Enrons share price collapsed from around $ 95 to
below $ 1. Enrons employees lost their savings as well as their jobs.
Mr. Kenneth Lay, the once renowned visionary chairman of the firm, resigned in
January 2002.

It appears now that the phenomenal success of Enron was a daydream and it seems
to have sunk into a financial predicament that is largely of its own creation. In just
sixteen years, Enron grew into one of America's largest companies, however, its
success was based on artificially inflated profits, questionable accounting
practices and fraud. Several of the companys businesses were losing operations; a
fact that was concealed from investors using off balance sheet vehicles or
structured finance vehicles.
F. Why Enron Fell from Grace
Enron was one of the first amongst energy companies to begin trading through the
internet, offering a free service that attracted a vast amount of customers. But while
Enron boasted about the value of products that it bought and sold online around $880
billion in just two years, the company remained silent about whether these trading
operations were actually making any money.
It is believed that Enron began to use sophisticated accounting techniques to keep
its share price high, raise investment against its own assets and stock and maintain the
impression of a highly successful company. These techniques are referred to as
aggressive earnings management techniques.
Enron also set up independent partnerships whereby it could also legally remove
losses from its books if it passed these assets to these partnerships. Equally,
investment money flowing into Enron from new partnerships ended up on the
books as profits, even though it was linked to specific ventures that were not yet up
and running. It now appears that Enron used many manipulative accounting practices
especially in transactions with Special Purpose Entities (SPE) to decrease losses,
enlarge profits, and keep debt away from its financial statements in order to enhance
its credit rating and protect its credibility in the market.
The main reason behind these practices was to accomplish favorable financial
statement results, not to achieve economic objectives or transfer risk. These
partnerships would have been considered legal if reported according to present
accounting rules or what is known as applicable accounting rules. One of these
partnership deals was to distribute Blockbuster videos by broadband connections. The
plan fell through, but Enron had posted $110 million venture capital cash as profit.

Although these practices were generally disclosed to Enrons investors, the disclosure
was inadequate. This inadequacy may have stemmed from conflict of interest to avoid
revealing, the extent to which some top Enron executives were enriching themselves,
which simply represents fraud. Another explanation may relates to Enrons
governance whereby Enrons structured finance transactions were so complex that
disclosure becomes necessarily imperfect. Therefore Enrons investors had to rely on
their business judgment of Enrons management ,but such reliance failed due to a
tangled web of conflicts of interests. This becomes crystal clear when it was known
that most of the senior Enron executives, especially Andrew Fastow, served as the
SPEs principals, receiving massive amounts of compensation and returns, in order to
skew their loyalty in favor of the SPEs.
G. The Crash of Enron:
The shockwaves of the corporate crash resonated worldwide as investors around the
world demanded answers. Congressional hearings began in December 2001. Four of
Enron's most senior executives (Andrew Fastow, Richard Buy, Michael Kopper and
Kenneth Lay) pleaded Fifth Amendment protection against self-incrimination and
refused to testify.
In January 2002, the US department of justice announced a criminal investigation.
For the average layman, the collapse of Enron is a scandal of a major energy provider
that used to be the seventh largest corporation in America and became the biggest
bankruptcy in the US corporate history. As revelations of the Enron affair continue to
tumble out, employees and investors are furious at the way senior executives behaved
and at how auditors, analysts, banks, rating agencies and regulators turned a blind eye
to what was going on.
The Enron fiasco is an unprecedented situation. This was a company with an
extraordinary complex and risky business model that entered into highly questionable
transactions. The market capitalization of Enron had reached exceptional valuations

