Sue Copeman discusses the demise of the giant US power company

A mega power company, a former presidential adviser, alleged insider dealing, and documents hastily shredded before investigation - it has all the makings of a Hollywood blockbuster. Unfortunately for Enron and its employees, creditors and investors, not to mention its auditors, this is no film but a true story. When Enron filed for bankruptcy on 2 December 2001, it was by far the largest company ever to do so.

Enron developed from an organisation dealing only in gas and crude oil into the world’s largest internet trader of a range of products such as electrical power price risks and weather exposures. Although still the largest supplier of natural gas and electricity in North America, its new activities came to represent more than 80% of its revenues ($40bn in 1999). After 15 years, it ranked seventh on the Fortune 500 list of companies.

Enron’s admission in October 2001 that it had overstated profits for four years, reducing shareholders’ equity by $1.2bn, led to a loan of $3bn to ensure liquidity, lawsuits and an investigation by the Securities and Exchange Commission (SEC). It also triggered doubts as to Enron’s creditworthiness, and many energy traders moved from Enron’s own B2B online trading system to other marketplaces such as New York Mercantile Exchange and the Intercontinental. Investors took fright, dumping the company’s shares and sending the price plummeting. With the failure of a proposed merger between Dynegy and Enron that would have provided a $9bn lifeline, credit rating agencies demoted Enron bonds to junk status, sounding the company’s death knell.

The company chose to file for bankruptcy under Chapter 11, a route that allows it to reorganise and keep in business. While its future remains in the balance, it is beset by a host of investigations and lawsuits. The fall-out has been huge. Enron’s auditors and consultants, Arthur Andersen, look unlikely to emerge untarnished, while banks, insurers and others are involved in actions and negotiations, trying to emerge as well as they can from the debacle.

Much of the media focus is on the behaviour of Enron’s management when it realised things were going wrong. Complex partnerships were used to hide huge debts by moving them off the balance sheet. Senior executives sold shares at a high price when they clearly knew the company was foundering. But the core problems started earlier. Possibly, they were not simply the result of a defective business plan, but reflected the pressure of a culture which placed a huge emphasis on success.

In its early years, Enron was extremely successful. It was high in the league tables, with accolades for creating the best internet venture ever and being a wonderful place to work. So, when some business decisions proved ill-founded, management did not want to admit failure openly. Unfortunately, Wall Street appears to have played along. Analysts, lenders and consultants all had a lot to lose by blowing the whistle, even if they had started to spot the warning signs.

It seems likely too that Enron’s management was hopeful of being able to trade out of trouble in a re-run of the ‘Maxwell syndrome’, that if you are big enough and look confident enough, failure seems unthinkable. Critics were discouraged. And it cannot have done any harm in maintaining the image of success that Enron’s auditors Arthur Andersen were also employed as consultants.

The demise of Enron could be said to strike a blow at the perceived effectiveness of enterprise risk management. Here, on the face of it, Enron did everything right. Headed by a chief risk officer with executive management status, the company’s risk assessment and control group, comprising around 150 people, focused on every aspect of Enron’s activities. The company had developed its own risk analysis and risk quantification tools and strategies. Its approach to risk seemed so successful that it was held up as an example to others.

For example, a feature in Treasury & Risk Management in December 2000/January 2001 gives a full description of how Enron ‘learned how to profit from risk’. The article (somewhat ironically in hindsight) was called Viewing the Opportunity in Risk, and quoted Rick Buy, Enron executive vice president and chief risk officer, as saying “You won’t make any money these days without taking on risk. We want to take on risk - a lot of risk - subject to prescribed limitations and insight into the associated outcomes. If the outcomes are palatable, we’ve got an appetite.” Unfortunately, for many companies, the outcome of having dealt with Enron is proving far from palatable.

Sue Copeman is editor, StrategicRISK

WARNING SIGNS
While the demise of a giant like Enron causes ripples around the world, even a much smaller company’s insolvency can produce significant losses for its creditors.

Apart from obvious signs of impending financial difficulty, such as a slowdown of established payment pattern and county court judgments, there are a number of possible clues as to future problems. Derek Barnett, underwriting manager for trade credit, QBE International Insurance Ltd, advises companies to watch out for the following. While the list is not exhaustive, it does include a number of the common indicators. Where several of these apply, you may well have a problem brewing.

  • Delays and late filings - Companies generally do not wish to advertise the fact that they are having difficulties. One way of achieving this is to delay filing financial information, putting off delivering the bad news to suppliers and competitors alike. A public limited company is required to file its accounts within 10 months of the year-end date of the accounts and is policed by the Stock Exchange authorities. Ordinary limited liability companies have much longer to file, are not policed as closely and can, as a result, delay filing for a considerable time before any penalties are likely. Late filing of accounts should always be viewed as a negative factor, as suppliers who are considering the credit worthiness of the company must rely on increasingly dated financial statements to make a judgment. Another ploy is to change the year-end date, which has the effect of delaying the next filing date.
  • Key employees leaving - Departures of key personnel are another sign of possible problems. Obviously, this does not apply in all cases, but analysis shows that key employees often depart prior to an insolvent company’s demise. Where the people concerned are key sales and marketing executives, you need to consider their motivation.
  • Changes in auditors or accountants - A change can indicate a clash between a company’s financial management and its auditors or accountants. It is often a warning of serious financial problems. Where the filing of accounts has been delayed and either the auditors or the accountants resign after filing, be very wary.

    LESSONS
    These should all be embedded in every risk manager’s and CEO’s mind, but the Enron experience suggests that they are not.

  • Make sure that controls are strong and enforced
  • No-one likes bad news - but biting the bullet is preferable to a cover-up
  • Be aware that expanding into developing countries is a high risk strategy and likely to involve short- term losses as well as potential long-term gains
  • Similarly, if you’re going to expand into new areas, make sure that you get people on board who understand those markets
  • Do not employ the same firm as both auditors and consultants: your company should be sufficiently robust to withstand a completely independent appraisal of its activities and financial status
  • Do not be complacent - encourage whistleblowers and investigate

    RECENT HISTORY
    2 December 2001 Enron files voluntary petitions for Chapter 11 reorganisation and sues Dynegy for breach of its merger agreement, seeking damages of at least $10bn

    3 December 2001 Enron arranges $1.5bn of debtor-in-possession financing for reorganisation

    January 2002 A new congressional investigation begins into the collapse of Enron, at a time when the company is already under investigation by the Securities and Exchange Commission, the Justice and Labor departments, and congressional committees in the House of Representatives

    15 January 2002 Enron and UBS Warburg agree a deal for Enron’s North American Gas and electric trading operation that entitles Enron to one-third of the profits generated by the new trading entity

    17 January 2002 Enron discharges Arthur Andersen as the company’s auditor

    23 January 2002 Kenneth L Lay resigns as chairman of the board and chief executive officer of Enron Corp

    25 January 2002 Former Enron vice chairman J Clifford Baxter commits suicide.