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Internet and Enron Robert M. Hayes 2002. Overview §PrefacePreface §The Internet and EnronThe Internet and Enron §Equity Funding Corporation of AmericaEquity.

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Presentation on theme: "Internet and Enron Robert M. Hayes 2002. Overview §PrefacePreface §The Internet and EnronThe Internet and Enron §Equity Funding Corporation of AmericaEquity."— Presentation transcript:

1 Internet and Enron Robert M. Hayes 2002

2 Overview §PrefacePreface §The Internet and EnronThe Internet and Enron §Equity Funding Corporation of AmericaEquity Funding Corporation of America §DeregulationDeregulation

3 Preface §This presentation will discuss the relationships between the Internet and Enron, the largest bankruptcy in the history of the United States and, apparently, one of the most massive cases of corporate fraud ever perpetrated. §It will cover the available data on the history leading up to the bankruptcy and roles of the Internet in the operations of Enron. §It will then present an earlier case of proven fraud that has striking parallels to the case of Enron (Equity Funding, in 1973). §It concludes with a discussion of the role of “deregulation” as the context for Enron operations, including arguments both pro and con.

4 The Internet and Enron §The Start as a Gas Pipeline Company in 1985The Start as a Gas Pipeline Company in 1985 §DeregulationDeregulation §Enron Finance in 1990Enron Finance in 1990 §Enron Communications and Internet StructureEnron Communications and Internet Structure §Enron Online and Internet BrokeringEnron Online and Internet Brokering §Enron and the Market in BroadbandEnron and the Market in Broadband §The Catches—one after another!The Catches—one after another! §The CollapseThe Collapse §Enron and E-Mail's Lasting TrailEnron and E-Mail's Lasting Trail §The FalloutsThe Fallouts

5 Gas Pipeline Company in 1985 §In 1985, Kenneth Lay, using proceeds from junk bonds, combined his company, Houston Natural Gas, with another natural-gas pipeline to form Enron. From that start, the company then moved beyond selling and transporting gas to become a big player in the newly deregulated energy markets by trading in futures contracts. In the same way that traders buy and sell soybean and orange juice futures, Enron began to buy and sell electricity and gas futures.

6 Deregulation §In the mid-1980s, oil prices fell precipitously. Buyers of natural gas switched to newly cheap alternatives such as fuel oil. Gas producers, led by Enron, lobbied vigorously for deregulation. Once-stable gas prices began to fluctuate. §Then Enron began marketing futures contracts which guaranteed a price for delivery of gas sometime in the future. §The government, again lobbied by Enron and others, deregulated electricity markets over the next several years, creating a similar opportunity for Enron to trade futures in electric power.

7 Enron Finance in 1990 §In 1990, Lay hired Jeffrey Skilling, a consultant with McKinsey & Co., to lead a new division—Enron Finance Corp. §Skilling was made president and chief operating officer of Enron in 1997. §Even as Enron was gaining a reputation as a "new- economy" trailblazer, it continued—to some degree apparently against Skilling's wishes—to pursue such stick-in-the-mud "old-economy" goals as building power plants around the world.

8 §Enron's Overseas Boondoggle Probe: The bankrupt energy trader's grandiose, U.S-funded projects, which sprouted in places no other firm would go, appear not to have earned it a dime. With operations in 20 countries, Enron Corp. set out in the early 1990s to become an international energy trailblazer, with grandiose projects and huge U.S. government-backed investments in places no other company would go. §Enron launched bold projects in poverty-ravaged countries such as Nigeria and Nicaragua. It set up huge barges--with names like Esperanza, Margarita and El Enron--in ports around the world to generate power for energy-starved cities.

9 §In mid-February 2002, the Overseas Private Investment Corp., which backed many of the projects, moved to stem its $1-billion Enron exposure by canceling $590 million in loans to the company, once one of its largest clients. Enron had missed deadlines for OPIC requirements in financing projects in Brazil, an OPIC spokesman said. OPIC's decision shifted more of the burden for the troubled projects from the U.S. government to Enron's creditors, lenders and partners.

10 §System Encouraged Executives to Gamble l Like other parts of Enron's vast operation, its international division was fueled by intense internal competition and huge financial incentives. Executives pocketed multimillion-dollar bonuses for signing international deals under a structure that based their rewards on the long-term estimated value of projects rather than their actual returns. The system encouraged executives to gamble without regard to risk, said Louis Wells, a Harvard Business School professor who has studied Enron's overseas investments.

