Enron Handout

1. What happened?

• Recognized future cash-flows as earnings although they had not been received yet.
• Recorded projects in profits on its balance sheet when they were actually loss making.
• Hidden debt and inflated profits through the use of unconsolidated SPEs.
•  Used stock price increase to r*report earnings.

All of these accounting frauds were validated by the oldest US audit firm Arthur Andersen.

2. How did corporate governance fail?

• Management board suffered serious conflict of interest. Six outside 14 of outside directors have financial ties with the company.
• Directors plead ignorance of the murky deals as a way of excusing themselves of the liability.
• Incompetent internal auditor faced with complex deal structure.
• Management compensated extensively using stock options, thus create expectations of rapid growth and short-term earnings.
• Power concentration. The possibility of board supervising the management gets diluted.

3. Bankruptcy Protection for Business Entities in the US

• Business entities have two different options when thinking about filing for bankruptcy protection in the US: Chapter 7 and Chapter 11.
• Chapter 7 (also known as “Liquidation” bankruptcy):

• Individuals, partnerships and business entities are allowed to file.
• Voluntary or involuntary filing.
• The company stops all operations and goes completely out of business.
• A case trustee is appointed by the US Trustee to gather the debtor’s debt and sell for cash.

• Money collected is first paid for administrative and legal expenses, and then the Absolute Priority Rule applies.
• Debts may be forgiven.

• Chapter 11 (also known as “Reorganization” bankruptcy)

• Individuals, partnerships and business entities are allowed to file.
• Voluntary or Involuntary.
• The company reorganizes its business and tries to become profitable again.
• Management continues to run the day-to-day business operations BUT all significant business decisions must be approved by a bankruptcy court.

• Debtor becomes “debtor in possession” while creditor is applied “automatic stay”

• Debts are not forgiven; debtors may seek an adjustment of debts.
• Money collected throughout the process will be distributed according to APR, after paying all administrative and legal expenses.

4. Why did Enron choose to file to for Chapter 11 as opposed to Chapter 7?

• Debtor-in-possession: Management stays in power and is free to operate the business
• Creditor can hope to recover some funds through sale of assets and operation of business as opposed to pennies under Chapter 7
• However, Chapter 11 gave way to a lot of “self-dealing”:

• e.g. One attempt was to sell healthy assets of Enron to a new company “OpCo Energy” (i.e. Enron #2)
• This would mean circumventing Chapter 11 and putting the interests of the company and managers ahead of that of the creditors

• In 2004, Enron Creditors Corp. is formed and the bankruptcy proceedings come to an end  

5.Aftermath

• Management

Andrew Fastow spent only 6 years in prison, was a witness against Lay and Skilling, Jeff Skilling was convicted of securities fraud and wire fraud, sentenced for 24 years in prison, Kenneth Lay was convicted of securities and wire fraud, but died before getting sentenced