Famous Failures in Finance: Shady Trading at Enron Before it was known for its financial problems, Enron, a utility firm

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Famous Failures in Finance: Shady Trading at Enron
Before it was known for its financial problems, Enron, a utility
firm operating pipelines and shipping natural gas, had become
famous as a business pioneer, blazing new trails in the market for
trading risk. In the 1980s the price of natural gas was
deregulated, which meant that its price could go down and up,
exposing producers and consumers to risks. Enron decided to exploit
new opportunities in the commodities business by trading natural
gas futures. The natural gas futures that traded on the New York
Mercantile Exchange did not take into account regional
discrepancies in gas prices. Enron filled this void by agreeing to
deliver natural gas to any location in the United States at any
time.
In addition to trading natural gas and other energy contracts,
in the late 1990s Enron began trading weather derivatives for which
no underlying commodities existed. These were just bets on the
weather. Its weather-derivatives transactions were worth an
estimated $3.5 billion in the United States alone. Thanks to its
near-monopoly position in derivatives products, Enron’s trading
business was initially highly profitable. At one point, the company
offered more than 1,800 different contracts for 16 product
categories, ranging from oil and natural gas to weather
derivatives, broadband services, and emissions rights, and it
earned 90% of its revenues from trading derivatives. And unlike
traditional commodity and futures exchanges and brokers, Enron’s
online commodity and derivative business was not subject to federal
regulations.
However, Enron eventually lost its unique position as the energy
business started to mature. When other firms entered the online
derivatives-trading business, they competed by charging lower
commissions and exploiting the same regional price discrepancies
that had been Enron’s bread and butter. Enron’s trading operations
became less profitable. To find new markets and products, the
company expanded into areas such as water, foreign power sources,
telecommunications, and broadband services. The farther it moved
from its core businesses of supplying gas, the more money Enron
lost.
The company sought to hide those losses by entering into more
risky and bizarre financial contracts. When financial institutions
began to realize that Enron was essentially a shell game, they
withdrew their credit. At that point, despite rosy assurances from
its founder and CEO Ken Lay, Enron went into a death spiral that
ended in bankruptcy on December 2, 2001.
In July 2004 Lay was indicted on 11 counts of securities fraud
and related charges. He was found guilty on May 25, 2006, of all
but one of the counts. Each count carried a maximum 5- to 10-year
sentence and legal experts said Lay could face 20 to 30 years in
prison. However, about three and a half months before his scheduled
sentencing, Ken Lay died on July 5, 2006, while vacationing in
Snowmass, Colorado. On October 17, 2006, as a result of his death,
the federal district court judge who presided over the case vacated
Lay’s conviction. Critical
Thinking Questions:
Could the Enron debacle have been prevented? If so, what
actions should have been taken by auditors, regulators, and
lawmakers?
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