Enron, corporate superstar of the US, has gone from dizzy heights to bankruptcy within a year. Starting as a humble gas pipeline operator, it diversified into power plants and water supply globally, then pioneered trading in electricity and gas when those industries were deregulated in the US.
An aggressive operator, Enron would sweep into new markets, invest massively despite the risks, and use innovative financial and marketing techniques (which later became its nemesis) to establish itself as the biggest of the new traders.
It became the darling of investors and banks, who poured money into a company that kept producing dizzy increases in profits, quarter after quarter. Fortune magazine called it the most innovative company in the US, and ranked it No 7 in the Fortune 500. With an annual revenue of $ 100 billion, Enron eclipsed traditional giants like IBM and AT&T.
Remarkably, Enron collapsed despite record profits in its latest accounting year. In India, loss-making companies carry on for years. Enron, on the other hand, was accused at beginning of 2001 of excessive profit- gouging from trading in gas and power in California. How could such a highly profitable company bite the dust just months later?
Not because of crimes, apparently. No prosecution has been proposed so far. But the company is guilty of impropriety, opacity, and creative accounting. This would attract little notice in India, where crooked businessmen routinely rip off shareholders.
But in the US, the disclosure of impropriety and creative accounting caused a massive loss of confidence in Enron. Suddenly its creditors shied away. So did gas traders, who had earlier used Enron online trading system to the tune of $2.8 billion per day. The traders left their screens one by one, and suddenly Enron’s cash flow dried up.
It might have survived had it financed its massive global expansion through equity. Instead it had borrowed heavily to do so, and huge repayments were due. Borrowings were done often through undisclosed partnerships, off the balance sheet.
This helped boost profits when the going was good. But by autumn, energy prices in the US were collapsing, and Enron’s profits with it. The company’s global investments — including Dabhol in India — often proved disastrous failures. So in October, Enron reported a big loss for the July-September quarter.
Worse, the company revealed for the first time that it had created partnerships off its balance sheet, often with top managers of the company. This technique made the true assets and liabilities of Enron opaque to investors.
It was not illegal. But it was unquestionably non-transparent, an attempt to fool investors. It also created a clash of interests between the company and its managers, some of whom made millions even as the company lost.
Adverse conditions hit the partnerships hard, and their losses could no longer be kept under wraps. Enron disclosed that it needed to shrink shareholder equity by $1.2 billion to make good the liabilities of the partnerships.
This shook everybody. Rating agencies lowered the company’s creditworthiness. The Securities and Exchange Commission opened an informal probe. Bankers and investors started demanding more details. On November 8, Enron admitted that, thanks to creative accounting, profits since 1997 had been overstated by 20 per cent ($586 million).
The fat was now in the fire. Investors and bankers often support a company that runs into losses, but will desert it if they think the company has been fooling them with false statements. Lacking cash or credit, Enron sought to be taken over by Dynegy, and a formal agreement was signed for their merger. But every day revealed more problems. Enron disclosed that it had to repay $690 million within a week, and another $9.6 billion by the end of 2002.
Rating agencies downgraded the company’s bonds to junk. This in turn triggered a stipulation in old loans for additional collateral to back $3.9 billion of debts. Faced with this unending stream of dismaying disclosures, Dynegy withdrew its takeover bid. That meant curtains for Enron.
What are the lessons for India? For companies, the big lesson is that if you choose to engage in risky ventures, do so with equity rather than borrowed funds. That way you can survive even if your gamble fails to pay off. The riskier the investment, the lower should be your debt.
For lenders, the main lesson is that you must monitor your borrowers closely even if they are corporate superstars. You must insist on transparency, and stipulate heavy penalties for off-balance sheet transactions.
For too long, Indian businessmen have been able to cook their books effortlessly, and our financial institutions have repeatedly bailed them out instead of abandoning them. The inevitable consequence has been the virtual bankruptcy of the financial institutions themselves, which are now pleading for rescues by the government.
For the public, the main lesson, and it is a startling one, is that a well-functioning market can provide rapid, definitive justice in a manner in which no laws or courts can.
Had Enron committed a crime, it would have got away with a fine, or the imprisonment of a couple of managers. But Enron was guilty merely of non-transparency and fooling the public.
The market viewed this as an infinitely greater evil than crime. The consequent loss of credibility with creditors and gas traders brought Enron to its knees within months.
In the old licence-permit raj, businessmen could rely on contacts with politicians to oblige banks and financial institutions to keep giving them loans whatever their track record. But once political patronage is replaced by markets, even the best contacts matter little.
Enron Chairman Kenneth Lay is a personal friend of President George Bush, and contributed $2 million to Bush’s various election campaigns. But once impropriety was disclosed, not even his White House connection could save Enron. We need that sort of climate in India too.