ENRON is a poster child for shareholder wealth and destruction and bad behavior. This case describes the company’s strategy, internal and external governance to allow stude

The Fall of Enron

Paul M. Healy and Krishna G. Palepu

F rom the start of the 1990s until year-end 1998, Enron’s stock rose by 311 percent, only modestly higher than the rate of growth in the Standard & Poor’s 500. But then the stock soared. It increased by 56 percent in 1999

and a further 87 percent in 2000, compared to a 20 percent increase and a 10 percent decline for the index during the same years. By December 31, 2000, Enron’s stock was priced at $83.13, and its market capitalization exceeded $60 bil- lion, 70 times earnings and six times book value, an indication of the stock market’s high expectations about its future prospects. Enron was rated the most innovative large company in America in Fortune magazine’s survey of Most Admired Companies. Yet within a year, Enron’s image was in tatters and its stock price had plummeted nearly to zero. Exhibit 1 lists some of the critical events for Enron between August and December 2001—a saga of document shredding, restatements of earnings, regulatory investigations, a failed merger and the company � ling for bankruptcy.

We will assess how governance and incentive problems contributed to Enron’s rise and fall. A well-functioning capital market creates appropriate linkages of information, incentives and governance between managers and investors. This process is supposed to be carried out through a network of intermediaries that include professional investors such as banks, mutual funds, insurance and venture capital � rms; information analyzers such as �nancial analysts and ratings agencies; assurance professionals such as external auditors; and internal governance agents such as corporate boards. These parties, who are themselves subject to incentive and governance problems, are regu- lated by a variety of institutions: the Securities and Exchange Commission, bank regulators and private sector bodies such as the Financial Accounting Standards Board, the American Institute of Certi�ed Public Accountants and stock exchanges.

y Paul M. Healy is the James R. Williston Professor of Business Administration and Krishna G. Palepu is the Ross Graham Walker Professor of Business Administration, both at Harvard Business School, Boston, Massachusetts. Their e-mail addresses are [email protected] and [email protected] , respectively.

Journal of Economic Perspectives—Volume 17, Number 2—Spring 2003—Pages 3–26

Despite this elaborate corporate governance network, Enron was able to attract large sums of capital to fund a questionable business model, conceal its true perfor- mance through a series of accounting and � nancing maneuvers, and hype its stock to unsustainable levels. While Enron presents an extreme example, it is also a useful test case for potential weaknesses in the U.S. capital market system. We believe that the problems of governance and incentives that emerged at Enron can also surface at many other �rms and may potentially affect the entire capital market. We will begin by discussing the evolution of Enron’s business model in the late 1990s, the stresses that this business model created for Enron’s �nancial reporting, and how key capital market intermediaries played a role in the company’s rise and fall.

Enron’s Business

Kenneth Lay founded Enron in 1985 through the merger of Houston Natural Gas and Internorth, two natural gas pipeline companies.1 The merged company owned 37,000 miles of intra- and interstate pipelines for transporting natural gas

1 Sources for information on Enron’s business include Enron annual reports and 10-Ks for the period 1990–2000, Tufano (1994), Ghemawat (2000), and Salter, Levesque and Ciampa (2002).

Exhibit 1 Timeline of Critical Events for Enron in the Period August 2001 to December 2001

Date Event

August 14, 2001 Jeff Skilling resigned as CEO, citing personal reasons. He was replaced by Kenneth Lay.

Mid- to late August Sherron Watkins, an Enron vice president, wrote an anonymous letter to Kenneth Lay expressing concerns about the � rm’s accounting. She subsequently discussed her concerns with James Hecker, a former colleague and audit partner at Andersen, who contacted the Enron audit team.

October 12, 2001 An Arthur Andersen lawyer contacted a senior partner in Houston to remind him that company policy was not to retain documents that were no longer needed, prompting the shredding of documents.

