Prof. Leigh Tesfatsion Department of Economics Iowa State University Ames, IA 50011-1070 http://www.econ.iastate.edu/tesfatsi/ Last Revised: 3 April 2011
The Enron Scandal and Moral Hazard
• Enron, the 7th largest U.S. company in 2001, filed for bankruptcy in December 2001. • Enron investors and retirees were left with worthless stock. • Enron was charged with securities fraud (fraudulent manipulation of publicly reported financial results, lying to SEC,…) • QUESTION: In what ways are security market moral hazard problems at the heart of the Enron bankruptcy scandal?
Brief Time-Line of the Enron Scandal
• Enron was a Houston-based natural gas pipeline company formed by merger in 1985. • By early 2001, Enron had morphed into the 7th largest U.S. company, and the largest U.S. buyer/seller of natural gas and electricity. • Enron was heavily involved in energy brokering, electronic energy trading, global commodity and options trading, etc.
Brief Time-Line of the Enron Scandal…Continued
• On October 16, 2001, in the first major public sign of trouble, Enron announces a huge third-quarter loss of $618 million. • On October 22, 2001, the Securities and Exchange Commission (SEC) begins an inquiry into Enron’s accounting practices. • On December 2, 2001, Enron files for bankruptcy.
: Oct – Dec 2001
Regulatory Oversight of Enron
Auditors Arthur Anderson Audit Committee (Directors)
Company Report Shareholders
Enron Board of Directors
1993-2001: Enron used complex dubious energy trading schemes Example: “Death Star” Energy Trading Strategy
Took advantage of a loophole in the market rules governing energy trading in California Enron would schedule electric power transmission on a congested line from bus A to bus B in the opposite direction to demand, thus enabling them to collect a “congestion reduction” fee for seemingly relieving congestion on this line. Enron would then schedule the routing of this energy all the way back to bus A so that no energy was actually bought or sold by Enron in net terms. It was purely a routing scheme.
Investigative Findings …
1993-2001: Enron also used complex & dubious accounting schemes • • • • •
to reduce Enron’s tax payments; to inflate Enron’s income and profits; to inflate Enron’s stock price and credit rating; to hide losses in off-balance-sheet subsidiaries; to engineer off-balance-sheet schemes to funnel money to themselves, friends, and family; • to fraudulently misrepresent Enron’s financial condition in public reports. WHY WASN’T ENRON STOPPED SOONER!
Case Study of One Accounting Scheme
(Based on WSJ site & Prof. S. Ravenscroft Notes)
• Enron’s rapid growth in late 1990s involved
large capital investments not expected to generate significant cash flow in short term. • Maintaining Enron’s credit ratings at an investment grade (e.g., BBB- or higher by S&P) was vital to Enron’s energy trading business.
Case Study … Continued
• One perceived solution: Create partnerships
structured as special purpose entities (SPEs) that could borrow from outside investors without having to be consolidated into Enron’s balance sheet.
• SPE 3% Rule: No consolidation needed if at least 3% of SPE total capital was owned independently of Enron.
Case Study … Continued
• Enron’s creation of over 3000 partnerships started about 1993 when it teamed with Calpers (California Public Retirement System) to create JEDI (Joint Energy Development Investments) fund. • Enron initially thought of these partnerships as temporary solutions for temporary cash flow problems. • Enron later used SPE partnerships under 3% rule to hide bad bets it had made on speculative assets by selling these assets to the partnerships in return for IOUs backed by Enron stock as collateral! (over $1 billion by 2002)
50% interest 50% interest
$250 Mil in Enron Stock