10

relative to the realism of the companys ability to produce recurring excess cash flow.
What finally brought the company down is finalized? Internal policies, investment
advisors, investment banks, undetermined criminal activity, poor auditing, poor rating
probably all played a role in its rapid demise.
1. Key Management at Enron:
Kenneth Lay:
Former Enron Chief Executive, Chairman and Board Member.
Lay took up the reins at Enron in 1986 after it was formed from the merger of two
pipeline firms in Texas and Nebraska. Prior to Enrons collapse, he was credited with
building Enron's success. Lay resigned as CEO in December 2000, and was replaced
by Jeffrey Skilling. In August 2001, he resumed leadership after Skilling resigned.
Lay resigned again in January 2002 after becoming the focus of the anger of
employees, stockholders and pension fund holders who lost billions of dollars in this
disaster.
Jeffrey Skilling:
Former Chief Executive, President and Chief Operating Officer.
Skilling joined Enron in 1990 from the consultancy firm McKinsey, where he had
developed financial instruments to trade gas contracts. Prior to becoming Chief
Executive in February 2001, Skilling was President and Chief Operating Officer of
the firm. Skilling was also seen as a key architect of the companys gas-trading
strategy. Skilling resigned his post as Enrons chief executive in August 2001 without
a pay-off.
Andrew Fastow:
Former Chief Financial Officer.
Fastow was fired in October 2001, when Enron made losses amounting to $ 600
million. Fastow was allegedly responsible for engineering the off-balance sheet
partnerships that allowed Enron to cover its losses. Fastow was also found by an
internal Enron investigation to have secretly made $30 million from managing one of
these partnerships.
Clifford Baxter:
Former Chief Strategy Officer and Vice Chairman.
Baxter was known to have been one of the Enron executives, who had opposed its
creative accounting practices. Baxter retired from Enron in May 2001. Baxter
committed suicide in January 2002.
2. Enrons Auditor (Arthur Andersen):
Arthur Andersen, one of the world's five leading accounting firms, was Enrons
auditing firm. This means that Andersens job was to check that the companys
accounts were a fair reflection of what was really going on. As such, Andersen should
have been the first line of defense in the case of any fraud or deception.

11

Arguments about conflict of interest had been thrown at Andersen since they acted as
both auditors and consultants to Enron. The company earned large fees from its audit
work for Enron and from related work as consultants to the same company. When the
scandal broke, the US government began to investigate the companys affairs,
Andersens Chief Auditor for Enron, David Duncan, ordered the shredding of
thousands of documents that might prove compromising. That was after the Securities
and Exchange Commission (SEC) had ordered an investigation into the speculative
actions of Enron. Duncan said he was acting on an e-mail from Nancy Temple, a
lawyer at Andersen, but Temple denied giving such advice.
While Andersen fired Duncan, its Chief Executive Officer, Joseph Berardino, insisted
that the firm did not act improperly and could not have detected the fraud. Berardino
conceded that an error of judgment was made in shredding documents, but he still
protested Andersens innocence.
3. Credit Rating Agencies:
Credit rating agencies like Moodys, Standard & Poors and Fitch IBCA, whose
main duty is to provide guidance to investors on a borrowers' creditworthiness i.e.
inform investors how risky buying a companys bonds might be, failed to spot any
problems with Enron until the company was nearly bankrupt, only downgrading its
bonds on 28 November 2001. The agencies claimed they could only act on public
available financial information.
An interesting comment regarding Enrons operations was made in March 2001, when
credit analysts at S&P and Fitch told a Fortune reporter they had no idea how Enron
made its money. Commentators attribute the lack of action on part of the credit
agencies to Enrons ordeal is their fear that downgrading a companys bond rating
could drive it into bankruptcy by sharply raising the costs of its loans. This is because
the analysis that rating agencies provide is influential in determining the interest rates
that borrowers pay on their debt.
Enron had been facing dreadful financial troubles throughout October and November
2001, but rating agencies only downgraded their bonds to junk status on November
28th. This has caused critics to wonder if they were doing their jobs correctly.
Rating agencies have responded by saying that Enron had evolved from a an energy
company to a broker and as a result in the context of a financial institution or a broker
that loses confidence, these things can happen relatively quickly," as quoted by Fitch's
chief credit officer Bob Grossman. However, the three big agencies confirmed that
they will be looking at modifying the way they do business.
4. Investment Banks:
Several investment banks were involved in Enrons collapse:
Credit Suisse First Boston (CSFB) played a central role in creating the controversial
partnerships that Enron used to hold billions of dollars of unprofitable assets and that
eventually contributed to its bankruptcy. Enron depended heavily on a team within
CSFB, known as the Structured Products Group, to engineer the partnerships.
The team worked closely with Andrew Fastow, Enron's ex-Chief Financial Officer,
and his deputies to develop partnerships that shielded unprofitable Enron assets.
CSFB devised three partnerships, known as Osprey, Marlin and Firefly, which held a