October 16, 2001 Enron announces quarterly earnings of $393 million and nonrecurring charges of $1.01 billion after tax to re� ect asset write-downs primarily for water and broadband businesses.

October 22, 2001 The Securities and Exchange Commission opened inquiries into a potential con� ict of interest between Enron, its directors and its special partnerships.

November 8, 2001 Enron restated its � nancials for the prior four years to consolidate partnership arrangements retroactively. Earnings from 1997 to 2000 declined by $591 million, and debt for 2000 increased by $658 million.

November 9, 2001 Enron entered merger agreement with Dynegy. November 28, 2001 Major credit rating agencies downgraded Enron’s debt to junk bond status,

making the � rm liable to retire $4 billion of its $13 billion debt. Dynegy pulled out of the proposed merger.

December 2, 2001 Enron � led for bankruptcy in New York and simultaneously sued Dynegy for breach of contract.

4 Journal of Economic Perspectives

between producers and utilities. In the early 1980s, most contracts between natural gas producers and pipelines were “take-or-pay” contracts, where pipelines agreed either to purchase a predetermined quantity at a given price or be liable to pay the equivalent amount in case of failure to honor that contract. In these contracts, prices were typically � xed over the contract life or increased with in� ation. Pipe- lines, in turn, had similar long-term contracts with local gas distribution companies or electric utilities to purchase gas from them. These contracts assured long-term stability in supply and prices of natural gas.

However, changes in the regulation of the natural gas market during the mid-1980s, which deregulated prices and permitted more � exible arrangements between producers and pipelines, led to an increased use of spot market transac- tions. By 1990, 75 percent of gas sales were transacted at spot prices rather than through long-term contracts. Enron, which owned the largest interstate network of pipelines, pro� ted from the increased gas supply and � exibility resulting from the regulatory changes. Its returns on beginning equity in the years 1987 to 1990, when it was primarily a pipeline business, were 14.2, 13.0, 15.9 and 13.1 percent, respec- tively, compared with an estimated equity cost of capital of around 13 percent.2

In an attempt to achieve further growth, Enron pursued a diversi� cation strategy. It began by reaching beyond its pipeline business to become involved in natural gas trading. It extended the natural gas model to become a � nancial trader and market maker in electric power, coal, steel, paper and pulp, water and broadband � ber optic cable capacity. It undertook international projects involving construction and management of energy facilities. By 2001, Enron had become a conglomerate that owned and operated gas pipelines, electricity plants, pulp and paper plants, broadband assets and water plants internationally and traded exten- sively in � nancial markets for the same products and services. A summary of segment results for the company, in Exhibit 2, shows how dramatically the domestic trading and international businesses grew during the late 1990s.3

This growth impressed the capital markets, and few asked fundamental ques- tions about the company’s business strategy. Could Enron’s expertise in owning and managing energy assets, and then developing a trading model to help buyers and sellers of energy manage risks, be extended to such a broad array of new businesses? Moreover, was Enron’s performance sustainable given the limited barriers to entry by other � rms that wished to mimic its success? To have a sense of how Enron’s business model evolved, it is useful to consider in more detail how its operations expanded.

2 This estimate is based on the average 30-year government bond rate for the period of 8.65 percent, a market risk premium of 7 percent and an equity beta of 0.6. The cost of equity capital is calculated using the capital asset pricing model: 8.65 percent 1 (0.6 3 7 percent) 5 12.85 percent. 3 It is dif� cult to � gure out which parts of Enron’s business model were working and which were not, since the company provided minimal segment disclosure. In addition, its 2000 domestic trading performance was affected by the California energy crisis, where illegal price manipulation by Enron and others is being investigated.

