RAY BROWN, A NEWLY HIRED MANAGER OF DERIVATIVES RISK ANALYSIS (DRA), was stunned by what he was hearing. Hired in July 1995, Ray had taken charge of Enron’s thirty-man group responsible for analyzing and structuring complex derivative-based hedge positions. As the year wound down, DRA had built up a substantial interest rate swap position.

At 9:00 am on November 11, Ray had been visited by Tom Hopkins, assistant manager of the Natural Gas Trading Division (NGTD). Tom had brought unsettling news. Upon further review, NGTD had determined that its forward purchase transactions were not as profitable as first assumed. Expectations of future natural gas prices had been revised to lower levels. This change reduced the expected differential between the projected forward curve and the contract price at which some gas had been bought. Based on this revised outlook, Tom asked Ray to adjust the interest rate swaps associated with the deal:

“Your swap position is too large now. There isn’t the same level of expected profits anymore. You probably need to readjust “notional principal” by about $70 million, spread over years five to ten.”

Ray immediately reacted with incredulity. Tom did not offer a good response. He just reiterated that the NGTD experts had revisited their projections, and, unfortunately, future prices had been overestimated. Everyone would have to adjust, including DRA.

Ray cast his mind back over the various NGTD transactions that DRA had hedged. Over the course of the year, Enron’s natural gas traders had bought and sold gas for long-term forward delivery. This combination of purchases and sales aimed to capture an economic margin, or spread, thereby producing a stream of expected long-term cash inflows. Sometimes, the purchases and sales would be exactly matched; in other transactions, traders would “go long or short,” leaving their positions unbalanced. Under the mark-to-market accounting, the present value of these expected cash flows was immediately reflected in operating profits; subsequently, however, these booked profits would have to be adjusted to the extent that the expected value of the flows fluctuated.

Interest rate variations were one factor that could cause booked trading profits to require adjustment. When trading profits were first taken to profit/loss, an interest rate was assumed in order to calculate the present value of expected gains. Frequently, the commodity traders would ask DRA to execute interest rate hedges, locking in the rate assumed for booking profits. This helped insulate recorded gains from subsequent adjustment. In the case at hand, DRA had entered into five to ten year swaps under which Enron would pay fixed and receive floating interest payments over the period. Attachment 1 outlines the essential features of the hedge and its underlying transaction.

Although new at Enron, Ray already possessed ten years of experience in the evaluation of derivatives. Much of this time had been spent at a leading Wall Street firm where aggressive trading of complex instruments was the daily rule. Ray felt that he knew the difference between an honest mistake and moves driven by a hidden agenda. Something here didn’t feel right. Ray decided that he needed time to dig deeper.

“Well, what you say doesn’t make sense to me. Possibly I’ve missed something. Give me a day or two to look into the transaction and think about what to do. I’ll be back to you before the week is out.”

Tom departed after a final comment that other deals were in the pipeline and time was of the essence. As the door closed, Ray reached for his company directory. A call to T.J. Malva would help clarify matters.

Conversation with T.J. Malva

NGTD had its own risk assessment group, RAC, whose charge was to assess the accuracy of the traders’ price assumptions and estimates of trading profitability. Although RAC reported to the senior vice-president in charge of NGTD, strong informal ties had developed among the executives in RAC and DRA. Thus, Ray knew that when he called, he would get a straight story from T.J.

“This is a funny one, Ray. Tom brought it to us yesterday. He said that his traders had reconsidered the natural gas forward price curve and were convinced that it needed a major downward adjustment. We couldn’t see what had changed since they cut the deals last month. It is true that spot prices have moved sharply higher. This winter is turning out to be abnormally cold, and a number of big traders have been caught short. Spot gas has rocketed up. The same is true for the near term futures market out to six months. However, the long-term gas futures have barely moved. Yet these earlier deals Tom is talking about are long term; suddenly, he’s saying that the traders see the long-term forward curve moving lower. If anything, it has moved up, if only fractionally. It doesn’t add up.”