12

total of $ 4 billion in assets. The team was part of US firm Donaldson Lufkin &
Jenrette (DLJ), which merged with CSFB in 2000. CSFB has defended its role in
advising Enron and handed over documents relating to its work with Enron to
Congressional investigators. A CSFB spokesman insisted that Enron officials
understood the partnership structures they worked on with CFSB.
Another US investment bank, JP Morgan Chase, was involved in the Enron tragedy.
The investment bank was a major lender to Enron and the bankrupt telecom group
Global Crossing. Loan losses related to Enron contributed to the bank's 2001 fourthquarter loss around $ 332 million and JP Morgan was forced to put aside another
$ 510 million in case of future loan defaults.
JP Morgan is also under probe by federal prosecutors as to whether the bank could
have helped Enron disguise loans as part of its normal trading. JP Morgan is known
to be one of the investment banks that helped Enron set up the "Special Purpose
Entities", which were at the heart of the company's collapse. Questions have also
been raised regarding trades between Enron and an offshore company set up by Chase
Manhattan Bank, which is now part of JP Morgan Chase. The offshore entity,
Mahonia, traded with Enron, paying it in advance for future delivery of oil and gas.
The resources it used came from JP Morgan itself.
In short, on 2 December 2001, Enrons total global investment exposure to major
financial institutions amounted to at least $4 billion.
INTERNATIONAL SHOCKWAVES:
Companies with substantial exposure to Enron
J P Morgan:
$900m

Sumitomo Mitsui Corp:

$210m

Citigroup:
$800m

Nikko Cordial:
$207m

Credit Lyonnais:
$250m

Principal Financial Group:

$171m

Bank of Tokyo-Mitsubishi:
$248m

Abbey National:
$164m

Chubb Corp:
$220m

National Australia Bank:

$104m

Canadian Imperial Bank:

$215m

Duke Energy Corp:

$100m

Some 25 further companies have declared Enron

exposure totaling an estimated $1bn
Total global investment exposure at least $4bn

5. Links with The Government (Bush Administration):

In spite of the fact that there are no suggestions currently that there were any illegal
connections between the current US administration and Enron officials, there are
close links that exist between Enron and the current administration at all levels
13

whether personal, social, financial, professional or political. According to reports,

thirty five administration officials have held Enron stock, some had six figure
investments. Several, less senior officials, have served as paid consultants for Enron.
According to the US Center for Public Integrity, Lay (CEO of Enron) and Enron
donated more than $ 500,000 to the Bush campaign, thus making Enron the
Presidents largest single patron. Bush has championed some issues Enron considered
important, such as deregulating utilities and limiting compensation awards. Bush has
also favored more oil exploration and drilling in spite of opposition from
environmentalists.
As for the US Vice President, Dick Cheney, he is alleged to have met Enron
executives four times in 2001 to discuss energy policy. Cheneys critics say that no
company in the US stood to gain more from the energy policies than Enron. Later the
General Accounting Office, the investigative arm of the US Congress, demanded that
the Vice President releases documents relating to the formulation of government
energy policy but he resisted. It is also known that Cheney was the former Chief
Executive of an oil services company named Halliburton, which built the Enron Field
stadium in Houston, when Mr. Cheney was its Chief Executive.
Paul ONeil, the current US Treasury Secretary, had been contacted by Lay who
asked O'Neil to encourage US banks to extend their credit to Enron, a request refused
by ONeil.
SEC Chairman Harvey Pitts was hand-picked by Lay for the position, due to his
notorious aversion to governmental regulation of any kind.
6. The Link of Enron with The British Front:
Shock waves of the Enron scandal have been felt in Britain too, where Enron acted as
a sponsor of the two main political parties, Labor and Conservatives.
The Labor party was accused of taking Enrons money in return for access to
government ministers. The party had apparently changed its policy on gas-fired power
stations after being lobbied by companies, including Enron. This was seen by some as
possible evidence of Enron's influence on government policy. However, the UK
Government insists its links with Enron have neither changed policy nor bought
access to ministers. The row has renewed campaigners calls for political parties to be
funded by the state rather than relying on business donations.
A second front of allegations emerged over Labors close ties with Andersen, Enrons
accountants, a company barred from government work for failing to prevent the
DeLorean car company collapse. This ban was later lifted, which has caused the rise
of awkward questions faced by the Labor party now.
Furthermore, Lord Wakeham, a former Conservative Cabinet Minister and a nonexecutive director in Enron. Lord Wakeham served on the audit committee that was
meant to oversee Enrons auditing procedures, which is at the heart of the scandal,
and supposed to protect shareholders interests. In response to these allegations, Lord
Wakeham stepped down as Chairman of the Media Watchdog, the Press Complaints
Commission (PCC).