Paul M. Healy and Krishna G. Palepu 5

From Regulated Industry to Energy Trading Jeff Skilling, who subsequently became Enron’s CEO in August 2001, envi-

sioned Enron’s trading model during a 1988 McKinsey engagement at Enron. While deregulation generally led to lower prices and increased supply, it also introduced increased volatility in gas prices. Further, the standard contract in this market allowed suppliers to interrupt gas supply without legal penalties. By creating a natural gas “bank,” Skilling foresaw that Enron could help both buyers and suppliers manage these risks effectively. The “gas bank” would act just as a � nancial banking institution, except that it would intermediate between suppliers and buyers of natural gas. Enron began offering utilities long-term � xed price contracts for natural gas, typically at prices that assumed long-term declines in spot prices.

To ensure delivery of these contracts and to reduce exposure to � uctuations in spot prices, Enron entered into long-term � xed price arrangements with producers and used � nancial derivatives, including swaps, forward and future contracts.4 It also began using off-balance sheet � nancing vehicles, known as Special Purpose Entities, to � nance many of these transactions.

By all accounts, the gas trading business was a huge success. By 1992, Enron was

4 A swap is a transaction that exchanges one security for another with different characteristics. A forward contract is for the purchase or sale of a speci� c quantity of a good at the current (spot) price, but with payment and delivery at a speci� ed future date. A futures contract is an agreement to buy a speci� ed quantity of a good at a particular price on a speci� ed future date.

Exhibit 2 Enron Segment and Stock Market Performance, 1993 to 2000

($ millions) 1993 1994 1995 1996 1997 1998 1999 2000

Domestic: Pipelines Revenues $1,466 $976 $831 $806 $1,416 $1,849 $2,032 $2,955 Earningsa 382 403 359 570 580 637 685 732

Domestic: Trading & Other Revenues $6,624 $6,977 $7,269 $10,858 $16,659 $23,668 $28,684 $77,031 Earningsa 316 359 344 332 766 403 592 2,014

International Revenues $914 $1,380 $1,334 $2,027 $2,945 $6,013 $9,936 $22,898 Earningsa 134 189 196 300 (36) 574 722 351

Stock Performance Enron 25% 5% 25% 13% 24% 37% 56% 87% S&P 500 7% 22% 34% 20% 31% 27% 20% 210%

Major Business Events Teesside opens

Begins electricity trading

Begins construc- tion of Dabhol plant

Acquires Portland General Corp.

Acquires Wessex Water in U.K.

Creates Enron- Online

Trading contracts double

Calif. energy crisis

Source: Enron 10-Ks. a Earnings are measured before subtracting interest and taxes. Note: The �gures reported are as originally announced by the company.

6 Journal of Economic Perspectives

the largest merchant of natural gas in North America, and the gas trading business became a major contributor to Enron’s net income, with earnings before interest and taxes of $122 million. The creation of the on-line trading model, EnronOnline, in November 1999 enabled the company to develop further and extend its abilities to negotiate and manage these � nancial contracts. By the fourth quarter of 2000, EnronOnline accounted for almost half of Enron’s transactions for all of its business units and had enabled transactions per commercial person to grow to 3,084 from 672 in 1999.

In the late 1990s, Skilling re� ned the trading model further. He noted that “heavy” assets, such as pipelines, were not a source of competitive advantage that would enable Enron to earn economic rents. Skilling argued that the key to dominating the trading market was information; Enron should, therefore, only hold “heavy” assets if they were useful for generating information. Consequently, the company began divesting “heavy” assets and pursuing an “asset light” strategy. As a result of this strategy, by late 2000, Enron owned 5,000 fewer miles of natural gas pipeline than when the company was founded in 1985—but its gas � nancial transactions represented 20 times its pipeline capacity.

Through its extensive network of pipelines, Enron was initially well positioned to intermediate between producers and utilities. The company had expertise in managing the physical logistics of delivering gas to customers through its pipelines. It quickly developed expertise in managing the trading business risks. These risks included exposure to general gas spot market volatility, exposure to gas price � uctuations at particular production and delivery locations (since gas cannot be transported costlessly from one location to another), exposure to reserve risks (since Enron had to ensure that it would have suf� cient gas reserves to be able to meet its commitments to utilities) and the risk that counterparties in its derivative transactions would default.

