Case 2
Enron Oil Trading (B): An Opening for Enron Audit?
I thought we had those oil traders under control. Seidl wouldn’t be getting on a plane unless they had done something that’s a problem.
ON OCTOBER 9, 1987, KEN LAY WAS OVER THE ATLANTIC flying back from meetings in Europe. In mid-flight he was handed a message. Enron president Mick Seidl was getting on a plane and flying to Newfoundland, where Lay’s plane would stop for refueling. This couldn’t be good.
Within a couple of hours, Lay and Seidl met at the Gander International Airport. Seidl told Lay what he had just learned from EOT president Louis Borget. EOT was “short” some 84 million barrels of crude oil. This meant that EOT had sold but did not possess oil equivalent to that amount. More significantly, EOT had sold the oil at prices well below current levels. If Enron were forced to cover the position at current prices, the company would incur more than $1 billion in trading losses. Clearly EOT had hugely exceeded its authorized trading limits and in the process had put the solvency of debt-laden Enron in jeopardy.
Lay immediately rerouted his flight to New York, interviewed Borget, and terminated him. Lay then returned to Houston and began figuring out how to salvage the situation.
Mike Muckleroy and a group of Houston traders were sent to EOT’s Valhalla, New York, office. Over a three-week period, they were able to shrink EOT’s short position to a level where it could be covered with “only” a $140 million pre-tax loss. After taxes, this would result in an $85 million hit to Enron’s 1987 earnings; this was an event that could not be hidden from investors. Enron eventually announced the charge to earnings but only after closing a financing transaction that had been in the works. Lenders were not informed of the news prior to closing.
Late in October, Ken Lay called an all-employees meeting at which he blamed the EOT incident on the now terminated Borget. Lay then made the following statement:
“We became involved in a business with risks that we did not appreciate well enough … and I promise you, we will never again risk Enron’s credibility in business ventures without first making sure we thoroughly understand the risks.”1
With the immediate crisis managed, Enron faced a decision about what to do with EOT. The unit’s management had been decapitated, and its image as a consistent profit generator was in ruins. EOT has also been positioned publicly as a rogue organization, so as to exonerate Enron management in general—and Ken Lay in particular—of responsibility.
Enron’s Internal Audit personnel knew that a public scandal of this magnitude could lead to big changes within the company. Senior leadership positions might change. A clean-up program might be instituted throughout the company. EOT might be reconstituted or shut down.
Would Internal Audit play any part in these changes? Would it actively seek to influence or shape how these future events would transpire?
Author’s Note
The facts of this case, including the extent of EOT’s short position, Lay’s actions and the role of Mike Muckleroy, are as reported in The Smartest Guys in the Room (pp. 21–24) and Conspiracy of Fools (pp. 37–39). The latter work described Lay’s presentation at the October 1987 all-employees meeting as follows:
“He [Lay] held himself up as a victim of Borget and Mastroeni, as someone who had no reason to suspect the problems in Valhalla.”2
There is no public record of what Enron’s internal auditors thought or did in the wake of EOT’s trading scandal breaking. The case imagines the possibility that they reflected on the implications for their function, in order to pose the issue: What should Internal Audit do now?