Tom took the adjustment to Bette Patucka in our group. As an aside, it seems that whenever NGTD needs a signoff on something questionable, they take it to Bette. Anyway, this was a bit much even for Bette. My understanding is that she initially refused to sign off. However, Tom apparently told her that the adjustment was going to get made whether she signed off or not. Tom also told her: “If your name isn’t on the approval sheet, it will look bad for you.” She signed off. Tom must have come to you next.

T.J.’s comments told Ray a lot. This transaction was definitely being steered by Tom Hopkins. That tended to happen when there was something questionable about the deal. Second, Bette Patucka had had exactly the same initial reaction as did Ray. This confirmed that no adjustment was warranted on the merits of the deal. Finally, it appeared that Tom had threatened Bette to get the approval he needed.

One needed to understand Enron’s Performance Review System (PRS) to fully appreciate the import of Tom’s words to Bette. One thing that had surprised Ray upon joining Enron was the manner in which compensation was determined. Under PRS, all executives were rated annually and grouped into quartiles. Rankings were fiercely, even bitterly contested; a two-quartile ranking difference could mean a six-figure differential in annual bonus. None of this was particularly unusual, however. Many firms employed such systems, especially those that emphasized trading and financial services, where annual revenue generation was a key driver of firm profitability.

What had surprised Ray was who sat on the PRS committee. Senior executives from the major trading departments regularly participated in ranking the risk-assessment managers who reviewed their deals. This sounded alarm bells for Ray; the opportunities for retaliation were obvious. Trading executives could consign a conscientious risk manager to the bottom with a few damning generalities, as in “not cooperative, not bottom line oriented, or can’t tell the difference between risk assessment and obstructionism.” Worse yet, the mere knowledge that this could happen was enough to make risk managers cautious about who they crossed; the more aggressive traders counted on this and became ever bolder in attempting to roll deals through RAC. T.J.’s account of Tom’s threats to Bette only demonstrated that Ray’s fears were well founded.

All this strengthened the case that Tom’s request was linked to a hidden agenda. However, Ray was still in the dark as to what that agenda might be. He spent the rest of the morning touching other bases without success. Finally, he placed a call to Max Anstadht in Accounting. Max handled the booking of NGTD’s trades and its quarterly profitability statements. Max told Ray that NGTD was in the process of producing a record quarterly profit. Just as T.J. had said, near-term natural gas prices had made a run and were now up 35 percent versus the end of 1994. NGTD had gone long on gas for delivery during the 1995–96 winter and beyond, correctly anticipating the price run up. As spot prices had moved higher, NGTD began to sell, booking huge gains in the process. NGTD’s interest in lowering the long end of the forward curve developed shortly thereafter.

“But, Max, why would NGTD be maneuvering to lower the profitability of its group? Usually when there is questionable dealing, it’s in the opposite direction—guys trying to pretty things up, bury losses. And why are they putting so much political heat behind doing this revision? I don’t get it. What’s going on here?”

Max adopted that careful tone of voice often used when someone ventures into dangerous territory.

“I can’t answer that definitively. Nobody has told me anything official. However, I did hear some discussion between Tom and another trader to the effect that the record quarterly profit was going to be a problem. Apparently, Ken Maddox—the COO to whom NGTD reports—is known for adjusting next year’s forecast profit upward when current-year results greatly exceed expectations. Perhaps Tom and his colleagues are concerned that they might end up with an impossible profit target for fiscal year 1996. Theirs is a volatile business, and NGTD may feel really challenged to repeat 1995’s performance. That could mean disappointing bonuses next year.”

For Ray, all the pieces suddenly fit. What Max had said about Ken Maddox squared with what Ray had heard from numerous other sources. Thus, NGTD was engaged in adjusting seasoned transactions after the fact to lower reported profits. This adjustment would create an offset to some of its recent gains from spot gas sales; the net effect would hopefully be to avoid Ken Maddox’s imposing a higher NGTD Corporate Plan objective for 1996. But now the problem came back to Ray. Would he agree to adjust his interest rate swaps? If not, what would he tell Tom Hopkins later in the week? Ray went back to his office and shut the door so he could deliberate in private.