14

7. The Victim: Employees and Pension Fund Holders:

The collapse of Enron has left thousands of people out of work. Thousands lost their
personal investments and pensions after the scandal broke out and Enron's stock
plunged.
Many employees had personal pension funds made up of Enron shares - a common
situation in America, where occupational schemes based on final salary payments are
increasingly rare and money purchase schemes, known as 401(K) plans, are the
norm. Employees at Enron were encouraged to do so by the company, which also
forbade them from selling their stocks, when the company share price came down.
In contrast, many Enron executives were able to cash in their share options when the
companys fate became clear.
H. Investigators and Regulators Involved
1. Capital Market Regulatory Authorities:
In theory, such a scandal should never have taken place. The US financial markets are
supposed to be the best regulated in the world, with the Securities and Exchange
Commission (SEC) enforcing strict rules on disclosure to protect investors, besides
the presence of private agencies that monitor companies. The SECs main role is to
ensure that investors have accurate information about companies and that companies
do not deceive investors or manipulate the market price of their shares. The SEC has
strong investigation powers and can fine companies for violations or failing to cooperate.
Although, the SECs investigation into Enron started in October 2001 based on
allegations regarding the mismanagement, mistreatment of shareholders and potential
fraud, the SEC was accused of failing to notice earlier irregularities in Enrons
accounts and failed to scrutinize the companys reports in detail since 1997. The SEC
has defended its actions by stating that Enrons accounts were impenetrable to
regulators, since its core business, energy trading, was only lightly regulated by
another set of government agencies, which exempted it from many reporting
requirements.
Moreover, the Commodity Futures Trading Commission (CFTC), the regulator of
futures and derivatives markets was supposed to regulate Enron. Originally most
futures trading were related to physical commodities like the price of wheat or pigs,
but in recent years, much of the trading has been in financial commodities like
exchange rates.
Enron pioneered the trading of energy contracts for the supply of gas and electricity,
which became the centerpiece of its business. The main problem is that CFTC
believed in light-touch regulation. In 1993, the CFTC exempted such energy
trades from its regulatory overview, a ruling that was confirmed in the 2000
Commodity Futures Modernization Act. The chair of the CFTC at the time was
Wendy Gramm, the wife of prominent Texas Republican Senator Phil Gramm. She
later joined the board of Enron!

15

Another regulatory body that oversees the energy market is the Federal Energy
Regulatory Commission (FERC), which was established to oversee the US domestic
energy markets in 1977 and is part of the US Department of Energy. The FERCs
main duty is to ensure that fair prices are paid for the transmission of gas, oil and
electricity across state boundaries, a job that gained importance as the deregulation of
energy markets gathered pace. However, the FERC exempted trading in electricity
contracts from its reporting requirements after lobbying from Enron in the 1990s. It
also failed to closely examine reports filed by Enron. Its current chairman is Pat
Wood, a close associate of President Bush. Wood was the chief energy regulator for
the state of Texas before taking up his current post. Press reports suggest that Enron
boss Lay suggested his appointment to the Bush administration.
The Financial Accounting Standards Board (FASB) is currently reviewing
industry standards to check their applicability and whether changes or amendments
are required to avoid future corporate collapses like Enrons.
2. Judicial and Legislative Entities:
The US Department of Justice investigates allegations of fraud and stock
manipulation on recommendation of the Securities and Exchange Commission (SEC).
Enron executives could be prosecuted for concealing evidence. Other charges that are
investigated include defrauding Enrons pension fund.
The Federal Bureau of Investigation (FBI) is charged with investigating federal
crimes. FBI agents in Houston have already been involved in sealing off Enrons
offices after allegations that crucial documents were shredded.
The US Congress began investigating the Enron scandal. The congress has the power
to call witnesses and compel them to testify over the scandal, but it cannot bring
criminal charges itself. Because a criminal investigation is under way at the same
time, witnesses have the right to remain silent in order to avoid incriminating
themselves. This right has already been exercised by Enron's Chairman Lay and
former Chief Financial Officer Andrew Fastow.
There are currently 11 investigations by Congressional Committees from both the
House of Representatives (controlled by the Republicans) and the Senate (controlled
by the Democrats) into why the Enron scandal happened.
There are four key areas that Congress is expected to investigate which include:

The regulation of energy markets.

