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Enron Scandal

Enron Scandal 

Introduction

From 1990-1998, Enron Corporation’s stock rose to 311 percent, only slightly higher than the rate of growth in the Standard & Poor’s 500. In 1999, Enron’s stock increased by 56 percent and then soared to 87 percent just one year later. By the end of 2000, Enron’s market capitalization far exceeded $60 billion, 70 times earnings and six times book value. During this time, Enron was ranked the most innovative American company in Fortune magazine’s survey of Most Admired Companies. Yet within a year, Enron’s image and reputation was shattered and its stock price plunged nearly to zero. In 2001, Enron filed for bankruptcy protection and emerged in 2004 with a plan of court-approved company reorganization. A new board of directors changed the name of Enron Corporation to Enron Creditors Recovery Corp. Its remaining business was sold in 2006.

A combination of inefficient governance, oversight and incentive problems contributed to Enron’s quick “apparent” success and equally rapid downfall. Ideally, an established and functioning capital-market fosters connections of information as well as regulation between managers and investors. Banks, mutual funds, insurance and corporate boards facilitate this linking process; all of these parties are subject to regulation from a variety of institutions, such as the Securities and Exchange Commission, Financial Accounting Standards Board, and the American Institute of Certified Public Accountants. Despite this intricate governance network, Enron was able to produce large sums of capital to fund a questionable business model, conceal its true income and performance through a series of elaborate accounting and financing maneuvers, and exaggerate its stock to unstable levels.

The Enron scandal is the most significant corporate collapse in the United States since the failure of many savings and loan banks during the 1980s, a scandal which indicated the need for substantial reforms in accounting and corporate governance as well as for an in-depth analysis of ethical quality of business culture and corporations in the United States. In 2002, the Sarbanes-Oxley Act was created in order to address key governance and oversight matters related to company boards and public accounting firms.

 

Rise and Fall of Enron

In 1985, Kenneth Lay, the former chief executive officer of House Natural Gas, founded Enron through the merger of two natural gas companies: Houston Natural Gas and Internorth. Lay soon become CEO and then later won the post of chairman.

In 1996, energy markets were transformed so that the price of energy could be established by competition among energy companies instead of being fixed. With this change, Enron began to function more as a middleman than a traditional energy supplier, trading in energy contracts instead of buying and selling natural gas.

From the pipeline sector, Enron began embarking upon other types of endeavors. In 1999, the company launched Enron Online, the company’s website for trading commodities, which soon became the largest business site in the world. About 90 percent of its income eventually came from trades over Enron Online. Growth for Enron was rapid; in 2000, the company’s annual revenue reached $100 billion. It ranked as the seventh-largest company on the Fortune 500 and the sixth-largest energy company in the world. In order to keep growing at this rate, Enron borrowed money to invest in new projects. However, because this debt would make their earnings look less impressive, the company began to foster partnerships that would allow it to keep debt off of its books.

One partnership created by Enron, Chewco Investments (named after the Star Wars character Chewbacca) allowed Enron to keep $600 million in debt off of the books it provided to the government and to people who owned Enron stock. This debt did not show up in Enron’s reports, thus enabling Enron to appear much more successful than it actually was. In addition, Enron attracted big investors by promising them secret information about the company that was not being disclosed to the government or the public. This secrecy violated laws intended to ensure that all investors have full access to accurate information about publicly traded companies.

Cracks within the company became apparent in 2001. In August of that year, Jeffrey Skilling, the company’s CEO for six months and catalyst in Enron’s revamp as an organization, announced his departure; Lay resumed the position. On March 5, 2001, Fortune magazine writer Bethany McLean published an article that questioned Enron’s method of making money. Later that same year in August, Enron vice president Sherron Watkins sent an anonymous letter to Lay, detailing particular accounting methods that she believed could lead Enron to “implode in a wave of accounting scandals”. That very same month, Lay sent e-mails to his employees stating that he expected Enron stock prices to go up. Meanwhile, he sold off his own stock in Enron. The real collapse began on October 16th when Enron announced a loss of $638 million due in part to the failure of its Internet investment.

On October 22nd, the SEC launched an investigation into the investment partnerships facilitated by Enron largely under the leadership of Andrew Fastow. This investigation would later expose the complex web of partnerships that had specifically been designed to cloak Enron’s debt. On November 8th, Enron said that it had overstated earnings for the past four years by $586 million and that it owed over $6 billion in debt by the next year. With these statements, Enron’s stock price plummeted to less than $1 and investors lost billions. This drop triggered certain agreements with investors that made it necessary for Enron to repay their money immediately. When Enron could not come up with the cash to repay its creditors, it filed for Chapter 11 bankruptcy.

On Dec. 2, 2001, Enron filed for bankruptcy protection in the largest case of bankruptcy in the history of the United States (soon followed by the collapse of WorldCom).Approximately 5,600 Enron employees lost their jobs. In January of 2002, the United States Justice Department opened its investigation of the company’s dealings and Ken Lay quit as chairman and CEO.

 

Trial and Verdict

On January 30, 2006, Judge Sim Lake presided over the trial of former CEOs Kenneth Lay and Jeffrey Skilling, both of whom were convicted for a total of 29 criminal counts including a conspiracy to hide a failing company by manipulating the public and investors. The trial lasted nearly four months and the jury deliberated for six days before issuing a final verdict. Skilling was convicted on 19 of 28 counts of securities and wire fraud including charges of insider trading. He was sentenced to 24 years and four months in prison, and cannot be released before serving less than 20 years and four months. Lay was convicted of all six counts of securities and wire fraud and faced a total sentence of 45 years in prison; however, on July 5, 2006, just prior to sentencing, Lay died of a heart attack.  Judge Lake vacated Lay’s conviction on October 17, 2006.  The accounting firm Arthur Andersen LLP was forced to surrender its license to practice as Certified Public Accountants in the United States. The jury found this firm guilty of obstruction of justice as it had confiscated documents related to its audit of Enron.  However, in May of 2005, the Supreme Court reversed this decision in the case of Arthur Andersen v. the United States. The Court found that jury instructions failed to convey the elements of a “corrupt persuasion” and obstruction of justice conviction.

 

Additional Resources

Accounting Alchemy -Moderated by Jim Lehrer, this resource provides an in-depth analysis of the factors which enabled Enron to achieve “success.”

Blind Faith: How Deregulation and Enron’s Influence Over Government Looted Billions from Americans- This publication compiled by Public Citizen (a 150,000-member, nonprofit organization based in Washington, D.C., representing consumer interests through lobbying, litigation, research and public education) calls for an investigation into the White House for the role Congress played in the Enron scandal.

The Enron Scandal and Moral Hazard This tutorial from the University of Iowa explores the following question: In what ways are security market moral hazard problems at the heart of the Enron bankruptcy scandal?

Enron Trader Tapes Available on the Internet -National Public Radio presents recording of Enron trader tapes available to listen to online.

Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues and Policy Recommendations-Prepared by the Joint Committee on Taxation, this publication provides a comprehensive overview of the Enron investigation.

Enron Investigation: Committee on Oversight and Government Reform -This resource provides a variety of links to publications on the Enron scandal, including the Bush administration contacts with Enron, White House connections with Enron and documentation regarding Enron’s emails to employees.