11 l Enron's international investment totaled more than $7 billion, including more than $3 billion in Latin America, $1 billion in India and $2.9 billion to develop a British water-supply and waste-treatment company. l It enlisted U.S. ambassadors and secretaries of State, Commerce and Energy to buttonhole foreign officials. Enron cultivated international political connections, recruiting former government officials and relatives of heads of state as investors and lobbyists.

12 l In reports to investors, the company played down or obscured what analysts and others saw as inevitable losses. But in an interview with academic researchers nine months ago, Jeffrey K. Skilling, who then was chief operating officer, conceded that Enron "had not earned compensatory rates of return" on investments in overseas power plants, waterworks and pipelines. Skilling said the projects had fueled an "acrimonious debate" among executives about the wisdom of its heavy foreign investments. l An internal investigation released this month showed that two foreign projects, in Brazil and Poland, were entangled in Enron's off-the-books partnerships, accounting devices controlled by then- Chief Financial Officer Andrew S. Fastow that shielded huge debts from investors.

13 l The report showed that Enron engaged in an unusual transaction to add $65 million to the revenue of the Brazilian pipeline project before it had even been completed. The Polish plant was briefly sold to an insider partnership and sold back to Enron a few months later. Those arrangements allowed Enron to present a more optimistic report to investors. l Other partnerships at the center of the Enron investigation also were involved, an Enron spokesman said. The Whitewing partnership had interests in the Trakya power plant in Turkey and Elektro, a power distributor in Brazil. It also owned a controlling interest in Promigas, a natural gas pipeline operator in Colombia, and the Sarlux power plant in Italy.

14 l Another partnership, called Ponderosa, had interests in the CEG, CEGRIO and Gaspart gas- distribution companies in Brazil, the Centragas distribution system in Colombia and the TGS gas transportation company in Argentina. §U.S. Supplied Billions for Enron Expansion l The U.S. government has been a major backer of Enron's overseas expansion. Since 1992, OPIC provided about $1.7billion for Enron's foreign deals and promised $500million more for projects that didn't go forward. The Export-Import Bank put about $700 million into Enron's foreign ventures. Both agencies provide financing and political-risk insurance for foreign projects undertaken by U.S. companies.

15 l Enron already has filed a $200-million claim with OPIC in connection with its troubled power plant in Dabhol, India, which is up for sale but considered unlikely to recover Enron's full investment. l OPIC spokesman Larry Spinelli said Enron was notified Wednesday that the agency would not proceed with processing $590 million in loans. Asked if they could be resurrected as Enron attempts to restructure under bankruptcy protection, Spinelli said, "Not under these circumstances. This is over now." Enron spokesmen declined to discuss the foreign projects in detail but acknowledged trouble at certain projects. l "There might have been some where we paid too much," Enron spokesman John Ambler said. "And there are others where there have been operational difficulties. But a large number of them are still good."

16 Enron Communications §January 21, 1999: “Enron Communications, Inc., introduced today the Enron Intelligent Network (EIN), an application delivery platform … that will enhance the company’s existing … fiber-optic network to create next generation applications services. The EIN brings to market a reliable, bandwidth-on-demand platform for delivering data, applications and streaming rich media to the desktop. §“The Enron Intelligent Network architecture is based on a unique approach to networking through distributed servers … that supports the development and maintenance of distributed applications across network environments.”

17 Enron Communications §“In November 1999, Enron Communications (as a wholly owned subsidiary of Enron) joined with Inktomi Corporation in a strategic alliance in which the Inktomi Traffic Server cache platform was to be integrated into the Enron Intelligent Network. The objective was to offer high quality network performance and bandwidth capacity to support broadband content distribution and e-business services. The integration of Inktomi's caching software into the Enron Intelligent Network was to enhance the ability of Enron Communications to seamlessly and selectively push content to the desktop while handling massive volumes of high bit rate network traffic in a scalable manner.”

18 Enron Communications §About Inktomi: ”Inktomi develops and markets scalable software designed for the world's largest Internet infrastructure and media companies. Inktomi's two areas of business are portal services, comprised of the search, directory and shopping engines; and network products comprised of the Traffic Server network cache and associated value- added services. Inktomi works with leading companies including America Online, British Telecom, CNN, Excite@Home, GoTo.com, Intel, NBC's Snap!, RealNetworks, Sun Microsystems, and Yahoo!. The company has offices in North America, Europe and Asia.”