Ethics Assessment and Tactical Options

Ray didn’t like Tom’s request, but that wasn’t good enough. Ray had to be able to identify—definitively and with precision—what was objectionable. Otherwise, his objections would be rebutted with half-truths backed by the same veiled threats that Tom had used on Bette.

Was the ex-post facto adjustment illegal? Ray decided that the answer was potentially yes, but it would be hard to prove it so. Enron is a public company. Manipulating the booking of transactions to move profits from one period to the next was potentially a violation of SEC disclosure rules. However, a large amount of judgment was involved in the setting of commodity forward curves when marking forward sale contracts to market. Price discovery is limited at the long end of the gas trading market. Relatively few long-dated trades are concluded, and little or nothing gets published on deal terms. Thus, the traders themselves become the source of information for long-term prices on the natural gas futures curve. Assuming that NGTD was smart enough not to leave retrievable detailed worksheets of its original forward curve estimates, the revised curves would survive as the one and only expression of NGTD’s professional judgment. This fact pattern would likely make it difficult to prove that NGTD was manipulating its reporting.

Ray thought about gathering a file of the original booking and discussing the matter with Accounting and Law. He noted this thought as option 1 on a list of objections and options that he began to compile (Attachment 2).

Was the adjustment unethical—unethical in a way serious enough to justify efforts to stop it? Ray soon found himself navigating between a complex set of “yeses” and “not reallys.” Companies moved reported accounting profits and losses around all the time. The options for doing so were numerous; many were openly taught in business school, such as managing year-end inventories or taking/reversing reserves for litigation, accidents, or credit losses. What NGTD was attempting—a smoothing of reported profits over a multi-year period—was no different in spirit from what other companies did routinely using other tools. Inevitably, the true profitability of the deal would have to be recognized in a subsequent adjustment.

What bothered Ray, however, was the damage this adjustment would do to good procedure for pricing future forward contract deals. If deals could be repriced without reference to external benchmarks, no price-discovery process with integrity would exist. Instead, deals could be reshaped after the fact for any reason. Today’s reason might be to move profits from one period to another. Tomorrow’s might be to hide divisional losses from management or stock market analysts. Once the moorings of external reference points were uprooted and the internal checks provided by RAC and DRA overrun, what was to stop business line management from going rogue or covering up any unpleasant results?

The consequences of such an environment for Ray were painful to contemplate. As manager of the group responsible for hedging the underlying gas transaction, DRA would always be the last to know about rebookings in NGTD. DRA would be routinely asked to provide after-the-fact adjustment to the hedges. At a minimum, this could put DRA repeatedly in the position of often appearing to get the hedges wrong. Ray wondered what a string of restructured hedge positions, with Enron having to pay money to break up existing deals, would mean for him and his group. It couldn’t be good for performance appraisals and job security.

Ray also feared this problem of incrementalism. Typically, a first test case has some reasonableness about it. Ray knew that if he confronted Tom Hopkins and turned down the request, that would not end the matter. There would be meetings at higher levels. Tom would accuse DRA of overreacting or being uncooperative. Tom would also argue that DRA should respect NGTD’s judgment on the forward curve. NGTD’s experts studied the curve every day. Who was DRA to second-guess the gas traders’ judgment? Hadn’t RAC signed off? If anyone had the right to dispute the traders’ decision, it was RAC, and it was on board.

With RAC already compromised, Tom feared that he would lose this debate. The consequences of such a loss were potentially worse than quietly conceding the matter. Openly losing at higher levels would only establish a precedent that traders could and would use to silence DRA on future cases.

Despite all these ambiguities, bureaucratic politics, and personal risks, a decision was still required on the fundamental principles at stake. Ray feared that it would be seen as huge overkill to accuse NGTD of illegality; however, the damage to the internal control system and the implications for future transactions were serious enough that DRA needed to resist. What form should this resistance take? Ray seriously considered letting the transaction go forward as a one-time exception, documented as such, with a warning sent to NGTD stating that similar future transactions would not be accepted. Would that be strong enough?