However, whether the company could expect to continue to earn high returns from gas trading was unclear. Skilling believed that the major barrier to entry in gas trading was Enron’s market knowledge achieved through its dominant market position. However, many other � rms were well positioned to challenge Enron’s dominance, including large gas producers, such as Mobil, gas marketers such as Coastal and Clearinghouse and � nancial � rms such as Phibro, AIG, Chase and Citibank. In comparable markets, early rents to � rst-movers had quickly dissipated as competitors entered. For example, in the interest rate swap market, margins declined tenfold during the 1990s.5 The Internet provided a low-cost platform for existing or potential competitors to develop energy markets that could compete with EnronOnline.

5 In the interest rate swap market, two parties agree to make payments to each other based on a notional (or imaginary) quantity of principal. The payments by the two parties are based on different interest rates. For example, one party might make payments based on a � xed interest rate while the other makes a payment based on a � oating interest rate. Thus, swaps provide a way of seeking lower-cost � nancing and of hedging risk.

The Fall of Enron 7

Extending the Natural Gas Trading Model In the mid-1990s, Enron began extending its gas trading model to other

markets. It sought markets with certain characteristics: the markets were frag- mented, with complex distribution systems, the commodity was fungible, and pricing was opaque. Markets identi� ed as targets included electric power, coal, steel, paper and pulp, water and broadband cable capacity. Enron’s model was to acquire physical capacity in each market and then leverage that investment through the creation of more � exible pricing structures for market participants, using � nancial derivatives as a way of managing risks. Enron argued that the systems and expertise it had acquired in gas trading could be leveraged to the new markets. The trading model therefore was touted as a way for Enron to continue to grow spectacularly as it diversi� ed from a pure energy � rm into a broad-based � nancial services company.

The � rst market to be developed was electric power. To implement its model in this market, Enron had to � gure out how to ensure that it could meet commit- ments to provide power in peak periods. Unlike natural gas, electricity cannot be stored to satisfy peak demand, leading to even higher price volatility than in the gas market. Enron responded to this challenge by constructing “peaking plants” de- signed to meet short-term peaks in demand.

Enron had some successes in applying the gas bank trading model to electric- ity, but the viability of the model for some of the other products selected for expansion was uncertain. Would the additional contractual � exibility offered by Enron in the gas and electricity markets be as popular in the new markets? Further, each new market posed unique challenges. For example, while customers could not distinguish differences in the sources of gas or electricity, they cared about and could observe changes in water quality. The challenges of selling long-term con- tracts for broadband cable access included the use of unproven and nonstandard- ized technology, dif� culties in extending � ber optic networks over the “last mile” into buildings and excess capacity. Finally, even if Enron was successful in creating these new markets, it was unclear whether early rents could be sustained given potential competition in each market.

International Expansion: Energy Asset Construction and Management As Enron expanded beyond the natural gas pipeline business, it also reached

beyond U.S. borders. Enron International, a wholly owned subsidiary of Enron, was created to construct and manage energy assets outside the United States, particu- larly in markets where energy was being deregulated. The unit’s � rst major project was the construction of the Teesside electric power plant in the United Kingdom, which began operation in 1993. Enron subsequently entered contracts to construct and manage projects in Eastern Europe, Africa, the Middle East, India, China and Central and South America. These projects represented signi� cant investments in these economies.

While the privatization of energy producers and deregulation of energy mar- kets created demand for the management of energy assets outside the United States, Enron faced some distinctive risks in entering these new markets. Some of

8 Journal of Economic Perspectives

the international projects were for the construction and management of pipelines, where Enron had a core competence, but many others were not. Could the company’s core expertise be extended to other types of energy assets, such as power plants? Also, international diversi� cation, particularly in developing economies such as India and China, exposed Enron to political risks. For example, the Dabhol power project in India represented the single largest foreign direct investment project until that time in India, and it attracted considerable political opposition and controversy. Given its limited business experience in developing economies, did Enron have expertise in managing the risk that any returns would be taxed or its asset expropriated after construction of the plant? Even if Enron was successful in the international energy market, questions could be raised about whether the company could create a sustainable advantage over competitors that later sought to enter the market. Many existing players had expertise in managing the construc- tion and operations of power plants.

