Case 1
Enron Oil Trading: Untimely Problems in Valhalla

This environment is hardly giving us room to breathe. The last thing we need is a public scandal.

IT WAS THE END OF THE BUSINESS DAY, February 1, 1987. Ken Lay, CEO of Enron Corporation, sat at his desk, ruminating over his agenda for the following day. Tomorrow's schedule showed a morning meeting with Internal Audit and two top officers from Enron Oil Trading (EOT). Louis Borget, president of EOT and Tom Mastroeni, the treasurer, were coming down from their headquarters in Valhalla, New York. They had been called to Houston to answer charges of opening undisclosed bank accounts to conduct unauthorized transactions.

Lay had already heard a bit about the controversy. He again skimmed an Internal Audit memo (Attachment 1) that summarized the issues. The essence of the matter concerned an account opened by EOT at the Eastern Savings Bank. Borget and Mastroeni were the authorized signatories on the account but had failed to report its existence to Enron's Houston headquarters. Millions of dollars from EOT trades had found their way into this account. More worrisome, some $2 million had then been transferred into Mastroeni's personal account at the same bank. Internal Audit suspected that Borget and Mastroeni had EOT engaging in unauthorized and/or fictitious trading, skimming money for personal gain.

Houston oversight of EOT was the responsibility of John Harding and Steve Sulentic. Lay sought out their views upon receiving Internal Audit's report. Eventually, they got back to Lay with a story that the undisclosed account involved transactions that were legitimate and in Enron's interests. The transactions in question were "twinned trades": equal and offsetting buy/sell transactions used to move profits from one accounting quarter to another; such trades, they observed, were not uncommon in the trading business. Borget and Mastroeni would come to Houston, bring their bank records, and explain everything. Lay had pressed lightly on the point of EOT's not reporting the Eastern Savings account to Houston and had gotten an answer to the effect that perhaps some unfortunate shortcuts had been taken but the underlying motives were ok.

Ken Lay hoped that this would turn out to be true. As he pondered how to run tomorrow's meeting, his mind wandered back over Enron's recent history and current predicaments.

Natural Gas Pipelines in Crisis

Ken Lay had only joined Enron in June 1984. It was not then known as Enron; the company that Lay took over as chairman and CEO was called Houston Natural Gas (HNG). Lay had assumed the helm at a difficult transition time for the natural gas pipeline industry. Long-standing players, such as HNG, were finding that the industry business model was rapidly changing. Prior to the mid-1980s, natural gas producers sold gas to pipeline owners under long-term contracts. In order to induce producers to commit their gas, pipeline owners customarily provided long-term deals with floor prices and a commitment to "take or pay" for gas, i.e., take a minimum volume of gas at a stipulated price or pay the cash equivalent of having taken the specified gas amount.

Two things happened in the 1980s to destabilize this model. The first concerned the value of newly produced natural gas; prices had fallen to rock-bottom levels, below $2 per million BTUs. The second was a regulatory change. No longer would pipeline operators be able to lock out producers who didn't commit to ship through their lines. Instead, gas producers were now able to sell directly to end users and require pipelines to ship their volumes for a simple transport tariff.

These changes rocked the gas pipeline industry. Newly developed gas started finding its way directly to end users at the low spot market price. Major carriers increasingly found themselves burdened with gas purchased earlier at higher prices under take-or-pay contracts. Pipeline company financial conditions deteriorated. Debt ratings were downgraded. The carriers labored to work their way out from under disadvantageous contracts. HNG was no exception.

Ken Lay thought he knew how things would play out. His assessment was that natural gas market deregulation would continue to progress; from this, he concluded that future profitability would become a function of scale-that is, the biggest pipeline companies with the most extensive networks would become low-cost providers and would end up dominating a market of natural gas production sold largely at spot prices and moved via low-cost logistics.