Enrons accounting practices.

Legislation on pension plans.

The political influence Enron enjoyed in the Bush administration.
The General Accounting Office (GAO), the investigative arm of the Congress, is
also involved trying to obtain from the White House records of the energy task force
headed by Vice President Cheney. Vice President Cheney refused to release
information on discussions between Enron and his special energy taskforce to the
General Accounting Office (GAO). The GAO is demanding details of the talks in
order to gauge the influence Enron exercised on US energy policy.

16

The refusal to release these documents has led congressional investigators to take an
unprecedented step of suing the White House. In an effort to calm down the anger of
the public, the White House has commissioned two task forces teams to report to
Bush on pensions and corporate disclosure standards. Bush has been quick to
underplay his links, both personal and political, with Enron.
I. Lessons Learned from Enron:
1. Concern over conflict of interest between auditing and consulting raises the
need for accounting firms to separate their consulting activities from their
auditing businesses.
2. Securitization and other legitimate structured finance deals have to be
disclosed with sufficient depth and detail to adequately inform sophisticated
investors.
3. Management has to be free of material conflicts of interest because private
investors rely on their business judgment.
4. There should be a method or basis that distinguishes between structured
finance transactions that should be allowed from those that should be
restricted. This requires regulatory re-examining of structured financing
transactions. However, a long-term perspective must be taken that excessive
safeguards can stifle business innovation
5. The importance of taking corporate codes of conduct seriously and carefully
thinking through their implementation.
6. There is a move considering forcing firms to routinely change auditors and for
accounting firms to separate their consulting from their auditing businesses in
an attempt to prevent Enron-style collapses. However, accountants are
opposing the move because they fear they could lose contracts with clients
dating back decades, which established cozy and dependant relationships. For
example last year FTSE 100 companies paid their auditors 216 million in
audit bills and 675 million in advisory fees. They also argue that the change
would increase the audit costs.
J. Proposed Reforms to Avoid Future Enronitis
After the collapse of Enron, several issues were earmarked for the attention of
reformers including:

The role of business funds in political campaigning.

The extent of energy companies' influence on national energy policy.

The need to reform pension laws to stop over-exposure to one stock and prevent a
company from investing its pension funds in its own stock.

The need for higher standards of transparency and disclosure in the audit
profession.

Potential conflicts of interest between consultancy and auditing work undertaken
by financial houses.

The need for tighter regulation on financial derivatives trading.
One of the first reforms that took place after the scandal was the appointment of
Stephen Cooper as Enrons Chief Executive in January 2002.

17

The most publicized repercussion of the scandal was the debacle of Enrons auditor,
Andersen. Andersen has lost several prestigious clients (including Delta Air Lines,
Merck, Freddie Mac, SunTrust Banks and FedEx) that provided it with combined
annual fees of about $100 million . As a result in February 2002, former Federal
Reserve Chief Volcker was hired by Andersen to help restore its credibility and
review policies and procedures within the accounting firm. In spite of Andersen
CEOs denial that it helped set up a series of complex external financial partnerships
to squirrel away millions of dollars of undisclosed debt, Volcker accused regulators of
being lax in front of the Senate Banking Committee saying that regulators had not
kept auditors in check after they became greedy during the financial boom.
In March 2002, Andersen announced that it was in talks to sell itself to one of its
major rivals; Ernst & Young or Deloitte, Touche & Tohmatsu or KPMG. Talks about
a possible merger or takeover started after it became clear to Andersen that the
Department of Justice and Federal prosecutors were seeking a criminal indictment
against it for shredding documents relating to the investigation.
The final blows came when Andersen was banned from US government work
after being indicted by a federal grand jury on the charge of obstruction of justice.
This was coupled with the case brought by the US Department of Justice against the
Andersen UK office for joining in the shredding of Enron documents. This caused
Andersen UK practice to reopen merger talks with other accounting firms in response
to these claims made against the office. Both KPMG and Deloitte had been interested
in Andersen's UK business, but KPMG's interest trailed off as more information
became available about Andersen's financial situation and the potential risk of
litigation. Andersen UK agreed to join with Deloitte, Touche & Tohmatsu. In
addition, Deloitte reached agreements with Andersen partners in Spain, Portugal, the
US and Mexico.
On June 15, 2000, a federal jury convicted Arthur Andersen of obstruction of justice
for impeding an investigation by securities regulators into the financial debacle at
Enron. The decision was based on a single altered internal memo that showed the
accounting firm interfering with the government's investigation into Enron's collapse.
The memo written by David Duncan, the lead partner on the Enron account, was
about a news release Enron was planning to issue regarding its third-quarter earnings.
That release characterized certain losses Enron was reporting as "nonrecurring;" at the
time, several Andersen experts, including Mr. Duncan, had concluded that such a
representation was misleading. Andersen did not approve that earnings release and
Enron went along anyway and issued it, then Andersen set about to change things to
alter documents to keep that away from the SEC.
Thus, the guilty verdict against Arthur Andersen on a charge brought because of
the shredding of thousands of records and deletion of tens of thousands of e-mail
messages was ultimately reached because of the removal of a few words from a
single memorandum.
Although Andersen has already lost much of its business, and two-thirds of its once
28,000 US workforce, the most important result of the verdict was that it closed the
books on the firm's hopes of surviving even in a reduced state. Also following the
conviction, multimillion dollar lawsuits brought by Enron investors and shareholders

