When Strategies Go Bad – Part 3
By Dana Baldwin, Senior Consultant
Note: This post is a part of a series taken from Dana Baldwin’s article When Strategies Go Bad previously published in Compass Points in April 2004. In Part 1, we introduced the series and discussed what happened with IBM. In Part 2, we discussed what happened to Global Crossing. In this part, we will discuss what went wrong with Worldcom, Enron, and the State of California.
Another area of serious concern is the recent rash of ethical lapses which have dominated the headlines for the last year plus. What leads companies and their leaders to stray from what is acceptable morally and ethically? Why do companies violate the laws for short term gain, when it is highly likely that the efficiency of the market place, in the long term, will force them public? Let’s look at a few of them.
Worldcom, formerly and lately known as MCI, had a fabulous idea. Become the primary carrier of telecommunications, from telephone to wireless and data, world-wide. The company made acquisitions and investments which took them to the top of their industry, but at what cost? They were overextended and overleveraged with more than $32 billion in debt, and when world wide capacity exceeded world wide demand by a large amount, they began to cover their tracks.
Part of their problem stemmed from the method by which the top people were compensated. Much of their compensation was based on their stock options and the price of their stock. In order to keep the stock price up, they started manipulating their books to reflect sales that were not real, by swapping contracts and counting the swaps as revenue. The further they got into the scheme, the harder it became to go back, principally because the market did not recover as they had expected. Nearly $3.1 billion of false profits had been reported by the company in 2001 and early 2002 prior to the schemes becoming public knowledge.
Worldcom was not the only company which fell prey to this general problem of not playing fair with its books. Enron, an energy company, started off as a leading reseller of electric power, natural gas and other energy. They developed a series of highly innovative schemes to resell energy and to make good returns while doing so.
When the state of California “deregulated” its electrical power market, Enron led the way in buying and reselling electric power. Everything they did at the beginning was acceptable, as far as we know. Not too long after this “deregulation” was implemented, the rules for trading of energy were seen to allow a very unusual situation.
As it turned out, the trading of electrical power during each day’s trading was priced at whatever the HIGHEST PRICE was for that day’s trading. This meant that there was considerable incentive for traders to bid up the contracts during the day, because at the end of the day, all contracts would be repriced at whatever the highest price paid during the day turned out to be. It is folly to think that a corporation is not going to maximize its return/earnings when the market will allow it to do so.
The problem is that Enron took this to extremes, while playing games with its liabilities at the same time. In order to maintain its share price, Enron developed a scheme to transport debt off its books and into affiliated partnerships. The need to keep share prices high was based on the reward scheme that the executives’ pay was based on. Compounding this, the partnerships were mostly funded with Enron stock. When the value of the stock tanked, the partnerships came apart and many, many people suffered.
The real problem here is not the trading of energy futures contracts, although they were ethically questionable at best. The larger problem was the development of the off-book partnerships without disclosure and using company stock to fund the partnerships. This scheme was the real undoing of Enron.
While we are looking at Enron, let us also look at the State of California. Under the guise of deregulating the energy markets for the purpose of lowering the costs of energy to California consumers, both individual and corporate, the laws passed to accomplish this actually put the power companies within the state at real risk. The reason for this is that only a part of the energy market was deregulated: the supply side. The demand side was limited in how much it could charge consumers. This caused the eventual bankruptcy of the two major power companies in the state, because of the prohibition on long term energy supply contracts, resulting in the companies having to buy power on the spot market.
The impact of this was huge because of the requirement that each day’s contracts had to be repriced at whatever was the highest intraday contract price. Added to this were limits on what the power companies could charge their customers. Eventually, after the two major power companies in the state filed for Chapter 11 Bankruptcy Protection, the state allowed them to increase their prices to cover their costs, only to discover that there were increases of up to 1200% which immediately drove consumers crazy and shut down businesses. In addition, at least two power generating plants were shut down for maintenance and upgrading, further aggravating the problems.
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M. Dana Baldwin is a Senior Consultant with Center for Simplified Strategic Planning, Inc. He can be reached by email at: firstname.lastname@example.org
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