Ray looked for other options. One was to consider whether potential allies might find the rebooking as objectionable as Ray did. One such potential ally was the controller, Don Cooke. Don had no organizational role in reviewing the booking of NGTD transactions. However, his writ did involve general matters of financial integrity, such as internal control. Don also was well respected for his expertise, fairness, and ability to explain complicated accounting to senior management. Don might be persuaded to see the “thin edge of the wedge” aspect of NGTD’s rebooking. If so persuaded, Ray thought that Don might be able to turn NGTD around. At a minimum, Don could prove a valuable ally if discussions moved to higher levels. However, Don would need documentation that the transaction had been fairly booked the first time and was being rebooked without cause.

Another option was to take the matter to Ken Maddox. Ken would have an interest in knowing what was transpiring. Ken would also have the clout to stop it and to protect DRA in subsequent PRS reviews. The risk in this approach lay in how NGTD could respond. NGTD would undoubtedly argue that this was their call, RAC was on board, and DRA was out of bounds. NGTD would try to make it a my-people-versus-those-other-people decision for Ken. If NGTD succeeded, serious retaliation against DRA would follow in the next PRS review. Tom Hopkins had a reputation for vicious retaliation when crossed.

A final option was to negotiate with NGTD on technical grounds. For example, Ray could insist that responsibility for the mishedged position lay clearly in NGTD’s original forward curve and pricing. Ray could demand that any and all adjustment costs on the swaps be borne by NGTD. Once this point had been conceded, Ray could make the swap-adjustment costs expensive or drag out a discussion with Accounting on the mechanics of transferring the cost from DRA to NGTD. Through some combination of such actions, he could make the adjustment process painful for NGTD in the hopes that this would discourage future such initiatives on its part. Ray recognized that none of this contested the principle of what NGTD was attempting. It also depended upon its conceding absorption of the adjustment costs. NGTD might instead just try to muscle DRA to go along as it did with RAC.

Lastly, Ray turned to his personal situation. Employed at Enron less than six months, he was not eager for another job change. Still, he had to be prepared for that eventuality if matters escalated. Ray was confident that he could find other work and probably quickly, too. Such was not the case for his staff. Accordingly, Ray determined to involve no one else from his department in the matter, regardless of which course of action he selected.

Author’s Note

As noted earlier, meetings on proposals with ethics implications are not always conducted as debates about the merits of the proposal. Case Study 4 provides students with an opportunity to see how capable maneuvering within the bureaucracy can be essential to sustaining an ethical business environment. The case also provides insight into the role that performance rating systems can play in these bureaucratic struggles.

The case is based on an incident that occurred during the second half of 1995. A reference and brief description of these events can be found in Power Failure (p. 88). This account dates the incident at year-end 1995, gives the earnings impact in question as $70 million, and implies that this sum ultimately was moved from 1995 to 1996’s results.

The account of the NGTD traders’ desire to reduce reported profits by adjusting their forward curves is historically accurate. So too is the resistance of DRA to the demand that it reopen and adjust its interest rate swaps. Ray Brown’s conversations with various parties and the meeting discussions all are historical creations. These dialogues were created to convey the internal political dynamics associated with resisting a powerful business unit and the tactical options for resisting. All names in the case are disguised. Since the case involves none of the Enron public figures and the story is heavily fictionalized, no point is served by using actual names of persons who will not be familiar to case readers. Ray Brown’s character is loosely based upon a participant who provided details of the case.

This case departs in one way from what happened at Enron. Don Cooke’s character is intended to illustrate the importance of having an executive concerned about financial control heading the finance functions. There is no evidence that such a figure was then operating at Enron. Don Cooke’s inclusion gives students an opportunity to examine the resistance options that such a figure makes possible. Students are encouraged to consider the implications of Don’s support for Ray Brown’s conduct and for his protection against retaliation.