18

demanding compensation are likely to follow, and could bankrupt the firm. In
addition Andersen faces the possibility of fines up to $500,000.
The company called the verdict wrong and is contemplating an appeal, but at the
same time informed the government that it would cease auditing public companies as
soon as the end of August, effectively ending, the life of the 89-year-old firm.
Investment banks are facing problems too. The first offensive was made by the New
York State Attorney General, Eliot Spitzer, against Merrill Lynch, the renowned Wall
Street banking firm. Merrill Lynch was accused of misleading small investors by
issuing buy recommendations on Enron while its analysts simultaneously warned its
investment-banking clients to steer clear of them. This has renewed criticisms for
investment bankers for failing to separate their research and banking departments.
The Reinstatement of Chinese Walls
As a result, talks about the reinstatement of the Glass-Steagall Act introduced in
1933, which placed barriers between commercial banking, investment banking and
insurance were again risen. The Act was introduced in the early thirties in response to
investors protests about conflicts of interest on Wall Street following the 1929 stock
market collapse.
The reinstatement of the act was brought up in response to allegations that the two
investment banks: JP Morgan and Citigroup have overlooked some lending standards
to win investment business from Enron. This allowed the energy giant to become
over-leveraged. It also fostered conflict of interest as the investment banks acted as
both creditors and advisors for Enron. This might have caused them attempt to
preserve whatever value was left for Enron and encourage it to pursue riskier
strategies to maximize their chance of being repaid and keep the company alive. That
could have been a reason why analysts refrained from warning the market about the
foreseen crash of the firm.
The Securities and Exchange Commission (SEC) is deeply troubled by the
underlying events that resulted in Andersen's conviction, especially as the verdict
reflects the jury's conclusion that Andersen engaged in conduct designed to obstruct
the SEC process. Accordingly, the SEC is currently considering implementing
changes to its corporate disclosure rules, including speedier and fuller explanation of
significant events. Under pressure from Harvey Pitt, the SEC's Chairman, the New
York Stock Exchange and Nasdaq are also reviewing their governance rules and
listing standards. In addition, the Financial Accounting Standards Board (FASB), is
planning changes to its rules on accounting for off-balance-sheet vehicles.
K. What Could be Done to Avoid Such Enron-like Crises in Emerging Markets
Such as Egypt?
Investors were scared away from the stock market following Enron's bankruptcy, and
an array of different companies have been infected by Enronitis, i.e. a lack of trust
in the accounting practices of those firm. Buying shares in a company, just like most
other transactions, has a lot to do with trust. Because investors do not necessarily
know the people who run the firm, shares come packaged with a form of guarantee with much legal back-covering. In other words, company reports are rigorously
19