19 EnronOnline §EnronOnline was launched Nov. 29, 1999. §“EnronOnline offers customers a free, Internet- based system for conducting wholesale transactions with Enron as principal.” §“EnronOnline is your best tool for trading energy-related products and other commodities quickly, simply and efficiently. Our Web-based service combines real-time transaction capabilities with extensive information and customization tools that increase your knowledge of what's happening around the world-even as it happens. EnronOnline sharpens your sense of the marketplace to make you a more knowledgeable trader.”

20 EnronOnline §“No matter what commodity you want to buy or sell, you're almost certain to find a live, competitive quote on EnronOnline. We cover markets all over the world including gas, power, oil and refined products, plastics, petrochemicals, liquid petroleum gases, natural gas liquids, coal, emission allowances, bandwidth, pulp and paper, metals, weather derivatives, credit derivatives, steel and more. EnronOnline covers almost every major energy market in the world. And we're not sitting still. We're adding new markets and new products all the time.” §An ironic example of "Trading Markets": Credit Risk Management Tools, including Bankruptcy Swaps

21 EnronOnline Claims §Real-Time Pricing §Fast, Free, Secure Execution §Price Limit Orders §Option Contracts §Market News and Quotes §Industry Publications §Weather Insights §Complete Customization Capabilities

22 Brokering (?) over the Internet §Note that Enron served NOT as a broker but as a Principal—active participant in transactions.

23 Enron High-bandwidth Venture §December 3, 1999: "Cutting the red ribbon for bandwidth commodity trading, high-bandwidth application service company Enron Communications Inc. Friday introduced its new approach to bandwidth." §"This is 'Day One' of a potentially enormous market," said Jeff Skilling, Enron president and chief operating officer. He compared the present inflexible agreements for pre-set capacity amounts to pre-reform "oil contracts in the 1970s, natural gas contracts prior to 1990 and electric power contracts prior to 1994." §May 2, 2000: “Enron Corp. announced today the expansion of EnronOnline to include products for the purchase and sale of bandwidth capacity.”

24 Enron Broadband Trading Strategy §The Purpose: Effect on Enron Stock Prices §The Technique l Step 1. Sell to an affiliated partnership l Step 2. Set an internal value on the sale l Step 3. Sell from one partnership to another l Step 4. Act as underwriter for the sale §The Lack of Substance §The Beginning of the Collapse §The Collapse

25 The Catches—one after another! §Acting as Principal in transactions! §Failing really to make money §Creating trading shell companies §Acting as partner in transactions! §Playing games with financial reporting §Being Greedy

26 The Collapse §Sudden announcement of losses in Oct 2001 §File for bankruptcy in Dec 2001 §Bankruptcy §Congressional Investigations began in Dec 2001 §Attempted destruction of documents

27 Enron and E-Mail's Lasting Trail §It is almost impossible to hide transactions: l Paper records at the source l Local computer system records l Internet communication records l Recipient records l Paper records at the destination

28 The Fallouts of Enron Collapse §On the Workers l Effects on their retirement accounts §On the Stock Market l Effects of “sophisticated accounting” l Effects on Internet-related stocks l Effects on Communications-related stocks §On the Accounting Profession l Effects of conflicts-of-interests: Combining Auditing & Consulting §On the Halls of Government l Effects on Energy Policy-Making l Effects on Political funding

29 Equity Funding Corporation of America §The insurance funding programThe insurance funding program §The first scamThe first scam §The next scamThe next scam §The really BIG scamThe really BIG scam §The final scamThe final scam §The house of cards collapsesThe house of cards collapses §The fallout from Equity FundingThe fallout from Equity Funding §An analysis of the causesAn analysis of the causes §The Lessons LearnedThe Lessons Learned

30 The insurance funding program The insurance funding program - 1 §Equity funding Corporation of America was founded in 1960. Its principal line of business was selling "funding programs" that merged life insurance and mutual funds into one financial package for investors. §The deal was as follows: first, the customer would invest in a mutual fund; second, the customer would select a life insurance program; third, the customer would borrow against the mutual fund shares to pay each annual insurance premium. Finally, at the end of ten years, the customer would pay the principal and interest on the premium loan with any insurance cash values or by redeeming the appreciated value of the mutual fund shares. Any appreciation of the investment in excess of the amount paid would be the investor's profit.