As if on cue, the gas pipeline industry began to consolidate. Again, HNG was no exception. In April 1985, a call came from Omaha-based InterNorth suggesting a merger. InterNorth was approximately three times the size of HNG. However, its senior management was aging, its board was divided and both were uncertain about how to cope with the deregulated market. A corporate raider, Irwin Jacobs, was stalking the company. InterNorth needed a deal.

Immediately prior to the merger talks, HNG stock was trading at $45 a share. In just eleven days, Lay was able to extract both a $70 per HNG share price (a 56 percent control premium) and a commitment that he would move up to CEO after a couple of years. The InterNorth/HNG merger closed within the year, and the new entity was christened Enron in 1986.

Unfortunately, the merger did little to alleviate the pipeline company's immediate economic straits. Profitability was miserable. The natural gas glut seemed to produce ever-lower prices. Enron had to face this deteriorating environment with more than $1 billion in take-or-pay contract liabilities. Enron reported a $79 million loss for 1985, its first year of operation. Attachment 2 details Enron's financial performance for 1985-86. Although Enron reported net profits of $556 million for 1986, the bulk of that reflected recoveries of past income taxes. Enron's financial condition was more accurately reflected by the following: earnings before interest and taxes (EBIT), $230 million; interest expense: $421 million.

Enron was now heavily debt-laden, the product of InterNorth's having used debt to fund the premium price for HNG's stock. To some extent, this leveraging up of the company had been intentional. Irwin Jacobs' group was being paid $350 million to hand over its InterNorth stake and go away. InterNorth thus reckoned that a heavy debt burden would act as shark repellant for future raiders; however, high debt levels also hamstrung the newly merged entity. Ken Lay found that his firm's bank loans contained covenants requiring quarterly interest expense to be covered 1.2 times by EBIT; failure to do so would mean an event of default. Enron would be especially exposed in such case, as the firm also had more than $1 billion of commercial paper outstanding. These unsecured short-term promissory notes had to be rolled over continuously. A hiccup on bank loan covenants could spark a full-fledged financial crisis should it lead commercial paper buyers to flee from Enron's paper.

In January 1987, Moody's Investors Service downgraded the company's long-term rating to below investment grade, i.e., to junk status.

This perilous financial condition meant that Ken Lay spent much of 1986 focused on maintaining liquidity and avoiding the default triggers in Enron's bank loans. Lay froze senior executive pay and sold some pipeline assets. Enron stayed afloat, but the company was barely scraping by.

In fact, a good portion of the company's razor-thin margin for error was being contributed by a little-known and understood entity, EOT. InterNorth had created the subsidiary back in 1984. Trading oil commodities was a relatively new business at that time. InterNorth chose to enter the business by hiring an established trader, Louis Borget. InterNorth lured him away from Gulf States Oil and Refining, where Borget had set up a similar unit three years earlier. The package to induce Borget to move included bonuses tied to the profits produced by the trading operation.

EOT immediately began to report profits. In 1985, when the merged InterNorth/HNG lost $79 million, EOT made $10 million. In 1986, when Enron couldn't cover interest expense with operating earnings, EOT reported profits of $28 million.

Ken Lay still wasn't sure what to do to fix Enron's financial problems. He believed that long term, deregulation would reward his company. For the near term, Enron seemed bogged down in a bad business environment of low prices, intense competition, and the burdens of high debt. One thing he did know was that EOT's contribution was helping the company cope in the short run while it waited for the longer run to bring improved conditions.

Lay had another, more political problem closer to home. The board of InterNorth had rebelled against his predecessor, Sam Segnar, concluding that he had caved in to HNG's demands during the merger negotiations. Segnar had ended up paying with his corporate head. Lay replaced him but soon faced bitter resistance from former InterNorth directors on a series of secondary but highly symbolic issues: the appointment of Enron's public accountant and the relocation of Enron's headquarters to Houston. The issues eventually were resolved, with Lay getting his way on the relocation. Lay had also begun to replace former InterNorth directors with selections more supportive of his leadership. Still, at the outset of 1987, Ken Lay was a CEO under the...