Financial Reporting

Enron’s complex business model—reaching across many products, including physical assets and trading operations, and crossing national borders—stretched the limits of accounting.6 Enron took full advantage of accounting limitations in managing its earnings and balance sheet to portray a rosy picture of its performance.

Two sets of issues proved especially problematic. First, its trading business involved complex long-term contracts. Current accounting rules use the present value framework to record these transactions, requiring management to make forecasts of future earnings. This approach, known as mark-to-market accounting, was central to Enron’s income recognition and resulted in its management making forecasts of energy prices and interest rates well into the future. Second, Enron relied extensively on structured � nance transactions that involved setting up special purpose entities. These transactions shared ownership of speci� c cash � ows and risks with outside investors and lenders. Traditional accounting, which focuses on arms-length transactions between independent entities, faces challenges in dealing with such transactions. Accounting rule-makers have been debating appropriate accounting rules for these transactions for several years. Meanwhile, mechanical conventions have been used to record these transactions, creating a divergence between economic reality and accounting numbers.

Trading Business and Mark-to-Market Accounting In Enron’s original natural gas business, the accounting had been fairly

straightforward: in each time period, the company listed actual costs of supplying the gas and actual revenues received from selling it. However, Enron’s trading

6 The primary source of information on the � nancial reporting failures at Enron was Powers, Troubh and Winokur (2002).

Paul M. Healy and Krishna G. Palepu 9

business adopted mark-to-market accounting, which meant that once a long-term contract was signed, the present value of the stream of future in� ows under the contract was recognized as revenues and the present value of the expected costs of ful� lling the contract were expensed. Unrealized gains and losses in the market value of long-term contracts (that were not hedged) were then required to be reported later as part of annual earnings when they occurred.

Enron’s primary challenge in using mark-to-market accounting was estimating the market value of the contracts, which in some cases ran as long as 20 years. Income was estimated as the present value of net future cash � ows, even though in some cases there were serious questions about the viability of these contracts and their associated costs.

For example, in July 2000 Enron signed a 20-year agreement with Blockbuster Video to introduce entertainment on demand to multiple U.S. cities by year-end. Enron would store the entertainment and encode and stream the entertainment over its global broadband network. Pilot projects in Portland, Seattle and Salt Lake City were created to stream movies to a few dozen apartments from servers set up in the basement. Based on these pilot projects, Enron went ahead and recognized estimated pro� ts of more than $110 million from the Blockbuster deal, even though there were serious questions about technical viability and market demand.

In another example, Enron entered into a $1.3 billion, 15-year contract to supply electricity to the Indianapolis company Eli Lilly. Enron was able to show the present value of the contract, reportedly for more than half a billion dollars, as revenues. Enron then had to report the present value of the costs of servicing the contract as an expense. However, Indiana had not yet deregulated electricity, requiring Enron to predict when Indiana would deregulate and how much impact this would have on the costs of servicing the contract over the ten years (Krugman, 2002).

Reporting Issues for Special Purpose Entities Enron used special purpose entities to fund or manage risks associated with

speci� c assets. Special purpose entities are shell � rms created by a sponsor, but funded by independent equity investors and debt � nancing. For example, Enron used special purpose entities to fund the acquisition of gas reserves from producers. In return, the investors in the special purpose entity received the stream of revenues from the sale of the reserves.

