Enrons Business Model
However, more details of Enron’s business model”, so successful until it crashed dramatically after October 2001, Indicate that the Enron bubble was Just an example of the manner In which speculative finance dominates business. OARSMAN DAVE/GAMMA Enron’s chief executive officer Kenneth Lay with wife Linda. In 1985, Enron started as a pipeline company selling gas. The deregulation of the energy and electricity markets, particularly since the asses, for which Enron was a leading campaigner, played a major role In determining Its business model, which endeared It to Wall Street for more than a decade.
The new opportunities that came its way after regulation, particularly the ambiguously defined energy-trading rules, gave Enron a head start over others. Enron increasingly became an energy broker, selling electricity and later, other commodities. However, Enron went beyond merely bringing together buyers and sellers which is what brokers do. Enron’s innovative spirit, for which it was recognized by Fortune magazine as the “most innovative” corporation in the U. S. For six years running, was in evidence early.
Normally the broker’s brief is to arrange a contract between buyers and sellers for a commission on the contracted price. Enron went a step further. It entered Into separate contracts with
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Over time, Enron began to design more complex contracts – essentially derivatives purportedly aimed at hedging risks arising out of uncertainties in interest rates or currency fluctuations. Often, more complex forms were aimed at hedging uncertainties about the weather or even a customer’s ability to settle a contract. Since Enron’s collapse. Former employees have revealed that the company employed a battalion of doctorates in mathematics, physics and economics to manage these complex contracts.
Wall Street analysts, wiser after the collapse, have been saying that the company was essentially betting to $100. 8 billion. These were far above revenues generated by other large American companies such as Microsoft, General Electric or Exxon Mobil. Enron was described by an analyst as “a giant hedge fund sitting on top of a pipeline”. While its revenues ere boosted through Innovative accounting practices, Its operating margins were rather thin – about 5 per cent In 2000 and 2 per cent In 2001.
Its return on capital In 2001 was just 7 per cent- rather low in the highly risky business of hedging. 1 OFF devices, Enron’s profitability was never as high. Wall Street analysts, tuned to the more short-term fugues on revenues and share prices, rarely questioned Enron’s practices. NEATEN ROCKY/GAMMA The Enron Corporation headquarters in Houston. Two things were needed to keep the show going. One, investor confidence had to be maintained so that Enron, the organizes of the betting system, was perceived as having pockets deep enough to sustain it.
Enron’s partnerships played a crucial role in maintaining the myth of the company’s invincibility. Debts had to be kept off its balance-sheet because that would have lowered its credit rating, affected the market’s (read Wall Street analysts) perception of the company’s profitability and lowered its credibility as the main broker in the energy-trading business. In the aftermath of the collapse, there have been suggestions that a few directors – notably the company’s chief financial officer, Andrew S. Fast – had mishandled the partnerships to siphon off funds to their own accounts.
However, it is clear that the more than 3,000 partnerships, more than 800 of which were in tax havens like the Cayman Islands, played a far more purposeful role in Enron’s business model. The other aspect attributed to Enron’s business style – and one in which the company’s deep connections with both sides of the political divide in the U. S. Played a crucial role – was the regulatory framework which governed its operations. At the heart of this arrangement was the utterly opaque nature of the business. There was no reinsurance in the energy-trading business.
Buyers and sellers were prevented from having any idea of the quotes in the market. This enabled Enron the market- maker to gain privileged information at the cost of other participants in transactions in energy-trading contracts. As its services became more complex and its stock soared, Enron created a network of partnerships that allowed its managers to shift debt off its books. In doing this it functioned like a bank, promising to deliver energy contracts, much the same way banks promise to make customers’ deposits available to them on demand.
Crucially, however, unlike bank deposits these contracts were not insured by federal agencies. Banks need to have cash in hand so that they can meet the demands of depositors. In Enron’s case, this was achieved by the massive manipulation of debt through its network of subsidiaries and partnerships, while keeping them off Enron’s own balance-sheet. Although partnerships and subsidiaries are not uncommon devices among corporate entities, Enron did not maintain an arm’s length with its partnerships.
In fact, it used these partnerships to raise debt and then backed these debts by issuing its own stock. In several cases, it backed such debts by promising to issue its stocks in value terms rather than in terms of numbers of shares, which would have been the norm. In one case, which Sharron Watkins, Enron’s vice-president, referred to in her memo to Enron’s former chief executive officer Kenneth Lay in August 2001, Enron guaranteed its own stock worth $1. 2 billion to back debts of its partner, which in turn was connected to other partnerships with which Enron dealt.
These partnerships commenced in 1997. Recent revelations indicate that Lay was very much aware of the nature and extent to which Enron was red in them with adverse consequences for its own employees and shareholders. However, instead of promising to issue a fixed number of shares, which would have billion worth of stock, irrespective of the market price of the share when it would have to meet its guarantee. For a company that was acclaimed as the past master in the art of hedging risks, this was not mere indiscretion but part of a deliberate strategy.
In return for Enron’s commitment, the partner gave Enron $1. 2 billion in promissory notes. Enron paraded this on its balance-sheet as an asset – managing to increase its net worth by that much. When this unraveled, Enron was forced to revise its financial statements for the preceding four years. In effect, Enron took upon itself an astonishing array of risks in order to protect its partner entities. While it is tempting to view such arrangements as mere favors extended to top officials, it is clear that the partnerships played a far more important role.
They were a key cog which kept Enron’s wheel of fortune spinning. Watkins, who testified before a congressional sub-committee on February 14, said that the partnerships were designed to boost Enron’s cash flow and possibly to mislead Wall street as well that al was fine. Enron’s backing of its partnerships’ debts by issuing its own high-value stock meant that its own shareholders (among them thousands of its own employees with most of their savings) were paying for gains made by the owners of these partnerships, some of which were tied to top Enron employees.
Among those who gained millions of dollars from this incestuous arrangement was Fast. Enron’s business model was built on the quicksand of speculation where appearances were more important than reality. The conjuring of this bubble required that Wall Street be pleased. One of the surprising facts of the Enron saga is that it never failed Wall Street’s expectations with regard to projections of earnings and profits. It is not a coincidence that Enron’s rise and fall mirrored the longest bull run in American history.
Robert J. Sheller, Professor at Yale and author of Irrational Exuberance, outlined the anatomy of speculative finance and the mechanisms that inflate the bubble of speculation (Frontline, November 25, 2000). Chiller’s analysis of the financial markets points to an insidious network of speculation. There are the stock market analysts who also double up as representatives of investment banks. Enron was after all a company whose stock kept soaring. The company kept issuing stock to take advantage of the boom in the market.
For the investment banks, therefore, Enron was a big and important client. Arthur Anderson, Enron’s auditor, now deeply mired in the scandal amid tales of shredded documents and indifferent auditing, was also Enron’s consultant. In fact, Anderson made as much money from consulting for Enron as from auditing its books. The credit rating agencies, whose primary task was to evaluate companies’ debt status and their ability to repay them, either ignored the unique and completely illegal mode of debt-raising that Enron resorted to, or were clueless about its ramifications.
Months before Enron’s collapse, two agencies, Fitch and Standard and Poor, continued to rate Enron triple-B plus. Even Moody’s, the agency which was the first to reduce it to Junk bond status, which triggered the final collapse, had continued to rate Enron bonds high until then. The rating agencies even failed to factor Enron’s announcement in October 2001 that it was reducing the company’s net worth by $1. 2 billion. The banks that extended credit to Enron’s readerships also helped maintain the fiction that sustained the Enron bubble.