audited, capped with the soothing statement that they represent fairly, in all material
aspects, the financial position of X Corp and subsidiaries. The dramatic collapse of
Enron has called into question the validity of such assurances and has besmirched the
good name of the accountancy industry.
Enrons scandal highlights several issues that emerging markets, including Egypt,
should be aware of.
 In Relation to The Exchange (CASE):
 Great care and due diligence should be undertaken in the listing of foreign
companies on CASE to avoid having Enrons. CASE should not suffice if a
foreign company is listed on an developed and well regulated stock exchange,
rather it must conduct due diligence analysis of prospective issuers prior to their
listing.
 Importance of educating investors about the importance of disclosure of listed
companies and how to be able to read financial statements of listed companies.
 Regulations should be enforced to ensure timely and full disclosure of
information from issuers.
 Imposing penalties on listed companies that are engaged in fraud or misguide its
investors.
 In Relation to The Regulator (CMA):
 Although Egypt does not currently have a derivatives market, capital market
regulators should undertake educational courses about futures and options
markets prior to their introduction in Egypt.
 Market regulators should be aware of sophisticated accounting practices that
firms can use to hide losses from investors and report unrealized profits.
Regulations should be passed to ban such practices.
 Capital market regulators should have publish a list of auditing firms that are
licensed to carry out auditing for listed companies on CASE.
 Capital market regulators should exert effort in the regulation on credit rating
agencies, their competency and the credibility of the ratings they publish to the
market.
 Pension funds regulations should be revised to ensure that investments are
properly placed. Pension funds investments are long term ones and consequently
influence is best exercised by ensuring that companies are well managed. This
should call into question corporate governance practices of the organizations that
attract these investments.
 Barriers should be reinforced between commercial banking, investment banking
and insurance arms of the same financial institution to avoid potential conflict of
interest. Regulators (Central Bank as well as CMA) should be aware that
conflicts of interest within the same organization leads to the demise of
corporations such as Enron.
 Fines should be levied on financial institutions where corporate clients or
investors were exploited. One of the suggestions that were recently introduced
after Enron scandal is to separate investment analysts from the underwriters of
initial public offerings.

20

 In Relation to Auditing & Accounting Practices:

 Expected changes in the international accounting standards. It is anticipated that
the US GAAP have become too rule based-so there will be a move towards
more principle based accounting or International Accounting Standards (IAS).
This will strengthen the global stature of IAS.
 The presence of Chinese walls between the auditing and consultancy divisions
in the big five auditing firms. Auditing is a quasi public statutory function that
merits maximum protection and consequently should not be infringed upon by
the consultancy division. For example, PricewaterhouseCoopers started
separating its auditing and consulting activities into two separate firms.
 Expected dramatic changes in the way information is presented in financial
statements or corporate report modeling. More emphasis will be placed on the
value of reporting where it is expected that capital markets will punish
companies whose financial statements are regarded opaque or
uncommunicative.
 In Relation to Investors:
 Investors must be aware not to follow market rallies blindly. Investors should
study companies based on fundamental and technical researches and not resort
to market rumors and rallies. Investors should review the board of the company,
its strategy, its industry, its competitive position, analyze long term projections,
cash flows, financial terms and changes in the share price.
 Investors should understand the underlying reasons for the rise and fall in stock
prices. They should monitor the reasons of the change in price and not merely
dismiss it without thought. While a high share price can give the investor some
comfort, the stock market can be brutal and send the share price to depressing
levels within a day. A low share price can be very indicative of bad news.
 Investors should be wary of poor recommendations and approvals by market
participants, credit rating companies and auditors.
 In Relation to Board of Directors & Management:
 There is a critical need for truly independent directors and knowledgeable audit
committee members, that are willing to be involved, ask tough questions to
management and accountable. Independent directors are directors, who own stock
and therefore, in theory, have interests aligned with those of shareholders.
 The Board must sufficiently understand the nature of and strategy behind major
transactions, including complex business structures and is willing to challenge
whether such transactions are beneficial to the company and make good business
sense.
 The Board must be fully aware of major risks inherent in the business, specially
in complex financial instruments and structured financial transactions and be
comfortable that there is an effective system of internal control in place covering
operations, financial reporting and compliance objectives.
 The Board must be proactive to ensure compliance programs and to question
management if red flags arise. The board should institute control processes to
ensure the effective performance of its role to oversee the general performance of
the company and its strategy in the market.

21

 The Board should monitor the integrity of the financials and ensure transparency
and disclosure of the firms financial position.
 The Board must make effective use of committees such as audit, compensation,
nomination and corporate governance.
 External auditing is a necessity since it supports proper corporate governance by
subjecting the results of the companys operations to an expert external review.
However, it is important to understand that auditors do not interfere with the
decisions of management. Therefore if anything goes wrong, it is the sole
responsibility of management.

22