31 The insurance funding program - 2 §The company had a huge sales force. The thrust of the salesman's pitch to a customer was that letting the cash value sit in an insurance policy was not smart; in fact, the customer was losing money. The customer was encouraged to let his money work twice by taking part in the above deal. §The development of such creative financial investments was a trademark of Equity Funding in the early years of its existence. After going public in 1964, Equity Funding was soon recognized across the country as an innovative company in the ultraconservative life insurance industry.

32 The insurance funding program - 3 §This kind of leveraging of dollars is a concept used by sophisticated investors to maximize their returns. They use an asset they already own to borrow money in the expectation that earnings and growth will be greater than the interest costs they will incur. However, it's a concept that is fraught with risks for the investor and should not be promoted by an ethical company without fully informing the investor of the risks. §Even so, there was nothing illegal or even immoral about the basic concept. Indeed, it was a captivating idea, except it didn't make enough money for the company or its executives. So some executives—led by the president, chief financial officer and head of insurance operations—got a little more creative with the numbers on their books.

33 The first scam §"Reciprocal income“ Preparing to take the company public in 1964, there was concern that its earnings were too low. To correct this "problem", the owners decided that Equity Funding was entitled to record rebates or kickbacks from the brokers through whom the company's sales force purchased mutual fund shares. The resulting income, called "reciprocal income" was used to boost 1964 net income for Equity Funding. So the fraud apparently began in 1964 when the commissions earned on sales of the Equity Funding program were erroneously inflated.

34 The next scam §Borrowing without showing liability l In subsequent years, to supplement the reciprocal income so as to achieve predetermined earnings targets, the company borrowed money without recording the liability on its books, disguising it through complicated transactions with subsidiaries. The fraud expanded in 1965, when fictitious entries were made in certain receivable and income accounts. l By 1967, revenues and earnings of Equity Funding had increased dramatically, and the stock price rose accordingly. Equity Funding began to take over other companies, and it became critical to maintain the price of the stock of Equity Funding so it could be used to pay for the companies being acquired.

35 The Really BIG Scam §Reinsurance §Fictitious policies §Forging files

36 The Final Scam §Killing off the policy holders

37 The computer makes it possible

38 The failure of the auditors

39 The house of cards collapses

40 The fallout from Equity Funding §Accounting and auditing practices §Insider trading §The aftermath of Equity Funding

41 An analysis of the causes §The Management l The ethics and integrity of management and employees l Management's philosophy and operating style §The Auditors l The independence of the auditors l Professional skepticism of the auditors l External impairments to the audit

42 The Management §The ethics and integrity of management and employees §Management's philosophy and operating style

43 The Auditors §The independence of the auditors §Professional skepticism of the auditors

44 The Lessons Learned

45 Deregulation §BackgroundBackground §Free-Market Mania of 1980s and 1990sFree-Market Mania of 1980s and 1990s §Retail Competition in StatesRetail Competition in States §Restructuring is not DeregulationRestructuring is not Deregulation §Deregulation and Enron: Apologia?Deregulation and Enron: Apologia?

46 Background §Energy Crisis of 1970s §National Energy Act of 1976 §Federal Energy Regulatory Commission (FERC) §The Public Utilities Regulatory Policy Act of 1978 (Public Law 95-617) l PURPA's Limits l Questioning the Rationale of Natural Monopoly for Regulation

47 Free-Market Mania of 1980s and 1990s §Energy Policy and Conservation Act of 1992 l Exempt Wholesale Generators l Utilities Could Expand Outside their Franchise Areas l Wholesale Competition Only §Deregulation in the States (starting in 1996) l Door Left Open for Retail Competition in States l Some of the issues

48 Retail Competition in States §Background §Historical §No undue preference

49 Some of the Issues §Stranded costs §Taxes §Stranded benefits §Others

50 Restructuring is not Deregulation §Need for New Institutions §Problems with Traditional Regulation §Management of Electric Utility Companies l During the Golden Years l Good Natured Competition l Troubled Times and Competition l New Leadership l Splits in the Ranks l New Strategies for Competition §New Technologies Can Change Everything §Coming Full Circle?

51 Deregulation and Enron: Apologia? §Enron is but a Pebble in the Wave l He did wrong but he had the right idea l Deregulation is Good l Commodity Trading is Good Equilibrium between supply and demand Bringing new ideas into production Risk Taking §Effects of bad people §Effects of lack of integrity

52 THE END

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