For � nancial reporting purposes, a series of rules is used to determine whether a special purpose entity is a separate entity from the sponsor. These require that an independent third-party owner have a substantive equity stake that is “at risk” in the special purpose entity, which has been interpreted as at least 3 percent of the special purpose entity’s total debt and equity. The independent third-party owner must also have a controlling (more than 50 percent) � nancial interest in the special purpose entity. If these rules are not satis� ed, the special purpose entity must be consolidated with the sponsor � rm’s business.

Enron had used hundreds of special purpose entities by 2001. Many of these were used to fund the purchase of forward contracts with gas producers to supply

10 Journal of Economic Perspectives

gas to utilities under long-term � xed contracts.7 However, several controversial special purpose entities were designed primarily to achieve � nancial reporting objectives. For example, in 1997, Enron wanted to buy out a partner’s stake in one of its many joint ventures. However, Enron did not want to show any debt from � nancing the acquisition or from the joint venture on its balance sheet. Chewco, a special purpose entity that was controlled by an Enron executive and raised debt that was guaranteed by Enron, acquired the joint venture stake for $383 million. The transaction was structured in such a way that Enron did not have to consolidate Chewco or the joint venture into its � nancials, enabling it effectively to acquire the partnership interest without recognizing any additional debt on its books. More details on Chewco are presented in the Appendix and also in Powers, Troubh and Winokur (2002).

Chewco and several other special purpose entities, however, did more than just skirt accounting rules. As Enron revealed in October 2001, they violated accounting standards that require at least 3 percent of assets to be owned by independent equity investors. By ignoring this requirement, Enron was able to avoid consolidat- ing these special purpose entities. As a result, Enron’s balance sheet understated its liabilities and overstated its equity and its earnings. On October 16, 2001, Enron announced that restatements to its � nancial statements for years 1997 to 2000 to correct these violations would reduce earnings for the four-year period by $613 mil- lion (or 23 percent of reported pro� ts during the period), increase liabilities at the end of 2000 by $628 million (6 percent of reported liabilities and 5.5 percent of reported equity) and reduce equity at the end of 2000 by $1.2 billion (10 percent of reported equity).

In addition to the accounting failures, Enron provided only minimal disclosure on its relations with the special purpose entities. The company represented to investors that it had hedged downside risk in its own illiquid investments through transactions with special purpose entities. Yet investors were unaware that the special purpose entities were actually using Enron’s own stock and � nancial guar- antees to carry out these hedges, so that Enron was not actually protected from downside risk. Moreover, Enron allowed several key employees, including its chief � nancial of� cer Andrew Fastow, to become partners of the special purpose entities. In subsequent transactions between the special purpose entities and Enron, these employees pro� ted handsomely, raising questions about whether they had ful� lled their � duciary responsibility to Enron’s stockholders.

Other Accounting Problems Enron’s accounting problems in late 2001 were compounded by its recogni-

tion that several new businesses were not performing as well as expected. In October 2001, the company announced a series of asset write-downs, including after tax charges of $287 million for Azurix, the water business acquired in 1998, $180 million for broadband investments and $544 million for other investments. In

7 See Tufano (1994) for a detailed description of these � nancial arrangements.

The Fall of Enron 11

total, these charges represented 22 percent of Enron’s capital expenditures for the three years 1998 to 2000. In addition, on October 5, 2001, Enron agreed to sell Portland General Corp., the electric power plant it had acquired in 1997, for $1.9 billion, at a loss of $1.1 billion over the acquisition price. These write-offs and losses raised questions about the viability of Enron’s strategy of pursuing its gas trading model in other markets.

In summary, Enron’s gas trading idea was probably a reasonable response to the opportunities arising out of deregulation. However, extensions of this idea into other markets and international expansion were unsuccessful.8 Accounting games allowed the company to hide this reality for several years. Capital markets largely ignored red � ags associated with Enron’s spectacular reported performance and aided the company’s pursuit of a � awed expansion strategy by providing capital at a remarkably low cost. Investors seemed willing to assume that Enron’s reported growth and pro� tability would be sustained far into future, despite l

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